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IndyMac was in fact taken over by the FDIC, becoming the IndyMac Federal Bank, while WaMu was acquired by JPMorgan Chase and Wachovia by Citigroup. So far as I know, not a single depositor at these banks has lost money. This is huge. And it suggests to me that if the Congress is unable to craft a deal for Treasury purchases of toxic assets, the nation is still in good hands as a result of the good offices of the highly professional, credible, and trustworthy Federal Deposit Insurance Corporation, run very well by Ms. Bair.

Who is Sheila Bair? Forbes just ranked her the second-most powerful woman in the world, behind German chancellor Angela Merkel. Before coming to the FDIC, Ms. Bair was a professor at the University of Massachusetts. She has served at the Treasury Department, the New York Stock Exchange, and the Commodity Futures Trading Commission, and was chief counsel to former Senate majority leader Robert Dole. Just as important, she has written two children’s books, showing the kids good examples of money management.

And now she’s showing the whole nation good examples of money management on a grand scale.

An editorial in Tuesday’s Wall Street Journal, called “Preemptive Plumbing,” walked through the details of the Wachovia takeover by Citigroup. The FDIC will backstop close to $300 billion of Wachovia assets while Citigroup is on the hook for the first $42 billion in potential portfolio losses from Wachovia. And Citi will give the FDIC $12 billion in ownership of preferred stock and warrants. This open-bank transaction flows from the emergency powers written into the FDIC Improvement Act of 1991. Systemic risk to the financial system provides that authority.

But each of these takeovers reveals the real FDIC glue that’s holding our banking system together, even in the absence of Paulson’s big-bang, toxic-asset purchase plan.

I think the Paulson plan is still essential. It will unclog the banking system and reopen the door to Main Street loans that are necessary to grow the economy. And taxpayers will wind up turning a profit since they will own the assets purchased by the Treasury, the roughly 10 percent yield on those assets, and the profits from the eventual Treasury sale of the bonds. And all these revenues will be used to pay down the national debt. But if there is no Paulson plan, the FDIC can carry the ball alone -- certainly through year end and until a new government comes into power.

Incidentally, as the FDIC crafts its preemptive takeovers of distressed banks, doing so before the banks crash, it is in effect injecting public capital to bolster sagging private bank capital. Former Reagan FDIC commissioner William Isaac suggests the agency can put even more capital into banks through a net-worth certificate program used in the 1980s for the troubled savings bank industry.

In addition, both presidential candidates are supporting at least a doubling of the FDIC’s deposit insurance program for banks. And this provision will likely be added to a new Paulson plan coming up in a day or two.

Hopefully, if there is a plan-B vote on the Paulson program, it will include a suspension of the so-called mark-to-market “fair value” accounting of assets, and replace that either with a net-operating-loss (NOL) carry-back or carry-forward, or at least a five-to-seven year amortization of loan losses incurred by banks that are selling their distressed assets.

NOL is used in many heavy industries where current losses can be offset by past or future profits for both tax and accounting purposes in order to smooth the profit cycle. Without this accounting relief, banks selling loans to the Treasury at a deep discount will further impair their already weak capital positions if they have to immediately post the losses. Congressman Paul Ryan had this provision in the House version of the first Paulson plan, but it was apparently taken out by Barney Frank. Former FDIC man Bill Isaac also supports this.

Tuesday’s stock market comeback -- with the Dow up nearly 500 points following Monday’s unbelievable plunge -- suggests that investors believe the politicians will deliver some relief. But my message to the investor class is this: If Mr. Paulson strikes out again, Ms. Sheila Bair is the ultimate backstop.

Eventually, the political climate changed, and Washington became a believer in the story. Crucial to this change was a Federal Reserve Bank of Boston study which concluded that although lender discrimination was not as severe as suggested by the newspapers, it nevertheless existed. This, then, became the dominant government position, even though subsequent efforts by other researchers to verify the Fed’s conclusions showed serious deficiencies in the original work. One economist for the Federal Deposit Insurance Corp. who looked more deeply into the data, for instance, found that the difference in denial rates on loans for whites and minorities could be accounted for by such factors as higher rates of delinquencies on prior loans for minorities, or the inability of lenders to verify information provided to them by some minority applicants.

Ignoring the import of such data, federal officials went on a campaign to encourage banks to lower their lending standards in order to make more minority loans. One result of this campaign is a remarkable document produced by the Federal Reserve Bank of Boston in 1998 titled “Closing the Gap: A Guide to Equal Opportunity Lending”.

Quoting from a study which declared that “underwriting guidelines…may be unintentionally racially biased,” the Boston Fed then called for what amounted to undermining many of the lending criteria that banks had used for decades. It told banks they should consider junking the industry’s traditional debt-to-income ratio, which lenders used to determine whether an applicant’s income was sufficient to cover housing costs plus loan payments. It instructed banks that an applicant’s “lack of credit history should not be seen as a negative factor” in obtaining a mortgage, even though a mortgage is the biggest financial obligation most individuals will undertake in life. In cases where applicants had bad credit (as opposed to no credit), the Boston Fed told banks to “consider extenuating circumstances” that might still make the borrower creditworthy. When applicants didn’t have enough savings to make a down payment, the Boston Fed urged banks to allow loans from nonprofits or government assistance agencies to count toward a down payment, even though banks had traditionally disallowed such sources because applicants who have little of their own savings invested in a home are more likely to walk away from a loan when they have trouble paying.

Of course, the new federal standards couldn’t just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, in other words, these became the new standards in the industry. In 1999, the New York Times reported that Fannie Mae and Freddie Mac were easing credit requirements for mortgages it purchased from lenders, and as the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on the lending standards promoted by the government.

Meanwhile, those who raced to make these mortgages were lionized. Harvard University’s Joint Center for Housing Studies even invited Angelo Mozilo, CEO of the lender which made more loans purchased by Fannie and Freddie than anyone else, Countrywide Financial, to give its prestigious 2003 Dunlop Lecture on the subject of "The American Dream of Homeownership: From Cliché to Mission.” A brief, innocuous description of the event still exists online here.

Many defenders of the government’s efforts to prompt banks to lend more to minorities have claimed that this effort had little to do with the present mortgage mess. Specifically they point out that many institutions that made subprime mortgages during the market bubble weren’t even banks subject to the Community Reinvestment Act, the main vehicle that the feds used to cajole banks to loosen their lending.

But this defense misses the point. In order to push banks to lend more to minority borrowers, advocates like the Boston Fed put forward an entire new set of lending standards and explained to the industry just why loans based on these slacker standards were somehow safer than the industry previously thought. These justifications became the basis for a whole new set of values (or lack of values), as no-down payment loans and loans to people with poor credit history or to those who were already loaded up with debt became more common throughout the entire industry.

What happened in the mortgage industry is an example of how, in trying to eliminate discrimination from our society, we turned logic on its head. Instead of nobly trying to ensure equality of opportunity for everyone, many civil rights advocates tried to use the government to ensure equality of outcomes for everyone in the housing market. And so when faced with the idea that minorities weren’t getting approved for enough mortgages because they didn’t measure up as often to lending standards, the advocates told us that the standards must be discriminatory and needed to be junked. When lenders did that, we made heroes out of those who led the way, like Angelo Mozilo, before we made villains of them.

Now we all have to pay.

This is notable now when we consider the controversy over “mark-to-market” accounting. Supposedly the latter accounting abstraction to some degree explains the banking crisis, and the thinking goes that if we merely change the accounting rules followed by the banking industry, firms on their last legs will suddenly be solvent; their renewed lending capacity a source of capital to an economy presently lacking it.

The main argument here seems to be that banks have assets on their balance sheets that can’t be properly valued in what is a “frozen” market for certain securities. It is then said when similarly difficult to value assets are sold into what is an allegedly frozen market that the aforementioned sales force banks possessing similar securities to mark their value down.

And there lies the contradiction. Markets are not frozen as evidenced by the fire sales that supposedly force insolvent valuations on certain banks. There is in fact a market for anything, including what many deem “toxic” securities. Those securities are toxic by virtue of the low value investors attach to them.

So while I can for insurance purposes claim I have a fever as opposed to cancer, if the firm writing my policy does its due diligence, my actual malady will quickly become apparent and this reality will be reflected through higher insurance costs. Banks or any kind of business can mark certain assets to a range of values depending on accounting rules, but diligent investors will quickly to deduce their real value, as opposed to what is assumed by the business pricing the assets.

It’s been said that J.P. Morgan’s fire-sale purchases of WAMU’s assets negatively impacted the financial health of Wachovia for the latter having to mark its assets down. This seems unfortunate on its face, but J.P. Morgan’s purchase merely gave investors a greater sense of the actual market.

If mark-to-market rules in fact did not exist, Wachovia could have used more liberal accounting rules to put a theoretically higher value on its assets. But it seems pure fantasy to assume that investors would have accepted the firm’s assessment of its economic health. J.P. Morgan’s purchase once again provided investors with market information that would have caused them to attach a different, real value to Wachovia’s balance sheet irrespective of accounting.

Looked at from the perspective of Lehman Brothers, City Journal’s Nicole Gelinas noted last week that investors didn’t so much short the firm’s shares because it had written its toxic assets down to zero, but instead they “shorted Lehman partly because they didn’t think that it had written such securities down far enough.” As Gelinas pointed out, Lehman still had assets on its books marked to 70% of original value in a market where Merrill Lynch had recently sold what seemed to be similar assets at “22 percent of their original value.”

If we go back to earlier in this decade, there was a similar accounting debate, though in this case it had to do with the expensing of stock options. Many technology firms that compensate with options lobbied against such a rule for fear that the expense would drive down earnings and earnings per share (EPS). In accounting terms this would certainly be true, but no investor would be fooled by this in much the same way that no investor would be hoodwinked by a stock split that would halve EPS.

In the end accounting is just accounting, and it can in no way exaggerate or downplay a company’s underlying economic realities. We could surely suspend mark-to-market accounting to make banks appear solvent, but if investors have a different opinion when it comes to a bank’s actual health, the more liberal rules will quickly become meaningless.

The reasoning goes that a strong negative feedback loop is in place causing markets to seize, and now the only solution is to use Public capital to stem the panic. I believe this view to be seriously mistaken. The only capital that the government can deploy is that which it takes from the private sector.

Unless we swap Amtrak or a National Park for these distressed assets, the government will be borrowing the necessary money from the private sector. Put simply, the government will be borrowing from the same pool of capital that currently does not want to buy these distressed assets.

It's argued that because of the panic, prices for these securities have disappeared, but maybe that's just because holders are reluctant to accept much lower prices. After all, Merrill Lynch had no problem dumping its mortgage portfolio a few months ago once its executives were willing to bite the bullet and sell at a very low price (I wonder if the buyers are still happy with their purchase).

While it's quite possible that the bailout will help stabilize markets in the near term (particularly since so many on Wall Street and Capital Hill have created their own panic by assuring everyone that there is no alternative, and failure to move forward on the plan would lead to a repeat of the Great Depression), there will be some significant long-term costs. The lessons of past financial inflection points are that we must let the markets reallocate capital from less efficient to more efficient uses. The sad fact is that we need to go through the brutal process of downsizing our financial and real estate industries. Actions taken to recapitalize doomed financial companies will only postpone the day of reckoning, which will make matters worse as the Japanese learned in the '90s.

Alternatively, why not just propose a massive tax cut as a way of driving private capital back into the markets? Let's return $700 billion to the private sector absent government allocation, and let the dispersed knowledge of millions of citizens make the decision on how best to deploy this sum.

To make it simple and quick, how about cutting all tax rates in half for at least the next 2 years? A sizeable tax cut like this would offer a tremendous boost to the economy, and it would make the transition to an economy with a smaller financial industry quicker and easier.

Income-tax reductions might put enough extra money in people's pockets such that they’ll be less likely to lose their jobs, not to mention default on mortgage payments whose underlying securities presently ail the financial system. While there's no doubt there would be additional pain in the near-term no matter the solution, a lower penalty on work would put us on surer footing sooner.

Importantly, the timing for tax cuts couldn’t be better. With economic conditions deteriorating, Keynesians should be just as supportive as free-market types. The fact that there's only a month until elections doesn’t hurt either. Are there any Democrats campaigning on how bad the economy is who will want to face their constituents after having voted against a tax cut like this?

Lower tax rates will help the economy begin the healing process immediately by increasing the expected after tax returns on capital, and by boosting expected GDP.

From a monetary perspective, there are other actions that would also help in the very short run. The Fed could continue to exercise its role as lender of last resort to protect the solvency of the financial system. And with a tax cut in place, the Fed would have more leeway to monetize debt without it causing inflation. That is because the tax cut would increase the productive capacity of the economy and effectively soak up or sterilize the growth in money supply. Without a massive tax cut the Fed will be caught on a razor's edge of not monetizing enough and feeding deflation, or monetizing and creating inflation.

But right now, to support the heavy hand of government is to countenance a continuation of the hubris which has brought us to where we are today. Rightly or wrongly it will lend credence to the arguments of those who say the solution is more spending and regulation; actions that will weigh on our economic health for generations to come.

Some of those ideas might be good, but do they really need to be in a bill addressing an economic crisis? While we're at it, doesn't it suggest a lack of seriousness on the part of Congress that what started out as an elegant, easy-to-understand three-page plan — the Paulson plan — ballooned to a byzantine 451 pages in just 10 days?

The emerging Senate compromise includes such things as relief for those hit by natural disasters ($8 billion), renewable energy tax breaks ($12 billion), a fix for the alternative minimum tax ($62 billion) and a temporary lift on deposit insurance limits to $250,000 from $100,000.

And, as part of the overall effort, the Securities and Exchange Commission has said it will encourage the Federal Accounting Standards Board to ease "mark-to-market" accounting rules that some companies claim have added to financial market chaos.

It's clear that rescue by committee isn't, as President Bush described it, very "pretty." The plan emerging from Congress looks needlessly complex, like a Rube Goldberg device. And yet, the clock is ticking; every day a rescue is put off is a day we edge closer to the financial abyss.

That's why we again call on Congress to move quickly to pass this legislation. Sure, the stuff they've hung on this Christmas tree is unsightly. But the basic rescue bill is needed, even vital.

And no, it's not a "bailout for Wall Street," as popularly repeated. Average Americans have yet to feel the full force of what a credit crisis means. Once they do, they won't like it a bit. A credit crisis doesn't just mean banks stop lending to one another, or call in loans from Wall Street "fat cats." It means you might not get the credit you need to pay for a car, a home or a child's education.

It means many medium to large companies will not be able to go into the money market to finance their daily operations. Those that can't will be forced to pull back on expansion, slash investments across the board, reduce their purchases, maybe shut down marginal businesses and lay off workers.

All this could cascade into a deep economic downturn that will last years. The victims, however, won't be gazillionaires on Wall Street. It'll be you. That's why, despite IBD's impeccable free-market credentials, we support the rescue plan. Time for taking effective action is running short .

As the old saying goes, the perfect is often the enemy of the good. We agree that this rescue package is far from perfect. But with time of the essence, we'll take the good and hope for the best.

It's possible that once the Treasury has snapped up a good chunk of the damaged mortgage portfolios now on banks' books, normal lending will resume and the economy will pick up. If so, the government will eventually be able to unload the bad mortgages at a small loss, limiting taxpayer cost.

This happened from 1988 to 1992, when the Resolution Trust Corp. unloaded a huge portfolio of real estate assets. Today as then, action is needed to prevent a meltdown.

The problems in the US economy and financial system have been apparent for years. But that didn’t prevent America’s leaders from turning to the same people who helped create the mess, who didn’t see the problems until they brought us to the brink of another Great Depression, and who have been veering from one bail-out to another, to rescue us.

As global markets plummet, the rescue plan will almost certainly be put to another vote in Congress. They may rescue Wall Street, but what about the economy? What about taxpayers, already beleaguered by unprecedented deficits, and with bills still to pay for decaying infrastructure and two wars? In such circumstances, can any bailout plan work?

To be sure, the rescue plan that was just defeated was far better than what the Bush administration originally proposed. But its basic approach remained critically flawed. First, it relied – once again – on trickle-down economics: somehow, throwing enough money at Wall Street would trickle down to Main Street, helping ordinary workers and homeowners. Trickle-down economics almost never works, and it is no more likely to work this time.

Moreover, the plan assumed that the fundamental problem was one of confidence. That is no doubt part of the problem; but the underlying problem is that financial markets made some very bad loans. There was a housing bubble, and loans were made on the basis of inflated prices.

That bubble has burst. House prices probably will fall further, so there will be more foreclosures, and no amount of talking up the market is going to change that. The bad loans, in turn, have created massive holes in banks’ balance sheets, which have to be repaired. Any government bailout that pays fair value for these assets will do nothing to repair that hole. On the contrary, it would be like providing massive blood transfusions to a patient suffering from vast internal hemorrhaging.

Even if a bailout plan were implemented quickly – which appears increasingly unlikely – there would be some credit contraction. The US economy has been sustained by a consumption boom fueled by excessive borrowing, and that will be curtailed. States and localities are cutting back expenditures. Household balance sheets are weaker. An economic slowdown will exacerbate all our financial problems.

We could do more with less money. The holes in financial institutions’ balance sheets should be filled in a transparent way. The Scandinavian countries showed the way two decades ago. Warren Buffet showed another way, in providing equity to Goldman Sachs. By issuing preferred shares with warrants (options), one reduces the public’s downside risk and ensures that they participate in some of the upside potential.

This approach is not only proven, but it also provides both the incentives and wherewithal needed for lending to resume. It avoids the hopeless task of trying to value millions of complex mortgages and the even more complex financial products in which they are embedded, and it deals with the “lemons” problem – the government gets stuck with the worst or most overpriced assets. Finally, it can be done far more quickly.

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. The government effectively pays 50% of the mortgage interest and real estate taxes for upper-income Americans, yet does nothing for the poor. Second, bankruptcy reform is needed to allow homeowners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs.

By contrast, US Treasury Secretary Henry Paulson’s approach is another example of the kind of shell games that got America into its mess. Investment banks and credit rating agencies believed in financial alchemy – the notion that significant value could be created by slicing and dicing securities. The new view is that real value can be created by un-slicing and un-dicing – pulling these assets out of the financial system and turning them over to the government. But that requires overpaying for the assets, benefiting only the banks.

In the end, there is a high likelihood that if such a plan is ultimately adopted, American taxpayers will be left on the hook. In environmental economics, there is a basic principle, called “the polluter pays principle.” It is a matter of both equity and efficiency. Wall Street has polluted the economy with toxic mortgages. It should pay for the cleanup.

There is a growing consensus among economists that any bailout based on Paulson’s plan won’t work. If so, the huge increase in the national debt and the realization that even $700 billion is not enough to rescue the US economy will erode confidence further and aggravate its weakness.

But it is impossible for politicians to do nothing in such a crisis. So we may have to pray that an agreement crafted with the toxic mix of special interests, misguided economics, and right-wing ideologies that produced the crisis can somehow produce a rescue plan that works – or whose failure doesn’t do too much damage.

Getting things right – including a new regulatory system that reduces the likelihood that such a crisis will recur – is one of the many tasks to be left to the next administration.

Joseph E. Stiglitz is a professor of economics at Columbia University, a 2001 Nobel Prize winner and is co-author of "The Three Trillion Dollar War: The True Costs of the Iraq Conflict".

Similarly, today’s state laws define the practice in vague terms (such as New York’s “unconscionably excessive” pricing of consumer items in times of emergency), and wrath seems reserved for the very visible gasoline price. While the average government official is ignorant of retail economics, gouging seems unfair. For example, at one station in Knoxville, Tennessee, gasoline selling for $4.99 per gallon hours after Hurricane Ike hit Galveston had fetched only $3.59 the day before, and this sharp price increase is connected in consumer minds with oil company profits more so than the retail station owner’s P&L.

In fact, popular anger over price gouging is misplaced, and dangerous if it leads to price controls or taxes on producer profits. Public officials need reminding that the fundamental, inescapable economic problem is scarcity. All economic goods require rationing, and the price mechanism is by far the most efficient, wealth-inducing, and impartial method for this. Rising prices instruct consumers to conserve, exactly the behavior required in times of supply disruption or increased demand. The market mechanism of freely moving prices conveys seminal information, signaling consumers to alter plans while simultaneously inducing helpful changes in supplier output. All this happens with immediacy, without any government dictates, and serves to optimally coordinate consumer and producer use of scarce resources.

In the case of recent hurricanes, 20% of U.S. refinery capacity was shut down, several Gulf oil rigs sustained damage, and the storms caused billions of dollars of damage in Texas, Louisiana, and elsewhere. In our interconnected economy, foodstuffs, water, ice, gasoline, batteries, building materials, and generators were rushed to the affected areas, causing retail supply shortages nationwide. As a general matter, retail prices for these items increased as supply distribution shifted, but given the circumstances, this was a blessing for the millions of affected storm victims.

Anti-price gouging statutes harm the aforementioned market-coordination process and inflict misery on consumers. The inability to raise gas prices in the face of both decreased supply and increased consumer demand guarantees shortages, outages, long lines, and distribution to the politically-connected or favored. Further, producers are not incited to bring new supply to impacted areas, exacerbating shortages. As in so many other cases of government regulation, the law of unintended consequences applies.

Additionally, retail gasoline marketing is an extremely low-margin business, with little pricing power in an industry with thousands of independent competitors and 170,000 locations nationwide. With oil at $100 per barrel, according to the Department of Energy, about 72% of the retail price of a gallon of gasoline is taken up by refining crude oil, with another 12-14% or so for distribution and marketing costs. About 11% of the current average retail price, or 40 cents per gallon, goes toward federal, state, and local excise taxes, leaving less than 5%, typically, for retailer profit. Or, a few pennies per gallon.

In fact, many retail gas stations average zero profits on gasoline, using it as a draw to other transactions such as consumer purchases of bottled water and drinks, cigarettes, confections, or other services, all of which have far higher profit margins. This explains the quick jump in retail gas prices, particularly in areas remote from the storm. Retailers announce pump prices based on replacement cost, and many have anticipated wholesale price increases soon. In fact, even if the global price of oil itself does not rise, refinery damage repair and constricted output temporarily necessitate higher wholesale gas prices nationwide.

This is no different, ultimately, from selling a house today for double its purchase price of ten years ago, yet no one accuses home-sellers of “gouging” when they might accept a price entailing a lower capital gain.

The price mechanism is indispensable to a well-functioning market economy, and a key impetus to the entrepreneurial energies which foster wealth creation. Its curtailment portends harm for consumers, and it is therefore fortunate that federal price-gouging legislation is stalled. State laws should be repealed, and politicians should instead salute owners of the 170,000 stations serving consumers. Many are small businesses eking out modest profits in a highly competitive industry, where uncertainty means pricing is volatile guesswork.

We need to remind ourselves that economic slumps—though wrenching and disillusioning for millions—rarely become national tragedies. Since the late 1940s, the United States has suffered 10 recessions. On average, they've lasted 10 months and involved peak monthly unemployment of 7.6 percent; the worst (those of 1973–75 and 1981–82) both lasted 16 months and had peak unemployment of 9.0 percent and 10.8 percent, respectively. We are almost certainly in a recession now, but joblessness, 6.1 percent in September, would have to rise spectacularly to match post-World War II highs.

The stock market tells a similar story. There have been 10 previous bear markets, defined as declines of at least 20 percent in the Standard & Poor's 500 Index. The average decline was 31.5 percent; those of 1973–74 and 2000–02 were nearly 50 percent. By contrast, the S&P's low point so far (Friday, Oct. 3) was 30 percent below the peak reached in October 2007.

The Great Depression that followed the stock market's collapse in October 1929 was a different beast. By the low point in July 1932, stocks had dropped almost 90 percent from their peak. The accompanying devastation—bankruptcies, foreclosures, bread lines—lasted a decade. Even in 1940, unemployment was almost 15 percent. Unlike postwar recessions, the Depression submitted neither to self-correcting market mechanisms nor government policies. Why?

Capitalism's inherent instabilities were blamed—fairly, up to a point. Over borrowing, overinvestment and speculation chronically govern business cycles. Herbert Hoover was also blamed for being too timid—less fairly. In fact, Hoover initially expanded public works to combat the slump. The real culprit was the Federal Reserve. Depression scholarship changed forever in 1963 when economists Milton Friedman and Anna Schwartz argued, in a highly detailed account, that the Fed had unwittingly transformed an ordinary, if harsh, recession into a calamity by permitting a banking collapse and a disastrous drop in the money supply.

From 1929 to 1933, two fifths of the nation's banks failed; depositor runs were endemic; the money supply (basically, cash plus bank deposits) declined by more than a third. People lost bank accounts; credit for companies and consumers shriveled. The process of economic retrenchment fed on itself and overwhelmed the normal channels of recovery. These mechanisms included surplus inventories being sold so companies could reorder; strong companies expanding as weak competitors disappeared; high debts being repaid so borrowers could resume normal spending.

What we see now is a frantic effort to prevent a repetition of this destructive chain reaction by which a disintegrating financial system compounds the economic downturn. It's said that the $700 billion bailout passed by Congress will rescue banks and other financial institutions by having the Treasury buy their suspect mortgage-backed securities. In reality, the Treasury is bailing out the Fed, which has already—through various channels—lent financial institutions roughly $1 trillion against myriad securities. The law's increase in federal deposit insurance from $100,000 to $250,000 aims to discourage panicky bank withdrawals (nearly three quarters of deposits will now be insured, up from almost two thirds before). In Europe, governments have taken similar actions; last week, Ireland guaranteed its banks' deposits.

The cause of the Fed's timidity in the 1930s remains a matter of scholarly dispute. Economist Barry Eichengreen of the University of California, Berkeley, suggests a futile defense of the gold standard; Allan Meltzer of Carnegie Mellon University blames the flawed "real bills" doctrine that, in practice, limited the Fed's lending to besieged banks. Either way, Fed chairman Ben Bernanke—a student of the Depression—understands the error. The Fed's massive lending and the congressional bailout both aim to prop up the financial system and avoid a ruinous credit contraction.

This doesn't mean the economy won't get worse. It will. The housing glut endures. With unemployment rising, cautious consumers have curbed spending. Economies abroad are slowing, hurting U.S. exports. Banks and other financial institutions will suffer more losses. But these are all normal symptoms of recession. Our real vulnerability is a highly complex and interconnected global financial system that might resist rescue and revival. The Great Depression resulted from the perverse mix of a weak economy and government policies that magnified the weakness and that were only partially neutralized by the New Deal. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.

What we wanted to make clear was until things are settled with what’s going on with the Wells bid, that the Citi deal was still there. We just wanted to make sure that it was clear to people the Citi deal was still there – we made that agreement.

MR. HUNT: So it may not necessarily – we should not assume that you have problems with the Wells deal –

MS. BAIR: It’s – no, you shouldn’t assume – we’re reviewing it. We’re absolutely reviewing it. We’re hoping we can – again, working with the other regulators, we’ve got to regulate –

MR. HUNT: Can that be done in a matter of days?

MS. BAIR: I would think so. I would hope so, yeah.

MR. HUNT: Let’s move to the big bill, the big financial rescue bill that was passed. It raised the – it raised the insurance ceiling to $250,000. First, I want to ask you – do you feel that’s sufficient? And I know you’ve said it’s only temporary but really, at the end of next year, realistically, we’re not going to go back to $100,000.

MS. BAIR: Well, that’s true. I think that’s the smart money in Washington saying that and so and I think you would certainly need to carefully think if you’re going to make it to remove the sunset that you know, what happens with deposits, you don’t want a lot of destabilization and that extra bump-up.

MR. HUNT: Right.

MS. BAIR: The flip-side is, though, if they make it permanent, obviously, right now, because it’s temporary, Congress said we don’t have to determine in our calculation of what the premiums are – what – required reserve ratio. So that would be the trade-off. We would have to bump up premiums to take in effect that additional –

MR. HUNT: But it is likely to stay at 250,000 dollars?

MS. BAIR: You know, it’s Congress’ call. They set our deposit insurance limits so I guess I wouldn’t want to prejudge Congress but I would certainly say that there’s some strong arguments, probably, for keeping it when it expires.

MR. HUNT: You have to all – I think – bolster the deposit insurance fund, which is now, I think at $45.2 billion.

MS. BAIR: That’s right.

MR. HUNT: You need to what, double that?

MS. BAIR: Well, that’s a good question. You know, we think – we’ve done a lot of stress test analysis of projected bank figures internal and what our losses would be given various protections, high loss and low, and we think we do need to raise premiums to make sure the reserves stay sound. But we’re going to do it in a measured way, spread it over a period of time. And we actually think our industry reserves will be sufficient. I think it’s important for the public to understand we are with the government – we’re backed by the full faith and credit of the United States government.

MR. HUNT: Right.

MS. BAIR: We already have a lot of authority to borrow Treasury. Now, we have even more with this bill. So that the money’s there to be able to borrow if we need it but we think our industry-funded reserves are going to be sufficient. I would also hasten to add that if we do have to borrow from Treasury, we pay that money back. That’s in our statute through industry assessments – it is paid back.

MR. HUNT: Right.

MS. BAIR: We borrowed once in the early 1990s, we paid it back within two years with interest so there’s no taxpayer cost, even if we do borrow it, we will pay it back through industry assessment.

MR. HUNT: So no necessity to raise that $45 billion by any appreciable amount?

MS. BAIR: Well, I think it’s a static – it’s not a static number. We’re bringing in, you know, billions of dollars in premium income now and we’re going to be bumping that up. Again, we’re going to be proposing some major premium increases next week. We’re required by statutes to do that. We’re supposed to maintain our ratio – our reserves within a 1.15 to 1.50 ratio. So to get it back to where it needs to be, we are required by Congress to implement what’s called the restoration plan, which will include some premium increases. But again, we’re trying to do measured increases, to build a fund, maintain public confidence without shocking industry too much.

MR. HUNT: You have had, I think, 13 bank failures this year, including a couple really big ones, WaMu. First, I think, the largest, any bank – do you expect any more big bank failures this year?

MS. BAIR: You know, I really try not to make predictions. I think we are in uncertain times –

MR. HUNT: You said there are going to be bank failures.

MS. BAIR: There will be bank failures and certainly, a number of smaller bank failures, which is what we’ve seen, which is more typical.

MR. HUNT: But how about big ones?

MS. BAIR: Well, you know, I think overall, banks are very well capitalized. They have – yes, they have some stresses in their outset quality, some a lot. But they also have very strong reserves; they’ve been very aggressive about getting reserves. So I really think the balance sheets are strong, they’re in a good position to what it is. What I’m really looking at now is liquidity issues. I think that’s really where the public confidence factor comes in. The policers need to maintain confidence in their banks and their deposit insurance.

Commercial users of banks and banks who lend to each other need to maintain confidence in the banks they do business with. Commercial customers in other banks should have the sophistication to be able to analyze a bank balance sheet and be able to make a judgment about its health. And so do that – just don’t irrationally pull back, which I am seeing a little bit now and it concerns me.

MR. HUNT: Madam Chair, now that this financial rescue plan has been adopted, there’s some talk to move the – shift the focus more from buying bad assets of institutions to perhaps government investing or in some cases –

MS. BAIR: Right, right.

MR. HUNT: It that a move that you would like to see? Would you like to move more in that direction?

MS. BAIR: Well, I think it’s – from the TARP, I think that’s Secretary Paulson’s call. He has multiple tools that he can use and I believe Congress gave him the ability to buy assets as well as credit guarantees and some direct capital infusion. We also, as part of our bank resolution process, when a bank becomes troubled, we have multiple tools we can use and that cost possibility could – in our own resolution process, that would be one technique we might be able to use.

With the Citigroup deal that you mentioned earlier, we used a combination – we provided some loss protection above a fairly large first-loss position but we also took an equity position through security as well as ones to make sure that, you know, as the value of the corporation, the value of the institution increase, that we would have some benefit too. So that’s the nice thing about taking the equity position, that you can recapture some of that value that you’re risking initially to stabilize the bank.

MR. HUNT: Let me – let me ask you two quick political questions.

MS. BAIR: Sure.

MR. HUNT: You know a little bit about politics. You have been praised by so many Democrats this week.

MS. BAIR: (Chuckles.)

MR. HUNT: You are a lifelong Republican. Barney Franks says you’re the best regulator he’s ever seen. If a Democrat should win the White House and asks you to keep serving, would you keep serving as FDIC chair?

MS. BAIR: Well, I would. I’ve said that. You know, I think the next president needs to be able to have an economic team that he wants to work with and yes, I’m happy to stay although I think it’s – it’s important to have stability now and I think it’s important for me as the chairman of the FDIC to signal that – my willingness to see this out. But that said, you know, I was in academia before I took this job. I was asked to take the job – I’m happy to go back to academia too. So I want to be flexible for the next president.

MR. HUNT: Sheila Bair, at the end an extraordinary week, thank you so much for being with us. And when we come back, the financial rescue plan’s now law. The economic outlook, though, is still dicey. We’ll talk with our reporters after the break.

The financial crisis and economic downturn clearly have buried Sen. McCain in recent weeks. Some of McCain’s supporters think he can turn the page on the economy Tuesday night and instead attack Obama on character and qualifications. That doesn’t seem realistic.

The recession economy and the financial crunch are front and center. Folks are asking: Can I get a loan? Will I have a job? Can I keep my house? Unfortunately, Sen. McCain’s message overemphasizes government spending cuts, almost to the exclusion of stimulative and expansive tax cuts. This just doesn’t seem like the right time for a government spending freeze, at least to the exclusion of other pro-growth policy levers. Sounds like too much root canal. More like Bob Dole than Ronald Reagan.

That’s why McCain needs to stress that tax hikes of any kind would be a total disaster during this economic emergency, and that letting folks keep more of what they earn is a recovery prescription. He needs to emphasize the need for across-the-board tax cuts for individuals and businesses. Lower marginal tax rates will reward work, investment, and risk-taking. They also will put money in people’s pockets as they keep more of what they earn.

McCain can point to Paul Ryan’s modified flat tax with two brackets of 15 and 25 percent. That would be a great message. This is an economic emergency and it calls for strong medicine. This is not the time to take away tax cuts. It’s a time to add them. And reducing marginal tax rates would add substantially to taxpayer benefits on a permanent basis with new incentive rewards.

McCain should next talk about a corporate tax cut from 35 to 25 percent as a means of boosting jobs and wages. He should note that study after study shows that roughly two-thirds of the benefit of a corporate tax cut goes to the workforce. A corporate tax cut also is pro-investment and will make this country more competitive. But the key point is that a lower corporate tax rate is a job-creator. McCain must explain that you can’t have jobs without healthy businesses that are funded by investment.

McCain also should state that the Federal Reserve needs to keep expanding the money supply. Milton Friedman taught us many years ago that the monetary contraction of 1929-32 was a key cause of the Great Depression. So Big Mac should tell Ben Bernanke to stop targeting the federal funds rate and pump up the money supply even more. Right now credit deflation and recession are the problems -- not inflation.

From the beginning of 2007 to the middle of 2008 the monetary base controlled by the Fed has grown only 1.6 percent at an annual rate. The basic M1 money supply has been flat. This amounts to a long-run liquidity squeeze. The credit-crunched economy desperately needs cash. But the Fed is not providing it.

Over the past three months the central bank has stepped up a bit to a 4 to 5 percent growth rate. But that is still way too little in today’s confidence-lacking banking environment. Everyone is hoarding cash rather than putting it to work. McCain should highlight this point.

He also should address all the Americans who might be worried about their bank accounts. He should propose that all deposits be guaranteed by the FDIC, at least temporarily. He might also suggest that G-7 central banks guarantee all inter-bank loans for regulated banks. (Hat tip to Wall Street economist John Ryding.)

He also should put Obama’s tax hikes and trade protectionism in historical context. Under Herbert Hoover, taxes were raised, trade protectionism increased, and the money supply contracted. Sound familiar? Obama’s tax hikes and trade protectionism are Hooveresque.

Right now, McCain sounds austere when he addresses the economy. Tomorrow night he must sound expansionary for economic recovery. Tax cuts, free trade, and money growth -- those are the pillars of recovery. An across-the-board tax cut for individuals and businesses will boost jobs at home and our competitiveness worldwide. Free trade benefits both consumers and businesses. The Fed’s money supply must keep expanding.

That message gives McCain a fighting chance.

Politicians touted the Paulson plan as a way to liquefy markets that were supposedly frozen, but in doing so, they ignored the obvious truth that markets for certain securities were illiquid precisely because investors thought those same securities unworthy. The latter in mind, it never made sense that the federal government could take money from the already risk-averse private sector in order to create a market that previously was thin. The simple truth is that rather than normalizing markets, government insertions of private capital only serve to distort them more, thus making all-important price discovery necessary for recovery a distant object.

Some make the important point that since governments are behind the vast majority of economic calamities, that they should spend precious capital to fix what they've broken. But governmental mistakes that lead to market meltdowns don't justify a compounding of the initial errors that led to government involvement to begin with. What's important to remember is that governments can't fix economies; instead they can only aid them by getting out of the way.

Fortunately for Paulson, one option that he hasn’t considered would not require legislative approval. Given Treasury’s traditional role as dollar steward, Paulson could announce a new dollar definition free of congressional oversight. Right or wrong, it is the federal government that issues dollars, so in this case an intervention by the branch of government meant to oversee the greenback would not set the economy back.

And while there are varying opinions about how the dollar should be defined, many believe a dollar measured as 1/500th of an ounce of gold would be ideal in terms of matching the needs of both debtors and creditors. If Paulson were to move in such a direction, some believe this would require a contraction in the money supply. More realistically, it’s not the amount of money that matters, but instead the quality of money. A market-defined dollar would be highly credible, and odds are that monetary authorities would have to create quite a bit more of them to match increased demand.

Importantly, this would have very positive implications for the mortgage securities that presently weigh on the financial health of banks.

For one, the income paid on mortgage securities would immediately be more valuable given the newly strong dollar. This in itself would boost the value of the underlying asset.

As for the housing market that somewhat impacts mortgage securities, much of the commentary surrounding housing centers on reversing the decline in home prices. This is mistaken. Mortgage securities aren’t so much weak due to declining home prices as they sag due to the inability of some Americans to pay down their mortgages.

A stronger dollar would directly impact the ability of strapped Americans to make their mortgage payments.

The above is firstly true because all commodities, including oil and gas, are priced in dollars. As such, a stronger dollar would drive down the nominal costs of those commodities, most notably gasoline purchased at the pump.

So in a very real sense a stronger dollar would serve as a large income boost for every American. All of us would enjoy a tax cut of sorts free of the legislative wrangling that makes tax cuts in the literal sense so hard to pass. With money going further, mortgage payments wouldn’t be so onerous.

Secondly, when we inflate as we have over the last several years, investment is distorted in ways that harm the wage earner. This is so because dollar holders, seeking to hedge the decline of the unit of account, plow money into hard assets such as commodities, art, and yes, property.

A stronger dollar would reverse this process. Rather than trying to protect their wealth with investments in tangible assets, investors would be more willing to invest in the entrepreneurial economy free of inflation worries. The impact would be greater capital formation that would boost wages, thus making mortgage payments even less troublesome.

In the end, Henry Paulson’s ill-considered efforts to fix that which isn’t working have taken the form of a solution that misses the problem. Mortgage securities are for a variety of reasons under water due to a dollar that has been in decline for years. A stronger, more stable dollar would reverse the decline of the assets that weigh on our banking system, and it could be achieved free of the very expensive legislation the effectiveness of which investors seriously doubt.

The declining portion of households who pay taxes is a direct result of policies pursued by both Republicans and Democrats over the last 15 years or so. While deductions and credits have always served to eliminate the tax bill for some low and lower-middle income workers, from 1950 through roughly 1990, the percentage of households with no income tax burden stood constant at slightly more than one-fifth of all filers, according to the Tax Foundation. But since 1990, Washington has added all sorts of tax credits—subsidizing everything from “lifetime learning” to adoption expenses--that have further reduced the tax tab, and in the process raised the proportion of households with no federal tax liability to 33 percent.

A big culprit in this evolution is the current Bush administration and its tax packages. Although the 2001 and 2003 tax cuts are often criticized as having favored the rich, in fact they were also laden with tax credits benefiting low and middle income families, and as a result, under Bush, the percent of families not paying taxes increased more than under any other president during the last 50 years.

Both presidential candidates would vastly accelerate the trend. Barack Obama’s tax cut proposals, if enacted, would boost the proportion of those paying no income tax by one-third to a whopping 44 percent of all households, according to the Tax Foundation. John McCain’s proposal is not much different in that regard. Under his plan, 43 percent of households would pay no federal income taxes.

But even among those who still pay an income tax, only a small percent would likely be on the hook for the additional costs of the bailout. By one estimate, the federal government already spends more than $20,000 per household in direct services or services that are considered part of the ‘general good’ of the nation (like national defense). That’s a big number, that $20,000. A married couple filing jointly wouldn’t pay $20,000 in income taxes until they earned about $110,000 in taxable income--that’s income after deductions.

Of course, we pay for Washington government in more ways than simply through our personal income tax. A report by the Congressional Budget Office, Historical Effective Tax Rates, looks at our total contribution in federal taxes, including payroll and Medicare taxes, excise taxes and the share of corporate taxes that individuals pay (because we all individually bear the burden of business taxes). That study suggests that we hit the $20,000 in federal taxes mark somewhere around $95,000 in taxable income—still a big number. Of the 138 million households who file tax returns, only about 16 million, or 11 percent, earn enough to pay more to the feds in taxes than they get back in services.

The largest differences are generational, because younger and older households have less income and use more in government services than those headed by adults in their peak earning years. Thus, households consisting of adults 34-and-under and those of adults 65-and-over are a net cost to the government, while families headed by people ages 45-to-54 are the biggest net contributors, paying $1 in taxes for every 73 cents in services. It’s a good bet that middle and upper income families in that age bracket will foot a big part of this bailout bill.

On the other hand, federal legislators could decide that in light of the massive government commitment to the bailout we need to cut federal spending, which might shift some of the burden for the bailout to those who benefit from whichever programs are reduced. And the next president could determine that the country can’t afford his tax plans, and not pursue them. That might spare high-income earners from paying an even bigger part of the tab. But nothing that I’ve heard emanating from Washington suggests either likelihood.

In the end, how we actually pay for the bailout is just part of the issue. The larger point is that if McCain or Obama follow through with their tax plans, we’ll continue a trend that makes us look more and more like some European social welfare state, where many people have a stake in growing government entitlements, which fewer and fewer taxpayers finance. At some point along that road, change becomes impossible because too many citizens benefit from the system in place, while those who pay the freight for this system try whatever they can, including starting businesses elsewhere, or reducing their output, to avoid the disproportionate tax bite.

That’s a prescription for a static economy largely bereft of opportunity. On the other hand, we probably won’t have to worry about volatile markets in such a world.

Recessions are staggeringly expensive. Let’s look at a case where the looming recession reduces 2008 GDP growth from an average of 2.0% to 1.0%, causes the economy to contract by 1.0% in 2009 rather than growing by 2.6%, and then has no affect in 2010 and beyond. On a “present value to the infinite horizon” basis, which is the method used by the Social Security Trustees, this recession would cost the economy $49.4 trillion in lost GDP. The Federal Government’s share of this cost, in the form of lower tax revenues, would be $9.1 trillion. As a point of reference, $9.1 trillion is 55% larger than the entire national debt, which currently stands at $5.9 trillion.

So, if a recession is unnecessary, pointless, and expensive, why have one? People are saying that the current problems in the financial markets will cause a recession no matter what we do. This is not true. Government mistakes caused this problem and strong corrective action—taken immediately—can head off the recession and its economic and social costs.

The root cause of this whole mess is the unstable U.S. dollar. The Federal Reserve has put our economy through two boom-bust cycles in the past ten years. During the first cycle, the excess money created by the Fed was used to bid up the price of tech stocks. During the second, it was used to bid up the price of housing. Both booms were inevitably followed by busts.

There is no point in blaming Silicon Valley, Wall Street, Main Street, or “greed” for these asset boom-bust cycles. If the Fed puts too much liquidity into the system, it has to express itself somewhere. The only way to stop these damaging oscillations is to stabilize the dollar.

To have a stable economy, we must have a stable dollar. Under the Constitution, it is Congress—not the Federal Reserve—that is responsible for regulating the value of our money. On July 31, “Judge” Ted Poe (TX-02) introduced a bill, H.R. 6690, that would require the Fed to stabilize the value of the dollar by making it equal to that of 1/500th of an ounce of gold. This bill would require the Fed to do this directly, by using their Open Market operations to target the COMEX price of gold, rather than indirectly, by manipulating interest rates.

So, the first step in aborting the oncoming recession is to pass H.R. 6690, or for the Fed to implement its provisions without being ordered to do so by Congress.

Making the dollar “as good as gold” would restore confidence in our money and respect for our country. It would put an end to boom-bust cycles in asset prices and allow sanity to return to the financial markets. It would cause interest rates to fall and capital investment to rise. It would make the dollar the de facto world currency and ignite a massive market demand for U.S. dollars.

Simply stabilizing the dollar would have been enough if we had done it in 1998. However, we are now so far down the road to recession that more must be done. Our economy needs stimulus—real stimulus, not phony stimulus like the bill enacted earlier this year.

The January “stimulus” bill was based upon economic superstition. I predicted at the time that the rebate checks would do nothing, and nothing is exactly what they did. In the real world, government rebates don’t stimulate anything other than the Federal deficit.

What can—and must—be stimulated is private business investment. It is investment that directly creates both employment and output. I described the mechanisms in detail here.

If we allow this crisis to depress private business investment, the unemployment rate could quickly soar to more than 10%. As it happens, H.R. 6690 also contains the most potent form of economic stimulus possible, short of repealing the corporate income tax. This bill would allow everyone to write off 100% of their capital investments for tax purposes in the year they were made. This would provide businesses with both more incentive to invest and more money to invest. It would quickly turn an investment bust into an investment boom.

The stimulus provided by H.R. 6690 would increase the present value of Federal tax revenues. This is because: 1) higher investment would lead to higher taxable profits; and, 2) “first year expensing” represents a deferral of, not a reduction in, taxes owed.

Still more must be done, however. The financial crisis has been allowed to progress to the point where businesses are worried about the safety of the money in their payroll accounts. There have been runs on banks. This must be stopped. Deposit insurance must be extended to all accounts in all financial institutions. Ireland and Germany have already done this. It is bizarre that the “Bailout” bill passed by Congress last week did not provide for this.

The Fed’s first boom-bust cycle led to Enron, which led to the ill-conceived Sarbanes-Oxley reform law. One provision of this law forces financial institutions to revalue all of their assets at “market” every day. Because of the financial panic, there is no functioning market for many mortgage-backed securities. Under these circumstances, the “mark to market” regulations can force a firm to take massive write-downs on assets, even if none of the underlying mortgages are in default. This, in turn, can drive the firm bankrupt—on what amounts to a technicality. These “mark to market every day” regulations must be suspended—now. Again, it is bizarre that Congress passed a “Bailout” bill that did not simply order the S.E.C. to suspend “mark to market”.

If H.R. 6690 were passed, all deposits were insured, and “mark to market” accounting were suspended, it is not clear that there would be any need to use government money to buy so-called “toxic securities”. However, if there were, the $700 billion provided in the “Bailout” bill should be more than enough to handle the problem.

There is nothing to be gained at this point from having a recession. Let’s bring Congress back into session and call the whole thing off.

How things have changed in just a couple of weeks. Just a month ago, EU officials were giddily ridiculing the "U.S. model." Said Sarkozy then, in an obvious reference to the U.S.: "A certain idea of globalization is drawing to a close with the end of a financial capitalism that imposed its logic on the whole economy."

Now, the panjandrums of the European Union are panicked, blaming the U.S., banks and greedy American homeowners — everyone but themselves — for their financial troubles. But the EU also had a housing boom, and they too gorged on debt, encouraged by their governments, and created a regulatory straitjacket that their banks can't escape.

The inability of EU leaders to craft a common strategy on the financial crisis suggests the unity is something of a sham. EU bureaucrats are great at telling everyone what the exact definition of a Parma ham is, or how many olives must go in a jar. But when it comes to Europe's badly out-of-date financial architecture, no one there seems to have a clue.

Worse, there's been precious little common action to stave off the EU's growing bank crisis. They've left it up to the U.S.

The European Central Bank has added cash to the system, but so far so far hasn't cut interest rates. Does anyone seriously think inflation should still be the No. 1 worry of any central bank, especially with the IMF predicting Tuesday that banks could end up losing $1.4 trillion as a result of this crisis?

The answer is, of course, no. Yet, the last move the ECB made — in July — was to tighten rates, showing how out of touch it is with reality. Even Australia's central bank, understanding the gravity of the situation, slashed rates a full percentage point on Tuesday. What's the ECB waiting for? Panic in the streets? An economic shutdown?

Meanwhile, European leaders keep talking as if this was all a U.S. problem. Well, the EU talks the talk, but it doesn't walk the walk.

Fortunately, that's not the case in the U.S. Like it or not, our financial authorities have acted, cobbling together a $700 billion bank rescue at the Treasury and $1.2 trillion in short-term loans from the Fed. And Fed chief Ben Bernanke said on Tuesday that interest rates will be cut again if necessary.

By contrast, Europe has chosen a series of ad hoc responses but no coherent strategy. On Wednesday, for instance, Britain is expected to unveil its own bank bailout. That follows loan packages and bailouts crafted by Germany, Denmark, France and Italy for their troubled banks and consumer loan businesses.

President Bush is calling for finance ministers from the G7 nations — the U.S., Canada, Britain, France, Italy, Germany and Japan — to meet Friday to discuss heading off a world recession.

It's a good idea. But comments like those heard from Europe about the "end to cowboy capitalism" or the need for a "new era" of regulation are neither helpful nor smart. Maybe the Europeans will show up with some ideas for a change, and leave the snarky anti-capitalist, anti-American rhetoric at home.

As many authoritative economists are desperately trying to explain amid all the confusion, the culprit was a system geared toward loaning money to people who were not in a position to pay it back. Two policies underpinned that system: easy money by the Federal Reserve and the government-induced lowering of standards for approving loan requests.

Lorenzo Bernaldo de Quiros, a leading European economist, is adamant that the crisis could have been avoided but for "the lax monetary strategy put in place by the Federal Reserve between 2001 and 2004. ... That is what caused the exuberant and unreal rise in the value of stock market and real assets, the excessive leverage on the part of families and companies, and the inevitable collapse of the house of cards once inflationary pressures forced the central bank to tighten its policy."

The Fed's policy would explain why asset values rose unrealistically, but not necessarily why they did so predominantly in the housing market. And here is where the second set of policies underpinning the system comes into play.

In a recent paper for the Independent Institute, University of Texas professor Stan Liebowitz argues that "in an attempt to increase homeownership ... virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s."

The government-promoted increase in homeownership dramatically increased the price of housing. As many as one in four buyers purchased property with purely speculative intentions. When prices stopped rising, the speculators tried to get out of the market. The rest is history.

Liebowitz chronicles the long march toward what we could call the Mortgage State, starting with the creation of the Federal Housing Administration in 1934 and all the way to the norms that made Freddie Mac and Fannie Mae acquire substantial loans given to people with weak credit. In between, legislation was passed requiring that banks serve the entirety of the geographic areas where they operate and that they receive scores from regulators on how they treat mortgage applications, factoring in race in order to expose discrimination.

Not surprisingly, once the Fed expanded credit, astronomical amounts of capital poured into a housing market that people assumed was protected by the government. What came next was a consequence of the original sin--Wall Street whiz kids creating, with the help of mathematical models, sophisticated financial instruments such as collateralized debt obligations and credit-default swaps, rating agencies giving those instruments AAA scores, and investors losing their mind over them.

Does the original sin excuse Wall Street from its colossal failure of judgment? No. The Wall Street geniuses should have figured out that scientific models cannot really predict human behavior and that any asset that experiences a quick, astronomical rise is suspect. But they acted on opportunities generated by the original sin.

The fact that, as Sebastian Mallaby pointed out in a recent op-ed in The Washington Post, "lightly regulated hedge funds resisted buying toxic waste for the most part" also belies the notion that deregulation was the culprit. The real purchasers were U.S. investment banks regulated by the Securities and Exchange Commission, U.S. commercial banks regulated by the Fed, and European banks that are among the most regulated in the world.

The crash of 1929 gave rise to an era of big government whose consequences millions of people continue to pay for today through deficits, debt and uncertainty over the future of Social Security. A politician is never more dangerous than in the midst of a commotion in which myth replaces reality. In an age where globalization has opened up extraordinary possibilities for billions of people, going back to overregulation and protectionism because of a myth would be a crime against humanity.

Fast forward seventeen years, change the words a bit to the “worst banking crisis since the Great Depression”, and you have more problems in the banking sector tailor-made for a Washington class political eager as always to be seen “doing something”. Make no mistake that today’s “solutions”, including an increase in federal deposit insurance from $100,000 per account to $250,000 will sadly set the stage for further banking crises in the future.

So while politicians perhaps possess a congenital inability to factor past legislative mistakes into any of their actions, for those of us not politicians, it’s certainly worthwhile to recap what happened the last time Congress tried to save a portion of the banking system. Indeed, the historical parallels are hard to ignore.

Nearly 30 years ago, the savings and loan (S&L) industry was on life support. Amid skyrocketing interest rates between 1979 and 1982, S&Ls lost $4.6 billion in 1980, and $4.1 billion in 1981. By 1982, S&Ls had a negative net worth of $100 billion. Rather than allow the industry to die a slow death, much as we’re witnessing at present, Congress stepped in to save the day.

The slow death of the S&Ls began in the 1970s when interested rates skyrocketed in response to the weak dollar. In previous decades, the S&L sector was a prosaic one where its assets were long-term mortgages paying higher rates, while its liabilities consisted of short-term, lower-rate deposits. This worked well until short-term rates rose sharply. Unable due to regulations to pay depositors more than 5-1/2 percent, S&Ls gradually lost deposits to money-market funds paying well in excess of 51/2 percent, while the falling dollar eroded the value of their fixed-rate mortgages.

Regulations and poor dollar policy surely hindered the S&L industry back then, while the explosion of the mortgage-backed securities market and worldwide banking competition rendered S&Ls obsolete.

But like most long-established industries in the U.S., the S&Ls had powerful political benefactors interested in keeping them alive. Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980, and the Garn-St. Germain Depository Institutions Act of 1982 to keep them afloat. Both acts served to privatize any deregulation successes, while socializing the inevitable failures.

Whereas S&Ls were previously limited in terms of the interest rates they could offer depositors, the aforementioned legislation removed all caps on rates they could post to attract deposits. Capital requirements were reduced from 5 percent to 3 percent, plus S&L loans were no longer limited to home mortgages. To pay the high rates offered on deposits, S&Ls had the incentive to make higher-risk loans and equity investments in areas beyond traditional home mortgages, including commercial and construction loans. If the S&Ls had been left to fend for themselves in this newly deregulated world, the new legislation would have been fine.

The problem, as previously mentioned, was that Congress also chose to socialize any failures. The Garn-St. Germain bill raised the level of federal deposit insurance from $40,000 to $100,000. This created enormous moral hazard in that depositors could place their funds at high rates of interest with the S&Ls worry-free. And just the same, S&L executives could be lax in their lending and investment standards with full knowledge that U.S. taxpayers were on the hook if their investments soured.

Importantly, the weakest S&Ls had the greatest incentive to swing for the fences in making loans, and this made it even more difficult for the healthy S&Ls to compete. The rest, as they say, is history. More than 1,000 S&Ls failed in the 1980s. The bloodbath continued into the 1990s; much of it on the dime of U.S. taxpayers.

Looked at from the perspective of today, history is once again repeating itself. Rather than allow the economically cleansing process whereby failed banks and toxic assets experience a change of ownership at distressed prices, our federal minders have passed a $700B bill meant to keep banks afloat, and which will supposedly put a floor under the value of unwanted securities.

What’s ironic here is that for politicians so intent on freeing up markets that are allegedly frozen, the insertion of capital taken from the private sector (the very capital that deemed these assets unworthy) will only distort the market for these assets even more, thus creating a false marketplace that will make it even more difficult for illiquid markets to become liquid. For that reason alone, the bailout won’t work.

Even more ironic is that alongside these efforts to delay reality, Washington has increased the very deposit insurance that made past banking crises more problematic. It’s surely unfortunate how soon legislators forget past mistakes, though voters should rest assured that the legislation passed last week will not just fail to revitalize markets or the economy; additionally the legislative mistakes made last week merely lay the groundwork for future banking scandals. History has warned us.

The investor class is a huge voting bloc. Shareholders in recent national elections represented nearly two out of every three votes cast. And most surveys put the investor-class population at slightly over 100 million. This includes direct investment through brokerage accounts, although the vast majority of investor-class members own IRAs, 401(k)s, and defined-benefit plans, such as state and city pension funds.

So why aren’t the presidential contenders trying to connect to investors? More glaringly, why isn’t McCain?

After the debate I checked in with TechnoMetrica’s Raghavan Mayur, who puts out the respected IBD/TIPP poll. Mayur consistently ranks among the top pollsters in terms of accuracy, including his work on investor preferences. For September, Mayur’s data show McCain with a small 45-41 lead over Obama among investors. That’s roughly within the poll’s margin of error, and for McCain it isn’t enough.

Four years ago this September, George W. Bush had a 10-point lead over John Kerry among investors. In November Bush won investors by a 53-42 margin. By this measure, McCain is now way behind. And I suspect it may be a function of his reluctance to talk directly about investor taxes -- especially on capital gains and dividends.

The Bush tax cuts in this area were very popular among shareholders since they reduced the cost of capital and raised after-tax investment returns. Of course, McCain has pledged to maintain President Bush’s investor tax cuts at the current 15 percent rate, while Obama proposes to raise them to at least 20 percent. But McCain seldom talks specifically about cap-gains and dividends, and the polling numbers strongly suggest he’s not connecting with investors.

Obama constantly bashes businesses and successful high-end earners, and one would think investors would be totally turned off by this. But Mayer’s polls don’t confirm it. Why? Perhaps investors sense a lack of tax-cutting passion from Sen. McCain.

For example, during the debate, McCain did mention how he and Obama differ on tax policy. At one point McCain even compared Obama to Hoover. “My friends,” he said, “the last president to raise taxes during tough economic times was Herbert Hoover, and he practiced protectionism as well.” McCain later said, “I’ve got some news, Sen. Obama -- the news is bad. So let’s not raise anybody’s taxes.”

But McCain never got specific on capital-gains and dividends, and he failed to educate voters on just how important investment is to healthy job-creating businesses.

Ditto for McCain’s proposed corporate tax cut. The senator wants to slash the business tax rate from 35 to 25 percent. It’s an excellent plan. But McCain doesn’t explain how two-thirds of the benefits of a corporate tax cut go to the workforce through higher wages, with the rest then going to shareholders. He also doesn’t point out that ordinary folks actually pay the corporate tax, since firms pass this tax cost along in the form of higher prices. So McCain could, in fact, call a corporate tax cut a consumer tax cut. But he’s not doing this.

McCain also needs to put investors on red alert about Obama’s middle-class tax cut. The Illinois senator’s huge government-spending plans will overwhelm his ability to cut taxes for 95 percent of the people. In fact, McCain needs to remind voters that Bill Clinton made exactly the same promise as a candidate in 1992 before he broke it as president in 1993.

Time’s running out. The investor class vote -- which still looks up for grabs -- has simply got to be a McCain priority if he is to win in November. Rag Mayur doesn’t have his October polling results in yet, but he believes the race will be much tighter than mainstream pundits believe. Message to Sen. McCain: The investor vote could well tip the balance.

The second distinction, a pervasive mood, is deep, widespread, long-lasting and mobilizes people to affect policy makers. A pervasive mood, positive or negative, generates a background assumption that often is the basis for taking the wrong actions. For example, the previous assumption that house prices will rise, combined with the regulatory incentives that made such an interpretation “guaranteed”, led to a widespread expectation by borrowers (and maybe everyone) that their real estate assets would increase faster than their payments would. The current assumption that all mortgages, whether in good standing or non-performing, are worthless has led to a widespread discounting of assets that in the long run will prove to be more reliable and valuable than now assessed.

We have successfully used these distinctions of assessment and action to build and secure wealth. Specifically, when company and economic fundamentals are positive and the pervasive mood is either neutral or positive, negative emotional reactions provide excellent opportunities to bet against the crowd, or rather move against the herd, either buying or selling in a contrarian manner. This works very well when markets are basically rational but interrupted by intermittent irrationalities due to emotional reaction. It is this approach, or rather the wisdom and courage to act against the emotional pull, that separates an experienced investor from the novice or lucky one. Unfortunately it is not enough if the pervasive mood is out of synch with the economic/company fundamentals.

Currently, the market has become irrational due to a pervasive mood, not merely an emotional reaction. This pervasive mood and the policies adopted in response to this mood are now impacting the real economy. By real economy, we mean not merely stocks and bonds but the ability of companies to make, buy and sell. This then feeds back to asset prices, business and consumer behaviors, thus reinforcing assessments and actions that support the pervasive mood and complimentary actions. This vicious circle of selling begetting more selling is where we are now. We are in a selling market, sustained by a mood and its related actions that remain unchecked as the circle feeds itself. This cascade will end at some point. Until it does, the way to preserve the scarce resource (capital) is to join the herd and to sell all the way down. In short, the market can stay irrational longer than many investors can stay solvent.

Over the course of 2008 we have raised cash substantially to near 50%. We hope this is the wrong trade and that markets will resume their uptrend. However, when facing a pervasive negative mood we think it is more important to preserve capital than risk picking the exact bottom. This strategy preserves our ability to act when the vicious circle turns to a virtuous circle. This will happen, suddenly and without notice, except to a few who are monitoring the interplay between these three distinctions. The goal is to preserve capital so that we can play when it is clear we can win the game and when the crowd is in an emotional response that will no longer affect the underlying economic and business financials. When the affects are already known, and the uncertainty diminished for those who are not ruled by their emotions, then the game tips into favor for experienced investors who understand the fundamentals.

The emotional reaction and the pervasive mood always overreact as we're experiencing now. The key is not to know how long a pervasive mood will last but be able to identify and move quickly when the shift occurs before the herd follows. You don’t have to be the first to move on the shift, but you can’t be the last.

Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. We divvy up the stream of payments on these home loans further into tranches of varying risk, compensating holders of the riskier kind with higher interest rates.

We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities.

If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of poorer and hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions.

It might have worked like a dream ― and until about a year and a half ago, many financiers, economists, and policymakers thought that it did.

Then it all came crashing down. The crisis that engulfed financial markets in recent months has buried Wall Street and humbled the United States.

The near $1 trillion bailout of troubled financial institutions that the U.S. Treasury has had to mount makes emerging-market meltdowns ― such as Mexico's ``peso" crisis in 1994 or the Asian financial crisis of 1997-98 ― look like footnotes by comparison.

But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind.

The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who devised credit terms ― such as ``teaser" interest rates and prepayment penalties ― that led unsuspecting borrowers into a debt trap?

Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.

So maybe the culprit is the housing bubble that developed in the late 1990s, and the reluctance of Alan Greenspan's Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations and similar securities went far beyond what was needed to sustain mortgage lending.

That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume.

So the crisis might not have reached the scale that it did without financial institutions of all types leveraging themselves to the hilt in pursuit of higher returns.

But what, then, were the credit rating agencies doing? Had they done their job properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did. Isn't this the crux of the matter?

Or perhaps the true culprits lie halfway around the world. High-saving Asian households and dollar-hoarding foreign central banks produced a global savings ``glut," which pushed real interest rates into negative territory, in turn stoking the U.S. housing bubble while sending financiers on ever-riskier ventures with borrowed money.

Macroeconomic policymakers could have gotten their act together and acted in time to unwind those large and unsustainable current-account imbalances. Then there would not have been so much liquidity sloshing around waiting for an accident to happen.

But perhaps what really got us into the mess is that the U.S. Treasury played its hand poorly as the crisis unfolded. As bad as things were, what caused credit markets to seize up was Treasury Secretary Henry Paulson's refusal to bail out Lehman Brothers.

Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional.

In view of what was about to happen, it might have been better for Paulson to hold his nose and do with Lehman what he had already done with Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money. Wall Street might have survived, and U.S. taxpayers might have been spared even larger bills.

Perhaps it is futile to look for the single cause without which the financial system would not have blown up in our faces. A comforting thought ― if you still want to believe in financial sanity _ is that this was a case of a ``perfect storm," a rare failure that required a large number of stars to be in alignment simultaneously.

So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know.

The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness.

That is why you can be sure that we will have another major financial crisis sometime in the future, once this one has disappeared into the recesses of our memory. You can bet your life savings on it. In fact, you probably will.

Dani Rodrik is Professor of Political Economy at Harvard University's John F. Kennedy School of Government.

Behind all this, the credit system is completely frozen. Banks are now loathe even to lend to each other in the overnight markets that are so vital to the daily financing of American business. And the profits outlook is deteriorating badly, sparking fears that we may have a deep and prolonged recession.

And yet, much good may ultimately come of this terrifying correction.

I commend everyone to read the Wall Street Journal op-ed of Friday written by John Steele Gordon, an eminent financial historian. Gordon writes that there have been financial panics roughly every twenty years throughout American history. He goes all the way back to Hamilton, who orchestrated the first banking bailout in 1792. From this came a regular money-supply system, a credible U.S. government debt system, and something of a disciplined banking system.

Gordon hopes that out of the current crisis we get a better system of well-capitalized banks regulated by a more unified government supervisory apparatus. My view is that the panic will pass and long-run American prosperity will continue. This may seem Pollyannaish right now, but I have great confidence that our free-market economy will come out better, with a strong financial underpinning, when the storm finally ends.

Paradoxical as it may be, strong government actions to stabilize banking are necessary to preserve the free-market-economy system. No free-market economy can survive without stable banking and credit. Without readily available credit, entrepreneurs can’t put their new ideas into commercial practice. And without that vital innovation, economic growth suffers.

The trick now is to use government levers in smart and efficient ways. Banks need to be recapitalized without punishing current and future shareholders. Henry Paulson is working on this. More than likely, the Treasury man and the G-7 finance ministers are figuring out a plan that will temporarily guarantee all short-term interbank lending in the New York and London money markets.

Britain has done this for its High Street banks. But the American and European banks in London are not guaranteed. This is the message of the LIBOR market, which has seized up. As of Friday, the three-month LIBOR dollar rate and its spread against Treasury bills have again increased significantly. This, in turn, is dragging down stocks.

In New York, the market for commercial paper issued by banks also has faltered. In fact, financial commercial paper has dropped nearly $160 billion in recent weeks. That’s why the authorities have to step in with a short-term backstop. Other measures to relieve banks of their distressed assets, backstop money-market funds, and guarantee all banking deposits will have a positive effect over time, as Paul Volcker noted in the Journal this week.

Meanwhile, the Federal Reserve has essentially moved off its fed funds rate target and is instead focused on injecting huge quantities of new cash into the banking system. The most basic money supply controlled by the Fed is now growing at a 16 percent rate after being nearly flat for 18 months. In the last five weeks the Fed has injected nearly $700 billion through a variety of lending facilities. This is important. The demand for liquidity during this period of asset and credit deflation cries out for massive new cash supplies from the central bank.

Then there’s oil, which is almost forgotten in this panic. The $150 oil shock and elevated prices at the pump are what worsened the credit crunch and hastened the recession. But now oil is about $80 a barrel. When the dust finally clears, lower energy prices will be an important tax-cut, pro-recovery factor. Meanwhile, the exchange value of the U.S. dollar is up 16 percent in recent months. That’s an anti-inflationary sign of confidence.

And as John Steele Gordon writes, hopefully we have learned to stop forcing banks to give mortgages to un-creditworthy customers, and to stop encouraging Fannie and Freddie to package these bad loans.

I recall the despair that surrounded the S&L/junk-bond credit crunch twenty years ago. Nobody believed prosperity would return for a long time. Commentators on the left wrote about the decline of the U.S. economy and American power. Yet the 1990s witnessed a strong prosperity boom; the free-market model of capitalism triumphed and the socialist model in Russia and elsewhere collapsed.

Yes, the months ahead are going to be tough. But I remain optimistic that our free democracy and free-market economy will survive this crisis as well.

The same unfortunate mindset meant to shield children from reality has polluted U.S. economic policy. Rather than expose Americans to the very failures that teach us how to succeed, politicians are devising more and more ways meant to protect us from failure. And, they pass laws that keep others from succeeding so those who are not rich don’t feel bad.

Taxation. Start with the presidential candidates, John McCain and Barack Obama. When McCain was asked in a November 2005 Wall Street Journal interview about his opposition to the 2003 income and capital gains cuts, he didn’t oppose them on economic grounds. Instead, he felt they were “too tilted to the wealthy and I still do.” Asked to clarify his position, McCain explained, “We have a wealth gap in this country, and that worries me.”

In April of this year, ABC’s Charles Gibson asked Barack Obama about capital gains taxes, specifically why he would seek to raise them at all “given the fact that 100 million people in this country own stock and would be affected?” Obama’s response paralleled McCain’s in that he would like higher taxes on capital formation “for purposes of fairness.”

When it comes to taxes in general, Barack Obama has made it plain that he would raise the tax rate on the highest earners, while John McCain comforts his supporters with a promise that he would penalize the earnings of the rich at a lower rate. Both candidates miss the disincentivizing nature of taxation.

Realistically, taxes should be seen as a price or a penalty against effort. This is important because no matter how many times politicians tell us they’ll stimulate the economy through income redistribution, the fact remains that economic growth is always and everywhere a function of productive work effort. Or, as Andrew Mellon (Treasury secretary under presidents Harding, Coolidge and Hoover) noted in Taxation: The People’s Business: “when a man’s initiative is crippled by legislation or by a tax system which denies him the right to receive a reasonable share of his earnings, then he will no longer exert himself and the country will be deprived of the energy on which its continued greatness depends.”

Both Obama and McCain miss Mellon’s point because in quibbling over the correct rate for the most productive taxpayers, they’re advocating that success should be penalized at a higher rate than lack of success. That the vital, productive few create enormous opportunities for every American seems to concern neither.

Obama also embraces the notion of an earned income tax credit (first floated by free-market hero Milton Friedman) whereby those whose economic production is low will not only escape tax, but be rewarded with a rebate from the government funded on the backs of the more productive among us.

The message from our federal minders couldn’t be clearer: if you succeed your reward will be higher taxation; and if you fail, government will embrace your failure through subsidies that reward a lack of productivity. In short, the broad economic message of both political parties retards economic growth by penalizing the productive in order to coddle those who aren’t. Everyone gets a trophy whether it is deserved or not.

The pursuit of happiness. Some say that financial wealth is but one measure of success, and that it is misleading to measure success in terms of one’s bank statement. At first blush this might make some sense, but only briefly.

To the extent that many Americans choose the arts, academia or nonprofits as their path to happiness, it must be understood why they’re able to follow their passions. Indeed, behind nearly every artist is a wealthy patron whose success has enabled the painter to paint. One need only visit the various museums on New York City’s Fifth Avenue to see that commercial success (see New York’s Frick, or the board of directors for the Museum of Modern Art) is what makes the pursuit of a career in art possible.

While university teaching is often hostile to wealth creation, it’s safe to say that a great deal less would exist (see the names on the buildings at Harvard, Stanford and University of Chicago to name a few) absent the eleemosynary nature of the rich. When Joseph Schumpeter wrote in Capitalism, Socialism and Democracy that capitalism’s “very success undermines the social institutions which protect it,” he doubtless had academia in mind.

The economy’s success also governs the work of charitable organizations. In 2007, charitable donations from Americans hit a record of $300 billion. But a recent newspaper headline noted that “Nonprofits Brace for Slowdown in Giving”. Sure enough, nonprofits frequently only exist thanks to the generosity of the rich. And with the rich in many cases hurting in this uncertain economic climate, the ability of charitable organizations to continue their missions will be severely compromised.

So when it is said that the rich must give back, or that they must be taxed at a higher rate for the “greater good”, those not rich should remind themselves why they get a “trophy” despite pursuing work that has little to do with wealth creation. Rather than greedy misanthropes, the rich are society’s benefactors. Those who countenance their penalization will also pay the price.

Bailouts. As is well known now, weak-dollar mischief this decade (meant to aid ailing manufacturers) has distorted investment in favor of the “real” while fostering an investment slowdown. The bill for bad policy from Washington has in the past year brought such harm to financial institutions that many believe we’re in the midst of the worst financial crisis since the Great Depression.

Sadly, much as in the ’30s, rather than allow the prices of houses, banks and the underlying securities on bank balance sheets to reach market-clearing levels, the federal government has inserted various new rules along with taxpayer money to soften the pain. Even if we ignore the fallacious assumption that money taken from the private economy can be profitably put back in, we should at least question this “everyone gets a trophy” philosophy that says no one can fail.

Homeowners are already subsidized by preferential capital gains treatment, tax-deductible interest payments and government-funded mortgage securitization. Treasury Secretary Paulson has now asked lenders to “voluntarily” rewrite mortgage contracts, while instituting an 800 helpline to the federal government for those fearful of defaulting on payments. During the last presidential debate, McCain, presumably seeking the votes of the irresponsible, said if elected that he would "order the secretary of the Treasury to immediately buy up the bad home-loan mortgages in America and renegotiate at the new value of those homes." The nationalization of Fannie Mae and Freddie Mac was, among other reasons, done so that the federal government could more aggressively step into the housing market with taxpayer dollars.

So while 95 percent of homeowners are still making their house payments on time, the government is subsidizing many who borrowed money that they won’t be able to pay back. The tax dollars of Americans who waited out this decade’s property boom in hopes of buying amid any downswing are spent to prop up the value of homes purchased by the irresponsible.

Short-selling. Short-selling of shares is a risky, but essential, market process whereby negative sentiment is introduced into the stock prices of publicly traded companies. But with various financial firms apparently unhappy with investor opinions of late, the SEC recently banned short sales of 799 firms supposedly harmed by those bears.

Investors had grown accustomed to parking their cash with money-market funds, but after holdings of Lehman Brothers debt led to a “breaking of the buck” in the Reserve Fund, the Treasury announced a $50 billion dollar bailout of money-market firms. The money for this will come from Treasury’s exchange-stabilization fund. Somewhat ironically, the money that Treasury could have used throughout this decade to resist the dollar’s decline will be used to stabilize the very funds harmed by Treasury’s weak-dollar policies.

And with financial institutions still in trouble thanks to bad investments on their books, Treasury Secretary Paulson pushed a $700b bailout plan through Congress meant to buy non-performing assets from struggling financial institutions. Implicit here is the assumption that the federal government has a hotline to the future that private investors lack. Instead of reducing corporate taxes and other penalties on business success, the government once again coddles business mistakes rather than rewarding achievement.

Absent a policy climate that rewards economic failure and irresponsibility, much of what vexes us now would not, or at the very least would be far more contained. But thanks to a political class that believes everyone deserves a trophy, we’ll never know what private economic actors might have done minus the presence of a money-wielding government. Whatever the ultimate result, the bailouts retard the process whereby devalued assets get into the hands of intrepid investors who possess huge incentives to make that which is hurting thrive.

Worse, the bailout culture will cruelly blind most Americans to the lessons learned through failure that very necessarily tell them how to achieve. Indeed, without failure, there cannot be success. So while everyone will perhaps get a trophy from the “benevolent” hand of Washington, it will be at the expense of long-term health and wealth for all.

The events of the weekend can be broken up into (i) the G7 communiqué; (ii) U.S. Treasury Secretary Paulson's press confidence on Friday night; (iii) the plan announced by the Euro-15 nations after the G7 communiqué; (iv) the further broadening of access to liquidity for financial institutions by global central banks; (v) other developments and announcements. Where do we stand relative to our wish list? The truth of the matter is that there was good news (e.g. the focus on the need to recapitalize financial institutions) and not so good news (particularly the lack of a coordinated guarantee of interbank lending and, contrary to Paulson's assessment at the press conference on Friday, we do not consider ourselves "naïve" in looking for such an outcome). On balance, however, there appears to be more good news than bad news and we would look for some easing in LIBOR pressures and some stabilization in equity values in the days ahead. However, we are disappointed that the G7 did not announce a plan that looked like a global version of the U.K. plan developed by Chancellor Darling and announced last week.

(i) The G7 Communiqué

The G7 communiqué was a statement of principles rather than a plan. However, the principles were at least focused on how to tackle the financial crisis. Below is the full text of the statement (we have broken up the bullet points for clarity):

"The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.

2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.

3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.

4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.

5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan."

These principles are comprehensive and, if policies are designed with them in mind, we should see a significant easing in the credit and money market freeze over the next few weeks. We are pleased that the G7 members are seeking to prevent the failure of financial institutions and the key phrase is "Take all necessary steps to unfreeze credit and money markets."

(ii) Paulson's Press Conference

We were disappointed that Paulson did not embrace the notion of guarantees of interbank loans. Indeed, he suggested that some commentators were "naïve" if they expected a coordinated plan in this regard. Perhaps it was naïve of us to expect the G7 to follow the outline of the terrific plan formulated by the U.K. government. The U.S. TARP plan, however, looks likely to be reworked to inject capital into U.S. financial institutions. However, in a global capital market, individual country solutions may be suboptimal to a global solution. One of the things to key on this week is the fate of Morgan Stanley and the proposed capital injection from Mitsubishi UFJ is reportedly being renegotiated (hardly surprising given the near-60% drop in Morgan Stanley's stock price last week). One of the sticking points appears to be the concern on the part of the Japanese that if Morgan Stanley has to be put into conservatorship (like AIG and the GSEs), the holders of preference shares could suffer severe losses. However, more encouragingly, Dallas Fed President Fisher told the IIF this weekend that "the Federal Reserve will do whatever it needs to do to be a credible backstop for the financial system" and added that the Fed will explore every avenue and option to ease credit conditions in the current crisis. We hope one thing that the Fed does is to include wholesale bank CDs (an important source of bank funding) in its CPFF program. Bank wholesale CDs carry similar ratings as bank CP and we hope the Fed will correct this potential oversight.

(iii) Euro 15 Actions

Following the G7 meeting, a summit of the leaders of the Euro 15 nations, chaired by French President Nicolas Sarkozy, worked on a plan for the European financial system. Sarkozy said "we need concrete measures, we need unity, which is what we achieved." The key measures were: (i) a promise to guarantee through end 2009 bank debt with maturities of up to five years; (ii) approval for governments to buy bank stakes (a necessary exemption given European competition rules); and (iii) a commitment to recapitalize systemically important banks in distress. This meeting went much better than the summit that took place eight days earlier and suggests that European leaders appreciate the importance of the problem. We would also argue that this plan is more concrete than the G7 communiqué.

iv) Early Monday morning, major global central banks announced further measures to provide access to liquidity and funding to financial institutions. The ECB, Bank of England and Swiss National Bank will offer unlimited U.S. dollar funding via 7-day, 28-day, and 84-day auctions. These funds will be provided at a fixed interest rate, set in advance of each operation. To support these auctions, the sizes of the reciprocal currency arrangements between the Fed and the ECB, BoE, and SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded. In addition, the Bank of Japan will considering introducing similar measures.

(iv) Other Developments

Other countries outside the U.S. and Euro-15 are taking steps to address the crisis. Oil-rich Norway, for example, announced a plan to swap up to 350 billion kroner ($55 billion) of government debt for mortgage assets, which can then be used as collateral for borrowing (this appears to be similar to the TSLF). It appears in the U.K. that HBOS and RBS are at the top of the action list, with some reports suggesting that the U.K. government may take majority stakes in both firms.

Our Assessment

Despite our disappointment at U.S. resistance to guarantee interbank loans, it appears that a lot of action is being taken to stabilize the financial system on an unprecedented scale. Moreover, if at first policymakers do not take dramatic enough action, they seem capable of revising their plans. We said the markets needed shock and awe tactics and the steps that have been taken so far are very significant. If markets continue to melt down, we would not be surprised by a global guarantee of interbank lending.

Many of these programs will take time to implement and there may well be a few rough trading sessions over the next few weeks. Nonetheless, it is our hunch that the scale of the promised interventions may put the worst of the market drops behind us. Indeed, European equities markets and U.S. equity futures have rallied strongly on these announcements. Confidence will take time to restore but this is an entirely different response than met the Wall Street Crash of 1929 and the risk of an extreme economic outcome has, in our view, diminished significantly. We are still in a U.S. and (likely) a global recession, but the equity markets have discounted an awful lot of bad news and we are feeling more neutral on the outlook for stocks. We will be watching LIBOR and EURIBOR resets carefully over the next few days as an important barometer of the progress that is being made in stabilizing the financial system. This morning, LIBOR rates were little changed as, for example, three-month U.S. dollar LIBOR fell to 4.75% from 4.82%. We expect the Fed to follow up these measures with a rate cut on October 29th and we have a year-end funds target forecast of 1%.

But then something happened: He fell off the political deep end, becoming at times an unhinged ranter against all things Bush, Republican and conservative. Nothing wrong with that, except it affected his once-lucid economic thinking.

Starting in 1999, when he began writing regularly for the Times, he started pushing weird, discredited left-wing economic notions in the media for all to see. Many in the economics profession were alarmed, to say the least.

He nonsensically argued, for instance,that 9/11 would have "favorable effects" on business investment and infrastructure spending, and that wealth disparities were bad because "if the rich get more, that leaves less for everyone else" — a statement that's false on its face, and not, as Krugman asserts, "simply a matter of arithmetic."

And, of course, he often argues strenuously in favor of redistributionist tax schemes that would hurt the economy and turn us into a slightly less stagnant version of Europe's welfare state.

Other economists were far more deserving than Krugman. Did the Nobel committee pick him mainly because he's a virulent critic of President Bush? (Recall, that was a reason for handing harsh Bush critic Jimmy Carter the Peace Prize in 2002, and widely surmised as the reason for global warming advocate Al Gore's prize, too.)

Much has been done to tarnish the Nobel brand in recent years, but nothing as much as the politicization of key awards that Alfred Nobel funded more than 100 years ago. Should we just strip his name from the honor and call it what it's become: the Bush Dementia Syndrome award?

In 1999, each dollar TFA produced $0.379 of GDP. As the housing boom took hold and capital was misallocated from business investment to housing, the GDP/TFA ratio fell steadily, sinking to 0.330 in 2007.

At the same time this was happening, the ratio of Residential Fixed Assets to Total Private Fixed Assets rose steadily, from under 0.500 during the economic boom of the 1990s to a peak of 0.546 in 2005. It then declined somewhat, to 0.535 in 2007. These numbers are unprecedented in the post-war era. The average for the 50 years from 1948 to 1997 was 0.498. The previous post-war high was 0.523, and this was in 1954, when the nation was catching up on housing following the Great Depression, WWII, and the Korean War.

If the artificial housing boom had not occurred, it is reasonable to expect that the fixed asset ratios would have stayed close to their values during the 1990s. If so, by 2007, we would have had about $1.2 trillion less invested in housing and $1.2 trillion more invested in business. Interestingly enough, $1.2 trillion is in the ballpark of current estimates of the write-offs that will ultimately be taken on mortgage loans.

Even more importantly, 2007 GDP would have been about $15.9 trillion rather than $13.8 trillion. And, we would not now be facing a nasty recession.

The best metric for comparing economic scenarios is the “present value to the infinite horizon” of future GDP and Federal revenues. This is the approach used by the Social Security Trustees to calculate the “unfunded obligations” of Social Security and Medicare.

Counting both the GDP lost to misallocation of capital and GDP lost to the recession caused by the inevitable “bust”, the housing boom cost America $284 trillion. Given that the Federal government typically collects 18.5% of GDP in taxes, the Treasury’s share of this is about $52.6 trillion. This is almost nine times the national debt, which is currently about $6.0 trillion.

Stated another way, the housing boom and bust reduced the present value of both future GDP and future Federal revenues by about 17.5%. This is a staggering cost. How did it happen, and what can we do about it now?

Americans are willing to invest capital in business, but business investment is risky. They would rather have a “sure thing”. During 2001 – 2007, policy errors by the Federal Reserve and Congress turned housing speculation into what looked like a “sure thing”.

Starting in 2000, the Federal Reserve began fighting the deflation it had caused in its mistaken efforts to curb “irrational exuberance” in the stock market and the real economy. By late 2003, it had gone from fighting deflation to causing inflation.

When the Fed creates excess liquidity, it has to go somewhere. Since the markets know that the value of the dollar is falling, they will direct the excess liquidity into assets that are perceived to be inflation hedges. Some of the excess liquidity went into commodities, but most of it went into housing. In the process, it commandeered capital that would otherwise have gone into business investment.

At the same time that the Fed started inflating, Fannie Mae and Freddie Mac, under mandate from Congress, began buying and guaranteeing massive amounts of “sub-prime” mortgage assets. From the market’s point of view, this converted risky loans into the equivalent of Treasury bonds—but with higher returns. It also permitted lenders to earn easy profits by originating risky, sub-prime loans and selling them to Fannie and Freddie (and to private investors trying to compete with these entities).

Meanwhile, the Fed’s inflation pulse was causing housing prices to rise. This made investment in housing look like a “sure thing” to both home buyers and mortgage lenders. At the same time, all of the things that Congress had done starting in 1977 to encourage “sub-prime” lending made it possible for people to play the housing game with no financial risk to themselves. People understood that buying a house that they could not afford with no down payment was a game of “heads, I win; tails, somebody else loses”. Also, people with no capital could now speculate in housing, which they could not do in, say, commodities.

The game created by Congress and the Fed made perfect sense for the individuals playing it. They were simply responding to incentives created by government. Unfortunately, the game made no sense for the economy as a whole, and it could not go on forever.

So, how do we dig ourselves out of a $284 trillion economic hole? We do it with economic growth. And how do we get economic growth? We get it with private capital investment. Only private business investment can produce real jobs and real growth. Government programs cannot produce economic growth. If they could, communism would have worked.

The first thing that we must do is to stabilize the dollar. H.R. 6690, which was introduced by Congressman Ted Poe on July 31, would do this by requiring the Fed to stabilize the dollar at a value equal to 1/500th of an ounce of gold. A stable dollar would mean no more bubbles, no more busts, and no more financial panics.

The other thing we need to do is to reduce the tax burden on capital investment. H.R. 6690 would take a step in this direction by permitting “first year expensing” of all capital investment. However, it would be even better to adopt the FairTax, which would replace all Federal income, payroll, and death taxes with a national retail sales tax. The FairTax would not only eliminate all taxes on saving and investment, it would eliminate the huge economic burden of complying with our complex tax code. As a bonus, the FairTax would raise the market value of all existing homes by 10%, or more, while at the same time making housing more affordable than it is now.

The combination of a stable dollar and the FairTax would boost America’s rate of real economic growth to well over 3 percent per year. At growth rates above the interest rate on government debt (which the Social Security Trustees estimate at 2.9%), the present value of future GDP is infinite. The present value of future Federal revenues is also infinite—at any non-zero FairTax rate. This would not only get us out of the financial “hole” created by the housing boom, it would assure America a prosperous future.

One sign of the good news is that even in places where the private economy is shrinking rapidly, government continues to expand. California, for instance, is plagued by a collapsing housing market which accounted for 28 percent of all U.S. subprime mortgage foreclosures in the first quarter of this year. The state’s unemployment rate is a whopping 7.7 percent. Legislators have been grappling in Sacramento with a $15 billion budget shortfall for months, and recently Gov. Schwarzenegger said he might need to ask the federal government for a $7 billion loan to tide the state over. No matter. The public sector continues to add jobs, albeit modestly, in California--a ray of hope in an otherwise dismal economic picture.

The scene is much the same in New York State. Although the Empire State might be seen as ground zero for the current fiscal crisis, given the collapse of institutions like Lehman Brothers and the general turmoil on Wall Street, public sector employment is holding up rather well, and state leaders seem determined to keep it that way. The state’s Assembly has already voted in favor of a tax increase on those earning more than $1 million—though no one knows how many millionaires will be left in New York after the turmoil in the markets. The state’s governor, trying to avoid tax increases which he thinks would further harm the local economy (what’s up with that?), is instead appealing to the federal government to send billions of dollars to New York. That would keep government programs and public sector jobs buoyant amidst the worst financial crisis since the Depression.

What’s happening in New York and California is characteristic of the rest of the country. More than half of the states have faced budget deficits this year, including more than a dozen which adopted what turned out to be overly optimistic budgets and suddenly confronted big shortfalls in mid-year tax collections. Fortunately, local government hiring is up a robust 1.5 percent in the last 12 months. Where would those states be without all those extra government jobs at a time like this?

There’s more good news. These aren’t just any jobs, not low paying jobs or dead end jobs. These are good jobs. A few years back, for instance, the Citizens Budget Commission, a New York group, compared public and private sector wages throughout the New York metropolitan region and found that public workers on average received 15 percent higher wages for the same jobs. Adding in benefits, the differences are even more striking. The nonpartisan Employee Benefit Research Institute concluded in a 2005 study that the average state and local government worker gets 46 percent more in compensation than the average private sector worker. Underlying that difference are stark contrasts in benefits spending, such as spending on employee retirements which cost governments 162 percent more per worker more than what private employers pay.

Faced with threats to this robust sector, state officials and policy experts have begun arguing that the federal government, which is allowed to run budget deficits (and is doing quite a good job at that), should be pouring aid into the states, even at the cost of further increasing the red ink in Washington. Otherwise states would have to raise taxes (which, after all, government workers pay too), cut spending, reduce services, and trim wages and benefits.

A few killjoys have argued that the federal government shouldn’t be so quick to subsidize further state budget gaps because Washington’s own deficit is scheduled to double in the next few years, even without accounting for the $700 billion bailout that’s supposed to save our financial system from ruin. Instead, the critics argue, state governments should respond to the crisis by having workers do more with less, while local government leaders might seek innovative solutions like managed competition and competitive bidding of public services to bring down costs and headcount. Elected officials might also bring public sector benefits packages in line with the private sector.

But I say, what are these critics trying to do, kill the one bright spot in our economy?

The above in mind, don't be surprised that when Americans possessing bad credit histories complain to politicians that they cannot get car loans, that the government will "softly" suggest to the lenders whose shares they own that they would do well to lend to people who are deeply in debt. Politicians will claim that no one can get to work without a car and no American can save money in tough economic times, so therefore they are saving America by requesting that car loans be made. Politicians forget that people, when left to their own devices, can easily join carpools.

Another point many forget is that governmental debt guarantees (seemingly made daily) are to some degree worthless. That is so because the government must print money if the guarantees are to be honored. The printing of more money will eventually lead to even higher rates of inflation that all Americans will suffer under. In short, the money that funds all manner of "compassionate" government programs must come from somewhere.

The banks the U.S. Treasury is placing money with will eventually be forced to finance all kinds of politically favored industries, all to save America. Freedom of our financial institutions to lend only to economically viable projects will be curtailed.

Recently we were told by the political class that businesses could not meet payroll, yet no significant increase in first-time unemployment claims occurred. Politicians claimed if they did not get their way a depression would ensue. They said commercial paper markets were frozen, yet the logical next step of mass layoffs never materialized.

In the 1970's this writer was issuing commercial paper for a company until "tight money" made cash for daily operations dear. The firm's commercial paper was backed by bank lines of credit and my company accessed those lines of credit when commercial paper was difficult to sell. Our lenders were very unhappy and told us as much, and the result was that we were forced to cut inventory and receivables in order to reduce the need for credit. Back then, companies either did what the banks wanted or risked bankruptcy. Then as now, banks did cut off businesses with poor credit histories.

Looked at in stock-market terms, the current decline is not just a panic by over-leveraged investors. While the latter has played a role, unspoken of is a liquidation of shares by intelligent investors who understand that centralized planning of bank-lending practices is on the way, and they're aware of the negative economic consequences that always reveal themselves when the power of governments grows.

The severe curtailment, or even destruction of capitalism in the United States has begun with many in the mainstream media happily repeating whatever the politicians claim. President Bush's assertion that we must interfere in free markets to save those same free markets is positively Orwellian.

Worse, look for further economy-enervating maneuvers by politicians, which will give the federal government even greater control over the most successful economic system the world has ever witnessed. And if politicians don't get their way as they seek to march us farther in the direction of serfdom, expect even more in the way of hysterical cries of Armaggeddon.

Unless voters elect people who will restore economic freedom so that those who make bad decisions go bankrupt and learn from their mistakes, the future for citizens of the United States will be one where the American dream of self-made success is mostly a thing of the past.

Culprits in this yearlong financial train wreck are many. The extremes of leverage and risk taken were unthinkable. But make no mistake: Unbridled short selling also played a role.

The SEC's fateful decision to repeal the rule has exposed us to the very same "bear raids" and "runs on the banks" that prompted the rule's original enactment in 1934. Prudent lessons learned from the crash of 1929 and the ensuing Depression have been unlearned and, in the process, left us unprotected from predatory trading abuses and financial terrorism.

Reasons given for the repeal show a regrettably shallow understanding of the issues. Fact is, politicians have been pressured for years by influential, deep-pocketed hedge funds and financial institutions that wanted faster, cheaper trading venues and looser rules.

The SEC studied the effects of repeal by conducting its pilot program on 1,000 stocks for 12 months from May 2005 to April 2006. Unfortunately, this was a period of low volatility that saw the Dow advance from 10,404 to 11,366 in an orderly fashion. The uptick rule was not enacted for such periods of tranquility. It was enacted as a lifeboat for severe financial upheavals such as those in 1929-1933.

Another excuse for repeal was that, in the era of decimal trading, the rule is impotent. But this is not about the increments of the uptick itself; it is about the negative obligation (in specialist speak) of not being able to short a security repeatedly lower and pound it into the dirt.

Besides, the rule does not have to apply to an uptick of a few cents. It can just as easily require, say, a 10-cent uptick for stocks priced below $20, and 25 cents on those above.

The evidence that volatility has increased after the rule change is powerful. A study by Birinyi Associates in April 2008 shows that after the rule change the VIX (Volatility Index) increased immediately from 13.25 to 23.55. In addition Birinyi showed that during the same period, the absolute dollar value of the daily change in each stock in the S&P 500 increased to $1.77 from $1.02.

Even more compelling is a chart showing the volume of stocks purchased on plus ticks (higher prices than prior sale) and those purchased on minus ticks (lower prices).

The real date — July 6, 2007 — shows an immediate and dramatic shift in volume from plus ticks to minus ticks, suggesting unbridled shorting pushing prices lower. Proponents of the repeal say these data are just coincidence. We think not.

Finally, much has been written and reported about the role of predatory shorting in the demise of Bear Stearns and Lehman Bros. Clearly, both of these venerable investment bankers were in serious trouble. Yet, if one carefully analyzes the price and volume action in the final five days of their dramatic declines (when most of the damage was done), the evidence is compelling.

Bear, with a float of 159,098,000 shares, traded down from $61.58 to $2.84 in just five trading days (March 14 to March 20) on stunning volume of 669,737,000 shares, or 4.2 times its total float.

Lehman had similar footprints, diving from $16.20 to 15 cents in five days on almost three times its floating supply. In the process of these startling declines, these firms' ability to fund their businesses disappeared, and both failed.

All this, according to many crusty old traders, smells like a replay of the 1929-33 bear raids that the uptick rule was designed to prevent from ever happening again. Proponents of repeal think not. The difference is that the traders can shake their heads and move on to the next trade.

Those who stand by the repeal must bear the burden of knowing that their poorly researched decision and reluctance to admit their mistake has put our very nation, our markets, our economy, and indeed our national security at risk. The uptick rule needs to be reinstated now.

Indeed, this week’s announcement that Henry Paulson’s Treasury will buy stakes in U.S. banks regardless of their health, and regardless of their desire for government funds would be truly shocking if we hadn’t already been conditioned to a resurgent federal government under the alleged heirs of Reagan conservatism. Sure enough, if there previously existed any uncertainty about the level of policy principle within today’s GOP, those questions were answered this week.

There is none. The very leaders voters sent to Washington based on their stated belief in small, non-intrusive government have betrayed those same voters on a stratospheric scale. What’s remarkable is that GOP partisans still comfort themselves with knowing references to the “socialist” instincts of Barack Obama; these comments made despite a growing level of federal intrusion by card-carrying Republicans into the workings of private markets that would make the few remaining New Dealers in our midst blush.

The Paulson plan to force formerly private money into banks was attempted once before; on President Herbert Hoover’s watch. Apparently untroubled by the past result, Paulson will try again. So if we’re willing to ignore the unfortunate history when it comes to a government-owned banking sector, it’s at least worthwhile to discuss the various holes and contradictions that are part of the Paulson plan.

First up, the federal government will now “guarantee new debt issued by banks for three years” as a way of encouraging interbank and customer lending. What’s impressive here is the very arrogance of such a proclamation. Last this writer heard, the federal government creates no wealth; meaning those in America who pay taxes will guarantee all government debt. The plan also presumes that the very kind of careful money that was not being lent in the private sector can somehow be taken from that same private sector, shoved into banks by bureaucrats, and then be lent out profitably despite market signals suggesting the opposite.

From an economic perspective, the above becomes even scarier due to the basic truth that capitalism is reliant on the efficient deployment of capital. But with the federal government as backstop, the need to be prudent when it comes to lending will become less pressing. Not only is Paulson seemingly unaware of Hoover’s mistakes, but he’s also unaware of what happened the last time Congress effectively told the S&Ls to go hog-wild with the funds entrusted to them.

Furthermore, it’s quite simply naïve to assume that in return for debt guarantees, the federal government won’t require new forms of non-economic lending. Many have made lots of noise about the Community Reinvestment Act, but with the federal government a preferred shareholder of the banking system, won’t the CRA become a minor nuisance relative to “soft” requests made to banks for loans to other politically preferred entities? As it is, Neel Kashkari, Paulson’s young lieutenant charged with oversight of the unfortunate plan, has made plain that a bank’s minority and/or gender status will be carefully considered when the money is passed around.

Treasury officials will of course protest that new federal oversight means more prudent lending, but even if this were somehow a good thing (the U.S. economy in the ‘80s was largely built on loans to firms whose debt was referred to as “junk”), the certain emasculation of our banking system by our federal minders promises to be bad for the innovation that will be lost.

For those who doubt the above, they need only reference the curtailment of executive pay that is part and parcel of the nationalization plan. And there lies the contradiction: Paulson et al ask us to have faith in their activities out of one side of the mouth, then they expect us to believe this will work alongside compensation rules that will surely drive the best-and-brightest away from the banking sector. Taxpayers beware.

Lastly, as Lawson noted in The View From No. 11, what “public ownership does is to eliminate the threat of takeover and ultimately of bankruptcy, and the need, which all private undertakings have from time to time, to raise money from the market.” Exactly. It is the fear of takeover, and the fear that markets will ignore capital requests that drives banks and companies of all stripes to be more efficient. With one fell swoop whereby Paulson is forcing all banks to take government money, the total sector’s future strength is understandably a major question mark.

Establishment economist Joseph Stiglitz has said in response to recent market troubles that “those who believe in free markets have received another rude shock.” But he mistakes the process in which markets correct for Washington mistakes with actual mistakes of capitalism. In short, Stiglitz misses the point.

What we’re experiencing is the correct market response to a collectivist ideology that has infected the political class. The weak-dollar policies of the Bush administration meant to redistribute wealth to the manufacturing and commodity sectors were surely the match that lit the property fire given the “money illusion” that made home purchases more and more profitable in terms of weakening dollars. Added to that, both parties to varying degrees endorsed all manner of lending practices given Washington’s politically correct, but ultimately impoverishing view that homeownership is something good.

So while Paulson and politicians generally will say bank bailouts are a necessity, be very wary. If you didn’t like the end result of government subsidization of the housing sector, just think how you’ll feel once the preferred owner of banking shares imposes its “compassionate” ideology on other parts of the economy.

Lawson concluded that the dangers of state ownership were “greater than even the Thatcher government realized.” But in a blast to the past, one that will bring us less economic vibrancy alongside rising unemployment, the very GOP operatives who would publicly refer to Thatcher and Ronald Reagan as the 20th century’s greatest leaders are seeking to undo all that they accomplished. So this is why we elect Republicans?

Kudlow: Do we have to take a recession? Are we in a recession right now, sir?

Paulson: Well, Larry, what I'm saying is, we're clearly in a difficult period, and it clearly -- the financial turmoil and the very, very difficult time we've had where the credit markets have frozen up, and when loans weren't being made, weren't being made to small businesses, people -- it was hurting jobs, it was hurting confidence, and this has to have an impact. And it's having an impact. But by far the most important thing we can do here is stabilize the markets, stabilize the banking system, and I'm very confident that the moves we've done, taken, will do just that.

Kudlow: All right. I want to get into all those things. They are very important points. Let me begin – front -page stories in all the major papers today. When you unveiled on Monday your rescue package to the nation’s top bankers, apparently it was a somewhat contentious meeting. I want to ask you, first of all, are the major bankers with you? Are they on your team for the rescue package? Second of all, what was the biggest bone of contention in that meeting? What was it you had to sell them on?

Paulson: Well, Larry, let me begin by saying I don’t believe it was a very contentious meeting. I think it was a candid meeting. I think it was pretty extraordinary to get nine bankers running key institutions – institutions with 54 percent of the assets, 50 percent of the deposits in the United States of America -- and to get them to sign up for this plan.

What I said to them was – this is about the United States of America – it’s about our economy – it’s about our banking system and this is a program for healthy banks. This is not about failure. We want healthy banks to participate in this, because healthy banks need to be well capitalized. They need to be dealing with other healthy banks and with businesses. They need to be deploying their capital. This will be good for the country, it will be good for the system, and good for all of you.

Kudlow: How did you persuade my friend Richard Kovacevich, who runs Wells Fargo? He seems to be the most prominently mentioned. I wasn’t at the meeting and he didn’t talk to me, but from the news accounts, how did you talk him into coming on board?

Paulson: Well, I’ve got to say this. We talked to everyone and there are institutions that could survive just fine without more capital – they have adequate capital – but they need to be well capitalized. What we want to do is to come up with a program. Remember something else about this program. There is nothing punitive about this program. This is a program that said to all the investors that want to come into the banking system, that when the government comes in it is not coming in to squash private investment.

Kudlow: Private shareholders.

Paulson: Private shareholders. No, it is encouraging private shareholders to invest in these banks. So, this is about increasing confidence in the banks and about increasing confidence of the banks and the banking system so that they can be proactive in deploying their capital.

Kudlow: Did some of these bankers worry about management control exercised by the Treasury Department? I mean clearly there are limits to executive compensation. There are limits with respect to dividend payments. And there are generic issues -- will you exercise your warrants and will you exercise voting strength. In other words, is this nationalization? I think that’s on the minds of a lot of people.

Paulson: Well anything but. Anything but and this is about taking the preventative action so we don’t need to do any more radical things. Let me just take the issues you mentioned one at a time. These are relatively small positions in ownership terms. These are passive investments. Management -- this is not anything like what you suggested.

In terms of executive compensation, there was broad agreement in that room that this is an important topic. No one spent time debating executive compensation. I explained what the law required and that we were going even further and that there wouldn’t be golden parachutes. If there were profits based upon financial information that turned about to be materially misleading, that compensation would be given back.

Kudlow: Both of which the country seems violently opposed to – the political nature of the country right now is so much against that kind of thing.

Paulson: And also that we couldn’t have incentives that made compensation based upon excessive risk-taking. All of those CEOs in that room understood it. As a matter of fact, when I outlined it, one of the CEOs said “Hank, why are we even spending time talking about this? Of course, we get it.”

Again, these are investments that are good for the country and good for the banks. These are temporary investments to bolster confidence and to bring capital to the system. It will be deployed and the economy will pick up and these investments will be refunded.

Kudlow: Do you think that with the preferred stock and all the other aspects you just described – really, you say passive investments, not active management control – will that attract private shareholders and private capital, not just the shareholders today, but the potential shareholders tomorrow?

Paulson: Absolutely. I think where people have gotten confused is there have been situations where we’ve had to come in where there is a failure. That is a totally different proposition.

Kudlow: AIG. Fannie and Freddie.

Paulson: Yes – that’s failure. That’s where you have to come in. This is about attracting private capital and it was clear to the whole world that these preferred share investments are going to come in right alongside other senior preferred and not senior to them. And again, preferred doesn’t vote with common shares. The warrants are for 50 percent of the value of the preferred shares. And again, the warrants are for non-voting common shares. So, this is about capital and protecting the American people by getting our financial system working the way it’s supposed to work. So, we’re going to be able to create jobs. This is about people’s 401k plan. This is about loans to send their children to college and keeping our economy going. That’s what it’s about.

Kudlow: So many people want to know. People stop me on the street – callers on my Saturday radio show – how can you get the bankers to deploy the government capital that you are injecting? For example, the yield on the preferred is 5 percent. Their cost on the preferred is 5 percent. Some of them have preferred stock that is 11 percent in yield. They have bonds outstanding that are 7, 8, 9, and 10 percent. What is to stop them from getting new government money at 5 percent and retiring the outstanding paper that is much more expensive, rather than deploying this new capital in the economy for the purposes you just described?

Paulson: Well, that's a key question, and let me say, even before that, the reason we set the terms where they were set, we didn't think this term should be set at what the market would demand in a crisis situation. That's why the government's coming in to begin with. We wanted the terms to be like what you would have in a normal situation.

Now, the way you get bankers to deploy the capital -- because they know it's their job to deploy the capital, making the loans which are so vital to our economy -- the way you get them to do that is they've got to have, first of all, plenty of capital; they've got to be well-capitalized. Secondly, they've got to be confident in the system. They've got to be confident that as the money flows between and among banks that they're confident in that and confident in the strength of the system.

Kudlow: Rather than pay down their own debt.

Paulson: They’re not going to be paying down their own debt. The regulators understand that and they understand that.

Kudlow: Will you jawbone from time to time -- that's a bad word, jawbone -- will you be talking to them in consultation as you did on Monday, for example?

Paulson: I will clearly be doing that, but I will also say to you that they understand this, and regardless of whether we had government investments there, we would be jawboning and encouraging them to do the right thing. And I will say it will be a lot more effective if people aren’t afraid. This is about confidence and confidence in the financial system.

Kudlow: Mr. Paulson, let me just ask you another question that I hear a lot. People are relieved that you are guaranteeing, the FDIC that is, is guaranteeing the interbank lending. The LIBOR markets are frozen up. Some say the New York markets are frozen up for the short-term loan. That’s a huge drag on the whole system. But, let me ask you this – when does this guarantee actually go into place? There is a 75 basis point cost that the banks have to pay. I assume there is some registration. LIBOR rates have slipped a little bit, sir, but not very much. When does this guarantee for the interbank loans really kick in?

Paulson: Larry, I think when you do something as quickly as we rolled this out, there may be some confusion in the marketplace. But, everyone has a guarantee for 30 days. So, there’s a 30-day guarantee.

Kudlow: Immediately?

Paulson: Immediately.

Kudlow: Do people know this key point?

Paulson: They should, because the guarantee is there immediately. At the end of the 30 days they need to subscribe to this. There is a 75 basis point fee. Then, if they subscribe, the guarantee lasts through June of next year. The guarantee applies to the senior obligations coming due – unsecured obligations – and they can refund those with a maturity out to three years.

Kudlow: Talking about the freeze up in London and New York and elsewhere, with the benefit of hindsight, was it a mistake to let Lehman go under? Because a lot of people are saying it was precisely the drop off in Lehman, which was roughly in early to middle of September when suddenly LIBOR rates went up, the spread against U.S. Treasuries went up something like 300 basis points and the whole system seemed to go haywire. The whole system was like a computer that completely froze up and there was nothing anyone could do about it. Was the Lehman decision an error?

Paulson: Let me talk a little bit about the Lehman situation. Some of you could argue -- are we dealing with a symptom or are we dealing with a root cause? Because one thing I saw clearly this weekend when we met with central bankers and finance ministers from around the world. There was something very good that came out of that weekend, which was the way in which we all agreed to work together with a common set of policies and objectives. The thing that wasn’t as good was to understand the extent of the problem with financial companies and banks in country after country where they said they didn’t have a real problem, to suddenly then have a significant problem.

But let me get back to Lehman. First of all, Treasury didn’t have any powers to do anything as it related to Lehman. We’ve been very clear. I’ve been very clear when I talked with Congress in July that we didn’t have the authorities to deal with a wind down of a non-bank financial institution. So we were very, very clear about that.

Kudlow: But in truth sir, weren’t you deeply involved in the wind down of Bear Stearns last winter?

Paulson: Yes, working with the Fed and the Fed could loan – under 13-3 – they could loan against securities. But there was a hole that needed to be filled in the case of Bear Stearns. There was a buyer, J.P. Morgan. and they could loan against securities.

We worked very hard on Lehman. We all knew about the problem with Lehman for a long time and Lehman tried to work through their problems. I think regulators knew that if there was not a solution before they announced their third quarter earnings, there was apt to be a problem. It turns out there wasn’t a buyer. There was no hole to fill. There just was not a buyer for Lehman. And, the Federal Reserve didn’t think they had the authorities to loan (under 13-3) against Lehman. And I certainly wasn’t urging that because, again, we had a system where we have authorities that were put in place a long time ago for a financial system that existed in a different world and there are broad authorities if a bank fails.

Kudlow: But in truth, when you go back and look at it, the stock market is down 25 percent since Lehman, which was really just a few weeks ago. It was an extraordinary event and, at the time, some people applauded you and said enough is enough we can’t take out every bank. But in looking back on it, that seemed to be the trigger to all this recent mayhem.

Paulson: I would say, Larry, looking back there’s a lot that happened. What was going on with Lehman, there is no doubt that when you look at the over-the-counter derivative markets, when you look at the complexity of today’s financial world, a failure of any big financial system creates a big issue.

I always look back, in addition to looking forward and deal with the facts presented to us. But I could not have been clearer in June and July, that we didn’t have the authorities. And, we certainly didn’t have them at the Treasury and I don’t believe the Fed had them. If there was a buyer for Lehman – we had a foreign buyer that was interested – but near the end their regulator wouldn’t let them. So, there was no buyer. There was no hole to fill.

Kudlow: Let’s move on. When you made your statements yesterday regarding the unveiling of the new rescue program, here’s what you said and I will quote. “We regret having to take these actions. Today’s actions are not what we ever wanted to do.” What did you mean by that?

Paulson: What I meant was, you know, we’re from the United States of America. We believe in free markets. We expect our markets to work well. Government intervention is about failure of a regulatory regime, mistakes on a lot of people’s parts, but to me this was much, much better than the alternative. And this was about preserving our free market system and preserving our banking system and stabilizing it for the American people. There’s going to be a good deal of work that needs to be done once we get through this period and a good deal of work to make sure we don’t get like this again.

Kudlow: Some people read your statement and they wondered out loud – did you mean the changeover in policy from the Treasury purchases of toxic assets to the new capital injections?

Let me read you what you told the Senate Banking Committee – this is just a couple of weeks old – in a very difficult Congressional battle, which you eventually won. “There were some that said we should just go and stick capital in the banks. Put preferred stock – stick capital in the banks. And what to do when you have failures, you know, that what happened in Japan and other spots. But we said the right way to do this is not going around and using guarantees and injecting capital. There have been various proposals to do that, but we want to use market mechanisms.”

What was it that made you shift your emphasis away from the toxic asset purchase and towards the injections of capital?

Paulson: Larry, I’m glad you asked me that question. Let me begin by saying that what we were talking about was always capital. Going back over a year ago, I did everything I could to jawbone institutions to raise capital. No CEO ever got in trouble by having too much capital. The illiquid asset purchase is about capital and about price discovery and freeing up capital. We’re going to do illiquid asset purchases and it’s going to be integrated very well with the program.

When we worked with Congress we knew we were going to have the ability to purchase preferred stocks if it was necessary. But that statement I made then was about putting in capital if we dealt with a situation like Fannie or Freddie or AIG or we had to move to prop up a failing institution.

Kudlow: But some people are saying that the movement of Europeans toward capital injection, the movement of the British toward capital injection, essentially forced you to play your hand. Is there any truth to that?

Paulson: I look at it differently here. You always need to look at the facts, then the facts before you determine what you do. What we’re doing is very different from what the British are doing. It was clear to me after spending time with the Europeans and what was happening there – learning more about this situation, that the problem was bigger than we had hoped and that the right way to make a big impact quickly was by purchasing preferreds on the terms of which we did it. That would make the taxpayer money go the furthest. This was clearly an investment where we should get these funds back with a profit.

We moved quickly, but remember let’s just talk about what we’ve done. In just twelve days after the legislation was passed, we had the nine institutions (voluntarily) with 50 percent of their deposits in the United States sign on for a program.

Kudlow: For $125 billion

Paulson: $125 billion

Kudlow: And you’re going to go for a second $125 billion

Paulson: And then we are going to go broadly to other financial institutions and we’ll be going to regional banks and smaller banks and community banks.

Kudlow: That leaves only $100 billion out of the authorization of $350 billion. Is that where the toxic asset purchase comes from?

Paulson: Remember, we have $700 billion.

Kudlow: But you have to go back to Congress for the remainder.

Paulson: For the next $100 billion, all the president has to do is notify. Then, to go beyond that, there is a notification process and Congress has the ability, obviously, to pass legislation to prevent it. In terms of the illiquid assets, this is a $250 billion purchase of preferred equities and it gets very different from what we were talking about when we were talking to Congress. This is a way in which to encourage shareholders to come in and not the way in which I answered the question where we were talking about injecting preferred on a punitive basis.

Kudlow: We talked earlier about the recession or the downturn and the difficult position with retail sales falling three straight months. We really have unprecedented commodity deflation, credit deflation, home deflation, and all the rest of it. When do you think realistically that new credit will flow to consumers, to businesses, to state and local governments? When do you think Americans can realistically expect that to happen?

Paulson: Larry, that is the important question and that, more than anything else, will make a difference in this economy. I’ve said we have a resilient country and a resilient economy and it can bounce back and this is about confidence. We’re going to have a number of difficult months here. We’ve taken the actions that I believe are the right actions based upon the facts that we looked at this week. I think they are the right actions and I think they can make a difference and they can make a difference more quickly than many people recognize, but it’s going to be confidence.

Kudlow: Whoever wins in November – we’re a few weeks away – would you be willing to stay on for a few months to keep this process intact before you hand it over.

Paulson: Larry, I’m going to work day and night through January 22 and right after the election I’m available to work with the best transition you’ve ever seen – with whoever the new Treasury Secretary is. We’re out looking right now for permanent leaders of this TARP and we’re looking to get someone that will be more than acceptable to the next president and his economic team. This is going to be a first-rate transition --I can guarantee you that.

Kudlow: Mr. Secretary Henry Paulson, we appreciate it ever so much

Anglo-Saxon financial institutions are known for their high dividend-payout ratios. From a European perspective, the hunger for dividends and the emphasis on short-term performance goals that characterize these institutions is both amazing and frightening. Investment banks, in particular, are known for their minimalist equity approach. While normal banks need an equity-asset ratio of at least 7 percent, investment banks typically operated on a ratio of only 4 percent.

The lack of equity resulted largely from the concept of "limited liability," which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.

Lack of equity capital, in turn, made risk-averse shareholders hire gamblers to manage their limited-liability investment companies. The managers chose overly risky operations, because they knew that the shareholders would not participate symmetrically in the risks.

While upside risks would be turned into dividends, downside risks would be limited to the stock of equity invested. Claims against the personal wealth of shareholders would be blocked by the limited liability constraint. The banks' creditors or governments ultimately would bear any losses. The mutual interaction between the incentive to minimize equity capital and the incentive to gamble in order to exploit the upside risks caused America's crisis.

In theory, bank lenders and the government could anticipate the additional risks they encounter when a company chooses a high-leverage strategy. Lenders may charge higher interest rates, and the government may charge higher taxes or fees.

But this theory fails to match reality. Governments do not tax the return on equity less than debt interest, and lenders do not sufficiently honor the benefits of high equity with lower interest rates, owing to a lack of information about the true repayment probability. This is why equity capital held by financial institutions typically is more than twice as expensive as debt capital and why these institutions try to minimize its use.

The provision of limited liability not only turned Wall Street into a casino, but so-called "Main Street" also was induced to gamble, because homeowners enjoyed a limited liability similar to that of the companies. When low-income borrowers took out a loan to buy their homes - often 100 percent of the purchase price - they typically could use the home as collateral without warranting the repayment with additional wealth or even their income. Thus, they were protected against the downside risk of falling house prices and profited by speculating on the upside risk of appreciation.

Such homeowners knew that with rising prices they would be able to realize a gain by either selling their homes or increasing their debt, while in the case of falling prices they could simply hand over the keys to their banks. Given the uncertainty about future house prices, they could reasonably expect gains, which induced them to pay even more in the first place. Gambling by Main Street caused the sub-prime crisis.

The crisis spread because the banking system was not sufficiently risk-averse - and in some cases even seemed to relish risk. Mortgage banks kept some claims on their books, but sold most of them to investment banks as "mortgage-backed securities." The investment banks blended these securities into "asset-backed securities" and "collateralized debt obligations" (CDOs) and sold them on to financial institutions throughout the world. These institutions, attracted by the high rates of return that were promised, invariably neglected the downside risks.

The buyers of the CDOs were often misguided by rating agencies that performed badly and did not provide reliable information. As private rating agencies live on the fees they collect from rated companies, they cannot easily downgrade important clients or the assets they sell. The big American investment banks received excellent ratings up to the last moment, and so did the CDOs with which they betrayed the world.

All of this explains why the US had such a formidable period of growth in recent years, despite the fact that household savings were close to zero, and why foreigners were willing to finance a record US current-account deficit of more than 5 percent of GDP - higher than it has been since 1929. That period is now over.

The US must carry out fundamental reforms of its financial system to plug the equity leaks and recover investors' confidence. But even then it will have a hard time continuing to sell financial assets to the rest of the world. American households will need to learn to accumulate wealth by cutting consumption rather than speculating on real estate. A painful decade of stagnation for America lies ahead.

Hans-Werner Sinn is Professor of Economics and Finance at the University of Munich and President of the Ifo Institute.

To omit any mention of the dollar at this stage of the game is for Bernanke to miss the point. At the heart of the present financial crisis lies investment mismatches, or what Von Mises referred to as mal-investment. With the dollar weak this decade, all manner of investments priced in dollars, or priced in currencies with either explicit or vague dollar definitions were distorted. Absent a weak dollar that created the illusion of a property boom, it’s safe to say that investment in same would have been more rational, and as such, any mistakes made in this area more easily contained.

Instead, Bernanke as mentioned talked up a strategy that “will continue to evolve” just a few paragraphs before his essential acknowledgment that “government engagement in times of severe financial crisis often arrives very late, usually at a point at which most financial institutions are insolvent or nearly so.” Exactly. If the Fed or any government agency had the kind of hotline to the future that even the best investors would admit they don’t possess, maybe the markets might feel more comfortable with present governmental efforts to fix what has gone awry.

The problem with governmental fixes is that Bernanke was perhaps unwittingly all too correct. There’s no way government bureaucrats with no money on the line and with very little market knowledge can know what the most seasoned of investors don’t. Regulators will always be late, which makes Bernanke’s promise of a “comprehensive review of our regulatory structures” so much wasted energy.

Bernanke writes that, “Over the past year, the Federal Reserve has actively used all its powers and authority to try to help our economy through this difficult time.” What seemingly hasn’t occurred to Bernanke is that with markets most useful for discounting the future, the Fed’s efforts have been resoundingly booed by investors; the Dow Jones Industrial Average down 40 percent over the period in which the Fed and federal agencies have sought to be relevant.

The above shouldn’t surprise us because in the end the Fed cannot create wealth or economic growth. Put simply, the Fed only distorts economic activity unless its efforts further the process whereby the dollar is made stable in value. Nothing of the sort has happened under Bernanke. Instead, the dollar in gold terms has bounced around on Bernanke’s watch; from $480 when he was nominated to $1,000 over the summer, to $800 today. Is it any wonder that banks are reluctant to lend dollars with the concept’s value a moving target, not to mention securities priced in dollars?

Bernanke suggests that “prompt passage of the financial rescue legislation” will allow financial firms to fulfill “their critical function of providing new credit”, but even there he misreads the problem. Banks don’t so much lack money to lend as they don’t trust the balance sheets of other banks. The latter in mind, the alleged financial rescue plan will only serve to make the health of banks and the securities on their balance sheets even more opaque due to the insertion of money not from market-disciplined investors, but from the federal government itself.

Bernanke argues that today’s problems, like those in the past, result from “a loss of confidence by investors and the public in the strength of key financial institutions and markets.” More realistically, investors regularly penalize the institutions they’ve lost confidence in, all the while rewarding those who’ve earned it. That is why capitalism works so well for capital always reaching those who will deploy it best.

What’s wrong right now is that investors don’t trust the federal policies that got us here, and they’re correctly horrified that the architects of today’s crisis will now be given seemingly unlimited money to fix that which they broke. In short, investors have lost confidence in Bernanke, Paulson and a Washington political class whose very confusion has made the formerly venerated U.S. economy a laughingstock.

For all his faults, John Connally, Nixon’s Treasury Secretary, made the essential point that money itself “cannot produce, increase efficiency, or open markets abroad.” Connally’s words were very true, and in light of today, simple “money” injections into banks, rate-target machinations, economy-harming "stimulus" packages (Bernanke's latest suggestion), and other eclectic solutions will not lay the groundwork for recovery as Bernanke assumes.

The answer in the end is far simpler in that while money itself is insignificant except as a measuring rod enabling wealth-enhancing investment and trade, it becomes very significant when its value is uncertain. So rather than spew worthless platitudes about evolving solutions, Bernanke would do well to keep it simple himself.

A stable dollar is what the economy lacks. That in mind, to fix the economy Bernanke should huddle with Paulson and craft a plan to stabilize the dollar in terms of something real. Once he and Paulson do that, their work will be done. Markets and economies don’t need government help, they simply need their governments to make stable the currencies they issue.

The repeated interventions of the Fed and Treasury over the last year have accomplished little but to delay the natural, evolutionary nature of capitalism. Capitalism thrives on the creative destruction described by Schumpeter and while that process can be disruptive, it is necessary to the long term health of the economy. Failure of poorly managed financial institutions should not to be lamented but rather cheered. The failure of Washington Mutual moved assets and customers to the better managed JP Morgan. Customers will be better served and capital will be lent more wisely. Why would policymakers want to thwart that process? It would seem desirable and more logical to encourage the process rather than impede its progress.

Government attempts to delay the market process have merely caused other problems. The TAF allows banks to borrow from the Fed for periods of 28 and 84 days anonymously (using dubious collateral) and at rates below the market clearing price. The last TAF auction had a stop out rate of 1.39%. Is it any wonder that banks aren’t willing to lend in an unsecured market when they can’t determine the credit worthiness of the borrowers? Is it any wonder that banks aren’t willing to borrow in the interbank market when the Fed is willing and able to lend at a lower rate? The rates in the LIBOR market are higher for a reason. That is the penalty the lending banks demand for the lack of balance sheet transparency. The LIBOR market will return to normal when the bad banks are removed from the system and the Fed gets out of the interbank market.

The move by Congress to raise the FDIC insurance limit to $250,000 will also delay recovery. A movement of deposits from questionable banks to the obviously healthy institutions is a natural response by depositors to the uncertainty. That is merely the market acting to allocate capital in an efficient manner. Raising the insurance limit short circuits this allocation process, makes the economy less efficient and increases the likelihood of reckless lending in the future. It also extends the time it will take to achieve the trust everyone is so anxious to restore.

The Treasury action to inject capital into the largest banks last week was cheered by markets, at least for a day, but even this action would not have been necessary if the Fed hadn’t done such a good job of hiding the identity of the bad banks. In an environment where it is hard or impossible to identify the troubled institutions, the market demands a premium to provide capital to the industry. Now the Treasury will take capital from private hands by issuing bonds and inject it into the favored institutions on better terms than would the market. One should be skeptical that government bureaucrats will make wiser decisions than the market on how capital is best allocated and at what price. At least Paulson seems to have heeded the words of Bagehot for now: “Any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”

The Fed’s various liquidity provisions are not having the desired effect because the problem is not one of liquidity but solvency. Paulson has now forced capital on the nine largest banks and admonished them to not hoard it. Let’s hope he gave them each a list of target banks and instructions to get some deals done. That is the best use of the new capital. More lending will not be of much use to a system drowning in debt.

The Fed’s special lending facilities are scheduled to end early next year. The Fed needs to make sure the market understands that they will not be extended again. That will give some urgency to the banks that need to raise capital or find a merger partner. When the undercapitalized banks are removed from the system, then, and only then, will the lending markets return to “normal”.

Change can be a disorienting process, especially in a world of instantaneous communication. Modern financial innovations such as Credit Default Swaps add information to the market and speed up the process of identifying companies in trouble. Failures such as Bear Stearns and Lehman that might have once taken years, now take mere months. We should not bemoan that fact but celebrate the efficiency of such a system. Slowing this process may be comforting, but it only prolongs the transition to a better economy. Why would we want to do that?

The exercise of direct democracy, as these ballot initiatives are often called, tends to get more intense during periods of economic stress, especially when citizens feel that politicians aren’t heeding voters’ interests. Indeed, direct democracy arose in the late 19th Century when Progressive reformers pushed ballot initiatives as a way to thwart the power of the political machines that had come to dominate many state legislatures and city councils. What is often called the modern era of direct democracy began in 1978 with, appropriately enough, Proposition 13 in California, which capped local property taxes. Since then, tax and fiscal matters have come to define much of the direct democracy movement, although propositions aimed at social issues like those banning gay marriage or ending affirmative action programs have also become enormously influential and controversial.

Direct democracy of this sort gives voters a chance to work out their frustrations with politicians who do their best to resist the will of the people. That’s partially behind the controversial Question 1 in Massachusetts, known as the Small Government Act to End the Income Tax. In 2000, the voters of the Bay State, resolutely refusing to go along with their reputation as among the country’s most liberal electorate, passed a ballot measure to reduce the state’s income tax rate to 5 percent from 5.75 percent. The state legislature responded with a fiscal maneuver which froze the rate at 5.3 percent, figuring this would assuage voters. It didn’t. In 2002, a local advocate decided to send a message by placing on the ballot an initiative to abolish the income tax, which produces 40 percent of state revenues. Government officials and public employee groups ignored the measure, which they considered too improbable to pass, and were shocked when it garnered 45 percent of the vote.

Now the initiative is back and the public sector is taking it seriously, warning that it would blow an enormous hole in the state budget. Groups opposing it have collected some $1.2 million to fight the ballot proposition, including about $1 million from the 800-pound gorilla of state and local policy fights—teachers unions. Right now, the proposition is supported by 45 percent of voters, compared to 47 percent who oppose it—just a tight enough race to give state politicians a serious headache. As one Massachusetts pol aptly summed up the public mood, “If people are finally fed up and people want to express it, Question 1 is the only game in town.”

Another reason why many are supporting it, despite talk of a fiscal meltdown if Question 1 passes, is because voters have heard the doomsday scenario before. In 1982, Massachusetts politicians warned of dire consequences when an initiative to limit property tax increases appeared on the ballot. The initiative passed anyway, forcing some local governments to tighten their belts but otherwise not producing nearly the dislocation that some predicted.

Another message to politicians that’s embedded in these ballot propositions is this: It’s not your money, but ours. In North Dakota, for instance, an expanding economy has produced some $1.3 billion in government surpluses. Some state politicians have argued for using the money to vastly expand the state’s spending on areas like K-12 education, college tuition aid for students, and loans and economic development incentives for businesses looking to expand in the state. But taxpayer groups argue that much of the surplus should be handed back to those who pay the bills in the form of cuts in personal and corporate taxes embodied by ballot initiative known as Measure 2. Right now, despite opposition from many politicians and government groups, voters are evenly split over the ballot question.

Advocates in some states see ballot initiatives are a way to avoid the fate of taxpayers elsewhere. Arizona voters, for instance, will vote on a ballot initiative to prohibit the state from enacting a transfer tax on realty—something that all but 13 states now have. As the proponents of Proposition 100 argue, a tax on selling your house isn’t exactly the best idea at a time when home prices are falling and are likely to be below the market peak for some time. In addition, proponents point out that the added revenues of a realty tax haven’t exactly cushioned other states from fiscal distress. New York, which has among the highest realty taxes in the country, used the unanticipated revenues generated by the levy during the housing boom to raise state spending sharply and now faces $12 billion in budget gaps over the next two years.

It wouldn’t be an election season without some discussion about the ‘fairness’ of our tax system. That’s what’s behind the battle in Oregon over Measure 59, which would abolish the $5,600 cap on federal income taxes that can be deducted when Oregon residents calculate their taxable state income. Supporters argue that Measure 59 is necessary because Oregon is double-taxing earnings. Advocates point out that those in the state earning more than $50,000 a year would see benefits from the proposition. But because the windfall from full deductibility rises as a household’s income rises, the initiative has also garnered opposition as a ‘gift’ to the rich. Noting that it would reduce Oregon’s income tax collections by an estimated $1.3 billion, public sector groups heavily oppose Measure 59. The Oregon Education Association, for instance, has earmarked some $4.1 million to defeat the initiative.

Even in a difficult economic environment, however, not all ballot measures are about cutting taxes or prohibiting tax increases. A number would raise taxes for dedicated purposes, including an increase in Minnesota’s sales tax to fund the arts and natural conservation, and an increase in Colorado’s sales tax to pay for more services for the developmentally disabled. Supporters argue that the tax increases are small and won’t be noticed by most consumers, but opponents disagree with tax increases dedicated to funding specific causes, which they argue should be allocated by the state legislature instead.

Ballot initiatives of this sort have become so popular in the past few years, in fact, that another trend in this year’s election is a series of measures seeking to limit the impact of ballot propositions--efforts in many cases funded by public employee unions, government associations and ‘grass roots’ groups set up by local politicians who would rather not deal with the sometimes messy consequences of direct democracy. The template is Florida’s 2006 ballot initiative to raise the threshold for future changes to the state’s constitution by requiring 60 percent approval from voters on amendments, as opposed to the more common simple majority vote in favor of a ballot initiative. The ballot question passed, though as opponents point out, with less than 60 percent of the vote, which means that it did not even garner as much support as the new standard for initiatives that its passage put in place. This year, three states—Colorado, Ohio and Wyoming—have initiatives on the ballot which would make future initiatives more difficult to pass.

Somehow, however, I doubt that the voices of direct democracy will be quieted anytime soon.

So apparently even Obama recognizes that his tax increases would be economically harmful.

Because Obama's tax credit does not reduce marginal tax rates, it will not benefit the economy. It provides no added incentives for work, savings, investment or business expansion.

Because it's refundable (meaning workers get it even if they have little or no income-tax liability), for many it will involve just another check from the government, rather than a reduction in tax liability. In those cases, it would not be a tax cut at all, but a transfer payment and a direct drain on tax revenues.

McCain proposes to double the personal exemption for each dependent from $3,500 to $7,000, for all families regardless of income. For middle-class workers in the 25% tax bracket, this $3,500 increase would reduce their tax liability by $875 for each child. While this tax cut also does not involve a reduction in marginal tax rates, it will promote working families with children.

But McCain also proposes marginal tax-rate reductions that do promote economic growth and encourage investment. Because America today suffers from the second-highest corporate tax rates in the industrialized world, McCain would help restore American competitiveness by reducing the federal corporate tax rate from 35% to 25%. This would benefit the middle class and workers by creating new jobs, at better wages, while strengthening the dollar.

It may even raise, rather than reduce, revenues. According to a 2007 study by the Treasury Department, Ireland — with a 12.5% corporate tax rate — raises almost 50% more revenue on a comparative basis than the United States does with a 35% rate.

McCain would also hold the top capital gains tax rate and dividend tax at 15%. Both would provide a much-needed boost for the value of stocks, which are now held by more than two-thirds of all Americans.

McCain further proposes to phase out the alternative minimum tax, which would otherwise burden 25 million middle-class families. This will save middle-class families $2,700 each year on average, an overall middle-class tax cut of $60 billion per year.

McCain's tax plan includes other provisions that would boost our economy, as well, including the expensing of new investment in equipment, machinery and technology.

Obama, by contrast, has proposed to raise marginal tax rates for almost every federal tax — the individual income tax, the capital gains tax, the dividends tax, the payroll tax, the death tax, etc. He would further increase corporate taxes through such measures as the windfall profits tax on oil companies.

These marginal tax rate increases would dramatically discourage savings, investment, business expansion and job creation. Such tax increases would consequently slow the economy even further and reduce jobs and wages for working people and the middle class, while simultaneously weakening the dollar.

Republicans should promote additional middle-class tax cuts through fundamental reform of our confusing, contradictory and confiscatory tax code. Rep. Paul Ryan, R-Wis., proposes to allow workers to choose a flatter tax system with a standard deduction of $25,000 for couples ($12,500 for singles), plus a personal deduction of $3,500 per family member (exempting the first $39,000 for a family of four).

A 10% tax rate would then apply to the next $100,000 for couples ($50,000 for singles), with a 25% rate above that. Currently, a 15% tax rate starts at $15,650 for couples ($7,825 for singles), with a 25% rate starting at $63,700 for couples ($31,850 for singles).

Ryan's plan, which McCain has praised, would promote a powerful economic and investment boom, while creating jobs and good wages for millions.

Finally, the biggest middle-class tax cut of all would be allowing workers the freedom to choose personal accounts for Social Security, which McCain has also praised. These accounts should grow eventually to replace the entire payroll tax for those who choose them, with the accounts financing all the benefits now paid through the tax.

To the extent workers make this choice, this would eliminate payroll taxes on working people and the middle class, now the highest tax they pay. Instead, working people would be paying into their own personal store of family wealth, opening up broad new vistas of opportunity.

One nuance that is often overlooked is, just as the economy is the shared production of a growing population, a growing roster of companies drives that economic growth. Entrepreneurial capitalism – new enterprise creation – is an important driver of economic growth, contributing roughly half of real GDP growth on average over time. The other half of overall real GDP growth is contributed by the growth of existing enterprises. This means that share prices and per-share earnings for broad indexes like the S&P 500 should match the growth of existing enterprises, roughly half of total GDP growth. As it happens, this growth closely mirrors per capita GDP growth.

The second truism is that if aggregate real per capita growth rate in the economy is a bit under 2%, the broadest sectors of the economy, like the corporate sector, have to deliver about the same per capita growth rate in the long run. If the growth rate were greater, that sector would eventually become larger than the entire economy, an outcome that is constrained by both economic and political forces.

Over the last several decades Americans at all levels in business, government and private life have behaved as if these first two truisms were no longer relevant. Implicitly, and in some cases explicitly, decisions were made, including investment decisions, that were based on the assumption of far greater growth. A common refrain was that even if real per capita growth in the aggregate economy is limited to about 2%, the latter number does not apply to us or to our investments, whether our domain is housing, technology stocks, hedge fund investments or the stock market.

The third truism is that valuation of long lived assets, like common stocks, are highly sensitive to the assumed rate of growth. The experience of Google is an obvious example. The stock price has plummeted to $330 from $750 despite continued impressive growth in earnings, because the earnings growth has not been fast enough to justify an initially-lofty multiple. Expectations for future growth have been continuously revised downward.

Applying these three facts to the market as a whole leads to several stark conclusions. First, as with any broad sector of the economy, corporate earnings are constrained by the same long run 2% limit. This means that, unless P/E ratios change, stock prices will also grow, on average, at no more than 2% in real terms for the truly long-term investor.

History supports this view. In the last 25, 50 and 100 years, real growth in S&P 500 per-share real earnings has averaged 3.2%, 2.0% and 1.5%, respectively. Meanwhile, the S&P 500 price index has risen by 5.1%, 2.7% and 1.9%, respectively, over and above inflation. The earnings have grown faster than per capita GDP growth in recent years, in large measure due to recent earnings that have subsequently proven illusory. Meanwhile, share prices have grown faster still, largely on the back of rising valuation multiples, which we dare not rely on in the future. This recent outsized growth in real per-share earnings and share prices, over and above the per capita real growth of the economy may be helping to foment the populist backlash we’re now seeing.

In this historical light, the current crisis is seen as more than simply the result of a housing bubble or an overstressed financial system. It is based on a widespread hubris that somehow the laws of economic growth do not apply, that share prices and earnings can grow faster than the overall economy. That hubris was reinforced by organizational structures that allowed executives, insurers, derivatives traders, bankers and many others to take large amounts of cash home as long as the euphoria continued, and as long as customers were willing to set aside logic in favor of a promised nirvana.

The ultimate return of stock prices to levels more consistent with economic growth is nothing more than another example of mean reversion at work. The good news is that, from current levels, mean reversion need not exact as severe a future toll as it has imposed on us in the last twelve months. This too shall pass.

Bank bailout efforts by the Treasury, Federal Reserve and their counterparts abroad are failing because those address symptoms not the systemic ills that caused credit crisis. While global investors and traders may not articulate their fears in such esoteric terms, failure to address systemic problems are driving down corporate sales and profits and destroying stocks values.

At the banks, the national officials have provided liquidity, injected equity and guaranteed over night and other short-term borrowing. However, large money center banks simply are not interested in using the massive funds provided them to make sound loans to consumers and businesses on the scale needed to get the economy going. These money center banks are no longer interested in providing liquidity to regional banks by bundling their loans into bonds for sale to insurance companies, pension funds and other fixed income investors that sit on vast pools of capital.

The bonus systems and compensations structures at large banks permit executives to earn much larger sums doing other things—engineering mergers, currency and derivatives trading and the like. Money center banks have become part of larger financial conglomerates over the last 25 years. These are run by executives that believe they should be able earn millions of dollars each year doing deals and creating exotic securities rather than by making loans and providing helping smaller banks raise needed funds.

The compensation restrictions put in place by Treasury when it injected capital into the largest banks only apply to a few top officers and are easily circumvented. They simply change little in what is wrong with executive incentives at the large money center banks.

Beyond that, demand for goods and services in the United States and Europe are being driven down by the undervalued currencies and massive purchases of dollars and euros by China, oil exporters like Saudi Arabia, and other emerging economies. Their huge trade surpluses translate into trade deficits in the United States and Europe and the need for massive borrowing to keep up demand for goods and services in western economies. That caused the housing bubble and over borrowing in the first place, and without a policy to realign currencies to redress trade imbalances, we simply can’t get beyond the current credit crisis without ruinous government deficits, reckless consumer borrowing and indenturing our children to foreign creditors.

Congress is talking about another stimulus package but tax rebates would only give the economy a temporary lift. As we saw last spring and summer, those gave consumption a boost that slipped back after a few months. That gave GDP growth a sugar high late in the second quarter and helped growth from slipping too much in the third quarter. Now, flagging construction and retail sales are taking the economy into an abyss.

The best purpose for another stimulus package would be to help get the economy through the first half of next year while the Treasury and Federal Reserve take even more assertive steps to straighten out the banks and address other structural problems such as the trade deficit, energy development and inadequate public facilities.

Infrastructure spending that fired up projects already in the pipeline would leave a more lasting legacy than facilitating a few more restaurant meals and trips to the mall. Such spending would also have a greater multiplier effect on GDP than tax rebates as it would result in fewer imports.

In parallel, we need aggressive programs to straighten out management at money center banks, assertive steps to correct currency misalignments with China and other countries with huge trade surpluses, and efforts to reduce oil imports through reduced gasoline consumptions and investments in both conventional and alternative energy sources and conservation. The latter includes incentives to build more hybrid automobiles quickly, more offshore drilling and onshore natural gas development, investments in nonconventional energy projects, and more energy efficient buildings.

At a time when the global economy is sputtering, we need growth. At a time when unemployment in many nations is rising, we need new jobs. At a time when poverty threatens to overtake hundreds of millions of people, especially in the least developed parts of the world, we need the promise of prosperity. This possibility is at our fingertips.

Economists at the UN call for a Green New Deal – a deliberate echo of the energising vision of US president Franklin Roosevelt during the Great Depression of the 1930’s. Thus, the UN Environment Programme is launching a plan for reviving the global economy while dealing simultaneously with the defining challenge of our era – climate change.

The plan urges world business and political leaders, including a new US president, to help redirect resources away from the speculative financial engineering at the root of today’s market crisis and into more productive, growth-generating, and job-creating investments for the future.

This new ‘Green Economy Initiative’, backed by Germany, Norway, and the European Commission, arises from the insight that the most pressing problems we face are interrelated. Rising energy and commodity prices helped create the global food crisis, which fed the financial crisis. This, in turn, reflects global economic and population growth, with resulting shortages of critical resources – fuel, food, and clean air and water.

The commingled problems of climate change, economic growth, and the environment suggest their own solution. Only sustainable development – a global embrace of green growth – offers the world, rich countries as well as poor, an enduring prospect of long-term social well-being and prosperity.

The good news is that we are awakening to this reality.

We have experienced great economic transformations throughout history: the industrial revolution, the technology revolution, and the era of globalisation. We are now on the threshold of another – the age of green economics.

Visiting ‘Silicon Valley’ in California last year, I saw how investment has been pouring into new renewable-energy and fuel-efficiency technologies. The venture capital firm that underwrote Google and Amazon, among other archetypal entrepreneurial successes, directed more than $100mn into new alternative energy companies in 2006 alone.

In China, green capital investment is expected to grow from $170mn in 2005 to more than $720mn in 2008. (In just a few short years, China has become a world leader in wind and solar power, employing more than a million people.) Globally, the UN Environment Programme estimates that investment in low-greenhouse-gas energy will reach $1.9tn by 2020.

The financial crisis may slow this trend. But capital will continue to flow into green ventures. I think of it as seed money for a wholesale reconfiguration of global industry.

We can already see its practical expression. More than 2mn people in the advanced industrial nations today find work in renewable energy. Brazil’s bio-fuels sector has been creating nearly a million jobs a year. Economists say that India, Nigeria, and Venezuela, among many others, could do the same.

In Germany, environmental technology is expected to quadruple over the coming years, reaching 16% of manufacturing output by 2030 and employing more people than the auto industry. Mexico already employs 1.5mn people to plant and manage the country’s forests.

Governments have a huge role to play. With the right policies and a global framework, we can generate economic growth and steer it in a low-carbon direction. Handled properly, our efforts to cope with the financial crisis can reinforce our efforts to combat climate change.

In today’s crisis lies tomorrow’s opportunity – economic opportunity, measured in jobs and growth.

Most global CEOs know this. That is one reason that businesspeople in so many parts of the world are demanding clear and consistent environmental policies. It is also the reason that global companies like General Electric and Siemens are betting their future on green.

But it is important that the global public recognise this fact, perhaps nowhere more so than in the US. When the next American president takes office, voters and elected officials alike should be reassured by studies showing that the US can fight climate change by cutting emissions at low or even no cost, using only existing technologies.

We know that the poorest of the world’s poor are the people most vulnerable to climate change. They are also the most vulnerable to the shocks of the financial crisis.

As world leaders, we are morally bound to ensure that solutions to the global financial crisis protect their interests, not just the citizens of wealthier nations. Those left behind by the previous boom – the so-called ‘bottom billion’, living on less than $1 a day – must be brought into the next economic era.

Again, a solution to poverty is also a solution for climate change: green growth. For the world’s poor, it is a key to development. For the rich, it is the way of the future.

Ban Ki-moon is Secretary-General of the United Nations.

In a New York Post story dated September 25, the proprietor of Soho-based Five Point Fitness spoke of his inability to attain financing for his popular workout facility. According to owner Kevin McGrath, “The guys [from the bank] said if this was a year ago, it would have been a slam dunk.” But as the Post story noted, as “the economy continues to tailspin, scores of small-business owners are struggling to get tightfisted banks to dole out loans for much needed expansion plans.”

It turns out McGrath is not alone. Four days later a Wall Street Journal account of major food franchisees found that they too are facing troubles with regard to finance. As the Journal put it, the tough financing environment for Panera Bread, Yum Brands and Sonic (employers of those who’d like to be rich one day) is “a sign of how the turmoil on Wall Street is spreading to large companies and small business owners.”

Seeking out other lower-income individuals impacted by problems on Wall Street, USA Today reporter Charisse Jones traveled to Greenwich Avenue in Greenwich (CT), a street famous for its fancy shops and restaurants. While it’s safe to say its shop owners and employees have traditionally earned microscopic fractions of what their customers have traditionally brought home, they’ve not been immune to the financial downturn that has plagued the elite of Greenwich.

Jose Candray, manager of Village Bagels in Greenwich told Jones that “tips are smaller” these days, while Greenwich resident (and investment banker) Bob Jermain referenced the fact that his kids no longer “need 20 sweaters”, which means sales at Greenwich Avenue clothing stores are set to fall. Are layoffs of the lower-wage workers these businesses employ not too far off?

It turns out yes, because as an October 14th USA Today story noted, with “stores doing all the cost cutting they can to preserve profit margins,” this “will mean fewer salespeople available to help shoppers.” It’s also notable that while those who make $100,000 or more only account for 10% of the U.S. population, according to a study conducted by the Harrison Group, those in the $100,000 income bracket account for 50% of retail spending.

The Harrison Group study dovetails well with a Bloomberg story from last month which detailed a looming financial shortfall when it comes to efforts “to combat hunger, poverty and disease.” Bill Gates was featured in the Bloomberg piece, and owing to his desire for “rich-world” governments to free up funds for poverty programs alongside his private efforts, Gates fears that “Rich-world budgets may not have room for increased generosity.”

The above is interesting when we consider whose economic efforts regularly fill rich-country coffers with so much cash. Not only do the rich account for the majority of retail sales, but as countless studies have shown, they similarly account for the vast majority of tax revenues taken in by governments. So if the economy continues to falter, tax authorities worldwide will collect less from the rich, and this will soon enough reveal itself through less in the way of government funding for poverty programs here and around the world. This is probably a good thing considering the persistent failure of government-led poverty initiatives, but the point is still valid.

A recent Washington Post story, “Crisis sparks search for new aid sources”, showed yet again how the poor hurt the most when the “dastardly” rich see their fortunes turn south. It turns out Lehman Brothers, as part of its expansive charity program, was until recently a $50,000 dollar donor to Habitat for Humanity. $50,000 may not seem like much, but those funds paid for the construction of over 100 one-room houses that put a roof over the heads of 500 citizens of New Delhi. According to the Post account, previously those 500 “had been living in shanties of tarpaulins and old clothes.” With Lehman no longer with us, it's fair to say that the beneficiaries of its charitable activities will have to get by on less.

Looked at from the perspective of private, non-charitable economic activity, an October 6 USA Today story wrote about taco vendor Jorge Flores in Nuevo Laredo, Mexico. While previously he would sell 300 tacos per day to laborers reliant on our robust economy, thanks to economic problems stateside, he now only sells 180. What’s that they say about a rising tide lifting all boats? A subsiding tide evidently lowers all boats if Mr. Flores's story is at all indicative.

More generally, in 2007 charitable donations from Americans hit a record of $300 billion. But a recent newspaper headline noted that “Nonprofits Brace for Slowdown in Giving”. Sure enough, nonprofits frequently only exist thanks to the generosity of the rich. And with the rich in many cases hurting in this uncertain economic climate, the ability of charitable organizations to continue their missions will be severely compromised.

What these various accounts tell us is that whether due to pure profit motive through which the rich supply capital to businesses, or through perhaps simple vanity that causes them to give to all manner of charities, it is thanks to the wealthy that job-creating businesses are funded, and it is also thanks to the rich that societal ills are addressed with ample funds.

So to deny the reality of trickle-down economics is the equivalent of denying that the sun sets in the west. It does, and trickle-down economics is. In short, politicians can dream up all sorts of tax plans and programs to harm the rich, but in doing so, they should make no mistake about who in fact will pay in the end.

In such cases, the new clarifications allow for nonmarket, "mark-to-model" methods — the very methods employed by Enron — to be used for fair value accounting. With its embrace of nonmarket valuation methods, the SEC has entered the twilight zone.

And the SEC is not alone. Under heavy lobbying from major banks and European politicians — notably French President Nicolas Sarkozy — the Expert Advisory Panel of the International Accounting Standards Board made its recommendations on Oct. 10, and they were endorsed by the IASB.

Under the new IASB rules, it will become easier for companies to throw current market prices to the winds and replace them with values based on amortized costs.

The recent failures of some financial firms have given new life to arguments against the use of market prices, or mark-to-market accounting (MTM). Critics claim that firms with assets under price pressure face losses that deplete their capital and increase their risk of insolvency.

Such firms are forced to shrink by selling assets, but these sales can spark further asset price declines and capital losses, requiring further sales. At every stage, critics argue, firms are pushed toward insolvency by MTM. According to the critics of MTM, the bogeymen of the current crisis are market prices.

MTM rests on two principles: the social value of market prices and the role of accounting information. First, an asset is only worth its price in the marketplace, which is the only objective measure of value. Second, accounting statements must provide accurate and meaningful information. Investors have a right to accurate and actionable information on the value of their corporate assets.

The transparency of MTM is most critical when a firm is likely to have to sell assets or when it nears bankruptcy. This is precisely the situation in which some firms find themselves. But never mind. Major bank trade groups and some banks argue that these firms should mark asset values to models or to other arbitrary measures.

Most responsible authorities, however, including until recently Treasury Secretary Paulson and Chairman Bernanke, have had to defend MTM over the past year, something unimaginable after the accounting scandals of less than a decade ago.

In the recent turmoil, Bernanke softened, proposing that the government buy bad assets at a "hold-to-maturity" price, based on estimates of what securities would eventually be worth in a normal market or when payments come in over time. But the market price is the correct hold-to-maturity price.

Besides, if such appreciation could reasonably be expected, private firms would bid up the value of toxic securities today. We do not believe that the government should be in the business of promoting erroneous information.

There is no question that a decline in market liquidity reduces asset prices, especially for assets that are long-term or relatively illiquid. Those who hold such assets are worse off, and that is precisely what market prices indicate. Managers who ignore prices hoping for a better day are ignoring the best interests of their stockholders and other stakeholders.

MTM does not force asset sales. If MTM leads to a write-down, nothing is gained by a new sale, except in two cases. If an owner expects prices to fall further, then it could be beneficial to sell in advance. Or if an asset price decline reduces equity below a required regulatory level, the owner may have to sell assets in order to restore a required capital ratio.

Prices may still fall further, but not because of MTM. Shrinking assets and prices are exactly what the market requires when asset supply has expanded too much, pushing value below the sustainable replacement cost of assets.

If one had gone to sleep at the end of 2001 when Enron failed and just awoke, one might conclude that nothing had been learned. Besides finding that some banks had rushed headlong into the disastrous off-balance-sheet creations that had allowed Enron to destroy itself, they would also find that the appeal of Enron's practice of "marking to model" or to other fictional "fair" prices is strong.

Today's "frozen markets" simply reflect an unwillingness to sell at low prices or a hope that some institution (government) will step in to put an artificial floor under prices. Calls for valuing assets at inflated fictional values and forbearance are reminiscent of similar industry pleas during the S&L crisis, which also featured frozen markets, funny accounting and fears of price volatility due to MTM.

The great lesson of the S&L mess was to cut the cost of the crisis by relying on the marketplace to set prices, to trade on them to get bad assets off the books and to use market prices to spot and close failed institutions. MTM is part of the cure, not the disease; it will help accelerate the end of the current crisis and reduce its cost.

I’ve never forgotten that advice. Mundell was saying: Choose the best policies as put forth by the great economic philosophers without being too rigid.

Of course, John Maynard Keynes was a deficit spender during the Depression. Milton Friedman warned of printing too much or too little money. And Mundell, along with Art Laffer, Jack Kemp, and others, revived the importance of reducing high marginal tax rates to reward work, investment, and risk. The idea was to make each of these activities pay more after tax, and in the process boost asset values across-the-board. This incentive model of economic growth was used effectively by President John F. Kennedy and the great 1920s Treasury man, Andrew Mellon.

During the 1980s Reagan enacted Mundell’s three-legged approach. He slashed tax rates on the supply-side and was not afraid to run budget deficits in the Keynesian mold. At the same time, Reagan gave Paul Volcker carte blanche to practice the tough-minded monetarism that curbed excess money and vanquished inflation. This eclectic policy mix reignited economic growth, and it ushered in a three-decade prosperity boom that revived free-market capitalism.

Today, however, the economic naysayers are ignoring the advice of Prof. Mundell. Looking at our financial crisis, with its deflationary sweep from stock markets to home prices to energy, they want to lurch leftward to a big-government tax-and-spend regulatory approach. Instead, we need to put all three legs of the Mundell hypothesis in place. And we’re already two-thirds of the way there.

Treasury man Henry Paulson is using a $700 billion rescue package to prop up banks with new capital, purchase distressed assets, and backstop inter-bank lending. Keynesian deficits will finance it. But it’s working. While ankle biters on the left and right have dissed Paulson’s plan, important credit-market spreads have declined significantly in the last two weeks.

Fed head Ben Bernanke, meanwhile, is combating deflation with a Friedmanite monetarist approach -- the second leg of the Mundell mix. Over the past two months the Fed has doubled its balance sheet and spurred a major increase in the basic money supply in order to meet the enormous liquidity demands that always accompany deflation. The Fed should keep this up in the coming months until stocks, commodities, and credit show life-signs of recovery.

But what’s missing is Mundell’s third policy leg: supply-side tax cuts. And here we find the partisan debate of the closing days of the presidential and congressional elections.

Democrats want to tax the rich, redistribute the wealth, and spend our way out of the economic doldrums. It won’t work. Senators Barack Obama and Harry Reid, along with Speaker Nancy Pelosi, disdain supply-side tax incentives. But Sen. John McCain wants to reemploy them as a recovery tool. McCain is right, and now is the time for the Republican party to call for sweeping tax cuts that would reduce marginal rates by half for businesses, individuals, and investors. Yes, it would be bold. But no bolder than Reagan in the 1980s, Kennedy in the 1960s, or Mellon in the 1920s.

The corporate tax rate should be slashed from 35 percent to less than 25 percent, including capital-gains. (Corporations, let’s not forget, don’t pay taxes. Only individuals do, since business costs are passed along to consumers.) The top individual rate should similarly be lowered, with fewer income brackets to clutter up the tax code. And investment taxes on capital-gains and dividends should be cut from 15 percent to 7.5 percent to revive the dormant animal spirits of investors.

These tax cuts would mean all three legs of Robert Mundell’s pragmatic approach to policy are in place. Use the money supply to combat deflation (inflation is not the problem), employ deficits to rescue and stabilize the banking and credit system, and slash tax rates to reignite economic growth.

In effect, a successful rescue plan requires a drawdown of all the major economic schools of thought. Given the current economic emergency, we need all the help we can get. For a change, how about a little pragmatism in the policy mix? That just might do the trick.

When future economic historians look back to trace the triggers for the October 2008 financial panic and the unnecessarily severe recession of 2009, they will likely put their fingers on two.

The failure to keep Lehman Bros functioning as a going concern.

The failure of the ECB and the Bank of England to use their interest rate setting firepower to organise a substantial globally co-ordinated interest rate cut (the 8 October 2008 cut was too timid).

Economics ministries, not central banks, demonstrated decisiveness

A convincing argument for independent central banks adopting an inflation targeting framework is that, where central banks are forward looking and responsive, they should be able to avoid deflationary slumps. The markets then should expect the central banks to assess clearly the global economic situation and the downside risks, and take decisive action. Instead, it was the European finance ministries, via the bank refinancing packages announced between October 8th and 14th, that demonstrated their far greater understanding of the risks involved. They acted in a timely and potentially effective internationally co-ordinated manner. It was less effective because the central banks failed to follow up their initial too small interest rate cut. They were persuaded into a co-ordinated half point interest rate cut on October 8th, with the Bank of England, it is rumoured, a late and hesitant participant. The central banks then sat on their hands, despite a daily barrage of deflationary news.

Emerging markets of the deflationary firestorm

By October 16th, the impact on emerging markets of the deflationary firestorm, in consequence of the collapse in global growth and in commodity prices, had become all too apparent. History shows that the resulting combination of financial and currency crises leaves long-lasting damage in lost output, bankruptcies and bad debts that handicap future recoveries. There is little chance of a significant commodity price recovery from recent levels in the next six months. The reason is that instead of stabilising the global economy, emerging market demand, such as China’s, is falling, and thus amplifying the shock. As I pointed out at the Bank of England’s Monetary Policy Roundtable (Sept 30th), a straightforward piece of economics underlies this idea. While consumer spending is closely linked with the level of income, investment is more driven by growth. It is the huge share of investment in national output in emerging economies that makes them, and their commodity demands, highly sensitive to the global slowdown.

The dual effect of the depreciation of emerging markets’ currencies and the massive falls in commodity prices will induce the largest negative shock to the price level in developed economies since WWII. Moreover, collapsing export demand and rapidly rising unemployment will add domestic deflationary pressure. The deflation will in part be offset by the improvement in the terms of trade for the developed countries, and eventually also by fiscal measures undertaken to boost demand. However, with the rise in food and energy prices accounting for approximately 80% of the rise in inflation in 2007-2008 in most European countries, the coming collapse of inflation in 2009 should have been obvious to every central banker.

What could have been?

As late as October 21st, the central banks of Europe still had an opportunity for credible and confidence boosting action on interest rates. A short-term rise in global stock markets gave a window for action which would not have been seen as a ‘too little, too late’ fire-fighting reaction to market panic. An accompanying statement could have noted the dramatic shift in the inflation outlook. It could have acknowledged that, in effect, monetary policy had involuntarily tightened with falling inflation expectations raising real interest rates. Policy had already been tightened through raised market interest rates paid by households and firms, due to widened spreads under the credit crunch.

Would a co-ordinated 1% cut, accompanied by the promise of decisive and timely further action in the light of rapidly evolving news, have worked to halt the panic? Sceptics, perhaps including some in the central banks, were doubtful, but quite wrong.

The most obvious impact of a cut would have been to raise the profit outlook of private sector banks in every country. This would have boosted the flow of investors’ funds to the sector and raised banks’ share prices, thereby enhancing their ability to lend and replenishing trust of depositors and in the interbank market. The result would have greatly amplified the benefits of the earlier refinancing operation of the ministries of finance, and lowered money market and credit spreads.

Some of the cut in policy rates would have lowered borrowing rates faced by hard-pressed households and firms, though more gradually for some types of debt. Where floating rate debt dominates (e.g. the UK), cash flow effects on consumer spending are large. In research (with Janine Aron and Anthony Murphy) summarised in my Jackson Hole paper of 2007, this effect was estimated for UK consumption. With credit now so restricted and debt levels so high, the size of the impact on spending of a cut in borrowing rates is larger than ever. Thus, had the policy rate fallen, the UK might well have experienced a less severe recession than Germany, which is far more exposed to the slump in exports of capital goods.

Currency crises in emerging markets

Another benefit would have been to ameliorate currency crises in emerging markets and smaller countries such as Denmark. Their exchange rates depend in part on interest rate spreads with the major currencies. A co-ordinated global interest rate cut would have widened spreads without these countries having to raise rates to support their currencies in the face of severe recessions. Moreover, as late as October 21st, many other central banks would have felt able to join a co-ordinated cut without exposing their currencies.

More generally, the reduction in policy rates, and the prospect of more to follow, would have reduced returns on safe assets, such as government bonds, and induced investors at the margin to rebalance towards riskier assets, such as equity and corporate debt. The rise in such asset prices would eventually have helped to restore collateral values, slowing the spiral of rising bankruptcies.

Following the panic beginning on October 22nd, the task of restoring confidence is far harder. With asset prices so much lower, the bad loan position of the banking system looks worse, and with it, the potential burden on tax payers. The damage for the UK looks particularly severe, with its debt and housing market vulnerability - reflected in the sudden decline in Sterling and in Treasury gilt prices.

Conclusion: Scrap the models and agree on a big, coordinated rate cut.

Why Europe’s key central banks made this potentially catastrophic error is a long story. One reason, however, rests in their econometric models, based on fashionable but outdated economic theory.

It is deeply ironic that central bankers who rightly have made much of the moral hazard of bailing out private bankers, have adopted central bank models excluding channels for real world moral hazard and credit crunches. These models are overdue for the scrap heap. Central banks making policy without functioning models are like aeroplanes flying without radar, and the consequences are now obvious.

They now have a last chance to undo the damage of last week. They need to put aside short-term currency wobbles, focus on the big picture and surprise the markets with a much larger cut, probably of 2 percentage points. If international co-ordination is now harder to achieve, then leadership by the ECB and the Bank of England will have to suffice.

John N. Muellbauer is Professor of Economics at Oxford University and CEPR Research Fellow.

References
John Muellbauer “Housing, credit and consumer expenditure.” in Housing Finance, and Monetary Policy: a Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30-September 1, 2007, Federal Reserve Bank of Kansas City, 2007, p. 267-334.

First the obvious. Taxes are nothing more than a price. The higher the tax on any activity, the more expensive it is to engage in same. Looked at from the perspective of capital-gains taxes, they are a price placed on investment success, and a tax on risk capital that drives the intrepid investor away from risky investments on the margin. When we consider that businesses and entrepreneurs are reliant on the willingness of investors to offer up capital in order to grow, the ideal rate when it comes to capital gains is by definition zero.

In many ways a non-existent capital gains rate should appeal to Obama. He clarified to ABC’s Charles Gibson his desire to raise the rate as something rooted in “fairness”, but given the basic truth that there are no wages without capital, the only fair action to take with respect to lower-income workers would be to erase the tax on capital investment. Abolishment of the rate would increase the amount of capital available for wages, plus it would increase the wage competition for what is always a limited supply of workers.

For those who own shares that have risen in value, the capital gains rate is most problematic. As mentioned, taxes are merely a price, and when the price of selling shares is high, the incentive for investors to defer the sale of appreciated shares rises.

At first glance the above is unfortunate given the implosions this decade of Enron, Worldcom, Bear Stearns, and Lehman Brothers to name a few. Politicians regularly talk up the importance of diversification with the aforementioned firms in mind, but with the price of selling potentially set to rise, the reluctance to unload appreciated shares will grow. Capital-gains taxes are a tax on investment diversification, so they work at cross-purposes with a bipartisan Washington consensus in favor of investment diversity.

But probably the greatest, though least spoken of reason for capital gains abolishment is that a vibrant economy is totally reliant on the unfettered flow of capital. When individuals with large share gains are made reluctant to sell due to taxes, the economy is burned twice:

The economy is first harmed by the aforementioned reluctance of individuals to realize gains. This is a problem because it’s through the sale of shares that investors voice their displeasure with the direction taken by company management. If tax distortions make this necessary process less likely, the growth companies of yesteryear will lose out on the all-important price signals telling them they must improve.

Put simply, how many longtime Microsoft, Dell and Cisco shareholders are reluctant to sell solely due to capital-gains taxes? If so, how does this help those firms if tax rules give them a distorted and elevated view of the job they’re doing?

Secondly, this reluctance to sell and redeploy capital to the most productive opportunities means that tomorrow’s Microsofts potentially go wanting for capital. And when you consider what today’s Microsoft has done for ours and the world economy, it’s essential that we foster an environment where the best ideas of the future get funding.

Capital-gains taxes discourage the above process whereby stale companies overseeing capital destruction lose out to tomorrow’s winners. This is unfortunate for the economy on its face, and when we remember that Obama seeks to promote economic fairness, capital-gains levies once again work at cross-purposes with his goals.

Indeed, taxes on investment gains merely reinforce the existing commercial outlook by virtue of the richest firms of today holding onto capital that would more likely depart in a tax-free environment. If the policy is one of “spreading the wealth around”, then it’s essential to remove the tax barriers that make this result less likely.

On a positive front, Barack Obama, if elected, will be positively restrained in what he does by the political economics of his desire to be a two-term president. That being the case, it is hoped that he’ll cross the aisle on the all-important question of capital-gains taxes. A lower or abolished rate would be a big economic boost all else being equal, plus it would help Obama realize what are now simply campaign platitudes about higher wages and greater economic fairness.

As a business anthropologist in the investment community (partner with Kairos Capital Advisors) I am always watching people, particularly those networks of people that make up businesses and the market. To understand more about what happened in the market, I first explained how people act with trust or distrust.

Have you ever had someone lie to you? Maybe not even lie, but a stretching of the truth? Have you noticed how the lack of trust spreads? They may have stretched the truth about their competence in one area, but knowing they exaggerated about one thing leads you to distrust them on unrelated issues. More obvious is when someone steals; say a housekeeper (not my housekeeper) pocketed a couple of dollars she found while doing laundry. You now begin to suspect that she has been stealing from you all along and this two-dollar incident leads you to believe she may have stolen hundreds of dollars. Perhaps you misplaced your earrings but you are now sure that the housekeeper must have stolen them.

It takes a long time to build trust. Unfortunately it can be destroyed in an instant. Now what if your housekeeper were to deny the incident, claim she never took the two dollars and you must have misplaced it? Distrust grows and there is no hope of rebuilding it.

The first step to rebuilding trust is to accept responsibility and offer to take action over time to rebuild what's been eviscerated. If you choose to salvage the relationship, you will give the person a chance to earn your trust back, though it takes time and repeated, observable actions to win what was lost back.

Distrust is an insidious mood; it can spread beyond the person who broke it in the first place. Perhaps you never hired a housekeeper before. This was your first experience. Would you not consider that perhaps ALL housekeepers steal and therefore you won’t hire another? At the very least you may step back, reassess, perhaps talk with your neighbors to be sure this is not a widespread practice by housekeepers in general before you hire another.

Let’s now take it one step further. Your housekeeper hasn’t actually stolen two dollars. You did indeed misplace it. However, you have been bombarded by friends’ tales of household help stealing from them left and right. You could possibly begin to wonder whether or not your housekeeper, like those of your friends, may be stealing and you just haven’t caught her yet.

With this background of distrust you begin to watch your housekeeper with new eyes. Now the two dollars disappear and you think “aha”, she is just like the others and jump to the conclusion that she is a thief even though she is not. This distrust may not be limited to your housekeeper. Now you begin to watch the gardener, the contractor and the pool man, anyone who could have the access and opportunity to steal from you. Distrust is dangerous because like a metastasized cancer, it spreads everywhere quickly. It destroys relationships, sometimes unnecessarily.

It is this spread of distrust, much of it caused by rumors that experienced investors knew to be false, which caused many to short or sell stocks. Throughout the history of the stock market, rumors always arise, though an experienced investor knows that false rumors usually are revealed to be false and normalcy is promptly restored. In fact these rumors (or rather invalid assessments) created buying opportunities for investors who understood that all would be righted in a short time; the drop in stock value temporary.

But before I could show Marcia, our housekeeper, how distrust toppled the investment banking industry, I needed to first show how businesses built trust and value. I started out explaining in an uncomplicated way how the market generally works.

As our readers already know (but wasn’t as clear to my Brazilian housekeeper), public companies usually report earnings each quarter and set new targets for the next quarter at the same time. People buy or sell stocks in these businesses based on whether or not they trust that these companies will reach the targets, and whether or not those targets will improve the valuation enough to warrant a higher stock price. Companies that achieve their targets over time build more trust. It takes many quarters and years to build a company’s reputation.

Now there are many “speed bumps” that can hinder a company’s race to their quarterly goal. These “speed bumps” can also make it more likely that some will reach their goal while others may not.

Importantly, there are external factors that could hinder a company’s growth. Rising gas prices would affect the firms, such as airlines and transportation companies, whose operating costs would rise. Trade regulations would affect those companies who rely on open markets to access customers in other parts of the world. Tax increases could make the cost of doing business increase and reduce profitability. Healthcare requirements could increase the cost of doing business and again affect profitability.

Many of these “speed bumps” are the result of policy changes, but sometimes they materialize due to internal mistakes. A failed product, such as an unsafe or unreliable air bag in a car, could lead to a recall jeopardizing future sales. Management could change, which would call into question the competence of the new team's ability to achieve a target.

Suffice it to say, investors are always assessing events of the internal and external variety in hopes of assessing their impact on company operations, not to mention what it will mean for the firm's future share price. These “speed bumps” and a company’s failure to achieve a target generally result in a lack of confidence. But a lack of confidence is different than distrust. It is generally contained to a specific set of circumstance, and doesn’t affect other domains. The path toward rebuilding confidence is usually clear.

What's happened in these uncertain markets of late has been the result of a growing lack of trust. This is not a “crisis of confidence”, but something much more powerful. Distrust is the story here, and it's been a paucity of trust so great that it obliterated the century long business of investment banking. How did this come about?

Before elaborating it's useful to remind reader that policy emanating from Washington drives individual behavior. It makes some assets more valuable than others.

And in 2007 there arose two policies that combined with mistrust to unravel the market. All of us remember the Enron and WorldCom scandals. Those were examples of earnings opacity that led to policy changes meant to rebuild confidence in firm balances sheets.

First the SEC made the management of those companies responsible for their actions. Secondly, regulators sought to enhance reporting rules in hopes of preventing the Enron/Worldcom mistakes from happening again.

Unfortunately, when politicians and regulators seek to fix yesterday's problems, they often overreact. In short, there were many regulations put into affect, and not all of them were good.

Notably, the Financial Accounting Standards Board (FASB) Statement No. 157 became effective after November 15, 2007. What is commonly referred to as mark-to-market accounting changed how assets on balance sheets were valued. This required that public companies adjust their asset values based on the market value, as opposed to the book value of assets. In the past, performing loans (an asset) would be valued at book value. If a compnay had a $300,000 mortgage, which had been in good standing for 10 years, it could be booked at its accrued value. FASB 157 required that its value be adjusted to reflect the current market value of the mortgage.

In a time of distrust, when investors were selling these mortgages at fire sale prices, FASB 157 required that banks reduce the value of similar assets, even if performing, to the amount they were sold at by the latest distressed seller. As more mortgages were sold at distressed prices, driving their value down with each desperate sale, banks had to repeatedly reduce the value of those assets on their balance sheets even if they planned to hold them for the life of the loan. Compounding the banks’ problems were requirements to maintain reserves to offset these assets. As their assets fell in value, their capital requirements rose. This is how Fannie Mae and Freddie Mac got into trouble.

The second policy change that was the nail in the coffin for the investment banks, banks in general and AIG was the SEC's alteration of short selling rules on the books since 1938. This allowed investors to sell securities they didn’t own even if the share price was falling. This made it much easier to "short" shares, thereby opening the market to short selling on a massive scale.

The above policies, fueled by massive distrust, led to an avalanche of falling valuations. It all happened so quickly that even the most experienced investors were caught in disbelief. In simple terms, here is how it happened. Many want to blame a few investors who allegedly conspired to topple the investment industry. Everyone looks to parcel out blame in an environment of distrust. It may turn out that a few violated the law with regard to short selling, but it's more realistic to assume that a lack of trust sparked a forest fire that couldn’t be contained.

And thanks to mark-to-market accounting, banks were forced to continuously write down their assets and raise more capital. After Paulson perhaps foolishly let Lehman fail, distrust rose and banks began to experience a run on their capital at the very time they needed to raise reserves. Congress didn’t contain the damage until the $700B bailout was passed, and the FDIC raised the government’s guarantee on deposits to $250,000. Meanwhile, people began to close their money market accounts and liquidate their portfolios. Unlike commercial banks, investment banks were less secure because they didn’t have the safety net of government guarantees.

Short sellers, again fueled by distrust, began shorting bank stocks. Rumors fomented the latter, the kind of rumors that experienced investors knew to be exaggerated and perhaps untrue. Many of them bet against the gossip since this approach worked in the past.

Unfortunately, it is much harder to regain trust than it is to destroy it, so there was no time to invalidate the rumors before people liquidated their accounts and shorted the banks.

To understand this, a non-banking scenario is perhaps useful. Suppose you had a group of friends. Everyone begins gossiping about one of your girlfriends. They say she is nearly bankrupt, her husband is about to lose her job, and they’ve been living beyond their means. Would you trust giving her a loan? You might give her a gift if you were able to, but it's unlikely she would rate a loan. Even if the rumor turns out to be untrue, it's unlikely that she'll merit a loan until it is soberly observed over time that the rumors are false and she remains solvent.

The above is how distrust works. This is what happened with the banking industry in general, but the investment banks more so because they lacked the government guarantees when it came to solvency.

Policymakers perhaps should have foreseen the consequences of the 2007 policy alterations, but there was little time. Alan Greenspan testified that he didn’t see it coming. Even Ace Greenberg, the wise investor who headed up Bear Stearns for as long as I’ve been alive, couldn’t see it and certainly couldn’t stop it. Personal phone calls by him to other investors couldn’t reverse the rumors. This man had more experience and integrity navigating markets than nearly anyone, but even he didn’t have the clout to set the rumors straight in time to save Bear Stearns.

The pervasive mood of distrust, and the policy changes that allowed people to act on it, destroyed trillions of dollars of wealth in just weeks. Experienced investors, ones that for years were able to make deals based on a handshake and their honorable reputations, were engulfed in the losses because all that they knew and had experienced to be true about rumors vs. integrity led them to bet against rumormongering that was terrifying the markets.

Now the investment banks no longer exist. After 100 years they are gone, possibly never to return. This business model failed. Even the giants like Goldman Sachs could not combat the widespread impact of eroding trust.

Sadly, it will take years to rebuild trust lost, and which led to the disappearance of some venerable institutions. But like all problems economic, this too shall pass, and when it does one can hope for the ushering in of new policies that enhance, rather than inhibit, the essential process whereby public companies develop trust with those possessing capital.

Most econometric studies agree that restricting greenhouse gas emissions would slow our already sluggish economy.

A study by the National Association of Manufacturers projected that emissions caps, similar to those rejected earlier this year by the U.S. Senate calling for a 63% cut in emissions by 2050, would reduce U.S. gross domestic product by up to $269 billion and cost 850,000 jobs by 2014.

The Heritage Foundation estimated that such restrictions would result in cumulative GDP losses of up to $4.8 trillion and employment losses of more than 500,000 per year by 2030.

Other studies suggest smaller economic costs: Duke University's Nicholas Institute estimates a GDP loss of $245 billion by 2030, while the Environmental Protection Agency forecasts a GDP drop of between $238 billion and $983 billion.

Sharp emissions restrictions would also push the costs of energy and other consumer products higher. According to a study conducted by researchers at the Massachusetts Institute of Technology, the restrictions could raise gasoline prices by 29%, electricity prices by 55% and natural gas prices by 15% by 2015.

The people most vulnerable to such price increases are the poor. A 2007 report by the Congressional Budget Office, examining the costs of cutting carbon emissions just 15%, noted that customers "would face persistently higher prices for products such as electricity and gasoline. Those price increases would be regressive in that poorer households would bear a larger burden relative to their income than wealthier households would."

Indeed, the lowest quintile income group would pay nearly double what the highest quintile income group would pay, as a proportion of income, in increased energy costs.

And it appears that all this economic pain would be an utterly meaningless gesture.

Dr. Patrick Michaels, former president of the American Association of State Climatologists, now with the Cato Institute, says reducing U.S. emissions by 63% would prevent a mere 0.013 degree Celsius in warming. With emissions from China, India and other developing nations growing at breakneck speed, even this modest benefit would be completely erased.

Some argue that we should undergo this pain anyway to set an example for others to follow. The European Union tried that and now, apparently, it's throwing in its recycled-material towel.

At a summit in Brussels last month, the EU applied the brakes to its ambitious program to reduce EU carbon emissions by 20% by 2020 after Italy, backed by 10 other EU nations, threatened to veto the plan. They argued that the costs of the climate plan couldn't be justified given the current economic turmoil.

Little wonder that Europeans are balking. Europeans have been paying enormous costs to meet their targets, getting little in return. In the United Kingdom, green tariffs already account for 14% of the average electricity bill. Yet only 2% of Britain's energy needs are met by renewables.

To meet its renewable target of 15%, these fees will have to be raised even further, increasing the number of Britons suffering from "fuel poverty," defined as spending 10% or more of income on energy. Over 4 million Britons currently qualify as fuel-impoverished.

Imposing such costs on Americans promises to do for the economy what Freddie Mac and Fannie Mae did for banking. We should bail out before it's too late. Let's hope that this is one bailout plan all Americans can get behind.

But if Congress and the White House do proceed, they should rise above self-indulgence. The great danger is that a new stimulus will become an excuse for politically pleasing tax cuts and spending programs that have only a modest economic effect and do nothing to improve the long-term outlook. What we really need is a package that also addresses the future.

Herewith, three proposals.

First, let's not let lower oil prices permanently filter through to consumers. We've seen this movie before. A surge in oil prices produces calls for conservation, less dependence on imported oil and more fuel-efficient cars. Then oil prices drop, and we revert to our energy-wasting habits. This sets us up for the next price surge or any politically motivated cuts in foreign oil production.

My suggestion: Raise fuel taxes the equivalent of one cent a gallon per month for four years (total: 48 cents). For now, consumers would benefit from most of the lower prices, but they'd also be on notice that prices won't permanently stay down. To offset any depressing effect of higher fuel taxes, we could lower other taxes in lock step. But the signal of higher long-term prices should affect Americans' driving habits and vehicle purchasing preferences. Congress has increased fuel economy standards for new vehicles from today's 25 miles per gallon to 35 mpg by 2020. But it must also create a market in which buyers favor fuel efficiency.

Second, we should increase the earliest age that workers can qualify for Social Security from 62 to 64. This change (again) should be phased in over four years. When people retire early, they take a cut in their Social Security benefits to reflect the fact that they'll receive benefits longer. At 62, benefits now average about 75 percent of benefits at the normal retirement age (today, 66 years). Many retirees later regret that, by starting benefits so early, they crimp their monthly payments.

Raising the minimum eligibility age wouldn't save the government much, if any, money on the assumption that the monthly payments at 64 would be higher. Although people would work longer, their retirement would ultimately be made easier by higher monthly benefit checks and by delaying by two years the need to rely on savings. This change would also indicate Congress's willingness to tackle the larger problems of Social Security and Medicare.

Finally, Congress should explicitly authorize offshore drilling for oil and natural gas in the Atlantic, Pacific and Gulf of Mexico. Last month, Congress let lapse the long-standing bans against this drilling. But Congress might try to reimpose some type of ban, citing lower prices. This would be a mistake. Exploration and production can be environmentally safe. At best, it will take years before new projects begin producing and thereby limit dependence on insecure foreign oil. Why wait? America's huge foreign oil bill weakens our economy but also destabilizes the world economy. Oil producers don't spend all they earn, dampening worldwide demand.

I am not naive. These are all controversial ideas. The odds against their enactment are perhaps 100 to 1. But wouldn't it be refreshing if politicians disproved the conventional wisdom that they will do only (a) what's popular or (b) what crises compel them to do? Wouldn't it be a pleasant surprise if the president-elect -- whoever he is -- could work with the present Congress to produce a package that addressed both the present and future? Now that would be real change. Heck, it might even improve confidence.

Though these are recent stories, their type have been a staple for months now among newspapers. Last February, just as the foreclosure story was starting to gain traction, the Newark Star-Ledger chronicled the plight of Charmaine Perryman--who couldn’t make payments on her subprime mortgage after she lost her job as a child-care provider. That same month, as defaults were growing in Minnesota, the Minneapolis Star-Tribune told the story of Michael Kelley, a respiratory therapist whose credit fell apart in 2004 after a divorce that ultimately cost him his home, and Sarah Shannon, who got hit with a big bill for emergency dental work, then lost her job and eventually her home.

No one will ever accuse our media of a lack of compassion, but still, in reading over these stories and dozens of others like them, I can’t help but notice how frequently they mischaracterize the foreclosure crisis in America. The central illustration in these articles and many others like them is of Americans overwhelmed by circumstances beyond their control, from job losses to health problems to personal crises like divorce which ultimately cost them their homes.

But this is not what this foreclosure crisis has been about up to this point. At any time, including the best of times, one can find homeowners struck by unanticipated personal reversals who lose their homes. That doesn’t account for the foreclosure mess we’ve seen. In particular, job losses have not been at the root of this problem, even if they are central to so many media tales. As Prof. Stan J. Liebowitz of the University of Texas points out in his study, “Anatomy of a Train Wreck,” the foreclosure problems began in mid-2006 when the nation’s unemployment rate was holding steady at a mere 4.6 percent. What triggered the crisis were not layoffs but an end of the rise in home prices. By contrast, in the economic slowdown that began earlier in this decade, unemployment started rising in early 2001 and peaked at 6.3 percent in mid-2003 but resulted in only a modest uptick in foreclosures by today’s standards.

There are many clues about what has actually been going on that don’t make their way into the media’s stories. One compelling piece of evidence is the sharp divergence in the performance of fixed-rate vs. adjustable-rate prime mortgages. As Liebowitz observes, what we are currently seeing is often characterized as a subprime crisis, but in fact, it is an adjustable-rate mortgage problem. Starting in mid-2006, foreclosures jumped sharply for both prime and subprime ARMs, but not for fixed-rate mortgages of any kind, including subprime ones.

What’s the difference? Well, ARMs draw a different kind of buyer, one who is often intent on selling or refinancing before rates re-set. We have some idea of the extent to which this kind of buyer drove sales at the height of the housing bubble. In 2005, according to data from the National Association of Realtors, speculative home purchases, that is, purchases of homes for investment purposes that the buyer didn’t intend to live in, amounted to a whopping 28 percent of all deals, and 22 percent in 2006. “These numbers are large enough that if only a minority of speculators defaulted when housing prices stopped increasing, it could explain all or most of the increases in foreclosures started,” writes Liebowitz.

The data suggest that speculation was rampant among average Joes and Janes and not something primarily that high-end buyers or ‘yuppie flippers” engaged in (as a hilarious Saturday Night Live skit suggested a few weeks ago). Indeed, one thing that probably accounts for the large number of defaults in lower income and moderate income neighborhoods is that these buyers were most likely to engage in speculation, according to the data that Liebowitz has crunched. He found that speculative purchases during the current bubble were higher as a neighborhood’s average income decreased. In neighborhoods where household income was about $40,000, or about one-fifth below U.S. median family income, speculative mortgages accounted for one-third of all loans, while in census tracts where average income was nearly double the nation’s median, speculative loans accounted for well under 10 percent of all mortgages.

Although you will rarely find a straightforward and accurate accounting of this and other issues, if you read press descriptions of the foreclosure crisis carefully, you can find all sorts of hints about what’s really going on. For instance, a number of stories point out that the foreclosure problem is persisting in part because so few people qualify for the federal government’s bailout plan. Typically these stories quote frustrated mortgage counselors at local community groups who say they would like to help more homeowners.

But many buyers don’t qualify precisely because they made speculative loans or were intent on flipping their homes, and they instead walked away from their mortgages at the first sign of home depreciation. These folks aren’t current on loans that haven’t even reset yet, and aren’t about to tough it out on a loan even if they can negotiate a lower monthly payment, because it will take years for the value of some of these homes to get back to the original selling price. Why pay back a loan even at a lower rate courtesy of Uncle Sam if you can walk on it instead and suffer at most a hit to your credit score?

Indeed, even before some of these folks bailed on their mortgage payments, they were looking to bail on their mortgages contracts. In March of 2007, the Miami Herald noted in one of the few realistic stories about how we got in this mess that buyers were flooding local real estate lawyers with requests to get out of contracts because home prices had hit the skids in Florida. ''The scary thing is, people who have flaked on me tell me they have like five other contracts in other buildings under construction,” one real estate developer told the paper. Added a local lawyer: ''These are not people who have been wronged. These are flippers who wouldn't be saying anything if the market was going well.''

As Prof. Liebowitz notes, markets where speculative buying went on aren’t a small part of this problem, but a big chunk of it. Defaults in California and Florida alone have accounted for 42 percent of subprime ARM defaults nationwide in the second quarter of 2008.

Of course, rising unemployment may play a role in the next round of foreclosures, especially as the larger implications of this credit mess have spread throughout the economy and driven down the stock market, bankrupted financial institutions and cut people’s equity in their homes. But that’s speculation about the future of foreclosures, not a description of the immediate past.

Why, then, is the typical media narrative so at odds with the facts? Knowing the way reporters work, I’m guessing that in many of these stories, the press finds their examples by calling their local social service agency specializing in mortgage counseling, which promptly serves up a compelling example of someone subjected to sudden, Dickensian reversals of fortune in their lives. By contrast, finding your typical home speculator and flipper, the kind inspired by TV shows like Flip This House and by infomercials on how to make loads of money in real estate, isn’t all that easy. Even if you can track someone like that down, he isn’t about to expose himself willingly to the sharp glare of media scrutiny.

Besides, focusing on buyers who are bailing on their mortgages at the first sign of trouble dramatically changes the tone of a story, especially when you find that many of these people are not slick out-of-town investors or greedy yuppie flippers, but maybe just the folks next door. There are many types of people whom your local reporter and editor are pleased to characterize as greedy and irresponsible, but the working-class guy across the street or the retired couple down the block rashly playing the market are not among them.

When it comes to the roots of the crisis, to echo Jack Nicholson’s character in A Few Good Men, I wonder if the media can handle the truth?

The methodology used in the Cato ranking obscures the true nature of the governors' fiscal policies by failing to take account of contingent liabilities put on the states' books during the governors' tenure. On the one hand, the Cato ranking gives governors credit and penalizes them for hypothetical policy changes they propose—points for proposing tax cuts and spending reductions and demerits for proposing tax hikes and spending increases—all of which are politically contingent upon adoption by the legislature. On the other hand Cato's methodology fails to factor in real contingent liabilities enacted into law during the governors' tenure—tax hikes, new borrowing and spending increases—that automatically take effect under specified circumstances. These contingent liabilities are fiscal time bombs just waiting to go off as Fannie Mae and Freddie Mac recently illustrated.

In the specific case of insurance regulatory policies, the contingent liabilities can be huge. For example, in Florida, Governor Crist has presided over the greatest expansion in taxpayer exposure in the state's history. This high-risk exposure came about when Governor Crist attempted to fix the price of insurance below actuarially sound levels by browbeating private insurance companies into a 15-percent cut in homeowners' premiums across the Sunshine State. Immediately, homeowners' insurance coverage began to dry up. Insurance companies fled the state, and those firms that remained dropped thousands of homeowners' policies that had suddenly became actuarially unsound under Governor Crist's price controls.

In order to provide insurance coverage to the insurance refugees who suddenly lost their coverage and came knocking at the statehouse door, Governor Crist offered lower property insurance rates to residents by socializing homeowner's insurance coverage in Florida and assuming enormous financial risks for the state. When a major hurricane hits Florida again, which is inevitable, state law now authorizes the sale of nearly $30 billion in bonds to cover the state's exposure.
To put the magnitude of this exposure into perspective, consider the fact that California with an economy two and one-half times larger than Florida holds the record for largest municipal debt offering of $11 billion. Florida taxpayers face now face exposure almost three times this size. Because of this enormous risk exposure, Florida's bond rating has fallen substantially since 2007.

The fiscal consequences of these policies already have begun to come home to roost. Early in 2008, Florida issued more than $5 billion in debt to build up the cash reserves of its so-called Cat Fund out of which insurance claims against the state will be paid—the state's largest-ever single debt issue, which increased the state's debt almost 20 percent. And the greatest irony is homeowners' insurance premiums in the Sunshine State continue to rise.

Had Cato factored the contingent tax increase on Floridians into its methodology, Governor Crist certainly would have received a failing grade. Eli Lehrer of the Competitive Enterprise Institute (CEI) put it succinctly: "There's a real chance that Governor Charlie Crist's recent insurance reforms could bankrupt the state."

Lehrer knows whereof he speaks. He was the principal investigator on another recent report put out jointly by CEI and The Heartland Institute ranking the states in terms of how their regulation of the insurance industry (a sole prerogative of the states under current federal law) burdens consumers and poses fiscal risks for state budgets. Florida came in near the bottom of the state rankings, receiving an "F" grade. Not only is Florida the only state remaining that directly dictates the insurance premiums private firms may charge for homeowners' coverage, it also has largely socialized homeowners insurance by entering the insurance business directly through a state agency that disguises itself as an insurance company—the Florida Citizens Property Insurance Corporation.

Unlike private firms that must measure risk actuarially and provide financial reserves to pay claims through risk-based premiums and conservative investments, the state simply relies on the taxpayer as its cash cow when the time comes. According to the CEI/Heartland report:
"Citizens [Insurance Corp.] has been given the authority to impose taxes on every insurance policy issued anywhere in the state of Florida. When it sustains a substantial loss—more than 10 percent—it has the unilateral power to impose taxes (called 'assessments') sufficient that 'the entire deficit shall be recovered through regular assessments of ... insurers [and] insureds (sic).' State law places no limits on these taxes and applies them to everybody in the state, including people who have never done business with Citizens."

If a law like that doesn't deserve an "F" grade for fiscal probity, I don't know what does.

The trouble began this summer when some ethanol companies speculated on corn prices at $7/bushel. Now that corn has fallen to less than $4/bushel, the ethanol companies that took positions are taking massive losses. But they'll survive if they can use the government loans to purchase lower cost corn to mix with the more expensive summer '08 vintage. An ethanol bailout will seal the deal.

What explains a bailout of an industry that almost no one likes?

Fiscal conservatives are opposed to ethanol because it is heavily subsidized by taxpayers. In 2005, the federal government mandated that at least 7.5 billion gallons of ethanol be added to the U.S. fuel supply by 2012 and last year increased that to 36 billion gallons by 2022. Even with a super-sized government mandate for production and blending of ethanol, ethanol companies are failing.

Many environmentalists now oppose the production of ethanol because it is at least as environmentally harmful as oil. Groups like the Environmental Working Group and Greenpeace strongly oppose the further production of ethanol because, they claim, it exacerbates climate change.

Left and right leaning activists who work on issues of global development and hunger are opposed to the production of ethanol. Why? Because it has driven up global food prices, so that they have dramatically outstripped gains in incomes levels over the past few years.

Who, then, is supporting ethanol?

First, corn producers love ethanol production. When corn prices hit $7/bushel, farmers were making more money than they ever thought possible.

Of course, the domestic ethanol industry wants to keep making it. Sugar-based ethanol imported from Brazil is cheaper and cleaner but ethanol producers want it to remain subject to high tariffs. That's what keeps sugar-based foreign ethanol more costly and less competitive than ethanol made from Midwest corn.

Politicians have a vested interest in ethanol if they come from districts that have corn growers and ethanol plants. However expensive it is to taxpayers, ethanol generates money and jobs for a politician's constituency, and that means votes.

Let's review. Leftwingers, rightwingers, and everyone overseas oppose domestic ethanol. Corn farmers, ethanol producers, and a handful of politicians support ethanol and its protection from foreign imports. Guess who has more power?

Yet a bigger bailout for ethanol producers will likely pass with minimal opposition. We’ve now created a moral-hazard-free, bailout culture. When the "Big One" passed a few weeks ago, the deluge commenced.

Now, it's almost hard to think of an industry that isn't clamoring for a bailout. What's $25 million for ethanol, plus billions in subsidies and mandates, compared to $25 billion for automakers and $85 billion for AIG, and whatever else may slip through the cracks in the coming late night lame-duck session?

If the United States can't make a market work, how will anyone? This is the question that people will ask themselves. But, it is the wrong question.

Governments cannot make markets work. The federal government has tried to make ethanol work for years now. It never worked on its own; and it is not working with considerable government giveaways. What makes the Agriculture policy czars think it will work if it is granted another bailout?

Obama, however, has merely said he will "look at" drilling, a craven sidestep by a candidate cowed by extremists, which McCain rightly called him on in the last debate.

When Obama says that we can't drill our way out of our energy problems, he is either ignorant or being dishonest. The OCS holds an estimated 115 billion barrels of oil and another 635 trillion cubic feet of natural gas. To put that in perspective, consider that the U.S. burns about 7.3 billion barrels a year. Taking what the Earth gives right off of our coasts will help us cut our imports from hostile nations and drive down prices.

The candidates have significant differences on nuclear power, as well. On this, McCain's position is clear. He has proposed building 45 new nuclear plants by 2030. They would generate enough electricity to power more than 33 million homes.

Obama's views on nuclear power are muddled. In a classic dodge, he said during the Democratic debates that "we should explore nuclear power as part of the energy mix," but he has tended to follow up this qualified support with nonsense about renewable and alternative sources.

Obama also wants to be sure nuclear energy is safe and clean before we go forward. We suggest that by merely checking the record — more than a half century of use without a single domestic death or combustion emission — Obama could clear up any questions he has.

Just as he did with drilling, Obama gives the appearance of one who favors nuclear power, yet he allows himself plenty of wiggle room to abandon his "support" in deference to environmentalists.

Anyone who thinks energy will be more plentiful and cheaper under an Obama presidency should familiarize themselves with his plan to gouge U.S. oil companies — and by extension consumers — with a Hugo Chavez-style 50% windfalls profit tax. Why can't a major-party candidate for president of the United States understand that confiscating energy company profits ruins those companies' incentives for bringing more oil to the market? If Obama would read the Congressional Research Service's study on Jimmy Carter's 1980 windfall profits tax on oil companies, he would learn that it cut domestic crude production by as much as 6% and increased imports by 8% to 16%.

Most middle-school kids will grasp, when told, the laws of supply and demand and will acknowledge that commodity prices rise when supplies fall and can't keep up with the demand. Yet the man that the media have almost elected seems unable to comprehend a basic lesson.

McCain wisely opposes a windfall profits tax on oil companies because he knows their impact — curtailed investment in exploration and additional production — would be counterproductive. The Democratic Party says McCain "refuses to crack down on profits made by oil companies." That Obama's party would treat profit as a crime that has to be cracked down on tells voters all they need to know about this and all the other issues of the 2008 presidential campaign.

Thomas Sowell once commented that in the politically correct world of today, individuals previously known as “bums” have become “homeless.” In a similar way, Washington will use the money of others to elevate the status of the irresponsible homebuyers to “victims” of troubled mortgages.

We’re told that federal aid is necessary because housing is in “freefall”, and absent mortgage relief, home prices will fall even more. This is pretty impressive considering the same political class eager to shield us from falling prices was not too long ago bemoaning the lack of affordable housing.

Furthermore, the allegedly enervated housing market that has Washington so riled up isn’t doing nearly as badly as some might assume.

Indeed, while various media members and economists regularly wring their hands over a “collapsing” housing market, the fact remains that the broadest measure of home prices, the Office of Housing Enterprise Oversight (Ofheo) index, reveals something quite different.

According to the latest Ofheo report, home prices over the past year have fallen not 48%, but rather a far less significant 4.8 percent. By contrast, over the past year the Dow Jones Industrial Average has fallen 40 percent.

But even if housing had collapsed in the way that equities have, it still wouldn't be wise for the federal government to try and arrest the collapse. Beyond the reality that periods of falling prices represent opportunities which attract capital, the reasons for the government staying out of the way are many.

First off, failure is a teacher, and it is impossible to separate the ability to fail from the ability to succeed. It is thanks to failure that we learn how to prosper, and removal of this essential signal from the marketplace would over time create a broad level of poverty that would eclipse any that results from natural market forces having their way at present.

Secondly, subsidies meant to reverse natural market forces are a major economic retardant. While in a normally functioning economy capital would flow from failed ideas to potentially profitable ones, subsidies meant to make that which is ugly shine keep capital from reaching its most profitable destination.

Think of it this way: the seen in today’s economy is the federal government using taxpayer dollars to stave off the inevitable decline of General Motors. The unseen, however, is a future Google unable to find relatively cheap capital thanks to a government that creates no wealth itself, all the while crowding out tomorrow’s economic champions for capital to redistribute.

Thirdly, as the late Warren Brookes noted, in order for the federal government to aid one set of rent seekers, it must punish those not looking to the government for help. That is so because the federal government is only able to offer capital to those who’ve made bad decisions thanks to the vital few in society working in ways productive. We haven’t reached this point yet, but there will come a time that the responsible and hard working will no longer work and produce so that the federal government can transfer their gains to the irresponsible and lazy.

This is important when we consider housing, because despite all the nonsensical commentary from economists which posits that our economy is reliant on the sector, the basic truth is that housing is merely a consumptive affect of our productive economy. For economists to suggest otherwise is for them to ignore basic economics.

Put simply, in any economy we produce in order to consume. It is because we are productive in our work endeavors that we have gains that enable us to consume in all manner of ways, included in that the purchase of a home. In much the same way that oil had very little market value prior to the creation of the internal combustion engine, so is housing a valued commodity thanks to prior work that made consumption of living space necessary.

Those who doubt this need only walk the streets of New Delhi and Madras looking for houses. Rather than weathering under a collapsing housing market, India quite simply lacks houses due to a level of economic productivity that is still well behind ours.

So in seeking to save the housing market, Washington is unsurprisingly getting the solution backwards. To subsidize irresponsible borrowers on the backs of the productive is for Washington to discourage the very work effort that created the housing market to begin with.

What is still unknown is how long this legal Ponzi scheme will work. At some point Atlas just might shrug. If so, Washington will have “saved” the housing market only to destroy it.

It all began with one solitary person who had nothing, and a single idea which by itself had no weight. But together, both had immeasurable power.

Hearing those words about not playing the coward’s role, I recognized I could never deny the mysterious and powerful force of grace calling me to courage and action. That powerful transformational call moved me to do what is right and great in America.

I knew if I denied this powerful force, I would be miserable with regret for the rest of my life. The regret of not living a life to its fullest is a form of death.

Since the founding of my company, I have never again felt those same intense forces - until now. I again have the undeniable urge to do what is essential and what is important, at the expense of all else. If I fight to suppress the overwhelming need to write this letter, I will be forever out of integrity. I know I would again assuredly and miserably perish.

I promise this is a totally authentic and non-ghostwritten letter. The grammatical mistakes and misspellings testify to my intention of communicating ideas rather than eloquence. After two days, I am too exhausted to re-read and proof it again.

Senator Obama, before you decrease my livelihood, compromise and possibly destroy the livelihoods of hundreds of very successful working-class small business owners who are my friends and clients, before you destroy the jobs of the middle class who you say you are trying to help, and before you destroy the aspirations of young Americans who aspire to be successful, please read this letter in its entirety.

I would appreciate a direct and complete personal response. This letter is far more important than any policy paper your campaign advisors have ever given you. I advise you sit down to read it because of its 9323 words, 20-pages, and the numerous serious questions it poses.

I am just one man in solitude choosing those private thoughts to enjoy and those to challenge. My country’s promise of free speech is my best means of preserving all the other promises made to me and my ability to make and keep promises to those I love.

Your ascension to power from obscurity has come by three means: (1) refined oratory skills, (2) pandering to the middle class with arguments based totally on emotion, and (3) demonizing a very important element of society -- successful working class business owners, the rich and those aspiring “to be” rich, who do not openly defend themselves because they have been falsely taught to feel guilty about their noble values and conservatism. They should not now or ever bear any guilt.

Your approach to obtaining power is not new. Each time it has happened in history the outcome has been destructive and tragic to its nation. I hope this time is different. I have my doubts.

Pandering to one group while demonizing another is the way to create a socialist state. But socialism cannot be sustained if grace is present.

I ask: how great a nation will grace enable America to be? I know beyond any doubt this is profoundly the most important question of our time.

I also ask: How would your presidency and your policies honor a liberating grace?

These are a few of the questions which must be answered and I do not think you can honestly answer them fully and truthfully, so I will do so for you.

To suspend your suspicions about me and this letter, I assure you I am not a right wing lunatic or a religious extremist. Unapologetically though, my faith will be part of this discussion.

I am a registered Republican who contributes to some of its committees, to some of its political candidates and to a few organizations with conservative and patriotic causes. I am not an agent of any of them.

I also assure you there is not a racist bone in my body and there never has been. I am totally color blind. I am not blind, however, to your very dangerous economic policies.

Finally, on these introductory points, despite my cool last name, I am not the Dark Knight, nor a wealthy Bruce Wayne. I am just an ordinary guy deeply concerned about his country.

SPIRIT OF JOE THE PLUMBER

You said in your response to Joe the plumber’s well publicized inquiry about how your tax policies would affect him, “I don’t want to punish you with higher taxes. I just want to spread the wealth around.” This says everything anyone needs to know about you.

What you said is dangerous to the nation. You should see by the power of my liberated mind and the minds of millions of other working class business owners, create wealth and already spread it significantly around to others.

I am a working class business owner, dedicated to a life lived completely by faith, hard work, gratitude, personal responsibility, self-sufficiency, living well within my means (especially when I had little) and most importantly -- the virtue of honoring promises. My values have been the foundation to a joyful and fulfilling life.

I am a former lower middle class farm kid now living the American dream, through grace.

I have never for one moment felt entitled to the productivity and prosperity of others, nor have I ever asked or made others sacrifice their happiness for mine.

I believe the extreme leftist wing of the Democrat Party which you lead will destroy some very important elements of our economy - notably the working class business owners like me and the millions of small closely-held businesses which are the nation’s lifeblood.

The policy agenda you share with Speaker of the House Nancy Pelosi and Senate Majority Leader Harry Reid contain elements that are the outright enemies of democratically-free economies.

I am the kindred spirit of Joe the plumber. I know his mind and he knows mine, though we have never met.

I am the spirited mind of 600 independently-owned businesses affiliated with ours and imbued with a common DNA to build, create and serve others. These are independent CPA firms and financial planning businesses, founded and owned by energetic working class business owners, to which my company provides essential and valuable services.

I am also the spirited mind of Tom, a successful physician burdened with a large administrative staff needed just to handle the bureaucracy of Medicare and health insurance claims.

I am the spirited mind of Steve, the co-founder and owner of a very successful chain of local delicatessens employing hundreds of employees.

I am the spirited mind of Ray, the founder and owner of a local successful aviation maintenance business and flight school.

I am the spirited mind of Carl, the founder of an extraordinary automobile dealership who takes care of his employees and his customers.

I am the spirited mind of another Karl who started and founded an excellent lawn and landscaping services company that employs about fifty year-round employees.

I am the spirited mind of Don, the owner and founder of a car valet service employing hundreds of part-time workers.

I am the spirited mind of Larry, the founder and owner of several local small gyms, who employs many hardworking people.

I am the spirited mind of Tony, the owner of a small car service with at least a dozen hardworking drivers.

I am the spirited mind of Newt, the co-founder of a law firm with at least ten lawyers plus support staff on his team.

I am the spirited mind of Pete, the founder and manager of a specialized high technology service company employing scores of dedicated workers essential to my own organization.

I am the spirited mind of Henry, who founded and runs a successful trucking business employing many drivers.

I am the spirited mind of Tim who co-owns a successful roofing business employing many hardworking seasonal and long-term employees.

I am the spirited mind of Arlen who has a family farm, employing many farmhands.

In essence, I am the spirited mind of the 5 million small businesses in America with fewer than 100 employees that provide jobs to over 42 million people. Each of them is a model for owners and employees dreaming and working hard and with pride toward self-sufficiency. Each of these successful businesses is the wellspring of productive energy of the nation, yet they are the very ones demonized by your tax policies and rhetoric, putting them and their employees at risk.

Both Joe, the plumber who aspires to own his own business soon, and I are weapons of mass jobs creation, bonafide WMJCs, and very proud of our substantial contributions to the prosperity of America. Society is far better off because of our tireless efforts.

Like the millions of Joe the plumbers in this country, love for America is a source of my energy. My patriotism and gratitude are never adequate to fully honor our founders’ values and ideals which have liberated our minds to pursue our own dignified happiness.

I have a life I do not deserve. Thus, I know the essence of “grace.” But please, do not rob me of this undeserved life until you fully understand how this life and lives like it come into being.

The enemies of democratically-free economies have now, under the cover of populist sentiment slipped in during the night. These enemies callously demonize and threaten the very engine of our economic prosperity for their own political ambitions. They do this hoping that we, the powerless business underclass, will not speak up to defend ourselves because of some guilt we are made to carry. Well, we are not guilty, we are speaking, and we are enraged.

On October 3, 2008, the government enacted a $700 billion response to a huge collective moral crisis, the culmination of millions of personal moral failures, with the partial nationalization of our banking system. Add to that your election promises to confiscate and redistribute my money and the fruits of my hard labor against my will through radical tax policies, and America is rapidly becoming a socialist order. History will say you finished the job of creating this new socialist experiment.

Your liberal rhetoric filled with indictments of working class business owners of “being unpatriotic if we do not spread the wealth around more”, and “greedy capitalists” is abhorrent to me. You would compel our benevolence through a reframing of our minds so that we feel guilt and shame for our hard work and our successes.

Let me tell you, Senator Obama, there is no better show of compassion for humankind than starting a business and making it prosper. You don’t seem to appreciate how hard this is to do having never attempted it yourself.

In these dangerous times, Americans not so much need to be enlightened as to be reminded as to our fate under your destructive tax policies.

Like a nightmarish slow motion fall off a cliff, it is surreal to see the unthinkable happening. But, this is no nightmare. For small business owners, it is becoming our new reality unless we vigorously awaken from our shock and our stupor.

Awaken we must. Awaken we will.

YOUR 95% DECEPTION

I am a CPA and do not have to think very hard to see your personal income tax plan is a prime example of your duplicitous pandering.

The effective total tax rate on my income in 2007 was an incredibly high 31%. This includes federal income tax, payroll tax, and Medicare tax. My earnings are almost entirely from productive work with only negligible amounts from passive income from savings and investments.

You read that correctly. About one-third of the income I earn from my hard productive work is confiscated by the federal government. I gather from your rhetoric you still don’t think 31% of my income is enough to take from me.

This entrenched progressive confiscation of the fruits of my increasingly productive activities is wrong. I do not consume any more of the nation’s infrastructure, nor any more of its defense capabilities, nor any more of its judicial system than the masses of Americans who pay no taxes whatsoever.

I have calculated that through your proposal my total tax bill will soon be an astonishing 42% of my productive work. You plan to tax the entirety of my productive earnings for Social Security even though I wish never to be part of Social Security. You want to redistribute my tax proceeds to less productive non-taxpayers.

Where is the fairness in this?

Dating back to the earliest civilizations, none has ever taxed its way to prosperity.

You know the data behind your deception, but let me go over the facts with you anyway.

The top 1% of income earners in America, a category in which I proudly fall, generate 20% of the nation’s income, and yet, pay an astonishing 40% of the federal taxes. (By the way, this is significantly up over the past eight years from 35%!)

The top 5% of income earners generate 40% of the nation’s income and pay 60% of its taxes.

The most destructive part of this equation is that the bottom 40% of income earners in the nation pay no taxes whatsoever.

You may think the high income earners are ripping off the nation. This is just not true. They have become the high income earners because they are the nation’s most productive segment and have borne economic and social risks to build successful businesses.

Your promise to 95% of Americans that they will receive a tax break is an outright deception and appalling. How can the 40% who pay no taxes receive a tax break? Under the guise of innovative tax policy, you are masterfully creating a new welfare entitlement system.

I like to work hard, very hard. I like to make money and I want to make more of it. I want to spend my money where I want to spend it and give it to the charities I like.

If you progressively confiscate my productive earnings, I will work far less hard. I will stop spending my money where others can benefit. This negative behavioral response to extreme progressive tax policies like yours has held true in all countries at all times throughout history!

Who ultimately will suffer from my choice to reduce my earnings, my spending, and my savings? The charities I give benevolently to, especially my church. The local businesses that work hard to serve our company’s needs. The banks that need my deposits to lend to its customers. And especially, the middle class you are trying to help. The unintended consequences of your policies are many.

In other words, whatever you tax, you get less of; whatever you subsidize, you get more of.

Senator Obama, your tax plan is a roadblock to your own objectives, to put more discretionary money in the pockets of middle class wage earners.

You will not help the middle class by penalizing the wealthy, especially working class business owners. This is so because wages for all people, including the middle class, can only rise when the total amount of capital increases. Simply put, without capital there are no wages. Ask any of your economic advisors from the University of Chicago.

I’ll suspend my emotional angle for a moment and speak to policy. Your proposed middle income tax cuts are larger than your proposed increases for families earning over $250,000. That math does not work. A 10% tax cut, not a tax increase, on incomes of over $250,000 frees up far more capital than a tax cut on income of $50,000. Your logic has it all backwards.

That is why it is so essential to keep the rate of taxation on high productive earners, especially the jobs-creating working class business owners and their businesses, as low as possible, perhaps the lowest rate of all. It is not open to question that despite historic reductions on top tax rates top earners foot a much greater portion of the tax bill. More importantly, middle class incomes went up as well.

You know this data. In the last eight years, the tax burden, by virtue of lower tax rates, has increasingly shifted to the high earners, to 40% from 35% for the top 1% of earners, those who account for 20% of the nation’s income. It’s not magic.

The single best way to increase middle class incomes is to reduce the success penalty on the most productive people in America, the working class business owners and their businesses.

Americans should not be fooled when you say you will help the poor and middle class by taxing the rich. It is pandering. If you actually believe your policies, then you are committed to reducing the earnings of those not yet rich.

You should consider the blessings America receives from the vital few who start businesses. Tomorrow’s yet-to-be-seen large successful monster corporations are currently small, maybe even barely incubated dreams of a few guys and gals, a card table and a couple of folding chairs in someone’s garage.

It is deceptive for you to say that small businesses will enjoy lower taxes under your plan. The reality is that because of the structure of sole proprietorships, s corporations, and partnerships, a significant number of small businesses pay individual rates of taxation on profits. So the reality is that an increase in top rates like you propose will actually harm a significant number of the small businesses you say you wish to wish to help. Astonishing!

Worse, when you betray your alleged “like for small business” with proposals of higher taxes on them, you show a blatant ignorance of how hard it is to start and grow a business. We hear the stories of successful startup companies in America like the one I started. What is unnoticed in America are the millions of small businesses that did not make it. I know personally about these. With many businesses reliant on the smallest of earnings margins to stay in operation, higher rates of taxation could constitute the difference between success and failure.

Your politics of envy is the essence of your pandering. The late Warren Brookes once noted that envy “is the single most impoverishing attitude of thought.” Of the seven deadly sins or immoral vices: envy, lust, gluttony, greed, sloth, wrath, and pride, it is only envy that does not make one feel better.

Increased taxes on the so-called “rich” – high income earners - and their businesses will affect the incomes of those who strive to move up from lower and middle classes to become high income earners!

WORKING CLASS BUSINESS OWNERS.

Like every human soul I now know and those I will never meet, I believe we have one common universal aspiration. We all seek joy, significance and meaning in our lives. All else is superfluous. Our happiness is attained by the honoring of our highest values and achieving the fruits those values can bear. Values like honoring one’s promises, hard work, merited struggle, curiosity, and the mandate we use our minds and our passions to their highest potential, are the road to happiness. The fruits these honored values bear are self-worth, meaningful friendships, and yes, financial security.

There are millions of us working class business owners in America. We do not draw attention to ourselves. We silently, tirelessly, and courageously do magic for the nation. Today, we are all terrified.

Please do not refer to us as “entrepreneurs” because the term is demeaning and offensive. It does not dignify us enough for what we do. We working class business owners perform entrepreneurial miracles. Entrepreneurship is only a small part of our genius. We make the magic look easy, but it is not. Our businesses are our lives. Our businesses are our artistry. For us, they are not some get-rich-quick scheme to flip to an unsuspecting buyer. We work and live in our businesses every day of our lives, 24-7.

We, the working class business owners have no political power in America; yet, we are the inspirational, creative, risk-taking, jobs creating, and economic engine of the nation. Some even call us America’s lifeblood. All we can rely upon is a truth about the world, about human nature which is self-evident, a truth which cannot be debated. I pray it is a power which uplifts our patriotic majority.

We, the working class business owners, understand the sentiments and the motivations of the elite liberal class far more than you. This fact should be a great source of anxiety to you because the source of our personal power and our motivations is infinitely stronger than yours could be.

We do not pander or demonize people.

As personally responsible motivated working-class business owners, we have the grounding and the motivation to ethically and legally overcome every political obstacle thrown at us, to overcome every economic catastrophe the government causes, like obscenely high personal and corporate taxes, because we have a love of life most people cannot fathom.

My business began as a powerful life-changing idea and it must withstand the onslaughts of billions of destructive tendencies in all people and all organizations. The biggest threat to small business is the force of the federal government.

I have experienced the wrath of big government impacting our own business. Since Enron, the financial services industry has become so overregulated that the onerous administrative and regulatory costs have caused us and most of our competitors to change the way we do business. Forced to raise prices to cover regulatory compliance costs, we have severely curtailed our services to average Americans, the middle class, the very families who now desperately need us and our 600 affiliated professional businesses. Instead of helping the mainstream of America, we now restrict our professional services to the more affluent tier of Americans. What a shame.

Working class business owners are not to be confused with the leisure class. The overwhelming source of our income is from our active work in our companies, the wages and income for which we work very hard. We are often confused with the leisure class with whom I have no problem and I respect. Their primary source of income is not from productive work, but from passive income their investments generate and from their store of wealth derived from once being working class business owners. I say good for them. No, it is the horrific tax policies on the earnings from work, the fruits of one’s labor, that portend terror for our businesses, our employees and our lives.

STOP PANDERING

Our terror stems from political pandering to hard-working middle class Americans through promises of unearned entitlements, risk-free home ownership, universal health care, and income redistribution, while simultaneously demonizing the most economically productive people the country needs.

Pandering in politics is defined in Wikipedia as the “portrayal of one’s views to fit in line with a certain crowd of voters the candidate is attempting to impress, when often, these are not the candidates true beliefs.” Apparently pandering by politicians is a legal license to lie. You have elevated it to an art form.

Your pandering is transparent. It attempts to gain the favor of all those who will keep the powerful in power or to replace those in power. It is very transparent. In so doing, all citizens eventually suffer. Abuses of the law of man ensure that our liberties, our freedoms, our right to justice, our right to private property and our right to pursue happiness will most assuredly disappear.

Moreover, you do not seem to understand human nature. You are willing to say only enough to get elected. You are not willing to expend any political capital to solve any real problems like social security and Medicare entitlements that lapse outside your next election cycle except by raising the taxes on the high earners, including working class business owners. We see this deception; do not act as though we do not understand it.

It is like going to a play. We the audience know the actors are acting and we forget they are acting sometimes. The actors know we know they are acting, but for a moment they wish the audience did not know. Stop the pandering and get honest with the American people.

MY PERSONAL STORY

Since you have written two memoirs before ever accomplishing anything of significance in your life, I can, with much humility tell you a little about me. It may help you understand.

Like the millions of working class men and women, my story is very ordinary.

I came from a family of lower middle class income and social values. I was a Catholic altar boy all the way through high school, with divorced parents, three younger brothers, one of whom is disabled, and a father who occasionally drank too much. All of these attributes are pretty standard American experiences that ultimately present a very strong foundation for big dreams and incredible success.

Like most of the so-called millionaire households in America where 70% are first generation wealth, mine is the fruit of very hard work, not the blessings of inheritance. Born from an enterprising mind, not from any family wealth. There was none available.

I bootstrapped my way through life to financial independence and happiness because those were the values I aspired to. I believed totally in the promises America made to me and to all its citizens.

My motivations were many. I could never tolerate the thought of being an economic burden to the government, society, or to my family. Self-sufficiency is a virtue. I grew up in a nation which promised that someone like me could commit himself totally and attain total self-sufficiency. I never ever once conceived someone or some government agency owed me a head start. I committed myself to live by unconflicted values and attain higher levels of joy, significance and meaning.

I am a product of public schools, local community college, and state university. I am only marginally educated beyond my intelligence. I was taught to think rigorously.

No job was ever beneath my dignity. I did farm work, drove a tractor to plow fields, operated a combine to harvest summer wheat, cut and stacked hay, navigated a Sunday morning newspaper route, was a fry cook at Kentucky Fried Chicken, cutter in a beef packing plant, roughneck on a drilling rig, night clerk at a liquor store, a bouncer at a discotheque, and I even trapped and killed gophers on a golf course. Yep, I was the original Carl Spackler in “Caddyshack.”

My parents never financially helped me because they could not, despite their desires to do so. They did the best they could in life and they would not have ever considered asking for a handout from anybody. I would never change one thing about my upbringing.

I have never asked for or received government assistance. It never even crossed my mind. I know a lot about struggle: the only path to joy, significance and meaning.

Even though I am successful and supposedly “have money,” I still retain my middle class values and teach them consistently to my children.

I have continuously prepared my mind for life’s fascinating intersections with chance and opportunity. I know personally the power of divine inspiration. I know the possibilities the human mind can create. I know by changing my thinking I have changed my destiny.

MY BUSINESS, MY LIFE

My wife and I started our company in 1992 with an $88,000 investment from our savings, a few untapped credit cards, a month-to-month rental on an executive suite, no customers and no employees. All we had was a dream, the willingness to work very hard and to honor the promises we made to people.

We lived frugally and saved money which allowed us to have options and choices in life like starting a business. For the first thirteen years of marriage, we lived in a 1,200 square foot home with our two young sons with mortgage payments of only $650/month. Frugality ruled the day and it still rules.

For two years after the start of the business, I drew less than a $30,000 salary, living mostly on additional savings. For the ensuing five years, I drew a salary substantially below my market value just to make the business work. This is the price a working class business owner pays for happiness.

Sixteen years later, we have a national payroll of over $125 million and the pride we feel is for the creation of so many good jobs and the opportunity to serve those we love.

A life centered on high and unchanging values is central to the life of a working class business owner. For me, the virtue of personal responsibility is so important that I will not even give a permanent job to my sons. They cannot even apply for a job at my company. They are not entitled to one from me. I love them and I only owe them a good education and an education in those life values essential to their personal joy, significance and meaning. They will be better and happier men for it.

Senator Obama, business and commerce together have solved far more of society’s problems than government ever has. Why don’t you see this?

The purpose of business is to make people’s lives better. Period. When this aim is the focus of the organization, ample profits and incredible economic value accrue to the owners, managers, employees and vendors to share.

Those businesses which make people’s lives better thrive and produce greater economic value to spread to owners, managers, employees, and vendors. Those vendors produce even more economic value to their owners, managers, employees, and other vendors. You see, productive success is contagious unless tax and regulatory policies like yours intercede and then the whole system crashes.

Government is a necessary, yet fundamentally ineffective element of society which has the power to make and to enforce laws. Yet it sabotages people’s lives. It does not make them better.

The sole purpose of government should be merely to defend the nation’s borders, protect its citizens from thugs on the street, and to assure private property is protected from the government and all others who would confiscate it.

As Ronald Reagan so aptly put, “we are a nation with a government, not the other way around.” America is a concept, a set of incorruptible values its citizens and its government must honor: justice, liberty, freedom, personal responsibility, and the pursuit of happiness. This does not include the guarantee of happiness.

Our loyalties can be directed only in one of three ways: to individuals, to institutions, or to our values. History proves loyalty to persons (especially aspiring presidential candidates) and to institutions (like the federal government) always, inevitably, disappoints because they are, at their core, self-serving. It is in their nature, and in the nature of their system to fail us.

One cannot and should not be patriotic or loyal to any government or person which distorts these values. We can only be patriotic and loyal to the values themselves.

Values will not fail us. They live strong and forever in our minds, unblemished, never corrupted, never corruptible.

Like artists, working class business owners gain the joy of work done extraordinarily well, the stress of it being in progress and unfinished, and the knowledge it will be done even better the next time. We never attain perfection. This is our struggle. In our mind’s eye we absolutely know what perfection looks like. This vision is the source of our power.

One of my objectives as a business owner is to educate and motivate our great employees to someday start their own businesses if they so dream for this is one path to ultimate happiness. Your confiscatory tax policies may eviscerate a major reason to ever strive -- the hope for real financial independence.

Those values that define the best in business character should be made manifest and expressed ever more in government. These values being: honoring of promises, fiscal discipline, honesty and transparency. You would not, if elected, find it in yourself to be as noble as the very best leaders of commerce that you seem not to respect.

HAPPINESS - THE GREATER PUBLIC GOOD

Senator Obama, we working class business owners will not sacrifice ourselves for the so-called greater public good. We will not sacrifice our happiness, which derives from honoring our values.

I once read that happiness is a state of “non-contradictory joy.” A joy without penalty or guilt. A joy which does not clash with our personal values. A joy which does not simultaneously work toward our own self-destruction. A drunkard knows no real joy though he may think so. Productive people, like working class business owners and their employees, know real joy.

You are seemingly intent on making the federal government the source of everybody’s happiness. For us, your scheme will not work. It can only cause our unhappiness.

In summary, you and the Democrats wish to destroy the very same system which enabled me to not be a burden to the nation and to take care of those Americans who legitimately suffer and need help.

In the secularist’s mind, I am independent and wealthy because I am either lucky, corrupt, or both. You probably think my ultimate goal in life is to be wealthy. I assure you it is not. My goal is happiness - there is a difference. Yet, my wealth, in large part, is a by-product of commitment to my values. The honoring of these values has led to my happiness.

There is a very high cost to happiness and most people will not pay its enormously high price which includes extremely hard work, long hours, loneliness, fear, doubt and personal struggle. With my success, others, especially the government through confiscatory tax policy, seek to take away the fruits of my pursuit of happiness.

SUFFERING

Senator Obama, do you really believe we are supposed to be benevolent and compassionate to anyone and everyone who suffers? I am sure you do not and your policies are an example of your pandering. There is a keen difference between “legitimate” and “illegitimate suffering.”

“As you do unto the least of these you do unto Me” is often misinterpreted and misquoted. Christ was talking about that segment of society that legitimately suffers, not through any sin of their own. He meant those whose circumstances are not a product of their choices in life, like a birth defect, extreme judicial abuses, or supernatural catastrophes. Christ did not mandate that altruism be shown to those who suffer because of their own bad choices, or their lack of a noble value system, or their lack of discipline to honor that value system.

Basic principles of fairness and personal responsibility support this philosophy.

I love my sons and tell them I do not care about their “self esteem.” But I do care deeply about them. There is a difference. I will not ease the emotional and financial suffering they bring onto themselves by their own choices. I will not protect them from the appropriate emotional responses to the consequences of their poor choices. This is a sign of my love for them.

The worst form of hypocrisy is the compromising of one’s innate values to obtain or retain power. We, the working class business owners, see clearly your hypocrisy.

STOP DEMONIZING CAPITALISM

Senator Obama, your policies are an affront to capitalism and you demonize it with your subtle cynicism and your condescension.

Where capitalism appears to have failed is because of government intervention. This fact is not even debatable. Government intervention has created such deviant versions of capitalistic democracy that those variants should not even be called true capitalism.

Venezuela’s Hugo Chavez has declared class war on capitalism and democracy in Latin America. Much of the Latin American form of capitalism should be called “capitalistic cronyism,” where true open and vicious head-to-head commercial competition was never allowed to take root and the best entrepreneurial minds were hamstrung by aristocratic legacies and corrupted governments.

Do not compare America’s capitalism to its failed imitators. Your plans for more federal government intervention and control of our economy will most assuredly lead to the same fate as the club of failed imitators.

UNINTENDED CONSEQUNCES OF YOUR IDEAS ON OUR COMPANY AND OUR EMPLOYEES

Senator Obama, your promises of horrifying tax increases on me and on the company I run and your threats of even more burdensome regulation are, in your own words, “game changers.”

Higher corporate income taxes and payroll taxes rob and neuter all businesses great and small of their ability to make and keep essential promises to the people who depend on them. This is a shame and a consequence of idiotic and pander motivated ideas.

Under your taxation plan, I may one day be in a position to no longer make any meaningful promises to our fantastic employees.

I need you to come to Dallas and join me some day in our bi-weekly company staff meeting and tell them why their hard work may not be rewarded with higher compensation, promotions and higher self-worth, which all should come from their successful efforts.

You need to explain to them why I may no longer be able to afford the 100% matching contribution in their 401(k) plan.

You’ll need to explain why I may no longer be able to afford top-tier group medical, eye care, and dental insurance for them.

You’ll need to explain why I may no longer be able to afford to continue our great personal development programs.

You’ll need to explain to them why their stock options may never be as valuable as they had hoped because the company is less profitable and less valuable.

You’ll need to explain to vendors why I may no longer be able to do business with them because our revenues may drop and corporate tax rates rise.

The mere threat of your policies is force enough to cause small businesses to react. You and the Congress do not even need to enact them into law.

I must eventually yield to the socialist state. I will unfortunately have to run our company much leaner in anticipation of these terrible policies because I was born to use my talents and gifts toward a better life, not to be forced to suffer for the so-called “betterment of the greater good.” That is my truth and the truth of all closely-held businesses and their working class owners.

You need to ponder today the inevitable consequences of working class business owners giving up on the pursuit of joy, significance and meaning in their own lives in America because of our hostile tax, regulatory and legal environment. What would happen if we simply took our talents to another country like Ireland, Russia, China, India, or Brazil where ideas, labor, capital and victories are loved and respected?

All great lives commence with a person’s quiet realization he or she will not play the coward’s role. Working class business owners are the most courageous people in America, except for our men and women in uniform, those police officers protecting us on the streets of America, and firemen who rescue us from tragedy and peril.

Where you see a successful business, where you see a successful life, I promise you tremendous gut-wrenching courage has been exerted again and again to build that life. High tax rates discourage many talented people from ever acting on that call to courage. They simply conclude that it is not worth it.

Your unspoken Socialist creed “From each according to his ability, to each according to his need” is a creed which will eviscerate any chance of a great and honorable society.

The source of America’s daily sustenance and the source of her eternal salvation is from grace. There is no salvation from the federal government.

I believe our nation can achieve greatness beyond our imagination only if salvation by federal government is erased completely from our consciousness. It is a toxic addiction - the heroin from which we must commence immediate withdrawal.

The federal government is dysfunctional beyond repair. Dysfunctional organizations are chaotic and grossly inefficient and you, amazingly, intend to make it bigger. Why?

The first axiom on organizational dysfunction is that dysfunction increases exponentially by the sum of (a) the square of the headcount of its non-productive persons (usually the people who feel most victimized by the organization and who express extreme forms of social compassion to fix all of the world’s problems utilizing the resources of the organization) and (b) the cube of the number of incompetent management people. The federal government has set the bar high for this axiom. Just ask any working class businessperson who knows all too well the causes and dangers of inefficiency.

You, who have never run an organization in your life, may be stepping into the chairman’s seat of the largest most dysfunctional organization in the world. I am astonished you think you are prepared for it. I am even more horrified you want to make it bigger.

The purpose of business is to make people’s lives better. Business and commerce have improved and will improve far more lives than any government. Yet under your policies, we who improve the lives of others are targeted for extinction. We might all collectively “shrug,” give up and go on strike. What happens when there is no one left to create jobs like we can?

I have risked my entire financial future on noble enterprises which have improved the lives of others, and yes, even my own family. My family and I have borne the high cost of the pursuit of happiness.

I wake up every morning thinking about what promises to make and how I will honor the promises I have already made. This is the result of grace, but it is not grace itself.

I have paced the hallways of my own home for three straight days and nights worrying and praying about how to solve an insurmountable problem that I could not even define, or whom to trust, or where the resources would come from, and in the end successfully turned the dire situation to the good. This too was the result of grace, but it was not grace itself.

In the early years, I had to make more than one payroll out of rotating a series of personal credit cards because of tight cash flow and the commitment to my employees that they were always to be paid before me. This too was the result of grace, but it was not grace itself.

I have many times out of compassion, and when I did not have money, carried on the company payroll employees who were not performing as needed or could not be helped to improve, or who were going through a traumatic personal crisis. My benevolence gave these employees time and money to sort out their problems or to find other employment. This too was the result of grace, but it was not grace itself.

I have taken many complex and almost desperate situations and, from the wits of our leadership team, turned them into positive outcomes. This too was the result of grace, but it was not grace itself.

I have been sued many times under nuisance pretenses. The distractions of litigation did not and could not divert the energy needed to run and grow my organization. This too was the result of grace, but it was not grace itself.

Two years ago at the age of 50, I was diagnosed with a rapidly growing stage three throat cancer with only a 15% statistical chance of a five year survival. I do not smoke and I drink only an occasional glass of wine with a restaurant meal. This was not a tragedy. This was just life.

I suffered through the dehumanizing and debilitating effects of 40 radiation treatments, two bouts of poisonous chemotherapy, and recovery from more than one surgery. I am victorious and cancer-free for many reasons: the love and care from my family, friends and business colleagues, great new cancer treatment protocols to name a few. And prayer, yes, prayer to Almighty God for my healing.

But my victory is also very much due to the love of my work, my business, my aspirations to finish the unfinished, to make it perfect, and to take care of the people who depend on me. This is why small businesses and working class business owners are important to America. This too was the result of grace, but it was not grace itself.

TEMPLE OF DEMOCRACY

Our exulted Temple of Democracy, the United States federal government, is miserably corrupted and shamelessly dysfunctional and its hubris will not even allow it to recognize its state of being. In this presidential campaign, you have fired the very loud shots of class warfare. The sickened pathology of our government would get much worse under your presidency before it hopefully eventually gets better under another.

Whether one is a secular humanist or a fundamentalist Christian (I am neither), our Judeo-Christian heritage should point us immediately to the testaments for some understanding. Regardless of whether one views the Bible as sacred scripture or as history or as mere mythology, it is embedded with essential truths about the nature of man and the nature of bureaucratic power. The testaments deliver an irrefutable reminder for all Americans.

Our metaphoric American temple is corrupted and ineffective for the very same reasons as the ancient holy Jerusalem temple, the seat of Jewish political, economic and religious power during the time of Jesus Christ. In its day, it was the most massive working construction project and the largest center of commerce in the entire Middle East.

“ON EARTH AS IT IS IN HEAVEN”

Your twenty years under the pastoral guidance of Reverend Jeremiah Wright has apparently not taught you the message of Christ’s complete desire for humankind. His desire for us is beyond imagination and He gave us the key to it. I apologize if I have read you wrong on your understanding of this point. I have never heard you speak about it.

Again, I am not a religious extremist.

“Thy kingdom come, Thy will be done, on earth as it is in heaven” from the Lord’s Prayer states emphatically Christ’s desire for humankind. The kingdom on earth does not mean a socialist state. That would be anything but a kingdom where “His will can be done.” A socialist state is enslavement of the human mind. Such a kingdom cannot possibly thrive.

The kingdom on earth is created by God’s liberating grace, the freeing of the mind from oppression and tyranny so we can be reunited with Him. You seemingly do not understand this.

Christ so loved His Father, He so loved His Jewish faith, and He so much hated the Jewish temple’s bureaucratic corruption, that for three years He engaged in the most famous political activism in history. His activism targeted the entrenched corrupt and arrogant powers which controlled the temple and oppressively ruled the subject Jewish people.

The oppression was manifested by impoverishing subjects with high taxes and a Gordian knot of abusive interpretations of Jewish law, akin to our modern federal regulatory environment and the plaintiff’s bar. Like them, we modern Americans are always in a legal and regulatory “gotcha” which is now suffocating our dynamic creative and liberating spirit. Your policies and your ideas are no different.

The rulers of the Jews were an intellectual class, similar to you and your friends, and backed and supported by the armies of their Roman occupiers. This intellectual class included hereditary aristocratic families and scribes, the ancient version of our modern lawyer class, of which you and much of Congress are members.

The oppressed Jews included the poor peasants, the farmers, and the working class small business owners.

The Sanhedrin, the seventy-one member ruling council of the temple, similar to a blend of our Supreme Court and Congress, was comprised of various intensely competing sects of Judaism. One of the largest, most powerful sects was the Sadducees, a hereditary aristocratic upper class, perhaps an ancient version of our Senate. Another sect was the Pharisees, the strict pious enforcers of the Jewish law who directly interacted with the common people and oppressed them with their schemes and intimidation.

Caiaphas, the Chief Priest of the Sanhedrin, and a Sadducee, was the most entrenched and corrupted of them all. He was the president of the Jewish temple and held sway over the economic and political system.

The corruption technique used by the Jewish power elite was to pander to some groups and demonize others. Some things never change.

Christ’s plan was to return the temple to a sense of judicial fairness and economic justice by empowering the oppressed and disarming the oppressors with a new paradigm -- a paradigm that brought forth truth about themselves, about power, about human nature and about love. He did not spread an evil message of robbing from the rich and giving to the poor as you have in your campaign. He was diplomatically speaking in code through parables to the Sadducees, the entrenched, corrupted, rich and powerful of the temple structure. He was thoughtfully telling them to deeply consider their motivations.

The wealthy class in the Jerusalem temple controlled all the land and productive agricultural assets of the nation. The so-called rich today, especially the working class business owners and their small businesses, ARE THE PRODUCTIVE ASSETS OF THE NATION. There is a vast difference between then and now.

His campaign for eternal Truth, as we know, cost Christ His life and in so doing, empowered ours in so many unimaginable ways. Christ changed humankind forever with the empowering concept of “grace,” a magnificent liberation from the impossible laws and regulations with which we can never comply and the high taxes we could only barely afford. His best gift to mankind was a direct, non-interpreted, reconnection with the source of liberating grace, God the Father.

The corruption and the ensuing destruction of the Jewish temple in A.D. 70, and the fall of virtually all the political temples of ancient and modern history, such as Greece, Rome, the Kings of France, the Czars of Russia, and numerous others, were as predictable as any of Isaac Newton’s laws of physics. You are about to ignite the greatest temple destruction in history with your policies.

With the destruction of the Jewish temple came the death of the Pharasitic/Sadducean system to be replaced by the modern rabbinical system. The point is that the strong values and the contributions to humanity Judaism made did not die with the temple. But, the ancient and corruptible power structure did die. You seem intent on destroying both the temple of America and also its founding values.

History shows that a condescending aristocratic and intellectual ruling class retains its power, its sole motivation in life, by abusive self-preserving means. It acts as both villain and hero by simultaneously creating and resolving class warfare and massive economic booms and busts through ill-conceived policies. It subtly abolishes any chance of a true meritocracy where the cream of society can rise to the top and unleash its brilliant mental and creative energies for the betterment of themselves and of society.

Justice, fairness, private property and liberty are denied in toto. Open class warfare ensues. Society suffers and silently fails, leaving the historians to explain to future generations what happened who then see the cycle repeat itself with later generations that either never study history, or simply believe “this time is different” and “history does repeat itself.”

The character of our current government and its policies are the enemies of democratically-free economies just as the abusive Jewish legal system enforced by the Sanhedrin created a domination system that oppressed the ordinary, hardworking Jews. You intend to take this oppression to its zenith.

The axiom, “Free people can never be equal, equal people can never be free” lives forever.

Righteous rage is brewing in this nation. What can we do to overthrow the modern “tables of the moneychangers?” What are we, the working class business owners of America, willing to do to make holy again our own temple of democracy? I do not yet know, but the energy and the rage are undeniably strong and growing.

GRACE

Grace, as the ancient Jewish Christians initially conceived it to be, when coupled with redemption, is the unearned gift to be freed from personal guilt, from despair, and from the sinful corruption of our own personal making.

Christ had a design for us on an even grander scale than simply forgiveness for our frequent moral failings which stem from the seven deadly sins. He made it so our minds are liberated from all oppression, freed from despair, and renewed to seek our own unconflicted happiness, to honor our noblest values, to be creators like He commanded us to be in His image, to be caregivers to the legitimate sufferers, not all who claim to suffer. Our nation’s government, our temple, must honor the same noble values as its citizens who are committed to honoring theirs.

How great a nation will grace enable America to be? Democratic capitalism is the only solution for humankind. It is the only manifestation of liberating grace for each and for all.

Grace liberates our energies from the demonic bureaucratic oppression that you unfortunately propose with plans for bigger government.

Grace liberates our minds to conceive and attain the true source of our happiness.

Grace liberates us from despair.

Grace liberates us to honor the very important promises we want to make to our loved ones.

Grace liberates us to be creators as God intends us to be.

Finally, grace liberates our souls to be reunited with the mind of God – to be in His image.

Your tax policies inhibit grace, and do not liberate it.

Senator Obama, we working class business owners do not cling to our guns and our religion when times get tough. Our faith and our connection to truth are the source of our energy. Do not destroy this energy with your ill-conceived policies.

Free up our minds. Liberate us from tyranny. Don’t promise to regulate us more. Don’t increase taxes on the most productive segment in society. Otherwise, this temple will also crumble.

Most importantly, grace, as Christ meant it to be, is the source of America’s daily sustenance and the source of her eternal salvation. The federal government is the source of neither.

Just as working class small business owners fully and personally bear the consequences of their decisions in life, I do so now by sending you this letter and making it public. Again, I am just an ordinary guy very concerned about the damage your policies will assuredly bring to my life, my business, and my country.

Senator Obama, I’d be glad to discuss the contents of this letter at a place and time of mutual convenience. With kindest personal regards, I am

Sincerely yours,

Stephen Anthony Batman
(Tony)