Real Financial Change Ahead?

10/01/2008 9:45 am EST

Focus: MARKETS

Mark Skousen

Editor, Forecasts & Strategies, High-Income Alert

Mark Skousen, editor, Forecasts & Strategies, discusses the tough decisions ahead.

Fearing Japanese-style doldrums, the Federal Reserve under Alan Greenspan reduced the Fed Funds target rate to 1% in 2004, far below the natural rate, causing a dangerous increase in irresponsible lending patterns, over-leverage of capital investment, and speculative heat waves in real estate, subprime ARMs, corporate bonds, and other assets.

To artificially heat up their economies, central banks in developing countries (especially Russia, China, and India) deliberately inflated their money supply at unprecedented rates. The resulting inflationary boom in real estate and other assets created a structural imbalance in the US and the global economy.
 
Followers of Ludwig von Mises and Friedrich Hayek of the Austrian school of economics warned about the risks inherent in artificially stimulating the economy by cutting interest rates below the natural rate and inflating the money supply.

Both major presidential candidates, Barrack Obama and John McCain, are promising "change." Whoever is elected president is going to face a daunting task of reforming an out of control financial whirlwind.

The new financial model should be based upon principles of sound economics and a systematic policy of stable money. The price of gold should be a good barometer in providing monetary stability and genuine growth.

Some regulations need to be abandoned or changed, such as the "mark-to-market" accounting rules. Also, private equity companies should be allowed to buy substantial positions in banks (more than the current 25%) without being regulated as a bank. The greatest threat now is more controls, not unlike the passage of the draconian Sarbanes-Oxley law following the collapse of Enron and WorldCom in 2002.

Finally, the federal government should not be too anxious to come to the rescue of every major corporation or bank as government guarantees, including insurance on bank deposits and brokerage accounts, can be costly, encouraging irresponsible behavior in the future.

Last month, the Bush administration made the right decision in refusing to guarantee Lehman Brothers. In the 1990s, the giant investment banking firm Drexel Burnham Lambert was allowed to go under, and the economy survived and prospered. It's an important lesson.

It also would help if the new president would preserve the 15% tax break for dividends and long-term capital gains, and reduce the corporate income tax, following the trend in Europe and Asia. These measures would help strengthen the dollar and create jobs.

These are real changes. While waiting for them to be implemented, investors should ride out the storm by investing conservatively, being well-diversified both here and abroad, and holding a safe haven in cash and gold.

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