Coronavirus and the Federal Reserve's Political Policy

It's when times are tough that you see what's really going on.  Last week, the stock market fell 11% because of fears over the economic impact of the coronavirus epidemic, dropping into a correction in a matter of days.  President Trump called loudly for a Fed interest rate cut.  Always ready for another government handout, Wall Streeters also chimed in for a rate cut.  Yesterday, rumors that the Fed and other central banks would act together pushed the Dow Jones Industrial Average up over 1200 points.

Early this morning, the Fed indicated it was considering accommodative action, but signaled that nothing was imminent.  https://www.cnn.com/2020/03/03/economy/federal-reserve-rate-cut/index.html.  However, a few hours later, the Fed announced a surprise 0.5% cut in short term interest rates.  The Dow, instead of responding positively, promptly fell almost 800 points.

What gives?  It's hard not to think the Fed gave in to political pressure.  A rate cut won't cure coronavirus.  Nor will it vaccinate humans against the disease.  It won't quarantine the virus or establish barriers to its spread.  People who are avoiding traveling, large gatherings, restaurants, concerts, sporting events, and other potential infection venues won't start spending and exposing themselves to the illness just because of a rate cut.  Even if stocks had risen, people wouldn't have started to engage in risky behavior.  Of course, things were only made worse because the market fell after the rate cut.  The market wanted a bigger welfare check.  The President, perhaps too lazy to do the work needed for a fiscal stimulus, promptly called for another immediate Fed rate cut.

But another immediate cut would only tell us that the epidemic is far worse than we thought, and that we'd best hunker down and isolate ourselves for a long time.  No travel, no restaurant meals, no public gatherings, no socializing, no contact with anyone we don't know and trust.  Romance would halt abruptly, as who'd want to meet new people in a time of epidemic?  Dating websites would collapse and singles bars would shutter. The President would be much better off committing billions of federal dollars to emergency medical research.  But he seems to have a problem with science, like he doesn't believe in it because it sometimes contradicts his political views.  So maybe the Fed will be bullied into another rate cut that will only instill even more alarm and panic.

There are powerful reasons for the historic independence of the Federal Reserve.  Most important among them is that an independent Fed can serve the public interest, not the short term scheming of politicians.  This means, among other things, that the long term vigor of the stock market is served by a rigorously independent Fed (see the story of Paul Volcker's career for further information).  Today's surprise rate cut gave the market and us discouraging news:  that the coronavirus crisis is much worse than we thought, that the Fed is becoming the sous chef of monetary policy, and that instead of focusing on medicine, the White House is focused on the political aspects of the coronavirus epidemic.  Now that the Fed is politicized, expect more poor policy and national distress.

The Good Deficit

You already know we're in Oz.  The government manages the federal deficit by making across the board cuts everyone thought would be so extreme that both Democrats and Republicans would work together to find a more rational solution.  Ha ha ha.  The joke's on us.  The government manages the debt ceiling by kicking the can down the road every few months.  The can is getting awfully dented.  And most tellingly, a surprisingly large number of the members of Congress bear a distinct resemblance to the flying monkeys in the movie.

But even as there were bad witches in the movie, there were also good witches.  There are good deficits as well.  Government spending for things that government is particularly good at is generally desirable, even if it requires deficit spending.  For example, government is good at national defense, education, law enforcement, and building or subsidizing transportation systems.  Government is also very good at funding basic research.  Deficit spending to pursue these goals is money well spent because it fills gaps that the private sector leaves open.  These kinds of spending protect and enhance the national wealth and welfare.

There's another problem that should be tackled, even if it requires deficit spending.  The unemployment rate for Gen Y (a/k/a the Millenials) is much too high.  It's generally about twice the level for Baby Boomers, and the less educated Millenials have even higher rates of unemployment.  Those that are African-American and lack college degrees need not apply, especially if they are male.  Large numbers of the better educated Millenials are burdened with heavy educational debts.  The ones with debts of $100,000 or more could face decades of 21st Century-style indentured servitude to their creditors, whose claims they cannot oust in bankruptcy proceedings except in extremely distressed circumstances. 

Millenials who are unemployed and underemployed represent wasted human capital. Modern economies are knowledge based, and human capital is the most important form of national wealth.  A vivid example of the overarching importance of human capital can be found in the aftermath of World War II.  Germany and Japan, the devastated losers (who deserved to lose), had only limited industrial capacity and not enough food to feed their populations.  But they also retained the advanced industrial knowledge they had acquired in building and supporting their massive and highly capable war machines.  Required by Allied occupation authorities to turn that knowledge to peaceful purposes, the two losing nations rebuilt their economies rapidly, and within three decades became industrial powerhouses.  Because they still had their human capital after the war, they could rebuild their tangible assets and prosper.

As a nation, we can't afford to let the human capital of Gen Y atrophy.  They are starting their working lives now, a crucial time for developing the skills of a self-supporting adult.  It's in your twenties and thirties that you learn how to apply all your book learning to the practical needs and purposes of the working world.  Learn those lessons well, and you'll be productive for 40 or more years.  Failing to learn them can result in permanent stunting of one's career.

Add a heavy load of school debt to the mix, and we can see how unemployed and underemployed Millenials could become a permanent economic underclass, unable to escape a shadow world of part-time jobs and episodic contract work, trailed by the baying of creditors hounding them at every turn. 

It's time to revive the Civilian Conservation Corps, 21st Century style.  The CCC of the 1930s employed some 3 million young Americans over the course of its decade of existence.  They were paid very modest wages, most of which were given to their parents (although the employees also received food and housing in addition to their pay).  They did mostly physical labor, as such work was integral to America's 1930s industrial economy.  The program was very popular with the American public, as it gave young people a chance to develop work skills and get a start in adult life.

A comparable program today could include jobs requiring manual labor.  America's highways, bridges and other infrastructure need a lot of maintenance.  America's cities need to be cleaned up, and abandoned buildings torn down, so that redevelopment can begin.  But there are many white collar jobs that need to be done as well.  Rural areas and inner cities lack physicians and other health care providers.  Many school districts are strapped for funding and need more teachers and staff for everything ranging from special education to music and drama.  Many jurisdictions have gravely inadequate funding for public defenders.  Criminal defendants, whom the law in its majesty presumes innocent until proven guilty, have little means to defend themselves and give their presumption of innocence tangible effect.  The poor need legal services for civil matters as well, such as battling indifferent landlords.  The list could go on.

CCC-21st Century jobs should be real jobs, not make work.  We can't ask taxpayers to pay people to dig holes and fill them up.  The pay should be low, because these aren't meant to be career jobs.  They are a way to give young people a start.  Part of the compensation should include generous provisions for government assistance in repaying school debt.  In effect, the government would help young people offload their school debt so they can get a fresh start in life.  Yes, yes, yes, there are countervailing considerations about holding people responsible for their debts and not bailing people out, etc., etc.  But we let egregious spendthrifts stiff their creditors for non-education debt as a matter of course in bankruptcy.  And we bail out really large financial institutions run by millionaire executives.  The burden of educational debt is getting to be too much.  As some guy put it about 400 years ago, the quality of mercy is not strained.  Let's be realistic instead of Puritanically moralistic.

Those CCC-21st Century employees who haven't gone to college could be compensated with the right to educational subsidies, akin to the GI Bill.  These young people could then go to college with less need for debt.  Their human capital would be enriched.

This isn't a perfect solution, and won't solve all the problems of Gen Y.  But it would give many of them a start.  And that's what they need.  Deficit spending for another CCC would be money well-spent.  The private sector isn't helping these people.  Government action is the only alternative.  We don't need more stimulus in the form of Federal Reserve money printing.  We could benefit greatly from stimulus in the form of deficit spending invested in our young adults.

How the Federal Reserve Discourages Consumer Demand

The Fed has, for the past four years, waged a relentless war on interest rates, suppressing them to zero at the short end of the yield curve and to record lows at the long end. This was all done in the hope of encouraging lending and fostering consumer demand. With about 70% of the U.S. economy coming from consumption, there is good reason to try to encourage consumers. But the Fed's basic approach has been to tilt the playing field sharply toward borrowers and punish savers for having the temerity to be frugal, all with questionable impact on consumer demand.

The boost given to borrowers appears to be limited. Interest rates on credit cards have, if anything, been rising. This is in part due to changes in the law that have limited some of the fees with which banks previously whacked their customers. But the sharp drop in short term rates since 2008 has not been mirrored in the credit card market. With recent credit card rate increases, borrowers have the incentive to reduce balances, not boost spending.

In the mortgage markets, rates are reaching all time lows. But only a limited segment of mortgage borrowers are able to qualify for refinancing (and a lot that can refi have already done so). The people who need help the most (i.e., those underwater on their mortgages) find refinancing a tough slog, if possible at all.

In the business world, rates may or may not be dropping, depending on the creditworthiness of the borrower. Business people tend to be cautious right now, with all the headwinds from slowing economies in America and Asia, recession in Europe, the unsolvable Euro crisis, and near complete political dysfunction in Washington. Drops in interest rates aren't likely to greatly affect their view toward business borrowing, investment or hiring. That's evident from the fact that businesses are choosing to hold billions of dollars in cash for essentially no return rather than invest or hire. If you're not deploying your own cash to invest or hire, why would you borrow even at a low interest rate to invest or hire?

But the impact of low interest rates on savers is significant. Let's hypothetically take a relatively frugal American who is approaching or in retirement, and in 2006 had $750,000 in a diversified portfolio. During the financial crisis of 2007-08, this portfolio, we'll assume, was pummeled down to $500,000. Many investors victimized in this fashion have fled equities and put their reduced savings into fixed income investments. For the sake of simplicity, let's assume the Fed's war on interest rates kept the yield curve 1% below where it might have been with a somewhat more balanced approach by the Fed. (Thus, at the low end, the Fed would today be targeting a fed funds rate of 1 to 1.25% instead of today's 0 to 0.25%.) The interest lost by our hypothetical saver would be $5,000 a year. Compounded over 4 years, the saver would have lost about $20,302 before taxes. While this amount after taxes wouldn't buy a yacht, and only a modest car, consumption would probably be noticeably boosted if millions of Americans had enough additional money to buy a modest car.

Given that the Fed has promised to keep interest rates ultra low until late 2014, the lost income will reach approximately $30,760 per hypothetical saver in a couple of years. And this amount could increase if the Fed extends that promise into 2015 (a serious possibility).

It's important to keep in mind that these income losses are permanent. There is no way savers can recoup these losses. The Fed won't boost interest rates extra high later on in order to bail out the frugal. So savers' consumption will be permanently reduced.

The Fed claims to be greatly concerned with consumer expectations and their general state of mind, believing that public confidence is crucial to restoring demand and prosperity. The message sent by the Fed's long and continuing war on interest rates is that things are bad and will be bad for a long time. Any rational consumer, particularly those that are frugal to begin with, will hunker down, dig the fox hole even deeper, cover it with a sturdy layer of thick logs, camouflage it with an abundance of branches and brush, and never even dare to peek out.

The situation in Japan is illuminating. The Japanese central bank has, since its own financial crisis in 1989-90, banished positive interest rates from the land (encouraging the so-called carry trade, where Japanese citizens deploy their savings or borrowed yen into investments in foreign currencies that offer positive returns; thus Japan's capital is productively used in other nations). Japanese consumers have gone from being luxury hounds to penny pinchers and bargain hunters. Japan has been stagnant for more than two decades, and its most recent economic statistics show that the stagnation has become a seemingly permanent and undesired house guest. America appears to be headed down the same path. Although the headlines generated by politicians and candidates for political office promise solutions, hard evidence to be optimistic remains scarce. Even the tech sector, America's economic sweetheart, has offered a lot of disappointment lately, with Facebook's stock losing almost half its IPO valuation and other familiar tech companies serving up results akin to the financial equivalent of Spam quiche. Will America become Japan? This is no longer the question. The question now is how will America stop being like Japan.

Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

A Morally Hazardous Day

Today, the Federal Reserve announced a $400 billion program called Operation Twist, which is designed to decrease interest rates at the longer end of the yield curve without printing money. This monetary action was $100 billion more than expected. Nevertheless, the stock market promptly dropped more than 2%. Like a toddler demanding a pint of ice cream, the market had wanted the Fed to announce another quantitative easing program--i.e., bond purchases that would add hundreds of billions to the money supply. In other words, the market wanted money (see http://www.youtube.com/watch?v=7Ql0xluujPs&feature=related). And, just like a toddler denied a pint of ice cream, the market threw a hissy fit when it didn't get what it wanted. The original Twist was better. See http://www.youtube.com/watch?v=xbK0C9AYMd8&feature=related.

Don't worry. The market sold off today because the news didn't match the rumors that speculators bought on. Tomorrow is another day, with new rumors to fuel speculation.

The big question mark hangs over Europe. EU leaders are killing entire forests to put out more press releases emphasizing how much they care about the sovereign crisis, and how they won't try to get their lives back until it's fixed. If you want talk therapy, you've got it. But things in the EU, already weird, are getting truly bizarre. Today, the European Central Bank announced that it would reduce the amount of exchange listed bank debt it would take as collateral, while lifting limits on non-listed bank obligations offered as collateral. In other words, easily-valued assets are less useful as collateral, while stuff (that's the polite term) with no readily ascertainable market value has become acceptable as collateral. One detects the aroma of ink used to print money. After all, if you can't readily determine the value of collateral, you can't easily determine how much you can safely lend. When the ECB lends more than collateral may be worth, skeptics would suggest that it's printing money. Then again, maybe it doesn't care; or at least it doesn't want others who care to have an easy time looking over its shoulder.

It's doubtful Operation Twist will have much impact on the economy. And the ECB's futzing around with collateral almost approaches alchemy. That takes us back to the Middle Ages. During the time of the Black Death, when the world seemed to be falling apart, some people believed that if they banded together and danced from village to village, their "jollity" would defeat the plague. There is no scientific record as to the effectiveness of dance on this illness. But when nothing else seems to be working, why not twist and shout?

Should We Bring Back the Leisure Suit?

The economy in America and Europe is stagnant. Gas prices have risen sharply in recent years, and the Bureau of Labor Statistics reports rising inflation. The job market stinks. Business investment has ground to a halt. America is unwinding from unpopular wars. Young people just entering the labor force believe they face a lifetime of limited opportunity and lower living standards. They envy their parents, who seem to have had it so good. Prospects for the future seem like a blurred swirl in a porcelain bowl. Whether you believe history repeats itself or simply rhymes, the times are looking a lot like the 1970s. Maybe we should bring back the leisure suit.

The leisure suit had many attributes. It was casual, a rejection of the stuffy old formality of the 1950s. It usually came in pastel colors, brightening things up as the lights dimmed for electricity conservation mandated by rising energy prices. It was made of polyester, which thankfully led us to rethink the whole idea of better living through chemistry. It was flashy, ideal for mindlessly dissipating evenings in artificially fogged discos. Considering today's pervasive gloom, a bit of self-referential, sartorial frivolity might be just the thing we need.

But thinking of the 1970s reminds us of how glad we were to escape the malaise of those times. What is worth examining is how we made the escape. The fundamental economic problem then was price inflation. Already a nagging problem in the 3% range at the beginning of the decade, inflation was aggravated by OPEC oil price fixing, which escalated it to 13% by the end of the decade. Wages tended to keep fairly close pace with inflation, but the value of savings was eroded as interest rates lagged (does this sound familiar?). The stock market stunk, worth much less after inflation than it was worth at the beginning of the decade.

As students of economic history know, then Fed Chairman Paul Volcker raised interest rates sharply at the beginning of the 1980s to stabilize prices. In the process, the U.S. economy belly flopped into recession, with unemployment rising above 10% and stocks falling. Despite a tidal wave of criticism from the left, right, Democrats, Republicans, and just about everyone else standing on or about a bully pulpit, Volcker held firm, like a latter day Rock of Chickamauga. And prevailed. The recession of 1981-82 wrung inflation out of the economy, and it has never returned at any level approaching the confidence sapping double digits of the 70s. With inflation whipped, real economic growth resumed, employment levels rebounded, and the stock market took off on an 18-year bull run. The bond market, even more amazingly, took off on a bull run that hasn't ended even today.

An essential, virtually forgotten lesson from the disco era is that real pain had to be endured before the economy could be set on the right track. Investors, workers, businesses, savers, and homeowners all made sacrifices. There was no easy way out. Inflation had created economic distortions that had to eliminated. The relatively lax Fed of the 1970s was replaced by a stern, unyielding inflation slayer who wielded a mighty halberd.

Such is the path America must take today if it is to end today's dreary replay of the 1970s. The economy is distorted by asset bubbles, the leverage that made them possible, the fantasy mortgage loans that can't be collected but haven't been written off by the banks, Fed-prescribed low interest rates that encourage speculation while discouraging savings, and the dependence of the private sector on federal stimulus. Private businesses won't hire or invest unless there is a prospect of more federal intervention. Everyone wants a risk-free environment, or absent that, a federal bailout. Free enterprise, which means taking risk, barely exists any more and can usually be found only in the small business sector, where federal manna is scarce.

If the Fed wants to stimulate risk taking, what it must do is reverse the tide of moral hazard and stop the endless stream of largely futile accommodations. It should force business executives to take risk, not force savers to gamble their hard-earned retirement funds on dodgy financial instruments. When businesses realize that they will have to make their profits the old fashioned way--by taking risks and managing those risks to attain profitability--then we will see organic economic recovery. No amount of Fed coddling of corporate interests, and no amount of Fed punishment of savers and holders of capital, will achieve the spontaneous and self-sustaining growth that produces lasting prosperity.

Before there was a Federal Reserve, there were recessions, and bad ones at that. There were also recoveries from those recessions that led to sparkling prosperity. It's not like America endured an unrelenting stream of recessions followed by more recessions until the clouds parted and the Federal Reserve System was handed down to someone on Mount Sinai. The Fed has a legitimate role in stabilizing the financial system, and has done yeoman's duty in that respect. But it isn't and can't be the progenitor of all prosperity in America. In a free enterprise system, private enterprise must take on that job, and if corporate interests hold back in hope of yet another federal bailout, they must be made to understand it won't be forthcoming.

America is becoming like Japan, moribund and without a vision of the future. We don't want to take risks any more, and we don't want to accept pain. Blame and culpability are denied by the most powerful, even though their responsibility is greatest. The less powerful and the powerless are made to suffer the worst consequences of the Great Recession, even though their ability to cope is the least. Capitalism requires that blame and responsibility be assessed, and that losses be imposed appropriately. Without right and wrong, there can be no morality. And without losses as well as gains, there can be no free enterprise. We can have all gains only if we become one big government enterprise (and those gains would ultimately prove ethereal). We can't escape our current predicament by having the federal government (and, even worse, the EU) artificially support or inflate assets that are in reality worthless. There won't be a revival of sustained economic growth as long as the government holds out the promise of yet another bailout, yet more accommodation. While there remains a legitimate role for government in taking on tasks for which the private sector isn't well-suited, like building and maintaining infrastructure, and funding and conducting basic research (recall that the Internet started off as a Defense Department project), the government should stop trying to alleviate general business risk.

Otherwise, we might as well bring back the leisure suit. A dose of self-delusion as we circle the drain will numb the process of decay and decline. If we're going to stop thinking about tomorrow, we might as well have fun while we can.

The Politics of Powerlessness

The Iowa straw vote and Tim Pawlenty's sudden withdrawal from the race for the Republican presidential nomination starkly highlights the pervasive feeling of powerlessness that drives politics today. Michelle Bachmann and Ron Paul finished a close first and second, with Pawlenty a distant third. Bachmann and Paul appeal to the far right, tapping into the anger of those that feel unconnected to the mainstream of American society. Pawlenty was very much the traditional conservative that the power brokers of the Republican Party would like as their candidate. He got clobbered.

Others who fit the profile preferred by the Republican power structure--Mitt Romney, Jon Huntsman, Rick Santorum, and Rick Perry--either stayed out or did poorly. Romney's campaign dropped hints to the press that his absence from the straw vote was strategic. But in politics, avoiding losses isn't the way to get elected. Romney may have deftly ducked a left jab from the far right. But his deliberate decision to stay out of the straw vote seems to quietly acknowledge his lack of appeal to the most powerful force in politics today: those that feel dispossessed.

A similar dynamic operates on the left. Union busting tactics in Wisconsin by recently elected Republican governor Scott Walker sparked an outpouring of liberal anger, weeks of demonstrations in Madison, and recall elections that weakened the Republican hold on the Wisconsin Senate. The demonstrators weren't powerful Democratic leeches sucking taxpayers dry. They were just moderate and middle income people trying desperately to hold onto their small portions of the national economic pie.

Middle class Americans are buffeted by enormous forces beyond their control. Wall Street created a financial crisis that threw the nation into a great recession. Workers are laid off through no fault of their own. They then lose their homes to foreclosure by human auto-pens. They see vast amounts of deficit spending by the federal government that doesn't seem to benefit them. Their children, raised to believe they could accomplish anything if they tried, now have little faith in the future. Both parents and children feel betrayed. A sovereign debt crisis in Europe that could wreck the international financial system, coinciding with an astonishingly inept process in Washington for raising the debt ceiling, knocks stocks down 15% in a few weeks. Daily volatility sweeps the financial markets, enriching firms whose computers trade in millionths of a second while trampling over Ma and Pa trying to patch up the holes in their 401(k) and IRA accounts. The homes they worked so hard to buy sink in value, but they still have to pay their debts in full with stagnating incomes.

The human survival instinct, normally well-concealed by the congeniality that prosperity allows, is the most powerful organic force on Earth. Humans have grown from a small number of short-lived hunter gatherers in Africa to a population of billions who control virtually every square mile of planet. When prosperity flags, and questions of survival begin to surface, adrenalin flows and emotions erupt. Many, many millions feel powerless against these gigantic forces beyond their control and see politics as the only outlet for their surging survival instincts. That is the force harnessed by Bachmann, Paul and the unions in Wisconsin. That is the force that will play a key role in the 2012 elections.

Paul won't win primaries; he has a track record in that respect. The mandarins of the Republican Party will quietly do everything they can to undermine Bachmann, in the belief that she might primaries, but can't win the general election. That belief is probably correct. The ghost of Barry Goldwater haunts the Republicans. A far right candidate is easy to demonize, and Democratic operatives are surely hoping that Bachmann will continue to fore check mainstream Republican candidates.

On the left, dissatisfaction with Barack Obama, now seen as too expedient a compromiser, has led to mutterings about a primary challenge. It's hard to see who would be a viable challenger. But in August 2007, few people considered Barack Obama a viable challenger to the presumed Democratic nominee, Hillary Clinton. So you never know. The ultimate in cool projected by Obama isn't the right teleprompter feed for this election cycle, and a more impassioned candidate may win over the Democratic left.

With the economy slowing and the chances of renewed recession rising, feelings of powerlessness will play an ever greater role in politics. Political doings in Washington could become even more unpredictable than they have been. And the stability of the financial markets, now determined by governmental action as much as the direction of the economy, is likely to suffer correspondingly.

Of course, voters' desperation and its political consequences would evaporate if the economy began to grow briskly. But what are the chances of that?

Facing a Never Ending Governmental Debt Crisis

As the federal debt ceiling scrum thrashes toward a short term solution, it's evident that we won't have a permanent solution for many months, maybe years. The Republican right made a mistake in thinking it could use the debt ceiling as a lever for reducing federal spending. The lever, it turns out, is one red hot tamale--not lifting the ceiling in time to prevent a government cash squeeze could blow up the stock and bond markets, slow economic and jobs growth, smack other nations with similar consequences, and worsen consumer malaise. The debt ceiling is like a nuclear weapon: too horrifying for actual use. So it doesn't provide much real leverage. Now, with time very tight, leaders of both parties are scrambling to stabilize an increasingly messy situation. Chances are they'll come up with something, but it will be short term, and the crisis will renew itself within months, if not weeks.

Across the pond, we have the same short termism managing an increasingly large load of governmental debt in the Euro zone. Greece's latest default spasm was quieted down with more borrowed money while a long term resolution was pushed off for a couple of months. The dominos in Ireland, Portugal, Spain and Italy quivered. High ranking EU officials debated what might be done without reaching agreement (sound familiar?). Banking officials in Europe applied extra lipstick to the latest round of bank stress tests, and admired the pigs as best they could. But the stink of the sty remained.

The sovereign debt problems on both sides of the Atlantic have taken on the quality of a sickening roller coaster ride, with crisis followed by crisis followed by crisis. Each crisis has the potential to blow up banks and sink financial systems, taking economies with it. With a frenzy of stress every few months, a toll on long term economic well-being will be extracted. You can't plan years ahead if your 401(k) is about to be torpedoed. A business can't hire for the future if its bank funding might evaporate in two months because a foreign nation 4,000 away can't get its national accounts straightened out. Just a few of the detrimental effects of such endemic crisis would include:

Lower business spending. It's well-known that corporate America is sitting on top of shiploads of cash, but not investing or hiring. While this reluctance to put money to work is due in significant part to overall economic sluggishness, the seasickness that comes from just watching the sovereign debt crises surely heightens cautiousness.

Less long term investment. The 2008 financial crisis drove large numbers of individual investors out of the stock markets. The sovereign debt dilemmas encourage further departures. With stocks still close to their two-year highs, it's easy to rationalize taking chips off the table, and some individual investors are doing just that.

More consumer malaise. If consumers keep hearing that the world as they know it will collapse in a couple of months, they won't: (a) buy a house, (b) buy a car, (c) buy household furnishings or equipment like washers and dryers, or (d) take a big vacation. Staycations devoted to buying bulk, discounted quantities of rice, beans, and ramen noodles will become all the rage.

Income stagnation, leading to economic stagnation. Incomes at almost all levels except the top 10 or so percent are stagnant. With federal deficits under scrutiny, governmental benefits may be trimmed. The continuing volatility created by these debt problems will only encourage the Federal Reserve to persist in its policy of never again allowing interest rates to rise. A future of low rates in America precludes a revival of the interest income on which millions of retirees and others used to depend. For an economy that's 70% consumption, income stagnation means economic stagnation. There's no possibility of growth if there's no income to spend. People aren't so crazy as to borrow money for consumption any more, nor are banks so crazy as to lend it. The inflation the Fed so desperate seeks won't spur consumption if there's no increased income to compensate for higher prices. Indeed, for most today, the response to inflation seems to be to stop spending on all but essentials.

A state of perpetual crisis precludes stabilization and growth. Today's sovereign debt crises are political problems more than anything else. Both Europe and America have the wealth to solve these problems. They just can't figure out how to allocate the burdens of the solutions. But the price of this political dysfunction is economic dysfunction. And that's our future, unless something really changes.

Avoid Vanishing Along With the Rest of the Middle Class

Statistics show that the richer are getting richer while middle class incomes stagnate. Income and net worth are increasing, sometimes dramatically, for the top 1% and 10% in America, while median incomes barely keep up with inflation (or don't). Mathematically, this means that the middle class are getting poorer relative to the well-off. But most middle class people don't need to see the math--they already know from their end of the month checkbook balancing frenzy that they're getting poorer. Add the strident calls from conservatives to slash Social Security, Medicare, unemployment compensation and other elements of the social safety net, and the middle class is starting to understand how the bison felt when hunters with breech loading rifles invaded the Great Plains 140 years ago.

But people--at least those who aren't herd animals--may have a way out. Let's assume you live in a household with $50,000 in annual income, which is about the median. Put $5,000, or 10%, annually into a 401(k) account that has a 4% employer match ($2,000 per year) over 40 years of work, invest in a diversified portfolio that generates a 6% return compounded annually (a modest amount by historical standards), and you'll have $1,080,000.

If you adjust this $1,080,000 for inflation of 3% per year, you'll find that it's worth the equivalent of $320,355 in today's dollars. But you can get around the inflation problem by increasing the amount you save each year by the inflation rate. Since most people's incomes tend to keep pace with inflation--even middle class incomes, although just barely--you can bump your retirement savings up pretty much in line with inflation. (And note that salary increases would also increase the dollar amount of the 4% employer match.) By increasing your contributions for inflation, you'll end up with the inflation adjusted equivalent of about $1,000,000 after 40 years. If you have a 401(k) without an employer match, or one with a smaller match, save more in some other account to make up the difference.

If you don’t have access to a 401(k) or similar plan, then this plan for a 25-year old could consist of saving the $5000 permitted per year in an IRA account until age 50 and then the $6,000 permitted per year for older folks until age 65. Increase your savings for inflation. Assuming a 6% return compounded annually, you’d have $797,084 after 40 years (or the inflation adjusted equivalent if you increase your saving in line with inflation). The amount is smaller because there is no employer match in an IRA. But if you save a bit more each year in another account or work a few years longer, you'll probably be a millionaire.

Only some 2.5% of the U.S. population has $1,000,000 in investable assets. But at least half the population, including many middle class households, have the potential to become millionaires. You have to be scrupulous about saving, and luck is a factor. Serious illness, disability, or other medical problems, aged parents who are unprepared for retirement, divorce, and other difficulties can blow up a financial plan. But a lot of folks who have the potential to be well-off in their golden years throw that chance away on big houses, cars, and TVs, nice vacations, frequent restaurant meals, fine clothes and other lifestyle enhancements. There's nothing inherently wrong with living large now, if you understand the consequences. But if you want to escape the multitude of middle class people being driven over a cliff by economic inequality, then think for yourself, act on your own, and separate yourself from the herd.

For more on how to build wealth, see the following: (a) http://blogger.uncleleosden.com/2007/05/how-to-become-millionaire.html, (b) http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html, (c) http://blogger.uncleleosden.com/2010/07/how-to-think-about-saving.html, (d) http://blogger.uncleleosden.com/2010/11/how-much-do-you-need-for-retirement.html, and (e) http://blogger.uncleleosden.com/2011/03/how-to-avoid-running-out-of-money-in.html.

If you think you really can't save, then take a look at http://blogger.uncleleosden.com/2011/01/hope-for-financially-lost.html.

A Tale of Two Recoveries

Near unanimity reigns on Wall Street that the economy will keep expanding and the stock market will rise further this year. Corporate profits are growing as worker productivity improves. Commodities prices are levitating. Retail sales have moderately increased. Even junk bond yields are relatively benign. Stock market investors, even if still shell shocked from two years ago, are doing better. In the tonier parts of Standard Metropolitan Statistical Areas, things are looking up.

Evidence of recovery is harder to find elsewhere. Food banks remain heavily patronized. Unemployment levels cling tenaciously near the 10% level. The long term unemployed are becoming entrenched in joblessness. Wages are stagnant. Many unemployed who find jobs have to accept lower incomes. Real estate prices are dropping again, after a brief and shallow upswing. Mortgage rates have risen off record lows, dampening refinancings and home purchases.

There has never been a lasting economic recovery without a restoration of full employment and a strong housing market. Neither seems to be in the offing, not for years. America is dividing into two camps. There are the relatively few well-off, who own most of the assets and are the least likely to be laid off. They have more resources to ride out the bad times and greater opportunities to profit from a rebound. Then, there is everyone else, for whom the Great Recession continues.

Today's politics only exacerbate the divide. Many moderate and middle income taxpayers, frustrated by the disparate impact of the recovery, became Tea Partiers and voted Republican. But the resurgent Republicans made sure that the wealthy were protected in the tax deal they cut with President Obama this past fall. The same tax deal also gave everyone a 2% cut in Social Security taxes, while the more progressive $400 Making Work Pay tax credit wasn't renewed. The first legislative maneuver by the new Republican majority in the House is to schedule a vote to repeal last year's health insurance reform law. This symbolic digital salute will do nothing to improve the economy or help the unemployed.

Deficit reduction is on every politician's list of resolutions for this year. But you know how it goes with New Year's resolutions. There's more water to be found in the Sahara than spending cuts in Washington. Last fall's tax deal, the first major product of the new bipartisanship, widened the deficit. The only way to truly reduce the deficit is to cut Social Security and Medicare spending, and/or raise taxes. Recent polls show that a large majority of Americans, from Millenials to the World War II generation, oppose cuts in either program. Yet there is no way today's Republican-controlled House would sign off on tax increases (even though a recent poll shows most Americans favor increasing taxes on the well-to-do in order to balance the budget). So the new bipartisanship will produce, at best, nominal deficit reductions in highly visible ways (a la the two-year pay freeze for federal employees, which hardly affects the deficit but sounds good in press releases). Given that today's recovery is largely due to deficit spending and the slackest monetary policy ever adopted by the Fed, there is little incentive in Washington to control deficits. No politician wants to be the grinch that stole the recovery.

But for most Americans (i.e., the majority trapped in stagnation), there hasn't been much of a recovery to steal. Current projections are for high unemployment and depressed real estate prices to linger for years after 2012. America may be morphing into a society where a small group of elites enjoy prosperity while everyone else just gets by (or not). That's not a good development for a nation dedicated to the pursuit of happiness. America was founded by immigrants aspiring for better lives. If hope dies, the essence of the nation is lost. The damage from the Great Recession will be great, indeed, if the nation loses its heart.

The 21st Century Global Economics Experiment

Not since the days of the Cold War has there been such a clash of national economics policies. The UK has made an abrupt U-turn away from deficit spending, embracing the hair shirt of austerity. Elsewhere in Europe, big spending EU governments have followed suit, although not with the fervor of true believers. Keynesian economics may be disproved, or not.

America is caught in political crosscurrents, with fiscal policy stifled by a prairie fire of populism. The Federal Reserve is the only show in town, and the financial markets believe the Fed will put on a dazzling performance. Stock, commodities and bond valuations all presume that the Fed is going to walk into the joint and be a real big spender. Monetary policy is at the plate, and no one is on deck. The Austrian school of economics may be disproved, or not.

In China, an ad hoc amalgam of state controlled enterprise and fiercely capitalistic forces has propelled the Chinese economy into a meteoric rise. The Communist Party in China has craftily exploited market forces to raise living standards, thereby legitimizing its continued control while it gradually jettisons a failed ideology. The Chinese are wittingly or unwittingly recreating an updated version of dynastic China, where government played a large role in the economy but allowed private trade and commerce to spark growth. Imperial China was for over 1,000 years the wealthiest nation in the world, so this model has a history of success. If China continues its upward trajectory, free market ideologues may be discombobulated. Or not, if the heavy hand of state control of the economy and political freedoms smothers the individual initiative needed for lasting prosperity.

Since economists can't conduct controlled experiments, the world today is about as good as it gets for students of comparative economics. Ten or twenty years from now, tentative conclusions might be possible. Or not, since nothing in economics is ever truly resolved. Schools of thought mostly go in and out of fashion.

But what if they're all wrong? What if austerity in the Old World produces stagnation or even recession? What if the Fed's forthcoming liquidity dump fails? The financial system already has a trillion dollars of unused liquidity on deposit at Federal Reserve banks. More liquidity is likely to be just the proverbial push on a string, while stagnation continues. And what if China's real estate and credit bubbles burst, pushing China into the stagnation experienced by Japan and now America? With China's severe demographic problem of too many old and not enough young, any slowdown in China's growth could upset the entire apple cart the government is trying to push along.

If all models and all schools of thought are wrong, we have a problem. There wouldn't be any credible paradigm in which to find solutions. We might find ourselves mired in slumps and malaise, with struggling to muddle through the only strategy. But Americans are good at muddling. Every major crisis in American history, from the Revolution to the Civil War to World War II to the Cold War, was a painful muddle. Even if all the economists are confounded, Americans can still have faith in themselves, and that's always proven to be enough.

The Fed Desperately Seeking Inflation

To nobody's surprise, at its meeting today the Fed kept short term interest rates where they are. After all, the slumping economy sags anew with each passing quarter. The Fed also fired a shot across the bow of bond market bears, pledging to use the proceeds of its maturing agency (meaning Fannie and Freddie) debt and mortgage-backed debt to purchase longer term U.S. Treasury securities. This latter measure is tantamount to monetizing federal debt--in other words, printing money for the federal government to spend.

Recall that last year, the Fed bought a shipload of mortgage-related debt in order to loosen up the mortgage market. This pumped a lot of money into the financial system (in effect, providing funds for new mortgage loans). The Fed didn't have the money it used. It simply printed it. We're talking hundreds of billions of dollars of printed money; maybe over a trillion. What the Fed now proposes to do is reinvest repayments of the mortgage-related debt in longer term Treasury debt. That keeps the printed money out in the financial system, perhaps for many years.

Printing money can cause inflation. The Fed believes that a dab of inflation adds a fillip to the economy, allowing businesses to raise prices more easily and debtors to repay creditors with cheaper dollars, thus spurring growth. The Fed has been seeking inflation, with cheap money policies and publicly announced inflation targets. But prices haven't cooperated. While they're still rising, the rate of increase is around 1% a year, the lowest in a half a century. The Fed would like to see 2% or a tad more.

By purchasing Treasuries, the Fed keeps the pressure on longer term interest rates and may push them down. In normal circumstances, lower rates would probably spur growth. But the process of deleveraging from the profligates' ball of the 2000s seems to be getting in the way. Banks don't want to lend, because they still have skeletons in their closets and are holding back cash to cover their butts. The creditworthy aren't borrowing because they're trying to pay down debt, not take on new loans. The uncreditworthy are being denied credit, for the first time in more than a decade but all parties run out of punch eventually. The days when a signature and a pulse could command hundreds of thousands of dollars of credit are over. So lowering long term rates won't be likely to have much stimulative effect. It will only reduce the federal government's interest expenses.

One wonders if that isn't something the Fed intends. There's no way for the federal government to quickly reduce its deficit by a meaningful amount. It will be borrowing a shipload of money as far as the eye can see. By keeping the federal government's borrowing costs low, the Fed prevents even more borrowing by the Federal government to cover rising interest expenses.

In addition, when the Fed uses some of the printed money from maturing mortgage-related debt to buy Treasuries, it's reducing the amount of "real" dollars the federal government has to borrow from holders of capital. That reduces the competition between the government and the private sector for credit. As much as Ben Bernanke jawbones the government to restrain spending, he's making it easier to run federal deficits. Lower prices spur consumption--that's Econ 101. Lower the price of government borrowing and the government will borrow more.

Best of all, printing money is a time honored way for governments to spawn inflation. By investing in longer term Treasuries, the Fed is saying it will keep those printed dollars out in the financial system potentially for a long time, where they might fluff up the price structure.

Or not. The deleveraging process in effect reduces the money supply. That's because a loan increases the velocity of money, which in effect expands the money supply. Paying down debt reverses the process. As our debt besotted society tries to sober up, the Fed's monetization of federal debt may simply offset some of the private sector debt shrinkage. The net impact may be little or none. This could be what's happening in Japan, where the private sector has gone through a gargantuan deleveraging from the mother of all credit expansions in the 1980s. Government debt in Japan runs 200% of GDP (America's is around 65%-70%), but inflation is almost non-existent. The economy is stagnant. Government leverage seems to have taken the place of private leverage, but on a net basis not much has changed.

So the Fed's monetization of debt, at least at the prospective levels indicated by today's announcement, may not spur inflation. And even if it did, there's no guarantee things will improve. Throwing a lot of cash out the door of the Federal Reserve System (directly or indirectly into the hands of the federal government) won't necessarily do anything to bolster the real economy. The cash has to be spent the right way, increasing investment in productive activity--meaning the production of goods and services that people want to buy--not more subsidies for banks that hoard cash that is invested in U.S. Treasury debt. To be valuable, money has to be spent wisely. There's no requirement for wisdom attached to the printed money the Fed is pushing off its loading dock.

Will the Bond Market Sandbag the Fed?

Improbably, bonds have rallied for the last 30 years. When Ronald Reagan was elected president in 1980, rates on 30-year Treasuries were in the range of 15%. Today, they pay about 4%. Economists have estimated that real interest rates (i.e., rates net of inflation) run around 3%. Buying a 30-year Treasury today is like gambling on 1% annual inflation for the next thirty years. That's a riskapalooza if there ever was one.

The corporate bond market is also glowingly optimistic about inflation. Recently, McDonald's sold $450 million of 10-year bonds bearing interest of 3.5%. That's like gambling on 0.5% inflation per year for a decade. Then again, if you bought 10-year Treasury notes, which today pay under 3%, you'd be speculating that there will be deflation for 10 years. One would have to go back to the Great Depression to find a time when these investments would have been winners. Reality is we've got a huge bond bubble.

The Fed is desperately seeking inflation. It's keeping interest rates (short, medium and long) ultra low in an effort to stimulate growth, hoping that a little inflation will be like a round of cocktails before dinner that gets the party going. While neither prices nor GDP are cooperating, the Fed persists, in the belief that manipulating the money supply will somehow work a miracle when consumers are scared, corporations are cautious, and Wall Street finances speculations in derivatives rather than production of goods and services.

Here's the catch: if the economy revives, the Fed will have to raise rates. That could pop the bubble in the bond markets, clobbering yet another asset class. If that happened, holders of capital, already pummeled by the 2000 tech stock collapse and the 2008 stock market crash, real estate crash, auction rate securities collapse, etc., would suffer aggravated battered investor syndrome. They'd pull back from risk and consumption. The stagnation the Fed so publicly fears would follow.

But if the Fed doesn't raise interest rates after the economy revives, inflation would flare, ravaging the value of bonds as borrowers repay creditors with cheaper dollars. The bond bubble would pop in this scenario as well, producing severe battered investor syndrome and stagnation.

Thus, the potential for lasting recovery from the Fed's monetary policies may be capped by the bond bubble. There are other reasons why monetary policies may well fail (banks refusing to lend, consumers too scared to spend). But we've got a built-in booby trap set to spring if the economy revives.

The Fed surely knows this, and will probably hold off on raising rates as long as possible. Forget about the widely accepted view that the Fed should raise rates before inflation rears its ugly head to nip the problem in the bud. By incentivizing borrowing as much as possible, short, medium and long term, the Fed faces the possibility of injuring a constituency, creditors, it has tried to protect 100 cents on the dollar since 2008.

The Fed is damned if it does and damned if it doesn't. It has statutory responsibilities to promote full employment and economic growth. But if it succeeds in promoting growth with a little inflation fillip, it will likely pop the bond bubble and produce potentially large investor losses and a renewal of stagnation. Only a slow, agonizing, years-long recovery, with interest rates barely crawling up, would allow creditors to adjust to a rising interest rate environment without sharp losses. But unemployment would have to remain painfully high in such a scenario. Millions of unemployed Americans would pay the price for easing the bond market out of its current dilemma.

The Fed has yet to pop an asset bubble before it became a systemic threat. No doubt, it won't pop the bond bubble now. But it's laying the foundation for painful choices in the future.

Demote GDP and Enhance Economic Well-Being

The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.

Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.

The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.

GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.

Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.

A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.

A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.

Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.

The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.

Strategy for the 10s: Add Value to America

The Aughts were for naught. During the first decade of the 21st Century, after adjusting for inflation, home values fell about 3% and the stock market fell over 30%. Unemployment stands at 10%. According to today's New York Times, 1 of every 8 Americans is on food stamps. One of every 50 lives in a household whose only income consists of food stamps. Now is a good time to reassess.

The signal events of the Aughts' financial history were the tech bubble that burst in 2000 and the real estate and credit bubbles that burst in 2007-08. Both bubbles lasted longer and pushed prices higher than anyone would have imagined. The illusion of wealth created by these bubbles encouraged consumption, and borrowing for the purposes of even more consumption. That would have worked out more or less okay if people had liquidated their stocks and sold their homes in time to capture their capital gains. But the bubble mentality dictated that they buy and hold their ever appreciating assets in order to finance more consumption.

Thus, Americans frontloaded their consumption before they had the money in hand to pay for it. Many stopped saving and counted on asset gains to finance their retirements. Others spent their asset gains along with all their earnings. Amidst the frenzied pursuit of upper middle class lifestyles for all, the most basic principle of financial planning--that each of us has a finite lifetime income--was forgotten. But lifetime income is finite, even when one counts not only earnings like wages and salaries, but also interest, dividends, capital gains, pensions, inheritances, gifts, Social Security and other government assistance, and all other sources of income. No one has unlimited income and if you borrow for the purposes of current consumption, you will simply consume more now, and less later, when you have to repay your debts. This dynamic becomes all the more stark if the unrealized capital gains you count on evaporate in collapsing asset bubbles. The Aughts were the time when many consumed more. The 2010s will be a time when they, of necessity if not by choice, consume less.

America did the same thing on a national scale. Those self-proclaimed guardians of fiscal restraint, the Republican Party, recklessly embarked on a program of sizeable tax cuts while whipping out the federal checkbook early and often. Meanwhile, the Republican controlled Federal Reserve never saw an interest rate cut it didn't like, and became almost a service organization providing low cost of funds to the big Wall Street banks that were making profits hand over fist from asset bubbles they helped to foster. The national welfare became a national bloat.

Japan, China, Europe and other foreign purchasers of U.S. Treasury securities were facilitators of the American bloat. If the federal government had been forced to fund its profligacy solely from domestic sources, interest rates would have risen quickly and imposed discipline. But the willingness of foreigners to transfer their wealth to the Treasury Department allowed the gravy train to keep running from sea to shining sea. American consumption served the needs of their export-driven economies, and American bloat made them better off. China could never have achieved its 10% plus growth rate during the Aughts without the American consumption frenzy. There were no angels on the road to Lake Wobegon.

But it turned out that Lake Wobegon is fictional. Now, everyone is scrambling for cover. Banks stopped lending. Consumers became savers. Foreigners are quietly slipping away from the dollar. Even as the stock market rose this past year, the relatively light trading volume betrayed the fact that much and probably most of the trading consisted of market pros tossing stocks back and forth between each other. The individual investor, busy packing a homemade lunch before carpooling to work, has largely stayed on the sidelines. The laid off hope that unemployment compensation and food stamps will be enough to get them through the month. Formerly upper middle class professionals pretend that peanut butter is Thai peanut sauce without the spices.

What the decline in the stock and real estate markets reveal is that America lost value over the Aughts. The decade was financed with borrowed money and illusory asset values. The government's current strategies for recovery--borrowing and printing money to save banks and stimulate consumption--have all the qualities of methadone. They ease the pain and allow the patient to stabilize. But true recovery requires increasing America's value.

Economic value emanates from the ability to produce things that other people will pay for. No nation has attained prosperity by borrowing or printing money. America can no longer compete with other nations by producing clothing, furniture, or a lot of other consumer goods. It must focus on its advantages--creativity, innovation, complexity, knowledge, skill, and risk taking. Industries that reflect these advantages include, among others, high tech, entertainment, agriculture, aircraft manufacturing, medical technology, machine tools and, indeed, automobile manufacturing. Granted, the American nameplate auto companies haven't exactly demonstrated much prowess recently. But millions of cars bearing foreign nameplates are made in America, and hundreds of thousands of Americans work in the plants where these cars are made. In actuality, Americans are skilled at auto manufacturing; just not always for companies headquartered in Michigan.

Another way to add value to America is to allow more foreign students to attend American universities. America has the largest and most comprehensive university system in the world. The economic downturn has put a lot of strain in schools and students. Increasing the numbers of foreign students, who would pay full freight (and out of state tuition, in the case of state universities), would enhance university revenues while enriching the educational process. A certain number of foreign students would stay, thereby bolstering America's intellectual capital. There are security concerns with allowing in greater numbers of foreign students. But the recent Detroit airline bomber was entering the U.S. on a tourist visa. Restricting the inflow of students won't stop a determined terrorist.

More federal assistance to small business and business startups is also desirable. Small businesses are crucial to job growth, and also innovation. Many and probably most of the biggest innovations in high tech were created in suburban garages or college dorm rooms by obsessed kids having low fiber diets. These kids may improbably be crucial to America's future.

There's no single policy or program that will accomplish the goal of adding value to America. Republican knee jerk demands for tax cuts ring hollow when one remembers their utter lack of fiscal responsibility during the W years. At this juncture, there's no way to reduce the government's role in the economy without reducing the size of the economy. Not many Americans favor shrinking the economy. International trade agreements prevent the government from providing direct subsidies to favored industries. But measures such as trade financing, intellectual property protection, visas for skilled workers and students, small business lending, protection of American goods from foreign trade barriers, and more federal support for basic research and development would all be helpful.

Saving should be encouraged. America is way too dependent on foreign capital. Domestic savings could provide a cheaper source of capital--American investors wouldn't demand a premium to cover the risk of currency fluctuations. Indeed, domestic savings would make the federal deficit easier to finance (one reason the Japanese government, which has a debt load much larger than the U.S. government, hasn't imploded is that the Japanese people themselves are financing their government's debt and they aren't inclined to transfer the bulk of their savings offshore). The government's obsession with stimulating current consumption keeps smashing against the rock of individual determination to save. Maybe the government should help the citizens have their way, and then enjoy the benefits.

The Revival of the Bank of the United States

The U.S. government is, for all practical purposes, becoming the most important bank in America. Two recent measures demonstrate the point. First, the Treasury Department announced yesterday that it was lifting the $200 billion limit it had previously placed on the funding it would provide to each of Fannie Mae and Freddie Mac. It will now back those two firms without limit. Admittedly, $200 billion is pocket change these days, with our multi-trillion dollar federal debt and all that. But the absence of any limit now means that for all practical purposes, the federal government, through its cheery sales staff (Fannie, Freddie, Ginnie Mae and the FHA) is responsible for virtually all the mortgage loans in America. Okay, the government is technically guaranteeing the loans, not funding them. But without the government (and taxpayers) being on the hook for defaults, there would be hardly any mortgages. The government makes today's real estate market (however weak it may be) possible.

Second, the Federal Reserve announced yesterday a new measure to "withdraw" some of the accommodative flood of liquidity it spewed into the financial system over the past year. It will offer interest bearing term deposits (equivalent to certificates of deposit) to member banks. These deposits will take cash out of the financial system for the length of the term, so there is a temporary reduction of liquidity. But what happens when the term ends? The deposit goes back to the member bank, where as part of the money supply it could have inflationary impact.

Why doesn't the Fed simply take back some of the cash it printed and sent out into the financial system? It hasn't said. Remember that much of that money was used to buy asset-backed securities and U.S. Treasury securities. One suspects that the reason is that it can't find buyers for those assets, not without pushing interest rates higher than it wants them to go. Thus, the Fed won't reduce its balance sheet (just as it wouldn't with its previously announced reverse repo idea; see http://blogger.uncleleosden.com/2009/12/will-feds-reverse-repos-reverse.html). The Fed will continue as a major financier of asset-backed securities and U.S. Treasury securities (the latter being really weird because it means the government is printing the money it "borrows" and spends; that would be a pure money print in any place except a rabbit hole).

One also suspects that another reason for the member bank term deposit idea is that these accounts would be treated as part of the bank's capital for regulatory purposes. The banks all know that higher capital requirements are in the picture. If they had to buy, say, U.S. Treasury securities in the bond markets to meet those requirements, they might push interest rates up. By offering special CDs to member banks only, the Fed allows them to meet capital requirements without having to roil the Treasury securities markets. In other words, the federal government would appear to be providing special funding to capitalize banks while keeping interest rates lower.

We've already proposed that Fannie and Freddie be reconstituted as nonprofit organizations whose public purpose would not be entwined with private, profit-seeking shareholder interests that distort incentives. See http://blogger.uncleleosden.com/2009/12/fannie-and-freddie-dont-privatize-them.html. Yesterday's announcement by the Treasury Department that it was lifting its ceiling on federal assistance boosted Fannie's and Freddie's stock prices by about 20% over the last two days. This was a nice belated Christmas present to the speculators who probably comprise most of Fannie's and Freddie's shareholders. But what about the taxpayers, who so generously now guarantee assistance without limit to Fannie and Freddie? They get lumps of coal, as far as we can tell.

There are good reasons for government intervention in times of crisis and panic. But growing mission creep is turning the government into another Bank of the United States. There were two Banks of the United States in the late 18th and early 19th centuries. The federal government twice created a national bank in order to provide financial services on a larger scale than it thought private banks of the day could handle. But the charter of the Second Bank of the United States was allowed to expire by President Andrew Jackson, out of concern that the Bank favored commercial interests of the East Coast, to the detriment of rural interests and the Western states (those now called the Midwest). This may ring bells in light of present day concerns that the federal government is too attentive to Wall Street while ignoring Main Street.

When the government supersedes private industry, market principles become diluted by politics. This isn't wrong by itself. Taxes, police and fire protection, national defense, social safety nets like unemployment compensation, workers compensation, Social Security, Medicare, Medicaid and so on all represent political solutions to problems that market principles were thought to handle poorly. But if the federal government is going to become the most important bank in the country, then we should have a serious, explicit discussion about how it will allocate credit--instead of today's quiet, step-by-step mission creep--and why so much federal support should be given to humongous private banks that compensate their executives munificently but lend so little the government needs to step in and lend in their place at the expense of the soon-to-be-more-heavily-taxed citizenry.

Japan: 20 Years of Lessons for America

On Dec. 29, 1989, the Nikkei 225, Japan's stock market benchmark, closed at an all time high of 38,915.87. On Friday, Dec. 25, 2009 (a trading day in Tokyo), the Nikkei 225 closed at 10,494.71. It's been lower, with a post-1989 low of 7,603.76 in April 2003. That's about an 80% drop, not quite as bad as the Dow Jones Industrial Average's 89% drop during the Great Depression but still pretty awful. An investor who bought the Nikkei 225 at its peak would have a 73% loss today.

Japan's economy was the world's most impressive from 1960 to 1989. In the 1960s, it grew at a rate of about 10% a year, comparable to China today. In the 1970s, it grew at an annual rate of 5%, and in the 1980s, 4% a year. The slowing growth rate reflected the maturation of the Japanese economy, but not decline. In the late 1980s, Japanese investors bought American icons like Rockefeller Center and Columbia Pictures. Many viewed Japan as an unstoppable economic juggernaut.

The 1980s Japanese stock market bubble, and a concurrent real estate bubble, were attributable to the ready availability of cheap capital stemming from Japanese government policies that encouraged saving and low interest rates. The combination of the two led many Japanese to speculate in stocks and real estate. If this sounds familiar, then look at the late 1990s and the 2000s in the United States. There is an eerie resemblance, with the Federal Reserve using monetary policy to ensure a steady supply of cheap capital.

Like all assets bubbles, the Japanese stock and real estate markets popped eventually. The Japanese response also resembled America's response to the 2007-08 financial crisis: all government all the time. Banks were propped up as their accounting standards were relaxed. Losses were swept under the carpet while banks stopped lending. Fiscal discipline evaporated and government deficits ballooned. Government cash handouts to consumers provided temporary stimulus.

But none of it did much lasting good. Japanese economic growth slowed dramatically after 1989, down to the range of 1% to 2% on average. Japanese unemployment levels rose, and remain high. The Japanese social safety net, much of it based on the lifetime employment policies of large companies, frayed. The Japanese consumer, already cautious, became yet more thrifty. Once a mecca for the world's fashion brands, Japan today is singlehandedly causing a depression among European fashion companies. The Japanese economy shrank by 0.7% in 2008 as a result of the world financial crisis and likely has shrunk by more in 2009.

A natural question is whether the U.S. is headed for anything like Japan's 20 years of stagnation. It has suffered a painful stock and real estate market crash, not as proportionately large as Japan's, but nevertheless the worst since the Great Depression. The U.S. government has responded faster than Japan's, but in much the same way--bailouts and grade inflation (in the form of relaxed accounting requirements) for banks, a surfeit of deficit spending, a trillion dollar plus money print by the Fed, and cash given one way or another to consumers. The private sector response has also been similar. Japanese banks didn't make new loans, because of all the bad loans they didn't have to write down. The Japanese government liquidity that was dumped into the economy found its way to investments in Japanese government debt (i.e., the Japanese trusted only their government and wouldn't make private sector investments), and the carry trade, where yen were swapped for higher yielding currencies (like the U.S. dollar) and invested overseas. Today, U.S. banks don't make new loans because they still hold a lot of bad loans and cranky assets. Vast shiploads of the U.S. government's stimulus money is flowing into the carry trade and going overseas, or is being used for commodities and stock speculation. Some of the money loaned by the Fed to U.S. banks is being invested in U.S. Treasuries or is left on deposit at the Federal Reserve Banks. The net effect of these circular transactions is the outright transfer of money by the U.S. government to banks (in the form of interest payments less the minimal costs of banks borrowing from the Fed) for no reason other than that they are member banks.

In short, sloshing a lot of money around is a poor substitute for dealing with economic fundamentals. One begins to suspect that the Fed's and Treasury's secret intention is to stall for time in the hope that the economy somehow recovers. But evidence of recovery is limited, and such that exists indicates a slow recovery. The U.S. stock markets have risen some 60% since March 2009. But the Nikkei 225 also had sharp spikes during its secular decline of the last 20 years. Today's bulls seem to assume that because the market has been on a tear recently, it will always and forever rise. There evidently is no bull market on the learning curve.

The Japanese experience of the last 20 years contains a couple of noteworthy lessons. First, monetary policy doesn't have much impact when the financial system is dysfunctional. Pumping vast amounts of cash into banks and other financial firms has little benefit for the real economy if the cash is siphoned off into commodities and stock speculation, the carry trade, U.S. Treasury securities, or is held in anticipation of having to write off losses banks have been allowed to defer. The velocity of money--or rate at which it turns over--is effectively zero when the cash simply is sent back to the government, as is the case when American banks take federal assistance and invest it in Treasury securities or deposit it with a Federal Reserve Bank. For the velocity of money to be positive (a predicate to effective monetary policy), new loans need to be made. That's been mighty slow to happen.

Second, zero or ultra low interest rate policies won't necessarily spark an economic revival. Indeed, they may be unproductive. When the cost of borrowing is virtually zero, a lot of basically stupid activities begin to make mathematical sense in an ROI (return on investment) analysis. Thus, a lot of the federal stimulus has gone into commodities and currency speculation. Or else it has been used to gamble in stocks when the price-earnings ratio is signalling with a big, bright yellow light (see http://blogger.uncleleosden.com/2009/12/warning-from-price-earnings-ratio.html). Asset speculation won't revive the real economy. At the same time, savers--especially retirees who live on interest from their assiduously accumulated CD's--embrace thrift more than ever, reducing consumption when consumption is most needed by the economy. It's one thing to reduce the fed funds rate to lower banks' costs of borrowing in order to motivate them to lend. But when they won't lend because their books are full of rotten-to-the-core assets, reducing interest rates only cuts consumption without increasing lending. The Fed may be pushing things backwards.

Huge government deficits and big money prints can stave off a plunge into depression. They did in Japan, and they have in America. But they won't produce prosperity. That's the lesson that Japan of the last 20 years teaches, and the one that America hopefully learns before suffering 20 years of stagnation itself. Raising interest rates would impose at least the beginnings of investment discipline resulting from an actual cost of capital, which in turn would lead investors to question the wackiness of some of the stuff that's now au courant. Perhaps some funds would even be put to use in the real economy. Even if GDP growth were muted in the short term by increasing interest rates, money invested more intelligently could lay the foundation for long term growth. If Wall Street won't serve the socially valuable purpose of intermediation between savers and economic investment (as opposed to financial speculation), it should be bypassed. Stimulus money could be used for job creation and funding Main Street, as the Obama administration has lately proposed. From massive subsidies for the Erie canal and transcontinental railroad, to mail delivery contracts for nascent airlines, to investment tax credits and job creation measures of every stripe and variety, governments have intervened in the economy for the public welfare. Why stop now? Conservative purists and theorists would object, but their guys, Alan and W, really screwed things up. Why listen to a bunch of failures?

Additionally, immigration standards should be relaxed for highly educated workers from other countries that could bolster America's high tech and other industries. Taking other nations' intellectual capital provides a competitive boost of the first order. Those seeking to come here are ambitious and hardworking. They're exactly the people needed to revive the economy.

There are good reasons for the Fed to pull back from its unprecedented liquidity dump of the last year. But that's not enough. The Fed should impose much more stringent bank capital requirements. It should also make banks book the losses that remain swept under the carpet and greatly improve their risk management controls. Capitalism works only if responsibility and accountability are part of the picture. The government, by intervening, prevented market forces from imposing full responsibility and accountability on Wall Street. The government's subsequent kind and gentle treatment of the reckless few, who caused so much harm to so many, leaves open the possibility of future morasses. Such morasses have been Japan's experience for the last two decades, and they portend America's future unless risk, as well as reward, falls on the high and mighty along with everyone else.

Is the Federal Reserve's Free Ride Ending?

The announcement on Friday, Dec.4, that the unemployment rate had fallen slightly from 10.2 % to 10 % surprised many, and perhaps dismayed some at the Fed. At its Nov. 3-4, 2009 meeting, the Fed announced that it expected to keep the fed funds rate at "exceptionally low" levels for an "extended period" of time. That announcement helped to fuel stock and commodities prices for the month of November. But after Friday's announced unemployment drop, stocks closed with only a modest gain, gold fell 4%, oil fell a little over 1% and the 10-year Treasury note fell about 0.75% in value (with an increase in yield of about 10 basis points). The dollar rallied.

These market reactions were spurred by the implication that the Fed will have to raise interest rates sooner than it expected. An interest rate hike would strengthen the dollar, reduce the value of gold, and push bond yields higher (and bond prices lower). The price drop in oil--seemingly odd because a recovering economy would be expected to consume more oil--is a reflection of the asset bubbling spurred by the Fed's cheap money policies. The huge amounts of cash pumped by the Fed into the financial system pushed down the dollar, thereby making oil more valuable in dollar terms. If the Fed begins to pull back on its accommodation, thereby strengthening the dollar, oil prices in dollar terms would naturally abate.

The Fed's predictive powers have been demonstrably lacking. It failed to see the implications of the growth in the mid-2000s of looney mortgages (the kind given to people who couldn't repay), the misplaced risks and rewards of the securitization process (where Wall Street made monstrous amounts of money from doing deals--including excessively risky deals, recklessly stupid deals and irredeemably bad deals), the increasing opacity of the financial system's true condition caused by derivatives and then derivatives of derivatives, and finally the monumental blockheadedness of concentrating at AIG credit default swaps insuring hundreds of billions of dollars worth of mostly mortgage-related investments. One wonders whether the Fed has underestimated the pace of the economy's recovery.

On one level, we hope it has. Continuation of the Great Recession much longer could inflict lasting damage to consumers, workers, businesses and investors that might lead to the stagnation that has bedeviled Japan since its massive asset bubble burst in 1989-90. There, people seem to have lost faith in just about everything except the government. This was most recently demonstrated by the Japanese government's cancellation of plans to privatize its postal system (which is not only a mail carrier, but an enormous bank and insurance company). The U.S. government's greatly expanded role in the economy could easily become permanent if the private sector doesn't revive soon.

But a Christmas present in the form of improved economic performance could lead to volatility in the financial markets. A lot of players (they used to be called investors, but today long term investing is about as trendy as a large SUV) have borrowed dollars at cheap, short term rates, converted them into other currencies and invested in longer term plays denominated in other currencies. Or else they invested in oil or oil futures, betting that continued bottom of the barrel interest rates would push oil prices ever higher in dollar terms. Or they took heart from the Treasury securities market's improbable rally this year and the Fed's ongoing trillion dollar program to buy Treasuries and mortgage-backed securities, and used cheap borrowed money to purchase higher yielding long term securities they thought would be propped up by the Fed's massive money print. Or they jumped into the stock market with the hope that the Fed's gusher of liquidity would continue to push stocks higher, even after a 60% rally this year.

All this activity was premised on the Fed correctly foreseeing economic stagnation and keeping short term interest rates virtually at zero, as it publicly proclaimed. If the Fed again turns out to be wrong, and has to hike rates sooner than expected, a lot of free rides will end. The players who have borrowed short and invested long may well have to unwind their positions, learning the hard way that not matching the duration of your borrowings with the duration of your investments entails risk. That could lead to volatility in the financial markets. If the volatility begins to create systemic problems, the credit crunch could again rear its hideous head and banks may again become catatonic. Then we'd probably have the much feared double-dip recession.

The Fed meets again on Dec. 15 and 16, 2009. Don't expect any rate hikes then. But the Fed may be compelled by continuing good news to modify its promise (that's how financial markets players have been viewing it) of ultra low interest rates. If it does, the speculators in the financial markets might have to make painful adjustments (as they probably already are).

Even as the Fed for the past year has given banks and other financial market participants a virtually free ride on borrowed money, it's gotten a free ride in terms of monetary easing. With banks making almost no new loans and pulling back existing credit, no amount of Fed accommodation seemed to have any impact on consumer prices. The Fed could keeping shoving printed money off its loading dock and not pay the price of monetary policy gone wild.

But the law of unintended consequences always lies in wait to ambush federal economic policy. The Fed didn't intend for its monetary easing to stimulate asset speculation here and abroad, even though it should have been sensitized to that risk by its role in the pumping up the real estate bubble. Chairman Bernanke's pledge of greater transparency of the Fed's thinking is a good idea. But when the Fed starts to play that most dangerous game--publicly predicting the future course of the economy and interest rates--it had damn well better be right. Or the rest of us will pay the price.

Warning from the Price-Earnings Ratio

The price-earnings ratio is one of the most widely used investing metrics. Simply put, it's the ratio of the price of a share of stock compared to its earnings per share. One can use past earnings (typically, the past 12 months), or predicted future earnings (typically, the next 12 months). Past earnings tend to be a more solid number, although they didn't work out real well in the case of Enron, or some other companies that turned out to have fabricated earnings. Predicted future earnings is theoretically a more significant number, since stock values tend first and foremost to be based on anticipated future performance of the company. But one investor's prediction is another investor's fantasy. The accuracy of the prediction makes all the difference in the world.

Low p/e ratios are viewed as indicating stocks are cheap. High p/e ratios are usually taken to mean stocks are expensive and perhaps headed for a fall, or else speculative (i.e., based on the hope of a rise, and perhaps a big rise, in future profits).

By and large, the S&P 500 has a historical average p/e ratio of around 15 (based on past earnings). In the stock market boom of the late 1990s, the S&P 500's p/e ratio spiked up into the 40s. In the late 1990s, the U.S. economy was riding a wave. A huge peace dividend from the end of the Cold War pumped up the private sector as defense spending fell. The United States avoided major military conflicts, and enjoyed large gains in productivity. The economy benefited from cheap money provided by the Federal Reserve (probably too much and too cheap). The Silicon Valley and other tech centers blossomed. The economic outlook was rosy, and avid investors pushed the p/e ratio to 40+. We now know it meant stocks were quite speculative and volatile.

After the 2000-01 tech stock crash, the S&P 500 settled into the mid-20s during the early to mid-2000s. Last year, when the stock market crashed, the ratio dropped to the 15-20 range. Considering how gloomy things looked, a p/e ratio of 15 may have seemed pretty optimistic.

One might argue that this year's stock market rally vindicated last fall's relatively congenial p/e ratio. But the economic picture creates cognitive dissonance. We have a feeble real estate market, rising unemployment, spasmodic job creation, likely federal tax increases, limited ability of the government to authorize more stimulus spending, and an American public scared shirtless into saving. Just about the only thing that explains the 60% rally this year is the relentlessly accommodative Fed, which pumped out printed money like it was beer at a frat party. That money wasn't loaned to Main Street, but had to go somewhere. The stock market was one popular destination.

Today's S&P 500 p/e ratio based on the past 12 months of earnings is 72.83 (see http://online.wsj.com/mdc/public/page/2_3021-peyield.html). That's well above the speculative peak of the tech stock boom. When almost all prognostications for economic recovery are guardedly cautious, or else cautiously guarded, such a high p/e ratio seems to indicate that corporate profits will grow at a dazzling rate next year, or that the market is on very thin ice. Few predict the former. At the same time, the Fed can't keep pumping out printed money. It may even take the radical step of withdrawing a bit of it. Think of what happens to a frat party if the beer runs low. Today's p/e ratio tells you that if you buy the market now, view your investment as a long term bet.