No Laffing Matter

In today's Wall Street Journal, noted economist Arthur Laffer published an editorial entitled "The Age of Prosperity Is Over". Mr. Laffer pulls no punches. He compares President Bush and the current Congress to Herbert Hoover and accuses Fed Chairman Bernanke of "bungling" monetary policy.

The following paragraphs, in my opinion, speak volumes:

"When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses."

"No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does any one of us enjoy watching banks go belly-up for making subprime loans without enough equity. But the taxpayers had nothing to do with either side of the mortgage transaction. If the house's value had appreciated, believe you me the overleveraged homeowner and the overly aggressive bank would never have shared their gain with taxpayers. Housing price declines and their consequences are signals to the market to stop building so many houses, pure and simple."

"But here's the rub. Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved."



As I have said in the (very recent) past, companies, investors and home owners who made poor decisions, must suffer the consequences (of some kind. Until banks are cleansed of bad assets, markets cleansed of weak companies and home prices are permitted to reset to prices which attract buyers, we will remain in a long and painful economic recession.

For political reasons, politicians in both parties are trying to avoid cutting the cancer out the economy out of fear that the operation will be too painful. In reality, not purging the economy of this rotting disease will prove fatal for capitalism in the U.S.

I am not convinced that this bank bailout will right the economy. It will result in larger banks swallowing relatively-healthy smaller institutions in an effort to pad deposits. Be concerned with large banks which cannot make a substantial acquisition and of smaller institutions which attract no buyers.

Many financial advisers have asked why break-evens on short-term TIPs are negative. The reason is the market is pricing in much deflation during the next two years. Whether or not this happens remains to be seen. However, keep in mind that no matter how cheap a TIP looks, if the rate of inflation declines significantly, one could lose money, even when receiving par at maturity is considered.

Investing in TIPs should be viewed similarly to investing in foreign currency bonds. If the inflation index falls, one can receive less than their investment at maturity. This is just like a currency decline on a foreign bond. I would be very cautious when investing in short-term TIPs. In spite of the fact that TIPs are government securities, investors are SPECULATING on the change in the rate of inflation.