40% of the corn crop is converted to ethanol.  Without these subsidies, which directly cost $6 billion per year and indirectly cost much more due to the tariff on imported ethanol, far fewer rows of corn will be needed.  Some of the effects of this policy change will be – lower profits at gasoline refiners, lower demand for fertilizer, herbicide, and farm equipment, lower prices for corn and corn substitutes like wheat, rye and soybeans, lower food prices, and lower farmland prices.

The Obama administration’s and Fed’s persistent weak dollar policy somewhat offsets these forces.  Today’s vote clearly does not mean an end to U.S. food price inflation, but it does put it on a lower trajectory.  We believe that Ag stocks will not be good investments.  We are also now alert for cuts in subsidies and tax expenditures for other industries.  While such reductions are clearly good economic policy, they negatively affect asset prices in the targeted industry.  It is always good to end the government distortion of economic products and asset prices.  However when policies change, portfolios must be dynamically reallocated.

The dollar is as weak as it is because the Fed is perceived to be the central bank that has eased the most and the central bank that will be the last to tighten; the Fed is falling behind the inflation curve. By over-supplying dollars to the world, the Fed has contributed significantly to weaken the US dollar, impoverishing us all and threatening to deliver years of uncomfortably high inflation. Will someone please forward these charts to Chairman Bernanke?

via Calafia Beach Pundit.

The above four multi-trillion-dollar liability balls are staggering in their implications. Remember first of all that the nearly $65 trillion of entitlement liabilities shown above are not some estimate of future spending. They are the discounted net present value of current spending should it continue at the projected demographic rate (importantly – it is much higher than the annual CPI + 1% used as a discounter because demand for healthcare rises much faster than inflation.) And while some Honorable Congressional Le Pews would counter that Medicaid is appropriated annually and therefore requires no discounted reserve, those words would surely count as “sweet nothings,” believable only to those whom they romance every several years at the polls. The incredible reality is that the $9.1 trillion federal debt that constitutes the next-to-tiniest ball in our chart is nothing compared to unfunded Medicaid and Medicare. It is like comparing Pluto to Saturn and Jupiter. The former (the $9.1 trillion current Treasury debt) does not even merit planetary status in our solar system of discounted future liabilities. It’s really just a large asteroid.

via PIMCO | Investment Outlook – Skunked.

Traditional sources of funding health care in Europe have been branded obsolete and unaffordable. The need for innovation has never been stronger and while some countries, such as the Netherlands and Switzerland, are embracing change, others are resisting any significant overhaul. Indeed, the notion of free, state-backed health care is ingrained in the psyche of most Europeans.

Reformers want to reduce the state’s role in health-care delivery and introduce a competitive element. Those against change are adamant that a health-care system without state involvement is health care without a heart. Good for the rich, calamitous for the poor. It is an issue heavily clouded by emotion. But many feel that without innovation, crumbling state-backed systems will collapse as they struggle to cope with aging populations, soaring overheads and, more recently, mounting budget deficits.

via Europe’s Failing Health – WSJ.com.

Are their politics a matter of principle over pragmatics?  That is, should one trade a safe but liberal GOP seat in Delaware for a long shot Tea Party Senator?  What effect will Christine O’Donnell’s victory in Delaware have on the rest of the country?  Peggy makes more than interesting points while gripping the reader in urgency. – Russell

So far, the tea party is not a wing of the GOP but a critique of it. This was demonstrated in spectacular fashion when GOP operatives dismissed tea party-backed Christine O’Donnell in Delaware. The Republican establishment is “the reason we even have the Tea Party movement,” shot back columnist and tea party enthusiast Andrea Tantaros in the New York Daily News. It was the Bush administration that “ran up deficits” and gave us “open borders” and “Medicare Part D and busted budgets.”

Everyone has an explanation for the tea party that is actually not an explanation but a description. They’re “angry.” They’re “antiestablishment,” “populist,” “anti-elite.” All to varying degrees true. But as a network television executive said this week, “They should be fed up. Our institutions have failed.”

via Peggy Noonan: Why It’s Time for the Tea Party – WSJ.com.

Ineffective Policy – Besides being costly, this tax policy is ineffective, Goolsbee wrote. “The benefit of investment tax incentives does not go to investing firms but rather to capital suppliers through higher prices,” as well as to wage increases.It’s nice that equipment makers get orders, and it’s good that workers see higher wages than they otherwise might have. But if tax breaks are eaten up by price increases then the value of the tax break fades.

via Reagan, Obama, Summers All Wrong on Tax Credit: Amity Shlaes – Bloomberg.

Those who oppose higher taxes and are fed up with record levels of U.S. debt may pine for Ronald Reagan, the patron saint of lower taxes and smaller government.

But it’s worth considering just what Reagan did — and didn’t do — as lawmakers grapple with many of the same issues that their 1980s counterparts faced: a deep recession, high deficits and a rip-roaring political divide over taxes

via taxes-what-people-forget-about-reagan: Personal Finance News from Yahoo! Finance.

Supply-side economist Brian Wesbury now believes PDF that Democrats will extend ALL of the Bush tax cuts, even those for the “rich.”  Here are the three scenarios in which he sees this possibly playing out:Ideally, it would happen before the election this year. But this would require President Obama and the Democrats to turn dramatically, just when the public is paying more attention to politics. It would look opportunistic, it would demoralize some liberal voters and it would undermine the Democratic position that tax rates on the rich don’t matter that much to the economy.  How about in a lame duck session? If the consensus is right and Republicans take the House and make large gains in the Senate, it would give Democrats a chance to say they are listening to the voters. But in a lame duck session, Speaker Pelosi would still rule the House with little to no incentive to do the heavy-lifting needed to pass a bill. That leaves us with one more scenario for extending the tax cuts, the one loaded with the most taxpayer uncertainty, but which may be the most likely outcome. In this scenario, Congress fails to extend any of the tax cuts before the end of the year. All of the tax rates from 2000 – on everyone, from the “rich” on down – come back on January 1. Then, sometime in 2011, President Obama – his political advisers telling him to maximize growth going into his re-election battle – agrees to an extension but only through 2012, with all the lower tax rates made retroactive to January 1.

via Will Democrats Extend ALL of the Bush Tax Cuts?.

Last August left little doubt that a conservative revival was underway. Constituents packed town-hall meetings across the country to confront Democratic House members and senators ill-prepared to explain why, in the teeth of a historic economic downturn and nearly 10% employment, President Obama and his party were pressing ahead with costly health-care legislation instead of reining in spending, cutting the deficit and spurring economic growth.

Still, whether that revival would have staying power was very much open to question. A year later—and notwithstanding the Democrats’ steadily declining poll numbers and the mounting electoral momentum that could well produce a Republican majority in the House and a substantial swing in the Senate—it still is

via Peter Berkowitz: The Death of Conservatism Was Greatly Exaggerated – WSJ.com.

An already polarized political environment is becoming even more fractured by real and far less substantive issues. There is virtually no political center that can anchor consensus and enable sustained implementation of policy. Meanwhile, as anti-Washington sentiments rise, interest in a national agenda is increasingly giving way to the election cycle. Internationally, the impressive degree of cross-border coordination seen during the global financial crisis has been reduced to inconsistent — and at times contradictory — national responses.
This worrisome trio of increasingly ineffective national and global policy stances, intense political polarization and growing social pressures speaks to the risk that the economy’s recent soft patch will evolve into something even more troublesome and sinister.

I hope that sober policy responses will accompany the coming cooler temperatures. Given the proximity of the November elections, however, I worry they may not.

Mohamed A. El-Erian is chief executive and co-chief investment officer of the investment management firm Pimco and author of the 2008 book “When Markets Collide.”

via Mohamed A. El-Erian – Why another fiscal stimulus won’t do.

Looking back, the mortgage refi business also has roots in tax arbitrage.  It was a way to convert home owner’s equity into a stream of interest payments in a tax advantaged way often with AAA ratings for the lenders. – Russell Redenbaugh

We’re not witnessing a bond bubble in the making, we’re living in a statist nightmare. Bonds are not in a bubble, because they are priced rationally if you believe, as the market seems to, that the outlook for the future is grim.

The future, however, is not written in stone, and there is little reason—in my view—to expect that the current state of affairs is going to go on forever. But you have to be an optimist to venture outside the safe haven of ultra-low Treasury yields that only the pessimists are content to receive. Today’s bond market will prove to be a bubble if and when the people take back control of government from the statists currently occupying the White House and running Congress. I believe they will, come November. If you don’t, then go out and buy some of those Treasury bonds; you’ll have plenty of company.

via Calafia Beach Pundit: A bond bubble?.

California has created its own problems. The state’s money is more than gone, and the unemployment system is massively under funded. The normal solution is to renegotiate the retirement plan – the world’s most “generous.” However, political types have rigged it so these changes can only be made if the state is in bankruptcy or if the state constitution is changed. What great protection.

As our good friend John Hearne said, “Socialism ends when the government runs out of the other fellow’s money.” Well, California is there. They say tax the rich, but the California border states are already receiving a migration flood of wealthy people fleeing an oppressive CA tax code. Watch California closely. The result there will tell us how the nation will fare.

A stable value of money eliminates these panics and sudden losses. However, with our money backed only by the promises of politicians we often fall into mistrust about the future value. This is what Art Laffer calls a loss of “moneyness.” We can fix this loss of trust or “moneyness” by tying the money to gold. This worked for thousands of years and was in a loose form until Nixon broke the standard in 1973, creating misery for the next decade. Let’s go back to a dollar we trust.

Forget Inflation Targets, Go for Dollar-Price Stability by John Tamny

by Natalia Redenbaugh

The price of gold has been the best way to measure changes in price level over the past decade or so. It first fell in half, from $500 to $250, then rocketed up four fold to $1000. This “gold signal” directed buyers to move capital into housing as an inflation hedge. Housing’s appeal as a store of capital was of course augmented by the Clinton administration’s favorable changes in the housing tax code and their push to cause Fannie and Freddie to easily make mortgage loans to unworthy borrowers. When the Fed ultimately tightened, the bottom dropped out of the housing market.

Now the gold price is signaling firmer prices ahead for houses and other things. This is good news, as we can deal with inflation far better than deflation. Of course the best outcome would be a stable price level. This would create trust in the value of the U.S. dollar and zero inflation. However, our monetary masters want to fiddle with the money system. This tinkering gives the very savvy a chance to profit from the mistakes of the less well informed. Our only recourse has been to try to be among the best informed.

March 05, 2009
Policy Matters, Now Profit From It
By Russell Redenbaugh & James Juliano
As a follow-up to our previous piece on absolute return, we will now show you one of the ways to make money when others are not. Investors must expand on our absolute return approach to investing and use changes in government policy to direct investment across multiple asset classes.

Understanding government policy is the best way we know to see and anticipate changes in asset values; not merely stocks, but also bonds, currencies, real estate, commodities and foreign markets. Changes in policy impact the economy by altering the supply/demand for products, labor and capital. This in turn changes the relative supply/demand for stocks and other asset classes.

For example, simple economics says if you tax something you get less of it, and if you subsidize something you get more of it. Consequently, an increase in the capital gains tax rate decreases the value of stocks, while a government subsidy requiring that cars use ethanol fuel increases the price of ethanol.

These examples are clearly understood in the framework of basic economic theory. However, what is often misunderstood, especially by investors, is that policy changes often have large ripple effects in ancillary areas and asset classes. Henry Hazlitt taught that all of economics can be reduced to one lesson, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

It is now clear that implementing a government ethanol policy several years ago had a considerable impact on driving up the price of not only ethanol, but corn, food, farmland, fertilizer, tractors and farmers’ incomes. Investors must understand that the impact of policies can be enormous and far reaching. Small changes in one area can cause very large and unanticipated changes in another.

Not only is it a fool’s game to invest for relative returns, but it is also a fool’s game to invest in only one asset class, like equities. Investors must use a multi asset class investment framework, not only for diversification, but to fully understand and capture investment opportunities.

Which policies are important?

Every single government policy, even down to the local approval of a park, has some far-reaching impact on supply and demand. We break the policy world down into four domains. By examining what is happening in these four broad areas we can make assessments about which asset classes will provide opportunities for positive returns.

Monetary – Monetary policy encompasses all things Federal Reserve. We are believers in Milton Friedman’s teaching that “inflation is always and everywhere a monetary phenomenon.” Therefore, the actions of the Federal Reserve will always be inflationary, deflationary or neutral. This will have large and differing affects on asset classes.

Since well before 2007, the Bush administration’s Fed was running an erratic monetary policy. The current deflation did not truly end until around September 2008 when the Fed began adding excess monetary base to the system. This should have marked the end of the asset price decline, and in some asset classes it did. As the Fed’s monetary base expansion began and accelerated, collapsing spreads and improving credit market conditions sparked enormous rallies in asset classes like municipal bonds, investment grade corporate bonds and precious metals. An investor who ignored the impact monetary policy had on these non-equity asset classes missed some extraordinary opportunities for return.

Tax – Tax policy encompasses taxes on personal income, capital, dividends, businesses, interest, and death. We believe incentives matter, and tax rates change behavior. Importantly, the incidence of a tax can be different from the burden. The Obama administration is clearly hostile towards wealthy individuals, shareholders, estates and businesses, especially Wall Street.

We have no doubt that they will raise tax rates in all of these areas, and the recently released budget outlines the magnitude of some of those increases. These rate hikes are not merely to increase revenues, but to execute their fundamental goal of changing social policy through the tax code. They believe wealth is a consequence of unfairness. Just as monetary policy determines the inflation rate, tax policy determines the operating rate. No matter how high the spending “stimulus,” higher taxes will result in downward pressure on income, output and employment.

Trade – Foreign trade is the visible side of international capital flows. A trade deficit must mean a capital surplus, and any country that imports capital must run what is called a trade balance deficit. Foreigners must sell us their products to earn the dollars to buy our titles to capital – our bonds, stocks and buildings.

We believe that this free flow of capital and trade is the voluntary exchange by which the entire world becomes more prosperous. Capital markets cannot work if product markets fail to work through open trade. Obama campaigned on a platform of protectionism and is now delivering on his promises with tough talk against NAFTA and the inclusion of “buy American” provisions in the “stimulus” bill. If we want the world’s capital, we must take their products. Impeding that process is something we already tried…it was called the 1930’s.

Regulatory – Regulatory policy specifies outcomes that would not be produced by the markets. Some of these can be very useful, like food safety standards, seat belts and standard size rail gauges. We believe that regulation is beneficial, improves commerce, facilitates trade, protects both buyers and sellers, and can strengthen markets.

However, central planning derails the economy. This happened in the Nixon/Carter era and is threatening to happen again. Disastrous regulations imposed by Bush, like mark-to-market accounting rules and the elimination of the uptick rule, continue under Obama. These policies are worsening the financial crisis and adding uncertainty to markets.

The mother of all regulation lurking out there is cap and trade. Based on questionable and unsettled science, cap and trade will dramatically increase energy costs, lower output, increase unemployment, and cause carbon intensive manufacturing to shift out of the U.S. What’s more, closing our borders to the importation of those products will collapse our capital markets. This is not a prosperity friendly policy. We should not sacrifice our economy for uncertain science. We need more data.

How to Invest?

Watching policy tells you not only when to buy/sell, but what to buy/sell. While we think the Bush financial crisis is ending, the Obama central planning crisis is beginning. Our read of the policy landscape has us positioned in the following asset classes.

Remember, in our absolute return approach we do not care about relative results. Our default is 100% invested in risk free Treasury Bills and all other asset classes must compete to pry investment capital away from cash. We do not have to own anything and only put capital at risk when we expect a positive return. We never “play to lose less.”

U.S. Equities – A perfect storm of Bush administration bad policies created the 2008 financial crisis. The Bush administration continued terrible Fannie Mae and Freddie Mac regulations. The Fed botched monetary policy by keeping rates too low for too long, then too high for too long. Then in 2007, after there were already signs of trouble, the Administration implemented mark to market accounting and removed the uptick rule, shattering trust in the banking system.

The final straws on this collapsing camel’s back were allowing Lehman to fail, beginning the process of bank socialization and being unclear about uses for TARP funds. The financial panic was mostly solved by the Fed’s bold and aggressive action. The Fed correctly flooded the system with excess monetary base, thus ending the blackout in credit markets. So why are equities at new lows? Because equities are not pricing the end of the Bush crisis, rather they are forecasting the upcoming Obama crisis.

Equities are titles to capital and very long duration assets. In this way they differ from other asset classes like bonds, which are a stream of payments on a fixed schedule for a time certain. Equities are ignoring stimulative monetary policy and instead are looking ahead at the worsening policy landscape in the tax, trade and regulatory domains. Policies in these areas are anti stock market. We have reduced our equity exposure from over 80% in 2007 to around 30%. We intend to further reduce equity exposure so long as policies remain hostile towards shareholders.

Fixed Income: Almost no other asset class tells the story of our policy and economic situation better than U.S. Treasuries. During the October/November panic, T-bills traded at 0% as investors fled risky assets. This pushed longer term Treasury bonds to unsustainably high prices. We were happy to sell all Treasury bond holdings and move out the fixed income risk curve.

On the heels of simulative Fed policy we invested in municipal bonds and investment grade corporate debt. These areas have rallied over 20% from their October lows and, unlike equities, held onto most of those gains through today. Lastly, we invested in Treasury Inflation Protected Securities (TIPS). We see a perfect storm brewing for inflation as the Fed supplies excess money while Obama’s “stimulus” and tax hikes collapse GDP. This is textbook “too much money chasing a shrinking supply of goods”, and it’s reminiscent of 1970’s inflation.

Commodities – The same inflation scenario pushing us into TIPS is also pushing us into hard commodities. Precious metals prices are mostly influenced by their nearness to money. Other industrial and agriculture commodities prices are determined by an inflation component plus a supply /demand component. We have a small investment in gold and gold mining companies as a direct play on higher inflation. So far we have stayed away from softer commodities like energy, agriculture and industrial metals whose sustained price increases will also require an increase in economic activity. As in all of our investment decisions, we are not trying to call a bottom.

Real Estate – House prices are not too high, but they are falling. Measures of affordability indicate that houses are as cheap as they’ll get…until next month. The Administration is so far failing to grasp the idea that the “just one thing” to fix many of the economy’s problems is to stop the house price decline. We are watching for policies that will restore real estate markets to their normal state. Only then can we begin viewing real estate as a valid asset class for investment. We see no reason to be early into homebuilders, REITS or housing sensitive investments. When the time comes, there will be excellent ways to invest in this important asset class.

Foreign Equities – It will be very difficult for most foreign markets to do well if the United States does poorly. The U.S. is the world’s customer, and no entity can do better if their customer does poorly. Success in foreign markets is connected to growth and stability in the U.S. When U.S. policy improves there are many dynamic and innovative foreign economies that will represent attractive investment opportunities.

Counterintuitively, when the U.S. begins to imitate China’s and India’s tax cutting and pro business policies, this will be the moment to invest. Their young workforce demographics are a perfect counterbalance to our older, pre-retirement population. Demography is the only destiny that is inescapable. Investors will want to be positioned for the rising prosperity of 40% of the world’s population.

The Future

Like so many things in life, our investment strategy is easier said than done. Investors often get trapped into certain asset classes and styles. This is so common that the entire investment industry is arranged in this manner.

There are managers and funds for large cap growth, small cap value, high yield foreign bonds and countless more. They all promise returns based on long term reversion to the mean analysis of their style or asset class. However this boxed thinking limits their observations and prohibits them from using a larger, worldlier lens to shape investment decisions. Many investors know that policy influences the markets, yet they are unable to capitalize on the range of asset class opportunities. Their underperformance continues.

Investors must take a bolder approach. Focus on an absolute return strategy. Diversify across multiple asset classes. Stay tuned to timing. Be risk averse with the default portfolio in cash. This has and will continue to produce attractive returns with very modest risk of loss.

In the face of negative and worsening polices we outlined above, is it time to give up? Far from it. Now is the time for action. We believe the “just one thing” for successful investing is the ability to make assessments, regardless of the direction of their price impact. As policy improves, very large returns can be anticipated due to today’s extremely low valuation levels.

While we don’t know when policy improvement will collide with these attractive valuations, we will be ready for it. In the interim we won’t be holding and hoping for stocks to bottom. We will be “Reading the World” to assess where the policy winds create investment opportunities. To not do so is truly a fool’s game.

Russell Redenbaugh, CFA and James Juliano are portfolio managers for Kairos Capital Advisors LLC (www.kairoscapitaladvisors.com). Redenbaugh has built a 40 year investment career learning that the best way to build wealth is through anticipation of changes in government policy.

Don’t be surprised markets are falling. Markets will not turn until policy turns positive. What’s more, could our national security be in jeoaprdy? What if we have a threat from a foreign enemy? Where is the will and the ability to respond? This could be a great chance for an oportunitic and adventuring enemy, and that is much scarier than falling markets. Obama, get it together.

It all begins with housing. According to housing affordability data, house prices should have already bottomed. The National Association of Realtors’ data shows housing affordability at an all time high of 160 (meaning a family earning the median income has 160% of the amount needed to purchase a median priced home). Despite record affordability, house prices have not bottomed as they should have. Lack of confidence, selling pressure related to “margin calls” on underwater properties and banks’ frozen balance sheet have prevented a return to normal housing supply/demand economics. Our plan to fix housing begins with a spark to ignite the market and restore the proper supply and demand forces.

To bottom house prices we must affect the economics of housing supply and demand. We must decrease supply, increase demand, or both. Market forces have already done much to decrease housing supply, so let’s assume no policy is needed to keep new home construction down. So, how can we increase house demand and at the same ignite the economy? Simple. The plan is to offer a temporary tax holiday to any purchaser of an existing (not new construction) home. The amount of income that will be tax free should be scaled to the size of the home purchase (to keep it simple assume purchasing a $500,000 existing home would qualify you for a 6 month income tax holiday on $500,000 of income.) House prices would immediately bottom. Remember, we do not need to stop foreclosures. We need to stop house price declines. This will not help those people who never could afford nor deserve to afford their house payments. But for people on the edge, a 10% increase in house values will prevent them from having to foreclose. A 10% increase in house values would also save banks from having to write down more toxic mortgage paper and raise more capital. Lastly the income tax holiday would create a tremendous surge in work activity and ignite U.S. GDP almost instantly.

What is the cost of this plan? The cost of this plan is the amount forgone from lower income tax receipts. This would no doubt be less than TARP 2 and stimulus 2.

by James Juliano and Russell Redenbaugh

“Counter party risk in the U.S. is now being increased by the Federal government messing with contractual obligations of borrowers who pledge their house as collateral. Call it sovereign risk imposed on private markets. So, lenders and borrowers can no longer agree on what promise is being made, or assess what actions will be permissible if the promise is broken. Therefore, they cannot assess the sincerity or the capability of the promissory. The government, therefore, has created a new kind of uncertainty — adding to the barriers to commerce world wide, and decreasing the market value of the assets already on the books of the banks.” – Chuck

Mean Reversion – Longer Than Your Life?

China favors free trade, even if U.S. doesn’t
from Associated Press

U.S. labor groups that pushed hard for inclusion of the measures have argued that their main purpose is to ensure that U.S. Treasury dollars are used to the fullest extent to support domestic job creation.China has promised to avoid “Buy China” protectionist measures in its own multibillion-dollar stimulus effort, and appealed to other governments to support free trade….

President Barack Obama is expected to sign the economic stimulus package on Tuesday in Denver, Colorado

“The U.S. Senate late Friday night passed a $787 billion economic stimulus package by a vote of 60-38. The vote on the 1,071-page American Recovery and Reinvestment Act (H.R. 1) came hours after the U.S. House of Representatives approved the bill 246-183, with no Republicans supporting the bill. The bill is expected to be delivered to President Barack Obama’s desk for his signature by Monday. “

Capitalized economic profits valaution chart shows that stocks are extremely undevalues. This gap will close and can do so in 4 ways. 1. Profits fall. 2. Interest rates rise. 3. Tax rates rise (after tax profits fall) 4. Stock prices rise. Laffer thinks gap will close due to first 3 reasons, not because stock prices rise.

1. Profits will fall as a % of GDP. Can fall by almost 50% from now levels to lowest levels, so lots of room for declinel. Also, GDP growth will be small, maybe negative.
2. 10 year yield is lowest in any time in recent history. Expect that to rise substantially. Monetary base signaling inflationary environment. Perfect storm for high inflation and rising rates – falling GDP and rising excess base.
3. Deficit projected to be over 8% GDP, not including all the new stimulus spending. Government will start worrying about raising revenues, and will raise taxes.

Grand policy areas (and ideal policy)

1. Fiscal – (fiscal restraint and low flat taxes)

2. Monetary – (Stable money, stable currency)

3. Trade – (minimal impediment to free flow of goods, services and people across boundaries.)

4. Incomes – (minimal regulations necessary to achieve order and structure in society)

What is happening in the policy domains:

Fiscal – there is no stimulus in the stimulus package. There is no Keynesian multiplier effect. For government purchases of goods and services there is a one quarter increase, then crowding out takes effect and there is n0 multiplier effect. Transfer payments actually reduce GDP.

Monetary – no linear relationship between any of the alphabet fed programs (TAF, etc) and bank reserves. And it is bank reserves that matter – monetary base. Until September 2008 the fed was too tight. This changed dramatically in September 2008 and the base has grown rapidly since. Fed assets gone from 904 billion to 1.9 trillion (2X). Total reserves 98 billion to 916 billion (10X). Monetary base 860 billion o 1.75 trillion (more than 2X). There is no sense from the Fed of taking these reserves out of the system. Largest increase of monetary base ever in US history. No sign the fed knows what it is doing or how to control it. Expect inflation and rates rise sharply. This is much worse than it was in the 1970’s.

Trade – In Davos the administration made it clear that they are putting in “Buy American” programs. In Britain there were riots over hiring foreign workers.

Incomes – green legislation, first presidential executive order was to strength unions.

Overall, very bearish on U.S. equities. Bullish on Gold and Real Estate (Laffer is buying Kentucky farm land for his grandchildren)

The following notes are from Davis Malpass of Encima Global:

EncimaGlobal.com

So, the Fed continues to supply plenty of liquidity aimed at our financial crisis. In fact, markets are beginning to think it could end up being to much. The recent run up in gold and silver prices signal growing inflationary expectations. The Fed data explains these moves.

Economic Enemies of the State

Russian Debt Moves Toward “Junk” Rating

The Russian ruble dropped to new lows, threatening to test the level at which the central bank has pledged to defend it.

Today’s Headlines:

Tom Daschle withdrew his nomination to be secretary of Health and Human Services. President Obama said Tuesday he accepted the withdrawal “with sadness and regret.” Mr. Daschle had failed to pay more than $100,000 in taxes in a timely fashion, and his relationship with EduCap is under investigation by the Internal Revenue Service.

Nancy Killefer, nominated by President Obama to be the federal government’s first chief performance officer, is withdrawing from the post, the White House said. An administration official confirmed that she is withdrawing over a tax problem. “On the heels of Geithner and Daschle, she just didn’t want to go through with it,” the official said.

Cap and trade, which recently was mentioned by the new administration as a possibility in 2009, hangs over energy investments. Not to mention ii has the potential to cripple our entire economy.

The administration’s social engineering agenda is most disturbing. They are pro labor and middle class while anti capital and prosperity. They really think the stock market is a bad thing and capital gains are just for the “rich.”

Overall, this violent lurch to the left is much larger and faster than we expected. It is now clear why a simple fix to this mess, a change in mark to market accounting rules, has not been implemented. Simple solutions are not embraced because they do not provide cover for other large agendas.

Deflaiton Risk is Disappearing

This financial crisis is a great blessing for those who seek a much larger role for government. They can expand their favorite projects and programs while increasing their influence over markets and outcomes. We would never want to do these things and know they will result negatively on our economy.

“Let’s Stimulate private Risk Taking” by ALBERTO ALESINA and LUIGI ZINGALES

In virtually all economics classes, including those taught by the many excellent economists on the Obama team, the idea of government spending as an engine for growth is not a popular topic. Yet despite their skepticism of Keynesianism in the classroom, when it comes to public policy, these economists happily endorse a large stimulus package that could bring our deficit to 10% of GDP. Why?

One explanation is that these economists think this recession is an extraordinary one. In normal recessions — the argument goes — an increase in discretionary government spending is unnecessary and even counterproductive. But in the event that a recession becomes a depression, a Keynesian stimulus package might work.

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There are certainly economic models that show how government spending can shift the economy from a bad equilibrium (where people do not search for jobs because they do not expect to find them, and firms do not invest because they do not expect to sell), to a good equilibrium (where people search for jobs, and firms invest and generate demand for their goods).

But this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors’ fear. Thus, the problem is how to increase investors’ willingness to take risk. It’s unclear how the proposed stimulus package would help inspire investors to do so.

The second reason this recession is unusual is that it was caused in large part by a significant current-account imbalance due to the low savings rate of Americans (families and government). Even assuming that more public spending would increase private consumption — a big if — such a measure would cause even more imbalance.

So how do we stimulate the economy without increasing the already large current-account deficit? It’s not easy, but here is an idea: Create the incentive for people to take more risk and move their savings from government bonds to risky assets. There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.

If we fear this is not enough, we can temporarily increase the size of the capital loss that is deductible against ordinary income. This will reduce the downside of new investments and increase the upside.

In Today’s Opinion Journal
REVIEW & OUTLOOK

A ‘Responsibility’ EraThe Latest EntitlementHow to Save $40 Billion

TODAY’S COLUMNISTS

Declarations: Meet President Obama
– Peggy NoonanBusiness World: Can Obama Make Government Solvent?
– Holman W. Jenkins Jr.The Tilting Yard: George W. Is No Martyr
– Thomas Frank

COMMENTARY:

Symposium: Hopes for the Obama PresidencyLincoln’s Lessons for a New President
– Jay WinikJudge Obama on Performance Alone
– Juan WilliamsMore savings need to be invested, and firms need an incentive to invest in order to help aggregate demand in the short term and promote long-term growth. The best way to do this is to make all capital expenditures and research and development investments done in 2009 fully tax deductible in the current fiscal year.

A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. Such a switch will also be fueled by the temporary capital-gains tax cut mentioned above, which will motivate people to move their savings from money-market funds to stocks, increasing valuations, investments and confidence.

Many are concerned about what we can do to help the poor weather this crisis. Unlike during the Great Depression, we have an unemployment subsidy that protects the poor from the most severe consequences of this recession. If we want to further protect them, it is better to extend this unemployment subsidy than to invest in hasty public projects. Furthermore, tax cuts have a much better effect on job creation than highway rehabilitation.

No doubt, it is much easier to sell the public and Congress a plan for more public works than tax cuts, particularly while Main Street despises Wall Street — with some good reason. But the role of a good economic team is to courageously propose the right economic policy, even when it is unpopular. The role of a president is to sell it politically, as real change we can believe in.

Mr. Alesina is a professor of economics at Harvard. Mr. Zingales is a professor of finance at the Chicago Booth School of Business

Gordon Brown’s VAT folly should be a sharp lesson to Barack Obama by John Tamny

The Fallacious Notion of ‘Money Supply’
By John Tamny

Alpha Bets Turn Sour
Pennsylvania Pension Now Faces Billions in Losses
By RANDALL SMITH, Wall Street Journal

The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.

The potential hit to the $27 billion pension fund is the result of an exotic strategy used to help finance $9.2 billion in hedge-fund investments. Those bets helped the pension fund beat the market when stocks were rising, but backfired when the market sank.

Use of the aggressive strategy, called “portable alpha,” has been cut in half, with officials of the Pennsylvania State Employees Retirement System acknowledging that the pension fund’s exposure was “too large.”

Since stocks began falling, the fund has had to pay out $1.5 billion. Based on current market values of derivatives still outstanding, Pennsylvania could owe another $1 billion, a fund spokesman says. With the pension fund down about 14% in the first nine months of 2008, it is possible that the state will have to quadruple its annual contribution to roughly $1 billion in 2012, according to people familiar with the situation.

The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.

An estimated $75 billion or more has been invested using portable alpha. Other pension funds that used the strategy include the San Diego County Employees Retirement Association, with $8.1 billion in total assets, and funds in Kansas, Massachusetts and South Carolina.

Sean Mathis, a partner at business-valuation firm Mathis & Co., believes some pension funds were pulled into portable alpha programs without fully realizing the risk. “When all the hand-waving is done, what investors ended up with is a highly leveraged bet on the market and a slug of money in hedge funds,” he said.

Barring a turnaround, pension funds and other devotees of portable alpha “may find out that all they’ve done is paid a lot of fees and maybe lost a lot of money to boot,” Mr. Mathis adds.

The idea behind portable alpha is that it’s easy to match the market. If you do it using derivatives like futures, you can tie up less cash and get the same return you would using an index fund. Then you can use the rest of your cash to beat the market. The strategy gets its name from the ability to generate alpha, or above-market returns. As long as the returns on the remainder of your cash beat the futures’ cost, you outperform the market. Typically, investors turned to hedge funds that are supposed to beat the market in good times and bad to invest that cash.

Last year, Pennsylvania pension-fund officials said the strategy would pay off as long as returns on the hedge-fund investments topped the interest rate owed on the investments. That is what happened when the market was rising. From 2003 to 2006, the pension fund’s U.S. stock assets beat the market by an annual average of 6.2 percentage points.

But this year, the portable alpha portion of their portfolio, worth about $6.4 billion at the start of the year, is trailing the market by an estimated 15 percentage points, indicating that with U.S. and world markets down by 41%, they have lost more than 55% of their value. Fund officials say that, even with that setback, the strategy has generated $500 million in cumulative above-market returns.

Pennsylvania’s portable-alpha strategy was put into place by the fund’s former chief investment officer, Peter Gilbert, who built the program over a decade but stepped down in mid-2007 to become chief of the Lehigh University endowment. A Lehigh spokesman said Mr. Gilbert declined to comment.

Pennsylvania invested more in hedge funds than any other state pension fund. Those hedge funds returned 2.8% for the year ended in June, but their performance turned negative in the third quarter and has remained so thus far in the fourth quarter, according to a spokesman for the pension fund.

Pennsylvania spokesman Robert Gentzel says the pension fund has had to sell liquid assets to make cash payouts on swaps it used to implement the strategy, but that such sales weren’t unexpected. Assets had been set aside as collateral for the swaps, he adds. Portable alpha was pioneered in the mid- to late 1980s at Pacific Investment Management Co., led by famed bond manager William Gross, and by corporate pension-fund manager Marvin Damsma at Amoco Oil Co., according to the book “Capital Ideas Evolving” by Peter Bernstein.

A Pimco stock mutual fund using portable alpha has trailed the market by more than 10 percentage points this year. A spokesman for Pimco, a unit of German insurer Allianz SE, which has $1.5 billion in mutual funds using the strategy and another $30 billion for institutional investors, declined to comment.

Other bond managers with funds that used portable alpha to boost returns also have suffered. Among them is the Western Asset Management unit of Legg Mason Inc. Assets in the unit’s $5 billion U.S. Index Plus accounts were invested mostly in mortgage, asset-backed and corporate securities, which have been clobbered amid the market’s meltdown.

“I think this particular strategy is going to be pretty widely discussed, debated and re-evaluated,” says Jim Hirschmann, chief executive of Western Asset Management

Following article from Stratfor.com:

Geopolitical Diary: Iran’s Bond Announcement and High Hopes For Talks

Iran’s deputy central bank governor, Hossein Qazavi, said Nov. 19 that Iran is considering issuing a $1 billion international bond “to attract international investment,” seven months after it repaid its last bond. The issuance would be Iran’s first since 2002, and only its third since the 1979 Islamic Revolution.

Through a bond market, countries look to “sell” their debts to international investors by parceling them into portions that can be bought individually. Raising money through the bond market is often easier than getting a loan from one or several banks; because the debt is divided into portions that investors of nearly any size can afford, banks and/or individuals with less capital on hand can come to the table. By getting more players involved, the country that needs its debt serviced can increase competition over the bond and thus decrease the price it has to pay for it. Of course, for this to work, someone actually has to want to buy the bond. Unlike a loan that is negotiated with one or several financial institutions, a bond market works on the principle of a market. It rewards credit-worthy countries whose debts are highly sought after (due to the state’s perceived financial strength and, therefore, its ability to repay the “loan” plus interest), and punishes countries that are not credit-worthy. In those terms, forays into the bond market are risky, as they potentially expose states to investor scrutiny.

The current conditions in global credit markets make investment in Iranian bonds highly unlikely, as very few sovereign or private investors have any money on hand, particularly to buy risky bonds. But leaving this aside, Qazavi’s announcement leads one to wonder about the overall health of the Islamic Republic.

With oil prices poised to sink below $50 per barrel any day now, Iran is scrambling to cover its budgetary costs, with potential social unrest looming if various government subsidies — particularly those for gasoline, which refinery-poor and gasoline-guzzling Iran must import — have to be cut. Tehran is staring social unrest in the face, and desperate times might call for such desperate measures as begging cash-strapped foreign investors for $1 billion.

Another problem with the bond issuance in the current geopolitical climate is that it is unclear whether any European or Asian bank would dare to finance the bond. Since 2002, when Iran’s last bond was issued, the United States has specifically targeted Iranian banks, cajoling the European Union to stop doing business with certain Iranian banks and getting more than 40 international banks to agree to halt business with Tehran. In October 2007, Washington also designated several Iranian banks as supporters of terrorism.

Furthermore, the United States’ Iran Sanctions Act (ISA), currently in place until 2011, strongly discourages foreign companies from investing in Iran’s energy sector and pledges retaliatory sanctions against those who do. In his announcement, Qazavi noted that the bond issuance would let investors “safely invest and take part in various projects including petrochemicals” — investments in which the ISA specifically tries to discourage the participation of non-U.S. entities. It’s unclear whether the ISA would give Washington the authority to put Iranian bond purchasers under sanctions, but the possibility clearly exists, and it will be enough to deter already bearish global investors.

On the flip side, Qazavi’s comments might be evidence that the latest round of negotiations between the Americans and Iranians are progressing well, and that they might even be nearing a conclusion. Washington’s ultimate goal in the negotiations is to limit Iran’s influence in Iraq, while Tehran wants to limit the United States’ ability to roll forces eastward from Baghdad. Negotiations began as early as months before the U.S. invasion of Iraq, but ultimately stalled on the most important issues, as an emboldened United States rejected Iran’s offers for a comprehensive deal on Iraq. Iran responded to the rebuff by restarting its nuclear program, and by supporting Hezbollah in its conflict with Israel in the summer of 2006, as well as backing Shiite groups in a flare-up of violence in Iraq in November of that year. The two sides went back to the negotiating table after the 2007 U.S. troop surge.

With the United States and Iraq inking a Status of Forces Agreement (SOFA) that will lead to the withdrawal of U.S. forces from Iraq in three years, it appears that Washington and Tehran also are now close to a deal. Iran’s judiciary chief, Ayatollah Mahmoud Hashemi Shahroudi, confirmed as much on Nov. 18, when he said the Iraqi government had done “very well” in approving the SOFA. It was the first time Tehran had voiced any sort of approval of the agreement. The United States of course hopes that the Baghdad of 2011 will be able to resist Tehran’s influence, and that the troop withdrawal will therefore be possible.

Qazavi’s comments on the $1 billion bond, put in the context of ongoing negotiations, suggest that Tehran might be betting that talks with the Americans are near an end. A U.S. rapprochement with Iran would certainly place a stamp of approval on foreign investment in Iran. Without such a stamp, any bond issuance would make little sense. Therefore, Iran either must be desperate for capital due to serious economic problems, or preparing for a positive announcement on the negotiating front.

The government can restore a banking system that is failing. However, if it pushes loans that lenders otherwise would not have made, then this simply adds to the problem of bad loans. This was the original source of the current probems (i.e. Community Reinvestment Act.)

If the government replaces private capital with public capital, it drives out more private capital. Government can “get out of the way’ or “get in the way,” but they cannot create prosperity.

“This is Obama’s Market, Good and Bad“ by john Tamny

This moment in history is one that I though I would never see. Born in 1945 and raised in the 97% white state of Utah, my early experiences were in an environment in which racial prejudice was not a direct or first hand experience. My schools were all white, and they were not segregated. As a life long believer in Equal Rights, not racial preferences, this election was so clearly won based on the man, not his color. Obama is a man that every one can respect regardless of one’s political philosophy. His journey is truly a testament of all that is possible in our great nation. Raised by a single mother with a father who was not only absent, but living in a far away country, Obama’s climb to the Presidency is the definition of the American dream.

As a former U.S. Commissioner for Civil Rights under three Presidents, I celebrate the achievement of my country in electing an African American to our nation’s highest office. It is amazing to me that in my lifetime we¹ve gone from Jim Crow segregation to the election of Barack Obama as President. As an economist, I am one of many who worry about the economic costs of President Obama¹s policies. But also as an economist, I see that there is a substantial benefit to reducing the economic friction of race awareness, ending the “victim” mindset and increasing human potential.

Discrimination is not over, but Obama’s election diminishes the manipulative power of the race card. It takes away the excuses for why, “I can¹t.” It forces the youth of our nation to embrace opportunity instead of falling back on victim hood. Already in communities across my state of California, there is a palpable improvement in the mood between the races. Local leaders are beginning to hold youths who hang out on street corners to a higher standard. Something is already different.

Russell Redenbaugh
U.S. Commissioner on Civil Rights 1990-2005

Reserve bank credit expanded another 182 billion from last week. Total reserve bank credit is now just over 2 trillion, up from 1 trillion last year.

WOW!

Obama Should Form National Energy Council, Group Recommends

Nov. 6 (Bloomberg) — The Center for American Progress, a Democratic group led by a top official for President-elect Barack Obama’s transition team, is recommending that the new administration open an office in the White House to guide U.S. energy policy.

The report, which is to be released publicly Nov. 12 as part of a broad blueprint for the transition, will recommend that a National Energy Council oversee the work of agencies that have a hand in energy policy, including the energy, interior, state and agriculture departments, said Daniel Weiss, who works for the Center for American Progress Action Fund.

CAP’s president is John Podesta, co-chair of Obama’s transition team. The council would be patterned after the National Economic Council and the National Security Council, which have the president’s ear and coordinate federal policy in those areas. Weiss said he doesn’t know if Obama will adopt the idea.

“President-elect Obama has made it clear that a transition to a clean energy economy will be a central element of an economic recovery,” Weiss said. “It makes sense to have a coordinating council to ensure that agencies are working together toward that goal.”

Obama has said that he would like to generate 5 million clean energy jobs and cut down on global warming through the adoption of fuel-efficient cars, the use of renewable energy sources like solar and other efficiency measures.

Working With FERC

The council would be responsible for ensuring that climate change and energy policy are moving forward on parallel tracks. It would not oversee the work of regulatory agencies like the Nuclear Regulatory Commission or the Federal Energy Regulatory Commission, Weiss said.

Collaboration with FERC on things like siting power lines to ensure electricity can be transmitted to population centers like Chicago from wind-rich areas like the Dakotas would be important, Weiss said.

The recommendation to start the National Energy Council and details about how it will be structured were written by attorneys David Hayes, a member of Obama’s transition team, and Todd Stern, Weiss said. A phone call and an e-mail to President- elect Obama’s transition team officials were not immediately returned.

To contact the reporter on this story: Daniel Whitten in Washington at dwhitten2@bloomberg.net

Find out more about Bloomberg on iPhone: http://bbiphone.bloomberg.com/iphone

Yesterday’s election was a vote for more socialism. It is what the majority of voters want, and it may even be what a majority of public companies want. But it is a bad idea.

We define socialism as the use of government and public resources to protect people from the consequences of their actions. Under this definition, we already have a great deal of socialism here in the United States. The current Bush administration’s financial bail outs, whether necessary or not, are just like the RTC in 1990 and are another example of the government socializing the losses in real estate, mortgage and financial markets.

Many large companies, especially those whose growth is behind them, prefer government to protect them from both change (especially in the form of new competition) and the consequences of their mistakes. There are numerous examples of these types of companies in the auto industry, insurance industry, banking industry and even in city and state governments.

The stock market is comprised of companies that are already public, and thus is a measure of successful companies. Ironically, these already successful companies often prefer to be protected from upstarts, the unformed or even the unborn company. There is no stock index of unborn companies. The unborn companies are often incubated in the hatcheries of venture capital firms. They may also start as your average “Joe the plumber” small business or in the dorm room of an entrepreneurial college student.

Microsoft certainly prefers to be protected from an upstart like Google in precisely the same way that Digital Equipment and IBM wanted protection from former upstart Microsoft. In fact, it is clearly in the self interest of well established public companies to encourage and support an environment that strangles current upstarts while they are still in the cradle, thus preventing future competition. If this is doubted, think back to how many large public companies actually supported Sarbanes-Oxley given the knowledge that the law’s draconian accounting rules would keep many companies from floating shares altogether.

An environment meant to keep out the upstarts would be characterized by higher capital gains tax rates, more restrictions on trade and capital inflows, higher marginal income tax rates, mandatory health insurance, and greater regulation of products, lending, leverage and the environment. These are all changes that protect the established firms from upstarts eager to take their place at the top of the pyramid.

It is clear that we already have a great deal of socialism here in the United States. And we certainly did socialize some of the housing market with the passage of the 1978 Community Reinvestment Act (CRA), which forced lenders to make non-economic loans that would never have passed muster in a truly free market. The CRA’s failure revealed that lenders would have not made many of these loans on their own, yet despite the negative outcome, yesterday’s elections show that the electorate wants more of the same.

The political question we must ask now is, “Do we really want more or less socialism?” Do we want the government to continue to tell lenders how they must lend now that “they” have, as Barney Frank said last Friday, “our money?” Do we want the power in the hands of a Congress with a 20% approval rating, a rating somehow lower than even President Bush’s?

If so, there will be consequences to this apparent yearning for more socialism. That is so because tighter regulation, greater government control over the economy, socialization of losses, and more public influence over private decisions will create winners and losers.

The winners in the private sector will be those with influence in Washington, and who support the “enlightened” wisdom of those elected. The losers in this battle for influence are sadly tomorrow’s innovators and upstarts, the very unborn companies that presently have no stock market index or influence in Washington.

It is interesting to note that the socialist politicians of Western Europe in modern times, as well as the nationalist, socialist and fascist leaders in the middle part of the century were all put into power by substantial, popular majorities. The powerful winners of today by definition have more political influence than those companies interested in taking their place.

In the end, it is a certainty that a highly regulated economy is far more orderly, while an entrepreneurial, regulation-free economy is far more erratic. But rather than blanch, we should embrace the latter because it is thanks to the “spontaneous order” wrought by free economies that great companies are born.

So while there are those who might deserve punishment for their roles in this financial crisis, the question we must ask is, “Punishment at what cost?” Should the expense be so great that the U.S. and the world miss out on the next Google, Apple, or Microsoft? We think not. In that case, the price of a resurgent state would be way too high.

Russell Redenbaugh, CFA and James Juliano are portfolio managers for Kairos Capital Advisors LLC. Redenbaugh has built a 40 year investment career learning that the best way to build wealth is through anticipation of changes in government policy.

Investors are happily watching as credit markets improve. Since early October spreads across most markets have been contracting, signaling an end to the credit market “blackout.” The TED spread has fallen from over 4% to 2.65%. LIBOR has fallen from nearly 5% to 3%. Two through ten year swap spreads have collapsed, with the 10 year swap spread falling from 80 basis points to under 50.

However there is one loudly barking dog that no one, especially the government, seems to be paying attention to. That barking dog is GSE spreads.

The story was that these bonds were government guaranteed, but are they really? Recently, Federal Housing Finance Agency Director James Lockhart changed his language when describing the government backing of Fannie and Freddie from “explicit” to an “effective guarantee.” This roiled GSE debt markets a week ago, but these markets have been pricing in mistrust for much longer. Since the government took control of Fannie Mae and Freddie Mac on September 6th, the spreads on these two GSE’s versus treasuries have rocketed higher. For example the five year Fannie to government spread climbed from around 60 basis points to 150 basis points while the ten year Fannie to government spread widened from 50 basis points to 120 basis points. So what is this barking dog telling us?

We think it is a clear warning that the housing markets can not bottom until these spreads contract. Without mortgage money, there will be no housing bottom. If the only backing of GSE debt is the house prices, then these bonds should go to junk yields. If they go to junk yields, well then game over for housing. While James Lockhart’s unclear language made the markets jittery, even strong language about a guarantee would not have necessarily solved the problem. Language can not make the debt guaranteed; only government policy can. Until we see Congress address this issue with clarity and follow through with policy action, we remain skeptical that the government has any idea about how to save the housing markets. If and when they do the right thing to collapse these GSE spreads, we expect equity markets to celebrate with higher prices.

Fed rate cut is likely, but that’s not what matters via Calafia Beach Pundit by Scott Grannis on 10/29/08

Today’s blog is the result of a conversation I had with our housekeeper in which I tried to explain the failure of the investment banks in the simplest of terms. The widespread panic has trickled down in such a way that even our housekeeper is affected by it. Like many, she is gripped by panic and a lack of understanding. We thought my conversation might be helpful in clarifying what happened and in understanding how experienced, highly competent investors (handicapped by their own knowledge) failed to protect themselves and their clients. The cause was simply: Widespread, pervasive DISTRUST.

As a business anthropologist in the investment community (partner in Kairos) I am always watching people, particularly those networks of people that make up businesses and the market. To understand more about what happened in the market, I first explained how people act with trust or distrust. Have you ever had someone lie to you? Maybe not even lie but stretch the truth? Have you noticed how the distrust spreads? They may have stretched the truth about their competence in one area but knowing they exaggerated about one thing leads you to distrust them on unrelated issues. More obvious is when someone steals; say a housekeeper (not my housekeeper) pocketed a couple of dollars she found while doing laundry. You now begin to suspect that she has been stealing from you all along and this two-dollar incident leads you to believe she may have stolen hundreds of dollars. Perhaps you misplaced your earrings but you are now sure that the housekeeper must have stolen them.

It takes a long time to build trust. Unfortunately it can be destroyed in an instant. Now what if your housekeeper were to deny the incident, claim she never took the two dollars and you must have misplaced it? Distrust grows and there is no hope of rebuilding trust. The first step to rebuilding trust is to accept responsibility and offer to take action over time to rebuild trust. If you choose to salvage the relationship, you will give the person a chance to earn your trust back but it takes time and repeated, observable actions to win your trust back.

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

Now let’s take it one step further. Your housekeeper hasn’t actually stolen two dollars. You did indeed misplace it. However, you have been bombarded by friends’ tales of household help stealing from them left and right. You could possibly begin to wonder whether or not your housekeeper, like those of your friends, may be stealing and you just haven’t caught her yet. With this background of distrust you begin to watch your housekeeper with new eyes. Now the two dollars disappear and you think “aha” she is just like the others and jump to the conclusion that she is a thief even though she is not. This distrust may not be limited to your housekeeper. Now you begin to watch the gardener, the contractor and the pool man, anyone who could have the access and opportunity to steal from you. Distrust is dangerous because like a metastasized cancer, it spreads everywhere quickly. It destroys relationships, sometimes unnecessarily.

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

Before I could show Marcia, our housekeeper, how distrust toppled the investment banking industry, I needed to first show how businesses built trust and value. I started out explaining in an uncomplicated way how the market generally works. As our readers already know (but wasn’t as clear to my Brazilian housekeeper) businesses usually report earnings each quarter and set new targets for the next quarter at the same time. People buy or sell stocks in these businesses based on whether or not they trust that these companies will reach these targets and whether or not these targets will improve the valuation enough to warrant a higher stock price. Companies that achieve their targets over time build more trust. It takes many quarters and years to build a company’s reputation.

Now there are many “speed bumps” that can hinder a company’s race to their quarterly goal. These “speed bumps” can also make it more likely that some will reach their goal while others may not. I then gave examples of obstacles that could hinder a company’s growth. Rising gas prices would affect those companies, such as airlines and transportation companies, whose operating costs would rise. Trade regulations would affect those companies who rely on free trade to access customers in global markets. Tax increases could make the cost of doing business increase and reduce profitability. Requirements for healthcare could increase the cost of doing business and again affect profitability. Many of these “speed bumps” are the result of policy changes but sometimes they are the result of business operating problems. A failed product, such as an unsafe or unreliable air bag in a car, could result in a recall jeopardizing future sales. Management could change putting into question the competence of the new team to achieve a target. There are many events, incidences, and circumstances that can affect a company’s ability to grow and so I can’t list them all here. Suffice it to say, investors are always assessing these events, incidences and circumstance to see their affects on different businesses, their valuation and their future stock price. These “speed bumps” and a company’s failure to achieve a target generally result in a lack of confidence but a lack of confidence is different than distrust. It is generally contained to a specific set of circumstance and doesn’t affect other domains. The path for rebuilding confidence is usually clear.

What happened with this market is deep, widespread distrust. This is not a “crisis of confidence” but something much more powerful. Distrust. Distrust so great that it obliterated the century long business of investment banking. Now let me explain in more detail how it did this.

Before elaborating I need to remind you that policy incents people’s behaviors. It makes some assets more valuable than others. In 2007 there arose two policies that together with distrust unraveled the market. All of us remember the Enron and WorldCom scandals. These were moments of distrust in reporting of earnings that lead to swift action to rebuild trust. First the SEC made the management of these companies responsible for their actions. We all remember the indictments and Kenneth Lay. Secondly, they changed laws and regulations preventing such poor reporting from happening again. In distrust people always over react so there were many regulations put into affect, not all of them good. The issuance of Financial Accounting Standards Board (FASB) Statement No. 157 “Fair Value Measurements which became effective after November 15, 2007 commonly referred to as mark-to-market accounting changed how assets on balance sheets were valued. This required that public companies adjust their asset values based on the market value not book value of assets. In the past performing loans (an asset) would be valued at book value. If I had a $300,000 mortgage, which I had been paying on time for 10 years, it could be booked at its accrued value. FASB 157 now required that its value be adjusted to reflect the current market value of the mortgage. In a time of distrust when investors were selling these mortgages at fire sale prices, FASB 157 required that banks reduce the value of these assets, even those performing assets, to the amount they were sold at by the latest distressed seller. As more mortgages were sold at distressed prices, driving their value down with each desperate sale, banks had to repeatedly reduce the value of these assets on their balance sheets even if they planned to hold them for the life of the loan and not sell them in the current market. Compounding the banks’ problems were their requirements to maintain reserves to offset these assets. As their assets fell in value, their capital requirements rose. This is how Fannie Mae and Freddie Mac got into trouble.

The second change in policy that was the nail in the coffin for the investment banks, banks in general and AIG was the SEC change in short selling rules ending short selling restrictions that had existed since 1938. This allowed investors to sell securities they didn’t own even though the share price drops. This made it much easier to short thereby opening the market to short selling on a massive scale.

These policies, fueled by massive distrust, lead to an avalanche of falling valuations. This happened so quickly that the most experienced investors were caught in disbelief. In simple terms, here is how it happened. Many want to blame a few investors who they believed conspired to topple the investment industry. Everyone looks for blame in an environment of distrust. It may turn out that a few violated the law by conspiring but more likely distrust sparked a forest fire that couldn’t be contained.

Poor assumptions lead banks and borrowers to enter into mortgages that jeopardized their financial futures. Many people walked away from homes with the knowledge that these non-recourse mortgages bolstered by consumer laws favoring borrowers would minimize their exposure. As Warren Buffet says, “first there are the innovators, then the imitators and finally the idiots.” As people watched their neighbors turn in their keys and walk away from their homes, imitation followed as some neighbors concerned that their houses would continue to drop in value, followed their predecessors. Finally, people such as my contractor walked away from his home (though he could afford the payments) because he felt that his neighbors must know something he doesn’t. He didn’t want to be the last idiot left in his empty neighborhood. No one anticipated that homeowners, especially those who could afford their payments, would walk away from their home and default on their loans. The very thing that people feared, falling housing prices, happened as a consequence of their fear. This fear was fueled by a righteousness that they had been defrauded by their realtors, mortgage brokers and the banks into buying an asset that went down instead of up in value. This story could arise because there was already an air of distrust in this nation fueled by Bush. People began to distrust their government and this spread to other institutions.

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

The short sellers, again fueled by distrust, began shorting bank stocks. Rumors lead to short selling, rumors that experienced investors knew to be exaggerated and perhaps untrue. Many of them bet against the gossip as this approach had worked in the past. Unfortunately it is much harder to regain trust than it is to destroy it and so there was no time to stabilize the rumors before people liquidated their accounts and shorted the banks. To understand this, let me put forth a scenario. Suppose you had a group of friends. Everyone begins gossiping about one of your girlfriends. They say she is nearly bankrupt, her husband is about to lose her job, and they’ve been living beyond their means. Would you trust giving her a loan? You might give her a gift if you were able but you wouldn’t give her a loan. The rumor turns out to be untrue but you still wouldn’t loan money until you’ve observed over time that the rumors are false and she remains solvent. This is how distrust works. Perhaps the rumor started because she bounced a check. Rather than the cause being insolvency perhaps she simply made an error when balancing her checkbook that month because she was overwhelmed by her parental responsibilities. But after seeing neighbors evacuate their homes, people in distrust can jump to false conclusions. This is what happened with the banking industry in general, but the investment banks more so because they lacked the government guarantees.

The true weapon of mass destruction is distrust, which has reached its highest levels under George W. Bush. My friend John points out the distrust started under the Clinton Administration with accusations of “right wing conspiracies.” It was Clinton’s own denial of his affair with Monica that gave Bush a chance to beat the incumbent Gore. Of course Bush’s win by U.S. Supreme Court decision left half of the nation dissatisfied and prone to distrust. This distrust, which deepened in Bush’s second term, affected not only his administration but also spread to policymakers in general. Policy makers perhaps should have seen the consequences of these dangerous 2007 changes but there was little time. Alan Greenspan testified that he didn’t see it coming. Even Ace Greenberg, the wise investor who headed up Bear Stearns for as long as I’ve been alive, couldn’t see it and certainly couldn’t stop it. Personal phone calls by him to other investors couldn’t reverse the rumors. This man had more experience and integrity navigating markets than nearly anyone and even he didn’t have the clout to set the rumors straight in time to save Bear Stearns. The pervasive mood of distrust, and the policy changes that allowed people to act on this distrust, destroyed trillions of dollars of wealth in just weeks. Those experienced investors, ones that for years were able to make deals based on a handshake and their honorable reputations, were engulfed in the losses because all that they knew and had experienced to be true about rumors vs. integrity lead them to bet against the distrust. Now the investment banks no longer exist. After 100 years they are gone, possibly never to return. This business model failed. Even the giants like Goldman Sachs could not combat the widespread actions of distrust.

Though this conversation was aimed at revealing how the investment banks failed, I couldn’t help but touch on politics, as Bush and the pervasive distrust caused by his administration was the spark that ignited the financial forest fire that is still raging. It will take years to build trust here at home and abroad.
We’ve seen how this affected the global markets as banks stopped trading with each other. The Europeans blame the U.S. for the financial crisis. The U.S. citizens blame Bush for the growing deficit. This blaming of Bush bleeds over to all those associated with him or his party. The great advantage that Obama and the Democrats have is their lack of association with Bush. Bush and his distrust is an obstacle too big to overcome for McCain and other Republicans running for office. Fortunately, (or unfortunately) Obama will win, handicapped by a looming deficit and an impending deep recession. This will give the Republicans four years to re-group, mobilize around a more moderate policy plan, and emerge with a young candidate (probably Gen-X instead of aging Boomer) who rises from the ashes unscathed, unhindered by the distrust that plagues Bush and the Republicans now.

The Great Hedge Fund Unwind is Underway

We have been warning about deflation (see “It’s Deflation Stupid“) and are happy the Fed finally got the memo. Also, it was John Rutledge over a year ago who was talking about the need for the Fed to stabilize asset prices not consumer prices in order to end the “blackout.”

Here is a good explanation of what is going on by one of the world’s best investors, Bill Gross. – PIMCO Investment Outlook October 2008

The distinctions are: 1) emotional reaction, 2) pervasive mood and 3) economic and company-specific fundamentals. We define an emotional reaction as a market over-reaction that can be either positive or negative. These reactions are usually fickle, short lived and based on looking at part rather than the whole economic or financial situation. Investors often assume that the current issue is critical, long-lasting and perhaps permanent. During the 2003-2007 bull market there were multiple opportunities to “buy the dips” as investors emotionally sold the bad news of the day. In each of these moments it paid to go against the herd.

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

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

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

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

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

Monetary base, or high powered money, has expanded dramatically in the last two weeks, the first such correct move from the Fed since the crisis began around last August.
From our point of view the key is excess base growth, as Laffer defines it Monetary Base minus M1 (demand for money). We will eagerly watch the weekly fed releases for data confirming excess base expands at high rates; one week of data is not enough.
Total reserve bank credit (the balance sheet of the Fed) has roughly doubled but this is NOT a measure of change in system liquidity.
Total reserves have also doubled in the last two weeks and since last year but again this is NOT a measure of change in system liquidity.
The Fed has lowered the effective funds rate by about 75bp to about 1.25% by paying interest on member bank deposits held at the Fed.
Excess reserves have increase from $2billion to $68billion, these are reserves held by banks above the “required reserves.”

Our assessments are:

The Fed finally is adding liquidity. This may be too little, too late
The Fed must continue adding liquidity to keep excess base expanding.
It is very confusing and very hard to interpret Fed policy. This is increasing mistrust and risk aversion

The Recession Debate Misses the Point
By John Tamny

Second, some claim that starting to drill now would have no benefit since it will take 10 years or more to actually bring any oil to market. There are two things wrong with this view. First, new discoveries will begin to depress future prices immediately even if new supply is years in the future. Second, 10 years is not that long, and venture capitalists often invest with a horizon longer than 10 years. A little known facts is that anyone who invests in stocks actually invests with a time horizon much longer than 10 years. Our good friend and scholar, John Rutledge, writes, “Only 2% of the intrinsic value of the S&P industrials is based on profits earned within the first year…The first ten future years together account for only one-fourth of total value. And you would have to reach more than 30 years into the future to account for half of the market’s intrinsic value.”

If you think 10 years is too long, sell all of your stocks. We don’t think it is to long, and support drilling NOW.

Russell and Jim

New Evidence on Fat vs. Slim Governments: The Early Supply-Siders Were Right
via CARPE DIEM by Mark J. Perry

- The election is a clear choice. Not since 1964 has there been a more distinct choice between different strategies for what should be a shared goal – prosperity. But the candidates have a very different goal in mind. One of shared hardship or prosperity. A choice between big government and even bigger government. A choice between what humans are: are we incapable of caring for ourselves? or are human beings capable, responsible selves who make mistakes and learn from them?

- Obama say the top 1% has captured all of the growth, not that they produced it, by implying that the top 1% took it from the other 99%. He clearly has no grasp of supply side effects.

- Obama wants to raise taxes on capital gains and dividends. 1/3rd of Americans (100 million people) are invested in the markets. So how does he plan to cut taxes for 95% of Americans while raising taxes on 1/3rd of them? Who is Obama’s chief arithmetic advisor?

- McCain is beginning to show up as having more character than Obama. There were even times during the interview when it seemed as if Obama was being outright deceitful.

“Is Min. Wage Behind the .50% Jobless Rate Jump? “ by Mark Perry

Following excerpt from Wall Street Journal titled “Cap and Burn”:
For months, Democrats and the environmental lobby promoted last week’s Senate global-warming debate as a political watershed. It was going to be the historic turning point in U.S. climate change policy. In the event, their bill collapsed in a little more than three days.

That’s not to say that cap and trade won’t return in a more politically potent form next year. The greens will regroup and try to do a better job of buying off their adversaries, especially businesses that could profit from carbon regulation. Nonetheless, this past week has shown that the more transparent any cap and trade debate is, the less chance this tax and spend idea will become law

2009 Budget Masks a Major Tax Hike, from Investors’ Business Daily.

The dollar matters. And the change in the dollar is a product of many policies: tax, trade, regulatory, etc.

“Ben Bernanke Mentions the Dollar” by John Tamney, Realclearmarkets.com

Following excerpt from Stratfor.com

Nymex crude oil closed at $122.06, down 1.8 percent for the day and down nearly 10 percent since the key commodity hit its record high two weeks ago.

The reason for the steep declines of the past few days could be one of a number of things. Possibilities include, but are not limited to, congressional discussion of limiting futures trading (leading to a surge of investor money out of the energy markets); sliding U.S. gasoline demand in the face of sustained high prices; normal seasonal shifts in consumption patterns; and statistical revisions that made oil traders think that supply shortages were not a likely development.

www.stratfor.com

Hard Dollar by Larry Kudlow.

McCain, the Cap-and-Trader by Larry Kudlow

FIRST, A LITTLE HISTORY…IN 1972 THE DEMOCRATIC PARTY EMBRACED THE ONE MAN ONE VOTE RULE. THIS WAS A LURCH TO THE LEFT IN REACTION TO NIXON’S VASTLY UNPOPULAR PRESIDENCY. THERE WAS AN UNPOPULAR WAR, A FAILING ECONOMY AND THE START OF WAGE AND PRICE CONTROLS. ALL OF THIS WAS TO GET MUCH WORSE SOON.

THIS POPULIST PARTY NOMINATED GEORGE MCGOVERN. HE WAS SEEN AS THE ONE WHO WOULD SAVE THE COUNTRY, SAVE THE ECONOMY, AND RESTORE THE MIDDLE CLASS. HE WOULD GIVE EVERY AMERICAN 1000 DOLLARS, AND THAT WAS REAL MONEY BACK THEN. BUT THE PARTY, THE MEDIA AND THE PROFESSIONALS WERE NOT LISTING TO THE COUNTRY. INSTEAD, THEY WERE LISTENING ONLY TO THEIR OWN SOCIALISTIC DREAMS OF A UTOPIA WITHOUT DIVISIONS OF RACE OR CLASS – A UTOPIA WHERE MARKET FORCES DIDN’T MATTER.

IRONICALLY IT WAS NIXON WHO IGNORED MARKET FORCES AND COLLAPSED BOTH THE DOLLAR AND THE WORLD ECONOMY. ISN’T GOOD TO FOOL MOTHER NATURE OR MARKET FORCES, WHICH ARE ONE AND THE SAME, BUT I DIGRESS.

IN THE ELECTION THAT FOLLOWED, SOCIALISM WAS REJECTED AS MCGOVERN CARRIED ONLY ONE STATE, MASSACHUSETTS. HE RECEIVED ONLY 17 ELECTORAL VOTES WHILE NIXON GOT ALL THE REST.

SO NOW WE HAVE IT AGAIN, A TEST BETWEEN MARKET FORCES AND IDEAL SOCIALISM. DEMOCRATS OFFER A DREAMY CALL FOR CHANGE AND HOPE. I MYSELF PREFER ACTIONS TO “HOPE”.

Russell

Hilary Gets No Respect, from New York Times

Clinton, Obama Put Middle Class On The Wrong Path To Prosperity By RAFAEL RESENDES AND JOHN TAMNY | Posted Thursday, March 06, 2008 4:20 PM PT.

The news flow (every headline about margin calls and the worsening credit crisis) as well as sentiment/psychology internals (put call ratios/insider buying, etc.) all point to short term fear and panic. The long term valuation story remains intact as well. According to a Laffer Associates model, the S&P 500 is almost 100% undervalued when compared to capitalized economic profits (NIPA). This all points to “A” bottom.

However for it to be “THE” bottom we need policy change.
– Fed must get fed funds rate down to short term Tbill rate
– Fed must produce enough liquidity to stop housing slide
– Treasury and White house should guarantee Fannie and Freddie

These actions can fix the financial markets. We will still uncertainty about November’s policy change hanging over the markets. The threat of anti growth policies from the next administration will keep markets in a trading range until we can assess what 2009 and beyond will look like policy-wise. However, if the Fed does the right thing now, that trading range prior to the election could have an upward bias. If the Fed fails to act soon, markets will trend even lower, deepening whatever flavor of recession we are currently in.

The big questions for investors who want to build long term wealth going forward are where to place bets once the future policy direction become clear. We are searching for opportunities. – Jim

Greenspan was not great. He was an average chairman who improved a lot when Wayne Angel served and guided him to use the gold price as a policy indicator. But Greenspan seems to be far better than Bernanke. At least Greenspan was able to confuse Congress in a way that sounded brilliant and like he knew what he was doing. Greenspan could produce trust. When Bernanke talks I feel lilke shorting the dollar.

Russell

“Obama’sLead in Delegates Shifts Focus of Campaign By ADAM NEGAUNEE Hillary Rodham Clinton’s advisers made it clear that they were prepared to take a number of potentially incendiary steps to build up her delegate count.”

For the boomers, this would be seen as yet another betrayal. For the Gen X’ers who came out for Obama, this betrayal would mean they stay home in November and fall back into political resignation. – Russell

The more Hillary attacks Obama, the better chance he has to win. He challenges all the African American stereotypes which makes him appealing to white voters. Consider this: Obama is a young African American male without any dirt. If there was anything to find, Hillary would have found and exposed it already. He’s a squeaky clean, charismatic, hard-working candidate. His attendance record is impeccable.

McCain is a true patriot. As A POW, he is the only candidate qualified to speak about war. His “straight talk” campaign builds on the trust he’s already earned.

There are so many, especially in my generation, independents. These independents will entertain either of these candidates based on the issues.
This is the first time that my liberal, Vegan assistant and I are entertaining the same candidate: McCain. His integrity and experience appeal to us both.

This is not to say that McCain has my vote yet. With Obama quoting Reagan, I may consider him. As Art Laffer said, if Obama adopts Reagan’s economic policies “I’d vote for him.” Obama is a more positive, appealing young candidate who could easily get my vote if he goes “supplyside.” He’s an engaging beacon of hope. -Natalia Davis

Inconvenient Tax Truths by Pete DuPont

Seduced by a Super Model

Cherry Garcia and the End of Socialized Medicine by Peter Huber

The Age of Mass Innovation from the Economist.com

Let the Good Times Roll by John L. Chapman

A Vital Engine of Economic Growth by John L. Chapman

Blinded by the Derivatives Boom by Doug Kass

Following from Stratfor.com May 16, 2007 23 55 GMT

By George Friedman and Reva Bhalla

At long last, the United States and Iran announced May 13 that they will engage in direct public bilateral talks over Iraq. From Washington, it was the office of Vice President Dick Cheney and the National Security Council that broke the news. From Tehran, President Mahmoud Ahmadinejad confirmed that the two sides will meet in Baghdad in a few weeks, most likely at the ambassadorial level. That makes these talks as officially sanctioned as they can be.

Already there have been two brief public meetings — albeit on the sidelines of two international conferences — between senior officials from the Iranian Foreign Ministry and the U.S. State Department in March in Baghdad and in May in Sharm el-Sheikh, Egypt. The upcoming meeting in Baghdad, however, will be the first official bilateral meeting. After months of intense back-channel discussions, both sides have made a critical decision to bring their private negotiations into the public sphere, which means Tehran and Washington must have reached some consensus on the general framework of the negotiations on how to stabilize Iraq.

Why Now?

The U.S. political situation illustrates why both sides are willing to come to the table right now. Both Iran and the United States are closely eyeing each other’s busted flushes, and they understand that time is not on their respective sides.

>From the U.S. perspective, it is no secret the Iraq war has soaked up an enormous amount of U.S. military bandwidth. With the 2008 presidential election fast approaching, the Bush administration is left with little time to put a plan in action that would demonstrate some progress toward stabilizing Iraq. It has also become painfully obvious that U.S. military force alone will not succeed in suppressing Sunni insurgents and the Shiite militias enough to allow the government in Baghdad to function — and for Washington to develop a real exit strategy. But by defiantly sending more troops to Iraq against all odds, Bush is sending a clear signal to Iran that it is not in the Iranians’ interest to wait out this administration, and that the United States is prepared to use its forces to block Iranian aspirations to dominate Iraq.

>From the Iranian perspective, Tehran knows it is dealing with a weak U.S. president right now, and that the next U.S. president probably will have much greater freedom of action than Bush currently does. The Iranians learned that dealing with former U.S. President Jimmy Carter would have been preferable to dealing with his successor. If you know negotiations are inevitable, it is better to negotiate with the weak outgoing president than try to extract concessions from a strong president during an increasingly complicated situation. The Iranians also know that the intensely fractious nature of Iraq’s Shiite bloc — which Iran depends on to project its power — makes it all the more difficult for Tehran to consolidate its gains the longer Iraq remains in chaos.

U.S. and Iranian Demands

And so the time has come for both Iran and the United States to show their cards by laying out their demands for public viewing.

U.S. demands for Iraq are fairly straightforward. Our understanding of what Washington wants from Tehran regarding Iraq rests on these key points:

1. The United States wants Iraq to be a unified and independent state. In other words, Washington knows a pro-U.S. regime in Baghdad is impossible at this point, but Washington is not going to permit an Iranian-dominated state either.

2. The United States does not want jihadists operating in Iraq.

3. The United States wants to be able to withdraw from security operations, but not precipitously, thereby allaying Sunni Arab states’ concerns.

Essentially, the United States is looking to create an Iraqi government that, while dominated by the Shia, remains neutral to Iran, hostile to jihadists and accommodating to mainstream Sunnis.

Iranian Demands

Iran’s answers to these demands were publicly outlined in a paper at the Sharm el-Sheikh summit. The Saudi-owned, U.K.-based daily newspaper Al Hayat established the details of this paper in a May 5 article. The key points made in the presentation include the following:

1. Iran does not want an abrupt withdrawal of coalition forces from Iraq for fear this would lead to reshuffling the cards and redistributing power. Instead, there should be a fixed timetable for the withdrawal of U.S. and British forces from Iraqi cities and relocation at bases and camps inside Iraq, provided the Iraqi forces have reached the point at which they can provide security. The Iranians also stated that they would extend all possible assistance so that foreign forces could exit “honorably” from Iraq.

The U.S. decision to surge more troops into Iraq forced Iran to think twice about placing its bets on a complete U.S. withdrawal. An abrupt withdrawal without a negotiated settlement leaves more problems than Tehran can manage in terms of containing Iraq’s Sunni, Shiite and Kurdish factions, and Iran does not want to be left to pick up the pieces in a country that is already on the verge of shattering along sectarian lines.

It is important to note that Iran is not calling for a complete withdrawal from Iraq, and actually acknowledges that U.S. forces will be relocated at bases and camps inside the country. Though this acts as a blocker to Iranian ambitions, the presence of U.S. bases also provides Iran with a stabilizing force placating the Sunnis and Kurds. Moreover, the Iranians are sending assurances to the United States that they are willing to cooperate so the Iraq withdrawal does not look like another Vietnam scenario for the U.S. administration to deal with at home.

2. Iran is “strongly opposed to all attempts to partition Iraq or impose a federal system that allows for regional autonomy.” No region should be allowed to monopolize the resources in its territory and deprive other regions of the revenues from these resources.

Iran is essentially saying that Tehran and Washington have a common desire to see a unified Iraq. The U.S. insistence on a unified Iraq takes into account Sunni concerns of being left with the largely oil-barren central region of the country. Iran is signaling that it is not interested in seeing Iraq get split up, even if such a scenario leaves Tehran with the second-best option of securing influence in a Shiite-dominated, oil-rich southern autonomous zone.

3. Iran wants a plan, involving the Kurds and Sunnis, drawn up to root out the transnational jihadist forces allied with al Qaeda in Iraq. Sunni tribes should also assume the responsibility of confronting jihadists, whether they are Iraqi citizens or are from other Arab and Muslim countries.

In this demand, Iran and the United States share a common goal. The jihadists will use every attempt to sow sectarian strife in Iraq to prevent a political resolution from developing. The United States does not want to provide al Qaeda with a fertile base of operations, and Iran does not want its ideological nemesis gaining ground next door and working against Shiite interests.

4. Iran clearly states that the negotiations over Iraq cannot be separated from other regional issues and Tehran’s nuclear file.

Stratfor has extensively discussed the nexus between Iran’s nuclear agenda and its blueprint for Iraq. Iran is trying to link the nuclear issue to its dealings with the United States on Iraq as a sort of insurance policy. Iran does not want to reach an agreement on Iraq and then leave the nuclear issue to be dealt with down the road, when the United States is in a stronger position to take action against Tehran.

Iran basically is looking for a deal allowing it voluntarily to agree to freeze uranium enrichment in exchange for political concessions over Iraq, but without it having to dismantle its program. That would leave enough room to skirt sanctions and preserve the nuclear program for its long-term interests. Washington is not exactly amenable to this idea, which is what makes this a major sticking point. The United States already has made it clear that it is leaving the nuclear issue out of the Iraq discussions.

5. Iran wants a new regional formula that would make Iraq a region of influence for Tehran.

While it does not appear that Iran explicitly stated this in its presentation, a majority of participants at the conference got the message. Washington cannot afford to allow Iraq to develop into an Iranian satellite, but it is looking for assurances from Iran that a U.S. withdrawal will leave in place a neutral, albeit Shiite-dominated, government in Iraq.

Iranian Offers

The Iranian paper outlined several key concessions it would offer the United States and Iraq’s Sunni faction if its demands were met.

1. Iran would help the Iraqi government rein in the armed Shiite militias and incorporate them into the state security apparatus.

2. The de-Baathification law can be revised to allow for the rehiring of former Iraqi army personnel, the bulk of whom are tied to the Sunni nationalist insurgency. However, Iran wants assurances that former Interim Iraqi Prime Minister Iyad Allawi and other former Baathists will not be allowed to hold the position of prime minister when the time comes to replace current Prime Minister Nouri al-Maliki.

3. Iran would be willing to see fresh parliamentary elections, the formation of a new Cabinet and the amendment of the Iraqi Constitution to double the Sunni seats in parliament to 40 percent, with the Shia retaining 60 percent. Tehran has said nothing about what would be left for Kurdish political representation, however.

4. Iran has proposed the “fair” distribution of oil revenues in Iraq to satisfy all parties, especially those in “central Iraq,” the Sunni-dominated, oil-deprived heart of the country.

Tehran’s offers illustrate the Iranians’ open acknowledgment that they are not going to be able to have their cake and eat it too. Instead, they are going to have to guarantee Iraqi neutrality by giving the Sunnis a much larger slice, leaving the Kurds to get screwed yet again.

Back in Washington, the Bush administration is looking at the Iranian withdrawal plan skeptically. Right now, the United States wants assurances that a withdrawal plan worked out with the Iranians does not simply leave a longer-term opportunity for Iran to gradually take control of Iraq once the major roadblocks are out of the way. In other words, the United States needs guarantees that, as it draws down its troop presence, the Iranians will not simply walk in. The Iranian proposal to expand Sunni representation is a direct response to these concerns, provided the relevant parties can actually deliver on their promises.

This is still highly questionable, though significant developments are already taking place that reveal the United States, Iran and various Iraqi players are making concrete moves to uphold their sides of the bargain. With Iran’s blessing, the Supreme Council for Islamic Revolution in Iraq (SCIRI) has announced it will undergo a process of “Iraqization” — a largely symbolic demonstration that SCIRI will not operate simply as an Iranian proxy. Meanwhile, the Sunni tribes and clans in Anbar province are increasingly broadcasting their commitment and progress in combating transnational jihadists. And finally, numerous reports in the Arab media suggest the United States would be willing to heed the Iranian demand that the Iraqi military not have offensive capabilities allowing it to threaten its Persian neighbor.

The negotiations are moving, and it is becoming more and more apparent that a consensus is emerging between Tehran and Washington over how the Iraq project should turn out. With enough serious arrestors in play for this deal to fall through, it is now up to all players — whether those players call Washington, Tehran, Riyadh or Baghdad home — finally to put their money where their mouths are.

following by Larry Kudlow from Kudlow’s Money Politic$
Democrats Dooming Themselves to Defeat (My latest syndicated column.)

The Democratic Party may be convincing itself that it’s riding high in the polls toward a White House victory in next year’s election. But you know what? On two key themes — taxes and national security — the Democrats may be dooming themselves to defeat.

Watching the two presidential debates, one can’t help but notice the stark differences between each party’s approach to these core issues. And it’s hard to see how the general electorate is going to buy what the Democrats are selling.

To a person, each Democratic presidential candidate wants to undermine the global war against jihadist terrorism — wherever it may be, and especially in Iraq. The Democrats see a civil war in Iraq, where the Republicans view a growing al-Qaida threat. And while Republicans talk about significantly increasing the defense budget and expanding American force levels for all the armed services, the Democrats are hoping for some sort of Iraqi peace dividend upon immediate withdrawal — one that can be re-channeled into higher domestic social spending.

To a person, each Democratic presidential candidate also wants to raise taxes on the rich and roll back President Bush’s tax cuts. The Republicans, however, understand that those tax cuts have propelled economic growth and contributed to a stock market boom. And they recognize that Bush’s Goldilocks bull-market economy — which I call the greatest story never told — relies on extending the investor tax cuts and perhaps even moving forward with a flat tax or national sales tax.

Finally, to a person, each Democratic presidential candidate also has it in for corporate America. The Democrats discuss various punishments for business — especially oil companies, but also drug, utility and insurance firms. Not so for the Republicans, who talk about helping businesses and promoting entrepreneurship in our successful free-enterprise economy.

The differences between the two parties couldn’t be clearer, and next year the voting public will have a very stark choice. But with this election season only two debates old, that choice already favors the Republican position.

Think of it: The Democrats talk about ending “tax cuts for the rich,” all while bashing American corporations. But isn’t this the same tired message that sunk Al Gore, Mike Dukakis, Walter Mondale and Jimmy Carter? It’s never been a winner, and it’s going to help cripple whoever grabs the Democratic nomination next year.

And as former Commentary editor Norman Podhoretz has written, as the Democrats pay too much attention to the left wing of their party, their defeatist, weak-on-national-security riff may have already sunk them in 2008.

Consider this: When the appropriate time comes for a gradual troop withdrawal from Iraq, the voting public is far more likely to want a tough-on-defense president to negotiate the event. Go all the way back to the Korean War. Voters selected Gen. Dwight D. Eisenhower to negotiate withdrawal, rather than the much more liberal Adlai Stevenson. Or recall that in 1968 voters chose the tough-minded Richard Nixon to manage a pullout from South Vietnam, rather than the fuzzy-thinking Hubert Humphrey.

Here’s another example of the ever-widening void that separates each party’s stable of candidates, and of the fact-versus-fiction choice that awaits voters in 2008: House and Senate Democrats are in the process of crafting a five-year budget resolution that leaves out investor tax-cut extensions for capital gains and dividends. They say they are trying to balance the budget and increase tax revenues. Yet the latest budget report unequivocally shows that these very same investor tax cuts have paid for themselves.

Non-withheld income taxes — read cap-gains, dividends and income from small owner-operated businesses — hit a record high of $49 billion on April 24. So far this year, this tax-collection category has shot up 30 percent, while withheld income-tax collections at lower tax rates have jumped 17.5 percent.

In other words, the Laffer curve is working: Lower tax rates lead to higher tax revenues through a growing economy and a larger income base. By removing pro-growth tax cuts, the Democratic budget will actually slow the economy, diminish revenue growth and increase the out-year budget gap.

Ignoring all this, in addition to the reality of a 4.5 percent unemployment rate and Dow 13,000, is a Democratic triumph of liberal ideology over objective empirical analysis.

It’s also a recipe for Democratic disaster about a year and half from now.