John Mauldin's Outside the Box : Politics

A 20-Year Bear Market?

John Mauldin — Tue, 30 Jun 2009 02:31:31 GMT

Long time readers know that I am a huge fan of the work of Neil Howe. His book, The Fourth Turning, was one of the seminal pieces of my reading over the last 30 years. And it has turned out to be stunningly prophetic. Uncomfortably so. A roughly 80 year cycle has been repeating itself for centuries in the Anglophile world, broken up into four generations or turnings. We have begun what Howe called many years ago The Fourth Turning.

Neil Howe is the co-author, with the late William Strauss, of a number of seminal works on the impact of generations on cycles of history. Howe is a founding partner of LifeCourse Associates (lifecourse.com) which provides research to institutions looking to capitalize on generational research.

The June 2009 edition of The Casey Report, the flagship publication of Casey Research, featured a comprehensive 23 page interview with Neil Howe as well as suggestions on how to position your portfolio to profit during a Fourth Turning crisis. I persuaded my friend David Galland to at least summarize it for my Outside the Box this week, and he graciously did so. David is the managing editor of The Casey Report and has had a long career in the financial services industry; as a founding partner of the successful Blanchard Group of Mutual Funds and, before joining Casey Research, as a founding partner of EverBank, one of the big success stories in independent online banking.

Casey Research is offering readers of Out of the Box the opportunity to read the full edition of The Casey Report featuring the Howe Interview, and receive the publication for the next three months with a 100% satisfaction guarantee. For details click here... http://www.caseyresearch.com/crpmkt/crpSolo.php?id=144&ppref=CSN144ED0609B

I trust you will find this week's Outside the Box to be helpful. The more things change.....

John Mauldin, Editor
Outside the Box

A 20-Year Bear Market?

By David Galland, Casey Research

In November of 1997, my partner and co-editor of The Casey Report, Doug Casey, wrote an article titled "Foundations of Crisis," which leaned heavily on the research of Neil Howe and the late William Strauss.

Howe and Strauss have written many books on how generations determine the course of history and how they will shape America's future. Their forecasts on a wide variety of indicators have turned out to be amazingly accurate. They were among the first to predict (back in the late 1980s) the rise of Boomer-driven culture wars and the simultaneous rise of Gen-X-driven free agency and distrust of government. And they were completely alone back then in predicting, for the post-X "Millennial Generation" (a label they coined), a decline in youth crime and risk taking and an increase in youth civic engagement that would first become apparent around the year 2000. Guess what? For the last ten years, everyone has been noticing exactly these trends among teens and 20somethings.

Howe and Strauss also made extensive predictions, based on generational aging, on how America's entire social mood would likely change, in dramatic fashion, during our current 2000-2010 decade. To quote Doug's prescient 1997 article, which was reprinted in Outside the Box late last year...

"... an excellent case can be made the U.S. is approaching another time of secular crisis, a Fourth Turning, with an expected due date of 2005 – seven years from now – plus or minus a few years in either direction.

The Stamp Acts catalyzed the American Revolution, the election of Lincoln catalyzed the Civil War, the Crash of '29 catalyzed the Depression/WW II era. What might precipitate the elements now floating in solution? The answer is practically any random event that's sufficiently traumatic. Any of the theses of current disaster/action novels and movies will do nicely. Perhaps the accidental or intentional release of a super plague vector. The crashing of an airliner into the Capitol during a joint session. An all-out assault on the IRS computers by an armed group – or perhaps the computers just melting down due to the Year 2000 Problem. Perhaps a financial disaster that cascades into the Greater Depression. In any of these, or a hundred other scenarios, the federal government would almost certainly act precipitously and with a heavy hand, which would bring on a whole other set of consequences.

There's no way of telling where the Crisis will lead, or how it will end. That's going to depend not only on exactly who's in control, but what they do, who they're up against, and a hundred other variables we can't even anticipate.

One thing that seems certain is that real crisis brings out strong leadership. Because of its age and size, it will come from the Boomer generation, and it will be in the mold of Roosevelt or Lincoln – both very dangerous precedents. The boomers in elderhood will be dogmatic, harsh, puritanical, and quite willing to burn down the barn in order to destroy whatever rats they see. Admix that attitude to a time resembling the Revolution, the Civil War, or WW II, overlain with today's ethnic strife, urbanization, financial overextension, and powerful, compact new weaponry in the hands of foreign fanatics out to teach the Great Satan a lesson and it's a real witch's brew.

As eye-opening as Doug's predictions were, they brought us only to the onset of the current crisis. Consequently, we thought it both timely and important to check back with the source of much of the research he relied on. And so it was that I spent several hours talking with Neil Howe, co-author of the seminal work on generational cycles, The Fourth Turning, and, just recently, the subject of the DVD "The Winter of History." Howe is not just an historian, but also a Washington DC-based economist and demographer. While our conversation covered a great many topics, the overriding focus was on how things are likely to unfold from here.

Many bullish readers won't be thrilled to hear Howe's latest findings about the future, but given his predictive track record, dismissing them out of hand could be a costly mistake.

The summary outlook, according to Howe, is that we are in the very early stages of a 20-year period of economic and institutional upheaval – an era denominated by a crisis during which we'll likely witness the tearing down and reconstruction of many aspects of society as we know it.

As individuals, understanding Howe's views and taking some reasonable precautions makes a lot of sense. As investors, those views also have the potential to make us a lot of money.

Following is my high-level recap of my long conversation with Neil Howe, along with some general thoughts on the investment implications of a 20-year bear market.

Remember the Sixties?

If you're old enough -- or possess even a rudimentary sense of history -- think back to the 1950s, with roller-skating waitresses, crew cuts, and nuclear families of the sort represented by the iconic Leave it to Beaver. Fathers worked, while many mothers stayed home. Life had a certain predictable quality and, as far as anyone knew, would continue along the same lines for time immemorial.

But then something happened... the 1960s. Literally no one saw it coming. It was as if someone had flipped a switch that electrified America and, quickly, the world. Most everything changed, and a society accustomed to conformity was blown away with a fierce individualism expressed with long hair, sex, drugs, and rock and roll, topped off with civil disobedience and bloody riots in the streets.

What happened?

According to Neil Howe, in the mid-1960s, generational change pushed society around a dramatic corner as idealistic, individualistic young Baby Boomers (born 1943 to 1960) rebelled against the midlife leadership of their G.I. Generation parents (born 1901 to 1924).

These periods of transitions are part of a larger cyclical pattern made up of four distinct eras, or "Turnings," each lasting approximately 20 years. It can be helpful to think of the four turnings as you might think of the four seasons, repeating predictably in their own natural rhythm. A full cycle of turnings takes place over a period of about 80 to 90 years -- roughly the span of a long human life. A new turning begins as a new youth generation comes of age, bringing a new social ethic that compensates for the excesses of the midlife generation then in power.

While we don't have the space here to go into the full details of Howe's research, it's important to the topic at hand that we quickly recap the Four Turnings.

The First Turning is referred to by Howe as a High. As this follows a period of crisis, one of the hallmarks of a First Turning is a heightened sense of community and collective optimism, driven in part by the fact that the society has just come through a difficult and challenging time. Consequently, during First Turnings, societal institutions tend to be strong while individualism is weak. The post-World War II "High" of the mid-1940s through early '60s is the most recent example of a First Turning.

The Second Turning, called an Awakening, typically starts out feeling like the high tide of a High, with signs of progress and prosperity everywhere. But just as everything seems to be going along swimmingly, large swaths of society begin to chaff under the social conformity of the High, beginning to gravitate to more individualistic pursuits and demanding that their personal interests come first. You may recognize the "Consciousness Revolution" of the mid-1960s through early 1980s, correctly, as the Second Turning.

Next up, the Third Turning, which Howe calls an Unraveling, is much the opposite of a High. To wit, individualism dominates, while institutions are increasingly weak and discredited. Quoting Howe on the Unraveling...

"This is a time when social authority feels inconsequential, the culture feels exhausted, and people feel bewildered by the number of options available to them. It is a time of celebrity circuses and a tremendous amount of freedom and creativity in our personal lives, but very little sense of public purpose.

The most recent Third Turning began in the mid-'80s with Morning in America, and continued through the '90s. Previous periods of Unraveling in American history were also decades of cynicism and bad manners. Think of the 1920s, the 1850s, the 1760s. And history teaches us that the Third Turnings inevitably end in Fourth Turnings.

Finally, there is the Fourth Turning, called a Crisis. The recent Third Turning appears to be winding down, and we are currently on the cusp of a Fourth Turning. This is a time of great turmoil, when society's basic institutions are torn down and rebuilt, and seemingly insurmountable problems are addressed. During Fourth Turnings, America engages in a struggle for its very survival and redefines its identity as a nation. Large wars are often a part of this process. The American Revolution, Civil War, Great Depression, and World War II were all features of past Fourth Turnings.

In sum, Howe's research has shown that, with remarkable predictability, history is not a straight line extending toward a better and brighter (or increasingly awful) future, but rather a repeating cycle of the four distinct social eras. These four turnings have recurred with remarkable consistency throughout Anglo-American history, as Neil Howe outlines at length in Generations and The Fourth Turning. It is therefore no accident that America has experienced great cataclysms or "Crises" about every 80 years. Travel back eighty years from Pearl Harbor Day, and you land in the middle of the Civil War. Eighty years before that takes you to the Revolutionary War. If the rhythms of history hold, America is now poised to enter another Fourth Turning.

Bad News, Potentially Good News

You don't need me to tell you that the United States and in fact the world are now facing a plethora of intractable problems. The world's former powerhouse economy, the U.S., is now the world's largest debtor nation – and by a wide margin. The nation has trillions in unpayable liabilities coming due on Social Security and Medicare, to name just two of many broken government programs weighing on the country. And our much vaunted democracy is increasingly dysfunctional – rotten to the core, truth be known – thanks largely to entrenched special interests and a voting public clamoring for their own piece of the pie, while trying to hand the bill off to somebody else.

Meanwhile, the economy – despite rigorous jawboning by the government and its many friends in the large banking institutions -- is in serious trouble, with the housing market buffeted by tsunami-like waves of defaults, foreclosures, overvaluations, historic levels of personal debt, and tight credit that has left the U.S. government as the sole lender in many markets.

Bernanke and his ilk may see green shoots, but what they're really seeing is the deep, green sea rising up once again to bury the economy.

That's the bad news.

The potentially good news, if you credit Howe's research, is that the Crisis we're now entering will change pretty much everything. While this change will entail a great deal of pain and a reduced standard of living for a large number of people, by the time the Crisis subsides, society will have pretty much remade itself in ways that no one can predict at this point.

Put another way, today's intractable problems will be solved... one way or another.

What's Next

When discussing what's likely to follow next, Neil Howe turns to his generational profiles and points out that the rising societal power today belongs to the generation he calls the Millennials, individuals born between 1982 and 2004. They are a "Hero" generation, just like the G.I. Generation that coped so well with the turmoil of the Great Depression and World War II -- the last Fourth Turning. Coddled as children, the G.I.s were ultimately called upon to help society through a dark and dangerous period and rose to the occasion. Again, quoting Howe on the Millennials...

"These are today's young people, who are just beginning to be well known to most Americans. They fill K-12 schools, colleges, graduate schools, and have recently begun entering the workplace. We associate them with dramatic improvements in youth behaviors, which are often underreported by the media. Since Millennials have come along, we've seen huge declines in violent crime, teen pregnancy, and the most damaging forms of drug abuse, as well as higher rates of community service and volunteering. This is a generation that reminds us in many respects of the young G.I.s nearly a century ago, back when they were the first boy scouts and girl scouts between 1910 and 1920.

Unlike the Baby Boomers, who are largely individualistic and anti-establishment, the Millennials are good team players. We hear a lot these days about working together for a common cause, volunteerism, and the need for stronger government institutions, largely because these are the new priorities of the Millennial Generation.

As you may recall, out of the devastation of World War II, a spate of transnational political and economic institutions were born, including the United Nations, the World Bank, the World Health Organization, and the International Monetary Fund. By the time the current Fourth Turning is over, expect more of the same -- but probably even bigger and more ambitious.

What Does This Mean to You?

Most importantly, if Howe is right, this crisis is far from over. In fact, when I asked him where we are today on a scale from 1 to 10 -- with 10 representing as bad as the crisis will get -- he replied that we are at either 2 or 3. In other words, the worst is very much yet to come. And, per above, he expects this period of turmoil to take 20 years to play out. Thus, if nothing else, you may want to continue approaching matters of personal finance cautiously.

Secondly, if you're the type of individual that tends to get steamed up by larger and more intrusive government programs, you may want to take a few deep breaths and resolve yourself to the fact that this phenomenon is likely to get far worse before we see a return to celebration of individual rights. (And the cycle shows that we will see such a return -- about 40 to 50 years from now, when the next Second Turning comes around.)

If it is any consolation, the Millennial Generation places a great deal of weight on teamwork and the notion of doing things "smart." That doesn't mean, of course, that the various programs that are kicked off in an attempt to fix the many problems now confronting society will in fact turn out to be technically smart. But they will almost certainly be better thought out than some of the numbskull initiatives we've seen over the last 20 years.

You can also take some comfort in the fact that Millennials are builders, not destroyers. By contrast, the individualistic Boomers that dominate today's aging political class are world-class dissenters, radio talk show aficionados always ready to scrap it out for their beliefs. Millennials want to skip the philosophical debate and get straight to fixing things.

Other insights about Fourth Turning periods gained from my conversation with Neil Howe...

Government grows powerful, and sweeping new legislation is enacted. The old 1990s rule was: just compete and stay off the state's radar screen. The new 2010s rule will be: better have a presence in Washington so you're not dealt out of the "new" new deal. One political party tends to dominate. The Democrats under FDR during the last Fourth Turning offer a good example. While Neil Howe doesn't think it will necessarily be the Democrats this time around, they are certainly in the pole position at this point.
While public history speeds up, personal life slows down. Families will spend more time together, like in the old Frank Capra movies. Ever more households will be multi-generational, a trend now spurred by Boomers with large, empty McMansions and Millennials without jobs. There will be a blanding of the pop culture, with the entertainment of the young (put Miley Cyrus or "High School Musical" on fast forward) increasingly regarded as tamer than the entertainment of the old.
Innovation tends to stagnate, while a few new technologies will be chosen to be adopted on a large scale. We will see the equivalent of canals or railroads or interstates being built across America. To borrow from Carlotta Perez' four-stage description of technological revolutions, we are moving from the "innovation" to the "implementation" stage.
New laws and regulations will do less to referee a free market and more to pursue one or another national priority. They will increasingly favor the large producer over the retail buyer, investment over consumption, planning over risk, debt over equity. Businesses will hustle to reposition themselves. Anti-trust legislation will weaken.
The authority and obligations of community will strengthen at all levels, from local to national and possibly beyond (if our alliances prove durable). Personal reputation and membership will matter more. A "new localism" will reshape town and urban planning. A global slide toward national or regional protectionism will loom as a real danger.
It is too early to tell whether the crisis will ultimately be inflationary or deflationary, though we at Casey Research come down on the side of inflation for the simple reason that the government possesses the means to inflate. Due to the gold standard, that was not the case early in the Great Depression.
In the past, Fourth Turning periods have always resulted in the nation redefining who we are in some essential way. That was certainly the case during the American Revolution, when we transitioned from a British colony into a collection of independent states -- and the Civil War, when those states were hammered into a single nation. And, again, after World War II, when the U.S. went from being a relatively isolated nation to a global empire. A wild card, for instance a terrorist nuke going off in a city anywhere on the planet, could similarly take the country, and the world, into unforeseeable new directions.

li>Baby Boomers will continue to be respected for their cultural achievements (it's not a fluke of history that Boomer music and other entertainments are still wildly popular among the young), but will be increasingly ignored in the political debate. The term "senior citizen," already in decline, will disappear entirely. And if push comes to shove, Boomer's financial interests – including Social Security – will be subjugated "for the greater good."
There will be a growing push to rebuild the middle class. The wealthy and the impoverished alike will both come under pressure thanks to new pro-middle class initiatives. If you are a high-income earner, it's a certainty your taxes are going up, and likely by a lot. If you want to make a fortune, don't pursue the niche or the "long tail." Invent the next big brand that will appeal to Everyman.

Don't Worry, Be Happy

That is, at best, a sketch of my long conversation with Neil Howe and doesn't do justice to his research. If nothing else, however, I hope I've succeeded in giving you at least some sense of the man and his unique research and encouraged you to think outside the box about the nature of today's crisis.

A couple of final observations.

First, Neil Howe is not a negative person, nor a professional doomsayer. Rather, he is a social scientist and historian with decades of experience in the social sciences. As you speak to him, you get the sense that he doesn't view the world through any particular philosophical bias, but rather is simply reporting what his research is telling him about the current players on the global stage, and which act we are currently in.

Secondly, speaking as a Baby Boomer and someone with a lifelong distrust of government and its meddling institutions, talking to Neil left me feeling oddly relaxed -- letting go, if you will, of some of the frustration that has been building within me as I watch the nanny state grow more and more bloated.

That is not to say we won't continue to speak out against government waste and prolificacy. We will. But it seems increasingly clear that we're now caught up in a powerful trend toward bigger, not smaller, societal institutions -- and that these institutions will, over the period ahead, change the world as we know it.

Of course, being active investors, at the same time we raise our voices in protest, we'll deal with the reality of the situation by strategically positioning our portfolios to profit from the coming changes.

And so, like the Rockefellers and J.P. Morgan during the Great Depression, we'll make the trend -- to matter how negative -- our friend. You may want to consider doing so yourself.

Making the trend your friend is more important than ever, if your assets are to make it through the Fourth Turning intact. The Casey Report discovers and analyzes budding economic trends and turns them into hands-on, actionable recommendations for its subscribers. Read the latest report from Casey Chief Economist Bud Conrad about our favorite investment of 2009... a play on an all but inevitable economic development. Click here to read more.

Iranian Elections, Israel and the United States

John Mauldin — Thu, 18 Jun 2009 15:13:19 GMT

Dear Friends,

In the midst of an economic crisis, we are inundated with data - information that often, a few years down the line, turns out to be wrong. Forecasts are made based on a single month's set of data or previous trends, and the public often doesn't know how to read the fine print about margins of error.

The problem is faulty methodology. Most media and even government intelligence agencies assume the information they get from leadership figures is 100% correct, no questions asked - leading to defective analyses. Instead, underlying assumptions should be constantly vetted in the face of new facts. I'd encourage you to consider the intelligence produced by my friend George Friedman at STRATFOR - a trusted source in forecasting future geopolitical trends.

Click here to watch this video by George and his intelligence team. It looks beyond the current protests in Iran and delves into what policy changes could be on the horizon in this pivotal Middle Eastern state. George extrapolates what these recent events mean for President Obama's and Israel's options in terms of Iran and the peace process.

Anyone looking to gain a leg up in the world of finance needs to understand geopolitics and foreign investments. Take a look at STRATFOR, which offers a special deal for my readers. Barron's referred to them in a cover-story profile as the "Shadow CIA," but I would say that their methodology gives them much greater accuracy than their government counterpart.

To Intelligence,
John Mauldin

The Geography of Recession

John Mauldin — Thu, 04 Jun 2009 21:16:46 GMT

Dear Friends:

One of the first things you learn about analyzing a company is how to dissect a balance sheet. What assets and liabilities can be deployed by a company to create equity over time? I've enclosed a fascinating variant on this process. Take a look at how STRATFOR has analyzed the "geographic balance sheets" of the US, Russia, China, and Europe to understand why different countries' economies have suffered to varying degrees from the current economic crisis.

As investors, it's precisely this type of outside-the-box thinking that can provide us profitable opportunities, and it's precisely this type of outside-the-box thinking that makes STRATFOR such an important part of my investment decision making. The key to investment profits is thinking differently and thinking earlier than the next guy. STRATFOR's work exemplifies both these traits.

I've arranged for a special deal on a STRATFOR Membership for my readers, which you can click here to take advantage of. Many of you are invested in alternative strategies, but I want to make sure that you also employ alternative thinking strategies. So take a look at these different "country balance sheets" as you formulate your plans.

Your Mapping It Out Analyst,

John Mauldin

The Geography of Recession

By Peter Zeihan

The United States and the Free Market

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world's largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts.

Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world's largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake. (The cake itself is free — and, incidentally, the United States had so much free capital that it was able to go on to build one of the best road-and-rail networks anyway, resulting in even greater economic advantages over competitors.)

Third, geography has also ensured that the United States has very little local competition. To the north, Canada is both much colder and much more mountainous than the United States. Canada's only navigable maritime network — the Great Lakes-St. Lawrence Seaway —is shared with the United States, and most of its usable land is hard by the American border. Often this makes it more economically advantageous for Canadian provinces to integrate with their neighbor to the south than with their co-nationals to the east and west.

Similarly, Mexico has only small chunks of land, separated by deserts and mountains, that are useful for much more than subsistence agriculture; most of Mexican territory is either too dry, too tropical or too mountainous. And Mexico completely lacks any meaningful river system for maritime transport. Add in a largely desert border, and Mexico as a country is not a meaningful threat to American security (which hardly means that there are not serious and ongoing concerns in the American-Mexican relationship).

With geography empowering the United States and hindering Canada and Mexico, the United States does not need to maintain a large standing military force to counter either. The Canadian border is almost completely unguarded, and the Mexican border is no more than a fence in most locations — a far cry from the sort of military standoffs that have marked more adversarial borders in human history. Not only are Canada and Mexico not major threats, but the U.S. transport network allows the United States the luxury of being able to quickly move a smaller force to deal with occasional problems rather than requiring it to station large static forces on its borders.

Like the transport network, this also helps the U.S. focus its resources on other things.

Taken together, the integrated transport network, large tracts of usable land and lack of a need for a standing military have one critical implication: The U.S. government tends to take a hands-off approach to economic management, because geography has not cursed the United States with any endemic problems. This may mean that the United States — and especially its government — comes across as disorganized, but it shifts massive amounts of labor and capital to the private sector, which for the most part allows resources to flow to wherever they will achieve the most efficient and productive results.

Laissez-faire capitalism has its flaws. Inequality and social stress are just two of many less-than-desirable side effects. The side effects most relevant to the current situation are, of course, the speculative bubbles that cause recessions when they pop. But in terms of long-term economic efficiency and growth, a free capital system is unrivaled. For the United States, the end result has proved clear: The United States has exited each decade since post-Civil War Reconstruction more powerful than it was when it entered it. While there are many forces in the modern world that threaten various aspects of U.S. economic standing, there is not one that actually threatens the U.S. base geographic advantages.

Is the United States in recession? Of course. Will it be forever? Of course not. So long as U.S. geographic advantages remain intact, it takes no small amount of paranoia and pessimism to envision anything but long-term economic expansion for such a chunk of territory. In fact, there are a number of factors hinting that the United States may even be on the cusp of recovery.

Russia and the State

If in economic terms the United States has everything going for it geographically, then Russia is just the opposite. The Russian steppe lies deep in the interior of the Eurasian landmass, and as such is subject to climatic conditions much more hostile to human habitation and agriculture than is the American Midwest. Even in those blessed good years when crops are abundant in Russia, it has no river network to allow for easy transport of products.

Russia has no good warm-water ports to facilitate international trade (and has spent much of its history seeking access to one). Russia does have long rivers, but they are not interconnected as the Mississippi is with its tributaries, instead flowing north to the Arctic Ocean, which can support no more than a token population. The one exception is the Volga, which is critical to Western Russian commerce but flows to the Caspian, a storm-wracked and landlocked sea whose delta freezes in the winter (along with the entire Volga itself). Developing such unforgiving lands requires a massive outlay of funds simply to build the road and rail networks necessary to achieve the most basic of economic development. The cost is so extreme that Russia's first ever intercontinental road was not completed until the 21st century, and it is little more than a two-lane path for much of its length. Between the lack of ports and the relatively low population densities, little of Russia's transport system beyond the St. Petersburg/Moscow corridor approaches anything that hints of economic rationality.

Russia also has no meaningful external borders. It sits on the eastern end of the North European Plain, which stretches all the way to Normandy, France, and Russia's connections to the Asian steppe flow deep into China. Because Russia lacks a decent internal transport network that can rapidly move armies from place to place, geography forces Russia to defend itself following two strategies. First, it requires massive standing armies on all of its borders. Second, it dictates that Russia continually push its boundaries outward to buffer its core against external threats.

Both strategies compromise Russian economic development even further. The large standing armies are a continual drain on state coffers and the country's labor pool; their cost was a critical economic factor in the Soviet fall. The expansionist strategy not only absorbs large populations that do not wish to be part of the Russian state and so must constantly be policed — the core rationale for Russia's robust security services — but also inflates Russia's infrastructure development costs by increasing the amount of relatively useless territory Moscow is responsible for.

Russia's labor and capital resources are woefully inadequate to overcome the state's needs and vulnerabilities, which are legion. These endemic problems force Russia toward central planning; the full harnessing of all economic resources available is required if Russia is to achieve even a modicum of security and stability. One of the many results of this is severe economic inefficiency and a general dearth of an internal consumer market. Because capital and other resources can be flung forcefully at problems, however, active management can achieve specific national goals more readily than a hands-off, American-style model. This often gives the impression of significant progress in areas the Kremlin chooses to highlight.

But such achievements are largely limited to wherever the state happens to be directing its attention. In all other sectors, the lack of attention results in atrophy or criminalization. This is particularly true in modern Russia, where the ruling elite comprises just a handful of people, starkly limiting the amount of planning and oversight possible. And unless management is perfect in perception and execution, any mistakes are quickly magnified into national catastrophes. It is therefore no surprise to STRATFOR that the Russian economy has now fallen the furthest of any major economy during the current recession.

China and Separatism

China also faces significant hurdles, albeit none as daunting as Russia's challenges. China's core is the farmland of the Yellow River basin in the north of the country, a river that is not readily navigable and is remarkably flood prone. Simply avoiding periodic starvation requires a high level of state planning and coordination. (Wrestling a large river is not the easiest thing one can do.) Additionally, the southern half of the country has a subtropical climate, riddling it with diseases that the southerners are resistant to but the northerners are not. This compromises the north's political control of the south.

Central control is also threatened by China's maritime geography. China boasts two other rivers, but they do not link to each other or the Yellow naturally. And China's best ports are at the mouths of these two rivers: Shanghai at the mouth of the Yangtze and Hong Kong/Macau/Guangzhou at the mouth of the Pearl. The Yellow boasts no significant ocean port. The end result is that other regional centers can and do develop economic means independent of Beijing.

With geography complicating northern rule and supporting southern economic independence, Beijing's age-old problem has been trying to keep China in one piece. Beijing has to underwrite massive (and expensive) development programs to stitch the country together with a common infrastructure, the most visible of which is the Grand Canal that links the Yellow and Yangtze rivers. The cost of such linkages instantly guarantees that while China may have a shot at being unified, it will always be capital-poor.

Beijing also has to provide its autonomy-minded regions with an economic incentive to remain part of Greater China, and "simple" infrastructure will not cut it. Modern China has turned to a state-centered finance model for this. Under the model, all of the scarce capital that is available is funneled to the state, which divvies it out via a handful of large state banks. These state banks then grant loans to various firms and local governments at below the cost of raising the capital. This provides a powerful economic stimulus that achieves maximum employment and growth — think of what you could do with a near-endless supply of loans at below 0 percent interest — but comes at the cost of encouraging projects that are loss-making, as no one is ever called to account for failures. (They can just get a new loan.) The resultant growth is rapid, but it is also unsustainable. It is no wonder, then, that the central government has chosen to keep its $2 trillion of currency reserves in dollar-based assets; the rate of return is greater, the value holds over a long period, and Beijing doesn't have to worry about the United States seceding.

Because the domestic market is considerably limited by the poor-capital nature of the country, most producers choose to tap export markets to generate income. In times of plenty this works fairly well, but when Chinese goods are not needed, the entire Chinese system can seize up. Lack of exports reduces capital availability, which constrains loan availability. This in turn not only damages the ability of firms to employ China's legions of citizens, but it also removes the primary reason the disparate Chinese regions pay homage to Beijing. China's geography hardwires in a series of economic challenges that weaken the coherence of the state and make China dependent upon uninterrupted access to foreign markets to maintain state unity. As a result, China has not been a unified entity for the vast majority of its history, but instead a cauldron of competing regions that cleave along many different fault lines: coastal versus interior, Han versus minority, north versus south.

China's survival technique for the current recession is simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

Discordant Europe

Europe faces an imbroglio somewhat similar to China's.

Europe has a number of rivers that are easily navigable, providing a wealth of trade and development opportunities. But none of them interlinks with the others, retarding political unification. Europe has even more good harbors than the United States, but they are not evenly spread throughout the Continent, making some states capital-rich and others capital-poor. Europe boasts one huge piece of arable land on the North European Plain, but it is long and thin, and so occupied by no fewer than seven distinct ethnic groups.

These groups have constantly struggled — as have the various groups up and down Europe's seemingly endless list of river valleys — but none has been able to emerge dominant, due to the webwork of mountains and peninsulas that make it nigh impossible to fully root out any particular group. And Europe's wealth of islands close to the Continent, with Great Britain being only the most obvious, guarantee constant intervention to ensure that mainland Europe never unifies under a single power.

Every part of Europe has a radically different geography than the other parts, and thus the economic models the Europeans have adopted have little in common. The United Kingdom, with few immediate security threats and decent rivers and ports, has an almost American-style laissez-faire system. France, with three unconnected rivers lying wholly in its own territory, is a somewhat self-contained world, making economic nationalism its credo. Not only do the rivers in Germany not connect, but Berlin has to share them with other states. The Jutland Peninsula interrupts the coastline of Germany, which finds its sea access limited by the Danes, the Swedes and the British. Germany must plan in great detail to maximize its resource use to build an infrastructure that can compensate for its geographic deficiencies and link together its good — but disparate — geographic blessings. The result is a state that somewhat favors free enterprise, but within the limits framed by national needs.

And the list of differences goes on: Spain has long coasts and is arid; Austria is landlocked and quite wet; most of Greece is almost too mountainous to build on; it doesn't get flatter than the Netherlands; tiny Estonia faces frozen seas in the winter; mammoth Italy has never even seen an icebreaker. Even if there were a supranational authority in Europe that could tax or regulate the banking sector or plan transnational responses, the propriety of any singular policy would be questionable at best.

Such stark regional differences give rise to such variant policies that many European states have a severe (and understandable) trust deficit when it comes to any hint of anything supranational. We are not simply taking about the European Union here, but rather a general distrust of anything cross-border in nature. One of the many outcomes of this is a preference for using local banks rather than stock exchanges for raising capital. After all, local banks tend to use local capital and are subject to local regulations, while stock exchanges tend to be internationalized in all respects. Spain, Italy, Sweden, Greece and Austria get more than 90 percent of their financing from banks, the United Kingdom 84 percent and Germany 76 percent — while for the United States it is only 40 percent.

And this has proved unfortunate in the extreme for today's Europe. The current recession has its roots in a financial crisis that has most dramatically impacted banks, and European banks have proved far from immune. Until Europe's banks recover, Europe will remain mired in recession. And since there cannot be a Pan-European solution, Europe's recession could well prove to be the worst of all this time around.

Obama's Strategy and the Summits

John Mauldin — Thu, 09 Apr 2009 16:30:00 GMT

Dear Friends:

A long-time religious land bridge between the Islamic and Western worlds, Turkey now finds itself an economic gatekeeper, a US-backed contender for the EU and the only key that could unlock Europe from dependence on Russian resources. The value of your dollar is intrinsically linked to last week’s summits—the most important multinational summits in history.

I’d like to share with you an article by my friend George Friedman at STRATFOR. It delves into the Summits (G20, NATO, bilaterals) and explores the connections between finance and geopolitics. In this case, it boils down to two string-holding puppeteers: Germany and Russia. Germany, the largest exporter in the world, is happy to up its production while the US spreads its dollar paper-thin by contributing to an IMF fund that will bail out countries who will in turn spend their money in Germany’s already tremendous export sector. Russia, the largest supplier of natural gas to Europe, too stands to benefit from US contributions to the IMF pot, as their slice of the pie gets bigger with the pan—as long as Turkey keeps her pipes closed.

The decisions made and policies enacted at the Summits trickle down to you and me. To make sense of it all, I encourage you to read STRATFOR. George has arranged a special offer for my readers: click here to take advantage of a 2-for-1 deal; you get a 2-year Membership for the 1-year price of $349. STRATFOR is the best global intelligence service in the world, and their unbiased coverage of the G20, NATO, and other extracurricular summits is unmatched by anyone else.

Yours,
John Mauldin

Obama's Strategy and the Summits

By George Friedman
April 6, 2009

The weeklong extravaganza of G-20, NATO, EU, U.S. and Turkey meetings has almost ended. The spin emerging from the meetings, echoed in most of the media, sought to portray the meetings as a success and as reflecting a re-emergence of trans-Atlantic unity.

The reality, however, is that the meetings ended in apparent unity because the United States accepted European unwillingness to compromise on key issues. U.S. President Barack Obama wanted the week to appear successful, and therefore backed off on key issues; the Europeans did the same. Moreover, Obama appears to have set a process in motion that bypasses Europe to focus on his last stop: Turkey.

Berlin, Washington and the G-20

Let's begin with the G-20 meeting, which focused on the global financial crisis. As we said last year, there were many European positions, but the United States was reacting to Germany's. Not only is Germany the largest economy in Europe, it is the largest exporter in the world. Any agreement that did not include Germany would be useless, whereas an agreement excluding the rest of Europe but including Germany would still be useful.

Two fundamental issues divided the United States and Germany. The first was whether Germany would match or come close to the U.S. stimulus package. The United States wanted Germany to stimulate its own domestic demand. Obama feared that if the United States put a stimulus plan into place, Germany would use increased demand in the U.S. market to expand its exports. The United States would wind up with massive deficits while the Germans took advantage of U.S. spending, thus letting Berlin enjoy the best of both worlds. Washington felt it had to stimulate its economy, and that this would inevitably benefit the rest of the world. But Washington wanted burden sharing. Berlin, quite rationally, did not. Even before the meetings, the United States dropped the demand — Germany was not going to cooperate.

The second issue was the financing of the bailout of the Central European banking system, heavily controlled by eurozone banks and part of the EU financial system. The Germans did not want an EU effort to bail out the banks. They wanted the International Monetary Fund (IMF) to bail out a substantial part of the EU financial system instead. The reason was simple: The IMF receives loans from the United States, as well as China and Japan, meaning the Europeans would be joined by others in underwriting the bailout. The United States has signaled it would be willing to contribute $100 billion to the IMF, of which a substantial portion would go to Central Europe. (Of the current loans given by the IMF, roughly 80 percent have gone to the struggling economies in Central Europe.) The United States therefore essentially has agreed to the German position.

Later at the NATO meeting, the Europeans — including Germany — declined to send substantial forces to Afghanistan. Instead, they designated a token force of 5,000, most of whom are scheduled to be in Afghanistan only until the August elections there, and few of whom actually would be engaged in combat operations. This is far below what Obama had been hoping for when he began his presidency.

Agreement was reached on collaboration in detecting international tax fraud and on further collaboration in managing the international crisis, however. But what that means remains extremely vague — as it was meant to be, since there was no consensus on what was to be done. In fact, the actual guidelines will still have to be hashed out at the G-20 finance ministers' meeting in Scotland in November. Intriguingly, after insisting on the creation of a global regulatory regime — and with the vague U.S. assent — the European Union failed to agree on European regulations. In a meeting in Prague on April 4, the United Kingdom rejected the regulatory regime being proposed by Germany and France, saying it would leave the British banking system at a disadvantage.

Overall, the G-20 and the NATO meetings did not produce significant breakthroughs. Rather than pushing hard on issues or trading concessions — such as accepting Germany's unwillingness to increase its stimulus package in return for more troops in Afghanistan — the United States failed to press or bargain. It preferred to appear as part of a consensus rather than appear isolated. The United States systematically avoided any appearance of disagreement.

The reason there was no bargaining was fairly simple: The Germans were not prepared to bargain. They came to the meetings with prepared positions, and the United States had no levers with which to move them. The only option was to withhold funding for the IMF, and that would have been a political disaster (not to mention economically rather unwise). The United States would have been seen as unwilling to participate in multilateral solutions rather than Germany being seen as trying to foist its economic problems on others. Obama has positioned himself as a multilateralist and can't afford the political consequences of deviating from this perception. Contributing to the IMF, in these days of trillion-dollar bailouts, was the lower-cost alternative. Thus, the Germans have the U.S. boxed in.

The political aspect of this should not be underestimated. George W. Bush had extremely bad relations with the Europeans (in large part because he was prepared to confront them). This was Obama's first major international foray, and he could not let it end in acrimony or wind up being seen as unable to move the Europeans after running a campaign based on his ability to manage the Western coalition. It was important that he come home having reached consensus with the Europeans. Backing off on key economic and military demands gave him that "consensus."

Turkey and Obama's Deeper Game

But it was not simply a matter of domestic politics. It is becoming clear that Obama is playing a deeper game. A couple of weeks before the meetings, when it had become obvious that the Europeans were not going to bend on the issues that concerned the United States, Obama scheduled a trip to Turkey. During the EU meetings in Prague, Obama vigorously supported the Turkish application for EU membership, which several members are blocking on grounds of concerns over human rights and the role of the military in Turkey. But the real reason is that full membership would open European borders to Turkish migration, and the Europeans do not want free Turkish migration. The United States directly confronted the Europeans on this matter.

During the NATO meeting, a key item on the agenda was the selection of a new alliance secretary-general. The favorite was former Danish Prime Minister Anders Fogh Rasmussen. Turkey opposed his candidacy because of his defense on grounds of free speech of cartoons depicting the Prophet Mohammed published in a Danish magazine. NATO operates on consensus, so any one member can block just about anything. The Turks backed off the veto, but won two key positions in NATO, including that of deputy secretary-general.

So while the Germans won their way at the meetings, it was the Turks who came back with the most. Not only did they boost their standing in NATO, they got Obama to come to a vigorous defense of the Turkish application for membership in the European Union, which of course the United States does not belong to. Obama then flew to Turkey for meetings and to attend a key international meeting that will allow him to further position the United States in relation to Islam.

The Russian Dimension

Let's diverge to another dimension of these talks, which still concerns Turkey, but also concerns the Russians. While atmospherics after the last week's meetings might have improved, there was certainly no fundamental shift in U.S.-Russian relations. The Russians have rejected the idea of pressuring Iran over its nuclear program in return for the United States abandoning its planned ballistic missile defense system in Poland and the Czech Republic. The United States simultaneously downplayed the importance of a Russian route to Afghanistan. Washington said there were sufficient supplies in Afghanistan and enough security on the Pakistani route such that the Russians weren't essential for supplying Western operations in Afghanistan. At the same time, the United States reached an agreement with Ukraine for the transshipment of supplies — a mostly symbolic gesture, but one guaranteed to infuriate the Russians at both the United States and Ukraine. Moreover, the NATO communique did not abandon the idea of Ukraine and Georgia being admitted to NATO, although the German position on unspecified delays to such membership was there as well. When Obama looks at the chessboard, the key emerging challenge remains Russia.

The Germans are not going to be joining the United States in blocking Russia. Between dependence on Russia for energy supplies and little appetite for confronting a Russia that Berlin sees as no real immediate threat to Germany, the Germans are not going to address the Russian question. At the same time, the United States does not want to push the Germans toward Russia, particularly in confrontations ultimately of secondary importance and on which Germany has no give anyway. Obama is aware that the German left is viscerally anti-American, while Merkel is only pragmatically anti-American — a small distinction, but significant enough for Washington not to press Berlin.

At the same time, an extremely important event between Turkey and Armenia looks to be on the horizon. Armenians had long held Turkey responsible for the mass murder of Armenians during and after World War I, a charge the Turks have denied. The U.S. Congress for several years has threatened to pass a resolution condemning Turkish genocide against Armenians. The Turks are extraordinarily sensitive to this charge, and passage would have meant a break with the United States. Last week, they publicly began to discuss an agreement with the Armenians, including diplomatic recognition, which essentially disarms the danger from any U.S. resolution on genocide. Although an actual agreement hasn't been signed just yet, anticipation is building on all sides.

The Turkish opening to Armenia has potentially significant implications for the balance of power in the Caucasus. The August 2008 Russo-Georgian war created an unstable situation in an area of vital importance to Russia. Russian troops remain deployed, and NATO has called for their withdrawal from the breakaway Georgian regions of South Ossetia and Abkhazia. There are Russian troops in Armenia, meaning Russia has Georgia surrounded. In addition, there is talk of an alternative natural gas pipeline network from Azerbaijan to Europe.

Turkey is the key to all of this. If Ankara collaborates with Russia, Georgia's position is precarious and Azerbaijan's route to Europe is blocked. If it cooperates with the United States and also manages to reach a stable treaty with Armenia under U.S. auspices, the Russian position in the Caucasus is weakened and an alternative route for natural gas to Europe opens up, decreasing Russian leverage against Europe.

From the American point of view, Europe is a lost cause since internally it cannot find a common position and its heavyweights are bound by their relationship with Russia. It cannot agree on economic policy, nor do its economic interests coincide with those of the United States, at least insofar as Germany is concerned. As far as Russia is concerned, Germany and Europe are locked in by their dependence on Russian natural gas. The U.S.-European relationship thus is torn apart not by personalities, but by fundamental economic and military realities. No amount of talking will solve that problem.

The key to sustaining the U.S.-German alliance is reducing Germany's dependence on Russian natural gas and putting Russia on the defensive rather than the offensive. The key to that now is Turkey, since it is one of the only routes energy from new sources can cross to get to Europe from the Middle East, Central Asia or the Caucasus. If Turkey — which has deep influence in the Caucasus, Central Asia, Ukraine, the Middle East and the Balkans — is prepared to ally with the United States, Russia is on the defensive and a long-term solution to Germany's energy problem can be found. On the other hand, if Turkey decides to take a defensive position and moves to cooperate with Russia instead, Russia retains the initiative and Germany is locked into Russian-controlled energy for a generation.

Therefore, having sat through fruitless meetings with the Europeans, Obama chose not to cause a pointless confrontation with a Europe that is out of options. Instead, Obama completed his trip by going to Turkey to discuss what the treaty with Armenia means and to try to convince the Turks to play for high stakes by challenging Russia in the Caucasus, rather than playing Russia's junior partner.

This is why Obama's most important speech in Europe was his last one, following Turkey's emergence as a major player in NATO's political structure. In that speech, he sided with the Turks against Europe, and extracted some minor concessions from the Europeans on the process for considering Turkey's accession to the European Union. Why Turkey wants to be an EU member is not always obvious to us, but they do want membership. Obama is trying to show the Turks that he can deliver for them. He reiterated — if not laid it on even more heavily — all of this in his speech in Ankara. Obama laid out the U.S. position as one that recognized the tough geopolitical position Turkey is in and the leader that Turkey is becoming, and also recognized the commonalities between Washington and Ankara. This was exactly what Turkey wanted to hear.

The Caucasus is far from the only area to discuss. Talks will be held about blocking Iran in Iraq, U.S. relations with Syria and Syrian talks with Israel, and Central Asia, where both countries have interests. But the most important message to the Europeans will be that Europe is where you go for photo opportunities, but Turkey is where you go to do the business of geopolitics. It is unlikely that the Germans and French will get it. Their sense of what is happening in the world is utterly Eurocentric. But the Central Europeans, on the frontier with Russia and feeling quite put out by the German position on their banks, certainly do get it.

Obama gave the Europeans a pass for political reasons, and because arguing with the Europeans simply won't yield benefits. But the key to the trip is what he gets out of Turkey — and whether in his speech to the civilizations, he can draw some of the venom out of the Islamic world by showing alignment with the largest economy among Muslim states, Turkey.

Market Vertigo

John Mauldin — Mon, 12 Jan 2009 22:07:13 GMT

I get a lot of newsletters from money managers around the country, which I try and read as they are written by people who are “in the trenches,” actually making decisions on behalf of their clients. It broadens my perspective. Frankly, most are not all that well written and unimaginative, but who ever said writing was easy? But some really strike a chord with me. Today’s Outside the Box I have read twice, which is unusual for me. Cliff Draughn is a wealth manager in Savannah, Georgia (Draughn Partners) and a good friend. His letter is a wide ranging tome on a variety of topics, but is full of common sense and one that I think will resonate with readers. I trust you will enjoy this.

John Mauldin, Editor
Outside the Box

Market Vertigo

"We give you a Republic; now see if you can keep it." -- Ben Franklin

As I have remarked in prior calendar-turning newsletters, it is this time of the year when most people pause to reflect on the past, ponder the present, and plan the future. The New Year always rings in with the soothsayers and fortunetellers of the market invading our consciousness with their predictions for the future. Investors' behavioral "herding instinct" seeks reassurance from the analysts of Wall Street that we indeed possess wisdom, and we search to find our thoughts confirmed in The Wall Street Journal, The Economist, Business Week and Forbes. Like most market pundits at the beginning of every New Year, I am tempted to weigh in on the absolute numbers prediction game and throw out my best guess as to what the next twelve months hold in store.

However, experience has taught me that these types of predictions always prove me to be far smarter or dumber than I deserve. For if I had predicted at the beginning of 2008 we would experience freezing credit markets, bankruptcies and near bankruptcies of our largest of financial institutions, massive amounts of taxpayer monies used to "save" the financial system, the worst recession numbers since the Great Depression, unemployment at 7% and rising, mortgage defaults at unprecedented levels, "deleveraging" on a global basis -- and toss in oil going from $95 a barrel to $145 a barrel and back to $37 -- then you would have sought to admit me into a mental ward for treatment last January. Add the miserable economic news reports of 2008, with market declines for the S&P 500 of 37%, the EAFE at -41.04%, and Emerging Markets of -48.88%, and is anyone surprised that most investors are beginning 2009 shell-shocked, scared, and (after Uncle Bernie's confession) doubtful that anyone on Wall Street is capable of the truth? Or, should we even call Wall Street the financial center anymore, since power in the financial markets has clearly shifted to Pennsylvania Avenue?

I fear that the US Treasury, the Federal Reserve, and the White House may decide who wins and who loses in the capital markets over the next three to five years. At the core of their decision-making process is the cattle prod of all cattle prods to get this economy moving: the existing TARP plus Obama's promised $850 billion stimulus package (with $310 billion in tax cuts). Could Pennsylvania Avenue be administering electrical stimulation to a dead horse? Perhaps it's time they consider breaking a new horse to ride, preferably one that does not gobble financial engineering as its main fare.

I titled 2008's first-quarter Newsletter "The Year of the Rat: Ultimate Minsky Time," and was that ever appropriate. In Hyman Minsky's economic teachings he states:

"The Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by hedge finance (stable) to a structure that increasingly emphasizes speculative and Ponzi finance (unstable)."

Our economy and markets could not have been perceived to be more stable from 2003-07, only to become completely unstable in 2008. As evidence of the market's instability, Howard Silverblatt, a noted S&P senior index analyst, observed that the S&P 500 rose or fell more than 5% on 17 trading days in 2008. When one considers there were only 17 trading days in the previous fifty years when the S&P rose or fell more than 5% in a day, then I think you can appreciate the unprecedented volatility we have experienced! As my grandmother would say, "Lordy, Lordy, what's the world coming to?" The increased volatility, sudden failure of credit and confidence, and a market crash unlike we have seen since the Great Depression are definitely indicative of "Ultimate Minsky" time. The volatility of the last quarter begs the question: could we get any more unstable?

In another reflection on last year's newsletter title, 2008 gave us the ultimate of all rats: Bernie Madoff. The warning signs were there: people like Harry Markopolos wrote the SEC on numerous occasions, and yet nothing was done. In my opinion, Mr. Madoff has done more harm to the investment community than any single individual I can remember in financial history. Samuel Isreal, Jerome Kerviel, Brian Hunter, Giancarlo Paretti, Nick Leeson, Ivan Boesky, Lou Pearlmen, and the eponymous Mr. Ponzi all pale in comparison to the economic, social, and trust destruction wrought by this single investment sociopath. In the Old Testament, the Bible speaks of the "Toevah," which is defined as "an abomination." On Bernard Madoff's tombstone, I hope they inscribe "The Great Toevah."

However, the financial crisis of 2008 cannot be blamed on worthless financial instruments; rather the fault in the system is worthless people. The credit default swap and derivative traders of AIG and other financial institutions who siphoned millions of dollars in bonuses for abusing the financial system and knowingly created unprecedented amounts of risk liability should be made to pay the bonuses back or be thrown in jail. The same could be said for SEC enforcement officers who turned a blind eye to certain institutions in hopes of securing lucrative employment once they left the SEC, from the very people they were supposed to be regulating. It disgusts me to think the taxpayers of this country are financing the multi-million dollar lifestyles of rogue traders and executives who now lounge on the beaches of Monte Carlo. I do not blame Main Street for its anger at Wall Street and the regulators who supposedly oversaw the investment world.

Without a doubt, 2008 was an historic year from a number of perspectives, and it is frankly one that I am glad to see in the rear-view mirror.

At the beginning of last year we put forth the following themes that would influence markets during 2008:

Credit and Liquidity
Bond Insurance Woes -- AMBAC, MBIA, FGIC
The Dollar
Commodities
Investor Psychology

Our thesis of a contracting credit market in the face of a declining real estate market was one of the easier predictions for 2008. What we missed, as did the Federal Reserve Chairman, Treasury Secretary, and almost everyone else in the investment world, was the severity and swiftness of the contraction and subsequent deleveraging of bank balance sheets. What happened to regulatory oversight and orderly markets? As we entered the fourth quarter of 2008 our financial system teetered on the edge of collapse, and the banking industry's ability to raise capital in the face of mounting loan and investment losses became impossibly difficult. Therefore, the Fed and the Treasury did the only thing they knew and utilized the taxpayers' balance sheet to be the lender of last resort for banks (Keynesian economics). Subsequently every other business lined up with its hand out, too. My fear of the 2008 government actions, specifically the enactment of the Housing and Economic Recovery Act (aka "HERA") in July and the Emergency Economic Stabilization Act (aka "EESA") in October, is that we are replacing our "Capitalist" system with a "Socialist" system and jeopardizing the principles that made this country great. The slope of socialism narrows and turns very slippery once government intervention and ownership of certain industries occurs. When corporate welfare programs begin, then it is inevitable that everyone jumps on the free-lunch bandwagon. One only need look at France and its economic picture to realize the problems associated with socialism in a supposedly free market environment. It reminds me of when Dr. Phil questions one of his guests who is obviously going down the wrong path. After the participant cops to his or her mistake, Dr. Phil typically looks up and asks, "And how's that working for you?" If the US continues a path of socialism and industry bailouts, then in another ten years our children are going to look up and ask, "So how's this working for you?' I think we know the answer.

So Cliff, what now? We all are very aware of where we are, but it is impossible to move forward by driving in the rear-view mirror. My investment themes for 2009 are as follows:

President Obama -- Great Expectations (also known as "ObamaRama")
Aging and Saving -- The Face of the American Consumer
A Market of Hope

Barrack Hussein Obama -- America's 44^th President

"So now, as an infallible way of making a little ease great ease, I began to contract a quantity of debt." -- Charles Dickens, Great Expectations

In November of 2008 we witnessed an election of epic proportions for the United States of America. The 2008 election will, in my opinion, foretell the fate of our industry and country throughout the lives of my children, as the actions taken over the next twelve months could reshape our systems and capital structure. To all the Op-Ed pieces that have been written on President Barrack Obama, I do not think I could add more commentary as to how one man will turn things around. He has instilled a sense of hope and a level of confidence not only to Wall Street but more importantly to Main Street. Hope and confidence are crucial to the eventual reversal of our current financial and economic woes, because they lead to the re-establishment of trust that is essential to the restoration of the global economy.

However, I caution anyone willing to place significant bets that Obama's "stimulus" plan will reverse the current recession tide any time soon, to simply examine the largess of issues confronting our economy. Expectations are off the charts as to the list of "fixes" that our President-elect and Congress should enact. Congress is essentially the same entity it was in 2004 and 2006, and the "system" does not change easily. The unions expect new labor laws (i.e. "protectionism"), investors expect revised financial regulations (i.e., protect us from the crooks), the auto industry expects to be saved (i.e., revive a corpse), environmentalist expect "green laws" (increased energy costs), the unemployed expect health care and extended benefits (entitlement, "it's my right"), the minorities expect enhanced affirmative action plans (ignoring a competitive global job market), and the average American consumer wants to continue to live an unrealistic lifestyle, given the level of global job competitiveness and increasing amounts of debt incurred by both consumers and our government (i.e., I deserve my father's lifestyle). As my own wise father once said, "Son, you can't borrow yourself out of debt".

President-elect Obama's immediate challenge is to deal with the current financial crisis and the economic recession. In periods of normal recessions, government debts (ours or anyone else's) generally rise because tax revenues decline and government expenditures climb. In 2008, the loss of about 1 million jobs, combined with declining corporate profits, resulted in a deficit of $455 billion versus a 2007 deficit of $163 billion (I am not including any expenses associated with the recent HERA or EESA bailout efforts). Will an $850 billion stimulus package that includes $310 billion of tax reductions work? Better yet, can Obama and his team even get the legislation passed in a timely manner without Congress layering on the special-interest pork and drawing out the legislative process for months while the recession only gets worse? Oh, and did I forget to mention Obama's promise for the withdrawal from Iraq? Israel's invasion of Gaza? The Russians now holding Europe hostage for natural gas? Or, that Pakistan is emerging as THE MOST volatile hot spot for military instability (remember, they have nukes)?

Even if Obama is able to pass the stimulus package and soften the current recession, our country still faces the fiscal task of dealing with the costs of Medicare, Social Security, and Medicaid that are growing at exponential rates due to an aging population. These entitlement programs, if left unchecked, are going to land our country in a much bigger financial crisis within the next 15 years than we are in today. I encourage you to visit these web sites:

www.fms.treas.gov/frsummary/index.html
www.gao.gov/financial/fy2008/citizensguide2008.pdf
http://www.pgpf.org -- Go the documentary feature I.O.U.S.A.

And, I fault Republicans and Democrats alike on this issue, as every administration and Congress since Reagan have punted Medicare, Medicaid, and Social Security to the next elected group. Should we expect any different this time around?

"When the people fear their government, there is tyranny; when the government fears the people, there is liberty." -- Thomas Jefferson

Obama faces multiple risks in the first year of his administration. In my opinion, the first risk he faces is one of "drifting," where he fails to deliver on the promises of the campaign trail and potentially loses credibility. Part of the "drifting" effect will be Congress' ongoing need to participate in all financial issues (and we thought the hearings on use of steroids in baseball were a waste) and to place demands on Obama's team to provide some form of "proof" that the benefits of public spending justify the costs. Of course, this is a ridiculous demand as (a) at no time before has Congress ever demanded proof to justify spending or tax cuts and (b) we are at an unprecedented moment where there are no comparative economic circumstances from which one could hypothecate proof.

The second major risk Obama faces will be the eventual protectionist cries in the name of defending American jobs. By restricting trade and imposing import tariffs (smells like Smoot Hawley all over again), our President and Congress will seek to protect America from an ever more competitive global economy. Sorry to say, but protectionism has not worked in the past nor will it work in the future. However, as unemployment continues to rise, Joe Plumber will want to know why his job is going overseas. The unions did not fully support Obama without reason, and I assure you that Mr. Gettelfinger will be calling on the current administration. When one considers that since the last G20 meeting in November, five of the twenty nations present have already announced intentions to raise import tariffs and restrict trade, then would it be any wonder if the unions pointed to these actions and demanded reciprocity? The countries who intend to begin "protectionist trade practices" include Russia, India, Indonesia, Brazil, and Argentina. What's good for the goose is … beware Mr. President, the wolves are close to the door.

The third risk I foresee for Obama's administration is the continued thought process of "too big to fail." Whether it is financial services, autos, transportation, etc., the "top-down" approach of providing more and more taxpayer dollars to weak corporations is ill-advised. In my opinion, if you're using taxpayer dollars, then either nationalize the company or let it fail. And, if you nationalize the company then wipe out the bond holders and shareholders, replace the management and board, sell the good assets to qualified buyers, and then and only then, have the taxpayers eat the remaining deficit. With the current "bailout system" we are merely trying to sustain the status quo, which penalizes those banking institutions that did not make bad decisions while at the same time rewarding poorly managed institutions by handing them taxpayer money. Until you put the stimulus money back in the hands of the private sector (i.e., the individual) you're fighting today's housing/mortgage fires with a garden hose. The bailout funds need to be distributed to the homeowners, not the banking and lending institutions. Banks currently taking the government TARP money (our tax money) are adding it as capital to their balance sheets and then sitting on the funds in anticipation of further losses, rather than lending back into the system. Obama should follow the laws of nature: if you have a herd of animals and some become sick, get rid of the sick. Why continue sustaining the sick animals that will eventually die anyway and at the same time risk the entire herd? A prime example of propping up the status quo occurred in December of this year when Treasury Secretary Paulsen made the unilateral decision to guarantee $306 billion of CitiGroup's assets. The guarantee was in addition to the $25 billion Citi had already received in TARP funding. The $306 billion "guarantee" was not part of TARP and was extended without Congressional approval! $306 billion is equal to what our government spent in 2007 for the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development, and Transportation combined. (The Economist) Unfortunately, the only money makers to come out of TARP and the proposed stimulus bill, in my opinion, will be the lobbyists, the legislators (imagine, with our taxpayer money, the campaign contributions to be received!), and a few "selected" legal, accounting, and infrastructure firms.

To date, the Fed/Treasury have made nearly $2 trillion of emergency loans in response to the economic crisis. On December 12, 2008, Bloomberg News sued the Treasury and the Federal Reserve for disclosure of the collateral being supplied by those institutions that were accepting these loans. To date, both Fed and Treasury have refused to disclose, claiming "It would be a dangerous step." Talk about taxation without representation. For the latest on TARP, I refer you to the following report:

www.ustreas.gov/initiatives/eesa/docs/TARPfirst-105report.pdf

"Any system produces winners and losers. If the gap between them gets too great, the losers will organize themselves politically and seek to recast the existing system -- within nations and between them." -- Henry Kissinger, in The Economist

Aging and Saving -- The Face of the American Consumer

Imagine if you will a snake that catches a rabbit for dinner. As we know from 7^th-grade biology class, the digestive tract of the snake simply engulfs the rabbit and, if watched over a period of days, the huge bubble progresses through the snake until the rabbit is gone. Now, as a metaphor, would you care to imagine the Baby Boomer generation as the rabbit in the American economy?

Initially, the boomers were the stimulus of economic expansion:

1950s -- parents buy new houses and cars, suburbs emerge, and America is King of Production
1960s -- more housing, more cars, college educations, Made in Japan = cheap, Vietnam, shaken values, Johnson's "War on Poverty"
1970's -- the Boomers emerge with jobs, are new consumers -- more housing, international manufacturing becomes more competitive, US corporations locate operations overseas
1980s -- Reagan tax cuts = increased discretionary spending, revenues up, social programs funded, Iron Curtain falls, technology enables global expansion
1990s -- peak Boomer earnings, corporate America dissolves pensions (funding liabilities, regulatory liabilities, increasing PBGIC premiums) and convince Boomers to "control" their retirement with self-directed 401(k)'s, Moore's Law at work in technology, the Internet becomes hostile to profits, emergence of private equity and venture capital on a large scale, increased financial engineering
2000s -- oops, where did the American Dream go?

The Boomers are now becoming retirees. The latest census data counted 303,824,640 US citizens. We are experiencing an annual birth rate of 14.18 births per 1,000; it is estimated we need at least 24.50 births per thousand to sustain our population (can you say immigration?). More importantly, we are only experiencing 8.27 deaths per 1,000, and the average life expectancy of an American male is 75.29 years, while the average expectancy for a female is 81.13 years … and growing. (CIA.gov library). America is aging, and as a result we are experiencing a decline in the number of workers that provide tax revenues and, more importantly, consumption.

The "big bulge" known as the Baby Boomer generation has been the growth engine of this country for the past five decades. But something happened in the last fifteen years that was not present in the prior years: we stopped saving. The bull market from 1982 to 2000, along with the ever-increasing value of our homes, made our balance sheets appreciate. Why save when our 401(k)'s were up an average of 15% a year and we kept upgrading our homes? Americans became spenders. During the period from 1980 to 2007, our savings rate went from 7.4% of wages and salaries to 1.7%. More importantly, since 2003 our savings rate has averaged less than 2% per year, and these numbers include both the private and government labor force. (Bureau of Economic Analysis)

Wages and salaries (both private and government) make up about 60% of personal income in the US. The remaining 40% is the combination of other labor income (benefits), proprietor's income (farm and non-farm), interest and dividend income, rental income, and transfer payments. Current annual income in the US is estimated at $12.1 trillion per year. As of 12/31/07, the average household income was $50,233 per year and the median was $67,609 per year. In addition, the current average savings rate in the US, as mentioned above, is currently at 1.7% of income per year, and the average amount of debt as a percentage of income is 21.19%. Why bring all this up? If you've read this far, stay with me a little further.

The American Consumer has been the engine of the last expansion. We have bought houses, cars, flat screens, beach condos, etc. and financed the purchases either by extracting the equity from our increasing home prices (home equity lines) or incurring additional debt through credit cards and other forms of consumer finance. In the average American's mind, as long as the bottom line of the balance sheet continued to increase (i.e., assets greater than liabilities) then all was well. But in 2008 something happened that had not happened to these Baby Boomers before: the value of all assets (stocks, houses, rental properties, etc.) declined. As a result the debt party began to unwind as the value of the assets declined while the debt (liabilities) remained, thereby shrinking the balance sheet. Americans are feeling poorer … much poorer.

If one considers that the average 401(k) is now a 201(k) and the average house (according to Case/Shiller) declined 26% from its peak value in 2006, then it's easy to understand why the Baby Boomer is feeling gut punched. The financial shock of watching the asset side of their balance sheets crumble while the debt side remained the same or actually grew has now forced the American consumer into a dilemma: How do I retire and live the same lifestyle that my parents enjoyed? Answer: I have to save money and reduce debt.

The consequence to the economy is, in my opinion, going to be a protracted, painful recession. Why? Because this recession is driven by asset devaluation, and that is different than a cyclical downturn. There is a need for institutions and households alike to reduce debt and restore equity to the balance sheet. For the consumer/individual this will only happen with an increase in his/her saving rate to reduce debt and fund future retirement. For example, if the average consumer goes from a 1.7% savings rate to a 5% savings rate, then that equates to $400 billion a year in either debt reduction or retirement funding. From the contra angle, that means there will be $400 billion less of American consumption. I label this the "Paradox of Thrift," in that we can't restore our balance sheets without additional savings, and our stock markets cannot recover without consumer spending and corporate profitability.

A Market of Hope

We have all read the papers and understand that 2008 was the worst year for stocks since the Great Depression. (As an aside, why do we call it "Great"?) As I read through the analysts reports, newsletters, Bloomberg, etc., there appears to me to be a decisive line between those who are either (a) cautiously optimistic that we have seen the worst and markets will improve or (b) see greater doom ahead, that will equal or surpass the depression of 1929 to 1936. I glean from the community of optimism the following:

How much more can stocks decline? A 52% decline in the S&P 500 from October of 2007 to the market low on November 20, 2008 is the most dramatic decline in history. The thought is that this decline reflects all the bad news of the economy looking out to 2010, and therefore the worst is over.
Mutual fund assets currently reflect that 37% of all mutual funds are invested in money market funds. In 2008, the net withdrawal from stock funds was a record $320 billion (Financial Times). The thought here is that at some point, with the cattle prod of .25% Fed Funds rates and negative T-Bill rates, the cash will seek other investment opportunities. Right now, the cash is simply scared while the market reprices risk.
The recent fall in gasoline prices will promote consumer spending again. The premise here is that the majority of Americans could care less about saving for the future. As a result, they will utilize any savings from energy expenses to resume their prior consumption practices and revive the economy.
The credit freeze and financial crisis continue to thaw, and the Keynesian policies of the Treasury and Federal Reserve will actually work this time.
Real estate prices are at a bottom, which will ease the credit and default issues of the mortgage market.

As you have heard me say or have read in prior newsletters: Hope is not a strategy. The following is data from my friend John Mauldin's newsletter regarding corporate earnings:

Let's look at their estimates for earnings in 2008. They started at $92 in early 2007 and are now down to $48. This chart is not something to inspire confidence in stock analysts.

On a trailing one-year basis, that puts the Price to Earnings Ratio (P/E) at over 19 as of today's close at 925, which does not make the market cheap. But last year's earnings are history. What about 2009? Again, the analysts are in a race to find the bottom.

The current projections are for $42.26 for 2009. That makes the forward P/E 22. That doesn't look like value at all, when the historical average is closer to 15.

Stocks are not cheap by valuation measures. As a result, we are finding far more opportunity in the credit (bond) markets than the equity markets at this time. I opine that we are bound to a "trade range" on stocks for 2009, with a bottom of 770 on the S&P and a top of 1120. On the housing and real estate front, I estimate that while most of the dramatic declines have occurred, real estate will not begin to recover until late 2010.

All bets and predictions to the upside of the stock market have as their common foundation a belief that the combined spending of the government, at unprecedented levels, combined with extremely low guaranteed interest rates (i.e., my "cattle prod") will lead the herd to a market recovery and stem the recession tide. For a lot of investors who have experienced 30% to 70% losses, the stock market is a thing of the past; however, the stock market is not dead. Short-term the market is a voting machine; long-term it is a weighing machine. In my opinion, we remain in a secular bear market that began in 2000. However, we will experience "mini-bull" markets and "mini-bear" markets during the secular bear that will probably last until 2014. One of the great sucker plays since the bear began in 2000 has been the "buy and hold for the long term" mantra that has been chanted by the sages of Wall Street. Simply look at the returns: from 12/31/99 to 12/31/08, if you invested in an S&P 500 index and held for "the long term," then your total return during this time would have been -28.13%, or an annualized rate of -3.6% per year. Small caps were better, with a total return of 11.66% or 1.23% annualized. If you expect to make money in the equity markets in 2009 going forward, then you must be willing to "trade" the volatility while also maintaining a high proportion of income-producing assets.

"Jay: You do know Elvis is dead, right?
Kay: No, Elvis is not dead. He just went home."

-- Men in Black

Because it is still applicable, I want to repeat two paragraphs from last year's first-quarter letter.

The Investor Psychology

People make mistakes when they invest. They do so as a result of their biases of judgment or mistake their perceptions as reality. There are several basic mistakes:

Over-Optimism: Most investors tend to exaggerate their own abilities.
Over-Confidence: Lends investors to overstate their knowledge, understate the risks, and exaggerate their ability to control the situation.
Cognitive Dissonance: Investors often have an incredible degree of self-denial.
Heuristic Rules: Rules of thumb that we employ for dealing with the daily information deluge by evaluating based on how closely a situation, person, etc., resembles someone or something, rather than examining and questioning; i.e., we "frame" and/or "anchor" the event/person/action.

Freud once said, "Thinking is rehearsing." What he meant was that after you accumulate the data and analyze the opportunities, then you have to take action. In the world of investing, there is no substitute for taking action. Therefore, as an advisor, I seek to understand our biases and attempt to make rational and prudent decisions based on fact and not perception. Savvy investors understand the risks inherent in their assumptions and adopt a more businesslike approach to investing by reducing and hedging risk. Investors are typically surprised when facing a loss, and the power of the loss far outweighs the power of gains. Each of you will always know of someone who made more money than we did: always. The critical thing we ask you to ask yourself is, What amount of risk was taken for the performance? Losses are inherent in any investment process; the key is to limit the size of the loss in order that you have more marbles to play with when good times return. Therefore remember the critical rule of compounding: Don't lose money.

As an investor, there are two steps you can take to improve your ability to handle the coming year:

Actively Manage the Asset Mix -- look to be contrarian (this is our primary job).
Develop Reasonable Expectations -- Wishful thinking is not a strategy.

It's not what you make, it's what you keep.

Cliff W. Draughn, Managing Principal

All In

John Mauldin — Tue, 06 Jan 2009 19:34:42 GMT

There is an ongoing debate on the current nature of the economic environment and what should the response be by government. Today's Outside the Box by Paul McCulley takes up one view, arguing that we need a federal response and stimulus package to protect the overall economy and save capitalism from itself. Tomorrow, I am going to send yet another view arguing that by doing so we are hurting the prudent investor and businesses that did not over-leverage and behaved responsibly. Both are important to understand. And as I will argue on Friday in my 2009 Forecast Issue, both are right. And that is one of the great economic paradoxes that we are faced with today. Navigating through this period is particularly challenging, but I think it is critical that you understand what Paul says today and what Bennet Sedacca will say tomorrow. Understanding what is going to happen, whether or not we agree with the philosophy behind it should be our goal, as it will make us better able to respond with our own portfolio and business decisions.

By the way, Paul McCulley, the Managing Director of Pimco, always features a "conversation" he has with his pet rabbit at the end of each year. Not only is it instructive, but it can also be downright funny. I think you will enjoy this letter a lot. And sorry about the Outside the Box coming later this week. We lost power for the day yesterday due to a mild ice storm here in Dallas.

John Mauldin, Editor
Outside the Box

All In

Global Central Bank Focus
Paul McCulley | December 2008/January 2009

(A conversation with Bun Bun, the author's Netherlands Dwarf pet bunny
and early-morning debating partner.)

PMc: Good morning, Bun Bun. Ready for our end of year chin wag?

BB: Again? And the question is not whether I'm ready, but whether you're ready. You're looking haggard, man, like a horse rode hard and put up wet. I never see you anymore, where you been?

PMc: First off, I ain't a horse. But I do catch your drift. As to where I've been, I've told you before: either at work or at my little rental cottage down on the water. I rented it for a weekend getaway, and found the water so soothing to my soul that I essentially live there now. So you got this big house all to yourself, Precious.

Except when my son, Jonnie is home from college, of course. He likes this space more than down on the water, not the least because I'm rarely here, I suspect. But that's only a suspicion. You know anything about that?

BB: Don't act dumb, Mac. He's 19 years old and has more girlfriends than the Fed has special liquidity facilities. Enough said, except that I think he ought to be taxed one fresh head of romaine lettuce for me every time he shows me off to a date. Remember, I just get to live here in your study, while he has roam of the whole house.

PMc: Okay, Okay. I'll work on that for you. Meanwhile, how do you know about all the Fed's liquidity facilities?

BB: Simple. Jonnie explained them to me, telling me the Bank of Ben is now doing for the capital markets what the Bank of Dad does for him: liberal liquidity provisions against all sorts of collateral, including the mere promise to behave in a more socially acceptable and responsible way in the future.

PMc: That's not exactly right, Bun Bun. Well maybe it is with respect to the Bank of Dad, but it is not the case with the Bank of Ben. As a general rule, also called the law of the land, the Federal Reserve is not in the business of lending on a wing and a prayer, but rather good collateral.

BB: You mean like you giving money to Jonnie but taking his iPod and putting it in the desk drawer until he pays you back?

PMc: Sorta like that, but in the case of the Fed, they wouldn't give Jonnie the purchase price of his iPod, but some lesser amount against the re-sale value of his iPod, minus a haircut.

BB: You mean that Ben would make him get a haircut, maybe even a shave, before taking in his iPod as collateral against a loan?

PMc: No, even though that's not a bad idea. In the collateralized lending business, in which the Federal Reserve traffics, a haircut is the margin of safety the lender demands for a loan against the re-sale value of the collateral. In your example, if an iPod cost $200 new and has a secondary market value of $100, the Fed would not even lend $100 against it, but rather some haircutted amount, say $75.

BB: So Ben would take Jon's iPod and put it the drawer, give him 75 bucks, and if he didn't pay off the loan, Ben would sell it for anything greater than 75 bucks, even if it's quoted at 100 bucks today?

PMc: Yep, that's more or less the mechanics of the matter, though to the best of my knowledge, the Federal Reserve has never taken in iPods at its various lending facilities. Very much unlike the Bank of Dad, who is not really in the banking business but the welfare business.

BB: But Jonnie told me that the Fed really can be like you, Mac, lending to anybody against anything with no-recourse, if the Board of Governors declares an emergency. He said something about a section 33. Was Jonnie wrong? You are paying way too much tuition for that fancy college he goes to if they are teaching him stuff that is wrong.

PMc: Jon's answer is not so much wrong as incomplete, similar to his efforts to clean up his room. And it's not section 33; it's section 13(3) of the Federal Reserve Act of 1934 which allows the Fed to lend to anybody, but not against anything.

The Fed can do so only if (1) a super majority of the Board of Governors - not the Federal Open Market Committee, known as the FOMC - declares the need for such lending to be the consequence of "unusual and exigent" circumstances, and (2) such lending is done against collateral that is "indorsed or otherwise secured to the satisfaction" of the Fed's lending officers.

BB: Technical details, I say, Mac. Jonnie was essentially right: if the Fed declares that the stuff is hitting the oscillator, the law allows for the Fed to unplug the oscillator, just so long as it dutifully declares that said oscillator is indeed an oscillator that needs to be unplugged. Jonnie said that's what the Fed has been doing ever since some stern dude named Bear needed a loan against a bunch of iPods with the batteries stripped out of them. Is that true?

PMc: I think perhaps I need to have a conversation with Jon's economics professor, who needs to remember that you are supposed to teach students textbook economics before teaching them real-world economics. But yes, back in March, the Fed invoked Section 13(3), for the first time since it was passed into law in 1934, to make a big loan that it otherwise wouldn't have been permitted legally to make.

But it wasn't to a stern dude named Bear, but rather to a special purpose vehicle, known as an SPV and named Maiden Lane LLC, which was set up to lend against dodgy mortgages previously held by the investment bank named Bear Stearns. The Fed made this loan to facilitate the merger of Bear into a bank named JP Morgan, so that Bear Stearns didn't go bankrupt, blowing the financial system sky high.

BB: All technical details, no? Your boss Mr. Gross is right, you are far too wonkish sometimes. Jonnie had the essence of the transaction down, no? In that case, the Fed's lending principles were similar to those of the Bank of Dad, no?

PMc: What's with all the no's, Bun Bun? You are starting to sound like a lawyer, leading the witness. Jonnie hasn't started dating girls in law school has he?

BB: Not that I know of; he's only a sophomore in college, for goodness sake. Just yanking your chain, Mac. But the way Jonnie explained it to me, the Fed really did do something very novel when it dealt with that Bear oscillator. It put some $30 billion of Bear's dodgy assets into that Maiden Lane thingamabob, telling JP Morgan that it had to stand up for the first $1 billion of losses and that the Fed would stand up for the remaining $29 billion, no recourse to JP Morgan. Is that right?

PMc: Yes, that's right, it was indeed an unusual Fed loan, and the Fed declared that it was, so as to legally be able to make it.

BB: But didn't you say that the Fed must be "secured"? How could making JP Morgan stand up only for the first $1 billion of losses against a $30 billion portfolio of iPods without batteries be deemed a secure loan?

PMc: Enough, Bun Bun, enough. I like your inquisitiveness, but sometimes some things are just best accepted as the way the world works, not how some textbook says it is supposed to work.

You're triggering a memory that goes back some twenty-five years ago, when Paul Volcker was chairman of the Federal Reserve. That was before CNBC, so guys who do what I do, called Fedwatchers back then, had to literally travel to Washington, DC to hear Mr. Volcker deliver the Fed's semi-annual report to Congress.

Some Congressman, whose name I've long since forgotten, was really getting after Mr. Volcker, demanding that he detail something that Mr. Volcker didn't want to detail. So Mr. Volcker took a long draw on his cigar and blew a big fog of smoke and said: "Congressman, we did what we did and we didn't do what we didn't do." And that was that, no more explanation needed.

BB: Hold on here. This Volcker dude was smoking a cigar while testifying before Congress? Was the session held outside?

PMc: No, Princess, it was held in a stately Congressional hearing room. And I was sitting right behind him. Back then, it was not against the law to smoke a cigar indoors, though most considered it impolite.

Even I did, and I rarely begrudge a man a good smoke, because Mr. Volcker's cigars were so cheap that they smelled like burning car seats when he puffed them. But he didn't care. At least not back then. A few years later, he gave up cigars.

But that wasn't my point. While Congress is the legal boss of the Federal Reserve, Congress is a boss with 535 heads, and sometimes the Fed boss simply has to do what he has to do, blowing smoke, literally or metaphysically, after the fact.

BB: So is this what the Fed did in making that funky loan against Bear Stearns' funky assets?

PMc: No, Bun Bun. Well maybe, as the Fed didn't and hasn't disclosed all the details of just how funky the funky stuff was. But the Fed, and especially Chairman Ben Bernanke, made clear to everybody that would - or wouldn't - listen that the Fed was not happy about making that loan, and didn't want to have to ever make such a loan again.

Not that the Maiden Lane loan didn't need to be made at the time, to save the capitalist financial system from its debt-deflationary pathologies. But the loan should have been made by the fiscal authority, not the monetary authority, with express blessing from Congress, who have express blessing from the electorate to do such things. For you see, Bun Bun, if there is the equivalent of the Bank of Dad in Washington, DC, it is supposed to be the Treasury, not the central bank.

BB: All very interesting, very interesting. Is this why the Fed refused to make a loan to that Lee Man chap when he was teetering on the edge of bankruptcy, feeling remorse for having made a loan against that Bear dude's stinky stuff?

PMc: It's Lehman, not Lee Man. And I don't know about any remorse for the Bear loan, Princess. All I know is that the Fed was not happy about it. Thus, when it came time to decide whether to lend against Lehman's stinky stuff, the question became just how stinky it was versus the Bear dude's stuff. Ben and the NY Fed Chief Tim Geithner decided it was just too stinky and took a pass. Or, as Mr. Volcker might have said, they didn't do what they didn't do.

BB: In which case, why didn't the Treasury step up and make the loan? After all, you said the fiscal authority can legally do what the monetary authority can't. Why didn't the Treasury unplug the oscillator, rather than let Lehman go down, effectively turning the oscillator on high?

PMc: Again, we'll never know precisely, Bun. But most fundamentally, the Treasury didn't have the express authority from Congress to do so. At least that is what Treasury Secretary Paulson says, while pounding the table with his shoe, Khrushchev style.

Could he have found some way, say using the Foreign Exchange Stabilization Fund? It's a fund of near $50 billion that the Treasury has Congressional approval to spend, if such spending is deemed necessary to keep the dollar from going wonky. Mr. Paulson later used it to establish a guarantee program for Money Market Mutual Funds. So conceptually, he could have used it to keep Lehman out of bankruptcy. I wasn't there, so I don't know. I certainly would have, but that assertion ain't worth a cup of coffee unless you have 4 bucks to go with it.

BB: So Lehman went down, and as was feared when the decision was made to prevent Bear from going down, the financial system blew sky high?

PMc: I might have been using a bit of hyperbole earlier when I said that, Bun Bun. But your Ockham's Razor conclusion is essentially correct.

BB: Never heard of such a razor, Mac. I think Jonnie uses something called a Gillette when he shaves that scruffy beard off every six weeks. What's an Ockham's Razor and what does it have to do with you becoming a much older man in the 100 days or so since Lehman was consumed by the oscillator?

PMc: Ockham's Razor is not a device for removing whiskers, but rather a mode of logic from the 14th century, defined loosely as cutting away all non-essential arguments when trying to answer a question or solve a problem. Which you just did, wonderfully, Bun Bun, when you asserted that what happened after Lehman went down was exactly what policy makers feared when they prevented bankruptcy for Bear: a systemic lock up of the global financial system.

BB: And out of that lacuna was born the TARP (Troubled Assets Relief Program), which explicitly gives the Treasury the authority and the money to unplug oscillators that need to be unplugged, when the Fed lacks the power to do so?

PMc: Yea verily, I say unto thee, Princess. You are a rather smart rabbit. Lacuna, that's a nice word. I don't recall saying it in front of you before. Where did you learn it?

BB: Looked it up on the web myself, and it precisely defines living in this place, while you live in the cottage. Take a hint, dude.

PMc: Taken. Now back to the matter at hand. The TARP, which Congress fought intensely about, and is still fighting about, given how the Treasury has used it to date, does indeed fill a gap in the federal safety net against systemic risk. It allows the Treasury to go where the Fed can't, literally lending to anybody against anything, or simply injecting equity into anybody against nothing, if necessary to maintain the capitalist financial system as a going concern.

BB: So is it 21st century socialism or welfare? Or is that a difference without a distinction?

PM: Bun, how am I to answer your machine gun questions if you keep answering them yourself? But yes, you've called it what it is. For my taste, I prefer the word socialism, but it does have a kernel of welfare in it, too. Whatever you call it, the TARP is a huge new tool for the visible fist of Treasury to support the invisible hand of capitalism.

BB: A fist, you say? How about calling it the taxpayers providing a hand out?

PMc: Ain't going there, Bun. Wouldn't be prudent, as the current President's father used to say. It is what it is, as everybody seems to say these days, in defense of what is unpalatable, but also necessary.

BB: So, if there was a positive externality of Lehman's demise, it is that policymakers finally found their socialist mojo, putting in place the necessary laws for the government to lever up and risk up its balance sheet more than proportionate to the private sector's new-found proclivity to do just the opposite?

PMc: Nice way to put it, Bun, with the operative phrase being "more than proportionate". That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can't bear alone. Only the Minsky Solution can lift that load.

BB: Ah, Minsky. I knew you would get ‘round to him, it was only a question of how long you could restrain yourself. You and I recently talked a lot about Professor Minsky, complete with his Forward Journey, followed by his famous or infamous Moment, followed by his Reverse Journey. But I don't recall talking about his Solution. I know I'm going to regret this, but could you refresh my memory?

PMc: Thank you, Princess, for asking. I'm quite sure a number of those listening in on this conversation similarly share your reservation about letting me loose to pontificate on Minsky. So out of respect for both you and them, I'm going to act on the old cliché that a picture is worth a thousand words, maybe more. Here's a stylized graph, created by my colleague and friend Ramin Toloui, that captures all you need to know about Minsky right now.

BB: You are a kind man, Mac, spoiling me relentlessly. Looking at the graph, which I see starts in 2003, you have the Forward Minsky Journey unfolding, complete with the ever-risky steps from Hedge to Speculative to Ponzi Finance. The Shadow Banking System expands explosively. And then, you have the Minsky Moment in August 2007.

And then you have the Reverse Minsky Journey, as Ponzi Units evaporate, Speculative Units morph after the fact into Ponzi Units, and even Hedge Units take a beating, as the Shadow Banking System contracts implosively. And then the pain stops with this new thing called the Minsky Solution, followed by something called Reflation.

But I don't see a precise date on the graph for when this happens. Are we there yet? Is the pain going to stop? Like, now?

PMc: Nice framing and clearing of the graphic, Bun Bun. Have you been taking an on-line course from Communispond while I haven't been looking?

BB: Nope, I just look up cool words on the computer. You never take me out on the speaking circuit, so I don't need to learn how to dance the Communispond dance steps.

Stop dodging the question, Mac. I presume this Minsky Solution thing is that "more than proportionate" socialist response that we were talking about just a moment ago?

PMc: Precisely - if you weren't a bunny, Bun, I'd call you grasshopper! That is precisely the Minsky Solution: the government not only steps up to the risk-taking and spending that the private sector is shirking, but goes further, stepping up with even more vigor, providing a meaningful reflationary thrust to both private sector risk assets and aggregate demand for goods and services.

BB: Okay, I got it even though I hate the notion of being called a grasshopper. So answer my question, master: Are we there yet? And if so, doesn't that mean that it's now time for all good peoples, and bunnies, to sell their T-bills and canned green peas into cheap corporate bonds and stocks?

PMc: I didn't put a date on that box, Bun, precisely to avoid answering the question as to precise timing. All I can say is that the timing is ripening, with the Fed now committed to an all-in reflationary campaign. This includes not just expanding its lending facilities, but doing so in joint ventures with the Treasury, now armed with TARP money, which can serve as the equity in new SPVs that are essentially government-sponsored Shadow Banks.

The recently announced Term Asset-Backed Securities Loan Facility, known as the TALF, and scheduled to come on in February, is a perfect example of just such a joint venture, with the Treasury putting up $20 billion of equity and the Fed putting up $180 billion of loans senior to the Treasury.

The TALF will effectively step around the risk-adverse commercial banking system and provide warehouse financing directly for securitization of new consumer and business loans to Main Street. It's a really cool innovation, which is likely to be expanded or replicated. And most important, it is likely to get reflationary traction.

The Fed also stands ready to print $600 billion of money to buy directly $500 billion of Agency MBS (Mortgage-backed Securities) and $100 billion of Agency debentures, so as to pull down and hold down long-term mortgage rates. The buying of the debentures is already under way, and the buying of MBS is likely to start in a matter of weeks.

And if necessary, the Fed is openly willing to print money to buy longer dated Treasuries, providing a further downward gravitational force for long-term interest rates. As my friend Colin Negrych argues, and indeed forecast when the rest of the world thought he was nuts, there is nothing like a 2% handle on longer-term Treasuries yields - the credit risk-free benchmark - to make private sector assets more valuable.

BB: But where are Ben's helicopters tossing out money?

PMc: Bun, you know that I don't like references to Helicopter Ben. It's a cheap shot, absolutely a cheap shot, fired by people who haven't bothered to actually read his famous November 2002 speech, when he discussed an anti-deflation technique conceived by the great Milton Friedman - a money-financed tax cut.

That said, it is indeed a fact, a glorious fact, in my view, that the Fed does presently stand ready to print as much money as necessary to accommodate the financing of an all-in reflationary fiscal policy thrust, as promised by President-elect Obama. Through holes in the floor of heaven, Hyman Minsky weeps tears of joy.

Call it good, very good: the monetary and fiscal authorities, separately yet together, going all in. And call me cautiously optimistic that Reflation will get traction.

BB: I hate that phrase, Mac, absolutely hate it. And you're the one that taught me to hate it. What is cautiously optimistic? Either you are or you aren't, no?

PMc: Touché, Bun, touché. With respect to the willingness of policy makers to do the right reflationary thing, we can drop the adverb cautiously. I'm flat out optimistic. But prudence demands that I at least acknowledge that even the best laid reflationary plans might go awry, at least in the short run.

BB: Well if that might happen, how can you call them the "right reflationary thing"? All in means all in, no?

PMc: Yes it does, Bun Bun. But it doesn't mean that all sectors and all companies have to flourish in response. The "right reflationary thing" is a macro concept, not necessarily a micro concept. It doesn't mean extending the soothing socialist hand to every square inch of the capitalist landscape.

The right reflationary thing to do is to systemically save capitalism from its inherent debt-deflationary pathologies, not to eliminate capitalism. Recall, capitalism at its micro core is a process called creative destruction, churning resources from yesterday's technologies and work methods to the more productive ones of tomorrow.

BB: Ok, that makes some sense. In my world, that's called the survival of the fittest. Wouldn't make sense for government to try to overrule that force of nature, I agree. But it would make sense for the government to put out a forest fire that threatened to consume all us creatures, right?

PMc: Nice way to put it, Princess. Very nice! It's a delicate balance.

BB: Thank you. In your world of investing, it seems the analog would be to go long the forest, because the government is going to keep the flames of deflation from burning it down, while taking a selective approach to going long particular creatures. Is that about right?

PMc: Yea verily, I say unto thee again. But with just a slightly finer point on the matter: In order to save the capitalist economic forest, there are certain creatures that the government must necessarily also save. The right investment strategy is to go long both the forest and those creatures.

BB: Fair enough. Now name them!

PMc: We have been publicly naming them for months here at PIMCO, Bun Bun. Well maybe not always particular names, but rather the attributes of those names. The most important is explicit government support, which is most notably the case with the debt issued by banks that get to drink a triple-thick socialist shake: Equity injections from the Treasury, debt guarantees from the FDIC, and access to the munificent liquidity facilities of the Federal Reserve.

BB: But isn't it time to get a little more daring than that? What would be wrong with starting to average into some funds in the major stock and bond indexes, as a play on your thesis that the American capitalist economy is a going concern? Yes, I know that means you would be indirectly going long some individual names that will be on the fatal end of the creative destruction process, but isn't that always the case?

PMc: I can't argue with you, Princess. Your suggested strategy is consistent with the all-in reflationary policy responses. Yet caution is still warranted. I'd tilt it toward corporate bonds over corporate stocks, however, as seemingly little known in the popular press, high grade corporate bonds have, on a risk- and volatility-adjusted basis, been beaten up even more than blue chips stocks this year.

BB: I'm glad you are finally seeing it my way, Mac. Sometimes, you can be so thick, letting the pursuit of the perfect become the enemy of grasping the good. Do some of my trade for the Morgan Le Fay Dreams Foundation portfolio, okay?

PMc: As you wish, Bun. And thank you for honoring her memory and wanting her portfolio to do well. Because by doing well, she can continue to do good, lots of good. With that lovely thought, let's end this chin wag with Morgan's favorite prayer of the season. You have the honors.

BB: Thank you, Paul.

May God bless you and keep you,
May God's face shine upon you
and be gracious to you,
May God lift up his countenance
upon you,
And give you peace.

Paul A. McCulley
Managing Director
December 23, 2008

The New President and the Global Landscape

John Mauldin — Wed, 01 Oct 2008 21:26:38 GMT

In times of crisis, those with psychological fortitude discover opportunities that most people miss. A friend of mine in Houston tells me of unending piles of tree limbs broken down by the hurricane. The homeowner laments his disaster; the tree trimmer and the roofer order a new Mercedes. Most of the world sees a Wall St. meltdown. Buffett takes the opening to deploy billions from his cash hoard. They're all seeing the same thing, but they're reacting differently based on different visions of the future.

I've included a piece today from my friend George Friedman over at Stratfor about the landscape the next US President will face. This article is a perfect example of why I rely on Stratfor for my geopolitical intelligence. The newspapers and other media do better or lesser jobs of telling me about what's happening right now. But that's not what an investor needs. What I need - and I recommend for you - is an analysis of what we're going to be facing. That's where George and his team absolutely excel.

For at least the next month, the public conversation is going to be completely dominated by the November election and the political maneuvering to address the financial crisis. There will be tremendous drama. There will be dizzying swings back and forth in emotions, expectations, and more than likely the markets. And if you focus on it, you'll miss the real opportunities to position yourself for the emergence. George has made a special offer on a Stratfor Membership available to my readers, and I strongly encourage you to click here to take advantage of this opportunity. Now is the time to get positioned for future opportunities, while everybody else is wallowing in the here and now.

John Mauldin, Editor
Outside the Box

The New President and the Global Landscape

By George Friedman

It has often been said that presidential elections are all about the economy. That just isn't true. Harry Truman's election was all about Korea. John Kennedy's election focused on missiles, Cuba and Berlin. Lyndon Johnson's and Richard Nixon's elections were heavily about Vietnam. Ronald Reagan's first election pivoted on Iran. George W. Bush's second election was about Iraq. We won't argue that presidential elections are all about foreign policy, but they are not all about the economy. The 2008 election will certainly contain a massive component of foreign policy.

We have no wish to advise you how to vote. That's your decision. What we want to do is try to describe what the world will look like to the new president and consider how each candidate is likely to respond to the world. In trying to consider whether to vote for John McCain or Barack Obama, it is obviously necessary to consider their stands on foreign policy issues. But we have to be cautious about campaign assertions. Kennedy claimed that the Soviets had achieved superiority in missiles over the United States, knowing full well that there was no missile gap. Johnson attacked Barry Goldwater for wanting to escalate the war in Vietnam at the same time he was planning an escalation. Nixon won the 1968 presidential election by claiming that he had a secret plan to end the war in Vietnam. What a candidate says is not always an indicator of what the candidate is thinking.

It gets even trickier when you consider that many of the most important foreign policy issues are not even imagined during the election campaign. Truman did not expect that his second term would be dominated by a war in Korea. Kennedy did not expect to be remembered for the Cuban missile crisis. Jimmy Carter never imagined in 1976 that his presidency would be wrecked by the fall of the Shah of Iran and the hostage crisis. George H. W. Bush didn't expect to be presiding over the collapse of communism or a war over Kuwait. George W. Bush (regardless of conspiracy theories) never expected his entire presidency to be defined by 9/11. If you read all of these presidents' position papers in detail, you would never get a hint as to what the really important foreign policy issues would be in their presidencies.

Between the unreliability of campaign promises and the unexpected in foreign affairs, predicting what presidents will do is a complex business. The decisions a president must make once in office are neither scripted nor conveniently timed. They frequently present themselves to the president and require decisions in hours that can permanently define his (or her) administration. Ultimately, voters must judge, by whatever means they might choose, whether the candidate has the virtue needed to make those decisions well.

Virtue, as we are using it here, is a term that comes from Machiavelli. It means the opposite of its conventional usage. A virtuous leader is one who is clever, cunning, decisive, ruthless and, above all, effective. Virtue is the ability to face the unexpected and make the right decision, without position papers, time to reflect or even enough information. The virtuous leader can do that. Others cannot. It is a gut call for a voter, and a tough one.

This does not mean that all we can do is guess about a candidate's nature. There are three things we can draw on. First, there is the political tradition the candidate comes from. There are more things connecting Republican and Democratic foreign policy than some would like to think, but there are also clear differences. Since each candidate comes from a different political tradition -- as do his advisers -- these traditions can point to how each candidate might react to events in the world. Second, there are indications in the positions the candidates take on ongoing events that everyone knows about, such as Iraq. Having pointed out times in which candidates have been deceptive, we still believe there is value in looking at their positions and seeing whether they are coherent and relevant. Finally, we can look at the future and try to predict what the world will look like over the next four years. In other words, we can try to limit the surprises as much as possible.

In order to try to draw this presidential campaign into some degree of focus on foreign policy, we will proceed in three steps. First, we will try to outline the foreign policy issues that we think will confront the new president, with the understanding that history might well throw in a surprise. Second, we will sketch the traditions and positions of both Obama and McCain to try to predict how they would respond to these events. Finally, after the foreign policy debate is over, we will try to analyze what they actually said within the framework we created.

Let me emphasize that this is not a partisan exercise. The best guarantee of objectivity is that there are members of our staff who are passionately (we might even say irrationally) committed to each of the candidates. They will be standing by to crush any perceived unfairness. It is Stratfor's core belief that it is possible to write about foreign policy, and even an election, without becoming partisan or polemical. It is a difficult task and we doubt we can satisfy everyone, but it is our goal and commitment.

The Post 9/11 World

Ever since 9/11 U.S. foreign policy has focused on the Islamic world. Starting in late 2002, the focus narrowed to Iraq. When the 2008 campaign for president began a year ago, it appeared Iraq would define the election almost to the exclusion of all other matters. Clearly, this is no longer the case, pointing to the dynamism of foreign affairs and opening the door to a range of other issues.

Iraq remains an issue, but it interacts with a range of other issues. Among these are the future of U.S.-Iranian relations; U.S. military strategy in Afghanistan and the availability of troops in Iraq for that mission; the future of U.S.-Pakistani relations and their impact on Afghanistan; the future of U.S.-Russian relations and the extent to which they will interfere in the region; resources available to contain Russian expansion; the future of the U.S. relationship with the Europeans and with NATO in the context of growing Russian power and the war in Afghanistan; Israel's role, caught as it is between Russia and Iran; and a host of only marginally related issues. Iraq may be subsiding, but that simply complicates the world facing the new president.

The list of problems facing the new president will be substantially larger than the problems facing George W. Bush, in breadth if not in intensity. The resources he will have to work with, military, political and economic, will not be larger for the first year at least. In terms of military capacity, much will hang on the degree to which Iraq continues to bog down more than a dozen U.S. brigade combat teams. Even thereafter, the core problem facing the next president will be the allocation of limited resources to an expanding number of challenges. The days when it was all about Iraq is over. It is now all about how to make the rubber band stretch without breaking.

Iraq remains the place to begin, however, since the shifts there help define the world the new president will face. To understand the international landscape the new president will face, it is essential to begin by understanding what happened in Iraq, and why Iraq is no longer the defining issue of this campaign.

A Stabilized Iraq and the U.S. Troop Dilemma

In 2006, it appeared that the situation in Iraq was both out of control and hopeless. Sunni insurgents were waging war against the United States, Shiite militias were taking shots at the Americans as well, and Sunnis and Shia were waging a war against each other. There seemed to be no way to bring the war to anything resembling a satisfactory solution.

When the Democrats took control of Congress in the 2006 elections, it appeared inevitable that the United States would begin withdrawing forces from Iraq. U.S expectations aside, this was the expectation by all parties in Iraq. Given that the United States was not expected to remain a decisive force in Iraq, all Iraqi parties discounted the Americans and maneuvered for position in anticipation of a post-American Iraq. The Iranians in particular saw an opportunity to limit a Sunni return to Iraq's security forces, thus reshaping the geopolitics of the region. U.S. fighting with Iraqi Sunnis intensified in preparation for the anticipated American withdrawal.

Bush's decision to increase forces rather than withdraw them dramatically changed the psychology of Iraq. It was assumed he had lost control of the situation. Bush's decision to surge forces in Iraq, regardless by how many troops, established two things. First, Bush remained in control of U.S. policy. Second, the assumption that the Americans were leaving was untrue. And suddenly, no one was certain that there would be a vacuum to be filled.

The deployment of forces proved helpful, as did the change in how the troops were used; recent leaks indicate that new weapon systems also played a key role. The most important factor, however, was the realization that the Americans were not leaving on Bush's watch. Since no one was sure who the next U.S. president would be, or what his policies might be, it was thus uncertain that the Americans would leave at all.

Everyone in Iraq suddenly recalculated. If the Americans weren't leaving, one option would be to make a deal with Bush, seen as weak and looking for historical validation. Alternatively, they could wait for Bush's successor. Iran remembers -- without fondness -- its decision not to seal a deal with Carter, instead preferring to wait for Reagan. Similarly, seeing foreign jihadists encroaching in Sunni regions and the Shia shaping the government in Baghdad, the Sunni insurgents began a fundamental reconsideration of their strategy.

Apart from reversing Iraq's expectations about the United States, part of Washington's general strategy was supplementing military operations with previously unthinkable political negotiations. First, the United States began talking to Iraq's Sunni nationalist insurgents, and found common ground with them. Neither the Sunni nationalists nor the United States liked the jihadists, and both wanted the Shia to form a coalition government. Second, back-channel U.S.-Iranian talks clearly took place. The Iranians realized that the possibility of a pro-Iranian government in Baghdad was evaporating. Iran's greatest fear was a Sunni Iraqi government armed and backed by the United States, recreating a version of the Hussein regime that had waged war with Iran for almost a decade. The Iranians decided that a neutral, coalition government was the best they could achieve, so they reined in the Shiite militia.

The net result of this was that the jihadists were marginalized and broken, and an uneasy coalition government was created in Baghdad, balanced between Iran and the United States. The Americans failed to create a pro-American government in Baghdad, but had blocked the emergence of a pro-Iranian government. Iraqi society remained fragmented and fragile, but a degree of peace unthinkable in 2006 had been created.

The first problem facing the next U.S. president will be deciding when and how many U.S. troops will be withdrawn from Iraq. Unlike 2006, this issue will not be framed by Iraq alone. First, there will be the urgency of increasing the number of U.S. troops in Afghanistan. Second, there will be the need to create a substantial strategic reserve to deal with potential requirements in Pakistan, and just as important, responding to events in the former Soviet Union like the recent conflict in Georgia.

At the same time, too precipitous a U.S. withdrawal not only could destabilize the situation internally in Iraq, it could convince Iran that its dream of a pro-Iranian Iraq is not out of the question. In short, too rapid a withdrawal could lead to resumption of war in Iraq. But too slow a withdrawal could make the situation in Afghanistan untenable and open the door for other crises.

The foreign policy test for the next U.S. president will be calibrating three urgent requirements with a military force that is exhausted by five years of warfare in Iraq and seven in Afghanistan. This force was not significantly expanded since Sept. 11, making this the first global war the United States has ever fought without a substantial military expansion. Nothing the new president does will change this reality for several years, so he will be forced immediately into juggling insufficient forces without the option of precipitous withdrawal from Iraq unless he is prepared to accept the consequences, particularly of a more powerful Iran.

The Nuclear Chip and a Stable U.S.-Iranian Understanding

The nuclear issue has divided the United States and Iran for several years. The issue seems to come and go depending on events elsewhere. Thus, what was enormously urgent just prior to the Russo-Georgian war became much less pressing during and after it. This is not unreasonable in our point of view, because we regard Iran as much farther from nuclear weapons than others might, and we suspect that the Bush administration agrees given its recent indifference to the question.

Certainly, Iran is enriching uranium, and with that uranium, it could possibly explode a nuclear device. But the gap between a nuclear device and weapon is substantial, and all the enriched uranium in the world will not give the Iranians a weapon. To have a weapon, it must be ruggedized and miniaturized to fit on a rocket or to be carried on an attack aircraft. The technologies needed for that range from material science to advanced electronics to quality assurance. Creating a weapon is a huge project. In our view, Iran does not have the depth of integrated technical skills needed to achieve that goal.

As for North Korea, for Iran a very public nuclear program is a bargaining chip designed to extract concessions, particularly from the Americans. The Iranians have continued the program very publicly in spite of threats of Israeli and American attacks because it made the United States less likely to dismiss Iranian wishes in Tehran's true area of strategic interest, Iraq.

The United States must draw down its forces in Iraq to fight in Afghanistan. The Iranians have no liking for the Taliban, having nearly gone to war with them in 1998, and having aided the United States in Afghanistan in 2001. The United States needs Iran's commitment to a neutral Iraq to withdraw U.S. forces since Iran could destabilize Iraq overnight, though Tehran's ability to spin up Shiite proxies in Iraq has declined over the past year.

Therefore, the next president very quickly will face the question of how to deal with Iran. The Bush administration solution -- relying on quiet understandings alongside public hostility -- is one model. It is not necessarily a bad one, so long as forces remain in Iraq to control the situation. If the first decision the new U.S. president will have to make is how to transfer forces in Iraq elsewhere, the second decision will be how to achieve a more stable understanding with Iran.

This is particularly pressing in the context of a more assertive Russia that might reach out to Iran. The United States will need Iran more than Iran needs the United States under these circumstances. Washington will need Iran to abstain from action in Iraq but to act in Afghanistan. More significantly, the United States will need Iran not to enter into an understanding with Russia. The next president will have to figure out how to achieve all these things without giving away more than he needs to, and without losing his domestic political base in the process.

Afghanistan, Pakistan and the Taliban

The U.S. president also will have to come up with an Afghan policy, which really doesn't exist at this moment. The United States and its NATO allies have deployed about 50,000 troops in Afghanistan. To benchmark this, the Russians deployed around 120,000 by the mid-1980s, and were unable to pacify the country. Therefore the possibility of 60,000 troops -- or even a few additional brigades on top of that -- pacifying Afghanistan is minimal. The primary task of troops in Afghanistan now is to defend the Kabul regime and other major cities, and to try to keep the major roads open. More troops will make this easier, but by itself, it will not end the war.

The problem in Afghanistan is twofold. First, the Taliban defeated their rivals in Afghanistan during the civil war of the 1990s because they were the most cohesive force in the country, were politically adept and enjoyed Pakistani support. The Taliban's victory was not accidental; and all other things being equal, without the U.S. presence, they could win again. The United States never defeated the Taliban. Instead, the Taliban refused to engage in massed warfare against American airpower, retreated, dispersed and regrouped. In most senses, it is the same force that won the Afghan civil war.

The United States can probably block the Taliban from taking the cities, but to do more it must do three things. First, it must deny the Taliban sanctuary and lines of supply running from Pakistan. These two elements allowed the mujahideen to outlast the Soviets. They helped bring the Taliban to power. And they are fueling the Taliban today. Second, the United States must form effective coalitions with tribal groups hostile to the Taliban. To do this it needs the help of Iran, and more important, Washington must convince the tribes that it will remain in Afghanistan indefinitely -- not an easy task. And third -- the hardest task for the new president -- the United States will have to engage the Taliban themselves, or at least important factions in the Taliban movement, in a political process. When we recall that the United States negotiated with the Sunni insurgents in Iraq, this is not as far-fetched as it appears.

The most challenging aspect to deal with in all this is Pakistan. The United States has two issues in the South Asian country. The first is the presence of al Qaeda in northern Pakistan. Al Qaeda has not carried out a successful operation in the United States since 2001, nor in Europe since 2005. Groups who use the al Qaeda label continue to operate in Iraq, Afghanistan and Pakistan, but they use the name to legitimize or celebrate their activities -- they are not the same people who carried out 9/11. Most of al Qaeda prime's operatives are dead or scattered, and its main leaders, Osama bin Laden and Ayman al-Zawahiri, are not functional. The United States would love to capture bin Laden so as to close the books on al Qaeda, but the level of effort needed -- assuming he is even alive -- might outstrip U.S. capabilities.

The most difficult step politically for the new U.S. president will be to close the book on al Qaeda. This does not mean that a new group of operatives won't grow from the same soil, and it doesn't mean that Islamist terrorism is dead by any means. But it does mean that the particular entity the United States has been pursuing has effectively been destroyed, and the parts regenerating under its name are not as dangerous. Asserting victory will be extremely difficult for the new U.S. president. But without that step, a massive friction point between the United States and Pakistan will persist -- one that isn't justified geopolitically and undermines a much more pressing goal.

The United States needs the Pakistani army to attack the Taliban in Pakistan, or failing that, permit the United States to attack them without hindrance from the Pakistani military. Either of these are nightmarishly difficult things for a Pakistani government to agree to, and harder still to carry out. Nevertheless, without cutting the line of supply to Pakistan, like Vietnam and the Ho Chi Minh Trail, Afghanistan cannot be pacified. Therefore, the new president will face the daunting task of persuading or coercing the Pakistanis to carry out an action that will massively destabilize their country without allowing the United States to get bogged down in a Pakistan it cannot hope to stabilize.

At the same time, the United States must begin the political process of creating some sort of coalition in Afghanistan that it can live with. The fact of the matter is that the United States has no long-term interest in Afghanistan except in ensuring that radical jihadists with global operational reach are not given sanctuary there. Getting an agreement to that effect will be hard. Guaranteeing compliance will be virtually impossible. Nevertheless, that is the task the next president must undertake.

There are too many moving parts in Afghanistan to be sanguine about the outcome. It is a much more complex situation than Iraq, if for no other reason than because the Taliban are a far more effective fighting force than anything the United States encountered in Iraq, the terrain far more unfavorable for the U.S. military, and the political actors much more cynical about American capabilities.

The next U.S. president will have to make a painful decision. He must either order a long-term holding action designed to protect the Karzai government, launch a major offensive that includes Pakistan but has insufficient forces, or withdraw. Geopolitically, withdrawal makes a great deal of sense. Psychologically, it could unhinge the region and regenerate al Qaeda-like forces. Politically, it would not be something a new president could do. But as he ponders Iraq, the future president will have to address Afghanistan. And as he ponders Afghanistan, he will have to think about the Russians.

The Russian Resurgence

When the United States invaded Afghanistan in 2001, the Russians were allied with the United States. They facilitated the U.S. relationship with the Northern Alliance, and arranged for air bases in Central Asia. The American view of Russia was formed in the 1990s. It was seen as disintegrating, weak and ultimately insignificant to the global balance. The United States expanded NATO into the former Soviet Union in the Baltic states and said it wanted to expand it into Ukraine and Georgia. The Russians made it clear that they regarded this as a direct threat to their national security, resulting in the 2008 Georgian conflict.

The question now is where U.S.-Russian relations are going. Russian Prime Minister Vladimir Putin called the collapse of the Soviet Union a geopolitical catastrophe. After Ukraine and Georgia, it is clear he does not trust the United States and that he intends to reassert his sphere of influence in the former Soviet Union. Georgia was lesson one. The current political crisis in Ukraine is the second lesson unfolding.

The re-emergence of a Russian empire in some form or another represents a far greater threat to the United States than the Islamic world. The Islamic world is divided and in chaos. It cannot coalesce into the caliphate that al Qaeda wanted to create by triggering a wave of revolutions in the Islamic world. Islamic terrorism remains a threat, but the geopolitical threat of a unifying Islamic power is not going to happen.

Russia is a different matter. The Soviet Union and the Russian empire both posed strategic threats because they could threaten Europe, the Middle East and China simultaneously. While this overstates the threat, it does provide some context. A united Eurasia is always powerful, and threatens to dominate the Eastern Hemisphere. Therefore, preventing Russia from reasserting its power in the former Soviet Union should take precedence over all other considerations.

The problem is that the United States and NATO together presently do not have the force needed to stop the Russians. The Russian army is not particularly powerful or effective, but it is facing forces that are far less powerful and effective. The United States has its forces tied down in Iraq and Afghanistan so that when the war in Georgia broke out, sending ground forces was simply not an option. The Russians are extremely aware of this window of opportunity, and are clearly taking advantage of it.

The Russians have two main advantages in this aside from American resource deficits. First, the Europeans are heavily dependent on Russian natural gas; German energy dependence on Moscow is particularly acute. The Europeans are in no military or economic position to take any steps against the Russians, as the resulting disruption would be disastrous. Second, as the United States maneuvers with Iran, the Russians can provide support to Iran, politically and in terms of military technology, that not only would challenge the United States, it might embolden the Iranians to try for a better deal in Iraq by destabilizing Iraq again. Finally, the Russians can pose lesser challenges in the Caribbean with Venezuela, Nicaragua and Cuba, as well as potentially supporting Middle Eastern terrorist groups and left-wing Latin American groups.

At this moment, the Russians have far more options than the Americans have. Therefore, the new U.S. president will have to design a policy for dealing with the Russians with few options at hand. This is where his decisions on Iraq, Iran, Afghanistan and Pakistan will intersect and compete with his decisions on Russia. Ideally, the United States would put forces in the Baltics -- which are part of NATO -- as well as in Ukraine and Georgia. But that is not an option and won't be for more than a year under the best of circumstances.

The United States therefore must attempt a diplomatic solution with Russia with very few sticks. The new president will need to try to devise a package of carrots -- e.g., economic incentives -- plus the long-term threat of a confrontation with the United States to persuade Moscow not to use its window of opportunity to reassert Russian regional hegemony. Since regional hegemony allows Russia to control its own destiny, the carrots will have to be very tempting, while the threat has to be particularly daunting. The president's task will be crafting the package and then convincing the Russians it has value.

European Disunity and Military Weakness

One of the problems the United States will face in these negotiations will be the Europeans. There is no such thing as a European foreign policy; there are only the foreign policies of the separate countries. The Germans, for example, do not want a confrontation with Russia under any circumstances. The United Kingdom, by contrast, is more willing to take a confrontational approach to Moscow. And the European military capability, massed and focused, is meager. The Europeans have badly neglected their military over the past 15 years. What deployable, expeditionary forces they have are committed to the campaign in Afghanistan. That means that in dealing with Russia, the Americans do not have united European support and certainly no meaningful military weight. This will make any diplomacy with the Russians extremely difficult.

One of the issues the new president eventually will have to face is the value of NATO and the Europeans as a whole. This was an academic matter while the Russians were prostrate. With the Russians becoming active, it will become an urgent issue. NATO expansion -- and NATO itself -- has lived in a world in which it faced no military threats. Therefore, it did not have to look at itself militarily. After Georgia, NATO's military power becomes very important, and without European commitment, NATO's military power independent of the United States -- and the ability to deploy it -- becomes minimal. If Germany opts out of confrontation, then NATO will be paralyzed legally, since it requires consensus, and geographically. For the United States alone cannot protect the Baltics without German participation.

The president really will have one choice affecting Europe: Accept the resurgence of Russia, or resist. If the president resists, he will have to limit his commitment to the Islamic world severely, rebalance the size and shape of the U.S. military and revitalize and galvanize NATO. If he cannot do all of those things, he will face some stark choices in Europe.

Israel, Turkey, China, and Latin America

Russian pressure is already reshaping aspects of the global system. The Israelis have approached Georgia very differently from the United States. They halted weapon sales to Georgia the week before the war, and have made it clear to Moscow that Israel does not intend to challenge Russia. The Russians met with Syrian President Bashar al Assad immediately after the war. This signaled the Israelis that Moscow was prepared to support Syria with weapons and with Russian naval ships in the port of Tartus if Israel supports Georgia, and other countries in the former Soviet Union, we assume. The Israelis appear to have let the Russians know that they would not do so, separating themselves from the U.S. position. The next president will have to re-examine the U.S. relationship with Israel if this breach continues to widen.

In the same way, the United States will have to address its relationship with Turkey. A long-term ally, Turkey has participated logistically in the Iraq occupation, but has not been enthusiastic. Turkey's economy is booming, its military is substantial and Turkish regional influence is growing. Turkey is extremely wary of being caught in a new Cold War between Russia and the United States, but this will be difficult to avoid. Turkey's interests are very threatened by a Russian resurgence, and Turkey is the U.S. ally with the most tools for countering Russia. Both sides will pressure Ankara mercilessly. More than Israel, Turkey will be critical both in the Islamic world and with the Russians. The new president will have to address U.S.-Turkish relations both in context and independent of Russia fairly quickly.

In some ways, China is the great beneficiary of all of this. In the early days of the Bush administration, there were some confrontations with China. As the war in Iraq calmed down, Washington seemed to be increasing its criticisms of China, perhaps even tacitly supporting Tibetan independence. With the re-emergence of Russia, the United States is now completely distracted. Contrary to perceptions, China is not a global military power. Its army is primarily locked in by geography and its navy is in no way an effective blue-water force. For its part, the United States is in no position to land troops on mainland China. Therefore, there is no U.S. geopolitical competition with China. The next president will have to deal with economic issues with China, but in the end, China will sell goods to the United States, and the United States will buy them.

Latin America has been a region of minimal interest to the United States in the last decade or longer. So long as no global power was using its territory, the United States did not care what presidents Hugo Chavez in Venezuela, Evo Morales in Bolivia and Daniel Ortega in Nicaragua -- or even the Castros in Cuba -- were doing. But with the Russians back in the Caribbean, at least symbolically, all of these countries suddenly become more important. At the moment, the United States has no Latin American policy worth noting; the new president will have to develop one.

Quite apart from the Russians, the future U.S. president will need to address Mexico. The security situation in Mexico is deteriorating substantially, and the U.S.-Mexican border remains porous. The cartels stretch from Mexico to the streets of American cities where their customers live. What happens in Mexico, apart from immigration issues, is obviously of interest to the United States. If the current trajectory continues, at some point in his administration, the new U.S. president will have to address Mexico -- potentially in terms never before considered.

The U.S. Defense Budget

The single issue touching on all of these is the U.S. defense budget. The focus of defense spending over the past eight years has been the Army and Marine Corps -- albeit with great reluctance. Former Defense Secretary Donald Rumsfeld was not an advocate of a heavy Army, favoring light forces and air power, but reality forced his successors to reallocate resources. In spite of this, the size of the Army remained the same -- and insufficient for the broader challenges emerging.

The focus of defense spending was Fourth Generation warfare, essentially counterinsurgency. It became dogma in the military that we would not see peer-to-peer warfare for a long time. The re-emergence of Russia, however, obviously raises the specter of peer-to-peer warfare, which in turn means money for the Air Force as well as naval rearmament. All of these programs will take a decade or more to implement, so if Russia is to be a full-blown challenge by 2020, spending must begin now.

If we assume that the United States will not simply pull out of Iraq and Afghanistan, but will also commit troops to allies on Russia's periphery while retaining a strategic reserve -- able to, for example, protect the U.S.-Mexican border -- then we are assuming substantially increased spending on ground forces. But that will not be enough. The budgets for the Air Force and Navy will also have to begin rising.

U.S. national strategy is expressed in the defense budget. Every strategic decision the president makes has to be expressed in budget dollars with congressional approval. Without that, all of this is theoretical. The next president will have to start drafting his first defense budget shortly after taking office. If he chooses to engage all of the challenges, he must be prepared to increase defense spending. If he is not prepared to do that, he must concede that some areas of the world are beyond management. And he will have to decide which areas these are. In light of the foregoing, as we head toward the debate, 10 questions should be asked of the candidates:

If the United States removes its forces from Iraq slowly as both of you advocate, where will the troops come from to deal with Afghanistan and protect allies in the former Soviet Union?
The Russians sent 120,000 troops to Afghanistan and failed to pacify the country. How many troops do you think are necessary?
Do you believe al Qaeda prime is still active and worth pursuing?
Do you believe the Iranians are capable of producing a deliverable nuclear weapon during your term in office?
How do you plan to persuade the Pakistani government to go after the Taliban, and what support can you provide them if they do?
Do you believe the United States should station troops in the Baltic states, in Ukraine and Georgia as well as in other friendly countries to protect them from Russia?
Do you feel that NATO remains a viable alliance, and are the Europeans carrying enough of the burden?
Do you believe that Mexico represents a national security issue for the United States?
Do you believe that China represents a strategic challenge to the United States?
Do you feel that there has been tension between the United States and Israel over the Georgia issue?

Haste Makes Waste

John Mauldin — Mon, 29 Sep 2008 21:48:06 GMT

The purpose of Outside the Box is to present views which cause us to think through our basic assumptions. This week our old friend Michael Lewitt of Hegemony Capital Management gives us a view as to why the bailout bill going down may not be as bad as I think it might. There is much we agree on, however. And part of our agreement is that a deeper recession is in our future. Let me be clear. Muddle Through is now at risk.

I have talked with my publisher, and for the next few weeks of The continuing Crisis, we are going to send more than one OTB per week, and I may also add some short commentary. These are extraordinary times, and I know a lot of you (as I can tell from phone and emails) are worried and are interested in analysis that is not biased with either a perma-bull or perma-bear stance. I will call it as I see it, as always, and forward you material from my best sources.

That being said, we will get through this, one way or another. Sanity and clarity will return, as it always does after times of crisis. I wish you the best in your situation.

John Mauldin, Editor
Outside the Box

Haste Makes Waste

by Michael E. Lewitt

"Examining the record of past research from the vantage of contemporary historiography, the historian of science may be tempted to exclaim that when paradigms change, the world itself changes with them. Led by a new paradigm, scientists adopt new instruments and look in new places. Even more important, during revolutions scientists see new and different things when looking with familiar instruments in places they have looked before. It is rather as if the professional community had been suddenly transported to another planet where familiar objects are seen in a different light and are joined by unfamiliar ones as well. Of course, nothing of quite that sort does occur: there is no geographical transplantation; outside the laboratory everyday affairs usually continue as before. Nevertheless, paradigm changes do cause scientists to see the world of their research-engagement differently. In so far as their only recourse to that world is through what they see and do, we may want to say that after a revolution scientists are responding to a different world."

Thomas S. Kuhn¹

The problem with trying to legislate in the middle of a revolution is that you aren't sure whether you are governing the world that is being destroyed or the one that is coming into being. There can be little question that the Wall Street that existed at the beginning of this year is no longer the industry that Congress is seeking to rescue from its own excesses. The financial world has been permanently altered by the collapse of the debt bubble that inexorably built up over the past three decades. Now Congress is trying to design a rescue plan for a world whose shape is highly contingent and unstable. Such an undertaking requires more than two weeks of work. Conventional thinking tells us that the government must do something to stabilize the markets immediately, and that doing something is better than doing nothing. Once again, conventional thinking is wrong. Congress would be much better advised to take the extra few days or week it would take to structure a plan that the world is going to have to live with for a very long time. As we were completing this newsletter, the House of Representatives voted down the emergency package and the financial markets are panicking. Such panic is unwarranted. The world should take a deep breath and consider whether defeat of a deeply flawed bill should be treated as a catastrophe or a rallying cry to develop a better plan that addressed the underlying issues that need to be fixed.

The Paulson Plan

HCM has been warning for years that all of the king's horses and all of the king's men wouldn't be able to put this mess back together again. It is now time for America to take the pain and figure out how to move forward. Any plan that is adopted must include a sufficient dose of strong medicine to prevent the culture of self-delusion and moral hazard that created the current crisis from further perpetuating itself. The purpose of the Paulson Plan has to be to rebuild confidence in the financial system. The manner in which the plan was presented and debated rendered that more difficult but hopefully not impossible. For any plan that fails to bring confidence back to the market will not work.

The great economic historian Charles Kindleberger wrote in his seminal study of financial crises, Manias, Panics, and Crashes, that, "[f]or historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."² This is a very important observation. While each financial crisis is unique in terms of its causes and the types of assets that it engulfs, the conditions that led to it are always driven by human irrationality and hubris. Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.

Recently, former New York Federal Reserve Governor Gerald Corrigan led a group of market experts that released a report entitled Containing Market Risk: The Road to Reform, The Report of CRMPG III (Corrigan III) (August 6, 2008). In that report, Mr. Corrigan and his colleagues wrote the following very wise words:

"The fact that financial excesses fundamentally grow out of human behavior is a sobering reality especially in an environment of intense competition between large integrated financial intermediaries which, on the upside of the cycle, fosters risk taking and on the downside, fosters risk aversion. It is this sobering reality that has, for centuries, given rise to universal recognition that finance and financial institutions must be subject to a higher degree of official oversight and regulation than is deemed necessary for virtually all other forms of commercial enterprise."

What is lacking from the public debate is a serious understanding of the difference between treating the symptoms of the crisis and trying to cure the disease. The disease is a total loss of confidence in the American model of debt-engorged free enterprise, and American economic and political leadership. The cure is regaining that confidence.

In his new book, economic consultant David M. Smick writes,

"the survival of the world financial system depends on an elaborate confidence game. The size of the financial markets, relative to the governments, has become so monstrously huge there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves cannot by edict restore order. They can only project to the markets a sense that they know what they're doing."³

What Henry Paulson and Ben Bernanke are desperately trying to explain to Congress is that America's leadership must immediately restore the world's confidence in American economic and political leadership. But the Paulson Plan was generated under impossible conditions. Were it to succeed, the best that could be expected at this point is a slow revival of the credit system. To hope for more is sheer folly. It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn't seen for decades. Frankly, HCM can't see any way that such a slowdown can be avoided, although HCM has some ideas on how to begin to work out of it. Moreover, if by some miracle it were to be avoided, it would merely delay the inevitable purging of the psychological and financial excesses that have been piling up in our economic system over the past thirty years. One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.

At one point during the bailout negotiations, Henry Paulson was seen genuflecting at the feet of House Speaker Nancy Pelosi, a fitting emblem of just how far the credibility of the Bush Administration has fallen.⁴ Earlier policy blunders are now haunting a lame-duck Administration. The Paulson Plan is being pushed with the same kind of urgency that pushed the U.S. to invade Iraq, and the President has no more weapons of mass destruction to sell. There are legitimate fears that anything approaching the Paulson Plan, like the Iraq War, will get quickly bogged down in the complexities and contingencies that will be encountered on the battlefield. Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all.

There is one practical problem that will plague the Paulson Plan and any plan that involves the government purchasing distressed assets from financial institutions. These assets are NOT(!!!) accurately valued on the books of financial institutions.⁵ Accordingly, these institutions are not in a position to sell them to the government at current fair market value. Any sales at current market value would inflict huge losses on these institutions. The alternative is for the government to grossly overpay for these assets, which would constitute a disguised capital infusion into these firms that would short-change the American taxpayer. This flaw in the plan is why members of Congress from both sides of the aisle insisted on some kind of profit-sharing structure that would compensate taxpayers in the event the government pays above-market prices for assets. HCM fears that very little of the $700 billion is going to be spent in the near future because of the reluctance of banks to part with assets at anywhere near their current value, and the government's reluctance to overpay for these assets.

HCM views the Paulson Plan as a matter of form over substance. The details of how the plan will work are ultimately less important than whether the plan succeeds in rebuilding market confidence. In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.

An Alternative Bailout Plan

A successful plan must address the following elements:

Confidence: It must restore market confidence by convincing both Wall Street and Main Street that the government will stand behind the mortgage obligations that are the weakest part of the financial system.
Time: It must provide time for financial institutions to earn profits that can be used to absorb future losses on bad mortgage paper. The primary way financial institutions make money is by borrowing money at one rate and lending it out at a higher rate. The cost of money for financial institutions must be lowered immediately.
Prevention: It must convince both the American people and the global community that the regulatory lapses that allowed this disaster to occur will not happen again, and that the system will be fairer in the future. This is closely tied to the issue of restoring confidence in the markets as well as in American economic and political leadership.

The government's plan must restore market confidence, give companies the time to heal their balance sheets, and prevent a recurrence of the most abject series of regulatory lapses in the history of Western financial markets. For the sake of contributing to the public debate, which will continue even after the initial plan is adopted by Congress, HCM suggests that the government move ahead with the following measures in an effort to restore order and stability to the global credit and financial markets:

The HCM Bailout Plan

The government should announce that it will effectively stand behind the U.S. financial system against failure through some sort of guarantee or insurance program. The government has already done this with respect to money market assets.
Mark-to-market accounting for financial institutions should be suspended for an indefinite period. Since nobody knows what these assets are worth, we should not drive the system into insolvency trying to place a value on assets that nobody is willing to purchase at the current time.
The Federal Reserve should reduce the overnight interest rate by 75 basis points immediately. This will allow financial institutions to begin to earn more on their assets, which will begin the process of rebuilding their balance sheets.
The Securities and Exchange Commission should announce the formation of a study group that will report back no later than December 31, 2008 on a comprehensive regime for regulating the credit default swap market.

As noted above, HCM is concerned that the plan to purchase mortgage assets from financial institutions will not produce the intended results because of the difficulty of reaching agreement on price without inflicting too much further damage on the sellers' balance sheets. That is why we favor a guarantee or insurance program rather than the Paulson proposal.

Will The Paulson Plan Work?

The American taxpayer is going to suffer economically whether the Paulson Plan, or some variation on it, is passed or not. HCM does not believe for a second that taxpayers will profit from this bailout as some prominent commentators are arguing. The assets that are clogging bank balance sheets are highly complex and illiquid, and the time required for them to return to any reasonable value will consume their recovery value in present value terms. Nonetheless, voices considered wiser than ours are touting the plan as a good deal for the American taxpayer.

Bill Gross of PIMCO, for example, has argued that taxpayers could profit from the $700 billion plan put forth by the Bush Administration. According to Barron's, Mr. Gross "estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries."⁶ Mr. Gross to his great credit has offered PIMCO's services to the government gratis in this endeavor (provided his competitors do the same). In PIMCO's hands, he argues, the government will get a fair deal for the assets it buys. "'The prices that Treasury will get will be somewhere between par, which of course might screw the taxpayer, and a fire sale price of, say, 20 cents on the dollar, which would likely bankrupt some weak institutions and defeat the purpose of the bailout.'"

We think Mr. Gross is unduly optimistic from a couple of standpoints. First, he appears to be assuming that virtually all of the assets that the government will be purchasing will be AAA-rated mortgage securities, since these are the only mortgage securities trading remotely close to 65 cents on the dollar today. Unfortunately, many of the securities that are weighing down the balance sheets of financial institutions carry lower ratings, and many AAA-rated tranches are trading at well below 65 cents on the dollar today. (We would note that the Federal Reserve had already agreed to take onto its balance sheet much lower rated collateral, including equities, in order to support these same financial institutions.) Current trading prices may be unduly depressed by speculative shorting of the ABX indices as well as crisis conditions in the marketplace, but by all accounts AAA-rated tranches of 2006 and 2007 vintage collateralized mortgage obligations are deeply distressed due to inordinately high levels of defaults in the underlying pools of mortgages. While current prices may reflect unrealistically pessimistic projections of future mortgage defaults, the fact remains today's prices are today's prices. If the government pays more for these securities, it will be giving the seller a windfall. Mr. Gross's scenario glosses over this dilemma, which lies at the heart of why the Paulson Plan is unlikely to yield rapid progress in moving troubled assets off bank balance sheets.

Second, we have yet to see the non-financial economy bear the full brunt of the collapse of the financial economy. Main Street is only starting to pay for the sins of Wall Street. The stock market remains in deep denial about the scope and depth of the economic slowdown this country is about to face. As the consequences of tighter credit seep into the mainstream of the American economy, there is every reason to expect that mortgage default rates will rise and home prices will continue to fall, further depressing the value of the mortgage securities that the government is supposed to be purchasing under the Paulson Plan. We wish we could share Mr. Gross's optimism, but we question whether deep in his heart he isn't trying to use his bully pulpit to talk up the market.

Japan Redux?

One of the tough questions that deserve to be asked in the wake of the U.S. government's bailout of the U.S. finance industry is whether American prosperity of the 1990s and 2000s was as illusory as Japanese prosperity of the 1980s? Just as Japan's prosperity was based on a rigged economic system constructed out of a cheap currency, cross-ownership of institutions and a nonmark-to-market accounting system, America's recent prosperity was also built on a cheap dollar, a non-mark-to-market accounting system, and an addiction to debt. While this comparison can be debated endlessly, and will likely be the subject of many scholarly articles and books, the real question is whether the United States will suffer anything like the "lost decade" that haunted Japan (actually, it has been almost two "lost decades"). There are significant differences between Japan and the United States (the most troubling, perhaps, being that Americans do not possess nearly the savings that the Japanese did entering their difficulties), but the question will gain more attention in the coming months.

While it is too soon to make any judgments that far into the future, America is certain to see very slow economic growth in the immediate future. The world's only superpower may see its first trillion dollar deficit within the next couple of years, although Washington will try to dress up the number to keep it under thirteen figures (an unlucky number in too many ways to count). That alone should be sufficient to knock down American hegemony a further peg or two. Such a deficit will contribute to a further debasement of the U.S. dollar against Asian currencies and the Swiss franc.

The primary reason why economic growth is going to be sluggish is that credit is going to be strictly rationed for the foreseeable future, which means that only the most creditworthy borrowers will be able to access capital at a reasonable cost. Companies that need capital will be the ones that find capital most difficult and expensive to access. This means that many companies will have to pay exorbitant rates to borrow, and many highly leveraged companies that have to borrow will be forced into bankruptcy or capital restructurings in order to do so. Many leveraged companies are already drawing down their revolving credit lines before their banks withdraw them. General Motors was the most prominent company to have done this recently, but HCM is seeing this occur throughout the corporate credit market.

American Oligarchy

One of the most discouraging parts of the debate over the Paulson Plan was the discussion about limiting executive compensation for those firms that might benefit from the plan. While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation. If troubled financial institutions are going to be run by individuals who would conduct themselves in such a manner, there isn't much hope that any plan is going to work. The mentality that led two of our best and brightest public officials to attempt to defend the kind of avaricious conduct that played a central role in the current crisis is something that must be changed if we are to avoid future market crises.⁷

This brings HCM to two related areas that need to be legislated immediately: financial institution leverage; and the taxation of highly compensated financial executives. There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it.

We do not believe it is presumptuous to state that the debate over whether Wall Street firms were too leveraged is over. The decision by Goldman Sachs and Morgan Stanley has decidedly ended the leveraged investment banking model that brought down Bear Stearns, Lehman Brothers and Merrill Lynch. The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets. Unfortunately, compensation schemes did not take into account the fact that adding leverage is far different than adding value (i.e. compensation schemes were not properly risk-adjusted). As a result, compensation structures for these executives were largely asymmetrical, particularly with respect to the portion of their pay that was distributed in cash. Multimillion dollar cash payments for profits earned in a single year were not subject to being repaid if losses in later years wiped out those earlier profits. Too much cash exited these firms each year in the form of compensation, significantly weakening their capital bases. Fortunately, a significant amount of compensation was also paid in stock, which did not weaken these firms' balance sheets but still failed to instill sufficient caution in management when it came to assuming balance sheet risk.

In addition to the gargantuan amounts of compensation being paid out, the taxes paid on these amounts continued to drop over recent years. This is a result not only of reduced taxes on capital gains and dividends, which are only good economic policy up to a point, but on tax deferral schemes and other aggressive tax stances taken by corporate, private equity and hedge fund executives to reduce their taxes to unconscionably low levels.⁸ Private equity managers, for example, are able to treat their "carried interests" as capital gains and pay taxes at only a 15% rate. Yet these earnings are no less the product of their labor than a teacher's or a policeman's earnings are a result of his or hers. Last year, several private equity billionaires actually had the gall to lobby on Capitol Hill to retain the 15 percent tax rate on their "carried earnings." These individuals argued that if their taxes were raised, they would no longer be willing to take the kinds of business risks that lead to new job formation and economic growth. Attempts to require these over-indulged [fill in the blank]⁹ to pay the same taxes on their income as ordinary Americans were derailed in what must go down as one of the most cynical lobbying efforts in history. It would be one thing if private equity firms were funding innovation and job creation, but in the last few years they have done little more than use cheap financing to engage in speculative transactions that generate fees for themselves and what are going to turn out to be at best mediocre returns for their investors.

Hedge fund managers play their own games. The most popular tax reduction technique among this crowd is the formation of offshore trusts that enable them to defer their management and performance fees for periods as long as ten years. A ten year deferral of taxes reduces the effective tax rate paid on these managers' already huge earnings to virtually zero on a present value basis while they continue to enjoy the ability to profit from investments in America's (once) free markets. This tax deferral scheme, which comes in a number of variations, further separates the interests of those hedge fund investors who are paying taxes on their income from those of managers who are not. (Of course, investors don't mind as long as they are making money. Investors never mind as long as they are making money. That's the problem.) As one memorable television commercial put it, "it's not what you earn, it's what you keep." And hedge fund managers have figured out how to keep virtually everything for themselves. Now that the bloom has come off the rose for many hedge fund strategies, investors are going to discover just how one-sided was the deal they made with their managers. Redemption requests from hedge funds are expected to reach epic levels this year, yet many investors are going to be greeted with the unhappy news that they can't get their money back right now (or anytime soon) because it is stuck in illiquid, hard-to-value investments. Others will be told that it would be unwise for their funds to liquidate positions to meet redemptions in the middle of a financial crisis, failing to be informed of the likelihood that many of these securities will most likely be worth less in the future.

Fairly taxing the upper 1/10 of 1 percent isn't going to plug the gaping U.S. budget deficit, but it will go a long way to returning a sense of fairness to a system that has lost its moral compass.

Footnotes:

1 Thomas S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1962), p. 111.

2 Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16. This book should be required reading in Congress.

3 David M. Smick, The World Is Curved (New York: Penguin Group (USA) Inc., 2008), p. 23. Not that we need more things to worry about, but Mr. Smick also makes a compelling case for why we should be concerned about China's future economic stability in the near future.

4 According to The New York Times, September 26, 2008 ("Day of Chaos Grips Washington; Fate of Bailout Plan Unresolved", p. A1)"n the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulsen, Jr., literally bent on one knee as he pleaded with Nancy Pelosi, the House speaker, not to withdraw her party's support for the package over what Ms. Pelosi derided as a Republican betrayal." Nothing else has worked, so why not try this?

5 Although in fairness all the blame for this can't be placed on these institutions. There is currently no market for many of these assets and placing a value on them would be an arbitrary exercise. This is why mark-to-market accounting should be suspended for an indefinite period of time.

6 Barron's, September 29, 2008, "Making A Mint," p. 30.

7 There were unconfirmed media reports late last week that certain Wall Street firms were marketing products to hedge funds that were designed to avoid the restrictions on short selling that were imposed by the Securities and Exchange Commission. Whatever one thinks of the short-selling restrictions, which were far from optimal, the prospect of financial institutions trying to circumvent them suggests that even the biggest financial crisis since the Depression has been insufficient to instill good judgment into some of those in positions of responsibility on Wall Street. Anti-fraud rules are designed, among other things, to prevent individuals from doing indirectly what they can't do directly. Gaming the short-selling restrictions would be a perfect opportunity to teach somebody a lesson that there are things more important in this life than making money.

8 It would not seem unreasonable, particularly during a period when the government is going to be starved for revenue, to impose a higher capital gains tax of 20% or 25% at significantly higher levels of gain, so that a taxpayer would pay 15% on the first $1 or $2 million of gain and the higher rate on gains over that amount. In general, however, lower capital gains rates stimulate economic growth and should be maintained. Dividend tax rates should be maintained at very low levels since these earnings are already taxed once at the corporate level.

9 HCM always likes to identify cultural images that capture the spirit of the times. There is currently an exhibition of modern sculpture called "Beyond the Limits" being held in the gardens of Chatsworth House, home to the Duke and Duchess of Devonshire, in England. One of the works on display is entitled "Planet" by Marc Quinn; it is a giant white sculpture of a baby lying/floating on its side. "Planet," which belongs more to the category of stunt or spectacle than art, seems to be a perfect emblem of these private equity chieftains groveling for tax relief from our elected officials (although the baby is not sucking its thumb). To view "Planet" on-line, see www.chatsworth.org.

Gaming the U.S. Elections

John Mauldin — Thu, 26 Jul 2007 18:10:00 GMT

Introduction This week in Outside the Box good friend George Friedman of Stratfor delves into that enigma that is Executive power and Presidential elections. George ventures to assess the current President in light of former Presidents, utilizing a methodical...(read more)

Life after Debt - Russia's New Millennium

John Mauldin — Mon, 26 Feb 2007 21:59:00 GMT

Introduction I got a lot of response from my recent letter on South Africa. Today we turn to another emerging market country. Since the late 90's, what country's equity market has performed the best? At first thought, many might say China or India...(read more)

Back to Iraq

John Mauldin — Thu, 09 Nov 2006 22:43:00 GMT

Introduction The past couple of days have been filled with anticipation over the outcome of which party will emerge victorious during this year's elections. Adding to the flurry of activity, Defense Secretary Donald Rumsfield unexpectedly announced...(read more)

John Mauldin's Outside the Box : Politics

A 20-Year Bear Market?

A 20-Year Bear Market?

Remember the Sixties?

Bad News, Potentially Good News

What's Next

What Does This Mean to You?

Don't Worry, Be Happy

Iranian Elections, Israel and the United States

The Geography of Recession

The Geography of Recession

The United States and the Free Market

Russia and the State

China and Separatism

Discordant Europe

Obama's Strategy and the Summits

Obama's Strategy and the Summits

Berlin, Washington and the G-20

Turkey and Obama's Deeper Game

The Russian Dimension

Market Vertigo

Market Vertigo

Barrack Hussein Obama -- America's 44th President

Aging and Saving -- The Face of the American Consumer

A Market of Hope

The Investor Psychology

All In

All In

The New President and the Global Landscape

The New President and the Global Landscape

The Post 9/11 World

A Stabilized Iraq and the U.S. Troop Dilemma

The Nuclear Chip and a Stable U.S.-Iranian Understanding

Afghanistan, Pakistan and the Taliban

The Russian Resurgence

European Disunity and Military Weakness

Israel, Turkey, China, and Latin America

The U.S. Defense Budget

Haste Makes Waste

Haste Makes Waste

The Paulson Plan

An Alternative Bailout Plan

The HCM Bailout Plan

Will The Paulson Plan Work?

Japan Redux?

American Oligarchy

Gaming the U.S. Elections

Life after Debt - Russia's New Millennium

Back to Iraq

Barrack Hussein Obama -- America's 44^th President