Re: As Warren Zevon said,

Norm, as you know I've made my career in finance all over the world. That
doesn't mean I claim to be able to predict the future - nobody, not even
Warren Buffett, can do that.

I have been through four of these deep cycles since I started my career -
the energy crisis of 73-74, the stagflation and resulting recession of the
late 70s through 1982, the junk bond and real estate crash of 1990-92, and
the technology stock bubble bursting in 2001-2002. The current one is much
worse than any of the others. The level of panic is more widely spread both
internationally and across different sectors of the financial services
industry. The international political/security situation is also worse with
Islamofascist terrorism and both Russia and China rattling their sabres. And
the fundamental cancer at the root of the problem - too many people have too
much debt, taken on to finance consumption rather than investment, and are
having problems paying it back - has been allowed to persist and grow to the
point where correcting it requires major surgery rather than the simple
lumpectomies that worked in the past. Economic major surgery is a painful,
bloody process.

There are a few common threads in the crises I've seen that I think reveal
principles worth considering. I am optimistic for the long term, although I
am very worried about the next year or three depending on what the
government does.

1. The world will not end. Even the depression was ending before WW2,
although it was prolonged and deepened by the government's New Deal
manipulations. People will find a way to do business together, inventors
will come up with more great advances, and these will make the economy heal
and continue to grow. In fact, the goods-and-services sector of the economy
isn't in all that bad shape.

2. The continued good will, resourcefulness, persistence, and responsibility
of the vast majority of people will carry the economy through. The vast
majority of people live within their means and are having no problems paying
their bills - even in the middle and lower middle classes. Because they
manage their lives responsibly. Increases in interest rates won't bother
them because their mortgages are fixed at affordable rates, and they don't
carry balances on their credit cards.

3. Any time that government interferes with the markets, bad things happen
that make things worse. Examples of this are Nixon's wage-price controls,
the current Congress's sponsorship of Fannie and Freddie as vehicles for
their political views, the New Deal, the Smoot-Hawley tariffs that were the
proximate cause of the global trade collapse that caused the Depression, the
Davis-Bacon Act, the mark-to-market accounting rules that have caused the
accounting crisis behind most of the banking industry's problems today, this
year's stupid and counter-productive "stimulus tax rebate", and the entire
history of Communist centrally-planned economies from Russia to Mao's China
to Cuba (and now unfolding before your very eyes in Venezuela).

The markets are not a select group of corporate fatcats conspiring to rip us
all off. The markets are you, me and everyone here. The free market is a
natural expression of human nature, and as such could be considered a force
of nature. There is no way to repeal it or to make a law against it - at
least, no way that will not fail. When the price of oil went up, millions of
us changed our behavior to drive demand down and that was the cause of the
late-summer price drop (35% from the peak of around $147 to the recent low
of around $95). That's the market at work. Whenever the tax rate is
increased, economic activity slows so that tax revenues decline. Whenever
the tax rate is decreased, economic activity grows so that tax revenues
increase. That's you, me and everyone else making rational decisions about
the value of our time compared to how much of our work's product we're able
to keep. In the current crisis, some people (those who overextended to buy
real estate at the top of the bubble, those who used too much leverage to
buy shaky securities at high prices) will lose a lot of money, and some
people (new homeowners buying in at bargain prices, investors buying all
this distressed paper at 30 cents on the dollar who will ultimately realize
50 cents or more) will make a lot of money.

The most important points are 1 and 2 and so I'm optimistic in the long run.

In the short run, the biggest concern is inflation. Viewed in financial
terms, inflation isn't the price of stuff going up, it's the value of money
going down. It's basic supply and demand: when supply rises more than
demand, the price of the commodity (in this case the dollar) goes down. An
extreme example is the hyperinflation of the Zimbabwe dollar over the past
few years, now in the billions percent per annum. Zimbabwe is essentially a
barter economy today. The incredible amount of new money being created by
the government worries me. The value of the dollar rose by record amounts,
and the price of oil fell today as the bailout bill failed. I think there is
a correlation there: the global investor markets saw the bill as highly
inflationary and its failure indicates that hundreds of billions of new
dollars may not be printed.

In high inflation environments, hard assets tend to be the best performing
investments: things such as metals, real estate, and probably guitars.
Owning the things whose prices are rising in dollar terms keeps you whole;
owning dollars is the losing position. In a high inflationary environment,
the Bank of Mattress is one of the worst places for your money, because the
money loses value every day.

The standard economic solution to inflation is a reduction in the money
supply, typically performed by raising short-term interest rates. Along with
this comes a contraction in economic activity, and delevering of balance
sheets (people and companies repaying their debts and becoming financially
healthier); i.e., a recession. That's my biggest worry for the next two
years. When inflation eases, those asset prices that were rising before
start to come down - and an asset bubble bursts. People who own those
assets whose prices have outstripped their real value will lose big. People
who buy those assets at distressed prices will win big. I first saw this in
the real estate market in California and the oil price in the early 80s (oil
dropped from around $45/barrel to $10). What we're in now is an asset bubble
bursting. What the bailout plan does is postpone the fall in asset prices
by creating inflation - but that's just smoke and mirrors and the world can
see through it.

Of course, there is a simple way to avoid or at least mitigate inflation:
cut tax rates. The economic growth that results creates demand for money so
that money demand catches up with the increased supply. Kennedy, Reagan, and
Bush 43 (in 2001) demonstrated it. Nixon, Carter and Bush 41 proved the
opposite effect works, too.

Bottom line: I think you're going to be ok. Don't panic.

Disclaimer: The above may only be worth what you just paid for it.


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