I've been noting in my writings and in my various tweets since Monday of last week that intermarket trends have been behaving more positively following the elections.

The post-QE3 corrective period has thus far, with hindsight, looked stunningly similar to the May "mini-correction" which was my base case for how the decline would play out, within the context of the "Fall Catalyst" idea of new all time highs in the Dow by end of year.

Stock market resilience cannot be denied. The S&P 500 is still on track for being the third best year in a decade performance-wise, and the German DAX is bumping up against 25% returns for the year. For all intents and purposes, equities have indeed behaved in a reflationary way.

Our ATAC models used for managing our mutual fund and separate accounts are extremely close to pulling the trigger on an aggressive allocation back into stocks, with a bit more confirmation needed to switch out of bonds.

How could this be when the so-called fiscal cliff is still such a risk? Why would stocks go up in the face of no deal being made yet, and with the world now focused on our government now that Europe has completed a debt deal with Greece?

First, consider that the fiscal cliff and "damage" done by going over it is extremely well publicized, with numerous websites and news programs actually going so far as to create a counter for how many days are left to get a deal done. Say what you will about Republicans or Democrats — in a democracy, you don't get elected through austerity as I said on CNBC recently .

The odds favor that a deal is struck in some way shape or form, lessening the depth of the cliff. However the details are worked out, in theory any kind of compromise would be bond bullish.

If spending cuts are made, the Treasury will end up issuing less debt, causing a reduction in new bond supply issuances presumably. We all know that the Fed plans on buying Treasurys at a constant rate from now until kingdom come. That inherently means bond prices continue to get bid up not because of new demand, but because of shrinking supply.

Would those spending cuts lessen economic growth? Perhaps, but if bond yields continue to hold at panic low levels on those spending cuts, it may be bullish for stocks due specifically to the “Bear Paradox” idea I have referenced on numerous occasions recently.

The Bear Paradox is the idea that with bond yields at such incredibly low levels, any kind of a deep correction and risk-off period would make stocks instantly more attractive as a better income play than fixed income. The more stocks decline, the higher dividend yields go relative to bond yields, which would likely only get closer to zero during such corrective periods.

As the gap of income widens between stocks and bonds (barring a credit event), money buys into stocks to take advantage of comparative higher yield. In an upcoming writing Marc Faber of the Gloom Boom and Doom Report will publish of mine in December, I greatly expand on this concept within the context of what I call the Fed's last hope for the economy.

If we go over some variation of the fiscal cliff then, and that ends up being bond bullish, then the Bear Paradox gets even more accentuated, causing stocks to outperform. Take a look below at the price ratio of the Pimco 7-15 Year U.S. Treasury Index ETF (TENZ) relative to the S&P 500 (SPY). As a reminder, a rising price ratio means the numerator/TENZ is outperforming (up more/down less) the denominator/SPY. For a larger chart, visit here.

Note that the spike up in bonds relative to stocks abruptly reversed, and may now be back in a downtrend. Given the Bear Paradox, this should make sense given that yields are once again at absurdly low levels, making stocks more attractive as money puts a bid into stocks.

If the fiscal cliff keeps yields depressed, the Bear Paradox alone makes stocks an asset class to be bullish on (barring a credit event or massive economic slowdown). This in turn then makes the ratio fall at least to the prior support level of around 0.59, and may result in the Fall Catalyst of new highs happening all in December.

This is an important juncture — price continues to not think the fiscal cliff will either a) happen, or b) happen and not matter for markets. Either way, we may be nearing a point where the odds of another "melt-up" in stocks takes place independent of how the fiscal cliff negotiations play out, which can be very tradable in the near-term for those willing to listen to price.

To put it simply, the Fed's QE can not stop as there is no real market, or demand for TSYs expressed in duration terms, a fact the Fed's 4 year meddling in the market has been able to conceal quite effectively. Alas, the Fed knows this. The Fed also knows that in a country which will continue piling up $1 trillion + deficits forever, there will always have to be a backstop funder of the US deficit. Since China is long gone as a buyer of US paper, this only leaves the Fed.

In other words, the simplest reason why the Fed will never exit is because the US will never again run a budget surplus, meaningless discussions over what a token $80 billion a year tax increase (which will fund the US deficit for 2-3 weeks) will do notwithstanding, and the Fed will need to monetize ever more US-sourced paper until Bernanke and his successor after 2014 are the only "market" for bonds left standing. 

"There is a general tendency for overheating impulses during China's economic transition process and we should always stress the need to control inflation," Zhou told a financial forum.

"In most occasions, pressures from various sides is to loosen monetary policy to spur growth, but there is less push for preventing economic overheating and inflation," he said.

A main feature of China's economic transition is that many entities, including local governments, are not subject to "soft constraints", which means they tend to spend more and fuel economic overheating, Zhou added.

"I think you're seeing the top of the dividend trade. I think if anything, what's going to end up happening is afocus back into cyclical sectors for 2013. You want the global trade. you don't want the domestic trade anymore.

You may have read one of Leo’s previous posts about my company in Argentina. We are in the wine business; one of our businesses is selling vineyards to private owners that produce magnificent wines in the shadow of the majestic Andes. I’ll describe it more below.

As I have business in Argentina, Leo asked me for a summary of the ongoing Argentina bondholder saga. I think it’s an incredibly interesting situation that could have serious ramifications on future sovereign restructurings and debt issuance. For some reason, only the Financial Times seems to be reporting on the story, so most are pretty unaware of what’s happening. The Economist had a decent article on it last week.

Now I will caveat that I’m no expert and I may have some of this wrong. But here’s how I understand it.

In 2001, as we all know, Argentine suffered a major crisis and devaluation. Over the next few years, they were unable to meet their debt obligations and defaulted on some bonds. At the time, it was the largest debt default in history: $93B. They tried to restructure the debt and negotiated firmly. Ultimately, they came to an agreement for about 75% of the defaulted debt, where the holders received about 30% of the par value. The new debt was to be paid over time and included warrant kickers based on Argentine GDP performance. In 2010, they reopened the exchange and ultimately they were able to get 94% of the old debt restructured. Since there were no collective action clauses in the debt instruments, Argentina couldn’t force the holdouts into the deal.

So that left 6% - and that’s where the story gets interesting.

The Holdouts claim that Argentine is in default and Elliott Management is leading the attack. Elliott argues that since the bonds were under New York law, the Argentine government couldn’t just unilaterally rewrite the bonds. The bonds are subject to the law of another jurisdiction. Argentine can’t really dispute that but they argue that Elliott can’t force them to pay.

The recent legal battle had to do with a clause in the bonds called the Pari Passu clause. Basically, the clause says that Argentina’s payment obligation under the bonds can’t be subordinated to any other unsecured debt of the country. Elliott argues that they are as entitled to payment as the ones who exchanged their bonds (the Exchange Bondholders). They’ve been fighting for years. Except last week, Elliott finally won a big battle.

A trial judge, perhaps angered by some of the rhetoric coming out of Buenos Aires, agreed with Elliott. He issued an order stating that Argentina had to pay the Holdouts along with the Exchange Bondholders. He also said that Bank of New York, who manages disbursements to Exchange Bondholders on behalf of Argentina must comply with the order, as must the Exchange Bondholders.

The Exchange Bondholders are angry because the order jeopardizes their chances of receiving payment. Argentina says they won’t pay the Holdouts – and if they can’t pay the Exchange Bondholders without paying the Holdouts, they may default on the Exchange bonds. BNY is angry because they just want to do their job – pay the Exchange Bondholders. So that's one of the key questions here - is the money paid to BNY (to be paid to Exchange Bondholders) the property of Argentina (which can be subject to seizure) or is it the property of the Exchange Bondholders (and perhaps should be immune from seizure, as the claim is against Argentina)?

An added factor is the Credit Default Swaps. There are many rumors that Elliott is betting on an Argentine default to the Exchange Bondholders using CDS instruments. If Argentine defaults on the Exchange Bondholders to avoid paying the Holdouts, Elliott wins big through its CDS bets. Smart.

Argentina may try to pay the Exchange Bondholders via Argentina or another, non-US jurisdiction. But that would probably constitute a default according to the bond rules – and Elliott wins on the CDS bets. Argentine doesn’t want to see Elliott making any money and while that’s really irrelevant to everything, it seems that some in Argentina are concerned with that.

A few days after the trial court’s ruling, the appeal circuit issued a stay, with a hearing to be held in late February. Now the Holdouts are asking for the court to ask Argentina for an escrow payment and the Exchange Bondholders are protesting (they are arguing that the Holdouts are trying to create a situation where Argentina will default). Holdouts should lose on this, but you never know.

Elliott realized that a sovereign default is different than a corporate default. In a corporate bankruptcy, the issuer can disappear and there is a finite amount of money that needs to be a spread around. In a sovereign default, the company will never ‘go bankrupt’. It will always be around (barring exceptional circumstances) – so there will always be a chance to collect.

This is a big deal because Elliott is proving that a country can’t force a restructuring if the bonds are in a foreign jurisdiction. And now they may be able to force Argentina to pay them. This could have severe repercussions in sovereign debt restructurings (Greece, Spain, Italy….). Issuers (and creditors) will be paying more attention to pari passu clauses and collective action clauses.

In the end, I think the final result will be that while Argentina owes the money, and Elliott can try and seize Argentina's assets (see the Ghana boat story), the money paid to BNY will be seen as property of the Exchange Bondholders (as it's due to them) and not subject to seizure. May not happen that way, but I'm not afraid of being wrong.

Argentina is a wonderful place. It’s a beautiful country with incredible scenery, great food, great wine and wonderful people. Unfortunately, it has a history of populism and a very screwed up government. But – that makes life interesting.

As to our company: We have a wine business in Mendoza, the wine capital of the country. It’s called The Vines of Mendoza (www.vinesofmendoza.com). While we are involved in many parts of the wine industry, our most interesting product is our Private Vineyard Estates. We sell small private vineyards to wine lovers all over the world. Our clients own their vineyards and choose what varietals to plant (of course, many choose Malbec). After a few years, when the vines are mature, they can make wine from their own grapes – or can sell the grapes on the market. We farm the vineyards for our clients and help them make wine in our unique state-of-the-art winery.

We started this business in 2007 and now have over 120 clients. We have clients who are interested in starting a small wine business and we also have clients who are only interested in making a barrel or two each year for their personal use. Our oldest clients are already making wine from their grapes and the wine is turning out to be truly magnificent. We also make wine for clients who don't own vienyards - these clients buy a barrel of wine (about 300 bottles) and get to choose the grapes and decide on the blend themselves. Our consulting winemaker, who works with each of our clients, is Santiago Achaval, arguably Argentina’s top wine-maker.

We are also building a resort on the property – when it’s completed in 2013, it will be the top boutique hotel in the country. Our restaurant will be run by Francis Mallman, one of the top chefs (if not the top chef) in Argentina. We are really looking forward to the opening.

If anyone would like to learn more about our vineyards, please give me a call at (848) 628-4261 and I’ll be happy to tell you more about the company.

Barring another attempt by holdout investors to win an order requiring a payment, Argentina looks to be in the clear to continue servicing its restructured debt without fear of court intervention.

Argentine Economy Minister Hernan Lorenzino welcomed the decision.

"It's a positive ruling," he told reporters in Buenos Aires. "It's (also) positive that the participation of interested third-parties -- not only (exchange) bondholders but also the payment intermediaries -- has been ratified."

Argentina has called the holdout creditors "vultures" and vowed never to pay them.

The latest battle stemming from Argentina's $100 billion sovereign default nearly 11 years ago centers on a 2nd Circuit decision in October that the country violated a bond provision requiring it treat all creditors equally when it paid the exchange bondholders without paying the holdouts.

December 15 is a critical day because Argentina is scheduled to pay $3 billion on warrants issued as part of the debt swaps.

This had raised fears of another default because if Argentina had refused to pay the holdouts, as was expected, U.S. courts could have disrupted payments to holders of restructured bonds handled by intermediaries such as banks and clearing houses.

Argentina next owes money on its restructured debt in March 2013.

The case is NML Capital Ltd et al v. Argentina, 2nd U.S. Circuit Court of Appeals, No. 12-105.

In May, an article in the Guardian newspaper in Britain carried the headline: “Greece should follow Argentina’s lead: As Argentina’s experience after 2002 shows, when an economic crisis hits, it is often best to go it alone.” Greece, or other nations, may consider the Argentine strategy of flouting international standards a profitable or desirable course. This would be a disaster for global economic stability.

Some governments are now recognizing the danger. In September 2011, the Obama Administration stated that it would henceforth oppose loans to Argentina (except in humanitarian cases) from the World Bank and IADB. Then in August, Spain and Germany also voted “no” to a $60m IADB loan. The following month, other European countries, including France and Denmark, did the same.

This, however, continues to look like what it is: a piecemeal, ad hoc approach. The way to apply pressure to Argentina would be through coordinated, clear, public statements from European governments that they will join together to vote “no” until Argentina starts acting responsibly.

Another antidote would be ending Argentina’s membership of the G-20. In June, with economist Alex Brill, I produced a study that advocated transparent, objective criteria for G-20 admission in three categories. Argentina fell far short of qualifying. The cutoff for G-20 membership was an index of 40; Germany scored 83, France 76, Argentina 18.

Incentives count. The government of an indebted nation watching Argentina’s misbehavior will undoubtedly be encouraged to follow its example. And in a world in which economies are so systemically linked, the actions of one country, even a relatively small one, can affect finances globally.

It is past time for responsible nations to ratchet up the pressure. Raising the future of Argentina’s membership in the G-20 would help, as would clear declarations, especially from European nations, that they will no longer devote their taxpayers’ money to further loans until Argentina settles its debt, stops fudging its statistics, and ends the seizure of property owned by others.

The managers of Virginia's pension fund got bonuses in 2010 and 2011 even though they failed to meet the benchmarks that would justify such payouts, a new report shows.

Investors for the Virginia Retirement System used to get bonuses based on the pension fund's performance. No one received a bonus in fiscal year 2009, and afterward the fund's trustees changed the system so that they -- and not a performance benchmark -- would decide who got a bonus.

A year after the system was changed, VRS employees shared $2 million in bonus payouts even though the pension fund did worse than in 2009, the Joint Legislative Audit and Review Commission reported Monday. After meeting benchmarks in 2012, staff split about $3.7 million, roughly the same amount employees received in 2011, when goals were not hit.

The state auditors faulted the new system, which they said led to "disproportionate reliance on qualitatively, subjective measures of performance" and inappropriate bonuses. VRS said it was examining its bonus policies.

"This is something that the VRS board looks at and will be continuing to look at in the upcoming year," said VRS spokeswoman Jeanne Chenault.

The auditors will re-examine VRS' policies next year to see if the system has improved.

Sen. John Watkins, R-Midlothian, who sits on the audit committee, said the pension fund has to pay performance-based bonuses because it competes with the private sector for investment managers.

"If we unloaded all of this work into the private sector, you're going to pay a premium for the work done," Watkins said. "[But] we've got to keep a good eye on this thing and make sure the performance match ups with the incentives they're being paid."

Virginia Gov. Bob McDonnell and lawmakers took steps this year to shore up VRS by requiring state workers to pay more toward their retirements and fully funding pension obligations in 2013 and 2014. But the audit found that the pension fund's shortfall is growing. VRS was 70 percent funded in 2011, but that dropped to 65 percent this year.

"The governor recognizes the challenges presented from unfunded liabilities in the pension system," said McDonnell spokesman Paul Logan.

Auditors told lawmakers in Richmond on Monday that the pension fund should be solvent late within the next decade.

"I'm probably not going to be here for another 14 years, so if someone goes in and upsets the applecart, all bets are off," Watkins said. "If we stay the course, we'll get back to where we need to be."

“We are pleased with the results we were able to achieve in a market fraught with volatility and depressed returns. In fact, the staff's skillful performance allowed them to beat the benchmark for the fund as a whole last year,” said VRS Chief Investment Officer Ronald D. Schmitz.

During fiscal year 2012, the fund's real assets program returned 11.9 percent. The private equity program returned 10.9 percent, the fixed income returned 7.9 percent and the credit strategies program returned 1.4 percent. The public equity program returned -4.6 percent, reflecting the market shifts during the year.

The portfolio included $21.8 billion in public equity, $12.5 billion in fixed income, $7.2 billion in credit strategies, $4.8 billion in private equity and $4.3 billion in real assets, as of June 30, 2012.

“Although the market did not produce the returns we had hoped for, our staff made the best of a difficult global market, taking advantage of every opportunity to protect the portfolio and add value. Realistically, the world has not recovered from the 2008 financial meltdown, and it is still a difficult time to be an investor. As the market has become more volatile, the Board of Trustees has redoubled its focus on the appropriate asset allocation and risk profile for the trust fund,” said VRS Board Chairman Diana F. Cantor.

VRS serves approximately 600,000 members, retirees and beneficiaries. The active employees include about 147,000 teachers, 104,000 local government employees and about 91,000 state employees. In addition, VRS provides benefits to over 162,000 retirees and beneficiaries. The retirement system ranks as the nation's 22nd largest public or private pension fund.

BCE Inc., Canada’s largest telephone company, reiterated its full-year sales and profit forecast and said it will add $750 million to its employee pension plan.

BCE expects 2012 revenue growth to be at the lower end of the range of 3 per cent to 5 per cent it gave as a target Aug. 8. Earnings excluding severance, acquisition and other costs should be $3.15 to $3.20, the Montreal-based company said in a statement. The pension contribution will come from its year-end cash balance.

BCE has been using excess cash to refinance bonds, pay down debt and shore up its pension plan amid stiffening competition both from its traditional rivals and new wireless operators in central Canada. BCE competes with Rogers Communications Inc. and Telus Corp. in providing mobile-phone service, cable TV and Internet packages to Canadian consumers.

BCE shares rose 13 cents to close at $42.95 in Toronto on Tuesday.

Phone company Verizon has transferred $7.5 billion in pension obligations to Prudential Insurance after a retiree association failed to convince a court to stop the move.

Members of the Association of BellTel Retirees sued in federal court in Dallas two weeks ago to stop the deal, saying it would weaken the legal protections for retirees. It effectively turns the company’s defined-benefit pensions into annuities to be paid by Prudential. Annuities aren’t covered by the federal Pension Benefit Guaranty Corp.

On Friday, the judge ruled that the retirees had failed to show they were likely to be harmed by the deal.

Curtis Kennedy, a lawyer for the plaintiffs, said they will likely appeal that decision. If they win on appeal, the companies may have to unwind some of the deal, he said.

“The legal issues are most significant for not only the group of affected Verizon management retirees, but for all corporate American retirees whose pensions are presently being sponsored by their former employers,” Kennedy said.

The Verizon plan covered 41,000 management retirees.

New York-based Verizon Communications Inc. has said that the deal lowers the risk that its pension obligations will end up costing more than projected.

Verizon Communications Inc. (VZ) pension- plan beneficiaries lost a bid to block the company’s transfer of $7.5 billion in plan obligations to Prudential Insurance Co. of America.

U.S. District Judge Sidney A. Fitzwater in Dallas today denied a request by two retirees who worked for a Verizon predecessor to issue an order stopping the deal, saying they failed to show a “substantial likelihood of success on the merits” of their case.

The transaction, under which the retired managers’ plan would be converted to an annuity, would strip them and about 41,000 other beneficiaries of the protections of federal law and cause irreparable harm, they said in lawsuit filed Nov. 27.

“Plaintiffs have failed to establish a substantial likelihood that Verizon has a specific intent to interfere with their rights,” Fitzwater wrote in his opinion today. “They do not offer a rebuttal to Verizon’s proffered legitimate, nondiscriminatory reasons for defining the group of retirees for the annuity contract.”

Verizon, the second-largest U.S. phone company, said on Oct. 17 that it planned to shift about one-fourth of its pension obligations to Prudential to remove risk from its balance sheet. The New York-based company has said the beneficiaries’ lawsuit is without merit and it may be harmed if the transaction isn’t completed by Dec. 10.

‘No Say’

Curtis Kennedy, an attorney for the retirees, said today that his clients should have been given “a voice and a choice,” as General Motors Co. beneficiaries were when their plan was transferred to Prudential.

“Verizon’s style was to do a ‘cram-down,’ giving retirees no say in the matter,” Kennedy said in an e-mailed statement. Fitzwater’s ruling will probably be appealed, the lawyer said.

“While we cannot immediately stop the Verizon/Prudential annuity transaction from going forward next week, all of the parties may, eventually, be faced with a need to unwind some of the deal,” Kennedy said.

In his 15-page ruling, the judge rejected the plaintiffs’ claims that by transferring the whole of their pension to just a single entity, Prudential, Verizon was breaching its fiduciary duty to diversify plan investments to minimize risk.

“This argument relies on characterizing the annuity contract as an investment instead of a distribution of benefits,” Fitzwater said. “But plaintiffs offer no support for their position that the fiduciary duty to diversify investments applies in this context.”

Protected Interests

Ray McConville, a spokesman for Verizon, said by phone today that the company is pleased with the court’s decision.

“Verizon’s actions regarding its pensions protect the interests of our retired management employees,” the company said in a Nov. 29 statement. “The monthly pension benefits of the retirees receiving an annuity from Prudential will remain unchanged.”

The unit of Prudential Financial Inc. (PRU), the second-largest U.S. life insurance company, is also a defendant in the suit. In a Dec. 5 filing, the Newark, New Jersey-based company told Fitzwater the plaintiffs’ pensions will remain safe and urged him to reject their request to block the transfer.

“Prudential has paid retiree benefits under group annuity contracts and other arrangements since 1928 without interruption,” according to the filing.

Dawn Kelly, a Prudential spokeswoman, declined to comment today on the judge’s ruling.

The case is Lee v. Verizon Communications Inc., 12-cv-4834, U.S. District Court, Northern District of Texas (Dallas).

Bell Canada says it plans to make a $750-million payment toward its defined benefit pension plan to help improve its funded status.

The company says the payment will be funded from cash on hand at the end of 2012.

It says the pension pre-payment is tax deductible and expects to realize $200 million in tax savings in 2013.

The pension plan's financing costs will benefit from the stronger position of the plan and therefore will help increase earnings by two cents per share starting next year.

"Accelerating the funding of Bell's future pension obligation is an efficient use of our cash given the backdrop of a persistently low interest rate environment," said Siim Vanaselja, chief financial officer at BCE and Bell Canada.

"With this contribution, which preserves the pension plan's funded status at a high level, we expect Bell's normal pension funding and cash income taxes for 2013 to be maintained at a similar level to 2012. This action both de-risks the pension plan and improves Bell's longer term financial flexibility to enhance returns to our shareholders through reduced future pension funding requirements and expense."

As a result of the payment, BCE reduced its projected free cash flow for the year to between $1.6 billion and $1.75 billion from an earlier projection of between $2.35 billion and $2.5 billion before the pension payment.

State and local governments issuing bonds to bolster their pension funds may increase the chance of defaulting on their debt while probably failing to improve their credit quality, Moody’s Investors Service said.

The securities will have either a neutral or negative effect on a government’s creditworthiness, depending on the size of the sale and the use of proceeds, Moody’s said in a report today. Turning unfunded pension promises into bonds keeps liabilities unchanged, though it raises the risk of a default as the amount of debt increases.

“Pension bonds are often a red flag associated with greater rigidity of long-term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future.” Moody’s analysts Marcia Van Wagner and Timothy Blake wrote in the report. In some cases, “the issuance of the bonds is sufficiently credit negative to put downward pressure on the issuer’s rating.”

Illinois has borrowed $17.2 billion since 2003 for pension benefits, according to Moody’s. The state’s worst-funded retirement system has only 43.4 percent of assets needed to cover its obligations, according to data compiled by Bloomberg. Moody’s downgraded Illinois in January, citing its “severe pension under-funding.”

Illinois Governor Pat Quinn said yesterday that the battle to control employee pension costs “is our fiscal cliff and we need to deal with it” or ratings companies would lower the state’s grade again.

Municipal defaults this year are still at the lowest since at least 2009, with 80 issuers failing to pay this year, according to data from Concord, Massachusetts-based Municipal Market Advisors.

Municipal bonds that states and local governments use to pay for some of their public pension obligations rarely improve the issuer's credit quality, Moody's Investors Service said on Tuesday.

"If bond proceeds substitute for annual contributions to pension plans or are used to pay pensioners, we consider it a deficit borrowing and would view the financing as credit negative," Marcia Van Wagner, the senior Moody's analyst who wrote the report, said in a statement.

Cities and counties in the United States seem to have gotten this message, even though many face big unfunded pension liabilities. Despite some large state pension obligation bond deals in 2012, issuance has declined from 2011.

In the first seven months of 2012, there were just 14 such deals worth $604 million, compared to $4 billion issued in 2011, according to Thomson Reuters data.

The negative credit implications hold especially true if the borrowing is large relative to the issuer's budget, for example over 5 percent. The bonds are also viewed negatively if they are part of a pattern of one-time fixes or don't come alongside a plan to restore budget stability, Moody's said.

"Pension bonds are often a red flag associated with greater rigidity of long term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future," said Van Wagner.

The U.S. municipal bond market shrank in the third quarter of 2012, to $3.719 trillion from $3.732 trillion in the second quarter, the Federal Reserve said on Thursday.

That was still larger than the level of outstanding debt the year before, when the market was $3.708 trillion in the third quarter of 2011, according to the Fed's quarterly report on fund flows.

Households' appetite for the bonds sold by states, local governments and other authorities continued to drop off. They shed $245.5 billion bonds in the third quarter and $3.5 billion in the second. Households have cut their holdings in muni debt for six quarters in a row.

America’s public pensions have hit a new low.

At a board meeting today, the Kentucky Retirement Systems (KRS) announced that its funded ratio is now 24.5%, according to former KRS trustee Christopher Tobe, beating out Illinois’ as the lowest in nation.

From 2007 to the fiscal year-end of 2011 (the latest date for which data is available), KRS’ total assets dropped by more than a third, from $6.44 billion to $3.97 billion. In KRS’ 2011 annual report, Chief Operations Officer William Thielen acknowledged the dwindling funding ratio, and attributed it to a variety of causes.

Funding ratios have fallen both steadily and significantly over the last decade as a result of unfavorable market conditions, higher than anticipated retirement rates, employer underfunding…and increased expenses or annual cost of living adjustments that are not pre-funded by the employers,” Thielen wrote.

It gets worse: “While improved market conditions and the increased funding in…FY 2011 have slowed the growth of the unfunded liabilities of the various systems, KRS uses a five-year smoothing method and the full effects of the market losses in 2008 and 2009 will not be realized for another three years.”

Tobe attributes KRS’ sorry state to other factors.

“This 24% is unique,” he wrote in an email. “Unlike Illinois, most Kentucky officials were not aware of the extent of this underfunding. This is primarily due to complete lack of transparency. KRS held back disclosing this level for nearly a month from their normal November meeting.” 

KRS officials were subpoenaed by the US Securities Exchange Commission in 2011 as part of an investigation into the role of middlemen in public pensions.

According to the Comprehensive Annual Financial Report (CAFR) of the New Hampshire Retirement System, the funding ration for the state pension system fell by 1.3 percentage points to 56.1%.

Plan liabilities grew by approximately $363 million while plan assets declined by roughly $116 million, leading to a decrease in the funding ratio. As a result, the unfunded liability grew to $4.5 billion.

Pension payouts to retired employees also rose by $28 million to just shy of $550 million.

On the asset side, total contributions by employees and employers grew by $28 million. Most employee groups saw an increase in total contributions as a result of the pension reforms passed in 2011, with the exception of Employees due to layoffs. State, Local and County Governments contributed roughly $255 million while employees contributed $200 million.

Investments gave the NHRS a 0.9% return, yielding an additional $32 million. Though returns were below the assumed rate of return of 7.75%, the NHRS’s investment experience for FY12 was in the same range as similar public sector pension systems.

Turning to demographics, due to layoffs, active membership in the NHRS fell by roughly 1,100 to 48,625. Conversely, the number of retirees grew by 1324 to 28,454.

Teachers' acquired its interest in 2003 through its Infrastructure Group.

"The Express Pipeline System was one of Teachers' earliest infrastructure investments and has been a good investment for the Fund," said Stephen Dowd, Teachers' Senior Vice-President, Infrastructure and Timberland. "We have had a positive relationship with our partners, Borealis and Kinder Morgan, and we will continue to look at future opportunities in the pipeline sector."

Teachers' Infrastructure Group currently manages an international portfolio of approximately $11 billion, including water and wastewater, electricity distribution, gas distribution, airports, power generation, high-speed rail, port facilities and timberland. 

My heart is breaking for the families of those affected by the events in Newtown, Connecticut this morning. Just as I'm sure yours is, regardless of your stance on the gun issue.

Now, we're going to hear people talk about this sudden need for a "national conversation" or a some grand debate over guns and gun control. I can't think of a more pointless waste of time.

There is a percentage of the US population - a fairly large one - that will never agree to the need for any kind of regulations or tighter controls on guns. No matter what evidence is presented, how many people are killed in any given massacre or what the statistics say. If anything, even the slightest hint of impingement on their "freedom" galvanizes them even more. They have their standard answers to everything you're going to attempt to say: "There was no shortage of violence in Ancient Rome or Feudal Japan before guns were invented" and "No one ever walks into a police station and tries to shoot at all the armed people" and on and on.

The Far Left will say it's time for the elimination of all guns period. Since there is zero chance of this happening right now, it will only serve to irk the other side. There is little value in these statements.

The Moderates will say that outlawing guns won't stop bad / crazy people from doing bad / crazy things. And they're right. But it certainly wouldn't hurt either.

The Center-Right will say that by removing firearms from the hands of law-abiding private citizens, you're virtually assuring that only the worst element in society will be armed and the rest of us will be defenseless. I can understand this point of view, even if I disagree because I think the trade-off is worthwhile when you consider the drastically decreased availability of these weapons.

The Libertarians will say that people passing laws against guns makes our need for guns even greater than ever. The Redcoats are always right around the corner, after all, lying in wait for 230 years.

And then there are the True Believers who will say that everyone should be armed, at all times, the more guns the better. Which is obviously just common sense. Of course having more people walking around armed is safer. Definitely safer than having almost no one armed and stiffer sentences for those who illegally obtain weapons. How can you not see that? I know some of these guys, a few are friends. I promise you there is no swaying them even an inch.

I don't claim to have the definitive answer in this fight nor do I necessarily believe that I inhabit the moral high ground, I'm just deeply saddened and a little bit scared. But I do know which side sounds more reasonable right now. I also know that the debate is utterly hopeless.

Think about it - Do you really believe that someone who has lost a relative to random gun violence is going to agree that we need to defend the ownership of assault rifles because "it's a slippery slope?"

Do you really think that a guy who collects, shoots, cleans and plays with handguns as a hobby is going to agree to anything other than the complete and total freedom to conceal and carry them everywhere? What statement is it that you think anyone's going to make that will change his mind? What elementary school bloodbath will he see on the television that might awaken inside him even an iota of doubt?

There is no statement anyone could make or massacre gruesome enough. They just want their guns.

No one will ever change anyone's mind. Not with a conversation or with discourse or with facts or with emotional arguments. Try explaining to an NRA member that the 2nd Amendment was actually not an argument for all citizens to be armed, but rather it was a method for preserving the existence of militias - the quasi-official organizations that were the precursors of our modern police and armed forces. You can quote him the actual words of the amendment itself and he will not budge. If anything, he'll fold his arms across his chest even tighter. "But it's my guns and my bullets and I want them and more than that I want my right to have them."

Good luck with that "conversation." Trust me, it goes nowhere.

This post was not intended to change the way anyone thinks or to try to convince anyone that they are right or wrong in whatever their stance is. I really don't care what you think, you probably don't care what I think.

This post is, however, intended to keep you from wasting your time. Do not engage each other in debate, friendly or otherwise. Do not attempt to spark a "national conversation." It will save zero lives and you will win no converts, regardless of the elegance or brutishness of the logic you employ on your argument's behalf. Gun people are gun people and gun control people are gun control people. That's it.

But I will say this - If you are anti-gun or at least pro-gun control, there is a silver lining you can keep in the back of your mind:

Progress comes slowly and society improves itself only by replacing itself with successive generations that are unencumbered by the social mores of their parents' and grandparents' eras. What was once acceptable to one generation in the course of American History eventually became unthinkable to a new generation just once, twice or thrice removed.

In my parents' lifetime, it was considered both lawful and socially acceptable in a large part of the country for people of one race to be treated differently than people of another. In my parents' parents' lifetime, discrimination against women and withholding from them the right to vote along with other basic freedoms and protections was totally acceptable. In my parents' parents' parents' generation the exploitation of child labor was considered to be acceptable and in their parents' generation Americans were legally allowed to buy, sell and own human beings.

But time passes and society weeds out that which proves to be more harmful than productive. People don't change their minds, it is the very people themselves who change, a progressive force for good which cannot be stopped. The religious wars that raged across Europe between Protestant and Catholic in which millions were slaughtered merely because of how they chose to speak with god did not end because people suddenly changed their minds. There was no "continental debate." No, these wars ended after hundreds of years because, eventually, the new people who came along didn't seem to be as hung up on the things that the old people were so concerned with.

This pattern repeats itself over and over again throughout history. Except where it doesn't. In places where this process is not allowed to run its course and the obsession with tradition distorts the natural trend of societal amelioration, you get primitiveness, dictatorships, warlords and stunted cultures. You get honor killings and forced marriages and regressive medical practices and radical religious fundamentalism and high infant mortality rates and female genital mutilation and ethnic cleansing.

But in America, we eventually evolve to where we need to be. You can ask "How many more innocent people need to die until things change?" I don't know. Maybe things never change. Maybe future generations remain as committed to their right to bear arms as past and current ones have. That is possible. Perhaps we'll also continue to allow big money interests to make the laws and packaged foods companies to poison us and tobacco companies to to murder us and schools to teach fairy tales as an alternative to science and lawyers to run wild with frivolous suits that act as a tax on the nation and government-guaranteed banking institutions to operate like casinos for the benefit of their employees and the lobbyists to ensure that we spend the equivalent of the next 19 countries combined on our military each year. Maybe we'll allow these things to continue forever.

Or maybe we won't. Maybe our children or their children will put a stop to it. Maybe enough people will decide that some aspects of our daily lives have outlived their usefulness or have begun to do more harm than good. And then something will be done.

But one thing's for damn sure - if it happens it won't be because you or I said anything to anyone, on TV or in an op-ed or on a blog or on Twitter.

My opinion doesn't matter and neither does yours, so save yourself the aggravation.

"As we mourn, we must sound a call for our leaders to stand up and do what is right," Kelly, a retired astronaut, wrote on his Facebook page. "This time our response must consist of more than regret, sorrow, and condolence. The children of Sandy Hook Elementary School and all victims of gun violence deserve leaders who have the courage to participate in a meaningful discussion about our gun laws - and how they can be reformed and better enforced to prevent gun violence and death in America. This can no longer wait."

Many years ago, filmmaker Woody Allen said "80 per cent of success in life is showing up." And so far he has lived up to his standards: for more than 40 years, he's been making a new movie every year.

I think this notion applies to the stock market as well: To earn the return of stocks - on average around 10 per cent per year - you first and foremost have to be invested in stocks.

My favourite annual reading (besides Warren Buffett's letter to his shareholders) is the Dalbar research on investors' behaviour. Let's go through the results as of 2011.

First, the average equity mutual fund retention rate over the past 20 years has been 3.29 years. Dalbar concludes: "One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets."

Now if investors are not holding their equity investments for long periods of time, it is probably because they believe they can "time" their buy and sell decisions wisely.

Dalbar shows in its study that "data further underscores the fact that investors fail at timing the market." Last year was a disaster for equity investors: The average investor lost 5.73 per cent in 2011 compared with a gain of 2.12 per cent for the S&P 500.

This is far from a one-year anomaly. Over the past 20 years, the average equity investor earned 3.49 per cent annually, compared with 7.81 per cent for the S&P 500. This 4.32 point difference is mostly linked to investors not having a long-term outlook.

They juggle their portfolio between stocks and bonds with few rewards. If they had simply stayed invested over those 20 years, they could have doubled their return. For investors, success really would be to stay invested instead of trying to "time" their entries and exits.

The professional (or institutional) investor is not immune to the psychological tendencies of trying to time the stock market. Like individual investors, they rarely can time their asset allocation decisions properly.

For example, I know a great money manager who has a 13.3 per cent annual return over many decades. This is an outstanding track record. Would you believe the stocks he owned have actually returned 15.8 per cent per year? But by holding lots of cash (on average, something like 20 per cent of assets), his annual return has been reduced by 2.5 per cent on average.

I never understood this. For me, it's quite simple: if stocks return 10 per cent a year over the long run, bonds return five per cent and cash returns three per cent, why on earth would you not be 100 per cent invested in stocks?

Ah ... but we hear all the time that we need diversification; we need a balanced portfolio; we need to hold cash for when the market goes down. These sayings are long on tradition but short on wisdom. If you can't sleep at night with a 100 per cent stock portfolio, I agree that holding fixed income securities makes sense (what's the point of being rich, if you don't sleep at night?). But for the sake of this article, let's put emotional reasons on the side and focus on purely financial parameters.

If holding stocks is far more rewarding than holding bonds and cash, why buy anything else than stocks? Moreover, if investors - individual and institutional - have proved time and time again that they can't predict when to buy and sell stocks, why even try?

That is why, 20 years ago, when I started to invest in the stock market, I decided I would always be invested in stocks and that I would spend no time trying to predict market fluctuations. I've focused all my efforts in finding the best companies to own for our portfolios and it's worked out pretty well.

1. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

2. I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over.

3. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you?

4. These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates an illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust price action. The pain of gain is just too overwhelming to bear.

5. There is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it.

6. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.

7. That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade?Why not make your life a pursuit of happiness rather than pain?’

8. If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.

9. Losers average down losers

10. The concept of paying one-hundred-and-something times earnings for any company for me is just anathema. Having said that, at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?

11. The normal progression of most traders that I’ve seen is that the older they get something happens. Sometimes they get more successful and therefore they take less risk. That’s something that as a company we literally sit and work with. That’s certainly something that I’ve had to come to grips with in particular over the past 12 to 18 months. You have to actively manage against your natural tendency to become more conservative. You do that because all of a sudden you become successful and don’t want to lose what you have and/or in my case you get married and have children and naturally, consciously or subconsciously, you become more conservative.

12. I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

13. I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.

Although I do not own RIM shares right now, the share price is attractive at these levels and on my radar. If the company is able to boost market share successfully launch Blackberry 10, RIM will rebound and thrive. And although I love my iPad and iPod, I will never give up my BlackBerry (but the Torch disappointed me, stick to the Bold).

Britt Harris arrived at the Teacher Retirement System of Texas in 2006 from the world’s biggest hedge fund with a mandate to improve the pension’s performance. He also brought a Wall Street attitude about pay.

Harris, the Texas fund’s chief investment officer, made $1 million last year in salary and bonuses, the most of any public pension employee in the 12 most populous U.S. states, according to data compiled by Bloomberg. Four other employees made at least $500,000, and the fund paid $9.7 million in bonuses in 2011, more than any in those states.

Funds where executives made far less posted better investment results than those produced by Harris and his staff over three and five years. They included, respectively, the Ohio Police & Fire Pension Fund, where the top-paid executive last year was William J. Estabrook, at $231,614, and the New Jersey Division of Investment, where director Timothy Walsh made $185,000 plus $7,500 for moving expenses, data show.

“These guys may claim to be worth their weight in gold,” said Edward Siedle, a former U.S. Securities and Exchange Commission attorney and president of Benchmark Financial Services of Ocean Ridge, Florida. “They absolutely can’t justify it.”

Falling Behind

While Harris says public pension compensation must be competitive with the private sector to attract top talent, the Texas fund -- seventh-largest in the U.S. with $112.4 billion in assets -- is falling further behind in long-term obligations to more than 1.3 million education employees and retired teachers, including Harris’s mother.

The pay-and-performance disparities at public pension funds are among the findings of a data review in which Bloomberg compiled payroll records for 1.4 million employees of the 12 largest states.

Of the highest-paid pension executives in those states last year, all but two worked at the Texas fund or the State Teachers Retirement System of Ohio, data show. Yet the Texas fund’s 2.12 percent return over five years as of June 30, 2012, net of fees, was less than five other state pensions, including the New Jersey pension plan, which returned 2.46 percent. The Texas fund’s three-year results of 13.17 percent trailed Ohio Police & Fire, which returned 13.25 percent.

Harris, who became chief investment officer in December 2006, was hired by a board of trustees appointed by the governor. He said it isn’t fair to judge his returns before 2009. It’s only since then that his strategy has been completely in place after attracting the investment talent he needs, Harris said.

‘Come Home’

“You get a better car, then you’ve got to have a good driver,” Harris said in an interview. “This whole structure has been like a magnet to all these investors from around the country to kind of come home to momma, come home and serve the teachers.”

The Texas fund’s three-year return was just ahead of the State Universities Retirement System of Illinois and the Pennsylvania Public School Employees’ Retirement System. Their top-paid executives earned $221,346 and $269,302, respectively, the data show. Neither fund pays bonuses.

“Strictly looking at performance for pay, there are a lot of people who are paid only mediocre salaries that deliver excellent performance,” said Charles Skorina, an executive recruiter retained by the boards of institutional investors to identify and hire investment professionals.

‘Loose’ Correlation

He found “a very loose correlation between pay and performance in public plans,” based on an analysis of the pay of chief investment officers and pension returns over five years.

The Texas teachers’ pension plan was 81.9 percent funded as of Aug. 31, down from 82.7 percent funded in 2011, 82.9 percent in 2010 and 83.1 percent in 2009. These percentages show how much money the fund projects it will have compared with its obligations to retirees over the long term. When a fund falls further behind on them, taxpayers have to make up the difference. The U.S. median for states fell to 71.7 percent in 2011 from 82.6 percent in 2007, according to data compiled by Bloomberg.

While retired teachers in Texas don’t oppose bonuses to keep good staff, they think the payments are too high and reward too many employees, said Tim Lee, executive director of the Texas Retired Teachers Association in Austin.

“They don’t like the fact that people are getting bonuses and raises but our retirees haven’t had a raise for 12 years,” Lee said in a telephone interview. “If we are the best, then we must perform better than anybody else.”

Pay, Bonuses

Harris’s compensation included $480,000 in annual pay plus $565,792 in bonuses earned in 2009 and 2010, according to the pension. He is scheduled to make $900,752 in 2012, including his annual salary, plus bonus amounts of $222,277 and $198,475 earned in 2010 and 2011, the fund said.

Harris, 54, joined the Texas system after managing the pension fund at Verizon Communications Inc. (VZ) and six months as chief executive officer at Bridgewater Associates LP, the world’s biggest hedge fund, based in Westport, Connecticut.

He was hired to improve a fund with below-average performance that was not well diversified, Harris said. With approval from the state legislature, Harris began ramping up stakes in so-called alternative assets including private equity and hedge funds. Alternatives have risen to 32.1 percent of assets from 4.1 percent in 2006, according to the fund.

Attracting Talent

Harris said he also sought to attract investment talent appropriate for one of the world’s 20 largest pensions. That, he said, addresses the “travesty” and “sin” of a public pension fund paying less to an investment staff working for retirees than private-sector managers earn at smaller funds serving affluent clients.

Standing at a white board in front of the conference table in his Austin office, with a panoramic view of the Texas Statehouse, Harris drew a diagram showing the scale of investment compensation at all pension funds, public and private.

“These people right here are being cheated,” he said, pointing to public funds at the bottom.

“It’s crazy to think about the fact that the way the world works is the largest, most important funds are expected to compensate people the worst,” Harris said.

After hiring a consultant to complete a comprehensive review of pay, Harris said he increased base salaries to the top quarter of public funds and bonuses to match the bottom 25 percent of private funds.

Incentive Changes

He changed the incentive program, which had paid bonuses of as much as 75 percent of base salaries only to investment directors, managers and executives. Awards now range from as much as 5 percent of base salary for administrative staff to as much as 125 percent for top officials. Bonuses are paid over two years, as long as an employee remains with the system.

Bonus pay at the fund increased from $622,918 for 34 employees in 2007 to $9.7 million for 108 in 2011, which included incentives earned in 2008, 2009 and 2010 and paid last year when the fund reached positive returns, according to records provided by fund. This year, Texas Teachers paid $6.1 million in incentives and expects to pay $6.9 million in February, records show.

With bonuses, 63 of the fund’s employees, or about 10 percent, made more than Republican Texas Governor Rick Perry’s $150,000 annual salary without his state pension last year, data show.

Good Stewards

The Texas Teachers Board of Trustees has a duty to act in the best interests of the people they serve while being good stewards of taxpayer dollars, said Josh Havens, a spokesman for Perry.

“Governor Perry expects the board to do its job,” Havens said in an e-mail.

The pension with the next-highest bonuses, State Teachers Retirement System of Ohio, paid $8.1 million to 88 workers last year, data show. That included $3.1 million in bonuses earned in 2009 but deferred until the pension reached $65 billion in assets last year, the fund said.

The California Public Employees’ Retirement System, the largest public pension in the U.S., paid $4.1 million to 50 workers in 2011, the fund said.

By comparison, the three highest-performing funds over the past 10 years, the Pennsylvania School Employees Retirement System, Ohio Police & Fire Pension Fund and Pennsylvania State Employees’ Retirement System, didn’t have an employee paid more than $270,000, and none pays bonuses, the funds said.

Since Harris joined the Texas fund in December 2006, Texas Teachers has paid $20 million in bonuses, records show.

‘Go Along’

A 2009 memo submitted to the Texas system’s board of trustees by Michael Green, one of the fund’s former senior managers, said Harris’ approach to running the system can be summarized in two phrases: “You’re too skeptical” and “You’ve got to go along to get along.” Reached by telephone, Green declined comment other than to say he stands by the memo.

While Harris said he can’t comment because Green is a former employee, he said, “I don’t need to get along with anybody” and “this is a job that I want to be in, not that I have to be in.”

Top public pension fund executives make less than their counterparts at investment-management companies. Compared with the $1 million Texas system paid Harris last year, Waddell & Reed Financial Inc. (WDR), with $95 billion now under management, paid Michael Avery, its president and chief investment officer in 2011, total compensation of $4.6 million that year, according to the Overland Park, Kansas-based company’s proxy statement.

Bonuses Falling

Yet bonuses are falling for money managers in the private sector. Wall Street’s cash bonus pool is likely to fall for a second straight year in 2012 as the financial industry grapples with market turmoil, economic weakness and new rules, New York state Comptroller Thomas DiNapoli said.

The average Wall Street bonus fell 13 percent to $121,150 in 2011, the lowest since 2008, and down almost 40 percent from a peak of $191,360 in 2006, according to estimates by DiNapoli.

Harris didn’t take an estimated bonus of $167,835 in 2009 after the TRS fund experienced a 27 percent drop in its market value in 2008. The fund pays bonuses even if the fund loses money -- deferring the payments until returns are positive again -- as long as employees beat their investment benchmarks, according to the plan.

Core Culture

Under Texas Teachers’ program, bonuses are calculated based 80 percent on investment performance against asset-class benchmarks and peer groups, with 20 percent based on how each employee rates against “core culture items” of candor, curiosity, accountability, teamwork and leadership, and promoting a constructive work environment, said Susan Wade, director of professional development.

Lee at the Texas Retired Teachers Association sent a letter to board trustees in June seeking to lower the amount of bonuses employees are eligible to earn, to raise the benchmarks used to qualify for a bonus and to limit the number of workers who qualify. The board didn’t agree, said Lee, the association’s executive director.

Among large, statewide pension plans, about one-quarter to a third have some sort of performance incentive program for their investment staff, said Keith Brainard, research director at the National Association of State Retirement Administrators.

Anecdotal Reports

Brainard said he hears growing anecdotal reports about retirement funds having difficulty attracting and retaining qualified investment staff, and that Harris and many asset managers could easily double or triple their compensation in the private sector. If they were working for an external money manager, most people wouldn’t be concerned, he said.

About 80 percent of the Ohio teachers’ $65 billion fund is managed internally by about 100 investment professionals, said Stephen Mitchell, deputy executive director of investments.

That includes Mary Ellen Grant, the fund’s highest-paid employee last year at $678,291. She oversees a staff of 35 that handles almost 90 percent of its real estate holdings, while other funds rely on more expensive external managers, spokesman Nick Treneff said. The fund’s three-year return on investments, net of fees, was 12.40 percent and its five-year return was 0.97 percent.

While relying on internal staff can inflate compensation totals, it’s more cost effective than paying external managers, Mitchell said in an interview in Columbus. He said an analysis by CEM Benchmarking concluded the Ohio Teachers’ fund saved $91 million in 2011 alone by managing assets internally compared with peer median costs to use external managers.

“Our costs are very low for what we do,” Mitchell said.

No Guarantee

Even so, there’s no guarantee that active management and higher compensation will produce better results, and funds can get competitive returns with passive management using external managers, said William Mabe, head of the State Universities Retirement System of Illinois. Mabe earned less than a third of what Grant was paid in 2011 and a quarter of what Harris made.

Mabe’s fund posted returns that ranked third-best among 20 funds in the 12 largest states over three years and 8th highest over five years, while Mabe’s compensation was lower than that of the top executives of all but three of the 20 plans.

“At the end of the day,” Mabe said in a telephone interview, “returns are really what matter.”

...at OTPP it is a 4y rolling until it isn't. What I mean is when 2008 rolls around and it potentially deep-sixes bonuses for the following four years, management makes a case that keeping the 4y rolling including 2008 performance will make it difficult to attract / retain talent and this justifies restarting the 4y avg from 2009 - so it only stays 4y avg as long as it suits management.

Canada’s finance ministers have announced a “way forward” on expanding the Canada Pension Plan, but put off any decisions until June to make sure the economy survives a potentially rocky few months.

With uncertainty over the so-called fiscal-cliff negotiations in the United States and the unstable economic picture in Europe, finance ministers emerged from two days of meetings saying they need a little bit more time on pension reform.

Federal Finance Minister Jim Flaherty said officials will spend the next six months working on what a modest CPP increase would look like and proposing potential triggers or signs that the economy is strong enough. The markers could include increased economic growth and reduced unemployment.

“We reviewed the work done on the CPP and agreed on a way forward,” he said on Monday after a day of meetings at Meech Lake with his provincial and territorial colleagues, which was preceded by a dinner in Ottawa the night before.

Positive comments from the other ministers on Monday mean that a major national policy move that had largely disappeared from public debate is now very much on the agenda and could be approved by the end of 2013.

Ontario Finance Minister Dwight Duncan, a leading advocate of enhancing CPP benefits, who had been critical of Mr. Flaherty’s previous reluctance, praised Monday’s development.

“This is an important step forward. I didn’t think we’d come out with this,” he said. “I think what’s important is that we’ll have a report back in six months and this moves the yardsticks considerably.”

Quebec Finance Minister Nicolas Marceau predicted a deal would be in place to enhance the CPP by the end of 2013.

“There is political appetite,” he said, adding that two pension-related reports expected in 2013 will help Quebec shape its position.

“I think there’s enough support for this enhancement to see the light of day,” he said.

Alberta Finance Minister Doug Horner, who represents a province that is seen as the most resistant to CPP changes, said he would wait and see what the proposals look like in June before taking a position.

“At this point, I’m not saying we are or we are not [supportive of expanding CPP,]” he said.

Dan Kelly, president of the Canadian Federation of Independent Business, said his group is disappointed that Mr. Flaherty was not more clear that hiking CPP premiums is off the table. The CFIB has been one of the main critics of a CPP increase, arguing it is unaffordable to employers and will cost jobs.

In contrast, the pro-CPP increase CARP – a national lobby group for seniors – said it is good news that CPP reform is back on the agenda. However CARP vice-president Susan Eng said the ministers’ reasons for delay amounted to “lame excuses.”

“The excuse that the economy is too fragile now to support a CPP change does not make any sense,” she said, noting that CPP changes likely would not start for three years and would be introduced gradually.

Another main advocate for CPP enhancements – the Canadian Labour Congress – called the meeting a failure because it did not produce a definitive action plan.

It’s not clear whether Ottawa will continue to insist that all provinces and territories must be on board before it would approve CPP enhancement. Mr. Flaherty appeared to soften his position on that issue on Monday, noting that the rule for changing the CPP requires the support of two-thirds of the provinces representing two-thirds of the Canadian population.

“I think the rule is two-thirds, two-thirds. That can be accomplished,” he said. “We’ll have to wait and see.”

...the expressed concern over impacts of increasing premium rates — like many objections to CPP expansion raised over the years — lacks empirical foundation. Between 1997 and 2003 CPP premium rates were increased by nearly 70 per cent (without any associated benefit hikes), while the national employment rate rose steadily and strongly with only a small slip in recessionary 2001.

A further hike in CPP premium rates would similarly be spread over six or more years, and the first small installment would undoubtedly be delayed at least until 2014 due to the requisite legislative and regulatory changes. The total rate hike would be smaller than in the earlier episode, and the linkage of increased premiums to increased benefits this time would blunt any adverse economic incentives.

Increasing CPP retirement benefits is supported by a multitude of public policy considerations, and studies suggest that it would be superior to the institution of PRPPs. Those plans, endorsed at the 2010 finance ministers’ meeting in preference to CPP expansion, offer few advantages beyond existing RRSPs and defined-contribution pension plans. They are also inferior to the Canada Pension Plan in their voluntary nature, retirement date risk, lesser pooling of various risks, and lack of indexation.

Instituting PRPPs with voluntary participation by both employers and employees is unlikely to redress much of the problems faced by the 60 per cent of Canadians who do not currently have access to a workplace pension plan. While initially supportive of the PRPP concept, the provinces have been slow to adopt enabling legislation.

Enlargement of CPP benefits has emerged as the best pension reform option in many independent expert analyses. Notable supporters of CPP expansion include former Bank of Canada and Canada Finance luminary David Dodge, former CPP chief actuary Bernard Dussault, former CPP Investment Board chief executive David Denison, and former Statistics Canada chief assistant statistician Michael Wolfson.

The format and scale of CPP benefit expansion advocated in the studies vary, but most would go well beyond the mooted “three 10 plan” now being considered by the Finance Ministers. Rather than hiking benefits from the current 25 per cent of insured earnings by 10 percentage points, an increase to the 40 to 50 per cent range is commonly endorsed. And rather than raising the insured earning maximum from the current $50,000 by a suggested $10,000, a hike on the order of 50 per cent is widely recommended.

Without changes of these magnitudes, the retirement prospects for middle-earning Canadian workers will continue to be at risk. A study by Mr. Wolfson projects that, without CPP expansion, about half of those now earning $35,000 to $80,000 annually can expect a substantial drop in their living standards after age 65.

The temptation for cautious policy makers — and politicians — is to dawdle in choosing options that carry near-term uncertainties but substantial albeit more-distant gains. CPP enlargement will take some 40 years to mature fully, as the reform raises benefits to individuals only in proportion to their higher contributions.

This long gestation period is all the more reason for the Finance Ministers to proceed quickly and boldly with plans to increase CPP retirement benefits. While the provinces have steadily shifted to support CPP expansion, the financial industry has been constant in its opposition ever since 1979. That remaining obstruction and economic misconceptions can hardly justify any failure to act effectively on the income security of future retirees.

Some politicians and unions in Canada are on an ideological mission to increase the Canada Pension Plan without understanding the key drivers and policy implications behind the move. Business is solidly against the move, seeing it as another payroll tax that our struggling economy can’t support.

Some key facts must be understood. An enhancement of the CPP will be a significant drain on investment capital, at a time when the public sector unions, and even the Bank of Canada, are calling for business to come off the sidelines and kick start our economy. Expanding the CPP now will have the opposite effect.

Increases in CPP will be a redirection of money from the private sector that creates capital investment. The CPP investment fund invests in mature companies and government bonds, not the innovative small business sector that is the driver of our economy.

It is important to examine how much capital is hoarded by the CPP. 

It took a while, but the owner of Freedom Group, the weapons conglomerate that makes the Bushmaster weapon used in last Friday’s assault in Newtown, Connecticut, finally said something.

At 1 a.m. on Tuesday morning, more than 80 hours after the event, Cerberus Capital, the high-profile private-equity firm that owns Freedom Group, issued a statement. Cerberus expressed sadness and attempted to distance itself from the assault, noting that Freedom Group “does not sell weapons or ammunition directly to consumers, through gun shows or otherwise.” It continued: “We do not believe that Freedom Group or any single company or individual can prevent senseless violence or the illegal use or procurement of firearms and ammunition.”

But you don’t need a weatherman to know which way the wind blows. Cerberus recognizes that the Sandy Hook even was a “watershed event that has raised the national debate on gun control to an unprecedented level.” And this higher level of public debate is making Cerberus uncomfortable. “As a Firm, we are investors, not statesmen or policy makers.” So rather than get involved in a messy debate, it is cutting Freedom Group loose.

“We have determined to immediately engage in a formal process to sell our investment in Freedom Group.” That way, Cerberus can give the money back to its investors, and go about its business “without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so.”

While welcome, the statement is troubling. And while it is tempting, even satisfying, to lash out at a secretive private-equity firm that profits from the sale of automatic weapons, a deeper look should cause us to pose questions to others, and to ourselves. The rich guys in New York weren’t the only beneficiaries of Freedom Group’s growth. In fact, many of the indirect beneficiaries are people of much more humble means.

Let’s start with the obvious. Cerberus claims that “as a firm, we are investors, not statesmen or policy makers.” But of course, Cerberus’s small leadership team includes statesmen and former policymakers like Dan Quayle, a former vice president of the United States, and John Snow, a former Treasury secretary. In recent years, Cerberus has purposely become involved with companies that benefit from, and rely on, public policy. One of its more successful investments has been in Air Canada, for example.

Private-equity executives, including the folks at Cerberus, have very strong opinions on matters of public policy when it comes to tax rates, the treatment of carried interest, and entitlement spending. Cerberus executives, including its founder, Stephen Feinberg, have given heavily to political campaigns (virtually all of it to Republicans). For people who chose to operate in regulated industries, who choose to invest in government contractors, and who participate in the political process at a high level to suddenly plead a lack of interest and competency in such areas now that there’s a national debate on gun control is highly convenient.

Cerberus is now going to have to dump Freedom Group at a fire-sale price. Who will buy a company that is the target of public opprobrium and likely new regulation—especially one that is now laboring under a higher debt load? At the end of the third quarter, Freedom Group had $646.8 million in debt, up from $487 million the year before. That’s a manageable load for a company whose sales are clocking upwards at a 20 percent annual rate. But the interest payments can quickly become problematic if the business suffers some setbacks, or if it is exposed to expensive litigation.

Of course, Cerberus has already extracted a few hundred million dollars on behalf of its investors from Freedom Group, by having the company issue debt and buy back shares. And this brings up a larger issue.

The dirty little secret of private equity is that many billionaires owe their fortunes and ability to conduct swashbuckling takeovers to civil servants. From its inception, the industry has raised money from public-employee pension funds—taxpayer-funded retirement-savings programs for teachers, DMV clerks, bureaucrats, sanitation workers, and police officers. Huge institutional investors like the New York State Common Retirement Fund, CALPERS (the California Public Employees Retirement System), and CALSTRS, which invests on behalf of California teachers, possess hundreds of billions of dollars in assets and are mainstays of the private-equity business. When Cerberus, and the Blackstone Group, or Bain Capital use debt to boost returns, and use the bankruptcy code to shuck obligations, a big chunk of the benefit goes to civil servants.

In its statement, Cerberus noted that “Our role is to make investments on behalf of our clients who are comprised of the pension plans of firemen, teachers, policemen and other municipal workers and unions, endowments, and other institutions and individuals.” Many of these funds are in turn controlled by publicly elected officials. And events like Newtown put them in a tough spot. The Financial Times reported that CALSTRS had expressed concern with Cerberus about the investment. Private-equity firms are much more responsive to questions from their investors than they are to questions from the public. If Cerberus, or other private-equity firms, invest in toxic companies that embarrass them, the big institutional investors may be less likely to participate in the next fund. Until recently, these large public funds were looking the other way, too.

The bottom line is that we are much more implicated in the search for profits than we like to think. Andrew Ross Sorkin reports in the New York Times on other gun companies that are owned by private-equity firms, which in turn invest on behalf of such pension funds.Other companies, like Smith & Wesson and Ruger Sturm, are publicly held, which means they may reside in index funds, ETFs, or mutual funds. If we were all to do a deep archeological dive into our portfolios, many of us would find some connection to a gun company.

The Supreme Court of Canada has ruled federal employees aren’t entitled to any of the $28-billion surplus the government took from their pension funds a decade ago to help pay down the deficit because the accounts were nothing more than “ledger” records with no real assets.

Wednesday’s unanimous decision, written by Justice Marshall Rothstein, rejected union and pensioners’ claims that the government breached its fiduciary duty when it scooped the surplus from the pension plans of Canada’s public servants, military and RCMP. They wanted the court to return the money to the plans.

The high court upheld previous lower court rulings and found the pension accounts were not separate funds with assets but “rather accounting ledgers used to track pension payments” and to estimate the government’s future pension obligations in its financial statements or the Public Accounts.

With no assets in the plan, the court rejected claims that employees and retirees had an “equitable or legal” interest in the plan and that the government had a fiduciary duty as the plan’s administrator to put members’ interests first.

If the accounts were just records, the court determined, employees and pensioners couldn’t suffer “any detriment” by the government’s accounting treatment and decision to amortize the surplus against the deficit.

“The … accounts are legislated records and do not contain assets in which the appellants have a legal or equitable interest,” the court concluded.

“The government was not under a fiduciary obligation to plan members nor was it unjustly enriched by the amortization or removal of the pension surplus.”

The ruling came as a disappointment to unions, but several privately admit they weren’t surprised by it because of their earlier court losses. It ends one of the longest and costliest legal battles undertaken by the unions and retiree associations.

The Supreme Court granted the groups leave to appeal because of the national importance of the case, which affects more than 700,000 retired and working public servants — many of whom live in the National Capital Region — who belong to one of the country’s largest pension plans.

The 79-page decision concluded employees’ only “entitlements” are the pension benefits promised under the mandatory defined-benefit pension plan. Public servants can collect pensions worth up to 70 per cent of the average salary of their best five years.

It also held that the government had the legal authority to take the surplus when it passed Bill C-78, the legislation that created a new pension plan in 2000.

If the unions had been successful, the government could have found itself with an additional $28-billion liability added to the national debt.

Unions knew such a win could risk another backlash against well-paid public servants. The Parliamentary Budget Officer recently estimated taxpayers are paying $114,100 a year for every public servant when pensions and other benefits are rolled in.

“It’s been a long fight and cost lots of money but the Supreme Court has ruled and we’ll respect the law. It’s final and we can now move forward,” said Gary Corbett, president of the Professional Institute of the Public Service.

The ruling comes at a time when the government is cutting public service jobs and trying to rein in spending, including pension costs.

Treasury Board President Tony Clement said the lawsuit, triggered by a decision of the Jean Chrétien government, would have saddled taxpayers with “an enormous expense” had unions won.

He said the Conservatives had to take steps in the March budget to reduce public service pension costs to ensure their sustainability and bring them more in line with pensions in the private sector. The government recently passed legislation that increased the retirement age from 60 to 65 for new employees and forced all public servants to pick up half the cost of premium contributions to the plan.

The historic case stands out because of its complexity, uniqueness and the billions of dollars that were involved.

The federal pension plan was an internal account. Employees’ contributions were taken off their paycheques and credited to the account. The act governing the plan required that the government match employees’ contributions, pay interest and cover any shortfall so it could meet its obligations. It was silent, however, on how to handle a surplus.

The contributions, along with interest and other charges, were dumped into the government’s Consolidated Revenue Fund. When it came to time to pay pensioners, the payments were taken from that revenue fund.

Unions and retirees maintained they were entitled to at least a portion of the $28-billion surplus. It was part of their “total compensation” and the surplus was partly built by their contributions and interest paid on those contributions. They argued the pension accounts were “trust funds” and the government had a “fiduciary duty” to manage the funds and only use them for pensions.

The court accepted the government’s argument that the pension accounts were “legislated ledgers” to track what went in and out of the accounts. There was no money, stocks, bonds, real estate or other tangible assets in them. The money credited to the accounts was deposited in the Consolidated Revenue Fund and became public funds for the government’s use.

The court said employees have no “property interests” in their contributions which were “costs” they paid for their future guaranteed benefits.

By the 1990s, the accounts started to post a surplus which exploded as the decade wore on, hitting $30 billion by 1999. It mushroomed for a number of reasons — low inflation rates, high interest rates on government bonds, a six-year freeze on public service salaries, caps on indexation benefits and changing assumptions on how to calculate the plan’s liabilities.

The unions argued the Liberals — led by then-finance minister Paul Martin — were obsessed with reducing the federal deficit and eyed the surplus as an easy way to cut expenditures.

As early as 1990-91, the government began to amortize the surplus to better reflect the pension liabilities it would be on the hook for in the future.

“The effect of this ‘amortization’ was twofold: it reduced the government’s annual budget deficit (or increased the annual budget surplus) by reducing annual pension expenditures, and it brought the government’s net debt down by reducing the net pension liabilities to an amount closer to the actuarial estimates of the government’s future pension obligations.”

In April 2000, the Liberal government passed Bill C-78 and changed how the pension funds were collected, managed and distributed. That law allowed the government to take the surplus and put limits on the size of surpluses.

Claude Poirier, president of the Canadian Association of Public Employees, said he was disappointed by the ruling. He said the surplus could have been used to offset higher contributions that public servants are now facing rather than being “siphoned off” by the government.

“These changes are due in part to the shortfall caused by the government’s appropriation of the pension plan surplus even though the pension plan remains solvent and fully funded,” he said. “In this sense, the public service pension plan is in much the same situation as other defined-benefit pension plans that are in trouble today because of the contribution holidays taken by many employers between 1994 and 2003.”

CAPE’s predecessor union initiated the lawsuit after one of its retirees discovered the government had been amortizing the surplus for several years without employees and retirees knowing. The surplus was used to offset the debt in the Public Accounts while the books for the pension accounts showed the surplus was still there.

Poirier said the ruling should reopen the debate over giving unions joint management in the running of the public service pension plan — especially now that employees have to pay half the costs in contributions.

Robyn Benson, president of the Public Service Alliance of Canada, said the ruling acknowledged that public servants contributed about 42 per cent — or $12 billion — of the surplus and that shows they have already done their bit to reduce the deficit.

She said the unions wanted the surplus returned to the plan to ensure it remained “healthy and viable” and protected taxpayers and public servants alike from rising contribution costs they now face.

Benson said public servants were “misled” for years by government documents and statements by ministers and senior bureaucrats that the pension fund had “assets” or was “fully-funded.” The court acknowledged the “words” government officials used to describe the plan didn’t “accurately” reflect how the plan operated.

“So while the court says there are no assets in the account, the government has been misleading its employees for decades and that was at the core of the problem,” said Benson.

Stock futures dropped more than 1 percent on Friday after a Republican proposal for averting the "fiscal cliff" failed to pass, dissipating hopes that a deal would be reached soon in Washington.

Trading is expected to be volatile as investors view a fiscal agreement between the White House and Republicans before the year-end as increasingly unlikely. With trading thin ahead of the holidays, market swings will probably be amplified. CBOE VIX front-month futures, a measure of volatility, rose 5.7 percent.

Late on Thursday, Republican House Speaker John Boehner conceded there were insufficient votes from his party to pass a tax bill, dubbed "Plan B," to help avert the cliff, tax hikes and spending cuts due to start in January that could tip the economy into recession.

Boehner said he would hold a press conference at 10:00 a.m. ET (1500 GMT), during which he is expected to discuss the vote.

Plan B had called for tax increases on those who earn $1 million a more a year, a far smaller slice of taxpayers than President Barack Obama had asked for.

The bill's failure suggested it would be difficult to get Republican support for the more expansive tax increases Obama has urged, making it less likely an agreement will be reached before the end of the year.

"We had been moving in the right direction, but now we need a different deal, and if this radical group of Republicans is so intransigent that they won't do any deal, it will be very difficult," said Wayne Kaufman, chief market analyst at John Thomas Financial in New York.

Investors had previously considered such an outcome unlikely. The decline implied by futures on Friday would wipe out most of the week's equity gains, which buoyed the S&P 500 close to two-month highs.

Banking and energy shares, which outperform in times of economic expansion and have led the market on signs of progress with the fiscal impasse, could be the most vulnerable to any setback. February crude futures dropped 1.3 percent in early trading on Friday.

S&P 500 futures sank 20.9 points, or 1.5 percent, and were below fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration on the contract. Dow Jones industrial average futures lost 184 points and Nasdaq 100 futures slid 43.25 points.

The S&P 500 is up about 1.8 percent this week, boosted by signs of progress in the fiscal negotiations between Obama and Boehner earlier in the week.

So far in 2012, the index has gained 14.8 percent, though uncertainty over the cliff may prompt many traders to lock in gains as the year draws to a close.

Orders for durable goods rose 0.7 percent in November, more than expected, while personal income and spending were also higher than forecast.

However, mirroring trading on Thursday, when strong economic growth and home sales figures failed to excite investors who were focused on the budget negotiations, futures didn't react to the data.

The Thomson Reuters/University of Michigan's final December consumer sentiment survey is due at 9:55 a.m., and is expected to come in at 74.7, compared with a prior reading of 74.5.

Nike Inc (NKE.N) rose 3.5 percent to $102.50 in premarket trading after reporting second-quarter earnings that handily beat expectations Thursday on strong demand in North America. Software distributor Red Hat Inc (RHT.N) posted third-quarter revenue that beat expectations.

U.S.-listed shares of Research in Motion (RIMM.O) slumped 14 percent to $12.20 in premarket trading. The company reported its first-ever decline in its subscriber numbers Thursday and outlined plans to transform the way it charges for its BlackBerry services.

Vanguard Group said customers had invested $130.4 billion in its mutual and exchange-traded funds during the first 11 months of 2012, beating the fund industry's previous annual inflow record.

The flows into Vanguard funds, mostly into equities, exceeded the previous annual record of $129.6 billion set by JPMorgan Chase & Co in 2008, according to fund research firm Strategic Insight. Vanguard's previous high was $104 billion, achieved in 2007, Vanguard said in a statement on Wednesday.

Investors and financial advisers have favored low-priced, passively managed index funds in 2012, playing to Vanguard's historic strengths. The trend has also benefited BlackRock Inc's iShares ETF unit, while hurting more traditional managers like American Funds, Dodge & Cox and Janus Capital Group Inc.

Vanguard's success is also due to its efforts to offer more products catering to self-directed retail investors, particularly ETFs, said Avi Nachmany, research director of Strategic Insight in New York.

"In the last few years, Vanguard has established a broader footprint," he said. "They have become a participant in virtually every part of the investment landscape."

Inflows remain "strong" in December, Vanguard spokesman John Woerth said. He declined to give a dollar total for the month.

Contrary to much of the fund industry, Vanguard said the majority of the flows, $72.3 billion, went into stock funds. Another $54.4 billion went to bond funds and $6.3 billion into balanced funds.

"Investors have flocked to low-cost index funds when investing in equities and we can see Vanguard provided both," said Tom Roseen, head of research services at Lipper, a unit of Thomson Reuters. Vanguard's actively managed stock funds actually had net customer withdrawals, Roseen noted.

Customers withdrew a net $2.5 billion from money market funds, Vanguard said. JPMorgan's 2008 record was fed largely by investors seeking the safety of money market funds.

Vanguard might have had even greater customer inflows - at least in the short term - if not for its decision to change benchmark indexes for some of its largest ETFs. In October, Vanguard said it was switching 22 funds away from benchmarks provided by MSCI Inc to cut costs.

As a result of the change, some institutional investors that were required to use funds tracking MSCI benchmarks had to switch to competitors, said Dave Nadig, director of research at ETF information firm IndexUniverse.

For example, investors pulled a net $900 million in November from the Vanguard MSCI Emerging Markets ETF, which is shifting to an index created by FTSE Group, while adding $2.3 billion to BlackRock's iShares MSCI Emerging Markets Index, according to data from Morningstar.

"The switch definitely slowed down or reversed their ETF flows in those products," Nadig said. Still, setting a new inflow record "is an enormous achievement and a vindication of Vanguard's core value proposition," he said.

Vanguard, based in Valley Forge, Pennsylvania, had total assets under management of $1.95 trillion at the end of November and is the largest U.S. mutual fund manager and third-largest ETF manager.

Hedge fund administrator SS&C GlobeOp's forward redemption indicator, a monthly snapshot of clients giving notice to withdraw their cash as a percentage of assets under administration, measured 6.19 percent in December.

This was the highest level since September 2009 and almost double the level just two months ago. A year ago, the index measured 4.58 percent.

After a tough time during the credit crisis, hedge funds have managed to avoid a third year of losses in five in 2012, but their gains have lagged stock market indexes.

The average hedge fund was up 4.89 percent in the first 11 months, according to Hedge Fund Research's HFRI index, compared with a 14.94 percent total return from the S&P 500.

Bill Stone, chairman and chief executive of SS&C Technologies, said fears that gains from hedge fund portfolios could be taxed at higher rates in the United States may have driven the increase.

"December is ... the final chance to change your tax liability. People are generating the cash to be able to make their quarterly estimated tax payment. A lot of people are going to make tax-influenced decisions," he said in an interview.

David comments:

“The chart below shows the spread between the yield on junk bonds and the yield received from holding stocks.  The spread recently turned negative for the first time ever, showing just how much the yields on high-risk bonds have come down as central banks keep benchmark borrowing rates depressed and investors search further out on the risk spectrum for yield.”

Shares of Research In Motion Ltd., which have soared over the past two months on a burst of positive sentiment, fell sharply Friday as investors digested a fresh reason to worry about the smartphone maker.

After gaining momentum with the unveiling of its new BlackBerry 10 device, RIM released earnings on Thursday that contained worrying new details about the company’s service revenue – a key source of much-needed income.

On a conference call with analysts Thursday, RIM management seemed unable to reassure investors worried about declines in RIM’s service revenues. That, combined with bearish analyst notes Friday, send the shares down about 22 per cent in Toronto.

RIM, which has struggled against Apple Inc. and Samsung Electronics Co. Ltd., hauls in roughly one-third of its revenues from wireless operators for BlackBerry access to RIM’s proprietary, secure messaging network. This is usually a per-device fee that ranges from a couple of dollars per month up, depending on how important the carrier is to RIM’s business.

As RIM’s market influence has faded, the company gradually lost the ability to demand steep fees from carriers. Now, even as smaller competitors in the mobile device management field offer ways to securely transmit communications from various smartphones, RIM will begin offering “tiered” pricing for access to its network in a way that analysts fear will reduce a crucial source of revenue.

And RIM’s service revenues are a significant source of cash: In the third quarter, services were 36 per cent of RIM’s $2.7-billion revenues. In the second quarter, service fees added more than $1-billion to RIM’s coffers – a sizable chunk to be at risk.

Kris Thompson at National Bank Financial, the analyst whose bullish note led to RIM’s unexpected 17-per-cent surge on U.S. Thanksgiving in late November, led the bears on Friday by downgrading RIM shares.

In his previous note, Mr. Thompson had raised his price target from $12 to $15, capturing the positive sentiment around a company in the lead-up to the January 2013 launch of RIM’s new BlackBerry 10 phones.

Friday morning, however, Mr. Thompson changed his mind: He downgraded the stock to “underperform” and slashed his price target from $15 to $10 on worries about RIM’s service revenue.

Unique among handset makers, RIM always pulled in extra cash from its proprietary messaging network – and fresh news in Thursday’s results reminded analysts of the risks to RIM’s business model.

“RIM reported decent overall results,” Mr. Thompson wrote in his note. “Then management disclosed that monthly service revenue will undergo a change to a tiered menu. When peppered with questions, management was ill prepared to provide satisfactory answers. We believe investors will punish the stock until service revenue can be better quantified. We do not believe that RIM can sustain profitability with a standalone hardware business.”

Mike Walkley, who follows big handset companies for Canaccord Genuity, reiterated his “sell” rating partially because the migration to the BlackBerry 10 platform – from RIM’s current BlackBerry 7 software – “adversely impacts” service revenues. RIM beat Mr. Walkley’s estimates for the third quarter, but he says his thesis remains unchanged.

“With our analysis indicating increasing competition from iPhone 5, Android and Windows 8 smartphones in Western markets … we expect softer sales of BB7 smartphones in future quarters with persistent pricing and margin pressure,” Mr. Walkley said. “While RIM management remains bullish for its BB10 smartphone launch January 30, we do not believe BB10 devices will turn around its struggling business.”

Still, some analysts saw much to admire in RIM’s third quarter. The company’s new CEO Thorsten Heins took hold of a struggling company that was missing product deadlines and has, to some extent, whipped it into fighting shape. Tom Astle of Byron Capital Markets noted RIM’s strong balance sheet, a new product that is raising eyebrows, a “motivated” global network of wireless operator partners and a “loyal and long-suffering user base” around the world.

“RIM reported what we think was a very well-executed quarter,” he wrote, adding, “for a company with an ancient product line.”

Prem Watsa began building a position in the third quarter of 2010 when the stock traded for $50 per share on average. He continued adding as the price continued falling. His largest buy took place in the third quarter of 2012 - he purchased more than 25 million shares at $7 per share.

Fairfax now has a lot riding on the RIM's comeback as the position equals a 9.89% stake in the company, and a full 21% of their investment portfolio.

Unfortunately, Research In Motion's third quarter results were mixed and injected volatility into the stock.

RIM announced a 47% year-over-year decline in revenue to $2.7 billion. Net income was $14 million, compared to $265 million a year previously. The company also bolstered its cash base by $600 million to $2.9 billion.

Earnings were better than expected, as the company forecast a loss last quarter due to a transition to its next generation of BlackBerry and the completion of its cost-reduction plan. Many investors, however, appeared more concerned with the decline in its BlackBerry subscriber base to 79 million users, from 80 million in the second quarter. RIM's share price has dropped 21% since the earnings results announcement.

But Watsa has a more far-sighted and comprehensive view of the company. In an interview with GuruFocus, he cited one big reason: "They have lots of cash, huge cash flows," he said.

Another less-known advantage of RIM is its leading market positions in other countries. RIM currently has a 60% of smart phone market share in Nigeria and 50% in South Africa, according to research from Canalys. South Africa and Indonesia are the company's two biggest markets after the U.S. and the UK.

Asia Pacific in particular is a key market for demand. "Asia Pacific accounted for over 53% of the worldwide smart phone market. China has been a powerful driver behind volumes again for many vendors and the market broke through the 50 million unit barrier this quarter," Canalys said.

On a long-term basis, the company has also been able to increase revenue at a rate of 58.7% over the past ten years, and book value at a rate of 29.1%. Introducing an ambitious new iteration of its once game-changing mobile device that led that growth will, it hopes, revive interest and sales going forward.

The new BlackBerry 10 features a touchscreen virtual keyboard, a "BlackBerry Flow" application grid for real-time multitasking in and out of programs. The BlackBerry "hub" keeps apps and messages together so users can respond to messages from any social networking platform from one place.

BlackBerry COE Thorsten Heins told the BBC in October that it was more than an update of previous phones. "We're not just building a new update of a Blackberry sub - we're building a whole new mobile computing platform. Don't underestimate the dynamic that this platform is going to create in the market," he said.

"What I see, in my markets, in the markets I'm in, outside of the U.S. - huge growth, huge commitment to BlackBerry, and in the U.S., we're going to regain our market share with BlackBerry 10" he added.

The BlackBerry 10 is set to launch on Jan. 30, 2013. The company is expecting that sales of its BlackBerry 7 could slow until then as users hold off purchasing new phones until the new version is available. To compensate, it plans to use pricing initiatives the BlackBerry 7 devices and services fees to maintain its subscriber base. It will also increase marketing spending on the new phone in the fourth quarter. Consequently, RIM said it expects an operating loss for that quarter.

“It’s one thing to have an opinion on the macro, but something very different to act as if it’s correct.”    --Howard Marks, Oaktree Capital Management

It can be a frustrating, and rather futile, experience to be an economist. Financial markets do not always behave as if there is a connection between economic fundamentals and stock prices, a subject I touched on in the October 2012 letter. In fact, if you believe the findings of a recent Vanguard study, rainfall statistics provide more value than either trend GDP growth or trend earnings growth in terms of their ability to predict future stock market returns (chart 1 below, click on image).

Using U.S. market data going back to 1926, Vanguard analysed the predictive powers of a whole range of metrics. The rather depressing conclusion – at least from an economist’s point of view – is that we are pretty much wasting our time by assigning any value at all to what goes on in the real economy.Of all the metrics tested by Vanguard, only P/E ratios seem to explain some reasonable proportion of future (real) stock market returns, and that is only if you are prepared to take a very long term view (10 years in the Vanguard study).

I have been writing the Absolute Return Letter since October 2003. At least 75% (I haven’t checked) of all those letters have focused on various aspects of the macro economy and a great many of them have gone on to make predictions on stock prices, interest rates, commodity prices and currencies. Have I been wasting my and, more importantly, your time during all those years?

I don’t think so, but my answer does require some clarification. At Absolute Return Partners, when structuring portfolios for our clients, we distinguish between three different time horizons – the very near term (the next few months), the medium term (from a few months to a few years) and the long term (many years). Most mutual funds, pension funds and insurance companies allocate the majority of their capital to the medium term, making it a very crowded space and the more crowded the space, the more efficient it usually is, and the more difficult it will be to generate alpha.

The short term is often ruled by more aggressive investors. Hedge funds dominate this space, frequently at the expense of private investors. The long term is the least crowded; it is in fact distinctly un-crowded in the current environment. As I have repeatedly pointed out over the past couple of years, one of the most noticeable implications of the financial crisis is the craving for liquidity. This has driven more capital than ever before towards the short and medium term, creating very attractive opportunities for those investors who can take a long term view.

Despite the findings of Vanguard and others I maintain my long held view that it is possible to identify long term economic trends which are likely to have a quantifiable impact on asset prices; however, the effect is only measurable over the very long term. Now, we cannot construct portfolios with only the long term in mind. If we did that, we would almost certainly go out of business before our ideas came to fruition.

1. High yield has never looked more expensive when compared to equities (chart 17).

Chart 17: The U.S. earnings yield is now higher than the HY yield

2. Investors with an appetite for income should therefore consider high income equities as an alternative to corporate bonds but, at the same time, remind themselves that the companies they invest in need to have a balance sheet of sufficient quality to maintain and possibly even increase the dividend over time.


3. Investors interested in riding the buy-out wave (which is a forecast, not a fact), should focus at the value/quality end of the market where private equity funds are more likely to be active.

4. If investing in hedge funds, doing what more than half of all hedge investors do (i.e. investing in ‘vanilla’ strategies such as equity long/short) could very well lead to disappointment. Investing in more esoteric, less crowded, strategies is likely to lead to better results.

China's stronger manufacturing and real estate sectors indicate a recovery, but there are some concerns on whether this is sustainable.

China Beige Book, an independent data roundup by CBB International, notes that the fourth quarter once again raises hope of a recovering manufacturing sector in China with far fewer manufacturers reporting declining production volumes.

"This is not surprising, but is a strong evidence of stabilization," the report said.

China's economy is an important bellwether and its slowdown for most of this year was a cause of concern. Its recent recovery is being watched closely as market participants try to analyze how the new administration will navigate the country through the rebalancing of its economy. One cause of concern, the China Beige Book highlights, is the rise in inventory at manufacturing and mining firms.

The stockpiling "calls into question on just how sustainable this expansion is," the report said.

Still, there were more positive signs in the economy. China's manufacturing base built on its recovery this quarter, with half of the firms reporting higher sales revenue and nearly as many volume gains. But the numbers were weaker than the first half of the year.

Once again, there was much more of an increase in domestic orders versus that of exports. Most of the export order book continued to come in from Asia and was down to the U.S. and Europe. The holiday season helped food manufacturers post both stronger volumes and revenues in the fourth quarter.

Retail spending increased modestly in the last quarter over the third quarter. In an interesting turn, luxury goods and furniture retailers reported a sharp pickup in revenues, the report said. Another notable feature of the quarter was the slowdown in sales of automotive products made by Japanese companies. The country's anti-Japanese sentiment affected sales, the report said.

Major regional differences in retail growth continue, with big overall gains in the Guangdong, Beijing, Northeast and Central regions, while Shanghai and the Southwest slowed.

Meanwhile, 56% of businesses surveyed reported spending more in the latest quarter, primarily in capital improvements. Firms in the recovering mining sector led the spending table, followed by retailers.

But what seems to be the highlight is the slow clawing back of China's mining companies. Though coal producers underperformed, metals and construction companies have begun to come back from their painful slump, the report said. Overall, 49% of mining companies saw revenues rise, a seven-percentage-point gain.

Real estate perked up this quarter, with 56% of the companies reporting higher revenues compared to 50% of the companies in the previous quarter, the report said. Residential and commercial developers improved on rebounding sales and rental prices.

The price of copper, among the biggest base metals in terms of global usage, has long been watched as a lead indicator on the health of the global economy.

Over the past five years, the orange metal has traded as low as $1.50 (R13.3) per pound but rose to as much as $4.50 per pound less than two years ago.

Prices over the past year have however fallen to as low as $3.30 a pound and are now about $3.60 a pound.

The Bank Credit Analyst (BCA), an independent research group based in Canada, says: “Copper prices are trading in a tight range, which cannot last forever. The combination of an improving global backdrop and a Chinese demand catalyst could soon result in an upside breakout.”

China ranks as the world’s biggest consumer of a number of commodities, including copper, which is used to conduct heat and electricity, as a constituent of various alloys and as a construction material.

According to BCA Research “evidence continues to accumulate that the Chinese economy is on a recovery path that is bullish for copper. The November preliminary HSBC PMI release for China showed the first expansion in 13 months”.

Going further into the detail, copper-specific, end-use indicators corroborate such views. Output of freezers, electrical meters, air conditioners, power-generating equipment and power cables all appear to have stabilised, says BCA Research.

“Together, these account for over 50% of copper consumption in China. Meanwhile, bearish sentiment and net speculative short positions are bullish indicators from a contrarian perspective.”

BCA Research says that the risks to its view on copper prices include a dollar spike, higher uncertainty in Chinese policy or a relapse in Europe, “but we assign these outcomes low odds of occurring”.

Mr. McGough joins BCA after four years at DTZ, where he was previously Global Head of Forecasting and Strategy Research. His previous work experience and extensive academic background make him the ideal candidate to lead the BCA Global Real Estate Strategy, scheduled for launch in Q1 2013.

BCA's CEO, Bashar AL-Rehany, adds: “With his vast knowledge of global real estate markets, the addition of Tony to our research team underscores our commitment to providing the most comprehensive independent investment research available in the marketplace."

In addition to DTZ, Tony's past career includes employment at JLL, PruPIM, CB Hillier Parker and the Bank of England, as well as six years as a Senior Lecturer and Director of MSc Real Estate courses at Cass Business School, City University London.

Tony is a member of the European Real Estate Society, the Society of Property Researchers and the Investment Property Forum. He is presently on the Board of Editors of the Journal of Property Research, is a Visiting Professor at The University of Ulster and a Visiting Fellow at the University of Reading. Tony has a BSc (Hons) Economics, from the University of Bath, and a MSc Economics from Birkbeck, University of London.

Tony will be based in BCA's London, UK office.

With more than 2.3 million people locked up, the U.S. has the highest incarceration rate in the world. One out of 100 American adults is behind bars — while a stunning one out of 32 is on probation, parole or in prison. This reliance on mass incarceration has created a thriving prison economy. The states and the federal government spend about $74 billion a year on corrections, and nearly 800,000 people work in the industry.

From some of the poorest towns in America to some of the wealthiest investment firms on Wall Street, CNBC’s Scott Cohn travels the country to go inside the big and controversial business of prisons. We go inside private prisons and examine an Idaho facility nicknamed the “gladiator school” by inmates and former prison employees for its level of violence.

We look at one of the fastest growing sectors of the industry, immigration detention, and tell the story of what happens when a hard hit town in Montana accepts an enticing sales pitch from private prison developers.

In Colorado, we profile a little-known but profitable workforce behind bars, and discover that products created by prison labor have seeped into our everyday lives — even some of the food we eat. We also meet a tough-talking judge in the law-and-order state of Texas who’s actually trying to keep felons out of prison and save taxpayer money, through an innovative and apparently successful program.

The United States is often hailed as the world’s largest ‘free market’. But this ‘free market’ is also the world’s largest penal colony. It holds over seven million adults – roughly five per cent of the labour force – in jail, in prison, on parole and on probation. Is this an anomaly, or does the ‘free market’ require massive state punishment? Why did the correctional population start to rise in the 1980s, together with the onset of neoliberalism? How is this increase related to the upward redistribution of income and the capitalization of power? Can soaring incarceration sustain the unprecedented power of dominant capital, or is there a reversal in the offing?

Back in May, as the euro zone veered deeper into crisis, Nobel Prize-winning economist Paul Krugman penned one of his gloomiest columns about the single currency, a piece in the New York Times entitled "Apocalypse Fairly Soon".

"Suddenly, it has become easy to see how the euro -- that grand, flawed experiment in monetary union without political union -- could come apart at the seams," Krugman wrote. "We're not talking about a distant prospect, either. Things could fall apart with stunning speed, in a matter of months, not years."

Krugman was far from being alone in predicting imminent doom for the euro in 2012. Billionaire investor George Soros told a conference in Italy in early June that Germany had a mere three-month window to avert European disaster.

Then in July, Willem Buiter, chief economist at Citigroup and former Bank of England policymaker, raised the probability that Greece would leave the euro to 90 percent, even going so far as to provide a date on which it might occur.

Buiter's D-Day -- January 1, 2013 -- falls next week. And yet no one now believes a "Grexit", or catastrophic implosion of the euro zone for that matter, is just around the corner.

Half a year ago the chorus calling an end to the euro reached a crescendo. Among the chief doom-mongers were some of the world's leading economists and investors, many of them based in the United States.

Fast forward six months and their prophesies look ill-judged, or premature at the least. The euro has rebounded against the U.S. dollar. The bond yields of stricken countries like Greece, Spain and Italy -- a market gauge of how risky these countries are -- have fallen back.

Even the gloomiest of the gloomy are revising their forecasts, although they warn of more trouble ahead.

"Europe has surprised me with its political resilience," Krugman admitted earlier this month in a blog post.

In October, Citi lowered its view on the likelihood of Greece exiting the currency area within 18 months to a still high 60 percent and there are plenty of economists who think that while a patchwork of measures have drawn some sting out of the crisis they have done little to address its root causes.

Krugman and Buiter did not return mails seeking comment. Soros declined to be interviewed.

POLITICAL WILL

With the benefit of hindsight, it seems clear that many simply underestimated the political will in Europe to keep the euro together, and the impact that a series of policy shifts in the second half of 2012 would have on sentiment.

The most important of these were European Central Bank President Mario Draghi's July promise to do "whatever it takes" to defend the euro -- which led to the ECB's commitment to buy euro zone government bonds in sufficient amounts to shore up the currency bloc -- and German Chancellor Angela Merkel's late-summer shift on Greece.

After wavering for many months on the costs and benefits of a Greek exit, she finally came around to the view that the risks to Europe and her own political prospects of letting Greece go were far too great.

"There may be a logic to Greece leaving, but the mechanics are too disruptive for both Greece and its neighbors," said Barry Eichengreen, an economist at U.C. Berkeley, who has long argued that the euro is irreversible.

"An appreciation of European politics makes you realize that everything will be done to prevent a breakup of the monetary union. It would be intensely catastrophic, economically and politically."

Capital Economics, a UK-based consultancy that forecast one or more countries would leave the single currency bloc by the end of 2012, now concedes that it underestimated the ECB's determination to save the euro and the market's faith in the bank's promises.

"It may simply take longer," Jennifer McKeown, senior European economist at Capital Economics said of a euro breakup. "It's obviously not happening this year."

Prominent investors have also paid a price for betting against the euro zone this year. Earlier this month celebrated U.S. hedge fund manager John Paulson blamed big losses suffered in 2012 on his bets that the sovereign debt crisis would worsen.

For those who placed their chips on the other side of the table, there were stellar returns of around 80 percent to be had on 10-year Greek and Portuguese government bonds this year.

CRISIS DEFERRED

Nouriel Roubini, the New York University economist whose bearish forecasts earned him the nickname "Dr. Doom", has been in the gloom camp from the beginning, predicting as far back as 2010 that countries would be forced to abandon the single currency.

Now he says the risks of a near-term catastrophe have been reduced. Reflecting the more cautious view of many of his colleagues, Roubini believes 2013 will be another year in which European politicians "muddle through", avoiding catastrophe.

But the euro's day of reckoning will come, he believes, with the risks metastasizing over the course of 2013 and Greece, once again, posing the biggest threat.

At the height of the crisis in June, the euro zone dodged a bullet when the conservative party New Democracy narrowly beat anti-bailout leftists SYRIZA in the Greek election.

Since then, Greek Prime Minister Antonis Samaras has been able to keep his three-party coalition together, and behind austerity measures needed to keep bailout money flowing. But as the country enters its sixth year of recession and support for the government wanes, his task will become harder.

Recent opinion polls show SYRIZA with a five point edge, underscoring the risks of a political earthquake in Athens at some point in 2013.

"By late fall of next year, the Greek coalition could collapse and an exit may be back on the table," Roubini told Reuters.

Even economists like Eichengreen are reluctant to declare the worst of the crisis over, pointing to deep recessions on Europe's periphery and the risk of political complacency.

At a December summit in Brussels, European governments delayed serious discussion on closer fiscal integration until mid-2013 and made clear that creation of a "banking union" would stretch into 2014 and beyond.

"What we have seen throughout this crisis is a cycle where steps are taken, politicians think the problems are solved, they sit on their hands and the situation worsens again, with spreads blowing out. I'm sure we'll see more of this going forward," Eichengreen said.

Krugman, while expressing surprise at Europe's ability to avert disaster in 2012, isn't backing off his predictions of gloom either.

In his recent blog post "Bleeding Europe", he likens the austerity imposed on countries like Greece, Portugal, Spain and Ireland to "medieval medicine" in which patients were bled to treat their ailments. When the bleeding made them sicker, they were bled some more.

Even if the euro has defied forecasts of its demise, the economics of austerity, Krugman says, are playing out "exactly according to script".

...allow me to share with you what I think this year's biggest tail risk is: a melt-up in stocks and other risk assets. And the biggest economic surprise in the next 12 months will be the strength of the US economic recovery.

You were one of the very few analysts to predict the full enormity of the financial crisis, writing as early as 2003 of a coming credit crunch that would have ramifications throughout the asset-backed securities sector, necessitating giant bail-outs for Fannie Mae, Freddie Mac and financial-insurance companies, and a possible meltdown in the multi-trillion-dollar derivatives market. This prescience was in stark contrast to the complacency of most mainstream economists.

Could you describe how you came to write The Dollar Crisis—what was the course of your intellectual development and what did you learn from your experience as a Far East securities analyst?

I grew up in Kentucky and went to Vanderbilt University. My plan was to go to law school, but I didn’t get in. Plan B was to go to France for a year, picking grapes. I got a job as a chauffeur in Paris, driving rich Americans, and made enough money to backpack around the world for a year, in 1983 and 84. So I was lucky enough to see the world when I was very young. I spent a couple of months in Thailand, Malaysia and Singapore—and even a couple of months there was long enough to realize: go east, young man.

Go east, because?

Economic opportunity. It was obviously booming—there were big skyscrapers going up, and people couldn’t read maps of their own street. So I went back to business school in Boston, at a time when there was of course very little economic growth in the United States. When I finished business school, going to Asia seemed the obvious thing to do. I found a job in Hong Kong, as a securities analyst with a local, Hong Kong–Chinese stock-broking company. This was 1986. In the first twelve months I was there, the Hong Kong stock market doubled—then I woke up one morning and learned that Wall Street had fallen 23 per cent overnight, and Hong Kong immediately fell back to where it had started. By 1990 I had joined James Capel, the oldest and largest UK stock-broking company at that time, and they sent me to Thailand to manage their research department there. We had ten analysts watching all the companies on the Bangkok stock market. At first, there really was something of a Thai miracle—the growth was solid and fundamental. But very quickly, by 1994, it was obviously a bubble and I started being bearish on the market. I wasn’t saying it was going to collapse, but the growth was going to slow down. But it just kept accelerating, and the bubble turned into a balloon. When it did finally pop, in 1997, Thailand’s GDP contracted by 10 per cent and the stock market fell 95 per cent in dollar terms, top to bottom.

So I witnessed at close quarters a very big boom-and-bust cycle, over a very short period of time. And while I was wrong for several years, I had plenty of time to think about why I was wrong. I started reading a lot of macro-economics: Keynes, Schumpeter, Milton Friedman’s monetary history of the US, the classic works. There was also a sort of lightning-flash moment, around 1994. Five years earlier I had taken a group of fund managers on a trip around the Pearl River Delta, from Hong Kong up to Canton, and back down the other side to Macao. What we saw, all along this vast delta, were miles and miles of factories, as far as the eye could see, full of nineteen-year-old girls earning $3 a day. It was in 1994 that the meaning of this really became clear to me: globalization was not going to work. The US would have a bigger and bigger trade deficit, and the American economy would continue to be hollowed out. It was unsustainable—the demographics made it impossible for this system to work. The Dollar Crisis, which came out in 2003, examined the way those global imbalances were blowing bubbles in the trade-surplus economies, and how the money boomeranged back into the US. I came to see that the unlimited credit expansion enabled by the post-gold, post-Bretton Woods international monetary system was where it all began.

Yet you’re not advocating a return to gold?

No. That is, I think that if the US had remained on the gold standard, it wouldn’t now be teetering on the edge of collapse. The global economy would be much smaller than it is; China would look nothing like it does. There would have been much less growth, but it would have been more stable. But now that we’re here, there’s no going back. If the US was to go back, the sort of deflation that would be required to take us there would be absolutely unbearable—like 1926 in Britain. But it’s important to understand what the effects have been of abandoning the automatic adjustment mechanisms inherent in the gold-linked Bretton Woods system and the classical, pre-1914 gold standard—they automatically served to correct large-scale trade imbalances and government deficits. Officially, the international monetary system that emerged after 1973 and the breakdown of Bretton Woods still doesn’t have a name. In the book I called it the ‘dollar standard’, because the US dollar became the medium for the world’s reserve assets, in place of gold. The Dollar Crisis focused on how this system had enabled worldwide credit bubbles to be created. Total international reserves, the best measure of global money supply, soared by almost 2,000 per cent between 1969 and 2000 (Figure 1), with the central banks creating paper money on an unprecedented scale.

The quantity of US dollars in circulation soared (Figure 2). One of the main features of the dollar standard is that it allows the US to incur a huge current-account deficit, as it pays for its imports in dollars—of which the Federal Reserve can print as many as it needs, without having to back them with gold—and then gets these dollars back from its trading partners when they invest them in dollar-denominated assets—Treasury bonds, corporate bonds, equity, mortgage instruments—as they must do, if they are to earn any interest on them. The French economist Jacques Rueff once compared this process to a game of marbles in which, after each round, the winners give their marbles to the losers. The larger the US current-account deficit has become, the larger the amount of dollars that wash back into the US through its equally vast financial-account surplus (Figure 3). The other option for America’s trading partners—the one US pundits are always calling for—would be to exchange the dollars they’re earning for their own currency, which would drive up its value and thereby make their exports too expensive for the US market, knocking them out of the game.

The post-Bretton Woods era had been plagued by financial crises long before 2008—Latin America in the 1980s, Japan in 1990, Scandinavia in 1992, the Asian Crisis of 1997, Russia, Argentina, Brazil, the dot.com bust. What is your explanation for this?

The Austrian economists were basically right in their understanding of the role credit plays. As long as it is expanding, credit will create an artificial boom, driving an upward spiral of economic growth and inflating asset prices, which create further collateral for yet more credit expansion. But the day always comes when ever-faster economic overheating and rising asset prices outstrip the growth of wages and incomes, to such an extent that these can no longer service the interest on the credit. Bubbles always pop and when that happens, it all begins to spiral into reverse: falling consumption, falling asset prices, bankruptcies, business failures, rising unemployment and a financial sector left in tatters. The depression begins—which, according to the Austrians, is the period in which the economy returns to some sort of pre-credit equilibrium. Nothing drops forever; at some point the asset price comes more closely in line with the income of the public, and the economy stabilizes. What changed under the ‘dollar standard’ was the advent of vastly greater quantities of credit, creating harder and faster boom-and-bust cycles. In fact the first boom-and-bust crisis of the post-Bretton Woods era was sparked off in the 1970s, when the New York banks recycled petro-dollars from the OPEC states as loans to South American and African countries, flooding their economies with credit. When the ‘miracle’ booms deflated into busts, this created the Third World debt crisis of the 1980s.

But destabilizing credit creation really took off once the US started to run current-account deficits of over $100 billion, from the early 1980s; a few years later it began running large government budget deficits, too, which it could fund through the resulting financial-account inflows. It could run the deficits because it could print all the dollars it needed. As these dollars entered the banking systems of countries with a current-account surplus against the US, they acted as ‘high-powered money’—that is, the original amount could be lent and re-lent by the banks, many times over—setting off an explosion of credit creation that would generate economic overheating and soaring asset prices, first in Japan in the 1980s, then in the ‘Asian Tiger’ economies in the 90s. In countries like Thailand, in particular, inflows of ‘hot’ capital attracted by the initial growth served to blow the credit bubble even bigger. Eventually, over-investment produced over-capacity and over-supply, followed by a downward spiral of falling profits, bankruptcies and stock-market crashes, leaving their banks laden with non-performing loans and their governments deep in debt. After the 1997 Asian Crisis, a surge of capital inflows washed back into the US, creating the ‘new economy’ stock-market bubble and credit boom there.

Now, there’s no doubt that Japan, for instance, derived tangible economic benefits from its export-led growth. Without the purchasing power that came from its trade surpluses with the US, its economy would have grown at a much slower rate through the 60s and 70s. But what’s less appreciated is the expansionary impact those surpluses had on domestic credit, once they entered Japan’s banking system. It was this that helped inflate the great Japanese bubble economy—the ratio of domestic credit to GDP rose from 135 per cent in 1970 to a massive 265 per cent in 1989. Japan actually tried to export large amounts of capital in the mid-80s, to avoid its economy overheating: after 1985, faced with the sharp appreciation of the yen, there was a big relocation of Japanese manufacturing capacity to other East Asian economies, setting off the growth of the ‘Asian tigers’, Thailand, Indonesia, South Korea, Malaysia (Figure 4). But after so many years of trade surpluses, rising international reserves and swelling money supply, it was impossible to stop a further surge causing drastic overheating in the late 80s. After the Japanese bubble popped in 1990, property prices fell by more than 50 per cent and the stock market by 75 per cent; twenty-two years later, its banks are still laden with bad loans and government debt is the highest in the world—230 per cent of GDP.

What was your assessment of the IMF ’s handling of the Asian Crisis?

I’d left Thailand before the bubble popped in 1997, but after six years studying the market there I felt I had a good understanding of what was happening, so I started calling up the IMF, the World Bank and the US Treasury Department, and harassed them until the IMF hired me as a consultant in May 1998. I flew over to Bangkok with them—there was a group of about thirty people from the IMF and the World Bank, and we all stayed at the very nice Oriental Hotel on the river. For three weeks I got to spend a little time with them, and got a glimpse into how they worked and what their thinking processes were. I have to say I was shocked at how little they seemed to know about Thailand’s economy and the nature of the crisis there. Maybe I’m being a bit unfair, because I’d had so much intensive experience there, but I had assumed that the IMF would be at least as knowledgeable as I was. They were a lot of very intelligent people, who had a great deal of experience in many economies around the world, but they didn’t seem to know much about what was happening in Thailand. At one meeting they decided—without any particularly good reasons that I could determine—to project a 3 per cent contraction for the Thai economy that year. I spent the next week writing reports explaining why I thought the economy would shrink by 9 per cent in 1998 and 9 per cent the following year, if it continued with the same IMF-imposed policies that were being pursued at that time. In the end, the economy did contract by about 10 per cent in 98, but then it rebounded the following year. By that time, they’d reversed many of the initial policies the IMF had demanded in the early days of the crisis. What really made the difference was a massive devaluation of the currency—from 25 baht to the dollar to 50 baht, at one point—which was very helpful in allowing Thailand to grow its way out of the crisis, by exporting into the still relatively booming global economy.

After that, I got a full-time job with the World Bank in Washington for two years, starting in October 98, and that was also very interesting. Both these Bretton Woods institutions had been created to replicate the automatic stabilizers of the gold standard, to help countries to re-establish an overall balance-of-payments equilibrium when they ran out of cash. The end of Bretton Woods and the expansion of global trade imbalances transformed the situation; but at the time of the East Asian crisis, I don’t think the IMF and World Bank quite understood how destabilizing the larger and larger cross-border capital flows had become. They didn’t understand how the capital inflows that had washed into Thailand during the 80s and 90s had completely changed and distorted the economy and blown it into a bubble—and when all the money washed back out, the economy really deflated. It would have destroyed all the banks and all the Thais’ savings, had they carried out the harsh policies that might have been appropriate in the 1950s or 60s.

To go back for a moment to the growing us trade deficit, which you see as at the root of the explosion of credit creation: the deficit had begun to widen in the early 80s, but by 1985 in fact the US was pushing for a sharply lower dollar, as agreed with Germany and Japan in the ‘Plaza Accord’, and this did succeed in boosting American manufacturing and narrowing the deficit. By 1995, though, that policy had gone into reverse.Why do you think the US did not continue to push for a lower dollar over the longer run, and what would the effects have been had it done so?

I’m not sure I know a complete answer to that question. By 1985, the US trade deficit was something like 3.5 per cent of GDP and this was very alarming, not only to US policy-makers but around the world, because the economies of the surplus countries, primarily Japan and Germany, were getting over-heated. The agreement at the Plaza Hotel in 1985 was that the dollar would be devalued against the yen and the mark, and over the next two years the dollar fell by roughly 50 per cent. That was enough to bring the US trade deficit more or less back into balance by around 1990. But by that point, Japan and Germany were no longer the problem. It was the Asian Tigers that were increasingly becoming large exporters to the US, with growing trade surpluses, followed by China. Once China really got going, its trade surplus became larger and larger. But the US didn’t have the same sort of control over China’s currency as it did over Japanese and German policies. In fact in 1994, China had a massive devaluation of its currency, which made the situation much worse in terms of the US trade deficit.

So the rise of China came athwart the us low-dollar export policy?

It’s a very complicated subject, but I think that, as time went by, American industry gave up on American manufacturing, and realized that they could make a profit by manufacturing outside the US in ultra-low-wage countries. And so it began. Eventually, more and more corporations realized that they could do very well by outsourcing. A tipping point came in the early 90s, when it was actually in the interest of major sectors of American society to have a strong dollar and a weak Chinese currency, or weak currencies in all the other countries from which American firms were exporting goods back to the US. The issue with Germany and Japan in the 80s had been different, because the workforces of those countries already had relatively high wages compared to the US. It was really only after the rise of the Asian Tigers, and above all when they were joined by China in the 90s, that American industry realized that it could make a lot more money just by making everything offshore. From 1997, the US deficit widened dramatically (Figure 3, above).

More generally, how has the ‘dollar standard’ affected the US economy itself?

Once the constraint was removed of the US needing to have 25 per cent gold backing for every dollar that it issued, it also lifted any constraint on how much credit could be created. It had been easy for the US to maintain gold backing in the first post-war decades, because it owned most of the world’s gold. But with multinationals relocating industry abroad and growing government spending, it finally came up against that binding constraint in 1968. So Congress simply changed the law, at Johnson’s request, removing any requirement for a gold link. But with no restraint on credit, either, credit growth exploded. Of course, credit and debt are simply two sides of the same coin. In the US, total debt—government, household, corporate and financial-sector debt, combined—expanded from $1 trillion in 1964 to over $50 trillion by 2007 (Figure 5). Credit growth on this scale has been taken for granted as natural; but in fact it is something entirely new under the sun—only made possible because the US broke the link between dollars and gold. This explosion of credit created today’s world. It made Americans much more materially prosperous than we would have been otherwise. It financed Asia’s strategy of export-led growth and it ushered in the age of globalization. Not only did it make the global economy much bigger than it would have been otherwise, it changed the nature of the economic system itself. I would argue that American capitalism has evolved into something different—in my latest book, The New Depression, I call it ‘creditism’.

How would you define the chief features of ‘creditism’?

First, an expanded role for the state. The US government now spends 24 per cent of GDP—one out of every four dollars. All the major industries are state subsidized, one way or another, and half the US population gets some sort of government support. Now, one can argue that capitalism was a 19th-century phenomenon that’s been dead since World War One; but clearly, this is not how capitalism’s supposed to function. Secondly, the central bank now creates the money and manipulates its value. Thirdly, and more interestingly, perhaps, the growth dynamic is entirely different now. Under capitalism, businessmen would invest, some would make a profit, which they’d save, in other words accumulate capital, and repeat: investment, saving, investment, saving. It was slow and difficult, but that was how economic growth worked. But for decades, the growth dynamic of the American economy, and hence increasingly the world economy as a whole, has been driven by credit creation and consumption. Total reserve assets had already swelled by almost 2,000 per cent between the end of Bretton Woods and the late 1990s (see Figure 1, above). Since then, they’ve quintupled (Figure 6).

The problem is that ‘creditism’ can no longer create more growth because the US private sector can’t sustain any more debt. The ratio of household debt to disposable personal income was around 70 per cent, from the mid-60s to the mid-80s; since then, it soared to reach nearly 140 per cent in 2007, on the eve of the crisis (Figure 7). At the same time, median US income is declining and the level of owners’ equity as a percentage of household real estate has plunged to a record low (Figure 8). In 2010, American households owed $13.4 trillion—92 per cent of USGDP (Table 1).

May we press you a bit on this concept of creditism, as a successor to capitalism. Firstly, of course, agencies of credit—banks, factors, money lenders—existed in the 19th century, on quite a large scale. Secondly, capitalism itself has developed through a series of historical phases, but arguably it has never been entirely ‘pure’ and free from state support; it has always been ‘mixed’ to some degree and there have been times when capital was a good deal more constrained than it is today. Nineteenth-century American capitalism was protected by high tariff walls and aided by US military expansionism, conquering territory and resources—iconically, the US Cavalry massacring the indigenous Americans, to clear the way for the railroads. Unprofitable sectors of American industry may be heavily subsidized today, but isn’t it precisely capitalism in general—however wrecked in parts—that Federal funds are supporting? There seems to be an argument for retaining the classical concept, which has been a trusty tool of analysis for both left and right, as long as the broad relations of private capitalist ownership and wage labour still persist. ‘Creditism’ may be a corruption of capitalism, but isn’t capitalism still there, underneath?

Yes and no. In the US, at the biggest level, it’s not, because every major industry is subsidized one way or another, by the government—all the manufacturing that’s still there, much of it related to military spending. All the hospitals and pharmaceutical companies benefit from Medicare and Medicaid. The universities also get subsidies from the government in the medical and military industry. Farmers get subsidies from the government. Price levels are still generally determined by market forces, but government spending directs those market forces—at the bottom, they allow the price system to work, but at the top level it’s all directed and supported by government spending. I think that the biggest impediment to fixing this crisis is the misconception that we have a capitalist economy. Fox News watchers in America all think, red, white and blue, we’re a capitalist economy, the government is evil and there’s nothing it can do that would help the situation.

They don’t understand what a large role the government plays—and that if government spending is reduced, the economy immediately collapses. I think it would help if they understood that we don’t have capitalism to begin with, we have a different kind of economy now. This is not a crisis of capitalism, it’s a crisis of creditism, and we have to work with the system that we have. And while it would be nice to rein in the bankers, if you rein them in too hard it’s going to blow up the whole system—the banks are so worthless that the losses would be enormous, if they were actually exposed; all the savings in the world would be destroyed as the banking sector failed. Creditism as a system requires credit growth to survive, and only the government can provide the credit growth now—the private sector can’t bear any more debt.

So there’s a polemical character to the concept of creditism, in the sense that it’s targeted at a policy level?

Right. And I would like to persuade not only policy-makers, but the general public as well. It’s not impossible to swing public opinion away from where it is now, which is stuck in a very boring debate between austerity and Keynesianism, neither of which, as it’s presented, makes any sense whatsoever.

Another term that’s been applied to this latest stage is ‘financialization’, or financialized capitalism, and it would be interesting to know how you’d compare that to creditism. It’s been suggested that, as the momentum of the American economy began to falter, the government stepped in in the 1990s with a form of privatized Keynesianism, or asset-price Keynesianism: that credit was used, in other words, to maintain the level of demand when it threatened to flag, rather than the big public programmes of classical Keynesianism.

I think that’s probably true, if you look at the way Alan Greenspan encouraged the expansion of credit and the way they all denied there was any kind of bubble: that benefited the bankers and the policy-makers, but it also benefited the people, as long as everything was expanding, because this was against the background of increasing globalization, which put strong downward pressure on US wages. The way to buy off the voting public, who were losing their jobs and not seeing any wage increases, was to make their asset prices go up—their houses increased in value, so they could spend more even if their wages didn’t go up. This worked very nicely for ten or fifteen years, and the authorities seem to have wanted to keep it going even longer—but bubbles always have to pop, in the end. So yes, I think that’s probably right, though it’s hard to know whether this was actually what was planned or whether it just evolved that way, as it could have done, because that was the easiest way to go.

But it’s worth emphasizing that the credit expansion in the US from the 1990s on couldn’t have taken place without the disinflationary impact of manufactured imports from extremely low-wage economies: low inflation permitted low interest rates. The scale of the income gap is enormous: Mexican GDP per capita is around 20 per cent of the US rate; Chinese GDP per capita is only 11 per cent. But another effect of globalization was that the expansion of credit was beginning to produce diminishing returns in economic growth in the US, well before the 2008 crisis. In The New Depression I show how total credit growth has correlated with economic growth in the US since the 1950s (Figure 9). Whenever total credit expanded by less than 2 per cent, the US economy fell into recession—or nearly did, in 1970. But from the early 1980s, the difference between the two growth rates became much more pronounced: total credit soared, but economic growth continued to weaken, cycle by cycle, apart from a slight increase during the late 90s ‘new economy’ boom. Part of the explanation for this must be that while credit growth did stimulate demand, that demand was largely met by imports, so there was little of the multiplier effect that US production would have achieved.

On top of this, the excess productive capacity created by years of credit expansion and capital misallocation has been a further disinflationary factor. It’s easy to increase aggregate supply in an economy: simply increase the flow of credit to the manufacturing sector—this is what happened with the ‘new economy’ boom in the United States (Figure 10). But once industrial capacity is put in place, it doesn’t go away again just because demand for its products doesn’t keep up; instead, excess capacity puts a downward pressure on the price of goods, even as capacity utilization slackens. It’s much more difficult to increase aggregate demand, which is ultimately linked to the public’s purchasing power. Over the past thirty years, the expansion of credit has produced a vast expansion in global industrial productive capacity—witness the Pearl River Delta—but the purchasing power of the world’s population has not risen at anything like the same pace. So we’re facing a glut of industrial capacity on a world scale.

In The Dollar Crisis you suggested a radical solution to the problem of aggregate global demand…

One of the cures I suggested was a global minimum wage, starting with raising the wages of Chinese workers in foreign-owned factories by a dollar a day, every year—it wouldn’t break Apple or Foxconn. To be diplomatic, I suggested that the poor developing countries could form a labour cartel, the way that OPEC has formed an oil cartel; but in reality that wouldn’t work—everyone would cheat. The most effective way to make it happen would be for the US Treasury Secretary to go on TV and announce to the world: if you cannot prove to us that you pay your workers six dollars a day, instead of five, then we’re going to put a 20 per cent tariff on your imports. And we’re going to ask the workers to report on whether it’s really being paid. That was written ten years ago, and if it had been implemented, by now the minimum wage would have tripled, from five dollars to fifteen, and that would have created much more aggregate demand to absorb all of this excess capacity.

So yes, it’s crucial to find a way to increase purchasing power at the bottom of the pyramid—otherwise the world economy will be heading back to what it was like at the beginning of the industrial revolution, when workers only earned subsistence wages and couldn’t afford to buy what they were making. In a sense, that’s the world economy in the age of globalization. As new manufacturing countries enter the world market, especially China, the ability to produce has skyrocketed; but wages don’t go up anymore. They’re going down in the West, and demographic trends, the sheer numbers of young people looking for jobs, don’t let them go up quickly enough in developing countries. That’s at the core of the global crisis. For a good fifteen or twenty years, that gap was filled by inflating US asset prices, which allowed the Americans to withdraw equity and spend it, consume with it, to import and to fill the gap that couldn’t be filled with normal wage income. But now that game seems to be over. Americans can’t sustain any more debt; home prices have dropped 34 per cent, on average, across the US. The only thing that’s filling the gap is government spending—that’s all that’s preventing the US from spiralling into depression.

What have been the US government’s aims in handling the crisis? How would you assess its policies to date?

The aim of US government policy has been to perpetuate the credit expansion, to prevent a collapse. So far it’s more or less been able to sustain the level of total credit market debt (Figure 11). It’s done so by racking up around $5 trillion in budget deficits, which it probably wouldn’t have been able to finance if the Federal Reserve had not printed $2 trillion dollars and injected that into the economy. Initially, in 2007 and 2008, the financial sector bail-out and the $787 billion stimulus for the economy were funded by selling government bonds. But that initial round of support for the financial sector already cost around $1 trillion—some $544 billion in loans to US banks, $118 billion to Bear Stearns and AIG, $333 billion to the Commercial Paper Funding Facility and more. So the Fed began its policy of quantitative easing in November 2008. Of course, QE is a euphemism for fiat money creation: the ‘quantity’ refers to the amount of money in existence, and ‘easing’ means creating more—‘easing’ liquidity conditions. The first round, QE1, was mostly used to relieve the banks and other institutions of mortgage-backed securities. It was expanded in March 2009, from a $600 billion to a $1.75 trillion money-printing programme, through to March 2010. As soon as it stopped, the US economy entered its ‘soft patch’, in summer 2010. By August 2010 Bernanke was hinting at another round, and QE2 was formally announced that November, to run till June 2011. This time the Fed printed $600 billion, which it mostly used to buy government bonds, to fund the budget deficit. With some differences, the same course has pretty much been followed by the ECB and the Bank of England, on a smaller scale.

Given the nature of the debate around the budget deficit in the US, it’s important to stress what the alternative would have been if governments had not jumped in. Total credit would have begun contracting in 2008, when the private sector could no longer cover the interest payments on its debt, and the sort of debt–deflation spiral that Irving Fisher described would have taken hold. The US economy would have already collapsed into a new Great Depression, and with it, the rest of the world. The size of the American economy in GDP is about $16 trillion, and the US budget deficit is $1.3 trillion. So if the government had balanced the budget in 2009—if there had been a balanced-budget constitutional amendment, for example—it would have shrunk to being a $14.7 trillion economy. There would have been an immediate contraction of 13.5 per cent, but with a large multiplier effect, because unemployment would skyrocket, consumption would drop, business profits would plummet and the economy would go into a sharp downward spiral. Now, the argument against huge budget deficits under Bretton Woods or on the gold standard was that government borrowing on such a scale meant pushing up interest rates and crowding out the private sector. But that’s not the case any more. In today’s world, there’s no limit to the amount of money that governments can create—or so it seems. Even though the US has trillion-dollar budget deficits, interest rates are at a historic low; the ten-year bond yield in the US is 1.5 per cent. Never lower. Today, if the US government cuts its spending, there’s no offsetting benefit of lower interest rates—however much government spending is cut by, the economy simply contracts by that amount.

What’s been the impact of quantitative easing on the economy as a whole?

The most important short-term effect has been to allow government spending to support the economy while keeping interest rates low. Another aspect, with QE1 in particular, was that the government bought up toxic assets, like the debt issued by Fannie Mae and Freddie Mac. That allowed the financial sector to deleverage by $1.75 trillion, as it swapped mortgage-backed securities for cash. It didn’t work that way in Britain, because the Bank of England didn’t buy assets like that from the banking system, it only bought government bonds. So the British financial sector is still very highly leveraged, whereas in the US it is much less leveraged than it was. Thirdly, every round of quantitative easing drives up the stock market and commodity prices (Figure 12). To some extent higher stock prices create a positive wealth effect, which supports the economy; some sectors will benefit from higher food prices—Mid-West agribusiness, for example—but it’s bad for American consumers; the same goes for the rising price of oil.

Since around 2011, I’d say the costs of QE have been starting to overtake its benefits, which are subject to diminishing returns.Quantitative easing has created food-price inflation that is very harmful for the two billion people who live on less than $2 a day. I’ve read that global food prices went up 60 per cent during QE2, and this was one of the factors that sparked off the Arab Spring. The oil-price spike has been very negative for the US economy; the 2011 slowdown in US consumption was due to higher food and oil prices. It comes back to the old quantity theory of money: if you increase the quantity of money, prices go up. So far, this has barely affected manufactured goods because of the huge deflationary impact of globalization and the 95 per cent drop in the marginal cost of labour that it’s brought. So we don’t see any CPI inflation, because of this offsetting deflationary force. But food prices have gone up everywhere. If the dollar price of food goes up—if rice prices go up in dollars—then rice prices go up everywhere in the world, because otherwise they’d just sell into the dollar market. So if US rice prices go up, Thai rice prices go up. And when the Fed prints dollars, food prices go up. That’s the main drawback, the one real big problem of QE—otherwise it’d be a great thing: print money, make the stock market go up, everybody’s rich and happy. But it has this impact of creating food-price inflation.

What effect has it had on profits and investment? US business profits have been hitting 15 per cent this year, according to the Economist, but corporations seem to be sitting on cash mountains that aren’t being used.

Yes, profits are very high, first of all because labour is getting a lower and lower share. Also, as a percentage of GDP, US corporate tax last year was the lowest it has been since the 1950s. In total, the tax revenue for the country as a whole was under 15 per cent of GDP, which is, again, the lowest since the 1950s. So, yes, corporate profits have been exceptionally good, although this quarter, suddenly everyone’s concerned that they may be dropping. But there’s a fundamental problem: there are no viable investment opportunities. So much credit has been expended and so much capacity built that we already have too much of everything relative to the amount of income, as it’s currently distributed, to absorb it. If you invest more, you’re going to lose your money; if you take your corporate cash-flow every year and buy government bonds, you can preserve your money for a better day—but that helps push down bond yields to these historic low levels. That’s why, even in Japan, after two decades of massive fiscal deficits, the ten-year government bond yield is only 0.8 per cent; in Germany, it’s 1.2 per cent; US, 1.5 per cent; UK, around 1.6 per cent. They’ve never been lower, and this is part of the reason. When bubbles pop, there’s no place to invest the money profitably, so it’s better to put it in government bonds.

What are the options, over the longer term?

I think there are three ways forward for the US economy—three paths policy makers could take. Option one is what the libertarians and Tea Party people want: balance the budget. That would result in immediate depression and collapse, the worst possible scenario. The second option is what I call the Japan model. When Japan’s great economic bubble popped twenty-two years ago, the Japanese government started running very large budget deficits, and have done that now for twenty-two years. The total amount of government debt to GDP has increased from 60 per cent to 240 per cent of GDP. That’s effectively what the US and British governments are doing now: running massive budget deficits to keep the economy from collapsing. They can carry on doing this for another five years with very little difficulty, and maybe even for ten years. The US government debt is only 100 per cent of GDP, so they could carry on for another five years and still not hit 150 per cent. But though it’s not clear how high it can go, it can’t go on forever. Sooner or later—say, ten or fifteen years from now—the US government will be just as bankrupt as Greece, and the American economy will collapse into a new Great Depression. So, that’s option two. It’s better than option one, because it’s better to die ten years from now than to die now; but it’s not ideal.

Option number three is for the US government to keep borrowing and spending aggressively, as they’re doing now, but to change the way they spend. Rather than spending it on too much consumption, and on war, for instance—the US government has so far spent $1.4 trillion invading Iraq and Afghanistan—they should invest it; not just in patching up the roads and the bridges, but invest it very aggressively in transformative 21st-century technologies like renewable energy, genetic engineering, biotechnology and nanotechnology, on a huge scale. The US government could put a trillion dollars into each of these industries over the next ten years—have a plan to develop these new sectors. A trillion dollars, let’s say, in solar energy over the next ten years: I’m not talking about building solar panels for sale in the market; I’m talking about carpeting the Nevada desert with solar panels, building a grid coast-to-coast to transmit it; converting the automobile industry to electricity, replacing all the gas stations with electric charging stations, and developing new technology to make electric cars run at 70 miles an hour. Then, ten years from now, the US will have free, limitless energy. Trade will come back into balance, because we won’t have to import any foreign oil, and the US will be able to spend $100 billion less a year on the military, because it won’t have to defend Gulf oil. The US government could tax the domestically generated electricity, and help bring down the budget deficit; and the cost of energy to the private sector would probably fall by 75 per cent—that in itself could set off a wave of private-sector innovation that would generate new prosperity.

If the US government invested a trillion dollars in genetic engineering, it’s probable they could create medical miracles: a cancer cure, or ways to slow the metabolic processes of ageing. We need to think in terms of peace-time Manhattan Projects: bring together all the best brains, the best technology, set them targets; use ‘creditism’ to produce results. We can all now see the flaws in creditism—they’re obvious. But as a society, I think the US is overlooking the opportunities that exist within this new economic system—the opportunity for the government to borrow massive amounts of money at 1.5 per cent interest and invest it aggressively in transformative technologies that restructure the US economy, so that it can get off its debilitating dependence on the financial sector, which has developed into a giant Ponzi scheme, before it all collapses. If not, then the US economy is likely to go down sooner or later into a lethal debt–deflation spiral.

Presumably this ‘creditist’ strategy could only apply to the US economy, though?

Not necessarily. For example, the Bank of England has printed so much money to buy up government bonds that it now owns more than a third of Britain’s entire debt. Now, it didn’t cost the Bank a single penny to buy all those bonds—it didn’t even have to buy any paper or ink to print the money; it’s all electronic now. So why not just cancel them? It wouldn’t cost anybody a thing; even if somehow it bankrupted the Bank of England, it could just print more money to recapitalize itself. Overnight, Britain would have a third less outstanding government debt and its credit rating would improve enormously. The government would announce that it was going to take advantage of this historic opportunity to increase government spending and invest it in new industries, so that Britain can finally wean itself off its debilitating dependence on Ponzi finance and develop manufacturing industries again. For example: throw $100 billion at Cambridge to invest in genetic engineering over the next three years, to become the dominant genetic-technology force on earth. Meanwhile create jobs and fix the infrastructure, at the same time.

But wouldn’t these new industries be subject to the same relative lack of aggregate demand?

Well, there would be no lack of demand for a molecular therapy that slows down ageing or cures a killer disease. The point would be to aim for technological breakthroughs that are completely transformative, like the agricultural technological revolution in the 1960s that changed the nature of global food production. In some respects this is an unprecedented opportunity because of the amount of money that governments could invest now, when interest rates are at such low levels. If they directed them into transformative technologies, they could create markets for products that just don’t exist at all now, where there would be demand. If we could actually shift the US economy from oil to solar, that would free up a lot of money that could be spent on other things. Polemically, if you like, the point is to stress that we can’t just wait for an old-fashioned cyclical recovery—it’s not going to come. We have a new kind of economic system, and either we master this system and take ultimate advantage of its opportunities to borrow and invest, or else it collapses into a severe depression, unwinding a $50 trillion expansion of credit. It’s going to be at least as bad as the 1930s.

In 2003 you called the Chinese economy a bubble waiting to pop. How do you see it today?

An even bigger bubble waiting to pop. When I wrote The Dollar Crisis, China’s trade surplus with the US was $80 billion a year; now it’s $300 billion a year, but the US can’t keep expanding its trade deficits, and that means China’s trade surplus is going to flatten out, creating a much more difficult environment there. In 2009, when the trade surplus corrected quite significantly, the headline was: 20 million factory workers lose their jobs and head back home to the countryside to grow rice. That almost popped the whole bubble then and there. The Chinese government’s policy response was to let Chinese banks increase total system bank loans by 60 per cent over the next two years. As a result of this massive stimulus, everybody borrowed money and property prices soared. But now, three or four years on, no one can repay the money, the banking system must be on the verge of collapse—although officially, non-performing loans are reported to be extremely low—and will have to be bailed out by the government. The whole China model is in serious trouble: they’ve been expanding industrial production by 20 per cent a year for decades, and now there’s massive excess capacity in every sector. The Americans can’t buy any more of it, and 80 per cent of the Chinese earn less than $10 a day, so they can’t buy what they’re making in their own factories. If they continue expanding their industrial production, the problem is only going to get worse. I think they’re going to have to follow the Japan model as well, and have very big government budget deficits to keep the economy from collapsing into a depression; if they do that aggressively, in a best-case scenario China can perhaps achieve 3 per cent growth a year on average for the next ten years.

Nevertheless, there is a potential market for first-generation purchases of cars and washing machines that’s still to be realized, on a massive scale—hundreds of millions of people. Isn’t that still ahead?

Not necessarily, unless Chinese wages go up—because people who earn $10 a day can’t afford a washing machine; even if they could, their flat wouldn’t be big enough to fit a washing machine. And the challenge is, if Chinese wages ever went to the astronomical level of $15 a day, then there are 500 million people in India who will work for $5 a day, and the jobs will move there. So there’s a real danger of a race to the bottom, unless we can agree on a global minimum wage.

How do you see the current state of the US banking sector? In August this year the New York Times was sounding the alarm about the fact that the cartel of the big banks was the sole regulator for the $700 trillion derivatives market, although it seems to have fallen silent again now.

One way of approaching this is, whoever creates the wealth has the political power. Under feudalism, power lay with the landed aristocracy. Under industrial capitalism, the captains of industry controlled political power. But in the last few decades, wealth in the US has come from credit creation. As bankers created more and more wealth, they became increasingly influential, politically; by the late 1990s they were unstoppable. First they repealed Glass–Steagall and then, the following year, they passed something called the Commodity Futures Modernization Act, which removed the regulations from the derivatives market and allowed them to trade over the counter with almost no regulation whatsoever. Since 1990, the total amount of derivatives contracts has increased from $10 trillion, which was already a very big number, to $700 trillion—the equivalent of $100,000 per person on earth, or global GDP for the last twenty years combined. There is nothing in the world you can hedge with that many derivatives contracts; the system has become increasingly surreal. You can imagine how much profit the banks make from $700 trillion—first from creating the derivatives, then from trading them and using them for structured finance.

Derivatives are basically used as gambling vehicles: you can gamble on the direction of interest rates or commodities, or anything else; if you actually want to hedge something, you can take out insurance by hedging it that way. But most of the trading is not between the real sectors of the economy; around two-thirds of it is done between the banks themselves. Ninety per cent of derivatives contracts trade over the counter, which means no regulator can see what’s going on; but 10 per cent of them do trade through exchanges, so we know something about them. The last time I looked, the average daily turnover for that 10 per cent—the amount they changed hands for, every day—was $4 trillion. Now, if the other 90 per cent traded as much—and it could be more, it could be less, I don’t know—that would be something like $40 trillion of turnover a day. If there were even a very tiny tax on each of these derivatives transactions, the government would have an enormous source of revenue, a tax that other people wouldn’t have to pay. Most of the trading is done in London and New York, so there’s no problem about relocation—the threat that all this business will move to China; the Chinese don’t let their banks do crazy things like this. Every major accounting scandal for the past twenty years—Fannie Mae, Freddie Mac, General Electric—has involved structured finance, with the culprits using derivatives to manipulate their accounts to avoid paying taxes; the bankers make a big fee on that. Given what we know about unregulated markets and the incentive structure of the banking industry, it seems unlikely that in this $700 trillion unregulated market there wouldn’t be every kind of fraud and shenanigan taking place. If you were a major oil-producing Gulf state, for example—not to name names—why would you not manipulate the price of oil, with the help of one of the large US investment banks and/or one of the major oil multinationals, when no one can see what you’re doing? You write contracts that push up the oil price, and the futures price pulls up the spot price. Most of the commodities are probably being manipulated this way, oil being the most obvious one.

Didn’t the Dodd–Frank law aim to put an end to over-the-counter derivatives trading?

Dodd–Frank required the banks to put all the derivatives through exchanges by the middle of 2011—more than a year ago. But it keeps getting pushed back to some unspecified date in the future. Somewhere along the way, the regulators may have realized that, if you actually put them all through exchanges, it would reveal such a degree of fraud and corruption that the whole system would implode. The actual net worth of the banks could turn out to be something like minus $30 trillion—that’s why they don’t break them apart; they’re too big to fail, because they’re too bankrupt for the government to take them on. They should be made to trade through exchanges and also to have proper margins on both sides, just like when people have an account with a stock broker; it’s okay to borrow money, but you have to have a certain degree of margin; and then, if anyone gets in trouble, they have enough margin to cover their losses or cut their positions. As it is now, there’s no exchange, so there’s no transparency—no one can see who’s doing what or why—and there are no margins. The industry complains that having to put up margins will be so expensive, it will damage their business. It’s like saying, I have to pay health insurance and I have to insure my house, that damages my business—but that’s the price of insurance. You don’t have insurance for free, you have to pay for it. But, of course, the industry is fighting this tooth and nail, because if they can no longer create more credit, because the private sector can’t take on more debt; and if they’re actually forced to stop proprietary trading on their own accounts, as the Volcker Rule requires; and if they are forced to put their derivatives through exchanges—then suddenly they will not be the major source of wealth-creation anymore, and their hold on political power will be greatly weakened. They are desperately trying to maintain their wealth-creating abilities in a very difficult environment. Creditism is much less stable, or sustainable, than industrial capitalism—and it seems to be teetering on the edge of collapse.

So there’s no hope that banking legislation will reform the sector? You’d argue that the banking system has to be propped up, because it would be such a global disaster if it was restructured?

I wouldn’t say I’m entirely hopeless about it, but it’s very difficult, because they’d have to find a way to restructure the banking system that doesn’t cause it to collapse completely, and I’m not sure there is such a formula. I don’t know what’s going to happen to the banking system. It’s not clear how they’re going to make any profits if they can’t continue to increase credit and can’t expand the unregulated portion of the derivatives market at an exponential rate anymore. The problem is that if the banking system went down, it would destroy so much credit that everything would collapse, just as it collapsed when the money supply was destroyed in 1930 and 31. Now it’s the credit supply that the policy-makers are determined not to allow to contract, for the same reason. So I don’t think any of the European banks are going to be allowed to fail. In November 2011 there was a lot of talk about the French banks going under, but it was clear that either the ECB or the IMF would bail them out. Or else, if no one else, the Fed would bail out Société Générale (for instance)—because if Soc Gen falls, Deutsche Bank’s going to fall, and then J. P. Morgan. They’re all going to fall together. So you might as well just bail out Soc Gen—it’ll be a whole lot cheaper than the Fed trying to bail out everybody. They have no choice. Sure enough, the ECB did a back-flip, printed a trillion new euros, and bailed everybody out. That’s what they’re going to continue to do as long as they can do it, because otherwise they know we’re going to collapse into the 1930s.

Working out positive and negative forms of creditism—this seems to be the crux of what you’re saying. This is the system we’ve got, but what we have to do is take control of it, and submit it to debt-forgiveness programmes and rational investment strategies that have a promise of being productive.

Exactly right. I think we can do better this time.

When World War I broke out in August 1914, economists on both sides forecast that hostilities could not last more than about six months. Wars had grown so expensive that governments quickly would run out of money. It seemed that if Germany could not defeat France by springtime, the Allied and Central Powers would run out of savings and reach what today is called a fiscal cliff and be forced to negotiate a peace agreement.

But the Great War dragged on for four destructive years. European governments did what the United States had done after the Civil War broke out in 1861 when the Treasury printed greenbacks. They paid for more fighting simply by printing their own money. Their economies did not buckle and there was no major inflation. That would happen only after the war ended, as a result of Germany trying to pay reparations in foreign currency. This is what caused its exchange rate to plunge, raising import prices and hence domestic prices. The culprit was not government spending on the war itself (much less on social programs).

But history is written by the victors, and the past generation has seen the banks and financial sector emerge victorious. Holding the bottom 99% in debt, the top 1% are now in the process of subsidizing a deceptive economic theory to persuade voters to pursue policies that benefit the financial sector at the expense of labor, industry, and democratic government as we know it.

Wall Street lobbyists blame unemployment and the loss of industrial competitiveness on
government spending and budget deficits – especially on social programs – and labor’s demand to share in the economy’s rising productivity. The myth (perhaps we should call it junk economics) is that (1) governments should not run deficits (at least, not by printing their own money), because (2) public money creation and high taxes (at lest on the wealthy) cause prices to rise. The cure for economic malaise (which they themselves have caused), is said to be less public spending, along with more tax cuts for the wealthy, who euphemize themselves as “job creators.” Demanding budget surpluses, bank lobbyists promise that banks can provide the economy with enough purchasing power to grow. Then, when this ends in crisis, they insist that austerity can squeeze out enough income to enable private-sector debts to be paid.

The reality is that when banks load the economy down with debt, this leaves less to spend on domestic goods and services while driving up housing prices (and hence the cost of living) with reckless credit creation on looser lending terms. Yet on top of this debt deflation, bank lobbyists urge fiscal deflation: budget surpluses rather than pump-priming deficits. The effect is to further reduce private-sector market demand, shrinking markets and employment. Governments fall deeper into distress, and are told to sell off land and natural resources, public enterprises, and other assets. This creates a lucrative market for bank loans to finance privatization on credit. This explains why financial lobbyists back the new buyers’ right to raise the prices they charge for basic needs, creating a united front to endorse rent extraction. The effect is to enrich the financial sector owned by the 1% in ways that indebt and privatize the economy at large – individuals, business and the government itself.

This policy was exposed as destructive in the late 1920s and early 1930s when John Maynard Keynes, Harold Moulton and a few others countered the claims of Jacques Rueff and Bertil Ohlin that debts of any magnitude could be paid if governments would impose deep enough austerity and suffering. This is the doctrine adopted by the International Monetary Fund to impose on Third World debtors since the 1960s, and by European neoliberals defending creditors imposing austerity on Ireland, Greece, Spain and Portugal.

This pro-austerity mythology aims to distract the public from asking why peacetime governments can’t simply print the money they need. Given the option of printing money instead of levying taxes, why do politicians only create new spending power for the purpose of waging war and destroying property, not to build or repair bridges, roads and other public infrastructure? Why should the government tax employees for future retirement payouts, but not Wall Street for similar user fees and financial insurance to build up a fund to pay for future bank over-lending crises? For that matter, why doesn’t the U.S. Government print the money to pay for Social Security and medical care, just as it created new debt for the $13 trillion post-2008 bank bailout? (I will return to this question below.)

The answer to these questions has little to do with markets, or with monetary and tax theory. Bankers claim that if they have to pay more user fees to pre-fund future bad-loan claims and deposit insurance to save the Treasury or taxpayers from being stuck with the bill, they will have to charge customers more – despite their current record profits, which seem to grab everything they can get. But they support a double standard when it comes to taxing labor.

Shifting the tax burden onto labor and industry is achieved most easily by cutting back public spending on the 99%. That is the root of the December 2012 showdown over whether to impose the anti-deficit policies proposed by the Bowles-Simpson commission of budget cutters whom President Obama appointed in 2010. Shedding crocodile tears over the government’s failure to balance the budget, banks insist that today’s 15.3% FICA wage withholding be raised – as if this will not raise the break-even cost of living and drain the consumer economy of purchasing power. Employers and their work force are told to save in advance for Social Security or other public programs. This is a disguised income tax on the bottom 99%, whose proceeds are used to reduce the budget deficit so that taxes can be cut on finance and the 1%. To paraphrase Leona Helmsley’s quip that “Only the little people pay taxes,” the post-2008 motto is that only the 99% have to suffer losses, not the 1% as debt deflation plunges real estate and stock market prices to inaugurate a Negative Equity economy while unemployment rates soar.

There is no more need to save in advance for Social Security than there is to save in advance to pay for war. Selling Treasury bonds to pay for retirees has the identical monetary and fiscal effect of selling newly printed securities. It is a charade – to shift the tax burden onto labor and industry. Governments need to provide the economy with money and credit to expand markets and employment. They do this by running budget deficits, and this can be done by creating their own money. That is what banks oppose, accusing it of leading to hyperinflation rather than help economies grow.

Their motivation for this wrong accusation is self-serving and their logic is deceptive. Bankers always have fought to block government from creating its own money – at least under normal peacetime conditions. For many centuries, government bonds were the largest and most secure investment for the financial elites that hold most savings. Investment bankers and brokers monopolized public finance, at substantial underwriting commissions. The market for stocks and corporate bonds was rife with fraud, dominated by insiders for the railroads and great trusts being organized by Wall Street, and the canal ventures organized by French and British stockbrokers.

However, there was little alternative to governments creating their own money when the costs of waging an international war far exceeded the volume of national savings or tax revenue available. This obvious need quieted the usual opposition mounted by bankers to limit the public monetary option. It shows that governments can do more under force majeur emergencies than under normal conditions. And the September 2008 financial crisis provided an opportunity for the U.S. and European governments to create new debt for bank bailouts. This turned out to be as expensive as waging a war. It was indeed a financial war. Banks already had captured the regulatory agencies to engage in reckless lending and a wave of fraud and corruption not seen since the 1920s. And now they were holding economies hostage to a break in the chain of payments if they were not bailed out for their speculative gambles, junk mortgages and fraudulent loan packaging.

Their first victory was to disable the ability – or at least the willingness – of the Treasury, Federal Reserve and Comptroller of the Currency to regulate the financial sector. Goldman Sachs, Citicorp and their fellow Wall Street giants hold veto power the appointment of key administrators at these agencies. They used this beachhead to weed out nominees who might not favor their interests, preferring ideological deregulators in the stripe of Alan Greenspan and Tim Geithner. As John Kenneth Galbraith quipped, a precondition for obtaining a central bank post is tunnel vision when it comes to understanding that governments can create their credit as readily as banks can. What is necessary is for one’s political loyalties to lie with the banks.

In the post-2008 financial wreckage it took only a series of computer keystrokes for the U.S. Government to create $13 trillion in debt to save banks from suffering losses on their reckless real estate loans (which computer models pretended would make banks so rich that they could pay their managers enormous salaries, bonuses and stock options), insurance bets gone bad (underpricing risk to win business to pay their managers enormous salaries and bonuses), arbitrage gambles and outright fraud (to give the illusion of earnings justifying enormous salaries, bonuses and stock options). The $800 billion Troubled Asset Relief Program (TARP) and $2 trillion of Federal Reserve “cash for trash” swaps enabled the banks to continue their remuneration of executives and bondholders with hardly a hiccup – while incomes and wealth plunged for the remaining 99% of Americans.

A new term, Casino Capitalism, was coined to describe the transformation that finance capitalism was undergoing in the post-1980 era of deregulation that opened the gates for banks to do what governments hitherto did in time of war: create money and new public debt simply by “printing it” – in this case, electronically on their computer keyboards.

Taking the insolvent Fannie Mae and Freddie Mac mortgage financing agencies onto the public balance sheet for $5.2 trillion accounted for over a third of the $13 trillion bailout. This saved their bondholders from having to suffer losses from the fraudulent appraisals on the junk mortgages with which Countrywide, Bank of America, Citibank and other “too big to fail” banks had stuck them. This enormous debt increase was done without raising taxes. In fact, the Bush administration cut taxes, giving the largest cuts to the highest income and wealth brackets who were its major campaign contributors. Special tax privileges were given to banks so that they could “earn their way out of debt” (and indeed, out of negative equity).[1] The Federal Reserve gave a free line of credit (Quantitative Easing) to the banking system at only 0.25% annual interest by 2011 – that is, one quarter of a percentage point, with no questions asked about the quality of the junk mortgages and other securities pledged as collateral at their full face value, which was far above market price.

This $13 trillion debt creation to save banks from having to suffer a loss was not accused of threatening economic stability. It enabled them to resume paying exorbitant salaries and bonuses, dividends to bondholders and also to pay counterparties on casino-capitalist arbitrage bets. These payments have helped the 1% receive a reported 93% of the gains in income since 2008. The bailout thus polarized the economy, giving the financial sector more power over labor and consumers, industry and the government than has been the case since the late 19th-century Gilded Age.

All this makes today’s financial war much like the aftermath of World War I and countless earlier wars. The effect is to impoverish the losers, appropriate hitherto public assets for the victors, and impose debt service and taxes much like levying tribute. “The financial crisis has been as economically devastating as a world war and may still be a burden on ‘our grandchildren,’” Bank of England official Andrew Haldane recently observed. “‘In terms of the loss of incomes and outputs, this is as bad as a world war.’ he said. The rise in government debt has prompted calls for austerity – on the part of those who did not receive the giveaway. ‘It would be astonishing if people weren’t asking big questions about where finance has gone wrong.’”[2]

But as long as the financial sector is winning its war against the economy at large, it prefers that people believe that There Is No Alternative. Having captured mainstream economics as well as government policy, finance seeks to deter students, voters and the media from questioning whether the financial system really needs to be organized in the way it is. Once such a line of questioning is pursued, people may realize that banking, pension and Social Security systems and public deficit financing do not have to be organized in the way they are. There are better alternatives to today’s road to austerity and debt peonage.

Today’s financial war against the economy at large

Today’s economic warfare is not the kind waged a century ago between labor and its industrial employers. Finance has moved to capture the economy at large, industry and mining, public infrastructure (via privatization) and now even the educational system. (At over $1 trillion, U.S. student loan debt came to exceed credit-card debt in 2012.) The weapon in this financial warfare is no larger military force. The tactic is to load economies (governments, companies and families) with debt, siphon off their income as debt service and then foreclose when debtors lack the means to pay. Indebting government gives creditors a lever to pry away land, public infrastructure and other property in the public domain. Indebting companies enables creditors to seize employee pension savings. And Indebting labor means that it no longer is necessary to hire strikebreakers to attack union organizers and strikers.

Workers have become so deeply indebted on their home mortgages, credit cards and other bank debt that they fear to strike or even to complain about working conditions. Losing work means missing payments on their monthly bills, enabling banks to jack up interest rates to levels that used to be deemed usurious. So debt peonage and unemployment loom on top of the wage slavery that was the main focus of class warfare a century ago. And to cap matters, credit-card bank lobbyists have rewritten the bankruptcy laws to curtail debtor rights, and the referees appointed to adjudicate disputes brought by debtors and consumers are subject to veto from the banks and businesses that are mainly responsible for inflicting injury.

The aim of financial warfare is not merely to acquire land, natural resources and key infrastructure rents as in military warfare; it is to centralize creditor control over society. In contrast to the promise of democratic reform nurturing a middle class a century ago, we are witnessing a regression to a world of special privilege in which one must inherit wealth in order to avoid debt and job dependency.

The emerging financial oligarchy seeks to shift taxes off banks and their major customers (real estate, natural resources and monopolies) onto labor. Given the need to win voter acquiescence, this aim is best achieved by rolling back everyone’s taxes. The easiest way to do this is to shrink government spending, headed by Social Security, Medicare and Medicaid. Yet these are the programs that enjoy the strongest voter support. This fact has inspired what may be called the Big Lie of our epoch: the pretense that governments can only create money to pay the financial sector, and that the beneficiaries of social programs should be entirely responsible for paying for Social Security, Medicare and Medicaid, not the wealthy. This Big Lie is used to reverse the concept of progressive taxation, turning the tax system into a ploy of the financial sector to levy tribute on the economy at large.

Financial lobbyists quickly discovered that the easiest ploy to shift the cost of social programs onto labor is to conceal new taxes as user fees, using the proceeds to cut taxes for the elite 1%. This fiscal sleight-of-hand was the aim of the 1983 Greenspan Commission. It confused people into thinking that government budgets are like family budgets, concealing the fact that governments can finance their spending by creating their own money. They do not have to borrow, or even to tax (at least, not tax mainly the 99%).

The Greenspan tax shift played on the fact that most people see the need to save for their own retirement. The carefully crafted and well-subsidized deception at work is that Social Security requires a similar pre-funding – by raising wage withholding. The trick is to convince wage earners it is fair to tax them more to pay for government social spending, yet not also to ask the banking sector to pay similar a user fee to pre-save for the next time it itself will need bailouts to cover its losses. Also asymmetrical is the fact that nobody suggests that the government set up a fund to pay for future wars, so that future adventures such as Iraq or Afghanistan will not “run a deficit” to burden the budget. So the first deception is to treat only Social Security and medical care as user fees. The second is to aggravate matters by insisting that such fees be paid long in advance, by pre-saving.

There is no inherent need to single out any particular area of public spending as causing a budget deficit if it is not pre-funded. It is a travesty of progressive tax policy to only oblige workers whose wages are less than (at present) $105,000 to pay this FICA wage withholding, exempting higher earnings, capital gains, rental income and profits. The raison d’être for taxing the 99% for Social Security and Medicare is simply to avoid taxing wealth, by falling on low wage income at a much higher rate than that of the wealthy. This is not how the original U.S. income tax was created at its inception in 1913. During its early years only the wealthiest 1% of the population had to file a return. There were few loopholes, and capital gains were taxed at the same rate as earned income.

The government’s seashore insurance program, for instance, recently incurred a $1 trillion liability to rebuild the private beaches and homes that Hurricane Sandy washed out. Why should this insurance subsidy at below-commercial rates for the wealthy minority who live in this scenic high-risk property be treated as normal spending, but not Social Security? Why save in advance by a special wage tax to pay for these programs that benefit the general population, but not levy a similar “user fee” tax to pay for flood insurance for beachfront homes or war? And while we are at it, why not save another $13 trillion in advance to pay for the next bailout of Wall Street when debt deflation causes another crisis to drain the budget?

But on whom should we levy these taxes? To impose user fees for the beachfront reconstruction would require a tax falling mainly on the wealthy owners of such properties. Their dominant role in funding the election campaigns of the Congressmen and Senators who draw up the tax code suggests why they are able to avoid prepaying for the cost of rebuilding their seashore property. Such taxation is only for wage earners on their retirement income, not the 1% on their own vacation and retirement homes.

By not raising taxes on the wealthy or using the central bank to monetize spending on anything except bailing out the banks and subsidizing the financial sector, the government follows a pro-creditor policy. Tax favoritism for the wealthy deepens the budget deficit, forcing governments to borrow more. Paying interest on this debt diverts revenue from being spent on goods and services. This fiscal austerity shrinks markets, reducing tax revenue to the brink of default. This enables bondholders to treat the government in the same way that banks treat a bankrupt family, forcing the debtor to sell off assets – in this case the public domain as if it were the family silver, as Britain’s Prime Minister Harold MacMillan characterized Margaret Thatcher’s privatization sell-offs.

In an Orwellian doublethink twist this privatization is done in the name of free markets, despite being imposed by global financial institutions whose administrators are not democratically elected. The International Monetary Fund (IMF), European Central Bank (ECB) and EU bureaucracy treat governments like banks treat homeowners unable to pay their mortgage: by foreclosing. Greece, for example, has been told to start selling off prime tourist sites, ports, islands, offshore gas rights, water and sewer systems, roads and other property.

Sovereign governments are, in principle, free of such pressure. That is what makes them sovereign. They are not obliged to settle public debts and budget deficits by asset selloffs. They do not need to borrow more domestic currency; they can create it. This self-financing keeps the national patrimony in public hands rather than turning assets over to private buyers, or having to borrow from banks and bondholders.

Why today’s fiscal squeeze adds to the economy’s costs and imposes needless austerity

The financial sector promises that privatizing roads and ports, water and sewer systems, bus and railroad lines (on credit, of course) is more efficient and will lower the prices charged for their services. The reality is that the new buyers put up rent-extracting tollbooths on the infrastructure being sold. Their break-even costs include the high salaries and bonuses they pay themselves, as well as interest and dividends to their creditors and backers, spending on stock buy-backs and political lobbying.

Public borrowing creates a dependency that shifts economic planning to Wall Street and other financial centers. When voters resist, it is time to replace democracy with oligarchy. “Technocratic” rule replaces that of elected officials. In Europe the IMF, ECB and EU troika insists that all debts must be paid, even at the cost of austerity, depression, unemployment, emigration and bankruptcy. This is to be done without violence where possible, but with police-state practices when grabbers find it necessary to quell popular opposition.

Financializing the economy is depicted as a natural way to gain wealth – by taking on more debt. Yet it is hard to think of a more highly politicized policy, shaped as it is by tax rules that favor bankers. It also is self-terminating, because when public debt grows to the point where investors (“the market”) no longer believe that it can be repaid, creditors mount a raid (the military analogy is appropriate) by “going on strike” and not rolling over existing bonds as they fall due. Bond prices fall, yielding higher interest rates, until governments agree to balance the budget by voluntary pre-bankruptcy privatizations.

Selling saved-up Treasury bonds to fund public programs is like new deficit borrowing

If the aim of America’s military spending around the world is to prepare for future warfare, why not aim at saving up a fund of $10 trillion or even $30 trillion in advance, as with Social Security, so that we will have the money to pay for it?

The answer is that selling saved-up Treasury bills to finance Social Security, military spending or any other program has the same monetary and price effect as issuing new Treasury bills. The impact on financial markets – and on the private sector’s holding of government debt – by paying Social Security out of past savings – that is, by selling the Treasury securities in which Social Security funds are invested – is much like borrowing by selling new securities. It makes little difference whether the Treasury sells newly printed IOUs, or sells bonds that it has been accumulating in a special fund. The effect is to increase public debt owed to the financial sector.

If the savings are to be invested in Treasury bonds (as is the case with Social Security), will this pay for tax cuts elsewhere in the budget? If so, will these cuts be for the wealthy 1% or the 99%? Or, will the savings be invested in infrastructure, or turned over to states and cities to help balance their budget shortfalls and underfunded pension plans?

Another problem concerns who should pay for this pre-saving. The taxes needed to pre-fund a savings build-up siphon off income from somewhere in the economy. How much will the economy shrink by diverting income from being spent on goods and services? And whose income will taxed? These questions illustrate how politically self-interested it is to single out taxing wages to save for Social Security in contrast to war-making and beach-house rebuilding.

Government budgets usually are designed to be in balance under normal peacetime conditions, so most public debt has been brought into being by war (prior to today’s financial war of slashing taxes on the wealthy). Adam Smith’s Wealth of Nations (Book V) traced how each new British bond issue to raise funds for a military action had a dedicated tax to pay its interest charges. The accumulation of such war debts thus raised the cost of living and hence the break-even price of labor. To prevent this from undercutting of British competitiveness, Smith urged that wars be waged on a pay-as-you-go basis – by full taxation rather than by borrowing and entailing interest payments and taxes (as the debt itself rarely was amortized). Smith thought that populations should feel the cost of war directly and immediately, presumably leading them to be vigilant in checking grandiose projects of empire.

The United States issued fiat greenback currency to pay for much of its Civil War, but also issued bonds. In analyzing this war finance the Canadian-American astronomer and monetary theorist Simon Newcomb pointed out that all wars must be paid for in the form of tangible material and lives by the generation that fights them. Paying for the war by borrowing from bondholders, he explained, involved levying taxes to pay the interest. The effect was to transfer income from the Western states (taxpayers) to bondholders in the East.

In the case of Social Security today the beneficiary of government debt is still the financial sector. The economy must provide the housing, food, health care, transportation and clothing to enable retirees to live normal lives. This economic surplus can be paid for either out of taxation, new money creation or borrowing. But instead of “the West,” the major payers of the Social Security tax are wage earners across the nation. Taxing labor shrinks markets and forces the economy into austerity.

Quantitative easing as free money creation – to subsidize the big banks

The Federal Reserve’s three waves of Quantitative Easing since 2008 show how easy it is to create free money. Yet this has been provided only to the largest banks, not to strapped homeowners or industry. An immediate $2 trillion in “cash for trash” took the form of the Fed creating new bank-reserve credit in exchange for mortgage-backed securities valued far above market prices. QE2 provided another $800 billion in 2011-12. The banks used this injection of credit for interest rate arbitrage and exchange rate speculation on the currencies of Brazil, Australia and other high-interest-rate economies. So nearly all the Fed’s new money went abroad rather than being lent out for investment or employment at home.

U.S. Government debt was run up mainly to re-inflate prices for packaged bank mortgages, and hence real estate prices. Instead of alleviating private-sector debt by writing down mortgages in line with the homeowners’ ability to pay, the Federal Reserve and Treasury created money to support property prices – to push the banking system’s balance sheets back above negative net worth. The Fed’s QE3 program in 2012-13 created money to buy mortgage-backed securities each month, to provide banks with money to lend to new property buyers.

For the economy at large, the debts were left in place. Yet commentators focused only on government debt. In a double standard, they accused budget deficits of inflating wages and consumer prices, yet the explicit aim of quantitative easing was to support asset prices. Inflating asset prices on credit is deemed to be good for the economy, despite loading it down with debt. But public spending into the “real” economy, raising employment levels and sustaining consumer spending, is deemed bad – except when this is financed by personal borrowing from the banks. So in each case, increasing bank profits is the standard by which fiscal policy is to be judged!

The result is a policy asymmetry that is opposite from what most epochs have deemed fair or helpful to economic growth. Bankers and bondholders insist that the public sector borrow from them, blocking the government’s power to self-finance its operations – with one glaring exception. That exception occurs when the banks themselves need free money creation. The Fed provided nearly free credit to the banks under QE2, and Chairman Ben Bernanke promised to continue this policy until such time as the unemployment rate drops to 6.5%. The pretense is that low interest rates spur employment, but the most pressing aim is to provide easy credit to revive borrowing and bid asset prices back up.

Fiscal deflation on top of debt deflation

The main financial problem with funding war occurs after the return to normalcy, when creditors press for budget surpluses to roll back the public debt that has been run up. This imposes fiscal austerity, reducing wages and commodity prices relative to the debts that are owed. Consumer spending shrinks and prices decline as governments spend less, while higher taxes withdraw revenue. This is what is occurring in today’s financial war, much as it has in past military postwar returns to peace.

Governments have the power to resist this deflationary policy. Like commercial banks, they can create money on their computer keyboards. Indeed, since 2008 the government has created debt to support the Finance, Insurance and Real Estate (FIRE) sector more than the “real” production and consumption economy.

In contrast to public spending for goods and services (or social programs that increase market demand), most of the bank credit that led to the 2008 financial collapse was created to finance the purchase property already in place, stocks and bonds already issued, or companies already in existence. The effect has been to load down the economy with mortgages, bonds and bank debt whose carrying charges eat into spending on current output. The $13 trillion bank subsidy since 2008 (to enable banks to earn their way out of negative equity) brings us back to the question of why taxes should be levied on the 99% to pre-save for Social Security and Medicare, but not for the bank bailout.

Current tax policy encourages financial and rent extraction that has become the major economic problem of our epoch. Industrial productivity continues to rise, but debt is growing even more inexorably. Instead of fueling economic growth, this of credit/debt threatens to absorb the economic surplus, plunging the economy into austerity, debt deflation and negative equity.

So despite the fact that the financial system is broken, it has gained control over public policy to sustain and even obtain tax favoritism for a dysfunctional overgrowth of bank credit. Unlike the progress of science and technology, this debt is not part of nature. It is a social construct. The financial sector has politicized it by pressing to privatize economic rent rather than collect it as the tax base. This financialization of rent-extracting opportunities does not reflect a natural or inevitable evolution of “the market.” It is a capture of market structures and fiscal policy. Bank lobbyists have campaigned to shift the economic arena to the political sphere of lawmaking and tax policy, with side battlegrounds in the mass media and universities to capture the hearts and minds of voters to believe that the quickest and most efficient way to build up wealth is by bank credit and debt leverage.

Budget deficits as an antidote to austerity

Public debts everywhere are growing, as taxes only cover part of public spending. The least costly way to finance this expenditure is to issue money – the paper currency and coins we carry in our pockets. Holders of this currency technically are creditors to the government – and to society, which accepts this money in payment. Yet despite being nominally a form of public debt, this money serves as public capital inasmuch as it is not normally expected to be repaid. This government money does not bear interest, and may be thought of as “equity capital” or “equity money,” and hence part of the economy’s net worth.

If taxes did fully cover government spending, there would be no budget deficit – or new public money creation. Government budget deficits pump money into the economy. Conversely, running a budget surplus retires the public debt or currency outstanding. This deflationary effect occurred in the late 19th-century, causing monetary deflation that plunged the U.S. economy into depression. Likewise when President Bill Clinton ran a budget surplus late in his administration, the economy relied on commercial banks to supply credit to use as the means of payment, charging interest for this service. As Stephanie Kelton summarizes this historical experience:

The federal government has achieved fiscal balance (even surpluses) in just seven periods since 1776, bringing in enough revenue to cover all of its spending during 1817-21, 1823-36, 1852-57, 1867-73, 1880-93, 1920-30 and 1998-2001. We have also experienced six depressions. They began in 1819, 1837, 1857, 1873, 1893 and 1929.

Do you see the correlation? The one exception to this pattern occurred in the late 1990s and early 2000s, when the dot-com and housing bubbles fueled a consumption binge that delayed the harmful effects of the Clinton surpluses until the Great Recession of 2007-09.[3]

When taxpayers pay more to the government than the economy receives in public spending, the effect is like paying banks more than they provide in new credit. The debt volume is reduced (increasing the reported savings rate). The resulting austerity is favorable to the financial sector but harmful to the rest of the economy.

Most people think of money as a pure asset (like a coin or a $10 dollar bill), not as being simultaneously a public debt. But to an accountant, a balance sheet always balances: Assets = Liabilities + Net Worth. This liability-side ambivalence is confusing to most people. It takes some time to think in terms of offsetting assets and liabilities as mirror images of each other. Much as cosmologists assume that the universe is symmetrical – with positively charged matter having an anti-matter counterpart somewhere at the other end – so accountants view the money in our pocket as being created by the government’s deficit spending. Holders of the Federal Reserve’s paper currency technically can redeem it, but they will simply get paid in other denominations of the same currency.

The word “redeem” comes from settling debts. This was the purpose for which money first came into being. Governments redeem money by accepting it for tax payment. In addition to issuing paper currency, the Federal Reserve injects money into the economy by writing checks electronically. The recipients (usually banks selling Treasury bonds or, more recently, packages of mortgage loans) gain a deposit at the central bank. This is the kind of deposit that was created by the above-mentioned $13 trillion in new debt that the government turned over to Wall Street after the September 2008 crisis. The price impact was felt in financial asset markets, not in prices for goods and services or labor’s wages.

This Federal Reserve and Treasury credit was not counted as part of the government’s operating deficit. Yet it increased public debt, without being spent on “real” GDP. The banks used this money mainly to gamble on foreign exchange and interest-rate arbitrage as noted above, to buy smaller banks (helping make themselves Too Big To Fail), and to keep paying their managers high salaries and bonuses.

This monetization of debt shows how different government budgets are from family budgets. Individuals must save to pay for retirement or other spending. They cannot print their own money, or tax others. But governments do not need to “save” (or tax) to pay for their spending. Their ability to create money means that they do not need to save in advance to pay for wars, Social Security or other needs.

Keynesian deficit spending vs. bailing out Wall Street to keep the debt overhead in place

There are two kinds of markets: hiring labor to produce goods and services in the “real” economy, and transactions in financial assets and property claims in the FIRE sector. Governments can run budget deficits by financing either of these two spheres. Since President Franklin Roosevelt’s WPA programs in the 1930s, along with his public infrastructure investment in roads, dams and other construction – and military arms spending after World War II broke out – “Keynesian” spending on goods and services has been used to hire labor or pay for social programs. This pumps money into the economy via the GDP-type transactions that appear in the National Income and Product Accounts. It is not inflationary when unemployment exists.

However, the debt that characterized the Paulson-Geithner bailout of Wall Street was created not to spend on goods and services, but to buy (or take liability for) mortgages and bank loans, insurance default bets and arbitrage gambles. The aim was to subsidize financial losses while keeping the debt overhead in place, so that banks and other financial institutions could “earn their way” out of negative net worth, at the economy’s expense. The idea was that they could start lending again to prevent real estate prices from falling further, saving them from having to write down their debt claims to bring levels back down within the ability to be paid.

Why tax the economy at all? And why financial and tax reform should go together.

Taxes pay for the cost of government by withdrawing income from the parties being taxed. From Adam Smith through John Stuart Mill to the Progressive Era, general agreement emerged that the most appropriate taxes should not fall on labor, capital or on sales of basic consumer needs. Such taxes raise the break-even cost of employing labor. In today’s world, FICA wage withholding for Social Security raises the price that employers must pay their work force to maintain living standards and buy the products they produce.

However, these economists singled out one kind of tax that does not increase prices: taxes on the land’s rental value, natural resource rents and monopoly rents. These payments for rent-extraction rights are not a return to “factors of production,” but are privatized levy reflecting privileges that have no ongoing cost of production. They are rentier rake-offs.

Land is the economy’s largest asset. A site’s rental value is set by market conditions – what people pay for being able to live in a good location. People pay more to live in prestigious and convenient neighborhoods. They pay more if there is local investment in roads and public transportation, and if there are parks, museums and cultural centers nearby, or nice shopping districts. People also pay more as the economy grows more prosperous, because one of the first things they desire is status, and in today’s world this is defined largely by where one lives.

Landlords do not create this site value. But speculators may seek to ride the wave by buying property on credit, where the rate of land-price gain exceeds the interest rate. This “capital” gain is the proverbial free lunch. It is created by public investment, by the general level of prosperity, and by the terms on which banks extend credit. In a nutshell, a property is worth whatever a bank will lend, because that is the price that new buyers will be able to pay for it.

This logic was more familiar to the public a century ago than it is today. A property tax to collect this “free lunch” rent is paid out of the rent. This leaves less to be capitalized into new interest-bearing loans – while freeing the government from having to tax labor and industrial capital. So this tax not only is “less bad” than others; it is actively desirable to reduce the debt overhead. Rent levels are not affected, but the government collects the rent instead of the property owner or, at one remove, the mortgage banker who turns this rent into a flow of interest by advancing the purchase price of rent-yielding properties to new buyers.

Real estate was the major source of rising net worth and wealth for America’s middle class for over sixty years, from the return to peace in 1945 until the 2008 financial collapse. Rising property prices were fueled largely by banks providing mortgage credit on easier terms. But by 2008 these terms had reached their limit. Interest rates were seemingly as low as they could go. So were down payments (zero down payment) and amortization rates (zero, with interest-only loans) and property values were becoming fictitious as a result of a tidal wave of fraud by the banking system’s property appraisers, while the income statements of borrowers also was becoming fictitious (“liars’ loans,” with the main liars being the mortgage writers).

If the rise in real estate prices (mainly site values) had been taxed, there would have been no financial overgrowth, because this price-gain would have been collected as the tax base. The government would not have needed to tax labor either via income tax, FICA wage withholding or consumer sales. And taken in conjunction with the government’s money-creating power, there would have been little need for public debt to grow. Taxing rent extraction privileges thus would minimize debt levels and taxes on the 99%.

The next leading form of economic rent is taken by oil, gas and mining companies from the mineral deposits created by nature, as well as by owners or leasers of forests and other natural resources. Classical economics from David Ricardo onward defined such income received by landlords, mining companies, forestry and fisheries as “economic rent.” It is not profit on capital investment, because nature has provided the resource, not human labor or expenditure on capital – except for tangible capital investment in the buildings erected on the land, saws to cut down trees, earth-moving equipment to do the mining, and so forth.

The basic contrast is between a productive industrial economy and a rent-extracting one in which special privileges, monopoly pricing and economic rents divert spending away from tangible capital investment and real output. Classical economists defined economic rent generically as “empty” pricing in excess of technologically necessary costs of production. This would include payments to pharmaceutical companies, health management organizations (HMOs) and monopolies above their necessary cost of doing business. Much like paying debt service, such economic rent siphons market revenue away from tangible production and consumption.

It was to demonstrate this that Francois Quesnay developed the first national income statistics, the Tableau Économique. His aim was to show that the landed aristocracy’s rental rake-offs should form the basis for taxation rather than the excise taxes that were burdening industry and making it uncompetitive. But for the past hundred years, commercial banks have opposed property taxes, because taxing the land’s rent would mean less left over to pay interest. Some 80 percent of bank loans are for real estate, mainly to capitalize the rental value left untaxed. A property and wealth tax would reduce this market – along with the government’s need to borrow, and hence to pay interest to bondholders. And without a fiscal squeeze there would have been less of an opportunity for the financial sector to push to privatize what remains of the public domain.

Today’s central financial problem is that the banking system lends mainly for rent extraction opportunities rather than for tangible capital investment and economic growth to raise living standards. To maximize rent, it has lobbied to untax land and natural resources. At issue in today’s tax and financial crisis is thus whether the world is going to have an economy based on progressive industrial democracy or a financialized and polarizing rent-extracting society.

The ideological crisis underlying today’s tax and financial policy

From antiquity and for thousands of years, land, natural resources and monopolies, seaports and roads were kept in the public domain. In more recent times railroads, subway lines, airlines, and gas and electric utilities were made public. The aim was to provide their basic services at cost or at subsidized prices rather than letting them be privatized into rent-extracting opportunities. The Progressive Era capped this transition to a more equitable economy by enacting progressive income and wealth taxes.

Economies were liberating themselves from the special privileges that European feudalism and colonialism had granted to favored insiders. The aim of ending these privileges – or taxing away economic rent where it occurs naturally, as in the land’s site value and natural resource rent – was to lower the costs of living and doing business. This was expected to make progressive economies more competitive, obliging other countries to follow suit or be rendered obsolete. The era of what was considered to be socialism in one form or another seemed to be at hand – rising role of the public sector as part and parcel of the evolution of technology and prosperity.

But the landowning and financial classes fought back, seeking to expunge the central policy conclusion of classical economics: the doctrine that free-lunch economic rent should serve as the tax base for economies seeking to be most efficient and fair. Imbued with academic legitimacy by the University of Chicago (which Upton Sinclair aptly named the University of Standard Oil) the new post-classical economics has adopted Milton Friedman’s motto: “There Is No Such Thing As A Free Lunch” (TINSTAAFL). If it is not seen, after all, it has less likelihood of being taxed.

The political problem faced by rentiers – the “idle rich” siphoning off most of the economy’s gains for themselves – is to convince voters to agree that labor and consumers should be taxed rather than the financial gains of the wealthiest 1%. How long can they defer people from seeing that making interest tax-exempt pushes the government’s budget further into deficit? To free financial wealth and asset-price gains from taxes – while blocking the government from financing its deficits by its own public option for money creation – the academics sponsored by financial lobbyists hijacked monetary theory, fiscal policy and economic theory in general. On seeming grounds of efficiency they claimed that government no longer should regulate Wall Street and its corporate clients. Instead of criticizing rent seeking as in earlier centuries, they depicted government as an oppressive Leviathan for using its power to protect markets from monopolies, crooked drug companies, health insurance companies and predatory finance.

This idea that a “free market” is one free for Wall Street to act without regulation can be popularized only by censoring the history of economic thought. It would not do for people to read what Adam Smith and subsequent economists actually taught about rent, taxes and the need for regulation or public ownership. Academic economics is turned into an Orwellian exercise in doublethink, designed to convince the population that the bottom 99% should pay taxes rather than the 1% that obtain most interest, dividends and capital gains. By denying that a free lunch exists, and by confusing the relationship between money and taxes, they have turned the economics discipline and much political discourse into a lobbying effort for the 1%.

Lobbyists for the 1% frame the fiscal question in terms of “How can we make the 99% pay for their own social programs?” The implicit follow-up is, “so that we (the 1%) don’t have to pay?” This is how the Social Security system came to be “funded” and then “underfunded.” The most regressive tax of all is the FICA payroll tax at 15.3% of wages up to about $105,000. Above that, the rich don’t have to contribute. This payroll tax exceeds the income tax paid by many blue-collar families. The pretense is that not taxing these free lunchers will make economies more competitive and pull them out of depression. The reality is the opposite: Instead of taxing the wealthy on their free lunch, the tax burden raises the cost of living and doing business. This is a major reason why the U.S. economy is being de-industrialized today.

The key question is what the 1% do with their revenue “freed” from taxes. The answer is that they lend it out to indebt the 99%. This polarizes the economy between creditors and debtors. Over the past generation the wealthiest 1% have rewritten the tax laws to a point where they now receive an estimated 66% – two thirds – of all returns to wealth (interest, dividends, rents and capital gains), and a reported 93% of all income gains since the Wall Street bailout of September 2008.

They have used this money to finance the election campaigns of politicians committed to shifting taxes onto the 99%. They also have bought control of the major news media that shape peoples’ understanding of what is happening. And as Thorstein Veblen described nearly a century ago, businessmen have become the heads most universities and directed their curriculum along “business friendly” lines.

The clearest way to analyze any financial system is to ask Who/Whom. That is because financial systems are basically a set of debts owed to creditors. In today’s neo-rentier economy the bottom 99% (labor and consumers) owe the 1% (bondholders, stockholders and property owners). Corporate business and government bodies also are indebted to this 1%. The degree of financial polarization has sharply accelerated as the 1% are making their move to indebt the 99% – along with industry, state, local and federal government – to the point where the entire economic surplus is owed as debt service. The aim is to monopolize the economy, above all the money-creating privilege of supplying the credit that the economy needs to grow and transact business, enabling them to extract interest and other fees for this privilege.

The top 1% have nearly succeeded in siphoning off the entire surplus for themselves, receiving 93% of U.S. income growth since September 2008. Their control over the political process has enabled them to use each new financial crisis to strengthen their position by forcing companies, states and localities to relinquish property to creditors and financial investors. So after monopolizing the economic surplus, they now are seeking to transfer to themselves the economic infrastructure, land and natural resources, and any other asset on which a rent-extracting tollbooth can be placed.

The situation is akin to that of medieval Europe in the wake of the Nordic invasions. The supra-national force of Rome in feudal times is now situated in Washington, with Christianity replaced by the Washington Consensus wielded via the IMF, World Bank, WTO and its satellite institutions such as the European Central Bank, backed by the moral and ideological role academic economists rather than the Church. And on the new financial battlefield, Wall Street underwriters have used the crisis as an opportunity to press for privatization. Chicago’s strong Democratic political machine sold rights to install parking meters on its sidewalks, and has tried to turn its public roads into privatized toll roads. And the city’s Mayor Rahm Emanuel has used privatization of its airport services to break labor unionization, Thatcher-style. The class war is back in business, with financial tactics playing a leading role barely anticipated a century ago.

This monopolization of property is what Europe’s medieval military conquests sought to achieve, and what its colonization of foreign continents replicated. But whereas it achieved this originally by military conquest of the land, today’s 1% do it l by financializing the economy (although the military arm of force is not absent, to be sure, as the world saw in Chile after 1973).

The financial quandary confronting us

The economy’s debt overhead has grown so large that not everyone can be paid. Rising default rates pose the question age-old question of Who/Whom. The answer almost always is that big fish eat little fish. Big banks (too big to fail) are eating little banks, while the 1% try to take the lion’s share for themselves by annulling public and corporate debts owed to the 99%. Their plan is to downgrade Social Security and Medicare savings to “entitlements,” as if it is a matter of sound fiscal choice not to pay low-income payers while rentiers at the top re-christen themselves “job creators,” as if they have made their gains by helping wage-earners rather than waging war against them.

The problem is not Social Security, which can be paid out of normal tax revenue, as in Germany’s pay-as-you-go system. This fiscal problem – untaxing real estate, oil and gas, natural resources, monopolies and the banks – has been depicted as financial – as if one needs to save in advance by a special tax to lend to the government to cut taxes on the 99%.

The real pension cliff is with corporate, state and local pension plans, which are being underfunded and looted by financial managers. The shortfall is getting worse as the downturn reduces local tax revenues, leaving states and cities unable to fund their programs, to invest in new public infrastructure, or even to maintain and repair existing investments. Public transportation in particular is suffering, raising user fees to riders in order to pay bondholders. But it is mainly retirees who are being told to sacrifice. (The sanctimonious verb is “share” in the sacrifice, although this evidently does not apply to the 1%.)

The bank lobby would like the economy to keep trying to borrow its way out of debt and thus dig itself deeper into a financial hole that puts yet more private and public property at risk of default and foreclosure. The idea is for the government to “stabilize” the financial system by bailing out the banks – that is, doing for them what it has not been willing to do for recipients of Social Security and Medicare, or for states and localities no longer receiving revenue sharing, or for homeowners in negative equity suffering from exploding interest rates even while bank borrowing costs from the Fed have plunged. The dream is that the happy Greenspan financial bubble can be recovered, making everyone rich again, if only they will debt-leverage to bid up real estate, stock and bond prices and create new capital gains.

Realizing this dream is the only way that pension funds can pay retirees. They will be insolvent if they cannot make their scheduled 8+%, giving new meaning to the term “fictitious capital.” And in the real estate market, prices will not soar again until speculators jump back in as they did prior to 2008. If student loans are not annulled, graduates face a lifetime of indentured servitude. But that is how much of colonial America was settled, after all – working off the price of their liberty, only to be plunged into the cauldron of vast real estate speculations and fortunes-by-theft on which the Republic was founded (or at least the greatest American fortunes). It was imagined that such bondage belonged only to a bygone era, not to the future of the West. But we may now look back to that era for a snapshot of our future.

The financial plan is for the government is to supply nearly free credit to the banks, so that they can to lend debtors enough – at the widest interest-rate markups in recent memory (what banks charge borrowers and credit-card users over their less-than-1% borrowing costs) – to pay down the debts that were run up before 2008.

This is not a program to increase market demand for the products of labor. It is not the kind of circular flow that economists have described as the essence of industrial capitalism. It is a financial rake-off of a magnitude such as has not existed since medieval European times, and the last stifling days of the oligarchic Roman Empire two thousand years ago.

Imagining that an economy can be grounded on these policies will further destabilize the economy rather than alleviate today’s debt deflation. But if the economy is saved, the banks cannot be. This is why the Obama Administration has chosen to save the banks, not the economy. The Fed’s prime directive is to keep interest rates low – to revive lending not to finance new business investment to produce more, but simply to inflate the asset prices that back the bank loans that constitute bank reserves. It is the convoluted dream of a new Bubble Economy – or more accurately a new Great Giveaway.

Here’s the quandary: If the Fed keeps interest rates low, how are corporate, state and local pension plans to make the 8+% returns needed to pay their scheduled pensions? Are they to gamble more with hedge funds playing Casino Capitalism?

On the other hand, if interest rates rise, this will reduce the capitalization multiple at which banks lend against current rental income and profits. Higher interest rates will lower prices for real estate, corporate stocks and bonds, pushing the banks (and pension funds) even deeper into negative equity.

So something has to give. Either way, the financial system cannot continue along its present path. Only debt write-offs will “free” markets to resume spending on goods and services. And only a shift of taxes onto rent-yielding property and tollbooths, finance and monopolies will save prices from being loaded down with extractive overhead charges and refocus lending to finance production and employment. Unless this is done, there is no way the U.S. economy can become competitive in international markets, except of course for military hardware and intellectual property rights for escapist cultural artifacts.

The solution for Social Security, Medicare and Medicaid is to de-financialize them. Treat them like government programs for military spending, beachfront rebuilding and bank subsidies, and pay their costs out of current tax revenue and new money creation by central banks doing what they were founded to do.

Politicians shy away from confronting this solution mainly because the financial sector has sponsored a tunnel vision that ignores the role of debt, money, and the phenomena of economic rent, debt leverage and asset-price inflation that have become the defining characteristics of today’s financial crisis. Government policy has been captured to try and save – or at least subsidize – a financial system that cannot be saved more than temporarily. It is being kept on life support at the cost of shrinking the economy – while true medical spending for real life support is being cut back for much of the population.

The economy is dying from a financial respiratory disease, or what the Physiocrats would have called a circulatory disorder. Instead of freeing the economy from debt, income is being diverted to pay credit card debt and mortgage debts. Students without jobs remain burdened with over $1 trillion of student debt, with the time-honored safety valve of bankruptcy closed off to them. Many graduates must live with their parents as marriage rates and family formation (and hence, new house-buying) decline. The economy is dying. That is what neoliberalism does.

Now that the debt build-up has run its course, the banking sector has put its hope in gambling on mathematical probabilities via hedge fund capitalism. This Casino Capitalist has become the stage of finance capitalism following Pension Fund capitalism – and preceding the insolvency stage of austerity and property seizures.

The open question now is whether neofeudalism will be the end stage. Austerity deepens rather than cures public budget deficits. Unlike past centuries, these deficits are not being incurred to wage war, but to pay a financial system that has become predatory on the “real” economy of production and consumption. The collapse of this system is what caused today’s budget deficit. Instead of recognizing this, the Obama Administration is trying to make labor pay. Pushing wage-earners over the “fiscal cliff” to make them pay for Wall Street’s financial bailout (sanctimoniously calling their taxes “user fees”) can only shrink of market more, pushing the economy into a fatal combination of tax-ridden and debt-ridden fiscal and financial austerity.

The whistling in the intellectual dark that central bankers call by the technocratic term “deleveraging” (paying off the debts that have been run up) means diverting yet more income to pay the financial sector. This is antithetical to resuming economic growth and restoring employment levels. The recent lesson of European experience is that despite austerity, debt has risen from 381% of GDP in mid-2007 to 417% in mid—2012. That is what happens when economies shrink: debts mount up at arrears (and with stiff financial penalties).

But even as economies shrink, the financial sector enriches itself by turning its debt claims – what 19th-century economists called “fictitious capital” before it was called finance capital – into a property grab. This makes an unrealistic debt overhead – unrealistic because there is no way that it can be paid under existing property relations and income distribution – into a living nightmare. That is what is happening in Europe, and it is the aim of Obama Administration of Tim Geithner, Ben Bernanke, Erik Holder et al. They would make America look like Europe, wracked by rising unemployment, falling markets and the related syndrome of adverse social and political consequences of the financial warfare waged against labor, industry and government together. The alternative to the road to serfdom – governments strong enough to protect populations against predatory finance – turns out to be a detour along the road to debt peonage and neofeudalism.

So we are experiencing the end of a myth, or at least the end of an Orwellian rhetorical patter talk about what free markets really are. They are not free if they are to pay rent-extractors rather than producers to cover the actual costs of production. Financial markets are not free if fraudsters are not punished for writing fictitious junk mortgages and paying ratings agencies to sell “opinions” that their clients’ predatory finance is sound wealth creation. A free market needs to be regulated from fraud and from rent seeking.

The other myth is that it is inflationary for central banks to monetize public spending. What increases prices is building interest and debt service, economic rent and financial charges into the cost of living and doing business. Debt-leveraging the price of housing, education and health care to make wage-earners pay over two-thirds of their income to the FIRE sector, FICA wage withholding and other taxes falling on labor are responsible for de-industrializing the economy and making it uncompetitive.

Central bank money creation is not inflationary if it funds new production and employment. But that is not what is happening today. Monetary policy has been hijacked to inflate asset prices, or at least to stem their decline, or simply to give to the banks to gamble. “The economy” is less and less the sphere of production, consumption and employment; it is more and more a sphere of credit creation to buy assets, turning profits and income into interest payments until the entire economic surplus and repertory of property is pledged for debt service.

To celebrate this as a “postindustrial society” as if it is a new kind of universe in which everyone can get rich on debt leveraging is a deception. The road leading into this trap has been baited with billions of dollars of subsidized junk economics to entice voters to act against their interests. The post-classical pro-rentier financial narrative is false – intentionally so. The purpose of its economic model is to make people see the world and act (or invest their money) in a way so that its backers can make money off the people who follow the illusion being subsidized. It remains the task of a new economics to revive the classical distinction between wealth and overhead, earned and unearned income, profit and rentier income – and ultimately between capitalism and feudalism. 

Footnotes
[1] No such benefits were given to homeowners whose real estate fell into negative equity. For the few who received debt write-downs to current market value, the credit was treated as normal income and taxed!
[2]Philip Aldrick, “Loss of income caused by banks as bad as a ‘world war’, says BoE’s Andrew Haldane,” The Telegraph, December 3, 2012. Mr. Haldane is the Bank’s executive director for financial stability.
[3] Stephanie Kelton, “The ‘Fiscal Cliff’ Hoax,” http://www.latimes.com/news/opinion/commentary/la-oe-kelton-fiscal-cliff-economy-20121221,0,2129176.story, December 21, 2012.

Keith Ambachtsheer has made a living advising pension funds on the best way to meet their obligations to retirees. In 2000, he warned funds to reduce their exposure to stocks, which had reached nose-bleed valuations after a two-decade bull run, and add long-term government bonds. Since then, bond prices have risen about 10 per cent a year on average, while stock markets have treaded water.

Today, his advice has flipped around. With the yield from long-dated bonds barely outpacing the inflation rate, the director of the Rotman International Centre for Pension Management says the safer investment for pension funds – and any long-term investor – is blue chip stocks.

“In this environment, it’s plausible that for long-term investors, their safest investment is buying and holding a diversified international portfolio of dividend-paying stocks” – companies such as Nestlé SA, pipeline utilities and Canadian banks, he said. “It takes a while to wrap your head around that.”

Indeed, it does. Trading in dull but dependable government bonds for inherently riskier stocks seems contrary to sound risk management. Yet, Mr. Ambachtsheer has a lot of company. The Caisse de dépôt et placement du Québec and GMO LLC, the Boston asset manager led by famed investor Jeremy Grantham, recently have said they are substantially reducing their holdings of bonds with long maturities.

“I’m pretty sure the odds of making money on bonds over a five-year horizon are zero,” added Leo de Bever, head of Alberta Investment Management Corp., the province’s public investment fund manager. “I agree being in high quality stocks is probably a better alternative to bonds. Five years ago I wouldn’t have said that.”

The shift in attitude among leading investors is an outcome of one of the most significant business stories of 2012 – record low interest rates. Not only did rates hit multidecade lows in Canada, the United States and elsewhere this year, many expect them to stay that way for a long time. Such a shift would reward borrowers at the expense of savers and pose an enormous challenge for pension funds, investors and anyone else attempting to finance a comfortable retirement.

“The one lesson I’ve learned is everyone will say: ‘This can’t last long,’” said Malcolm Hamilton, a long-time adviser to Canadian pension plans, who is retiring as a partner with Mercer LLC this month. But, just as rates were unusually high for roughly 20 years in the 1980s and 1990s, “it may be that rates are low for a long time.”

Four years after the global financial crisis, central banks continue to push down interest rates in the hopes of spurring economic growth. Many observers fear that tepid GDP growth of 2 per cent or less will be the new norm for developed countries, not the 3 per cent-plus that has been the standard for decades.

With declining population growth, rising resource costs, limited productivity gains from a declining manufacturing base and other factors, “you have this basically stuck economy in real terms,” Mr. Ambachtsheer said. “The canary in the coal mine is Japan [which has experienced weak growth for a generation]. This is what things look like down the road for the rest of us.”

While low rates have so far been unable to spark the global economy, Meanwhile, the collateral damage has been considerable. Bargain-basement borrowing rates have spurred Canadians to rack up record levels of debts and removed their incentive to save money.

Low rates have hit pension funds especially hard. As interest rates fall, the amount of money that funds have to put aside to meet their future obligations increases. Even solid investment returns in recent years haven’t been enough to offset the impact of low rates, which have mired many pension funds in deficits, said Jim Leech, president and chief executive of Ontario Teachers’ Pension Plan, consistently one of the country’s top performing pension funds.

The cost of funding a typical pension for a teacher in Ontario has risen to close to $1-million from about $600,000 in the mid 2000s, Mr. Leech said. “[Low interest rates are] penalizing all the savers in our society and rewarding the consumers. It’s putting a whole bunch of the burden on to people like pension plans who don’t have any choice. I’m not saying monetary policy should take an about-face – it’s just the reality of what’s happening.”

To make up for their deficits, pension funds have moved into what used to be called alternative assets, such as real estate and infrastructure, which take them into riskier areas of investing. Some, such as Teachers and the Healthcare of Ontario Pension Plan, have had success by employing a complex derivatives investment strategy. In other cases, governments have bought some time for plan sponsors, allowing them to use IOUs such as letters of credit instead of injecting cash into their pension funds to make up for deficits.

But these strategies will go only so far to help pension funds – and besides, prices for some alternative assets have already crept up to what some fear are unsustainable levels. “To be honest, there isn’t much to invest in, and as a result, pension funds are getting desperate,” Mr. de Bever said.

The dim outlook for investing returns has prompted most companies to move away from defined benefit pension plans, the traditional arrangement that gave retirees the security of knowing how much they will collect in pension benefits down the road. Defined contribution plans, which set out how much an employer will contribute to the pension pot but put the onus for investing the money on the employee, are the new standard.

The minority of working Canadians who still enjoy defined benefit plans will either have to pay more in contributions or see their benefits decline. Ontario teachers – who are engulfed in a labour conflict with the province – have already seen their mandated contributions climb to roughly 12 per cent of their salaries from the old level in the high single digits, or “about the maximum level people [and the government] can afford,” Mr. Leech said. Meanwhile, the fund has clawed back on indexing, so only half of pension payments are guaranteed to rise with inflation, while the other half depends on the fund’s performance.

“Plans aren’t in financial crisis, but these are very, very challenging times,” Mr. Leech said. “We need to address the issues now. The effect of making a small course correction today will be amplified over time.”

It’s a choice Canadians face with their own retirement nest eggs, Mr. Hamilton said. “Defined benefit plans are no different than RSPs. If you constructed your plan on the assumption you’ll earn 8 per cent a year, you have to look around and say: ‘That 8 per cent isn’t there any more.’ You’ll have to construct a plan that works at 4 per cent.”

That means putting away more, or preparing to live on less in retirement.“People don’t want to have to deal with that for obvious reasons, and you might get lucky,” he said. “But you’re taking risks. The adjustments you make later on might be more abrupt and painful than those you make if you get ahead of it now.”

As far as sectors, I'm still long US financials, technology and energy but my focus remains on coal, copper and steel ('CCS' sectors). It will be volatile but these sectors have tremendous upside. Here are some companies I track and trade in CCS sectors: Alpha Natural Resources (ANR), Arch Coal (ACI), Cliff Natural Resources (CLF), Peabody Energy (BTU), Freeport-McMoran (FCX), ArcelorMittal (MT), Nucor (NUE), Walter Energy (WLT), Teck Resources (TCK),  and US Steel (X). I'm also tracking some specialized metal and rare earth companies like Allegheny Technologies (ATI) and Molycorp (MCP).