The Four Pillars

For many years, we have analyzed the investment conditions using four foundational criteria that are vitally important for investors to understand.

These four areas are so important that they form the foundation for business growth and investment prospects, and can be seen as the four "pillars" on which everything else depends.

These Four Pillars are:

• Tax Rates.
• Interest Rates.
• Inflation.
• Global Freedom.

Clearly, these four are very much interdependent. Interest rates and inflation are closely interconnected, for example, as we discussed in greater detail in this previous post.

The concept of "Global Freedom," which is perhaps the most important of all of them, includes the other three to some extent. It is a measure of the degree to which people around the world are permitted to seek to fulfill their individual needs by producing and exchanging peacefully with others, and the degree they can be free of the fear of confiscation of their property or their lives.

One resource we use to find data points on the level of "Global Freedom" is the Heritage Foundation's annual Index of Economic Freedom, which provides insight into a variety of components of economic freedom and the level of such freedom around the world.

There has been a remarkable increase in the overall level of Global Freedom over the past three decades, which have seen countries including China and India and many countries in Eastern Europe make dramatic advancements in the level of economic freedom permitted to their citizens.

Unfortunately, intrusive government regulation has been on the rise in the United States, such as the Sarbanes-Oxley regulation enacted at the end of the 2000-2002 bear market, and we would argue that the mark-to-market accounting rules that played such a negative role in the most recent financial crisis were another example of intrusive regulation by government agencies, which is an important factor in the measurement of "Global Freedom" in any given country.

In fact, there are some disturbing signs in the important area of Tax Rates in the US as well, as Arthur Laffer discusses in a recent Wall Street Journal article called "Taxes, Depression, and our Current Troubles."

In it, he argues that many academics and economists, including the current Federal Reserve Open Market Committee, are looking to the Great Depression and seeing only the problems caused by excessively tight interest rates (the second of the Four Pillars) and ignoring the deleterious effect of increased taxation (the first pillar), devaluation of the currency (the third pillar), and the elimination of free trade by the Smoot-Hawley Act and reciprocal tariffs it led to world-wide (the fourth pillar, since freedom to trade is an important component of Global Freedom).

Arthur Laffer's analysis is that we are in danger of making the same mistakes today, based on looming tax rate hikes when the 2003 tax rate cuts expire in 2011, as well as tax hikes that would be necessitated by proposed government healthcare expansions and by proposed cap-and-trade legislation.

While this particular article doesn't specifically mention them, we can also add that recent events suggest both the danger of inflationary Fed policy and the danger of increased restrictions on free trade.

The value of using the Four Pillars to evaluate the business and investment climate lies in the additional clarity that it can provide in making the investor aware of the real situation. We have written before in "Return of the 1970s, part 2" that economically difficult environments may call for subtle changes in the types of companies to which you allocate capital, but that just because such conditions may be on the horizon does not mean that there are no opportunities.

We believe that investors would greatly benefit from taking the time to understand each of these Four Pillars and consciously incorporating an analysis of each one of the "pillars" into their analysis of the overall investment picture.

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For later posts on this same topic, see also:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "The Consumer" 10/19/2009.

• "The 97-pound weakling" 12/16/2009.

• "Index of Economic Freedom Released; US Slips" 01/27/2010.

• "Avatar and long-term inflation" 03/02/2010.

• "Does a rising tide really lift all boats?" 07/20/2010.

• "Lower tax rates stimulate growth" 07/27/2010.

• "Reducing taxes is the best way open to us to increase revenues" 08/03/2010.