Finance Digest for Week of April 5, 2004

WHY AMERICA’S ECONOMY IS GOING DOWN... IN ONE WORD, DEBT

We were being interviewed by a French financial publication and had been asked to explain why we were so “negative” on the U.S economy. “Debt levels are too high. The last time it was so cheap to borrow money -- back in the Eisenhower era -- total debt in the U.S. was less than 150% of GDP. In fact, it was almost always under 150% of GDP... except during bubble periods. Now, it’s higher than it’s ever been, at more than 300% of GDP. The New York Times tells us that the average family’s debt went up by 50% over the last 13 years... from $54,000 to $79,000. And over the last 18 months, the Feds have been adding to the national debt at the rate of $2 billion per day.”

KERRY’S ECONOMIC PLAN

John Kerry unveiled his long-awaited economic plan -- one that he says will create 10 million new jobs in the United States. It is an extraordinarily unambitious plan, one that relies primarily on two tax gimmicks of dubious value. One would penalize U.S. companies with foreign operations to pay for a cut in the corporate tax rate. The other would revive a discredited job subsidy plan that has been tried before and failed.

There are many problems with Kerry’s plan to tax the unrepatriated overseas profits of U.S. companies. The main one is that few other countries tax the foreign profits of their companies at all. Consequently, U.S. firms are already at a competitive disadvantage tax-wise. Kerry’s plan would make the situation worse, encouraging U.S. companies to reincorporate in other countries.

Kerry’s other bright idea is a new jobs tax credit, which would reward companies for increasing employment over some base period. This was also one of Jimmy Carter’s ideas, but it never worked. Although Kerry cites one academic paper in 1979 that found modest positive results from Carter’s program, he fails to note a much larger body of research that found the program to be totally ineffective.

THE JOBS REPORT FOR MARCH -- GOOD NEWS?

Bottom Line: More service jobs, fewer hours worked, anemic if not falling hourly and weekly income levels for those service jobs. And this is GOOD news? The market’s wisdom on the labor report is that it might justify a little Fed tightening... a chance for the Fed to painlessly extricate itself from the dilemma it is in. But despite the jobs data last week, you still have three overriding realities: debt, lack of consumer income growth, over-leveraged housing prices, and no savings. Can the Fed really afford to raise rates in such an environment? My guess: no rate increase from the Fed -- at least, not yet.

THE DOG THAT DIDN’T BARK

The Fed has screwed up, massively. And the result is, the United States is headed down the path to economic ruination. If you want a good explanation why, then look no further than the Wayne Angell article in the Wall Street Journal last Thursday, entitled “The Rubin Recession”. This Angell character was a member of the Fed Board of Governors from 1986 to 1994. So you would think that he would have a pretty good idea what he was talking about when he is talking about economics. But then you would be wrong, sort of.

The first sentence of the article sets the tone, as Angell blames the recession that started in “the third quarter of 2001” on -- and hold onto your hat because it is going to comically jump up off of your head when you hear this -- “the Clinton administration’s attempt to pay down the federal debt.”

You do not need a big brain to see what is coming. All you need to do is stop drinking heavily, lay off those prescription medications that have a mind-altering component, and take a look at some of the other times in history when people did what we, and I am talking about us Earth creatures again, are doing. And the one thing that you would notice, if you were paying close attention with your magnifying glass, snooping around looking for clues as to what is going on around you, is what you did NOT see. It is another famous case of the Dog That Didn’t Bark.

Specifically, you never read about a time when people used a fiat currency to expand government and its spending, multiplied by a massive fractional reserve system of banking, where everybody ended up rich and fat and happy. Instead, what you always read, and lots of times there are really neat pictures and photos with captions to make it a more interesting read, is how all the fiat-currency people went broke and died of starvation in utter poverty at the end of the boom-bust cycle, usually involved in some disastrously expensive and destructive war.

BILL GATES DETHRONED AS WORLD’S RICHEST PERSON BY IKEA FURNITURE CHAIN MAGNATE

The Swedish founder of the IKEA furniture chain has passed Microsoft Chairman Bill Gates as the world’s richest person, according to reports out of Sweden. Business weekly Veckans Affarer is set to report that Ingvar Kamprad holds a fortune of 400 billion crowns or $53 billion. This would put him $6 billion ahead of Gates.

In its most recent survey, Forbes magazine placed Gates’ wealth at $47 billion and had him topping the world’s richest list. Kampard, 77, came in at 13 on the list with $18.5 billion. The Swedes, however, believe that a weak US dollar has thrust Kampard to the top of the list since Forbes did its calculations. Kamprad is said to be on the frugal side, flying economy and driving an old Volvo. He keeps his wealth secure in tax-haven Switzerland.

IKEA founder denies being richest man.

The founder of Swedish furniture giant IKEA is not hurting for money, but the company he founded denied on Monday a report that he surpassed Bill Gates and Warren Buffett as the world’s wealthiest man. “This is completely wrong. It’s a mistake that is made all the time,” said IKEA spokeswoman Marianne Barner. “Estimating the value of the company, including all the stores, and saying it’s all Ingvar’s, that is totally wrong.”

IKEA claim sparks rich-list row.

A fierce debate has been sparked in Stockholm, after a business magazine argued that software tycoon Bill Gates was no longer the world’s richest man. But according to the furniture store, the magazine forgot that Mr. Kamprad has not owned IKEA since 1982. Veckans Affarer admits the anomaly, but insists that Mr. Kamprad still calls the shots at the firm, and so can be considered its de facto owner.

Gates still on top, according to Forbes.

A Swedish magazine created quite a furor when it reported IKEA founder Ingvar Kamprad was worth $52.5 billion, more than Microsoft’s Bill Gates. The news was picked up in publications around the world. IKEA later issued a terse press release stating that the information was incorrect, based on an evaluation of the entire Ikea Group. It then claimed that Kamprad does not own the group.

Based on Forbes’s estimates, Kamprad is very rich, but not as rich as the Swedish news weekly Veckans Affaerer estimates (nor as poor as IKEA suggests). The self-made Swede ranked No. 13 in the world, worth $18.5 billion, in our 2004 Billionaires list. That was a jump of $5.5 billion from the previous year, thanks largely to the strength of the Swedish krona against the dollar. But it was far short of Gates and his $46.6 billion.

This furniture fortune is certainly complicated. Kamprad has shrouded his business in an opaque collection of trusts and holding companies, in part to shelter IKEA from Sweden’s confiscatory taxes and death duties. But after seven years of delving into the fortune, we feel we have come up with a fair and conservative valuation method.

TAX CUTS HAVE LOWERED MARGINAL TAX RATES ON INVESTMENTS

President Bush’s tax cuts have lowered the marginal effective tax rate (METR) on new investments, measured as the share of an investment’s economic income needed to cover taxes over its lifetime, according to an announcement by the Treasury Department. According to the Treasury, reductions in personal income tax rates, including the lower tax rates on dividends and capital gains, enacted in 2001 and 2003 have reduced the METR in the corporate sector by 18% and in the overall economy by 16%.

“The temporary bonus depreciation provision enacted in 2001 and expanded in 2003 to 50% provides a potent short-term investment stimulus,” explained a Treasury statement. “This provision lowered the METR on new equipment investment from 24.8% to 13.0% in 2003, and could even reduce it further in 2004, the year the provision expires.”

MAN GROUP LAUNCHES NEW US TAX EXEMPT HEDGE FUND PRODUCT

Man Group, the world’s largest listed hedge fund manager, announced the launch of a new fund of hedge funds designed specifically for tax-exempt US investors. The fund, the latest in a series of registered products that the firm is launching in the US, will provide qualified investors access to the portfolio of an already established multi-strategy fund-of-hedge funds which has a ten year track record.

The structure of the fund allows eligible investors with tax-advantaged status -- pension plans, employee benefit plans, foundations and endowments, and individual retirement accounts (IRAs) -- to invest with a minimum of $25,000. This is Man Group plc’s first registered fund designed to eliminate unrelated business taxable income (UBTI) which is otherwise taxable to tax-advantaged investors. The fund is a closed-end investment company that uses a fund-of-hedge-funds strategy designed to preserve capital and generate attractive returns that have low correlation with traditional stock and bond markets.

RECOMMENDATION: REPLACE THE SCANDAL-PLAGUED CORPORATE INCOME TAX WITH A CASH-FLOW TAX

Americans have been inundated with financial scandals at large corporations during the past two years. In many cases, unethical behavior and poor oversight of corporate management are to blame. But a deeper look reveals that the flawed structure of the corporate income tax has been a key driver of corporate waste and inefficiency. The tax code distorts financial and investment decisions and spurs executives to hunt for tax shelters.

Three fundamental flaws in the corporate income tax are behind the distortions and tax shelters. The first flaw is that the corporate income tax rate is very high. Currently, the U.S. statutory corporate rate is the second highest among the 30 major industrial countries. That high rate reduces investment, encourages firms to move profits abroad, and provides incentives to push the legal margins of the tax code.

The second flaw is that the corporate tax base of net income or profits is inherently complex because it relies on concepts such as capital gains and capitalization of long-lived assets that are difficult to consistently account for in a tax system. Costs of capitalized assets are deducted through depreciation, amortization, and other rules. The tax rules for capitalized assets and capital gains are repeatedly exploited in corporate tax shelters. These rules also cause economic distortions as they interfere with capital investment, business reorganizations, and other decisions.

The third flaw is the gratuitous inconsistency of the tax code. Examples include the different tax treatment given to debt and equity and the different rules imposed on corporations and the half dozen other types of businesses. Such inconsistencies played a key role in the tax shelters exploited by Enron and other firms. Worse, they have created large costs to the economy by distorting capital markets and channeling investment into less productive uses. A cash-flow tax would eliminate these distortions and put all businesses and investments on an equal footing.

GORDON BROWN HINTS AT TAX BREAKS FOR LONDON’S FINANCIAL DISTRICT

UK Chancellor of the Exchequer Gordon Brown suggested that the government may be prepared to use tax breaks in order to maintain the City of London as Europe’s pre-eminent financial center. While opening the new European headquarters of Lehman Brothers in London’s Docklands district on Monday, Brown pointed out that the City accounted for 5% of the nation’s GDP, and was responsible for more financial serives firms in euro terms that any of the twelve euro-zone nations.

ISLE OF MAN FIRM ANNOUNCES “NEW CONCEPT” IN OFFSHORE INVESTMENTS

Isle of Man-based firm Linsure Management Ltd. has announced a new investment product that promises to be a “new concept” in offshore investment by putting money directly into the claims and litigation industry. “The investment opportunities created by these claims have traditionally been taken up by the major institutions, which meant that the private investor was not given the opportunity to take advantage of higher returns while enjoying the safety of an investment in which the capital is protected against falling,” the firm stated.

Linsure explains that the money is provided to solicitors to fund litigation cases using a conditional fee and loan agreement. When the case is won the solicitor repays the loan amount back to the fund plus fixed high interest. The offer is a fixed term, fixed interest growth investment fixed at a 3 year term. The capital plus interest will be provided on the expiry of the agreed term and there are no setting up costs and no deductions from the maturing proceeds.

ELLIOTT WAVE ADVISORY SERVICE HINTS THAT GOLD MAY BE TOPPING OFF

When gold prices rocketed to a 15-plus-year high last week, the bullion bulls seemed to rampage: “Now is the Perfect Hour to hold Gold” and “The next price spike for gold could be many times the past market high of $850/ounce” being typical headlines. Now, when gold prices plunged to a two and a half-week low this Monday, $15 down from their previous high, the bullion bulls were -- well-- still rampaging: “The game in gold is far from over,” “We see this fall as a “healthy pullback,” etc.

Opinions just do not come any more one-sided than this. But who cares as long as they are right, right. So -- are they? Well, nothing answers that question faster than the latest Commitment of Traders data, as presented in the April 5th Short Term Update. This picture -- which plots the positions of commercial hedgers and larger speculators against gold prices -- is more than worth its weight in gold. It shows that the net-short position of one of these two groups has moved into unprecedented territory to set a new all-time record.

THE DAY THE FED STOOD STILL

On the day when we expected it the least, The Fed stood still. It did nothing. It just stood by and watched. When gas hits $3.00 a gallon, we will remember that day as The Day the Fed Stood Still.

Thanks to runaway inflation in retail gasoline and a phenomenal rise in demand globally for goods and services for a world population rapidly moving in on 6.4 billion people, we are facing the most severe inflationary crisis since the oil embargoes of the 1970’s. It should be worse, mostly because credit inflation is bullish for goods price inflation. Credit is the foundation of speculative capital, and inflation is its offspring. It is growing up while we watch TV.

And in the face of this crisis do not expect the usual. Do not expect The Fed to do something about it. In the prior generation -- when The Fed was more independent and was not omnipotent -- it responded to rising prices by increasing the cost of borrowing money and reducing the amount of circulating currency, thus slowing down the rate at which supply chains passed along rising prices and preventing damaging forms of price competition (a natural occurrence during inflationary cycles). Yes, the economy slowed down along with it, but at least you could put some money into safe investments like money markets and U.S. treasuries and earn double-digit, guaranteed returns. No deflation, just safe, high-yielding safe-haven savings. All of that is now gone.

In its place today is a financial system that is structurally, theoretically, and actually flawed. Stocks are at risk, especially non-dividend bearing mid- and small-cap issues. Even dividend bearing stocks could suffer because of the effects of inflation upon the value of dividends over time. What may look like a good dividend yield today would calculate itself as a negative yield if consumer inflation rises beyond the 6% annualized threshold. Indeed, the aggregate yield on most stocks is already in negative yield territory. Bonds, especially treasuries that are currently in a deflationary crater of negative yields, would be pummeled into discount prices, creating huge losses for the biggest institutions that have used the bond markets for stability and safety for years. This points directly at the reason why The Fed Stood Still.

A BLUNT WARNING IN PLAIN ENGLISH

The National Association of Securities Dealers (NASD) issued an “Investor Alert” last September. You did not need to read it three times to get the point. It warned of the dangers of borrowing money to invest -- a.k.a., “trading on margin”. The amount of margin debt had exploded in 2003: The NASD said, “we are concerned that many investors may underestimate the risks of trading on margin,” and even called it a possible “sign that the speculative trading of the ‘90s may be returning.”

How did investors respond? With ever greater amounts of margin debt. “During the past four months ... margin debt has risen by an average of $21 billion a month,” according to smartmoney.com. The total is now a record $284 billion. The 75% increase in the past 12 months is “three times the average growth rate over the 1997-to-1999 period.”

So, a couple of weeks ago, the NASD issued a second Investor Alert. The language is not the dense legalese of someone covering their backside. It is a blunt warning in plain English, addressed to people who are using home equity loans “for the specific purpose of investing in securities. ... In short, investors who bet the ranch could lose it.”

“Unlike investing with savings,” it goes on to say, “when you invest with mortgage money, you stand to lose more than your principal if the investment goes sour. You can lose the collateral supporting the loan -- namely your house.”

THE FINANCIAL MARKETS ARE LEVERAGED FOR A CRASH

The financial press has been noticing that the small investor is still putting massive sums of cash into stock mutual funds, while corporate insiders are, on average, selling like crazy. The average investor, who has benefited from increased stock market prices through January 2004, is just like the major hedge funds who are sitting on “pins and needles”. They have one finger on the buy button and another finger on the sell button and are ready to jump one way or the other at a moment’s notice. We predict that before the spring of 2005, the vast majority of investors and hedge funds will be hitting the sell button.

The problem for the American investor and, consequently, world stock and bond markets, is excess and unsustainable leverage. Stock and bond prices can only be sustained if interest rates are held artificially low. The riskiest stuff such as internet stocks, junk bonds, and emerging markets, have gone up the most in price and are “flying pigs” priced for perfection. The financial markets need constant jolts of new stimulus to keep them up in the air. The capital markets have become one massive casino – anyone and everyone can come in and play and everyone’s credit is good! Our financial system supports about $35 Trillion of debt and we have virtually no savings. Very few people believe they are gambling with their own money because borrowing with other people’s money to place the bets has become so easy.

The capital markets have become one massive casino -- anyone and everyone can come in and play and everyone’s credit is good! Our financial system supports about $35 Trillion of debt and we have virtually no savings. Very few people believe they are gambling with their own money because borrowing with other people’s money to place the bets has become so easy. Even the average patriotic homeowner with a variable rate mortgage is borrowing short-term to buy stocks, and to pay the bills. The NASD has finally come out and warned brokers that they should not be suggesting to their individual clients to borrow against their houses to buy stocks (see story immediately above). This warning may be too late!

The situation today could be much worse than 1929. In 1929, the major fault in the financial system was stock market leverage. In the 1920’s, stocks could be bought with 10% down. Those who waited to sell stocks were crushed. The problem for our financial system is that in many asset classes, the leverage is more extreme than that. In order to run a leveraged position in mortgage-backed securities, a firm may only need 5% equity -- a 5% fall in prices is not major and can occur very quickly, but could wipe out 100% of a financial player’s equity.

Moreover, the direct leverage in the financial system is only the tip of the iceberg of total leverage. Our financial system is held together with more than $150 Trillion of notional derivatives and “spit and bubble gum”. A crash in stocks or bonds will shatter the derivatives market. It is inevitable that major counter parties to these contracts will fail. When that occurs, you do not want to be on the other side of the trade. Indeed, the U.S. financial markets are nothing more than a huge “Long Term Capital.” The pressure points are everywhere. In the silver, copper, gold and other commodity markets, the open interest in long and short futures positions dwarf the actual physical markets. In many cases, the short financial derivative positions in financials can not possibly be delivered in physical form. Exchanges will suffer financial distress and likely need aid; smaller counter parties will be wiped out. Brokerage firms will fail. The biggest hedge funds and derivative players, as well as one or more Wall Street firms, may need to be effectively taken over by our central bank.

Ultimately, if an investor is risk adverse, there are very few places to keep your money safe. Holding gold coins works because, by weight, the value is high. For silver, if you have a safe place to store it, physical holding is certainly preferable to leaving it in any financial institution or exchange. Short-term Treasuries, bank CD’s (but only up to $100,000 per institution), I-bonds, and TIPS are a wonderful place to sit out any potential storm. Asset managers who run bearish funds are worth a serious look.

This spring would be an opportune time to go to cash using any rally to get liquid, and out of margin debt. For the average investor who is risk adverse and for any investor who considers losing a dollar, worse than making a dollar, our advice is to get into cash and be prepared to wait until early 2005. Good hunters know how to wait and good things happen to those who are patient, like buying what they like at half price! But remember, you can only afford to buy assets at a discount if you have the cash. If you understand this, you can truly appreciate Warren Buffet’s greatest secret -- having the patience to sit on cash (currently over $32 billion) earning little but losing nothing, until the great deals come his way! Nothing beats cash and patience in the long run.

MOST AMERICANS TO USE TAX REFUNDS TO PAY HOUSEHOLD BILLS

Nearly seven out of ten Americans who have already received or are anticipating a tax refund this tax season, plan to spend it on everyday items or paying bills, according to a recent survey by Cambridge Consumer Credit Index. “While the results indicate good news for the economy in the short term, they also indicate a more worrisome trend that an increasing number of Americans are relying on their tax refunds for everyday purchases and paying bills,” observed Jordan Goodman, a financial analyst for the CCCI.

WHO IS WINNING AND WHO IS LOSING OUT IN GLOBALIZATION

I am often asked why I am so bearish on financial markets right now. The answer is that man behaves even more poorly as a political animal than he does as a rational economic one. And the world’s financial markets are more and more driven by politics... on a global scale. It is a trend, unfortunately, that is gathering momentum, from bombings in Madrid to assassination attempts in Taiwan to successful assassinations in Gaza. None of this is good for markets. But political change does not happen haphazardly. It is driven by economic change. And some regions are going to do better than others in the future. The questions are: which regions, why, and how do you profit? To answer those questions, you have got to understand who is winning and losing out in globalization.

The globalization process of the ‘90s used to look like nothing but good news for the affluent West. Western economies outsourced the production of manufactured goods to Asia and got lower prices in return. And for a while, this had no immediate effect on Western job markets, or the direction of global capital flows. In fact, capital flows favored the West, too. High-saving Asian countries loaned us capital on the cheap or bought our financial assets and supported our bond prices. And every so often, Western capital poured into an emerging market, created an asset bubble, took profits, and moved on for the next high yield.

But the unintended consequences of globalization are only now making themselves apparent. And if I am right, they are not good for the unprepared investors. Falling financial asset prices, rising prices for commodities and raw materials, lower average incomes, and a much, much more competitive world appear to be on the horizon.

The rest of the world perceives America as a hotbed of technology-driven research and development. As such, America will continue to attract capital and interested risk-takers, as well as new technology businesses. But given Asia’s manufacturing advantage and India's ability to provide low-cost professional services, the U.S.’s role in these two areas is coming under pressure. These are generalizations, of course. But if market forces hold sway, I think these trends will more or less hold true for the next 50 years. Shifts like these cannot help but lead to, and in fact have already begun to create, significant social and political disruption. But more important in the United States today is financial disruption -- that is going to come first.

THE COMING GENERATIONAL STORM

“In 2030, as 77 million baby boomers hobble into old age, walkers will outnumber strollers; there will be twice as many retirees as there are today but only 18 percent more workers. How will America handle this demographic overload? How will Social Security and Medicare function with fewer working taxpayers to support these programs?”

While some boomers are hopeful we will not hobble into old age, these are the very reasonable questions asked by Larry Kotlikoff and Scott Burns in their guaranteed to be controversial new book, hot off the press, called The Coming Generational Storm. I have often written about the coming demographic problems facing our nation. This is a topic I have researched at length. Yet reading The Coming Generational Storm, I was constantly confronted with new facts and analysis. Some of the facts amazed me. Some of it was disturbing. Kotlikoff and Burns not only offer solutions to the coming problems, but personal financial advice to deal with the implications of their conclusions.

We are going to look at some aspects of this book at length, but before we do, let me strongly suggest that this is a book you should buy. In fact, some of you should buy two. Those who have a relationship with their Congressman or Senator should put the second copy in their hand. If you have adult children, you should buy them a copy as well. Links to Amazon.com are at the end of this article.

The point of the book is NOT their proposed solutions, but the very convincing presentation of the magnitude of the problem and a step-by-step plan for protecting your own retirement funds. It helps that Scott is a very, very good writer who can make the complex very simple. It also helps that he has a sense of humor and quick wit. Unless you are well-off or plan to die within 10 years, this “Coming Generational Storm” is going to affect your retirement plans and ability to fund a reasonable retirement.

REAL ESTATE BREAKS HARD

As this year began, the U.S. housing market was in (or close to) record territory by nearly every statistical measure: the percentage of families that own homes, housing starts, housing permits, new and existing home sales. Mortgage rates were at 40-year lows, the number of real estate agents at all-time highs. I could produce reams of enthusiastic quotes about how rosy this scenario would be for 2004, including claims that “This ‘bubble’ won’t POP!” Our opinion in February’s Elliott Wave Financial Forecast could not have been more starkly contrasting: “January brought several indications of a top in real estate prices.”

The EWFF discussed one of these “indications” at length, specifically the growing celebrity of the world’s best-known real estate developer, Mr. Donald Trump. EWFF noted, “Trump, one of the great heroes of [the bull market], is a master at climbing into the limelight near important market peaks.” The REIT index chart that accompanied the article made it clear how true this was. Well, it is starting to appear as though The Donald has done it again. An exchange-traded fund that mimics REIT indexes just saw its largest decline in some 18 months -- as shown in the chart below.

CENTRAL BANKS AIMING FOR WRONG TARGET?

Sir Andrew Large, deputy governor of the Bank of England, has been pondering the rapid build-up of household debt in the United Kingdom over recent years. The Bank, apparently, looks at household debt from two perspectives: will the rising burden of debt lead to a crisis at some point in the future or will it interfere with the Bank’s duty to meet the inflation target set by the Chancellor of the Exchequer? While it is natural that the Bank address these difficult questions, it ignores a far more important issue; namely, whether the pursuit of consumer price stability by central banks around the world has itself become a potential source of financial instability.

The 1920s were a decade that resembled in many respects our own age: there was strong productivity growth, great technological innovation, and a rapid growth in credit. It was also a time when great faith was placed in central bankers, who were believed to have ushered in an era of endless prosperity. What policy did the Federal Reserve Board implement in order to bring business depressions to an end? A policy of consumer price stability, naturally.

Some economists, among them prominently Friedrich von Hayek, argued that the Great Depression was the inevitable consequence of the Fed’s misguided pursuit of monetary stability. Their argument runs as follows. Consumer prices in a dynamic economy have a tendency both to rise and fall. In a period of technological innovation and rising productivity, such as the 1920s, when more goods are being produced with the same amount of inputs, prices will tend to fall. In order to prevent prices from falling, the central bank must set the market rate of interest at below its “natural rate”. This is what the Fed did in the 1920s, thereby causing investment and credit to expand rapidy.

In most periods, such a fast growth of credit would have produced consumer price inflation, but in the 1920s it mere offset deflationary forces in the real economy and promoted speculation in real estate and stocks. Rising asset prices were used as collateral for yet more credit creation. For as long as the boom continued, a virtuous cycle operated. When it came to an end, a vicious cycle ensued: falling asset prices impaired collateral. Credit took flight. People paid off their debts whenever possible. The money supply collapsed along with bank liabilities. A depression ensued. The recent experience of Japan lends further support to the views of Hayek and his followers.

Modern central bankers believe that economic stability is best achieved by pursuing stable consumer prices. But both history and economic theory suggest that there is little comfort to be derived from the fact that a central bank is meeting its inflation target. On the contrary, a combination of strong credit growth, low inflation and asset price inflation has in the past presaged economic catastrophe. The Bank of England should be explaining to us what reasons, if any, it has for believing why this time it’s different.

IS GREENSPAN PREPARING TO LEAVE THE FED?

How high do I rank the possibility of Alan Greenspan’s departure from the Federal Reserve during 2004? Well, I suspect the current consensus view assigns a next-to-nothing probability to such an outcome. I could be talked into something approaching, say, 30%, maybe even a little higher. Granted, these certainly are not odds you would like to take to the racetrack. Nevertheless, I do not think you can dismiss the possibility out of hand.

Under any circumstances, word that Greenspan was departing the Federal Reserve would roil the financial markets, at least initially. Therefore, if he is going to leave -- either of his choice or Bush’s -- I would expect an announcement to be made pretty soon. June 20 is no longer too far down the road.

WAL-MART, CHINA, & THE AMERICAN PRODUCTIVITY MIRACLE

Recent reported U.S. productivity growth has been nothing short of amazing. From a 3.8% annual pace in the early 60s, productivity growth slowed to 2.4% in the late 60s and 1.8% in the 70s and 80s. But after growing at an abysmal 1.5% in the early 90s and a stronger 2.6% in the late 90s, it has averaged a muscular 3.9% over the last 3 years ... best in over four decades!

A remarkable number like that has provoked, naturally, many remarks. Mainstream U.S. economists in general have hailed this as the “latter day” American productivity miracle. The pied piper of the American economy, Federal Reserve Chairman Alan Greenspan, considers this performance a prime harbinger of future economic health. Yeah, job growth is anemic because we are producing GDP growth without adding to the payrolls, they say. However, in the long run, rising productivity means higher standards of living for all of us. Detractors, not unexpectedly, are skeptical.

So what is the cause of this seeming miracle? Is it the computers and communications revolution? Is it the Internet? Or is it good, old-fashioned American ingenuity? Or maybe, it’s all a pack of lies -- an artifact of “creative accounting”, as Dr. Kurt Richebacher claims. Our task today is to investigate this “whodunit”. We will use the time honored scientific method. Start with a hypothesis. Flesh out the hypothesis with a real life example. And finally, test the hypothesis with actual data. Our hypothesis rests on a simple assertion -- the seeming acceleration in U.S. productivity growth is due to the substitution of U.S. made goods with significantly cheaper imports. We can readily test this hypothesis with data.

THE ANNUAL CEO PAY CARNIVAL

Every year about this time, the nation’s leading newspapers and business magazines begin to compete to see who can appear most outraged about how much the top corporate CEOs were paid during the previous year. Thus on June 25, 2001, Fortune featured “The Great Pay Heist”, complaining about the “highway robbery” of the year before. We are sure to be deluged by similar stories in the next few weeks. This is an annual sport. These annual reports on CEO pay need to be read more carefully than they are written.

It helps to begin with a few tips for the unwary learned from previous years: 1.) Nearly every major newspaper and business magazine has its own uniquely dubious way of handling the way stock options are valued as executive pay; 2.) Although estimates of the “fair value” of new stock options are commonly lumped together with cash salaries and bonuses, such estimates tell us next to nothing about how much cash executives will receive; 3.) “Pay for performance” does not mean tying future pay to last year’s stock performance.

If this year’s festival of journalistic indignation about CEO pay turns out to be even half as deceptive as previous years, I might even hand out (with appropriate ceremony) the coveted Krugman Award for Economic Trickery.

OIL RESERVES AND POLITICS

OPEC agreed to cut production targets by 4%. White House spokesman Scott McClellan said, “The United States continues to emphasize that oil prices should be determined by market forces.” But the OPEC oil cartel is one of those “market forces”. And so is the U.S. Strategic Petroleum Reserve (SPR). Since November 2001, the U.S. government has been adding about 160,000 barrels a day to the 651 billion barrels already stockpiled in the SPR. During that time, oil prices rose from less than $20 a barrel to as much as $37. The Energy Department cannot resist a bad bargain and plans to buy another 202,000 barrels a day in April. Some 55 members of the House of Representatives wrote to the president earlier this month urging the administration to stop adding to reserves.

On Jan. 17, 1991, the elder President Bush publicly announced he had authorized the Energy Department to sell as much as 2.5 million barrels a day from the strategic stockpile. That would be like adding another Iraq overnight. The Washington Post reported what happened next: “Oil prices tumbled in London today, defying nearly unanimous predictions prices would skyrocket once war broke out in the Persian Gulf. After jumping $7 a barrel to nearly $40 in the first hour of the war, prices on world markets began to tumble. By midday, the price of benchmark North Sea Brent crude had dropped to near $21 a barrel.” A follow-up story said, “The dramatic sell-off to $21.44 shocked traders and led several oil companies to announce immediate price cuts.” Cutting oil prices in half was not a negligible effect; nor was it temporary. Oil remained at or below $20 until late 1999. Ironically, the United States did not even have to sell much oil. The announcement alone was enough to shock traders, forcing them to liquidate futures and options for whatever they could get. They never found out if the president was bluffing. But they knew he had a lot more oil than they did.

Yet the current administration now insists on buying high and not selling at all. This has always been an endemic problem with government-run commodity stockpiles. Politicians and bureaucrats are sure to be deluged with advice from industry-financed experts peddling ingenious reasons to keep buying when prices are very high and to never sell.

With nearly 700 million barrels of oil in its war chest, the United States is quite capable of giving OPEC a bloody nose. Far from being a well-disciplined cartel, most OPEC producers would scramble to “make hay while the sun shines” by maximizing production if they feared the United States might flood the market, even for short while. The U.S. government should simply let it be known that significant yet undisclosed sales of petroleum reserves are by no means out of the question. That would scare OPEC a little, and it would scare oil traders a lot.

CUTTING THE FEDERAL BUDGET TO PREVENT U.S. BANKRUPTCY

Part I – Why It Needs To Be Done

With the federal budget deficit now estimated to exceed the $500 billion level and not apparently likely to decline rapidly in the near future, citizens should rightly worry as to when, and not if, the United States will go bankrupt. While foreign governments like Japan, China, and Taiwan are financing a large part of the U.S. deficit (from 4/02/03 through 3/31/04, foreign government holdings of U.S. government debt increased by nearly $262.3 billion, from over $897.0 billion to just under $1,159.3 billion) as a way of supporting the dollar and thus spurring their exports to the U.S., how long will they continue to finance the U.S. government spending spree?

To prevent the U.S. slide into a near-term national bankruptcy with an associated catastrophic collapse in the value of the U.S. dollar and in living standards and to stimulate longer-term U.S. economic growth, federal spending needs to be cut drastically, and the time to begin those cuts is now. An independent presidential candidate needs to state that the welfare-warfare state concept on which the U.S. government has been run for more than a century has got to come to an end. Otherwise, the U.S. will plunge into economic chaos.

Sharp cuts in spending would give the Congress time and fiscal resources to provide for existing retirees under Social Security and Medicare but abolish that severely flawed system (which is nothing more than an inter-generational Ponzi scheme) so that future retirees could provide for their own retirement and health care independent of state control. One of the added longer-term benefits of pushing through some sharp cuts in near-term federal budgets is that, once implemented, the public will get used to being without what were once thought of as “necessary federal services”. In other words, the public will be able to see through the scam of other federal spending programs, enabling further major cuts to be made after this initial round of budget cuts.

During the course of this multi-part series of articles, I will keep track of proposed near-term cuts in what I call the “Cut-o-meter”. Unlike the phony budget cut numbers that come out of Washington, claiming that the budget has been cut, the totals on the “Cut-o-meter” will give readers an idea of how much would actually be saved and not spent compared to the current budget for fiscal year 2004, which has been approved and is being spent. Major cuts in defense spending and the abolition of foreign aid, accompanied by a major change in U.S. defense strategy and tactics, are the area that offers a way of ending the warfare state. Once the warfare state has been ended, the welfare state will become easier to slim down and then abolish.