Sunday, March 27, 2011

American Fear

By Don Cooper

Whether they realize it or not Americans live in a constant state of fear every day. I'm not referring to the fears of everyday life like losing a job or having an accident of some kind, but rather a more sinister and devious fear; a fear that Americans only dare talk about around the water cooler or at cocktail parties so as not to be taken seriously; a fear they try to mask with a with a whimsical tone of sarcasm or indifference. Whether Americans want to admit it or not, it's the single greatest fear in their lives: fear of the government.

Right about now there are those reading this thinking: Don Cooper is a drunk. To which I reply: what's that got to do with it? Maybe more people should drink if that's what it takes to sober up and confront what they are really afraid of.

In their defense, I'll admit that reality is scary. No argument that living in delusion is warmer, safer, cozier, and easier. Pretending is always more fun than reality, that's why we go to the movies. But fear of the government is a fear that invades a person's soul and - since the government intervenes in every aspect of our lives - it affects every move we make every day.

Fear of the government is hard to recognize and acknowledge. It's a fear that we are taught early on in life and to which we become accustomed. We inevitably end up tucking it away in the far reaches of our minds in order to function "normally" every day and live our lives. But just as a car backfiring will trigger a sense of fear from a shell- shocked veteran, so too can the State trigger that sense of fear they've instilled in us.

One need only ask: when you see a cop in your rearview mirror with his lights on, do you feel a sense of safety and comfort or do you get a shot of adrenaline from your body's "fight or flight" reflex? Do you immediately start asking yourself what he could possibly pull you over for, other than the fact that he was abused as a child, bullied at school and his mother didn't love him, and now he's going to whittle away at that chip on his shoulder by abusing you.

As you search for your proof of government permission to drive (i.e., your license), and your government permission to own the car (i.e., your registration), and your proof of government mandated insurance, do you do so calmly and with a smile on your face and with gleeful anticipation of speaking with someone who gives of himself to serve and protect you, or do you do so nervously, fumbling through your papers hoping everything's up to date and acceptable to him for fear of being detained for whatever reason and having it affect your job, your family, and every aspect of your life?

And when it's all over, do you feel glad that it happened or are you just glad it's over? Later that evening do you recount the story to others with a sense of pride, or do you do so with a sharp tongue and kick yourself for all the things you wish you would have had the presence of mind to say at the time but didn't? Do you feel happy that you have to pay $150 to the government because you were driving down the street faster than the government allows you to, or are you angry? And in the end, do you send the money to the government even though you don't agree with it? Even though you feel it's unfair to have to pay so much money yet you've harmed no one? Of course you do. And why? Because you're afraid of what the government will do to you if you don't.

In the end, you'll retreat back into your cubby-hole of delusion in order to justify paying the fine by convincing yourself that what you did was wrong, the government was right, and you deserve the punishment. My favorite delusional argument from those still attached to the matrix is that they pay their taxes voluntarily. To these people I ask: when you do your tax returns, do you take as many deductions as the government will allow you? Of course, the answer is always yes. Then I ask them that if they could take enough deductions such that their tax liability was zero would they do so? Again, not surprisingly, the answer is yes. I then ask them that if their preference is to pay zero taxes then why don't they simply refuse to pay taxes. Inevitably, that's where their train of thought always runs out of track. Of course everyone knows the answer: because they're afraid of what the government will do.

I challenge everyone to ask themselves: when was the last time you even thought about the possibility you might be robbed, your house broken into or shot at? Can you even remember?

Now ask yourself when was the last time you were afraid of doing something that could be deemed "illegal" by the government and for which you could be fined, detained or arrested? Something like not wearing a seatbelt, speeding, making a U-turn, going through a yellow light, not crossing the street at the cross-walk, riding a bike on a sidewalk, forgetting your license at home, taking too many deductions on your taxes, talking on your phone while driving, not allowing strangers to touch you or your children at the airport, cutting down a tree on your own property, owning and transporting a gun, collecting rain water and the list goes on. I would wager the answer is: daily! The first word out of everybody's mouth when asked a normal, completely benign question these days is: "Well legally..." It's first and foremost on our minds, and why wouldn't it be, there are 76,000 pages to just the federal register alone. Some argue that everyone commits at least three felonies every day!

Ignorance is a dangerous thing, and it must be stopped in our lifetime, fo' it kill somebody. At the end of the day, all government mandates are enforced at the end of the barrel of a gun, and that scares the hell out of everyone, as it should. But if we truly believe we are free then we have to start acting like it. It's time we cared about something bigger than ourselves.

It's time we stopped living our lives in fear. Having said all that, I'm not holding my breath. It's proven to be difficult to convince people that freedom is more important than the real housewives of New Jersey. And that's why I drink!

Regards, Don Cooper for The Daily Reckoning

Saturday, March 26, 2011

When the Fix is In

Government Profits from the “Never Go Bust” Guarantee

Gold is hitting new records. It's telling us that there is something very wrong with the world's dollar-based money system.

But most investors don't notice. Gold is still a "kooky" thing to buy.

And the feds have no idea what is going on.

You gotta hand it to the feds. They're cool. They're incompetent. They could pass a lie detector test no matter what they did.

Over at the US Treasury, they've been crowing about how much profit they've made. They rushed to save AIG and Citi by buying their toxic bonds. Then, they flew to the side of Fannie and Freddie when they were in trouble.

As a result of these selfless rescue efforts, they came to hold a huge portfolio of securities; the Fannie and Freddie portion alone is worth $142 billion, say the papers. The Treasury has already sold its AIG and Citi paper - at a profit. And now, it is getting set to unload its hoard of Freddie and Fannie paper.

Can you believe it; its eggs haven't been sold yet, but it's already counting on profits between $15 and $20 billion. Are they investment geniuses at the Treasury, or what?

Well, in a way, they're a lot smarter than we are. We could have bought those notes and bonds too. We should have had more faith in the feds. We could have looked ahead and seen that they would get away - for a while, at least - with one of the biggest financial scams in history. We could have made a profit on it too!

Let's look at how it works. The borrowers - AIG, Citi, Freddie, Fannie - make bad bets. By all rights, they should go broke and their bondholders should lose money. But as Mr. Market is doing his work - marking down junk debt of all kind in anticipation of a clean up - in come the feds. No need to sell that stuff, they say. We're behind it 100%. Thus did they pledge the full faith and credit of the United States of America to guarantee that bondholders wouldn't pay for their own dumb mistakes.

We should have bought then; the fix was in. But we had doubts about the credit of the US. Still do. We worried that the fix may not stay fixed long enough to make money.

We were wrong. As to their ability to refloat the financial sector, we should never have doubted the feds. The Fed went out and bought every stray dog and cat of a mortgaged-backed security it could find - $1.4 trillion worth of them. It also lent money to the financial industry at 0.5%. That's about 8.5% below the real rate of consumer price inflation - according to John William's "Shadow Stats" estimate. And if that weren't enough, the banks were guaranteed profits - by allowing them to borrow from the Fed at 0.5%, use the money to buy US Treasury bonds, yielding between 3% and 4%...and sell them back the Fed. Not taking any chances, the Fed is also printing up an extra $4 billion per day, money coming out of nowhere, to buy Treasury bonds. Not only is it financing more than America's entire monthly leaves the financial industry free to use its own (borrowed) money to speculate on other things.

Naturally, when you have this kind of racket going, you're not going to bother making risky loans to the private sector. Instead, you're going to go where the fix is're going to gamble on debt - buying more "junk" bonds...and pushing up bond prices!

Oh, Dear Reader, we hate a scam, but we admire an elegant scamster. In other words, the feds gave the financial sector the money to bid up its own paper...the very paper that the feds themselves held in great quantity.

And now they claim to have made a profit from this operation.

How about this? We'll start a phony baloney business. We'll sell shares all over town. When people realize that the business is a loser, the shares will fall and our business will be in danger of collapse. Then, the feds can come to our aid too. They can buy up our shares, guarantee that we'll never go bust, and give us money so we can buy shares too. The price of the shares will go back up...and the feds can sell their shares, quietly. Hey, this will be profitable for the feds too - if they ignore all that money they gave us to make the flimflam work.

But here's a question: why couldn't they make this sort of razzmatazz work in Europe? Didn't the Irish have a boatload of bad mortgage debt? Didn't the government step in to guarantee the lot of it? And now look. Not only is the original mortgage debt getting marked is the Irish government's debt.

Why can't the Irish get the hang of this?

Well, a couple of reasons.

First, the Irish have much more debt to deal with; they've already given their banks an amount equal to 1/4 of the nation's entire GDP. That would be like reflating the US financial sector with $3.5 trillion.

Wait a minute. You say the US financial sector has gotten nearly that much? Hold on...maybe you're right...

The money printing from the Fed is the aforementioned $1.4 billion, right? Okay... Another $200 billion or so in asset purchases from the Treasury. And surely handling all those US Treasury bonds didn't hurt - what's that, about $3 trillion there, but you can't really count that as a bank bailout.

But the big difference is that the US can print money; Ireland can't. Ireland has to borrow the money with which to bail out its banks. And the more it borrows, the more investors worry that it won't be able to pay it back.

And they're right. At current yields, the Irish can't borrow at all - not on the open market. Two-year bonds issued by Ireland now yield more than 10%. So, the Irish have to beg loans from the euro-feds. And even they are charging them 6%. Even at that subsidized rate, Ireland can't go on much longer.

Ireland is more like California or Illinois. It doesn't print its own money. And it doesn't have a central bank that will lend at zero percent...

In the long run, this is a good thing. They can't destroy their entire economies with make-believe money, while claiming to make taxpayers' a profit.

-- Bill Bonner/ The Daily Reckoning

Friday, March 25, 2011

Two Ways for the US to Go Broke

By Bill Bonner

We're in the airport. We can't seem to get a signal. So, here's an abbreviated reckoning.

From what we can tell from the newspapers, the US housing market got very bad news yesterday. New house sales dipped to a record low. Never before since they began keeping records a half century ago have so few new houses been sold.

Naturally, house prices are falling too. Why is that? Because the housing industry built and sold today's houses yesterday. A credit bubble takes from the future. Now we're in the future. Naturally, there's not much here. It's already been taken away...used up...built...spent...consumed. We've got yesterday's houses on the market. And today's. And tomorrow's.

Which shows how ridiculous the feds can be. First, they nationalized Freddie Mac and Fannie keep them from going broke. Then, they bought mortgaged-backed securities by the boatload...and lent money at zero interest re-flate the banking/mortgage industry. Then, they tell us that we (the taxpayers) are making money on those securities. Yes, we're supposed to make a profit as they are sold back into the market!

But now the housing market is in a double dip, and a report in today's news tells us that Fannie and Freddie may be hiding $100 billion in losses.

Our advice: if you buy a house today, mortgage it heavily. Long term. Fixed rate. Your house will go down in price...but your mortgage may disappear completely.

Another thing taking a beating today is Europe's periphery debt after the Portuguese voted against austerity. To put this into perspective, there are only two ways to go. When you borrow too much money from the future, you either have to pay it back or you go broke. The Portuguese were trying to pay down their debts, by cutting "services." But it's harder to cut services than you might think. Modern democratic welfare states are built on a fraud - that the government can give people more in services than they pay for. Typically, the government takes the extra money from groups that are politically weak - such as the next generation, which doesn't get a vote.

Citizens don't like it when the government tries to cut back. And when a majority of voters are on the taking end of the exchange - getting more from the feds than they pay in taxes - it's very hard (maybe impossible) to impose "austerity" measures.

What the Portuguese election is telling us is that many governments will go broke before they pay down their debt. At least, that's what it implies...

As Dear Readers know, the US situation is a little more complicated. We have the world's reserve currency. Our debt is largely held by foreigners. And it is denominated in a currency we alone control. So, we have the ability to go broke in two different ways.

We can do it the old-fashioned way, that is, by being unable to pay our bills when they come due.

Or we can do it the inflationary way - by paying our bills in a currency that is not worth as much as the stuff we borrowed.

Clearly, the second way is the preferred approach. It's what the feds are aiming for. It's a major reason the Fed is pumping $4 billion per day into the world economy. And it's an additional reason to keep interest rates at zero - even after, by the feds' own reckoning, the emergency is past.

In short, you can cheat your creditors in two ways. You can default honestly. Or you can inflate.

The trouble with inflation is that it is like a bad dog. It doesn't come when it is called. And when it does come, it comes on so fast it knocks you over. Then, it goes into the house and tears up the furniture.

Japan hasn't been able to get the cur in the door in over 20 years of calling. And when it came to Argentina, Zimbabwe and Weimar Germany, it what such a nuisance they wished they had never whistled.

But there's Ben, Tim, and all the rest - dog lovers, everyone of them.

Exactly How Does This Turn Out?

By Byron King

"It's hard to know exactly how this turns out," said Adm. Mike Mullen, chairman of the Joint Chiefs of Staff, this past Sunday, in answer to a question about the US-French-British-et al. aerial assault on Libya. Oh, really?

The admiral made his statement after US and British ships opened fire and put 114 million-dollar Tomahawk cruise missiles downrange at Libyan targets over the weekend. Another 25 or so US and British Tomahawks have left the launch boxes in the past couple of days.

Meanwhile, over the weekend, French jets bombed the tar out of Libyan armored and troop columns near Benghazi. While a flight of B-2 bombers soared from Missouri, crossed the Atlantic Ocean and Mediterranean Sea and dropped precision weapons on other Libyan targets - according to Aviation Week & Space Technology magazine.

So let me see if I've got this straight. The US armed forces, and allies, are waging intercontinental, techno-war against Libya - a desert-dictatorship that is, at root, a failing, North African petro- state with mostly third-rate military capabilities. But according to the top honcho of the JCS, we don't know how it's going to turn out?

We don't know? That's quite an admission by Adm. Mullen. If nothing else, whatever happened to sounding confident for the TV cameras and saying, "We win, they lose"?

Then again, what else doesn't Adm. Mullen know? Let's get down to basics. What's the alliance? Who's fighting whom? Who's with us? Who or what are we targeting? Is this Libyan air show a NATO thing? If so, why does NATO member Turkey oppose it? Why is a core NATO member, Germany, pulling out?

More broadly, what's the strategy? What's the operational concept? What's the order of battle? What are the military goals? When the shooting stops (and it will stop, right?), with whom do we make peace? So maybe we won't have a signing ceremony on the deck of a battleship, but what's the theory of victory? the way, who's in charge?

Sure, there's an adrenalin rush from picking up the morning newspaper and seeing front-page photos of bombs bursting, airplanes falling and tanks smoking.

Then again, you could get your heart rate up by going to see the recently released movie Battle: Los Angeles. Wow, what a campy ordnance flick! It's a Marine Corps recruiting infomercial from start to end. And at least in Battle: Los Angeles, you can set aside your moral qualms. Battle: Los Angeles is a sci-fi bug hunt, in which space aliens have invaded Santa Monica and are, in turn, getting what they asked for. But I digress.

Space aliens aside, it's not as if Libya's Generalissimo Gaddafi doesn't have serious pain coming to him. He's never paid for his role in the gratuitous 1988 bombing of Pan Am Flight 103. On that point of history, the US should maintain a very long memory - and be open and honest about it when the right time comes along.

In case you can't tell, Pan Am 103 brings out my inner Roman Legionnaire. I think that Pan Am 103 supports the ancient concept of a purely punitive expedition. Blow up one of our airliners? We'll pulverize you, out of raw vengeance. Under most circumstances, I'm OK with bombing Gaddafi under the doctrine of payback and specific deterrence. That is, he'll never blow up another airliner because he'll be toast.

But something troubles me about the current military display. The air raids are occurring absent anything like a formal US declaration of war against Libya, let alone a mere congressional authorization to employ arms. Indeed, before the Romans destroyed Carthage, they debated the purpose of their effort in their Senate. The outcome? Well, they set a clear policy. "Carthago delenda est" (Carthage must be destroyed.)

Now, however, the US is waging war under a rather novel form of legal reasoning, if not presidential war powers. Shoot first, and notify Congress later. Or are we saying, perhaps, that the legal authority to attack Libya is embodied in the "Marines' Hymn"? You know, "From the Halls of Montezuma/to the Shores of Tripoli," and all that. In which case, does Mexico have to worry?

Let's get past the military fact that it's raining steel in Libya. Something else troubles me. The US government doesn't have a 2011 budget for its Department of Defense - and we're six months into the fiscal year. This is, at root, courtesy of the last Congress, which failed to pass a defense budget in the waning days of 2010.

No defense budget? Last year, there was political capital for Congress to pass "don't ask, don't tell" legislation. But for some strange reason, Congress could not pass anything as mundane as a law to fund procurement and operations, let alone to pay the troops.

Not to put too fine a point on it, Congress has authorized no money to fight wars - at least not this one. Thus, right now, the US is shooting missiles, dropping bombs and engaged in its third, simultaneous "hot" war (actually, the fourth, if you include bombing Pakistan), and there's no budget. Not to be legalistic, but isn't every fire-breathing Tomahawk missile a violation of the Antideficiency Act?

Let me refine this last point. There's a recently passed congressional "Continuing Resolution" (CR), valid until April 8 that appropriates funds to the DOD. But the nature of the CR is that it restricts the DOD to fighting this year's wars on last year's budgeting structure. I don't believe there's a line item for "bombing Libya."

The whole thing is very strange. And no, I am NOT making any of this up.

At the beginning of this note, I said that I'd come around to the investment side of things, and here we are. What should you do?

Easy. Buy gold and silver. Buy shares in mineral developers with assets in the ground. Buy oil- and energy-related shares, as well as oil service players. See? Easy.

Why buy gold and silver? Because the US government is fighting wars without really knowing what it's doing (Adm. Mullen, call your office), let alone how it's paying for the bullets (see above). And this is just a mini-version of all the other things the US government is doing without having the resources to pay for them.

Using the above-noted DOD budget mess as an example, the US is not just spending money it doesn't have fighting an unauthorized war. No, the US is spending money when Congress has not even passed a real budget. Of course, this is just a small step removed from the usual routine of Congress spending money that's not there.

The bottom fiscal and monetary line is that the federal budget is out of control. Federal spending is out of control. The federal deficit is out of control. The national debt is out of control. Interest on the national debt is out of control. Neither the president nor Congress is in control. To quote Adm. Mullen, "It's hard to know exactly how this turns out."

The endgame is that the dollar is destined for inflation, loss of value and the long-term impoverishment of people who don't invest around this nation-busting, failed-state-walking issue. Buy gold. Buy silver.


Byron King,
for The Daily Reckoning

Wednesday, March 23, 2011

Regulatory Cops

Why we need regulatory cops on the beat – and why they make bankers cringe

By William K. Black

One of the paradoxes of effective financial regulation is that the best way to help bankers and banks is to virtually never think in terms of helping banks and bankers. Financial regulators’ primary task is to detect, put out of business, and deter accounting control frauds. Those are the frauds that cause catastrophic individual failures, hyper-inflate financial bubbles, and produce our recurrent, intensifying financial crises. Accounting control frauds also produce “echo” epidemics in other professions (e.g., auditors, appraisers, and credit rating agencies) and industries, e.g., loan brokers. Fraud begets fraud and it can make fraud endemic in entire lines of business such as liar’s loans. The senior officers of investment and commercial banks spread these frauds through an industry and to other industries and professions by deliberately creating “Gresham’s” dynamics. In this context, the dynamic refers to situations in which bad ethics drives good ethics out of the market. George Akerlof first used this variant of the Gresham’s dynamic in his famous article on markets for “lemons” that led to the award of the Nobel Prize in Economics. Akerlof explained that if firms that defrauded their customers gained a competitive advantage over their honest rivals private market discipline became perverse and drove honest firms into bankruptcy.

The CEOs that lead accounting control frauds create intensely criminogenic environments by shaping perverse incentives that maximize such Gresham’s dynamics among their own officers – by basing executive compensation largely on short-term reported (fictional) income. They create perverse incentives among loan officers, “independent” professionals, and other firms (e.g., loan brokers) by hiring, firing, promoting, praising, and making wealthy those that will create and “bless” their fraudulent accounting practices. The art is to suborn – not defeat – “controls” by perverting them into allies.

The senior officers that control fraudulent banks are exceptionally successful in using these Gresham’s dynamics to produce fraud epidemics and massively overstated asset values and earnings. They routinely get clean accounting opinions for financial statements that do not comply with GAAP and are deliberately contrary to reality. They routinely get grossly inflated appraisal values. They routinely got “AAA” ratings for toxic waste that was not even single “C.” They routinely got “liar’s” loan applications and appraisals that their employees and agents falsified to make them appear to have far lower loan-to-value (LTV) and debt-to-income ratios. The result was loans with a premium yield that looked (to the credulous) as if they were not exceptionally risky. The lenders could sell these fraudulent liar’s loans at a premium or keep them in portfolio and claim high (fictional) earnings. Liar’s loans, of course, produce severe adverse selection and negative expected value (losses). The fictional reported income in the near-term, however, is a “sure thing” for accounting control frauds because they do not create remotely adequate allowances for loan and lease losses (ALLL).

These unique abilities, and dangers, posed by banks that are accounting control fraud mean that regulators are the only ones that can break a Gresham’s dynamic prior to catastrophe. Regulators’ unique advantage is that they are not paid, hired, or fired by bank CEOs. This logic also explains an important exception – if banks can create a “competition” in laxity among regulators (as they did with the Office of Thrift Supervision during the recent crisis) they can crate perverse incentives that can drive laxity. The worst bank CEOs often seek to create this competition in regulatory laxity by threatening to move internationally to the weakest regulator. They also seek to create regulatory black holes that serve as safe havens for control fraud.

When financial regulators are not captured by the industry and do not seek to serve the industry, then they can serve as regulatory cops on the beat. Their function is to break the Gresham’s dynamic by making it far less likely that cheaters will prosper through fraud. Regulators are in a better position to exercise real independence than any private sector “control.” This means that vigorous financial regulators who make fighting control fraud their top priority are honest bankers’ best friends and the control frauds’ worst nightmare.

As with Adam Smith’s paradox (which works well for the local village baker and fails utterly for global banker) financial regulators can be successful only when they do not act out of any desire to help banks, but rather to serve as the regulatory cop that is passionate about enforcing the law against even the most powerful banks when they engage in intentional misconduct. By taking the profit out of fraud, successful financial regulators help honest bankers and greatly reduce the scope, length, and damage of financial crises.

All of this explains why the “reinventing government” movement (a bipartisan project of then Texas Governor Bush and Vice President Gore) was a disaster for financial regulation. We were instructed to refer to banks and bankers as our “clients.” This is the worst possible mindset for effective financial regulation. Unfortunately, key politicians are determined to recreate this disastrous mindset.

Spencer Bachus (R. Ala.), the incoming Chair of the House Financial Services Committee, told the Birmingham News: “In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks.”Ron Paul (R. Tex.), asked to comment on Bachus’ statement, said: “I don’t think we need regulators. We need law and order. We need people to fulfill their contracts. The market is a great regulator, and we’ve lost understanding and confidence that the market is probably a much stricter regulator.”

The latest manifestation of this mindset was in response to Professor Elizabeth Warren’s recent congressional testimony. Dana Milbank’s March 16, 2011 column reported:

“You kept saying ‘cop on the beat, cop on the beat,’ ” complained Rep. Shelley Moore Capito (R-W.Va.), who chaired the day’s hearing. Basically, the members of the panel didn’t want the new [Consumer Financial Protection Bureau] CFPB to have anything that would displease bankers. Rep. Blaine Luetkemeyer (R-Mo.) said the agency was “the last thing that our lenders need.” Rep. Robert Dold (R-Ill.) ridiculed the “theoretical consumer protection” the agency would provide. Rep. Sean Duffy (R-Wis.) complained that, in Warren’s agency, “consumer protection could trump safety and soundness.”

Apparently, these politicians learned nothing useful from the crisis. The first thing honest bankers need is an end to fraudulent mortgage lending. Ending fraudulent mortgage lending does not “trump safety and soundness” – it is essential to attain and maintain safety and soundness. Liar’s loans destroyed trillions of dollars in wealth and caused many lenders to fail. They created inverse Pareto optimality – both parties were made worse off by the typical liar’s loan. The agents were the winners. Akerlof & Romer explained this dynamic in the title of their 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The looting causes the bank to fail (unless it is bailed out) but the senior officers walk away wealthy. Fraud is almost always a negative sum transaction – the losses exceed the gains. Accounting control fraud produced exceptional net losses at banks because the recipe for creating short-term fictional reported income also maximizes real losses.

A vigorous regulatory cop on the beat, and Elizabeth Warren is the exemplar, is exactly what honest banks and bankers need. But even honest bankers are typically Pavlovian about financial regulation. They have been taught for decades by theoclassical economists and anti-regulatory ideologues that regulation is evil. Regulators also ask embarrassing questions and criticize senior managers. So, it is the rare honest bank CEO who will publicly support vigilant regulation. If you have a psychological need to be liked by the bankers or if you think of them as your “clients” or “customers” you are unsuited to be a financial regulator because you are incapable of functioning as a cop on the beat.


*Bill Black is the author of The Best Way to Rob a Bank is to Own One. He is an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Monday, March 21, 2011

Why Aren’t Arab States

– Instead of the U.S., France and Britain – Taking Care of Libya?

By Washington’s Blog

Gaddafi is a lying psychopath who is slaughtering his own people.

So is the imposition of a no-fly zone a good thing?

Perhaps. The Arab League called for it. And even some Libyan rebels pleaded for imposition of a no-fly zone.

But if someone is going to stop Gaddafi, it should be Arab League nations – like Saudi Arabia, which is armed to the teeth.

America should not be involved, because:

• Most Americans are strongly against U.S. intervention in Libya

• America was already involved in 2+ wars costing the U.S. many trillions of dollars (Nobel prize winning economist Joseph Stiglitz says that the Iraq war alone will cost $3-5 trillion dollars.) Indeed, America’s engagement in multiple wars is bankrupting our country – despite the claims by the military Keynesians

• We are creating more terrorists than we’re stopping by bombing and invading Arab countries

• And both conservatives like Ron Paul and liberals like Dennis Kucinich have pointed out that American intervention is unlawful without a Congressional resolution of war … which no one bothered to ask for.

So I don’t care whether or not someone imposes a no-fly zone or takes out Gaddafi … but the U.S. shouldn’t be the one to do it, even as part of a coalition with France and Britain.

Indeed, Gaddafi has accused the efforts by the three former colonial powers – U.S., France and Britain – as being “neo-colonial” aggression and a “crusade“.

If Arabic countries were the ones to intervene, Arabs wouldn’t be able to make those charges.

And if Arab countries are not willing to intervene themselves, that speaks volumes as to their true priorities … especially since Saudi Arabia just sent 1,000 troops to Bahrain to help the tyrants in that country brutally put down a pro-democracy protest

Sunday, March 20, 2011

Putting an end to Wall Street’s ‘I’ll be gone, you’ll be gone’ bonuses

By Barry Ritholtz

Want to reform Wall Street bonuses? Try clawbacks.

That’s right. We need to make executives personally liable for their reckless bets if we want to remove the risk for taxpayers. That means giving shareholders, boards of directors and regulators the ability to “clawback” past gains when new speculations go horribly wrong.

The Federal Deposit Insurance Corp. and the Securities and Exchange Commission have floated proposals on performance-based compensation for traders and bankers. Firms that have more than $1 billion in assets would have to disclose incentive-based bonuses. The largest firms (those with more than $50 billion in assets) would have to pay at least half of their bonuses in compensation that is deferred for three years. The SEC could, in theory, deny plans that encourage excessive risk-taking or outrageous bonuses.

While this approach is well-intentioned, Wall Street has proven itself especially adept at circumventing compensation laws. Rules that seek to limit bonuses will likely shift compensation more to salary and commissions.

Private profit, public risk

Understand this: I do not care what shareholders and their boards pay the people who create enormous value. Whether it’s a chief executive such as Steve Jobs of Apple or a hedge-fund manager such as Steve Cohen of SAC Capital, the people who are paid handsomely for creating incredible profit are not the problem.

On the other hand, many others received huge bonuses for bankrupting their firms and driving the economy into recession. Their job performance should be the subject of your ire and of regulators. They brought the world to the abyss of economic collapse because they had incentives to do so.

If that sounds unbelievable, consider:

• Subprime mortgage brokers who were paid based on the quantity – not the quality – of their mortgage writing. The loans lenders sold to Wall Street to be securitized carried a 90-day warranty. Hence, the brokers’ jobs were to find people who would make the first three monthly payments of a 30-year loan. After that, it was no longer their concern.

• Derivative traders who knew that what they were buying was going to blow up. In 2007, I published an e-mail from one such trader who wrote, “We knew we were buying time bombs.” The motivation was deal fees and bonuses. Once the derivative machinery was in motion, they had to “keep buying collateral, in order to keep issuing these transactions.”

• Collateralized debt obligation managers whose job it was to assemble pools of mortgages, yet had little or no understanding of the underlying loans. The salespeople, traders and managers working in the mortgage sector had incentives that were upside down. The greater the risk they took, the more they were paid. But brunt of those risks was on third parties, never themselves. It was shareholders and taxpayers who shouldered them.

This is backward. The people who should bear the downside are the ones who have the upside. Instead, the system was perversely one of private profit but public risk.

Note that it wasn’t merely the staff that engaged in this reckless risk-taking. At investment banks, senior managements were so reckless that they managed to destroy their firms. For this act of gross incompetency, they were rewarded with vast bonuses in cash and stock options. By the time their firms collapsed, they had cashed out hundreds of millions of dollars in legal booty.


• Lehman Brothers Chairman and CEO Richard Fuld Jr. made nearly a half-billion – $490 million – from selling Lehman stock in the years before it filed for Chapter 11 bankruptcy.

• Countrywide Financial (now owned by Bank of America) founder and CEO Angelo Mozilo cashed in $122 million in stock options in 2007; His total take is estimated at more than $400 million dollars.

• Stanley O’Neal, who steered Merrill Lynch into financial collapse before it was taken over in a shotgun wedding with Bank of America in 2008, was given a package of $160 million when he retired.

• Bear Stearns former chairman Jimmy Cayne, rescued by a $29 billion Fed shotgun wedding to JPMorgan Chase, received $60 million when he was replaced;

• Fannie Mae CEO Daniel Mudd received $11.6 million in 2007. His counterpart at Freddie Mac, Richard Syron, brought in $18 million. In 2008, the two were forced into government conservatorship.

Add to this list Washington Mutual, Wachovia, IndyMac and other bankrupted firms whose senior management took a boatload of money and ran.

Nice work if you can get it – and still live with yourself.

Blame game

How did this happen? Some people blame excessive greed; others say crony capitalism is at fault. I believe we can sum it up in one word: liability.

In recent years, there was no legal liability for extreme recklessness. Take a healthy company, roll the dice and if it comes up snake eyes, all you lose are your unvested stock options. Most management does not have significant capital at risk.

The cost for pushing a healthy firm into insolvency by excessive risk-taking is some snickering at the golf course. In terms of lost monies, it is minimal.

You might be surprised to learn that it was not always this way. Before these firms went public in the 1970s and 1980s, bank management had full liability for their firm’s losses. During the era of Wall Street partnerships, if employees were so reckless as to lose billions of dollars, the partners were on the hook for the full amount. This meant that after the firm was liquidated to pay its debts, the partners’ personal assets were next on the auction block: Houses, cars, boats, even watches were sold to satisfy the debt.

Not surprisingly, partnership liability worked wonders in focusing attention on taking appropriate risks.

Once a bank or investment firm went public, this liability shifted from management to the company’s stockholders and creditors (namely, the bond holders). Add to this the rise of stock-option compensation, and you have a recipe for extreme short-termism.

In his book “The Accidental Investment Banker,” Jonathan Knee described this mercenary attitude with the phrase “IBGYBG.” As bankers signed off on increasingly risky deals, IBGYBG meant “I’ll be gone, you’ll be gone” by the time the really messy stuff hit the fan. Call it what you will – smash and grab, take the money and run. Without partnership liability or clawback terms, IBGYBG was perfectly legal.

The simple solution to IBGYBG is legal liability.

How this works: There must be a civil liability for recklessness that caused a collapse or loss. Liability for loss accrues when a trader knew and disregarded the risk or, failing that, should have been aware of the risks they were taking.

The ability to clawback past gains in the event of a subsequent collapse should accrue to the board of directors, the shareholders and the SEC.

It is too late to force the big banks and investment houses to go private and become partnerships again. However, we can return the liability for their recklessness back to where it belongs – on the traders, fund managers and executives who profited from extreme risk-taking.

Saturday, March 19, 2011

Japan, the Persian Gulf and Energy

By George Friedman

Over the past week, everything seemed to converge on energy. The unrest in the Persian Gulf raised the specter of the disruption of oil supplies to the rest of the world, and an earthquake in Japan knocked out a string of nuclear reactors with potentially devastating effect. Japan depends on nuclear energy and it depends on the Persian Gulf, which is where it gets most of its oil. It was, therefore, a profoundly bad week for Japan, not only because of the extensive damage and human suffering but also because Japan was being shown that it can’t readily escape the realities of geography.

Japan is the world’s third-largest economy, a bit behind China now. It is also the third-largest industrial economy, behind only the United States and China. Japan’s problem is that its enormous industrial plant is built in a country almost totally devoid of mineral resources. It must import virtually all of the metals and energy that it uses to manufacture industrial products. It maintains stockpiles, but should those stockpiles be depleted and no new imports arrive, Japan stops being an industrial power.

The Geography of Oil
There are multiple sources for many of the metals Japan imports, so that if supplies stop flowing from one place it can get them from other places. The geography of oil is more limited. In order to access the amount of oil Japan needs, the only place to get it is the Persian Gulf. There are other places to get some of what Japan needs, but it cannot do without the Persian Gulf for its oil.

This past week, we saw that this was a potentially vulnerable source. The unrest that swept the western littoral of the Arabian Peninsula and the ongoing tension between the Saudis and Iranians, as well as the tension between Iran and the United States, raised the possibility of disruptions. The geography of the Persian Gulf is extraordinary. It is a narrow body of water opening into a narrow channel through the Strait of Hormuz. Any diminution of the flow from any source in the region, let alone the complete closure of the Strait of Hormuz, would have profound implications for the global economy.

For Japan it could mean more than higher prices. It could mean being unable to secure the amount of oil needed at any price. The movement of tankers, the limits on port facilities and long-term contracts that commit oil to other places could make it impossible for Japan to physically secure the oil it needs to run its industrial plant. On an extended basis, this would draw down reserves and constrain Japan’s economy dramatically. And, obviously, when the world’s third-largest industrial plant drastically slows, the impact on the global supply chain is both dramatic and complex.

In 1973, the Arab countries imposed an oil embargo on the world. Japan, entirely dependent on imported oil, was hit not only by high prices but also by the fact that it could not obtain enough fuel to keep going. While the embargo lasted only five months, the oil shock, as the Japanese called it, threatened Japan’s industrial capability and shocked it into remembering its vulnerability. Japan relied on the United States to guarantee its oil supplies. The realization that the United States couldn’t guarantee those supplies created a political crisis parallel to the economic one. It is one reason the Japanese are hypersensitive to events in the Persian Gulf and to the security of the supply lines running out of the region.

Regardless of other supplies, Japan will always import nearly 100 percent of its oil from other countries. If it cuts its consumption by 90 percent, it still imports nearly 100 percent of its oil. And to the extent that the Japanese economy requires oil — which it does — it is highly vulnerable to events in the Persian Gulf.

It is to mitigate the risk of oil dependency — which cannot be eliminated altogether by any means — that Japan employs two alternative fuels: It is the world’s largest importer of seaborne coal, and it has become the third-largest producer of electricity from nuclear reactors, ranking after the United States and France in total amount produced. One-third of its electricity production comes from nuclear power plants. Nuclear power was critical to both Japan’s industrial and national security strategy. It did not make Japan self-sufficient, since it needed to import coal and nuclear fuel, but access to these resources made it dependent on countries like Australia, which does not have choke points like Hormuz.

It is in this context that we need to understand the Japanese prime minister’s statement that Japan was facing its worst crisis since World War II. First, the earthquake and the resulting damage to several of Japan’s nuclear reactors created a long-term regional energy shortage in Japan that, along with the other damage caused by the earthquake, would certainly affect the economy. But the events in the Persian Gulf also raised the 1973 nightmare scenario for the Japanese. Depending how events evolved, the Japanese pipeline from the Persian Gulf could be threatened in a way that it had not been since 1973. Combined with the failure of several nuclear reactors, the Japanese economy is at risk.

The comparison with World War II was apt since it also began, in a way, with an energy crisis. The Japanese had invaded China, and after the fall of the Netherlands (which controlled today’s Indonesia) and France (which controlled Indochina), Japan was concerned about agreements with France and the Netherlands continuing to be honored. Indochina supplied Japan with tin and rubber, among other raw materials. The Netherlands East Indies supplied oil. When the Japanese invaded Indochina, the United States both cut off oil shipments from the United States and started buying up oil from the Netherlands East Indies to keep Japan from getting it. The Japanese were faced with the collapse of their economy or war with the United States. They chose Pearl Harbor.

Today’s situation is in no way comparable to what happened in 1941 except for the core geopolitical reality. Japan is dependent on imports of raw materials and particularly oil. Anything that interferes with the flow of oil creates a crisis in Japan. Anything that risks a cutoff makes Japan uneasy. Add an earthquake destroying part of its energy-producing plant and you force Japan into a profound internal crisis. However, it is essential to understand what energy has meant to Japan historically — miscalculation about it led to national disaster and access to it remains Japan’s psychological as well as physical pivot.

Japan’s Nuclear Safety Net
Japan is still struggling with the consequences of its economic meltdown in the early 1990s. Rapid growth with low rates of return on capital created a massive financial crisis. Rather than allow a recession to force a wave of bankruptcies and unemployment, the Japanese sought to maintain their tradition of lifetime employment. To do that Japan had to keep interest rates extremely low and accept little or no economic growth. It achieved its goal, relatively low unemployment, but at the cost of a large debt burden and a long-term sluggish economy.

The Japanese were beginning to struggle with the question of what would come after a generation of economic stagnation and full employment. They had clearly not yet defined a path, although there was some recognition that a generation’s economic reality could not sustain itself. The changes that Japan would face were going to be wrenching, and even under the best of circumstances, they would be politically difficult to manage. Suddenly, Japan is not facing the best of circumstances.

It is not yet clear how devastating the nuclear-reactor damage will prove to be, but the situation appears to be worsening. What is clear is that the potential crisis in the Persian Gulf, the loss of nuclear reactors and the rising radiation levels will undermine the confidence of the Japanese. Beyond the human toll, these reactors were Japan’s hedge against an unpredictable world. They gave it control of a substantial amount of its energy production. Even if the Japanese still had to import coal and oil, there at least a part of their energy structure was largely under their own control and secure. Japan’s nuclear power sector seemed invulnerable, which no other part of its energy infrastructure was. For Japan, a country that went to war with the United States over energy in 1941 and was devastated as a result, this was no small thing. Japan had a safety net.

The safety net was psychological as much as anything. The destruction of a series of nuclear reactors not only creates energy shortages and fear of radiation; it also drives home the profound and very real vulnerability underlying all of Japan’s success. Japan does not control the source of its oil, it does not control the sea lanes over which coal and other minerals travel, and it cannot be certain that its nuclear reactors will not suddenly be destroyed. To the extent that economics and politics are psychological, this is a huge blow. Japan lives in constant danger, both from nature and from geopolitics. What the earthquake drove home was just how profound and how dangerous Japan’s world is. It is difficult to imagine another industrial economy as inherently insecure as Japan’s. The earthquake will impose many economic constraints on Japan that will significantly complicate its emergence from its post-boom economy, but one important question is the impact on the political system. Since World War II, Japan has coped with its vulnerability by avoiding international entanglements and relying on its relationship with the United States. It sometimes wondered whether the United States, with its sometimes-unpredictable military operations, was more of a danger than a guarantor, but its policy remained intact.

It is not the loss of the reactors that will shake Japan the most but the loss of the certainty that the reactors were their path to some degree of safety, along with the added burden on the economy. The question is how the political system will respond. In dealing with the Persian Gulf, will Japan continue to follow the American lead or will it decide to take a greater degree of control and follow its own path? The likelihood is that a shaken self-confidence will make Japan more cautious and even more vulnerable. But it is interesting to look at Japanese history and realize that sometimes, and not always predictably, Japan takes insecurity as a goad to self-assertion.

This was no ordinary earthquake in magnitude or in the potential impact on Japan’s view of the world. The earthquake shook a lot of pieces loose, not the least of which were in the Japanese psyche. Japan has tried to convince itself that it had provided a measure of security with nuclear plants and an alliance with the United States. Given the earthquake and situation in the Persian Gulf, recalculation is in order. But Japan is a country that has avoided recalculation for a long time. The question now is whether the extraordinary vulnerability exposed by the quake will be powerful enough to shake Japan into recalculating its long-standing political system.

Tuesday, March 15, 2011


Both Natural and Unnatural

Looking at history, there are often major international economic declines after big natural disasters. The example I like is how the San Francisco earthquake of 1906 led to the bankruptcy of many insurance carriers and to an outflow of cash from London and New York money centers. This led directly to the Panic of 1907 - and eventually to the creation of the US Federal Reserve. So in a sense, you could say that a natural disaster produced an unnatural disaster.

Getting back to the present, the earthquake-induced drop in oil prices is just a short-term blip. Oil prices are on the way up because many nations are increasing not just demand, but oil stockpiles - due to uncertainty of supply from the Middle East.

In the Philippines, for example, the government recently required that refiners keep a 90-day oil supply, versus, the former 30-day supply. Other countries and large oil-using firms are doing similar things, in terms of building stockpiles.

So which news trumps the other news? Will generally rising oil demand keep pricing strong? Or will unexpected events continue to keep a lid on that oil demand, and thus hold down prices?

Bottom line is that this earthquake oil-selloff is likely a short-term phenomenon. There's strong upward momentum built into oil prices due to fundamental supply issues, not the least of which relate back to political unrest in the Middle East. We could see a quick rebound in oil price strength due to concerns over supply.

Looking further ahead, China only has enough oil in its strategic reserves to cover one month's consumption, according to Wang Qingyun, head of the State Bureau of Material Reserves. Mr. Wang says China is working towards building a 90-day reserve, but the energy bureaucrats are still working on selecting the storage locations and constructing facilities.

Oil availability and pricing is certainly a matter of growing concern for China, whose daily oil imports, as a fraction of total consumption, now exceed that of the US. China now imports about 63% of its daily oil consumption - double the percentage of ten years ago.

As China's consumption grows, the prospect of "permanently high" oil prices also grows. And that will mean investment dollars will continue pouring into the oil exploration industry.

For example, in the past five years we've seen (net) about 100 new jack-up and deep-water drill ships float away from the shipyards of the world. These vessels reflect over $40 billion of new capital expenditure. Then there's the multiplier effect of new-build vessels on the vendors, equipment builders, steel mills and all the way back to the iron mines.

Meanwhile, a hiring craze is on at Halliburton (NYSE:HAL), which has just announced that it will hire about 5,000 new geologists and engineers, worldwide. Heck, even I - your humble editor - routinely field calls from headhunters, seeking geological talent.

It all sounds like positive investment news for the oil industry. But there are other things to consider as well. What's the payback for all of this investment and hiring? Are we seeing an "energy return" for all the new capital outlay?

Let's compare some recent numbers. Between 1995 and 2004, the global oil industry spent $2.4 trillion on various capital expenditures. This $2.4 trillion helped increase crude oil production by 12.3 million barrels per day, to about 85 million barrels of output per day by 2005 (and hold that thought). This is just the raw, historical data set.

Coincidentally, between 2005 and 2010, the world oil industry spent another $2.4 trillion on capital expenditure. Yet for the same amount of money - $2.4 trillion - global crude oil production actually fell by about half of one percent.

What does this mean?

There are many implications, of course, but one key point is that the world's overall daily oil supply is not growing. For all the stories you see about "new" supply coming online from deep-water fields, from onshore discoveries, from enhanced oil recovery, from oil sands, from gas liquids out of tight gas deposits, etc., these are only replacing other oil supplies that are vanishing in the form of depletion.

It's fair to say that oil output is flat, worldwide, and prices are not really being set or moderated by efficiency, conservation or even by adding capacity.

No, the key control over oil prices in the past couple of years has been the recession. The recession has set the price of oil. And had it not been for the recession, the world might be consuming upwards of 93 million barrels of oil per day...and might be paying much higher prices than $100 a barrel.

Looking ahead, wherever things go with the world economy, we're in an environment that's supply-constrained. We're not going to find any "new" Saudi Arabias or Russias - although it's good to know the story of what's happening off shore Brazil.

Peak Oil is here, except right now we're experiencing it solely as an issue of affordability ($100-plus oil), versus lack of day-to-day supply.

Eventually - well, maybe - the world economy will begin to move out of recession. And maybe we'll even have a period of time without international crises (Middle East comes to mind) or large-scale natural disasters. Then we'll see what true supply constraint looks like - and prices will rocket upwards.

How does one deal with all of this? Well, begin by investing in companies that hold real assets in the form of oil and natural gas, as well as uranium and other resources of value - gold, silver, etc. That, and the energy-technology players of the oil service sector - the usual suspects of Schlumberger (NYSE:SLB), Baker Hughes (NYSE:BHI) and Halliburton.

Stay tuned and we'll figure it out together.


Byron King,
for The Daily Reckoning

Wednesday, March 9, 2011

Modern Investors in Search Normal Markets

By Bill Bonner

Reckoning from Baltimore, Maryland...

Rope a dope.

Want a winning investment strategy? Find out what the dopes are doing with their money. Do the opposite.

Some investment advisors are smart. Some aren't. Some are mavericks with original, interesting ideas. Some just read the paper and do what everyone else is doing.

Last week, we got an advisory letter from one of the of the dopes. We read it carefully; if he were pointing investors in the same direction we are going, we'd have to change course.

But no! He urges investors to buy major US stocks and to sell gold. Gold is "overpriced" he says.

What a relief. He still has no idea what is going on; he thinks things are getting back to "normal."

And wait. Here's James K. Glassman, writing in The Washington Post. His piece is entitled, "The Modern Investor."

What's the modern investor supposed to do? Put half your money in stocks. The other half in bonds.

Wait a minute... Is this the same man who came out with "Dow 36,000" in 2000 - the year the stock market peaked out? It is? Well, great! That does it for us.

We don't want to be a modern investor. We don't want stocks or bonds. We'll stick with being an old fashioned investor and stick with our program: Sell stocks on rallies; buy gold on dips.

Headline in The Financial Times on Friday:

"ECB hint on rate rise jolts markets."

The European Fed said it might raise its key lending rate in April. The euro rose sharply...the Dow fell 88 points. Gold rose $12.

The case we've been making is that the ECB can't "normalize" interest rates. Neither can the Fed. In Ireland, most people have floating rate mortgages. If rates floated up to market levels, the Irish would sink. They can't afford higher interest payments.

The situation is the same for the Irish government. At market rates - 9% or more - it will go broke immediately. So, it looks to the ECB, the IMF, and the World Bank...and every other possible source of below- market meet its budget needs.

And the US? Ditto!

Historically, which is to say for the last two decades, the average rate of interest on US 10-year Treasury notes is about 5.7%. You'll notice that that's a bit more than the 3.5% the Treasury is paying now.

And then you can do the math. Nah, we'll do it for you. Imagine that the whole of the federal debt was financed at 5.7%. The total bill would be about $800 billion per year - or more than a third of total tax receipts. Of course, much of the debt is fairly it won't have to be rolled over tomorrow. And much of it is held by the government itself...

But you can imagine what would happen to the bond market.

And imagine what would happen to the stock market if interest rates went back to 5.7%?

If interest rates returned to "normal" stockholders and bondholders would lose trillions of dollars.

What's more, there's no law that says interest rates can't go higher than the recent average. Suppose they went to 18% - as they did at the end of the '70s? Suppose the whole of the federal government's debt were financed at 18%? Then, guess what, the total interest charge would be approximately equal to 100% of tax revenues.

Well, you can imagine how long that would last. Not a single minute. The whole system would fall apart long before it came to that.

But you see what we mean? Normal is out of the question. Grotesque. Weird. Strange. Extraordinary. Perverted. That's the financial system we have. And that's the financial situation we'll have for a while longer...until it finally blows up.

At least, that's our theory.

No recovery. No "back to normal." No exit.

If the feds try to exit from their twilight zone policies they're going to hit a bridge abutment. Markets will crash. The economy will go to pieces. Unemployment will go up. People will point fingers and accuse them of exiting "too soon."

We saw, too, editorial opinions already stating that the ECB was "trigger happy"...and urging the Fed to avoid following its lead.

No worries on that score. Here at The Daily Reckoning we put the odds of an exit at zero.

The economy now depends on cheap money. It can't survive without it.

And more thoughts...

"That's one of the big differences between the French and British aristocracy," Elizabeth enlightened us. "The French aristocrats were encouraged to move to Versailles and take part in the life of the central government. They may have owned vast estates in Normandy or Aquitaine. But the real action - social as well as political - took place in and near Paris. So, they lost contact with their sources of power...their "terres"...their family strongholds. When the revolution came, they had no local support. Their peasants turned against them. Many lost their estates and their heads.

"The English aristocracy, on the other hand, tended to be jealous of its local rights and privileges and stuck close to its land. They were never so cut off from the local people and never so dependent on the court of St. James in London. That was part of the reason they evolved a different, more decentralized system of government with more emphasis on individual rights and limited central power. And it's probably why there was never any popular uprising against them."

Lesson? If you want to keep your head, stay close to your roots...your base...and your family stronghold.

We never concluded our rambling comments on the importance of a Family Stronghold. So, we'll continue...

It's one of the things we recommend for our members at the Bonner Family Office. You need roots...a sense of being connected...a refuge from the outside world...a place where your family is safe and sure of itself. As our old friend Gary North says, you need a place where you can "dig in."

In earlier reflections on the subject, we noticed how, as society becomes wealthier, each part of it becomes more dependent on the others. Today, very few people can survive on their own. In developed countries there are few subsistence farmers left. Very few could people live for more than just a few days if the sophisticated system of production and distribution were interrupted. And yet, it seems very unlikely that the system won't be disrupted. War, revolution, Internet bugs, real bugs, bankruptcy, hyperinflation...there are so many things that could go wrong, it is hard to believe that at least one of them won't.

In light of this, we urge members of our Family Office to have a place where the family can run...hide...and survive.

Where? The best place is a farm...a place not too far from where you usually are...easy to get to...and stocked with enough food and water to keep you going for a few months. Best bet is an old-fashioned pantry full of canned goods, chickens in the hen house and a pig or two in the sty.

Here in Maryland, your editor has not completely followed his own advice. He has a country house in Maryland, for example. But has no animals...and has never gotten around to stocking anything more than firewood and wine. How long can you survive on Bordeaux? We don't know, but in case of a total breakdown, we intend to find out.

Does this sound alarmist? Paranoid? Nutty?

Maybe. We are so accustomed to thinking that everything will work out fine. It always least in our lifetimes. But everything doesn't always work out fine. There are, remember, a few black swans as well as many white ones. Those black swans can be nasty. And it only takes one to wipe you out.

Here's one way to look at it... A bolt-hole of your own is like an insurance policy. Maybe you won't need it. But if you do need it, you'll need it very, very badly.

Of course, if an asteroid strikes the earth...or the Yellowstone volcano blows up...or if government goons go through the countryside, as the Soviets did in the Ukraine, torturing peasants to find out where they had hidden grain...even a family farm of your own may not save you. But in the case of many other calamities, it might make the difference between life and death.

"You're just looking at the negative side of it," adds Elizabeth. "On the positive side, a family stronghold can give you a richer family life. You need a place that gives your family a sense of identity, unity, and stability. Generations come and go. But places last. A place gives a family a sense of permanence too.

"Family strongholds help families develop their own culture...their own resources...their own histories. They are good places to get the family together for holidays...for reunions...and to help family members learn to work together. They're places that you matter where you go...or where you live. They're places where grandparents live. Where family portraits and family papers are stored. Places you think about. And, I know what you would say; they're the places where you bury your gold.

"A family stronghold...or a a also a good place to recover...and to think. It should be fully paid for, of course. You don't want to have to worry about it. It should be a real stronghold...where you're safe. And where you're happy. So, if you lose your job, for example, it's a place where you go back take time to think about your next move. Or, if you wan to write a book...or invent a new computer app...or just try to figure out what's going on in your life, a family stronghold is a good place to do it. It should be quiet, tranquil, and protective."

Your editor's family recovered its family farm in Maryland last year, after spending 15 years in Europe. The place was a mess - overgrown with trees and bushes, with fallen-down fences and grown-up fields...cracked and rotting shutters on the house...and barn roofs that you could see daylight through.

Almost every weekend since, we've spent fixing the place up. Sometimes just Edward (the last child still living with us) would be available to help. Sometimes one of the other boys would come home for the weekend. Occasionally, the girls would be able to help out too. And sometimes - such as Thanksgiving weekend - we had the whole family outside - pruning, clipping, digging, raking, nailing...

It is a great thing when you can get the children to help. There's nothing quiet or tranquil about it. The noise of chainsaws and old, diesel tractors.

"Hey, don't hitch it up that way..." "Wait, we're not finished..." "You bent the nail..."

The kids often disagree, tease each other...and fool around. They have their own ideas. Their own programs. They laugh. They joke. Progress often slows. Still, it is always heartwarming to watch them work.


Bill Bonner
for The Daily Reckoning

Tuesday, March 8, 2011

Musings on a Failed Experiment

By Joel Bowman
Reporting from Buenos Aires, Argentina...

The state of the states is not good, Fellow Reckoner. Cracks are beginning to appear in their veneer. The illusion of vitality and control is coming into question. Even people with better things to do than pay attention to politics are beginning to sense that the charade may be up. They suspect their mayors and governors - and perhaps even their kings and queens - have no clothes on. Some have started pointing fingers and waving placards. They vow to stay and fight. Others are planning their exit...while they still can.

We are not gathered here today to offer tears and condolences for failing and flailing states. By any measure one cares to employ, the very idea of "The State" itself has had a pretty good run. Forged in the crucible of ancient Egypt some 6,000 years ago, the state has morphed through iterations as many and varied as the seasons between them. From the Pharaohs through to warlords, kings and queens, generalissimos, barbarians, emperors, chairmen, f├╝hrers, shoguns, sheiks, tsars, presidents, prime ministers and the rest of the scoundrels, nobody could say we humans didn't give The State a fair go. Quite the contrary. We gave it every opportunity to succeed. And more.

Our forefathers tried hereditary rule, divine rule, rule by majority, minority, by power, money and force of every stripe and style. They drafted manifestos, constitutions, bills of rights and Little Red Books. Every conceivable form of "The State" has been given its turn. We've tweaked it, tortured it and tinkered with it for long enough. And now, after six millennia in the political lab, after countless wars and untold lives surrendered to whatever the "cause" of the day happened to be, we see what we have for our troubles.

There are resources enough to feed every moth in the world. Yet, most of one entire continent starves to death. People living in vast swathes of another are not much better off. Two more, at least, face imminent insolvency and surefire social upheavals, revolutions, even wars. Brutal, iron-fisted dictators rise in the poorest regions of our world, supported and installed by their democratically elected counterparts in far off lands, where people who call themselves good don't care to read bad news. And in the most powerful nation the planet has ever seen, a mighty behemoth with military arsenal enough to lay waste to the entire human population many times over, more than 40 million of its own citizens live on food stamps, barely able to get by. That many again are supported directly by the state, that grand experiment we've devoted six thousand years to testing, but which we still don't quite understand.

It is said that nature abhors a vacuum. The same is true of political and economic eco-systems. Where one species, one gene, one dollar staggers toward extinction, another evolves, emerging to fill the void. Financial crises, revolutions, bankruptcies and currency crashes are all part of the process. Rather than be feared, these occurrences ought to be celebrated as a necessary part of the cycle. A renewal, of sorts. It is the unleashing of productive capital and the freeing of minds for new and better ways to trade, think and arrange ourselves politically and economically. Of course, this is by no means a new idea.

Charles Darwin, his focus more on the animal kingdom than the political thrones of man, called the process "evolution by natural selection." The weak perish at the hands, and to the advantage, of the strong as nature selects for and promotes the most efficient, adaptive species. Cruel as the system sounds, we simply wouldn't be here without it. Joseph Schumpeter, in his 1942 work, Capitalism, Socialism and Democracy, coined for the same economic process the term "creative destruction." Innovative entrepreneurs are the driving force behind long-term economic growth and prosperity, Schumpeter argued, but they occasionally, necessarily, displace the "value" of established companies and business models in the process.

And in the political realm? What happens when a government spends too much of its citizens' money, or grows too inefficient, or simply loses the support of those who, knowingly or not, spend their efforts creating the means and circumstances for its existence? What becomes of that king, that governor, that political philosophy when those who fuel it lose faith in their leaders' power and the viability of the system in general? Communism, monarchism, fascism, feudalism...nothing lasts forever. Right now, across the Middle East and North Africa the sword is falling on some well-deserved necks. What started in the relatively minor economy of Tunisia has now spread to Kuwait and even threatens the House of Saud.

What will fill this Middle East-shaped political vacuum, then? We've tried statism in every manifestation conceived. After 6,000 years and counting, isn't it about time for something new?

Back in the US, we're keeping an eye on the states within The States. As you may have read, we're down to the finalists in our Daily Reckoning Financial Darwin Awards: The State Edition. We announced the final ten in the weekend edition (in alphabetical order) - California, Connecticut, Illinois, Louisiana, Massachusetts, Mississippi, New Jersey, New York, Ohio and Wisconsin.

Each day this week we'll count down from fifth place to the winning state, which we'll announce on Friday.

Today's State, coming in at fifth place, is rather small and not usually one to pop up on the radars. One reader, who has since relocated to warmer climes, described his former state of residence as a "financial basket case with a political class full of clowns." we'll need more specifics...

Although her projected budget shortfall for 2012 is "only" $3.7 billion, much less than some of the larger states, today's feature state suffers a debt to GDP ratio of 12.5%...only marginally lower than that of Greece. And, like the shaky Club Med economies, individual states don't have the option of printing/inflating their obligations away.

Writes another reader:

"No doubt you are well aware of the budget and jobs crisis circus in [this state]. Any intelligent person would think it should be right at the top of the priority list for our Senators and Representatives to act on. Not so!

"Recently, the two clowns representing my district have introduced legislation to have the Tibetan Language put on our licenses, in addition to English. Although hard to believe, this is the type of legislation our Legislators consistently deem to be important and appropriate.

"Needles to say, I believe our state is a prime contender for your Darwin Awards.

"By the way, I'll be proposing our State's motto be changed from 'The Constitution State' to 'The State of Denial.'"

In case you haven't guessed it yet, with almost $5,000 in per capita state debt and unfunded pensions per capita weighing in closer to $18,000, our fifth place choice for this year's Daily Reckoning Financial Darwin Awards is...


Michael Moore Speaks Out

Watch this and pass it on:

Thursday, March 3, 2011

China’s Highly Unequal Economy

By Victor Shih

Double-digit growth can’t hide the fact that China’s state-controlled economy is leaving the vast majority of citizens behind.

During a round table with business leaders during Chinese President Hu Jintao’s visit to the United States in January, US President Barack Obama stated optimistically that ‘With China’s growing middle class, I believe that over the coming years, we can more than double our exports to China and create more jobs here in the United States.’ To be sure, that is a reasonable expectation. When other Asian economies like Japan and Korea grew toward the GDP per capita level of $10,000, sizable middle class populations did indeed emerge.

However, when looking under the bonnet at China’s economic engine, it’s clear that a growing middle class with rising disposable income and consumption is missing. Instead, there’s an economy that is still dominated by state owned firms and state-led investment, as well as by rapidly rising inequality. Instead of an enlarging urban middle class, China is increasingly splitting into a small upper class that spends freely on luxury goods, and a remaining population whose earnings and savings are eroded by inflation and state confiscation.

The underlying dynamics are clear in a recent statistical release by the government. First, real urban disposable income rose a comparatively tepid 7.8 percent in 2010, despite economic growth of nearly 10 percent. However, urban retail sales of consumer goods grew 14.5 percent. While the growth of consumption is good for China's economy, the pattern of this growth suggests rising inequality.

The biggest growth in consumption included jewellery (46 percent), furniture (37 percent), cars (34 percent) and construction material (34 percent). Essentially, these are items related to the spending of the upper class. These ‘consumer’ goods also made up 33 percent of all retail consumption in China. The large size and strong growth in luxury items implies that grey income was substantial in 2010, as suggested by a Credit Swiss report authored by Prof. Wang Xiaolu.

In this report, released last year and based on a survey of urban households in 2009, Wang found nearly 1.5 trillion dollars in grey income unreported in the official household income numbers. He further found that over 60 percent of this grey income accrued to the top 10 percent of households. The latest numbers also suggest that while income of normal households likely grew at around 8 percent, the top 10 percent of households may have seen income growth above 25 percent.

A growing middle class is also absent among recent college graduates. According to the Ministry of Education, only 68 percent of college graduates in 2010 were able to find permanent employment. Even among those who found employment, wages were often no better or sometimes even worse than those for migrant workers in factories. Unlike the rest of the world, however, China enjoyed a spectacular 10 percent growth rate. This impressive growth, however, didn’t translate to high paying jobs for college graduates. In major cities, many college graduates live as an ‘ant tribe,’ packed tightly in small dormitory rooms with four or more roommates.

And, lest we begin to think of China as a dynamic market economy, the latest data showed that of the 27.8 trillion yuan in fixed asset investment, 15 trillion was accounted for by investment undertaken by state-owned enterprises or investment in real estate. Even among the ‘joint stock’ firms, many are actually state-controlled. Thus, at least in terms of investment, the state still controls the lion's share. Meanwhile, well-financed state owned enterprises have nationalized firms in the coal, automobile, and steel industries in recent months, meaning competition and efficiency in these sectors might actually have suffered from large-scale, state-led investment.

Why does China have an economy that is highly unequal and dominated by the state? The answer is quite simple when considering China’s political system and contemporary history. Despite economic reforms that liberalized goods markets and the labour market, the state continues to hold a tight grip over most of the financial institutions. The financial sector in essence takes money from foreign exchange earnings and from household savings and channels it to state-owned firms controlled by the central or local government. Having little choice, households in China must deposit money in the state banks, and when there’s inflation as there is today, they earn a negative real interest rate from the banks because the government fixes deposit rates at a level that is below inflation. Meanwhile, real estate developers with political connections and large state-owned enterprises can borrow money at interest rates that are near zero in real terms. In effect, the Chinese financial system channels wealth from ordinary households to a small handful of connected insiders and state-owned firms. To be sure, other Asian countries have also pursued this state-led financing model. But China has pursued it for the longest period of time. Meanwhile, there’s still no liberalization of the financial sector in sight.

At the local level, local governments confiscate the other major source of wealth—land and real estate holding—often giving residents illegally low compensations. Without political accountability and elections, ordinary people can do little to change what amounts to property theft. Even escalating welfare spending in recent years can’t make up for the large transfers of income and savings from ordinary households to the wealthy and connected, which are shaped by government policies.

As a result of all this, ordinary households actually get poorer in relative terms and even in absolute terms. Meanwhile, although growth appears robust, the nature of the growth has changed over time. As Yasheng Huang at the MIT Sloan Business School has documented in his Capitalism with Chinese Characteristics, the healthiest period of growth in China was in the 1980s, when farmers made and sold light manufacturing goods and agricultural outputs to rapidly emerging goods markets. Into the late 1990s, however, China ‘restructured’ its banks so that they could continue to channel cheap loans to state-owned behemoths, now even larger due to consolidation in the 1990s. Growth from that point increasingly relied on net exports and state-led investment and decreasingly on household consumption. Although growth of this sort can continue for a few more years, the vast majority of China’s population won’t see many of the benefits.

Victor Shih is associate professor of political science at Northwestern University and author of ‘Factions and Finance in China’ (Cambridge University Press).