Q1 ’09:   Lifestyle Downsizing

The meltdown consuming the global economy is already the worst since the Great Depression. This fact does not necessarily mean we are going to experience another depression of that magnitude and length, although we may. What it does mean with certainty that life in America is going to be different, and considerably more modest, for the foreseeable future. However the specifics unfold, change is the operative word. I don’t think President Obama had any idea just how prescient his campaign theme was.

Since the collapse of the Soviet Union the world has been waiting for the other shoe to drop and now with the collapse of the global Capitalist credit bubble, it finally has dropped. Among the consequences has been a substantial loss of geopolitical power for the U.S. American influence on the global scene has been waning since the invasion of Iraq, and since the bursting of the credit bubble the pace of re-alignment has been picking up speed, seen most clearly in the increasingly aggressive moves by China to establish itself as a power player on a global scale. Allies and enemies alike no longer look to the U.S. position before pursuing their own interests, even if those interests directly conflict with those of the U.S. High profile efforts to solve intractable conflicts in the Middle East and Afghanistan notwithstanding, we are witnessing the end of the U.S. as global hyper-power and the beginning of what will soon be a retreat from Empire.

This re-alignment is in turn spawning a cascading raft of changes for the U.S. both globally and domestically. It is the end for American style laissez-faire capitalism, of the American consumer as the driver of the global economy, and the beginning of the end of the U.S. dollar as the world’s reserve currency, which is a much bigger deal than most people realize. At home it is the end of the long run of excessive consumption enabled by the status of the dollar, and it is probably the end of the Republican Party, which relentlessly promoted (and unapologetically continues to promote) the policies which have undone us.

Chief among those policies is “trickle down” economics, otherwise known as Reaganomics, once appropriately called “voodoo economics” by George Bush Sr. Trickle-down economics has never been anything other than a pernicious fraud, and now the fraud is unmasked for all the world to see. It will be at least 50 years before it can raise its ugly head again, if ever.

Robert Reich wrote an excellent essay on this matter in the 3/28 Wall Street Journal entitled “Obamanomics Isn’t About Big Government.” In a very balanced presentation, Reich reviews the ascendance and consequences of trickle-down economics and highlights the sea-change in philosophy represented by Obamanomics.  

Where We’re Headed

The foundations of our economy have been rotted by decades of bi-partisan fiscal irresponsibility, and utterly destroyed by the excesses of the Bush era. The efforts of the Obama administration to arrest the collapse are akin to catching a falling anvil. These efforts will soften the blow for awhile at considerable cost, and may give us time to better manage the retrenchment; but ultimately the full price is going to be paid, one way or another.

In the near term much of the change, or more appropriately — debt withdrawal — will continue to be painful, very much like the experience of a drug addict in withdrawal. Long term, just how long and painful the changes will be will depend on the policy decisions made by our leaders in Washington, and ultimately on ourselves. Are we the people able to accept the retreat from Empire and the inevitable lifestyle downsizing that goes with it with equanimity? Can we give up our toxic politics in order to come together as a nation to deal with our self-inflicted problems and build a better future?

Some are expecting the current difficulties to be fairly short lived and that we will soon see a return to business as usual, if somewhat less vigorous than normal for a few years. I’m afraid those people are destined to be disappointed, and I am concerned that Obama’s economic team appears to fall into this category. Treasury Secretary Tim Geithner and senior advisor Lawrence Summers, Director of the President’s National Economic Council, have both been deeply involved in the Wall Street culture of greed and in the implementation of policies that enabled the current debacle, and they are clearly intent on maintaining the institutional structure and primacy of the big banks that are directly responsible for it.

Try as it might, even the U.S. government is not big enough to stop the balancing of accounts that is underway. The entire financial system is de-leveraging from the 40:1 madness of recent years, leaving a huge hole in the global capital structure, on top of the $4 trillion or so in outright losses at the big banks from their clever Enron style off-balance sheet investment schemes.

Meanwhile, consumers (70% of GDP), having doubled up on debt and saved virtually nothing over the past decade or so, are suddenly realizing that they actually have to pay for all that stuff they’ve been buying on credit. At the same time they are faced with double digit declines in the value of their primary asset, their homes, and unemployment steadily climbing toward double digits. Yikes! And if that isn’t enough of a drag on the economy, the corporate world is reeling from the severe recession and laboring under its own massive debt load and overcapacity in every sector as well.

Corporations are cutting back and spending less, consumers are pulling back to start saving and paying off debt, and the banks are just trying to stay alive. That leaves government to pick up the slack, which they have been doing by borrowing, printing and pledging trillions of dollars…over $12 trillion so far. However, all the new debt is not going to give us much bang for the buck. In 1966, one dollar of debt boosted GDP by almost one dollar. That was good value, but after 40+ years of relentless debt creation we now get less than twenty cents of GDP from every new dollar of debt. Clearly the creation of ever more debt is not going to get us out of the hole, and in fact will just dig the hole deeper. So what to do???….Anybody???

The status quo cannot long be maintained at any price and we would be far better off to get ahead of the curve rather than be dragged along behind it. The changes that are coming are not going to be cosmetic or short lived. They are going to be sweeping and permanent, and few seem to understand just how much so at this time.

“Make no mistake. We are selling off our future and the future of our children to prevent the bondholders of US financial corporations from taking losses. We are using public funds to protect bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own.” -John Hussman

The most illuminating commentaries I have read on this matter are Mauldin’s most recent Outside the Box newsletter entitled “The End Draws Nigh” by Dr. Woody Brock, and a piece by Steve Waldman on Seeking Alpha entitled “Banking Reform: Value for Value.” Please read these articles and forward them to your representatives in Congress and anyone you might know in the Obama Administration. Here is the money quote from Waldman:

“If we “get past this crisis” by restarting a consumer-credit-based, indiscriminate-investor-financed, current-account-deficit-making, income-inequality-expanding economy, we will have increased, not diminished, the likelihood of a major collapse.”

Getting From Here to There

It is ironic that America is the primary promoter of democracy globally when a critical issue we face at home is repairing our seriously degraded political process. The foundation principle of democracy is that an informed electorate will make the best choices. But in the current environment of spin, counter-spin and deliberate misinformation campaigns it is impossible for the average person to know the truth about anything, let alone be adequately informed about the critical issues of the day.

If there is any hope of favorable resolution of our problems we need at a minimum a political process grounded in truthful dialogue and mutual respect, and political leaders who are genuinely committed to public service rather than to their personal and party advantage. (See Q2 ‘05 Risk & OpportunityAmerica’s Truth Deficit”) It is clear that Obama is trying to foster this essential change, and his election against all odds is confirmation that the majority support him in this effort. So far his opponents are having none of it.

Since the election Republicans have been acting like mad people, ranting endlessly about a wide range of paranoid fantasies and attacking any and every action of President Obama, to the extent of publicly wishing for the failure of a sitting President. If this behavior persists and gains traction, America is going to be in for some very bad times. We can only hope that the current hysteria emanating from the Republican Party is the death cry of the lunatic fringe, and that soon the adults will reclaim ownership of their party, or start a new one.

The corrupted values and boorish behavior of our elite are not limited to our political leaders. Our B-schools have raised up a vast army of economically and technically savvy but culturally and spiritually impoverished business leaders who have foisted their pirate culture onto the world. We need to start cultivating business leaders who understand the place of business within the context of society, not separate from it, and who recognize that the proper function of business is to serve the aspirations and needs of society, not exploit them.

Some will reflexively reject such a notion as “socialism.” This is an unrealistic and outmoded concern. The reality is that 20th century socialism has clearly proven itself a failure and is not on the menu going forward. However, laissez-faire capitalism has also proven itself a failure. We need to find the middle way that allows the creativity and vitality of capitalism to support and grow the whole of society, not just the fortunate few at the top, and which at the same time enables the public sector to do the things that only it can do, without crowding out private initiative. Finding this middle way is entirely within our capacity.


We are still nearer to the beginning of the debt-withdrawal process than to the end. For decades government has been pushing the day of reckoning down the road, but at each turn of the cycle the amount of force (debt) required to stem the downturn has been greater, and the response (recovery) has been less robust. The Bush regime doubled the national debt after the dot-com meltdown and produced a substandard recovery by every measure. Obama will likely double up again, but this time the recovery will be even weaker. The overhanging debt load is becoming so great that without fundamental changes in the way we make policy and conduct our affairs, the next downturn will not be supportable.

Once a secular bear market begins, it will run its course until the last excesses are wrung out of the system and the last holdouts have sold out. This is by nature a gradual process. Hope springs eternal and every bear market sponsors numerous rallies which draw the unwary back into the market, only to be disappointed again. This bear will take its own time. The massive stimulation will have its effect, and we should have a recovery / consolidation period that could last some months or even years, but however events unfold in the near to intermediate term, it should be clear to anyone who is paying attention that the process is far from complete.

John Mauldin sums up the situation very clearly in his recent newsletter, “Sell in May and Go Away”:

“The Fed and the Obama administration are playing a dangerous game. The Fed is going to print trillions of dollars to forestall deflation and try to re-ignite the economy. But for a variety of reasons we will go into next week, a real, sustainable recovery may be a few years away. What happens when the market start balking at high and unsustainable national deficits? What happens when inflation (finally) does return? Can the Fed remain independent and take back the money it is printing in the face of what will likely be a tepid recovery? And if they don’t, what happens to the dollar?”

As individuals, how can we prepare ourselves for the inevitable? Here are Richard Russell’s thoughts on the matter:

“What to do? I’ve done a lot of thinking on this question, and my conclusion is as follows — hold a fairly large quantity of physical gold (coins), hold cash, hang on to your house, and you might even buy a bargain-priced foreclosed home if you wish — but above all, cut back on unneeded expenses (cut back on coffee, vacations, movies, fast food, and other non-essentials). Cash is for deflation if it continues, gold is insurance against future inflation, a bargain-priced foreclosed home is good value and it’s also a tangible asset.”

As a nation, our challenge going forward is primarily political. There are no problems that Americans cannot solve if they come together with focus and intent. As the recognition of our lost wealth and status dawns on the nation, we will see if we have the maturity and political will to set aside our differences and do the right thing. I am confident that Obama is the right man to guide us through this difficult period of adjustment…his unshakeable cool, moral character and superior intelligence have won the trust of the American people. We can only hope that he can sustain that trust through the difficult times to come and convince the American people to keep their cool and come together to create a balanced and sustainable recovery. Regardless of our conservative or liberal tendencies, we should all be rooting for that outcome.


Q4 ’08:   Setting the Stage for Hyperinflation

With enthusiasm and hope for a brighter future, the world is celebrating the inauguration of Barack Obama as the 44th President of the United States.

Meanwhile, the marketplace is gripped by historic pessimism and chaos. The economic laws of nature are inexorably moving events toward the restoration of balance following the unprecedented abuses of economic power on Wall Street and simultaneous abdication of oversight responsibility by regulatory authorities during the Bush era. This is necessarily a painful process. How much more pain must be endured is uncertain, but it is clear that we have not yet reached a point of equilibrium.

The long term prognosis is that there are still major adjustments to be made in order to restore balance and health to the economy. Those adjustments will include a continuation of the de-leveraging process, a continued clearing of corporate “dead wood,” continued downsizing and job losses, and a continued downward adjustment in the real value of real estate in America and globally. I expect at least two more years of restructuring and recession and possibly outright depression. At some point another big move down in the stock market accompanied by another wave of bankruptcies will mark the beginning of the end of the process of resolution.

However, nothing in nature proceeds in a straight line. After the economic savagery of 2008 and the historic level of pessimism currently in the marketplace, we are likely to see a pause and even a substantial rebound in 2009. Also, it appears that the cycles which called for a strong market in 2008 have inverted. It would not surprise me to see that inversion continue and give us a bear market rally in 2009. On the other hand, if the November lows are decisively taken out, we will most likely see another major leg down to the 5,000 level in the Dow. Such a move would signal that the economic carnage will continue unabated.

At the end of the day America’s pre-eminent place in the world and the overall lifestyle of Americans will have been permanently altered. Only from that point on can reality-based growth begin anew. Until that point of final resolution is reached, all efforts to stimulate the economy will at best soften the impact of the normalization process, and that softening too will have its price.

The world needs America’s leadership. The process of restoring that leadership has already begun with the election of Obama. But America’s future leadership will come from a position as first among equals, which will spring from our culturally derived creativity, optimism and good will, not from a position of global dominance and subjugation…in other words, real leadership, not simple domination.

The Coming Hyperinflation

The actions of our government in the current economic crisis have been reasonable, if rather confused and inconsistent, given the situation “on the ground,” i.e., the prospect of a deflationary depression brought on by the contracting credit bubble. This situation could have been averted and our economy and our global position vastly strengthened by now, had the Bush administration been willing to take advantage of the balanced budget they inherited and apply the alleged Republican principle of “fiscal responsibility.” Instead they proceeded in the other direction and ran up the deficit beyond anything previously imaginable in a failed attempt to mold the world in their image. That lunacy is water under the dam now, and we have to deal with the consequences. Our options at this point are pretty straightforward.

We could deliberately let the market seek its level and purge the weakness all at once: the shortest but most painful route to fiscal and economic health. The question is, would the patient survive the treatment? Probably not. And the reality is that no modern politician would follow that route. So this is really only a theoretical option.

Given political reality, the only realistic route forward is the Keynesian option of “quantitative easing” currently being employed, which essentially means keep pumping money into the economy until it comes to life. This is akin to injecting adrenalin into a dying patient, and there is no guarantee that it will work. But unlike the adrenalin injection, the money injected into the economy will not dissipate through natural processes over time. It will continue to have impact going forward. In theory, once the economy comes to life the excess liquidity would be withdrawn; in reality withdrawing that liquidity is not going to be so easy and is not likely to happen to any significant degree. Politicians have always been quick to create money to stimulate the economy, but they never seem to get around to pulling the money out once things get going again.

The actions currently being taken will have consequences — long term irreversible consequences. Primary among those consequences is that sooner or later the rest of the world is going to stop buying our debt (lending us money). This borrowing is what we have been living on for years. When that happens two more things will occur immediately: interest rates will skyrocket and the government will be forced to inject even more liquidity into the system, much more. The value of the dollar will be severely impacted. Once begun, this process will proceed rapidly to its completion. This phenomenon is called hyperinflation. The devaluation of the dollar will not necessarily be obvious in comparison to other currencies, as they are also being devalued by their respective governments. Rather, the change in value will be seen in terms of the goods and services a dollar will buy, and most clearly in terms of the price of gold.

A gentleman named Alf Field recently published an excellent essay entitled “Crisis Cogitations,” which thoroughly reviews the ongoing economic crisis, the actions of our economic authorities, and the likely consequences of those actions. Understanding this situation and its likely outcomes is critical for all investors going forward. I thought this essay to important enough to include in full.

“Crisis Cogitations”
By Alf Field

“Everyone must be wondering where this “unprecedented global financial crisis”, (the World Bank’s words), is heading. What follows, for what they are worth, are my cogitations on this crisis.

There is no doubt that the world is dealing with a credit/debt deflation of historic proportions. It is worth spending a little time understanding how such events are precipitated. An economy, as in personal households, corporations and other entities, is financially sound when expenditures are less than incomes. The difference can be saved and invested to produce additional income and capital growth in the future.

When debt is introduced into the system, a different dynamic emerges. We are not talking about self-cancelling debt but new consumer debt which is spent in the economy. This results in expenditure exceeding income and delivers a boost to the nation’s GDP. In the initial stages the boost to GDP is quite large but as time goes by and the debt total climbs higher, the cost of servicing that debt reduces the economic benefit received from new increases in the debt mountain.

A continuing supply of easily available and cheap debt leads to speculative bubbles in one or more of the following areas: real estate, financial assets, commodities and collectibles. Once a bubble gathers momentum, a positive reinforcing feedback loop develops. More debt pushes up asset prices and this higher collateral value permits more borrowing which in turn pushes up asset prices which provides collateral for further increases in borrowing, and so on.

Eventually when debt becomes excessive, reaching extreme and unsustainable levels, an extraneous event occurs that shatters confidence and destroys the rationale that was underpinning the bubble. This results in assets being sold to repay debt and a downward reinforcing feedback loop develops. Asset sales reduce the prices of those assets, which diminishes their collateral value, which causes lenders to demand more security, which causes more asset sales, and so on. Weaker lenders go bankrupt and the economy starts to collapse into recession and possibly depression.

It is impossible to time the peaks of these debt bubbles as they can develop a life of their own that continues for longer than any rational person would think possible. In the recent debt binge we were blessed (cursed?) with bubbles in all four categories, real estate, financial assets, commodities and collectibles. Combined debt in the USA has been estimated to have exceeded $50 trillion, which is 3.5 times the estimated $14 trillion GDP level of that country. This is at least a 30% greater ratio of debt to GDP than was achieved in 1929 just prior to the last great debt deflation.

Once debt becomes excessive, and there is little doubt that this status was achieved some time ago, debt cannot be repaid out of savings and must be repaid in one of the following ways:

  1. Via bankruptcies, which causes lenders to wear the losses of debt failures, but eventually the broader community also suffers from the economic depression that follows;
  2. Via a rapid debasement of the currency which allows debt to be repaid in currency with vastly reduced purchasing power. Lenders are repaid but suffer a reduction in the purchasing power of their capital. The broader community suffers from massive price inflation and the economic dislocations that flow from this.
  3. Via a combination of the above two methods where there are initial bankruptcies followed later by a lesser degree of currency debasement than that contemplated in 2 above. This appears to be the course that the world leaders are headed towards by their actions to date.

There are 3 major differences between the present debt deflation and prior episodes. They are very important differences and will probably impact on whatever new decisions our political leaders take to ameliorate the crisis. These new factors are:

  1. Modern economies are linked by an electronic global interconnectivity which assists modern commerce and trade to operate smoothly. This system relies on the ability of banks around the world to readily respond to transactions elsewhere. If you use your credit card to withdraw funds from a Moscow ATM, the Russian bank must have instant certainty that the funds will be delivered from your bank to settle the cost of the cash withdrawal. This global electronic system has been developed over the past 30 years and we now have electronic money. People are paid electronically and make payments out of their bank accounts electronically. Modern commerce and industry relies on this electronic system in order to function properly.
  2. OTC derivatives did not exist 30 years ago but have become an important aspect of modern commerce, investment and banking. These instruments are now massive in quantity and have the potential to deliver staggering losses. They have already become a destabilising influence in the world banking and economic systems. A major problem is that these losses cannot be quantified and nobody knows where they will settle, leading to distrust between banks.
  3. For the first time in history a world wide debt deflation is occurring in a situation where virtually all countries have the ability to create unlimited quantities of their own local currencies at will.

If the modern global banking electronic interconnectivity system breaks down, world commerce will grind to a halt and the world will almost certainly be pitched into an economic depression. The continued operation of the system requires banks to have confidence in each other and knowledge that the overall system works.

One area where the system is breaking down is in large international trades for which special settlement systems called Irrevocable Letters of Credit (ILC) are used. There are special difficulties when the physical transactions are large in quantity and value, when the buyer and seller are in different countries and when lengthy sea voyages are required. The buyer does not want to pay for the shipment until he is certain that he will receive it and that it meets specifications. The seller, on the other hand, does not want to ship the goods until he is certain that he will be paid.

The solution is for the buyer to go to his local bank and open an ILC in favour of the seller’s bank, or possibly his bank’s agent bank in the seller’s country. Irrevocable means just that, it cannot be cancelled once it has been issued. It is effectively a guarantee by the buyer’s bank to the seller’s bank that once the shipment arrives in the buyer’s home port and is of correct specification, the seller’s bank can pay the seller under the ILC and claim the money from the buyer’s bank.

What has happened in recent months is that these international trades are grinding to a halt because sellers are saying to buyers: “We don’t trust the ILC from your local bank. Go and get an ILC from a bank that we trust”. This is why international trade has hit a brick wall recently and why the Baltic Dry Goods index, which measures the shipping costs for dry cargoes, has declined incredibly by 90% in just a few months! It is also the reason for the most recent sharp decline in commodity prices.

It is like trying to pay for your restaurant meal in a foreign country and the restaurant refusing to take your credit card because their local bank is not prepared to do business with the bank that issued your credit card.

Stimulus packages and bailouts are helpful but will prove to be of no avail unless confidence in the banking systems of the world is restored. It cannot be stressed strongly enough: it is imperative to restore confidence in the banking systems around the world. If this is not done quickly, world trade will grind to a halt and the world economy will do likewise. How does one achieve this resurgence of confidence in an environment of debt deflation with proliferating bankruptcies?

There seems to be only one option. Governments will have to take control of their national banking systems and be responsible for all the bad debts, including the unquantifiable OTC derivative losses.

Nationalisation is anathema to those bred in a free enterprise system. Economists of the Austrian school argue that the deflation should be allowed to run its course. They say that this would speed up the process of debt liquidation and reduce the pain in the longer run. The immediate consequences of this would be horrific and would certainly bring down the world’s banking systems in the current environment. The issue at the moment is not whether the Austrian school is correct or not, but rather what our leaders will do and what the consequences of their actions will be.

Unfortunately, some form of nationalisation or Government guaranteeing of banks around the world seems to be the logical expectation. Short of this, we are headed for a depression of the 1930’s variety, or something worse, and nobody wants to experience that.

Having nationalised (or guaranteed) the banks, the problem of how to handle the debt will still remain. If we accept that option 3 above – part deflation of debt and part inflation of the currency – is the aim, one could postulate a situation where the US debt mountain has deflated to say $35 trillion and that the massive new funding required to instil confidence in the system produces a five-fold increase in money and prices. In this situation, nominal GDP would have increased from $14 trillion to $70 trillion. Real GDP will remain unchanged, it is just the purchasing power of the currency that will have been reduced by 80%.

A $35 trillion debt level is manageable with a GDP of $70 trillion.

This seems to be the best “middle road” route that we can hope for. Much will depend on how our politicians and central bankers handle the situation. There is still plenty of scope for the situation to get out of hand at either extreme, resulting in either a deflationary depression or a hyperinflation.

In conclusion, I would like to discuss how the world got into this situation. We have been bombarded by views that it was caused by Greenspan’s excessive liquidity and low interest rates, combined with weakness in regulation, rating agency mistakes and obfuscation from Wall Street. Even the OTC derivatives have been blamed for part of the problem.

These issues are all valid but to use a medical analogy, they are secondary cancers. They could not have existed without a primary cancer being the underlying cause and stimulus. So what was the primary cancer, the one which made it possible for all the other problems to exist?

We need to go back to basics. This subject was dealt with in the article “Chaos Chronicled” which can be found at:


This article explains how the fractional reserve banking system works.

Briefly, the fractional reserve system requires approximately 10% of new deposits to be lodged with the Federal Reserve or Central Bank. Thus if a new deposit of say $1.0m of fresh money arrives in the banking system, the bank receiving the deposit must put $100,000 with the central bank and can loan the balance of $900,00. When that loan arrives as a deposit with another bank, $90,000 must be placed with the central bank and $810,000 can be loaned out. That in turn will arrive as a deposit elsewhere and $81,000 must be placed with the central bank and $729,000 can be loaned out, and so on. Finally when all these iterations are complete, the central bank ends up with $1.0m as deposits from the banks that have made loans of about $9.0m.

At this point new loans can only be made from profits generated within the economy. This is important as the banking system will have reached a period of stability which will remain until a fresh deposit of newly created money appears in the system from somewhere. That new money will allow the banking system to generate loans of approximately 9 times the amount of new money.

What happens if there is a money tap open somewhere in the system and each day a large dollop of newly created money enters the system? Very soon the banks will be awash with deposits and desperately seeking new secure loans.

As lions kill instinctively in order to survive, bankers make loans instinctively in order to survive. Eventually in these circumstances of excess deposits, lending standards deteriorate and new loans are made to less credit worthy borrowers. In time, anyone with a good story gets a loan.

It is this desperate search for secure new loans by the banking systems of the world that is the primary cancer referred to earlier in the medical analogy. It allowed Wall Street to develop racy new products which were gobbled up by banks around the world in the belief that they were secure investments.

This is what actually happened in the real world. There was an open tap pouring large dollops of newly created money into the world banking systems over many years that created the insatiable appetite for new banking loans and investments.

What is important to understand is that without this insatiable demand for secure loans and investment by banks, it would not have been possible for all the other irregularities to have taken place. Credit standards would have remained robust and the banks would have avoided the bulk of the toxic waste that they got involved with.

What was the money tap that was left running? It is a flaw in the international monetary system which allows the USA to pay for its trade deficit using newly created US Dollars. This has been going on for two decades but has mushroomed in recent years. Ten years ago, the US trade deficit was of the order of $100 billion per annum. This number grew steadily until a couple of years ago it was running at $800 billion per annum. An injection of $800 billion into the world’s banking system could accommodate new loans of nine times that amount, or $7.2 trillion in a single year!

Recently the US trade deficit has been averaging $700 billion per annum, allowing new loans of the order of $6.3 trillion per annum to possibly be created. These numbers are in addition to other sources of new money which individual countries injected into their local monetary systems to stimulate their economies.

The simple fact is that the world’s banks were awash with deposits looking for anything that resembled a reasonable loan or investment. Wall Street created the products required to meet that demand, resulting in the huge debt bubble that recently came to an end. In addition, banks (prompted by the large availability of new deposits) made many unwise loans across national borders which are now creating problems in countries in Eastern Europe and South America.

The problems are manifold, but the most pressing one is to restore confidence in the banking systems of the world. Failure to do so will measurably increase the odds of a deflationary depression. The power of the modern electronic money creating machine suggests that the odds still favour an inflationary outcome, hopefully of the category 3 type referred to earlier.”

Other articles by Mr. Field can be accessed here.


Q3 ’08:   Market Meltdown Into the Election

The collapsing credit bubble tsunami has hit the financial sector with full force. In a few short months America’s storied investment banking industry is history. Bear Stearns…gone! Merrill Lynch…gone! Lehman Brothers…gone! The remaining investment banks have either been bought out or have converted to commercial banks and are busy de-leveraging. Many other financial institutions have disappeared, and those that are still standing are on shaky ground. This financial crisis has even claimed its first nation — Iceland.

Meanwhile, the stock market is also taking a pounding. The Dow Industrials and S&P 500 have given back 90% of the ’02 – ’07 bull market and 45% of total value so far. Richard Russell estimates total U.S. market and real estate losses at $9 trillion, almost a full year’s GDP. Foreign markets have fared even worse. The Vanguard Emerging Market Index has given up 60% of total value. The bad news is that the stock market is a leading indicator. So far the contraction has been primarily a financial sector phenomenon. The shock wave is only beginning to hit the general population. How long will it last? It will last until all the excess is wrung out of the system, which could happen quickly or it could take a decade or longer. How bad will it get? Considering that the recent expansion has been substandard by every measure, and was itself entirely driven by unprecedented deficit spending and borrowing, the downturn is most likely going to be pretty severe.

The U.S. has been living beyond its means for a long time. When Ronald Reagan entered the White House he inherited a $1 trillion national debt accumulated over 200 years. He added $1.6 trillion in his eight years. George Bush Sr. added another $1.6 trillion in his four years, and Bill Clinton another $1.5 trillion in his eight years. George W. Bush has equaled all three of his predecessors by adding another $4.5 trillion. The national debt now stands at $10 trillion, not counting unfunded liabilities such as Medicare and Social Security. Consumer debt has followed a similar trajectory. Total U.S. debt now stands at over $50 trillion, not counting unfunded liabilities. (See the Grandfather Economic Report for detail.) This unprecedented debt creation has been fueled by a national delusion that we could continue to live forever on borrowed money without paying the price.

The credit bubble collapse is ushering in a period of adjustment to a reality based lifestyle. This is necessarily going to be a painful process. We can only hope that the adjustment can be managed to avert a sudden and destructive collapse.

We face a major potential hazard going forward: our entire financial system operates on the faith-based “fractional reserve model.” If people lose faith in the system and begin demanding their money in large numbers, the system will collapse completely. That would look like an old fashioned “run on the bank.” However, now the entire system is globally integrated, and a run on one bank anywhere is a run on all. This is why the Feds have been so aggressive in backstopping any failing institutions, and also why the financial markets freaked out when they let Lehman Brothers go under.

Another major potential hazard is the approximately $60 trillion in outstanding credit default swaps. SEC Chairman Chris Cox gives an excellent explanation of the swap problem and what needs to be done about it in his 10/19 New York Times Op-ed piece, “Swapping Secrecy for Transparency.” What he fails to mention is that this entire problem mushroomed on his watch. The good news is that Lehman Brothers $400 billion portfolio of credit default swaps has recently been settled at a cost of only $5 billion. If that ratio holds, and if the process is carefully managed, the $60 trillion of outstanding swaps could be unwound for a cost of a mere $1 trillion.

Our financial authorities are fully aware of the problems and are doing everything they can to try to hold things together. It is likely they will be able to do so, at least for awhile — not certain but likely. But there will be a big price to pay. The deficits necessary to stem the tide will be huge. Various estimates are anywhere from $1 trillion to $4 trillion just next year! Most likely there will be at least several additional years of trillion dollar deficits. These massive deficits will threaten the stability of the dollar. Presently the dollar is rallying as huge short dollar positions are unwound. But the massive printing of dollars will eventually be reflected in the value of the dollar. If the world starts to bail on the dollar, the game is over.

I must confess that I have been taken by surprise by the severity of the breakdown in equities during the bullish phase of the Presidential Cycle. I had been expecting a major bear market beginning after the election. The collapse of the market during the lead up to the election is testimony to the utter incompetence of the Bush regime, which has all the monetary, fiscal and regulatory tools necessary to manage a traditional market rally going into the election.

The good news is that we are at that time of year when the stock market usually bottoms. Technical and sentiment indicators are oversold to extremes not seen since 1929, which would indicate at least a temporary bottom. Warren Buffet published an Op-ed piece in the 10/16 New York Times entitled “Buy American, I Am,” touting the values in U.S. equities. Bill Gross said he thinks that the steps that have been taken by the Feds will lead to market stabilization within weeks.


The presidential election cycle is mercifully coming to a close. After two years of steadily increasing hyperbole and spin, everyone is exhausted. Obama is leading in all of the polls, anywhere from two to sixteen points as of this writing. The political betting sites, which have a better track record than the polls, have Obama 85-15 to win. An objective observer would say this is Obama’s to lose, and he has shown himself to be a very steady hand under pressure, so it is unlikely that he will do anything to undermine himself. However, no one in America is objective about this one. Republicans are desperately trying to generate as much hysteria about an Obama victory as they can. Democrats are still feeling uneasy after the close losses in the last two presidential elections, and are worried that Republicans may somehow steal the election.

McCain has been steadily losing ground against the background of the Bush legacy, a crashing economy and a backlash from the selection of Sarah Palin as his VP. He has unsuccessfully tried a variety of tactics to try to change the trajectory of the campaign, and lately he has taken to ultra-sleazy Karl Rove style personal attacks, trying to paint Obama as un-American, dangerous and a friend to terrorists, and grossly misrepresenting Obama’s record and positions. The personal attacks, which were so effective against Kerry in ’04, do not seem to be helping McCain. Perhaps the American people have finally had enough of this kind of campaigning.

As he did against Clinton in the primaries, Obama is mostly ignoring the personal attacks and focusing on economic issues and his signature call for “change.” Sticking to the high road when hit by Republican sleaze attacks has been a losing strategy for Democrats during recent elections, and Obama is giving Democrats heartburn by consistently refusing to respond in kind. So far it seems to be a winning strategy for him, but as the great American philosopher Yogi Berra once said, “It ain’t over ‘til it’s over.”

For those political junkies who want to check the latest on the polls right down to the wire, FiveThirtyEight.com aggregates all of the polls, and Intrade and Iowa Electronic Market both run election futures markets.


For the time being, geopolitical concerns have been eclipsed by the presidential election. The world is hoping for an Obama victory by an overwhelming margin. Polling around the world has shown the preference for Obama in the 80-90% range.

The financial meltdown has accelerated the global realignment begun in reaction to the Bush foreign policy. After the Georgia invasion, Russia began a campaign to reassure Europe that Georgia was a one-off deal and that Russia is not a threat. At the same time it is warning that the U.S. missile defense system will not be tolerated in Eastern Europe, and in a tit-for-tat move it is offering missile defense to Cuba.

Meanwhile, G7 leaders have called for a summit to update the global financial framework created at Bretton Woods after WW II. At the upcoming summit, to be held on November 15th, Washington will want to keep the focus on the need for a new global regulatory regime. But the special reserve status of the dollar is certain to come up. It may not happen all at once, but this summit will likely be the beginning of a formal process to replace or adjust the dollar’s supremacy as the global reserve currency. This will be a seismic event that will have a severe impact on U.S. living standards. It is probably in everyone’s interest that these changes not occur all at once, but the adjustment is going to happen and we should be prepared for it.


Market volatility and sentiment are at levels not seen since 1929. We can only hope that the actions of our financial and monetary authorities will halt the meltdown, at least for awhile, to allow preparations for an orderly decline. Historically, such extremes mark market lows, and I would expect at least a temporary low. We could even have a substantial rally coming up into the first quarter. I would consider such a rally as a last chance to get out of equities and put my house in order for the inevitable. I do not expect a final low in this bear market until at least the latter part of 2010.

Our next President is going to be starting out deep in the hole and will be spending at a minimum their entire first term repairing the extensive damage done by the Bush administration to our foreign relations and our economy, as well as cleaning up the corruption in the Justice Department and repairing the widespread damage to the function of government across the board. It is my hope that our next President will be able to unify the country to confront these serious challenges. If we see a continuation of the politics of division, mistrust and obstruction that have characterized recent years, things are going to get much, much worse.

Our departing President, George W. Bush, has left his own special mark on America and the world, so eloquently expressed recently by London mayor, Boris Johnson:

“However well-intentioned it was, the catastrophic and unpopular intervention in Iraq has served in some parts of the world to discredit the very idea of western democracy. The recent collapse of the banking system, and the humiliating resort to semi-socialist solutions, has done a great deal to discredit – in some people’s eyes – the idea of free-market capitalism. Democracy and capitalism are the two great pillars of the American idea. To have rocked one of those pillars may be regarded as a misfortune. To have damaged the reputation of both, at home and abroad, is a pretty stunning achievement for an American president.”


Q2 ’08:   The Mother of All Messes

At the macro level, the same issues are dominating this quarter as were last. (1) Will our financial system be able to withstand the credit contraction following the bursting of the global credit bubble; (2) Will the dollar survive said contraction; and (3) Will George Bush attack Iran before he leaves office (or green light Israel to do so)?

The news on all fronts has been bad recently. More bank failures, more government bailouts, tighter credit and no end in sight to the housing slump. The stock market – a leading indicator — has decisively taken out its January lows, signaling that the worst is yet to come. My point & figure downside target remains at 10,000 for the Dow.

Technically, it is possible that the latest move down has put in the low for the year. The market is oversold, consumer sentiment is at a record low, and short interest is at an all-time high. The market is not likely to give all those short sellers a free ride down, so at a minimum we are due for a short covering rally. A strengthening dollar and moderating oil prices increase the odds for a rally.

Also in the plus column, the Presidential Cycle indicates that we should expect a rally, beginning either now or in September – October that should complete in March – April. After that, a resumption of the bear market is indicated. Richard Russell points out that the Dow Transports have not confirmed the new lows in the Industrials and S&P 500, a downside non-confirmation that sets up a possible Dow Theory buy signal. If this is the case, then the entire move down from the October highs has been a correction in the ongoing bull market begun in 2002, and new stock market highs will follow.


The contracting credit bubble is like a tsunami bearing down on the global economy. No-one is sure where the high watermark will be or whether monetary authorities have sufficient resources to stop its advance. Meanwhile the banks and large hedge funds are sitting on an interlocking network of some $60 trillion in credit default swaps that could be even more toxic than sub-prime. This is the fruit of the globalization of finance. If any major player in the network fails, the whole system will collapse and we will immediately enter into a global depression. This is why the Fed has been so aggressive in backstopping any collapsing financial entities. I think that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson are doing a heroic job, but in the end they may not be able to hold the line without crashing the dollar.

Our economy has been so dependent for so long on artificial stimulants that, as with a drug habit, there comes a time when no amount of stimulus can bestow the desired high, and the only solution is to go cold turkey. Cleansing and healing, but very painful. The only thing I see on the horizon that could possibly provide an avenue for re-flating the bubble economy is alternative energy. Even this would only delay the day of reckoning, just as the credit bubble delayed the consequences of the bursting dot-com bubble, but at least an alternative energy boom would have many benefits other than simply delaying paying the piper. It might even buy enough time to for our “leaders” to put our fiscal house in order – then again, maybe pigs will learn to fly.


On the geopolitical front everything is as it was three months ago, only more so. The central issue on the geopolitical stage is Iran’s nuclear program. Whether Iran is really the threat that it is posing to be is debatable, but given repeated threats to Israel’s existence by Iranian President Ahmadinejad, Israel does not feel inclined to take the existential risk and simply will not tolerate a nuclear Iran.

After a period of saber rattling all around, recently the rhetoric in the Middle East has cooled noticeably. However, the stage is set, and if Iran doesn’t yield by election time, my perception is that Washington will give Israel the green light, and they will attack. The Israelis would rather go down now fighting a three front war with Iran, Hezbollah and Hamas than be vaporized by an Iranian nuke three years from now. See the New Yorker article “Preparing the Battlefield” by Seymour Hersh for an overview of the preparations being made for war in Iran. Also, a straightforward and rather grim assessment of the outcome if Iran doesn’t yield, “Using Bombs to Stave Off War” by Benny Morris in the July 19th New York Times.

Meanwhile, peacemaking efforts are urgently underway even as preparations for war are being made. The various Gulf States are attempting to negotiate an agreement to make the region a nuclear free zone. Israel is also in serious discussions with both Syria and West Bank Palestinians to create a realistic framework for peace. U.N. sponsored talks with Iran have been ongoing and in a surprise move, after years of refusing to participate, the U.S. recently sent an envoy to these talks.

Taking the long view, the nuclear genie is already out of the bag. Many countries are pursuing nuclear technology, and even if the Iranian program is put down over the short run, it is only a matter of time before the world is going to have to confront the reality of ubiquitous nuclear weapons. And thanks to our geometrically expanding technological capabilities, nukes are now merely #1 on a growing list of potentially “civilization destroying” weapons. In the long run, the survival of human civilization demands that we evolve to a more co-operative global political culture that is not based on violence and the threat of violence.


Things have been relatively quiet since the Obama / Clinton smack-down was finally settled, but a recent flurry of activity has signaled an early start to the final run. Despite two candidates who would prefer to take the high road on principle, the pressures of modern American politics simply are not going to allow it. Obama is consistently ahead in the polls and McCain is carrying the burden of the Republican brand, which is radioactive after 8 years of corruption, incompetence and fiscal profligacy. Consequently, McCain took the first step to the dark side with a series of low-tide attack ads and Obama is sure to follow. This one is going to get really nasty, and will probably set the bar for negative politics even lower than it has been, if that is possible.


From time to time I come across an article that transcends the day-to-day cacophony of the chattering classes and puts current political events in broad perspective. The following article, written by Paul Craig Roberts, a card carrying conservative Republican, puts the impact of the recent era of Republican rule in perspective.

Paul Craig Roberts was Assistant Secretary of Treasury in the Reagan administration. He has also been Associate Editor of the Wall Street Journal editorial page as well as Contributing Editor of the National Review. Given the conservative credentials of the author, I feel that his article is an important statement and it deserves broad distribution.

The Mother of All Messes

By Paul Craig Roberts

Republicans are sending around the Internet a photo of a cute little boy whose T-shirt reads: “The mess in my pants is nothing compared to the mess Democrats will make of this country if they win Nov. 2nd.”

One can only wonder at the insouciance of this message. Are Republicans unaware of the amazing mess the Bush regime has made?

It is impossible to imagine a bigger mess. Republicans have us at war in two countries as a result of Republican lies and deceptions, and we might be in two more wars—Iran and Pakistan—by November. We have alienated the entire Muslim world and most of the rest.

The dollar has lost 60% of its value against the euro, and the once mighty dollar is losing its reserve currency role.

The Republicans’ policies have driven up the price of both oil and gold by 400%.

Inflation is in double digits. Employment is falling.

The Republican economy in the 21st century has been unable to create net new jobs for Americans except for low wage domestic services such as waitresses, bartenders, retail clerks and hospital orderlies.

Republican deregulation brought about fraud in mortgage lending and dangerous financial instruments which have collapsed the housing market, leaving a million or more homeowners facing foreclosure. The financial system is in disarray and might collapse from insolvency.

The trade and budget deficits have exploded. The US trade deficit is larger than the combined trade deficits of every deficit country in the world.

The US can no longer finance its wars or its own government and relies on foreign loans to function day to day. To pay for its consumption, the US sells its existing assets—companies, real estate, toll roads, whatever it can offer—to foreigners.

Republicans have run roughshod over the US Constitution, Congress, the courts and civil liberties. Republicans have made it perfectly clear that they believe that our civil liberties make us unsafe—precisely the opposite view of our Founding Fathers. Yet, Republicans regard themselves as the Patriotic Party.

The Republicans have violated the Nuremberg prohibitions against war crimes, and they have violated the Geneva Conventions against torture and abuse of prisoners. Republican disregard for human rights ranks with that of history’s great tyrants.

The Republicans have put in place the foundation for a police state.

I am confident that the Democrats, too, will make a mess. But can they beat this record?

We must get the Republicans totally out of power, or we will have no country left for the Democrats to mess up.

I say this as a person who has done as much for the Republican Party as anyone. I helped to devise and to get implemented an economic policy that cured stagflation and that brought Republicans back into political competition after Watergate. If I could have looked into a crystal ball and seen that under a free trade banner, Republicans would enable corporate executives to pay themselves millions of dollars in “performance pay” for deserting their American work forces and hiring foreigners in their place, thus destroying the aspirations and careers of millions of Americans, I never would have helped the Republicans. If a crystal ball had revealed that a neoconned Republican Party would launch wars of naked aggression against countries that posed no threat to the United States, I would have shouted my warnings even earlier.

The neoconned Republican Party is the greatest threat America has ever faced. Let me tell you why.

How many Republicans can you name who respect and honor the Constitution? There are Ron Paul, Bob Barr, and who? The ranks of Republican constitutional supporters quickly grow thin.

The reason is that Republicans view the Constitution as a coddling device for criminals and terrorists. Republicans think the Constitution can be set aside for evil-doers and kept in place for everyone else. But without the Constitution we only have the government’s word as to who is an evil-doer.

This would be the word of the same infallible government that told us that Saddam Hussein possessed weapons of mass destruction that were on the verge of being used against America, the same infallible government that told us that Guantanamo prison held “770 of the most dangerous persons alive” and then, after stealing 5 years of their lives, quietly released 500 of them as mistaken identities.

Republicans think the United States is the salt of the earth and that American hegemony over the rest of the world is not only justified by our great virtue but necessary to our safety. People this full of hubris are incapable of judgment. People incapable of judgment should never be given power.

Republicans have no sympathy for anyone but their own kind. How many Republicans do you know who care a hoot about the plight of the poor, the jobless, the medically uninsured? The government programs that Republicans are always adamant to cut are the ones that help people who need help.

I have yet to hear any of my Republican friends express any concern whatsoever for the 1.2 million Iraqis who have died, and the 4 million who have been displaced, as a result of Bush’s gratuitous invasion. Many tell me that the five- and six-year long wars in Iraq and Afghanistan are due to wimpy Americans “who don’t have the balls it takes” to win. Killing and displacing a quarter of the Iraqi population is just a wimpy result of a population that lacks testosterone. Real Americans would have killed them all by now.

Macho patriotic Republicans are perfectly content for US foreign policy to be controlled by Israel. Republican evangelical “christian” churches teach their congregations that America’s purpose in the world is to serve Israel. And these are the flag-wavers.

Those of us who think America is the Constitution, and that loyalty means loyalty to the Constitution, not to office holders or to a political party or to a foreign country, are regarded by Republicans as “anti-American.”

Neoconservatives, such as Billy Kristol, insist that loyalty to the country means loyalty to the government. Thus, criticizing the government for launching wars of aggression and for violating constitutionally protected civil liberties is, according to neoconservatives, a disloyal act.

In the neoconservative view, there is no place for the voices of citizens: the government makes the decisions, and loyal citizens support the government’s decisions.

In the neocon political system there is no liberty, no democracy, no debate. Dissenters are traitors.

The neoconservative magazine, Commentary, wants the New York Times indicted for telling Americans that the Bush regime was caught violating US law, specifically the Foreign Intelligence Surveillance Act, by spying on Americans without obtaining warrants as required by law. Note that neoconservatives think it is a criminal act for a newspaper to tell its readers that their government is spying on them illegally.

Judging by their behavior, a number of Democrats go along with the neocon view. Thus, the Democrats don’t offer a greatly different profile. They went along with the views that corporate profits and the war on terror take precedence over everything else. They have not used the congressional power that the electorate gave them in the 2006 elections.

However, Democrats, or at least some of them, do care about the Constitution. If it were not for Democratic appointees to the federal courts and the ACLU (essentially a Democratic organization), the Bush regime would have completely destroyed our civil liberties.

Some Democrats are “bleeding hearts,” who actually care about suffering people they don’t know, and who think that we have obligations to others. Have you ever heard of a bleeding heart Republican?

Traditionally, Democrats objected whenever policies resulted in a handful of rich people capturing all of the income gains from the economy. There might still be a few such Democrats left.

Looking at the Republican mess, I doubt that Democrats, try as they may, can equal it.


Q1 ’08:   Back From the Brink

The world seems to be moving in slow motion right now, waiting to see whether the central banks can contain the credit bubble contraction, and whether the U.S. will attack Iran. At the same time the U.S. presidential campaign has completely overshadowed every other aspect of national life. The media are blathering endlessly about the campaign to the exclusion of almost anything except housing foreclosures and the latest scandals. The campaign itself has devolved into a parody. John McCain has taken to pandering to the lunatic fringe he once derided while stumbling from one senior moment to the next. On the Democrat side the seemingly endless Clinton / Obama demolition derby may finally, mercifully be coming to an end. Only six more months of this lunacy!

Meanwhile, there are three overriding macro concerns in the world at present: (1) Will the world’s central banks be successful in containing the collapsing global credit bubble? (2) Directly related to this issue is: will the dollar survive the actions taken to try to contain said bubble? (3) Will George Bush attack Iran before he leaves office?

The answer to questions one and two appears to be yes, at least for now. The underlying instability of our financial system remains an unresolved matter, but for now the banks have survived the sub-prime meltdown and are busy writing down their losses and gathering equity. The muni market has survived the collapse of the auction market and is beginning to function normally. The stock market has stabilized and rallied in the face of a relentless barrage of negative news. The Dow is now down only 10% from its all-time high. That says a lot. Even housing is beginning to show some signs of stabilizing, in spite of ongoing record foreclosures. See the Wall Street Journal May 6th op-ed, “The Housing Crisis is Over.”

For its part, the Fed has demonstrated it is willing to do whatever it takes to prevent an economic meltdown. From the Bear Stearns shotgun marriage, to the largest ever reduction in the Fed funds rate, to the massive injection of dollars into the economy (M3 is currently growing at a smoking 16% rate), the Fed is doing whatever is needed to hold the line. The question is: Can the dollar take all of this benevolence?

The dollar is already down 40% since George Bush took office. If it picks up speed on the downside from here we will soon see a massive global rush out of the dollar. The full extent of the disruption this would cause is not even predictable, except to say that it would be epic. However, technically the dollar is hugely oversold, and sentiment is almost uniformly negative. This leaves the dollar ripe for a short covering rally, which is already underway, and if the ECB starts lowering rates as expected, that rally could extend considerably. Under these conditions a coordinated central bank intervention would put a bottom on the dollar that could last for quite some time. That would be a major stabilizing development.

Unfortunately, the sad reality is that long term the dollar is toast. The actions of our “leaders” in Washington have assured this outcome. The best that can be done at this point is to engineer a continued gradual devaluation of the dollar. If the inevitable happens too suddenly that sad reality could easily turn into a catastrophe. So let’s hope that Mr. Bernanke and cohorts are up to the task. For the real skinny on the long term outlook for the dollar, I recommend the recent “Hyperinflation Special Report” by John Williams at Shadow Government Statistics.

Regarding issue number three:
We can look at our current geopolitical situation through the lens of the “poetry” of former Defense Secretary Donald Rumsfeld:

As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don’t know
We don’t know.

We are spending $3 billion and sacrificing the lives of 10 or more soldiers every week in Iraq. This is a known known. Why we are doing this is a known unkown. Those who have been wrong about everything related to this war since before the beginning seem to get endless face time on Fox and CNN to explain their ever changing rationale for the war. I recently saw a political cartoon with troops marching in formation chanting “we’re here because we’re here because we’re here.” That seems to be the bottom line. We’re there because we’re there and our “leaders” don’t have the courage to say “enough, we made a mistake, we’re out of here.” The acronym “fubar” was the term coined in Vietnam for this kind of situation. Fubar in Iraq is a known known.

Centcom commander William Fallon was fired by President Bush and replaced by George Petraeus. This is a known known. What this means for the prospect of an attack on Iran is a known unknown. It is not a good sign, however, since Fallon had let it be known he thought attacking Iran would be a reckless act, and Petraeus is known to be a political general, willing to do whatever it takes to curry favor with the President. What might trigger an outbreak of hostilities is an unknown unknown, but the stage is well set.

Debka recently published a piece taking note of all the strange events going on in the Middle East: A super-secret Israeli bombing mission in Syria that is suddenly not a secret any more; the firing of Admiral Fallon; additional warships heading to the gulf; a sharp increase in U.S. saber rattling; $125 oil; Israel’s first ever nationwide civil defense drill; military maneuvers in Syria; stepped up preparations for war by Hamas and Hezbollah, and increasingly harsh rhetoric between Israel and Iran. There is no smoking gun, but taken together all of the unusual goings-on point in the direction of war. There is also the domestic political consideration. War has been great politics for Republicans. Another war would presumably be to their advantage going into the fall election.

The biggest unknown unknown is what will happen if we do attack Iran. There has been a lot of bluster from Iran, and the talking head “experts” predict regional chaos. Given the track record of all these experts, I would assign equal probability of Iran folding under the onslaught and suing for peace, or of a dirty bomb exploding in Cincinnati, or of Russia moving in to protect Iran. The truth is that no-one knows what will happen. One thing worth considering, however, is the track record of the Bush regime in its military activities. Gives one pause. Do we really want these guys to initiate something in their final hours that is so fraught with uncertainty and potentially disastrous consequences? On the other hand, the only way to stop them if they are intent on another war is to impeach Bush and Cheney. Given the track record of Congress in standing up to Bush and Cheney, I’d give that outcome the probability of nil. So it appears we are subject to the whims of our President, who is clearly living in his own world. If he wants unleash the dogs of war one more time, we’re stuck with it. The weight of the evidence points in that direction, but is not conclusive. Stay tuned.

The Bottom Line

We all need to try to take a long term perspective on our world. That is difficult to do with all the spin and distraction aimed at us daily, but it is essential in order to make sound decisions. I have been over this numerous times in past editions of this letter, but just to recap: It will be wise to reduce debt to that which will be manageable in difficult times. Zero if possible. Tangible assets are generally desirable over paper. Some amount of gold is a good idea. Your own debt free, cash flowing business is probably your best investment. Non-dollar denominated assets are desirable, but one needs to be very careful in identifying “where and what”, in addition to the timing issue. Recent developments in Russia are a good example. Russian “raiders” have been expropriating assets of every kind, often using the courts to make their thefts “legal,” and investors have been left with little recourse. At least one Western fund manager with substantial investments in Russia has been denied entry into the country. Let the buyer beware.

For the immediate future the Presidential cycle is still operative and the Fed is in hyperactive firefighting mode. Thus, barring another major shock to the system, I expect to see a general improvement in economic activity and the stock market moving sideways to higher into the first quarter of ’09. After that all bets are off.


Q4 ’07:   A Time for Caution

Wall Street loves to tell the world that there’s no free lunch. Except, of course, when lunch consists of Wall Street bankers feasting on OPM.

If you want to understand the underlying issues driving the current market turmoil, I recommend the following two articles, both published on January 23rd:

The Worst Market Crisis in 60 Years” in the Financial Times by George Soros.
The Dollar and the Market Mess” in the Wall Street Journal by Bill Wilby.

The financial world is transfixed by the ongoing fallout from the sub-prime meltdown. Of course it is not really the sub-prime mortgages that are causing the big problems. Sub-prime mortgages comprise only 10-12% of all mortgages and the vast majority of them are performing just fine, thank you. Worst case sub-prime losses, somewhere in the neighborhood of $250 billion, would still only amount to a fairly minor hit to the economy.

What the sub-prime debacle has done is unmask the gigantic pyramid scheme that Wall Street bankers and their big hedge fund pals have been running.

The story begins with the financial innovation known as “structured finance.” In a structured deal, assets such as mortgages, credit card debt, corporate debt – any assets with cash flow associated – are pooled into stand-alone investment companies. Credit agencies such as Fitch, S&P and Moody’s analyze the cash flow and default characteristics of those asset pools and create a laddered structure of bonds with the bulk of the bonds being transformed by financial alchemy into AAA and the balance laddered down from AA, A, BBB, BB, B, and finally the unrated or “equity” portion. Income from the assets flows into the laddered structure from the top and is distributed in a preferred sequence from AAA downward to unrated, while losses from defaults flow into the structure from the bottom with the unrated taking all losses until it is wiped out and the single B then taking all losses until it is wiped out, etc.

Structured finance is a truly brilliant and benefic innovation unto itself. It creates a series of investment opportunities for those with varying risk appetites, and enables liquidity to flow to otherwise neglected segments of the economy. As long as everyone in the system behaves with integrity, structured finance is a boon to the economy. But as one might suspect, this is where the plot thickens.

A big problem with structured finance is that for the uninitiated, the arcane models with endlessly creative features and the related array of derivatives used for “balancing” risk seem hopelessly complex. As a result, few people really understand it in detail, even most otherwise sophisticated investors. I’m told that even new Fed Chairman Ben Bernanke needed a refresher course in structured finance when faced with the sub-prime meltdown.

The arcane nature of structured finance along with a lack of any regulatory oversight created an environment ripe for abuse. Structured Investment Vehicles (“SIV’s”) and “credit default swaps” became all the rage. The SIV’s allowed the banks to hide their liabilities to the structured deals by placing them “off book,” and the credit default swaps allowed everyone to pretend that they had “balanced” their liabilities.

In recent years investment banks and big hedge funds have generated a blizzard of credit default swaps. CDS contracts today total over $45 trillion, which, to give some perspective, amounts to over three times US Gross National Product and is more money than is on deposit in all the banks in the world. Total outstanding derivatives are over 10 times that amount. These are what Warren Buffett has been calling “economic weapons of mass destruction.” Every swap contract has an issuer and a buyer, each dependent on the other to fulfill their obligations. And of course each side can offset their obligations to others. All of this operates on an honor system with no regulatory oversight, no central exchange or clearing house and no reserve requirements.

The SIV’s and related derivatives amount to what Bill Gross calls a Shadow Banking System. Everyone in the system is exposed to massive counterparty risk. Worse, since there is no transparency in the system, no-one knows how badly exposed anyone else is. Hence, now that the bubble has popped, a reluctance to lend, and the resulting credit contraction.

The big investment banks and big hedge funds (this was an exclusive club) were literally creating money…trillions of dollars…issuing, trading, packaging, swapping and repackaging asset backed deals and derivatives. The result was a global tsunami of liquidity that caused a global run-up in asset prices, which is beginning to deflate. Our central banks are now trying to monetize this bubble without destroying our paper currencies and crashing the markets. Read “The Global Money Machine” by David Roche in the December 14th Wall Street Journal, an excellent review of the rise and incomplete fall of the global credit bubble.

The most remarkable thing about this whole fiasco is the huge bonuses being paid to the executives who are responsible for it. Citicorp is an excellent example.

Citicorp’s Sandy Weil, widely hailed as a banking genius as he led the way in the massive pyramid scheme, was paid the largest bonus in Wall Street history, $850 million, when he retired in 2003. He handed off the pyramid scheme to his successor, Chuck Prince. The roof fell in on Prince, but he still got a firing bonus of $100 mil. Together Weil and Prince were paid almost $1 billion dollars, while Citicorp has so far written off $24 billion in losses from their clever deals, and shareholders have lost $150 billion. Over at Merrill Lynch, Stan O’Neil got a firing bonus of $159 million even as Merrill was writing down $12-15 billion in losses and shareholders were taking a $50 billion hit. Is it too strong to call this “board room looting”

Meanwhile, as you would expect, lawsuits are sprouting like weeds in a vacant lot. So far, the common defense is “we were clueless but not conniving.” If you believe that one, I’ve got some really good income producing property I’d like to talk to you about. It’s a bridge…steady traffic, perfect for a toll booth…


Most of the political news we are getting these days is either heavily slanted or the product of insipid “inside the beltway” horserace reporting, or both. CNN and Fox are especially egregious as they jockey for market share by spinning and hyping the news into “newsertainment” designed to capture one segment or another. You have to do some digging to get good in-depth information.

I have come across a few good pieces recently. There was an excellent and dispassionate review of the accomplishments and frustrations of the new Democrat majority in Congress in the December 12th Los Angeles Times by Richard Simon and Noam N. Levey entitled “Democrats savor power for a year but end it feeling unfulfilled.” The New Yorker (January 29th edition) published a very good piece contrasting Hillary and Obama entitled “The Choice.” Ari Berman has been doing some good in-depth reporting at The Nation. And of course, Frank Rich’s Sunday columns in the New York Times are always brilliant and insightful.

In my opinion the most interesting phenomenon in the political world right now is the rising tide supporting Barack Obama. He is talking unity and non-partisanship and getting a strong response from an electorate weary of the destructive partisan warfare. Young people in particular are going for him in a big way.

The Lieberman Factor: Republicans have been exulting in their success in obstructing almost all of the Democrat initiatives since the Dems took control of Congress. Pretty tacky if you ask me after all the huffing and puffing about “up or down votes” when they were in the majority. Rank and file Democrats are furious with the weak Democrat response to Republican obstructionism. It especially makes Harry Reid look like a pansy. But what most people are not cognizant of is the Lieberman Factor. Lieberman caucuses with the Democrats, and his presence among the Democrats is what gives them their one vote majority in the Senate. Why Lieberman continues to caucus with the Democrats is a mystery to me. But he does, and that is a huge consideration in all that happens in the Senate. If Lieberman decides to bolt to the Republicans, all the committee chairmanships will switch back to the Republicans. This is something that Democrats will avoid at all costs if possible. So Lieberman gets what Lieberman wants. If Lieberman wants capitulation to the President on war funding, FISA or any other specific measure, that’s what Harry Reid gives him. Reid has been taking a pounding from liberal bloggers who deride him as the chief Bush enabler. The reality is that Harry Reid despises Bush and would go to the mat with him in a heartbeat if he had the votes. But he doesn’t. So for one more year at least, Lieberman will call the shots in the Senate.


What a difference a few months can make. As recently as November the Bush folk were actively promoting another pre-emptive war, this time with Iran, which even they acknowledged would probably ignite all out regional war in the Mideast. But resistance began to rise from within the military, which has grown weary of being cannon fodder for the neo-con agenda. The Joint Chiefs let it be known that they think an attack on Iran would be lunacy, and at least five Generals and Admirals are reportedly prepared to resign rather than participate in what they would consider a reckless act. Such a mass revolt at the top level of the U.S. military would be unprecedented.

In November the CIA dropped a bomb on the neo-cons in the form of its Report on Iran, which stated that Iran shut down their nuclear weapons program in 2003. The neo-cons are up in arms (even more than usual) over the CIA report. They have convinced the President that the CIA report is baloney and that he needs to continue to beat the drum for confrontation against Iran, which he did loudly during his recent visit to the Middle East.

Israel is also not happy about the U.S. retreat from confrontation with Iran. They are convinced that Iran is not only working full speed ahead on nuclear weapons technology, but also on warheads and delivery systems. Unchecked, Israel expects Iran to have nuclear weapons in three years. Who is right? It’s not possible for us ordinary folks to know, but if I had to bet my life on intel from the CIA or Mossad, I think I would have to put my chips on Mossad. Israel’s survival depends on Mossad’s accuracy.

Israel is in a difficult situation. Iran is arming, training and financing Hamas in Gaza and Hezbollah in Lebanon, as well as Syria. The Iranian President regularly announces the inevitable destruction of Israel. All of these parties have been preparing for war and Hamas is launching dozens of missiles daily into Israel. Under these conditions the prospect of a nuclear Iran is simply not tolerable to Israel and it is entirely possible, even likely, that they will decide they need to take care of Iran themselves if the U.S. can’t or won’t do it. Any cost is better than a nuclear Iran. They will be watching the U.S. election campaign carefully to decide whether they need to act while Bush is still in office, or whether the likely winner will be a reliable supporter down the road.


It becomes increasingly difficult to find solid opportunities. The global tsunami of liquidity created by the Shadow Banking System has run up the price of assets across the board. Real estate is done and overpriced everywhere, as are assets in general. Stocks may hold here and even rally for awhile, but they are rich just the same. Foreign investments, especially emerging markets have been great beneficiaries of the sagging dollar, but the dollar is already down almost 40% since 2001 and sentiment is in the sub-basement. It could go down more, and over the long run it most likely will. But in the intermediate term I think the dollar is more likely to surprise on the upside than on the downside. Forget about bonds. Everything that is being done and will be done to try to stabilize the markets and pump up the economy is inflationary. Sooner or later bonds will start discounting that inflation. All things considered, cash is looking like a pretty good opportunity.

Gold has had a great run, up 268% since 2001. Over the long run it will probably continue much higher, but at $900 it’s tough to pull the trigger on gold. Richard Russell is probably the guy to listen to on gold. In fact, I would say that if you don’t subscribe to Dow Theory Letters, you should. At $300 this newsletter is the best value in the business. Russell is one of our most successful long term investment advisors and his sage perspective is valuable, especially in uncertain times.

The Bottom Line

The sub-prime shock has unmasked the house of cards that Wall Street built, ushering in a bear market of as yet undetermined magnitude. The stock market has put in a rather ominous looking top and has sold off approximately 20% from the October highs. My point and figure chart projects the potential for a move down to 10,000 in the S&P 500. That’s another 20% for a potential total correction of 36%. That is not unreasonable. However, considering the extreme negative sentiment at the lows and the lack of follow through so far, I am starting to feel that the bottom may be in on this bear market, or close. Also, the Presidential Cycle has been a pretty reliable general guide of stock market behavior, and we are in a bullish phase of that cycle until March of next year. See Risk &Opportunity Q1’07 for more detail on the Presidential Cycle.

At present I see three possibilities for the stock market. (1) The market chops sideways for the next year before rolling over and heading down. (2) The market sells off now (possibly already complete) and then rallies into the election to make a new or possibly a secondary top before beginning the real bear market in ‘09. (3) An export boom ignited by the weak dollar and global injections of liquidity by governments and central banks takes stocks on another major move up. Which do I favor? Currently, based on sentiment and cycles I would favor option #2, but only time will clarify which scenario is unfolding.

As Richard Russell likes to day, the Fed’s mantra is “inflate or die.” The Fed has made it clear they are going to do everything in their power to put off or minimize any recession. After 40 years of fiscal mismanagement we are now trapped in a semi-permanent stimulus driven, “inflate or die” economy, and the Fed currently has its foot down hard on the stimulus pedal.

Eventually, central bank intervention will no longer have the desired effect of jumpstarting the economy. Globalization and serial bubbles have both eroded Fed power and the day will come when the Fed pulls all the levers at its disposal and nothing happens. That will be the day that the cumulative impact of many delayed recessions will have to be endured.

The big question is…has the day of reckoning come? I think we’re not there yet. The Fed still has considerable power to impact the marketplace and has made it clear that it is going to act aggressively to do so.

My read is that volatility will continue to be high. The bear may take another bite out of the market, but the market will come back strong into the election for a secondary or possibly a new high. After that…well, we can’t put off our debts forever.

All things considered, caution should be exercised in all matters financial. Cash may well be your best opportunity right now.


Q3 ’07:   A Look On the Bright Side

We are facing many challenges these days. There is no end of bad news to focus on if you are so inclined. In fact, if you are not careful, you could become downright paranoid from too much exposure to the relentless push of bad news from our media, which are now almost entirely owned by bottom line oriented entertainment companies.

We don’t really have much of a “news” business left in America. There is not enough money in news. The news must be spun into entertainment in order to capture enough eyes and ears to pay the corporate freight. Profits come from readers, watchers and listeners, and the best way to get those eyes and ears focused is to create diversion and/or fear. Simply stated…bad news sells. Scandal, tragedy and mayhem are the staples for our media companies.

Obviously this is not the good news I want to focus on in this letter. The point is that we need to make a conscious effort to disengage from the base appeals and endless distractions coming through our media in order to gain perspective on our civilization.

When we disengage from the narrow framework of day to day life and expand our vision to take in the historical view of human civilization, our situation looks pretty darn good. Advances in medicine, technology and governance have vastly improved our lot. Two thousand years ago human life was brutish and short, twenty years on average. Only a hundred and fifty years ago the average lifespan in America was in the 40’s. Today it is approaching 80 and ageing researchers predict that lifespan will continue to expand to 120, maybe more. Our lifestyle, even for the poorest among us, is filled with comforts and conveniences our ancestors could not even imagine.

For our ancestors the chances of a violent death were quite high. Today, unless one is so unfortunate as to live in Iraq, Sudan or a few other hot spots on the globe, the chances of a violent death are probably the lowest they have ever been. Despite the best efforts of our “leaders” in Washington to keep us all in fear of being blown up by terrorists, the lifetime odds for an American of death by terrorist attack are approximately 88,000 to 1, equal to those of landing a date with a supermodel. The odds of being killed by lightning are considerably greater — 55,928 to 1.

The bottom line is…we are not in mortal danger from terrorists and we all have a lot to be grateful for. We live in a far, far better and more peaceful world than our ancestors. It is important to give our attention to the risks threatening our world, because it is our attention which leads to mitigation of those risks and it is the risks that we ignore that burn us. At the same time it is important to maintain perspective and give thanks for our many blessings.

Harvard psychology professor Steven Pinker has put things in perspective in an excellent article on the history of violence, previously published in The New Republic and Edge, which I have included below.


In sixteenth-century Paris, a popular form of entertainment was cat-burning, in which a cat was hoisted in a sling on a stage and slowly lowered into a fire. According to historian Norman Davies, “[T]he spectators, including kings and queens, shrieked with laughter as the animals, howling with pain, were singed, roasted, and finally carbonized.” Today, such sadism would be unthinkable in most of the world. This change in sensibilities is just one example of perhaps the most important and most underappreciated trend in the human saga: Violence has been in decline over long stretches of history, and today we are probably living in the most peaceful moment of our species’ time on earth.

In the decade of Darfur and Iraq, and shortly after the century of Stalin, Hitler, and Mao, the claim that violence has been diminishing may seem somewhere between hallucinatory and obscene. Yet recent studies that seek to quantify the historical ebb and flow of violence point to exactly that conclusion.

Some of the evidence has been under our nose all along. Conventional history has long shown that, in many ways, we have been getting kinder and gentler. Cruelty as entertainment, human sacrifice to indulge superstition, slavery as a labor-saving device, conquest as the mission statement of government, genocide as a means of acquiring real estate, torture and mutilation as routine punishment, the death penalty for misdemeanors and differences of opinion, assassination as the mechanism of political succession, rape as the spoils of war, pogroms as outlets for frustration, homicide as the major form of conflict resolution—all were unexceptionable features of life for most of human history. But, today, they are rare to nonexistent in the West, far less common elsewhere than they used to be, concealed when they do occur, and widely condemned when they are brought to light.

At one time, these facts were widely appreciated. They were the source of notions like progress, civilization, and man’s rise from savagery and barbarism. Recently, however, those ideas have come to sound corny, even dangerous. They seem to demonize people in other times and places, license colonial conquest and other foreign adventures, and conceal the crimes of our own societies. The doctrine of the noble savage—the idea that humans are peaceable by nature and corrupted by modern institutions—pops up frequently in the writing of public intellectuals like José Ortega y Gasset (“War is not an instinct but an invention”), Stephen Jay Gould (“Homo sapiens is not an evil or destructive species”), and Ashley Montagu (“Biological studies lend support to the ethic of universal brotherhood”). But, now that social scientists have started to count bodies in different historical periods, they have discovered that the romantic theory gets it backward: Far from causing us to become more violent, something in modernity and its cultural institutions has made us nobler.

To be sure, any attempt to document changes in violence must be soaked in uncertainty. In much of the world, the distant past was a tree falling in the forest with no one to hear it, and, even for events in the historical record, statistics are spotty until recent periods. Long-term trends can be discerned only by smoothing out zigzags and spikes of horrific bloodletting. And the choice to focus on relative rather than absolute numbers brings up the moral imponderable of whether it is worse for 50 percent of a population of 100 to be killed or 1 percent in a population of one billion.

Yet, despite these caveats, a picture is taking shape. The decline of violence is a fractal phenomenon, visible at the scale of millennia, centuries, decades, and years. It applies over several orders of magnitude of violence, from genocide to war to rioting to homicide to the treatment of children and animals. And it appears to be a worldwide trend, though not a homogeneous one. The leading edge has been in Western societies, especially England and Holland, and there seems to have been a tipping point at the onset of the Age of Reason in the early seventeenth century.

At the widest-angle view, one can see a whopping difference across the millennia that separate us from our pre-state ancestors. Contra leftist anthropologists who celebrate the noble savage, quantitative body-counts—such as the proportion of prehistoric skeletons with axemarks and embedded arrowheads or the proportion of men in a contemporary foraging tribe who die at the hands of other men—suggest that pre-state societies were far more violent than our own. It is true that raids and battles killed a tiny percentage of the numbers that die in modern warfare. But, in tribal violence, the clashes are more frequent, the percentage of men in the population who fight is greater, and the rates of death per battle are higher. According to anthropologists like Lawrence Keeley, Stephen LeBlanc, Phillip Walker, and Bruce Knauft, these factors combine to yield population-wide rates of death in tribal warfare that dwarf those of modern times. If the wars of the twentieth century had killed the same proportion of the population that die in the wars of a typical tribal society, there would have been two billion deaths, not 100 million.

Political correctness from the other end of the ideological spectrum has also distorted many people’s conception of violence in early civilizations—namely, those featured in the Bible. This supposed source of moral values contains many celebrations of genocide, in which the Hebrews, egged on by God, slaughter every last resident of an invaded city. The Bible also prescribes death by stoning as the penalty for a long list of nonviolent infractions, including idolatry, blasphemy, homosexuality, adultery, disrespecting one’s parents, and picking up sticks on the Sabbath. The Hebrews, of course, were no more murderous than other tribes; one also finds frequent boasts of torture and genocide in the early histories of the Hindus, Christians, Muslims, and Chinese.

At the century scale, it is hard to find quantitative studies of deaths in warfare spanning medieval and modern times. Several historians have suggested that there has been an increase in the number of recorded wars across the centuries to the present, but, as political scientist James Payne has noted, this may show only that “the Associated Press is a more comprehensive source of information about battles around the world than were sixteenth-century monks.” Social histories of the West provide evidence of numerous barbaric practices that became obsolete in the last five centuries, such as slavery, amputation, blinding, branding, flaying, disembowelment, burning at the stake, breaking on the wheel, and so on. Meanwhile, for another kind of violence—homicide—the data are abundant and striking. The criminologist Manuel Eisner has assembled hundreds of homicide estimates from Western European localities that kept records at some point between 1200 and the mid-1990s. In every country he analyzed, murder rates declined steeply—for example, from 24 homicides per 100,000 Englishmen in the fourteenth century to 0.6 per 100,000 by the early 1960s.

On the scale of decades, comprehensive data again paint a shockingly happy picture: Global violence has fallen steadily since the middle of the twentieth century. According to the Human Security Brief 2006, the number of battle deaths in interstate wars has declined from more than 65,000 per year in the 1950s to less than 2,000 per year in this decade. In Western Europe and the Americas, the second half of the century saw a steep decline in the number of wars, military coups, and deadly ethnic riots.

Zooming in by a further power of ten exposes yet another reduction. After the cold war, every part of the world saw a steep drop-off in state-based conflicts, and those that do occur are more likely to end in negotiated settlements rather than being fought to the bitter end. Meanwhile, according to political scientist Barbara Harff, between 1989 and 2005 the number of campaigns of mass killing of civilians decreased by 90 percent.

The decline of killing and cruelty poses several challenges to our ability to make sense of the world. To begin with, how could so many people be so wrong about something so important? Partly, it’s because of a cognitive illusion: We estimate the probability of an event from how easy it is to recall examples. Scenes of carnage are more likely to be relayed to our living rooms and burned into our memories than footage of people dying of old age. Partly, it’s an intellectual culture that is loath to admit that there could be anything good about the institutions of civilization and Western society. Partly, it’s the incentive structure of the activism and opinion markets: No one ever attracted followers and donations by announcing that things keep getting better. And part of the explanation lies in the phenomenon itself. The decline of violent behavior has been paralleled by a decline in attitudes that tolerate or glorify violence, and often the attitudes are in the lead. As deplorable as they are, the abuses at Abu Ghraib and the lethal injections of a few murderers in Texas are mild by the standards of atrocities in human history. But, from a contemporary vantage point, we see them as signs of how low our behavior can sink, not of how high our standards have risen.

The other major challenge posed by the decline of violence is how to explain it. A force that pushes in the same direction across many epochs, continents, and scales of social organization mocks our standard tools of causal explanation. The usual suspects—guns, drugs, the press, American culture—aren’t nearly up to the job. Nor could it possibly be explained by evolution in the biologist’s sense: Even if the meek could inherit the earth, natural selection could not favor the genes for meekness quickly enough. In any case, human nature has not changed so much as to have lost its taste for violence. Social psychologists find that at least 80 percent of people have fantasized about killing someone they don’t like. And modern humans still take pleasure in viewing violence, if we are to judge by the popularity of murder mysteries, Shakespearean dramas, Mel Gibson movies, video games, and hockey.

What has changed, of course, is people’s willingness to act on these fantasies. The sociologist Norbert Elias suggested that European modernity accelerated a “civilizing process” marked by increases in self-control, long-term planning, and sensitivity to the thoughts and feelings of others. These are precisely the functions that today’s cognitive neuroscientists attribute to the prefrontal cortex. But this only raises the question of why humans have increasingly exercised that part of their brains. No one knows why our behavior has come under the control of the better angels of our nature, but there are four plausible suggestions.

The first is that Hobbes got it right. Life in a state of nature is nasty, brutish, and short, not because of a primal thirst for blood but because of the inescapable logic of anarchy. Any beings with a modicum of self-interest may be tempted to invade their neighbors to steal their resources. The resulting fear of attack will tempt the neighbors to strike first in preemptive self-defense, which will in turn tempt the first group to strike against them preemptively, and so on. This danger can be defused by a policy of deterrence—don’t strike first, retaliate if struck—but, to guarantee its credibility, parties must avenge all insults and settle all scores, leading to cycles of bloody vendetta. These tragedies can be averted by a state with a monopoly on violence, because it can inflict disinterested penalties that eliminate the incentives for aggression, thereby defusing anxieties about preemptive attack and obviating the need to maintain a hair-trigger propensity for retaliation. Indeed, Eisner and Elias attribute the decline in European homicide to the transition from knightly warrior societies to the centralized governments of early modernity. And, today, violence continues to fester in zones of anarchy, such as frontier regions, failed states, collapsed empires, and territories contested by mafias, gangs, and other dealers of contraband.

Payne suggests another possibility: that the critical variable in the indulgence of violence is an overarching sense that life is cheap. When pain and early death are everyday features of one’s own life, one feels fewer compunctions about inflicting them on others. As technology and economic efficiency lengthen and improve our lives, we place a higher value on life in general.

A third theory, championed by Robert Wright, invokes the logic of non-zero-sum games: scenarios in which two agents can each come out ahead if they cooperate, such as trading goods, dividing up labor, or sharing the peace dividend that comes from laying down their arms. As people acquire know-how that they can share cheaply with others and develop technologies that allow them to spread their goods and ideas over larger territories at lower cost, their incentive to cooperate steadily increases, because other people become more valuable alive than dead.

Then there is the scenario sketched by philosopher Peter Singer. Evolution, he suggests, bequeathed people a small kernel of empathy, which by default they apply only within a narrow circle of friends and relations. Over the millennia, people’s moral circles have expanded to encompass larger and larger polities: the clan, the tribe, the nation, both sexes, other races, and even animals. The circle may have been pushed outward by expanding networks of reciprocity, à la Wright, but it might also be inflated by the inexorable logic of the golden rule: The more one knows and thinks about other living things, the harder it is to privilege one’s own interests over theirs. The empathy escalator may also be powered by cosmopolitanism, in which journalism, memoir, and realistic fiction make the inner lives of other people, and the contingent nature of one’s own station, more palpable—the feeling that “there but for fortune go I”.

Whatever its causes, the decline of violence has profound implications. It is not a license for complacency: We enjoy the peace we find today because people in past generations were appalled by the violence in their time and worked to end it, and so we should work to end the appalling violence in our time. Nor is it necessarily grounds for optimism about the immediate future, since the world has never before had national leaders who combine pre-modern sensibilities with modern weapons.

But the phenomenon does force us to rethink our understanding of violence. Man’s inhumanity to man has long been a subject for moralization. With the knowledge that something has driven it dramatically down, we can also treat it as a matter of cause and effect. Instead of asking, “Why is there war?” we might ask, “Why is there peace?” From the likelihood that states will commit genocide to the way that people treat cats, we must have been doing something right. And it would be nice to know what, exactly, it is.


Q2 ’07:   The End of an Era

The disastrous world wars of the early 20th century were fought between largely self-sufficient industrial empires. Based on the bitter experience of those wars, generations of American leaders, beginning with Franklin Roosevelt, deliberately embraced a political framework and trade policy designed to promote global industrial interdependence as the best way to prevent future wars and thus guarantee national security. The early architects of this system would be in awe if they could see the fruit of their vision. Global industrial interdependence is now a reality. Whether the global production system will ultimately accomplish its primary goal of a sustained peace remains to be seen, but if it is to succeed in this noble purpose, the challenge ahead will be to make the system safe, stable and more equitable.

This quarter’s letter was inspired by the recent publication, “End of the Line: The Rise and Coming Fall of the Global Corporation” by Barry C. Lynn.

The title was most likely conjured up by the publisher’s marketing division, because the content of the book is not nearly as apocalyptic as the title. It does, however, point out features of our global production system that urgently require attention to forestall a global crisis. All investors should read this book and encourage their government representatives to do so as well. This is a book of economic wisdom, with a warning and prescriptions that I hope our policy makers will heed.

Author Lynn devotes 80% of the book to the policy, legal, market and technology developments, from the founding of America to present, that have led to the current form of the global outsourced corporation. In particular he goes into great detail, sometimes painfully so, in documenting the developments over the past twenty years that transformed the system of trade between national economies into the integrated global production system of today. He then spends the last two chapters zeroing in on the vulnerabilities of this system, and outlining policy changes needed on both government and corporate levels to stabilize it.

Lynn begins with the tale of a little known incident on September 21, 1999 – an earthquake in Taiwan — that brought the global electronics industry to a sudden halt. The one week shutdown of two critical chip producers in Taiwan (between them producers of the entire world’s supply of a certain chip used in virtually every electronic device) had repercussions that lasted well into the 1st quarter of 2000 and caused a 7% hit to global electronics production.

We were all lucky that the chip plants were not directly hit. If they had been destroyed, the consequence would have been a total meltdown of the global electronics industry along with their suppliers, financiers and downstream beneficiaries, and quite possibly the entire global economy with it.

There have been numerous events since 1999 that have highlighted the same issue: the SARS outbreak, 9/11, the 2002 West Coast dock strike, and others less well known. A recent earthquake (July 16th) in Japan immediately shut down 70% of that nation’s auto production when a critical parts supplier was damaged in the quake.

The main point of the book is that the concentration and hyper-specialization of each link in the global outsourced “just-in-time” supply chain of every major industry has made the entire system fragile at its core. As Lynn puts it, “Our corporations have built… the most efficient system of production the world has ever seen…a global production system that is so complex, and geared so tightly and leveraged so finely, that a breakdown anywhere increasingly means a breakdown everywhere…”

Lynn points out that the global production system is already a done deal, and that the policies that fostered its development and growth are not the policies needed to keep it stable and healthy into the future. “Our primary need is no longer to promote more global scale efficiency. These systems have already been made more efficient than is safe. The challenge now is to ensure their stability and their ability to keep growing.”

The Issues:

No one in charge. Government policy makers today embrace an economic orthodoxy defined by a blind faith in “the market” to solve all problems. This thinking took root in Washington with Reagan, was greatly expanded by Clinton, and has been given free reign by Bush II. This attitude means that even as the global economy has undergone unprecedented change, expansion and integration, making the entire world dependent on one integrated system (with power consolidated into the hands of self-interested top executives of massive global corporations), there is no-one overseeing the safety and stability of the system itself.

My response to the sentiment that the market will solve all problems is: yes, the market (nature) will solve all problems in the end, but the cost may be extreme in ways not foreseen or desirable, or even survivable. For those who are inclined to buy into the all-wise market argument: I suggest you go count the number of trees in Haiti. During a firewood crisis in Haiti, demand for firewood overwhelmed supply, and the failure of government to regulate the cutting of trees ultimately meant virtually no trees left, with severe long term consequences for the people of Haiti. Meanwhile, neighboring Dominican Republic remains nicely forested due to proactive government policies to protect their trees.

Relentless pricing pressure. “Once outsourcing begins to work its way through any industrial sector it often becomes nearly impossible for any one firm to stand alone against the pricing pressures that are unleashed. Absent government action to ensure that all companies around the world face the same costs of making their supply chains more secure, the marketplace tends to dictate one fact: Taking more precautions than your competitor is a good way to lose market share big time.”

The pricing pressure produced by global outsourcing has promoted ever increasing dependency on single sourcing, not only for individual corporations but also for industries as a whole. This has resulted in the dismantling of most of the redundancy and layers of management oversight developed from long experience to ensure the safety and stability of the corporate enterprise. These developments have exposed virtually every industry, and the system in its entirety, to potentially catastrophic risk. Without intervention to ensure the safety of the system, inevitably the day will come when some one event will cause a chain reaction that brings down the entire system.

Total dominance of global lead firms. Global lead firms such as Wal-Mart, Dell, Cisco, GE and Boeing have consolidated such power that they have managed the neat trick of shifting the business risk of manufacturing onto their suppliers (and in some cases customers) while extracting most of the profit from the business enterprise. With the implied and sometimes outright threat of taking their business elsewhere, lead firms retain dictatorial pricing power over their suppliers, which they relentlessly exploit. The suppliers in turn lean on their suppliers and employees in the same way. The system is devouring its own foundations. These global lead firms have for the most part outsourced all facets of the actual making of things and no longer own or maintain productive assets. Therefore, they have little incentive to plan and invest, or to attend to the wellbeing of the productive assets on which they depend. The function of the global lead firm has devolved from the creation, innovation and maintenance of the business enterprise to protection of market share and extraction of maximum short term profit. “Their power is mainly extractive, and increasingly destructive.”

Failure to innovate. Our global outsourced corporations are no longer engines of creativity and innovation. The relentless push for efficiency leaves no room for innovation. Despite endless, breathless corporate PR about innovation, the only real innovation that is going on in the corporate world these days is innovation in service to greater efficiency. Case in point – Six Sigma at 3M. See Business Week’s June 11th cover story, “3M’s Innovation Crisis.”

Excessive shareholder power. Ultimately a corporation must serve a social need in order to sustain itself over time. Today’s global outsourced corporations have no incentive for long term planning, investment in research, productive assets or employees, and no loyalty to community or nation. Huge CEO stock and option deals have aligned CEO incentives totally with the interests of shareholders (short term profit) to the detriment of all other interest groups impacted by corporate activity: suppliers, employees, customers, communities and society.


All of these problems are solvable with appropriate attention from government policy makers to set the ground rules and incentives for safety and sustainability of the system. With appropriate policy measures in place to put a stop to the industrial cannibalism, the system will be freed from the relentless downward spiral of outsourcing driven pricing pressure. Corporate policies and activities will quickly adjust and begin to create more balanced and sustainable policies, systems and structures.

Lynn offers a series of measures (pp. 256-257) to address these imbalances and vulnerabilities and to promote the long term stability and health of the global production system. These are all measures which have been used effectively and safely in the past, to bring the activities of the industrial giants of the early 20th century into line with the interests of society, and which can be enacted unilaterally by the U.S. without harming the interests of any other nation. These solutions are U.S. centric because the global system is the creation of U.S. corporations, and the U.S. is still by far the dominant force in the system.

  1. “Use anti-trust power to ensure that no global lead firm controls more than 25% of any American market.
  2. Limit how much of any key input any industry can source from capacity located in any single foreign nation, to no more than 25% of the amount consumed in the U.S.
  3. Require firms to double or even triple source all components and business process services, in real time, from suppliers in two or more different nations.
  4. Strengthen the ability of true manufacturers to counterbalance the price-setting power of global lead firms, by strengthening and enforcing anti-monopsony laws. (A monopsony is a market situation in which a single buyer exerts a disproportionate influence on the market.) This would allow true manufacturers to capture a greater share of the profit in the production chain, and thereby be able to invest more in the maintenance of their productive assets.
  5. Require managers to make public their sourcing and supply-chain relationships, to enable investors to shy from firms that take unnecessary risk.
  6. Enable workers to more effectively counterbalance the power of shareholders by giving them an absolutely equal right to act collectively within the U.S. economy. Practically, this would reduce the ability of large corporations to seek profits by mining the social infrastructure.
  7. Professionalize management of the U.S. corporation by compensating top management only in salary and not in stock or stock options. One result would be a very different assessment by top managers of risk within the production system and of the attractiveness of owning, developing and maintaining productive assets.
  8. Reconsider the nationality of the global-scale lead firm, even if it maintains its headquarters in the U.S. Practically, this would give Americans a much clearer sense of how to shape national and state-level policies, where and how to subsidize research, and how to employ the private sector to develop defense technologies.”

My comment: These measures will necessarily be inflationary, but we have before us a choice of continuing to chase short term gain in the form of marginally (from this point forward) lower prices until the system itself collapses from neglect, or we can accept a period of inflation while the imbalances in the system are normalized.

Market Update

At press time stocks are recovering somewhat from the recent sell-off, which has given pause to an otherwise pretty good year so far for the stock market. The sub-prime debacle has pricked the complacency bubble, causing a long overdue re-pricing of risk premiums in the credit markets. This has made investors nervous. But the rather dramatic spike in negative sentiment generated by this relatively minor sell-off (S&P down 6% from its highs) leads me to believe that while there is probably more to the downside in this move, it is not the end of the bull market.

I do, however, see some early signs of topping activity.

One such early warning sign is the Blackstone IPO. (See TheStreet.com’s analysis of this deal.) This is no ordinary IPO. Blackstone is one of the premier private equity companies and the Blackstone principals are masters of value — they buy cheap and sell dear. They buy companies that are “under-performing” for various reasons, “add value” by introducing operational efficiencies and technology, shutting down or selling unprofitable operations, outsourcing, off-shoring, and off-loading pension and health care obligations. These activities greatly increase the cash flow to the bottom line and to the shareholders, in this case the Blackstone principals and their investors. But that is not the end of the game. Increased profit and cash flow is very nice, but the big bucks are made when the transaction is completed.

Private equity companies complete the transaction and realize their profit by creating a “liquidity event.” This is either the sale of a portfolio company to another company, or the sale of the company through an IPO, in either case at a multiple of earnings. In this case Blackstone chose to offer shares in itself rather than offering the individual portfolio companies or the funds they manage. The fact that Blackstone has seen fit to do an IPO signals that the principals believe they have maximized the value of their portfolio and want to start cashing in. They are selling dear, and would not be selling if they thought their stock was anything other than dear.

If the Blackstone principals believe that they have realized the bulk of the value from their portfolio, that would indicate that valuations in general are peaking, and it also sends a signal to the dozens of other private equity companies which will now be looking for a liquidity event as well. In fact, KKR, another legendary private equity group, has also announced its intention to offer an IPO, as have numerous hedge funds. Others will surely follow. This new supply of stock will begin to put pressure on the market, a turnabout from the steady disappearance of stock caused by the de-listing of public companies during the buyout boom of recent years.

The private equity boom has been fueled by cheap money. Blackstone and other private equity companies, and public corporations as well, have been able to finance their acquisitions by selling junk bonds at historically low rates. That source of money is now starting to get more expensive as lenders, in the wake of the sub-prime meltdown, have suddenly realized that they are taking more risk than they are getting paid for. This will also begin a trend toward issuance of stock rather than debt as stock values are high and debt is now getting more expensive. So from various sources we will begin to see an increased supply of stock coming to market. Two excellent articles on the private equity business are the July 7th Economist cover article “The Trouble With Private Equity,” and Business Week’s July 2nd article, “Bashing Private Equity.”

Political Update

President Bush’s intransigence on the war and his resulting spiral dive in ratings has finally begun to wear out the patience of his Republican supporters. In recent weeks numerous Republican Senators have publicly broken ranks with the President on Iraq and Senate Democrats are planning keep the pressure on with new votes on withdrawal. The President continues to reject all counsel but his own on this matter, and gives no indication he will alter his course regardless of political damage to his party.

The President’s commutation of Scooter Libby’s prison sentence has been a PR disaster for the White House, and for Republicans who have generally been unsympathetic and unyielding to the many thousands who have been sentenced to life destroying terms under the inflexible federal sentencing guidelines. Remarkably, the President’s rationale for commuting Libby’s sentence consisted of the very same litany of issues that defense attorney’s have been pleading since the onset of these guidelines: the sentence was too harsh, it will have an outsized effect on his innocent family, it failed to take into consideration all of his good works and character, and it failed to take into consideration any mitigating or unique circumstances.

The irony of this commutation is that it may well turn out to be a good thing for the country by opening up a debate on the harsh and inflexible federal sentencing guidelines and may over time yield changes on that score. “Law and order” Republicans who have stonewalled efforts to moderate these guidelines since their adoption in the ‘80’s will have a difficult time making their case after their support for (or failure to oppose) the Libby commutation. See “Bush Rationale on Libby Stirs Legal Debate” in the July 4th N.Y. Times.

Geopolitical Update

The Mideast continues to dominate all geopolitical concerns. The situation is, in a word, hot.

The wheels are coming off of the U.S. effort in Iraq. Political support at home is collapsing, and while the “surge” is suppressing the overall level of violence in the short run, our troops are for the most part playing “whack-a-mole” with insurgents. Meanwhile, political progress in the Iraqi government is nonexistent. Having made zero progress on any of the critical issues it is facing, the Iraqi government has decided to take vacation for the month of August. The reality is that partition is the only viable option at this point. Turkey is ready…it reportedly has 140,000 troops massed on the Iraqi border.

Meanwhile, the Hamas coup in Gaza has upended the Israeli-Palestinian stalemate. Negotiations are suddenly going full tilt between Israel and Fatah in the West Bank to try to begin normalizing relations. We can all hope, but keep in mind that many Palestinians refer to Fatah as “the mafia” because of their well deserved reputation for corruption. Also, Hamas is not likely to sit idly by while peace breaks out between Israel and Fatah.

The big “known unknown” in the Mideast is Iran. Some feel that Iran is overreaching, and in the grips of hubris will trigger a regional war. The mullahs clearly feel that their star is ascendant. Their clients, Hamas and Hezbollah, have had big successes recently. They are working effectively with Syria to keep Lebanon destabilized. The U.S. is mired in Iraq. Their nuclear program is going full speed ahead. Iran is emerging from the neo-con era as the dominant force in the Middle East, and they feel this is their moment of destiny.

On the other hand, Iran is facing growing financial and domestic political problems. Despite sitting on the world’s second largest oil reserves, they are rationing gasoline. Two thirds of the population of Iran is under 30, and unemployment is very high among those under 30 — approximately 30%, and projected to reach as high as 50% in two years.

Terror Free Tomorrow recently conducted an unprecedented national poll of Iran, documenting the unhappiness (by wide margins) of the Iranian people with the policies and structure of their government. They would like a democracy; they would be happy to give up the nuke program, and they want to be open to the West. This information creates a delicate policy challenge for the Bush administration (unfortunately not known for its subtlety or nuance): an opportunity to mine this discontent to replace the existing regime without going to war and making enemies of those who desire to be our friends. I hope the Bushies are up to the challenge. See the July 11th Wall Street Journal op-ed, “What Iranians Think” by the President of Terror Free Tomorrow. Also, the Economist has an excellent special report entitled “The Riddle of Iran” in the July 21st edition.

At the same time Iran has pushed the U.S. about as far as they can without incurring a military strike. The Guardian recently reported that “The balance in the internal White House debate over Iran has shifted back in favour of military action before President George Bush leaves office.”

The U.S. has been building a public dossier of Iranian transgressions against American interests in Iraq and around the Mideast. The most inflammatory elements are repeated charges that Iran is directly supporting Iraqi insurgents by providing materials and training in IED’s, which are the #1 killer of U.S. troops in Iraq. When the time comes, this dossier will be used as justification for U.S. military action against Iran based on self-defense.

The grip of the mullahs will eventually start unraveling from the combined domestic and international pressures. The big questions are whether that will happen in time to satisfy George Bush, and whether it will happen before they develop nuclear weapons.


It remains my opinion that the primary opportunity these days is to prepare for the coming storm. Systemic risk is increasing, and the list of potential catalysts for a major crisis remains long. There is still time to pay down debt and reduce leverage.

Our government has long ago discarded any semblance of fiscal sanity, so long term the dollar has only one way to go. Gold, foreign currencies and assets owned outright are the counterweight to the dollar…but timing is everything. Economic and geopolitical disturbances can still cause a short term “flight to quality,” which can mean sharp rallies in the dollar. The cost of energy will probably continue to rise for the foreseeable future, but be prepared for serious volatility if you invest in this sector. There is a lot of interest in alternative energy but this is a nascent industry and it is very difficult to tell which technologies and companies are going to be the winners in the alternative race. Of course the best hedge against decline is your own debt free business, and on that score there seems to be more opportunity in the virtual world these days than in the physical. Here are some useful tips for newbie internet entrepreneurs. Also, one place to begin searching for on-line knowledge and inspiration is SreeTips.com.

Local food is gaining in popularity. I believe we are in a very early stage of a long term trend back to local agriculture. If for no other reason than the dramatically increased cost of flying and trucking food all over the globe, local agriculture is the future of the food business. A starting place for local agriculture resources is the USDA Alternative Farming Systems Information Center.

BCA Research recently ran an interesting piece about South American stocks. Apparently, while South Asia has been getting all the attention and most of the money, South American stocks have been outperforming South Asian stocks. You can check out South American indexes on Bloomberg and Latin American funds at Yahoo Finance.

South America has not come close to the economic performance of South Asia, but it is a lot closer to home, and many Americans are looking Southward for opportunity.


Q1 ’07:   The Presidential Cycle and Mideast Tensions

One of the useful tools for divining the future course of the stock market is the basic four year cycle that tends to peak shortly after presidential elections and is thus called the Presidential Cycle. Like all cycles it can be useful for analyzing past market behavior, but tricky to use projecting forward. Cycles in markets can run like clockwork for long periods of time and then suddenly disappear, become intermittent, or even invert for periods of time. The point is that cycles are useful tools, but they are not guaranteed; they need to be used in combination with other analytical tools.

The rationale for the Presidential Cycle is that any major economic policies that may cause hardship are likely to be implemented early in the presidential term in hopes that the economy will recover in time for the next election. Conversely any opportunities to relieve hardship and stimulate the economy will be implemented as the major four year election approaches, thus improving the chances of re-election for the party in power.

The average presidential cycle from 1897 to present is shown in the following chart, courtesy of Dogs of the Dow.

Dogs of Dow

The chart demonstrates that most of the stock market gains over the last 100 years have been realized during the two years preceding presidential elections. If you look closely you can see that the cycle tends to bottom in September — October just prior to the mid-term and top out in March following the presidential election. Any readers who might choose to trade on this information should keep in mind that individual years can deviate widely from the average, and also that some of the largest corrections in stock market history have been in October.

The last election cycle peaked a year early in March of 2000 and bottomed on schedule two and a half years later in October of 2002 after a 44% decline (S&P 500). It then proceeded to climb from its mid-term lows into the 2004 election, for an overall loss on the cycle of 22% (year end). The current cycle has so far had a more bullish cast, up 17% in the bearish post-presidential period. On a strictly cyclical basis, that should bode well for gains through March of ’09.

Does this mean we should expect a raging bull market for the next two years? I think not. With all the headwinds facing the economy and the excesses of past and present weighing on the market it’s hard to get too excited about the upside. Furthermore, the primary drivers of the move up from the ’02 low — wage savings from globalization and outsourcing, gains in productivity from the technology boom of the ‘90’s, and massive fiscal and monetary stimulus — have all seen their best days.

However, given cyclical realities and massive global liquidity it’s not time yet for a serious and extended pullback. So with all the caveats about unexpected events, I expect the stock market to be sideways to higher over the next two years with the market tracing out a major top in preparation for the real correction which will begin in ’09. Volatility will increase, with a good chance of at least one nasty correction, but overall the Presidential Cycle will likely hold and the market will continue to “climb the wall of worry.”


Despite the headlines, the housing market is not falling apart. Housing certainly has its problems…see “The Trouble With the Housing Market” in the March 24th Economist. But houses are still being built and sold; just not at the white hot pace that we have seen in recent years. In fact housing is doing reasonably well by historical standards. 2007 starts are currently projected to be about 1.50 million, which is not far off the average (1.532 mil) for the years 1995 through 2001. It is only compared to the peak years of 2004 and 2005, which averaged over 2 mil, that ’07 looks weak.

Problems in the sub-prime sector have been hyped in the press, but sub-prime is just one sector of housing, about 10-12% of the total, and problem loans, which might be as much as 15% of that total, amount to less than 2% of the total housing market and about 1/10th of 1% of GNP. Furthermore, structured finance has allowed the mortgage risk to be spread far and wide making the probability of major bank failure or systemic damage somewhere between remote and nil at this point. So, while the problem loans are very stressful for the affected mortgage holders and for dedicated sub-prime lenders, many of whom have already declared bankruptcy, the impact on the system as a whole is not much…yet. If we get into a real recession then we will have a different story to tell.

This does not mean that housing is not overvalued or that there are not imbalances that need to be corrected, but it remains to be seen whether the needed correction will be achieved through an extended period of flat to slightly lower prices, or through a washout. Considering the amount of political capital riding on the housing market, it is certain that every effort will be made to uphold nominal house values.


This is a very exciting time politically as the authoritarian Bush Administration butts heads with a determined opposition in Congress. The main event currently is the Iraq war but many other points of conflict are breaking out as the new Democrat Congress begins scrutinizing the activities of the Administration after six years of a rubber stamp Republican Congress. The current hubbub over the firings of DOJ prosecutors is certain to be just the first of many dust-ups, and probably a constitutional crisis or two before it’s all over.

Over the next two years numerous issues regarding the balance of powers and the exercise of executive power are likely to be decided in the Supreme Court, including the limits of executive privilege (silly us…we thought that was settled with Watergate), whether the President can make a law passed by Congress more to his liking by simply attaching a “signing statement,” and possibly the limits of the powers of the Commander in Chief. Noteworthy regarding this last issue is that Samuel Alito, the newest Supreme, is a proponent of the “unitary executive” theory, which among other things states that the President has absolute power in wartime…all the incentive some Presidents might need to make sure we are always at war, and a bad idea if ever I heard one. Wild cards are potential terrorist attacks on U.S. soil and/or expanded war in the Middle East. In a crisis the Court is likely to defer to the Executive, a tendency certainly not lost on the Administration.

Things are going to get really interesting if a Democrat wins the White House in ’08. I think it would be fair, and even kind, to say that the Bush team has had a rather cavalier attitude toward the law. It will be “the mother of all scandals” as one commentator put it when the lid is lifted on the secret activities of this administration. What we are seeing now is just a teaser.

Republicans are in a funk. Their presidential candidates are a bunch of old white guys with not much to sell but the ageing vision of Ronald Reagan. Many in the rank and file are disillusioned with their leadership and some have even thrown in the towel on the party. See the Salon interview with Bob Barr, one of the Clinton inquisitors in the House, who has abandoned the party.

Democrats are trying hard to exercise party discipline and control their exuberance over the destruction Republicans have heaped on themselves. They are playing it safe, being firm but not overly aggressive in their opposition, and hoping to coast into the White House and total control of government on the tails of the Bush implosion. Unfortunately this caution has rendered Democrat presidential candidates even more prone to uttering platitudes than usual, most importantly regarding Iraq, where real policy substance has been missing from the outset and is most desperately needed. See Andrew Bacevich’s op-ed ”’Your Iraq plan?’ Is a Baseless Question” in the April 9th Los Angeles Times.


A great deal is happening on the global stage: growing Russian anger at the U.S., the Taliban resurgence, the North Korean “deal” (promptly violated by North Korea), a short lived Venezuelan coup, the early stages of a nuclear arms race, and much more. But all of this is only faintly visible in public awareness as the world stands transfixed by the debacle unfolding in Iraq and the looming prospect of regional war in the Middle East.

The Iraq War, and the belligerent foreign policy that spawned that war, have caused a huge loss of stature on the global stage for the U.S. On the plus side, if you can look at it that way, the resulting mid-term drubbing seems to have woken President Bush from his delusions on foreign policy. Beginning with the removal of Donald Rumsfeld and installation of Robert Gates as Secretary of Defense, the Bush Administration has been steadily retreating from its “my way or the highway” foreign policy.

With North Korea, Iraq, Palestine, Iran, Russia and elsewhere, attempts at dialogue, negotiations and compromise have replaced intimidation, outright threats and contemptuous disregard as the preferred mode for engaging other countries. While it is a relief to see the Administration actually trying to deal with other nations rather than bully them into submission, six years of neo-con foreign policy has created so much anti-American anger, mistrust and chaos that the question now is: does this administration have any credibility at all on the world stage and can it actually do any good or will we have to wait two years for a new group to begin to repair the damage? See the “Sidelined by Reality” in the April 19th Economist on the downfall of the neo-cons.

On January 5th the New York Times published an insightful commentary by Slavoj Zizek on the myopic vision of American foreign policy makers and the consequences of their policies. His argument is that America has used its considerable power to undermine distasteful but predictable regimes in the Mideast, thus delivering power into the hands of our most implacable and unpredictable enemies, while at the same time earning global enmity by confusing our position as global hyper-power and policeman on the one hand and as a nation-state on the other. By using the power of empire to aggressively pursue one-sided “America first” policies we have demolished the foundation of empire, which is the support and cooperation of the subordinate nations because their interests are being considered and their needs met.

I would add that the realignment stimulated by these misguided policies is now irreversible. The short-lived age of America as global hyper-power is over. It is ironic that efforts to implement the neo-con fantasy of total global domination have resulted in the beginning of the end of their beloved American empire. But then again this is the inevitable consequence of hubris.

The military is paying a severe price for the policies of George Bush’s A-team. (Remember the A-team?) Read Time magazine’s April 5th cover story, “America’s Broken Down Army.” The “surge” is putting a huge strain on the Army, coming on the heels of extended and ongoing deployments in Iraq and Afghanistan. The generals tell us the increase in troops can only be sustained for about six months without doing serious damage to the military’s overall readiness, yet plans are already being laid to extend indefinitely. I have heard nothing about how these two realities are going to be bridged. It appears that the plan is to try to ignore the problem until it can be handed off to the next administration.

The President and Congress have locked horns over Iraq war funding, with Congress demanding a withdrawal timeline, and the President adamantly refusing. However, this battle of wills could become moot if tensions with Iran should erupt into open conflict. The drumbeat in the mainstream press has been that there is a consensus that there is no military solution to the Iran problem. Don’t believe it. There is a vigorous ongoing debate on this issue and the positions range the spectrum from “military intervention won’t work” to “military action is the only solution.”

Things have certainly improved from only a year ago when the neo-cons were still in charge and plans were being made for an attack on Iran including the use of tactical nukes. See “The Iran Plans” by Seymour Hersh in the April ’06 New Yorker. Since the changing of the guard, sentiment on Pennsylvania Avenue has shifted to favor at least a serious effort at a diplomatic solution, which means economic sanctions, negotiations and containment if sanctions and negotiations fail. However, the diplomatic track has only so long to yield concrete results.

A nuclear Iran is a grim prospect for the U.S., and for the world, but it is utterly unacceptable to Israel. Iranian leaders have repeatedly stated their intention to “wipe Israel off the map.” Unofficially the talk is that if Iran doesn’t yield to diplomatic pressure within a reasonable time frame, and so far there is no reason to think that they will, then Israel will have no choice but to go after them if we don’t. If Israel does take the lead we will back them totally.

For its part, Iran has threatened to cut off the tanker traffic flowing through the Straight of Hormuz, conduit for 20% of the world’s oil supply, if it is attacked. In that event, $100 a barrel oil is probably a conservative estimate. Osama bin Laden must be pleased. If you remember, his initial objectives were $50 a barrel oil and U.S. troops out of Saudi Arabia.

To top it all off Dick Cheney is now talking about a “20 or 30 or 40 year” conflict. This guy definitely lives in his own world. See the CNN interview with Cheney.

For those interested in gaining broader input on the prospects for war with Iran the following links feature a range of information and opinions:

Meanwhile, the Islamic jihad against America is metastasizing. Arab “moderates” who after 9/11 were willing to acknowledge that extremism and terrorism in the Arab world were problems that they needed to deal with, are now blaming all problems in the Middle East on Israel and America’s policies in support of Israel. See David Brooks’ op-ed, “A War of Narratives.” Also, Islamists and Communists, two groups which until now have had nothing but loathing for each other, have found common cause in their hatred of America. See “Anti-Americans on the March” in the December 9-10 Wall Street Journal. And if you want to get a good sense of how the toxic culture of martyrdom is spreading, see the May 4th NY Times article, “Jordan’s Jihadists Long to Kill and Die in Iraq.”


At this point geopolitical trends and market cycles are in conflict. There is a very real prospect of chaos overtaking the Middle East as early as this summer. War is not always a negative for the markets, but a general war in the oil producing Mideast would certainly deliver a global economic shock. Meanwhile, markets are discounting the current economic slowdown as temporary and cycles point upward going forward. What could bring the two trends into harmony would be an unexpected positive development on the geopolitical scene.

For the most part Republicans are still supporting the President’s open ended war policy but they are losing the political battle at this point, and absent some unexpected event will continue to lose ground until they change their tune. As we approach the election the pressure will be intense for Republicans to abandon the President and start looking for resolutions, or at least the appearance of resolutions, to the conflicts in the Middle East. High stakes; high drama. Someone should write a script…???…maybe someone already did!

The bottom line in the marketplace is that complacency rules but risk continues to escalate. I do not believe the bottom will fall out of the markets over the next two years, but I do expect increasing volatility, at least one substantial correction of 10%+, and a major top developing. Some commentators are calling for recession in ’07 but most economists are expecting the current period of slower growth to lead to a renewal of economic expansion this summer, BCA Research notable among them. The entire recovery from the ’02 low has been anemic by historical standards and I believe that the renewal of the expansion will be even more anemic, setting the stage for a major markdown in ’09-10. The housing market, which has finally topped out, will not collapse, but it will not go back to a bull market either. The dollar will be volatile, and will remain under pressure.


Q4 ’06:   Martin Luther King on Iraq

I was putting the finishing touches on a Q4 letter focused on the Presidential Cycle when I came across this speech given by Martin Luther King in 1967 as the Vietnam War was raging.  Many of the details cited in this speech are specific to Vietnam but the wisdom and sentiments expressed are timeless and as relevant today as they were 40 years ago.  In the face of the unfolding disaster in Iraq and President Bush’s plans to expand the conflict, I felt it more important to share this speech at this time and pick up on the Presidential Cycle in the next newsletter.

You can read the full text and listen to a recording here. 

Excerpted from “Beyond Vietnam – A Time to Break Silence” April 4, 1967, Riverside Church, New York City.

As I have walked among the desperate, rejected and angry young men I have told them that Molotov cocktails and rifles would not solve their problems. I have tried to offer them my deepest compassion while maintaining my conviction that social change comes most meaningfully through nonviolent action. But they asked — and rightly so — what about Vietnam? They asked if our own nation wasn’t using massive doses of violence to solve its problems, to bring about the changes it wanted. Their questions hit home, and I knew that I could never again raise my voice against the violence of the oppressed in the ghettos without having first spoken clearly to my own government. For the sake of those boys, for the sake of this government, for the sake of hundreds of thousands trembling under our violence, I cannot be silent.

Now, it should be incandescently clear that no one who has any concern for the integrity and life of America today can ignore the present war.

As if the weight of such a commitment to the life and health of America were not enough, another burden of responsibility was placed upon me in 1964; and I cannot forget that the Nobel Prize for Peace was also a commission — a commission to work harder than I had ever worked before for “the brotherhood of man.” This is a calling that takes me beyond national allegiances, but even if it were not present I would yet have to live with the meaning of my commitment to the ministry of Jesus Christ. To me the relationship of this ministry to the making of peace is so obvious that I sometimes marvel at those who ask me why I am speaking against the war. Could it be that they do not know that the good news was meant for all men — for Communist and capitalist, for their children and ours, for black and for white, for revolutionary and conservative? Have they forgotten that my ministry is in obedience to the one who loved his enemies so fully that he died for them? What then can I say to the “Vietcong” or to Castro or to Mao as a faithful minister of this one? Can I threaten them with death or must I not share with them my life?

Finally, as I try to delineate for you and for myself the road that leads from Montgomery to this place I would have offered all that was most valid if I simply said that I must be true to my conviction that I share with all men the calling to be a son of the living God. Beyond the calling of race or nation or creed is this vocation of sonship and brotherhood, and because I believe that the Father is deeply concerned especially for his suffering and helpless and outcast children, I come tonight to speak for them.

This I believe to be the privilege and the burden of all of us who deem ourselves bound by allegiances and loyalties which are broader and deeper than nationalism and which go beyond our nation’s self-defined goals and positions. We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy, for no document from human hands can make these humans any less our brothers.

They must see Americans as strange liberators. For nine years following 1945 we denied the people of Vietnam the right of independence. For nine years we vigorously supported the French in their abortive effort to recolonize Vietnam. When Diem was overthrown they may have been happy, but the long line of military dictatorships seemed to offer no real change — especially in terms of their need for land and peace.

The only change came from America as we increased our troop commitments in support of governments which were singularly corrupt, inept and without popular support. All the while the people read our leaflets and received regular promises of peace and democracy and land reform. Now they languish under our bombs and consider us — not their fellow Vietnamese — the real enemy.

Somehow this madness must cease. We must stop now. I speak as a child of God and brother to the suffering poor of Vietnam. I speak for those whose land is being laid waste, whose homes are being destroyed, whose culture is being subverted. I speak for the poor of America who are paying the double price of smashed hopes at home and death and corruption in Vietnam. I speak as a citizen of the world, for the world as it stands aghast at the path we have taken. I speak as an American to the leaders of my own nation. The great initiative in this war is ours. The initiative to stop it must be ours.

This is the message of the great Buddhist leaders of Vietnam. Recently one of them wrote these words:

“Each day the war goes on the hatred increases in the heart of the Vietnamese and in the hearts of those of humanitarian instinct. The Americans are forcing even their friends into becoming their enemies. It is curious that the Americans, who calculate so carefully on the possibilities of military victory, do not realize that in the process they are incurring deep psychological and political defeat. The image of America will never again be the image of revolution, freedom and democracy, but the image of violence and militarism.”

The world now demands a maturity of America that we may not be able to achieve. It demands that we admit that we have been wrong from the beginning of our adventure in Vietnam, that we have been detrimental to the life of the Vietnamese people. The situation is one in which we must be ready to turn sharply from our present ways.

A true revolution of values will soon cause us to question the fairness and justice of many of our past and present policies. On the one hand we are called to play the good Samaritan on life’s roadside; but that will be only an initial act. True compassion is more than flinging a coin to a beggar; it is not haphazard and superficial. It comes to see that an edifice which produces beggars needs restructuring.

A true revolution of values will lay hands on the world order and say of war: “This way of settling differences is not just.” This business of burning human beings with napalm, of filling our nation’s homes with orphans and widows, of injecting poisonous drugs of hate into veins of people normally humane, of sending men home from dark and bloody battlefields physically handicapped and psychologically deranged, cannot be reconciled with wisdom, justice and love. A nation that continues year after year to spend more money on military defense than on programs of social uplift is approaching spiritual death.

America, the richest and most powerful nation in the world, can well lead the way in this revolution of values. There is nothing, except a tragic death wish, to prevent us from reordering our priorities, so that the pursuit of peace will take precedence over the pursuit of war. There is nothing to keep us from molding a recalcitrant status quo with bruised hands until we have fashioned it into a brotherhood.

This kind of positive revolution of values is our best defense against communism. War is not the answer. Communism will never be defeated by the use of atomic bombs or nuclear weapons. Let us not join those who shout war and through their misguided passions urge the United States to relinquish its participation in the United Nations. These are days which demand wise restraint and calm reasonableness. We must not call everyone a Communist or an appeaser who advocates the seating of Red China in the United Nations and who recognizes that hate and hysteria are not the final answers to the problem of these turbulent days. We must not engage in a negative anti-communism, but rather in a positive thrust for democracy, realizing that our greatest defense against communism is to take offensive action in behalf of justice. We must with positive action seek to remove those conditions of poverty, insecurity and injustice which are the fertile soil in which the seed of communism grows and develops.

A genuine revolution of values means in the final analysis that our loyalties must become ecumenical rather than sectional. Every nation must now develop an overriding loyalty to mankind as a whole in order to preserve the best in their individual societies.

This call for a world-wide fellowship that lifts neighborly concern beyond one’s tribe, race, class and nation is in reality a call for an all-embracing and unconditional love for all men. This oft misunderstood and misinterpreted concept — so readily dismissed by the Nietzsches of the world as a weak and cowardly force — has now become an absolute necessity for the survival of man.

When I speak of love I am not speaking of some sentimental and weak response. I am speaking of that force which all of the great religions have seen as the supreme unifying principle of life. Love is somehow the key that unlocks the door which leads to ultimate reality. This Hindu-Moslem-Christian-Jewish-Buddhist belief about ultimate reality is beautifully summed up in the first epistle of Saint John :

Let us love one another; for love is God and everyone that loveth is born of God and knoweth God. He that loveth not knoweth not God; for God is love. If we love one another God dwelleth in us, and his love is perfected in us.

Let us hope that this spirit will become the order of the day. We can no longer afford to worship the god of hate or bow before the altar of retaliation. The oceans of history are made turbulent by the ever-rising tides of hate. History is cluttered with the wreckage of nations and individuals that pursued this self-defeating path of hate. As Arnold Toynbee says : “Love is the ultimate force that makes for the saving choice of life and good against the damning choice of death and evil. Therefore the first hope in our inventory must be the hope that love is going to have the last word.”

We are now faced with the fact that tomorrow is today. We are confronted with the fierce urgency of now. In this unfolding conundrum of life and history there is such a thing as being too late. Procrastination is still the thief of time. Life often leaves us standing bare, naked and dejected with a lost opportunity. The “tide in the affairs of men” does not remain at the flood; it ebbs. We may cry out desperately for time to pause in her passage, but time is deaf to every plea and rushes on. Over the bleached bones and jumbled residue of numerous civilizations are written the pathetic words: “Too late.” There is an invisible book of life that faithfully records our vigilance or our neglect. “The moving finger writes, and having writ moves on…” We still have a choice today; nonviolent coexistence or violent co-annihilation.

We must move past indecision to action. We must find new ways to speak for peace in Vietnam and justice throughout the developing world — a world that borders on our doors. If we do not act we shall surely be dragged down the long dark and shameful corridors of time reserved for those who possess power without compassion, might without morality, and strength without sight.

Now let us begin. Now let us rededicate ourselves to the long and bitter — but beautiful — struggle for a new world. This is the calling of the sons of God, and our brothers wait eagerly for our response. Shall we say the odds are too great? Shall we tell them the struggle is too hard? Will our message be that the forces of American life militate against their arrival as full men, and we send our deepest regrets? Or will there be another message, of longing, of hope, of solidarity with their yearnings, of commitment to their cause, whatever the cost? The choice is ours, and though we might prefer it otherwise, we must choose in this crucial moment of human history.

As that noble bard of yesterday, James Russell Lowell, eloquently stated:

Once to every man and nation
Comes the moment to decide,
In the strife of truth and falsehood,
For the good or evil side;
Some great cause, God’s new Messiah,
Off’ring each the bloom or blight,
And the choice goes by forever
Twixt that darkness and that light.

Though the cause of evil prosper,
Yet ‘tis truth alone is strong;
Though her portion be the scaffold,
And upon the throne be wrong:
Yet that scaffold sways the future,
And behind the dim unknown,
Standeth God within the shadow
Keeping watch above his own.