My new book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption has started shipping: order now!

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

Government deficits around the world are at risk of spiraling out of control. Aside from the obvious choice, to reduce spending, policy makers should take a step back and look at what may be the most effective way to raise revenue. How about simplifying it into two very basic parameters: public trust and the rule of law.

The vast majority of people are willing to pay their fair share in taxes. But when faced with taxes and regulations deemed unreasonable, people will get creative – call it market forces at work. This may be as simple as postponing a sale to avoid capital gains tax; or it may give rise to a shadow economy.

Italy’s recent tax amnesty yielded over US$100 billion in repatriated funds in a sign of how deep the mistrust in government is. A shadow economy extends to regulations as well, though: take China, where it is no secret that it is one thing to create laws, but another to enforce them. The shadow economy in China keeps the country running, even if it deprives the country of tax revenue.

However, if people mistrust their government because of onerous taxes or regulations, yet enforcement is flawless, the result may be a totalitarian regime akin to the Soviet Union. Crime may have been low in the Soviet Union, but there were chronic shortages of goods and services. With the fall of the Soviet Union, the rule of law imploded and a shadow economy quickly filled the vacuum.

The best way to maximize tax revenue for governments may be to earn the trust of their citizens. What’s fair is, of course, in the eye of the beholder. Generally speaking, however, the simpler the tax code and the simpler the regulation, the higher the odds that people will have income to report and pay taxes. A bonus tax in the UK, for example, may backfire as institutions shift future banking business elsewhere.

When it comes to reducing systemic risk in the banking system, policy makers would be well served to work with market forces and implement reasonable regulation (e.g., move derivatives onto regulated exchanges), rather than try to regulate greed away. Ultimately, this may lead to a more stable financial system and higher tax revenue.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

First, let’s look at prices. Home prices have come down substantially in areas where subprime lending was most prevalent, but have held up better in more affluent areas. In Palo Alto, where I bought my house, prices are down, but not by much compared to the run-up in prior years. One reason is that the typical Palo Alto homebuyer had a greater financial buffer and may have been able to hold off selling their home if they don’t like current market prices. There is also less pressure in more affluent neighborhoods because of foreclosures; note, by the way, that the recent abatement in foreclosures on a national level is mostly a reflection of bottlenecks in processing foreclosures , the pipeline of homes in various stages of default has continued to grow steadily. The reality is that many higher end homes in Silicon Valley have been bought with “options money” , that is, the cashing in of previously awarded stock options. However, the number of potential homebuyers able to purchase with “options money” is presently very small. As a result, while home prices in higher end neighborhoods in Silicon Valley have held up longer, the downward pricing pressures may last longer. A similar analysis can be applied to other regions; further, as baby boomers retire, fewer McMansions will be needed, putting long-term pressure on high-end real estate. As a result, my assessment is high-end real estate is likely to lag in any housing recovery. In the same context, consider the trend to have bonuses vest over years with claw-back provisions (in what may be the beginning of a trend, Goldman Sachs just eliminated the cash element on bonuses for its top executives). While that may be healthy (although never underestimate the creativity of con artists amongst them to hide their dealings throughout the vesting period), that is bad news for New York and Connecticut luxury goods dealers and real estate; New York governor Paterson has realized that tax revenues have also evaporated, and is now urging banks to pay bonuses. But I digress.

A lot has been said about the affordability of homes; even with the price adjustments to date, a dual income family can barely afford a home. 50 years ago, a single breadwinner in the family with an average income was able to afford a house. Because of various government subsidies , whether through subsidized loans (think Fannie Mae, amongst others) or artificially low interest rates – home prices have been pushed to artificially high prices. Many of these policies are put in place with the best of intentions, but all efforts to make homes more “affordable” have actually done the opposite for future buyers. If you want affordable home prices, don’t subsidize buyers.

Fannie Mae was first established in 1938 to promote home ownership to low-income families; the scheme it promotes lasted for 70 years before it imploded and the government had to take Fannie Mae into conservatorship. Few have noticed that Fannie Mae, now that it is a quasi-government branch, continues to have access to the Federal Reserve’s (Fed’s) discount window. That’s akin to the Treasury borrowing from the Fed, rather than issuing bonds to finance its spending.

The policies are designed to push home prices higher. That’s because when a great number of home owners are under water in their mortgages, they may stop spending, pulling the U.S. consumer “machine” to a grinding halt. And that’s policy makers’ worst nightmare, as it jeopardizes their re-election odds. What is different about the current bust is that the Federal Reserve has teamed up with politicians to push home prices higher at just about any cost: ultra-low interest rates and aggressive intervention in the mortgage market through purchases of mortgage-backed securities (MBS) stems against natural market forces playing out.

Simplistically speaking, homeowners who are underwater in their mortgages have a couple of choices:
‚ Homeowners can work harder to earn more and pay off excess debt. Though, while that may happen on select cases, it is unlikely real wages will soar anytime soon.
‚ Homeowners can downsize. That’s the healthiest choice as someone who downsizes will once again be able to save and one day, possibly, be able to afford that larger home. However, a homeowner who is subsidized to stay in a home they cannot afford may never be able to save, as all their hard-earned money is continually poured into the home; that person won’t have the savings, either, to fix the roof or take care of other ongoing maintenance issues associated with home ownership.
However, downsizing implies foreclosures, bankruptcies, bank write-offs, not the type of headlines that get politicians re-elected.
‚ Receive a government bailout through inflation. If real home prices won’t move up, the Fed can try to engineer a higher price level by flooding the market with freshly printed dollars. Just a few days ago, Fed Chair Ben Bernanke once again emphasized how going off the gold standard during the Great Depression allowed the Fed to allow the price level to rise. He cherishes that “flexibility”. Of course it’s difficult to engineer just where that inflation will fall, but if you create enough inflation, odds are that home prices may also rise.

Potential homebuyers will find reasons why prices should be lower; once they switch to being homeowners, many find thousands of reasons to justify why their home’s value should be higher! However, when faced with such opposing forces, the decision to buy a home should not be an assessment of price, but one of risk. Can you afford not just the monthly mortgage payments, but can you afford it should the price of your home come down? Market forces warrant lower home prices to bring them in line with incomes; as such, that risk must be taken into account, even if we trust helicopter Ben to create house price inflation.

When discussing Sustainable Investing choices in my book SustainableWealth, I list renting rather than buying as a sacrifice. Beyond the reasons given here, Patrick Killelea in his blog eloquently lists many reasons why “it’s still a terrible time to buy“. Yet, when you rent, you have few rights as a tenant and you may be asked to leave your property when your lease is up; often, leases are only a year. In my personal situation – we have four children – it’s not that easy to find a rental home that satisfactorily accommodates us, and every move is a hassle. Is it worth the many thousands one can save a year when renting? Looking at the pocket book, yes, but it is more of a sacrifice than, say, saving money with a low budget vacation instead of spending vast amounts for a stay at a luxury resort. My wife did also make the point that she would like to own a home before the kids are in college (our oldest is twelve; our youngest two).

Some have said that home prices have gone up since the beginning of the decade and we should have bought a house earlier. But these arguments miss the point about risk , it would simply not have been prudent for us, just as it wasn’t prudent for millions of others. In our particular situation, we were investing a lot into our business throughout the decade; now that the business is running well, we can afford the risks associated with home ownership, including the risk that the price may fall.

But I was motivated by more than the ability to bear the risk. If you have followed my writings over the years and read my book, you know that I’m skeptical of the economic recovery. Specifically, I cannot see a sustainable recovery even if all the fiscal and monetary stimuli get the economy to grow in the short-term: if and when the Fed starts to tighten (raise interest rates or mop up all the excess liquidity), I’m afraid the economy may crash right back down, precisely because we did not allow homeowners to downsize, i.e. the de-leveraging to play its course. With too much leverage still in the system, the Fed simply may not be able to fight inflation without destroying all the “progress” it has achieved in reflating the economy. Because of this conundrum the Fed may find itself in, the Fed is, in my assessment, going to firmly err on the side of inflation: something that may push home prices higher.

One key reason why inflation may result from all the policies employed is that the money isn’t flowing to the intended parts of the economy. Sure, those with pristine credit get financing at ridiculously low levels right now. But what about Dubai, Greece, Ireland or American consumers with scars on their credit history? For most of these groups, if credit is available at all, it is at a cost they can’t afford. Because the money doesn’t flow to the places policy makers would like it to flow, they print ever more money and institute ever more aggressive stimulus programs.

With that in mind, future access to credit is a real risk. Governments around the world will need to raise unprecedented amounts of money to finance their deficits. Will there be credit available at reasonable cost to you and me? Banks are racing to pay back government loans, not because they are suddenly so healthy, but because of the burdens that come with having the government question your business and compensation decisions. If you look at how the Treasury markets are behaving, you would think another crisis is just around the corner: one month Treasury bills recently auctioned off with a zero yield (negative after commission) , that’s a few days ago (December 8th), not a year ago (click here for auction result) , and that’s not a sign of a recovery. Sure one can argue that this means the governments will simply continue to print money in an ill-guided attempt to unfreeze the markets, but my concern is that unless you are in bed with the government, you may not have access to credit. And if you are a weaker government, you may also have an increasingly hard time financing your debt. Incidentally, the latest U.S. 30-year auction drew disappointing demand.

I am a big believer in scenario planning; if a scenario has a sufficient enough probability, then I take it into account in my investment allocation. The big advantage of scenario planning versus merely forecasting the most likely outcome is that one takes boundary conditions / black swans / flat tails / call them what you want, into account. Is a crash in this or that market likely? Possibly no, but is it a risk you can afford to ignore? It’s important to move beyond analyzing, to implementation, otherwise the exercise can be worthless, or worse, you may incur significant downside costs.

Through a home purchase, I can extend the average maturity of my personal debt substantially through a conventional 30-year mortgage (maturity means the date on which a debt security is due and payable). Businesses and governments manage the maturity of their debt, and so can you. The U.S. government has the equivalent of an adjustable rate mortgage and in recent weeks has shown signs of shifting from shorter-term debt to longer-term debt. As the U.S. government refinances into longer-term debt, the cost of long-term financing for everyone may go up. This doesn’t mean that I encourage folks to exchange their unsecured credit card debt with a mortgage where the creditor may seize your home, but if you access the credit markets through some other means , a car loan, a business loan or other investment property – accessing the mortgage market may be a way to lock in low long-term rates.

Of course there is the valid concern home prices may fall as long-term rates rise. I can’t give specific investment advice in this analysis, but if you have debt, you may want to consider refinancing it to take advantage of current long-term rates.

In my situation, I bought a house to take the scenario into account that inflation may eventually push home prices higher. If the government actions cause inflation, but they can’t stop it in time , and remember: nothing in this crisis has really worked out as policy makers intended – real estate may once again be treated like hard assets and investors may want to hold on to anything but U.S. dollar cash. While real estate is a hard asset, it has not been acting like other hard assets because of the leverage included in most real estate ownership; in a period of credit contraction, the weight of the credit contraction may be overwhelming. But pushed hard enough, real estate will at some point also join the rise of other hard assets. If we did not have Bernanke as the head of the Fed, I would assign this a low probability; but with him at the helm, I very much doubt he will deviate from his determination to move home prices firmly higher to bail out all those with too much debt.

Conversely, there is a risk to holders of U.S. dollar cash: cash is at risk of losing its store of value and investors may want to take a diversified approach to something as mundane as cash. As a result, I took buying a home a step further and hedged my down payment against a weakening of the dollar. This is not something I would necessarily recommend to others as such hedging carries its own set of risks and may not be appropriate for many; I engaged in this risk not because of some “profit potential” when measured in U.S. dollar, but because a) I see downside risks to the U.S. dollar and b) I can afford the risks associated with the hedging.

If my concern is right and inflation will be a serious problem, at some point investors may grab any hard assets, not just precious metals and commodities, but also housing, amongst others; in that case, it may be a profitable investment. As such, I see it as a diversification; however, for those who consider the same, do remember that housing is typically a highly leveraged investment and being wrong can be rather costly. In summary, I bought a house because I can afford to be wrong on the risk that inflation may get serious enough to push home prices higher.

In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

Axel is asked what one ought to do to achieve SustainableWealth; click to listen to the interview.

Axel Merk discusses his new book, Sustainable Wealth

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

The Fed will look for “low rates of resource utilization, subdued inflation trends and stable inflation expectations” to keep interest rates low. Resource utilization is likely to remain low, so that’s not a factor. Secondly, inflation trends will quite likely inch upwards as year-on-year comparisons will be tougher. That leaves the last point: inflation expectations. The Fed has to contain inflation expectations, but the Fed ultimately controls inflation expectations. The best way to control inflation expectations is through sound monetary policy. What the Fed is doing instead is to see whether it can get away with ultra-loose monetary policy without causing inflationary expectations to be dislodged. Differently said, the Fed will tighten only if the credibility in the Fed erodes as that would be the reason for inflationary expectations to rise. In the best of cases, this is a very risky strategy; it may be a precursor for a rather volatile, if not inflationary monetary environment.

The ECB has a different approach. To start out with, the ECB is upfront that inflation will return to positive territory as expected. This may partially be a reflection of managing inflationary expectations upward, but more to the point, it’s a frank assessment of reality. While the Fed continues to expand its balance sheet, the ECB, when asked about the unlimited liquidity provisions, made it clear that it does not disagree with the market’s assessment that these provisions will be phased out. That’s an actual reduction in liquidity, whereas at the Fed, we talk about reducing the rate at which money will be printed.

With regard to exit strategy, the ECB has taken its mandate a step further and urges eurozone governments to lay out a “clear and credible exist strategy” to the fiscal spending initiatives. We have similar calls in the U.S., but using the press conference for such calls may be more effective than the Fed’s approach to mention such wishes in speeches on occasion.

Finally, the ECB is using rather strong language to encourage banks to seek more capital. European banks may have more catching up to do, but the point here is again that the ECB addresses the challenges head on, whereas the Fed seems mostly interested in buying time.

It’s not surprising to us that the euro has been outperforming the U.S. dollar. But then again, it seems to us that the Fed wants to have a weaker dollar – after all, why else would they buy government bonds and mortgage-backed securities, encouraging rational investors to look overseas for securities that are not intentionally overpriced.

In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

Listen to the interview:
(source: KNX 1070 Radio)

My new book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption has started shipping: order now!

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

The U.S. is the most prosperous nation because it has embraced risk taking. Silicon Valley has created some of the greatest innovation because it has been a magnet for entrepreneurs. When we evaluate our love-hate relationship with investment banks, let’s not forget that as one of their key roles, they facilitate the aggregation and deployment of risk takers’ capital. When policy makers interfere with crucial elements of the American growth engine, we all deserve a broad debate on the subject.

The reason why most of us invest is because we are concerned about the purchasing power of our savings. Sure it’s great to achieve returns in excess of what it takes to preserve purchasing power, but inflation and taxes are bound to destroy savings over time if we don’t take risks in an effort to achieve higher returns.

My new book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption has started shipping: order now!

There are very few families in the world that have managed to retain great wealth over generations. There are two main reasons for this: those who rely on their savings to support their lifestyle are bound to lose them over time; and those who do take risks may or may not make the right decisions. But those who do not take risks are certain to lose. Those who do take risks have a chance of staying ahead of the game. A society thrives when creative destruction is endorsed: rewarding successful risk takers makes a society prosper as a whole, as successful companies and industries will grow, whereas weaker ones are allowed to fail.

The U.S. is not the only country that thrives by endorsing creative destruction. China has allowed the low-end toy industry to fail, accelerating a shift towards goods and services that cater to, as we call it, the higher end of the value chain. The country is positioning itself where it can compete. China knows it can’t keep its currency peg forever; it knows that allowing the currency to rise is the most effective way to tame domestic inflationary pressures.

And the U.S.? We try to destroy the financial services sector on top of manufacturing. Jimmy Rogers, the former hedge fund manager known for his love for commodities in particular (he says Wall Street traders should learn how to drive a tractor to cater to the boom in soft commodities), has just been appointed to the board of a commodities exchange in China; China is ready if we want to give up the quasi-monopoly the U.S. has enjoyed in trading commodities. Singapore, too, is waiting with its doors wide open: Singapore may be the winner of those alienated by policies coming out of New York and London. In the U.S., in contrast, policies all decade long have fostered an acceleration of outsourcing in an ill-guided pursuit of consumption at any cost. I would like to say that it ended in the credit bust, but unfortunately, there’s no end in sight to the policies that got us into trouble in the first place.

Don’t take me wrong: a lot of bad has come from Wall Street and the anger in the public is real and justified. But we need to keep a cool head and not throw out the baby with the bathwater when meddling with the core values of what made the U.S. successful over time. Risk itself is not bad. What is bad is that we say we need to set up bureaucracies to manage systemically critical institutions without even defining what “systemically critical” actually means. What is bad is to think a super-regulator will somehow prevent the next crisis rather than merely increasing the barrier to entry further. What is bad is to reward bad decisions and reward good ones in the banking sector by draining money from taxpayers to support failed banks. What is bad is to put in place wage controls without a public debate on whether that’s indeed a prudent course of action; traditionally, wage controls have never worked , the most recent time, when Congress decided to no longer allow tax deductibility of salaries in excess of $1 million in the ‚ 90s, it gave rise to an explosion in stock options being awarded and the focus shift to micro-manage quarterly earnings, inadvertently contributing to the present mess we find ourselves in.

Greed is part of human nature. The challenge for policy makers is to put the right incentives in place to increase the odds that , for society as a whole , more good, than bad, results from greed. I emphasize incentives because incentives typically work better than regulation. The Chinese have long tried to manage economic growth with regulation , giving mandates to banks about how many loans may be issued; the Chinese may soon come to the realization that it is far more efficient to allow market forces to dictate growth, and that using levers such as interest rates and a freely floating exchange rate will be more effective.

Regulation breeds corruption, loopholes, lobbying, etc., and, by implication, inefficiencies. The more general the levers of policy makers, the more effective they are. For a central bank to engage in private sector asset purchases is extremely inefficient. The Fed has been substituting rather than encouraging private sector activity. The Fed’s actions to buy mortgage-backed securities have cemented the government’s ownership of the mortgage market. A free society with a government owned mortgage market? Please don’t tell Adam Smith, who would turn in his grave. The government hasn’t stopped there, but there’s no need to expand for the purpose of this argument.

Risk taking is good. What is not good is to have gains privatized, yet losses socialized. It is good that someone is willing to risk their savings to put their money where their mouth is. It’s not good that someone puts someone else’s money where his or her mouth is, then collects the gain, but is not responsible for the losses. How do you fix this? With salary caps? With a systemic risk regulator? In our humble opinion, no, that’s he wrong approach, as it paralyzes financial institutions. We may hate them now, but without them, we would be worse off. We need to turn our anger into constructive suggestions, not destroy a backbone of economic growth.

Every major bust in history was the result of excessive credit expansion. Some have argued that one needs to actively restrict credit expansion. The argument against this debate , a debate worth having , is that it would put regulators in the game of managing asset prices. As we are in a world where central banks set interest rates and control money supply, I do think they should be vigilant that excessive money supply does not push up all asset classes without a comparable pickup in real economic activity , the clearest bubble indicator, in our view.

If risk is good, what is bad? What is bad is that someone’s risk appetite can bring down someone else. And that this threat provides a guarantee that the risk the speculator takes is asymmetrical: Heads, I win; Tails, you lose. Well, fix that. How about: Heads, I win; Tails, I lose. It’s really that simple. I don’t have a problem with anyone speculating, as long as his or her risk does not impose on my wellbeing. Indeed, speculators are a crucial part to our economic system; without speculators, we would have frequent shortages in commodities: producers, be they in oil or agriculture, would not be able to hedge their production and thus produce less as they face uncertain revenue, but certain production costs. In many areas, speculators are crucial to the real economy.

There has been much debate about certain transactions that, in some people’s eyes, serve no common good. Should parties A and B be allowed to engage in a contract that party C goes out of business, even if parties A and B have no stake in C’s success or failure otherwise? But let me turn the question around: what is our business to regulate such transactions? Regulators start meddling with such transactions if such decisions become “systemically important” , presumably this means when such transactions can rock the financial system as a whole because of the leverage typically inherent to them.

There’s a cure for this: force anyone engaging in a leveraged transaction to post collateral and to mark such transactions to market every single day. On regulated exchanges, this happens all the time. Take as an example, when oil traded at $100 a barrel in 2008, a speculator placed a leveraged bet it would fall down to $50. As oil soared to over $140 a barrel, the speculator would have been asked by the exchange to post additional collateral along the way. If the speculator is unable post the collateral, the exchange will close out the position, even if the speculator may ultimately be right (as oil did make it down to $50 later in the year). The point of this mechanism is that the failure of any one player does not jeopardize the system. Further, because the rules were clear from the outset, the speculator better think twice before putting up so much leverage.

Banks are fighting tooth and nail about applying the same rules to credit derivatives and other transactions. They argue it is not necessary because their positions will ultimately be profitable, that the crisis valued their securities inappropriately. Of course they would say this: anyone holding an asset is inherently biased to the upside. In any event, that’s besides the point. It’s the risk to the system that must be averted. And the way it is averted is by providing a market-based mechanism to wind down leverage before it causes a problem. A regulated exchange is ideal in such situations, but similar mechanisms can be implemented when a regulated exchange is not practical.

One can require financial institutions to have a greater capital cushion. Trouble here is that most proposals are not working with market forces and, as a result, will be diluted through lobbying once the memory of the latest crisis fades. It’s beyond the scope of this newsletter to go into details of possible avenues here, but there are market based approached to make banks more resilient, e.g. by making them more dependent on long-term debt and less on the overnight funding markets , the lack of access to capital in the overnight funding markets brought both Bear Stearns and Lehman to their knees.

One can also work with tax incentives , for example, apply them to leverage in general, such as eliminating the possibility for corporations to deduct interest expenses (one needs to offset this with a reduction or elimination in corporate income tax).

Aside from risk, the place regulators should tighten the reigns in boardrooms. Executives foremost report to the board of directors, and that’s where the oversight must be rooted. Boards must have in have oversight of policies that reflect their fiduciary duty when it comes to how much risk executives may take. Such policies must be clearly communicated to stakeholders. The point is not to unnecessarily restrict risk taking, but to inform everyone that deals with the firm what their risk profile is. It’s then up to others to choose to conduct business with or invest with the firm.

Important is that the public has a healthy debate on what is to be done; we are rather concerned that policy makers impose restrictions in the heat of the moment that will cause more harm than good. The peak of the crisis has abated , in some ways, the perceived stabilization has reduced the sense of urgency. But, ultimately, the reforms being negotiated will not only affect your ability to achieve and sustain wealth, but that of the U.S. as a whole. Tell your elected officials they have a job to get done.

Your savings are at risk if you don’t engage in this fight. This fight is rather unpopular right now as we see how executives of companies on government support are fast rebuilding the system that proved unsustainable the first time around; while receiving top dollars in compensation. But that’s precisely because too few are involved in the real issues that foster bad decision making. As the financial crisis has shown, there is a real impact on your wealth when bad incentives lead to a financial meltdown; but there is also a real impact on your wealth when America’s growth engine gets crippled. If we don’t initiate a broader debate, we may get the worst of both worlds.

In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel

Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.