Q3 ’06:   The Mid-Term Election and the Military Commissions Act

On October 17th, 2006 President Bush signed into law the Military Commissions Act. This dangerous and profoundly un-American Act marks a new low in our ongoing political devolution. The alleged debate around this bill consisted of posturing among Republicans to line up for more (the Bush Plan) or less (the McCain plan) egregious violations of our Constitution, our international treaty obligations, and our fundamental liberties. Democrats were nowhere to be seen in this “debate,” preferring, as they have through this entire election cycle, to not stand on principle for anything, but to stand in the shadows and watch the Republicans destroy themselves. Republicans are doing a rather good job of self-destruction, but they are also unfortunately destroying our precious heritage along with themselves.

In the end the President got everything he wanted, which is in effect absolute power to identify, detain, try and execute or imprison whomever he in his sole judgment designates as an “enemy combatant,” without accountability to anyone or interference from the courts. He can also allocate these powers to whomever he chooses. Habeas corpus, the primary defense of the individual against unlawful detention, has been suspended. Ostensibly this provision only applies to non-citizens, but the power granted is so broad and the constraints so vague that in practice there is no such restriction. The Act also allows the President to define what is and what is not torture, and it gives retroactive cover to the agents of this Administration who have deliberately and blatantly violated domestic and international law in their pursuit of the War on Terror.

There was only one conscientious Republican who opposed this bill on principal — Lincoln Chaffee of Vermont. Olympia Snowe abstained. But in the end the Military Commissions Act was passed with the support of 12 Democrat Senators, who should not be forgotten for their part in this abomination. You can review the votes of individual members of both the House and Senate at GovTrack.us. Our hope at this point is that this law will be quickly challenged and declared unconstitutional by the Supreme Court.

As the ’06 mid-term election is upon us, Republicans are still staking their claim to power on the so-called War on Terror. None of the failures of this campaign, strategic or moral, have swayed them from their course, nor have their dismal poll numbers. (See the latest poll numbers at RealClearPolitics.com.) The President continues to demand absolute power to conduct this “war” as he sees fit without oversight or interference from Congress or the courts, and our Republican Congress continues to roll over and surrender all power to the Executive.

Voter frustration is showing up in a dramatic and sustained swing of sentiment to the Democrats. Just the same, primarily due to the influence of gerrymandering, an election that would otherwise be a landslide for Democrats will be very close. See the Balance of Power Scorecard on CQPolitics.com. CQPolitics’ final analysis prior to the election is summed up in the following paragraph:

“This final overview of the political landscape finds the Nov. 7 elections shaping up as a collision between the Republican Party’s fundraising and voter turnout proficiency with an ever-expanding field of competitive seats and a consistent decline in the GOPs support among voters on issues across the board. The result is a Congress up for grabs, and an energized Democratic Party trying hard not to seem overconfident.”

As for the validity of the election…that’s another story altogether. Read the Salon review of the disturbing HBO documentary “Hacking Democracy.”

The changing political landscape is also seen in the increasing willingness of the press, which has been extremely docile over the past five years, to stand up and “speak truth to power.”

On October 18th Keith Olbermann, anchor of MSNBC’s Countdown, delivered a stunning, historically framed denunciation of the profoundly un-American Military Commissions Act. In the spirit of Edward R. Morrow on steroids, Olbermann’s commentary will stand as a classic example of the essential role of an independent press in a free society. As a public service, I relay this commentary to you.

For the full impact of this powerful commentary, you can go directly to the video, here or here. The text follows:

We have lived as if in a trance.

We have lived as people in fear.

And now—our rights and our freedoms in peril—we slowly awake to learn that we have been afraid of the wrong thing.

Therefore, tonight have we truly become the inheritors of our American legacy.

For, on this first full day that the Military Commissions Act is in force, we now face what our ancestors faced, at other times of exaggerated crisis and melodramatic fear-mongering:

A government more dangerous to our liberty, than is the enemy it claims to protect us from.

We have been here before—and we have been here before led here—by men better and wiser and nobler than George W. Bush.

We have been here when President John Adams insisted that the Alien and Sedition Acts were necessary to save American lives, only to watch him use those acts to jail newspaper editors.

American newspaper editors, in American jails, for things they wrote about America.

We have been here when President Woodrow Wilson insisted that the Espionage Act was necessary to save American lives, only to watch him use that Act to prosecute 2,000 Americans, especially those he disparaged as “Hyphenated Americans,” most of whom were guilty only of advocating peace in a time of war.

American public speakers, in American jails, for things they said about America.

And we have been here when President Franklin D. Roosevelt insisted that Executive Order 9066 was necessary to save American lives, only to watch him use that order to imprison and pauperize 110,000 Americans while his man in charge, General DeWitt, told Congress: “It makes no difference whether he is an American citizen—he is still a Japanese.”

American citizens, in American camps, for something they neither wrote nor said nor did, but for the choices they or their ancestors had made about coming to America.

Each of these actions was undertaken for the most vital, the most urgent, the most inescapable of reasons.

And each was a betrayal of that for which the president who advocated them claimed to be fighting.

Adams and his party were swept from office, and the Alien and Sedition Acts erased.

Many of the very people Wilson silenced survived him, and one of them even ran to succeed him, and got 900,000 votes, though his presidential campaign was conducted entirely from his jail cell.

And Roosevelt’s internment of the Japanese was not merely the worst blight on his record, but it would necessitate a formal apology from the government of the United States to the citizens of the United States whose lives it ruined.

The most vital, the most urgent, the most inescapable of reasons.

In times of fright, we have been only human.

We have let Roosevelt’s “fear of fear itself” overtake us.

We have listened to the little voice inside that has said, “the wolf is at the door; this will be temporary; this will be precise; this too shall pass.”

We have accepted that the only way to stop the terrorists is to let the government become just a little bit like the terrorists.

Just the way we once accepted that the only way to stop the Soviets was to let the government become just a little bit like the Soviets.

Or substitute the Japanese.

Or the Germans.

Or the Socialists.

Or the Anarchists.

Or the Immigrants.

Or the British.

Or the Aliens.

The most vital, the most urgent, the most inescapable of reasons.

And, always, always wrong.

“With the distance of history, the questions will be narrowed and few: Did this generation of Americans take the threat seriously, and did we do what it takes to defeat that threat?”

Wise words.

And ironic ones, Mr. Bush.

Your own, of course, yesterday, in signing the Military Commissions Act.

You spoke so much more than you know, Sir.

Sadly—of course—the distance of history will recognize that the threat this generation of Americans needed to take seriously was you.

We have a long and painful history of ignoring the prophecy attributed to Benjamin Franklin that “those who would give up essential liberty to purchase a little temporary safety, deserve neither liberty nor safety.”

But even within this history we have not before codified the poisoning of habeas corpus, that wellspring of protection from which all essential liberties flow.

You, sir, have now befouled that spring.

You, sir, have now given us chaos and called it order.

You, sir, have now imposed subjugation and called it freedom.

For the most vital, the most urgent, the most inescapable of reasons.

And — again, Mr. Bush — all of them, wrong.

We have handed a blank check drawn against our freedom to a man who has said it is unacceptable to compare anything this country has ever done to anything the terrorists have ever done.

We have handed a blank check drawn against our freedom to a man who has insisted again that “the United States does not torture. It’s against our laws and it’s against our values” and who has said it with a straight face while the pictures from Abu Ghraib Prison and the stories of Waterboarding figuratively fade in and out, around him.

We have handed a blank check drawn against our freedom to a man who may now, if he so decides, declare not merely any non-American citizens “unlawful enemy combatants” and ship them somewhere—anywhere — but may now, if he so decides, declare you an “unlawful enemy combatant” and ship you somewhere – anywhere.

And if you think this hyperbole or hysteria, ask the newspaper editors when John Adams was president or the pacifists when Woodrow Wilson was president or the Japanese at Manzanar when Franklin Roosevelt was president.

And if you somehow think habeas corpus has not been suspended for American citizens but only for everybody else, ask yourself this: If you are pulled off the street tomorrow, and they call you an alien or an undocumented immigrant or an “unlawful enemy combatant”—exactly how are you going to convince them to give you a court hearing to prove you are not? Do you think this attorney general is going to help you?

This President now has his blank check.

He lied to get it.

He lied as he received it.

Is there any reason to even hope he has not lied about how he intends to use it nor who he intends to use it against?

“These military commissions will provide a fair trial,” you told us yesterday, Mr. Bush, “in which the accused are presumed innocent, have access to an attorney and can hear all the evidence against them.”

“Presumed innocent,” Mr. Bush?

The very piece of paper you signed as you said that, allows for the detainees to be abused up to the point just before they sustain “serious mental and physical trauma” in the hope of getting them to incriminate themselves, and may no longer even invoke The Geneva Conventions in their own defense.

“Access to an attorney,” Mr. Bush?

Lieutenant Commander Charles Swift said on this program, Sir, and to the Supreme Court, that he was only granted access to his detainee defendant on the promise that the detainee would plead guilty.

“Hearing all the evidence,” Mr. Bush?

The Military Commissions Act specifically permits the introduction of classified evidence not made available to the defense.

Your words are lies, Sir.

They are lies that imperil us all.

“One of the terrorists believed to have planned the 9/11 attacks,” you told us yesterday, “said he hoped the attacks would be the beginning of the end of America.”

That terrorist, sir, could only hope.

Not his actions, nor the actions of a ceaseless line of terrorists (real or imagined), could measure up to what you have wrought.

Habeas corpus? Gone.

The Geneva Conventions? Optional.

The moral force we shined outwards to the world as an eternal beacon, and inwards at ourselves as an eternal protection? Snuffed out.

These things you have done, Mr. Bush, they would be “the beginning of the end of America.”

And did it even occur to you once, sir — somewhere in amidst those eight separate, gruesome, intentional, terroristic invocations of the horrors of 9/11 — that with only a little further shift in this world we now know—just a touch more repudiation of all of that for which our patriots died — did it ever occur to you once that in just 27 months and two days from now when you leave office, some irresponsible future president and a “competent tribunal” of lackeys would be entitled, by the actions of your own hand, to declare the status of “unlawful enemy combatant” for — and convene a Military Commission to try — not John Walker Lindh, but George Walker Bush?

For the most vital, the most urgent, the most inescapable of reasons.

And doubtless, Sir, all of them—as always—wrong.


Q2 ’06:   The Incredible Shrinking U.S.

That the world is rapidly changing is undeniable. A big challenge for everyone is to perceive the ways in which the world is actually changing, and not simply to project onto the world the ways that we would like it to be changing.

The title of this quarter’s letter is taken from a Såalon piece of the same title by Christian Science Monitor columnist Helena Cobban. Cobban is a sage commentator and the bottom line in her piece is that the die is now cast: U.S. influence around the world is shrinking rapidly and will soon contract in a major way. George Bush’s big gamble in Iraq, intended to serve notice to the world of U.S. dominance and resolve has had the opposite effect. The surprise is that this is not entirely a bad thing. The transition will certainly be bumpy but a redistribution of global influence and responsibilities, once accomplished, will be better for everyone.


The overall tenor of the markets at this writing is nervous, highlighted by a general concern over rising inflation and rates, the growing instability in the Middle East, spiking oil prices and growing awareness that the housing market has topped out. Stocks have seen the first sustained sell-off in over a year, so far a modest 8% decline in the Dow and S&P. Sentiment indicators have been at negative extremes recently, indicating that the downside is limited in the near term, and a test of the May highs is likely.

Since the bear market low in October of ’02 the stimulus driven recovery has delivered mixed results in stocks. Small and mid-cap indexes and the Dow Transports have made new all-time highs; the benchmark Dow Industrials has recovered 98% of the bear market decline. The S&P 500 has recovered 71% of its bear market losses, and the NASDAQ has managed only a meager 24%. All-cap stock market gains on a value basis have been 85%.

During the same time period, gold rallied 140% to a high of $732, and after correcting is currently at $625; crude rallied 190% and is currently hovering $4 below its recent all-time highs of $78; the dollar index lost 33% and is currently in position to test its lows.

The 10 year housing bull market has finally petered out. Inventories of unsold houses are growing rapidly and some sectors are seeing high foreclosure rates, particularly in the sub-prime market. Prices are generally holding near their highs, but we are early in the cycle. The large number of ARMS due to reset next year (5% of total outstanding mortgages) will put some pressure on the market. Considering the length and large gains of the housing bull market, this correction will likely be long and/or deep.


Now that interest rates have gradually been hiked to a more natural level and the yield curve is essentially flat, the carry trade is no more. Deficit spending continues unabated, but the big party is over and future economic expansion will have to come for the most part from real organic economic growth. The Fed has a challenge ahead in trying to find a point of equilibrium between strong inflationary and deflationary crosscurrents. Stagflation, anyone? We should all wish Chairman Bernanke great success.

Risk management has become the gold standard among American investors. Most investment capital in the U.S. today is under the control of risk managers who want every risk to be hedged but still want outsized returns. Ironically, the Oz-like culture that the risk managers have created has resulted in massive leverage throughout the financial sector, commonly at levels that make Long Term Capital look prudent. This massive exposure is masked by an array of derivatives — options, swaps, swaptions, caps, floors, collateralized debt obligations (CDO’s), synthetic CDO’s, and more. The various players are swapping, packaging, trading and repackaging positions and laying off their risk in a Byzantine round robin, at each round adding another layer of fees and increasing their exposure, in a system reminiscent of the Japanese keiretsu system before the Japan meltdown. The whole cloth is so vast and complex that it can only be (partially) understood through such risk assessment tools as value at risk, which are backward looking, totally dependent on risk assumptions, and are vulnerable to “the big event” and to counterparty risk, which are not assessed by the models at all.

There is nothing inherently wrong with derivatives or with risk management. In fact, the latter is an essential function and the former are useful tools. However, the managers of our financial institutions are so enamored of their clever models and their ability to leverage up by using derivatives that they have completely lost sight of the basics. The condition is called hubris. This situation is what Warren Buffet was referring to when he said that derivatives are “economic weapons of mass destruction.” If any major player defaults, the entire system is at risk. See Business Week’s June 12th cover story, “Inside Wall Street’s Culture of Risk.”

The Dollar

The massive leverage in the financial sector is a reflection of the unsustainable debt across the board in America. So how is this going to play out? Whether we will be able to manage our way back to sanity or whether nature will take care of it for us, one thing certain is that the dollar is going to continue to be devalued. There is no ability or intention to repay the ocean of U.S. debt floating around the world. That debt is going to be disposed of by devaluing the dollar. What may mask this decline in part is the fact that the dollar is typically viewed in relation to other currencies, which are all, to greater or lesser degrees, being degraded by their own central banks.

The real value of the dollar is seen in terms of its purchasing power, which has been in steady decline for a long time — down over 90% in the last 70 years and down 50% just during the 18 years of Alan Greenspan’s reign. In fact, Greenspan’s singular achievement as Fed Chairman is that he engineered a 50% devaluation of the dollar without anyone realizing he had done it. Greenspan’s motto: Keep it slow and no-one will know. (Thanks to Richard Russell.)

Since purchasing power is the real measure of the worth of the dollar, one would think that one could monitor the real value of the dollar by simply tracking inflation, which, all things being equal, would be a simple matter. But alas, all things are not equal. The problem is that the official inflation numbers are not what they used to be. (Are we surprised?) If inflation was calculated the same way it was in the Carter years, current inflation would be 8%, not 2-3%. To put this in practical terms, 2% annual inflation means that the dollar will be devalued by another 50% in 35 years; 8% inflation will do the same in 8 years.

For more information on the sad state of government statistical reporting, go to John Williams’ Shadow Government Statistics. (Thanks to Al Beimfohr of Knightsbridge Asset Management.)


The scent of desperation is emanating from the Republican camp. Recent efforts by Republicans to shore up their dismal poll numbers have generated a rather sleazy series of diversionary campaigns: a Pledge of Allegiance amendment, a flag burning amendment, a “cut and run” Democrats are cowards campaign, frequent attacks on the treasonous liberal press, and general hysteria over illegal immigrants.

Most of this effort has been rendered ineffective by the daily onslaught of bad news from Iraq.

The upcoming election certainly looks like a good opportunity for Democrats, but the big question heading into election season is: will the Democrats actually show up for this one? They seem to be hoping that the fruit will just fall out of the tree into their waiting hands. Not a promising strategy. Despite the rosy polls (from a Democrat perspective) there is a lot of time between now and November, and one should never underestimate the capabilities of Karl Rove & Co.

Going into election season, political junkies will want to sign up for the free daily feed from non-partisan CQPolitics.com…”Every district. Every state. Every day.”

On the corruption front, one can only marvel at the audacity. It just doesn’t pay to get upset about it. I was shocked recently to learn that municipalities have taken to spending taxpayer money to hire lobbyists to get their Congressmen to send them money. Apparently this has worked quite well for the early adopters. Also, new House leader John Boehner has hit the ground running, outstripping even his mentor Tom Delay in fundraising, living large on the donations of his patrons and wearing his corruption like a badge of honor. And from the seamy side of government contracting, Brent Wilkes, a defense contractor implicated by jailed Republican Congressman Randy Cunningham as “co-conspirator #1” recently shared his experience in the Art of Greasing Palms in Washington. This reading is strictly for adults. Of course Wilkes is denying any wrongdoing.


The geopolitical stage is where the real action is taking place.

The Middle East is smoking…literally. Israel has demolished southern Lebanon in its quest to root out Hezbollah. Whether this action will introduce greater stability or instability into the region is uncertain at this time. Condoleezza Rice is reportedly enthralled by what we can call a reverse domino theory. (See “Domino Diplomacy ” by Sidney Blumenthal.) Rice’s theory is that our proxy war with Iran (Israel vs. Hezbollah) will demolish Hezbollah and Hamas, weaken Syria and Iran, and help to turn around Iraq. Another clever strategy from Foggy Bottom. We can only hope that this one works out better than our previous attempts at geopolitical engineering in the Middle East. Indications in the immediate aftermath are not encouraging, and I would expect to see round two of this conflict coming up soon.

Iraq is an unmitigated disaster, with 100 people a day succumbing to violence in the burgeoning Sunni-Shiite civil war. The best that can be hoped for there is that the inevitable dismemberment can be achieved without igniting a regional free-for-all. The White House regularly announces new policies, campaigns and progress reports for Iraq but from all the information I have been able to gather, our troops there are primarily occupied with just staying alive. Read The Last True Story I’ll Ever Tell by John Crawford.

The negative side of our failure in Iraq is that our enemies globally are emboldened. Iran has been the primary beneficiary of our blunder in Iraq and it is flexing its muscles by stirring up trouble in Iraq and with Israel, and by flaunting its nuke program. The Taliban is resurgent in Afghanistan. North Korea is launching long range test missiles and is reportedly preparing for a nuclear test. Russia is re-asserting itself on the global stage and China continues on its forced march to dominate its sphere of influence, militarily as well as economically. Cesar Chavez has just completed a major arms deal with Russia, and anti-Americanism (anti-USism?) is sweeping South America and the globe. All of these events are occurring in direct contradiction to publicly stated U.S. policies and in some cases outright U.S. threats.

The positive side of all these events is that they are hastening the day when America will be relieved of the burden of being global policeman and enforcer. As we work our way through this transition, America will dramatically reduce its global military footprint and the gargantuan expenses that go along with that global presence. The world will find a new equilibrium and we will be freed of the distractions and responsibilities of empire. We will be able to turn our attention and resources to dealing with neglected domestic and regional problems, and to repairing the extensive damage that has been done to our national character, our national unity, and our relations with our friends and neighbors.

America still has much that is good to offer the world. But the good that America has to offer cannot be given at the end of a cruise missile. Our national character is not that of an imperial people. We cannot be true to ourselves and simultaneously be slaughtering tens of thousands of people and destroying the lives of millions in imperial wars on the other side of the world. We need to withdraw from empire to heal our collective spirit and regain our moral center. Events are leading us to that place, whether we realize or want it or not.


The current situation on every front reminds me of the ancient Chinese curse, “May you live in interesting times.” Instability and change are everywhere…but where there is change there is opportunity.

I do believe that we have gone past the point of no return as far as fiscal responsibility is concerned. I suppose I am late in coming to this, or have been too idealistic to want to admit it, but going forward I believe it will be critical to stay ahead of the falling dollar while implementing one’s investment and business strategies. On the trading front, the dollar should be sold on rallies, and geopolitical instability guarantees that there will be plenty of volatility. On a portfolio basis, a diversified currency overlay weighted toward Far Eastern currencies and gold is basic insurance against a potential dollar debacle, and should be profitable on its own merits over time.

Over the long run, the inevitable dollar decline augers well for assets of all kinds, in nominal terms anyway, and also for emerging markets. But timing is everything, and quality will pay dividends. The dollar decline also argues for leverage, but systemic risk is increasing which argues for debt liquidation. It’s a coin toss on leverage, and the choice will be an individual one depending on ability to control exposure.

The latest round of the WTO has failed, placing the entire thrust of globalization in jeopardy. The basic concept of globalization needs a fundamental overhaul if it is not to collapse entirely. The advanced nations cannot expect the third world to continue to give up the lion’s share of the fruit of their economic growth to global corporations when they are still struggling just to feed their people. Either way, investment in community — global localization — will become a trend at some point and will offer good value and use of capital in a time of uncertainty and potentially serious global disruption. Service to elders, local agriculture and infrastructure, education, alternative energy and alternative medicine are viable prospects going forward. Also, good opportunities exist in certain areas of Mexico and Central America, which are becoming meccas for U.S. retirees and artists. And skill-based management programs, in the form of well run hedge funds or managed accounts still offer good returns and liquidity. Commodity markets are in the early stages of a major bull market and should offer good upside for the next 10-20 years.


We are subjected to so much noise from the media on a daily basis that it is very difficult to maintain perspective on the economy and the marketplace, or anything else for that matter. In order to stay centered, grounded and clear, and thus make good decisions, it is essential to have recourse to high quality economic reports such as those put out by BCA Research or Ned Davis Research. Business Week and The Economist are also valuable sources of un-spun information. It is hazardous to one’s economic health to even turn on the television.

Tectonic shifts are taking place in the geopolitical order. As America withdraws, willingly or by force of events, from its position as global hegemon, there will be a cascade of realignment which will have major economic consequences. The globalization experiment will be recast or it will collapse. Whether these changes will take place in slow motion, over decades, or in a few short years is impossible to tell at this point. And how this will play out at home economically will depend to a large extent on policy responses to the changes. What we need more than anything is a sea change in attitude in Washington. We need leadership that is genuinely concerned with the wellbeing of our nation and our world and is willing to put that wellbeing ahead of personal or partisan advantage. Since it is we the people who choose our leaders, ultimately it is we the people who decide our fate.

Q1 ’06:   Christ Among the Partisans

Religion and politics are the most toxic of mixtures, having brought the world countless abominations such as the Inquisition, the Reformation and Counter-Reformation and now global Islamic terrorism. Throughout history, more blood has been shed in the name of God than for all other causes combined.

As we approach election season ’06 and start warming up for the ’08 presidential marathon, the religious left is gearing up a campaign to claim Jesus as a leftie and counter the long running dominance of the religious right in political discourse. This will only further inflame partisan passions and widen the partisan divide in America. The so-called religious right has done a pretty good job of discrediting itself. We don’t really need an equally deranged religious left. What we need in our national debate is more wisdom and less spin, religious or otherwise.

Garry Wills, professor emeritus of history at Northwestern University and the author, most recently of “What Jesus Meant,” has penned a truly wise commentary on the partisan battle for Jesus. In recent years we have heard endless obsequious references to the “faith” of this or that person. Politicians and the press have been bending over to show their politically correct respect for all expressions of “faith” in the political arena. What no-one has been willing to say publicly until now is that this political activity in the name of religion is a betrayal of the fundamental purpose of religion. Wills concerns himself with solely with Jesus and Christian scripture, but the core impulse of all religions is one and the same, and the essence of Wills’ comments are applicable to all religions.

Following is the text of Wills’ essay, published on April 7th in the New York Times. As a public service I make this offering to political and religious integrity as my Q1 commentary. I hope that it finds wide distribution.

THERE is no such thing as a “Christian politics.” If it is a politics, it cannot be Christian. Jesus told Pilate: “My reign is not of this present order. If my reign were of this present order, my supporters would have fought against my being turned over to the Jews. But my reign is not here” (John 18:36). Jesus brought no political message or program.

This is a truth that needs emphasis at a time when some Democrats, fearing that the Republicans have advanced over them by the use of religion, want to respond with a claim that Jesus is really on their side. He is not. He avoided those who would trap him into taking sides for or against the Roman occupation of Judea. He paid his taxes to the occupying power but said only, “Let Caesar have what belongs to him, and God have what belongs to him” (Matthew 22:21). He was the original proponent of a separation of church and state.

Those who want the state to engage in public worship, or even to have prayer in schools, are defying his injunction: “When you pray, be not like the pretenders, who prefer to pray in the synagogues and in the public square, in the sight of others. In truth I tell you, that is all the profit they will have. But you, when you pray, go into your inner chamber and, locking the door, pray there in hiding to your Father, and your Father who sees you in hiding will reward you” (Matthew 6:5-6). He shocked people by his repeated violation of the external holiness code of his time, emphasizing that his religion was an internal matter of the heart.

But doesn’t Jesus say to care for the poor? Repeatedly and insistently, but what he says goes far beyond politics and is of a different order. He declares that only one test will determine who will come into his reign: whether one has treated the poor, the hungry, the homeless and the imprisoned as one would Jesus himself. “Whenever you did these things to the lowliest of my brothers, you were doing it to me” (Matthew 25:40). No government can propose that as its program. Theocracy itself never went so far, nor could it.

The state cannot indulge in self-sacrifice. If it is to treat the poor well, it must do so on grounds of justice, appealing to arguments that will convince people who are not followers of Jesus or of any other religion. The norms of justice will fall short of the demands of love that Jesus imposes. A Christian may adopt just political measures from his or her own motive of love, but that is not the argument that will define justice for state purposes.

To claim that the state’s burden of justice, which falls short of the supreme test Jesus imposes, is actually what he wills — that would be to substitute some lesser and false religion for what Jesus brought from the Father. Of course, Christians who do not meet the lower standard of state justice to the poor will, a fortiori, fail to pass the higher test.

The Romans did not believe Jesus when he said he had no political ambitions. That is why the soldiers mocked him as a failed king, giving him a robe and scepter and bowing in fake obedience (John 19:1-3). Those who today say that they are creating or following a “Christian politics” continue the work of those soldiers, disregarding the words of Jesus that his reign is not of this order.

Some people want to display and honor the Ten Commandments as a political commitment enjoined by the religion of Jesus. That very act is a violation of the First and Second Commandments. By erecting a false religion — imposing a reign of Jesus in this order — they are worshiping a false god. They commit idolatry. They also take the Lord’s name in vain.

Some may think that removing Jesus from politics would mean removing morality from politics. They think we would all be better off if we took up the slogan “What would Jesus do?”

That is not a question his disciples ask in the Gospels. They never knew what Jesus was going to do next. He could round on Peter and call him “Satan.” He could refuse to receive his mother when she asked to see him. He might tell his followers that they are unworthy of him if they do not hate their mother and their father. He might kill pigs by the hundreds. He might whip people out of church precincts.

The Jesus of the Gospels is not a great ethical teacher like Socrates, our leading humanitarian. He is an apocalyptic figure who steps outside the boundaries of normal morality to signal that the Father’s judgment is breaking into history. His miracles were not acts of charity but eschatological signs — accepting the unclean, promising heavenly rewards, making last things first.

He is more a higher Nietzsche, beyond good and evil, than a higher Socrates. No politician is going to tell the lustful that they must pluck out their right eye. We cannot do what Jesus would do because we are not divine.

It was blasphemous to say, as the deputy under secretary of defense, Lt. Gen. William Boykin, repeatedly did, that God made George Bush president in 2000, when a majority of Americans did not vote for him. It would not remove the blasphemy for Democrats to imply that God wants Bush not to be president. Jesus should not be recruited as a campaign aide. To trivialize the mystery of Jesus is not to serve the Gospels.

The Gospels are scary, dark and demanding. It is not surprising that people want to tame them, dilute them, make them into generic encouragements to be loving and peaceful and fair. If that is all they are, then we may as well make Socrates our redeemer.

It is true that the tamed Gospels can be put to humanitarian purposes, and religious institutions have long done this, in defiance of what Jesus said in the Gospels.

Jesus was the victim of every institutional authority in his life and death. He said: “Do not be called Rabbi, since you have only one teacher, and you are all brothers. And call no one on earth your father, since you have only one Father, the one in heaven. And do not be called leaders, since you have only one leader, the Messiah” (Matthew 23:8-10).

If Democrats want to fight Republicans for the support of an institutional Jesus, they will have to give up the person who said those words. They will have to turn away from what Flannery O’Connor described as “the bleeding stinking mad shadow of Jesus” and “a wild ragged figure” who flits “from tree to tree in the back” of the mind.

He was never that thing that all politicians wish to be esteemed — respectable. At various times in the Gospels, Jesus is called a devil, the devil’s agent, irreligious, unclean, a mocker of Jewish law, a drunkard, a glutton, a promoter of immorality.

The institutional Jesus of the Republicans has no similarity to the Gospel figure. Neither will any institutional Jesus of the Democrats.

Q4 ’05:   The Great Debate: Debt Bubble vs This Time is Different

The great debate ongoing in financial circles is this:

On the one hand we have the traditionalists, the real conservatives (not to be confused with Republicans), libertarians and those who generally think that virtue is a desirable pursuit; who say that we have been living beyond our means for far too long; that a debt incurred must and will be paid one way or another, and that we are sooner or later going to have a day of reckoning. The basic position here is that if you create a debt, you must take responsibility for that debt; that our fiscal and monetary policies have been wildly irresponsible if not downright fraudulent; that the mountain of debt we have created is unsustainable and will inevitably cause us great pain, and that we are impoverishing our children and grandchildren in our “live for today” orgy of consumption. (For more detailed information on this position see the Grandfather Economic Report.) This is a pretty simple, straightforward, common sense position. That is its strength, but in the age of spin, that is also its weakness.

On the other hand we have the market cheerleaders and government officials, and an army of paid publicists and pundits who claim that this time is different; that “deficits don’t matter;” that we can continue to run up debt with no horizon in sight, and that we are doing the rest of the countries of the world a favor by borrowing their savings in order to consume their products so they can keep growing their economies. The debt, we are told, will be worked off by “growth,” and unofficially, by devaluation of the dollar. And this will work because we are more intelligent, creative and industrious than the rest of the world, and also conveniently because our dollar is the world’s reserve currency and everyone has to have dollars, so the world will continue to buy them, like it or not. The economic and moral consequences of the fact that we are creating a mountain of debt that we have no intention of repaying are ignored. This position is complex, consisting mainly of clever arguments that in the end amount to “this time is different” and “we can have our free lunch and eat it too.”

In the interest of full disclosure, if it’s not already apparent, I am in the former camp. It is my contention that virtue is not out of style, that the laws of nature have not been repealed and that we will indeed have a day of reckoning.

The primary operating principle of natural law is balance. Natural events and processes swing from one extreme to the opposite within a band of dynamic equilibrium. These extremes, by the way, are not “inefficiencies.” They are the natural rhythms and cycles evident in all natural processes. The meandering path of a river, for example, is not inefficient. It is a natural path, appropriate, responding to and balancing all influences seen and unseen in its sphere of passage. Whether rivers or markets, as any natural phenomenon progresses through time, it moves periodically toward one extreme or another and imbalance is created. Opposing forces manifest to bring that phenomenon back into balance. This is an entirely natural process. It can be observed in all natural phenomena, in markets and in the aggregate of markets, the economy.

If the natural corrective or balancing process of any natural phenomenon is impeded for a long time, eventually the unresolved backlog is balanced all at once in a catastrophic event. The Yellowstone fire of 1988 and the Midwest floods of 1993 are good examples. Our fiscal and monetary policies have worked to prevent recession for decades in just the same way the forest service worked to prevent forest fires and the Army Corps of Engineers dammed the rivers to prevent flooding. The end result of all of these interferences with natural law are, have been and always will be the same – disaster.

There is a corollary to the law of balance, which we can call the reality of personal affinity. The gist of this corollary is that nature, in this case the marketplace, seems to know each one of us individually. Any trader can tell you that it is uncanny how the market seems to know what they are doing…personally! This is felt most acutely when the trader puts himself in a vulnerable position, i.e. does something stupid. Hence the trader’s prayer, “Lord, please let me get out of this trade whole, and I promise I’ll never do it again.” The market is a harsh master, however, and usually the price for indiscretion is pain.

There is no question that America has put itself in a vulnerable position. With our fiscal and monetary policies working for decades to block the natural cleansing and balancing effects of recession, we have created an extreme imbalance. Like a drug addict desperate to avoid the inevitable, we have spent our savings and gone deep into debt, and are currently increasing our debt by record amounts each month. We are dependent on foreigners to continue buying our debt in order to put off the need to bring our spending into balance. We are taking the position that “if I owe you a thousand dollars, that is my problem, but if I owe you a million, it is your problem.” If the world stops buying our debt, then we can no longer afford to buy the world’s products and everyone will suffer. Our position is the economic equivalent of the cold war nuclear strategy called MAD, or mutually assured destruction. MAD worked in our nuclear standoff with the Soviet Union, but just barely. However, the specter of economic calamity does not have quite the same restraining power as the specter of literal annihilation. MAD as an economic strategy is a riverboat gambler’s strategy.

John Mauldin recently ran a series of his free weekly newsletter, Thoughts From the Frontline, devoted to this debate. If you are not already a subscriber I suggest that you sign up. Mauldin does a great job of keeping his readers of informed of the major economic issues, developments and publications. His series on this topic begins with the 11/11/05 issue entitled “It’s Different This Time.” Mauldin has staked out a position he calls “muddle through” which essentially states that we are in a secular bear market and, yes we have major imbalances which are inevitably going to balance themselves in the coming years, but that we will manage to work our way through this rebalancing in an orderly, albeit not necessarily painless manner, without a depression and without economic chaos. Let’s hope he’s right.

Mauldin frames his series around two books that take opposite sides of the argument: Empire of Debt; The Rise of an Epic Financial Crisis by Bill Bonner, CEO of Agora Inc. and Addison Wiggin, publisher of the Daily Reckoning, the title of which gives away their position, and Our Brave New World by Charles and Louis-Vincent Gave and Anatole Kaletsky of GaveKal Research, which takes the position that “this time is different.”

I took the time to read these two books, and they are both highly recommended. In fact, for any serious investor or individual professionally or otherwise concerned about our economic future, these books should be considered required reading.

The GaveKal gang begin their work by acknowledging that “anyone who has spent ten minutes on a trading floor knows that saying ‘things are different this time’ is: 1) the easiest way to get laughed out of a room, 2) the most expensive words ever pronounced, 3) the surest way to lose any credibility…” and that in “arguing that ‘things are different this time,’ we freely admit that we might end up making the wrong conclusions, say silly things and establish relationships where there are none.” Then they spend the rest of their book arguing that this time is different.

The foundation of their argument is that we have entered into a “third wave” post-industrial information based society as described by Alvin Toffler. An essential part of the third wave economy as they see it is the “platform company,” multinationals like Dell Computer and Reebok that outsource their manufacturing to the lowest bidders world wide and keep the fat margin design and marketing for themselves. “The new business model is to produce nowhere, but sell everywhere.” This allows the platform companies to continuously make big profits by adapting quickly to changing conditions, seizing new opportunities as they arise and avoiding getting trapped in non-productive markets.

The platform company business model is dependent on four main elements; free trade, technological progress, recurrent overcapacity in most industries, and the ability to move goods around without difficulty. The problem with this model is that it takes about two seconds to recognize that at least two and maybe all of these elements are dependent on global political stability, avoidance of protectionism, and the probability that the rest of the world is going to allow these platform companies to eat their lunch forever. Already the third world is up in arms over what they see as unfair practices by the advanced nations and their proxies, the platform companies. For the first time, the latest round at the WTO was unable to achieve its agenda because the third world countries consolidated in protest. Even in the U.S., protectionist sentiment is quick to rise whenever economic adversity threatens.

The GaveKal “Brave New World” as they aptly name it comes down to a global economy in which the rich nations continue to get richer by dominating the fat margin design and marketing of products and services while outsourcing the capital intensive low margin, high risk manufacturing to the lowest bidders among the low wage countries. In this model the rich will continue to spend more than they earn and finance their consumption with savings from the poor, and rich country real estate will continue to appreciate because the poor will have no safe place to invest their savings but in the stable rich countries.

“One of the major characteristics of the new cycle…is that ‘those who have, get more’…the poor get richer through falling prices, low interest rates and rising disposable income. The rich get insanely rich by capturing entire markets where the marginal cost of production is zero…Income disparities then grow, but the overall society prospers.”

This will work out for two reasons, they say. First, because our fat margins are allowing us to accumulate wealth faster than we are incurring debt even with the massive trade deficits…“The so-called ‘US debt to the outside world’ can easily be repaid by the sale of US assets to foreigners…As long as the US has assets to sell, then there will be no reason to worry.” Please read those statements again. If this is the basis of our “third wave” global economy then I confess…I’m worried!

Second, the growing debt in the Western world is not a problem, they say, because we have outsourced the volatile high risk part of economy to the poor countries, so our jobs and our balance sheets are more stable and can therefore justify more debt, both at the collective and individual levels!!! “Given the joint collapse in the volatility of the US economy and of US employment…why shouldn’t the US consumer borrow more and consume today instead of tomorrow?” Yes, go ahead. Read that one again, too.

The problem with the first argument is that it is depraved. The problem with the second argument, aside from its moral turpitude, is that it can be likened to the Long Term Capital approach to leverage, and we all know how that worked out.

The bottom line remains always that more debt equals more risk, and the difference between manageable debt and excessive debt is the difference between crisis and catastrophe when something unexpected happens…and something unexpected always happens eventually. Yes, less volatility means you can handle more debt, but what happens if you have exceeded any prudent measure of debt, and suddenly volatility returns from some unexpected source? You’re screwed, that’s what.

You have to give the GaveKal guys credit. They are smart; perhaps too smart for their own good. Their logic is excellent and their arguments elegant. But like many very smart people they tend to get too caught up in their own high flying brilliance and overlook the basics.

Empire of Debt takes the other side of the argument. Rather than focus on the trees of economic minutia and spinning clever arguments for the status quo, Bonner and Evans expose the forest of moral decay, consumption addiction and hubris that have allowed our republic to morph into an empire, and note with considerable historical references the certainty of the end path of empire.

A unique element of the American empire is that we finance our empire through debt. We borrow from our vassal states and from our enemies alike, unlike previous empires. Rome, for example, levied a 10% tax on its vassal states. We instead tax ourselves, a punishing 50% plus all-in, and borrow from everyone else.

A large part of the volume is spent looking at the history and characteristics of empires and empire builders past from a libertarian viewpoint, which is to point out the follies and delusions of same, and to generally debunk the claimed benefits of empires. Also, considerable space is dedicated to the history of the transformation of the American Republic created in 1776 to the American Empire of today and to the coincident development of militarism and bloated bureaucracy. Included is a fascinating history of Ho Chi Minh, the French, and the blind imperial militarism that drew us into Vietnam, including a detailed and rather disturbing play by play of the development of U.S. strategy there.

Most of the book is spent revealing a picture of imperialism — the thinking and actions of an imperial people. The purpose of this history of imperialism is to lay the groundwork for understanding how and why Americans today believe the absurdities that they do, including:

  • That you can get something for nothing;
  • That we can spend more than we earn forever;
  • That domestic savings and capital investment are no longer necessary;
  • That house prices will go up forever;
  • That the virtues that made America rich and powerful are no longer required to keep it rich and powerful;
  • That the rest of the world will continue to take American IOU’s forever;
  • That “deficits don’t matter;”
  • That the rest of the world wants to be more like America, even if it is forced on them;
  • That America has the most dynamic economy in the world; and
  • That Americans are more intelligent and more creative than the rest of the world.

Bonner and Evans make numerous interesting high level observations including that people come to believe what they need to believe when they need to believe it. “America is an empire; its people must think like imperialists…An imperial people must believe that they deserve to be the imperial power…that their own culture, society, economy, political system, or they themselves are superior to others. It is a vain conceit, but it is so bright and so big it exercises a kind of gravitational pull over the entire society. Soon it has set in motion a whole system of shiny vanities and illusions as distant from the truth as Pluto and as bizarre as Saturn. Americans believe they can get rich by spending someone else’s money. They believe that foreign countries actually want to be invaded and taken over. They believe that they can run up debt forever, and that their debt laden houses are as good as money in the bank.”

The fiscal status of the U.S. is painfully detailed, including the following items.

  • The total value of all assets in America is approximately $50 trillion.
  • Current U.S. debt is 37 trillion.
  • Unpaid liabilities and obligations equal $44 trillion.
  • Add those numbers and we are bankrupt.
  • America pays the direct cost of empire; military budget (over half the global expenditure) and trade deficit combined equal 10% of GDP.
  • Debt service is another 5% of GDP.
  • In 1950 approximately 5% of US government debt was in foreign hands; today that number is close to 50%
  • When Ronald Reagan entered the White House foreign owned US assets were less than 15% of GDP; today they’re over 78% and growing.
  • A dollar from 100 years ago is now worth approximately 4 cents.
  • A dollar from 20 years ago is now worth approximately 50 cents (my addition).
  • The mean value of paper currency is zero, and that is the value to which all paper currencies past have gone, and to which the dollar will eventually go.

The most important part of this book in my opinion is the last chapter, “Subversive Investing,” which begins with a quote from Uncle Remus, “Dere’s dem dat’s smart, an dere’s dem dat’s good,” which is the perfect frame for this debate. The key to this chapter is virtue, something held to be of great value by Americans in generations past and sadly forgotten in public life today. The most important virtue in relation to markets is humility. One can never know what is going to happen tomorrow, let alone next week, month or year, and one can never know whether a given action is going to produce a desirable result. What one can do is humbly rely on the accumulated wisdom of those who have gone before us, learn the lessons of history, stick with the tried and true. In the case of markets we strive to buy cheap and sell dear, and above all to be very cautious in the use of debt and leverage. As for the bigger picture, the economy, it is the failure to humbly heed the wisdom of generations past that has led us to our current situation wherein we have squandered our wealth, become the world’s greatest debtor and have taken to squeezing the poor countries of the world for their savings in order to put off the inevitable in our own society.

In summary, the GaveKal viewpoint is a reflection of the tendency of our economic elite to make economic efficiency the arbiter of the moral and the good. It is the hubris of an epic market top in my opinion, and the failure of the entire argument rests on the practical consequences of this point. However this book is a valuable read. The authors frame numerous issues with great clarity and put forth some interesting ideas that merit further thought and debate. Interestingly enough, one of the final notes of Our Brave New World is a lamentation of the takeover of the money management business by risk managers and accountants, a development that is sure to have long term negative consequences…a sentiment I am certain they share with the authors of Empire of Debt.

But if you only read one book this year, it should be Empire of Debt. I see that it has found its way onto the NY Times bestseller list, and rightly so. This book is grounded in wisdom. It is important for everyone to have a clear perspective on where we stand in historical terms, and it is all too easy to become transfixed by the relentless onslaught of data and spin and to lose perspective. Bonner and Evans do a good job of presenting the long view of where we stand and they do this with great humor, which makes for an enjoyable read.

Q3 ’05:   Uncertainty and the Fruit of Hubris


All the talk these days is about the “housing bubble.” Do we have a housing bubble? Housing prices have clearly gotten ahead of themselves, especially in hot markets such as California, Florida, DC and Las Vegas, and the growing popularity of such mortgage products as zero down, interest only and option ARMS, which allow negative amortization, are downright alarming. The double digit increases certainly cannot go on forever, and a correction of some degree is inevitable. But the increase in housing prices, while substantial, is a small blip compared to the 90’s run-up in technology stocks, which was a genuine mania. Of course the size and import of the housing market to the overall economy also dwarfs the tech market, so a smaller correction in housing will have a relatively bigger economic impact.

So the big question is: since the Fed has made clear its intention to bring the party to a halt and we are clearly coming to some kind of top, how will the housing market resolve? With a severe shakeout and a nasty recession? Or with a soft landing and long sideways consolidation? Let’s all hope for the latter. In any case the bubble, if that’s what we have, is not likely to burst until long rates move decisively higher, and is also not likely while the national press is on “bubble watch.” Real bubbles are recognized by the public in retrospect, not ahead of time.

One thing that is clear is the continuing impact of the disparity in incomes and the hollowing out of the great American middle class. As of last fall, approximately fifteen percent of economic growth was going to wages and salaries, the smallest share since WWII. Adding to the squeeze is the steady shift of the burden of health care and pensions from employers to workers. These trends have combined to make take-home pay as a share of the economy the lowest since 1929 when the government first started keeping track of this statistic. As a result, large numbers of workers are in ever more precarious financial condition. Throughout the recovery the number of American families living in poverty has steadily increased. The next recession will generate a dramatic and probably unprecedented increase in this number.

Official inflation is low, but the soaring cost of housing, energy, health care and education, along with relentless corporate downsizing and outsourcing are making upward mobility for large numbers of Americans a fond memory. Bullish commentators cite aggregate numbers in making their case for a healthy economy, but they fail to factor in the combined influences of technology, globalization and government policies causing the fruit of the growth to go to a shrinking number of people on top. We have, in fact, two economies: one for the well connected, well educated and technically proficient, which is doing very well, and another for everyone else, which is struggling.

When thinking about our economy these days, the image I get is that of a huge updraft extending outward at the top like a thunderhead. This vision represents the transfer and gathering of our wealth in the upper tier where it is being deployed in increasingly sophisticated, risk-averse strategies, perpetuating and exacerbating this re-distribution. Wealth is being hoarded on a broad scale, real opportunities are becoming scarce, and the natural vitality of our economy is being eroded at the base. This development is being masked by low interest rates and excess liquidity.

I have made my case over the past three years. Briefly, it is and has been my position that unless there is a dramatic transformation in the behavior of those in power, we are soon going to experience some serious pain. In fact, given the excesses of the past five years, we may already be past the point of no return. It is ironic that the allegedly conservative Republican Party, so long the (ostensible) party of fiscal responsibility, would be the vehicle for this development. As I see it, what is happening in Washington is our greatest market risk.

I recommend re-reading “America’s Truth Deficit ” by William Greider. This article goes to the heart of the matter.


Fortunately the public has begun to take notice of the dysfunction in Washington. Recent polls show increasing concern over the behavior of the President and Congress. The President’s approval rating is at his lowest ever, plunging into the 30’s at press time, and it’s only that high because the public still generally supports his aggressive policy on the war on terror (ex-Iraq). Congress fares even worse. Only one-third of the people approve of Congress right now and more than 80% think that Congress does not share their priorities for the country.

The national political scene remains hyper-polarized. For insight into the root causes and possible solutions to our political dysfunction, I recommend an article by former Republican Senator John Danforth entitled “Onward Moderate Christian Soldiers” and also a recent David Brooks commentary, “The Designated Hitter.”

The Bush team has used war and the terror threat skillfully to its advantage up until now. As the scandals and indictments pile up and the approval numbers plummet, I would expect those cards to be played again in ’06. If Iran does not yield on their nuclear program before next year, there is a very good chance that President Bush will order an attack in the spring. Even if we don’t have another hot war in ’06, I would expect a lot of saber rattling and numerous “terror alerts” in the lead up to the election.

Abuse of power, hubris, corruption, cronyism and related issues, as well as Iraq and the economy, will weigh heavily on the Republicans in ’06. The ’02 election, under the cloud of the buildup to the invasion of Iraq, defied the normal mid-term election pattern, in which the party in power loses seats. The normal pattern will almost certainly reassert itself in ’06, quite possibly with a vengeance. Democrats have a fair chance of taking back at least one house if they can pull themselves out of their stupor. They could improve their prospects dramatically if they actually offered some alternatives to Republican policies that most Americans are clearly disenchanted with.


Pressure is building for an exit from Iraq. Public sentiment is now almost 2-1 against the war. Many conservatives, including former war hawks, are acknowledging that the Iraq war is a distraction from the war on terror and our failures there are in fact undermining our security. There is also growing concern that the Iraq war is damaging the military from within. The problem with enlistments is well reported but a much more serious problem is that a high percentage of junior officers are now considering leaving the military. See “The Not So Long Gray Line ” by Lucian Truscott IV, grandson of the famous WWII Army general.

The grandiose scheme to democratize the Mid-East and remake the world in our image has been extremely damaging to our standing in the world. I confess that I too believe in America’s special place in the world, and in its leadership role. What we have witnessed over the past five years, however, is the dark side of that vision: the arrogant belief that we can violate the laws of man and nature with impunity and impose our values and our system on the world at the end of a cruise missile.

For those caught up on the receiving end of our campaign to democratize the world our actions don’t look much different than previous efforts to impose utopian systems “at the end of a bayonet.” A dead wife or child or brother is simply dead. A life ruined is a life ruined. It doesn’t matter that your initial intent was noble. Like they say, the road to hell is paved with good intentions.

Retired General George Odom, Vietnam veteran and former head of the NSA, recently said “The invasion of Iraq, I believe, will turn out to be the greatest strategic disaster in U.S. history.”

For an excellent history of the bi-partisan development of this neo-con fantasy, read “The New American Militarism: How Americans Are Seduced by War ” by Andrew Bacevich, professor of international relations at Boston University and Army War College graduate.

We all know about the chaos in Iraq, the Iranian nuclear program, China’s military buildup, the Taliban resurgence in Afghanistan, North Korea’s nukes and the bombings around the world. But the situation flying under the radar most likely to threaten global stability is in Russia.

Russia possesses more than half of the world’s nuclear weapons — some 22,000 of them — many of them poorly guarded. Russia is crumbling economically and politically, and we are piling on, pressuring them from all sides. If we push Russia into collapse, it will be very difficult to prevent the emergence of a black market in nuclear weapons. As they get closer to the brink, they may also re-assert themselves militarily, laying claim, and waste if necessary, to Georgia and Ukraine. Needless to say, this would raise global tensions considerably. If you like horror stories, you might want to read “Failed Crusade: America and the Tragedy of Post Communist Russia ” by Stephen Cohen, Professor of Russian studies and history at NYU.

It all adds up to a rather gloomy outlook on the global scene, but just when one starts to feel like all hope is lost, something good pops up.

For a surprising and very encouraging read, see “The End of War” by Greg Easterbrook, and also “Peace is Spreading ” by Niall Ferguson. According to Easterbrook and Ferguson, citing research from the Center for International Development and Conflict Management at the University of Maryland, despite the war on terror, the rise of militarism in the U.S. and outbreaks of religiously inspired violence around the world, global violence has in fact been in decline for the past 15 years, down over 60% in fact, and the average human today may well be the least likely in history to be the victim of war. Given the daily media barrage we are subjected to concerning wars and mayhem around the world, this information is rather counterintuitive, but it’s nice to be surprised to the upside sometimes.


Keep in mind that the global housing and commodity boom is not just a demand phenomenon, but also a reflection of the general debasement of currency by the world’s central banks. With the U.S. running massive trade and budget deficits, other countries are printing currency to buy our dollars and keep the global economy afloat. Hence the world is awash in liquidity. This money has to go somewhere and it has been going into assets…housing and commodities, as well as into U.S. Treasury securities. We are involved in a de-facto competitive currency devaluation rather than a straightforward asset bubble, and it is quite possible that we have not begun to see the froth in the housing bubble.

The best opportunity these days is…defense…defense…defense. Also, know your banker, broker and/or customer. Liquidity is valuable, but quality trumps liquidity. Uncertainty reigns, but by the middle of next year we should have a better sense of where things are headed.


We have entered the bearish stage of the presidential cycle. The March high, which I expected to be the cyclical top, was slightly bettered in July, and tested again in September. I expect this expanded top be the high for at least the next two years. Given the tremendous debt that the next administration will inherit, this could well be the top for the next 6 years, 10 years or longer.

The bottom line is that instability and uncertainty are the ground state of global affairs, and the list of potential triggers for an economic accident remains long. At the same time the corruption and the obsession of our leaders in Washington with their ongoing tribal warfare denies us the leadership we need at this critical time. Our leaders, with our consent and support, have been doing the things that have historically brought great nations to their knees — running up enormous debt, allowing epic scale corruption and engaging in foreign wars.

Hubris is the defining characteristic of our current government. The result is that we have made a shambles of our balance sheet, created growing doubt, division and confusion at home, and lost the respect of the world. If you have not seen the movie Ran, I suggest that you rent it.

Hubris is not manifest only among politicians, but is widely evident in our society. U.S. corporate chieftains are still up to their sleazy ways, SEC scrutiny notwithstanding. Failed Morgan Stanley CEO Philip Purcell left in disgrace after only nine months on the job with a $32 million paycheck. $25 million is now average compensation for CEO’s, regardless of their performance. In the world of science, the bio-tech industry is bringing the Frankenstein myth to life. Human cloning is moving full steam ahead in South Korea. American scientists are injecting human genes into plants and animals, and recently celebrated the creation of the first mice-humans. The talk these days among technophiles is about the merging of man and machines to create a super race with Godlike power and virtual immortality. (See “The Singularity is Near ” by Ray Kurzweil.) We are definitely due for an attitude adjustment.

All of the smartest people I am aware of seem to be on the same page these days. Yes, we have created big problems with our profligate ways, and yes, the imbalances we have created must sooner or later come into balance. In fact, they are waiting for some trigger event to send them cascading to their new equilibrium. But when, how and over what time period no-one is prepared to offer. Could it be a disaster? Yes, it certainly could. Can we save ourselves from disaster? With some real leadership, yes we can, even now. It seems that the thing everyone is in agreement on is that the dollar will fall further, probably much further. Of course just to spite everyone, the dollar has rallied 10% over the last several months. So there you have it. No-one knows anything. Did they ever?

I think that the defining principle of our current situation is that the fruit of hubris is beginning to come home to roost and the risk to all sectors is high. Think defense. Think new paradigm…that will be a good topic for the Q4 letter.

Q2 ’05:   America’s Truth Deficit

In the process of preparing my Q2 letter I came across a recent article by William Greider, the national affairs columnist of The Nation, entitled “America’s Truth Deficit.” I felt that this article was valuable and worthy of dissemination as this quarter’s offering.

It is my opinion that our current government, ideologically driven and blinded by hubris, has waded ever deeper into an economic and geopolitical quagmire. Extraction will now be difficult at best. I believe that the greatest market risks we face today are systemic, created by the arrogance, corruption and tribal political warfare of our leaders in Washington. Greider’s article goes right to the heart of the matter.

“DURING the cold war, as the Soviet economic system slowly unraveled, internal reform was impossible because highly placed officials who recognized the systemic disorders could not talk about them honestly. The United States is now in an equivalent predicament. Its weakening position in the global trading system is obvious and ominous, yet leaders in politics, business, finance and the news media are not willing to discuss candidly what is happening and why. Instead, they recycle the usual bromides about the benefits of free trade and assurances that everything will work out for the best.

Much like Soviet leaders, the American establishment is enthralled by utopian convictions – the market orthodoxy of free trade globalization. The United States is heading for yet another record trade deficit in 2005, possibly 25 percent larger than last year’s. Our economy’s international debt position – accumulated from many years of tolerating larger and larger trade deficits – began compounding ferociously in the last five years. Our net foreign indebtedness is now more than 25 percent of gross domestic product and at the current pace will reach 50 percent in four or five years.

For years, elite opinion dismissed the buildup of foreign indebtedness as a trivial issue. Now that it is too large to deny, they concede the trend is “unsustainable.” That’s an economist’s euphemism which means: things cannot go on like this, not without ugly consequences for American living standards. But why alarm the public? The authorities assure us timely policy adjustments will fix the matter.

Reporters and editors typically take cues from the same influential sources and learned experts in business, finance and government. If the news media decided to cast these facts as the story of the world’s only superpower losing ground in global competition and becoming financially dependent on strategic rivals like China, the public would take greater notice. But governing elites would regard such clarity as inflammatory. America’s awesome trade problem is instead portrayed as something else – an esoteric technical dispute about currency values, the dollar versus the Chinese yuan. The context is guaranteed to baffle and benumb citizens.

The possibility that the United States can no longer afford globalization, at least not as it now functions, is what opinion leaders do not wish to discuss. A few brave dissenters have stated the matter plainly and called for significant policy shifts to stop the hemorrhaging. Warren Buffett, the legendary investor, says the United States is destined to become not an “ownership society,” but a “sharecropper society.” But his analysis, and others like it, are brushed aside.

An authentic debate might start by asking heretical questions: Why is the United States one of the few advanced economies that suffers from perennial trade deficits? Why do new trade agreements, despite official promises, always leave the United States with a deeper deficit hole, with another wave of jobs moving overseas? How do the authorities explain the 30-year stagnation of working-class wages that is peculiar to America? Are we supposed to believe that everyone else is simply more competitive or slyly breaking the rules? In the last three decades, American policymakers have succeeded in closing the trade gap with only one event – a recession.

The American predicament is shaped by operating dynamics grounded in the global system, singularly embraced by Washington because Washington originated most of them. At the outset, these practices were both virtuous and self-interested for the United States – encouraging industrialization in poor countries, binding cold war allies together with trade and investment, furthering the global advance of American business and finance. With its wide-open market, America played – and still plays – buyer of last resort for world exports. Its leading companies and banks gained access to developing new markets, often by sharing jobs, production and technology with others. American policymakers also got to run the world.

The utopian expectations behind this arrangement turned out to be wrong, judging by empirical evidence rather than theory. But why wrong? American political debate is enveloped by the ideology of free trade, but “free trade” does not actually describe the global economic system. A more accurate description would be “managed trade” – a dense web of bargaining and deal-making among governments and multinational corporations, all with self-interested objectives that the marketplace doesn’t determine or deliver. Every sovereign nation, the United States included, uses its vast arsenal of policies to pursue its national interest.

But on the crucial question of how policy makers define “national interest,” Washington stands alone. Western Europe, whatever its problems, manages economic policy to maintain modest trade surpluses. Japan manages to insure far larger surpluses in recessions (its export income subsidizes inefficient domestic employers). China strives to acquire a larger, more advanced industrial base at the expense of worker incomes and bank profits. Germany and Japan, despite vast differences, both manage to keep advanced manufacturing sectors anchored at home and to defend domestic wage levels and social guarantees. When they do disperse production and jobs overseas, as they must, they do so strategically.

By contrast, Washington defines “national interest” primarily in terms of advancing the global reach of our multinational enterprises. Elites are persuaded by the reigning orthodoxy that subsidiary domestic interests will ultimately benefit too. The distinctive power of America’s globalized companies is reflected in trade patterns. Nearly half of American exports and imports are not traded in open markets – the price auction idealized by neoclassical economics – but within the companies themselves, moving materials and components back and forth among their far-flung factories. A trade deficit does not show on the company’s balance sheet, only on the nation’s. In recent years, much of the trade deficit has reflected the value-added production and jobs that companies moved elsewhere.

The United States is thus especially vulnerable to the downward pressures on working-class wages that exist on both ends of the global system. American producers are generally free – and even encouraged by Washington – to shift production to low-wage locations. Companies regularly use this cost-cutting technique as a competitive weapon without regard to the domestic consequences. The practice works for companies and investors, but not so well for a nation.

INDEED, the cumulative effects of retarding labor incomes worldwide repeatedly threatens stagnation or worse for the entire system. Workers, to put it crudely, cannot buy what the world can make. Too much capital leads to the speculative “bubbles” that bounce around the world, visiting financial crisis on rich and poor alike.

At a different moment in history, American leadership might have stepped up to these disorders and led the way to solutions. If globalization is to continue without encountering more crisis and random destruction, governments must together shift the balance of power so labor incomes can rise in step with rising productivity and profits. If the United States is to avert its own reckoning, it must take decisive action to draw firm limits on its exposure to trade deficits, that is, resign its position as the open-armed buyer of last resort. In effect, Washington would also reform its own national interest imperatives so that they more closely resemble what other nations already embrace. Ultimately, American remedial action may protect the global system from its own crisis – the moment when trading partners discover they have just lost their best customer.

But to describe plausible remedies is to explain why none are likely. The webs of mutual interests connecting government, corporate boardrooms and Wall Street are too deeply woven, as are habits of thought among policy makers and politicians. So I do not expect anything fundamental will be altered in time. We are going to find out if the dissenters are right.”

Q1 ’05:   Wisdom From Paul Volcker

The most relevant and straightforward commentary on the challenges facing our economy that I have seen recently was made by Paul Volker, former Chairman of the Federal Reserve, at a February economic summit sponsored by the Stanford Institute for Economic Policy Research. This speech pretty much sums up the situation and needs no additional comment from me. So without further ado, I give you Paul Volker.

“The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India — with close to 40 percent of the world’s population — have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable.

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks — call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

We sit here absorbed in a debate about how to maintain Social Security — and, more important, Medicare — when the baby boomers retire. But right now, those same boomers are spending like there’s no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared.

To be sure, businesses have begun to rebuild their financial reserves. But in the space of a few years, the federal deficit has come to offset that source of national savings.

We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6 percent more than we are producing.

What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.

Most of the time, it has been private capital that has freely flowed into our markets from abroad — where better to invest in an uncertain world, the refrain has gone, than the United States?

More recently, we’ve become more dependent on foreign central banks, particularly in China and Japan and elsewhere in East Asia.

It’s all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It’s surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth.

And it’s comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency.

The difficulty is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.

It’s not that it is so difficult intellectually to set out a scenario for a “soft landing” and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand.

But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all?

The answer is no. So I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s — a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

The clear lesson I draw is that there is a high premium on doing what we can to minimize the risks and to ensure that there is time for orderly adjustment. I’m not suggesting anything unorthodox or arcane. What is required is a willingness to act now — and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable.

What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline. This is not a time for ideological intransigence and partisan posturing on the budget at the expense of the deficit rising still higher. Surely we would all be better off if other countries did their part. But their failures must not deflect us from what we can do, in our own self-interest.

A wise observer of the economic scene once commented that “what can be left to later, usually is — and then, alas, it’s too late.” I don’t want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.”

Q4 ’04:   What, Me Worry?

The current theme among investors seems to be “what, me worry?” The stock market rallied nicely after the election, closing the year on its highs; the Dow up 3.1% and the S&P up 9%. The bond market has continued to defy gravity — ten year Treasuries are at 4.15% as of this writing and corporate spreads are at historic tights. Housing sales continue to make history as October sales set a new record, and then fell off sharply in November to a still high level. Market cheerleaders are predicting clear sailing for the foreseeable future. Bullish consensus is at multi-year highs; volatility at 10 year lows.

And judging from the overwhelming consensus of the sycophants at the recent “economic summit” in Washington, who fell all over themselves for an opportunity to kiss George Bush’s hindquarters, we have entered into a golden era with, in the words of AP reporter Tom Raum, “an economy of blue skies, happy workers and prosperity for all…just around the corner.”

From the viewpoint of a contrarian, to which I confess, all the above is ominous.

Fiscal Madness Phase II

On the fiscal front, the White House is planning to slash domestic spending in an attempt to execute the second half of the “starve the beast” strategy. The President has promised to halve the deficit, but this does not necessarily mean a real reduction in spending or borrowing. An increasingly fractious Republican caucus, drunk from four years of unrestrained spending, represents a substantial obstacle to spending restraint, so the deficit reduction will be accomplished primarily by using accounting procedures that would make Ken Lay blush.

Real spending cuts would have the effect of cutting off much of the juice to our stimulus dependent economy. But not to worry. Real cuts will only be felt by those without a Republican sponsor, such as the environment and the indigent. More importantly, creative accounting is in vogue at 1600 Pennsylvania Ave. First up on the agenda is Social Security “reform,” a Trojan Horse designed to undermine Social Security while running up another $2 trillion or so in debt — off budget of course, as is Iraq and lord-knows-what-else. We book the cuts and borrow off budget. Now why didn’t I think of that? More tax cuts are also planned.

If successful in this shell game, Republicans may squeeze enough juice out of the economy to keep the wheels turning for two more years while claiming the moral high ground of fiscal responsibility. I give the Bush folk an overall fiscal grade of C: an F for responsibility, a C for creativity and an A for audacity.

Consumption Frenzy

Our debt-driven economy, powered by the insatiable American consumer, is the locomotive of the world economy. But U.S. consumers have been taking on debt for 20 years, and are nearing the end of their run. Noteworthy — consumer borrowing dropped 5% in November, the largest monthly drop on record.

America is currently sucking up over 80% of global savings to finance our consumption, and U.S. net savings hover just above zero. This bad behavior has not gone unnoticed by the currency markets. The dollar is down over 30% in the past three years (matching the decline in positive attitudes toward America ). Even so the trade deficit continues to set new records month after month…$60 billion in November alone!

The big question for macro economists is whether China and the rest of the world will be able to rev up their consumers in time to take up the slack when Americans start to deal with their debt burden. One question no-one seems to ask, publicly at least, is whether this kind of debt-driven consumer economy on a global scale is healthy or sustainable to begin with.

The following chart is a good visual aid for realizing the consequences of our unbridled consumption combined with faith based economics.

U.S. External Debt and Primary Trade Deficit (share of GDP)

This mountain of debt will have to be retired one way or another. Dollar devaluation is one way to reduce the size of the mountain. Despite the 30% devaluation to date, there is virtual unanimity in the marketplace that the dollar remains overvalued, and many commentators expect that it will have to drop another 30% to restore balance. A gradual devaluation is in everyone’s best interests, and great efforts will be made to see that it happens that way. So it would seem the outcome is ordained; the path is uncertain. With so much dollar bearishness we could see some dramatic rallies.

For a perspective on what could happen if things don’t unfold according to plan, or if the plan becomes even more divorced from reality than it already is, check out “Episodes of Hyperinflation ,”a website maintained by Thayer Watkins of the San Jose State Economics department. This site is a study of many cases of hyperinflation from Rome forward. Interestingly, all cases lasted for a short time, from 1-3 years, coming on the heels of many years of escalating imbalances.

Showdown in the Senate

The President has announced that he is going to re-nominate the judicial nominees filibustered by Democrats in his first term. In support, Senate Majority Leader Frist has announced that he plans to invoke the “nuclear” option to limit filibuster on judicial nominees. This will usher in a period of virtual hand to hand combat in the Senate and make it difficult to generate bi-partisan support for anything over the next two years.

The dustup over judicial nominees will be the first major battle in the renewal of all out political warfare. The Republican leadership, not content with victory but pushing for total domination, is teeing up an aggressive agenda of controversial issues with Karl Rove style PR campaigns in support. The impending retirement of Chief Justice Renquist, seriously ill with cancer, will release a torrent of partisan flak attacks. See “The Coming Firestorm ” in the January 1st Economist. The way things are shaping up, we may soon find ourselves yearning for the relative civility of the ’04 campaign.

There are signs that the Republican juggernaut is stalling. The normal pattern is that the party in power loses seats in the mid-term election. All indications are that the Republicans are going to overplay their hand and that it will cost them in ’06. Numerous scandals, the plague of second-termers, are brewing. Abuses of power will hurt also. House leaders in particular, acting more like a crime family than a political party, seem especially intent on shooting themselves in the foot on this score.

In many ways all the above is politics as usual, although incrementally more depraved with each new campaign. But probably the most significant development of the 2004 campaign is that the Big Lie is now unchallenged as the dominant mode of public policy discourse. The old Soviet commissars would be in awe at the sophistication of the machinery of deception. We call it spin these days, and good spinners are held in high regard by our political class. But like a bad case of termites, this spinning business is degrading the foundations of our society. Ironically, those who champion morality and values have become the best spinners.

Spinning now permeates our society. In the words of Jonathan Alford in a recent Salon article, “We have all become implicit spinners. No one likes it and no one knows how to stop it. We look simultaneously at content and predicted effect, at what actually happened and how it will play. If it doesn’t play, it never happened. Conversely, even blatant lies, if they play, become true.”

The War on Terror

Global instability and the terror threat remain at high levels and continue to present one of the most likely sources of crisis for the markets and the economy, although if this threat manifests it will most likely do so in a completely unexpected way.

According to Stratfor, a global intelligence service dubbed “the shadow CIA” by Barrons, the aggressive U.S. strategy in Iraq and elsewhere has brought about considerable moderation in Muslim regimes regarding the jihadis, and the latter’s strategy of creating a global conflict has stalled. In the view of Stratfor, despite the fact that Iraq has turned into a huge and unexpected headache, the U.S. is winning the battle at present.

Other terrorism experts have a different view. Michael Scheur, the ex-CIA bin Laden expert, formerly known as Anonymous, author of “Imperial Hubris,” and Yossef Bodansky, former director of the U.S Congressional Task Force on Terrorism and Unconventional Warfare and author of “Bin Laden: The Man Who Declared War on America ,” both state unequivocally that we are losing the war against terror and that a terror attack against the U.S. using unconventional weapons is virtually inevitable.

A third view is that the entire global terror threat is an invention. A BBC documentary “The Power of Nightmares: The Rise of the Politics of Fear” makes the case that ambitious politicians and an eager press have taken the terror threat to the bank based on the singular spectacular events of 9/11. Producer Alan Curtis puts forth some compelling arguments for this view. See the Guardian review entitled “The Making of the Terror Myth .”

In the Orwellian world of 21st century public discourse, it is difficult if not impossible for the average citizen to know the real truth of the matter. However, regardless of whether we are winning or losing, or if the entire sad story has been an exercise in group paranoia, the management of the war on terror, according to a Pentagon panel, has been an unmitigated disaster. For details see “The New Pentagon Paper ” by Salon columnist Sidney Blumenthal.

I have repeatedly pointed out the obvious: that the continued arrogance and brutality of U.S. foreign policy is hardening anti-American attitudes globally. This has many unfortunate consequences, one of which is that many who did otherwise after 9/11 are now turning a blind eye toward the activities of terrorists and their supporters. The result may or may not come in the form of a major terrorist attack, but if it should the world will not rally to us as they did after 9/11.

Meanwhile, realignment is moving full speed ahead. China in particular has been moving steadily and intently to supplant U.S. hegemony in South Asia, expanding its military capabilities and moving globally to secure the inflow of raw materials. Russia and China recently announced their first ever joint military exercises. (Can we envision a Sino-Russian mutual defense pact?) The recent ASEAN meeting saw the creation of a tariff free Asian trading zone to vie with Europe and the U.S. Many younger people in the region are abandoning their English studies to learn Mandarin. See the NY Times article, “Chinese Move to Eclipse U.S. Appeal in Southeast Asia ” by Jane Perlez.

Elsewhere on the global scene there have been some positive developments. The high point over the last few months certainly was the election in Afghanistan, an act of national courage. See the LA Times Op-ed piece, “Afghanistan ‘s Minor Miracle “byRajan Menon.

Also, the passing of Arafat offers new hope in the Middle East, and China and Taiwan have taken a breather from their saber rattling. It’s too soon to know if any of these developments mean anything for the long term, but one can take note of what it feels like when the pressure recedes rather than increases.


“I object to violence because when it appears to do good, the good is only temporary; the evil it does is permanent.” Mahatma Gandhi

This quote from Gandhi is especially pertinent to the situation in Iraq. The apparent good of removing Saddam from power has resulted in the creation of a terror vortex where there was none before, the destruction of tens if not hundreds of thousands of lives, the vast majority of them innocents as in all wars, and irreparable harm to America’s honor and standing in the world.

Iraq is unraveling day by day, increasingly reminiscent of Vietnam. A recent report by the CIA’s Baghdad chief stated that the situation there is out of control and there is little hope of improvement any time in the foreseeable future. Even the President, the election now in the bag, has finally acknowledged that things there are not going well.

Those who want the real skinny on the reasons for the Iraq invasion should read Stratfor founder George Friedman’s book, “America ‘s Secret War.” Hint: it wasn’t about the phantom WMDs.

Right now it appears that the strategy (which changes often) is to conduct the election no matter what, see the new government installed no matter how illegitimate, and then retreat into a “supportive” role, forcing the ill-prepared Iraqi security forces to the front lines in a bloody civil war with the Baathists while attempting to keep Iran and Turkey from entering the fray — another high-risk strategy from the Bush foreign policy team.

Iraq is having a negative impact on our standing in the global marketplace. While there are no formal boycotts outside the Muslim world at this time, a recent poll in Europe discovered that 20% of Europeans are now avoiding American products. This number will surely grow. This will not be helpful in our efforts to balance the trade deficit.


The best outright long term opportunities remain in the developing world. India, China and the entire South Asia region are growing stronger and are moving toward a solid regional stance with China in the lead. Unfortunately, however, the entire developing world is set up for export to the U.S. When the U.S. finally starts dealing with its debt problems, consumption will plummet, and with it the developing world’s export market. This is a difficult call, because the dollar is also vulnerable to collapse. If you wait too long, you may not have any foreign purchasing power. If you go in too soon, you may have to weather a bone crushing correction. A tough call. Probably the most prudent strategy is to spread (or hedge) assets into five or six currencies including gold and the dollar and wait for the correction.

Gold will move inversely to the dollar, and in case of serious global instability gold will become the choice over any paper currency. Real estate in Canada and Mexico and further South may be worth investigating. Also, as an insurance play it may be a good idea to consider buying leap puts in the S&P’s.

The fiscal agenda involves a continuation of massive borrowing. Much of the borrowing will be off budget – e.g. the social security “fix” and Iraq spending. While the off-budget spending may provide political cover, the markets won’t buy it, which pretty much guarantees that the dollar devaluation will continue. This will continue to be positive for hard assets and commodities as well as for stocks.

Be aware of the hidden tax in the dollar devaluation. Even if you are smart or fortunate enough to have your entire net worth in assets that are appreciating relative to the dollar devaluation, you are going to be taxed on the nominal appreciation, leaving you a net loser. Still better than being in a dollar denominated money market, but less gainful than you think.

The outstanding issue that makes picking strategy so difficult right now is that it is clear that our debt-based economy is overextended and vulnerable. Natural law guarantees that sooner or later, one way or another, it will come into balance, but the way that it will come into balance is unknown. A worrisome sign is that despite the unprecedented stimulus of the past four years we have still seen very little inflation, and the bond market is not anticipating any.

So, on the one hand we could see overhanging deflationary forces take over and force massive defaults. On the other hand, in a debt-based economy policy makers recognize that they must “inflate or die” as Richard Russell is fond of saying. Efforts to counter deflation could get out of hand, causing hyperinflation. Or we could see extended stagflation followed by one of the above. Or we could even see a sudden blossoming of enlightenment and self-sacrifice by our leadership, leading to a global co-operative effort to consciously manage our way to a just and sustainable global economy. I wouldn’t hold my breath waiting for the latter, but then again no-one would have believed that the Berlin wall was going to come down before it happened. The ways to position for these various outcomes are quite different. So the best stance overall remains liquidity, prudence, flexibility and diversification…and patience.


I fully expect that when the borrowing stops, or rather when the lending window is closed, the Bush gamble on faith-based economics is going to end up being a matching bookend for his other big gamble in Iraq . Hubris is not corrected by 20%. Hubris is corrected by disaster.

Economists and other market commentators, mesmerized by each latest set of economic numbers, miss the forest for their laser-like focus on the trees. The fact remains that we are badly overextended fiscally and militarily, and therefore vulnerable to any number of crisis generating breakdowns. With the exception of corporate balance sheets, the excesses of the ’90’s bubble have not been dissipated, and have only been exacerbated by the massive borrowing and relentless stimulus. This is the dominant reality that everyone is trying to ignore. The criminal culture in corporate boardrooms is as bad if not worse than ever, Sarbanes-Oxley notwithstanding. Corruption in government is at epic levels, and extreme political polarization has made it impossible to deal with any national issue in an honest and balanced way. Outsourcing continues to build steam, going upscale as it grows. The disparity in incomes continues to grow; poverty is growing; our health care system is in meltdown and pension programs are almost universally under funded – those that haven’t already defaulted. All of this in the fat part of a “recovery.”

Judging from a convergence of factors: all the points in the previous paragraph; the presidential cycle turning down; the failure of the stock market to make new highs in the bull phase of the current cycle; widespread complacency; soaring bullish consensus; the zero savings rate; the soaring twin deficits; unsustainable consumer debt; the housing bubble, and last but not least, the classic, almost storybook hubris, corruption and casual brutality of our current government, I have to call it like I see it and predict that the time to pay the piper is fast approaching.

I expect the stock market to top out in January or by March at the latest. Given the right catalyst, we could see a sudden and sustained sell-off, but barring a major blowup in one of the many potential economic or geopolitical flashpoints – e.g. Korea, Iran, Saudi Arabia, terrorism, dollar, debt, housing — we are more likely to see a year of continued distribution, sideways to lower with increasing pressure as the year goes on, and with lots of M&A activity. I expect recession by the end of ’05 or early ’06; resurgent deflation and new lows in the bear market by mid-’06. This will be disastrous for some, and present major opportunities for those who are prepared.

Q2 ’04:   Marking Time

Things have not changed much since my last letter. Oil is $10 higher, at an all-time high of $43 at this writing, but otherwise markets, risk factors and opportunities remain pretty much the same. For the most part we are marking time, waiting for the outcome of the election.

Markets & Economy

Complacency has been the dominant sentiment in the marketplace for the past few months but anxiety has been rising lately over rising rates…how high and how fast will they go? The first uptick in rates was a delicate 25 bp increase on June 30th, which still leaves the cost of money far below growth, expected to be in the neighborhood of 4% this year, and inflation — currently running in the neighborhood of 3%, with consumer inflation over 5% by some measures. By any measure the Fed is still holding to a very stimulating stance.

Is the recovery really that fragile? Apparently so. After surging for several months, June economic numbers showed softness across the board and the July numbers have continued the trend. Are the stimulants of the past four years wearing off already? According to Alan Greenspan the soft numbers are a transient phenomenon, and the recovery is in a self-sustaining phase.

Someone who takes a different view is Stephen King, head economist at HSBC, a British bank, who recently published a paper entitled “Dicing with Debt.” The Economist reviewed King’s paper in its July 3rd issue. According to King, U.S. policy makers have overreacted to the deflation of recent years, which he claims was not the much feared debt deflation, but rather a benevolent kind of deflation with historic precedent, caused by technology, improved trade relations and other factors. By misreading the threat, pushing rates to historic lows and running up the debt, policymakers have inadvertently created conditions that may well yield the more malevolent variety of deflation.

The Economist summarizes King’s argument…”If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years.”

“There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think – and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America ‘s economic armoury is much depleted.”

We will soon know who is right.

Meanwhile a general malaise has overtaken professional investors, who are lamenting the imminent loss of easy money from the “carry trade” and who don’t see a lot more upside in this market. P/E’s are once again at nosebleed levels and a big part of the E’s has been the direct result of record low interest rates, which are soon to be history…we think. General concern is also rising that Al Queda or related Islamic terrorist groups will try to mount attacks on U.S. soil as we approach election time.

Investors are also suffering from the loss of vitality of the latest fad in investing – “market neutral” strategies. Over the past 10 years or so computer technology has enabled a whole new generation of arbitrage strategies with fancy names like volatility arbitrage, statistical arbitrage and pairs trading to produce outsized returns for awhile, but their success has drawn so much money into these low volatility strategies that they have stripped most of the “inefficiencies” out of the market and have effectively been reduced to operating between the wall and the wallpaper. Returns from market neutral strategies have fallen off dramatically and are not likely to come back. Worse, the low volatility/high return historical profile of these strategies has given investors some twisted ideas of what a good track record should look like. Most investors now want free lunch in the form of outsized returns without the risk and volatility required to earn those returns.

Fiscal update

The fiscal insanity has only slightly abated. House Republicans, having abandoned traditional Republican values and wholeheartedly adopted the “starve the beast” strategy (see the Q3 ’03 letter, “The Twilight Zone “), with White House encouragement, have been pushing for more tax cuts in the face of record budget deficits. Senate Republicans, however, are worried about voter retribution if they run up the deficit even more going into the election, as well they should be. Also, some of the so-called “deficit hawks” are belatedly finding their voices and complaining about the fiscal madness. We will hear more from this group as we approach November, anxious as they are to pretend that they are not in league with those borrow-and-spend Stepford Republicans. Add these cross-currents together and the result is that additional budget busting legislation is unlikely for the time being.

Meanwhile we ran up a whopping $144 billion trade deficit in the 1st quarter!!! Policymakers have been asleep at the wheel on this matter for a long time, but ignoring it is like ignoring the soil eroding from under your foundation. When it finally lets you know it’s a problem is when your house washes away in a heavy rain.

Recommended reading: an upcoming release entitled “Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It” by Peter Peterson, former Secretary of Commerce in the Nixon Administration.

Risk Factors

Bill Gross of PIMCO fame has put forth the most relevant analysis of economic risk factors I have seen recently in his May/June letter, the theme of which is “walking the tightrope,” with inflation (fire) on one side and deflation (ice) on the other. You may read the entire letter at www.pimco.com. The following quotes sum up Gross’s outlook.

“In a financed-based economy, which the U.S. surely is, the only real way to keep an economy going is via cheap money, more and more tax cuts, and/or additional leverage. With tax cuts politically unpalatable and recent yield movements along the curve making leverage less profitable, the beginning of the end is in sight.”

“What has changed this year in our 3-5 year forward economic forecast is that the conditions for instability have accelerated – more U.S. consumer leverage dependent on cheap financing; more Treasuries in foreigners’ hands; more geopolitical instability; and more risk of a slowdown/shock in Asia…”

The following charts, courtesy of PIMCO demonstrate some of the major challenges facing the economy and U.S. policymakers. These charts tell their own story.

According to Morgan Stanley 98% of global GDP for the past 10 years has been generated by the U.S., and two-thirds of that has been generated by consumers. With U.S. consumers having nearly doubled their debt load over the past 20 years to 80% of GDP, it is not likely that they will continue to be the locomotive that drives the global economy for much longer.

Housing Update

From Mark Zandi of Economy.com, courtesy of John Mauldin, the following housing statistics: housing has been a huge generator of jobs – in the neighborhood of 750,000 over the past five years, which is approximately 30% of all jobs created over that time. Housing was responsible for roughly two-thirds of inflation adjusted GDP growth since the beginning of 2000, and has continued its contribution during the recovery, adding 25% to real GDP growth over the past year. As for consumer spending: for every dollar of housing value gained, consumers spent 8 cents in that year, but for every dollar of housing value lost, 30 cents not spent.

Virtually all of the “experts” assure us that housing will not go down; it may go flat for an extended period of time but not down. But if there is one thing I can tell you with certainty it is this: markets do not go straight up for years and then go flat; they correct. The super-EZ credit and low, low rates have brought in legions of unqualified borrowers, leveraged speculators and other weak hands. During the next recession large numbers of these people will be forced to sell. With virtually everyone who can qualify, even with 100% financing, having bought something, and many having leveraged those purchases to buy additional houses using “subject to” and other creative financing techniques, or having cashed out of equity to meet expenses, who will be the buyers when the market starts down? And how far down will the market have to go with tighter credit and higher rates before new buyers can be found? A typical market correction is 50-65 %; a shallow correction is 30-35 %. Can’t happen you say? That’s what every cab driver, construction worker and actor tells me. I say that in this regard housing is not different from any other market.

Another piece of the housing puzzle is the potential for big problems at Fannie Mae and Freddie Mac, holders of $4 trillion of heavily leveraged mortgage debt between them. Many economists and politicians, including Alan Greenspan, have been publicly expressing their concerns about the twin mortgage giants, particularly about hedging operations. My sources with deep roots in the mortgage business are more concerned about the big banks that are on the other side of these hedges. Fannie and Freddie are fairly well hedged against losses on their portfolios but those holding the other side of these hedges could become liabilities for meltdown if housing comes under pressure, creating counterparty default risk for Fannie and Freddie and the potential for a crisis on the scale of Long Term Capital or worse. Read The Economist , April 7th issue, “Playing With Fire .”

Regarding housing, the question is not what will happen – housing will correct — but when will it correct, how deeply will it correct and how much of an impact will that correction have on the overall economy? The notion that housing values are going to simply level off is a fantasy.


Until just recently it seemed as though the nasty rhetoric had calmed down quite a bit. I confess that I even had a fantasy about an honest national debate emerging from this relative calm, but clearly I was engaged in wishful thinking. The venom is flowing freely again as partisans are warming up for the home stretch, and the media are only too willing to give broad exposure to every inflammatory remark and attack ad.

Every kingdom divided against itself is brought to desolation.”
Matthew 12:25, Luke 11:17

An encouraging counterpoint to the gloomy state of our politics is an article by John Tierney in the June 13th Week in Review section of the New York Times entitled “A Nation Divided? Who Says? ” This upbeat article points out that most voters are still centrists and that our basic differences have actually been shrinking over the past two decades. According to Tierney “…the polarized nation is largely a myth created by people in the Beltway talking to each other or, more precisely, shouting at each other…it’s not the voters but the political elite of both parties who have become more narrow-minded and polarized.”


I think we can sum it up at the outset and say that things are not going our way on the global scene. Events in Iraq and Afghanistan have soured both enemies and allies alike toward us. Adding to the enmity, it seems that the Bush folk seldom pass up an opportunity to stick a thumb in someone’s eye.

The perception of American omnipotence, a major stabilizing influence in and of itself, has been dealt a serious blow by our inability to force our will in Iraq, and the stain on America ‘s honor from the Abu Ghraib scandal has not helped either. Nor has our failure to follow up and finish the job in Afghanistan where elections have been delayed again due to killings of election workers and registered voters by a resurgent Taliban. Recently, NATO’s Secretary General made an unusual public plea for co-operation on Afghanistan and Iraq, stating that both are doomed to become failed states (read: terrorist incubators) if we don’t all work together to save them, and castigating the U.S. for ignoring NATO except when it wants something.

We are paying a big price in terms of blood, dollars and political capital in order to pursue our “war on terror.” Result: we have killed a lot of people but global terrorist activity has surged since in the years since 9/11, particularly since the Iraq invasion, to 20 year highs. Clearly our “war on terror” has not had the desired impact to date.

Reflecting the seriousness of our global position, the CIA has cleared the publication of a book entitled “Imperial Hubris: Why the West is Losing the War on Terror” by an active senior agent, Anonymous, who was in charge of the Bin Laden station at the CIA. Anonymous laments the “imperial mindset” of U.S. policymakers and predicts that unless we learn to view world events from the perspective of our adversaries, and thus learn to understand them, we are going to lose this war on terror. Michiko Kakutani has written an in-depth review of this important book.

For those who want to follow Anonymous’ advice, see Control Room , a documentary by Egyptian-American director Jehane Noujaim that looks at Al Jazeera’s coverage of the Iraq war. One insightful GI labels Al Jazeera the Muslim version of Fox News. Indeed, Al Jazeera recently announced an ethics standard of “balanced and sensitive” reporting.

China update: World stability was granted an extension in March when Taiwan ‘s independence initiative failed on a technicality: the election failed to draw the required 50% participation for the referendum to be considered valid. Tensions remain high in the area however, and not ones to miss an opportunity, the neo-con geniuses running the Pentagon have arranged to deploy seven aircraft carrier battle groups for what may be the largest military exercises in history off the coast of China and have invited Taiwan to join in. A typical deployment in a genuine crisis, like Iraq or Afghanistan, is three or four battle groups.

Not surprisingly, China has not taken kindly to this provocation. China will be conducting its own military exercises and has announced a crash program to beef up to a level able to counter seven carrier battle groups. Keeping in mind the Powell Doctrine that no nation should be allowed to challenge American military supremacy, a more muscular China will probably not be a stabilizing influence in Asia. Also, any bets on Japan ‘s response? And since it is China that is financing our debt addiction right now, might they decide to exercise a little muscle of their own and dump a pile of U.S. Treasuries on the open market, or maybe just stop buying?

Now that we are bogged down in two unfinished wars in Afghanistan and Iraq and stirring the pot in Asia, neo-cons are beating the drum for war against Iran. Numerous articles have appeared recently about the connection between Iran and Al Queda. The 9/11 Commission raised the question, “why did we go to war with Iraq when, given the rationale for the war, the case was actually much stronger against Iran?” The White House is “investigating” this matter. The Wall Street Journal in a June 14th editorial entitled “Coddling the Mullahs” called for applying the doctrine of pre-emptive war to Iran.

All of the above is promoting general instability in global relations and undermining the co-operative foundations of global trade. Western interests in general and American interests in specific are now and will increasingly come under attack first in the Islamic world and then elsewhere. If you are doing business or holding interests internationally and have not already done so, you would do well to develop contingency plans to deal with attacks on your interests and even on your person if you need to travel internationally.


No change here since the last letter. See the March ’04 letter, “The Home Stretch .”


Barring a sudden shock from one of the many potential sources of geopolitical or economic trouble, the Presidential cycle will continue to dominate. Stocks will continue sideways to higher into the election and probably into January. An alternative scenario is a sell-off into September followed by a rally to a new or secondary high in November or January. Rates will rise slightly for the time and more sharply after November and inflation and deflation will continue to co-exist side-by-side. With due consideration of the opening caveat, we are not likely to see any big trends or trend reversals developing prior to November but we are likely to see some market gyrations as positions are unwound going into the election and/or bets are put in place. Most likely is an uneasy peace between the bulls and bears.

One could say that the foundation of my macro outlook going forward is that efforts to manipulate endless “controlled” inflation and avoid recessions have introduced latent instability into the system and are doomed to failure. Recessions are natural corrective phenomena. With each corrective cycle that we charge our way out of, we increase the burden we must carry during the next expansion. This simply can’t go on forever and the longer we delay paying what we rightly owe, the bigger the debt will be and the more painful it will be to pay it. We can only violate natural law for so long before nature takes action to restore balance.

The power brokers in Washington have become highly skilled in manipulation and deception, so we have seen and can expect to continue to see many delaying tactics, but in the end I believe that we are going to experience a period of extreme dislocation as the accumulated excesses, weaknesses and corruption are purged from the system. The trigger for this purging could be economic or geopolitical, but once begun, instabilities in both spheres will feed off of each other until the process is complete.

Q1 ’04:   The Home Stretch

As we enter the home stretch of the presidential cycle the risk side of the ledger is laden with issues. In this letter I will highlight a few interlocking social, political and economic trends that will have a big impact in shaping our future and which bear monitoring as we close out this presidential cycle and move into the “piper paying” phase of the next cycle.

Aggregate Debt

The elephant in the issue room is aggregate debt. The reckless spending by the Bush Administration, aided and abetted by Congressional Republicans who have betrayed their heritage and the public trust, has pushed the federal deficit to its highest level ever — well over $500 billion in one year; closer to $700 billion by some counts. In addition, states and localities are in dire straights. California voters have just approved $27 billion in new debt, more than half of that just to cover deficit spending from the past two years. Household debt, excluding mortgages, has doubled over the past 10 years, increasing 10% last year alone. Despite an all time high in aggregate household wealth, driven by spiking home prices, personal bankruptcies are at record levels. The only bright spot in the debt picture has been the improvement in corporate balance sheets courtesy of the massive stimulus of recent years, to be paid for by John Q over the next two generations. But even this positive is being overshadowed by the record number of small businesses going bankrupt (a strange phenomenon in the middle of a recovery), and the troubles at the Pension Benefit Guaranty Corporation after two years of record failures by corporate pension programs.

Let’s face it. We are debt junkies. The IMF issued a loud warning in January that the U.S. is running up a foreign debt of such record breaking proportions that it threatens the financial stability of the global economy, further noting that the U.S. budget deficits are also reaching dangerous proportions. The twin deficits equaled well over $1 trillion last year. Moody’s has made some noise that it is contemplating downgrading U.S. sovereign debt. Maybe that would wake some people up.

And as sure as winter follows summer, following on the fiscal lunacy of the first Bush term will be increased taxes. If you have been employing any strategies to roll forward or otherwise delay taxes you should probably give some thought to paying up soon. Tax wise, it isn’t going to get any better and is inevitably going to get worse.

Fiscal Madness

On the fiscal side of things we have probably seen the end of the reckless run-up of the deficit as this issue has finally become a political liability for Bush. Thank God for that. Even so, much damage has been done and we are going to start paying the price after the election. Exactly how the price is going to be paid; how much pain we are going to feel and in what form is difficult to read right now. Investors are facing a dilemma. Both inflationary and deflationary forces are on the rise. Will either of them gain the upper hand, or will the crosscurrents continue, backing us into an inflationary recession? Considering that we have had precious little inflation resulting from three years of historic stimulus one would think that the weight has to be given to deflation. However, it’s not that simple. Stubbornly high oil prices, a weak dollar and spiking housing prices are a short list of things that are creating inflationary pressure. It’s worth noting that the esteemed Bank Credit Analyst is calling for steadily increasing inflation for at least the next two years. Their track record is enviable and their forecasts are not to be taken lightly.

John Mauldin has been focusing on this complex topic recently and I encourage my readers to consider his balanced assessment of the matter. Read the February 20th issue of Mauldin’s newsletter “Barbarians at the Fed.” The previous two issues, February 6th “The Unemployment Quandary,” and February 13th “The Bond Uncertainty Principle ” also shed light on this topic. In particular the Feb 6th issue contains a description of the debt supercycle taken from the Bank Credit Analyst. I recommend that my readers subscribe to this excellent free weekly newsletter at www.frontlinethoughts.com.

The following quote taken from the Feb 20th issue goes to the heart of the matter: “According to economic theorist Joseph Schumpeter, economic recoveries that are purely a consequence of fiscal and monetary stimulus must ultimately fail. Schumpeter writes: ‘Our analysis leads us to believe that recovery is sound only if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.'” (The Daily Reckoning) This seems to be pretty simple and straightforward to me, but simple wisdom doesn’t necessarily carry the day in Washington.

Like the dam builders of the Army Corps of Engineers who spent 100 years damming every river in America only to finally realize that they were violating nature’s law in a fundamental way and were doing more harm than good, it is my contention that policymakers will come to realize that their economic engineering has been violating natural law in a fundamental way and has also done more harm than good. We will have a serious economic crisis, or more likely a series of them, that will be exacerbated by the buildup of excesses caused by constant manipulation and failure to allow the natural purification cycles to play themselves out.


There has been a great deal of press lately focused on the issue of jobs, especially a heated debate about job outsourcing prompted by the President’s chief economic advisor Gregory Mankiw’s comment that outsourcing is good for us, as we send away the tedious jobs and will eventually produce more high end jobs by virtue of improved productivity. This is economic canon but of little comfort to the growing legions of American workers who are struggling to keep up. This argument assumes that displaced workers have or can gain the knowledge and skills needed to compete, overlooking the decrepit condition of our education system, which is not preparing its graduates for the demands of the increasingly high-tech, hyper-competitive global job market. Proponents of outsourcing are also ignoring the fact that, on balance, the jobs we are producing are paying 40% less than those we have been losing. This is a rather shocking statistic, not what should be happening according to theory, and not a very auspicious sign for “growing” the economy.

Capitalism on the steroids of advanced technology has unleashed a seemingly endless wave of “creative destruction” that is overwhelming the ability of many people to adapt. Like fighter pilots who black out in high performance jets that can perform beyond human tolerances, ordinary humans are being overwhelmed by the adaptive demands of our increasingly high-tech economy and culture. It’s increasingly a machine culture that we live in and we mere humans can’t keep up. This is one of the driving forces behind the steadily growing divide between rich and poor and the steady erosion of the middle class. Capital can keep moving with the relentless changes, and benefit from the huge productivity gains from technology. However, individual workers who have been downsized, Walmarted or otherwise displaced have to go through a long adaptive cycle and more often than not end up coming back in to the job market at a lower level than they were dropped out from. And they are not safe from further displacement after re-entry.

In the long run proponents of outsourcing are right but in the long run we are also all dead. Given the very real difficulties of the growing legions trying to keep up, and the hyper-partisan and polarized political environment, it is doubtful that we have the political will to tough out this cycle without resorting to a self-destructive binge of protectionism.


Conservative Republicans are determined to win the culture war at all costs, and the sudden appearance of gay marriage on the political scene has made this objective an imperative. As they see it, winning the war hinges on getting to appoint conservative judges to the Supreme Court, and that in turn hinges on getting George W re-elected. No price is too great to pay for this, and I do mean no price. With the country polarized to an extreme not seen in my lifetime and Democrats equally determined to get rid of Bush, expect to see new lows in political depravity, if that is possible, and growing enmity among Americans as a consequence. What is it they say about a house divided?


The situation in Iraq is deteriorating even as we move toward transfer of governing authority and a declared victory by the Bush administration. Violence is escalating as Islamic radicals have made it their purpose to deny victory to any effort to reshape Iraqi society by the U.S. This will be done by murdering any Iraqi’s who co-operate with the U.S. Ominously, the entire Arab world is beginning to close ranks around the cause of resistance to the U.S. campaign to “remake the face of the Middle East,” giving both popular and tacit government support to the radicals throughout the Arab world. See an illuminating Op-ed piece by Graham Fuller, former vice chairman of the National Intelligence Council at the CIA, entitled “A Sharp Point in Iraq’s ‘Pointless’ Violence .”

The world is seething with unresolved tensions and steadily growing resentment and resistance toward the U.S. In England, our strongest ally in the war against Iraq, 75% of the people feel that America is a negative force in the world right now.

For now, we are effectively forcing our will on an increasingly resentful world, but we can continue to do so only as long as we have the political will and financial resources to do so. We are suspect on both counts. Regarding political will, the Bush team is not desperate to get out of Iraq for nothing. Americans are simply not interested in shedding blood for Empire. In our hearts we are the defenders of freedom, not the imposers of our will on others. Most Americans don’t realize how far down the road of Empire we have already gone and how much it is costing us. Colin Powell put forth an eloquent statement of the Bush Administration’s global agenda in the January 1st issue of the NY Times (“What We Will Do in 2004 “). This is a noble vision but the practical, and most importantly for our considerations, fiscal, implications of imposing this vision are enormous.

We spend as much on our military as the rest of the world combined. The cost of sustaining our military “footprint,” which spans the globe, including the “arc of instability” from Columbia through North Africa and the Middle East to Central Asia, Afghanistan, Korea, the Philippines and Indonesia, with over 700 bases, is simply not sustainable. Sooner or later we are going to take that one last step which is going to break the fiscal camel’s back, if we haven’t already done so. Once that step has been taken domestic spending will first come under the knife, as it is even now. Note Alan Greenspan’s recent call for cuts in Social Security and Medicare. At a certain point, and it won’t take much, the domestic cuts will create so much political backlash that military spending will then come under the knife and we will have to start withdrawing our global deployment. It may happen gradually and we can hope for that. But it could also happen suddenly, in which case the withdrawal may look more like the evacuation of Saigon, only global. Either way, as the withdrawal proceeds, American interests will come under attack in its wake. We are sooner or later likely to end up “fortress America” for a long stretch. This does not augur well for the existing global economic paradigm. I once again refer my readers to “False Dawn ” by John Gray.

Another geopolitical issue to be aware of is that demographics are destiny. The West is aging. The U.S. is barely expanding its population; Europe and Japan are contracting. But the Muslim world is exploding. The average family in Pakistan, for example, has five children. This is a long term trend and it is going to affect everything. The fast growing Muslim world will invest its youthful vitality in economic competition or it will vent its frustration in violence.

Considering the fiscal and demographic realities, we would do better spending our borrowed money cultivating friends than bombing the daylights out of third world countries and threatening “shock and awe” for anyone who opposes us. Intimidation and violence can only take us so far and will create inevitable backlash down the road. As soon as we demonstrate any weakness we will begin to pay the price for our arrogance and violence.

One final thought on the geopolitical scene. There is growing concern among oil analysts that stubbornly high oil prices are here to stay, prompted by the emergence of China and soon India as big energy importers and the steady decline for decades now in new oil discoveries, which presages an inevitable leveling off and eventual decline in oil production. Unless we make a serious effort to find better ways to generate energy we are facing astronomical oil prices in the not too distant future. If Arab radicals get their way it will be sooner rather than later. Similar dynamics are in play regarding water and other natural resources. Resource wars are coming. Or are they already here?


It is very difficult to predict where the best opportunity is going to be at this time. We are certainly headed for a crisis of some sort, which will generate big changes, and where there is change there is opportunity. But there are two basic approaches to opportunity at this time and they are diametrically opposed. On one hand there are large and growing deflationary forces bearing down on the economy, and with so many stimulus cards already played any slowdown could get easily out of hand. Under this scenario cash is king; debt is death.

On the other hand there are also inflationary forces at work, including the above mentioned pressure on natural resources and the multiple efforts of our government, which is doing everything it can to stave off deflation. The manipulative capabilities of the U.S. government should not be underestimated. The Fed has announced that it is willing to take extreme measures to insure that deflation does not take hold, including revving up the printing presses, ignoring, for now at least, the history of disastrous consequences for those who have gone down this path. If reflation efforts are successful then assets are most desirable, and leverage even more so.

So where are the opportunities? To use an inverted sports adage, there are times when a good defense is the best offense. It is my opinion that this is one of those times. As a hedge it may be a good idea to buy some leap puts, as far out as you can get them. A modest position in gold and natural resources is a good idea, and currency diversification is also a good idea. In general, any leverage that you cannot hedge or get out of quickly is not a good idea. Various alternative investments remain excellent opportunities. See past letters for more specifics on alternatives and for other ideas.


Expect increased volatility in all markets this year and a resumption of the bear market after the election. Note that historically the presidential cycle peaks closer to inauguration day than election day. Stocks are most likely to finish higher this year, although considerably less so than last year. Rates are going to rise some time but every effort will be made to hold them down until November. After the election all bets are off. I expect that by the end of ’06 we will see the stock market testing the bear market low and possibly making new lows.

Upcoming events to be aware of:

March 20th – Taiwan votes on whether to increase missile defense against the 500 missiles China has pointed at it and whether to hold talks with China to normalize relations. China considers this referendum a step toward a declaration of independence and has vowed to take military action to reclaim the island if such a declaration is made. The U.S. is sworn to defend Taiwan. China is the primary buyer of US bonds. The Bush Administration is working feverishly to try to defuse this growing crisis. Would the U.S. abandon Taiwan in exchange for a currency float and/or a deal on North Korea?

June 30th – Karl Rove’s date for transfer of governing authority to the Iraqi interim government. Clearly Iraq is not ready but the election calendar must be accommodated. Can Iraq transition without civil war?