Stephen’s Posterous

Larry Samuel’s Rich: The Rise and Fall of American Wealth Culture is about the cultural artifacts of the wealthy in current times.

Mr. Samuel writes that the 20th century has seen the creation of a distinct American wealth culture that is more democratic and diverse than anything the world has seen before.

Mr. Samuel begins his story of wealth democratization in the 1920s during the age of the Mellons and Rockefellers. It was a decade that produced Main Street millionaires as well as Wall Street speculators.

By 1929, Park Avenue in New York housed four times as many millionaires as Great Britain, with a collective value of $3 billion. High society had expanded to 4,000 from 400.

The Great Depression delivered a blow to the rich with shrinking their fortunes and handing power to politicians. In 1933, there remained only 46 Americans earning a million dollars or more, but the rich survived the squeezing.

The new economy of radio broadcasting, and later television, began to generate huge fortunes. The 1950s saw the arrival of two very different types of millionaires. The rich from Texas were of a different type. In 1957, the only American to be numbered among the five richest people in the world was Texan H.L. Hunt.

There were the millionaires in the grey flannel suit, the people who ran America’s great corporations who set the tone of its sprawling suburbs. Many of them relied on generous expense accounts as much as on their salaries.

From 1960 on, the story of America’s wealth culture is almost as multifaceted as the story of American culture in general. The rise of the counterculture stimulated hedonistic consumerism even as it eroded Puritan morality.

The growing power of celebrity further shifted power from the East Coast to the West while the barriers between the wealthy and everyone else continued to erode.

The road from John D. Rockefeller to Bill Gates is a long one. The landscape of American wealth remains the same. The U.S. has a genius for producing entrepreneurs who can turn the latest technology into piles of gold.

Less than 10% of today’s rich inherited their wealth and many are "instapreneurs," transformed in an instant from penury to prosperity.

The country also has a genius for turning those fortunes into philanthropic empires. Bill Gates, now in league with Warren Buffett, often echoes Rockefeller’s calls for "damming up the causes of poverty" by applying the latest business methods to charity.

The American rich have proved themselves to be too creative, too diverse and too adaptable to be vulnerable to the politics of class envy. "Lifestyles of the Rich and Famous" has many remakes left in it yet.

Rich: The Rise and Fall of American Wealth Culture

By Larry Samuel

AMACOM, 320 pages, $24.95

Read an excerpt from the book.

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Robert Prechter is the head of market-forecasting firm Elliot Wave International and the author of several books, including Conquer the Crash.

He has been quoted recently as saying that the current recession could lastawhile and even force stock markets back down to levels seen at the market bottom reached in March 2009 of this year. Mr. Prechter is known as market forecaster who told investors to sell their stocks weeks before the October 1987 crash.

Barron's Online exchanged a Q&A with Mr. Prechter.

In it's first question, Barron's Online asks why Mr. Prechter sees today's recession being similar to the 1929-1932 depression.

Robert Prechter responds:

My model is that naturally occurring waves of optimism and pessimism, which result from unconscious herding, are the driver of financial and macroeconomic trends. Upon rare occasion, waves of very large degree come to an end. In the financial realm, when people get more pessimistic, they sell stocks and curtail credit. They also take fewer risks in the realm of production, which causes the economy to contract. Taken together, these changes -- at very large degree -- portended a downward revaluation of the stock market, a deflation in credit and a depression.

Mr. Prechter says he judges this pessimism by utilizing indicators like price/dividend, price/book, bond yield/stock yield ratios, mutual fund cash percentages, the number of investors bullish vs. bearish, credit spreads, savings rates, consumer sentiment, duration of optimism, etc. He says that the P/E set records from 1998 to 2007.

When asked whether steps taken by President Roosevelt during the early part of the Great Depression ended up prolonging the depression, Mr. Prechter replied:

Governments' policy decisions hamper and ruin economies all the time, but their meddling does not affect waves of social mood. On the contrary, waves of social mood generally spur governments to act. The 1929-1932 collapse caused the government to get restrictive and separate commercial and investment banks in 1933; this was after the bust it was designed to prevent was over.

The 1990s boom caused government to get frisky and repeal the act in 1999; this was just as the boom it was designed to foster was ending. These policy decisions did not cause any changes in social mood, but the social mood trends predicted the character of the policy changes. Government herds, just like everyone else, but it is at the tail end of the herd, because it takes time for a consensus to develop so extensively that government has the public support to act.

When asked if Mr. Prechter sees a recovery in the second half of the year, Mr. Prechter said that social actions result from social mood change. When pessimism is low as it was late February and early March, stocks will rally, credit spreads will narrow, housing sales will pick up, and authorities would utilize effective liquidity and stimulus programs.

Mr. Prechter recommends U.S. Treasuries as a safe investment along with other cash equilavents like Swiss money-market claims, some New Zealand bonds, gold and cash. However, Mr. Prechter believes that the U.S. government will eventually need a bailout, but until then Treasuries are a good bet. Mr. Prechter believes that the U.S. dollar is the most inflated currency in the world and it will deflate further.

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"How serious is the present economic mess?" Munger asks. "Deadly serious. The worst mess since the Great Depression. You can't tell what happens when people get discouraged enough."

He praised the government's aggressive response to the crisis. But he says it might not work -- and cites the example of Japan, where significant government intervention in a financial crash was ineffective.

Mr. Munger is positive on stocks today, but negative on the economy. And does he think Coca Cola and Wells Fargo are good investments? Yes, he does.

Kathy M. Kristo from the Los Angeles Times continues:

"The natural consequence of capitalism is that some companies succeed and some companies die," Munger said. But capitalism, he said, doesn't equal deregulation. Financial firms, which were at the forefront of the economic cataclysm, need to be re-regulated into boring, slow-growing businesses, Munger said.

"I don't see any reason why a major bank that was 'too big to fail' should be anything but a very boring business," he said. "I don't see any reason why you should have a system where every bright young man fresh out of college should have $8 billion to play with."

"If you wait until the economy is working properly to buy stocks, it's almost certainly too late," he said. "I have no feeling that just because there's more agony ahead for the economy you should wait to invest." But you need to be selective.

Green energy is an example. A government push toward sustainable businesses might help revive the economy, but dumping money into every environmental firm to come along would be a dangerous path.

In a move likely to be watched by peers, the giant California pension fund Calpers is considering expanding its own internal hedge-fund investments even as it presses established external funds to cut fees and make other client-friendly changes that many money managers have resisted.

Calpers is raising the prospect of providing start-up money to new and relatively unknown teams of traders and portfolio managers, with hopes that the best would spin out later as bigger, independent firms with many additional clients, according to public documents from Calpers.

The proposed seeding program, which the California Public Employees' Retirement System says is designed to counteract declining hedge-fund returns and give it more control over its money, would mirror an approach the $175 billion pension fund has taken with private-equity managers.

Not every other public pension has the heft to seed hedge-fund managers. But Calpers is a bellwether in the money-management business. After a year when hedge-fund managers disappointed some clients, pension-fund managers are likely to take an interest in any moves to cut investment costs and gain more control.

In the public documents, on Calpers's Web site, Calpers notes that last year, "almost all hedge funds lost money, regardless of strategy or leverage." Calpers points out that its hedge-fund investments as a whole "protected capital in the face of some of the worst markets since the Great Depression," but too many fund managers showed they couldn't adapt to the volatility or cut risks to avoid losses during market swings.

Calpers's hedge-fund proposals are part of a comprehensive review of Calpers's $5.9 billion in direct investments with 26 hedge funds and nine other firms, called funds of funds, that distribute money to multiple funds. The proposals are on the agenda for Calpers investment committee meeting on April 20, 2009.

The current market environment has been tough for hedge funds, which had their worst collective loss in 2008 despite beating major stock indexes. Hedge-fund assets are on track to shrink to about $1 trillion this year, roughly half of the industry's peak about a year ago.

Calpers and other big investors have said this is an ideal time to help talented money managers get started, as well as to demand fee cuts from existing hedge funds that for years typically have charged 2% of assets they manage plus 20% of profits. Calpers also wants to know more about how the funds it hires are investing.

Those demands were laid out in a March 11 memo sent to hedge funds where Calpers has money; it was reviewed by The Wall Street Journal. Calpers's track record in picking hedge-fund managers has been about average since 2002, when it started putting money with the private investment funds, according to its review and industry data.

Last year took a bite out of Calpers's returns just as it did for most hedge-fund clients. Calpers's hedge-fund holdings posted a 19.6% investment decline in 2008, slightly worse than the 19% average decline of hedge funds globally, according to Chicago research firm Hedge Fund Research Inc. Since April 2002, Calpers has made a 4.3% profit on average per year from its hedge-fund investments, slightly trailing the 4.7% average return of hedge funds globally.

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This bear market has been a painful experience for many, but a new experience only for some. Veteran fund managers vividly remember the 1973-74 market slide, the worst downturn since the Great Depression, until now. Seasoned fund-company executives, too, have seen this kind of trouble before.

"This is not unprecedented," says Harry "Hersh" Cohen, 68 years old, chief investment officer of ClearBridge Advisors, an affiliate of Legg Mason Inc.

In the '70s bear market, things "just looked hopeless," recalls Mr. Cohen, a money manager since 1969. Soaring energy prices and inflation, war and political turmoil added up to two years of unforgettable gloom. But recovery did come, as it has after each slump since.

Mr. Cohen and other experienced fund hands shared their perspectives on the current turmoil, each drawing on roughly four decades or more in the business. Each has a slightly different take. Some say the crisis in the 1970s was more serious; others say things are worse now.

Some are looking abroad for new engines of growth; others are focused on bonds and dividend-paying stocks. But they all agree that this market, too, eventually will recover, and that optimism will replace the gloom.

"We will in some fashion get through this," says Will Browne, 64, a managing director of fund manager Tweedy, Browne Co. "One of the lights at the end of the tunnel is no longer going to be another train coming at you," he says. "It is going to be daylight."

Stocks have a long way to go to climb out of this bear market, in which the Dow Jones Industrial Average fell as much as 54% from its October 2007 high. But the market climbed back from its 45% drubbing in 1973-74.

Some investors thought they saw promising signs last month, when the Dow gained 21% in just 13 trading days after hitting a new low on March 9. The average diversified U.S.-stock fund was down 9.1% during the first quarter, after gaining 8.4% in March, according to figures from Lipper Inc.

Here's a closer look at how some fund-industry veterans compare this bear market to earlier downturns -- and where they think the market is headed next.

Will Browne and John Spears, Tweedy, Browne

Back in 1973-74, Mr. Browne was a junior analyst at a brokerage firm, and John Spears was a stock analyst. Since that time, says Mr. Browne, the two have gained an ability to recall that recessions end and that carefully selected companies will prosper.

"Three or four years down the road, this will have proved to be an extraordinary time to invest," says Mr. Browne. He and Mr. Spears, 60, are among five managing directors and part-owners of Tweedy, Browne, majority-owned by Affiliated Managers Group Inc.

So far, the team has navigated the turmoil deftly, with the flagship Tweedy Browne Global Value fund landing in the top 10% of its Morningstar Inc. category last year.

But deciding what and when to buy is more complicated than it was, say, during the one-day 23% crash on Oct. 19, 1987. That was a collapse in demand for stocks, says Mr. Browne, who grabbed up drug shares and other stocks at fire-sale prices that day. Now there is a collapse in demand for goods and services, he says.

That broader weakness makes the two men more wary than ever about investing in companies with debt. "You want to make sure you don't have a company that will be dependent on the capital markets anytime soon to finance the business," says Mr. Browne.

Mr. Spears says investing in a company with a lot of debt is like buying a home and assuming an outstanding mortgage: You may only pay $100,000 in cash, but if you also assume a $300,000 mortgage, your total cost is $400,000.

Robert Dow, Lord Abbett Mutual Funds

As head of private money-management firm Lord Abbett & Co., Robert Dow says that from the company's perspective, today "doesn't feel as bad as 1973-74." During that slump, most assets under management by the firm were in stock funds. "That was a pretty scary business proposition," says Mr. Dow.

Now Lord Abbett has more relatively safe funds, like money-market and bond funds, which has helped it retain clients who were fleeing stocks in recent months.

Mr. Dow, 64, joined the firm in 1972 as an analyst. He is now senior partner and develops the overall strategic direction of the firm. One stark difference in this crisis, he says, is that except for Treasurys, bonds for the most part haven't provided a safe haven.

Typically, bonds gain value in periods of declining interest rates. But this time, even though short-term Treasury interest rates are nearly zero, prices for corporate and municipal bonds have fallen. This is partly because investors have questioned the ability of issuers to pay back their debt.

Still, Mr. Dow says, "extreme volatility creates extreme opportunities." Since late last year, for his personal account he has been buying funds that invest in corporate bonds and riskier high-yield, or junk, bonds. He says his bond-fund managers are buying these junk bonds so cheaply that even if they default he expects them to return more than their current trading price. To be sure, he is allocating just 5% of his portfolio to these types of investments.

He says bond investors should currently be paying attention to how much interest-rate risk they have in their portfolio. Interest rates will eventually go up, and that will hurt long-term bonds the most.

He thinks the market might already have seen its lows.

John Gunn, Dodge & Cox

The investment team at Dodge & Cox looks for cheap stocks, and typically adds to positions when prices fall. So, when financial stocks slid in late 2007 and the first half of 2008, Dodge & Cox Stock fund loaded up on names like American International Group Inc., Fannie Mae and Wachovia Corp. Last fall, these struggling companies either received capital infusions from the government or were merged into other companies.

"Like Dorothy in 'The Wizard of Oz,' we weren't in Kansas anymore," says Mr. Gunn, 65. "We said, 'Well, let's sit on the sidelines and watch the game a little bit.' "

The fund ended the year with a 43% decline, more than six percentage points behind the total return of the Standard & Poor's 500-stock index. Mr. Gunn says the government intervention in the markets caught Dodge & Cox by surprise. When the government took over Fannie Mae, he says, the U.S.-backed mortgage company was meeting required capital ratios.

Mr. Gunn says "people were seriously depressed" during 1973 and '74. In all economic slowdowns, he finds that investors typically say it is "unlike anything in the past." The typical refrain, he says, is, "At best, it's going to be a very slow recovery because of -- you fill in the blanks."

Dodge & Cox believes that the long-term outlook is bright, and that innovations and deeper integration of countries like China into the global economy will lead growth. At the end of last year, Dodge & Cox Stock fund had 44% of its money in either multinational foreign companies or U.S. companies that have more than half of their sales abroad. The managers are buying stocks of companies that exhibit a "strong business franchise," says Mr. Gunn.

"The U.S. economy is very strong and resilient," he says. "It's bad in the long-term to bet against it." He sees the current bear market as similar to the broad-based bear markets of 1907 and 1973-74, when the market returned to near its previous high within seven to nine quarters from the bottom.

Based on that parameter, he estimates that things could turn around possibly by the end of 2010 or mid-2011. For companies in the S&P 500 to return to their peak earnings of 2006, he says, it could take longer.

Chuck Royce, Royce Funds

During the 1970s bear market, when Charles "Chuck" Royce was managing what is now Royce Pennsylvania Mutual fund, Mr. Royce was "scared to death" as the market slowly declined for nearly two years.

But "this period feels worse to me because it happened so fast," says Mr. Royce, now 69 and president of Royce & Associates, an affiliate of Legg Mason that specializes in small-cap and micro-cap investing.

Mr. Royce says he was surprised by the "panic and disarray in the major financial institutions," and by the volatility of the past year. In the 1970s, stocks moved 1% to 2% on big days -- like "a raindrop," he says, compared with recent swings. He cites the speedy, electronic dissemination of information as one cause. In his early career, he and colleagues spent a lot of time digging through annual reports and regulatory filings.

During 1973-74, the Pennsylvania fund was fully invested, and he basically held on to his investments through a "white-knuckle experience." This time, he says, some of the firm's funds have attracted new money and so have added to favored stocks. A few Royce funds also have reopened to new investors. The Royce Pennsylvania fund fell about 35% in 2008, beating the S&P 500 by two points.

Mr. Royce says investors "should be investing throughout a bear market." He thinks that the economy will improve this year, and that the stock market will go up much before that. To boot, he says, right now "the opportunities are excellent."

David Booth, Dimensional Fund Advisors

One big difference between today's bear market and that of the 1970s is that indexing -- a new and much-disparaged idea back then -- is now an accepted investing strategy, says David Booth, 62, chief executive of Dimensional Fund Advisors LP, manager of the DFA family of funds.

In 1973, Mr. Booth was a vice president in a think-tank unit of Wells Fargo Bank, which two years earlier had created what many view as the first indexed portfolio, for institutional investors. (The first index fund for individual investors was introduced by Vanguard Group in 1976.

The indexing advocate saw the 1970s bear market shoot down one of the biggest criticisms of index funds: the idea that portfolio managers would be able to escape some of the damage by making smart investments. Active managers actually did worse than market benchmarks in the downturn.

This time, actively managed mutual funds have similarly provided little shelter. Since October 2007, active managers in seven of nine U.S.-stock categories have trailed the corresponding Standard & Poor's indexes, investment researcher Morningstar found in a recent analysis.

Dimensional, which Mr. Booth co-founded with Rex Sinquefield in 1981, tweaks the indexing approach. Dimensional uses computer formulas to search for stocks that fit specific financial criteria to build funds that have broad diversification, low turnover and low costs.

Lately, some DFA funds have done worse than comparable indexes, which Mr. Booth attributes to the company's designing its small-stock funds to hold even smaller stocks than market indexes, and its "value" funds to hold even rougher diamonds in the rough.

Mr. Booth remains convinced Dimensional's criteria will pay off over time as investors are rewarded for buying riskier stocks compared with indexes. "We win about two-thirds of the time, an incredibly good batting average," he says. Last year was a reminder of how unpredictable the market can be, he adds.

Harry 'Hersh' Cohen, ClearBridge Advisors

Mr. Cohen disapproves of one change he's seen in the funds industry: measuring a fund manager's performance against a benchmark index. He thinks a manager's performance should still be measured by whether the fund makes or loses money. Mr. Hersh's fund, what is now Legg Mason Partners Appreciation fund, lost 29% in 2008, but soundly beat its bogey, the S&P 500's negative return of 37%.

In 1974, as Mr. Cohen was managing his first fund, he kept more than 50% of the assets in cash. "All I was interested in was not losing money for people," he says. Now, "there's all this emphasis on relative returns," he says. "It's ridiculous." Given this pressure, he fears that inexperienced fund managers might be scared of veering too much away from their benchmark index.

Mr. Cohen himself felt the heat in 1998 because he wasn't loading up on technology stocks. That year, his Appreciation fund trailed the S&P 500's 29% return by about eight points. But from 2000 to 2002, when the market plunged as the tech boom turned to bust, the fund fell far less than the S&P 500 index. "I went from being a dinosaur to being smart again," he recalls.

While Mr. Cohen held a large cash position in 1999-2000, in the recent market downturn the cash balance was less than 10%, partly because he didn't anticipate the continued declines across all stocks.

While the fund beat the S&P 500 by eight percentage points in 2008, it isn't much solace for Mr. Cohen, who rues that he lost money for clients. A student of psychology, he has lately been going back to his college books to find and share with his colleagues the history of panics in markets. "Human behavior is always the same; the causes might be different," he says.

Mr. Cohen says that some of the worst years for the market, like 1974 and 1982, were great years for buying stocks. He believes that this is again the case. Mr. Cohen thinks that the panic in November and early March might have shaken out the worst of the selling. As stocks tumbled earlier this year, he says he told his co-manager, Scott Glasser, "They're just giving stuff away here." He adds, "Stuff was just being thrown out the window."

He and Mr. Glasser have bought stocks of consumer goods and other high-quality companies that pay dividends and are expected to do relatively well during recessions. But he cautions it could be another two to three years for the market to go back to its old high.

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Stephen Roach, Chairman of Morgan Stanley Asia and the bank’s former chief economist, answers questions.

How should capitalism evolve to create a sustainable economy and limit the occurrence of boom and busts and asset bubbles, while at the same time creating opportunities and incentives for innovation and wealth creation?

Stephen Roach: The demise of capitalism is greatly exaggerated. As the free-enterprise system survived the Great Depression of the 1930s, I have little doubt it will reinvent itself and endure the current crisis. Yet we can and must do much better in making market-based capitalism a safer, more stable and sustainable system. There has been a major systemic failure of the model that has held the world together since the 1930s.

Governance, or the lack thereof both within the private sector as well as by those charged with regulation and oversight proved to be the weak link in the chain. As a first priority, that shortcoming now needs to be addressed head on.

In one key respect, that is already happening: Wall Street is being turned inside out right before our eyes. But the new post-crisis regime must also include a revamped code of governance not just regulatory streamlining and reform but also the hardwiring of financial stability into the policy mandates of central banks.

Independent central banks that operate apolitically and free of ideology could well be the most important stewards of a post-crisis capitalism. But they can’t do it alone. Only through better discipline and more effective governance of regulators, rating agencies, and the political oversight function, can the invisible hand of Adam Smith start to work its magic once again.

How should global imbalances, the savings glut in the U.S. funded by China and Japan, be addressed?

SR: The theory is simple: spenders need to start saving and savers need to start spending. Easier said than done, of course. Execution is the problem for a world that simply doesn’t seem to have the appetite, i.e., political will, for the heavy lifting of global rebalancing.

Significantly, powerful market forces have already sparked the early stages of an endogenous rebalancing. In the US, the simultaneous bursting of property, equity, and credit bubbles is forcing households to shift from asset-based saving strategies back to income-based saving strategies. The ageing of 77 million US baby boomers, the first of whom started retiring last year, underscores the urgency of this adjustment, as a large generation of Americans now comes face to face with the imperatives of retirement security.

In China, a massive external demand shock has brought its export-led growth strategy into serious question. If a multi-year compression in US consumer spending growth leads to a protracted slowing in the growth of China’s external markets, Chinese policymakers will have no other choice than to accelerate the transition to a more balanced, and increasingly consumer-led, growth.

Critical in this regard is for China finally to put in place policies that will expand its social safety net, especially social security, private pensions, unemployment insurance, and public support to education and healthcare.

The United States is adding to its already great national debt to fight the recession. Should the US enact laws now, which state that we will raise taxes and cut spending in the future to guarantee that we will stand behind our national debt and prevent catastrophe, e.g. increased interest rates if our debt is considered worthless or has reduced credit worthiness?

SR: The good news is that the coming explosion of federal debt starts from a relatively low base, just 40 per cent of GDP at the end of 2008. The bad news is that open-ended deficit spending seems likely to take the debt-to-GDP ratio toward 60 per cent by 2013 and to over 100 per cent by 2022.

The real problem is the lack of a credible exit strategy from fiscal and monetary stimulus, alike. Post bubble economies are very fragile and not easy to wean from the life support of fiscal and monetary accommodation. Just ask Japan. Twenty years after the bursting of its big bubbles, public sector debt-to-GDP is nearly 150 per cent and the Bank of Japan’s zero interest rate policy is celebrating its 10th anniversary.

While I am not worried about a debt default of the United States government, I am very sympathetic to your suggestion that we codify an exit strategy to the massive fiscal expansion now under way. Toward that end, I believe that the Congress and the White House should collectively declare a formal fiscal emergency and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era, deficits that now look like child’s play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big and the long-term stakes are too high for fiscal sustainability to be entrusted to the oft-politicised whims of the year-by-year discretionary budgeting process.

Given the balance sheet repair needed by the Western consumers, do you see Asia growing at all over the next two years? And more specifically, is there any way that China can juice its economy now that global demand has evaporated?

SR: In light of prospects for a multi-year compression of US consumer demand growth, together with persistent sluggishness of private consumption in Europe, Japan, and elsewhere in the developed world, there can be no mistaking the challenges faced by export-led Developing Asia.

Those challenges are all the more acute in light of Asia’s sharply increased dependence on exports. Over the past decade-plus, the export share of Developing Asia’s GDP went from about 36 per cent in 1997-98 to fully 47 per cent by 2007. This strategy worked brilliantly while global trade was booming. But now that this boom has gone bust, Asia has been hit extremely hard leaving it with no choice other than to come up with a new growth strategy.

The answer for Asia is obvious, to embark on the heavy lifting of structural rebalancing and stimulate internal private consumption. Nowhere is that more evident than in China, where the private consumption share has fallen to a record low of about 36 per cent of its GDP.

In the meantime, Developing Asia will still grow, driven by ongoing infrastructure-led investment and less than optimal growth in personal consumption. I suspect the growth rate for the region over the next few years will average only around 5 per cent about half the pre-crisis norms and not strong enough to prevent unemployment from rising further. For a region that has long worried about social instability, this is a disconcerting outcome, to say the least. It underscores the critical imperatives of Asian rebalancing.

What is the likelihood of Anglo-Saxon-style capitalism morphing toward a more state-involved Chinese approach, along with more draconian penalties for moral lapses?

SR: Your point is provocative and well taken, but I just can’t get on board this ideological spin to the twists and turns of a post-crisis capitalism. The history of capitalism is very much a continuum of tough tests. Yet in the end, it is a system with strong survival instincts, one that periodically reinvents itself. Financial panics, periodic recessions, and even the Great Depression are all part of the stress testing that has long shaped the rough and tumble evolution of market-based capitalism.

Notwithstanding the claims of a sensationalist media, the scale of state-directed intervention in America’s privately-held corporations remains relatively small.

According to US Commerce Department statistics, the value added by banks, securities firms, and other financial intermediaries collectively accounted for 6.2 per cent of the private sector’s gross domestic product in 2007; the insurance sector made up another 2.8 per cent, whereas the share going to motor vehicles manufacturers was just 0.8 per cent.

Private employment shares of these newly protected industries are even smaller, 5.3 per cent for finance and insurance and just 0.7 per cent for motor vehicles.

These figures provide an outside estimate of the US government’s recent intervention share of around 6-10 per cent in the private economy. That means, of course, that more than 90 per cent of the private sector in the United States is still operating largely as a free-enterprise system. That is not exactly consistent with the widely popularised image of a bail-out nation that has been offered up to depict a US economy in chaos and a market-based system on the brink of collapse.

Still, there is good reason to be concerned about the implications of these recent interventions. Emergency government investments in privately-held companies, capital injections as well as backstop financing, have become an all-too-frequent outgrowth of what started out as a mere sub-prime crisis. At the same time, compensation caps, home mortgage foreclosure mitigation efforts, and politically-engineered consumer lending programs all smack of a quasi-socialisation of American finance.

Add to that, Washington’s new-found aggression on trade policy, “buy America” government procurement policies, along with Chinese currency bashing and it seems as if the US strain of capitalism is being turned inside out. The US body politic is rushing headlong toward a very slippery slope!

The intro asks what is to be done to restore ”faith” in the free market. Is anyone using reason to re-examine free-market ideology itself, or considering the possibility that free markets might be less lethal if they were a little less free?

SR: The current mess is deeply rooted in an ideological approach to economic governance, namely, America’s recent penchant for market libertarianism. Alan Greenspan, the high priest of this approach, framed most of the Federal Reserve’s critical policy choices in the context of this ideology.

As seen through this lens, asset bubbles were not judged to represent a dangerous build-up of speculative excesses instead, they were repeatedly perceived by Greenspan as outgrowths of America’s thriving free enterprise system. The equity bubble of the late 1990s was justified by the breathtaking acclaim accorded to IT-enabled, productivity-led advances of a New Economy.

Property bubbles were presumed to be local, not national,  especially in an era of rising homeownership at the lower or subprime end of the income distribution. And the credit bubble, together with the risk bubble it spawned, was offered as testament to the genius of financial innovation and American creativity. Market libertarians simply looked the other way as the US lurched recklessly from bubble to bubble.

Bubbles, of course, are always based on a shred of truth. But the post-bubble wreckage of the US economy begs for a very different interpretation than that which became conventional wisdom over the past decade. So, too, does the Fed’s blatant abrogation of its regulatory responsibilities during the Greenspan years.

Nowhere was that more apparent than in the central bank’s failure to make the distinction between financial engineering and financial innovation. Far from playing the widely popularised role as the ultimate shock absorber, the originate and distribute hallmark of the derivatives explosion became a lethal transmission mechanism of cross-border and cross-product shocks.

Ideology blinded America’s central bank, as well as its political overseers, to the imperatives of discipline. That same ideology let an unregulated and increasingly unstable free-enterprise system veer unnecessarily out of control. I don’t think that markets have to be any less free, as you suggest.

We just need to be more vigilant in attending to their potential for instability and in recognising the repercussions such destabilising adjustments can have on increasingly asset-dependent real economies. Market risk must be taken far more seriously by the Authorities in the future.

Some form of regulation is undoubtedly needed, but it can sometimes be counter-productive, merely adding layers of costs and giving more business to corporate lawyers and auditors. Sarbanes-Oxley is a perfect example of this form of regulation. In light of such issues, what in your opinion is the ideal form of regulation, and do you foresee a return to Glass-Steagall?

SR: While I agree that misplaced regulation can be counter-productive, I also believe that our system of self-regulation failed miserably in an increasingly complex and globalised economy. An important corollary of this failure is the dangerous and destabilising implications of bubble-dependent economic growth.

We must be very careful, however, in rushing to judgment in designing a new regulatory approach in this post-bubble era. The search for scapegoats can become an obsession; in effect, a lightning rod for national angst. But scapegoating can play an even more destructive role as it can bias and eventually undermine the re-regulatory fix that invariably follows any crisis.

Therein lies one of the greatest potential pitfalls in the post-crisis backlash of 2009. Wall Street has been singled out as the villain in this crisis. On one level, this is understandable. Financial service firms did make many serious and regretful mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. But they were hardly alone.

The modern US financial system has long been under the purview of an institutionalised network of checks and balances controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment. Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess.

The task ahead is to pick up the pieces, learn the lessons of this crisis, and take actions to insure these types of problems never occur again. The post-crisis fix can succeed only if it is grounded in the premise of shared responsibility. A targeted politicised fix is not a solution to a systemic problem. Fix the system that gave rise to the crisis not just the banks that have defined ground zero of a wrenching credit crunch.

It is hard to know where the re-regulatory fix will end up. I would not be surprised if new Glass-Steagall-like regulations were enacted in order to shield the credit intermediation function from riskier activities. Moreover, a much broader umbrella is likely, covering banks and non-bank financial institutions, alike.

In the face of government picking winners and losers both of businesses and individuals have we had a free market in reality during the last 40 years? Isn’t it correct to state that what we have had is a hybrid economic system that depended on government manipulation of the financial system to exist?

SR: To the contrary. During the Era of Excess, market libertarians were in charge, embracing a regime of self-regulation and unbridled free-market capitalism. Led by Alan Greenspan, there was very little of the manipulation you seem to believe in.

Those days appear to be over at least for the time being. With many of the once proud icons of Corporate America now on the skids, emergency government intervention has become the norm in this crisis. That is closer to the hybrid system that you seem to be alluding to. As I noted above, the real trick will be to wean the patient from the life support measures of such interventions without triggering a relapse.

To what extent might governments try to influence the business strategies of the financial institutions, which agreed to state aid?

SR: That is a little close to home. The words “might” and “try” should be stricken as this train has already left the station. The feeding frenzy of US Congressional bonus bashing has taken on a life of its own with extreme “clawback” legislation having already passed the House of Representatives and now working its way through the Senate.

If signed into law, these draconian measures would severely impact talent retention, as well as the willingness of any financial institution to accept government “assistance” in the future. Your choice of the word “influence” is a massive understatement of the destructive intent of America’s increasingly vengeful body politic.

Personally, I am sickened by the hypocrisy of the blame game that has been spawned by this wrenching crisis, a politically inspired witch-hunt that has now singled out Wall Street as the villain in this mess. While our industry is hardly blameless for developments that gave rise to the so-called sub-prime crisis, it is dead wrong to lay it all on Wall Street.

Yes, we made many serious mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. I personally have great regret for these errors, honest mistakes that were made by a few but with implications for far too many.

But the verdict must be rendered in context. Governance of the modern US financial system has long been relegated to an institutionalised network of checks and balances, controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment.

Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess. In short, the system failed. And in this new era of responsibility, as President Obama calls it, all of us must accept shared responsibility for that, from Wall Street to Washington to Main Street.

America’s politicians, the stewards of a system that went to excess, apparently can’t stomach the possibility that they, too, played an important role in shaping the endgame. They prefer, instead, to opt for the blame game, in particular, singling out Wall Street as the major culprit in this devastating crisis.

Focusing on the fall guy deflects attention away from the tough choices that ultimately must be made by elected leaders to avoid the repetition of a crisis like this in the future. Never mind the hypocrisy. It is as if the people’s representatives were innocent passengers on a runaway train.

The blame game is the darkest side of any crisis. The search for scapegoats often becomes an obsession, in effect, a lightning rod for national angst. And it brings out the very worst in an otherwise great nation. Accountability is, indeed, a critical issue in any post-crisis debate. But it must be adjudicated objectively and fairly.

Capitalism is failed in the form it is in and will fail again. If the only target of a system is to accumulate wealth for the minority, it is a worthless system. What do think about the ideas of Mahammad Yunus and his Grameen Bank?

SR: I stand by what I said above. The failure is not capitalism but the system of governance or should I say, the non-governance of self-regulation, that was put in place to manage the capitalist system. Fix that, and capitalism will be fine.

No one could reasonably have expected the boards of directors of major financial institutions to foresee the devastation caused by the financial crisis, but was it not reasonable to expect them to be much more effective in forcing their chief executives to protect against the demise of their banks? If not, what real value can boards play in a governance system if they cannot be relied on to do the right thing when it is most critical?

SR: It is premature to judge the most critical failures in the system of corporate governance that guided financial institutions into the eye of this storm. Was it directors, senior managements, risk managers, credit departments, incentive systems or a lethal interplay between all of the above?

Or was it a siloed decision making process and a related failure to communicate effectively across these different constituencies? Getting to the bottom of these concerns is an urgent matter for every financial services firm.

But there is a very human piece to this sad tale, as well. Call it greed, blind greed, for that matter. Like it or not, booms, artificial or real, distort incentives. Booms also warp values and blind us to downside risks. And denial, that most powerful of human defenses, leads us to dismiss the tough questions that might draw the staying power of a boom into question.

In the now-ended boom, there was everything to gain from keeping the magic alive. And much to lose by drawing it all into question. But it wasn’t just Boards of Directors that failed. It was the American body politic – from Wall Street to Main Street to Washington that was consumed by the hopes and dreams of a bubble-induced boom.

As long as the music kept playing, went the painfully accurate metaphor, no one wanted to stop dancing. We even found heroes to worship: Alan Greenspan, anointed as the Maestro, knighted by the Queen, lionised by US Congress, and yet derelict in his responsibilities as a tough and disciplined central banker was the champion of the Era of Excess.

In the end, the ultimate seduction came from the appearance of unbridled wealth accumulation, soaring stock prices, surging home values, and the ultimate in retirement security. But it wasn’t just us. The rest of the world was delighted to go along for the ride, especially export-led developing economies whose newfound prosperity was built on selling anything and everything to over-extended American consumers. Literally, no one, not even you guys in Shanghai, Peter, wanted this party to end.

If the core reason for the current financial crisis was the failure of the American consumer to save, how will policies designed to simulate spending massively at a time when the consumers’ financial position is even more precarious be conducive to the long term change in behaviour needed to really solve this crisis?

SR: There is enormous push-back to my pro-saving prescription for a saving-short US economy. “America needs to spend,” is the increasingly desperate cry of the born-again Keynesians steeped in fear of the dreaded “Paradox of Thrift.” Greg, you have your finger on one of the biggest issues of this crisis: do we want to go back to the failed macro of bubble-and debt-driven consumption that got us into this mess, or do we have the guts to try and break the mold of years of excess?

The answer is clear to me: the US needs to shift its growth dynamic away from excess consumption and de-minimus saving toward enhanced saving and increased investment. The surplus savers of the world need to do the opposite. To do this, we need to rethink our views on the “paradox of thrift”, viewing this phenomenon in the context of an open global economy rather than something as seen through the lens of a closed domestic economy.

I am not suggesting that the world boost its saving rate. What I am suggesting is a critical shift in the mix of global saving with the US doing more of it and Asia doing less of it. As Developing Asia moves to more of a consumption-driven economy, its currencies should also appreciate, allowing the US dollar to work its way lower and helping American boost its export competitiveness.

If the Obama Administration delivers on other aspects of its competitiveness agenda, namely, infrastructure, educational and healthcare reforms, and energy independence, the excesses of bubble-dependent consumption growth should give way to increasing support from export-led growth.

If, however, the US backtracks and goes back to the well for another dose of excess consumption growth, imbalances will only build again, culminating in an even more treacherous endgame. The ever-expedient quick fix must be avoided at all costs. It is a recipe for disaster.

What would be the very first sign that you will be looking for to tell you that this crisis has come to an end and recovery should begin soon? Do you think there will be a long gap between the end of this crisis and the start of recovery?

SR: I wish it were that easy, one magical indicator turns and the end would finally be in sight. This is a lethal and very complex crisis, with many moving parts. The first stage was the credit market contagion that started with the bursting of the subprime bubble in the summer of 2007 and then spread like wildfire in a cross-product contagion that engulfed the remainder of the capital markets.

Moreover, courtesy of the “originate and distribute” technology of the derivatives explosion, toxic instruments found their way all over the world. This interplay between cross-product and cross-border contagion has created a crisis of truly epic proportions.

The second stage of this crisis is the impact of the capital markets contagion on the real side of asset-dependent economies. The asset-dependent American consumer has been first to tumble. But quick to follow has been export-led economies elsewhere in the world – especially in Asia, Europe, and now Latin America. The decoupling dream was just that – actually a bad dream, bordering on a nightmare.

The third stage of this crisis involves the adverse feedback loop between a deteriorating real business cycle and the loan quality of the same financial institutions that bore the brunt of the credit market contagion in the first stage. That stage is now unfolding with a vengeance. Unfortunately, these stages tend to feed on each other – creating the true vicious circle that is exceedingly difficult to break.

Politicians, policymakers, media pundits, and many business leaders have argued for quite some time that this is mainly a crisis of confidence. If only we all just started smiling more and spinning the good news, then the vicious circle would magically turn virtuous and the worst would be over. As I said, I wish it were that easy.

What will be the global consequences of the Fed’s decision to buy US government bonds and bad bank debt on such a massive scale? Will we see hyper-inflation in the US, and will the creditor nations in Asia now want to stop lending them money? What strategic opportunities/risks do you see as a result of this situation?

SR: For a world in recession, the immediate impact of Helicopter Ben’s unconventional monetary easing is not nearly as problematic as you seem to imply. Given the slack in the global economy, together with its still massive imbalances, it is highly unlikely that inflation will spontaneously ignite or that the world will stage a buying protest against dollar-denominated assets.

Keep in mind that trend growth in the world economy has been about 3.7 per cent per annum over the past 35 years. That means if global GDP contracts by over 1 per cent this year as many, myself included, now suspect, such an outcome will open up about a five percentage point gap relative to the global economy’s longer-term growth potential. Given the multi-year sluggishness I envision, I suspect that the global output gap will expand further in the years immediately ahead, possibly peaking at around 7 per cent to 10 per cent of world GDP.

Such a huge global output gap implies a lingering risk of deflation rather than the immediate risk of an outbreak of inflation. If, however, the gap starts to narrow and the Authorities have been unable to develop effective and credible exit strategies for their massive monetary and fiscal stimulus campaigns, then there will be good reason to worry about inflation. Those worries are distant, however, at least three years, and maybe even five years out in time.

In the meantime, I doubt if the export-dependent surplus savers in Asia would stop lending capital to the US. If they did, their currencies would appreciate, undermining their export competitiveness and thereby threatening a key source of their economic growth.

However, if Asia is successful in migrating to more of a consumption-dependent growth strategy, it will start to absorb its surplus saving and have less capital to send to the US. And then, Asians can truly afford to be far more demanding in seeking better terms on dollar-denominated assets. Doesn’t sound very symbiotic to me.

If banks are too big to fail,  too important to our economy, are they not also too important to be owned and managed by capitalists alone? How can we have smart and well-paid bankers and traders make the right decisions for the long-run benefit of their organisations, and not just churn and burn for short-term bonuses?

SR: Having worked for one firm on Wall Street for over 26 years, I am obviously biased in attempting to answer this critical question. But I believe very strongly that financial institutions are too important to be turned back into state-owned public utilities. In an era of globalisation and interdependent markets, financial intermediation and capital allocation have taken on new dimensions of complexity and risk. These are critically important functions in any economy’s quest for prosperity.

Alas, as we have painfully learned, that quest can cut both ways. That provides one of the most important lessons for the financial services industry, the need to redress the asymmetries of reward and compensation. Remuneration, in my view, can no longer be paid out on a point-of-sale basis. It must be aligned with the longer-term risk-adjusted returns of individuals and their companies. Only then, can we avoid the distorted incentives that encouraged short-term payouts from bubble-driven momentum in trading and banking activities.

Of course, in the Era of Excess, we ended up with a very different system. The profusion of bubbles distorted everything, from the financial system to the real economy. If we do a better job in containing the excesses of asset and credit bubbles in the future, I think we will go a long way in establishing a stable and secure market structure that will force the financial services industry to adopt a more reasonable and equitable system of incentives and rewards.

This critical adjustment can not be taken for granted. The trick will come in aligning a new financial system with the industry’s contribution to broader measures of national prosperity. That is a very contentious point.

Former Fed chairman Paul Volcker put it all too well in an April 2008 speech to The Economic Club of New York when he said, “It is hard to argue that the new (financial) system has brought exceptional benefits to the economy generally. Economic growth and productivity over the last 25 years has been comparable to that of the 1950s and 60s, but in the earlier years the prosperity was more widely shared.” Volcker concluded that. “The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place.”

If the next financial system fails the Volcker-like test of the market place, its rewards, or lack thereof, should be aligned with its failed returns. If, however, the outcome is more favorable, remuneration to its workforce, and presumably to its shareholders, should follow. This is the crux of the challenge for our industry and for those charged with its governance. It is an especially critical challenge for the central bank, an institution, which owes its very existence to the crises of yesteryear.

The role of the central bank is, in fact, testament to one of capitalism’s most important covenants, that finance cannot be entrusted to self-regulation. That is the most painful flaw of the Greenspan era. Never again should we let ideology guide central banking and its regulatory responsibilities.

Central banks need new mandates that explicitly tie their policy targets to the requirement of containing the excesses of asset bubbles and the severe economic distortions they spawn. Then, and only then, can the new financial system be on much sounder footing than the old one. But that’s not to say that we in the industry shouldn’t take a long and hard look in the mirror before we embark on our own Herculean task of attempting to rebuild a failed financial system.

Source.

From George Soros, Chairman of Soros Fund Management and Founder of the Open Society Institute

The forthcoming Group of 20 meeting is a make-or-break event. Unless it comes up with practical measures to support the less developed countries, which are even more vulnerable than the developed ones, markets are going to suffer another sinking spell just as they did last month when Tim Geithner, Treasury secretary, failed to produce practical measures to recapitalise the US banking system.

This crisis is different from all the others since the end of the second world war. Previously, the authorities got their act together and prevented the financial system from collapsing. This time, after the failure of Lehman Brothers last September 2008, the system broke down and was put on artificial life support. Among other measures, both Europe and the US in effect guaranteed that no other important financial institution would be allowed to fail.

This necessary step had unintended adverse consequences: many other countries, from eastern Europe to Latin America, Africa and south-east Asia, could not offer similar guarantees. As a result, capital fled from the periphery to the centre. The flight was abetted by national financial authorities at the centre who encouraged banks to repatriate their capital.

In the periphery countries, currencies fell, interest rates rose and credit default swap rates soared. When history is written, it will be recorded that in contrast to the Great Depression protectionism first prevailed in finance rather than trade.

Institutions such as the International Monetary Fund face a novel task: to protect the periphery countries from a storm created in the developed world. Global institutions are used to dealing with governments; now they must deal with the collapse of the private sector.

If they fail to do so, the periphery economies will suffer even more than those at the centre, because they are poorer and more dependent on commodities than the developed world. They also face $1,440bn (€1,060bn, £994bn) of bank loans coming due in 2009. These loans cannot be rolled over without international aid.

Gordon Brown, the UK prime minister, recognised the problem and designated the G20 meeting to address it. Yet profound attitudinal differences have surfaced, particularly between the US and Germany. The US has recognised that the collapse of credit in the private sector can be reversed only by using the credit of the state to the full.

Germany, traumatised by the memory of hyperinflation in the 1920s, is reluctant to sow the seeds of future inflation by incurring too much debt. Both positions are firmly held. The controversy threatens to disrupt the meeting.

Yet it should be possible to find common ground. Instead of setting a universal target of 2 per cent of gross domestic product for stimulus packages, it is enough to agree that the periphery countries need aid to protect their financial systems. This is in the common interest. If the periphery economies are allowed to collapse, the developed countries will also be hurt.

As things stand, the G20 meeting will produce some concrete results: the resources of the IMF are likely to be doubled, mainly by using the mechanism of the “new arrangements to borrow”, which can be activated without resolving the vexed question of reapportioning voting rights.

This will be sufficient to enable the IMF to help specific countries at risk but it will not provide a systemic solution for the less developed countries. Such a solution is readily available in the form of special drawing rights. SDRs are complex but they boil down to the international creation of money. Countries that can create their own money do not need them but periphery countries do. The rich countries should therefore lend their allocations to the nations in need.

Recipient countries would pay the IMF interest at a very low rate, equivalent to the composite average treasury bill rate of all convertible currencies. They would have free use of their own allocations but would be supervised in how the borrowed allocations were used to ensure they were well spent.

In addition to the one-time increase in the IMF’s resources, there ought to be a big annual issue of SDRs, of say $250bn, as long as the recession lasts. It is too late to use the April 2 G20 meeting to agree this, but if it were raised by President Barack Obama and endorsed by others, this would be sufficient to give heart to the markets and turn the meeting into a resounding success.

Source.

While most investors fear deflation, Gary Shilling is looking forward to it. The idiosyncratic economist manages about $100 million for clients from a small office here. For many, many years, he has predicted an era of falling prices that never arrived. Now, finally, it just might.

He has a batch of advice for investors on how to weather deflation: Don't expect your house's worth to rebound. Stash your money in apartment real-estate trusts and conventional Treasurys. Don't invest in companies that carry a lot of debt or in inflation-protected Treasurys.

The last time deflation appeared was in the Depression. U.S. prices slid 32% from 1929 to 1933. Suddenly, many observers these days fear that the popping of the housing bubble, along with the financial crisis, could be pushing the U.S. toward a new deflationary era.

The consumer-price index including food and energy dropped 0.8% for December 2008, year over year, and was flat for January 2009. When the February CPI is reported on Wednesday, March 18, 2009, many expect it to be flat or negative again.

Mr. Shilling believes price drops of 2% to 3% yearly will persist long after this recession because of huge efficiencies driven by globalization and technology, plus retirement-panicked baby boomers curbing their spendthrift ways and pumping up their puny savings. That would echo similar deflationary spells during prosperous, high-growth times like the late 1800s and the 1920s.

Increasingly, Mr. Shilling is getting company from economists who think deflation may be on the way, notably New York University's Nouriel Roubini and Merrill Lynch's David Rosenberg. Of course, others such as Northern Trust's Paul Kasriel, argue that heavy federal spending by the Obama administration to jump-start the economy risks just the opposite, a vexing inflation.

Yet few go as far in seeing persisting deflation as Mr. Shilling, 71 years old, a Stanford Ph.D. in economics who once was Merrill's chief economist.

Deflation in the Depression was truly baleful because it fostered a falloff in demand, since consumers were leery to buy what would be cheaper in the future. And it punished debt holders, who had to pay fixed amounts even as the value of the underlying asset sunk. The same condition bedeviled Japan in the 1990s.

A frequent talking head on CNBC, Mr. Shilling sometimes comes across as an oddball with his chronic bearishness. "People say I'm always negative, and when I'm right, it's like the stopped clock being right twice a day," Mr. Shilling says. Indeed, in January 2004, he predicted a housing crash within the year. "I was early," he says.

Even Mr. Shilling's hobby is on the eccentric side: He keeps bees. At his Short Hills, N.J., home and a nearby property, he tends 80 hives. Mr. Shilling gives the honey away to friends in plastic bear containers with labels saying things like: "Our bountiful bees need no bailout."

Over the years, Mr. Shilling has devised a virtual deflationary handbook for investors. Good ideas: Longer-term Treasurys and certificates of deposit, which will continue to pay interest in the low single-digits. If the CPI is down 2% and 30-year Treasurys yield 3.6%, as they do now, then you get an effective 5.6%.

The housing bust is showing Americans that a place to live is no longer a can't-lose investment, Mr. Shilling says. Hence, he forecasts a surge into rental apartments, which should boost now-flagging apartment REITs. In health care, Mr. Shilling thinks winners will be companies dedicated to cost containment, like pharmacy-benefit managers.

His expected victims of deflation? Auto makers as savings-minded consumers will hold onto their old cars longer and sellers of other big-ticket goods like refrigerators. He also is down on mortgage-backed securities, linked to the plummeting housing sector.

Source.

Must we look back to the Great Depression to really understand the current stock market?

A year or so ago, when a select few investment newsletter editors began arguing that we need to do so, the overwhelming majority of advisers believed that drawing such an analogy served little purpose other than fear mongering. It is testament to the severity of this bear market that the consensus opinion has shifted so much that it is now respectable to look to the 1930s for guidance about what is in store for equities.

I'm skeptical, however. That's not because I don't think that decade has much to teach us.

My skepticism instead traces to the small number of analysts and commentators who have really analyzed what an analogy to the 1930s truly entails. And if we are to genuinely learn the lessons of history, we have no choice but to start with an accurate assessment of what actually happened.

After examining several aspects of the stock market's behavior during the 1930s, it would appear as though a replay of that decade might very well be less scary than assumed by many of those who superficially draw the analogy.

Here are some myths about the Depression that should be dispelled.

Myth 1: It took 25 years for the stock market to recover its losses from the high reached just before the stock market crashed in October 1929.

It's easy to see why investors believe this myth to be true: It wasn't until Nov. 23, 1954, that the Dow Jones Industrial Average closed above the level at which it closed on Sept. 3, 1929, the date of its closing high before that year's crash. That's a recovery period of more than 25 years.

If the recovery from the bear market over the last year and a half were to take the same length of time, the Dow wouldn't again close above its all-time high from Oct. 9, 2007, of 14,164.53 until, you'd better sit down, Dec. 28, 2032.

The truth, however, is that it took stocks far less than 25 years to recover. According to Wharton finance professor Jeremy Siegel, the inflation-adjusted total return index of the U.S. stock market was just as high in late 1936 and early 1937 as it was at its precrash peak in 1929. That was less than eight years later.

That may not be great news to investors who are hoping to recover their bear market losses in just one or two years. But it's a whole lot better than taking 25 years to recover those losses.

Why the Big Difference?

One factor is dividends, which were substantial during the 1930s. At the depths of the Great Depression, in fact, the Dow's dividend yield was in the double digits. Ignoring dividends, which is what investors do when focusing on price alone, therefore, introduces a significant pessimistic bias into any historical analysis.

Another Factor is Deflation

The consumer price index actually dropped by 27% between its 1929 peak and its low in 1933. A stock that dropped by less than this amount in nominal terms over this four-year period, therefore, actually turned a profit in inflation-adjusted terms.

Yet another reason why it took the Dow so long to surmount its 1929 peak: The decision in 1939 to delete International Business Machines from the average. It wasn't added back until years later. According to Norman Fosback, editor of Fosback's Fund Forecaster, the Dow would today be more than twice its quoted level had IBM not been removed from the average in 1939.

Myth 2: If we're playing out a 1930s script, now would be a bad time for long-term investors to get into the stock market.

Actually, if the stock market were to exactly adhere to a 1930s-like script, equities would provide a handsome return over the next five years.

Once again, this insight relies on data from Professor Siegel. To locate the date during the 1930s that is most analogous to today, he looked for the point at which the stock market after 1929 had, as is the case today, declined by around half on a dividend-adjusted and an inflation-adjusted basis. That point came at the end of 1930, just 16 months after the August 1929 stock-market top. Ironically, the current bear market is just 16 months old too.

According to Siegel, over the five-year period beginning in January 1931, the stock market produced an inflation-adjusted total return of 7%. That's right in line with stocks' long-term average performance, in fact.

To be sure, this myth does have a big grain of truth to it. Over the first five months of 1931, the first five months of this five-year period -- the stock market fell 60%. You read that right: That's a 60% drop on top of a 50% drop over the previous 16 months.

If the stock market today were to suffer a further decline of similar magnitude, the Dow Jones Industrial Average would be trading below the 3,000 level by the end of July.

So, to that extent, it is true to say that, on the assumption we're playing out a 1930s-like script, now would not be a good time to enter the stock market. But this truth pertains more to shorter-term investors than to longer-term investors. According to Siegel, in fact, an investor who entered into the stock market in early 1931 was made whole again by June 1933, despite digging a 60% whole in the first five months.

Myth 3: The stock market's recent extraordinary volatility provides a clue to the wild ride that lies ahead if we're playing out a 1930s-like script.

Actually, undeniably large as it has been, recent volatility doesn't even begin to compare to what it was like during the 1930s. In fact, there were eight calendar months during the decade of the 1930s in which the Dow rose or fell by more than 20%. The month with the biggest Dow move was April 1933, when the Dow rose by 40.2%. In August 1932, furthermore, the Dow rose by 34.8%.

The biggest monthly losses during that decade were almost as big. The largest came in September 1931, when the Dow lost 30.7%. These monthly changes dwarf what has been seen in the current bear market. The biggest calendar month loss so far came last October, when the Dow fell by 14.1%. The month-to-date loss for February is minus-17.2%.

To measure the magnitude of the stock market's volatility during the 1930s, I calculated the standard deviation of the Dow's monthly returns on a trailing 36-month (or three-year) basis. In mid-1933, this statistic rose to 15.4%, an extremely high number. During the current bear market, in contrast, this comparable statistic has never risen above 4.1%.

The bottom line? If we are indeed playing out a 1930s-like script, we have an incredibly wild ride ahead of us. But for those who have the intestinal fortitude to hang on, such a story would have a surprisingly happy ending.

Source.

From Roberto Barr, Professor of Economics at Harvard and a Fellow at Stanford University's Hoover Institution

Central questions these days are how severe will the U.S. economic downturn be and how long will it last?

The most serious concern is that the downturn will become something worse than the largest recession of the post-World War II period,1982, when real per capita GDP fell by 3% and the unemployment rate peaked at nearly 11%. Could we even experience a depression, defined as a decline in per-person GDP or consumption by 10% or more?

The U.S. macroeconomy has been so tame for so long that it's impossible to get an accurate reading about depression odds just from the U.S. data. My approach uses long-term data for many countries and takes into account the historical linkages between depressions and stock-market crashes. The research is described in "Stock-Market Crashes and Depressions," a working paper Jose Ursua and I wrote for the National Bureau of Economic Research last month.

The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.

Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870.

Our conjecture was that depressions would be closely connected to stock-market crashes at least in the sense that a crash would signal a substantially increased chance of a depression.

This idea seems to conflict with the oft-repeated 1966 quip from Paul Samuelson that "The stock market has predicted nine of the last five recessions." The line is clever, but it unfairly denigrates the predictive power of stock markets. In fact, knowing that a stock-market crash has occurred sharply raises the odds of depression. And, in reverse, knowing that there is no stock-market crash makes a depression less likely.

Our data reveal 251 stock-market crashes defined as cumulative real returns of -25% or less and 97 depressions. In 71 cases, the timing of a market crash matched up to a depression. For example, the U.S. had a stock-market crash of 55% between 1929-31 and a macroeconomic decline of 25% for 1929-33.

Likewise, Finland had a stock-market crash of 47% for 1989-91 and a macroeconomic fall of 13% for 1989-93. We found that 30 cases where there were both crashes and depressions were also associated with wars. In fact, World War II is the worst macroeconomic event of the period, with strong U.S. wartime economic growth as an outlier.

In the post-World War II period, the Organisation for Economic Co-operation and Development (OECD) countries were strikingly tranquil up to 2008. The worst macroeconomic event in that period came in Finland in the early 1990s. Sweden also faced a financial crisis in the early 1990s, though it reacted quickly and is now being touted as a possible guide for leading the U.S. out of its current economic crisis.

Outside of the OECD, there have been many linked stock-market crashes and depressions since World War II -- including the Latin American debt crisis of the 1980s, Mexico's financial crisis in the mid-1990s, the Asian financial crisis of the late 1990s, and Argentina's financial turbulence that lasted until 2002.

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a "minor depression," macroeconomic decline of 10% or more will occur when there is a stock-market crash.

There is a 9% chance that a "major depression," a fall of 25% or more will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes, our data show the probability is 92%.

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war. The Iraq and Afghanistan conflicts are not comparable to World War I or World War II. Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing.

In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes, 69% for minor depressions and 83% for major ones.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

The bright side of a 20% depression probability is the 80% chance of avoiding a depression. The U.S. had stock-market crashes in 2000-02 by 42% and 1973-74 by 49% and, in each case, experienced only mild recessions. Hence, if we are lucky, the current downturn will also be moderate, though likely worse than the other U.S. post-World War II recessions, including 1982.

In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.

Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions -- including several pursued by Franklin Roosevelt during the Great Depression -- can make things worse.

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Source.