the Dynamist

Maybe Ron Paul is on to Something

So the bailout bill fails, and everybody freaks out.  There is pretty good reason to freak out.  Our whole system is built upon a mountain of credit, much of it short-term credit, so when the mountain gives way, the whole edifce comes crashing down.  Fair enough.  The government needs to "do something".

Something else is bothering me though.  What kind of system do we have, if that system is subject to collapse if it doesn't receive a $700 billion injection from the federal government?

Maybe Ron Paul is right to bang on about our monetary policy that is designed to promote ever-increasing levels of leverage, currency inflation and trade deficits.  Oh yeah, and our fiscal policy that perpetually runs big deficits and seems so manifestly corrupt.  How did things get so unstable?

It's not just the "anything goes", laissez-faire regulatory regime of the Bush Adminsitration that got us here.  While the extremely loose financial market regulation of the last 7 years brought everything to a head, it was an endpoint we were destined to reach all along.  This process didn't start in 2000 and it didn't start in 1980.  It started back in the late 1800s and became the dominant system in the 1930s.

Our current economic system is based on three basic principles: (1) the promotion of inflation; (2) the promotion of consumption and homeownership and (3) relatively open immigration.  This economic system has been traditionally promoted by southern and western states, first by the Democratic Party, then by both parties.

Much of the current government edifce is built to promote inflation, consumption and homeownership while discouraging deflation and savings.  The federal reserve, the progressive income tax, Fannie Mae and Freddie Mac, Social Security, deficit spending, the abandonment of the gold standard, Medicare, the mortgage interest deduction, homestead laws, unionism, high estate tax rates, generous public pensions, low tariffs, loose bankruptcy laws, the interstate highway system, the earned income tax credit, etc.: all are designed to promote inflation, redistribute income to promote consumption and/or stimulate consumer borrowing for homeownership and consumption. Also, think about what happens every time we have an economic downturn...the Fed lowers rates to try to encourage people to borrow against their houses and/or the government sends out rebate checks for consumers to spend.

None of these things are bad, per se.  They've just been building up over the past 70 years and have been taken as far as they can go.  The American consumer is as leveraged as he or she can possibly get.  The US government has some scope to borrow more, but not that much scope.  Clearly the US financial system is overleveraged and needs to retrench.  The US balance of payments has been running a deficit for most of the last 30 years, so it's probably not advisable to increase our borrowing from abroad, either.

On the other hand, US businesses are actually in good shape and are the most competitive in the world.  We should be actively encouraging more business and production to be conducted in the United States.

[It should also be noted that I acknowledge that the old Republican system of high tariffs, restricted immigration and the gold standard collapsed in the 1930s when it, too, was taken too far.  These systems tend to have about 70 years in the sun before they collapse.]

What should a new system look like?  It should promote savings, investment, technological innovation and exports.

• The tax code should be used to encouraged savings, perhaps moving to a progressive consumption tax
• Low corporate tax rates and generous deductions for capital expenditures to encourage production in the US
• Financial regulations that target the leverage of financial companies
• Remove the full employment mandate from monetary policy a set an inflation target or price rule
• Currency policy that targets a stable dollar relative to other currencies and limits big swings in international capital flows
• Federally-supported investment in internal improvements, particularly our transportation, communications and energy infrastructure
• Funding for high-tech, health, space and military research
• Encourage more defense spending by our allies and sell them high-tech military equipment
• Scale back on US defense spending, consider a more limited direct role for the US military
• Scale back the home mortgage interest deduction and/or eliminate Fannie Mae and Freddie Mac
• Bring the estate tax down to a non-confiscatory level
• Make Social Security needs-based and potentially cut the payroll tax
• Promote skills training and certification throughout a worker's lifetime as part of the social security and/or unemployment insurance program
• Have a health system based on either consumer-purchased insurance or government-provided insurance and remove that burden from employers

So I'm basically saying we should have a progressive, more globalist version of Ron Paul's program of sound money, less debt, and low taxes.

Long term opportunities abound

I am a believer in long cycles. As part of that framwork, I believe we are in the bottoming phase of the long cycle that arose out of the Great Depression.  The changes that are happening today in the economy are not of the cyclical nature, they are of the secular nature.  We are in the midst of the final collapse and restructuring of the old "mass market" economy.  In its place, the "new economy", or what I call the "mass customization" economy, will take control.

As the tide of consumer credit that has been building since the New Deal in the 1930s washes away, so does consumer demand, leaving the industries that benefitted from that credit creation awash in excess capacity.  There are additional old economy industries that are seeing consumer tastes or technological advances leave them behind.  A list of industries with excess capacity is below:

Industries with excess capacity

Commercial and residential real estate, homebuilding, appliances, autos, retail, consumer lending, broker/dealers, airlines, media, land line telephony, pharmaceuticals, fast food

That said, there are several sectors that are dealing with capacity shortages:

Industries with capacity shortages

Data centers, developing market infrastructure, railroads, mass transit, electricity generation/transmission, oil production/refining, LNG transportation/storage, financial advisory, wireless network capacity, biotech, organic foods

Mostly, the list of industries with capacity shortages are those that require investment to complete the modernization of the old communications, energy and transportation networks. 

Given the economic shift, there should be investment opportunities in the following sectors:

Long term investment opportunities

Electrical equipment, smart grid technology, mobile platform developers, capital goods manufacturers, steel and basic materials manufacturers, very light jets, carbon fiber manufacturers, ETF providers, private equity, retail financial advisors, financial services software, software-as-a-service, solar panel developers/manufacturers, organic food packagers/distributors, railroad equipment manufacturers, wireless towers, oil field services/equipment, LNG shipping, oil & gas pipelines, machine-to-machine communications, seafood farming, developing market consumer goods companies, next gen battery developers, home automation, biotechnology

I could keep going.  The point is, there are a ton of sectors that have terrific long term prospects, and the United States is well positioned to lead in most of them.  The current crisis will pass and yield to better times, as it always does.

Am I the prophet of doom?

Investing Watch:  While my long term view is that the United States economy is actually in a much better competitive position than people give it credit for, I appear to be on a roll with my doomsday predictions.  First Bear Stearns, then the "conservatorship" of Fannie Mae and Freddie Mac, I've referred several times to the eventual demise of Lehman Brothers, and I poked fun at the business model of Merrill Lynch.  As of now it looks like Lehman Brothers will be liquidated and Merrill Lynch is getting swept up into the arms of Bank of America.  The shrinking of capacity in the financial services industry continues and will continue, I'm sure.  I had no idea, for example, that the venerable AIG was in trouble.  We will also get to watch the drama of what happens to Washington Mutual.  Perhaps even Morgan Stanley will lose its independence someday.

Beyond the specifics of who blows up, the important question is what it means for us regular folk.  The process of deleveraging is called deflation.  You can have deflation fast, like the great financial panics of the 1800s and early 1930s.  You can have deflation slow, like Japan for the last 15 years.  Or you can have hyperinflation, like Germany in the 1920s, where the government prints away the debt.

Given that the Treasury and Fed have been pretty adept at handling the crisis by engaging in the lender-of-last-resort role, it is unlikely that we will have deflation fast.  And given the dollar's key role in the financial system, the US government has too much to lose geopolitically to rapidly inflate away our debts.  Thus, we will likely have deflation slow.

The gears of credit creation will have a hard time catching as the system goes through deleveraging, restructuring, and changing regulations.  Overleveraged consumers and baby boomers facing dim retirement prospects will save more and work later in life.  Consumption as a share of GDP will have to decline.  The US may even start running persistent trade surpluses.

And so after the deluge, the mailaise.  We'll probably spend years griding sideways, with financial market participants dying of boredom and many drifting off the work in other sectors of the economy.  The debt load of the American consumer will gradually abate.  And sometime next decade, the US economy will be ready for rebirth and prosperity will return.

Just don't hold your breath.

Both candidates are wrong about Afghanistan

Policy Watch:  The election of Barack Obama vs. John McCain is ostensibly between two moderates, although on domestic policy I would define Obama as a classic liberal with a moderate temperament and McCain as more unorthodox than either moderate, liberal or conservative.

On foreign policy, however, McCain's instincts come across as a belligerent Wilsonian, what used to be known as a "liberal hawk" but is now known as a "neoconservative".  Obama pays lip service to the "realist" foreign policy of George HW Bush (from the traditonally conservative camp), talks tough about surging troops into Afghanistan and potentially invading nuclear-armed Pakistan, yet otherwise reminds me of Jimmy Carter. 

In terms of the sweep of American history since World War II, it's actually kind of a weird choice to have to make.  The current president Bush, while generally viewed as a extremist warmonger due to the invasion of Iraq, is actually more of a moderate than either McCain or Obama appear to be, if you look at his administration's foreign policy in toto (not their talk, but their actions). 

This is not a political blog, and I certainly don't want to get involved in a fight about the Bush administration.  I do, however, care about geopolitics and its effect on our national interests and the world trading and security system.  I feel compelled to point out that much of the Sturm und Drang surrounding the foreign policy debate in the 2008 election is divorced from reality.  On the two big foreign policy issues of the election the two candidates will end up having the exact same policy.

The first is the War in Iraq.  They will both end up with the same policy in Iraq because we have won the war.  McCain won't admit we've won, because he wants to use it to paint Obama as a wimp.  Obama won't admit we've won, because half his base wants us to lose to prove George Bush wrong.  It's example A of the classic baby boomer polarization that Obama deplores on the stump, and he's right to, but on this one he won't overcome it because opposition to the War in Iraq was the original thrust of his candidacy against Hillary Clinton.  Either way, US troop levels in Iraq will come down dramatically over the next two years and both candidates will leave a remnant force like we have in South Korea.

The second is the War in Afghanistan.  Both candidates want to surge more troops into Afghanistan to build up its democracy and fully defeat the remnants of the Taliban.  On this point I think both candidates are wrong.

I am one of those strange ducks that supported the War in Iraq and is ho-hum about the "Good War" in Afghanistan.  I looked at Iraq as important geopolitically, but fell more into the Joe Biden camp of overthrowing Saddam and then carving the country into three states.  I was less concerned about building a democracy there, but felt that the best chance of doing so lay in creating three mostly ethnically homogeneous states.  I understood the geopolitical logic of keeping the country intact to avoid the Shiite south becoming a vassal state of Iran, but felt that the risk/reward was less favorable than breaking the country up.

I am not a big believer in the viability of democracies in multi-ethnic nation states whose borders were drawn by european powers.  If you look at most of the hotspots since the end of the Cold War (Yugoslavia, the Caucuses, Iraq, Lebanon, Afghanistan, Sudan, most African countries and, potentially soon, Pakistan) they all have borders drawn by western powers, usually designed to factionalize the internal population so their imperial masters could play them off one another.

Afghanistan, in fact, is only a country because it is the area that couldn't be conquered by the British or Russians during the "Great Game" era of the 1800s.  Within its borders are Pashtuns (the largest ethnic group), Hazeris, Tajiks, Uzbeks, Balochis and Turkmens, among others.  There are no actual "Afghans", other than in a we-get-to-send-a-delegation-to-the-United Nations sense.  The Taliban came from the Pashtuns in the south of the country.  Our allies in the overthrow of the Taliban, the Northern Alliance, consisted of non-Pashtuns in the north. 

No offense to the citizens of Afghanistan, but it is also one of the most backward countries in the world.  I can't quite understand why people think it is a waste of time to nation-build in Iraq, a relatively advanced country with the potential to be quite weathy, but are excited to do so in Afghanistan, a mountainous and rugged country that resisted the British, czarist Russia and the Soviet Union, all of which tried alot harder to subdue the country than NATO ever would.

Our national interest in Afghanistan lies only with keeping the remaining al Qaeda terrorists in the region off-balance enough that they can't operate with impunity and plan attacks.  Right now, even though some of them are alive, the old al Qaeda hierarchy in Afghanistan and Pakistan has been heavily degraded.  It would be easier to plot and execute an attack on the US from Germany than from Afghanistan, and neither would be very easy.  If the goal is to co-opt the Pashtun into politcs, then perhaps carve out a separate Pashtunistan in the south with its capital in Kandahar, and leave the remaining grab bag as "Afghanistan" in the north, with its capital in Kabul.  Sure, the Taliban might come back to power, but if they are forced to actually govern and don't have the excuse of needing to fight the Northern Alliance, they are far more likely to be internally-focused rather than wasting their time thinking about plotting attacks on the US, halfway around the world.  Besides, the Bush Doctrine would remain operative...start allowing terrorists sanctuary again, and you will get punished.

Anyway, it appears as if we are going to spend more blood and treasure in this quest and there is going to be little debate about it.  The Democrats want to prove that Bush was wrong to divert the War on Terror into Iraq, and McCain just seems to always be itching for a fight.  By defining the mission up, we are decreasing the odds of success while diverting spare resources from potentially more important uses. 

Like positioning to prevent Russia from retaking Georgia and the Ukraine, for example.  Or a tax cut.

Two good recent essays on the subject:

Bartle Breese Bull writing an opinion piece in the New York Times; and

Leon Hadar in The American Conservative.