The Micro Effect Broadcast Network

I send you Outside the Box each week not to make you comfortable but to make you think. Usually it is on some financial topic, but life is more than investments. Economics is not an isolated discipline (more like an art form I think) so we have to have a real understanding of the world around us. This week I offer two essays which made me both think and reflect. We live in a world which wants easy solutions to complex problems, and wish as we may, will not get easy solutions which will work.

The first essay is by Pewter Huber on the reality of energy production. We all want to be able to "go green." How realistic is that? The second is by my friend George Friedman on torture and US intelligence failures.

Peter Huber is a Manhattan Institute senior fellow and the coauthor, most recently, of The Bottomless Well. His article develops arguments that he made in an Intelligence Squared U.S. debate in January. George is well known to OTB readers. He is president of Stratfor and was with the CIA (as was his wife Meredith) before they founded Stratfor, what I think of as the premier private intelligence agency in the world.

I suggest you put on your thinking caps and take some time to read both of these very important essays, and enjoy your week. I am off to Orlando and the CFA conference.

John Mauldin, Editor
Outside the Box

Bound to Burn

Humanity will keep spewing carbon into the atmosphere, but good policy can help sink it back into the earth.

By Peter W. Huber

Like medieval priests, today's carbon brokers will sell you an indulgence that forgives your carbon sins. It will run you about $500 for 5 tons of forgiveness — about how much the typical American needs every year. Or about $2,000 a year for a typical four-person household. Your broker will spend the money on such things as reducing methane emissions from hog farms in Brazil.

But if you really want to make a difference, you must send a check large enough to forgive the carbon emitted by four poor Brazilian households, too — because they're not going to do it themselves. To cover all five households, then, send $4,000. And you probably forgot to send in a check last year, and you might forget again in the future, so you'd best make it an even $40,000, to take care of a decade right now. If you decline to write your own check while insisting that to save the world we must ditch the carbon, you are just burdening your already sooty soul with another ton of self-righteous hypocrisy. And you can't possibly afford what it will cost to forgive that.

If making carbon this personal seems rude, then think globally instead. During the presidential race, Barack Obama was heard to remark that he would bankrupt the coal industry. No one can doubt Washington's power to bankrupt almost anything — in the United States. But China is adding 100 gigawatts of coal-fired electrical capacity a year. That's another whole United States' worth of coal consumption added every three years, with no stopping point in sight. Much of the rest of the developing world is on a similar path.

Cut to the chase. We rich people can't stop the world's 5 billion poor people from burning the couple of trillion tons of cheap carbon that they have within easy reach. We can't even make any durable dent in global emissions — because emissions from the developing world are growing too fast, because the other 80 percent of humanity desperately needs cheap energy, and because we and they are now part of the same global economy. What we can do, if we're foolish enough, is let carbon worries send our jobs and industries to their shores, making them grow even faster, and their carbon emissions faster still.

We don't control the global supply of carbon.

Ten countries ruled by nasty people control 80 percent of the planet's oil reserves — about 1 trillion barrels, currently worth about $40 trillion. If $40 trillion worth of gold were located where most of the oil is, one could only scoff at any suggestion that we might somehow persuade the nasty people to leave the wealth buried. They can lift most of their oil at a cost well under $10 a barrel. They will drill. They will pump. And they will find buyers. Oil is all they've got.

Poor countries all around the planet are sitting on a second, even bigger source of carbon — almost a trillion tons of cheap, easily accessible coal. They also control most of the planet's third great carbon reservoir — the rain forests and soil. They will keep squeezing the carbon out of cheap coal, and cheap forest, and cheap soil, because that's all they've got. Unless they can find something even cheaper. But they won't — not any time in the foreseeable future.

We no longer control the demand for carbon, either. The 5 billion poor — the other 80 percent — are already the main problem, not us. Collectively, they emit 20 percent more greenhouse gas than we do. We burn a lot more carbon individually, but they have a lot more children. Their fecundity has eclipsed our gluttony, and the gap is now widening fast. China, not the United States, is now the planet's largest emitter. Brazil, India, Indonesia, South Africa, and others are in hot pursuit. And these countries have all made it clear that they aren't interested in spending what money they have on low-carb diets. It is idle to argue, as some have done, that global warming can be solved — decades hence — at a cost of 1 to 2 percent of the global economy. Eighty percent of the global population hasn't signed on to pay more than 0 percent.

Accepting this last, self-evident fact, the Kyoto Protocol divides the world into two groups. The roughly 1.2 billion citizens of industrialized countries are expected to reduce their emissions. The other 5 billion — including both China and India, each of which is about as populous as the entire Organisation for Economic Co-operation and Development — aren't. These numbers alone guarantee that humanity isn't going to reduce global emissions at any point in the foreseeable future — unless it does it the old-fashioned way, by getting poorer. But the current recession won't last forever, and the long-term trend is clear. Their populations and per-capita emissions are rising far faster than ours could fall under any remotely plausible carbon-reduction scheme.

Might we simply buy their cooperation? Various plans have circulated for having the rich pay the poor to stop burning down rain forests and to lower greenhouse-gas emissions from primitive agricultural practices. But taking control of what belongs to someone else ultimately means buying it. Over the long term, we would in effect have to buy up a large fraction of all the world's forests, soil, coal, and oil — and then post guards to make sure that poor people didn't sneak in and grab all the carbon anyway. Buying off people just doesn't fly when they outnumber you four to one.

Might we instead manage to give the world something cheaper than carbon? The moon-shot law of economics says yes, of course we can. If we just put our minds to it, it will happen. Atom bomb, moon landing, ultracheap energy — all it takes is a triumph of political will.

Really? For the very poorest, this would mean beating the price of the free rain forest that they burn down to clear land to plant a subsistence crop. For the slightly less poor, it would mean beating the price of coal used to generate electricity at under 3 cents per kilowatt-hour.

And with one important exception, which we will return to shortly, no carbon-free fuel or technology comes remotely close to being able to do that. Fossil fuels are extremely cheap because geological forces happen to have created large deposits of these dense forms of energy in accessible places. Find a mountain of coal, and you can just shovel gargantuan amounts of energy into the boxcars.

Shoveling wind and sun is much, much harder. Windmills are now 50-story skyscrapers. Yet one windmill generates a piddling 2 to 3 megawatts. A jumbo jet needs 100 megawatts to get off the ground; Google is building 100-megawatt server farms. Meeting New York City's total energy demand would require 13,000 of those skyscrapers spinning at top speed, which would require scattering about 50,000 of them across the state, to make sure that you always hit enough windy spots. To answer the howls of green protest that inevitably greet realistic engineering estimates like these, note that real-world systems must be able to meet peak, not average, demand; that reserve margins are essential; and that converting electric power into liquid or gaseous fuels to power the existing transportation and heating systems would entail substantial losses. What was Mayor Bloomberg thinking when he suggested that he might just tuck windmills into Manhattan? Such thoughts betray a deep ignorance about how difficult it is to get a lot of energy out of sources as thin and dilute as wind and sun.

It's often suggested that technology improvements and mass production will sharply lower the cost of wind and solar. But engineers have pursued these technologies for decades, and while costs of some components have fallen, there is no serious prospect of costs plummeting and performance soaring as they have in our laptops and cell phones. When you replace conventional with renewable energy, everything gets bigger, not smaller — and bigger costs more, not less. Even if solar cells themselves were free, solar power would remain very expensive because of the huge structures and support systems required to extract large amounts of electricity from a source so weak that it takes hours to deliver a tan.

This is why the (few) greens ready to accept engineering and economic reality have suddenly emerged as avid proponents of nuclear power. In the aftermath of the Three Mile Island accident — which didn't harm anyone, and wouldn't even have damaged the reactor core if the operators had simply kept their hands off the switches and let the automatic safety systems do their job — ostensibly green antinuclear activists unwittingly boosted U.S. coal consumption by about 400 million tons per year. The United States would be in compliance with the Kyoto Protocol today if we could simply undo their handiwork and conjure back into existence the nuclear plants that were in the pipeline in nuclear power's heyday. Nuclear power is fantastically compact, and — as America's nuclear navy, several commercial U.S. operators, France, Japan, and a handful of other countries have convincingly established — it's both safe and cheap wherever engineers are allowed to get on with it.

But getting on with it briskly is essential, because costs hinge on the huge, up-front capital investment in the power plant. Years of delay between the capital investment and when it starts earning a return are ruinous. Most of the developed world has made nuclear power unaffordable by surrounding it with a regulatory process so sluggish and unpredictable that no one will pour a couple of billion dollars into a new plant, for the good reason that no one knows when (or even if) the investment will be allowed to start making money.

And countries that don't trust nuclear power on their own soil must hesitate to share the technology with countries where you never know who will be in charge next year, or what he might decide to do with his nuclear toys. So much for the possibility that cheap nuclear power might replace carbon-spewing sources of energy in the developing world. Moreover, even India and China, which have mastered nuclear technologies, are deploying far more new coal capacity.

Remember, finally, that most of the cost of carbon-based energy resides not in the fuels but in the gigantic infrastructure of furnaces, turbines, and engines. Those costs are sunk, which means that carbon-free alternatives — with their own huge, attendant, front-end capital costs — must be cheap enough to beat carbon fuels that already have their infrastructure in place. That won't happen in our lifetimes.

Another argument commonly advanced is that getting over carbon will, nevertheless, be comparatively cheap, because it will get us over oil, too — which will impoverish our enemies and save us a bundle at the Pentagon and the Department of Homeland Security. But uranium aside, the most economical substitute for oil is, in fact, electricity generated with coal. Cheap coal-fired electricity has been, is, and will continue to be a substitute for oil, or a substitute for natural gas, which can in turn substitute for oil. By sharply boosting the cost of coal electricity, the war on carbon will make us more dependent on oil, not less.

The first place where coal displaces oil is in the electric power plant itself. When oil prices spiked in the early 1980s, U.S. utilities quickly switched to other fuels, with coal leading the pack; the coal-fired plants now being built in China, India, and other developing countries are displacing diesel generators. More power plants burning coal to produce cheap electricity can also mean less natural gas used to generate electricity. And less used for industrial, commercial, and residential heating, welding, and chemical processing, as these users switch to electrically powered alternatives. The gas that's freed up this way can then substitute for diesel fuel in heavy trucks, delivery vehicles, and buses. And coal-fired electricity will eventually begin displacing gasoline, too, as soon as plug-in hybrid cars start recharging their batteries directly from the grid.

To top it all, using electricity generated in large part by coal to power our passenger cars would lower carbon emissions — even in Indiana, which generates 75 percent of its electricity with coal. Big power plants are so much more efficient than the gasoline engines in our cars that a plug-in hybrid car running on electricity supplied by Indiana's current grid still ends up more carbon-frugal than comparable cars burning gasoline in a conventional engine under the hood. Old-guard energy types have been saying this for decades. In a major report released last March, the World Wildlife Fund finally concluded that they were right all along.

But true carbon zealots won't settle for modest reductions in carbon emissions when fat targets beckon. They see coal-fired electricity as the dragon to slay first. Huge, stationary sources can't run or hide, and the cost of doing without them doesn't get rung up in plain view at the gas pump. California, Pennsylvania, and other greener-than-thou states have made flatlining electricity consumption the linchpin of their war on carbon. That is the one certain way to halt the displacement of foreign oil by cheap, domestic electricity.

The oil-coal economics come down to this. Per unit of energy delivered, coal costs about one-fifth as much as oil — but contains one-third more carbon. High carbon taxes (or tradable permits, or any other economic equivalent) sharply narrow the price gap between oil and the one fuel that can displace it worldwide, here and now. The oil nasties will celebrate the green war on carbon as enthusiastically as the coal industry celebrated the green war on uranium 30 years ago.

The other 5 billion are too poor to deny these economic realities. For them, the price to beat is 3-cent coal-fired electricity. China and India won't trade 3-cent coal for 15-cent wind or 30-cent solar. As for us, if we embrace those economically frivolous alternatives on our own, we will certainly end up doing more harm than good.

By pouring money into anything-but-carbon fuels, we will lower demand for carbon, making it even cheaper for the rest of the world to buy and burn. The rest will use cheaper energy to accelerate their own economic growth. Jobs will go where energy is cheap, just as they go where labor is cheap. Manufacturing and heavy industry require a great deal of energy, and in a global economy, no competitor can survive while paying substantially more for an essential input. The carbon police acknowledge the problem and talk vaguely of using tariffs and such to address it. But carbon is far too deeply embedded in the global economy, and materials, goods, and services move and intermingle far too freely, for the customs agents to track.

Consider your next Google search. As noted in a recent article in Harper's, "Google . . . and its rivals now head abroad for cheaper, often dirtier power." Google itself (the "don't be evil" company) is looking to set up one of its electrically voracious server farms at a site in Lithuania, "disingenuously described as being near a hydroelectric dam." But Lithuania's grid is 0.5 percent hydroelectric and 78 percent nuclear. Perhaps the company's next huge farm will be "near" the Three Gorges Dam in China, built to generate over three times as much power as our own Grand Coulee Dam in Washington State. China will be happy to play along, while it quietly plugs another coal plant into its grid a few pylons down the line. All the while, of course, Google will maintain its low-energy headquarters in California, a state that often boasts of the wise regulatory policies — centered, one is told, on efficiency and conservation — that have made it such a frugal energy user. But in fact, sky-high prices have played the key role, curbing internal demand and propelling the flight from California of power plants, heavy industries, chip fabs, server farms, and much else (see "California's Potemkin Environmentalism," Spring 2008).

So the suggestion that we can lift ourselves out of the economic doldrums by spending lavishly on exceptionally expensive new sources of energy is absurd. "Green jobs" means Americans paying other Americans to chase carbon while the rest of the world builds new power plants and factories. And the environmental consequences of outsourcing jobs, industries, and carbon to developing countries are beyond dispute. They use energy far less efficiently than we do, and they remain almost completely oblivious to environmental impacts, just as we were in our own first century of industrialization. A massive transfer of carbon, industry, and jobs from us to them will raise carbon emissions, not lower them.

The grand theory for how the developed world can unilaterally save the planet seems to run like this. We buy time for the planet by rapidly slashing our own emissions. We do so by developing carbon-free alternatives even cheaper than carbon. The rest of the world will then quickly adopt these alternatives, leaving most of its trillion barrels of oil and trillion tons of coal safely buried, most of the rain forests standing, and most of the planet's carbon-rich soil undisturbed. From end to end, however, this vision strains credulity.

Perhaps it's the recognition of that inconvenient truth that has made the anti-carbon rhetoric increasingly apocalyptic. Coal trains have been analogized to boxcars headed for Auschwitz. There is talk of the extinction of all humanity. But then, we have heard such things before. It is indeed quite routine, in environmental discourse, to frame choices as involving potentially infinite costs on the green side of the ledger. If they really are infinite, no reasonable person can quibble about spending mere billions, or even trillions, on the dollar side, to dodge the apocalyptic bullet.

Thirty years ago, the case against nuclear power was framed as the "Zero-Infinity Dilemma." The risks of a meltdown might be vanishingly small, but if it happened, the costs would be infinitely large, so we should forget about uranium. Computer models demonstrated that meltdowns were highly unlikely and that the costs of a meltdown, should one occur, would be manageable — but greens scoffed: huge computer models couldn't be trusted. So we ended up burning much more coal. The software shoe is on the other foot now; the machines that said nukes wouldn't melt now say that the ice caps will. Warming skeptics scoff in turn, and can quite plausibly argue that a planet is harder to model than a nuclear reactor. But that's a detail. From a rhetorical perspective, any claim that the infinite, the apocalypse, or the Almighty supports your side of the argument shuts down all further discussion.

To judge by actions rather than words, however, few people and almost no national governments actually believe in the infinite rewards of exorcising carbon from economic life. Kyoto has hurt the anti-carbon mission far more than carbon zealots seem to grasp. It has proved only that with carbon, governments will say and sign anything — and then do less than nothing. The United States should steer well clear of such treaties because they are unenforceable, routinely ignored, and therefore worthless.

If we're truly worried about carbon, we must instead approach it as if the emissions originated in an annual eruption of Mount Krakatoa. Don't try to persuade the volcano to sign a treaty promising to stop. Focus instead on what might be done to protect and promote the planet's carbon sinks — the systems that suck carbon back out of the air and bury it. Green plants currently pump 15 to 20 times as much carbon out of the atmosphere as humanity releases into it — that's the pump that put all that carbon underground in the first place, millions of years ago. At present, almost all of that plant-captured carbon is released back into the atmosphere within a year or so by animal consumers. North America, however, is currently sinking almost two-thirds of its carbon emissions back into prairies and forests that were originally leveled in the 1800s but are now recovering. For the next 50 years or so, we should focus on promoting better land use and reforestation worldwide. Beyond that, weather and the oceans naturally sink about one-fifth of total fossil-fuel emissions. We should also investigate large-scale options for accelerating the process of ocean sequestration.

Carbon zealots despise carbon-sinking schemes because, they insist, nobody can be sure that the sunk carbon will stay sunk. Yet everything they propose hinges on the assumption that carbon already sunk by nature in what are now hugely valuable deposits of oil and coal can be kept sunk by treaty and imaginary cheaper-than-carbon alternatives. This, yet again, gets things backward. We certainly know how to improve agriculture to protect soil, and how to grow new trees, and how to maintain existing forests, and we can almost certainly learn how to mummify carbon and bury it back in the earth or the depths of the oceans, in ways that neither man nor nature will disturb. It's keeping nature's black gold sequestered from humanity that's impossible.

If we do need to do something serious about carbon, the sequestration of carbon after it's burned is the one approach that accepts the growth of carbon emissions as an inescapable fact of the twenty-first century. And it's the one approach that the rest of the world can embrace, too, here and now, because it begins with improving land use, which can lead directly and quickly to greater prosperity. If, on the other hand, we persist in building green bridges to nowhere, we will make things worse, not better. Good intentions aren't enough. Turned into ineffectual action, they can cost the earth and accelerate its ruin at the same time.

And now to George Friedman:

Torture and the U.S. Intelligence Failure

By George Friedman

The Obama administration published a series of memoranda on torture issued under the Bush administration. The memoranda, most of which dated from the period after 9/11, authorized measures including depriving prisoners of solid food, having them stand shackled and in uncomfortable positions, leaving them in cold cells with inadequate clothing, slapping their heads and/or abdomens, and telling them that their families might be harmed if they didn't cooperate with their interrogators.

On the scale of human cruelty, these actions do not rise anywhere near the top. At the same time, anyone who thinks that being placed without food in a freezing cell subject to random mild beatings — all while being told that your family might be joining you — isn't agonizing clearly lacks imagination. The treatment of detainees could have been worse. It was terrible nonetheless.

Torture and the Intelligence Gap

But torture is meant to be terrible, and we must judge the torturer in the context of his own desperation. In the wake of 9/11, anyone who wasn't terrified was not in touch with reality. We know several people who now are quite blasé about 9/11. Unfortunately for them, we knew them in the months after, and they were not nearly as composed then as they are now.

Sept. 11 was terrifying for one main reason: We had little idea about al Qaeda's capabilities. It was a very reasonable assumption that other al Qaeda cells were operating in the United States and that any day might bring follow-on attacks. (Especially given the group's reputation for one-two attacks.) We still remember our first flight after 9/11, looking at our fellow passengers, planning what we would do if one of them moved. Every time a passenger visited the lavatory, one could see the tensions soar.

And while Sept. 11 was frightening enough, there were ample fears that al Qaeda had secured a "suitcase bomb" and that a nuclear attack on a major U.S. city could come at any moment. For individuals, such an attack was simply another possibility. We remember staying at a hotel in Washington close to the White House and realizing that we were at ground zero — and imagining what the next moment might be like. For the government, however, the problem was having scraps of intelligence indicating that al Qaeda might have a nuclear weapon, but not having any way of telling whether those scraps had any value. The president and vice president accordingly were continually kept at different locations, and not for any frivolous reason.

This lack of intelligence led directly to the most extreme fears, which in turn led to extreme measures. Washington simply did not know very much about al Qaeda and its capabilities and intentions in the United States. A lack of knowledge forces people to think of worst-case scenarios. In the absence of intelligence to the contrary after 9/11, the only reasonable assumption was that al Qaeda was planning more — and perhaps worse — attacks.

Collecting intelligence rapidly became the highest national priority. Given the genuine and reasonable fears, no action in pursuit of intelligence was out of the question, so long as it promised quick answers. This led to the authorization of torture, among other things. Torture offered a rapid means to accumulate intelligence, or at least — given the time lag on other means — it was something that had to be tried.

Torture and the Moral Question

And this raises the moral question. The United States is a moral project: its Declaration of Independence and Constitution state that. The president takes an oath to preserve, protect and defend the Constitution from all enemies foreign and domestic. The Constitution does not speak to the question of torture of non-citizens, but it implies an abhorrence of rights violations (at least for citizens). But the Declaration of Independence contains the phrase, "a decent respect for the opinions of mankind." This indicates that world opinion matters.

At the same time, the president is sworn to protect the Constitution. In practical terms, this means protecting the physical security of the United States "against all enemies, foreign and domestic." Protecting the principles of the declaration and the Constitution are meaningless without regime preservation and defending the nation.

While this all makes for an interesting seminar in political philosophy, presidents — and others who have taken the same oath — do not have the luxury of the contemplative life. They must act on their oaths, and inaction is an action. Former U.S. President George W. Bush knew that he did not know the threat, and that in order to carry out his oath, he needed very rapidly to find out the threat. He could not know that torture would work, but he clearly did not feel that he had the right to avoid it.

Consider this example. Assume you knew that a certain individual knew the location of a nuclear device planted in an American city. The device would kill hundreds of thousands of Americans, but he individual refused to divulge the information. Would anyone who had sworn the oath have the right not to torture the individual? Torture might or might not work, but either way, would it be moral to protect the individual's rights while allowing hundreds of thousands to die? It would seem that in this case, torture is a moral imperative; the rights of the one with the information cannot transcend the life of a city.

Torture in the Real World

But here is the problem: You would not find yourself in this situation. Knowing a bomb had been planted, knowing who knew that the bomb had been planted, and needing only to apply torture to extract this information is not how the real world works. Post-9/11, the United States knew much less about the extent of the threat from al Qaeda. This hypothetical sort of torture was not the issue.

Discrete information was not needed, but situational awareness. The United States did not know what it needed to know, it did not know who was of value and who wasn't, and it did not know how much time it had. Torture thus was not a precise solution to a specific problem: It became an intelligence-gathering technique. The nature of the problem the United States faced forced it into indiscriminate intelligence gathering. When you don't know what you need to know, you cast a wide net. And when torture is included in the mix, it is cast wide as well. In such a case, you know you will be following many false leads — and when you carry torture with you, you will be torturing people with little to tell you. Moreover, torture applied by anyone other than well-trained, experienced personnel (who are in exceptionally short supply) will only compound these problems, and make the practice less productive.

Defenders of torture frequently seem to believe that the person in custody is known to have valuable information, and that this information must be forced out of him. His possession of the information is proof of his guilt. The problem is that unless you have excellent intelligence to begin with, you will become engaged in developing baseline intelligence, and the person you are torturing may well know nothing at all. Torture thus becomes not only a waste of time and a violation of decency, it actually undermines good intelligence. After a while, scooping up suspects in a dragnet and trying to extract intelligence becomes a substitute for competent intelligence techniques — and can potentially blind the intelligence service. This is especially true as people will tell you what they think you want to hear to make torture stop.

Critics of torture, on the other hand, seem to assume the torture was brutality for the sake of brutality instead of a desperate attempt to get some clarity on what might well have been a catastrophic outcome. The critics also cannot know the extent to which the use of torture actually prevented follow-on attacks. They assume that to the extent that torture was useful, it was not essential; that there were other ways to find out what was needed. In the long run, they might have been correct. But neither they, nor anyone else, had the right to assume in late 2001 that there was a long run. One of the things that wasn't known was how much time there was.

The U.S. Intelligence Failure

The endless argument over torture, the posturing of both critics and defenders, misses the crucial point. The United States turned to torture because it has experienced a massive intelligence failure reaching back a decade. The U.S. intelligence community simply failed to gather sufficient information on al Qaeda's intentions, capability, organization and personnel. The use of torture was not part of a competent intelligence effort, but a response to a massive intelligence failure.

That failure was rooted in a range of miscalculations over time. There was the public belief that the end of the Cold War meant the United States didn't need a major intelligence effort, a point made by the late Sen. Daniel Moynihan. There were the intelligence people who regarded Afghanistan as old news. There was the Torricelli amendment that made recruiting people with ties to terrorist groups illegal without special approval. There were the Middle East experts who could not understand that al Qaeda was fundamentally different from anything seen before. The list of the guilty is endless, and ultimately includes the American people, who always seem to believe that the view of the world as a dangerous place is something made up by contractors and bureaucrats.

Bush was handed an impossible situation on Sept. 11, after just nine months in office. The country demanded protection, and given the intelligence shambles he inherited, he reacted about as well or badly as anyone else might have in the situation. He used the tools he had, and hoped they were good enough.

The problem with torture — as with other exceptional measures — is that it is useful, at best, in extraordinary situations. The problem with all such techniques in the hands of bureaucracies is that the extraordinary in due course becomes the routine, and torture as a desperate stopgap measure becomes a routine part of the intelligence interrogator's tool kit.

At a certain point, the emergency was over. U.S. intelligence had focused itself and had developed an increasingly coherent picture of al Qaeda, with the aid of allied Muslim intelligence agencies, and was able to start taking a toll on al Qaeda. The war had become routinized, and extraordinary measures were no longer essential. But the routinization of the extraordinary is the built-in danger of bureaucracy, and what began as a response to unprecedented dangers became part of the process. Bush had an opportunity to move beyond the emergency. He didn't.

If you know that an individual is loaded with information, torture can be a useful tool. But if you have so much intelligence that you already know enough to identify the individual is loaded with information, then you have come pretty close to winning the intelligence war. That's not when you use torture. That's when you simply point out to the prisoner that, "for you the war is over." You lay out all you already know and how much you know about him. That is as demoralizing as freezing in a cell — and helps your interrogators keep their balance.

U.S. President Barack Obama has handled this issue in the style to which we have become accustomed, and which is as practical a solution as possible. He has published the memos authorizing torture to make this entirely a Bush administration problem while refusing to prosecute anyone associated with torture, keeping the issue from becoming overly divisive. Good politics perhaps, but not something that deals with the fundamental question.

The fundamental question remains unanswered, and may remain unanswered. When a president takes an oath to "preserve, protect and defend the Constitution of the United States," what are the limits on his obligation? We take the oath for granted. But it should be considered carefully by anyone entering this debate, particularly for presidents.

I've been in this business a long time. Some days it feels like a very long time. But never in all the years that I've been in the financial markets have I felt like business per se has less impact on my investment decisions. Let me explain.

GM shares have gone from being a claim on earnings from car sales to being a call option on whether the US government will extend another lifeline. Banks' capital structures have gone from being the province of Boards of Directors and CFOs to the "expertise" of Congressional committees and appointed regulators. Used to be when I thought about Financial Centers New York and London came to mind. Instead now I have to think about Washington and Brussels.

My friend George Friedman and his team at STRATFOR are where I turn when I need help thinking about these new realities. George's team provides me context and understanding of the environment in which financial developments are going to take place. I may tweak him about his ties, but if you saw George speak at my conference in La Jolla, you know that he's an absolutely compelling speaker. And it's small wonder that his latest book spent those weeks on the New York Times bestseller list too.

Below you'll find STRATFOR's 2Q Forecast. I hope you find it as helpful as I do in formulating my plans. What I can tell you with certainty is that if you're not taking into account the impact of geopolitical events on the markets, it's no different than trading agricultural futures without a weather forecast. George and his team provide their Members - myself included - with forecasts and on-going analysis that's invaluable in understanding the seachange in the global economy. And in exchange for me not teasing him any more, he's offering my readers a special rate on a STRATFOR Membership. Click here to join STRATFOR at this special rate and get access to a full year of the same geopolitical intelligence I use in my strategic planning. You'll be glad you did.

Yours, John Mauldin
Editor, Outside the Box

Second Quarter Forecast 2009: Global Trends

Editor’s note: STRATFOR arranges its primary forecasts — in this case the document below — topically rather than geographically. Thus, the entirety of our South Asia and Global Economy coverage for the quarterly is included in this primary forecast. Those portions of the Middle East and Eurasia forecasts that are not included in this forecast have been appended with the other regional sections.

Executive Summary

STRATFOR’s 2009 annual forecast focused on three broad trends: the global recession, the Russian resurgence and the evolution of the jihadist war.

There are number of indications that the U.S. economy is showing signs of life, but it will be weeks — if not months — before these glimmers may assemble into a firm recovery. At that point, it would be a minimum of an additional three months before a U.S. recovery could foster a global recovery. This means that for the second quarter, STRATFOR is able to take a pass on this part of our forecast. Either this quarter will be the dark before the dawn, or it will be the dark before midnight. Either way, it will be dark. A noticeable recovery will have to wait until the third quarter.

In the first quarter, Russia was convinced that it had the new U.S. president and his administration right where it wanted them: so obsessed with the Afghan war that Russia could demand anything it wanted in exchange for allowing military supplies to enter Afghanistan from the north. Russia miscalculated. It seems the Obama administration puts something above fighting the Afghan war on its priority list: limiting Russia’s resurgence. The second quarter will be Russia’s time to consolidate the advances it has made over the course of the past four years, before the Americans can gain any capacity from their planned Iraqi drawdown. Washington will be looking for ways to bolster allies against Moscow, with a somewhat ambivalent Turkey taking center stage.

Finally there is the jihadist war itself. The U.S. divide-and-conquer strategy has worked reasonably well in Iraq: Some Sunni militants, rather than shooting at U.S. forces, are now being integrated (after a fashion) into the fragile yet strengthening Iraqi federal government. This is allowing the United States to remove some forces from Iraq, and thus to surge some into Afghanistan. The American intent is to rework the divide-and-conquer trick on the Taliban. However, this tactic is not likely to be replicable for a mixture of historical, demographic and geographic reasons. The most likely reason for the plan to not succeed is because in Iraq, the “good” Sunnis the Americans courted were locals — nationalists under pressure from Shiite Iran — while the “bad” Sunnis were foreign Islamists. In Afghanistan, there is no neat factional split within the Taliban. So for the Americans, the next three months will be about trying to force a square peg into a round hole. There will be little if any progress, and the Pakistani government’s lack of enthusiasm for the conflict will allow the region’s militants to expand the scope of the war.

Primary Forecast

Global trend: The Economy

Undoubtedly, there is plenty of bad news — stock market surges tend to be the first major sign that the U.S. economy is healing, but the stock market cannot seem to find its feet, and employment remains well off ideal levels. Yet in the latter half of the first quarter, there were several developments indicating that the credit chokehold that caused the American recession to go global has begun to slacken. The availability of credit is the critical issue when evaluating this recession. Until firms and consumers can reliably borrow, economic growth cannot recover.

There are limited signs that credit is indeed loosening, and that some life is creeping back into the U.S. economy. Recent changes in accounting rules in the United States and Europe should grant banks the confidence they need to resume lending, independent of anything the governments might attempt. The Obama stimulus package — albeit far from perfect for actually stimulating the economy — is beginning to take effect. Retail sales have been surprisingly buoyant and since consumer spending comprises 70 percent of the American economy, this is a critical factor. Even more important is the fact that the stock of inventories has dropped for six consecutive months (September 2008 to February 2009, the latest month for which data is available) in the steepest decline on record. With inventories low, producers will soon be getting orders. That is how economic recoveries begin. There are even flickers of activity in the most moribund U.S. economic sector: housing.

But even if the United States economy is indeed showing signs of life, four caveats must kept in mind.

First, even a robust resumption in U.S. growth will not begin on any specific date. Instead, there will be increasingly bright glimmers of light here and there that will not be fully recognized until six months after the fact. It appears that the second quarter may be a transition quarter for the United States, with the more noticeable growth happening later in the year.

Second, the future of the American automotive industry his shifted from bleak to dark, with General Motors Corp. in particular planning for imminent bankruptcy (and GM is not the worst off of the Detroit Three). The dislocations caused by this industry’s implosion will be felt far and wide and even if they somehow do not delay the recovery, they are certain to have a material impact on how serious the average American views the recession as being.

Third, a resumption in growth in the United States historically does not mean an immediate rebound in either income or employment figures — both tend to be lagging indicators — particularly if the automotive industry breaks apart. Therefore, even if the recession does let up in the second quarter and growth turns nominally positive, that does not mean that most Americans will feel like the situation has improved. Bear in mind that it did not become conventional wisdom that the United States’ 2001 recession — which actually ended in October 2001 — had ended until 2004. Dispelling Americans’ mental gloom required more than two years of strong and sustained growth.

Fourth, while STRATFOR is certain that the U.S. economy will lead the world out of recession — the roughly $10 trillion American consumer market will demand products from, and thus generate growth in, Asia and Europe — STRATFOR is equally certain that there will be a lag of one to three quarters between a U.S. recovery and a global recovery. Most of Asia has suffered export plunges of at least 50 percent, and industrial output is down by a third the world over. Even if the Americans already have eaten through existing inventory, it will take some time for foreign suppliers to spin their industrial bases back up. The global system does not turn on a dime.

This means in the quarter ahead STRATFOR actually gets to opt out of taking a hard stance on this issue. If the United States does not recover, the world will remain mired in recession. If the United States begins to recover, the world will remain mired in recession and will begin pulling out later in the year. Either way, the second quarter is not going to be a comfortable time; it just might be slightly less uncomfortable for the Americans.

Internationally, there will be only one force aside from the U.S. economy to watch: the International Monetary Fund (IMF), which was recapitalized at the April G-20 summit to handle the growing need for bailouts. The IMF’s assistance programs can be split into two parts. First, traditional structural adjustment programs will provide funds to states that have made poor economic decisions. These states then fall under the IMF’s tutelage, and they must make often-wrenching changes to how their systems are run. States tapping this sort of loan program include Ukraine, Hungary, Iceland, Sri Lanka and Pakistan. These states in essence are on a sort of life support while undergoing economic surgery.

The second kind of program — introduced in March — is a bridge loan for states that have been doing a decent job of economic management but are affected by factors related to the recession that lie utterly beyond their control. This second type of program does not require any meaningful changes to a state’s economic management as (in the IMF’s eyes) they have not done anything wrong, and could perhaps be extended to countries like South Korea, Brazil, Mexico and Poland. It is this second sort of program that will have a deeper effect on the system in the short run as it will allow larger states to maintain economic activity independent of the United States, somewhat blunting the effects of the recession without threatening social stability. It is also going to absorb the lion’s share of the IMF’s funding; the first program negotiated under this system — a $40 billion line of credit to Mexico — is two-thirds as large as the combined total of the more traditional loans granted since the crisis began.

Global trend: The Russian resurgence

In STRATFOR’s 2009 annual forecast, we outlined how a dominant issue for the year would be Russia’s effort to force the United States to make a strategic bargain: Russia would grant U.S. forces a northern supply route into Afghanistan in exchange for an expunging of Western influence from the former Soviet space. At a series of summits in the first week of April, the Obama administration broadly rebuffed Russia’s demands, and the two states are sliding quickly into confrontational stances.

From the U.S. point of view, Russia has overreached and has failed to consolidate its position in the key former Soviet spheres it assumed were under its control. From the Russian point of view, the U.S. refusal to accept Russia’s superior position has forced Moscow to redouble its consolidation efforts in order to erode Washington’s confidence and limit Washington’s future options inside the former Soviet sphere.

Russia will make three major consolidation efforts during the next three months. First and most important, Moscow will try to manipulate Ukraine to remove pro-Western elements such as Ukrainian President Viktor Yushchenko from power. Second, Moscow will undermine the Georgian government to destabilize pro-Western elements there. Georgia, unlike Ukraine, is solidly pro-Western, so Russia is satisfied simply to destabilize or neutralize it rather than transform it into something useful to Moscow. The deck is stacked in the Kremlin’s favor in both states due to Russia’s overwhelming energy, intelligence, political, economic and cultural influence, as well as geographic proximity.

But it is the third consolidation attempt where things will get tricky: Armenia.

Turkey and Russia’s spheres of influence overlap in many regions, including the Caucasus. Not only is Russia very active in Georgia, but Turkey — as part of its efforts to relaunch long-dormant geopolitical ambitions — is trying to normalize relations with Armenia. Turkey ended relations with Armenia in 1993 after Armenia began its war with neighboring Azerbaijan over the secessionist Armenian region of Nagorno-Karabakh located inside Azerbaijan — and the Turkish-Azerbaijani relationship has only strengthened (especially against Armenia) since then.

However, the normalization of relations between Turkey and Armenia would open the Caucasus to a flood of Turkish political and economic influence. Until now, Moscow has actually facilitated this process, thinking that a grateful Turkey would not side with Europe and particularly the United States in containing Russian influence. Now that U.S. President Barack Obama has personally forged a partnership with the Turks, the Kremlin is not so sure.

The restoration of ties between Turkey and Armenia was rumored to occur in the first week of April, though now dates for the event range from May to October. Russia has many levers, including energy, which it can use to counter Turkey’s orientation toward the Americans, including Moscow’s power to decide whether its protectorate of Armenia will go forward with any deal with Ankara.

The wild card in talks between Turkey and Armenia is Azerbaijan. Baku — which considers Yerevan its worst enemy — feels that its close ally Turkey has abandoned it and wants to ensure its interests are not overlooked in any deal between Turkey and Armenia. Baku is considering two means of scuttling the talks, both with the intent of severing growing Turkish-Armenian ties: appealing to Russia (the logic being that Turkey does not wish to simply trade energy-rich Azerbaijan for energy-poor Armenia), or directly attacking Armenian-held territory (triggering a war in which Turkey would feel forced to take sides).

Global trend: The U.S.-jihadist war

While STRATFOR maintains that the overall strategic threat posed by the transnational jihadist movement continues to wane, the U.S.-jihadist war, which stretches from Iraq to the Indian subcontinent, remains a dominant theme for 2009.

The United States has no choice but to wrap up the war in Iraq so that it can devote more resources to the war in Afghanistan, but the transition from the Middle East to South Asia will not be easy. A fragile power-sharing deal among the Shiite, Sunni and Kurdish power groups remains intact, and violence levels are still low. Yet, as STRATFOR expected, the United States is facing difficulties ensuring that the Shiite-dominated Iraqi government is integrating into the security apparatus members of the Sunni militia forces that split off from al Qaeda and allied with the United States. Shiite-Sunni tensions will continue to simmer. Al Qaeda in Iraq (AQI), while a much-weakened force, may still appeal to dissident Sunnis — which may allow AQI to regain space and carry out more attacks.

Kurdish-Arab tensions are also likely to escalate over the next several months. Kurdish claims to the oil-rich city of Kirkuk and constant political maneuvering among Sunnis, Kurds and Shia (most notably involving the Iraqi prime minister) could ignite the dispute over Kirkuk’s future for political gain. In addition, political infighting within the Patriotic Union of Kurdistan (PUK) is likely to worsen as PUK leader and Iraqi President Jalal Talabani prepares for his succession.

The United States will try to improve its chances of holding Iraq together internally by laying the groundwork for a more constructive relationship with Iraq’s Persian neighbors. On the surface, the U.S.-Iranian relationship is improving: Obama has made clear his intent to engage Iran; his administration has agreed to direct, multilateral talks with the Iranians on the nuclear issue; and Iran is participating in U.S.-led summits on Afghanistan. But beyond the rhetoric, little has changed between Tehran and Washington. Iran is more likely to ratchet up ambiguity and Western anxiety over its nuclear program than make concessions to Washington. Like AQI, Iran’s influence may have slipped, but it has not evaporated: Iran’s influence with Shiite militants remains strong enough to upset the delicate Sunni-Shiite balance the Americans are counting on holding.

Iran is also unhappy with the developing U.S. strategy in Afghanistan that calls for engaging with “moderate” members of the Taliban — a radical Sunni force that Tehran regards as a strategic threat. Tehran will keep up appearances in the diplomatic sphere but will continue to keep its distance from Washington on any issues of substance in the near term. Iranian presidential elections will be held in June, but regardless of which camp the winner comes from — hard-line, moderate or reformist — Iran’s foreign policy goals and concerns are unlikely to shift significantly.

Meanwhile, Washington will shift its focus to South Asia even though there are evidently many loose ends to tie up in the Middle East. The developing U.S. strategy for this region will focus on bolstering the U.S. forces in Afghanistan, negotiating with moderate Taliban and diversifying supply routes to deny Pakistan some of the leverage it holds in this war. However, this plan suffers from a number of strategic flaws.

The second quarter will be a trying one for U.S. forces in Afghanistan. The initial surge of 21,000 troops into Afghanistan will not be in place until summer’s end. Though European NATO members have contributed additional forces to help secure the country for elections in August, most are temporary commitments and do little to alter the overall U.S. and NATO force structure being directed at a native guerrilla force with superior local knowledge and intelligence. This puts NATO on its heels in combating Taliban and al Qaeda forces, which will use this spring fighting season to shape the battlefield, carrying out operations in the countryside that aim to expand their territorial control and launching complex attacks in urban centers that aim to degrade the confidence of Afghan civilians and security forces.

American attempts to elicit cooperation from Pakistan through aid packages are unlikely to affect Pakistani behavior significantly in the near term. Though Pakistan is threatened by a separate Taliban insurgency at home, it prefers negotiations over force on its side of the border. This gap between U.S. and Pakistani policy in managing the insurgency will become more evident in the coming weeks and months as Pakistan fends off U.S. attempts to overhaul the Pakistani intelligence apparatus and makes agreements that undermine the writ of the Pakistani state in its northwest periphery. Pakistan’s preference to avoid combat will allow Taliban forces to concentrate their attacks on the U.S. and NATO supply routes that originate in the port of Karachi.

The United States had attempted to diversify its supply lines by opening up a northern route that enters Afghanistan through Russian-dominated Central Asia, but talks have frozen as U.S.-Russian relations deteriorate. The United States is now almost completely dependent on Pakistan; the logistical burden is rising with support for the troop surge, and the militants feel emboldened as Pakistan feels it can use a lighter touch in combating them.

India’s concerns will rise as little progress is made in the war.

As STRATFOR forecasted in the 2009 annual, New Delhi has refrained from taking overt military action against Pakistan after the November 2008 Mumbai attacks for fear of destabilizing Pakistan further and giving regional jihadists an excuse to focus their attention on India. Yet the gradual unraveling of command and control within the Pakistani military establishment has enabled many more of Islamabad’s Islamist militant proxies operating in Pakistan and India to team up with transnational jihadists to carry out deadlier and more strategically targeted attacks. Though the timing is uncertain, India is likely to witness another large-scale Islamist militant attack on its soil that will once again escalate cross-border tensions on the subcontinent.

India has thus far stayed on the sidelines of U.S. dealings with Pakistan and Afghanistan. Its involvement is largely limited to two items: first, making clear to Washington that Kashmir is not up for debate as Washington attempts to rehabilitate Pakistan, and second, increasing its presence in Afghanistan, devoting effort to reconstruction projects and perhaps providing covert support to anti-Taliban groups in the north (in part to counter a U.S. strategy to engage “pragmatic” Taliban). Much like the Iranians and the Russians, India has no interest in engaging Taliban forces who share a Pashtun link with the Pakistanis.

India is currently in the midst of a general election that will conclude in mid-May. No party is likely to win a clear majority, and it will be up to the incumbent Congress party and the main opposition Hindu nationalist Bharatiya Janata Party (BJP) to cobble together a ruling coalition of smaller regional parties. STRATFOR will not attempt to predict the outcome of this uncertain election, which will largely be based on the populist votes of India’s lower classes, but should the BJP manage to overcome its setbacks and take the lead, Indian restraint against Pakistan would not be assured in the event of another large-scale militant attack.

Part Two: Second Quarter Forecast 2009: Regional Breakouts

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter does just that. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation and our experience to be rising inflation and not a serious problem with deflation.

Van Hoisington and Dr. Lacy Hunt give us a seminar on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.

Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter- intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable.

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And their track record over the last 20 years suggests we should pay attention. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook
First Quarter 2009

Inflation/Deflation

Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that "sooner or later" inflation will inevitably return, probably with great momentum. This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed's balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.

These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks. This is a reminder that both stock and Treasury bond returns are sensitive to inflation, albeit with inverse results.

Economic Theory

If inflation and interest rates were to rise in this recession, or in the early stages of a recovery, the expansion would be cut short and the economy would either remain in, or relapse into recession. In late stages of economic downturns, substantial amounts of unutilized labor and other resources exist. Thus, both factory utilization and unemployment rates lag other economic indicators. For instance, reflecting this severe recession, unused labor and other productive resources have increased sharply. The yearly percentage decline in household employment is the largest since current data series began in 1949. In March the unemployment rate stood at 8.5%, up from a cyclical low of 4.4%. This is the highest level since the early 1980s. The labor department's broader U6 unemployment rate includes those less active in the labor markets and working part time because full time work is not available. The U6 rate of 15.6% in March was the highest in the 15 year history of the series and up from its cyclical low of 7.9%. The operating rate for all industries and manufacturing both fell to their lowest levels on record in March. Manufacturing capacity was around 15% below the sixty year average (Chart 1). Given these conditions, let's assume for the moment that inflation rises immediately. With unemployment widespread, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending.

A technically superior and more complete method of capturing the concept of excess labor and capacity is the Aggregate Supply and Demand Curve (Chart 2). Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity exists. Excess capacity causes firms to cut staff, wages and other costs. Since wage and benefit costs comprise about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD. Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve thus creating higher price levels. In our opinion such a process will take well over a decade.

Record Expansion of the Fed's Balance Sheet and M2

In the past year, the Fed's balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman's famous quote that "inflation is always and everywhere a monetary phenomenon."

These gigantic increases in the monetary base (or the Fed's balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves. These factors, beyond the Fed's control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.

If this all sounds complicated you are right, it is. The bottom line, however, is that it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

What about the M2 Surge?

M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system. The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed.

The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4). Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long-term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged. From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008. Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year.

The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.

Are Massive Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S. Government Debt will jump to almost 72% of GDP in just four fiscal years. As such, this debt ratio would advance to the highest level since 1950 (Chart 5). The conventional wisdom is that this will restore prosperity and higher inflation will return. Contrarily, the historical record indicates that massive increases in government debt will weaken the private economy, thereby hindering rather than speeding an economic recovery. This does not mean that a recovery will not occur, but time rather than government action will be the curative factor.

By weakening the private economy, government borrowing is not an inflationary threat. Much light on this matter can be shed by examining Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of Japan government debt to GDP ratio surged from 50% to almost 170%. So, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, their economy is in shambles. After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector (Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

This recent Japanese experience mirrors U.S. history from 1929 to 1941 when the ratio of U.S. government debt to GDP almost tripled from 16% to near 50%. As the U.S. debt ratio rose, long Treasury yields moved lower, indicating that the private sector was hurt, not helped, by the government's efforts. The yearly low in long Treasury yields occurred at 1.95% in 1941, the last year before full WWII mobilization. In 1941, the S&P 500, despite some massive rallies in the 1930s, was 62% lower than in 1929, and had been falling since 1936. Thus, two distinct periods separated by country and considerable time indicate that stock prices respond unfavorably to massive government deficit spending and bond yields decline.

The U.S. economy finally recovered during WWII. Some attribute this recovery to a further increase in Federal debt which peaked at almost 109% of GDP. However, the dynamics during the War were much different than from those of 1929 through 1941 and today. The U.S. ran huge trade surpluses as we supplied military and other goods to allies, which served to lift the U.S. economy through a massive multiplier effect. Additionally, 10% of our population, or 12 million persons, were moved into military services. This is equivalent to 30 million people today. Also, mandatory rationing of goods was instituted and people were essentially forced to use an unprecedented portion of their income to buy U.S. bonds or other saving instruments. This unparalleled saving permitted the U.S. economy to recover from the massive debt acquired prior to 1929.

Bonds Still an Exceptional Value

Since the 1870s, three extended deflations have occurred–two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of "extreme over indebtedness," a term originally used by Irving Fisher in his famous 1933 article, "The Debt-Deflation Theory of Great Depressions." Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan's recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond (Table 1).

This table also speaks to the impact of massive government deficit spending on stock and bond returns. In the U.S. from 1874-94, no significant fiscal policy response occurred. The negative consequences of the extreme over indebtedness were allowed to simply burn out over time. Discretionary monetary policy did not exist then since the U.S. was on the Gold Standard. The risk premium was not nearly as negative in the late 19th century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when the government debt to GDP ratio more than tripled in both cases. In the U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S. 1928-41 and in Japan in the past twenty years, stocks posted compound annual returns of negative 2.4% and 2.3%, respectively. Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

This week we will look at two shorter essays for this edition of Outside the Box. The first is some thoughtful words by Tom Au on whether or not we have put in a true bottom for the market. I particularly want you to read his thoughts on what earnings will look like going forward, and whether we can get back to the highs in corporate earnings we saw in 2006.

Tom is the executive vice-president of R. W. Wentworth, a contributor to Real Money at www.thestreet.com and the author of "A Modern Approach to Graham and Dodd Investing"

In last Friday's letter I mentioned an article by William Hester, CFA, who is the Senior Financial Analyst at the Hussman Funds. (www.hussmanfunds.com) While I quoted a few paragraphs from his essay, on reflection I think I will re-produce it below, as this is a very important concept. I have written in past letters and in Bull's Eye Investing about how powerful a driver earnings surprises can be (both positive and negative). Powerful bear and bull markets develop when there are numerous surprises in the same direction, re-enforcing market psychology.

So, read Hester's essay with the knowledge of what Au writes about earnings. I think the two make a very powerful, thought-provoking concept. And I am off to Europe.

John Mauldin, Editor
Outside the Box

Watch Out For the Second Leg of the Downturn

by Tom Au

Do you think that the crash is over, as certain former bears do? This question arises as we have breached the first downside target, of Dow 7000, based on my proprietary investment value model, that was first published in thestreet.com October 24, 2007. It was less a forecast than an evaluation. The Dow has now vindicated this model by reaching "fair value," as one would expect from a simple definition. Does that represent a base for a new bull market? Or is it just one more stop to the nether regions?

To understand my model, note that a stock can be analyzed as a combination of a bond plus a call option. My proprietary investment value metric for a stock is book value plus ten times dividends. That is a Ben Graham like construct that treats stocks almost like bonds, and gives no effect to growth over and above the pro rata return from the reinvestment of retained earnings. On the other hand, many investors prize stocks, particularly tech stocks, for their "optionality," the hypothetical ability to generate "positive surprises" over and above what economic theory would support. At bottom, the belief in the new economy was a belief in "optionality," that random positive events that occur from time to time, and did so with particular frequency in the 1990s, will become a recurring fixture of the economic landscape.

But such a process can also work in reverse, as it has recently. We are now experiencing what my colleague Robert Marcin calls the Great Unwind. A turbocharged economy is most likely to become "unstuck" when the conditions that initially favored it no longer exist. When this happens, an economy can grow as much below trend as it was formerly above trend, a fact that is likely to be reflected in the financial markets. History is not very encouraging on this score. In past downturns, such as those of 1932 and 1974, the Dow troughed at one half of my investment value metric, reflecting then-prevailing investor beliefs for negative optionality; that the economy will be worse than normal economic forces would dictate. With investment value at 7000 (actually a rounded version of 6600) on the Dow, half of that would be 3300. And during the 1930s, this metric actually fell, meaning that the "ultimate" low could be half of a number lower than 6600.

So having completed a first downleg, the market is now working on a second one. And this would be fully reflective of economic forces. For instance, financial earnings used to represent some 40% earnings (if you count the financing arms of some old line "industrial" companies such as General Electric and General Motors). Thus, they made up $32 of what used to be normalized S& P earnings of $80. But most of those financial earnings have disappeared. That, by itself, would take the S&P earnings into the $50s.. But how many of those non-financial earnings (of $48) were tied to the finance bubbles such as the homebuilding and the "housing ATM?" At least 10%, or around $5, and that is being conservative. Thus, normalized S&P earnings are likely to be no more $50 a share, if that.

The problem comes at payback time. For instance, much of the borrowing was tied to the housing market, on the bogus theory that houses could be made twice as valuable (as a multiple of rent) as they were for all of American history if prices could be kept on steady incline. The problem was that valuations collapsed when house prices fell, or even failed to rise, bringing down the market with it. To make up the shortfall, the U.S. economy now has to consume less than it produces, for a time. But the formerly virtuous circle became a vicious circle when falling prices (and consumption) led to falling production in a self-reinforcing process of the kind best described by George Soros in the Alchemy of Finance. This is a process called underabsorption, which in its strongest form, is called disintermediation. When a major part of the economy becomes "unstuck, the rest of it doesn't merely go into retrograde. It has to fall apart also to keep pace.

But I can live with $50 trough earnings, say many. And at historical multiple of 14-16 times trough earnings, the S&P should stop its downside in the 700-800 range. But the point is, they're not trough earnings, they are the "new normal." And in the current "slow" (zero or worse) growth environment, a trough P/E of 6-8 times earnings is more likely. Put another way, we are about to get the worst of all worlds; below trend earnings, below trend growth from a depressed base, and below trend P/E, after having gotten the best of all worlds, astronomical P/Es on above-trend and rapidly growing earnings, about a decade ago. Warren Buffett now agrees, saying that we will get "almost the worst of all possible worlds…"

The bears-turned-bulls have taken the latter stance because the market now reflects at least a severe recession. One such commentator likened the recent market to 1938-1939, and feels that the latter represents a bottom. But the 1930s bottom was 1932, not 1939, which is to say that the market probably has further to fall. Having correctly dodged the "overvaluation" bullet earlier, the new bulls pin their hopes on the prospect that the current market represents everything bad short of the 1930s Depression. Unlike us, they aren't willing to grasp the nettle that the current crisis will likely be as bad as anything including the Great Depression.

A Stock Market Rebound Closely Linked with Economic Data Surprises

by William Hester, CFA - April, 2009

There are several ways to interpret the economic data in March, most of which came in above what economists were expecting. Some analysts concluded that the worst is over for the economy, and a rebound is ahead. Others suggested that the economy is still contracting, but at a slower rate for now. In any case, economists have overestimated the economy's rate of contraction lately. The rebound in the stock market has been at least partially fueled by economic data that consistently came in better than expected last month. Some part of this rally is likely relying on the continuation of these "positive" surprises.

To track the trends in economic performance, we keep an ongoing tally of how data is announced relative to expectations – a method of analysis originally inspired by Bridgewater Advisors . Economic data that surpasses expectations gets added to a 3-month running total. Data that comes in weaker than expected gets subtracted. A rising line means that economic data is generally coming in above expectations, while a falling line means that the data has disappointed. A descending line could be the result of an economy that is not expanding as quickly as economists predict or – like in 2008 – it could be the result of an economy that is contracting at a faster rate than expected. In the first graph, and the others below, I've isolated only the data that measures the growth in the economy, leaving out measures that track the rate of inflation and sentiment. The first chart below shows the surprise line for growth-related economic data since last August, just prior to the passing of the Emergency Economic Stabilization Act, from which the first version of the TARP was born.

There's nothing quite like pointing out how bad a shape the economy is in to get people acting like the economy is in bad shape. During the early part of last summer the economy was actually holding up better then what was generally expected. But during the final quarter of last year, the economic surprise line (in blue) collapsed. Data persistently came in below expectations, which created the steepest drop in the line tracking economic performance versus expectations in the available data.

The red line in the graph above tracks the S&P 500 Index and it shows that stocks have recently closely tracked the trend in data surprises. The market fell along with the deteriorating surprise line last year, rallied slightly prior to improved news in December, and then rolled over again as the news weakened versus expectations in late January. In March the market rebounded along with a more pronounced persistence in favorable economic news versus expectations.

The data released in March was better (or less negative) than expected on a number of fronts. The slowdown in spending eased, there was temporary relief in the new and existing homes sales data, and sentiment measures mostly halted their steep decent of recent months. But while much of the data was surprising relative to expectations, it's difficult to point to any piece of data that was surprisingly strong (outside of some of the volatile data series like, for example, durable goods). New homes sold at an annual rate of 337 thousand versus 300 thousand (and a peak of 1.4 million). GDP was revised to -6.3 percent versus an estimate of -6.6 percent.

Much of the excitement in the stock market – at least that is related to the current performance of the economy - seems to be centered on an economy that is performing less badly than expected. The risks here seem to be that if the trends in data surprises change, so could investor's attitudes toward stocks that are currently overbought on a number of measures.

There are a couple of reasons why the trend in the rate of data surprises could change. The first is that trends in economic surprises are very prone to reversals. The chart below shows a longer-term picture of the changes in the trends in economic data surprises. The one thing that stands out looking at the graph is that the trends in surprises often reverse abruptly. When the estimates of economists fall behind in an expanding economy - underestimating its strength - expectations are adjusted upward. These estimates eventually become too optimistic. The same can be said of an economy that is contracting more quickly than expected. And the data shows that the more pronounced their forecast errors – the more abruptly economists begin to overestimate the economy's recent trend.

Another reason why the economic news may begin to disappoint at some point is that recoveries rarely proceed smoothly. The trends in month-to-month and quarter-to-quarter data tend to lurch forward and backward as the economy regains its footing (and at times, like in 1982, the economy can fall right back into recession).

One recent example of this was in 2002, which is shown in the graph below. The trends in economic data versus expectations were persistently better than expected from late 2001 as the economy emerged from recession that year through late spring of 2002. The S&P 500 surged by more than 20% from its 2001 low as the economy began to regain its footing and offer up positive data surprises. But by the summer of 2002 the rebound proved not robust enough when compared with economist's expectations, and the surprise line rolled over. With stocks not yet at valuation levels that were attractive to investors, the S&P plunged along with the data surprise line.

It's important to note that this was during a period where the economy was, in hindsight, no longer in recession, and where there were many measures that showed the economy was growing again. But the market was still tripped up at least partly because expectations had moved ahead of the economic recovery. The bear market remained unfinished, and stocks fell to new lows. This may turn out to be an important risk over the next couple of months. The economic data is certain to be uneven, which in turn may cause investors to begin to question whether an economic recovery is really at hand. Risks will likely be higher at points where the market is overbought.

Investors tend to punish economic disappointments much more strongly during bear markets than during bull markets. The graph below, which shows the S&P 500 and the surprise line from 1998 to 2002, highlights this tendency.

Although it's just a portion of one cycle – the late stages of an expansion and a mild recession, it's worth noting how stocks performed in response to economic data surprises. In the last part of the 1990's bull market, a rising economic data surprise line mostly fueled rallies. Data worse than expected weighed on performance – often causing shallow declines like in 1998 and late 1999. Conversely, during the 2000-2002 bear market, disappointing economic data coincided with steep declines in equity prices, while positive surprises usually eased the market's deterioration.

These trends were also evident during the market's advance from 2003 through 2007, but were somewhat less dependable. During that period, the trends in the surprise data were shorter and more variable than the market's slow, persistent advance. Since last summer, the correlation between the two has tightened considerably. In fact, the correlation between the S&P 500 and the data surprise line has climbed above .80, implying that investors are keeping a close eye on how data comes in relative to expectations.

If the high correlation between stock prices and data surprises holds, the recent rally in stocks might be tested. Even if the economy has bottomed, it's very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven. During these periods, the risks to stocks will be greatest when the market is overbought and investors have priced in high expectations of positive data surprises continuing.