Reprise

He made me do it

He made me do it

But we only have

Ourselves

To blame

Reprise...

He made me do it

He made me do it

But we only have

Ourselves

To blame

Investors could easily sing these bastardized lyrics from Chicago's "Cell Block Tango."  The "he" is Federal Reserve's Ben Bernanke (a.k.a. Uncle Ben) and the "it" is, well, investment allocation and spending decisions which, probably, in retrospect, we will "only have ourselves to blame."  Poor Ben.  He was dealt an impossible hand, an economy teetering on the brink of depression, investment bankers gone wild in a regulatory free-for-all, and a calcified Federal government.  In the absence of long-term prudent fiscal policy, monetary policy became a surrogate.  While the inexorable march towards zero interest rates seemed to be the right Keynesian tonic to drag the economy back from the brink, it has gone on long, too long perhaps, and it is leading to investment consequences of unknown dimensions. 

Just a glance at the blogosphere and financial publications demonstrates completely divergent opinions, ranging from new highs, and not merely marginal ones, for the S&P 500, to apocalyptic prognostications.  The problem is the ' rear view mirror' is less useful than in the past.  Into uncharted waters we have sailed, not knowing whether this economic world is really round.

John Hussman, who has been coined a "perma-bear" is nonetheless an astute economist.  He has accused Bernanke of creating an investment bubble of historic proportions, making people feel wealthier and thus more willing to spend, spend, spend, on "stuff" and on more speculative investments.  Whether that was Bernanke's objective, or whether it is merely a side-effect of righting the sinking ship is anyone's guess.

Hussman's most recent column, A Reluctant Bear's Guide to the Universe provides a lengthy, well reasoned, and highly statistically supported view, concluding with his own prediction:

...market conditions remained characterized by an overvalued, overbought, overbullish, rising-yields condition, the extremes of which have been observed only 6 other times in history: 1929, 1972, 1987, 2000, 2007, and 2011 (the last being reasonably forgettable, but still followed by a near-20% market decline). I doubt that the present instance will end any better, but that resolution may not be immediate, and I am quite aware how quickly each marginal new high in the market can erode both patience and prudence.

But, if that doesn't grab one's attention, there is Bill Gross' latest missive Credit Supernova!

As Gross is known as the "Bond King" managing more debt securities than anyone on the planet (other than Uncle Ben perhaps), one has to sit up and take notice when he forebodes possible economic disaster.  He cites the work of the economist Hyman Minsky on what he called "Ponzi finance:"

First, he claimed the system would borrow in low amounts and be relatively self-sustaining – what he termed “Hedge” finance. Then the system would gain courage, lever more into a “Speculative” finance mode which required more credit to pay back previous borrowings at maturity. Finally, the end phase of “Ponzi” finance would appear when additional credit would be required just to cover increasingly burdensome interest payments, with accelerating inflation the end result.

Minsky’s concept, developed nearly a half century ago shortly after the explosive decoupling of the dollar from gold in 1971, was primarily a cyclically contained model which acknowledged recession and then rejuvenation once the system’s leverage had been reduced. That was then. He perhaps could not have imagined the hyperbolic, as opposed to linear, secular rise in U.S. credit creation that has occurred since....While there has been cyclical delevering, it has always been mild – even during the Volcker era of 1979-81. When Minsky formulated his theory in the early 70s, credit outstanding in the U.S. totaled $3 trillion....Today, at $56 trillion and counting, it is a monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet, in the process begins to consume itself. Each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result. Minsky’s Ponzi finance at the 2013 stage goes more and more to creditors and market speculators and less and less to the real economy. This “Credit New Normal” is entropic much like the physical universe and the “heat” or real growth that new credit now generates becomes less and less each year: 2% real growth now instead of an historical 3.5% over the past 50 years; likely even less as the future unfolds.

So our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.

Gross' recommendations: (1) Position for eventual inflation.....(2) Get used to slower real growth....(3) Invest in global equities with stable cash flows...(4) Transition from financial to real assets if possible at the margin: buy something you can sink your teeth into – gold, other commodities, anything that can’t be reproduced as fast as credit....(5) Be cognizant of property rights and confiscatory policies in all governments....(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.

Wow, this is a bond guy arguing for hard assets and even intimating government confiscation.

One only has to look at the stock market, real estate, and even collectibles to see the results of a prolonged zero interest rate environment.  How far and how long is the question.  Meanwhile, investors and savers are left with a conundrum, a sense of cognitive dissonance in a world in which an inflationary or disinflationary outcome can be argued simultaneously.  No doubt though, the longer the asset bubble lasts, the more comfortable people become with it as a representation of reality and they spend and invest accordingly, until we reach either the implosion of the supernova Gross mentions, or, in the best of worlds, a governmental devised glide path, over time, to reduce the deficit, setting down the economy in the halcyon fields of a balanced budget. If the latter can be engineered, then, perhaps, the market is discounting the same.  Otherwise, watch out below!

As a retiree I have chosen to self manage my investment portfolio.  These last couple of years have been exasperating; old asset allocation rules seem to no longer apply, with many categories now highly correlated. Bonds mature and reinvesting in the same at today's interest rates seems insane.  This is exactly what the Fed wants, so either one goes out further on the risk curve, (in fact, much further) or sits with cash earning no return, or spend it (the other option the Fed would like one to do).

I've resisted the latter until now.  We went to the Art Palm Beach Exhibit at the West Palm Convention Center as we did last year. Talk about collectibles and at astronomical prices. But if we have the inflationary engine that some predict, these might be bargains. 

One such painting I liked was Pham Luan's Boats at Sam Son Beach at $9,200, but I've always been a sucker for boat and sea scenes.

Or the whimsical Vextrola by Jerry Meyer (note some of the "hits" such as those by the band I'm Through with Love entitled "Carl's Got the Clap" and on the flip side "Herpes Forever" and the more appropriate -- for us -- the band Senescence Singers' top hits, "Did I Take My Pills?" and "I Forgot What I Forgot").  Alas, no price was listed, but that was one I'd be interested in. 

For a mere $595k one could buy the star of the show, Marc Chagall's Le Paysan à la Hache, and who knows, that might be a steal if central banks induce an inflationary binge. Our check book was short a few bucks.

If I had money to invest in art at the show, no doubt I would have just stopped at the exhibit of Lino Tagliapietra's beautiful glass work.  Lovely to see, and he was honored as the recipient of the Visionary Award.

I also liked a piece that seemed to capture the essence of today's merriment on Wall Street, the one of the three dancing sheep. Unfortunately, I failed to note the artist's name, so apologies to him/her.

Returning from the exhibit, we decided to buy another kind of "work of art" -- this one is guaranteed to depreciate, no matter what the economy does.  Nice to have some certainty for a change!   Returning to the beginning theme, a reprise if you will, "he made me do it!"  As the Federal Reserve is encouraging either risky investments or just plain old vanilla consumer spending, we chose the latter and bought a new boat, not just any boat, but one we think is beautiful and one that will indubitably be the last boat of my life.  It is a small boat, and although Grady-White gives it the moniker of the "209 Fisherman," I am outfitting it for cruising, not long range of course, but something Ann and I can take out on a lovely day, perhaps to Peanut or Munyon Island, or down to West Palm Beach, or even an occasional overnight to Ft. Lauderdale or Stuart, staying at a marina/hotel.  It even has a head so that makes a full day on the boat practical. 

We are naming it 'Reprise' and with the magic of Photoshop we've been able to get an idea of how the name will look on the hull, using Grady's stock photograph (the younger version of me and my two sons do not go with the boat). The name of course comes from our love of music, and Wikipedia describes it best: "In musical theatre, reprises are any repetition of an earlier song or theme, usually with changed lyrics to reflect the development of the story."  And at our stage in life, the developmental section is definitely a thing of the past, and this represents a true "reprise" as we started with a 20' boat more than thirty years ago.  And, so, our boating life will ultimately conclude with the same size boat, one that is being made to our specifications. Most would consider it a folly, but to us it will lovely to look at sitting on our boat lift and a joy to run with its quiet four-stroke Yamaha while listening to some of our favorite jazz pieces on its stereo. Thanks for the suggestion, Uncle Ben!

What To Do?

If I were a Tweeter I'd be retweeting these two links. I've mentioned Barry Ritholtz's The Big Picture blog before. He has a measured view of the markets, and politics, not a raving bull or bear. And I've also mentioned John Hussman's Monday morning entries published in The Hussman Funds site. He has been criticized as a "Permabear" which is unfair as he looks at long economic cycles and he has been spot on long-term. His analysis can be technical and hard to follow for us lacking a PhD in economics, but well worth reading.

The recent gyrations of the market, Dow up 400, down 500, up 200, down whatever seems to signal that we are in uncharted economic and investing waters. The Fed's zero interest rates feed the fire of uncertainty. No longer is there the opportunity of having a "balanced" investment portfolio of stocks and bonds as the latter yields nothing. In fact the zero yield is adding fuel to the gold market as there is no longer an alternative cost (loss of interest) holding the yellow metal.

Hussman's recent write up makes two interesting points and then his very long piece elaborates: The reason we are facing a renewed economic downturn is that our policy makers never addressed the essential economic problem, which was, and remains, the need for debt restructuring. There are two one-way lanes on the road to ruin, and these - in endless variation - are unfortunately the only ones on the present policy map:

1) Policies aimed at distorting the financial markets by suffocating the yield on lower-risk investments, in an attempt to drive investors to accept risks that they would otherwise shun;

2) Policies aimed at defending bondholders and lenders who made bad loans, which they now seek to have bailed out at public expense.

Ritzholz writes a "slightly" lighter piece, with a list, A Decade of Punditocracy, Pathetic Edition. It shows how some policy makers and prognosticators drive with a rosy rear view mirror. I love the first on the list, George W. Bush, June 17, 2002: “Now, we’ve got a problem here in America that we have to address. Too many American families, too many minorities do not own a home. [...] Freddie Mac will launch 25 initiatives to eliminate homeownership barriers.”

So what is one to do? I still believe that well chosen dividend stocks held through thick and thin is part of the answer. This week's Barron's gives some valuable information on this topic, citing S&P's Howard Silverblatt's screen: Silverblatt has provided a substantial list of companies as a starting point for dividend investing. It's not a buy list but a screened set of stocks meeting certain criteria. It's available at www.marketattributes.standardandpoors.com. At the site, click S&P 500 Monthly Performance Data and then Dividend Starting File, at the bottom of the menu. Again, it's merely an interesting place to start.

Chances are that AAA firms such as Johnson & Johnson, Exxon, and Microsoft will survive, no matter what the economy might do, and one is paid to wait. Balance that with some Treasury Inflation Protected securities, and perhaps gold, and even cash, and wait out the market turmoil (it may be a very long wait). The key is to buy any of these on weakness and make the mix appropriate for one's own investment needs and risk tolerance.

Take Tea and See

The electorate has spoken and so has the Federal Reserve. The Party of No will now be in a position to speak words of more than that one syllable.

Meanwhile, Mr. Bernanke's monetary gift to the markets of quantitative easing is propelling them to new highs, especially assets benefitting from a weak dollar. Like sheep investors are being herded into a pen of commodities, export-focused stocks, and corporate bonds, anything but prosaic government bonds and CDs. QE2 is to stem deflationary forces and to stimulate the economy but the Fed is entering uncharted waters with its actions and will it create jobs? Beware of Federal Reserve economists bearing gifts to stimulate inflation and then be careful of getting more than what we wish for. The markets might party while Bernanke plays out QE2, and maybe even QE3, but what is the end game and don't markets ultimately discount what IT perceives as the end? I refer again to John Hussman's important observations on the subject

As to the election, the results were no surprise. I remember being "amused" by the rhetoric heard immediately after Obama's victory into his first few months in office, the Dow dropping almost two thousand points in that short period of time as being "evidence" of his "dangerous" economic agenda. It was immaterial that the markets had already been in a swoon for a year before by even a greater percentage. As the Dow recovered, up more than four thousand points since the "Obama low" not a peep about his policies being responsible.

Of course, neither the decline shortly after his taking power, or the Dow turnaround have much to do with his policies. The Federal Reserve can take responsibility for markets on steroids. A year ago I said "I still think the President could have devoted more of his first year to policies addressing what I called a 'new economic morality.' But Main Street seems to have been sacrificed at the altar of Wall Street and we are angry. Who truly believes the economic crisis is solved rather than being merely postponed?" That anger has spilled over into the midterm elections and, now, we will have the help of the Party of No -- and, who knows, perhaps they will have something positive to say and do. Time to take some tea and see?



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Tale of Two Economists

In an ironic twist, an economist turned entrepreneur writes a rigidly academic critique, The Recklessness of Quantitative Easing, and an academic pens an anecdotal piece of writing on a different but related subject, I Can Afford Higher Taxes. But They’ll Make Me Work Less.

Recklessness by John Hussman, whom I’ve quoted before in this blog as I consider him to be one of the clearer thinkers about the uncharted territory we call today’s economy, argues that the Federal Reserve’s announced intention to pursue a second round of QE is to drive “interest rates to negative levels in hopes of stimulating loan demand and discouraging saving” and to “increase the supply of lendable reserves in the banking system.” But will this increase output and employment?

Hussman thinks not as “interest rates are already low enough that variations in their level are not the primary drivers of loan demand.” There is simply a lack of confidence – both for the consumer and businesses -- that they will have the income in the future to pay off loans. So low or even negative interest rates is not a barrier and “removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back (the economic term being "constrained optimization" as he explains.)

“Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels, or driving real interest rates to negative levels, will provoke consumers and businesses from acting in their best interests to improve their balance sheets?”

The effect of all the talk about QE2 has been to propel gold to new highs and to further erode the value of the US dollar as the Fed dramatically expands its balance sheet. “But once the Fed has quadrupled or quintupled the U.S. monetary base from its level of three years ago, how will it reverse its position?” Hussman’s answer is that many years down the road it will be forced to sell off the instruments it is buying, driving interest rates much higher as foreign buyers might be absent from such auctions, and undermining whatever recovery might have begun of its own accord, just further accentuating the boom bust cycle.

He has constructive suggestions, fiscal responses that might include “extending unemployment benefits, ensuring multi-year predictability of tax policy, expanding productive forms of spending such as public infrastructure, supporting public research activity through mechanisms such as the National Institute of Health, increasing administrative efforts to restructure debt through writedowns and debt-equity swaps, abandoning policies that protect reckless lenders from taking losses, and expanding incentives and tax credits for private capital investment, research and development.” Of course many of these require the cooperation of Congress and watching the mud slinging of the mid term elections, one has to wonder.

But Hussman’s article is must reading it its entirety, especially if you are an individual investor and wondering how to position a portfolio in this strange new economic world. The net effect of the Fed’s actions, besides the obvious nearly zero return on any CD you might buy, is to “force” the investor to move into riskier assets commodities in particular and equities as well. One could also “play” the decline of the dollar by investing overseas or in US multinational companies, which derive a majority of their income abroad. But to what extent QE2 is already baked into the prices of these riskier assets is anyone’s guess. There is also the possibility of a more protracted deflationary period than anyone can imagine right now, with the ongoing real estate crisis and high unemployment having a continuing impact. There seems to be a heavy reliance on the Fed’s future actions leading to an idyllic outcome. I think Hussman would disagree.

One of his suggestions as noted is “ensuring multi-year predictability of tax policy” which leads me to the other economist, Professor Mankiw who is professor of economics at Harvard and was an adviser to President George W. Bush, whose administration has to share some if not a majority of the responsibility of our present economic morass.

Professor Mankiw op-ed piece in the October 9th New York Times, through a convoluted and highly subjective mathematical exercise, argues the proposed tax increase on the 2% wealthiest Americans – some attempt at least to close the budget abyss -- will lead to such people not working much, including, alas, movie and rock stars and even novelists! Outraged, and disappointed that I might not see another Harrison Ford movie, or see my first Lady Gaga “concert” or that Jonathan Franzen will put down his pen, denying us his next novel in protest, I immediately shot off a letter to the editor of the NY Times business section, in which Mankiw’s article appeared. Some very good letters were published in response, but not mine. The nice thing about a blog is I can publish my own rejections! So here is what I wrote:

While it is hard to argue with Professor Mankiw’s math (“I Can Afford Higher Taxes. But They’ll Make Me Work Less”) of what his incremental income might become thirty years in the future in a halcyon tax-free world, his conclusion that movie stars, novelists, rock stars, and surgeons might work less if taxes are increased is based more on his own anecdotal view of working. By his own admission: “I don’t aspire for much more than a typical upper-middle-class lifestyle,” and that’s fine, but don’t blame the tax code for declining his next free lance opportunity. If he should climb down from his Ivy tower and look at the real world with real unemployment around 15%, people trying to work to simply support their families and hold onto their homes rather than handing down wealth to succeeding generations, he might have a little more empathy for a progressive tax code that did not seem to destroy incentives during the Clinton years, the last years in which our country actually had a surplus. And even Warren Buffett and Bill Gates see the fairness in having some sort of an inheritance tax.

Maybe the Times found it too preachy or politically oriented. Perhaps I should have concentrated on the nature of work itself. Remember Hussman’s comment about constrained optimization, that removing a particular barrier only has a beneficial impact if indeed it was that particular barrier holding you back? If Mankiw is entitled to personalize his argument, so can I. I worked as hard when in a higher incremental tax bracket as I did when they were lowered. Why? I loved work, simple as that. And, that is what is missing not only from Mankiw’s formula but how our society looks at work and values workers.

I remember my first visit on business to Japan in the 1970’s, the taxi cab drivers waiting at the hotel for a fare, their cabs gleaming as between fares they would polish and clean their cars. The refuse collector doing his job well was as highly valued by society as a company executive. Japan today, of course, suffers some of the same maladies as ours, with a twenty-year head start on the phenomenon of deflation, so perhaps that has taken its toll on their workers. Somehow, as a society, we need to value all workers and restore work as something to be embraced.

Of course we don’t always have an idyllic choice of the work we do in our lifetimes, but we do have a choice of doing it well or not and by choosing the former, we open a path to finding it meaningful. I’m sorry Prof. Mankiw chooses whether he will write an article or accept an invitation for a speech merely based on what his incremental income bracket might be, although I think most people would envy that he actually has a choice.

I like what the great short story writer, Raymond Carver, wrote thinking about a friend who admitted he wrote something just to make a deadline and make a buck, knowing he could have written something better if he took the time. “If writing can’t be made as good as it is within us to make it, then why do it? In the end, the satisfaction of having done our best, and the proof of that labor, is the one thing we can take into the grave. I wanted to say to my friend, for heaven’s sake go do something else. There have to be easier and maybe more honest ways to try and earn a living. Or else just do it to the best of your abilities, your talents, and then don’t justify or make excuses. Don’t complain, don’t explain."

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Market Report

The S&P was down 3.1% today as the market reacted to slowing growth in China, continuing high unemployment, and signs that deflation, not inflation, is the problem de jour. The 10-year Treasury Note now yields less than 3% reflecting that belief. New York Times’ Paul Krugman characterizes this as The Third Depression. John Hussman, the economist turned mutual fund manager, more mildly states that this is a resumption of the recession. Pain management stocks were up 2.4% in today’s down market.

Long-Term Thinking

This entry is a redirect to the site of the John Hussman, an academic economist turned mutual fund manager, who takes a long-term perspective and invests accordingly. He has been a frequent critic of the overall bailout strategy arguing that until we clear out bad loans, requiring those who made them to take losses, we are doing nothing more than applying band-aids to wounds that need major suturing.

It is amazing to watch the markets since late 2007 as governments around the world have gone into hock, writing blank checks to the financial sector. This has reengaged investors, driving up markets, and leaving risk-adverse investors with the option of getting no return or being forced into riskier investments. It is as if governments are introducing the same problem as a solution. We all get a sense that there will be serious long-term consequences and perhaps recent developments in Europe are indicative. In the U.S. we have time bombs of Fannie, Freddie, deteriorating state and municipal government finances, Medicare and, now, the economic consequences of an ecological disaster in the Gulf, which will linger for generations. How much longer can difficult, lasting solutions be deferred?

Meanwhile, investors can always follow Dilbert’s Scott Adams’ investment “advice” bearing in mind that in humor there is much truth, although he does carry the disclaimer “not to make investment decisions based on the wisdom of cartoonists.”

Here are some key points Hussman makes in his latest piece:

* The fundamental problem is that we have not, as a global economy, accepted the word "restructuring" into our dialogue. Instead, we have allowed our policy makers to borrow and print extraordinarily large band-aids to temporarily cover an open wound that will not heal until we close the gap. That gap is the difference between the face value of debt securities and the actual cash flows available to service them. The way to close the gap is to restructure the debt. This will require those who made the bad loans to accept the associated losses. By failing to do that, we have failed to address the essential problem faced by the world, which is that we have created more debt than we are able to service.

* When our policy makers insist on defending reckless lenders with public resources, we have to recognize that this is not free money. When the government issues a paper liability for real value, that real value gets directed to the recipient at the expense of countless other activities. Even seemingly costless interventions can be redistributions of wealth. For example, the strategy of dropping short-term interest rates to nearly zero as a way of increasing the interest spread earned by banks has the direct effect of impoverishing savers, very often elderly people who rely on lower risk investments for capital preservation.

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Volcker, Stiglitz, Hussman….

Here’s some positive news from or about people who can help point us in the right direction. First there was the big news that Paul Volcker will finally take a key role in addressing economic reform, particularly with the reinstatement of some of the key features from the Glass-Steagall Act. Joseph Stiglitz touches upon that need as well as other issues in an extract from his new book, Freefall; Free Markets and the Sinking of the Global Economy in a piece entitled “Why we have to change capitalism”

We now know the true source of recent bank bonuses: “free money” profits: According to Stiglitz, “the alacrity with which all the major investment banks decided to become ‘commercial banks’ in the fall of 2008 was alarming – they saw the gifts coming from the federal government, and evidently, they believed that their risk-taking behaviour would not be much circumscribed. They now had access to the Fed window, so they could borrow at almost a zero interest rate; they knew that they were protected by a new safety net; but they could continue their high-stakes trading unabated. This should be viewed as totally unacceptable.” Also, Stiglitz puts the bailouts in the context of the bigger picture: “the failures in our financial system are emblematic of broader failures in our economic system, and the failures of our economic system reflect deeper problems in our society. We began the bailouts without a clear sense of what kind of financial system we wanted at the end, and the result has been shaped by the same political forces that got us into the mess. And yet, there was hope that change was possible. Not only possible, but necessary.” As a consequence he argues for “a new financial system that will do what human beings need a financial system to do.”

Meanwhile, the Financial Times carried an excellent piece on Paul Volcker now that he is again front-and-center, Man in the News: Paul Volcker. For too long now Volcker inexplicably had been pushed off the center stage. Last March, as the market was in complete free fall, my tongue-in-cheek piece about “the new era of the 177K” asked, “Where is Paul Volcker to lead the way back to the 401K?”. Per the Financial Times: “this week the towering former Fed chief stood by Barack Obama’s side as the president embraced what he dubbed the “Volcker rule” banning proprietary trading – over the reservations of some of his most senior economic advisers.”
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Then, John Hussman, the economist who runs his own mutual funds, and each Monday blogs about his views, published, today, a lengthy, carefully reasoned Blueprint for Financial Reform.
This is an extraordinarily detailed eight point plan/proposal and rather than giving the bullet points here, go to the link. It deserves careful consideration by our elected officials. Needless to say, he sides with Volcker. Hussman for Chairman of the Federal Reserve or bring back Volcker?
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I've argued that in addition to financial reform, the main economic focus must be job creation: “a true recovery requires jobs, jobs, jobs – and how are they going to be created – by banks trading energy futures? What happened to the commitment to the infrastructure? Our roads, utilities, and public transportation are falling apart. Alternative energy seems DOA. Aren’t these the areas our financial recourses should be focused on, ones that will create jobs, in construction, technology, and finance, and can lead a true economic recovery we can pass on with pride to future generations?”

Green shoots first, then…..

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Well Worth Noting…

Two interesting articles, one an interview with Richard Koo, a former economist with the Federal Reserve Bank of New York and now chief economist of Nomura Research Institute, which appeared in this week’s Barron’s Magazine, A Japanese Rx for the West: Keep Spending and the weekly commentary of the economist and mutual fund manager John Hussman, Timothy Geithner Meets Vladimir Lenin

Koo’s views might seem to be counterintuitive – government needs to increase deficit spending on a three to five year plan while the private sector is repairing its balance sheet. Japan failed to recognize the dangers of “a balance sheet recession” and the USA could make the same mistake. I would agree, provided spending is focused on our infrastructure or alternative energy, or on myriad other public projects that resonate in our economy, creating jobs while fixing our roads and public transportation, encouraging energy independence, reducing greenhouse gases, and improving our educational system. Such investments are aimed at Main Street, not Wall Street. I would imagine Koo would be the first to note that bailouts of irresponsible investment bankers do not constitute the kind of government borrowing he means.

Koo contends that while the private sector repairs its balance sheet, writing down debt on devalued assets, it is imperative for the Federal government to borrow because even if interest rates are zero, the public sector cannot be induced to borrow: “The only way the government can turn this economy around is to do the opposite of the private sector -- borrow the money the private sector saved and spend it, which means fiscal stimulus. That's what saved Japan from entering a Great Depression.”

In effect we can’t make businesses borrow by giving capital to the banking system which only encourages more reckless economic behavior – it has to be spent elsewhere, and what better place than our infrastructure and energy independence?

John Hussman, meanwhile, writes about the very kind of borrowing we must eschew, especially as it is being done without our elected constituency’s input: the Treasury’s recent announcement that it would provide Fannie Mae and Freddie Mac UNLIMITED financial support for the next three years, reminding us that it was Vladimir Lenin who said: “The best way to destroy the capitalist system is to debauch the currency.”

As Hussman notes, “in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone.” And perhaps worse, “…homeowners who have been diligently making their payments will keep their homes, and homeowners who took out mortgages they couldn't afford will keep their homes as well with no adverse consequence to the lenders – since the underlying loans are now owned largely by the Fed, and the Treasury has pledged its unlimited support. Why pay one's debts if it becomes optional, and the Treasury stands to absorb unlimited losses at public expense?”

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Krugman Vs. Hussman

John Hussman, the erudite economist who runs his own mutual funds, and Paul Krugman, the Nobel Memorial Prize winner in Economics have a bone to pick over inflation. Essentially, Krugman thinks such an outcome from the current economic turbulence is a non sequitur as the funds being created with all this debt is essentially not being lent out – they are going back into Treasuries. Therefore, he concludes, “when it comes to inflation, the only thing we have to fear is inflation fear itself.”

Hussman has some pointed rejoinders to this view. The lack of money velocity will have to be indefinite for inflation to remain tame. Eventually this debt will have to be addressed via inflation or through a dramatic expansion of economic activity. He expects a doubling of the U.S. price level over the next decade.

Their discussion takes me back me to the 1970s when the fear of inflation led Paul Volcker to raise short-term rates to unheard of levels, with ultimate success but not before the inflationary genie escaped the bottle. Certainly, recent gyrations in the Treasury market as well as the resurgence of commodity prices show this debate is now being waged in the marketplace as well.