Not fragile

Over the weekend, the Wall Street Journal opinion page editors published an opinion entitled "The Keynesian Dead End," arguing that world leaders were finally seeing the folly of the idea that government "stimulus" is required to prop up economic growth, and predicting: "We suspect that Mr. Obama will find a stonewall in Toronto when he pleads with his fellow leaders to join him again for a spending spree [a third round of government stimulus]."

That turns out to be exactly what happened. We believe this is a very good sign, although many policymakers in the US seem to have missed the memo, including the Federal Reserve, which continues to hold interest rates essentially at zero.

Calls for more stimulus (or to continue holding the Fed funds rates at "emergency" levels for over a year) are built upon the Keynesian assumption that the economy depends for the most part on the constant ministrations of the government, like a fragile patient on life support, or a rickety machine always in danger of clattering to a stop.

Listen to this story broadcast today on National Public Radio, which tends to approach most economic stories from this Keynesian point of view. In it, the narrator continuously refers to the economy and the recovery as "fragile" and in need of government "support" or "propping up."

The narrator describes a "warning from President Obama that big cuts in government spending could choke off the fragile economic recovery" and then repeats the same "fragile" description saying, "he warned that recovery is still fragile and says it would be a mistake for governments who have been propping up the economy to rush for the exits all at once."

Later, the narrator explains that Treasury Secretary Tim Geithner "insists the US will not repeat the common mistake after financial crises of withdrawing government support too quickly."

We have written extensively in the past that this view of economics is completely upside-down: free economies are surprisingly robust, and when they break down it is generally because of misguided government tampering (see for example this previous post). We have also presented arguments full of evidence from history that injecting them with government "stimulus" actually acts more like a sedative, and that the misguided stimulus plans of the past two years have actually retarded the recovery, which could have been even stronger.

The silver lining to the financial chaos of the past few years is that people everywhere (even in Europe!) appear to be waking up to the follies of such misguided economics (what the Wall Street Journal article calls the Keynesian "dead end").

Even better, they are rediscovering the truths articulated by economists who offered the antidote to the Keynesian view, such as Friedrich Hayek and Ludwig von Mises, as George Mason University economist Russ Roberts explains elsewhere in the Journal's opinion page today. For further arguments about the importance of Hayek, see our previous posts here, here, and here.

This last aspect is critical, because it slices through the artificial dilemma that NPR and other media commentators try to paint around this subject -- namely, the false choice between expensive "stimulus" and anti-growth "austerity," which is often a code-word for "higher taxes." The real way out, as Steve Forbes points out in yet another recent WSJ opinion piece, is to set the stage for growth. The way to do that is to incentivize innovation and entrepreneurship through low taxes, to stop drugging the economy with "stimulus," and to provide stable currency so that businesses can operate in a predictable environment.

Thus, while the rejection of more "stimulus" by the European leaders is heartening, they are probably still missing the other half of the story, since they are following the IMF-style austerity prescription of cutting spending and raising taxes. The best path would be to cut taxes and cut spending, or at least leave tax rates low and as flat as possible to encourage economic growth; the only thing that can pay for the profligate ways of politicians.

We believe that all investors should understand these issues, and that a working knowledge of these topics is extremely beneficial to sorting out the economic questions of the day and to deciding where and how to invest their capital.

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Double dip ahead?

Lately, there's been a lot of chatter in the financial media about the prospects for a "double dip" recession -- the idea that the economic recovery that began in the first quarter of 2009 was just a short interruption in a larger catastrophe and that in the months ahead or in 2011 we will plunge back down into an abyss as deep or deeper than the one before. (The origin of the term "double dip" to describe a recession probably stems from one measure of a recession, which is two consecutive quarters of negative GDP growth -- a "double dip").

We have always disavowed any ability to predict the economic future (and noted that economists are uniquely ill-equipped to do so themselves), but we believe that most of this talk is based upon a misunderstanding of what caused the financial panic in the first place, which leads to a misunderstanding of what is behind the recovery, and an incorrect assessment of what could lead us back into another recession.

We have laid out our view in great detail, and believe that by having the correct view we have been able to interpret events more accurately than those with flawed assumptions about the events of the past three years.

For an example, take a look at our post from March 13, 2009 entitled "Big news on mark-to-market accounting," where we said: "Yesterday was a momentous day. The press chose to focus more on the emotionally-charged story of Bernie Madoff pleading guilty to a Ponzi scheme and being sent (at last) to his new jail cell, but the bigger story was about an accounting rule that few Americans really find interesting or understand completely. This accounting rule has caused far more havoc in their lives than Bernie Madoff, however."

For investors who can now see, with the benefit of hindsight, that March 9 of 2009 was the bottom of the bear market, our assessment that the real story of the week was the accounting rule and not the Madoff guilty plea can be seen to have been right on target. We concluded that blog entry back on March 13, 2009 with the words, "While accounting rules are not very exciting to most members of the general public, this is a significant issue that we would urge everyone to examine and understand. If this problem can be fixed and the banking system allowed to begin to return to healthy operation, we believe the economy -- and the markets -- can recover much faster than most investors realize."

We would argue that history has borne out these predictions, and that this supports the view of the financial crisis and recovery that we have put forth on this blog since 2008. To investors who understand this view, the current talk about soft housing numbers precipitating a double-dip into a new recession becomes somewhat silly.

While the double-dip talk mainly surfaced in conjunction with a disappointing housing construction data point for the month of May, we do not believe this part of the economy is going to derail the economy, particularly at this point in time. Housing construction is already at such ridiculously low levels that any further deterioration would be almost meaningless.

The chart below shows that housing construction (measured by what economists call "housing starts") is at historically rock-bottom levels -- almost as if Americans are never going to buy any new houses again.

The chart shows data for housing starts going back to 1950 and up through May, 2010. Even with new home construction contributing nothing positive to the overall GDP, GDP growth has been close to 4% in real (inflation-adjusted) numbers and above 4% nominally (not inflation-adjusted).

We believe the focus on "double-dip" by the financial media is just another example of their need for attention-grabbing stories to fill up the day, and should not cause investors to panic out of investments in well-run, growing companies.

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Let's make it even harder to obtain oil in the US

Yesterday, a US federal judge struck down a six-month moratorium on all drilling for oil at depths greater than 500 feet (and industry participants note that drilling permits in shallower waters were being delayed as well). While it is nice to see the rule of law being upheld against government restrictions of legal business activity, the fact is that the heavy-handed intrusion of the US government into the oil business has been going on for decades, with grave and wide-ranging consequences.

As professor emeritus of economics at Pepperdine University George Reisman noted in his 1996 tome entitled Capitalism: a treatise on economics, the US government has restricted the supply of US oil in the following ways:
  • Preventing exploration and development in "wildlife preserves" and "wilderness refuges."
  • Preventing the development of offshore wells on much of the continental shelf.
  • Preventing the construction of oil and gas pipelines, refineries, storage facilities, and facilities for handling supertankers, and when not banning them outright, greatly increasing the difficulty of obtaining permission to build them -- in one instance, plans to build a pipeline were abandoned due to the cost and difficulty of obtaining the necessary permissions from over 750 federal, state, and local government agencies.
  • Imposing price controls on oil (leading to the oil crisis of the 1970s).
  • Imposing punitive taxes on energy companies, particularly through the removal of the depletion allowance for crude oil reserves.
  • Discouraging business growth and capital investment through the threat of antitrust lawsuits against large oil firms and mergers.
  • Imposing price controls on natural gas, thus limiting the growth of an important alternative fuel, and thus increasing the demand for oil.
  • Preventing the construction of nuclear power plants (and preventing the use of nuclear power plants already constructed), thus reducing an alternative and again artificially increasing the demand for oil. Similarly restricting coal exploration and use, with the effect of again artificially increasing the demand for oil.
  • Forcing power plants to burn oil instead of coal, which also artificially increases the demand for oil (234-235).
All the government policies which make oil more difficult to obtain, more expensive to transport, and more in demand (by the removal of major viable alternatives including coal, natural gas and nuclear) have made oil-derived products far more expensive for American consumers than they otherwise needed to be. The impact is most noticed in the price of gasoline, but it goes far beyond that.

In fact, the fallout from this government interference includes the enrichment of Middle Eastern states which sponsor terrorism. The policies of the US government over the past several decades (stretching back to the 1960s) have made demand for Middle Eastern oil higher than it would have been if it were easier to obtain oil here, and higher than it would have been if alternatives such as coal, natural gas and nuclear had been allowed to relieve some of the demand for oil. Not only has demand been higher than it otherwise would have been, but the prices those states could charge for that oil has been higher as well.

George Gilder points out in the Israel Test Benjamin Netanyahu's argument that terrorists rarely if ever can act on their own, but are sustained by sovereign states. "Sustaining this terrorist network of states," Gilder says, "is largely foreign aid to governments, together with environmental bars to energy production in the West that endow despots with economic power. Terrorism will continue as long as these suicidal Western policies continue" (218).

We believe investors should understand these connections between economics and global issues. Further, as the recent events in the Gulf have shown, investors should be very wary of investing in industries with excessive government intrusion, and should be ready to move their investment capital elsewhere when that intrusion appears likely to increase.

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The price of protectionism

We've written before about the often-unappreciated costs that result from government attempts to "protect" an industry or sector from competition of one form or another.

Now, in the wake of the Gulf oil spill disaster, comes a shocking example of the horrendous costs that protecting some favored group, regardless of consequences, can have.

According to this article in the Houston Chronicle, the Dutch government offered to help by supplying ships equipped with oil-skimming booms three days after the explosion and start of the oil leak, but the US government refused. There is a protectionist US law, the Jones Act, which has been on the books since 1920 and prevents ships from operating in US coastal waters unless they are flagged in the US, constructed in the US, owned by US citizens, manned by American crews, and that those crews be composed of crewmen who make the US their permanent residence.

Five weeks later, the Dutch oil-skimming booms are being airlifted to the US and fitted to US ships. If these booms can (as estimated) process 5 million gallons a day and remove 20,000 tons of oil and sludge each day, how much damage could have been prevented if they had been deployed sooner? And, why does the federal government care more about upholding a 1920s-era anti-competition law -- even in the face of a titanic disaster -- than in getting the resources needed to aid in solving the problem?

The Dutch are flabbergasted. The Ambassador from the Netherlands in Houston said, "The embassy got a nice letter from the administration that said, 'Thanks, but no thanks.' [. . .] What's wrong with accepting outside help? If there's a country that's experienced with building dykes and managing water, it's the Netherlands."

The Dutch aren't alone -- according to this Heritage Foundation article, they are one of thirteen countries whose offers to help have been turned down.

This aversion to "outsourcing" is a particularly jaw-dropping example of the potential ugliness of protectionism, and it demonstrates the futility of government laws which favor one group against competition from another (which is exactly what the Jones Act was written to do, and why it is still on the books today).

However, there are other egregious examples. For instance, many in government these days are taking up "the fight against obesity" and urging local leaders to build more parks, bring healthier foods into schools, and support farmers markets (as Health and Human Services Secretary Kathleen Sebelius told mayors at the annual US Council of Mayors this past Friday).

We don't have anything against farmers markets (in fact, we like them, although we're not sure we like the idea of having government "support them," whatever that means). However, what never gets mentioned by all these "healthier foods" advocates is the impact of long-standing protectionist measures on the food choices that citizens and businesses make.

Take a look at the price of sugar worldwide versus the price of sugar in the United States, as illustrated in this discussion of the subject by Professor Mark Perry of Carpe Diem:

The US government has been imposing high sugar tariffs against sugar produced outside of the US almost non-stop since 1816, through administrations and Congresses of both the existing political parties and all the parties that existed before the current ones came into being.

As you can see from the chart, in order to protect local farmers and sugar-industry companies from foreign competition, American consumers pay more than twice the world rate, and so do American companies making food products with ingredients that call for sugar. Is it any wonder that more and more of them are switching to high-fructose corn syrup as a cheaper alternative?

While the jury is still out on the impact of high-fructose corn syrup, there are dietitians who believe that pouring it into the human body is as unhealthy as pouring oil and sludge into the ocean.

The point is that protectionism always seeks to insulate one small group and disregards the cost to everyone else. The sooner this basic economic fact is understood, and the more widely it is known, the better.

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News flash! Computer model enables you to beat Wall Street!

Technology Review, a publication of MIT, published an article today with the headline, "AI that picks stocks better than the pros."

The story describes a computer program designed by college computer science professors which analyzes the text in news articles found in Yahoo! Finance about various stocks and then buys them or shorts them based on the news it finds*. When they tested it out, according to the author, they found that "it appears to be able to beat Wall Street's best quantitative mutual funds at their own game."

Before investors run out and buy a computer that can "beat Wall Street" and stop researching good companies themselves, a few important points are worth considering.

First, according to the story, the maximum period of time this black-box strategy holds a long position or a short position is . . . twenty minutes! Talk about having a short-term focus! Trading at that frequency would be extremely expensive in terms of both commissions and taxes and impractical for a real investor.

More importantly, we believe that the criticisms we have raised about "black box" investment strategies in the past are reinforced by this new story.

Note well the line in the story in which it is revealed that, in order to test their computer investment strategy, the college professors selected "five non-consecutive weeks in 2005, a period chosen for its lack of unusual stock market activity."

We have pointed out before that backwards-looking, mathematics-driven investment strategies, such as the "quant" or "black box" strategies of the computer age or the "various systems" of market prediction that T. Rowe Price wrote about all the way back in the 1930s, usually fail (in the words of Rowe Price) "at crucial turning points in the market."

It's great to have a sophisticated investment strategy that "beats the pros" if you can manage to only use it during "periods chosen for their lack of unusual stock market activity." This is exactly why so many quant strategies were wiped out by the "unusual activity" of 2008 - 2009.

We would point investors to our post from last year entitled "The Dismal Science" in which we discuss the real problem with this kind of thinking, and the real way out for investors. The problem is that "no mathematical model can predict the next entrepreneurial development that will create new markets and drive economic activity in a completely different direction."

It is these unexpected innovations, and the companies which develop them or take advantage of them, which create real wealth and growth. This is the message to which we constantly return in our posts on various topics, and we believe it is the real investment truth which our readers should never forget.

* The principals of Taylor Frigon Capital Management do not own securities issued by Yahoo! (YHOO).

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Bubble alert!

Hat tip to Professor Mark J. Perry and his always-fascinating Carpe Diem blog, where today he points out a dangerous bubble that has yet to burst -- the "higher-education college-tuition bubble."

Professor Perry's chart shows that the price of the average college tuition has increased by over ten-fold since 1978 -- far outstripping the price increases of the average "basket of goods and services" measured by the CPI each year. He notes that "the college tuition bubble makes the housing price bubble seem pretty lame by comparison."

Both Professor Perry and the article he cites by University of Tennessee law professor Glenn Reynolds make some reference to the fact that this "tuition bubble" is being fueled by access to cheap credit from lenders who are "eager to encourage buyers to buy." Neither directly pointed out that the lender most responsible for fueling the recent explosion of college costs has been the federal government (just as Fannie Mae and Freddie Mac in the housing bubble -- a role rarely mentioned by politicians or the media and two entities who are not even addressed in the House and Senate's so-called "financial reform" legislation).

The government has since taken over student lending entirely, which makes it difficult to tell when the college tuition bubble will finally deflate, but deflate it will, when the irresistible forces of innovation and disruptive technology finally catch up to it.

We have written a little on the subject of higher education previously, during the graduation season a year ago, in "Intellectual Affluence." We recommend it, along with this week's articles by Professor Perry and Professor Reynolds to all recent graduates, upcoming seniors, current collegians, and their families -- and congratulations to all members of the Class of 2010!

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Exaflood update

Back in December, we published a post containing a link to some of the excellent analysis Richard McManus has been publishing at ReadWriteWeb on the exponential growth of data taking place all around us, often unnoticed and taken for granted.

Recently, he published a post entitled "The Coming Data Explosion" discussing some very interesting statistics, some of which were presented in a talk by Google's Marissa Mayer* in August of 2009.

These statistics confirm the predictions of Bret Swanson and George Gilder we pointed out to readers in our February 2008 post "Must-read: Unleashing the Exaflood by Bret Swanson and George Gilder."

For example, in Ms Mayer's presentation, she notes (beginning at 19:00 in the talk) that the amount of data on the internet was about 5 Exabytes in 2002 and had grown to 281 Exabytes by August 2009. She also cited analysis concluding that the average web user is uploading about 15 times more data today than the average web user just three years ago.

These statistics confirm the arguments we published throughout the financial downturn that the technological changes currently taking place are too powerful to be derailed by either economic catastrophes or political bungling. There may have been a financial panic in the past three years, but it didn't seem to make much of a dent in the progress of the "Exaflood."

This observation is extremely important for discerning investors to understand. There are plenty of negative geopolitical and/or economic developments for the media to focus on at any given time, which distract many investors from noticing tectonic events beneath the surface.

Instead, investors should be asking themselves how they can participate with well-run businesses that are unlocking new value based on those changes. We believe the Exaflood is still in its initial stages, and that investors should take the time to understand it thoroughly.

* The principals of Taylor Frigon Capital Management do not own securities issued by Google (GOOG).

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