u201CI was scared to death,u201D says Paul Brown. u201CI felt like a hostage.u201D

On Sept. 14, 2012, Mr. Brown was working on his own computer… in his home… in Beach Park, Ill. Suddenly, a gang of thugs smashed in his front door, pointed guns at him and several family members — including his 77-year-old mother-in-law — handcuffed them and ransacked his house.

Wayward drug lords?

Nah. The local SWAT team. Yes, they were looking for drugs. But they didn't find any. Nor did they make any arrests.

WTF: Plywood takes the place of lead and stained glass in Paul Brown's front door…

u201CThe authorities had burst in immediately after a postal worker delivered a package to the home that they said contained marijuana,u201D the Chicago Tribune reports. Brown's son-in-law accepted the package. It was addressed to someone named u201COscar.u201D No one by that name lives there.

The cops aren't saying much. They believe they had the right house and the target of their investigation wasn't home at the time. They are not going to repair the door… or help with the $3,000 in damages.

It was u201Cjust another day in the war on drugs,u201D excuses the Trib, unwittingly kicking off a disturbing episode of the 5 in which we try to highlight and detail what we've been affectionately referring to as the War on You.

Like the troubling collapse of municipal services, the increased militarization of domestic life in the U.S. is a visceral symptom of the collapse of a wayward empire. It's not a topic we take up lightly.

Back in 2008, in a now infamous example in these parts, a SWAT team raided the home of Cheye Calvo, the mayor of Berwyn Heights, Md.

u201CThe raid,u201D Wikipedia recalls, u201Cwas the culmination of an investigation that began in Arizona, where a package containing 32 pounds of marijuana was intercepted in a FedEx warehouse, addressed to the mayor’s residence.

u201CIn spite of intercepting the package in transit, the police allowed the package to be delivered, and once the package arrived at the house, a SWAT team raided and held the mayor and his mother-in-law at gunpoint, and shot and killed his two Labrador retrievers, one while it attempted to run away.u201D

It turns out drug runners frequently address packages to innocent homeowners, figuring FedEx will leave the package on the doorstep when no one's home… and the traffickers can retrieve it before anyone who lives there shows up.

That turned out to be the case in the Calvo incident. As a result, the Prince George's County Sheriff's Office fired several officers, implemented new procedures and conducted workshops with other police agencies from around the country to prevent innocent people from ever being terrorized again — like Mr. Brown in Illinois.

Just kidding: An internal investigation found the raid was justified. No one was punished. Prince George's County Sheriff Michael Jackson, running for reelection in 2010, said, u201CWe’ve apologized for the incident, but we will never apologize for taking drugs off our streets… Quite frankly, we’d do it again. Tonight.u201D

They must have been conferring with the Billings, Mont., police department Tuesday morning of last week. During an early morning raid, a SWAT team, looking for a meth lab, broke into the home of the Fasching family.

The cops found no meth lab and made no arrests… but they did set off a u201Cflash-bangu201D grenade that aims to disorient the people inside before the officers storm the house. The grenade was tossed through the window of a bedroom where Jackie Fasching's 12-year-old daughter was asleep. The girl suffered first- and second-degree burns in the attack.

u201CA simple knock on the door and I would've let them in,u201D says Jackie.

As in the suburban Chicago case, the Billings Police aren't backing down. u201CIf we're wrong or made a mistake,u201D Chief Rich St. John says, u201Cthen we're going to take care of it,u201D he said. u201CBut if [the department's claims process] determines we're not, then we'll go with that.u201D

Chicago… Billings… suburban D.C…. we mentioned the family in Delaware last week. There's another case this month in Salt Lake City.

“I saw them crashing through the door,” recalled Paul Fracasso. “There were guns and flashlights going everywhere [and police] telling them: ‘Get down. Get down. Get down.’”

Fracasso was lucky: He's the next-door neighbor.

Once police burst inside, the only person they saw was a 76-year-old woman. Her son says she was asked if she had a gun or drugs. u201CShe was petrified,u201D Raymond Zaelit told the Salt Lake Tribune. u201CShe didn’t know what to think. This was traumatizing for her.” At least in this case the police apologized.

By the way, USA Today has followed up on the research we cited last week on the number of SWAT raids that take place nationwide. From a mere 3,000 per year in the early 1980s, the number has exploded to as many as 80,000. That's an average of 228 per day.

Seriously.

Here in Maryland, a study commissioned by the governor found that a full one-third of those raids don't even result in an arrest.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

Volatility tends to correlate with risk, but not always with return. Skydiving delivers more heart-stopping thrills than chess, but it also produces more heart-stopping disasters. Driving a Formula 1 race car produces a lot more million-dollar paydays than sitting in a La-Z-Boy. But no one ever crashed their La-Z-Boy into a wall and burst into flames.

At least skydivers and race car drivers understand their risks – more or less – and are knowingly accepting these risks in the pursuit of a particular reward. By contrast, many investors assume risks unwittingly, and out of all proportion to the potential rewards.

They are driving race cars, not to win millions of dollars, but to win a $50 gift card to Dave & Busters. They are tight-rope walking across Iguazu Falls, not to obtain international acclaim and a possible movie deal, but simply to get to the other side. That’s not a good trade.

It is important to understand the risks one is taking…and to be as certain as possible that the risks and the rewards align intelligently.

Every investment carries some degree of risk, the successful investor merely insists that he receive compensation commensurate with the risk he assumes.

That’s easy to say, but how do we do it? Most of us have a hard enough time identifying a truly compelling investment opportunity, much less trying to assess the risks involved. So what’s our opportunity?

Good news. You don’t have to be an expert stock-picker to rack up expert investment returns. But you do have to build a risk-resistant portfolio – one that is diversified in ways that will provide genuine protection against severe capital loss.

The “Permanent Portfolio” has delivered that kind of protection for more than 30 years.

In 1981, the best-selling investment author, Harry Browne, developed a set-it-and-forget-it strategy he called, simply enough, the Permanent Portfolio. The strategy is embarrassingly simple – consisting of just four components: gold, bonds, stocks and cash.

The idea was that at any given time, two or three of these four components might underperform – but the other portfolio components would perform so strongly, you’d get an overall gain that would outpace any increase in the cost of living.

So during an inflationary environment like the 1970s, gold would provide the juice. In prosperous times like the 1990s, stocks would be the engine that pulls the rest of the train. In a garden-variety recession, your cash and long-dated Treasury positions would put you in good stead, while gold and stocks struggled.

Over time, the Permanent Portfolio has followed through on its objective admirably. From 1981-2010, the annual average return was a healthy 8.4%. Only two years have seen losses, and those were relatively small.

And what about 2008? The Year of Doom? The Permanent Portfolio held its ground, and then some – gaining 1.9%.

The Permanent Portfolio isn’t about trying to catch a wave. It’s about surrendering to the reality that you can’t predict the future – and still building up a nice nest egg, whatever the future brings. Set it and forget it.

No doubt about it, Harry Browne’s Permanent Portfolio has performed brilliantly during the last 30 years… and perhaps it will continue to do so. But conditions have changed since 1981. Maybe we should change with them. Browne’s basic strategy remains as valid as ever, but maybe the components that populate Browne’s strategy need to change.

For example, the Permanent Portfolio mutual fund (PRPFX), although based on Browne’s strategy, has tweaked his original allocation somewhat. The mutual fund’s allocation is as follows:

20% gold, 5% silver, 35% US Treasury bonds and bills. 10% Swiss government bonds, 15% aggressive growth stocks, 15% natural resource stocks and/or real estate stocks.

This revised portfolio has been more volatile than the original, but it has also delivered greater returns, especially recently. During the last 15 years, for example, PRPFX has not only produced double the returns of the S&P 500 Index, but it has also outpaced the returns of that other permanent portfolio, Berkshire Hathaway.

But that was then. What about now? Is Browne’s original allocation still optimal? Or is the Permanent Portfolio mutual fund’s allocation an intelligent refinement? Or should investors be heading in an even more radical direction?

If, for example, you are very worried about the future of the US dollar, should you be allocating portions of the permanent portfolio to foreign stocks or bonds?

We don’t know. But we’d like you to tell us. What do you think would be the ideal permanent portfolio for the next 10, 20 or 30 years?

Here are the ground rules:

1. Select three to five investible assets – that means no less than three and no more than five.
2. Do not include any individual stocks, unless those stocks be an ETF or closed-end fund. Do not, for example, include Apple Computer as one of your Permanent Portfolio components (no matter how brilliant that allocation might be!)
3. Make sure the assets you select are public securities or indices. That means they are a mutual fund, ETF, index or commodity.
4. Design your portfolio with the idea that it would be re-balanced annually.
5. If you’d care to add a little color behind the thought process that produced your permanent portfolio, feel free.

We look forward to your submissions and hope to be publishing many of them in a future edition of The Daily Reckoning.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

A little more than a year ago, a very successful professional investor declared, u201CIf you don't own a home, buy one. If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home.u201D

Since that declaration, house prices have continued drifting lower in most parts of the country. The Case-Shiller index of national home prices is down about 4% year over year. Even so, we're betting this professional investor was merely early…not wrong. US housing isn't just cheap; it is the cheapest it has been in more than 40 years. And when one considers the possibility that inflation may rear its head soon, housing looks even cheaper still.

If you think we're crazy, you're not alone. The housing market is a complete bust right now. The following chart shows the median home price in terms of per capita disposable income. Based on this calculation, home prices are lower than they have been in 40 years!

And it isn't just that home prices have fallen a long way. For most home buyers, the price of the home is only one part of the true cost of a home. Mortgage rates matter as much, or more, than the purchase price itself. In other words, buying a house is not just a bet on real estate; it is also a bet against interest rates. For the typical buyer of a home who takes out a 30-year mortgage, an increase in interest rates is just like an increase in the price of a home.

Today, because home prices and interest rates are both at extremely low levels, the cost of buying a home with a 30-year mortgage is at an all-time low. To illustrate this stunning fact, the chart below shows the average monthly mortgage payment on the median-priced home, expressed as a percentage of per capita disposable income.

If you can get a mortgage, you are basically taking a reverse bet on the bond market. You could be a long-term borrower at fixed rates, instead of a long-term lender. Right now, you can borrow for 30 years at around 3.3%. After the mortgage tax deduction, for some people the net effective interest rate is nearer to 2%! That's going to prove an awesome deal if we see inflation again.

But here's the factor that clinches the case for investing in residential real estate: the long-term supply and demand for housing. Let's start with supply.

Consider how long it will take to bring new supply to the market. As investors, we want new supply to come slowly.

The number of housing starts is currently lower than at any time in at least the past 50 years. Moreover, new construction is only about half the long-term average. Again, good news for investors in housing, since this means that new supply is growing very slowly.

Meanwhile, housing demand – based simply on demographic trends – should rise inexorably for years to come. Take the growth in households – driven by population growth – and apply a home ownership rate. Demographically, the US is still a growing country. By 2030, there will be 370 million Americans. Even using the long-term average home ownership rate means we'll need 1.1-1.2 million new single-family homes per year.

In other words, busted markets don't last forever. The cure for low prices, as the old saw goes, is low prices. Furthermore, a bet on the housing market is not merely a bet on real estate; it is also a bet that inflation will rise.

The US economy may be idling in neutral for the moment, but inflation is revving its engines. How should you prepare?

u201CBuy goldu201D is the time-honored answer, and we don't quarrel with it. But an alternative answer, especially this time around, might be: u201CBuy a house.u201D

That's the advice offered by a growing – but still small – number of very successful investors. John Paulson is one of them. He is the guy who said about a year ago, u201CIf you don't own a home, buy one. If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home.u201D

He was early…and his hedge fund performed very poorly last year, mostly because he was too early betting big on a rebound in the US economy. Double wrong! But we still think Paulson's call on housing may be close to the mark.

Despite his dismal performance in 2011, Paulson is the guy who turned one of the greatest trades of all time. Betting against the housing market, he netted a cool billion dollars for himself in 2007. One fund he managed rose 590% that year. Today, he is one of the richest men in America…still.

His advice today is very different than it was in 2007. u201CBuy a house,u201D he says.

And he has put money where his mouth is…He already owns posh digs in Manhattan on 86th Street, plus a Southampton house he nabbed in 2008. In 2010, he snapped up an 8-acre ranch in Aspen for a cool $24.5 million, before buying a Fifth Avenue condo at a 23% discount to the asking price. (This 26th-floor pied–terre will be his u201Cguest house.u201D)

Let's flash back in time for a second…

Another successful investor gave similar advice in 1971 – the dawn of one of America's biggest housing bull markets. The investor was Adam Smith (George Goodman) on The Dick Cavett Show. Here is a snippet from that conversation:

Smith: The best investment you can make is a house. That one is easy.

Cavett: A house? We were talking about the stock market. Investments…

Smith: You asked me the best investment. There are always individual stocks that will go up more, but you don't want to give tips on a television show. For most people, the best investment is a house.

Cavett: I already own a house. Now what?

Smith: Buy another one.

How good was that advice?

Houses, as an investment, trounced stocks during the inflationary 1970s. The chart below tells the tale.

In the 1970s, US stocks returned about 5% annually – failing to keep pace with inflation. Still, it was an up-and-down ride. In 1974, the stock market fell 49%. But here are the average selling prices for existing homes in the 1970s, as inflation heated up:

1972 – $30,000 1973 – $32,900 1974 – $35,800 1975 – $39,000 1976 – $42,200 1977 – $47,900 1978 – $55,500 1979 – $64,200

That was a pretty impressive run-up in home prices. Today, I think we could be on the threshold of another once-in-a-generation buying opportunity in the housing market.

The homebuilding stocks seem to agree. Many of them have doubled during the last five months from their very depressed levels. Although the ISE Homebuilders Index is still down about 80% from its 2006 peak, it has been gaining steady ground relative to the rest of the stock market.

The chart below shows the rolling three-year price performance of the S&P 500 index, minus the rolling three-year price performance of the ISE Index. As you can see, the ISE has been lagging far behind the S&P 500 for most of the last five years. But during the last few months, this index has been closing the gap…and looks like it is about to begin a period of outperformance relative to the rest of the stock market.

So we like select homebuilding stocks, but we don't love them. Unlike the housing market itself, homebuilding stocks have priced in quite a bit of good news already. Not surprisingly, therefore, the insiders at these companies have been doing a lot more selling of their own shares than buying. (Pulte is one conspicuous exception.)

We also like housing-related stocks. As Chris Mayer, our colleague over at Capital & Crisis, observes, u201CCompanies such as Lowe's (LOW) and Home Depot (HD) would benefit from a recovering housing market…as would the makers of flooring, Mohawk Industries (MHK), the makers of kitchen cabinets, Fortune Brands Home & Security (FBHS) and a whole bunch of stuff in between…In a robust housing market, good fortune would also smile on A.O. Smith (AOS), which makes water heaters for homes.u201D

But again, we don't love these stocks. Not at their relatively rich valuations. Even so, we'll be combing through this sector very carefully for promising investment ideas. In the meantime, for those with the means and the inclination, the best buy in the housing sector is an actual house!

This picture is unequivocal. US home prices are very, very cheap today. u201CCheapu201D does not preclude u201Ceven cheaper,u201D of course. Home prices could certainly continue sliding. But even if that were to occur, mortgage rates might begin rising, which would cause the effective price of a home to increase.

Obviously, buying residential real estate at both a housing market low and an inflationary low would be the optimal entry point – in fact, it would be a screaming buy. And that's exactly what today's circumstances seem to be offering.

Perhaps that's why a large number of very successful professional investors are licking their chops over opportunities in the US residential real estate market.

This out-of-favor asset class has attracted the attention of David Ackman, a hedge fund manager with a fondness for contrarian investments. He calls them SFHRPs, an acronym for u201CSingle Family Home Rental Property.u201D

u201CThe best investments we have made are the ones no one else would touch,u201D Ackman explains.

As housing prices have continued drifting even lower, Paulson and Ackman have picked up a little bit of company. The US housing market is becoming a central focus of several u201Cdeep valueu201D investors. Over the past weeks, I've bumped into three very successful professional investors who were much more eager to talk about their real estate investments than about their stock market investments.

One gentleman in particular, who has made billions of dollars for his investors by buying deep value stocks, was much more eager to talk about his recent real estate investments than his recent stock market investments. He was talking glowingly – if not giddily – about the opportunities in real estate he was coming across.

u201CI'm not finding much to buy in the stock market at the moment,u201D he explained. u201CBut real estate is a different story. I wish I had the capital to act on more of the ideas that are coming across my desk.u201D

We asked this investor if he was concerned about the risk of real estate prices falling even further.

u201CNah,u201D he said as he waved the question aside, u201CI assume the housing market will remain soft for a while. But the kinds of deals we're finding should work out well, even if the housing market keeps sliding for a bit. Besides, there's one lesson I've learned repeatedly as a value investor in the stock market: You can have good news or cheap prices. You can't have both.u201D

The US housing market has absolutely no good news…but plenty of cheap prices.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

In my investment letter, Addison Wiggin’s Apogee Advisory, we spend a great deal of time, money and resources looking for new investment ideas that our subscribers can act on independently. Sometimes what we find instead is outrage.

For example, the federal government is about to dump millions of the foreclosed homes at fire-sale prices to hedge funds and private-equity firms with government connections. If you’re an individual investor who might like to get in on the action, forget it! You’re shut out of this deal.

Homeowners who might be interested in buying the foreclosure property next door? Out of luck. And retirees hoping for a return on their money more than 1.8% on a five-year CD find another avenue closed off.

Prior to the calamity of 2008, we might have thought the deal we’re profiling today unthinkable. But now we’re becoming as immune to new instances of blatant cronyism as American babies are to diphtheria.

If you’ve got the hammer for it, we may as well get down to brass tacks: As many as 10,000 properties might be unloaded in a single transaction during the first quarter of 2012 – thanks to a government program so new it doesn’t have a catchy name yet, only the working title “Enterprise/FHA REO Asset Disposition.”

Roger Arnold, chief economist for Pasadena, Calif.-based ALM Advisors, has a different name for it – “the largest transfer of wealth from the public to the private sector.”

As of last September, there were about 800,000 “real estate owned” or REO homes in the United States – homes repossessed and on the market. Close to one-third of these – 250,000 – sit on the books of Fannie Mae, Freddie Mac and the Federal Housing Administration. That is, 250,000 homes are owned by you and me, the US taxpayers.

But that number is about to explode: According to Ken Harney at the real estate industry publication Inman News, “The three agencies face a tsunami-sized shadow inventory that is now heading their way – a combined 1.4 million delinquent loans on their books, at least half of which, they estimate, will end up in foreclosure.”

So now we’re talking that 250,000 number suddenly ballooning to nearly a million. The early-warning waves of the tsunami started lapping at the shore in November, when foreclosure auctions reached a nine-month high. The final numbers might end up even higher: Late-stage delinquencies tallied by Lender Processing Services in January approach 2 million.

Thus, the hypothetical excuse for the fire sale: “Even with heroic efforts,” Harney says, “Fannie, Freddie and FHA won’t be able to handle that level of REO volume using their current systems of individual sales, directed at owner-occupants and small investors.”

Thus, “You and I will not be allowed to participate,” says Roger Arnold of the newprogram. “These [new] investors will come from the private-equity and fund community, Goldman Sachs and its derivatives, as well as foreign sovereign wealth funds that can bring a billion dollars or more to each transaction.

“The US taxpayer will get pennies on the dollar for these homes, and then be allowed to rent them back at market rates.”

The groundwork is being laid right now. During the first week of January, the Federal Reserve issued a white paper on housing: “A government-facilitated REO-to-rental program,” it said, “has the potential to help the housing market and improve loss recoveries on REO portfolios.” Three Fed governors put the word out in speeches the same week.

The big boys can smell the money and they are lining up to play.

Among the players that expect to profit big from this government-sponsored scam are the private firms that already manage properties for the government. The Department of Housing and Urban Development calls them “management and marketing contractors.” Their principal owners and officers tend to consist of former high-ranking officials with HUD, the Treasury, FHA and so on.

There are 20 of these “M&M” firms, according to a list on HUD’s website. On the theory that perhaps you could reclaim some of your tax dollars by investing in these firms – the same theory with which we suggested ITA, the defense and aerospace ETF – we examined whether any of them are publicly traded. None are. Sorry.

No, the only way you’ll be able to make any money off these insider deals will come long after the feast is over and you’re allowed a few crumbs. “Once the privatization has occurred,” one analyst observes, “and the properties are generating rental income for the investors, the initial investors will cash out by forming real estate investment trusts (REITs), real estate operating companies (REOCs) or limited partnerships that will be made available to retail investors.”

Alas, by then, the easy money will have been made…at your expense. Feels pretty good, doesn’t it?

That’s why, increasingly we find ourselves casting our gaze overseas, longing for returns in foreign lands in places where the governments are somewhat less corrupt and the playing field slopes somewhat less directly toward the pockets of crony-capitalists.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

It’s hard to crawl the Internet today without running across something like this…

Wikipedia and several other sites are “blacked out” to protest the Stop Online Piracy Act, or SOPA – an odious piece of legislation that would allow domain names to be erased from the web without due process of law.

Possible Website Block by US Authorities

Not that this is deterring members of Congress determined to get the bill passed.

“Due to the Republican and Democratic retreats taking place over the next two weeks,” says its sponsor, Rep. Lamar Smith (R-Tex.), “markup of the Stop Online Piracy Act is expected to resume in February.”

“It’s D.C. versus Silicon Valley in the SOPA fight,” observes colleague Greg Grillot. “You have Google, Mozila, Wikipedia, Reddit, Firefox and Boing Boing against it. And how many D.C. shills for it?”

“It’s a true war: the last bastion of creative/productive ingenuity in America versus the swamp of D.C.’s parasitic, industry-conflicted bureaucracy.”

Is D.C. winning?

Last year, Census data revealed Washington moved past San Jose as the wealthiest U.S. metropolitan area.

Meanwhile, we see the House will likely vote today against raising the debt ceiling, which Uncle Sam is once again hitting.

It’s purely symbolic: Under the debt-ceiling deal reached last August, the president need merely notify Congress that he’s going to raise it; it’s up to both houses to vote against it. With the Senate under the control of the Democrats, that won’t happen.

The $1.2 trillion increase coming soon should be enough to tide over Uncle Sam until… oh, right around Election Day. And that increase would have to be passed the old-fashioned way.

Next crisis, please…

“While Washington has spent the last year (and much of the last quarter-century) fighting about the national debt, most of our leaders have blithely ignored America’s staggering level of household debt,” writes American University history professor Andrew Yarrow.

Time was Americans observed National Thrift Week along with Ben Franklin’s birthday, which was yesterday. Now Americans are once again raiding their savings to get by.

“In an ominous sign for America’s economic growth prospects,” Reuters reported yesterday, with no reference to Ben Franklin, “workers are paring back contributions to college funds and growing numbers are borrowing from their retirement accounts.”

Indeed, the savings rate has fallen back to December 2007 levels – right when the official “recession” began.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

What a difference nearly three years makes. On Inauguration Day 2009, 2 million people converged on Washington, D.C.

“Two million people don’t gather in one place unless things are really good, or really bad,” we observed that day. “We’re having trouble telling the difference these days… One thing is certain: Obama sure has a lot of hype to live up to. Guess that’s inevitable when you allow the nation to project all their fears and hopes on you.”

“I am new enough on the national political scene,” wrote the president two years after his election to the U.S. Senate, “that I serve as a blank screen on which people of vastly different political stripes project their own views.”

“As such, I am bound to disappoint some, if not all, of them.”

Well, at least he had some idea what he was getting into. But he couldn’t shake the delusion that the solution to whatever ails “the economy” lies in politics.

Thus, nearly three years later, the palpable disappointment is manifesting itself, like the now-dashed high hopes, outdoors…

The “Occupy Wall Street” crowd is marching uptown today to protest at the homes of J.P. Morgan Chase CEO Jamie Dimon and Koch Industries chief David Koch, among others.

“Objectively,” writes retired CIA station chief Haviland Smith, “the demonstrators seem broadly preoccupied with their own powerlessness. They decry the inordinate amount of power and influence held by our very rich and our corporate enterprises and the power of lobbyists to further their goals in a Congress that is essentially for sale.”

Reading this assessment, we’re struck – and we know we’re going to make people uncomfortable saying this – by the parallels between Occupy Wall Street and the Tea Party.

Both movements are born in part from outrage over the 2008-09 bank bailouts. Both feel the “American dream,” however they define it, is out of their reach. Both feel left out by a ruling class.

The Tea Party drove one long-time Republican operative to quit after 30 years as a Capitol Hill staffer. But Mike Lofgren recognized where their grievances came from.

“Historical circumstances,” he wrote last month, “produced the raw material: the deindustrialization and financialization of America since about 1970 has spawned an increasingly downscale white middle class – without job security (or even without jobs), with pensions and health benefits evaporating and with their principal asset deflating in the collapse of the housing bubble. Their fears are not imaginary; their standard of living is shrinking.”

How different is that, really, from the motives impelling the OWS protesters to the streets? For all we know, the OWS protesters are the college grads with no jobs stuck living in their Tea Party parents’ basement.

Heck, even some of the Tea Partiers might support the OWS protesters notions of “tax the rich.”

Eight out of 10 Americans support raising taxes on households earning more than $250,000 a year, according to a new Bloomberg/Washington Post poll.

That includes 81% of Democrats, 67% of independents, and 51% of Republicans.

The poll also finds 82% ruling out any cuts to Medicare, and 83% opposing any cuts to Social Security.

Presumably that would include the Tea Partiers who were insisting two years ago, “Keep your government hands off my Medicare.”

Sure gets ugly when people can no longer project their views onto the president.

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

Something – we’re not altogether sure what – touched off MSNBC’s Dylan Ratigan yesterday.

We love it when these guys lose their cool. This is not nearly as entertaining as Jim Cramer’s tantrum imploring the Fed to “open the discount window” in 2007, but pay attention to the content…

“The country is living in debt,” Russian Prime Minister Vladimir Putin said yesterday when asked about the Grand Bargain the U.S. Congress is voting on today.”It is not living within its means, shifting the weight of responsibility on other countries and in a way acting as a parasite.”

History’s cruel irony: The deficit spending justified in the 1980s to defeat the Soviet Union became “business as usual” for the ensuing three decades.

The agreement cut yesterday to avert default “was not that great overall because it simply delayed the adoption of a more systemic solution,” according to Putin, who was addressing a youth camp in central Russia.

“If the U.S. encounters a systemic malfunction, this affects everyone,” he said. Thus does the prime minister suggest, and not for the first time, his own “more systemic solution.”

“There should be other reserve currencies.”

Russia holds $115 billion in U.S. Treasuries. That’s only a 10th of China’s holdings, but still nothing to sneeze at.

For its part, South Korea – the world’s seventh-largest holder of U.S. dollars reserves – reacted to the “agreement” by announcing the Bank of Korea has tripled gold holdings over the past two months.

The $1.25 billion purchase is the first addition to Korean gold holdings since the Asian financial crisis of the late 1990s.

Thailand also made an announcement today. They added $900 million to their gold stash in June.

“The trend,” says the Financial Times, “means central banks, sovereign wealth funds and other so-called ‘official sector’ buyers are on track to record their largest collective purchase of gold since the collapse of the Bretton Woods system, which pegged the value of the dollar to gold, in 1971.”

With that, gold is powering into record territory this morning, the spot price currently up $17, to $1,637. Silver, meanwhile, has pushed past $40 again, sitting at $40.11 as we write.

Meanwhile, one of the “frontier markets” we follow is running away from the dollar in a different direction. Cambodia’s stock market, opened last month, will allow trading in U.S. dollars… but only for the next three years. Then the Cambodian riel will take center stage.

According to the Asian Development Bank, U.S. dollars account for 90% of the currency in circulation in Cambodia. But that’s due to change, says our contact on the scene – Leopard Capital chief and Vancouver speaker Doug Clayton.

“The U.S. dollar is losing its credibility from the reckless ‘quantitative easing’ programs of the U.S. Federal Reserve,” he tells MarketWatch. “It is becoming unsafe for Cambodia to delegate its monetary policy to the bankrupt U.S., which hopes to inflate its way out of its recession and huge debts.

“Foreign investors would initially prefer to trade shares in dollars since that is simplest for them,” he continues. “But once there are enough riels in circulation and sufficient liquidity in the foreign exchange market, trading shares denominated in riels will not pose any problems for investors.”

Reprinted with permission from The Daily Reckoning.

Addison Wiggin [send him mail] is the editorial director and publisher of The Daily Reckoning. He is the author, with Bill Bonner, of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century and the upcoming Empire of Debt. His latest book is The Demise of the Dollar…and Why It’s Great for Your Investments.

The Best of Addison Wiggin

Well, Ben Bernanke can’t say he wasn’t warned. You may recall, the hacker group known as Anonymous issued a demand on March 11 that Bernanke step down as Fed chairman.

“We aim to break up the global banking cartel centered at the Federal Reserve, International Monetary Fund, Bank of International Settlements [sic] and World Bank,” their video manifesto declares.

The outfit managed to briefly shut down the websites of Amazon, PayPal, Visa and MasterCard in retaliation for those firms’ cutting business ties to WikiLeaks, so we assume the original threat was more than just an idle one.

Fast-forward 90 days. Big surprise, Bernanke has not resigned. But on Saturday, hackers broke into the computer system of the International Monetary Fund. They got away with a “large quantity” of data, including documents and e-mails.

At least, that’s what a security expert “familiar with the incident who wasn’t authorized to speak on the subject” told Bloomberg. As of this morning, no one knows who did the job.

Only hours later, however, Anonymous issued a new statement, with the ingenious title “Ctrl+Alt+Bernanke.”

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Most people
can relate to the realities of how jobs and profits shift, and why.
The idea that higher-wage manufacturing jobs are being lost and
replaced by lower-wage retail jobs, for example, is a reality that
working people understand. They get it. The same is not always true
when we talk about trade deficits. Like the falling dollar itself,
it's worth asking the question: How does it affect you, the individual?

The trade deficit
— the excess of imports over exports — has a direct and serious
effect on the value of our dollars. As long as we continue having
big trade deficits, it means we're spending more money overseas
than we're making at home. Our manufacturing profits are lower than
our consumption. If your family's budget has a "trade deficit"
of sorts, you'll soon be in trouble. If your spouse spends $ 4,000
for every $2,000 you bring home, something eventually gives way.
This is what is going on with the trade deficit.

In fact, the
trade deficit is one of the most important trends in the economy,
and the one most likely to affect the value of the dollar. Combined
with our government's big budget deficit, the trade deficit only
accelerates the speed of decline in our dollar's value.

Speaking in
terms of spending power of the dollar, the trade deficit is the
third rail of the economy. Here is what has been going on: The United
States used to produce goods and sell them not only here at home,
but throughout the world. We led the way, but not anymore. The shift
away from dominance in the production of things people need has
allowed other countries (most notably China and India, and with
Colombia, Russia, Brazil, and Mexico not far behind) to pass us
up, and now the U.S. consumer has become a buyer instead of a seller.

This international
version of conspicuous consumption is financed not from the profits
of commerce, but from debt. Let's think about this for a minute.
If we were buying from domestic profits, the trade deficit wouldn't
be such a bad thing. It would mean we were spending money earned
from domestic productivity. But this is not what is going on. We
are going further and further into debt to buy goods from other
countries. Our wealth is being transferred overseas and, at the
same time, we are sinking deeper into debt. This is taking place
individually as well as nationally. Consumer debt (you know: credit
cards, mortgages, lines of credit) is growing to record levels,
and the federal current account deficit is moving our multitrillion-dollar
national debt into new high territory.

Sure, we should
be concerned about retirement income from savings, investments,
pension plans, and Social Security. But a bigger danger is that,
even with a comfortable retirement nest egg by today's standards,
what if those dollars are worthless when we retire? What then?

The big question
today is, how long can this debt-driven economy continue? If you
quit your job and refinance your home, you could live for a while
on the money. The higher your equity, the longer you would be able
to spend, spend, spend. But then what?

This is precisely
what is going on in the U.S. economy, and, at some point very soon,
we are going to have to face up to it and change our ways. The trade
deficit is the best way to track what's going on. Returning to the
analogy of quitting your job and living off of your home equity,
you may stay home all day and order an endless array of electronics,
furniture, toys, computers, and the like; in other words, you could
consume goods in place of working. But remember, you didn't win
the lottery; you are financing this new plan with borrowed money.
The lender will want that repaid. So this individual version of
a trade deficit (the deficit between generating income and spending
money) is what is happening on a national level in the United States.

This is the
problem that is directly affecting the value of the dollar; and
the situation is getting worse. We know that the dollar is in trouble
because we see it depreciating against the floating currencies of
other countries.

The United
States has a lot of wealth, but that wealth is being consumed very
quickly. History shows that no matter how rich you are, you can
lose that wealth if you're not productive. Meanwhile, the dollar's
value falls and — in spite of the Fed's view that this is a good
thing — it means our savings are worth less. Your spending power
falls when the dollar falls, and as this continues, the consequences
will be sobering.

The dollar's
plunge has taken many people, currency experts of banks included,
by surprise. For many of them, it is still impossible to grasp.
Some talking head on CNBC said that he was at a complete loss to
understand how such weak economies as those seen in the European
Union could have a strong currency. For American policy makers and
most economists, the huge trade deficit is no problem.

They find it
natural that fast-growing countries import money while slow-growing
economies export money. At least, that is the recurring theme. So
Americans traveling abroad may continue to complain that "it
has become so expensive to travel in Europe" as though the
problem were somehow the fault of the Europeans. But in fact, it
is the declining spending power of the dollar that is to blame,
and not just the French, the Italians, and the residents of the
so-called chocolate-making countries.

This problem
is pegged not to some speculative or fuzzy economic cause, even
though the concept of currency exchange rates continues to mystify.
A historically large trade deficit is at the core of the declining
dollar. Somebody needs to get over the notion that our economy is
strong and other economies are weak, merely because this is America.
In the United States, the reason for the trade deficit is not a
high rate of investment as we see in some other countries, but an
abysmally low level of national savings. We are spending, not producing.

A second argument
offered by some is that "capital flows from high-saving countries
to low-saving countries, wanting to grow faster." Under this
reasoning, a deficit country, looking at both consumption and investment,
is absorbing more than its own production. But whether this is good
or bad for the economy depends on the source and use of foreign
funds. Do those funds pay for the financing of consumption in excess
of production (as in the United States) or for investment in excess
of saving? That is the key question that ought to be asked in the
first place about the huge U.S. capital imports.

To quote Joan
Robinson, a well-known economist in the 1920s and 1930s close to
John Maynard Keynes:

"If the
capital inflows merely permit an excess of consumption over production,
the economy is on the road to ruin. If they permit an excess of
investment over home saving, the result depends on the nature of
the investment."

The huge U.S.
capital inflows (economic jargon for money coming into the country),
accounting now for more than 6 percent of gross domestic product
(GDP), have not financed productive investment; in fact, they are
financing more and more debt. Capital grew from 5 percent in 2005
to more than 6 percent in 2006, according to a report from the Bureau
of Economic Analysis (BEA), "U.S. International Investment
Position." Our net investments are among the lowest in the
world, meaning we prefer spending and borrowing over actual production
and growth. The huge capital inflows have not helped finance a higher
rate of investment. The United States has been selling its factories
and financial assets to pay for consumption.

It's helpful
to use a real means for measuring economic strength. Money coming
here from overseas finances higher personal consumption. The steep
decline in personal saving is a symptom of our spending, and along
with that habit we have lower capital investment and a growing federal
budget deficit. In the third quarter of 2005, for the first time
ever, the rate actually fell into negative territory — to — 1 percent.

The
U.S. economy has for years been the strongest in the world, leading
the rest of the countries. Our Daily Reckoning newsletter routinely
gets reader responses saying, in effect, "How dare you impugn
the superiority of the American economy! How dare you!" We're
rather thick-skinned, so the insults bounce off rather easily. But
"facts are stubborn things." The fact that the U.S. economy
has outperformed the rest of the world in the past several years
is easily explained: Our credit machine has been operating in overdrive
nonstop. It is geared to accommodate unlimited credit for two purposes
— consumption and financial speculation. Let's look at these two
things a little more deeply.

Credit
is not the same thing as production, despite the fuzzy logic you
get from the financial media. There is a severe imbalance between
the huge amount of credit that goes into the economy and the minimal
amount that goes into productive investment. Instead of moving to
reign in these excesses and imbalances, under Greenspan, the Fed
clearly opted to sustain and even to encourage them. I want to believe
that under Bernanke, the Fed will do better, but so far, it is still
customary to measure economic strength by simply comparing recent
real GDP growth rates. It is pointed to as proof and applauded by
U.S. economists when U.S. economic growth outscores Europe — like
some kind of dysfunctional futbol match.

Financial
speculation is equally unproductive. An investor puts up capital
to generate a sustained and long-term growth plan. For example,
buying and holding stocks is a form of investment and a sign that
the investor has faith in the management of that company. Speculators
don't care about long-term growth. They want to get in and out of
positions as quickly as possible, make a profit, and repeat the
process. So speculative profits — especially those paid for with
borrowed money — tend to be churned over and over in further speculation
and increased spending. None of that money goes into investment
in the long-term sense. The speculator is invested in short-term
profits, nothing more. Even so, the speculator is today's cowboy,
the risk-taking, living-on-the-edge market hero willing to take
big chances. He is seen as a guy with big stones because he's staring
the prospect of loss right in the eye.

May
12, 2008

Addison
Wiggin [send him mail]
is the editorial director and publisher of The Daily Reckoning.
He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. His
latest book is The
Demise of the Dollar…and Why It’s Great for Your Investments.

Addison
Wiggin Archives

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History has
shown that money — not counterfeit, but official money printed by
the government — has been known to lose value and become virtually
worthless. Examples include Russian rubles from pre-Revolution days,
50-million marks from 1920s Germany, and Cuban pesos from pre-Castro
days. In all of these cases, jarring political and economic change
destroyed currency values — suddenly, completely, and permanently.

What kinds
of events could do the same thing to the U.S. dollar, and what can
you do today to position yourself strategically? The potential fall
of the dollar is good news if you know what steps to take today.
We’re not as insulated as many Americans believe. In the 1930s,
20 percent of all U.S. banks went broke and 15 percent of life savings
went up in smoke. After the emergency measures put into effect by
President Franklin D. Roosevelt through the Emergency Banking Relief
Act of 1933, confidence was restored with another piece of legislation:
the 1933 Glass-Steagall Act. This bill created the Federal Deposit
Insurance Corporation (FDIC), insuring all U.S. bank deposits against
loss.

The severity
of the growing situation had been seen well in advance. The financial
newspaper Barron’s, established in 1921, editorialized in 1933 that:
“Since early December, Washington had known that a major banking
and financial crisis was probably inevitable. It was merely a question
of where the first break would come and the manner of its coming.”

Two weeks earlier,
the same column cautioned its readers that when the dollar begins
to lose value, this leads to a series of “flights” — from property
into bank deposits, then from deposits into currency, and finally
from currency into gold.

We can apply
these astute observations from 1933 to today’s currency situation.
The government, anticipating a flight from currency into gold, had
already made hoarding gold or even owning it illegal. The second
step — insuring accounts in federal banks — helped to calm down
the mood. By preventing the panic, currency stabilized. But in those
times, we were still on the gold standard. The currency in circulation
was, in fact, backed by something. Remember, that riverboat gambler
who keeps asking for ever-higher markers will eventually run out
of credit. At some point the casino boss realizes that his ability
to repay is questionable. Maybe those markers are just a heap of
IOUs that can never be cashed in.

In the 1930s,
the causes of the Great Depression were complex but related to a
series of obvious abuses in monetary, financial, and banking policies.
History has simplified the issue by blaming the Depression on the
stock market crash (which takes us back to the explanation that
“wet sidewalks cause rain”). The stock market crash, one of many
symptoms of policies run amok, has lessons for modern times. The
unbridled printing of money — expansion of the “IOU economy” — is
good news for those who recognize the potential for gold.

We hear experts
on TV and in the print media shrugging off the deficit problems.
“Our economy is strong and getting stronger” is the mantra of those
with a vested interest in keeping dollars flowing: Wall Street brokers
and analysts, for example. But we cannot ignore the facts. The federal
deficit is growing by more than $40 billion per month. It is not
realistic to point to this economy and say it’s doing just fine.

Gold is the
beneficiary of reckless monetary policies and the War on Terror.
Check the average value of an ounce of gold over the past decade.
It has been rising steadily since the end of 2001. The cause of
this change in gold’s price may be attributed at least partly to
the attack on the World Trade Center. But it reflects equally on
the Fed’s monetary policies and spiraling debt-based economic recovery.
During the same period that gold prices have begun to rise, we should
also take a look at the trend in money in circulation.

This is troubling
for the dollar but — again — great news for gold. Remember what
the world economic and political situation was like in the early
1970s: a weakening dollar, easy money, and international unrest.
Sound familiar? We’re back in the same combination of circumstances
that were present when gold prices went from $35 to over $800 per
ounce.

The numbers
prove that gold is going to be the investment of the future. World
mining in gold averages 80 million ounces per year, but demand has
been running at 110 million ounces. So if central banks want to
hold the value of gold steady, at least 30 million ounces per year
must be sold into the market. This creates a squeeze. As the dollar
weakens, central banks will want to increase their holdings in gold
bullion, not sell it off.

This is why
gold’s price has started to rise and must continue to rise into
the future. As long as that demand grows — and it will rise as the
dollar’s value continues falling — the price of gold simply has
to reflect the forces of supply and demand.

But, you might
ask, why do central banks want to hold down the value of gold? We
have to recognize how this whole money game works. Most world currencies
are off the gold standard, following the U.S. example. So as gold’s
value rises, it competes with each country’s currency. Of course,
the trend toward weakening currencies and the continuing demand
for gold mean that the growth in gold’s value could continue strongly
for many years to come.

When the United
States removed its currency from the gold standard, it seemed to
make economic sense at the time. President Nixon saw this as the
solution to a range of economic problems and, combined with wage
and price freezes, printing as much money as desired looked like
a good idea. Unfortunately, most of the world’s currencies followed
suit. The world economy now runs primarily on a fiat money system.

Fiat money
is so-called because it is not backed by any tangible asset such
as gold, silver, or even seashells. The issuing government has decreed
by fiat that “this money is a legal exchange medium, and it is worth
what we say.” So lacking a gold backing or backing of some other
precious metal, what gives the currency value? Is there a special
reserve somewhere? No. Some economists have tried to explain away
the problems of fiat money by pointing to the vast wealth of the
United States in terms of productivity, natural resources, and land.
But even if those assets are counted, they’re not liquid. They’re
not part of the system of exchange. We have to deal with the fact
that fiat money holds its value only as long as the people using
that money continue to believe it has value — and as long as they
continue to find people who will accept the currency in exchange
for goods and services. The value of fiat money relies on confidence
and expectation. So as we continue to increase twin deficit bubbles
and as long as consumer debt keeps rising, our fiat money will eventually
lose value. Gold, in comparison, has tangible value based on real
market forces of supply and demand.

The short-term
effect of converting from the gold standard to fiat money has been
widespread prosperity. So the overall impression is that U.S. monetary
policy has created and sustained this prosperity.

Why abandon
the dollar when times are so good? This is where the great monetary
trap is found. If we study the many economic bubbles in effect today,
we know we eventually have to face up to the excesses, and that
a big correction will occur. That means the dollar will fall and
gold’s value will rise as a direct result.

The
sad lesson of economic history will be that when the gold standard
is abandoned, and when governments can print too much money, they
will. That tendency is a disaster for any economic system, because
excess money in circulation (too much debt, in other words) only
encourages consumer behavior mirroring that policy.

Thus,
we find ourselves in record-high levels of credit card debt, refinanced
mortgages, and personal bankruptcies — all connected to that supposed
prosperity based on printing far too much currency: the fiat system.

We
can see where this overprinting will lead. As debt grows relative
to gross domestic product (GDP), we would expect to see positive
signs elsewhere, such as a growth in new jobs. But like a Tiananmen
Square Rolex watch deal, the value simply isn’t there. Job growth
is slow but, in reality, there is a decline in earnings. High-paying
manufacturing jobs have been replaced and exceeded by low-paying
retail and health care sector jobs, so even if more people are at
work, real earnings are down. Instead of simply measuring the number
of jobs, an honest tracking system would also compare average wages
and salaries in those jobs. Then we would be able to see what is
really going on — more low-paying jobs being created, replacing
high-paying jobs being lost.

December
6, 2006

Addison
Wiggin [send him mail]
is the editorial director and publisher of The Daily Reckoning.
He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

Addison
Wiggin Archives

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The year was
1944. For the first time in modern history, an international agreement
was reached to govern monetary policy among nations. It was, significantly,
a chance to create a stabilizing international currency and ensure
monetary stability once and for all. In total, 730 delegates from
44 nations met for three weeks in July that year at a hotel resort
in Bretton Woods, New Hampshire.

It was a significant
opportunity. But it fell short of what could have been achieved.
It was a turning point in monetary history, however.

The result
of this international meeting, the Bretton Woods Agreement, had
the original purpose of rebuilding after World War II through a
series of currency stabilization programs and infrastructure loans
to war-ravaged nations. By 1946, the system was in full operation
through the newly established International Bank for Reconstruction
and Development (IBRD, the World Bank) and the International Monetary
Fund (IMF).

What makes
the Bretton Woods accords so interesting to us today is the fact
that the whole plan for international monetary policy was based
on nations agreeing to adhere to a global gold standard. Each country
signing the agreement promised to maintain its currency at values
within a narrow margin to the value of gold. The IMF was established
to facilitate payment imbalances on a temporary basis.

This system
worked for 25 years. But it was flawed in its underlying assumptions.
By pegging international currency to gold at $35 an ounce, it failed
to take into effect the change in gold’s actual value since 1934,
when the $35 level had been set. The dollar had lost substantial
purchasing power during and after World War II, and as European
economies built back up, the ever-growing drain on U.S. gold reserves
doomed the Bretton Woods Agreement as a permanent, working system.

This problem
was described by a former senior vice president of the Federal Reserve
Bank of New York:

“From the
very beginning, gold was the vulnerable point of the Bretton Woods
system. Yet the open-ended gold commitment assumed by the United
States government under the Bretton Woods legislation is readily
understandable in view of the extraordinary circumstances of the
time. At the end of the war, our gold stock amounted to $20 billion,
roughly 60 percent of the total of official gold reserves. As
late as 1957, United States gold reserves exceeded by a ratio
of three to one the total dollar reserves of all the foreign central
banks. The dollar bestrode the exchange markets like a colossus.”

In 1971, experiencing
accelerating depletion of its gold reserves, the United States removed
its currency from the gold standard, and Bretton Woods was no longer
workable.

In some respects,
the ideas behind Bretton Woods were much like an economic United
Nations. The combination of the worldwide depression of the 1930s
and the Second World War were key in leading so many nations to
an economic summit of such magnitude. The opinion of the day was
that trade barriers and high costs had caused the worldwide depression,
at least in part. Also, during that time it was common practice
to use currency devaluation as a means for affecting neighboring
countries’ imports and reducing payment deficits. Unfortunately,
the practice led to chronic deflation, unemployment, and a reduction
in international trade. The lessons learned in the 1930s (but subsequently
forgotten by many nations) included a realization that the use of
currency as a tactical economic tool invariably causes more problems
than it solves.

The situation
was summed up well by Cordell Hull, U.S. secretary of state from
1933 through 1944, who wrote:

“Unhampered
trade dovetailed with peace; high tariffs, trade barriers, and
unfair economic competition, with war… If we could get a freer
flow of trade … so that one country would not be deadly jealous
of another and the living standards of all countries might rise,
thereby eliminating the economic dissatisfaction that breeds war,
we might have a reasonable chance of lasting peace.”

Hull’s suggestion
that war often has an economic root is reasonable given the position
of both Germany and Japan in the 1930s. The trade embargo imposed
by the United States against Japan, specifically intended to curtail
Japanese expansion, may have been a leading cause for Japan’s militaristic
stance.

Another observer
agreed, saying that poor economic relations among nations “inevitably
result in economic warfare that will be but a prelude and instigator
of military warfare on an even vaster scale.”

Bretton Woods
had the original intention of smoothing out economic conflict, in
recognition of the problems that economic disparity causes. The
nations at the meeting knew that these economic problems were at
least partly to blame for the war itself, and that economic reform
would help to prevent future wars. At that time, the United States
was without any doubt the most powerful nation in the world, both
militarily and economically. Because the fighting did not take place
on U.S. soil, the country built up its industrial might during the
war, selling weapons to its allies while developing its own economic
strength. Manufacturing by 1945 was twice the annual rate of 1935–1939.

Due to its
economic dominance, the United States held the leadership role at
Bretton Woods. It is also important to note that the United States
owned 80 percent of the world’s gold reserves at the time. So the
United States had every motive to agree to the use of the gold standard
to organize world currencies and to create and encourage free trade.
The gold standard evolved over a period of hundreds of years, planned
by a central bank, government, or committee of business leaders.

Throughout
most of the nineteenth century, the gold standard dominated currency
exchange. Gold created a fixed exchange rate between nations. Money
supply was limited to gold reserves, so nations lacking gold were
required to borrow money to finance their production and investment.

When the gold
standard was in force, it was true that the net sum of trade surplus
and deficit came out to zero overall, because accounts were eventually
settled in gold – and credit was limited as well. In comparison,
in today’s fiat money system, it is not gold but credit that determines
how much money a country can spend. So instead of economic might
being dictated by gold reserves, it is dictated by a country’s borrowing
power. The trade deficit and the trade surplus are only “in balance”
in theory, because the disparity between the two sides is funded
with debt.

The pegged
rates – the value of currency to the value of gold – maintained
sensible economic policy based on a nation’s productivity and gold
reserves. Following Bretton Woods, the pegged rate was formalized
by agreement among the leading economic powers of the world.

The concept
was a good one. However, in practice the international currency
naturally became the U.S. dollar and other nations pegged their
currencies to the dollar rather than to the value of gold. The actual
outcome of Bretton Woods was to replace the gold standard with the
dollar standard. Once the United States linked the dollar to gold
at a value of $35 per ounce, the whole system fell into place, at
least for a while. Since the dollar was convertible to gold and
other nations pegged their currencies to the dollar, it created
a pseudo-gold standard.

The British
economist John Maynard Keynes represented Great Britain at Bretton
Woods. Keynes preferred establishing a system that would have encouraged
economic growth rather than a gold-pegged system. He favored creation
of an international central bank and possibly even a world currency.
He proposed that the goal of the conference was “to find a common
measure, a common standard, a common rule acceptable to each and
not irksome to any.”

Keynes’ ideas
were not accepted. The United States, in its leading economic position,
preferred the plan offered by its representative, Harry Dexter White.
The U.S. position was intended to create and maintain price stability
rather than outright economic growth. As a consequence, Third World
progress would be achieved through lending and infrastructure investment
through the IMF, which was charged with managing trade deficits
to avoid currency devaluation.

In joining
the IMF, each country was assigned a trade quota to fund the international
effort, budgeted originally at $8.8 billion. Disparity among countries
was to be managed through a series of borrowings. A country could
borrow from the IMF, which would be acting in fact like a central
bank.

The Bretton
Woods agreement did not include any provisions for creation of reserves.
The presumption was that gold production would be sufficient to
continue funding growth and that any short term problems could be
resolved through the borrowing regimens.

Anticipating
a high volume of demand for such lending in reconstruction efforts
after World War II, the Bretton Woods attendees formed the IBRD,
providing an additional $10 billion to be paid by member nations.
As well-intended an idea as it was, the agreements and institutions
that grew from Bretton Woods were not adequate for the economic
problems of postwar Europe. The United States was experiencing huge
trade surplus years while carrying European war debt. U.S. reserves
were huge and growing each year.

By 1947, it
became clear that the IMF and IBRD were not going to fix the problems
of European postwar economic woes. To help address the issue, the
United States set up a system to help finance recovery among European
countries. The European Recovery Program (better known as the Marshall
Plan) was organized to give grants to countries to rebuild. The
problems of European nations, according to Secretary of State George
Marshall, “are so much greater than her present ability to pay that
she must have substantial help or face economic, social, and political
deterioration of a very grave character.”

Between 1948
and 1954, the United States gave 16 Western European nations $17
billion in grants. Believing that former enemies Japan and Germany
would provide markets for future U.S. exports, policies were enacted
to encourage economic growth. During this period, the Cold War became
increasingly worse as the arms race continued. The USSR had signed
the Bretton Woods agreement, but it refused to join or participate
in the IMF.

Thus, the proposed
economic reforms turned into part of the struggle between capitalism
and Communism on the world stage.

It became increasingly
difficult to maintain the peg of the U.S. dollar to $35-per-ounce
gold. An open market in gold continued in London, and crises affected
the going value of gold. The conflict between the fixed price of
gold between central banks at $35 per ounce and open market value
depended on the moment. During the Cuban missile crisis, for example,
the open market value of gold was $40 per ounce. The mood among
U.S. leaders began moving away from belief in the gold standard.

President Lyndon
B. Johnson argued in 1967 that:

“The world
supply of gold is insufficient to make the present system workable
– particularly as the use of the dollar as a reserve currency
is essential to create the required international liquidity to
sustain world trade and growth.”

By 1968, Johnson
had enacted a series of measures designed to curtail the outflow
of U.S. gold. Even so, on March 17, 1968, a run on gold closed the
London Gold Pool permanently. By this time, it had become clear
that maintaining the gold standard under the Bretton Woods configuration
was no longer practical. Either the monetary system had to change
or the gold standard itself would need to be revised.

During
this period, the IMF set up Special Drawing Rights (SDRs) for use
as trade between countries. The intention was to create a type of
paper gold system, while taking pressure off the United States to
continue serving as central banker to the world. However, this did
not solve the problem; the depletion of U.S. gold reserves continued
until 1971. By that time, the U.S. dollar was overvalued in relation
to gold reserves. The United States held only 22 percent gold coverage
of foreign reserves by that year. SDRs acted as a basket of key
national currencies to facilitate the inevitable trade imbalances.

However, Bretton
Woods lacked any effective mechanism for checking reserve growth.
Only gold and the U.S. asset were considered seriously as reserves,
but gold production was lagging. Accordingly, dollar reserves had
to expand to make up the difference in lagging gold availability,
causing a growing U.S. current account deficit. The solution, it
was hoped, would be the SDR.

While
these instruments continue to exist, this long-term effectiveness
can only be the subject of speculation. Today SDRs make up about
1 percent of IMF members’ nongold reserves, and when in 1971 the
United States went off the gold standard, Bretton Woods ceased to
function as an effective centralized monetary body. In theory, SDRs
– used today on a very limited scale of transactions between
the IMF and its members – could function as the beginnings
of an international currency. But given the widespread use of the
U.S. dollar as the peg for so many currencies worldwide, it is unlikely
that such a shift to a new direction will occur before circumstances
make it the only choice.

The
Bretton Woods system collapsed, partially due to economic expansion
in excess of the gold standard’s funding abilities on the part of
the United States and other member nations. However, the problems
of currency systems not pegged to gold lead to economic problems
far worse.

September
29, 2006

Addison
Wiggin [send
him mail] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

DIGG THIS

A weakened
U.S. economy shouldn’t surprise anyone. It is a direct result of
the questionable nature of the so-called economic recovery. Any
other country faced with these many imbalances would have collapsed
long ago. But the U.S. dollar was spared this fate when Asian central
banks began accumulating the dollars needed to avoid rises in their
currencies.

Both the United
States and China practice credit excess, but with a crucial difference:
In the United States, the credit excesses went into higher asset
prices and, more notably, into personal consumption.

In Asia, credit
excesses went into capital investment and production. The result
is an odd disparity between the two economies: Americans borrow
and consume, and the Asians produce. This symbiosis plays out in
the trade gap. Ironically, this ever-growing problem is ignored
on the national level and plays virtually no role in U.S. economic
policy or analysis. In the second quarter of 2004, the increase
in the trade gap subtracted 1.37 percentage points from GDP (based
on domestic demand growth). In comparison, during the 1980s, policy
makers and economists worried about the harm that trade deficits
were causing in U.S. manufacturing.

In a September
1985 move orchestrated by James Baker, the U.S. Treasury secretary,
the finance ministers of the G-5 nations agreed to drive the dollar
sharply down in concerted action. By the mid-1990s U.S. policy makers
decided that trade deficits were beneficial for the U.S. economy
and its financial markets.

Cheap imports
were playing an important role in preventing inflation and, as a
result, higher interest rates. Had the decision been to allow interest
rates to rise, it would have had the effect of slowing down consumer
spending. Instead, spending is out of control and the trade gap
is the consequence. Ultimately, the victim in all of this is going
to be the U.S. dollar.

The economic
cycle involving inflation, higher interest rates, monetary tightening,
recession, and recovery has a predictable postwar pattern in America
and in the rest of the world. But we’ve taken a departure from this
for the first time. A critic might argue that now the United States
is enjoying a prolonged period of strong economic growth with low
inflation and low interest rates. What could be bad about that?

Well, what’s
bad about that is the fact that we are not experiencing strong economic
growth. U.S. net business investment has fallen to all-time postwar
lows, under 2 percent of GDP in recent years. At the same time,
net financial investment is running at about 6 percent of GDP. In
other words, the counterpart to foreign investment in the U.S. economy
has been higher private and public consumption, accompanied by lower
saving and investment.

Official opinion
in America says that the huge U.S. trade gap is mainly the fault
of foreigners, for two reasons. One is the eagerness of foreign
investors to acquire U.S. assets with higher returns than in the
rest of the world; the other is supposed to be weaker economic growth
in the rest of the world. In this view, the trade gap directly results
from foreign investment because it provides the dollars that the
foreign investors need.

The first thing
to realize about a deficit in foreign trade is that, by definition,
it reflects an excess of domestic spending over domestic output.
But such spending excess is actually caused by overly liberal credit
at home, and not really by cheaper goods produced elsewhere.

Just as shaky
is the second argument, ascribing the trade gap to higher U.S. economic
growth. Asian economies, in particular China, have much higher rates
of economic growth than the United States. Yet they all run a chronic
trade surplus, which is caused by high savings rates. This is the
crucial variable concerning trade surplus or trade deficit.

The diversion
of U.S. domestic spending to foreign producers is, in effect, a
loss of revenue for businesses and consumers in the United States.
Is this important? Yes. The loss is higher than $500 billion per
year. This is America’s income and profit killer, and it can’t be
fixed with more credit and more consumption. This serious drag of
the growing trade gap on U.S. domestic incomes and profits would
have bred slower economic growth, if not recession, long ago. This
has so far been delayed by the Fed’s extreme monetary looseness,
creating artificial domestic demand growth through credit expansion.
The need for ever-greater credit and debt creation just to offset
the income losses caused by the trade gap is one of our big problems.

An equally
big problem is a distortion of the numbers. We are officially in
great shape, but the numbers don’t support this belief. Personal
consumption in the past few years has increased real GDP at the
expense of savings, while business investment has grown only moderately.

This can only
end badly. Normally, tight money forces consumers and businesses
to unwind their excesses during recessions. But in the latest round,
the Fed’s loose monetary stance has stepped up consumers’ spending
excesses. Our weight trainer is feeding us Big Macs. If we were
to measure economic health by credit expansion, the United States
has the worst inflation in history. And still our experts are puzzled
by a soaring import surplus.

The problem
here is that American policy makers and economists fail to understand
the significance of the damage that is being caused by monetary
excess and the growing trade gap. The trade gap is hailed as a sign
of superior economic growth, while the hyperinflation in stock and
house prices is hailed as wealth creation.

Until the late
1960s, total international reserves of central banks hovered below
$100 billion. At the end of 2003, they exceeded $3 trillion, of
which two-thirds was held in dollars. By far the steepest jump in
these reserves, of $907 billion, occurred in the years 2000–2002.
With China and Japan as the main buyers, Asian central banks bought
virtually the whole amount.

In a speech
given in Berlin in 2004, Alan Greenspan was amazingly frank about
the “increasingly less tenable U.S. current account deficit,” suggesting
that foreign investors would eventually reach a limit in their desire
to finance the deficit and diversify into other currencies or demand
higher U.S. interest rates. He expressed the new consensus view
in America that the dollar has to bear the brunt of reducing the
U.S. federal budget deficit.

American policy
makers seem to want a lower dollar, apparently believing (or hoping)
that this will take care of the U.S. trade deficit, and they appear
to regard this as an easy solution to this problem.

But this will
not solve the problem at all. The premise is wrongly based on the
assumption that an overvalued dollar has caused of the U.S. trade
deficit – an entirely unsupported view.

It is widely
assumed that rising stock and house prices will keep American consumers
both willing and able to spend, spend, spend their way to wealth
– indefinitely. But the transfer of U.S. net worth to interests
overseas is alarming, and it endangers U.S. economic and political
health. Warren Buffett, who kept his vast fortune invested at home
for more than 70 years, decided in 2002 to invest in foreign currencies
for the first time. Buffett and management of Berkshire Hathaway
believe the dollar is going to continue its decline. We should not
need confirmation such as this to recognize the inevitable; but
it bolsters the argument that the dollar is, in fact, in serious
trouble, and that this trouble is likely to continue.

In addition
to debt problems at home, Buffett made his decision based at least
partially on the ever-growing trade deficit. He warned:

“We
were taught in Economics 101 that countries could not for long sustain
large, ever-growing trade deficits. At a point, so it was claimed,
the spree of the consumption-happy nation would be braked by currency-rate
adjustments and by the unwillingness of creditor countries to accept
an endless flow of IOUs from the big spenders. And that’s the way
it has indeed worked for the rest of the world, as we can see by
the abrupt shutoffs of credit that many profligate nations have
suffered in recent decades. The U.S., however, enjoys special status.
In effect, we can behave today as we wish because our past financial
behavior was so exemplary – and because we are so rich.

Buffett
is especially concerned about the transfer of wealth to outside
interests. He notes:

“Foreign
ownership of our assets will grow at about $500 billion per year
at the present trade-deficit level, which means that the deficit
will be adding about one percentage point annually to foreigners’
net ownership of our national wealth. As that ownership grows, so
will the annual net investment income flowing out of this country.
That will leave us paying ever-increasing dividends and interest
to the world rather than being a net receiver of them, as in the
past. We have entered the world of negative compounding – goodbye
pleasure, hello pain.”

September
8, 2006

Addison
Wiggin [send
him mail] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

Counting
obligations under Medicare and Social Security, the real debt of
the United States is more than 10 times the reported national debt:

“Taking present
values as of fiscal year end 2002 and interpreting the policies
in the federal budget for fiscal year 2004 as current policies,
the federal government’s total fiscal imbalance is equal to $44.2
trillion.”

The
argument favoring the current fiat system is that the demand for
it grew out of barter, the need to facilitate ever-higher volumes
of trade. If this were true, there would be a reasonable expectation
that a system of paper drafts would make sense. But the reality
is that fiat money has not grown out of barter, but from the previous
gold standard. Given the lack of control over how much fiat money
is placed in circulation – after all, it is based on nothing
– we can only expect that the currency will continue to lose
value over time. The model of fiat money is supported and defended
with arguments that consumption is good for the economy, even with
the use of vacant monetary systems. But there is a problem:

“The predictions
of these models are at odds with the historical evidence. Fiat
money did not in fact evolve . . . by means of a great leap forward
from barter. Nor did fiat monies ever emerge out of thin air.
Instead, fiat monies have always developed out of some previously
existing money.”

Can
we equate the problems inherent in fiat money with the effects of
inflation? We have all heard that saving for retirement today is
problematical because, by the time we retire, we will need more
dollars to pay for the things we will need. By definition, this
sounds like the consequences of inflation. But inflation is not
simply higher prices; it has another aspect, which is devalued currency.
We have to pay higher prices in the future because the currency
is worth less relative to other currencies. That is the real inflation.
Higher prices are only symptoms following the debasement of currency.
If we examine why those prices go up, we discover that the reason
is not necessarily corporate greed, inefficiency, or foreign price
gouging. At the end of the day, it is the gradual loss of purchasing
power, the need for more dollars to buy the same things. That’s
inflation. And fiat money is at the root of the problem.

The
intrinsic problem with fiat money systems is how it unravels the
basic economic reality. We know that it requires work to create
real wealth. We labor and we are paid. We save and we earn interest.
Government, however, produces nothing to create wealth so it does
so out of an arbitrary system: fiat money. The problem is described
well in the following passage:

“It takes
work to create wealth. ‘Dollars’ are created without any work
– how much more work is involved in printing a $100 bill
as compared to a $1 bill? Not only are ordinary people at home
being deceived, but foreigners who accept and save our “dollars”
in exchange for their goods and services are also being cheated.”

So
are we “cheated” by the fiat money system? Under one interpretation,
we have to contend with the reality that the dollar is not backed
by anything of value. But as long as we all agree to assign value
to the dollar, and as long as foreign central banks do the same,
isn’t it okay to use a fiat money system?

The
problem becomes severe when, unavoidably, the system finally collapses.
At some point, the Federal Reserve – with blessings of the
Congress and the administration – prints and places so much
money into circulation that its perceived value just evaporates.
Can this happen? It has always happened in the past when fiat money
systems were put into use. We have to wonder whether FDR was sincere
when, in 1933, he declared that the currency had adequate backing.
It wasn’t until the following year that the president raised the
ounce value of gold from $20.67 to $35. He explained his own monetary
policy in 1933 after declaring the government’s sole right to possess
gold:

“More liberal
provision has been made for banks to borrow on these assets at
the Reserve Banks and more liberal provision has also been made
for issuing currency on the security of those good assets. This
currency is not fiat currency. It is issued on adequate security,
and every good bank has an abundance of such security.”

It
was the plan of the day. First, the law required that all citizens
turn over their gold to the government. Second, the value of that
gold was raised nearly 70 percent to $35 per ounce (after collecting
it from the people, of course). Third, the president declared that
currency printing was being liberalized – but it is backed
by gold, so it’s not a fiat system. This may have been true in 1933,
but since then – having removed ourselves from the gold standard
– the presses are printing money late into the night. The gold
standard has been long forgotten in Congress, the Federal Reserve,
and the executive branch.

It
may be the view of some people that a perfect monetary system may
include changes in value based on purchasing power and on the demand
for money itself. Thus, rich nations would become richer and control
the cost of goods, while poor nations would remain poor. In spite
of the best efforts under the Bretton Woods Agreement, it has proven
impossible to simply let money find its own level of value. Unlike
stocks and real estate, the free market does not work well with
monetary value because each country has its own self-interests.
Furthermore, today’s post-Bretton Woods monetary system has no method
available to prevent or mitigate trade imbalances. Thus, trade surplus
versus deficit continues to expand out of control. The United States
ended up accumulating current account deficits totaling more than
$3 trillion between 1980 and 2000.This perverse twist on world money
has had a strange effect:

“These deficits
have acted as an economic subsidy to the rest of the world, but
they have also flooded the world with dollars, which have replaced
gold as the new international reserve asset. These deficits have,
in effect, become the font of a new global money supply.”

This
is what occurs when international money supplies become unregulated.
We need a firmly controlled world banking system if only to stop
the unending printing of money. If, indeed, U.S. deficits continue
as a form of subsidy to the rest of the world, that can only lead
to a worldwide economic collapse like the one seen in the 1920s
and 1930s.

If
it were possible to create a controlled international monetary unit,
its effectiveness would demand ongoing regulation to prevent the
disparities between nations with varying resources and reserves.
Ludwig von Mises wrote that:

“The idea
of a money with an exchange value that is not subject to variations
due to changes in the ratio between the supply of money and the
need for it . . . demands the intervention of a regulatory authority
in the determination of the value of money; and its continued
intervention.”

Mises
concluded that this need for intervention was itself a problem.
It is unlikely that any government would be trustworthy enough to
properly ensure a fair valuation of money, were it left up to them;
instead, governments are more likely than not to fall into the common
fiat trap. Without limitations on how much money can be printed,
it is human and governmental nature to print as much as possible.
Mises observed that fiat money leads to monetary policy designed
to achieve political aims. Mises:

“The state
should at least refrain from exerting any sort of influence on
the value of money. A metallic money, the augmentation or diminution
of the quantity of metal available which is independent of deliberate
human intervention, is becoming the modern monetary ideal.”

To
an extent, the enactment of a fiat money system is likely either
to be politically motivated or to soon become a political tool in
the hands of government. We have to see how government attempts
to influence economic health through a variety of means and in tandem
with Federal Reserve policy: raising and lowering interest rates,
enacting tax incentives for certain groups, legislating tax cuts
or tax increases, and imposing or reducing trade restrictions or
tariffs. All of these moves invariably have a pro and con argued
politically rather than economically. The argument in modern-day
U.S. politics is between Republican desires to reduce taxes as a
means of stimulating growth versus Democratic views that we cannot
afford tax cuts and such cuts are given to favored upper-income
taxpayers. The arguments are complex and endless, but they are not
just political tools; they are part of overall monetary and economic
policy trends as well.

This
has become our modern entry in the history of money. The belief
on the part of government, rooted in an arrogant thinking that power
extends even to the valuation of goods and services and monetary
exchange, has led to a monetary policy that makes utterly no sense
in historical perspective. Having gone over entirely to a fiat standard,
government has chosen to ignore history and those market forces
that ultimately decide the question of valuation, in spite of anything
government does. This has always been true, as Jeffrey M. Herbener
observed:

“The use
of the precious metals was historically the choice of the market.
Without interference from governments, traders adopted the parallel
standard using gold and silver as money.”

If
monetary policy were left alone and allowed to function in the free
market, what would happen? Perhaps governments ultimately do follow
the market by adopting the gold standard, as we have seen repeatedly
in history: going on the gold standard, moving to fiat money, experiencing
a debasement, and then returning to the gold standard. Herbener
continued by observing,

“The
fly in the ointment of the classical gold standard was precisely
that since it was created and maintained by governments, it could
be abandoned and destroyed by them. As the ideological tide turned
against laissez-faire in favor of statism, governments intent
upon expanding the scope of their interference in and control
of the market economy found it necessary to eliminate the gold
standard.”

Today,
we live with that legacy. While historians marvel at the “end of
history” and the triumph of free market economics, the Fed maintains
“price controls” on the very symbol of economic freedom – the
U.S. dollar itself.

August
19, 2005

Addison
Wiggin [send
him mail] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

Business
investment creates economic recoveries. Without that investment,
we have no right to expect a recovery. The Fed and other monetary
gurus claim that the low level of business investment is to be blamed
on excess inventories and low demand overseas. But realistically,
corporate America has gone through a trend in the past two decades
in which dwindling profits have led to increased levels of mergers
and acquisitions, but little change in the lagging profit picture.
The belief, or the hope, that merging and internal cost cutting
would solve profitability problems has been dashed. It hasn't worked.

Corporate
America is coming to the point of having to face its own set of
realities. First of all, merging does not improve profits if the
market itself is weak. Lacking real investment in plant and equipment,
long-term growth is less likely today than before the merger mania
and the growing trade deficit. Coupled with this is an expanding
obligation for pension liabilities among large corporations.

The
problem of deceptive reporting isn't limited to the government.
Corporations do the same thing.

Consider
the following: many corporations have notoriously inflated their
earnings reports – and not just Enron. Quite legitimately, and with
the blessings of the accounting industry, companies exclude many
big expense items from their operating statements and may include
revenues that should be left out. Exclusions like employee stock
option expenses can be huge. At the same time, including estimated
earnings from future investments of pension plan assets is only
an estimate, and cannot be called reliable. Standard & Poor's
has devised a method for making adjustments to arrive at a company's
core earnings.

Those
are the earnings from the primary business of the company, and anything
reported should be recurring. The adjustments aren't small. For
example, in 2002, E.I. du Pont de Nemours (DuPont) reported earnings
of more than $5 billion based on an audited statement and in compliance
with all of the rules. But when adjustments were made to arrive
at core earnings, the $5 billion profit was reduced to a $347 million
loss. Core earnings adjustments that year of nearly $5.5 billion
had to be made.

That
is a big change. Other big negative adjustments had to be made that
year for IBM ($5.7 billion reported profits versus $287 million
in core earnings) and General Motors ($1.8 billion reported profits
versus $2.4 billion core loss). That year, the two largest core
earnings adjustments were made by Citicorp ($13.7 billion in adjustments)
and General Electric ($11.2 billion in adjustments).

Here's
where the question of realistic net worth comes into play: In accounting,
any adjustment made in earnings has to have an offset somewhere.
So when Citicorp overreports its earnings by $13.7 billion, that
means it has also understated its liabilities by the same amount – a fact that should be very troubling to stockholders. One of the
largest of the core earnings adjustments is unfunded pension plan
liabilities. United Airlines, for example, announced in 2004 that
it was going to stop funding pension contributions. After filing
Chapter 11 bankruptcy in 2002, the United Airlines unfunded liability
is an estimated $6.4 billion.

We're
just scratching the surface. When we hear that a corporation has
not recorded employee stock option expenses of $1 billion, that
also means the company's net worth is exaggerated by the same amount – and the book value of the company is exaggerated. So all of the
numbers investors depend on are simply wrong.

The
escalating pension woes have been building up for years. A booming
stock market a few years back added to corporate profits. But once
the market retreated, those profits disappeared. In this situation,
stock prices fall while ongoing pension liabilities rise. As employees
retire, obligatory payments have to be made out of operating profits
and – while few corporate types want to talk about this – those
very pension obligations and depressed returns on invested assets
may be a leading factor in the high number of corporate bankruptcies.

Filing
for bankruptcy often becomes the only way out when the corporations
cannot afford to meet their pension obligations. We can learn a
lot from the corporate dilemma. And we can apply what we observe
to the way the Fed is running monetary policies.

In
explaining the complexities of calculating value and explaining
how or why dollars fall (thus losing purchasing power), the Fed
has become very much like a corporate chief financial officer (CFO)
trying to explain why things have gone south.

Corporate
management may be reined in, to some extent, by changes in federal
law. The Sarbanes-Oxley Act changed the culture in some important
ways. But until the accounting industry goes through some changes
of its own, the corporate problem won't disappear.

It
appears so far that the disaster of Arthur Andersen has been viewed
in the accounting industry as a public relations problem rather
than what it really is: a deep, cultural failure within the business
to protect the stockholders.

The
parallels between corporate failures and government policy are alarming,
if only because the Fed is not accountable to the Securities and
Exchange Commission (SEC) or to stockholders in the same way that
a corporate CEO and CFO are – and civil fines or imprisonment are
out of the question. So as far as accountability is concerned, it
looks like the borrowing and spending should continue – with yet
more wild abandon.

The
halfhearted debate over the twin deficits in trade and budget involve
some big numbers, but the Fed is not concerned. In his penchant
for understatement, Greenspan reported last year to the House Financial
Services Committee on these matters. Noting that many Asian central
banks have thus far purchased large amounts of Treasury securities,
Mr. Greenspan cautioned that they "may become less willing"
to continue that trend indefinitely.

On
the subject of high-paying jobs disappearing, leaving many Americans
able to find only low wages, Greenspan observed that the situation
"is very distressful to people." Continuing on the jobs
theme, he said:

"We
obviously look with great favor on the efficiencies that are occurring,
because at the end of the day that will elevate standards of living
of the American people. . . . It's only a slowdown in productivity
or an incredible and unexpected rise in economic growth from an
already high level that will create jobs."

This
high productivity and economic growth the chairman refers to is
nowhere to be seen today, and it wasn't visible in 2004, either,
when he made this statement. About one year later, Greenspan was
back. In February 2005, he talked about the trend in consumer spending
and savings:

"The
sizable gains in consumer spending of recent years have been accompanied
by a drop in the personal savings rate to an average of only 1 percent
over 2004 – a very low figure relative to the nearly 7 percent rate
averaged over the previous three decades."

But
is this bad news? It is a negative trend, but Mr. Greenspan explains:
"The rapid rise in home prices over the past several years
has provided households with considerable capital gains. . . Such
capital gains, largely realized through an increase in mortgage
debt on the home, do not increase the pool of national savings available
to finance new capital investment. But from the perspective of an
individual household, cash realized from capital gains has the same
spending power as cash from any other source."

Exactly!
That is the Fed policy. Translated to its most obvious form, Greenspan
is admitting the cultural attitude in America: a penny borrowed
is a penny earned.

Something
related to this that Greenspan did not address was the relationship
between consumer borrowing and GDP. He likes to make comments about
productivity like the one he offered in this same testimony: "Productivity
is notoriously difficult to predict. "But productivity itself
is not the issue related to the spending problem. As borrowing increases
as a percentage of GDP – up to more than 70 percent during
the 1980s – savings rates fall and continue falling. By the
end of the 1990s, borrowing had reached 90 percent of GDP. That's
where the real damage is being done. And in the middle of the very
same trend, nonfinancial business profits have been falling as well.

The
so-called U.S. expansion has been a nonexpansion. Corporate profits
fell in the 1980s from 5.1 percent of GDP down to 3.7 percent. By
definition, a profitless expansion is not really an expansion at
all. The bubble economy of the 1980s was the beginning of a worsening
effect in real numbers that built throughout the 1990s and beyond.

August
13, 2005

Addison
Wiggin [send
him mail] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century and the upcoming Empire
of Debt. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

~
George Washington, letter, April 7, 1799

If
the history of United States federal budgets – and the debts that
grow out of them – tells us anything, it is this: the dollar’s in
it up to its eyeballs. Today’s level of debt and continuing deficit
spending is only the visible portion of that problem; beneath the
surface we face an unavoidable day of reckoning for our great national
past-time: spending money.

Long
before Lord Keynes opened his mouth in the 30s, the attitude in
Washington, and among academics, has been that we don’t really have
to ever repay debt. It can be carried indefinitely for future generations
to worry about. Most people today would claim that debt “doesn’t
matter” or even that it is a wise policy to spend more than you
bring in. The mind boggles.

Early
on in U.S. history, Americans learned from British ancestors that
empires could be built on a foundation of debt – and continued indefinitely.
In the early part of the 18th century, Sir Robert Walpole introduced
an innovative system for financing Britain’s colonial expansion
and ever-growing military might.

Government,
Walpole demonstrated, is able to create a revenue stream by issuing
bonds and other debt instruments. The interest is paid regularly
and eventually, upon maturity, the face value is paid off – and
for every maturing bond, a new one is issued. This simple means
for the expansion of revenue through debt was the venue by which
Britain built its empire, from the 1720s through the next 100 years.
Among those who observed this phenomenon of “endless debt financing”
was the first Secretary of the Treasury of the United States, Alexander
Hamilton.

In
the early days of the American nation, a host of fiscal problems
faced Hamilton and the other Founders. The War for Independence
left a large debt; there was no unified currency and each state
issued its own money; the currency itself was of dubious value and
inflation made it difficult to imagine how the young nation would
even survive.

Hamilton’s
view was that growth and expansion would be possible with the use
of debt. “Hamilton’s rationale for a perpetual public debt included
his belief that it would help keep up taxes and preserve the collection
apparatus,” writes Scott Trask on the Mises.org site, “He believed
Americans inclined toward laziness and needed to be taxed to prod
them to work harder.”

Not
everyone agreed.

Thomas
Jefferson argued: “It was unjust and unrepublican for one generation
of a nation to encumber the next with the obligation to discharge
the debts of the first. After all, the following generation cannot
have given their consent to decisions made by their fathers, nor
will they have necessarily benefited from the deficit expenditures.”

During
the 19th century, American debt did not grow substantially. When
he began his presidential term, Jefferson had an $83 million debt,
mostly left over from the costs of the war. During his term, Jefferson
reduced the debt to $37 million even after spending $15 million
on the Louisiana Purchase.

In
Madison’s term of office, the ill-fated War of 1812 ran the national
debt up to $127 million by 1816. Monroe and John Quincy Adams were
both able to reduce the debt during their terms of office and by
1829 the debt had fallen to $58 million. And then, during Andrew
Jackson’s presidency, the national debt was entirely paid off. For
the first time in its history (and the last) the United States had
no national debt.

Over
the next decade, the country ran up $46 million in new debt and
by 1848 it rose to $63 million. However, in all fairness, one advantage
of this was that the Mexican War resulted in U.S. expansion all
the way to the Pacific and the acquisition of the entire southwest
and California. Under the Pierce administration, the debt was paid
down to $28 million; but it never got that low again.

The
Civil War exploded the national debt up to $2.8 billion, or 100
times higher than in had been in 1857. Per capita debt in 1860 was
$2 per capita; at the end of 1865, it was $75. The temporary tax
measures in place during the war were repealed and, by the end of
the 19th century, the debt had been reduced to $1.2 billion, less
than half of its 1865 level.

Given
the vast expansion of U.S. territory and the wars the country fought
to create and then hold together the United States, this does not
seem a large debt level. In fact, in its first 110 years of history,
the United States had shown its ability to fund expansion while
reducing debt over time. And this was accomplished without an income
tax. In fact, in 1869 and again in 1895, the Supreme Court ruled
federal income taxes unconstitutional.

The
story was quite different in the 20th century. By the end of World
War I, the national debt had risen to $26 billion. Even though the
debt level had been reduced over the next decade, the Great Depression
caused further deficit spending and FDR’s New Deal tripled debt
levels up to $72 billion.

World
War II created even higher debt levels. By 1945, the country owed
$260 billion – small by today’s standards, but gargantuan in its
time. But one outgrowth of that war was a new one, the Cold War.
Military spending took the national debt up to $930 billion by 1980
and under Reagan’s administration, in rose to a staggering $2.7
trillion. In Clinton’s eight years, the debt tripled to $6.9 trillion.
Estimates as of 2005 are that the debt will reach $10 trillion by
2008.

In
other words, the national debt is growing exponentially. We may
blame the War on Terror, the inheritance of the Cold War, or the
new international market and its competitive forces, or a combination
of these realities. In any event, it is clear that the levels of
debt reach new records, virtually on a month-to-month basis.

We
make a distinction in reviewing all of this history, between debt
levels and deficit spending. Many people are confused about the
differences here and some, even experts, use “debt” and “deficit”
interchangeably.

A
“debt” is the amount of money owed. A “deficit” is the shortfall
in a current budget. For example, if we begin the year with a $6
trillion national debt, and in the following year we spend $1 trillion
more than we bring in, we are running a deficit of $1 trillion.
At the end of the year, that deficit will increase the debt to $7
trillion.

Why
does the government need to spend more than it takes in? After all,
in most of the 19th century there were no income taxes (except during
the Civil War). And the debts the nation incurred were paid down
time and again. Even by 1900, the debt level was manageable…not
so today. And since 1980, the debt has exploded to levels that are
inconceivable.

If
a currency reflects a nation’s economic health, as the quaint classical
economists believed, the current bull run in the dollar is but a
correction in a long-term bear market and an opportunity to sell.

May
18, 2005

Addison
Wiggin [send
him mail] is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments.

What
could possibly interest us about a Chinese bureaucrat's white paper
on impending global war? First of all, his conclusion: "In
the last century," writes Wang Jian, "American people
were pioneers of system and technology innovation. However, the
interests of a few American financial monopolies now lead this country
to war. This is such a tragedy for the American people.

"Clouds
of war are gathering. Right now, the most important things to do
for China are:

1. Remain
   neutral between two military groups while insisting on an anti-war
   attitude.
2. Stock
   up in strategic reserves
3. Get ready
   for a short supply of oil
4. Strengthen
   armament power
5. Speed
   up economic integration with Japan, Hong Kong, Korea and Taiwan…"

It's
a rather unsettling idea. China as the neutral power in a war between
the United States and a united Europe. How did Wang get there? That's
the subject of the second part of the article, which we find intriguing…and
even more unnerving. Wang's view is disturbingly similar to our
own understanding of the way the global economy works.

"War
is the extension of politics and politics is the extension of economic
interests," Wang asserts. "America's wars abroad have
always had a clear goal; however, such goals were never made obvious
to the public. We need to see through the surface and reach the
essence of the matters. In other words, we need to figure out what
the fundamental economic interests of America are. Missing this
point, we would be misled by American government's shows and feints."

Wang's
argument in a nutshell: By the mid 1970s, the U.S., the U.K., France,
Germany, Italy, Japan and other major capitalist countries had completed
the industrialization process now underway in China. In 1971, when
Nixon closed the gold window, the Bretton Woods system collapsed,
and the dollar – the last major currency to be tethered to gold
– came unstuck. Economic growth as measured by GDP was no longer
restricted by the growth of material goods production. Toss in a
few financial innovations, like derivatives, and the "fictitious"
economy assumed the central role in the global monetary system.

"Money
transactions related to material goods production," writes
Wang, "counted 80% of the total [global] transactions until
1970. However, only 5 years after the collapse of the Bretton Woods
the ratio turned upside down — only 20% of money transactions were
related material goods production and circulation. The ratio dropped
to .7% in 1997."

As
we note in our book, since Greenspan assumed the central role at
the most powerful central bank in the world, he has expanded the
money supply more than all other Fed chairmen combined. From 1985–2000,
production of material goods in the U.S. has increased only 50%,
while the money supply has grown by a factor of 3. Money has been
growing more than six times as fast as the rate of goods production.
The results? Wang's research reveals that in 1997 – before
the top blew off in the U.S. stock market, mind you – global
"money" transactions totaled $600 trillion. Goods production
was a mere 1% of that.

"People
seem to take it for granted that financial values can be created
endlessly out of nowhere and pile up to the moon," our friend
Robert Prechter writes in his book, Conquer the Crash. "Turn
the direction around and mention that financial values can disappear
into nowhere and they insist that it isn't possible. u2018The money
has to go somewhere…It just moves from stocks to bonds to money
funds…it never goes away…For every buyer, there is a seller,
so the money just changes hands.' That is true of money, just as
it was all the way up, but it's not true of values, which changed
all the way up."

In
the fictitious economy, the values for paper assets are only derived
from the perceptions of the buyer and seller. A man may believe
he is worth a million dollars, because he holds stocks or bonds
generally agreed in the market to hold that value. When he presents
his net worth to a lender, a mortgage banker for example, and wishes
to use the financial assets as collateral for a loan, his million
dollars is now miraculously worth two. If the market drops, the
lender, now nervous about his own assets, calls in the note…and
the borrower once thought to be worth two million discovers he is
broke.

"The
dynamics of value expansion and contraction explain why a bear market
can bankrupt millions of people," Prechter explains. "When
the market turns down, [value expansion] goes into reverse. Only
a very few owners of a collapsing financial asset trade it for money
at 90 percent of peak value. Some others may get out at 80 percent,
50 percent or 30 percent of peak value. In each case, sellers are
simply transforming the remaining future value losses to someone
else."

As
we saw in the 2000–2002 bear market, in such situations, most
investors act as if they were deer caught in the headlights of a
speeding truck at night. They do nothing. And get stuck holding
financial assets at lower – or worse, non-existent – values.
Anyone suffering glances at their pension statements over the past
few years knows their prior "value" was a figment of their
imagination.

Back
to Wang: "In the era of fictitious capitalism, a fictitious
capital transaction itself can increase the u2018book value' of monetary
capital; therefore monetary capital no longer has to go through
material goods production before it returns to more monetary capital.
Capitalists no longer need to do the u2018painful' thing – material
goods production."

Real-life
owners of stocks, bonds, foreign currency and real estate have increasingly
taken advantage of historically low interest rates and applied for
mortgages backed by the value of these financial assets. Especially
since the rally began 8 months ago, they then turn around and trade
the new capital on the markets. "During this process,"
writes Wang, "the demand of money no longer comes from the
expansion of material goods production, instead it comes from the
inflation of capital price. The process repeats itself."

Derivatives
instruments, themselves a form of fictitious capital, help investors
bet on the direction of capital prices. And central banks, unfettered
by the tedious foundation set by the gold standard, can print as
much money as is required by the demands of the fictitious economy.
You can, of course, trade the marginal values of these fictitious
instruments and do quite well for yourself. [See: 22
Trading Rules For The Fictitious Economy.]

But
Wang sees a darker side to the equation. "Fictitious capital
is no more than a piece of paper, or an electric signal in a computer
disk. Theoretically, such capital cannot feed anyone no matter how
much its value increases in the marketplace. So why is it so enthusiastically
pursued by the major capitalist countries?"

The
reason, at least until recently, is that the “major capitalist countries”
have been using their fictitious capital to finance consumption
of "other countries'" material goods. Thus far, the most
major of the capitalist countries, the U.S., has been able to profit
from the system because since the establishment of the Bretton Woods
system, and increasingly since its demise, the world has balanced
its accounts in dollars.

"Until
now," writes Wang, "U.S. dollars [have counted] for 60–70%
in settlement transactions and currency reserves. However, before
the u2018fictitious capital' era, more exactly, before the fictitious
economy began inflating insanely in the 1990s, America could not
possibly capture surplus products from other countries on such a
large scale simply by taking advantage of the dollar's special status
in the world…Lured by the concept of the u2018new economy', international
capital flew into the American securities market and purchased American
capital, thus resulting in the great performance of U.S. dollar
and abnormal exuberance in the American security market."

And
here we arrive at the crux of Wang's argument that a war is brewing.
"While [fictitious capital] has been bringing to America economic
prosperity and hegemonic power over money," he suggests, "it
has its own inborn weakness. In order to sustain such prosperity
and hegemonic power, America has to keep unilateral inflow of international
capital to the American market…If America loses its hegemonic
power over money, its domestic consumption level will plunge 30–40%.
Such an outcome would be devastating for the U.S. economy. It could
be more harmful to the economy than the Great Depression of 1929
to 1933."

Japan's
example suggests, as your editors have oft reminded you, that a
collapse in asset values in a fictitious economy can adversely affect
the real economy for a long time.

In
the era of fictitious capital, Wang surmises, America must keep
its hegemonic power over money in order to keep feeding the enormous
yaw in its consumerist belly. Hegemonic power over money requires
that international capital keep flowing into the market from all
participating economies. Should the financial market collapse, the
economy would sink into depression.

America's
reigning financial monopolies, he believes, (whoever they may be),
would not stand for it.

December
6, 2003

Addison
Wiggin [send
him mail] is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century.