Sunday, January 31, 2010

A Chill Wind from Davos Blows onto Wall Street

The annual meeting of the World Economic Forum in Davos, Switzerland is a gathering of the world's business and political elites that inflames the paranoia of the gun-cleaning, nonperishable food stocking, cabin on a ridge dwelling crowd. High ranking people with easily recognized names schmooze, eat, drink--and talk about what? It's not entirely clear. Imaginations step in to fill the informational void. Conspiracies are avidly inferred. Entrenchment of the well-to-do is strongly suspected. Speculation abounds that ordinary people are mocked and their interests laughingly sold down the river.

But perhaps not this year. CNBC reports that the big banks were told by government figures that more regulation was on the way, whether or not they liked it. Evidently, the bankers didn't even bother to protest, seemingly recognizing that they've overstepped by recovering so exuberantly from last year's crisis with the benefit of government bailouts, while everyone else continues to struggle with economic stagnation and high unemployment.

They probably thought they had things taken care of. Going back to the 2008 Presidential election, Wall Streeters, led by the folks at Goldman Sachs, contributed more to Barack Obama than John McCain. And the difference wasn't small. Of course, you didn't need a Wharton MBA quality intellect to figure out that Barack Obama would win. And Wall Street, an industry kept afloat by government bailouts, obviously had to side with the winner. Since Obama was sworn in, Wall Street lobbyists have quietly but furiously pushed back against the various proposals to reform financial regulation, with considerable success. A couple of months ago, only modest changes seemed likely. The big banks were surely breathing easier.

Then, the Republicans screwed everything up. They slipped into Massachusetts in the dead of night and ambushed a somnolent Democrat in the special election for Ted Kennedy's replacement. Having lost in a flash his best chance to reform the health insurance mess, President Obama went with the flow and joined in the populist outrage over big bank bailouts. He immediately rehabilitated Paul Volcker, the former Chairman of the Fed who was being confined to a re-education camp for liberals, and ordered column left march. The ghost of the Glass-Steagall Act was seen wandering the streets of lower Manhattan during market trading hours.

Things got worse in Davos. Reportedly, Rep. Barney Frank (D-Mass.), not exactly a minor recipient of campaign contributions from the financial services industry, was vocal among the eminent about the imminence of increased regulation. In step with him were several high ranking European governmental officials. The message was that regulators would work across international borders to prevent financial institutions from pulling . . . things . . . in one country that they couldn't do in other countries. There would be no exit from increased regulation.

With the Davos 2010 manifesto beginning with "regulators of the world, unite," all of Wall Street's careful political planning in 2008 seems to have been for naught. Stricter rules are coming down the pike. And the Street has nowhere to go, since the Republicans started the whole thing with their victory in Massachusetts. Maybe the moral of the story is hell hath no fury like a political party scorned. Today's populist anger is like flood waters overwhelming a dam, and some Republican members of Congress are trying to catch the insurgent wave. The erstwhile party of big business won't make a united stand to protect Wall Street.

There is a lesson here for the financial services community. The free market ethic of the 1980s and 1990s is dead and gone, crushed by hundreds of billions of dollars of undocumented, unsupported, unjustified and plain old stupid mortgage loans that impelled the largest government intervention ever in America's financial system. The polity no longer believes that what's good for corporate profits is good for America. An industry sometimes can, through a well-funded lobbying campaign, slip quietly through the weed-infested, brackish, swamp waters of political Washington and fix things so its interests appear protected. But not when its survival requires an enormous helping--and then seconds and thirds--of the nation's resources. You ultimately can't ask the middle class many in a democracy to serve the interests of a privileged few. When the electorate believes it's been ripped off, it has the means to take action. Even when the most powerful corporations are concerned. No business in a democracy is a profit center unto itself. To survive and thrive, it must find a way to fit into and serve the needs of the larger community, giving as well as taking.

We've been here before. The industrialization and cartelization of America in the 19th century led to populism at the turn of the 20th century. The ensuing fifty years of political struggle witnessed the creation of the federal regulatory structure we now have, along with unemployment compensation, Social Security and the other social welfare programs that form today's safety net. Although the business community slowed the process of change, the electorate eventually had its way. It will again. Free market theoreticians may sputter and fume as the perfection of their markets is muddied by politicians and bureaucrats. But free markets as they exist in the real world tend toward, and eventually wallow in, excess. Lacking the ability to restrain themselves, yet with their excess inflicting massive collateral risk and damage on society, they sooner or later invite government regulation. Thus it has been, and thus it is now.

We should also recall that the 20th Century was, on the whole, a time of great economic growth and rising prosperity. The increase in government regulation and participation in the economy eased political conflict, improved education, infrastructure, communications and transportation, and enhanced the legitimacy of the status quo. Calls for radical change lost their appeal. The social balance and stability achieved by the growth of government enhanced business opportunities and facilitated investment. Profits are less predictable when a lot of people wave pitchforks at corporate headquarters. The truth is, increased regulation is for Wall Street's own good.

Thursday, January 28, 2010

The Bubble Keeps on Bursting: Municipal Debt

The Big Asset Bubble of the early and mid-2000s continues to burst. The next big splatter may come from municipal debt, especially state government debt.

As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.

All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.

The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.

Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.

The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.

These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.

The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.

Tuesday, January 26, 2010

Ben Bernanke and Moral Hazard

At the end of last week, when it looked like Ben Bernanke might not be confirmed for re-appointment as Chairman of the Fed, the stock market was in a tizzy, with the Dow dropping over 200 points on Friday alone. Now, after repeated insistent pronouncements by high level administration and Congressional figures that Bernanke will be approved for a second term, the markets have stabilized and even moved slightly upwards. If you're invested in stocks, that's good. But only for now. In the long run, you, we and all have a problem.

It's no secret the stock markets are complex. With the Internet's informational horn of plenty and thousands of pages of SEC filings per year per company, the data flow is overwhelming. But the crucial information of what a company is truly about and where it's going is very difficult to discern. Add to this the fact that there are thousands of public companies, and anyone who tries to rationally analyze the totality of the markets is destined for discombobulation. Some investors seek out talismanic signs--those would be the now tarnished credit rating agencies' little letter and number grades. Others follow gurus--whichever analyst du jour has the best discernible track record from whatever point of view one considers meaningful. But, more than anything, today's markets rely on big medicine--the big medicine of big government.

Not long ago, the most esteemed medicine man was Alan Greenspan. In an age of asset volatility, beginning with the 1987 stock market crash, Greenspan seemed to have magical powers. He could calm roiling waters. While the Japanese stock and real estate markets boomed and busted, leaving Japan in seemingly perpetual stagnation, Greenspan wielded the monetary wand first to expunge any signs of inflation, and then transport American assets--equities and real estate--to Lake Wobegon, where they all performed above average. Nary a cloud was to be seen in ever brighter blue skies. Seldom was heard a discouraging word. The buffalo roamed. The deer and the antelope played. Chairman Greenspan was practically deified and the markets rose ever higher while he presided over the Fed.

But Chairman Greenspan's big medicine offended the gods of supply and demand. He, a professional economist, had the hubris to think that he could magically stop prices from falling, and the economy from contracting. The gods simmered, then fumed, and then raged. Finally, they cast fearsome bolts of lightning that set the financial world ablaze and burned down numerous houses of cards. The nation was tossed out of Lake Webegon. Justice, untempered by mercy, was administered by the laws of supply and demand.

Alan Greenspan's luck continued to hold. By the time the ship hit the iceberg, he had departed the Fed and taken up a new role as eminence grise to the financially powerful. In his place was a new Chairman, Ben Bernanke, whose medicine was untested.

It's conceivable that the stock market crash of 2007-08 was severe as it was because the Fed was then chaired by a rookie. Because Bernanke wasn't predictable at that time, asset prices couldn't be easily established, and demand fell away.

We know what happened next. The Fed opened up all of its doors, even the emergency exits in the cafeteria, and invited every imaginable financial institution to come in for loans. It organized the first ever money printers' SWAT team to work 'round the clock rescuing beleaguered financial firms. Short term interest rates magically disappeared, and they've been gone for so long many teenagers and children don't believe they ever really existed.

But the stock market revived, and the real estate market may soon be moved from the ICU. Ben Bernanke was complimented, then toasted, and most recently, deified as Man of the Year. The markets now believe in his magic. As long as Bernanke serves as their totem, they will know that no bullet can kill them. Appetite for risk has made a comeback. The bulls strut in the range.

The financial markets' reliance on Great Men is a bad sign. Trading and investing have become bets on the direction of government policy. It's easier to rely on the perceived avuncular omniscience of a senior federal official than deal with the markets in all their mindnumbing complexity. Enormous political pressure is placed on the Chairman of the Fed to pump out soothing liquidity forever. Enormous political pressure is placed on the administration and Congress to keep the seemingly gifted Medicine Man in the Fed Chairmanship forever.

As long as the Big Medicine Man stays in office, no risk will be deemed too great, no speculation foolish. All assets will be good buys, because if supply ever threatens to exceed demand, Uncle Ben will pump out more liquidity to absorb the evil excess.

It was this way with Uncle Alan that we got the Great Bursting Bubble of 2007-08. Now, with the financial markets clinging to Ben Bernanke like lint, the cycle appears poised to renew itself. The financial markets have become increasingly addicted to government policy--and in particular, government handouts. This isn't a story that will have a happy ending in the long run. Lasting prosperity won't come from Big Medicine Men. It will come from the individual efforts of people producing things that other people want to buy, and from the financial markets financing the efforts of these productive people. But the near term profits and bonuses of Wall Street are harder to harvest from the pedestrian activities of the production process. Massive cash flows provided by the Fed are much more lucrative. Plus ca change, plus c'est la meme chose. And that's too bad.

Sunday, January 24, 2010

Uncertainty: Wall Street's Nightmare

Last week, the stock market fell 4%. Although somewhat disappointing earnings announcements were part of the reason, politics were the driving factor. Republican Scott Brown's surprise win as senator to replace Ted Kennedy was predicted by some to be positive for the stock market. Wrong. As soon as the Obama administration realized that it had been ambushed, it reversed course on financial regulatory reform, wheeled Paul Volcker out of the closet where it had been hiding him, and aimed the heavy political artillery at Wall Street. Stocks fell away at the end of the week, as renewed vigor for increased regulation and taxes implied moderation of future corporate earnings.

Political disarray is increasing. Democratic discipline, not exactly Prussian in the best of times, is evaporating fast. More and more senators are announcing their opposition to the renomination of Ben Bernanke as Fed Chairman. He must be reconfirmed by midnight, Jan. 31, 2010, or he ceases to be Chairman (and becomes an ordinary Fed governor). Frenzied headcounts indicate over 40 uncommitted senators. Considering that Scott Brown won in a last minute wave of populist insurgency, it's hard to predict what will happen. Republicans, smug over their guerrilla victory in Massachusetts, have put themselves in a bind. Bernanke is closely linked with Alan Greenspan and his Wall Street-centric outlook and policies. A vote for Bernanke is a vote to continue massive government subsidized profits and bonuses for Wall Street. A good case can be made for re-confirming Bernanke. But it's harder to make in the face of large numbers of angry people waving pitchforks.

If Bernanke, a George W. Bush appointee, isn't re-confirmed, President Obama can choose his own nominee. He isn't likely to choose the usual suspects--Larry Summers or Tim Geithner. They're too easily linked to policies favoring Wall Street. Christina Romer, Chair of the Council of Economic Advisers, is a possibility. She is less well-known in official Washington and therefore presents a smaller target for confirmation proceedings. Although she is seen as neo-Keynesian, anathema among the laissez-faire, a populist insurgency demanding job creation might endorse big government that helps ordinary people instead of Wall Street. And if Romer doesn't vet well, expect another nominee who won't cater to Republican preferences.

The Fed Chairmanship problem isn't exactly a win-win for Obama, since he re-nominated Bernanke and rejection would leave some splatter on him. But it's a lose-lose for the Republicans. It they support the Wall Street-subsidizing, money printing Bernanke, they offend the mob. If they vote against Bernanke, they'll face a Democratic nominee whose proclivities may match Bernanke on the monetary front and exceed his on the regulatory front.

The same dynamic operates with the President's call for more stringent bank regulation. If Republicans oppose it, they'll be painted as running dogs for the big banks that the mob detests. But supporting increased regulation only imperils a traditional Republican bulwark.

The President has just announced his support of a bipartisan deficit commission to develop ways to combat the federal deficit. This proposal, sponsored by Republican senator Judd Gregg (R-N.H.) and Democratic Senator Kent Conrad (D-N.D.), presents another dilemma for Republicans. The populist insurgency has demanded control over the deficit. With current and projected deficits as large as they are, the commission will have little choice but to recommend tax increases as well as spending cuts. More heresy looms in Republicans' futures.

All this leads to uncertainty on Wall Street and in corporate America. Uncertainty is bad for stock prices. It's harder to project corporate earnings when government policies are in flux. In many ways, businesses and especially Wall Street, can do well regardless of what the rules are, as long as the rules are clear and predictable. When federal marginal income tax brackets were 90% (as they were during and just after World War II), Wall Streeters made good money selling tax shelters. When the Glass-Steagall Act prevented commercial banks and investment banks from operating in the same corporate structure, investment bankers nevertheless got monster bonuses--it was commercial bankers, ulcerated with envy, who pushed for the repeal of Glass-Steagall. But when the rules are vague and likely to change, and members of both parties become internal dissidents, stock prices waver.

As stock prices fall, so do the values of 401(k) accounts across the nation. This portends more instability. The New Populism is really the Great Unalignment. There's no way to know where the outrage will flow. Neither Democrats nor Republicans can count on the nouveau insurgents. The anger Republicans surreptitiously fueled with their quiet funding of Scott Brown's campaign could easily boomerang against them. President Obama, who snidely sniped at Scott Brown's truck, again revealed an elitism--now toward truck owners in addition to gun owners--that he needs to get over fast. He may not realize it, but he simply isn't in touch with the American middle class. Maybe it's because he's spent too much time around elites and elite-wannabes. Maybe it's because he has a burning drive to escape the modesty of his own upbringing. But he has this problem--and it's him, not his advisers, not his party. Maybe he should change the oil and filter in a pickup truck a couple of times. Maybe, once every week, he should have a hot dog and baked beans for lunch. Maybe he should spend a half an hour at a firing range with a 9mm semiautomatic, and then another half an hour with a .38 special. However he does it, he needs to deal with this disconnect. His Democratic colleagues on the Hill are scrambling for cover and they'll abandon him in a heartbeat if that's necessary to saving their hides this fall.

It's always been true that political friendships exist only in fair weather. But storm clouds have rolled in and it's likely to keep raining until the mid-term elections. The Democrats are likely to lose some seats. But they may gain others if Republicans start to believe too much in their own publicity (as happened in upstate New York recently). However things turn out in November, the continued uncertainty portends a tough year for stocks.

Friday, January 22, 2010

Blowback on Wall Street from Scott Brown's election in Massachusetts

A problem with blowback is you can't be sure what it will hit. Scott Brown's election as the senator from Massachusetts to replace Ted Kennedy was blowback from the Obama administration's inattentiveness to the independent voters who put it in office. But that election led the administration to cater to those same independents by shifting focus away from health insurance reform and back toward Wall Street.

The big money lobbyists almost pulled it off. A quiet, but determined lobbying effort in the second half of 2009 had persuaded the administration and Congress to slide financial regulatory reform toward the back burner. Most Democratic political capital was committed to reforming health insurance. The Republicans, realizing that the Dems were tied up with Washington problems, set an ambush in Massachusetts. Just as inattentive deer don't survive the time in the fall when a lot of people wearing blaze orange enter the woods, Martha Coakley and the Dems paid the price for not staying alert.

Then, Barack Obama demonstrated why he was elected President. Two days after the debacle, the President announced a proposal to place new restrictions on the activities of big banks designed to prevent them from using federally insured deposits or loans from the Federal Reserve to engage in risky and speculative activities. Remember that last week, the administration proposed a tax that would fall primarily on big banks' short term borrowings (excluding customer deposits), thus discouraging them from using fast money leverage. Taking these two initiatives together, big banks will have powerful incentives to formally split their depositary and investment banking operations. Add the extensive regulation of bank holding companies that exists and the increased holding company regulation that may well be on the way, and you have a regulatory mix that would encourage a complete corporate breakup between depositary banks offering federally insured deposits and the Masters of the Universe who do the wild and woolly stuff.

Yesterday, the political theater was vivid, with Paul Volcker standing next to the President as he announced the proposal to revive, sub silentio, the Glass-Steagel Act. Volcker, a former Chairman of the Federal Reserve and an unyielding proponent of increased prudential regulation for banking, is widely reported to have been in the Democrats' gulag for the past year. It seems that Scott Brown unintentionally got Volcker sprung, and along with him serious intent to crack down on Wall Street.

That wasn't quite what the Republican agents provocateurs assisting Brown intended, either. But they placed their chips on the outrage of independents. Those who live by populist ire die by populist ire. Wall Street stands shoulder to shoulder with the federal government as a target of independents. The President and his aides know this, and they have turned their agenda on a dime to steer the pitchforks toward the big banks. If the Republicans use their 41-vote minority in the Senate to block the new, improved financial regulatory reform proposal, they will find themselves on the wrong side of pickup truck-driving insurgents. It's very unpleasant to be hit by a pickup truck.

Wednesday, January 20, 2010

The Ten Biggest Losers in the Massachusetts Special Senatorial Election

There was more than one loser when Scott Brown won yesterday's special election in Massachusetts to replace Ted Kennedy.

Barack Obama. His already complex job just became a lot more complicated.

Sarah Palin. She's been upstaged almost as badly as Barack Obama. The Republicans desperately need new, younger candidates. Scott Brown, although not entirely without baggage himself, doesn't need a battalion of bellhops the way Palin does, with McCain's former campaign staff carefully calibrating their telescopic sights to snipe at her, the issues from her family, the issues from her almost inlaws, those interesting reimbursements from the State of Alaska while she was governor, the photo of her with a dead, bloody caribou, and quitting the governorship promptly after attaining national stature and cashing in with a book contract, the Fox commentator deal, etc. Today, Brown didn't exactly deny harboring Presidential ambitions, so watch for Palin to sneak up on the rug he's standing on and give it a hard yank.

Mitt Romney, Mike Huckabee, Newt Gingrinch, et al. The old, white guys in the Republican Party are finished. The party's way back to the White House will be through a younger, fresher insurgent candidate who appeals to the ever fickle independents that are now the key to victory. Republican power brokers will be looking for ways to quietly offload those same old, same old guys.

White House staff. It is the way of Washington that someone take the fall for a disaster like Brown's successful guerilla campaign. The vicious flood of leaks over who's to blame and who was asleep at the switch indicate a fierce internecine battle among Team Obama. Sooner or later, someone will have to resign to spend more time with their family or pursue other interests.

Levi Johnston. Another guy who posed nude has suddenly gained the limelight. As Sarah Palin's public aura fades, so does Levi Johnston's. He's said he'd be content as an electrician. He'd better stay on track to get licensed.

The uninsured. Those without health insurance had better reach down for their bootstraps and pull hard, because they may be getting no other options.

The insured. Reality is that the insured and paying patients pay for the emergency room and pro bono care that the uninsured often rely on. Maybe your taxes won't be raised now, but your health care costs and insurance premiums will remain high and probably go higher.

Health care providers. With today's crazy quilt health care insurance/no insurance system likely to stay largely in place, and with taxpayers less likely to contribute to covering health care costs, the only remaining pool of cash to be tapped as health care costs inexorably rise is the dollar flow to health care providers. Reimbursement rates are likely to be squeezed. The plastic surgeons and neurosurgeons forced to trade down from Maseratis to Mercedeses won't get any sympathy. But pediatricians already sometimes vaccinate kids at cost, or even at a loss. And they and general practitioners scarcely make what executive assistants on Wall Street make. Cutting their reimbursements rates isn't likely to produce a good outcome.

Scott Brown's truck. Driving on the small town roads of Wrentham, Mass. doesn't put a lot of wear and tear on a motor vehicle, especially something as sturdy as a pickup truck. But D.C.'s potholes interspersed with short stretches of macadam are a very different story. When you idle a truck for eons in rush hour congestion and then drive it off a cliff every 50 feet, the tires, suspension, undercarriage, frame, and engine earn their keep. One D.C. mile is the same as 20 Wrentham miles. Senator Brown won't be able to add 200,000 D.C. miles to the truck.

And, oh yeah, Martha Coakley. It's hard to exclude the losing candidate from this list, but, all things considered, she's far from the biggest loser.

Tuesday, January 19, 2010

Team Obama: No Longer the Smartest Guys in the Room

With the election of Republican Scott Brown as Ted Kennedy's replacement from Massachusetts, it's clear that Team Obama needs to rethink things. Forget the close analysis of who's responsible for what remark or who made the wrong call with which policy position. This election was as much a referendum on the administration as it was about the merits of the candidates.

Brown won by adopting Obama's strategy of tapping into voter discontent. Martha Coakley, the Democrat, was a legacy candidate, trying to ride into office on Ted Kennedy's legacy. But legacy candidates don't do well these days. Both Hillary Clinton and John McCain invoked the past during their 2008 campaigns and it didn't serve them well. Creigh Deeds, a Democratic candidate for governor of Virginia last year, had a similarly bad experience running as a legacy candidate. Scott Brown is a heretofore minor politician, a Massachusetts state senator with nothing to lose. In a campaign involving such a candidate, the size of the fight in the dog is what counts the most. With the agility of a judo master, he characterized himself as the outraged underdog, and won over outraged voters.

It's unclear that there is much logic to his or their outrage. The Obama administration's health care reform effort seems to have drawn the most populist ire. That defies logic, as this is the one program in Obama's agenda that might offer the broadest benefit to the electorate. But as much as people were tired of George W. Bush's failures, they're also scared of changes in their insurance coverage (if they have any), and they're scared of higher premiums and higher taxes.

Voters are also angry with economic policies. The Bush II administration, in providing hundreds of billions of bailout dollars to banks and having the government assume myriad liabilities that would otherwise have pushed the banking system into bankruptcy, practically socialized the financial system and left taxpayers at risk for untold losses. The Obama administration bought into the Bush administration's bank-loving policies lock, stock and barrel, and added its own economic stimulus package. Bankers rejoiced as their earnings and bonuses rebounded, but taxpayers bemoaned the bonuses and shivered at the thought of their burdens. Even though President Obama has promised to recover the costs of the bailouts, Scott Brown caught him at a moment when he hadn't yet acted on the promise.

Team Obama needs to stop politicking and take a hard look in the mirror. In 2008, they were the smartest guys in the room, propelling a former state senator from Illinois into the White House in 6 years. Then, the Republicans, with footprints all over their butts, did the thing Americans do so well. They thought about what had just happened, how painful it had been, the ways in which they needed to change, and adapted. Some of their changes are weird--it remains possible that the party could melt down in an Inquisitional drive for ideological purity. But other Republicans realized that Barack Obama had won by working from the ground level up, and that they could do the same thing.

Team Obama, by contrast, seems to have become remote, elite. They've appointed a lot of very well-credentialed Washington insiders into high level positions, who've given them a lot of conventional advice that won't ruffle the feathers of too many powerful people. Their policies of bailout and stimulus have mostly helped those that are well-off and influential, but scare the hell out of the middle class. They try to influence bellwether Democratic campaigns, like the recent Virginia governor's election and Martha Coakley's campaign in Massachusetts, but are quick to dodge any hint of responsibility for failure, pre-emptively pointing fingers at the losing candidates. In short, they've taken on a distinct inside-the-Beltway aura, and within less than a year. That's exactly what pisses voters off.

They have to take stock of themselves. Whether or not they can see it, they aren't so smart any more. They didn't anticipate how quickly and completely the Republicans would learn from the 2008 Obama campaign. They don't seem to understand how fickle uncertainty and frustration have made the electorate. They seem more indwelling and hesitant. Why hasn't the President publicly taken the lead on health insurance reform? News stories report that he has been quietly negotiating potential compromises between the House and the Senate. But getting something as big and as controversial as health insurance reform done requires leadership from him more than it requires negotiation. The Democrats haven't wrapped up health insurance reform after a year, and now their lack of alacrity traps them in a situation they failed to anticipate from a special senatorial election.

The Obama team are consummate politicians. But running a campaign and running a Presidency are two different things. In the first, you have to make sure you say the right thing at the right time. The second requires executive ability--the skills needed to get things done. Bill Clinton, whose cup runneth over with charisma, was and still is a superb politician. But his lack of executive ability resulted in an eight-year Presidency that was one of the least productive in the 20th Century. His legacy as a President will be modest.

Barack Obama still has time for achievement. Health care reform can yet be passed by Congress. The result won't be as pretty as many would like, and the Senate's leadership would have to commit to work to change the objectionable features. But President Obama now needs to step out front and center and take the lead. He is no doubt stinging from the fact that he campaigned for the losing candidate in Massachusetts this past weekend, after first saying he wouldn't. That hesitant participation in the Coakley campaign is precisely the sort of stutter step that makes the President look weak. But Obama is now in for a dime; he might as well go in for a dollar. If he flinches, the Republicans will know they've got him, not just for health insurance reform, but for the rest of his Presidency. Lyndon Johnson kicked every reluctant Congressional butt necessary to get the great civil rights laws of the mid-1960s adopted, putting his standing at risk. His success made him a great domestic President, second in the 20th Century only to FDR.

By all indications, Barack Obama has an introspective side to his personality, and he's probably thinking things over furiously. No doubt he realizes that his honeymoon with voters is now over. But some of the people around him need to consider carefully that Barack Obama's election in 2008 wasn't as much about him as it was about voter discontent. That discontent is hydralike--it goes in many directions, is difficult to channel, and if seemingly suppressed can sprout back up with greater force than before. Team Obama doesn't have everything figured out, and they have less figured out now than they did three or six months ago. Once they understand this, and embrace it, they'll do better.

Sunday, January 17, 2010

The Stock Market: Priced, Again, for Perfection

Last week, both Intel and J.P. Morgan announced earnings that significantly beat Street estimates. The market promptly dropped. What gives?

Analysts questioned the loan losses at J.P. Morgan; revenues were also below expectations. Intel's results generally drew praise. The problem, it would seem, is that the improvements at both companies didn't surpass expectations enough. In other words, hitting a home run isn't good enough these days. To see your stock price rise, you have to hit a grand slam home run out of the park, beyond the parking lot and across the street. One doesn't have to delve into the world of whisper numbers and other market rumors to understand what's going on. Just look at the price-earnings ratio.

The price-earnings ratio for the S&P 500, based on trailing earnings, is 70.79 (see p. B4, The Wall Street Journal, Jan. 16-17, 2010). This is way, way, way higher than the historical average of 15. A p/e ratio this high means that investors expect tremendous improvement in earnings or that we have a deliriously bubbly market. Or both. (See Whatever the case, it's clear that the market is priced for perfection. Anything less than absolutely gorgeous, gem quality financial reports from bellwether stocks like Intel and J.P. Morgan, and the market will start getting butterflies in its tummy. If this seems familiar, think back to the market peak in 2007, when the Dow topped 14,000, or the tech stock peak in early 2000.

After rising 60% in six months, the market has risen only 4% or so in the last three months. The bull is tired after its long run. Most analysts predict high quality earnings reports this month. But will that be enough? A p/e ratio of 70.79 sets the bar at stratospheric levels.

Some gamblers think that if Scott Brown, the Republican candidate in the Massachusetts special election for senator (to replace the late Ted Kennedy) wins, the market will take off in the belief that a Republican victory will kill health insurance reform and constrain federal spending. If you want to bet on this play, make sure you have your stop loss orders in place. The Democrats can work their way around the loss of a 60-vote majority in the Senate by having the House approve the Senate version of the reform bill or by rushing a compromise bill through the Senate before Brown can be sworn in. Neither alternative would be easy, but both are more palatable to the Democratic leadership than a failure of health insurance reform. The Democrats misjudged the voter sentiment in Massachusetts. But their problems with control of the Senate and the threat it poses to health insurance reform now have their full attention. Be cautious about betting your money on the Democrats making more mistakes.

You might want to get stop loss orders in place anyway. Even if Martha Coakley, the Democratic candidate for senator in the Massachusetts special election, wins, the late Republican surge sends a loud and clear signal to the Obama administration to hold the line on deficit spending, something the administration cannot ignore with the fall mid-term elections approaching. Whether or not the economy needs more stimulus, it won't be getting much more, if any, from the federal budget.

Of course, there's always the monetary printing press at the Federal Reserve, which recently installed showers and bunkrooms for the employees working 'round the clock. But even the Fed, which in the last 15 years hasn't met an asset bubble or an inflationary threat it didn't like, will eventually realize it's pushing on a string. The banks the Fed has been subsidizing are sitting on top of their very cheap federal funds instead of lending them out, while maintaining myriad unbooked losses (with the help of a politically coerced relaxation of accounting standards last year), reporting the resulting "earnings" (it's amazing how well a bank will do if loan losses are unbooked instead of booked), and paying really big employee bonuses. The Fed has avoided triggering inflation because the banks have avoided lending out their federal assistance. They hoard it against the need to book more loan losses. Since the funds don't circulate, they don't trigger inflation, but they also don't stimulate economic activity. That doesn't bode well for a stock market priced for perfection. Caveat emptor.

Wednesday, January 13, 2010

IRAs and 401(k)s Aren't Retirement Plans. But a Roth Conversion May Help Your Estate Plan.

It's easy to think of IRAs and 401(k)s as retirement plans. They're not. IRAs and 401(k)s are retirement accounts. They serve as tax shelters to delay taxation of the money contributed to them. However, the amounts that you are allowed to shelter have no particular relationship to how much money you need for retirement. The IRS limits on contributions to IRAs ($5,000 in 2009 or $6,000 if you're 50 or older) and 401(k)s ($16,500 in 2009 or $22,000 if you're 50 or older) are simply the amount you can shelter from taxation. In both the saving phase and the withdrawal phase of your retirement planning, don't confuse tax issues with financial planning. Here's why.

Saving. How much you need to save for retirement may be more or less than the amounts the tax code lets you shelter. You should base your saving rate on a prudent estimate of your life expectancy. That is more easily said than done. Life expectancy is influenced by family history, your personal habits and diet, your occupation, the availability and quality of health care, and a host of other factors. If you dabble with life expectancy calculators on the Internet, you're likely to get a range of estimates as wide as 15 or so years. That's a big difference from a financial planning standpoint. Make the best estimate (meaning most accurate) you can of your life expectancy. Then add 10 years to account for medical advances. The resulting lifespan is probably a pretty safe assumption for financial planning purposes. Save in aftertax accounts if the amount that you can shelter in 401(k)s and IRAs isn't enough.

If all this number crunching is painful, then follow a simple formula: if you save 15% to 20% of your pretax earnings over the course of a 30 to 40 year career and invest it in a diversified portfolio, the amount you save plus Social Security will probably let you have a retirement lifestyle pretty close to what you enjoyed while working. For more details, see

Withdrawals. Once you reach the age of at least 59 and 1/2, you can start making withdrawals from your retirement accounts. At the age of 70 and 1/2, you are required to begin making withdrawals, whether or not you want to. The IRS has no objections if you withdraw your savings faster than required; they get more taxes upfront that way. But at 70 and 1/2, the process of minimum withdrawals begins. The exact amount of your minimum withdrawal will depend on IRS formulas designed to increase sales for antacid manufacturers. But the important point here is that the amount you're required to withdraw may or may not be safe for you to spend. If you have a longer than average life expectancy, save some of the aftertax portion of the withdrawal. Remember that the IRS withdrawal formulas are tax rules, not financial plans.

Avoid withdrawals with a Roth Conversion. One step that may simplify your retirement planning would be conversion of your IRA(s) to a Roth IRA. Traditional IRA accounts may be converted to Roth IRAs in 2010 without any income limitations (which were a problem in the past for many people). Conversion requires paying current income taxes on the amount converted, and you have to consider whether you're prepared to do that. There are lots of arguments why conversion will or won't save you taxes. How this analysis turns out could depend on tax legislation that remains to be adopted in 2010 and you may want to delay the decision whether or not to convert until later this year. But if you don't think you'll need your IRA assets, conversion to a Roth will let you avoid mandatory withdrawals altogether. That way, you can pass the entire account onto your heirs. Paying taxes now, but then letting the account grow on an aftertax basis could provide your heirs with quite a tidy sum. They'll have to make minimum withdrawals, but the withdrawals are tax-free and the remaining balance continues to grow tax free. Thus, converting a traditional IRA to a Roth can be an effective estate planning tool.

Tuesday, January 12, 2010

Bankers' Bonuses and the Tilt in the U.S. Economy

There isn't a level playing field in the U.S. economy. The government gives major advantages to banks and other financial companies. Banks are subsidized by the Federal Reserve, which gives them very cheap credit compared to say, Boeing, Ford or Disney. It also buys funky assets (like mortgage-backed securities) from them and stabilizes their counterparties (like AIG) when the latter get into trouble. When the going gets rough in the financial markets, the banks don't have to get tough. The government brings in a stretch limo and drives them to Easy Street.

The government also tilts the playing field in favor of residential real estate. Government alter egos like Fannie Mae, Freddie Mac, Ginnie Mae and the FHA provide financing at interest rates lower than market forces would justify, and tax benefits like the mortgage interest deduction and now buyers' credits. When liquidity for mortgages dries up, the Fed buys a trillion dollars plus worth of mortgage-backed securities with printed money, holding down interest rates and propping up residential real estate while putting wage earners at risk of inflation.

Thus, capital flows into financial services and residential real estate, where the generosity of taxpayers reduces the chances of loss and increases the potential for profit. Other sectors of the economy can only imitate Oliver Twist holding an empty bowl. Since those other sectors, especially medium-sized and small businesses, might otherwise create jobs crucial to economic recovery, putting them on a starvation diet for capital steers the economy toward stagnation.

News media stories report that Wall Street is about to reveal record or near record earnings, and pay record or near record bonuses. Although no one in the government will admit it, this is a problem created by the government. By giving the banks such massive subsidies and benefits, humongous profits were predictable. Indeed, they're exactly what the Fed and Treasury intended, as buffers to stabilize the financial system. But putting huge profits on bank financial statements is like putting mountains of corn and rice in front of ravenous hogs. What do we think will happen? That bankers will retain profits in the banks' capital accounts for the good of the nation?

No doubt, senior officials at Treasury, the Fed and the White House, as well as almost all members of Congress, are preparing their statements of outrage over the soon-to-be announced bank mega-bonuses. They should save those statements and back them up--twice--because they'll be using those statements a lot. Given the way the government has tilted the playing field in the economy, banks will be making headline profits at taxpayer expense, and paying headline bonuses, as far into the future as one can see.

America is more like to prosper long term if there is a level playing field for capital. But undoing a federal subsidy is greater challenge than climbing Mt. Everest blindfolded. Practically no one in the government, in either party, wants to make major changes to these rules of the game. Meanwhile, back at the ranch, unemployed formerly middle-class Americans are hoping for one day a week when they can have franks and beans instead of rice and beans. Small businesses are looking for anyone who can lend them a dime.

Sunday, January 10, 2010

Politics on the Potomac in 2010

Congressional elections will be held this fall. The campaigning has begun already, as some incumbents announce their retirements and would-be replacements jockey for position. In a time when the economy is all government, all the time, the upcoming elections will be the driving force behind federal economic policy. Here's what the new year is likely to bring.

Continued Stimulus. The Obama administration has to combat unemployment in a big way, and federal spending is the only measure that can be implemented quickly enough to have an impact before the elections. If the Fed curtails some of its accommodative measures, look for Obama administration replacements--the recent lifting of the cap on assistance for Fannie Mae and Freddie Mac (see could pinch hit for the Fed's announced curtailment of mortgage-backed securities purchases in March 2010. Don't be surprised if there is one form or another of federal assistance to the states. State employees are often unionized, and the Democratic Party will be under pressure to protect its most loyal constituencies. Although the Dems will need the independents to hold onto their majorities in the House and the Senate, you don't win if your base stays home (John McCain's 2008 presidential candidacy serves as Exhibit A in this regard).

Health Insurance Reform. The Democrats have enough control of Congress this term to pass legislation reforming health insurance. They will, because they need bragging rights for the fall. They won't pass a perfect bill, and the Republicans will turn up the whining about principles and costs. But the Republicans underestimate how grateful numerous ordinary Americans will be for progress on the health insurance problem. Medicare Part D, which has one of the most obtuse structures imaginable, is now popular and regarded as a success. When the Democratic bill is passed, the score will become advantage, Dems.

The Fed Will Stay the Course. For better or for worse, the Fed has locked itself into a policy of easy money and overtime pay for its printing press staff. The Governors have made explicit their priority of alleviating unemployment, essentially promising to keep rates ultra low until the bread lines dwindle. Nothing in the annals of mission creep--not even fiction like Joseph Heller's Catch-22--approaches the never ending expansion of the Fed's activities. It's grown from being a lender of last resort to failing banks, to knight errant in the fight against inflation, to promoter-in-chief of economic growth, to banker for an asset-bubble beset international financial system, and now to grand poobah of employment opportunity. Next, perhaps, the Fed will provide borrowing facilities to distressed states and countries. Why not? The sovereign debt market is looking uglier by the day--perhaps the UK might circle the drain--and the Fed lends to just about everyone else.

Inquisition on the Right. A major confounding factor for the Republicans will be their internecine struggle between the zealots of ideological purity and the devotees of inclusiveness. The Republican Party has been shrinking, and now may encompass only its hard core of faithful. The Democrats can do little to win these people over. But they can do much among themselves to damage the party. The Savanarolas of the far right are stoking the flames, but the outcome may have been recently presaged in upstate New York, where the true believers won the Republican primary only to see the Democrats win the general election. The Republicans will be shrilly communicating with us a lot in the days leading up to the elections. But their impact on policy will be minor.

No changes in the cast until late November. The same faces will appear on the Washington reality-potboiler through the election season. The Obama administration will probably keep its current cabinet in place, lest the President appear to be a poor judge of people. After the election, Team Obama will surely check out the list of free agents. With the 2012 elections just around the corner in Washington time, cabinet members who have accumulated baggage can expect to take an express train out of town.

Thursday, January 7, 2010

Jobs Growth May Not Reduce the Unemployment Rate

The stock market eagerly awaits tomorrow's unemployment numbers. Economists, on average, predict that job losses will have stopped, but that jobs growth hasn't resumed. The unemployment rate, last reported at 10%, is expected hover around that level, with perhaps a minor increase.

This data, whatever it turns out to be, will probably tell us less than the stock market seems to think it means. Employment levels must be viewed in a dynamic context. The labor force keeps growing, whether or not there is a recession. Kids reach adulthood, and immigration continues (although it's now at a much lower level because of the recession). To deal with population growth, we need 100,000 new jobs a month or more simply to keep the unemployment rate level. It's been close to 2 years since the number of jobs in the U.S. has increased. Even if it turns out that job growth has resumed, the unemployment level could increase if the number of new jobs isn't enough to accommodate the entry of new workers into the labor force.

Aside from population growth, another confounding factor is the return to the labor force of discouraged workers. The Bureau of Labor Statistics includes unemployed persons in the labor force only if they have actively sought work during the last 4 weeks. Those who want jobs but are too discouraged to look for them aren't counted in the labor force. In other words, increased despair lowers the unemployment rate. Conversely, as the economy swings back toward recovery, discouraged workers may become hopeful again and start actively searching for jobs. Those that do so are deemed to have re-entered the labor force, and their re-entry can worsen the unemployment rate by increasing the numbers of unemployed persons actively seeking work.

The stock market is always looking for short cuts, simple ways of telling if things are getting better or worse. But economies and financial systems are complex and sometimes opaque. Life is difficult. Monthly unemployment figures are sometimes revised in subsequent months. You need to look at a lot of data and information to figure out where the economy is and where it is going. Don't read too much into tomorrow's unemployment numbers. Invest for the long term.

Tuesday, January 5, 2010

Why 2010 Could Be a Tough Year for Wall Street

Most investors dislike volatility. When the market drops, stomachs churn. When the market rises, stomachs again churn if you missed the pop (as did many individual investors). If you bought on the way up, the ride is exhilarating--until it stops. And the damndest thing about markets is that they invariably stop rising at some point, and then fall.

On the other hand, Wall Street loves volatility. When stocks and bonds swing up and down, investors buy and sell them. That means commission income, and markups and markdowns, for brokers.

Volatility also provides trading opportunities, and the more volatility there is, the bigger the opportunity. The great housing collapse of 2007 gave hedge fund manager John Paulson the chance to make $15 billion for his investors, and over $3 billion personally. The next year, 2008, he reportedly made another $5 billion for his investors betting against big banks. His trading ability was crucial to spotting these opportunities. But the outsized volatility in housing prices and bank stocks enabled him to make gargantuan profits.

The big Wall Street banks often try to profit from volatility through proprietary trading--i.e., trading as principals. Goldman Sachs is famously skilled at this, and it's no accident that Lloyd Blankfein, Goldman's current CEO, came up through the ranks of the proprietary traders. Goldman has done well as a principal trading the ups and downs of the last three years.

Few prognosticators predict 2010 to be volatile. Most expectations for the economy range between modest growth to a double dip recession late in the year. Not many money managers are making glowing promises to their clients about the stock market, and the bond market seems murky more than anything else. Real estate may trend up slightly, or it may drop some more. No one really knows. Taken as a whole, the weight of current prognostications seems to indicate a muddled picture, with some asset classes moving up a bit and others down a bit. Assuming this to be true, Wall Street won't have the trading opportunities to hit the home runs of recent years. Hedge funds may struggle to stay ahead of the S&P 500. The big banks may have more modest returns than they did in 2009.

A year of pedestrian operating profits could prove tough for the big banks. They continue to hold many billions of hinky assets from the real estate crash, the credit crunch and the recession--CDOs, commercial real estate loans, defaulting credit card debt and so on. With the economic recovery slow, the banks will likely have to take more writedowns on these old lending mistakes. And there's always the risk of a new crisis in 2010. A major sovereign debt default (say, Greece or California) could dampen investor appetite for risk and highlight the virtues of holding cash.

Some believe commodities will be the big play in 2010. John Paulson and other money managers reportedly are betting on gold. But if the world's economies are truly recovering, they will pull up the fiat currencies against which the gold bulls are betting. And nobody expects a big jump in oil prices. One wonders if the recent reports of a brief cutoff by Russia of Belarus' supply might not have been someone in the Kremlin figuring on giving prices a little fillip.

If 2010 is a year without volatility, investors will breath easier. But Wall Street will probably make less money. With the ghosts of a lot of bad loans still haunting the Street, that could make it a tough year for the banks.

Sunday, January 3, 2010

Strategy for the 10s: Add Value to America

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

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

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

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

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

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

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

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

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

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

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

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