Excellent analysis of the recent Fed decision

Economist Brian Wesbury explains in the above video why the markets threw a tantrum after the Fed announced Operation Twist last week. To see the video, follow the link in the previous sentence (or just click on the photo) and then press the "play" button on the video entitled "The Fed squashes gold bugs."

Mr. Wesbury's analysis is very insightful and we largely agree with his conclusions. In fact, in our previous post on "Operation Twist" we described the reasons why Wall Street and Washington need to be weaned from the baby bottle of Federal Reserve reactions to every economic worry. After that post was published, the markets threw a tantrum on the following day, and we remarked that the markets had screamed for the bottle (more easing) and the Fed had handed them a pacifier instead (Operation Twist), which the markets promptly spit out and then threw a hissy fit.

Mr. Wesbury argues that the realization that the Fed was not giving more easing was the primary cause for the sharp 20% drop in the price of gold, and that gold may have topped after this action from the Fed. We have written many times before about the dangers of trying to time the gold market (and other commodity-based speculation), and why we believe that investors would be better served focusing on the fundamentals of businesses. For those previous posts we recommend revisiting this one, this one, and this one.

We advise all our readers to watch the above video for themselves.

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Operation Twist

Today, the Federal Reserve announced that it will begin increasing its purchases of longer-dated Treasurys in an attempt to lower longer-term interest rates across the board, thus potentially spurring more borrowing. This plan, nicknamed "Operation Twist" because by doing so the Fed is attempting to bend or "twist" the yield curve to their liking, is yet another attempt to "boost an economy flirting with recession" (in the words of this Wall Street Journal article describing the move).

Our first reaction to this decision is something we've stated many times before: we do not believe the Fed should be trying to steer the economy, especially since Fed attempts to grab the steering wheel in the past have not ended well (see this previous post and this previous post, among others).

We believe that Wall Street and Washington need to be weaned from their habit of looking to the Fed to provide comfort every time they believe the economy is "flirting with recession". And we would add that we are not convinced that the recent signs of panic necessarily mean that an economic recession is inevitable, as we explained in this recent post. It is certainly possible that "taking the baby bottle away" would cause a few market tantrums, but in the end we believe it would be a good thing if markets would stop looking to the Fed to comfort them with some new stimulus every time they feel uneasy.

On the other hand, it's hard to blame the Fed, because it has been given a "dual mandate." That mandate is to provide a stable currency, and minimize unemployment. This dual mandate is the real problem. As we wrote some three years ago, an economist we respect compares the Fed's dual mandate to telling a football coach that he has been hired to win games and to make sure his players keep their uniforms clean during the game, and that he will be fired if he doesn't accomplish both missions!

We believe the better solution would be for the Fed to have one task: to maintain a stable monetary policy. In reality, the Fed can't do much more to improve the economy anyway. Think about it this way: the Fed has already lowered rates to effectively zero for going on three years, promised they would keep it that way until mid-2013, and initiated and concluded QE1 and QE2. How effective have these extreme and unprecedented measures by the Fed been at improving economic growth and lowering unemployment?

Operation Twist is supposed to spur borrowing by lowering long-term interest rates. But long-term rates have been extremely low for quite some time, as current mortgage rates indicate. Perhaps there are other factors affecting the level of borrowing and lending taking place in this country -- namely the massive new regulations regime that has been enacted which makes bankers scared to lend.

Politicians may be urging bankers to get out and lend, but regulators are sending bankers the opposite message, and it's the regulators who have the power to shut banks down. We've referred before to the titanic size of the new regulation included in the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year.

This huge new landmark in the history of regulatory expansion gets to an even bigger problem than the Fed's dual mandate. In our view, federal lawmakers have largely abdicated their Constitutionally-given responsibility of making law to bureaucratic agencies such as those created by the Dodd-Frank Act, and for that matter to agencies such as the IRS and many others. These bureaucracies generate volumes of regulations that spend thousands of pages defining and regulating aspects of business which would be ridiculous if they weren't so damaging to economic growth and jobs creation (see for evidence the famous 1992 letter to the Wall Street Journal written by former Senator George McGovern after his experience trying to run a hotel in New England).

The two threads of discussion in this blog post are tied together: if politicians realized that the way to foster economic growth is to get rid of the nonsensical regulations and lower and flatten the tax rates, then the Federal Reserve could concentrate on keeping a stable money supply, and wean Wall Street and Washington from the baby bottle of "Fed stimulus."

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Want a fair tax system? Get the steamroller!

In all the recent uproar about taxes and people paying a "fair share," nobody is talking about Alvin Rabushka, and we think that is a tremendous oversight.

Dr. Rabushka is a political scientist and the David and Joan Traitel Senior Fellow at the Hoover Institute at Stanford University. Along with economist Robert Hall, he is the author of numerous books about the flat tax, which he has championed since the early 1980s.

We would challenge all the politicians arguing about the tax code, on both sides of the aisle, to read through the book The Flat Tax by Hall and Rabushka. We would advise all investors to do the same.

Right now in the US, we have one faction saying "millionaires need to pay their fair share" and another faction saying raising tax rates on the upper brackets and on capital gains is not a good idea "in a fragile economy" (as if it is a good idea at other times). We believe that to really get everyone to pay their fair share, and to do it in a way that actually helps the economy, policymakers should enact a flat tax that taxes everything and does so at a low flat rate, and that in doing so they should entirely do away with all of the deductions that special interest groups and social engineers have introduced over the years.

The benefits of such a flat tax policy are enormous. As Hall and Rabushka write:

Our flat tax solves many tax problems that have challenged academics and politicians for years: it eliminates double taxation; it improves capital formation; it correctly defines the tax base; it provides true simplification; it dramatically improves incentives; it removes millions of low-income households from the tax net; it lowers the costs of compliance; it puts a serious dent in tax cheating; it even reduces the adversarial stance of the Internal Revenue Service toward tax payers. 4.

The argument for the simplicity of the flat tax is incontrovertible. For example, if lawmakers decided that 18% of income was going to be collected, they could get to that number by a simple 18% flat tax or by a complicated system of brackets and deductions which charged higher than 18% on some earners but gave back deductions and credits to various groups for various activities, which ended up netting the government about 18%, although by a much more circuitous route. As a taxpayer, if you earned $100,000 of income in a year and were going to end up paying about $18,000 in taxes, would you rather do that with a postcard-sized tax return under the flat tax, or would you rather do it through a 40-page tax return that took hours of your time or hours of work by your accountant (charged to you)?

While nobody disputes the simplicity of the flat tax versus the current system, Hall and Rabushka note that many reject the flat tax on the basis of "fairness." However, they present extensive evidence that the flat tax is eminently fair, despite the criticisms often leveled against it. In fact, as argued in this chapter from their book exploring the concept of "fairness," the authors explain why the flat tax is far more "fair" than the current system (or any other practicable taxation system).

They point out that by almost any traditional definition of fairness, the flat tax is fair, except for a relatively new understanding of "fairness" that developed during the twentieth century among "politicians and intellectuals" who redefined it to mean "redistributing income" to "attain their egalitarian goals" (42-43). Aside from the philosophical and ethical problems with this new definition, Hall and Rabushka point out that attempts to redistribute wealth via higher tax rates on higher earners don't work very well in practice either: "Despite attempts to equalize after-tax incomes through steeply graduated tax rates, one Congress after another has riddled the tax code with hundreds of loopholes that permit some millionaires to pay no income taxes whatsoever and some high earners to pay low taxes" (43).

We would also add that philosophically, we disagree with Robert Hall and Alvin Rabushka over the idea in the quotation above that the flat tax should remove "millions of low-income households from the tax net." Their flat tax plan calls for no tax on those earning up to a certain minimum amount, after which the flat tax would kick in. We believe that there is moral hazard involved with excluding any group of voters from the tax system entirely, and believe that the tax rate should truly be low, flat, and the same for everyone.

Not only do all the complexities of the tax code waste time, money and energy for filers every year, and not only are they "not fair" in that they end up allowing some people to get away with paying less than others in similar circumstances and with similar incomes, but they have another huge problem that's not always well understood, which is that they encourage massive misallocation of capital, also known as malinvestment. By privileging various types of investment through the tax code, lawmakers encourage capital investment to go where it otherwise may not.

For example, real estate enjoys tremendous tax benefits in the US: many kinds of mortgage interest expenses are tax deductible, and sales of real estate property can be rolled into other "like kind" real estate investments without being taxed in between. In contrast, proceeds from selling shares in one company cannot typically be rolled into shares of another "like kind" corporation without being taxed in between. Similarly, insurance products and annuities enjoy different tax benefits. All of these tax loopholes and deductions encourage investors to commit more capital to those types of instruments than they would otherwise do, and this can lead to gross misallocations of capital, such as the real estate bubble that imploded with great collateral damage from 2007 to 2009.

(As an aside, we might ask Warren Buffett why -- if he is so keen on increasing "fairness" in the tax code -- he doesn't agitate to remove the inequitable tax loopholes that have been afforded to the insurance industry over the years in the United States).

A simple, low flat tax -- accompanied by the elimination of all the deductions and loopholes that politicians of both parties have enacted on behalf of lobbyists and favored industries over the decades -- would have a tremendous positive benefit on the US economy.

We are under no illusions as to the likelihood of such a commonsense solution ever being enacted. However, we believe it is important to go on record as supporting the flat tax as the most pro-growth policy that lawmakers could possibly introduce. With awareness growing of the problems inherent in the current abominable tax system, we can only hope that at some point more people will start listening to Alvin Rabushka.

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We don't need to stimulate consumption

Last week, President Obama rolled out the framework for his long-anticipated economic recovery and employment-improvement plan. Details of the plan are being sent to Congress today for their inspection. Mr. Obama says that the only reason anyone could be against this plan would be "political games," but from what we have seen of the plan so far, the economic approach of the plan is almost completely "demand-side" or "consumption" oriented, which is a reason to remain very skeptical.

We have written before about the difference between seeing our economic problem as one of boosting production versus boosting consumption. We would recommend all our readers understand this crucial distinction, and perhaps go back and review previous posts on the subject, including this one and this one, and this external article by the professor emeritus of economics at Pepperdine University, George Reisman, first published back in 1964.

The demand-side or "consumptionist" view of economics teaches that demand for goods and services is always in danger of growing too weak to consume what is being produced, leading to recessions and unemployment. Those who follow this view naturally believe that the way to improve the economy is to stimulate this demand in various ways.

The supply-side or "productionist" view of economics teaches that demand is a given -- it does not need to be stimulated. People will consume things -- in fact, if we do not consume food every day, we will soon die. Furthermore, left to themselves, people do not simply consume the minimum, but will naturally desire more and better goods and services. The desire to consume does not need to be stimulated, because it is built-in.

Each of the above approaches believes that the basic economic problem is very different. The consumptionist school takes supply for granted, believing that goods and services will naturally be produced, and that the problem is getting consumers to buy them. The productionist school takes demand for granted, believing that consumers always want to consume, but that producing enough for them is the problem.

We believe the productionist or supply-side school is much closer to the real situation experienced in the economy, and that this view of the world has demonstrated its worth over the demand-side/consumptionist theories that dominated the twentieth century (championed most famously by John Maynard Keynes and his followers and intellectual descendants).

The president's policies from the beginning have focused on stimulating demand and consumption, and last week's speech was no different. While the plan is ostensibly about creating jobs, the details it did contain centered around government spending on infrastructure (which will create temporary work for those involved, who will then spend and increase demand and consumption), lowering the interest rates on mortgages for homeowners (enabling them to spend more money, thereby increasing demand and consumption), and paying small businesses that have contracts with the federal government more quickly (enabling them to start spending sooner and thus boosting consumption and demand). These are all demand-side or consumptionist approaches.

We believe that the best way to increase economic growth and hiring is to remove obstacles to production, and the plan appears to do very little in that department. To be fair, there were some points about lowering payroll taxes for certain workers (such as those who have been unemployed for six months). However, these payroll tax reductions are always "targeted" (for certain employees only) and temporary -- which does not fool potential employers.

The speech also promised a review of government regulations in order to "cut away the red tape that prevents too many rapidly-growing start-up companies from raising capital and going public." We applaud any proposals that actually reduce obstacles to production, including reduction of government red tape, but must confess to being skeptical in light of the fact that this administration recently pushed for and signed into law a massive increase in red tape in the form of the Dodd-Frank bill, which dwarfs even the Sarbanes-Oxley Act in terms of red tape -- see the amazing graph posted by economics professor Mark Perry in his Carpe Diem blog here.

We also applaud the line in the speech about signing free-trade agreements, including the trade agreement with Colombia that has languished for years since being signed in 2006, and like the reduction of red tape will be more inclined to believe it when we see it.

However, the demand-side bias in the plan is revealed by the suggestion that any tax cuts in the plan be paid for by raising tax rates "on those who are most fortunate and can best afford it." This kind of statement ignores the simple truth that we have discussed in previous posts, that tax rates in the wealthiest brackets have a disproportionate impact on production because most of the capital used for business investment and backing for start-ups and new innovation comes from these brackets. Penalizing gains from such investments reduces the incentive for investors to risk that capital. If investors lose their capital, nobody pays them back, and if the government takes more of their gains when they invest in a winner, the risk-reward equation changes dramatically.

Finally, the plan does not reduce corporate tax rates in the US, which are among the highest in the developed world, a point that has been discussed by legislators from both political persuasions as a necessary ingredient to give US companies equal footing in the global markets. All he did was promise to eliminate loopholes and deductions that some companies receive. This reveals the fundamental demand-side bias of the plan, which was on display in this segment:

Should we keep tax loopholes for oil companies? Or should we use that money to give small business owners a tax credit when they hire new workers? Because we can’t afford to do both. Should we keep tax breaks for millionaires and billionaires? Or should we put teachers back to work so our kids can graduate ready for college and good jobs? Right now, we can’t afford to do both.

None of this is to suggest that consumption is not important -- it is obviously necessary to create demand for goods and services. However, it does not need to be stimulated. And when government reduces the obstacles to production, those producing companies end up expanding, hiring more workers, and creating more demand.

This fundamental distinction should be understood by all investors.

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The lessons of Switzerland

Earlier this week, the central bank of Switzerland (the Swiss National Bank) announced that it will enact a policy of buying euros in order to ensure that the Swiss franc does not continue to strengthen against the foundering euro. They set a target of requiring that the euro retain a value equal to at least F1.20 per euro.

Without this intervention, fewer and fewer Swiss francs would be required to obtain one euro (or, seen from the other direction, more and more euros would be required to obtain a set number of Swiss francs from one day to the next, as demand for Swiss francs drove the price of a franc higher and higher versus the declining currency of the economically troubled European Union).

This is a momentous occasion and a sad but probably necessary move from Switzerland, which abstained from joining the EU and which has been a true model of stable currency over the years.

As the European debt crisis intensifies, Switzerland has found itself in a difficult position, surrounded by eurozone countries filled with investors who have been trying to get their capital out of euros and into something more solid. Switzerland has been a rock in the midst of the recent stormy European sea (see diagram below), and as demand for their francs soared, their economy was put at risk by the rapid and increasing relative overvaluation that resulted.

























Here is a link to an editorial in today's Wall Street Journal opinion page which explains that this move by the Swiss National Bank should not necessarily be seen as a sop to Swiss exporters whose goods were becoming too expensive for the rest of the world (or Swiss tourism, which would suffer as eurozone visitors found that their euros were not buying them much traction when turned into Swiss francs), nor as a nod to inflating their currency, but rather as a move to keep their foreign exchange rates more stable (having your currency appreciating rapidly can be as destabilizing as can having it depreciate rapidly).

The Wall Street Journal editors explain that the Swiss concern for stability is all too rare in recent decades, saying:

It's not fashionable these days for central bankers to worry too much about the external value of their currencies. Since the collapse of the Bretton Woods exchange-rate system in the 1970s, policy makers have grown fond of saying that markets should set exchange rates. But markets can't set the value of a commodity whose sole supplier is the central bank, and this pseudo-laissez-faire is an abdication of central banks' duty to control the supply of their currency, both internally and externally. Full marks to the Swiss for breaking with this mistaken central-bank orthodoxy.

This echoes arguments we have put forward in previous posts regarding the US dollar, saying that we are not among the camp that argues for a weaker dollar, but neither are we among the camp that argues for a constantly strengthening dollar. We are among the tiny camp of those who argue for a stable dollar.

On a related note, we also believe it is worth pointing out that the current turbulence in Europe is revealing once again that in a crisis, investors from around the world do not just flee to Swiss francs, but also to US dollars. There has been a lot of doomsday talk in the US in recent months that the US dollar cannot last much longer as the world's reserve currency.

We believe that such fearmongering is irresponsible: the US may be making egregious monetary and fiscal mistakes, but the fact remains that the US is by far the largest economy in the world and the only one with a system large enough to handle the job of acting as the reserve currency. We take our hats off to the bankers and policymakers in Australia and Canada (and Switzerland) who have done a far better job than those here in the US in managing their fiscal and monetary affairs than has the US, but the fact remains that those economies are nowhere near as diversified as the American economy in terms of goods and services produced, nor are they anywhere near as large. This should be well understood by investors who are being bombarded on all sides by politically-motivated messages threatening the end of the US dollar's reserve currency status.

The real thing that investors should take out of all this currency turbulence of late is the core lesson that we have tried to make central to everything we say here on this blog: that investors should be focusing on the businesses to which they commit capital, and avoid being sucked in to the siren song of chasing currency-based speculations (or any other primarily market-driven trading activity, all of which are the opposite of making business-based investments).

The real question for investors at any time and in any economic situation is, "What kind of businesses do you own (or to what kind of businesses do you lend investment capital)?" This is the question investors should ask themselves, rather than the seductive but dangerous questions of "How are you playing the (weakening/strengthening) US dollar?" or "What kinds of international plays are best to take advantage of the current situation in (insert latest headline-grabbing country or region of the world)?"

These are some of the important lessons investors should take out of the current situation in Switzerland and Europe.

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The Solyndra bankruptcy

A couple days ago, on August 31, tubular solar-cell company Solyndra filed for Chapter 11 bankruptcy. This fact is notable for a few reasons, most prominent among them being the fact that the company received a $535 million loan guaranteed by the US government, which guaranteed the loan in order to promote the solar industry.

Because of the government involvement, and the "green energy" connection, this bankruptcy is turning into something of a political football, with predictable battle lines forming almost immediately. This blog post on the Forbes website describes the two sides of the argument, and then makes the argument that "Solyndra’s failure, while unfortunate, is hardly an indictment of federal energy technology policy. Failure is to be expected with emerging, innovative companies, whether they are financed by the government or the private sector."

A similar argument is made in this blog post from the Huffington Post website, in which the authors make the case that "it would be a serious mistake to over-interpret regarding the Solyndra crack-up, whether to generalize about the solar industry and cleantech or to broadly indict particular technology and development policies" and that "the blow-up of one particular loan guarantee to one particular company with one particular technology should not be spun into any broad new chilling of U.S. efforts to compete more aggressively in cleantech and other advanced manufacturing industries."

As professional investors who also back private companies with venture investments, our perspective on this matter is that the environmental angle is a gigantic red herring (or in this case a "green herring") and the bigger problem is the idea that tax dollars should be used for venture investment at all.

As investors, we are not particularly fond of the "cleantech" craze that has seized Silicon Valley and many private venture investors (many of whom were backers of Solyndra as well), but if private investors want to throw their money at businesses that they judge to be worthwhile investments, that is their concern and we don't begrudge them their right to do so. However, when the government ventures taxpayer money, an entirely different dynamic comes into play. As Milt Friedman said on many occasions, "very few people spend other people's money as carefully as they spend their own" (see for instance this video).

While the bloggers in the two articles cited above argue that government dollars are necessary to foster innovation, the fact is that if a company is innovative and is judged to have a high likelihood for future success, there will be investors who will be willing to fund that innovation for an opportunity to participate in that success. The technology companies which made Silicon Valley what it is today (and which provided much of the wealth of the founders of Solyndra and of their private investors) were built on private investment, not public investment.

No matter how much the authors of those blogs promise that greater government focus on "developing rigorous, market-informed finance strategies" will enable wise investment in the future, the fact that government investors are committing taxpayer dollars rather than private investors committing private dollars completely changes the equation. We believe this is true regardless of whether the government is committing those taxpayer dollars to solar technology companies or to any other business.

With taxpayer dollars, the market forces which penalize imprudent investment are absent: the providers of those dollars cannot in any way hold the person(s) who invested them accountable for their imprudence.

Those readers who are familiar with venture capital investment and the dollar amounts involved will appreciate the fact that $535 million is an enormous venture investment in a company. They will also appreciate the fact that getting a venture capitalist to give your company $535 million is an inordinately difficult thing to do, and would entail extremely rigorous examination with many blunt questions and no beating around the bush with small talk.

On the other hand, getting a loan from a bank which has the prospect of collecting interest on the loan if things go well, and of receiving their money back from the government if things do not go so well, is an entirely different proposition.

The operative point in all this is that it doesn't really matter whether the company in question is a solar-cell company or some completely different business -- the government should not be in the business of trying to determine which companies will be winners and receive taxpayer-backed loans or venture investments.

Critics of this position will of course argue that there are some very long-term projects which are appropriate for the use of taxpayer dollars, such as putting a man on the moon or building freeways, and we would agree. But those projects are owned by the government. Giving taxpayer dollars to someone's business as an "investment" is different and it should fall within the sphere of private investing, where those who make those investments bear the risks, have a vested interest in making sure the money is not wasted, and then can profit from the success if they invested wisely.

We believe investors should be aware of the Solyndra case and the issues involved, and should see through the distracting "green" debate to the deeper issues that this case reveals.

Here is a recent video in which Taylor Frigon President and Chief Investment Officer Gerry Frigon discusses the recent Solyndra news.

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