Finance Digest for Week of December 6, 2004

BUBBLE DAY

December 1, 2004 could well go down in history as yet another important milestone for America’s bubble-prone economy. No, I am not referring to the 162-point surge in the Dow Jones Industrial average that occurred on that day. Instead, my focus is on two widely overlooked statistical reports put out by U.S. government statisticians -- the latest tallies on home prices and personal income. Collectively, these reports paint a worrisome picture of an asset economy that has now truly gone to excess. As was the case in early 2000 when Nasdaq was lurching toward 5000, denial is deep over the potential downside of yet another post-bubble shakeout. That is what worries me the most.

The just-released report on U.S. house prices for the third quarter of 2004 was a shocker -- an 18.5% annualized surge from the second quarter and a 13.0% increase from year-earlier levels, according to the tabulation of the Office of Federal Housing Enterprise Oversight (OFHEO). That represents a stunning acceleration from the 9.8% year-over-year increase of the second quarter and pushes nationwide house price appreciation to a 25-year high. It is an even larger rise in real, or inflation-adjusted, terms. The surge over the past year is now running nearly five times the 2.7% annualized increase of the non-housing components of the CPI.

According to the latest OFHEO tally, house-price inflation over the past year has run at double-digit rates in 25 out of 50 states plus the District of Columbia. In six states -- Nevada, Hawaii, California, Rhode Island, Maryland, and Florida --- home prices increased by 20%, or more, over the past year. Housing is an asset class that is just as prone to excess as are stocks, bonds, currencies, or commodities. If it feels like a bubble, acts like a bubble, and looks like a bubble, it probably is one.

Meanwhile, also on December 1, the Bureau of Economic Analysis released its regular monthly update on personal income. Stronger-than expected gains in both income (+0.6%) and consumption (+0.7%) that were perceived as signs of ongoing resilience of the indefatigable American consumer. I found the report appalling. What caught my eye was a further reduction in the already sharply depressed personal saving rate -- down to 0.2% in October from 0.3% in September. The September numbers were widely thought to have been distorted by temporary hurricane-related losses to personal income. Most expected personal saving would rebound from this artificially-depressed reading. There was no such bounce in October. The consumer saving rate has now basically gone to zero.

Nor is the profligate American consumer the only source of the US saving shortfall. A day earlier the government also released its third-quarter report on national saving. America’s net national saving rate fell to just 1.2% in the third quarter of 2004 -- down 0.9 percentage point from the already depressed second quarter reading and nearly back to the record low of 0.4% recorded in the first quarter of 2003. The rest of the story is all too familiar: Lacking in domestic saving, the US must then import surplus saving from abroad in order to grow -- and to run massive current-account and trade deficits to attract that capital.

The key to this puzzle is to recognize that the housing bubble and the saving shortfall go hand in hand. The “asset economy” is a conceptual framework that brings these two seemingly disparate trends together. As seen through this lens, “rational” consumers take their income-based saving rates to zero only if asset-based saving provides an offset. As long as asset markets keep rising, that makes perfect sense. However, when asset markets correct, this decision can backfire. That was the case when the equity bubble popped in 2000 and could well be the case following the bursting of today’s rapidly expanding US housing bubble. That is why the latest trends in house prices and saving are so disturbing. In my view, they underscore the distinct possibility that America’s asset economy is in the midst of yet another bubble-induced blow-off.

Not surprisingly, these circumstances put the Fed in an especially difficult position. That is because the US monetary authority used up most of its basis points in order to contain the damage from the equity bubble. Unfortunately, in doing so, the Fed kept interest rates at extraordinarily low levels for far too long -- setting the stage for the housing bubble that was to follow. The risk all along is that the Fed had only a one-bubble damage containment strategy -- leaving itself with little ammunition to deploy in the event of another serious problem. The last thing America’s housing bubble needs is an interest rate shock. That is a classic recipe for a sharp decline in U.S. housing prices -- an outcome that might spell curtains for an overly-indebted American consumer.

Ironically, there have been a number of positive developments that have fallen into place recently -- an orderly depreciation in the dollar, sharply declining oil prices, and grounds for encouragement on the prospects for a soft landing in China. But America’s imbalances have taken a turn for the worse, and the housing bubble could well be the final straw. Income-short consumers are playing this bubble for all it is worth. Unfortunately, these trends have led to the virtual elimination of US saving -- triggering a classic current-account-adjustment dynamic with attendant risks to the dollar and interest rates. That makes the downside of this bubble potentially far worse than that of the equity bubble.

While it has only been four and a half years since the bursting of the equity bubble, memories have already dimmed of that extraordinary speculative excess. Yet in retrospect, that may have only been the warm-up for the main event. Bubbles have a way of feeding on each other -- ultimately compounding the problem and leading to an even more treacherous shakeout. That is certainly the lesson from Japan and could well be the case in the U.S.. America’s housing bubble is now in the danger zone. So is its saving rate, current account deficit, and overhang of consumer indebtedness. It has been a U.S.-centric world for so long, that everyone takes it for granted. Yet global rebalancing poses challenges for all major countries in the world. Saving-short America will not be spared -- especially if it must now come to grips with the biggest asset bubble of them all.

Anatomy of a Bubble

As a homeowner in one of the nation’s hottest housing markets, your editor would prefer that there not be a housing bubble. He would prefer, instead, that housing be in a healthy bull market, destined to continue until his youngest child enters college (at which point your editor would sell his home for several million dollars and move to Thailand). But since he cannot quite persuade himself to trust in that soothing notion, he has devised a theory. It goes like this: the housing market is in a bubble of sorts, but one that accelerating inflation will gently deflate. In other words, most of us homeowners will barely notice the demise of the bubble because the NOMINAL value of our houses will not drop. Indeed, they might even continue rising. At the same time however, the REAL value of U.S. housing will slide in step with the dollar’s depreciating value.

Your editor did not dream up his theory without any supporting evidence. Rather, he bases it upon the experience of the 1970s. During the decade of the 1970s, U.S. home prices increased each and every year...in nominal terms. But after subtracting the effects of inflation during that tumultuous decade, U.S. housing values actually fell. Furthermore, the current home-price trend does not exactly scream, “Bubble!” On AVERAGE, American home prices display very few bubble-like traits, pockets of speculation notwithstanding.

We like our housing non-bubble theory, even though we are aware of its flaws. Anecdotal evidence -- cocktail party chatter, etc. -- persuades us that the U.S. housing market has reached a “bubble-like” phase in its bull market life cycle. But we suspect this phase will pass silently into the night, as the “magic” of inflation deflates the bubble under the guise of nominal price appreciation.

California, U.S. in a housing “bubble”, UCLA forecast says.

Economists at UCLA have invoked the B-word again. In an outlook to be formally released today, forecasters say California and the nation are beset by a housing “bubble” that will depress construction next year, slowing the nation’s economic recovery. Yet the fallout from the bubble in California will not be devastating, according to the UCLA Anderson Forecast. Indeed, the Golden State’s economy will expand at a faster clip than the nation’s in 2005, thanks in part to a recovering Bay Area, the widely watched forecast says. All in all, next year is shaping up as “solid but not spectacular” for California, said Christopher Thornberg, a UCLA Anderson Forecast senior economist and author of its state outlook.

Although UCLA economists have raised the specter of a housing bubble in previous reports, they are now identifying it as the biggest risk to the U.S. economy. “The housing sector’s high and unusual contribution” to economic growth “is not going to continue in 2005,” said Edward Leamer, director of the forecasting group and author of its national outlook. The less-than-upbeat analysis is sure to raise plenty of eyebrows because the UCLA group was among the first to foresee the 2001 recession as well as slower growth earlier this year. For all that, though, many experts inside and outside the housing industry reject the notion that there is a bubble waiting to pop. They say real estate prices today are rationally propelled by low mortgage rates and high demand, while construction is justified by population growth. In California, they note, demand continues to be strong, and building in many areas has been constrained by land limitations and regulatory hurdles.

For their part, UCLA economists contend that inflation-adjusted mortgage rates are on par with those of the 1970s and early 1980s, and above those of the 1960s -- all periods when prices did not rise as fast as they have today. What is more, they contend, current population growth is being driven by lower-income immigrants who cannot afford homes at current prices. UCLA economists pointed out that inflation-adjusted home prices have risen by more than 5% annually over the last five years, five times the usual rate. Prices nationwide are now 25% above their historical long-term average, they said.

In the eyes of the UCLA analysts, the main culprit for California’s housing bubble is excessive price increases rather than overbuilding. “People here have been buying homes as if prices are going to go up 10% every year” forever, Thornberg said. But when prices finally level off or even decline, he suggested, consumers will curb spending, and that could slow the state’s economy.

U.S. housing data are in touch with unreality.

It might come as a big surprise to anyone who bought a house in 2004 that prices were up just 2.7% from the year before. In fact, you might be downright stunned by that number especially since Fannie Mae -- the largest mortgage lender in the country -- recently reported that home prices were nearly 13% higher in that same period. This is not, as the mathematicians say, just a rounding error. These two numbers are so different and contradictory, in fact, that you might think either Fannie Mae or the Labor Department -- which produced the 2.7% figure — made a big mistake.

So did they? Oh, no! The difference -- in a splitting of semantic hairs that would make even Bill Clinton proud -- is all in how you define the phrase “price increase”. This is the next in my series of columns on government statistics and I would like to welcome you to the wacky world of the CPI.

The CPI is supposed to tell Americans how much more things are costing from month to month, and year to year. But thanks to government economic theorists -- who apparently do not get out very much -- you will not see much reality sneaking into this index. You should understand from the get-go that everyone has an agenda -- politicians and Fannie Mae both.

OF COURSE INVESTORS CAN BEAT THE MARKET

Speculating in the stock market is a very popular activity. Millions of people do it regularly, and hundreds of millions of people around the world hire fund managers to let others trade for them. Yet, according to some economists, these people are just wasting their time. Sure, some of them might be lucky and earn a lot. But just as many will lose because of their trading activity. In the long run, only people who have as much luck as the Disney character Gladstone Gander will be able to profit in the stock market, they say. Ordinary people like Donald Duck and Daisy Duck, but also astute businessmen like Scrooge McDuck and his arch-rivals John D. Rockerduck and Flintheart Glomgold, are at best likely to earn the average return of the market.

In fact given that active trading is likely to be associated with transaction costs during the many trades, active trading is in fact likely to push people to below-average returns. And the loss for the average trader is of course compounded by the profits made by the Gladstone Ganders of the real world. Stock market trading is according to this theory nothing but a form of gambling. This theory is known as Random Walk Theory or the Efficient Market Hypothesis (EMH) with its foremost advocates being the economists Eugene Fama and Louis Bachelier. Instead of active trading, they recommend that everyone put their money in low-fee funds which monitor the stock market averages, so-called index funds. Since index funds do very little trading they are likely to have low transaction costs and can thus hold fees down which gives savers the highest return since they cannot beat the indexes (and accordingly the index funds) anyway.

The basic idea behind EMH is that because there are so many investors out there hunting for good investment opportunities there can be neither undervalued stocks nor overvalued stocks because if there were, investors would instantly rush to buy the undervalued stocks and sell the overvalued stocks until no under- or overvaluation existed any more. Of course, there is a lot of truth to this. Investors will certainly try to act in a entreprenurial fashion and bid up any stocks they see as undervalued and sell any stocks they see as overvalued.

EMH has a great paradox. In order for their scenario to occur then people will have to believe there are profit opportunities, but what EMH in effect says is that there are no profit opportunities! But if people believed there were no profit opportunities then there would be no one who would act to correct the discrepancy between fundamental value and current price. So a necessary condition for EMH to be true is that investors believe it is not true. The more people believe in it, the less true it will be.

From this comes yet another paradox. For EMH to be true we would have to assume that investors are always extremely rational and well-informed. Otherwise they could not immediately find any discrepancies between stock prices and true value. But if they are engaged in such an allegedly futile activity as trying to gain from speculation then they could hardly be considered rational. The most fundamental error of EMH is that it uses the results of the entrepreneurial process (the elimination of discrepancies between fundamental value and current price) to deny the existence of the reason (the opportunity to make profits) for the existence of that process.

The EMH advocates are right that in general speculation will move prices to the fundamental value. And they are also right when they say that most people will be unable to out-perform the market since after all “most investors” are the market. They are also right that because of this it would be just as well for them to put their money in an index fund (assuming the stock market is not generally overvalued). But they are clearly wrong in saying that it is impossible for astute investors to gain money from speculation other than through sheer luck. While most fund managers will not be able to beat the indexes, some smaller managers with superior abilities will be able to do that.

DEBT, GROWTH, AND DIMINISHING RETURNS

Over the years I have had to unlearn most of what I was taught in Economics 101, and I suspect that today’s students continue to get hatfuls of the same rubbish. Apart from the little chart that showed how the price of widgets is a function of the supply/demand curve, the only other useful idea I took away was the law of diminishing returns. Perhaps you remember it too. The classic illustration is fertilizer and crop yields -- picture a graph with a simple domed curve inside a vertical and a horizontal axis. Use “fertilizer” for the horizontal axis and “crop yield” for the vertical axis and you have the basic idea. Each additional pound of fertilizer results in steadily diminishing additions to crop yields. Too much fertilizer, and you eventually get lower output than would be the case with less fertilizer.

Now let us discuss debt and economic growth, and you probably know where I am headed: As with fertilizer and crop yields debt can “yield” economic growth. And yes, there comes a point where too much debt will produce diminishing returns. The question is, “When” is debt at the optimum point for economic growth? Is such a thing even measurable? It is measurable, and that is the good news. The bad news is, the returns from each $1 of new debt in the U.S. economy have been diminishing since 1967.

EAT IT AND ... WEEP

Introducing the newest menu item from the popular fast-food chain Hardee’s: The Monster Thickburger. This 2/3-pound double Angus beef patty including four strips of bacon, three slices of cheese and mayonnaise all between a buttered sesame seed bun makes the Big Mac look like rabbit food. A day after the Monster’s debut, late-night talk-show host Jay Leno quipped, “The megaburger actually comes in a little cardboard box shaped like a coffin.” No matter who you are, you have to admit that a burger whose caloric intake would take 22 miles of brisk walking to burn off is, as a November 30 FOX NEWS piece so aptly put it, a “monument to decadence”.

Now, here is some food for thought you will not find in the mainstream press: The Monster Thickburger is also a “monument” to a recognizable Elliott wave pattern in stocks. At this point, investors are thoroughly convinced that the bull market is back to stay as stocks continue to retrace the bulk of the previous advance. Here is the beef on how it plays out: Optimism and confidence exceeds that seen during the preceding wave up, leading to feelings of invincibility, exorbitance, decadence, and a renewed appetite for risk into speculative investments.

Speaking of “appetite” for risk, “since the introduction of the Thickburger family in April 2003, Hardee’s sales have risen steadily.” (FOX NEWS Nov. 30). In the words of one Monster Thickburger fan, “calories schmalories”. The “world’s deadliest food” is so far making a killing, and for us, that means the underlying trend in stocks could not be clearer.

GLOBAL REBALANCING AT WORK

The world economy is finally getting on with the heavy lifting of global rebalancing -- albeit grudgingly and not without a new set of tensions. Currency realignments are leading the way, triggering a long overdue shift in a lopsided world’s relative price structure. But a weaker dollar cannot do it alone. Adjustments in real interest rates, a narrowing of saving and consumption disparities, and the imperatives of fiscal discipline are all ahead if global rebalancing is to succeed. These are the major issues we ponder as we go through the annual ritual of extending our forecasting horizon.

Even I have to concede that a number of positives have fallen into place recently. I am on record of assigning a 40% probability to a global recession scenario in 2005. However, given recent favorable shifts in oil, the dollar, and China, I now believe that it is appropriate to reduce this risk to 25%. While it seems reasonable to reduce near-term risks, I am still not willing to go below the 25% threshold on the recession alternative. Moreover, I would stress that a 25% recession probability is more than double the 10% odds that I would normally assign to such an outcome at this point in the global business cycle.

While I am less concerned about near-term risks, I would hardly characterize that as optimism. In my view, downside risks still outweigh those on the upside by a factor of about two to one. All the wildcards in the equation are symptomatic of what I have called the global blame game -- the tendency of rebalancing to pit nations and regions against each other in a fashion that could heighten trade frictions and protectionist risks. By pointing the finger at the proverbial “other guy”, the global village will have a hard time accepting the shared responsibility for the rebalancing of an unbalanced world.

The most serious downside risk to our new baseline forecast remains concentrated in the U.S., which, in my view, remains on a dangerous and reckless course -- consuming out of asset-based saving at a point in its demographic life-cycle when it should be building up income-based saving to fund the looming retirement of 77 million baby-boomers. Record lows in the personal saving rate and the current account deficit, to say nothing of record highs in household sector indebtedness, all speak of a U.S. that is living dangerously beyond its means. Subsidized by unusually low interest rates, in large part underwritten by equally myopic foreign investors and governments, America has managed to keep the magic alive. But there is nothing sustainable about that arrangement.

If America stays this course, the endgame will not be pretty. The day will come when US interest rates rise -- driven by either domestic or foreign developments. That would undoubtedly spark a painful unwinding of the Asset Economy -- all the more conceivable now that the US housing market is firmly in bubble territory (see “Bubble Day” dispatch link above). The heavy lifting of global rebalancing remains a tricky and perilous undertaking. It is human nature to seek the painless way out. But that is not the way macro works -- especially for a global economy that is so dependent on an over-extended U.S. economy.

RETURN OF THE “NEXT BIG THING” IN IPOS

Volterra Semiconductor’s planned initial public offering may be a throwback to “The Next Big Thing”, the elusive dream of the 1990s tech bubble that drove many deals skyward beyond reason. The technology company offers great promise but minimal earnings and a hefty deficit. The deal will be handled by one of Wall Street’s top underwriters and the company has heavy-hitter venture capital (VC) backing. This should sound familiar to anyone who tracked the IPO market during the boom -- and will send some investors diving under their desks because the ghosts of once-popular IPOs such as VA Software, Theglobe.com, or Foundry Networks live, even if the portfolios they once inhabited are croakers.

Look for Volterra to follow the familiar trajectory of a popular IPO: A strong opening, a solid first day followed by a climb, a quick leveling off and finally, a plunge. Nevertheless, it has great potential and the stock is worth taking a second look at the right price. “It’s a crapshoot,” says Tom Taulli, author of Investing In IPOs and co-founder of CurrentOfferings.com. “Those willing to make a big bet on this deal are the crowd you see at Monte Carlo betting on red or black.”

Despite Volterra Semiconductor’s potential, only “The Greater Fool” would buy and hold its shares. If you like the stock and do not get in at the opening price, let it season for several quarters. Then give it a long look. The company could be a long-term winner ... eventually.

TAR BABIES

Ouch! We commodity bulls suffered more pain and misery yesterday than an insubordinate sailor on the HMS Bounty. Mr. Market viciously lashed us resource investors, as if he were wielding a cat-o’-nine tails. The salty and seasoned buyers of resource stocks understand that sell offs in the sector tend to be fast and furious, which is why we mentioned earlier this week the idea of finding “backdoor” plays. Even so, the trauma of sharply falling share prices is always slightly more shocking and slightly more painful than anticipated. Yesterday’s most notable “lowlight” would be the nine-dollar intraday drop in the shares of Phelps Dodge, as copper prices suffered their biggest one-day drop in 14 years.

Perhaps -- although we strongly doubt it -- the bull market in natural resources is winding down. This bull market seems to be the real deal -- potent, durable and long-lived... so let us turn our attention to this new “buying opportunity”, and in the process return to Mr. T. Boone Pickens. What do T. Boone Pickens and your New York editor have in common? Almost nothing, as it turns out. Pickens earned a few of his millions in the 1980s by raiding large corporations. Your editor has never raided anything larger than a cookie jar. Pickens runs a billion-dollar, oil-based hedge fund. Your editor once used an oil-based paint... But there is one lone similarity between us; we are both keen to invest in the oil sands of Alberta, Canada. Specifically, we both own shares of Suncor Energy, a company that extracts synthetic crude oil from oil sands -- also known as tar sands. “Our number one pick is Suncor”, Pickens informed Bloomberg News last August.

We first recommended the stock in April of 2001 at a price of $12.69. The stock closed yesterday at $32.58. But Suncor, itself, is not the focus is today’s column. Rather, our interest lies in the long-term investment appeal of the oil sands themselves. Suncor is but one of the three main publicly traded entities devoted to extracting “syncrude” from the oil sands -- the other two being Western Oil Sands and the Canadian Oil Sands Trust, both on the Toronto Stock Exchange. The oil sand reserve is massive -- currently pegged at 175 billion barrels, based upon current extraction technologies. This elevates Canada to the number two slot on the petroleum pecking order, right behind Saudi Arabia’s 259 billion barrels (if we are to believe the official numbers). However, the Alberta Energy and Utilities Board believes that rapidly emerging technologies will boost recoverable reserves to 315 billion barrels, thereby vaulting Canada into the number one slot.

$50 oil renders the relatively high-cost production of syncrude immensely profitable. Is it any wonder the Chinese are descending on Alberta to secure long-term supplies from the oil sands? Until recently, investors exhibited little evident preference for “safe” oil reserves, versus “at risk” oil reserves. But over the last several months, the oil sands stocks have been outpacing the shares of multinational oil giants like BP and Exxon. We would not be surprised to see this trend continue, as the world’s oil buyers develop a growing appetite for Alberta’s “safe and sane” oil sands reserves.

WEAK DOLLAR THREATENS TO UPSET EQUILIBRIUM

Is the delicate balance that has kept the global economy going despite jaw-dropping U.S. debts about to give way? A growing number of economists think so. Harvard University president Larry Summers has dubbed this the “balance of financial terror”. He and other economists fear a crisis that will lower U.S. living standards. The current arrangement, where America buys and borrows while Asia sells and saves, is creaking under the weight of exchange rates that many analysts say are coming apart. If the analysts are right, American consumers may soon confront sticker shock at favorite retailers such as Wal-Mart and Home Depot. American automakers, on the other hand, might get a chance to climb out of a bathtub of red ink. Economists with Germany’s Deutsche Bank say recycling dollars from America to Asia and back again will keep rewarding both sides. Other economists do not see how that approach can be sustained.

OPEC sharply reduces dollar exposure to avoid purchasing power loss and asset seizures.

Oil exporters have sharply reduced their exposure to the U.S. dollar over the past three years, according to data from the Bank for International Settlements. Members of the Organisation of OPEC have cut the proportion of deposits held in dollars from 75% in the third quarter of 2001 to 61.5%. Middle Eastern central banks have reportedly switched reserves from dollars to euros and sterling to avoid incurring losses as the dollar has fallen and prepare for a shift away from pricing oil exports in dollars alone. Private Middle East investors are believed to be worried about the prospect of U.S.-held assets being frozen as part of the war on terror, leading to accelerated dollar-selling after the re-election of President George W. Bush.

OPEC officials say the cartel is trying to protect its purchasing power per barrel, as Europe is its largest trading partner. OPEC imports from Europe rose 29% between 2001 and 2003 while those from the U.S. fell by 14%, according to Morgan Stanley.

Hans Redeker, global head of foreign exchange strategy at the French bank, said the PATRIOT Act was worrying private investors. “If you trade with what the U.S. regards as a ‘dodgy’ bank, you are at risk of your assets in the US being frozen,” he said. “After the re-election of George Bush, the Middle East started to sell dollars like crazy due to the fears of assets being frozen.”

Japan threatens huge dollar sell-off.

Japan is warning the White House that there will be “enormous capital flight” from the dollar if the Bush administration maintains its laissez-faire approach to the mounting currency crisis. Tokyo fears that Japan’s strongest economic recovery in a decade could be derailed by the sudden appreciation in the yen against the greenback.

The criticism of President Bush’s inaction, by a senior member of the ruling Liberal Democratic Party, will be taken as a veiled threat that Japan could start to sell off its multi-billion-dollar holdings of U.S. Treasuries. “The Japanese government is going to ask for a strong dollar policy; if it continues to fall, there would be enormous capital flight from the dollar,” said Kaoru Yosano, chairman of the LDP’s policy council, adding that Japan would be calling on its fellow G7 governments to demand the US deal with the massive fiscal deficit that has helped to prompt the dollar’s decline.

Gold exposes the dollar.

One year ago I wrote about the precipitous decline in the value of the U.S. dollar against other world currencies, a decline that continues unabated today. A Euro note worth only 89 cents shortly after its introduction was worth about $1.16 at the end of 2003. Today it is worth $1.33. In fact, the dollar has fallen to an all-time low against the Euro, and a 12-year low against the British pound. Since 2000, the dollar has lost 30% of its value. Gold, by contrast, has surged 70% in the same period. The New York Times last week acknowledged that gold “was now a more favored currency than the U.S. dollar.” As analyst Harry Schultz points out, when gold prices are low the financial press calls gold a commodity. When prices are high, they call it a currency. Investors cannot afford to sit idly by while their dollar accounts lose another 30% in value, so the rise in demand for gold is hardly surprising.

The consequences of a rapidly declining dollar are not yet obvious to the American public. A trip to Europe costs more than it did a few years ago, but most Americans still do not sense they are becoming poorer as the dollar falls. The long-term significance has not yet begun to sink in. However, our relative wealth as a nation is measured in dollars, and the steady erosion of the value of those dollars means we will all be poorer in the future. Federal Reserve chairman Alan Greenspan has relentlessly increased the money supply throughout his tenure, ostensibly to keep the economy expanding. But this artificial stimulation through cheap money comes with a price. When dollars are abundant, they are worth less. This is the reality facing Americans today, especially older Americans who rely on savings to finance their retirement years.

The U.S. dollar: Singing in the Pain?

By now, saying that the U.S. dollar has been down in the dumps is like saying the Beatles were just another boy-band from Britain. In the past three months, the greenback has plunged 12% against the euro to a record low, 8% against the Japanese Yen to a near five-year low, and 9% against the Canadian loonie. Talk about many, many hard days’ nights for the now loneliest of lonely-hearts clubs -- the dollar bulls.

So, while it would not surprise us if this group of traders were belting out the blues in the privacy of their bathroom showers, it means quite another thing when song parodies about the greenback’s demise are being published in the mainstream financial press. Check out this spin on a seasonal favorite:

“Twas the death of the dollar and all through the land / not a greenback was traded for more than a Rand / The sheeple did bleat with their hands full of cash / shell-shocked and seeing their wealth was now trash.” (Financial Sense.com, Nov. 24) Ouch.

Yeah, and it gets worse. This week’s edition of Barron’s magazine presents a spoof on the 1971 song favorite “American Pie”. The December 6 Short Term Update prints the first three stanzas, but the lines below convey the idea: “So bye-bye, dollar assets good-bye... / Singin this’ll be the day that it died, this’ll be the day that it died.” Trust us, this ditty is about as catchy as the common cold: Once you’ve got it, you cannot get rid of it.

Now, while the dollar’s nose-dive is nothing to sing about, the emergence of these song parodies is music to our ears. The December 6 Short Term Update explains: “When the trend of a financial market is so entrenched that it reaches the consciousness of those who would write such parodies, odd are that” a major move is near.

LUCK BE A TRADER...

I have often been faced with questions of the sort: “Who do you think you are to tell me that I might have been plain lucky in my life?” Well, nobody really believes that he or she was lucky. But in game where everyone has a 50% of winning, from a starting population of 10,000 game players at the end of five games played there will be (on average) 313 who won every time. If the “game” involved trading and if we threw one of these successful traders into the real world we would get very interesting and helpful comments on his remarkable style, his incisive mind, and the influences that helped him achieve such success. And the following year, should he stop outperforming, the same voices would start laying blame, finding fault with the relaxation in his work ethics, or his dissipated lifestyle. The truth will be, however, that he simply ran out of luck.

Even a population entirely composed of “bad” managers with, say, only a 45% of winning, will produce a small amount of great track records. As a matter of fact, assuming the manager shows up unsolicited at your door, it will be practically impossible to figure out whether he is good or bad. The results would not markedly change even if the population were composed entirely of managers who are expected in the long run to lose money. Why? Because owing to volatility, some of them will make money. We can see here that volatility actually helps bad investment decisions. The number of managers with great track records in a given market will depend far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits. This means that we would see more “excellent managers” in 2006 than in 1998, provided the cohort of beginners was greater in 2001 than it was in 1993 -- I can safely say that it was.

In real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills: Consider that even if one has 55% probability of winning, the odds of 10 wins in a row is still very small. This can be easily verified in stories of very prominent people in trading rapidly reverting to obscurity, like the heroes I used to watch in trading rooms. One word of warning: All deviations do not come from this effect, but a disproportionately large proportion of them do.

The information that a person derived some profits in the past, just by itself, is neither meaningful nor relevant. We need to know the size of the population from which he came. In other words, without knowing how many managers out there have tried and failed, we will not be able to assess the validity of the track record. If the initial population is composed of 10 managers, then I would give the performer half my savings without a blink. If the initial population is composed of 10,000 managers, I would ignore the results. The latter situation is generally the case; these days so many people have been drawn to the financial markets. Many college graduates are trading as a first career, failing, and then going to dental school.

DROP IN GOLD RINGING THE BELLWETHER?

On December 7, an AP photograph captured a swarm of locusts turning the bright blue sky of a Mexican village pitch black. At first glance, we thought it was a snapshot of the bevy of gold bugs flooding Wall Street these days. No joke. Since gold prices soared to a 16-year high in mid-November, bullish enthusiasm for the yellow metal has reached Biblical proportions. Even a global convention inviting the top investment minds of our time was feeling the fever, the yellow fever that is. In the November Elliott Wave Theorist, Bob Prechter writes:

“I have just returned from the New Orleans conference... If there was one theme of the conference, it was the inevitability of soaring gold...” F.Y.I. -- Bob stood out at that particular conference like a sore... well... fourth digit on a paw. In the November Theorist, he continues, “The [bullish] consensus is not surprising if [gold is closing in on a top] which is exactly what our analysis indicates.” Bob concluded his commentary with the following forecast, “In the context of Elliott waves, the $450s are a very good target for the daily closing high.”

In the weeks that followed, Short Term Update grabbed the baton of near-term gold forecasts. In the December 3 issue, we wrote, “18 straight days of 90% and above bullish sentiment measures and a historic overbought condition... leaves a trend that is out, out on a limb. The market is primed for a reversal.” We identified key support levels that would signal the beginning of a turn down, and, on December 7, prices broke through our cited area. 24 hours later, (on December 8) gold suffered its biggest one day-drop in seven months.

Now, think about this: In recent weeks, many major financial markets have taken a turn for the worse in addition to gold: Crude oil is down 16% since last week and 24% since October peak, Natural Gas is down 22% since last week and 33% since October, Silver wass down 9.3% on December 8, the CRB Index is down 4.5% since hitting a 23-year high on November 30. The fact is, this kind of coordination is a rare event that accompanies one kind of economic environment -- one that very few expect, BUT one that the entire world will remember for years to come.

WHY NOT “BET THE HOUSE ON THE STOCK MARKET”?

The National Association of Securities Dealers is shocked, shocked, because -- in the words of a Wall Street Journal headline -- some people are “Betting the House on the Stock Market”. Homeowners are “pulling money out of their property at a greater rate than ever,” and now that the toothpaste is out of the tube, someone thinks somebody needs to do something. “The consequences of this problem can be so devastating,” said an NASD official, “that we’d really like to address this to keep it from becoming a big problem.”

Sheesh -- what a nag. Do they not know that debt is only a tool that allows money to flow from home equity into the equity market? Who is to say which sort of “equity” is better anyway? And the really bizarre thing is, the NASD’s warning is based on data more than two year old: “From 2001 through the first half of 2002, 11% of total funds obtained from mortgage refinancings were used for stock-market and other financial investments.” The fact is, the toothpaste came out of the tube slowly back then; these days it is a gush. According to data on the Federal Reserve’s web site, revolving home equity loans stood at $211.1 billion on Dec. 4, 2002. As of Nov. 24, 2004, the figure is an all-time record $394.1 billion.

In truth, no one should be surprised that Mr. & Mrs. Homeowner are cashing out their equity to purchase stocks. They have cashed out to make purchases of every other kind, and the economic powers-that-be proclaimed that, “It is good”:

“According to survey data, roughly half of equity extractions are allocated to the combination of personal consumption expenditures and outlays on home modernization.... the extraction of equity from homes has been a significant support to consumption during a period when other asset prices were declining sharply. Were it not for this phenomenon, economic activity would have been notably weaker in the wake of the decline in the value of household financial assets.” For the record, this was Mr. Alan Greenspan’s testimony to Congress last year.

Refinancing is good; cashing out is better; new stuff from the mall is better still. Within this progression, is buying stocks really so outlandish? No individual can stop the train wreck that is coming, but you do not have to be on the train. Safety begins with seeing the danger before the herd does, and getting out of the way.

A NEW ILLUSION: THE FALLING DOLLAR

In his recent speech in Berlin, Greenspan was amazingly frank about the “increasingly less tenable U.S. current account deficit,” suggesting that foreign investors would eventually reach a limit in their desire to finance the deficit and diversify into other currencies or demand higher U.S. interest rates. In essence, he expressed the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. current account deficit. Clearly, American policymakers want a lower dollar, apparently entertaining strong hopes that this will take care of the U.S. trade deficit, and we suspect that they regard it as an easy solution for this problem.

We doubt first of all that it is a solution at all. Such expectations essentially presuppose that an overvalued dollar is the main cause of the U.S. trade deficit. This is bogus. By the measure of purchasing power, the dollar was hardly out of line with the currencies of other industrialized countries. The favorite American explanation for the huge and growing trade deficit is the U.S. economy’s superior growth performance and lacking foreign demand. But the Chinese economy is growing much faster than the U.S. economy yet has a big trade surplus.

This explanation of the trade deficit with superior U.S. GDP growth is another illusion among many others. What crucially matters for a country’s trade balance is not its economy’s growth rate, but its internal resource allocation between consumption and investment. High rates of saving and investment make for a strong trade balance, while high rates of consumption make for a weak trade balance. America’s unusually poor trade performance reflects extremely poor rates of saving and investment. Overconsuming and undersaving America lacks the necessary capital stock to increase its exports.

Lowering the trade deficit first requires a lowering of domestic demand growth, and a drastic shift in resource allocation away from consumption and toward investment in the longer run. A mere fall of the dollar is definitely no solution. Yet we very much doubt that policymakers in Washington have the slightest intention to implement or foster the necessary changes in demand and resource allocation with policy measures.

What about the risks for the dollar and the markets? In short, they are frightening. The most frightening risk is that the dollar’s fall gets out of control. Superficially, the dollar’s steep fall in the 1980s and 1990s may seem encouraging in this respect. However, there is something that makes all the difference between then and now. When the dollar’s decline started in 1985, dollar assets held by foreigners were close to zero. This time, they are close to $9,000 billion, one-third of which is held by central banks.

The dollar has plummeted despite highly optimistic expectations about the economy’s outlook as reflected in stellar growth forecasts. It is our assumption that increasingly bad economic news will shake this overconfidence and speed up the dollar’s decline. For reasons already explained, we expect that sharply weaker consumer spending will soon distinctly slow the U.S. economy. Two events in particular are putting the brakes on economic growth: first, the full stop of the income creation through tax cuts; and second, the waning of the housing and mortgage refinancing booms. The risks are frightening.

DOES P.P.I. SPELL INFLATION?

If Wall Street had its own color-coded advisory system that measured the impending threat of inflation to the U.S. economy, it would have registered “BLAZING INFERNO RED” on December 10. The main cause for raising the alert: The early morning Labor Department report revealing a “sharp” 0.5% rise in the Producer Price Index (P.P.I.). But before you start imagining gas lines and $10 gallons of milk, you should take a closer look at the key components of the recent P.P.I. data. The bulk of the “up” in the PPI came from an 8.7% increase in the cost of raw materials, the largest gain since March 2003. But the key thing to realize here is -- the sticker shock is on the factory floor where products are assembled, NOT in the discount stores where they are sold.

A December 10 CNN Money article observes: “We are seeing a rise in raw material costs and commodities, but companies have not been able to pass these through to consumers ... These rising producer costs are more of a threat on the corporate profit side than on the inflation side.” The average airfare paid by the nation’s business traveler has fallen to its lowest point ever. In November, computer prices plunged 3.1% to their lowest level since February 2003. The world’s biggest car marker, GM, saw a 13% drop in sales with U.S. market shares at its lowest level on record. Check out the new “Red tag” Holiday promotion where buyers of certain 2004 and 2005 models will receive rebates between $5000 or $6000.

The cash registers at the world’s largest retailer tell the same story. We write: “A full 25 shopping days before Christmas, Wal-Mart signaled that the ‘strategy against deep discounts backfired.’ Instead, it will cut prices in the weeks before Christmas.” Our bottom line: inflation may be making the headlines, but an altogether different economic scenario is “catching all the breaks”.

KREMLIN FEARS SPARK 10% SLIDE IN RUSSIAN SHARES

Russian shares on Thursday fell below their level at the beginning of the year as investors took flight at signs of government interference in private business. After a 10.9% slide in the past two days, the Russian market is set to record its worst performance since 2000 in spite of the country’s robust economic growth. Panic selling followed news on Wednesday of a $158 million back tax claim against VimpelCom, Russia’s second-largest mobile telephone operator, raising fears that tax authorities are being used for political ends. The move against VimpelCom, the first Russian company to list in the U.S., comes just two weeks before the forced sale of the main production company of Yukos, Russia’s biggest oil producer, to cover back tax claims. Alexander Kim, equity strategist at Renaissance Capital, said the VimpelCom claim raised “questions about whether the government cares about the business climate.”

VimpelCom has seen its American depositary receipts fall 31% over the past two days, wiping $2.1 billion off its market capitalization. Observers saw the tax demand as the latest stage in the Kremlin’s fight against Russia’s oligarchs. The claims on VimpelCom were seen as a move against Mikhail Fridman, the billionaire owner of Alfa Group, which has a 25% stake in the mobile phone group and has been locked in a dispute over a 25% stake in rival Megafon. Megafon is widely thought to have links with Leonid Reiman, the communications minister.

Mattias Westman, director at Prosperity Capital Management, said, “The move on VimpelCom is the last straw for many people because it is one of the most widely held stocks among foreign investors.” Foreign investors have been eager to capture the rapid growth in Russia’s mobile phone market. Many of Russia’s biggest mobile operators are listed on U.S. stock exchanges.

The collapse of investor sentiment in the stock market is in sharp contrast to Russia’s strong economy, which is enjoying bumper revenues from oil and commodities exports and growing at the rate of 7% a year. Fears of reprisals against privately owned businesses have driven investors to state-owned stocks and away from companies controlled by the oligarchs. “There has been a flight to state-controlled companies, even though their productivity is lower ... this is a flight from quality,” Mr. Westman said.

BLAIR’S RACE AGAINST TIME

British prime minister Tony Blair is said to be aiming Britain’s General Election, (which must be held before June 2006), for May 2005, about the earliest he can reasonably hold it without attracting a storm of criticism. For the sake of his re-election, he had better not delay it -- because the British economy could be looking pretty sick by the end of the year.

Since the Blair government took office in 1997, Britain has had a number of good years. British economic growth was steady in 1997-2000 and since 2001 has been higher than most other countries in the EU, and among the highest in the world. Nevertheless, the current account has been consistently in deficit, to the tune of about 3% of GDP, and the public sector borrowing requirement has swung from a substantial surplus to a deficit that even the Chancellor is estimating at well over £30 billion per annum, 3% of GDP. Both the deficits are relatively smaller than in the U.S., but not by much, so the question must arise, is this sustainable in the long run?

The British stock market, like most other stock markets around the world, underwent a substantial run-up in the 1990s, talking it far beyond traditional valuation levels; since 2000 it has however dropped rather more than the U.S. stock market, and so is only moderately overvalued currently. However, the British housing market tells a different story. As followers of Britain will remember, British house prices reached an unsustainably high level in 1989, then spent the next half decade in sharp retreat, causing a huge wave of consumer bankruptcies and great economic hardship. The British recession of 1990-1993 was much more severe than the U.S. recession over the same period, and affected the south of England and the middle class, who had been relatively unaffected by the prolonged northern industrial recession of the early 1980s.

This time around, it is much worse. The house price to earnings ratio, calculated by the Office of the Deputy Prime Minister, which peaked at 140 in 1989, is currently standing at 180, so house prices are as much as 30% more overvalued in relation to average earnings as they were at the peak of the 1980s bubble. Prices have risen by more than 2.5 times since the Labor government came to power in 1997. Recent visitors to London can confirm this. House prices in central London are astonishingly high by U.S. standards, even compared with the overpriced markets on the East and West Coast.

The problem is more severe than in the U.S., where in most occupations, if you find house prices too high in New York or Los Angeles, you can always move to Chicago or Dallas. In Britain, many professions, particularly at the top end, are completely concentrated in London, and so young people are trapped by absurdly priced real estate, and compelled either to live in ghetto areas with very high crime rates or to endure multi-hour commuting on Britain’s appallingly inefficient public transport.

With house prices at record highs, and the payments deficit also close to historic highs, it is likely that the Bank of England will be forced to raise interest rates further from their current 4.75% (in this context, one should give credit where it is due -- British monetary policy since 1997 has been far sounder than in the U.S., probably a result of Brown’s giving the Bank of England monetary independence on coming to power in 1997.) If British house prices then begin to decline, in an environment where most home mortgages are based on floating interest rates, the already excessive levels of consumer borrowing will start to exert a real squeeze. At that point, the house of cards is likely to fall, causing a prolonged period of economic misery similar to that in 1990-93, only with much larger budget deficits.

It is unlikely, however, that this unpleasantness will have become fully apparent by May 2005, which is why Blair, if he is wise, will take an election win while he can get it. In the long run, if Blair indeed calls a relatively early election and wins it, there may be a major tectonic shift in the landscape of British politics. Further Conservative party mismanagement may leave the Liberal Democrats as the leading alternative government when Labor becomes terminally unpopular. The Liberal Democrats are now left of Labor on economics, and strongly pro-EU. Britain’s public spending, already moving sharply up towards the EU average, may rapidly come to match it or even exceed it, and Britain will take its place, with a sclerotic economy, a huge public sector, tiny armed forces and a neutralist, anti-U.S. foreign policy, securely within the ranks of Old Europe. Half a millennium of British exceptionalism will thereby come to an end.

A GOLDBUG’S LIFE

Mr. James Surowiecki wrote a wise and moronic piece on gold in the New Yorker. His wisdom is centered on the insight that neither gold, nor paper money are true wealth, but only relative measures, subject to adjustment. There is no law that guarantees gold at $450 an ounce. It might just as well be priced at $266 an ounce, as it was when George W. Bush took office for the first time. That was just four years ago. Since then, a man who counted his wealth in Kruggerands has become 70% richer.

But gold was not born yesterday ... or four years ago. Mr. Surowiecki noticed that the metal has a past, just as it has a present. He turned his head around and looked back a quarter of a century. The yellow metal was not a great way to preserve wealth during that period, he notes. As a result, he sees no difference between a paper dollar and a gold doubloon, or between a bull market in gold and a bubble in technology shares.

Pity he did not bother to look back a little further. This is, of course, the moronic part. While Mr. Surowiecki has looked at a bit of gold’s past, he has not seen enough of it. Both gold and paper dollars have history, but gold has far more of it. Both gold and dollars have a future too. But, and this is the important part, gold is likely to have more of that, too. The expression, “as rich as Croesus”, is of ancient origin. The king of historic Lydia is remembered, even today, for his great wealth. Croesus was not rich because he had stacks of dollar bills. Instead, he measured his richness in gold. We have also heard the expression, “not worth a continental” (see next article), referring to America’s Revolutionary-era paper money. We have never heard the expression, “not worth a Kruggerand”.

Likewise, when Jesus said, “Render unto Caesar that which is Caesar’s”, he referred to a denarius, a coin of gold or silver, not a paper currency. The coin had Caesar’s image on it, just as today’s American money has pictures of Lincoln, Washington or Jackson on them. Dead presidents were golden back then. Even today, a gold denarius is still about at least as valuable as it was then. America’s dead presidents, whose images on printed in green ink on special paper, lose 2% to 5% of their purchasing power every year. What do you think they will be worth 2,000 years from now?

Gold has a long history. And during its history, many was the time that humans were tempted to replace it with other forms of money -- which they believed would be more convenient, more modern, and most importantly, more accommodating. Paper money, by contrast, offered irresistible possibilities. But the story of paper money is short and always sad. Since the invention of the printing press, a new paper dollar or franc can be brought out at negligible cost. Nor does it cost much to increase the money supply by a factor of 10 or 100 -- simply add zeros. It may seem obvious, but adding zeros does not add value.

Still, the attraction of being able to get something for nothing has been too great to resist. That is what makes goldbugs so irritating: They are always pointing it out. Even worse, they seem to enjoy saying that “there ain’t no such thing as a free lunch”, which comes as a big disappointment to most people.

Once people were able to create “money” at virtually no expense, no one ever resisted doing it to excess. No paper currency has ever held its value for very long. Most are ruined within a few years. Some take longer. Even the world’s two most successful paper currencies -- the American dollar and the British pound -- have each lost more than 95% of their value in the last century, with is especially remarkable since both were linked by law and custom to gold for most of those years. For the dollar, the final link to real money was not cut until August 15, 1971. That was when the world found out what the greenback was really worth -- nothing much.

Some paper currencies are destroyed almost absent-mindedly. Others are ruined intentionally. But all go away eventually. By contrast, every gold coin (and silver, for that matter) that was ever struck is still valuable today -- and the coins almost always have more value than when they first came out of the mint.

MAKING MONEY IN EARLY AMERICA

You would have been hard put to find much in the way of real money in colonial America. The Eastern regions of North America had no mineral districts that yielded precious metals, hence gold and silver were scarce in the best of times. Each coin used in exchange had to travel a long and dangerous path from mints in England or Holland or Spain. As to the Western frontier, across the imposing Alleghenies and their blanket of almost impassable forest, few coins ever made the trip, and even fewer entered into the stream of commerce. Much of the economic activity in colonial times was based on barter.

In the decades before 1776, pre-Revolutionary currency was issued -- out of necessity and usually against the will of the agricultural and mercantile classes -- by colonial governments and private banks. These forms of scrip were typically paper notes, supposedly backed by gold and silver reserves allegedly on deposit in a vault. The process led to much abuse and fraud, with many a note rolling off the printing press without any security to back it up. There are historical anecdotes of creditors literally mounting their horses and riding away as debtors approached them with colonial scrip in hand, so as to avoid a legal dispute over whether or not a debt had been repaid by the passing of mere paper currency.

In 1764, in an effort to arrest an epidemic of worthless notes spawned during the just-concluded French and Indian War, Britain barred the North American colonies from issuing paper currency. Despite the many flaws of the paper notes, the lack of it for use in commerce precipitated an economic contraction throughout the region and became a grievance raised in the Declaration of Independence.

During the American Revolutionary War, 1775-1783, the Continental Congress authorized the printing of paper money, named, appropriately enough, “continental” money. The colonies pledged their state credit to deliver sufficient gold and silver to back the currency and as collateral for the redemption of the bills of credit. But as with most such promises by governmental bodies throughout history -- to issue honest money for use in commerce and as a store of value -- this never happened. During the Revolutionary War, continental paper notes were issued in immense quantities despite the fact that they were not backed by any hard asset, least of all gold or silver. Without any security backing these continental notes, and with immense numbers of them flowing from both American and British printing presses, they became worth barely more than the paper on which they were printed -- “not worth a continental” became part of American slang for several generations after the Revolution, meaning something that was utterly worthless.

The Revolutionary War left the national government broke and insolvent, with a reputation for having issued worthless currency and forcing people to use it literally at the point of a gun. Real money, gold and silver coin, was so scarce at the end of the Revolutionary War that the national government could not even pay the troops. Following the Revolutionary War and its associated financial fiasco, the 13 states were reluctant to give any central government much in the way of financial power. The result was the Articles of Confederation, which provided for a weak central government. Along with a weak central government, the confederation of 13 former colonies had a monetary system that was essentially useless. The Framers of the U.S. Constitution intended specifically to address the monetary affairs and failings of the young republic. In particular, they intended that money in the new republic would be based on the use of precious metals, and not on paper currency.

But tens of millions of dollars (at least at face value) of continentals and other state-issued scrip were still floating about in the economy, and there was little in the way of gold or silver to be had by anyone. The Framers were taking a very bold chance that a constitutional requirement for sound money, and a secure legal framework for commerce, would attract foreign investment and foster the growth of capital.

President Washington, who recalled not being able to pay the troops, and America’s first secretary of the Treasury, Alexander Hamilton, decided that the nation had to clean up the financial mess left in the wake of the continental notes. Hamilton came up with a proposal that the new federal government assume the underlying obligations of the continentals, originally backed by state governments. In 1790, Congress passed the Assumption Act, by which the federal government assumed the payment of the state debts contracted during the Revolutionary War, and formerly worthless continental currency and scrip would be “assumed” at face value.

From the time that Hamilton’s assumption plan was first suggested, continental paper began rising in price as speculators acquired it for pennies on the dollar. As passage of the Assumption Act looked more and more likely, the value of continentals rose toward par. However, in the more remote regions of the country, many people were ignorant of this development. Taking advantage of this situation, the moneyed interests of the East Coast cities, not a few of whom were members of Congress or their relatives and business associates, sent agents into every state and county to buy up the old continental paper before large numbers of people began to understand its value. Speculators employed couriers and relay horses to reach the most isolated areas. The result was a swindle of truly national proportions, which economic historian C.M. Ewing called “the greatest financial atrocity in our national history... The rich were made richer and the poor made poorer.”

Treasury Secretary Hamilton then proposed that the new federal government raise the revenue necessary to pay for its repurchase of the continentals at face value by levying federal excise taxes. Some of the most significant of these taxes fell on the backs of many of the very same people who had parted with the continental notes at great discount some months before. In particular among Hamilton’s proposals for raising revenue was a tax on whiskey, a staple of life along the Western frontier. This “whiskey tax” compounded the sentiment of many people that the new federal government was simply the replacement of the British king by swindling, moneyed East Coast speculators.

In today’s world, in which American taxpayers routinely part with 40-50% of their income in the form of federal, state, and local taxes, it might seem strange that the collection of a tax on whiskey would usher in a defining episode in the history of the United States of America. But absent that tax and the rebellion that it sparked, the U.S.A. would be a very different nation.