Lawson for Congress

For those who study our financial system, the past few weeks have been interesting, and concerning. I don’t know if it’s possible to overstate my concern for our future — both as citizens as the United States of America, and as inhabitants of a world that is increasingly interconnected yet dependent on a fundamentally flawed financial and monetary system.

If asked to pick one word to describe why I’m running for Congress, that word is sustainability. Sustainability doesn’t mean stability, it doesn’t mean safety, and it doesn’t mean protection from life’s inevitable uncertainties. Sustainability does mean recognizing and obeying the natural laws that govern of our world.

Every branch of science has certain laws: Objects in motion tend to stay in motion; force equals mass times acceleration; every action has an equal and opposite reaction; energy in a closed system cannot be created or destroyed but merely changed in form; and closed systems tend towards increased entropy are a few good examples.

These laws of motion and conservation of energy are not limited to high school physics class. Every system in nature must obey these underlying principles — including our financial and monetary systems.

Let’s start with Newton’s laws of motion — it’s a short hop from there to defining leverage as the ability to move a large object a short distance using a small force exerted over a long distance. Leverage is a concept in finance, as well — using borrowed money to increase returns based upon small underlying price movements. Just as the car lifted with a hydraulic jack can hurt you if it falls, a small price movement in an imprudently leveraged investment can wipe out a lifetime of savings.

Next consider conservation of energy and open versus closed systems. Since energy within a closed system cannot be created or destroyed, and since closed systems tend towards increasing entropy, every growing system must be open to an external energy source. In this setting, one can immediately see problems with our debt-based monetary system.

What is debt-based monetary system? It’s where money is debt, and every dollar in circulation exists because a bank created it out of nothing based upon someone’s promise to pay it back, with interest.

Our economy is an open system relative to money, which is created and destroyed by banks. Banks create the money through loans — but they only create the amount you borrow. They don’t create the interest that you also promise to repay. Where do you get the interest? You have to earn it, but first it has to be created — yes, by someone else borrowing more money that they promise to repay with still more interest.

In the end, our monetary system is like a game of musical chairs — the banks create money based upon someone’s willingness to borrow, and the bank’s ability to lend. The constant demand for new money to repay interest on existing money compels growth and new money creation at an accelerating rate.

Refer to the chart of America’s total debt, which raises obvious questions about sustainability. Trees do not grow to the sky — and when banks cannot lend, or people are no longer willing to borrow, the music stops. When the music stops, there are more loans outstanding than money to repay, so everyone left standing loses whatever they pledged in exchange for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the room.

Leverage, debt-based money, fractional reserve banking, and interest are fundamental features of our economic system. Our economic history of boom/bust cycles and decisions dominated by short-term gain as opposed to long-term stewardship are fundamental consequences of this underlying system. In short, our system has undesirable consequences and is fundamentally unstable — but it’s working as designed.

What we are experiencing today is a perfect storm of rising demand for natural resources in the setting of  global growth, a declining domestic currency due to decades of unsustainable debt (= money) creation and spending, coupled with an unfolding credit crisis that has crippled the debt (= money) creation system. What happens next?

I don’t know. Economists and analysts are searching for an analogy to our current position. Are we in the 1970s? Are we Japan in the 1990s? Are we entering the 1930s? Each situation is unique, and this one is no exception. There is evidence that we have experienced “peak credit“, and are popping a credit bubble that has been forming for over 20 years. That is reminiscent of Japan in the 1990s, or the 1930s. We’re also suffering from high energy prices, like the 1970s, although in this case we’re facing global tight supplies in the setting of rising demand.

Today’s news capped off several weeks of concerning developments. Illustrating the danger of leverage, our largest mortgage companies, Freddie Mac and Fannie Mae, are fighting rumors of insolvency:

The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt.

These companies funded 80% of the mortgages issued in the first half of 2008, and are thus almost fully responsible for supporting the housing market at its current levels. Ready to talk about leverage? In May, Fannie and Freddie had $83 billion in capital supporting over $5 trillion in debt and other obligations. That’s leverage — every dollar in debt is supported by less than two cents.

Here are some excellent commentaries on the dangers of these quasi-federal companies (read: we’re all going to take the hit) that inflate housing prices and define moral hazard:

Former St. Louis Fed President Poole Calls Freddie, Fannie “Insolvent”

Disaster Planning for Freddie and Fannie

Freddie and Fannie: Conservatorship as Endgame?

Fannie and Freddie Waterfalls Are Too Big to Bail

Fannie and Freddie are just the most recent problem to flare up, however. A contraction in the mortgage market was only the beginning — losses are spilling over throughout the economy. As Nouriel Roubini notes, total loss estimates from the credit crisis across all sectors of the economy are up to $1.6 trillion:

As I argued in writings last February such credit losses would be at least $1 trillion and could be as high as $2 trillion, well above the $300 billion of subprime writedowns that have been recognized so far. At that time the $1 trillion estimate was considered as lunatic but by now the IMF estimates these losses at $945 billion, George Magnus of UBS estimated them at $1 trillion; Goldman Sachs put them at $1.1 trillion, the legendary hedge fund manager John Paulson (who made last year $3.5 billion of income on shorting subprime) put them at $1.3 trillion; and a couple of days ago Bridgewater Associates estimated such losses at $1.6 trillion. Thus, as I argued then $1 trillion would be floor, not a ceiling, to such credit losses.

Of course such losses have been in part transferred from US banks to capital market investors and to foreign investors via securitization. But with the entire capital of the US financial system at $1.3 trillion such staggering losses will lead to a systemic banking crisis and systemic financial crisis. No wonder that Bernanke is now telling non-bank primary brokers that the Fed exceptional liquidity support (TAF, TSLF and especially PDCF) will be extended into 2009. And no wonder that Geithner, Paulson and Bernanke have now all three spoken of the need to find orderly ways to let even large and systemically important institutions go bankrupt if they are insolvent.

The consequences of this credit unwinding and a hard landing in the United States have damaging global consequences, as well. This article, again by Nouriel Roubini, outlines why the current international monetary regime known as Bretton Woods 2 could collapse in the wake of an expanding global credit crisis, and our current trade imbalances:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Every country is between a rock and a hard place:

By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: inflation is so high that only an abandonment of pegs or of heavily managed rates and a very sharp nominal exchange rate appreciation would be able to control inflation Even in that case nominal appreciation would not be enough to control expected inflation: a much tighter monetary and credit policy – that is feasible only if enough exchange rate flexibility is allowed – would be necessary to control actual and expected inflation. But now the global economic outlook has much worsened with the US recession and the sharp economic slowdown in most advanced economies. The need to control inflation with a stronger currency and much tighter monetary policy in emerging markets is happening at a time when downside risks to growth are emerging in these countries because of the US recession and the slowdown in the advanced economies growth rate. Thus, emerging market policy makers face a serious dilemma: controlling inflation requires exchange rate flexibility and much tighter monetary and credit policy. But such policy may exacerbate the growth landing of these economies at the time when global conditions are leading to a sharp slowdown of growth in advanced economies that – in due time – will slow down exports and growth of the emerging market economies.

Thus, it is not obvious that the members of BW2 will decide to phase out this regime and move to greater currency flexibility and tighter monetary and credit conditions. Rising oil, energy and food inflation in these economies is already leading to popular unrest, riots and – in some cases – ruling governments being toppled. Thus, the last thing that these economies need is a sharp growth slowdown on top of socially unpopular rising inflation. That is why – while the rational choice would be phasing out BW2, allow greater exchange rate flexibility, regain monetary autonomy, allow currencies to appreciate and tighten monetary/credit conditions – many of these BW2 may be reluctant to follow this painful policy path.

But again, these problems, consequences, and suboptimal “solutions” are simply the result of a suboptimal and unstable system working as designed.

Finally, we must consider these financial instabilities in a world where the fundamental life-giving resources such as food and energy are becoming increasingly precious:

Every Barrel Now Counts: What Prospects for More Oil Supplies?

IEA Medium-Term Outlook

While we complain about high food prices, other countries — some to whom we owe a great deal of money — are seeing riots and social unrest. The bottom line is that food and energy prices are not separate from this economic crisis. They are intimately related, for two reasons.

First, food and energy are fundamentally equivalent even beyond irrational corn ethanol subsidies. By some estimates, our unsustainable system of industrial agriculture requires 10 calories of fossil fuels for each one food calorie produced. What happens as fossil fuels become more expensive based upon growing global demand against finite supplies?

Second, many countries with food and fuel inflation high enough to spark riots and social unrest, and to whom we owe a lot of money, are keeping their currency artificially low against our dollar to stimulate exports. What happens if the pain of social unrest in China is great enough for them to abruptly let their currency float?

A rapid strengthening of China’s currency would reduce the value of their $1.4 trillion in dollar holdings. On the other hand, such a rapid appreciation would give them an instant discount on their dollar-denominated commodities such as fuel and fertilizer, and is the ultimate solution to their price inflation.  What would be the consequence for us, however, as high prices causing riots and social instability abroad transfer to our shores?

Mutually assured destruction did not end with the Cold War — our position in the global economy can also be described as mutually assured economic destruction.

We need principled leadership that recognizes the root causes behind the threats we face, and we need a government that empowers us to build a sustainable society. Such sustainability has not, and cannot, come from a federal government that consolidates power, exceeds its Constitutional authority, and serves corporate and special interests.

Critically, we must recognize that our economic, energy, environmental, and agricultural policies do not operate in isolation — they are all related, and they all exist on the foundation of an unstable monetary system that bring us to this precarious situation. We live in interesting times.

In Walt Whitman’s poem about Abraham Lincoln, O Captain! My Captain!, Lincoln is represented as the captain of a ship — the ship representing America. The poem details the struggles Lincoln endured as President, such as The Civil War, and how he guided the country through them as the “captain” (President) of our “ship” (country) until there was calm again.

Nearly 150 years later one must wonder what measure of drunken sailor is currently steering our ship at sea, or whether anyone has the wheel at all, when you consider the current state of our country, especially when it comes to the economy.

The reality is the entire “crew” currently steering our ship at sea has gotten into the rum and they’re steering us right into a fiscal hurricane. You might know the “crew” better by their more common name — Congress.

It became even more evident that they’re sailing us right into the path of a storm last week when the House of Representatives approved a nearly $150 billion dollar “stimulus package.” The Senate is expected to follow suit.

While the “stimulus package” will certainly come too late to stop top economists from setting off alarms that (and perhaps the reality that) we are already in a recession, one has to wonder if it will have any positive impact on the economy at all. And could it actually have a negative impact?

Shawn Tully, editor for Fortune Magazine, thinks so. In a recent article for Fortune he asks the question “will the cure be worse than the disease?” and makes the following point:

The wobbly economy is overtaking Iraq as the issue weighing most heavily on the minds of America’s voters. And Washington has noticed. The White House and Congress are almost certain to enact some kind of stimulus package. But like all such temporary, feel-good measures, it will generate a quick blip in growth that will quickly evaporate.

So if Mr. Tully is correct and the “stimulus package” will only “generate a quick blip in growth” and then “quickly evaporate” than is it worth it? And more importantly where do we get the $150 billion dollars? Since we’re running a deficit and we have a national debt we have two choices that can be likened to a choice between getting punched in the stomach or punched in the face: Borrow or print it.

If we choose to simply print the money we’ll further weaken our already weak dollar which will then trigger more inflation — just like what happens when the Fed cuts interest rates also in the name of “stimulating the economy.” Obviously this would be bad for the economy, or as Mr. Tully points out in his article:

Indeed, while the economy is sending mixed messages about growth, the signs of increasing inflation are flashing bright red. For 2007 the consumer price index rose 4.1%, the biggest annual increase in 17 years. Gold, historically a reliable harbinger of inflation, set an all-time high of more than $900 an ounce. The dollar is languishing at a record low against the euro and a weighted basket of international currencies. “Flooding the market with liquidity is a disaster for the purchasing power of the dollar,” says David Gitlitz, chief economist for Trend Macrolytics.

If we choose to borrow the money the obvious consequence will be a greater national debt, but there also hidden consequences as well. To understand these hidden consequences first let’s understand who we’d be most likely to borrow the bulk of the money from — China, our banker.

China is quickly emerging as a global military superpower and a couple years back the FBI and the Pentagon investigated whether Chinese spies had been hacking into U.S. government computer systems. Then, in June of last year, it was alleged that China’s military hacked the Pentagon’s computer network, an allegation that the Chinese government denied.

Whether true or not it’s hard not to see why this isn’t the best country to owe money, or in other words: O Banker! My Hacker!

When this is considered the hidden consequences of borrowing from them are revealed and they can be summed up in one sentence: our national security is weakened.

It’s also not hard to see why Shawn Tully asks “will the cure be worse than the disease?” when the ’swallow spiders to kill flies’ approaches — which will hurt the economy more in the long term in favor of short term gain by either increasing the national debt or further weakening the dollar and causing inflation — to the economy Congress and the Fed are taking are considered.

To this end, Congress treating an ailing economy with a $150 billion dollar “stimulus package” makes about as much sense as a doctor treating cancer with AIDS. We’ll either have to print the money and further undermine our currency at a time when New York City stores are putting up signs that they accept the stronger Euro almost as fast as other stores are putting up “out of business” signs and “for sale” signs are going up in front of foreclosed homes. Or we’ll have to borrow the money from countries like China, weakening our national security in the process and forcing future generations to pay the price of our unpaid bills.

In front of the Chinese with hat in hand on bended knee is no place for our children to end up.

Thomas Jefferson once said “timid men prefer the calm of despotism to the tempestuous sea of liberty.” The sea of liberty is, indeed, tempestuous, but at least there’s always a destination with calm seas ahead. We need a new crew in Washington made up of people like B.J. Lawson steering our ship at sea, one with a destination of liberty, and the current crew and their status quo needs to be made to walk the plank.

low for the U.S. dollar against the Chinese yuan:

China yuan central parity rate set at record 7.2566 to dollar vs 7.2672

I guess we’re celebrating… it’s the inevitable consequence of our twin deficits, the $9.2 trillion (yes, it’s now 9.2) national debt and over $800 billion current account deficit. When I was in China this summer, the rate was closer to 7.5 to 1.

So is this good news, or bad news? As with many things economic, you can’t really talk in terms of “good” and “bad”. It just is.

Imports from China are a bit more expensive. Chinese buyers will find our goods (and our companies, and commodities priced in dollars) a bit less expensive. Companies earning money in yuan will see their earnings grow based upon appreciation of the currency alone.

The self-correcting nature of trade and currency imbalances suggests that our currency will continue weakening as we try to reduce our deficits by repaying in “cheaper” dollars. At some point, we’ll be forced to again “work for a living” when a weaker currency makes goods and materials on the international market relatively more expensive.

But we’ll still be competing for our own raw materials and finished goods with consumers in a global market who have more valuable currency to spend. As a corollary, the U.S. consumer stands to lose its status as the privileged “consumption engine” of the global economy to the growing Asian (and especially Chinese) middle class. Watch your grocery bill, and your energy bill.

Wait, you mean we can’t thrive and prosper as a free country by issuing new government debt alone?

Lord Josiah Stemp, Director of the Bank of England, 1937:

“The modern banking process manufactures currency out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. If you want to be slaves of the bankers, and pay the cost of your own slavery, then let the banks create currency.”

To paraphrase the title of Rothbard’s classic book, the past few weeks in the markets illustrate the consequences of irrational and frankly treasonous fiscal, monetary, and economic policies. Our groceries have not been getting more expensive, our dollars are worth less. Gasoline is not more valuable, our dollars are less valuable. Our cost of living has not gone up, our salary is worth less.

A friend of mine sent me the following summary, which uses some great analogies. If we’ve not previously considered the importance of a sound currency, we’re getting a lesson right now:

The measuring stick (US $) is 40% shorter than it was 3 years ago. If one is using a shorter measuring stick then everything looks longer and higher as in the case of the stock market. The US has been losing ground vis-à-vis the rest of the world for about 17 years now, which is just after the Berlin Wall came down and most of the super cheap labor, in the often well-educated rest of the world, began to be a factor in the world economy.

Initially it was really good for the US because the cheap imports really kept inflation down. Then more companies began to move production off shore and more “creative destruction” ensued, but inflation & interest rates continued to drop in the ‘90s which is good for just about everything in the economy, especially the stock market and home prices. As more and more dollars were exported for more and more goods, emerging countries began to realize that the wealth transfer would inflate their own currencies and thus make their goods more expensive for their best customer (US) unless they invested those exported dollars back into our capital markets.

Their markets were not very well developed and so those emerging countries, especially in the Pacific Rim, were only too glad put their money back into our capital markets, which meant that their own currency had to be converted back into dollars. That wasn’t a bad deal for them because both our bond and stock markets were in super bull markets in the 90s, especially between late 1994 & 2000.

Now it is a different story, and for the last 4 to 7 years the various economic elements that are relevant have been in a state of flux. First the dot com & tech bubble burst, then we had 9-11, then the S&P went into the worst bear market since the 1970s, then the Fed was afraid of deflation so they dropped Fed Funds to 1%, which was lower than the rate of inflation and represented a negative interest rate.

Along about this time the dollar really began to drop. The S&P 500 was down 50% at its low in 2002 (that is the trading rule that will make you rich, or richer, whatever. Buy when a market is down 50%, just make sure that it will go back up before you do that though. <grins>) but with the 2002 midterm elections coming up everyone was focused on “growing the hell out of government.”

That is a euphemism for fighting terrorism through expansionary, but mostly worthless fiscal policy. Soooo, “Greenspasm” cut Fed Funds to 1%, Bush browbeat Congress into a tax cut, and Congress browbeat Bush into providing full employment though Homeland Security. They were all in a race to see who could stimulate the economy the fastest and the dollar lost big time.

Everyone I talked to about markets (3 people) knew that the dollar would tank and it did. The dollar was sacrificed at the altar of big government and political expediency. The stock market was propped up and made to look higher & better with the shorter measuring stick.

All of that cheap money shot housing prices through the roof in 2005. That was also one of the most predicted things that I have ever seen. Most people don’t think about what happens when an asset class can be leveraged at ten to one or more, like housing, but that kind of leverage plus loose money was one of the main things that led to the stock market crash in 1929 and the housing bubble may do something similar to the economy before it is over.

Meanwhile the dollar is on the back burner politically because only a small percentage of Americans realize or care that the wealth transfer to the rest of the world is on full burner, and many of those who know how to hedge or benefit from the dollar weakness.

The stock market may bounce for a while because it was pretty washed out at the close of trading today but there is a good chance during this quarter it will roll over into a bear market. It has not been totally confirmed yet, which is why it will probably bounce for a little while but I don’t see much of a chance that that it can avoid a major swoon in the first half of 2008. They will find a way, some way, any way to get it up going into the election but it will probably be from a much lower level than it is now. 2009, the first year of the new administration is traditionally the year when all of the built up economic pain is recognized by the politicians and the treatment will really need to be radical and harsh this time.

2009 could be an exceptionally bad year in the stock market.

A final word from Alan Greenspan in 1968:

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.

No equivocation there. I wonder what happened?

I just finished reading this fascinating commentary in the Wall Street Journal about why an American military presence is essential in the Persian Gulf, compliments of Mr. Walter Russell Mead of the Council on Foreign Relations. Here are some favorite quotes:

While U.S. import needs are projected to grow significantly, U.S. dependence on Persian Gulf energy is not, thanks largely to expected production increases in the Western Hemisphere and sub-Saharan Africa. U.S. energy imports from the Persian Gulf are expected to remain below 20% of total consumption. The oil market, of course, is global, and if something were to happen to the Middle Eastern supplies, prices would rise world-wide, and the U.S. economy would be seriously disrupted. But domestic supply is not the key to American interest in the Gulf.

OK, excellent. So we don’t need to be there to secure our domestic energy needs.

For the past few centuries, a global economic and political system has been slowly taking shape under first British and then American leadership. As a vital element of that system, the leading global power — with help from allies and other parties — maintains the security of world trade over the seas and air while also ensuring that international economic transactions take place in an orderly way. Thanks to the American umbrella, Germany, Japan, China, Korea and India do not need to maintain the military strength to project forces into the Middle East to defend their access to energy. Nor must each country’s navy protect the supertankers carrying oil and liquefied national gas (LNG).

Wait… so our soldiers and tax dollars are paying to secure energy supplies for Germany, Japan, China, Korea, and India? Does that make sense?

For this system to work, the Americans must prevent any power from dominating the Persian Gulf while retaining the ability to protect the safe passage of ships through its waters. The Soviets had to be kept out during the Cold War, and the security and independence of the oil sheikdoms had to be protected from ambitious Arab leaders like Egypt’s Gamal Abdel Nasser and Iraq’s Saddam Hussein.

Oh, I see. So it really is up to us. Since we’re the ones who helped put Saddam in power in the first place, we had to clean up that mess ourselves.

But wait — does anyone really believe that widespread piracy and looting of supertankers would prevail without a U.S. military presence? Would the oil companies, shipping companies, sellers, and buyers tolerate such chaos? That’s a ridiculous assertion on many levels: there are other sources of oil outside the Middle East, and the countries in the Persian Gulf are highly incented to get their oil safely to market. After all, they can’t drink it.

The end of America’s ability to safeguard the Gulf and the trade routes around it would be enormously damaging — and not just to us. Defense budgets would grow dramatically in every major power center, and Middle Eastern politics would be further destabilized, as every country sought political influence in Middle Eastern countries to ensure access to oil in the resulting free for all.

Hmmm… but our defense budget would shrink. And we would not need to borrow as much money to finance our deficits from (gulp) Japan, Saudi Arabia, the UK, China, and our Federal Reserve. Finally, what exactly is a “free for all” in this context? The oil certainly isn’t free for all, or free for any. It will only be available to those who have a valuable currency with which to purchase it.

The potential for conflict and chaos is real. A world of insecure and suspicious great powers engaged in military competition over vital interests would not be a safe or happy place. Every ship that China builds to protect the increasing numbers of supertankers needed to bring oil from the Middle East to China in years ahead would also be a threat to Japan’s oil security — as well as to the oil security of India and Taiwan. European cooperation would likely be undermined as well, as countries sought to make their best deals with Russia, the Gulf states and other oil rich neighbors like Algeria.

Is Mr. Mead suggesting that our current world is a “safe and happy place”? The amount of global insecurity and suspicion today is already staggering. Even more ironically, Mr. Mead then implies that we’re keeping China on a short leash to prevent her from threatening her Asian neighbors, when we are actually dependent on China’s willingness to lend us money to defend her oil tankers.

America’s Persian Gulf policy is one of the chief ways through which the U.S. is trying to build a peaceful world and where the exercise of American power, while driven ultimately by domestic concerns and by the American national interest, provides vital public goods to the global community.

I strongly disagree with the assertion that our Persian Gulf policy is an exemplar for how to build a peaceful world. Talk about cognitive dissonance.

Following my discussion with Carl Kenney a couple of days ago, I’ve been reflecting on a fundamental question: What is freedom?

I won’t pretend to have a universal answer for everyone, but I really started thinking about this issue while spending several weeks in China and Hong Kong over the summer. Having been investing in Asia for some time, I really wanted to see firsthand what this “Asian Miracle” is all about. What does capitalism look like in a totalitarian state? Is the 10-12% GDP growth in China “real”? Are average people benefiting from the growth, or is it just multinational corporations exploiting cheap labor? Those were some of my questions, and as I dove in and talked with folks, some patterns became clear.

First, I was amazed to meet a lot of Chinese in major cities from my generation (20s-30s) who speak English, are extremely well educated, and are enjoying a rapidly increasing standard of living. These folks are literally “Chuppies”, and they are seizing China’s transition to a market economy and the opportunity that provides with both hands. Importantly, there is hardly ANY consumer debt, and the household savings rate in China is over 25%.

Think about that for a moment — no consumer debt. Want to buy a car? You’d save and pay cash. You’d have no student loan, credit card, or home equity loan payments. China is only JUST beginning to embrace mortgages to buy property/housing. What would your life be like if you only had to buy food, gas, clothing, insurance, and educational/recreational stuff?

That’s not to say the Chuppies aren’t consuming. They want, and have earned, a Western standard of living: from rice to beef, from bike to car, from room air to air conditioning… everything that the middle class and above takes for granted in the United States is also being enjoyed by China’s growing middle class. They’re just not borrowing money to do it.

So that’s one way to look at freedom — economic freedom. When you have a bunch of money invested and saved, no debt to service, and just living expenses to cover every month, would you feel forced to take a job that you find unrewarding? Might you possibly be inclined to think like an owner, instead of an employee, and start your own entrepreneurial venture?

What I found talking with folks in China is that the entrepreneurial instinct for the average, educated urban Chinese has never been more alive and well. People in this growing middle class are focused on creating value for themselves in the market. I was so shocked by this realization — here I was in a country with a totalitarian government, no tradition of individual liberty such as in our Declaration of Independence, and a censored Internet… yet I’m meeting folks in offices and tea rooms who feel “freer” economically than many (if not most) people I know in the United States!

Not to say that China doesn’t face significant challenges — they also struggle with dirty air, dirty water, rising inflation, and questions of how to address the folks who haven’t kept up with the economic boom. But the important distinction for me isn’t China’s current position, but its direction. With economic liberalization comes increasing prosperity for more people. Those increasingly prosperous people are also less tolerant of arbitrary and capricious social restrictions, as well. Who knows how far social freedom will go in China? Based on my experience, however, it’s moving in a positive direction — certainly relative to the history of the Cultural Revolution.

Contrast China’s dynamic with the United States. We cheer over 2-3% GDP growth, suffer from rising inflation that is understated by the government, and have a negative household savings rate. Of course, with inflation, it doesn’t make sense to save in the traditional sense — a savings account gets eaten alive by inflation, so you have to take additional risk and invest in high-growth opportunities to keep up. But more folks aren’t even trying to invest OR save. We base our purchase decisions on what the monthly payment will do to our budget, and God forbid we lose our job, and our healthcare benefits.

The average American with credit card debt, student loans, mortgages, and car payments NEEDS his job. Leaving a job is a high-risk proposition, and forget about financing your OWN business to test that great idea that you always wanted to commercialize. Instead, we live in The Office, or The Matrix, and forget what it means to be free.

Ironically, in a situation as perverse as ours, one can argue that we really DO need minimum wage laws. You see, people are so enslaved by debt, and so dependent on monthly cash flow, that it’s tough to walk away from ANY offer when you’re desperate. What would happen if people felt free to say “No, thanks” and start their own business, if they couldn’t find an employer that met their expectations for job satisfaction and income?

Does it have to be this way? Well, having governments that encourage consumption and punish production through a punitive tax code and cheap debt doesn’t help. But ultimately, it’s an individual decision to take on debt. The fact that our society makes it so easy doesn’t eliminate our responsibility for the problem. Would you like to be economically free? Meet Dave Ramsey. He’ll help you figure it out.

Note that my focus on economic freedom thus far is on folks who are earning (or attempting to earn) a wage. There’s a whole other category of people who depend on the generosity of others to survive. Ironically, many people in the so-called “welfare state” are actually closer to true economic freedom than the “middle class” two-income family just fighting to survive.

How can that be? Simple — If you’re debt-free and used to a lower standard of living, what do you have to lose by trying something new? If you’ve figured out how to survive on welfare, even barely, you are MUCH better positioned to take a risk and create some REAL value for yourself. Go figure.

Nancy Pelosi released a statement in the wake of Chairman Bernanke’s kick-in-the-pants to the market this afternoon. Here it is:

Pelosi Statement on Federal Reserve Interest Rate Cut

| 18 Sep 2007 | 08:38 PM ET |

WASHINGTON, Sept 18, 2007 /PRNewswire-USNewswire via COMTEX/ — Speaker Nancy Pelosi issued the following statement after the Federal Reserve cut interest rates by half a percentage point: “Today’s announcement by the Federal Reserve to reduce interest rates underscores the economic insecurity that middle-class Americans have long been feeling. A weakening economy, record home foreclosures, record energy prices, and meager job creation are not just numbers, but rather serious challenges for working families across the country. I hope that the action taken today by the Fed will bring some relief to the middle-class.

“For families facing skyrocketing mortgages, Congress is taking action today.

With crucial reforms to the Federal Housing Administration, we will enable it to serve more subprime borrowers at affordable rates, offer refinancing to families struggling to meet their mortgage payments, and help create more affordable rental housing across the country.

“This Congress is taking us in a New Direction: we have made college more affordable, increased the minimum wage, and passed legislation to spur U.S. innovation. To reduce the pressure of growing energy and health care costs, we will make sweeping changes to our energy policy that will declare America’s energy independence, and pass a health care bill to cover millions of children.

That is a New Direction that the vast majority of Americans support.” (from http://www.cnbc.com/id/20853362/for/cnbc)

My favorite quote: “I hope that the action taken today by the Fed will bring some relief to the middle-class.“

Sorry, Nancy. The Great Inflation started today. You missed it? The Dow was up over 300 points! Don’t get me wrong, I’m thrilled. Oil sands, natural gas, gold, international growth stocks… liquidity is flowing, and it’s going straight into my portfolio, baby! Just don’t hold U.S. dollars (yep, Federal Reserve Notes), and you’ll be fine.

But the “middle class” will be lucky to keep their homes. And these folks who are trying to earn a “decent” wage in dollars will find that those dollars will buy less and less with every passing day. Less gold, less stocks (at least the good ones), less food, less energy… it’s called inflation. And that’s how we’re going to get out of this little pickle we’re in. Pelosi complains about “record energy prices” — she’s not seen anything yet.

Let’s see how the dollar reacts. We’re approaching 1:1 parity with the Canadian dollar, new historic lows against the euro, and as China’s central bank loosens the reins on the RMB, it’s going up against the dollar. That’s good news if you’re a multinational or foreign company with earnings in foreign currencies, but bad news if you’re a U.S. consumer trying to buy stuff in a global market with a depreciating currency.

How can anyone believe our legislators are upholding their oath of office to defend the Constitution? What does the Constitution say about New Directions of creating more money for more bailout programs? Making higher education “more affordable” by throwing more fiat money at it? And since when has the federal government “spurred innovation”?

Wake up, America!

The Financial Times has an interesting series of articles exploring the rapid growth of Sovereign Wealth Funds (SWFs). These are investment vehicles for governments to invest surplus reserves from foreign exchange. As you can see below, while these funds were traditionally the domain of oil-producing countries, China’s prowess in accumulating dollars is formidable. They’re taking baby steps towards being greater activists with their investments, allocating $200 billion for a new SWF that is still a relatively small proportion of their $1.3 trillion in foreign exchange reserves.

Why is this phenomenon interesting? Well, SWFs provide an alternative to governments’ central banks simply buying and holding U.S. Treasuries for a “risk-free” return. Looks like China is beginning to hedge its dollar exposure through this type of diversification, long practiced by our friends such as the UAE in the Middle East. It’s estimated that SWFs have $2.5 trillion currently under management, expected to grow to $12 trillion by 2015. (I wonder what a dollar will buy in 2015, though?)

So how is China going to deploy its $200 billion? Well, they started (and took an initial hit) with a $3 billion position in Blackstone Group prior to its IPO. Needless to say, all of their investments won’t be in the United States, though. I’d imagine they’ll look for opportunity where they’re comfortable looking, and where they expect growth. In any case, it’s clear that their appetite for U.S Treasury bonds is limited.

The increasing importance of government funds taking investment positions sparked a healthy debate led by Lawrence Summers here. It’s also created a bit of protectionist rhetoric, as well.

It’s interesting to consider the consequences of our government’s creating such massive amounts of debt. Without our government selling several hundred billion dollars in new debt every year, the dollars that China and other trading partners receive from foreign exchange would be either be exchanged back into their native currency, or used to purchase other dollar-denominated investments or goods. Those choices are the desired outcomes from trade and foreign exchange.

If anyone you know tries to blame China for their creative efforts to deploy their surplus reserves, just ask them who sold the bonds to China in the first place. Too bad no one ever read us the Miranda warning of international finance: “You have the right to sell debt. Any debt you sell can and will be used against you in the marketplace.”

David Walker, our Comptroller General and head of the Government Accountability Office, is taking his message to the street. Despite his ability to communicate directly to our elected officials in Washington, it appears that he’s just not getting though to our senators and representatives. Perhaps they’re too busy discovering new ways to shelter payments from their favorite lobbyists.

No, instead, he’s decided that he needs to talk to us. That’s right, we the people. The voters who elect these august leaders, and then watch their antics from the comfort of our couch.

Why is he so concerned? He understands that we are wearing a noose that is slowly tightening around our neck. You might not feel it just yet, but it’s there. The government’s own annual report shows a pretty bleak situation: as of 2006, the federal government has $1.5 trillion in assets, but $10.4 trillion in liabilities. But those are just the assets and liabilities “on the books”. Like Enron, we have lots of interesting liabilities that are not on the balance sheet. As I wrote in a discussion over at Redstate:

[The balance sheet] also does not account for the massive unfunded (and unfundable) long-term net liabilities of Social Security and Medicare. I wasn’t going to bring this up, as I didn’t want to depress you, but even the optimistic official estimates are sobering. Look at pages 46-47:

Social Security: ($6.4 trillion)
Medicare Part A: ($11.3 trillion)
Medicare Part B: ($13.1 trillion)
Medicare Part D: ($7.9 trillion)
Railroad Retirement: ($101 billion) <– what a bargain!

Add those up… over $38 trillion in long-term liabilities that are not on the balance sheet.

Of course, there are those who try to put things in perspective. Various commenters then tried to reassure me that the balance sheet doesn’t include significant assets, as well — namely the value of land owned by the federal government, and the assets owned by the American people.

OK, so if our government owns a few $trillion in land, and the total wealth of our citizens is estimated at $55 trillion, how does that help us fund these entitlements? I guess we can just sell off the National Park System, and confiscate the majority of private assets and sell those as well. But who will buy them? Perhaps the Chinese? Good plan. I feel much better.

Seriously, check out the presentation U.S. Financial Condition and Future Fiscal Briefing, available at the GAO’s Web site. Or just watch David Walker’s 60 Minutes interview below:

While his message is a wake up call, I actually think he’s too optimistic regarding how much time we have. You see, he’s focused solely on our government’s out of control spending. He’s not considering the impact of our fiscal policies on our place in the global economy. Having spent time in China and seen firsthand the impact of their rapidly-growing middle class, it is clear that China is transforming over the next 4 to 10 years from a low-cost producer and exporter to the world’s most voracious consumer.

We are the world’s largest debtor nation with a population of 300 million, and we will soon be competing for food, energy, natural resources, and manufactured goods with China’s 1 billion consumers. Also consider that China is, slowly, allowing their currency to appreciate. As their middle class grows and domestic consumption expands, their domestic market will become more valuable than export markets. At that point, the People’s Bank of China won’t need to keep their currency artificially low relative to our dollar. So not only will we be competing with their billion consumers, we’ll be competing with a currency that is significantly weaker than it is even today.

Unless we can reign in our government, and again make our nation attractive for investment, it’s going to be a rough ride. Perhaps we the people will wake up in time to realize that we actually do have the power to change the equation.

If there’s any truth to reincarnation, given the current environment, I’d love to come back as a multinational corporation. While I’d read about the tax minimization strategies of large corporations, it never really hit home until I saw it firsthand.

I recently transitioned from a small technology startup company to a large multinational corporation. As part of my orientation to the new environment, I had a great opportunity to meet folks throughout the organization, and learn about the tremendous corporate resources at our disposal. One of the most memorable conference calls occurred with my introduction to the corporation’s overseas subsidiary. I’d done enough reading to know the purpose for this entity, so when the director on the call asked if I knew what they did, I figured I could show off: “Sure, you’re an intellectual property holding company that upstreams income for tax efficiency.”

(In English, that means that the businesses operating in the United States and other high-tax jurisdictions sell their products as “intellectual property” to this overseas subsidiary. Then, the U.S. operating business pays a handsome royalty to the overseas subsidiary for using/selling their product every year. Thus, the net income of the U.S. operating business is minimized, since the royalty payments to the overseas subsidiary are subtracted from revenue. Since tax is calculated based on net income, the corporation can then deliver more post-tax income to its owners.)

Judging from the prolonged silence on the other end of the phone, I thought something might have been lost in translation. The response, while delayed, was emphatic: “Uhhh… You can’t say that.” You see, the IRS takes a dim view of companies that set up corporate structures just to minimize taxes. (I don’t understand why, though. Why shouldn’t a person or a corporation act in its economic best interest?) So while there is widespread acknowledgment that this technique is being used, the IRS generates work for lots of accountants and lawyers to show conclusively that these sorts of overseas subsidiaries are not just passive intellectual property holding companies. Instead, they need to be operating companies that direct strategy and operations for the business units located in the high-tax jurisdiction.

As you can imagine, there are lots of late-night discussions as to how one might “prove” or “show conclusively” that an offshore company is really calling the shots and not just sitting there generating huge tax savings. You’ve clearly got to hire people over there, and those people have to be busy. They have to create Excel spreadsheets, PowerPoint presentations, have conference calls, and put cover sheets on their TPS reports. It also helps if they travel and interact regularly with their colleagues in the United States as well. Isn’t that a wonderful system?

Over time, I began to realize that I was incorrect with my initial response. This overseas subsidiary did not just collect income, it really did play an active role in operations. But is that a good thing? When you have highly-specialized, nuanced products serving folks in the U.S. market, is it good business sense to have to balance the input from “corporate” half a world away? How does that serve the customer? How does that help make the organization more agile and responsive to challenges in the marketplace?

Hint: it doesn’t. Overall it hurts the company’s competitiveness. But it still enhances the after-tax profitability of the company relative to just earning the income in the high-tax jurisdiction.

Consider this: when a country’s tax system is so punitive that companies who can afford it will create entire divisions overseas, is that country likely to create a lot of new entrepreneurial ventures as well? In the world of Internet-based businesses and global competition, the answer is increasingly no. While there still are certain industries where the advantages in the United States outweigh the high costs, new ventures are increasingly creating jobs and wealth outside of this country.

This data is a bit dated, but it gets the point across. As recently as 2005, we’re squarely in the middle of the pack, and behind China and India. So I’ll ask the question again, when will our government stop strangling the goose that lays the golden eggs of domestic entrepreneurship and job creation?