The Future of Gold
The historic wealth destruction of 2008 was obviously deflationary. Defaults strip away wealth. Institutions respond by selling assets to raise capital. Widespread deleveraging leads to supply expansion in assets and contraction in money and credit. Deflation.
Nevertheless, the response has been unprecedented in its own right. Government debt held by the public was $5.51 trillion when September began; by the end of 2008, it had risen to $6.37 trillion. The more than $1 trillion expansion in Treasury borrowing surely partially serves to offset the $438 billion budget deficit. But what about the additional half a trillion dollars?
On September 17, the Treasury announced the creation of the "Supplementary Financing Account" in the Federal Reserve. This is a capital reserve in the Fed financed by the Treasury selling new debt, but its excess capital is "trapped" and does not immediately reach currency in circulation. As of January 2, $259 billion is in this cash pool and $365 billion counting the Treasury's "General Account." The capital itself is money borrowed by the public, so its immediate net effect is deflationary.
On top of that, the Fed in an unprecedented gesture has started incentivizing excess bank-reserve deposits by issuing interest on these holdings, trapping liquidity. The Fed is essentially issuing debt, and banks are engaging in what amounts to a dollar-based Fed vs. interbank carry trade. Banks borrow money from the Fed, deposit it back into the Fed, and profit from the differential between the federal-funds and overnight rates. Less than $40 billion a year ago, the excess reserve deposits held by the Fed have ballooned to $860 billion. These deposits comprise another huge pool of excess liquidity on the Fed's balance sheet that doesn't immediately affect circulated currency.
Another Fed-induced cash trap has been in the form of increased reverse repurchase agreements, which are up to $88 billion. Reverse repurchase agreements are the offering of collateral in exchange for a cash loan. The Fed has utilized reverse repurchase agreements in its liquification of banks. It buys off toxic defaulting assets in exchange for cash and immediately reclaims the cash by selling the banks' T-bills. The Fed printed money to pay for these T-bills, so there is excess liquidity that is trapped in time-sensitive debt.
The Fed's risk transfer to the taxpayer is only worsened by its lack of transparency in doing so. The $2 trillion in lending is going to unknown places in exchange for unknown collateral. This leads me to believe the Fed has been busy buying up all of the toxic assets held by banks. This explains why it let the congressional bailout funds be used for equity purchases and not toxic debt. It hides the huge toxic-asset purchases — which it paid for with printed money — in its balance sheet's opacities. Bloomberg recently made a Freedom of Information Act request for details on bailout fund appropriations, but the Fed refused to comply and is being sued. This secrecy by the Fed in its appropriations of taxpayer money and the most-likely worthless collateral it exchanged it for represents inflationary risks the Fed is attempting to conceal.
The Fed's balance sheet suggests it has been cranking the printing presses like mad. Fed liabilities have expanded to $2.26 trillion, up over 140% since September. However, currency in circulation is up only 7% in that same time period. Where is this "trapped" $1.37 trillion? The answer is it's confined in temporary cash pools, whether in the Supplementary Financing Account or excess reserve deposits or in time-sensitive T-bills. The Federal Reserve seems to be sequestering all of this cash to buy time for the Treasury to finish its funding activities.
But who is going to keep funding this expansion of Treasury debt issuance? The American public is broke and cannot offer its capital in return for terrible yields. Foreign nations don't have the means or will to continue financing our debt. Commodity prices have collapsed, cutting deeply into foreigners' export revenues. Oil is down from highs around $150/barrel this past summer to around $40/barrel now.
In November, China announced a $585 billion economic stimulus package to be fully invested by the end of 2010. The Chinese government agreed to provide only $170 billion of the funds. How will China raise the other $415 billion for continuous use until the end of 2010? Surely, local governments and private banks and businesses can't finance such a large package in the midst of a historic recession.
The only reserve China can tap into to finance its stimulus package is its $1.9 trillion foreign exchange reserves, $585 billion of which is in US Treasury securities. Financing its stimulus package would require selling Treasury securities, but becoming a net seller of US debt could have disastrous economic, political, and even militaristic consequences for China, so it will be interesting to see how events unfold. What seems certain, however, is that China can no longer purchase more American debt to finance the US Treasury (and consequently the Fed).
This is a problem echoed by the rest of the big creditor nations. After China, the biggest holders of American debt securities are Japan, the United Kingdom, Caribbean banking centers, and OPEC nations. Japan is facing enormous headwinds as its quality-focused exports are suffering massive demand destruction as its consumers abroad lose wealth at epic proportions. Japan was a net seller of US Treasuries in 2008 and it is highly unlikely it will switch to being a net buyer anytime soon. The British demand for American debt represented Middle Eastern oil-financed investment, but with oil prices collapsing, it will be next to impossible for this proxy demand from the UK to rise and finance additional debt. The demand for US debt by Caribbean banking centers is because of their tax laws but as the credit crunch leads to liquidity destruction in Caribbean banks, these banking centers will no longer be able to buy additional debt. OPEC nations' US debt demand, similar to the UK's, is tied to Middle Eastern oil revenues financing American consumption (of their oil exports). As oil prices tank, so will OPEC nations' economies and they too will have no wealth to buy up more American debt.
Bernie Madoff is well recognized as the perpetrator of the biggest Ponzi scheme in history, at $50 billion. I beg to differ with that assessment. The United States has financed debt with debt since the late 1980s, when its external debt/GDP broke the 0 mark. Since then, it has risen to over 100% of its GDP (which in itself is quite artificially inflated because of manipulated hedonics-adjusted inflation figures), and now stands at $13 trillion. That is what's called a debt bubble. Bernie who?
But the debt bubble appears ready to collapse. The pyramid scheme is finally running out of investors, and many Treasury ETFs (like SHY, TLT, IEF, and IEI) are showing classic parabolic topping patterns and the next few weeks should confirm or deny my suspicions. Interest rates are at an obvious floor at zero, so there is nowhere to go but up. That means bond prices have nowhere to go but down, and the falling prices will cascade into more selling until the debt bubble deflates and all the spending is financed by quantitative easing. Judging by gold backwardation (discussed later) and the bearish charts on the bubbly debt ETFs, I think the debt monetization and dollar devaluation will begin within the next six weeks. The ProShares UltraShort Lehman 20+ Year Treasury Bond ETF (TBT) and ProShares UltraShort Lehman 7–10 Year Treasury Bond ETF (PST) are good ways to play this debt-market collapse.
With an insolvent public and no foreign demand for Treasuries, the Federal Reserve will monetize debt to finance its continued bailouts and economic stimulus. This is purely created capital pumped right into the system. This is not anything new for the Fed — for the past two decades, it has kept interest rates artificially low and created massive artificial wealth in the form of malinvestment and debt financing. In the past, the Fed has been able to funnel the inflationary effects of its expansionary monetary policy into equity values with its low rates, which discourage saving, causing bubble after bubble. The excess liquidity was soaked up by the stock market, which gave the appearance of economic growth. With inflation being funneled into equity and real estate over the last two decades, illusory wealth was created and the public remained oblivious to the inflationary risk and the great disparity between real returns and nominal.
Now that the "artificial-wealth bubble" of the past two decades is finally collapsing, one of two scenarios can occur: capital destruction or purchasing-power destruction. Capital destruction occurs when the monetary supply decreases as individuals and institutions sell assets to pay off debts and defaults and savings starts growing at the expense of consumption, otherwise known as deleveraging. This is deflation and the public immediately sees and feels its effect, as savings accounts, equity funds, and wages start declining. Deflation serves no benefit to the Federal Reserve, as declining prices spur positive-feedback panic selling and bank runs, and debt repayments in nominal terms under deflation cause real losses.
Purchasing-power destruction is much more desirable by the Fed. Its effects are "hidden" to a certain extent, as the public doesn't see any nominal losses and only feels wealth destruction in obscure price inflation. It breeds perceptions of illusionary strength rather than deflation's exaggerated weakness. The typical taxpayer will panic when his or her mutual fund goes down 20% but will probably not react to an expansion of monetary supply unless it reaches 1970s price-inflationary levels. In addition, the government can pay back its public debt with devalued nominal dollars, which transfers wealth from the taxpayers to the government to pay its debt. Inflation is essentially a regressive consumption tax, which the government wants and the Fed attempts to "hide." Not only is the Treasury's debt burden reduced but the government's tax revenues inherently increase.
The Fed, in an effort to minimize inflationary perception, has for the last two decades supported naked COMEX gold shorts to keep gold prices artificially low. The Fed, as well as European central banks, unconditionally supported these naked shorts to deflate prices and stave off inflationary perception, as gold prices stay artificially low. This caused gold shorts to be "guaranteed" eventual profit, by Western central banks offering huge artificial supply whenever necessary, causing long positions in gold to be wiped out by margin calls and losses.
Now that the economy is contracting, the Fed won't be able to funnel the excess liquidity into equities or other similar assets. It also can't allow the unprecedented excess liquidity of today to be directly injected into the economy, as that would be immediately very inflationary, with more than three times the money chasing the same amount of goods, technically leading to 300% price inflation. These figures are strictly based on monetization of the Fed's current liabilities, not including any future deficit spending (which is sure to dramatically increase, especially with Barack Obama's policies), the American external debt, or unfunded social programs that need payment as Baby Boomers retire.
In order to funnel the excess liquidity into a less harmful asset, the Fed appears to be abandoning its support for gold naked shorts, causing shorts to suffer their own margin calls and cause rapid price expansion in gold. On December 2, for the first time in history, gold reached backwardation. Gold is not an asset that is consumed but rather stored, so it is traditionally in what is called a contango market, meaning the price for future delivery is higher than the spot price (which is for immediate settlement). This is sensible because gold has a carrying cost, in the form of storage, insurance, and financing, which is reflected in the time premium for its futures. Backwardation is the opposite of contango, representing a situation in which the spot price is higher than the price for future delivery.
On December 2, COMEX spot prices for gold were 1.99% higher than December gold futures, which are for December 31 delivery. This is highly unusual and it provides strong evidence for the theory that the Fed is abandoning its support for gold shorts. Backwardation represents a perceived lack of supply (in this case, the artificial supply the Fed would always issue at strategic times no longer exists), causing investors to pay a premium for guaranteed delivery. I consider gold's backwardation as a leading indicator to a dramatic increase in prices. In fact, crude began its most recent backwardation in August 2007 at around $75/barrel and increased dramatically over the next nine months to $133/barrel at contango levels.
But why would the Fed abandon its support for naked COMEX shorts? The unique nature of gold and precious metals provides its desirability in this Fed operation. Gold has little utility except as a store of value, unlike most commodities (like oil, which is consumed as quickly as it's extracted and refined), so its supply/demand schedule has unusual traits. Most commodities and assets go down in price as the public loses capital, because the public has less to consume with and that is reflected in demand destruction that leads to price deflation. Gold is not directly consumed and has much less industrial use than most other commodities.
As a result, gold is relatively "recession-proof," as evidenced by its relative strength in 2008. Gold prices rose 1.7% last year, which is quite spectacular considering equity values went down 39.3%, real estate values went down 21.8%, and commodity prices went down 45.0% in the same period (as determined by the S&P 500, Case-Shiller Composite, and S&P Goldman Sachs Commodity Indices, respectively). Because gold is not easily influenced by consumer spending, highly inflationary gold prices don't do any direct damage to the public and are a good way to funnel excess liquidity without economic destruction.
Federal Reserve Chairman Ben Bernanke is a staunch proponent of devaluing the dollar against gold and is very supportive of President Franklin D. Roosevelt's decision to do so in 1934. In the past, manipulating gold prices to artificially low levels was beneficial because it prevented capital flight into a nonproductive asset like gold and kept production, investment, and consumption high (even if it was malinvestment and unfunded consumption).
Bernanke's continued active support for gold-price suppression would lead to widespread deflation that would collapse equity values and cause pervasive insolvencies and bankruptcies. Insolvency in insurers removes all emergency "backups" to irresponsible lending and spending, which would surely ruin the economy. Bernanke's plan seems to be to devalue the dollar against gold with huge monetary expansion, causing nominal equity values to rise. I've heard estimates of 7500 and 8000 in the Dow Jones Industrial Average as being minimum support levels that would cause insurers and banks to realize massive losses, causing widespread insolvencies in them and other weak sectors like commercial real estate that would irreversibly collapse the economy.
This gold-price expansion, set off by the massive short squeeze, will continue until gold prices reflect gold supply and Federal Reserve liabilities in circulation. The "intrinsic" value of gold today (called the Shadow Gold Price), calculated dividing total Fed liabilities by official gold holdings, is about $9,600/oz, compared to the actual spot price of around $850/oz today. This gold-price calculation essentially assumes dollar-gold convertibility, as is mandated by the US Constitution and was utilized at various periods of American history.
The US dollar's strength as the equity and commodity markets collapsed was due to deleveraging and an effect of the Fed's temporary sequestration of dollars, taking dollars out of supply. That is over. Oil seems to be putting in a bottom on strong volume, no one is left to buy any more negative real-yield securities the Treasury is issuing, and gold has started looking very bullish.
But a good speculator always considers all situations. Even if deflation is to occur, which I see as next to impossible, the price of gold should still rise to $1,500/oz levels next year, because it has shown relative strength as one of the most viable assets left to invest in. In addition, the short squeeze occurring in gold will provide substantial technical price expansion, even in the absence of dollar devaluation. A rise in nominal values in deflation represents an ever greater rise in real values, so I think gold's price ascent in real terms will be nearly identical in inflation or deflation.
I see the market breaking down from these levels to about the November lows, with commercial-real-estate stocks like Simon Property Group (SPG), Vornado Realty Trust (VNO), and Boston Property Group (BXP) leading the way, as well as retailers like Sears Holdings (SHLD). I recommend short positions (including leveraged bear ETFs) against these stocks for the very near term. If the market indeed breaks down but shows bouncing/strength around 7500–8000 in the Dow Jones, that would confirm to me that the Fed is able and willing to inflate its way out of this crisis and I will sell my bearish positions and buy into bullish gold positions.
Because in inflation the dollar is devalued, I am a proponent of owning bullion and avoiding gold ETFs, but I do believe gold and gold-miner stocks will provide great returns over the next few years. Royal Gold (RGLD), Iamgold (IAG), Jaguar Mining (JAG), Anglogold Ashanti (AU), Newmont Mining (NEM), Randgold (GOLD), Goldcorp (GG), and Barricks (ABX) are among my favorite gold equities at this early stage in the process.
I leave you with this, a quote from Fed Chairman Ben Bernanke about President Franklin D. Roosevelt's 1934 Gold Reserve Act, which was the greatest theft of wealth I'm aware of in American history:
The finding that leaving the gold standard was the key to recovery from the Great Depression was certainly confirmed by the U.S. experience. One of the first actions of President Roosevelt was to eliminate the constraint on U.S. monetary policy created by the gold standard, first by allowing the dollar to float and then by resetting its value at a significantly lower level … With the gold standard constraint removed and the banking system stabilized, the money supply and the price level began to rise. Between Roosevelt's coming to power in 1933 and the recession of 1937–38, the economy grew strongly.
My predictions: gold at $2,000/oz by the end of the year and $10,000/oz by 2012 and silver at $30/oz by the end of the year and $130/oz by 2012.
Robert Lucas's Strange Faith in Bernanke
Lately the Mises Daily may have given the impression that we just bash Paul Krugman. In the interest of balance, today I will cast aspersions on another Nobel laureate, the Chicago School economist Robert Lucas. As is typical among many "promarket" economists, the undeniably sharp Lucas inexplicably sees no problem with government price fixing when it comes to interest rates.
In his recent Wall Street Journal op-ed, Lucas writes,
The Federal Reserve's lowering of interest rates last Tuesday was welcome, but it was also received with skepticism. Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.
The present article is hardly the place to go into the debate over the Great Depression, but suffice it to say, Herbert Hoover's (and then FDR's) very conscious efforts to "maintain purchasing power" by preventing wage cuts was one major factor in turning the stock-market crash into a decade-long slump. (The fact that Hoover slapped on major tariff and income tax hikes didn't help, either.)
Lucas's view — namely, that the 1929 downturn would have been a run-of-the-mill depression, but the Fed's timidity turned it into the Great one — was popularized by Milton Friedman. It resonates well with free-market types, because after all, it blames the Depression not on laissez-faire capitalism, but instead on regulatory blunders.
However, as Matt Machaj argued in a previous Mises Daily, such rhetoric is difficult for a proponent of truly market-based money and banking to accept. Is it really government "intervention" if the Fed refrains from flooding the economy with more paper money?
Let me put it this way: if Lucas is right, and the Fed's "passive role" helps explain the genesis of the Great Depression, then what about all the little-d depressions that occurred in US history before the Fed was founded in 1913? Was the Fed even more passive in the 1930s than during its nonexistence the previous century?
But let us return to Lucas's article:
Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.
There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount — lend against — a wide variety of securities held by a variety of financial institutions….
This action has been the boldest exercise of the Fed's lender-of-last-resort function in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates.
Before analyzing this statement, let's make sure we see just how bold this Fed exercise has been. Below is a chart of total bank borrowings from the Fed, from 1919 to the present. (If you squint your eyes, you can see the slight uptick to which Lucas refers.)
Now people have rightly focused on the dangers such a massive infusion poses to the strength of the dollar. These fears are entirely justified. But I want to focus on the political aspects of the recent Fed behavior.
Let us parse Lucas's description: the infusion of some $600 billion in just a few months has come from Fed loans to banks, based upon collateral that no one in the market would accept at face value (literally). Lucas himself says,
Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.
What's this "we," Ke-mo Sah-bee? It is amazing how flippant Lucas is concerning these new developments. He can barely bring himself to admit that a $600 billion infusion of new money — which no private investor would be foolish enough to make — constitutes a bailout. Moreover, Bernanke's pledge to continue this pattern as "long as the situation dictates" sounds an awful lot like a blank check.
Lucas's touching innocence is illustrated even more so with his endorsement of Bernanke's policy:
It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities.
That last phrase in particular amused me. I confess I didn't actually try this, but I'm betting that if I emailed Mr. Bernanke and explained that my business was desperate for liquidity, he would inform me that I wasn't eligible for any of his generous loans.
I am not accusing Ben Bernanke of being anything more than a misguided academic. I believe his policies have been terrible during this crisis, but I am willing to attribute them to intellectual error. Be that as it may, he has opened Pandora's box. The precedent is now set for the Federal Reserve to make injections of hundreds of billions of dollars as it sees fit. In October, Barney Frank suddenly realized the awesome power that the Fed has held all of these years, according to this account:
"He [Bernanke] can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified. I asked the chairman if he had $85 billion to bestow in this way. He said, 'I have $800 billion.'"
Clearly unnerved after his exchange with Fed Chairman Ben Bernanke, Massachusetts Congressman Barney Frank, the chairman of the House Financial Services Committee, concluded that no one should have that kind of money to dispense as he sees fit.
Unfortunately, this realization will not lead to a return of the gold standard or (better yet) a complete return of money and banking to the market.
Rather, what will surely happen is that Congress will move to bring the Fed more closely under its control:
"He can't debase the currency at will! That's our job!"
The next few years are going to be very interesting. It is clichéd to say such things, but our country truly is moving through a revolutionary period. But I liked the Beatles song a lot better than Paulson and Bernanke's rendition.
World's Elite Visit Davos in Doubt
Leaders, CEOs Seek New Model at Forum, as IMF Prepares to Lower Growth Forecast
MARC CHAMPION
In the 38 years that business and political leaders have been trekking to the Swiss ski resort of Davos to talk about the world economy, the outlook hasn't been bleaker or global capitalism more racked with self-doubt.
World Economic Forum Executive Chairman and founder Klaus Schwab addresses a news conference in Cologny, near Geneva, Jan. 21.
Forty heads of state -- compared with 27 last year -- have signed up to attend the annual meeting of the World Economic Forum that begins Tuesday evening with two questions dominating: Just how bad will this global recession get? And what will provide the growth needed to end it?
The International Monetary Fund is recalculating its estimate of global growth and on Wednesday is likely to lower it to less than 1%, similar to what the World Bank estimated last month, according to people familiar with the IMF calculations. The IMF is refining its estimates in light of lower-than-anticipated growth figures last week from China.
"Why are we surprised all the time, almost weekly" by bad financial news, said Victor Halberstadt, professor of economics at Leiden University in the Netherlands and a veteran of the Davos event. "Do we really understand too little about the economy? I'm afraid the answer may be 'yes,' and that is why policy makers are going to Davos."
Davos could mark an opportunity to seek a new economic model, he and others say. "Everyone is at a loss, this is the start of a period of huge improvisation. There is no longer any best practice around to refer to," Mr. Halberstadt says.
Over the years, Davos has become as much a marketing event, where companies look for business and polish images, as the intimate brainstorming venue of the event's early years, when a few hundred executives attended.
Key Speakers at Davos
See an interactive schedule of events at the World Economic Forum.
The five-day confab, which has signed up about 2,500 participants, will be a more sober affair than usual, organizers say. There are fewer gimmicks -- such as scents pumped into session rooms last year by a high-profile perfumer -- fewer movie stars have been invited, and fewer lavish parties are being thrown by governments and companies. Goldman Sachs won't be holding its usual party this year. "In the current environment, we didn't think it was appropriate," says spokesman Lucas van Praag.
Still, more than 1,400 chief executives and chairmen of companies are making the trip despite the deep slump in corporate revenues and stock markets.
And Davos doesn't come cheap. The annual corporate membership required in order to send executives costs 42,500 Swiss francs ($36,768), plus 18,000 francs to attend the meeting, not including accommodations, according to a Forum spokesman.
There have been gatherings during other economic crises, in the 1980s and 1990s, that seemed severe at the time. But none was so global or open-ended, says Klaus Schwab, who founded the World Economic Forum in 1971 and runs it through a nonprofit organization.
"This is absolutely new in Davos. The only parallel would be in 2002, where people were similarly concerned about terrorism," he says, referring to the Forum meeting that followed the Sept. 11, 2001, attacks on the U.S.
This year, big government looks set to seize the Davos limelight from the banks, hedge funds and sovereign wealth funds that attracted attention in recent years. The reason for this change, economists say, is simple: The taxpayer now holds what money and power remain in an ailing global economy. Many big banks are on government life support and even state-controlled sovereign wealth funds aren't offering capital to struggling Western corporations.
"This may be the first Davos where capitalism is widely viewed as a failure, rather than something to be admired," says Ethan Kapstein, professor of economics and political science at French business school Insead, who has been going to Davos since 1994.
In a sign of the times, many of the financial elite present at past sessions won't be coming this year. Richard Fuld Jr., former CEO of Lehman Brothers Holdings Inc., which filed for bankruptcy in the fall, won't be back this year, according to the organizers. Nor will John Thain, former CEO of Merrill Lynch & Co., who was forced to resign by Merrill's new owner Bank of America last week. One point of contention was that he had scheduled a trip to Davos, even though Bank of America had signaled it wouldn't be a good idea for him to attend.
Citigroup Chief Executive Vikram Pandit and Lloyd Blankfein of Goldman Sachs have chosen to stay home, though they will send other executives. Sir Win Bischoff, Citi's chairman, is scheduled to come, but was told last week he is being replaced at Citi by former Time Warner Inc. CEO Richard Parsons.
B. Ramalinga Raju, former chairman of India's Satyam Computer Services Ltd., was to have been on a panel this year at the Forum, but instead is in jail, arrested in connection with a massive fraud. One banker scheduled to attend, Edgar de Picciotto, chairman of Union Bancaire Privée, lost big -- to the tune of $700 million -- for clients by investing in Bernard Madoff's alleged Ponzi scheme.
The U.S. is likely to be the subject of finger-pointing at Davos, as the country where the global financial crisis started. It is also the focus of most hopes for recovery. Yet the Obama administration is planning to send just one official, White House senior adviser Valerie Jarrett. Ms. Jarrett, a longtime friend of President Barack Obama, is subbing for Lawrence Summers, head of the National Economic Council, and National Security Adviser James Jones, who are remaining in Washington "to advise the president on the near-term issues he must address," according to an administration official.
The headline governmental names this year instead come from emerging markets. China's premier, Wen Jiabao, and Russian Prime Minister Vladimir Putin are to give speeches on Wednesday, at a time when their economies, too, are getting hit hard. Mr. Wen will be the first Chinese leader to go to Davos. The leaders of Japan, Germany and the U.K. speak later in the event.
"The capitalist myth is lovely and youthful. It kicked off the industrial revolution, but maybe we need a new one," says Richard Olivier, son of the late British actor Sir Laurence Olivier. Mr. Olivier, who owns a company that gives seminars, will give a dinner talk on business leadership at Davos, based on Shakespeare's tragedy Macbeth. The tale shows a heroic soldier turned bad, led to self-delusion by his own ambition and greed -- think Lehman Brothers, says Mr. Olivier.
German novelist Thomas Mann called Davos "the Magic Mountain" back when it was a center for tuberculosis cures. Whether people will find the medicine they are looking for at this meeting is doubtful. But Mr. Halberstadt believes it is a good sign politicians want to meet and talk informally at a moment when the globalized economy and its institutions will be under growing stress from protectionism and other threats, as governments respond to domestic pressures.
Amid the bad economic news, Mr. Schwab and others such as philanthropist and Microsoft Corp. Chairman Bill Gates will be pressing governments and CEOs to continue to address and fund other global challenges from climate change to dwindling water supplies to Third World disease. That, say Davos regulars, could prove to be a much tougher sell than a ticket to the Magic Mountain.
Bolivians Projected to Approve New Constitution
ANTONIO REGALADO
LA PAZ, Bolivia -- Bolivians approved a new constitution Sunday and handed a victory to populist President Evo Morales in his campaign to establish a new economic and political order in Latin America's poorest nation, preliminary results indicated.
Television stations reporting early vote counts projected voters had approved the constitution, 60% to 40%, in the national referendum. A simple majority is needed to approve the constitution.
Bolivian Voters Head to the Polls
![[SB123292429989713715]](http://s.wsj.net/public/resources/images/OB-CZ997_bolivo_D_20090125174928.jpg)
The result signaled continued support for Mr. Morales, an Aymara Indian elected in 2005 who has clashed with the U.S. over drug policy, recently expelled the U.S. ambassador, and faces stiff domestic opposition in Bolivia's eastern states.
But preliminary results didn't appear to indicate the overwhelming victory Mr. Morales's party wanted. The projected 60% support would be enough to prevent opposition leaders from contesting the results, but illustrates how the country remains sharply divided. The margin of victory appeared to be less than a recall election in August, which Mr. Morales won with 67% of the vote.
On a day in which liquor sales were banned and only official vehicles were allowed to circulate, Bolivia was calm and voting progressed largely without incident.
According to television reports, heavy support for the measure came from Bolivia's highlands, populated by poor, largely indigenous voters for whom the constitution promises greater economic inclusion and new legal protections.
"In our country there are 36 languages, and the new constitution takes us all into account. For the first time there will be justice for everyone, we are all included," said Apolonia Sanchez Miranda, an indigenous leader and a deputy in the ministry of justice.
In Bolivia's wealthier low-lying eastern states, which are threatened by Mr. Morales's efforts to redistribute farmland and natural-gas revenues, a large majority of voters rejected the constitution, according to preliminary results. That could translate into continued support for autonomy movements in those provinces.
Bolivia is split on ethnic and geographic lines, and in the months leading to the vote sporadic clashes between Mr. Morales's supporters and opposition groups left more than a dozen people dead.
On Sunday, Mr. Morales sought to strike a conciliatory tone, saying "I congratulate the opposition on their democratic attitude and for leaving violence aside."
The new constitution seeks to give the central government greater control over natural resources and "decolonize" the country by redistributing wealth and recognizing new rights for Bolivia's majority indigenous population.
It also will allow Mr. Morales to run for another five-year term in general elections planned for December.
Bolivian political analyst George Gray Molina said despite flaws, the document may be a step towards uniting the divided country.
"What most Bolivians want and what I think we need is a hybrid constitution that can juggle liberal democratic values and indigenous rights," which the new constitution does, he said.
The document was the result of a political compromise reached in October after an increase in violence raised fears the country was sliding toward civil war. It removed some provisions favored by Mr. Morales's supporters, such as a requirement that all public servants be able speak an indigenous language, such as Quechua, in addition to Spanish.
"What the October agreement did is that it avoided violence," said Mr. Molina. "The downside is that it kicked forward some of Bolivia's problems."
For instance, more than 100 new laws will be needed to implement the constitutional changes. Mr. Morales has said he would institute the laws by decree if congress doesn't pass them.
The constitution also calls for the election of judges, a feature critics say is likely to allow Mr. Morales's party, the Movement to Socialism, or MAS, to dominate posts and politicize the judiciary.
"I think they want a government where the MAS and Evo Morales are the controlling factor, and where they can carry out what they think are the desires of the Bolivian people," said Peter DeShazo, director of the Americas Program of the Center of Strategic and International Studies in Washington.
Mr. Morales, a former coca grower and union leader, has followed populist political strategies similar to those adopted by Venezuelan President Hugo Chávez.
In 2006, Mr. Morales nationalized Bolivia's natural-gas and oil producers, creating a windfall in government revenue that his government has used to fund social programs, including a monthly $28 stipend for the elderly poor.
Although such policies are politically popular, they risk backfiring if foreign investment drops as a result of greater nationalization.
On Friday, in a show of force apparently timed to influence Sunday's vote, Mr. Morales deployed troops to seize the Bolivian units of Argentina's Pan American Energy LLC, which the government said had failed to abide by nationalization rules.
Watch Out for Stimulus 'Leaks'
The architect of Kennedy's tax cuts would have been skeptical of the Obama plan.
GEORGE MELLOAN
In economics textbooks the "leaky bucket" principle holds that when government transfers income or wealth from rich to poor a lot leaks out and is wasted. Some estimates put the leakage at most of what is meant for the poor, especially if you measure the damage to economic efficiency from the reduced work incentives of both the donor and the recipient.
The leaky bucket metaphor was coined years ago by Arthur Okun, a Yale economist who advised John F. Kennedy and later became chief economic adviser to Lyndon B. Johnson. Okun was a leading architect of the Kennedy tax cuts, passed shortly after the president's death with salutary economic effects. Because those cuts sharply reduced the top marginal rates on income, Okun has been called the first supply-sider -- one who worked for Democratic presidents no less. In his day, he would have been called a classical economist.
Although Okun's rule focused specifically on "antipoverty" programs, it can be argued that nearly all government outlays are transfers. Money from taxpayers and the credit markets goes to uses chosen by Congress. Thus, the leaky bucket has special application now as Democrats grope for ways to use wealth transfers to revive the economy.
Even before Barack Obama's inauguration, the Democrat-controlled House crafted a record-breaking $825 billion program to "stimulate" the U.S. economy. One measure -- withholding less income tax from paychecks over the next two years -- is a Keynesian effort to restore consumer demand for goods and services by sweetening take-home pay. Its authors assume that this $140 billion tax break will work better than last spring's $152 billion tax rebate, which seems not to have worked at all, judging by the economic debacle in late 2008.
The central question, however, is not whether "stimulus" programs are ineffective. It is whether they are counterproductive. A case can be made that the bucket not only leaks but that the leaks tend to drown out chances for economic recovery.
Circumstantial evidence that "stimulus" packages actually delay recovery can be derived from the Keynes-guided New Deal of the 1930s, which put large faith in federal deficits as a Depression cure. Federal debt climbed to 43.86% of GDP in 1939 from 16.34% in 1929 with very little relief from hard times. Huge Keynesian deficits in the 1970s did not arrest stagflation. The misery index, combining inflation and unemployment, soared above 20%.
Of the $825 billion package not slated for tax credits, the lion's share will go to states and cities, ostensibly for such things as infrastructure repairs. But in reality it is a partial federalization of state and city budgets -- of particular benefit to New York, New Jersey and California -- that are in large pools of red ink with no prospect of climbing out without federal help. The "stimulus" is partly a matter of the political class in Washington looking after its own in the nation's state houses. One danger of federalization is that it will reduce competition among states to attract investment, thereby weakening another driver of economic efficiency.
The Troubled Asset Relief Program (TARP) was at least a government attempt to make amends for the damage Washington did to the financial sector through monetary mismanagement and the pollution of the mortgage market by Fannie Mae and Freddie Mac. The second tranche of the $700 billion TARP authorization has now been approved by the Senate. It, like the $825 billion stimulus plan, is attracting lobbyists like flies to honey.
The central defect of government bailouts and stimulus packages is that the money is allocated through a political process. It goes to recipients who have the most political influence. Private entrepreneurs and even big business, by contrast, employ investment to earn a profit. The record shows that the latter yields greater economic efficiency, and hence creates real jobs.
The new stimulus package pays lip service to aiding the private sector with various tax incentives for hiring and investing capital. It acknowledges, just barely, that the private sector will be the engine for recovery if recovery is to be had. But the record for such measures is about as dismal as the one for short-term supplements to consumer income. They do very little to change the decisions or behavior of the recipient. If the recipient is wary and uncertain about the future, he or she will probably remain so.
Socialist economies, where governments decide how to allocate resources, are notoriously less efficient than market-capitalist economies. As in Washington, every politician demands his share. The late Abram Bergson of Harvard, after prodigious research, concluded that the old Soviet Union -- the ultimate in socialism -- employed capital only about half as efficiently as the U.S. That is one reason the Soviets collapsed from economic exhaustion.
Democrats are putting a lot of faith, to the tune of over $1.5 trillion, in economic policies with dodgy track records. At this time of a new president and great expectations, one hopes the political class will succeed better with massive spending than it has in the past. But don't bet the farm.
Geithner Is Exactly Wrong on China Trade
The dollar-yuan link has been a great boon to world prosperity.
BRET SWANSON
Treasury Secretary-designate Tim Geithner's charge that China "manipulates" its currency proves only one thing. Three decades after Deng Xiaoping's capitalist rise, America's misunderstanding of China remains a key source of our own crisis and socialist tilt.
The new consensus is that America failed to react to the building trade deficit with China and the global "savings glut," which fueled our housing boom. A "passive" America allowed China to steal jobs from the U.S. while Americans binged with undervalued Chinese funny money.
This diagnosis is backwards. America did not underreact to the supposed Chinese threat. It overreacted. The problem wasn't "global imbalances" but a purposeful dollar imbalance. Our weak-dollar policy, intended to pump up U.S. manufacturing and close the trade gap, backfired. Currency chaos led to a $30 trillion global crash, an energy shock, bank and auto failures, and possibly a new big government era. For globalization and American innovation to survive, we must first understand the Chinese story and our own monetary mistakes.
We've heard the refrain: China's rapid growth was a mirage. China was stealing wealth by "manipulating" its currency. But in fact China's rise was based on dramatic decentralization and sound money.
After 500 years of inward looking stagnation, Deng opened 1979 with a bang. He freed 600 million peasants with history's largest tax cut. He emulated Hong Kong and Taiwan by establishing four Special Economic Zones on the sleepy southern coast. Before Beijing hard-liners knew it, mayors across China were demanding similar low-tax, local-control freedoms. By 1993, 8,000 of these of these entrepreneurial free trade zones had swept the nation. Two hundred fifty million people migrated to this "new China," where tax rates were low and regulations few. Capital poured in from China and the world.
Township and Village Enterprises (TVEs) were an unexpected but powerful innovation. Fiercely competitive and locally owned, these quasigovernment entities escaped Beijing taxation. Propelled by local knowledge and a zero corporate tax rate, the TVEs by 2000 accounted for half of China's output.
China needed an anchor for its complex transformation and in 1994 linked its currency, the yuan, to the U.S. dollar. The dollar-yuan link allowed a real price system to arise in China and created a single economic fabric stretching across the Pacific. Before long, the whole region had adopted what Stanford economist Ronald McKinnon calls the East Asian Dollar Standard.
The opposite of currency "manipulation," this dollar standard was a victory for free trade and global growth. But U.S. economists missed its portent. The Fed and Treasury of the late-1990s did not supply sufficient dollars to match rapidly growing global demand. A scarce dollar shot higher, and hard assets fell. Oil plummeted to $10 a barrel, gold fell to $250 from $400, credit shriveled, and dollar debtors across Asia went bankrupt. With an appreciating dollar and a world in turmoil, capital flooded into the U.S. and especially our soft, intellectual assets -- Cisco, Microsoft and dot-coms. The technology boom and bust was not a function of easy money but a scarce dollar.
In 2003, Alan Greenspan and Ben Bernanke identified an exotic threat: deflation. The Fed was seven years late. Mr. Greenspan's post-9/11 liquidity had already ended the 1997-2001 deflation. Yet the Fed persisted with 1% interest rates through 2003-04 and easy money thereafter. Meanwhile, Treasury Secretary John Snow targeted China and its trade surplus as a big threat. He and his successor Hank Paulson agitated for a stronger yuan and thus a weaker dollar.
Treasury's trade-deficit mania encouraged anti-China politicians. Messrs. Snow, Greenspan, Paulson and Bernanke several times talked Sens. Chuck Schumer and Lindsay Graham off the protectionist precipice. But the administration did not realize that the weak-dollar policy was itself protectionism.
China was imparting deep changes on the world economy. Yet in 2003 U.S. manufacturing was 50% larger than in 1994. U.S. knowledge industries were generating most of the world's profits and wealth. American consumers were benefiting from low-cost imports. Meanwhile, many Asian goods were rerouted through China for final assembly. The U.S.-China trade deficit thus grew even as the total portion of U.S. imports from East Asia fell below 35% from 40% in 1990.
The real threat was a devalued dollar. In mid-2005, we finally forced China to delink from the dollar and mildly appreciate the yuan. Nevertheless, the trade deficit accelerated. Robert Mundell -- Nobel laureate, China expert, father of the euro and supply-side economics -- continued to warn that the trade deficit was perfectly natural. Worry about currency instability instead.
But other eminent economists urged a "more competitive dollar." On May 13, 2006, this newspaper headlined: "U.S. Goes Along With Dollar's Fall to Ease Trade Gap." All these "more competitive" dollars had to go somewhere, and with amazing efficiency found their way into oil and subprime mortgages.
The weak dollar had the opposite of its intended effect. Cheap-dollar commodities exploded the trade gap. Conceived to make the U.S. "more competitive," the policy channeled money away from technology innovators and into home-building and home-equity consumption. Inflation for a time does pump up demand, and so U.S. consumers bought, and Chinese growth shot even higher. Chinese, Russian and Middle Eastern foreign reserves grew, further depressing the yields of U.S. Treasurys.
Some credit indicators are now improving, but the Fed's past destabilization policy will reverberate. The weak-dollar blunder helped scuttle the Doha Round of trade talks and will make the successful Bush tax cuts difficult to preserve. American interventionism could absolve Europe's anti-innovation "antitrust" policy and excuse China's worst intellectual property violations and "national champion" subsidies.
And yet, with sound-money advocate Paul Volcker in the Obama White House and Mr. Mundell plugged into Beijing, the monetary mayhem of the last decade could give way to a worldwide, sound-money revival in 2009 and beyond.
Mr. Swanson is a senior fellow and director of the Center for Global Innovation at the Progress & Freedom Foundation.
Drug Gangs Have Mexico on the Ropes
Law enforcement south of the border is badly outgunned.
A murder in the Mexican state of Chihuahua last week horrified even hardened crime stoppers. Police Commander Martin Castro's head was severed and left in an ice cooler in front of the police station in the town of Praxedis with a calling card from the Sinoloa drug cartel.
According to Mexico's attorney general, 6,616 people died in drug-trafficking violence in Mexico last year. A high percentage of those killed were themselves criminals, but many law enforcement agents battling organized crime were also murdered. The carnage continues. For the first 22 days of this year the body count is 354.
President Felipe Calderón began an assault on organized crime shortly after he took office in December 2006. It soon became apparent that the cartels would stop at nothing to preserve their operations, and that a state commitment to confrontation meant that violence would escalate.
As bad as the violence is, it could get worse, and it is becoming clear that the U.S. faces contagion. In recent months, several important American voices have raised concerns about the risks north of the border. This means there is hope that the U.S. may begin to recognize the connection between American demand for prohibited substances and the rising instability in Mexico.
The brutality of the traffickers is imponderable for most Americans. Commander Castro was not the first Mexican to be beheaded. It is an increasingly popular terror tactic. Last month, eight soldiers and a state police chief were found decapitated in the state of Guerrero.
The Americas in the News
Get the latest information in Spanish from The Wall Street Journal's Americas page.
There is also plenty of old-fashioned mob violence. As Agence France Presse reported on Jan. 19 from Chihuahua, 16 others -- besides Commander Castro -- died in suspected drug-related violence across the state the same night. Six bodies were found, with bullet wounds and evidence of torture, in the state capital. Five of the dead were police officers. On the same day, Reuters reported that Mexican vigilante groups appear to be striking back at the cartels.
Tally all this up and what you get is Mexico on the edge of chaos, and a mess that could easily bleed across the border. The U.S. Joint Forces Command in Norfolk, Va., warned recently that an unstable Mexico "could represent a homeland security problem of immense proportions to the United States." In a report titled "Joint Operating Environment 2008," the Command singles out Mexico and Pakistan as potentially failing states. Both "bear consideration for a rapid and sudden collapse . . . . The Mexican possibility may seem less likely, but the government, its politicians, police, and judicial infrastructure are all under sustained assault and pressure by criminal gangs and drug cartels."
The National Drug Threat Assessment for 2009 says that Mexican drug-trafficking organizations now "control most of the U.S. drug market," with distribution capabilities in 230 U.S. cities. The cartels also "maintain cross border communication centers" that use "voice over Internet Protocol, satellite technology (broadband satellite instant messaging), encrypted messaging, cell phone technology, two-way radios, scanner devices, and text messaging, to communicate with members" and even "high-frequency radios with encryption and rolling codes to communicate during cross-border operations."
A report by retired Gen. Barry McCaffrey, the former drug czar, makes similar observations. "The malignancy of drug criminality," he writes, "stretches throughout the U.S. in more than 295 cities." Gen. McCaffrey visited Mexico in December.
Here is how he sees the fight: "The outgunned Mexican law enforcement authorities face armed criminal attacks from platoon-sized units employing night vision goggles, electronic intercept collection, encrypted communications, fairly sophisticated information operations, sea-going submersibles, helicopters and modern transport aviation, automatic weapons, RPG's, Anti-Tank 66 mm rockets, mines and booby traps, heavy machine guns, 50 cal sniper rifles, massive use of military hand grenades, and the most modern models of 40mm grenade machine guns."
How is it that these gangsters are so powerful? Easy. As Gen. McCaffrey notes, Mexico produces an estimated eight metric tons of heroin a year and 10,000 metric tons of marijuana. He also points out that "90% of all U.S. cocaine transits Mexico" and Mexico is "the dominant source of methamphetamine production for the U.S." The drug cartels earn more than $25 billion a year and "repatriate more than $10 billion a year in bulk cash into Mexico from the U.S."
To put it another way, if Mexico is at risk of becoming a failed state, look no further than the large price premium the cartels get for peddling prohibited substances to Americans.
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