Finance Digest for Week of July 16, 2007

SHEEP IN WOLVES’ CLOTHING

Time to favor large capitalization companies again?

Smaller companies, by which I mean the ones with market capitalizations below $20 billion, have done well in the past few years. This streak has to end someday – sooner rather than later, I would wager. Then, portfolios with large capitalizations will come to the fore. Which ones to buy? Why, the large-cap funds with the best ratings, of course. Fund tracker Morningstar’s star rating system is a widely used guide, so its best-rated funds (five stars) are very popular.

In too many cases, however, the fine performances that earned them those stellar ratings are deceptive. Many large-cap managers with five stars have gotten them by dabbling in mid-cap and small-cap stocks or large caps at the bottom of the category’s range, thus jazzing up returns. While no hard-and-fast boundaries exist for stock sizes, many on Wall Street define midsize as any capitalization between $2 billion and $20 billion, and large-cap as any capitalization more than $20 billion. Morningstar currently puts the large-cap cutoff at $12.5 billion. That is not a big number, really. It takes you down to TJX, 713th-largest company on the Forbes 2000 Market Value ranking.

Morningstar’s definition makes 5-star winners out of funds that do not always deserve the large-cap definition. DFA U.S. Large Cap Value Portfolio, for example, recently had only 49.3% of its portfolio in stocks above $20 billion, 48.2% in midcap stocks listed as $2 billion to $20 billion and 1% in small companies, with the remainder in cash. This has enabled the fund to score an 18% annual average over the past three years, six percentage points better than the S&P 500. The same game is played successfully by Hotchkis & Wiley Large Cap Value, the BlackRock Large Cap Value fund, and LSV Value Equity. But market values above $20 billion account for 59% of the combined value of all U.S. companies, so these “large-cap” funds are actually less weighted to giants than the universe of companies.

If you were unaware of this up until now you may have gotten a lucky break – your large-cap fund did better than it deserved to. But if the tide is running out for midcap outperformance, as it normally does every 5 to 7 years, you may want to look at a champion large-cap manager’s portfolio much more closely before sending in your money. My bet is that the current proud holders of Morningstar’s 5-star designations in the large-cap contest will start shedding stars before too long.

Meanwhile, here are several genuinely large companies I would look at now, before large stocks’ day dawns. Health insurer Aetna (NYSE: AET), presents a good value at a trailing P/E of 16. Wyeth (NYSE: WYE), the giant pharmaceutical firm (market value: $78 billion), has put behind it the serious problems with fen-phen, an antiobesity drug that caused heart problems. The stock changes hands at a 17 multiple and yields 2%. Lowe’s (NYSE: LOW), the home-improvement chain, has a $47 billion market value. This normally double-digit grower is fighting the sharp downturn in the housing realm. Earnings for 2007 are likely to fall 1% to 2% from 2006. That said, the company has been the best hardware chain for growth, profitability and customer service over the past decade. Although calling the housing turnaround is impossible, the stock presents good value for buyers willing to wait. Lowe’s is trading at 16 times depressed earnings.

APRES SARKOZY’S VICTORY, LE DELUGE

I was seated in one of those impossibly old-fashioned French restaurants, where they still serve frogs legs and escargots, when I got the news of Nicolas Sarkozy’s victory. The impressive legislative majority his conservative UMP party commands for the next five years provides the new president with a mandate for change not seen since the beginning of the Fifth Republic in 1958.

America’s love-hate relationship with the French is complicated. While we admire their quality of life, we harbor a deep mistrust of their motives. When they opposed the U.S. on the Iraq invasion, we retaliated with the pettiness of “freedom fries”. Nevertheless, the boldness of Sarkozy’s new program has left U.S. conservatives gasping in admiration. Newt Gingrich, mastermind of the GOP’s “contract with America” and the party’s resulting takeover of Congress in 1994, has called for Republicans here to “find a candidate who, like Mr. Sarkozy, is prepared to stand for very bold, very dramatic and very systemic change.”

France has some economic advantages that the right policy can harness. It is the world’s 6th-largest economy, with strong internationally oriented companies and, thanks to its nuclear plants, cheap electricity. Sarkozy proposes to unleash the economic energy now stifled by a 35-hour workweek, letting laborers work overtime tax-free. His proposal to cut corporate taxes will need to be balanced by a commensurate increase in the VAT – and that move will predictably be unpopular. But the trend is on his side. A torrent of corporate tax cuts is spreading throughout Europe.

The Socialists, who lost the election, deride Sarkozy’s program as a handout for the rich. The son of a minor Hungarian aristocrat, he is vilified as an enemy of the disenfranchised for his tough stand on urban unrest. But he might well achieve most of his economic agenda. Some of Sarkozy’s promises sound Reaganesque – to cap individual tax rates at 50%, to allow the deductibility of mortgage interest, to prohibit strikes on essential public services and to control illegal immigration. Certain ideas sound wacky, like the proposal to pay illegal immigrant families to return home. But all of them are pro-business, pro-capitalist and, most important, great for productivity.

A pro-business French government, for once, is an investor’s dream. Talk about an inflection point. Just as the DAX index in Germany took off after Angela Merkel’s election as chancellor, the French economy and therefore its stock market should prosper mightily. Fortunately, the June swoon in global equity markets created a reasonable entry point.

The most widely followed proxy for the French stock market is the CAC-40, a narrow, market-cap-weighted index of some of France’s largest companies, some of which are so internationally diversified that they are barely French at all. The CAC-40 trades at 16.5 times trailing earnings, 2.4 times book and 1.2 times sales. The dividend yield is 2.8%. CAC futures currently trade with a contract size of just under $80,000 on the Euronext exchange in Paris. Going long one futures contract is like buying that amount of French shares.

For traders who do not relish getting up in the middle of the night, the best proxy for the French market is an ETF, the iShare MSCI France (EWQ). It tracks the Morgan Stanley France Index, a market-cap-weighted index of 63 publicly traded French stocks. That makes it slightly more representative of the broader underlying market than the CAC.

Another way to bet on the revitalization of France is to invest in shares of BNP Paribas, which trades in euros on the French exchange. This commercial bank has assets of $1.9 trillion. Paribas is quite reasonably priced at 10 times consensus earnings of $11.60 for 2007 and $12.40 for 2008. Buying this from the U.S. is not cheap, but it is worthwhile.

PROFIT FROM THE MESS IN MORTGAGES

Some experts would have you believe that the subprime mortgage meltdown is contained. I do not subscribe to this viewpoint. If we have seen the worst, why are states like Ohio, New Jersey and California talking about bailing out homeowners from their adjustable-rate mortgages, using a raft of new muni bonds to fund the rescue? And why are two Bear Stearns-sponsored hedge funds that traffic in mortgage-backed bonds teetering?

A lot has gone wrong in subprime, with plenty of blame to go around. Some mortgage applicants lied about their finances, some mortgage brokers did not bother to verify credit applications, some brokers enticed gullible borrowers with teaser rates and played down how the rates would reset upward, and all participants kidded themselves about how rising house prices would cure all defects. We can also blame the Wall Street firms that repackaged these risky mortgages and sold them to public pension plans, hedge funds, cities, counties and a conga line of unsuspecting others. And then come the subprime lenders, many of them unscrupulous and irresponsible. Since 2006, 60 or so have closed or filed for bankruptcy protection.

Nevertheless, amid this mess, there is a bright side. The survivors have proved worthy and are cheap. The most prominent of the survivors are Fannie Mae and Freddie Mac, which have fixed their bad business practices and accounting lapses. But neither their bonds nor preferred shares yield that much to get excited about. A 10-year Fannie bond yields 0.4 percentage points over a comparable, risk-free Treasury.

Countrywide Financial (NYSE: CFC), however, is a different story. It issued some subprime loans and lost money on them. Yet as other lenders have gone bust, Countrywide has picked up their business. With tightened credit standards and competition greatly reduced, Countrywide will be in a good place when housing recovers. I recommend Countrywide 7% preferred (CFC B) rather than the bonds. Even though preferred shares are lower in the capitalization structure than bonds, I am not worried about a default from this strong company. The preferred, which is very liquid, yields 7.17% – 67 basis points better than what you get on Countrywide’s bond maturing in nine years.

Another worthwhile, if lesser-known investment, is Thornburg Mortgage (NYSE: TMA), an REIT that originates and purchases ARMs. The REIT makes money on the spread between the yield on its loans and its cost of borrowing. Delinquencies, defaults and foreclosures are always the wild cards, of course. But these should be limited at Thornburg: Its mortgage holders are high quality (median annual income: $204,000). Their average loan size is $630,000, and during the next 20 months $6.7 billion of their ARMs will reset from 4.6% to significantly higher rates, which they likely can afford.

The REIT pays bond investors well. The Thornburg 8% due May 15, 2013 bonds are a $305 million issue rated BB- by Standard & Poor’s and are Thornburg’s only bond issue. Now priced slightly over par, they yield 7.85% to the worst call in 2011 and 7.9% to maturity. Thornburg shares sport a pleasant 10.4% dividend yield, but do not be surprised if Thornburg cuts the lofty dividend later this year since earnings are softening. Still, a lot of that already is priced into the shares. Buy half a position now and add on when the cut occurs.

Residential Capital, the mortgage lending unit of GMAC, has had the stuffing knocked out of it. The housing sector’s woes and ResCap’s subprime lending exposure forced S&P to downgrade its bonds to barely investment grade, BBB-. Despite all this gloom, ResCap has installed new management, reduced its subprime portfolio and strengthened lending standards. Those are the marks of a successful turnaround. Buy the ResCap 6.125% due Nov. 21, 2008. This $750 million issue is easy to obtain. These bonds yield 6.5% to maturity. Step out a little longer and try the $2.5 billion ResCap 6.375% due June 30, 2010, which yields 6.9% to maturity. Even if the bonds get downgraded to junk, your interest and principal will be paid on time. GMAC, now 51%-owned by the canny private equity shop Cerberus Capital Management, is a solid parent.

A FEW LITTLE QUESTIONS ABOUT GOOGLE’S BUSINESS

James Altcher’s recent TheStreet.com article comes with the title ,“The Threat to All of Google’s Revenue”. That is ridiculous, of course. Nothing could threaten Google’s revenue unless Paris Hilton goes so straight we all stop searching for prison photos. But it turns out that Mr. Altcher really thinks that Google’s revenue growth is at risk even with Ms. Hilton back in street clothes and even richer after the Blackstone buyout of Hilton. James figures that Google’s revenue growth is at risk three ways:

1. The price advertisers pay for Google’s keyword ads will come down, notwithstanding that there has been nothing but inflation of keyword prices. He argues that advertisers’ renewed focus on “free search” will put downward pressure on “paid search” pricing.
2. There will be fewer mortgage broker ads. Whatever they buy going forward will be something less than a ton.
3. The ability for annoying fake websites to make money arbitraging Google ads will not last forever. This is where someone pays for cheap keywords (e.g., misspelled words) to cleverly send visitors to a website that is nothing but a list of other Google ads. As a result, the annoying website generates more money from clicks on the ads it hosts than what it pays for the cheap keywords that lured people there. Mr. Altcher figures this business will become less attractive, reducing pressure on keyword pricing and likely volume as well.

Is he right? Who knows? That would require real research. At least one critic argues that point #1 is invalid because ensuring a business shows up on “free search” is actually an expensive proposition. Thus advertisers will keep paying for paid search. But that should not stop an investor from asking the rhetorical questions below. In fact they do not even have to be rhetorical if the investor is having dinner with someone and cannot stop talking about the stock prices of search engine companies. How much should you pay for a company that:

1. Gets almost all of its revenues from a single product or business line?
2. Competes against other corporate behemoths?
3. Will undoubtedly face new competitors in the future?
4. Operates in a rapidly changing subset of the rapidly changing technology industry?

As we all know, if the company is Google, the market’s answer is a lot. A whole lot. But there is another question that an investor could ask: What if it becomes illegal for online advertisers to bait and switch consumers using other companies’ brand names? How would that affect Google? Huh?

For example, say you are Frank’s Marshmellow Mattress Company in Beeville, Texas, you might want to capture the attention of internet users outside of Beeville. Being a clever mattress man, you might just bid on the keyword “Tempurpedic”. That way, people looking to learn more about the famous Tempurpedic mattresses would stumble upon your own product. Clever huh? And all without spending a gazillion dollars on brand recognition. For some reason, directing internet users to your site when they type in your competitor’s name is an accepted practice in the paid search world – even though Frank would never hang a neon Tempurpedic sign in his window when all he sells are burlap sacks filled with stale marshmellows.

No wonder then, this practice has some big companies ticked off. They are especially peeved that they pay Google for an ad with their own brand name getting more and more expensive because so many others are bidding on it. Geico was so annoyed that it sued Google for tolerating the practice. They lost. The court ruled that Google was not liable for selling the keywords to competitors. However, some advertisers were boldly using Geico’s trademarks in the little text ads themselves, and the court did declare that practice taboo. And it left it to Google and Geico to work out a settlement.

Speaking of settlement, this whole keyword poaching thing is hardly settled even with the Geico verdict. A company called American Blind and Wallpaper filed a suit similar to Geico’s years ago and should finally go before a jury this fall. According to the always popular Managing Intellectual Property magazine, this whole keyword issue was a hot topic at the International Trademark Association’s annual meeting recently held in Chicago. The June 1 issue reported that lawyers from the search engine companies tried to “diffuse some of the emotional issues” at the packed meeting.

Well, no one can sniff out an emotion that needs diffusing like a politician, and Utah lawmakers are all over this one. Back in March, Utah passed a law that requires Google to check a trademark registry before displaying keyword searches to Utah residents. In other words, if Frank uses the keyword “Tempurpedic”, internet users in Utah better not see it. In addition, Utah companies cannot buy keywords that are officially registered as trademarks by other advertisers. Even if this law gets tossed out, the point is, big marketers are ticked off at Google’s hands off approach to keyword bidding. Google, of course, will argue that any attempt to stifle this business will bring ecommerce to a screeching halt.

But this sort of stifling is already underway overseas and Google knows it. French courts ruled against Google in keyword poaching suits by Louis Vuitton and a fancy French hotel chain. Recently Australia’s “Competition and Consumer Commission” announced it was taking Google to court over the keyword issue. Different courts around the globe are dealing with the issue and delivering varying rulings. But there is enough resistance to the practice in Europe to support at least one company that tracks down offenders and forces Google to stop selling ads to them. The company, IC-Agency, claims to have squelched brand name keyword ads in 11 European countries. Company literature boasts that its work for a Nestle product resulted in the price of the brand’s keyword falling by 60%. IC-Agency’s free diagnostic checkups are available here.

Looks like Google is so not evil after all. They have created another business.

AN I.P.O. GLUT JUST WAITING TO HAPPEN

Over the last two years, a flood of public companies, including some of the most recognizable names on the markets, have gone private. But when will they go public – again? And if there is a long line for IPOs, will private equity firms have a tough time cashing out? The deal flow has been staggering, with private equity undeniably on a tear. From 2005 through last week, the market has witnessed 1,287 leveraged buyouts, with a total value of $787 billion.

But buying is the easy part. “Any fool can buy a company,” Henry R. Kravis, one of the buyout industry’s godfathers, said earlier this year. “You should be congratulated when you sell.” So what will happen when buyout firms try to bring the companies they have acquired back onto the market? In a research note in June, Tobias M. Levkovich, Citigroup’s chief U.S. equity strategist, wrote that investors fear that current deals will come back in the near future as a glut of stock offerings, causing a drag on stock prices.

“What happens when all this stock comes back on the market?” Robert B. Reich, the former labor secretary, said in a radio commentary in May. “The loud thud you’ll hear will be the sound of shares falling back to earth.”

Meanwhile, the heat is on when it comes to selling. Although buyout firms typically plan to wait 3 to 5 years before selling companies in their portfolios, many firms, especially those in the middle market, are feeling pressure to exit their investments more quickly, said Peter Fitzpatrick, a partner at Bryan Cave, a law firm. Perhaps the most prominent example is that of Hertz, the rental car company that was privatized and then brought public again within a year. Yet so far, many in the industry are not worried. The market for I.P.O.’s over the last 6 years has been relatively quiet. “Right now, the advantage is still with the acquirer,” Mr. Levkovich said.

Moreover, the business acumen on which private equity prides itself in its deal-making extends to its selling as well, practitioners in the field say. Instead, private equity may turn to other tools at its disposal as it seeks to wipe off its slate. Buyout firms can sell their portfolio companies to others in the same industry. Or they can sell them to other buyout firms, in what is known as a secondary buyout. “Before, I.P.O.’s were kind of the only game in town,” said Robert A. Profusek, the head of the M&A practice at law firm Jones Day. “Today, it’s more like a casino in terms of the number of games available.”

I.P.O.’s require cumbersome road shows to woo investors and hefty fees that sometimes have to be paid to investment banks that underwrite those sales. Because several offerings are usually required to completely sell off a company, they can be time-consuming and drawn out. A sale to another buyout firm or a strategic buyer, by contrast, is quicker and easier. So long as the easy credit that has fueled the buyout boom is available, buyers can borrow the cash necessary to make these acquisitions.

Sometimes, the acquired company can be broken apart. Shortly after closing its $39 billion acquisition of Equity Office Properties Trust, the Blackstone Group turned around and sold huge swaths of the office landlord’s properties to various buyers, recouping much of what it had paid in the first place. Or private equity can hold onto companies for longer periods these days. After all, TPG Capital, formerly the Texas Pacific Group, spent nine years turning around J. Crew, the popular preppy clothier.

Still, there is reason to be at least a little concerned that we might see an I.P.O. squeeze a year or two down the road. For one, there is only so much credit available to potential buyers. If interest rates rise, the borrowing that has made so many of today’s deals possible will become far more expensive, making secondary buyouts less likely. Size would also remain an obstacle. There are only so many players in the industry that are big enough to snap up such recently privatized behemoths as Harrah’s Entertainment ($16.7 billion) or Hilton Hotels ($18.5 billion). That still leaves the I.P.O. as the default option for most of the big purchases made during the current buyout wave. But finding the ideal opportunity to sell may be much more difficult. So if private equity firms see an open door, do not be surprised if there is a traffic jam at the exit.

WORSE THAN IRRELEVANT

Ben Bernanke and the Fed should dispose of their old academic articles and notions of inflation and start from scratch.

For lack of a better adjective, I will say last week was a rather “idiosyncratic” one for the markets and otherwise. Citigroup’s CEO Chuck Prince made curious comments regarding the boom in M&A finance:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing ... The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.”

Not all that comforting. I could only chuckle when a journalist from the Wall Street Journal, appearing on CNBC, compared Mr. Prince to a ticket scalper outside a concert venue imploring potential buyers with assurances that the show was going to be so good they would not want to miss out.

And when it comes to “selling a bill of goods,” I refuse to let Dr. Bernanke’s speech, “Inflation Expectations and Inflation Forecasting”, before the Monetary Economics Workshop of the National Bureau of Economic Research, go unanswered. For starters, I do not recommend reading it. It is academic, written specifically for so-called monetary economists, and basically propounds doctrine that is Worse Than Irrelevant with respect to current inflation dynamics. I found it disturbingly detached from reality.

I will plead once again that the issues of “money”, credit, and inflation are much too vital to the long-term health of free-market democracies to be left to a select group of policymakers and “ivory tower” dogma. Rather, it is imperative that citizens become sufficiently educated on the perils of credit inflation, financial excess, and unsound “money”. This would provide our only hope against the inflationary tendencies of politicians, the Fed, and the Financial Sphere – tendencies that turn highly toxic when mixed with high octane contemporary finance. Whether by design or, perhaps more likely, his theoretical indoctrination, Dr. Bernanke’s inflation discussion continues to evade and obfuscate when it comes to the central monetary issues of our day.

Dr. Bernanke: “As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve’s dual mandate from the Congress, is a good thing in itself, for reasons that economists understand much better today than they did a few decades ago.”

All well and good, but to commence fruitful discussion and debate first requires up-to-date, understandable, and reality-based definitions of “inflation” and “price stability”. It should be clear by now that sticking with Milton Friedman’s “too much money chasing too few goods” over-simplification does more analytical harm than good. “Money” was already too much of an unclear, amorphous and indefinite concept during Dr. Friedman’s heyday – the ongoing “evolution” of contemporary “money” only lunged ahead madly over the past decade or so. Moreover, adherence to a Friedmanite monetary perspective leads one to an ill-advised focus on “narrow money” and confined “core” consumer price inflation, along with a false notion of the government’s capacity to manage both. Today, “good monetary policy” and “price stability” are erroneously associated with perpetual – if perhaps only moderate – inflation in a narrow index of aggregate of consumer goods and services prices that represents such a small (and shrinking) part of total economy- and market-wide expenditures.

It is more productive to start with “inflation” as a multitude of potential effects emanating from the creation of excess purchasing power (credit). These may include various price effects, although excess purchasing power also typically engenders elevated real investment, imports, and/or market speculation. Inflation’s price influences may develop in “core” consumer prices, or perhaps become more prevalent in energy and food prices. Especially if a credit system is heavily focused on real (i.e., real estate, commodities, sport franchises, art, collectables, etc.) and financial (bonds, stock, “structured” instruments, commodities-related, etc.) assets, asset prices will be a prevailing inflationary manifestation. Contemporary “price stability” must be examined in the context of system-wide price levels, credit growth by sector and in aggregate, and the scope and nature of speculation – and to be reality-based it should begin with the asset markets.

We have today a unique finance-driven economy that becomes more finance-dominated by the day. Analytically, it is important to conceptualize the evolving nature of finance generally and appreciate that a finance economy will be an atypically mutating economic animal. The inflationary impacts more dramatic nd the real economy effects more pernicious – yet almost by design effects upon the general (“core” CPI) price level are nominal and lagging. In particular, incredible amounts of financial “wealth” (financial sector inflation) are being generated, distributed and expended quite unequally (a key credit bubble-induced inflationary dynamic). At the same time, highly-populated emerging economies are engulfed in credit bubble dynamics, with obvious inflationary consequences for global food and energy prices. It is not hyperbole to suggest that financial, economic and inflationary dynamics have been radically transformed over recent years to the point of leaving policymakers and conventional economic doctrine in the dark.

Today, the U.S. and global economies are buffeted by powerful inflationary forces unlike anything experienced in decades – if ever. Years of unrelenting credit and speculative excess have created a vast global pool of enterprising “purchasing power” (hedge funds and other leveraged speculators, sovereign wealth funds, pension funds, etc.) searching high and low for robust returns. At the same time, the perception that the U.S. dollar is now a perpetually devaluing currency has created a powerful inflationary bias in myriad “non-dollar” asset classes (and economies) across the globe. Dr. Bernanke and the Fed would be better off disposing of their old academic articles and notions of inflation and starting from scratch.

In a week when Dr. Bernanke applauded a tradition of “good monetary policy” and “price stability”, U.S. financial markets were notable for demonstrating acute instability. He reiterated the commonly accepted view that, because of the Fed’s ongoing commitment and success in fighting inflation, inflation expectations “have become much better anchored over the past thirty years.” This may have been somewhat the case for a period of time, but it is foolhardy to believe it holds true these days. After all, seemingly the entire world prescribes to the view of ongoing asset and commodities inflation. And these expectations – in conjunction with liquidity and credit abundance – provide one of the more highly charged inflationary backdrops imaginable.

I do not recall Dr. Bernanke’s mentioning asset inflation in his speech, although he does sanguinely address the inflationary (non-) ramifications from the surge in oil prices. This blindly disregards the key issues and prevailing dynamics of contemporary finance. Oil has always been the most important commodity in the world, yet it has never been as economically and financially critical across the globe as it is today. The huge inflation in oil and energy prices has had much to do with the massive expanding global pool of dollar balances (mostly emanating from our current account deficits), the depreciating value of the dollar, and the associated massive liquidity over-abundance throughout Asia. Energy and related inflation has had and will, going forward, have only greater geopolitical consequences. It is nonsensical today to concentrate on oil inflation’s (to date) impact on “core” U.S. consumer prices.

Liquidity-induced oil price inflation has been exacerbated by the interplay of boom-time global demand increases (especially in Asia). Knock-on effects then included the liquidity/purchasing power accumulated by OPEC and other exporters, as well as liquidity created in the process of leveraged speculation internationally. Importantly, inflating energy prices have fostered credit creation through myriad channels. For one, U.S. companies, governments, individuals and the economy overall have borrowed more for energy purchases, in the process working to sustain destabilizing current account deficits in the face of a weakening dollar.

Across the globe, more borrowed finance has been needed to acquire energy resources and companies. The rising values of energy assets have created additional collateral to borrow against. The surge in energy prices has also led to more broad-based secondary effects, including the large transportation and food sectors – which will work to encourage additional borrowing and broadening price effects. Importantly, rising oil prices were initially an inflationary effect which, accommodated by easy “money”, then spurred greater credit creation and increasingly potent inflationary forces. Inflation begets inflation, and the Fed can continue to downplay asset and commodities inflation at our currency’s peril.

The Fed is forever fond of gauging “long-run inflation expectations” by measuring the difference in yields between nominal and inflation-indexed bonds. This is comforting but flawed analysis. It may illuminate the markets’ best guesswork with respect to prospective CPI levels, but when it comes to actual “inflation expectations” I would suggest the Fed monitor a “basket” of indicators including the price of gold, oil, energy, and general commodities indices, the relative value of “commodity” currencies, global equities and real estate prices and, importantly, the global demand for credit. The key inflationary focus today should be on factors and dynamics driving credit growth and speculative excess.

While on the subject, it is worth noting that speculative excess in the U.S. stock market has reached the greatest intensity since early-2000. The nature of current synchronized global market speculation is extraordinary to say the least – virtually all markets everywhere. Here at home, all the fun and games, squeezes and intoxication should have the Fed alarmed. Surely, a destabilizing market “melt-up” is the last thing our vulnerable system needs right now.

My comment that Dr. Bernanke’s (and the Fed’s) inflation doctrine was “Worse Than Irrelevant”, I had today’s global financial backdrop in mind. A policy of pegging short-term rates with promises of fixating two eyes on “core” CPI and no eyes on asset prices/credit/or speculative excess has been fundamental in nurturing history’s greatest credit bubble. Or, from another angle, relatively stable consumer prices have ensured runaway credit inflation and speculative asset bubbles. And the marketplace’s inability to orderly adjust to rising global bond yields, surging energy prices and mounting inflationary pressures, and unfolding credit market tumult portend problematic market dislocations at a future date.

THE RICHEST OF THE RICH, PROUD OF A NEW GILDED AGE

The tributes to Sanford I. Weill line the walls of the carpeted hallway that leads to his skyscraper office, with its panoramic view of Central Park. A dozen framed magazine covers, their colors as vivid as an Andy Warhol painting, are the most arresting. Each heralds Mr. Weill’s genius in assembling Citigroup into the most powerful financial institution since the House of Morgan a century ago. His achievement required political clout, and that, too, is on display. Soon after he formed Citigroup, Congress repealed the Depression-era Glass-Steagall Act that prohibited goliaths like the one Mr. Weill had just put together anyway, combining commercial and investment banking, insurance and stock brokerage operations. A trophy from the victory – a pen that President Bill Clinton used to sign the repeal – hangs, framed, near the magazine covers.

These days, Mr. Weill and many of the nation’s very wealthy chief executives, entrepreneurs and financiers echo an earlier era – the Gilded Age before World War I – when powerful enterprises, dominated by men who grew immensely rich, ushered in the industrialization of the United States. The new titans often see themselves as pillars of a similarly prosperous and expansive age, one in which their successes and their philanthropy have made government less important than it once was. “People can look at the last 25 years and say this is an incredibly unique period of time,” Mr. Weill said. “We didn’t rely on somebody else to build what we built, and we should not rely on somebody else to provide all the services our society needs.”

Those earlier barons disappeared by the 1920s and, constrained by the Depression and by the greater government oversight and high income tax rates that followed, no one really took their place. Then, starting in the late 1970s, as the constraints receded, new tycoons gradually emerged, and now their concentrated wealth has made the early years of the 21st century truly another Gilded Age. Only twice before over the last century has 5% of the national income gone to families in the upper 0.01% of a percent of the income distribution – currently, the almost 15,000 families with incomes of $9.5 million or more a year, according to an analysis of tax returns by the economists Emmanuel Saez and Thomas Piketty. Such concentration at the very top occurred in 1915 and 1916, as the Gilded Age was ending, and again briefly in the late 1920s, before the stock market crash. Now it is back, and Mr. Weill is prominent among the new titans.

At 74, just over a year into retirement as Citigroup chairman, Mr. Weill sees in Andrew Carnegie’s life aspects of his own. Carnegie, an impoverished Scottish immigrant, built a steel empire in Pittsburgh, taking risks that others shunned, just as the demand for steel was skyrocketing. He then gave away his fortune, reasoning that he was lucky to have been in the right spot at the right moment and he owed the community for his good luck – not in higher wages for his workers, but in philanthropic distribution of his wealth.

Other very wealthy men in the new Gilded Age talk of themselves as having a flair for business not unlike Derek Jeter’s “unique talent” for baseball, as Leo J. Hindery Jr. put it. “I think there are people, including myself at certain times in my career,” Mr. Hindery said, “who because of their uniqueness warrant whatever the market will bear.” He counts himself as a talented entrepreneur, having assembled from scratch a cable television sports network, the YES Network, that he sold in 1999 for $200 million.

A handful of critics among the new elite, or close to it, are scornful of such self-appraisal. “I don’t see a relationship between the extremes of income now and the performance of the economy,” Paul A. Volcker, a former Federal Reserve Board chairman, said in an interview. The great fortunes today are largely a result of the long bull market in stocks, Mr. Volcker said. Without rising stock prices, stock options would not have become a major source of riches for financiers and chief executives. Stock prices rise for a lot of reasons, Mr. Volcker said, including ones that have nothing to do with the actions of these people. “The market did not go up because businessmen got so much smarter,” he said, adding that the 1950s and 1960s, which the new tycoons denigrate as bureaucratic and uninspiring, “were very good economic times and no one was making what they are making now.”

James D. Sinegal, chief executive of Costco, the discount retailer, echoes that sentiment. “Obscene salaries send the wrong message through a company,” he said. “The message is that all brilliance emanates from the top; that the worker on the floor of the store or the factory is insignificant.”

A legendary chief executive from an earlier era is similarly critical. He is Robert L. Crandall, 71, who as president and then chairman and chief executive, led American Airlines through the early years of deregulation and pioneered the development of the hub-and-spoke system for managing airline routes. He retired in 1997, never having made more than $5 million a year, in the days before upper-end incomes really took off. He is speaking out now, he said, because he no longer has to worry that his “radical views” might damage the reputation of American or that of the companies he served until recently as a director. The nation’s corporate chiefs would be living far less affluent lives, Mr. Crandall said, if fate had put them in, say, Uzbekistan instead of the United States, “where they are the beneficiaries of a market system that rewards a few people in extraordinary ways and leaves others behind.”

Revisionist History

The new tycoons describe a history that gives them a heroic role. The American economy, they acknowledge, did grow more rapidly on average in the decades immediately after World War II than it is growing today. Incomes rose faster than inflation for most Americans and the spread between rich and poor was much less. But the U.S. was far and away the dominant economy, and government played a strong supporting role. In such a world, the new tycoons argue, business leaders needed only to be good managers.

Then, with globalization, with America competing once again for first place as strenuously as it had in the first Gilded Age, the need grew for a different type of business leader – one more entrepreneurial, more daring, more willing to take risks, more like the rough and tumble tycoons of the first Gilded Age. Lew Frankfort, chairman and chief executive of Coach, the manufacturer and retailer of trendy upscale handbags, who was among the nation’s highest paid chief executives last year, recaps the argument. “To be successful,” Mr. Frankfort said, “you now needed vision, lateral thinking, courage and an ability to see things, not the way they were but how they might be.”

Arthur Levitt Jr., a former chairman of the S.E.C., who started on Wall Street years ago as a partner with Mr. Weill in a stock brokerage firm, has publicly lamented the end of Glass-Steagall, while Mr. Weill argues that its repeal “created the opportunities to keep people still moving forward.” Mr. Levitt is skeptical. “I view a gilded age as an age in which warning flags are flying and are seen by very few people,” he said, referring to the potential for a Wall Street firm to fail or markets to crash in a world of too much deregulation. “I think this is a time of great prosperity and a time of great danger.”

In contrast to many of his peers in corporate America, Costco C.E.O. Sinegal, 70, argues that the nation’s business leaders would exercise their “unique skills” just as vigorously for “$10 million instead of $200 million, if that were the standard.” As a co-founder of Costco, which now has 132,000 employees, Mr. Sinegal still holds $150 million in company stock. He is certainly wealthy. But he distinguishes between a founder’s wealth and the current practice of paying a chief executive’s salary in stock options that balloon into enormous amounts. His own salary as chief executive was $349,000 last year, incredibly modest by current standards.

“I think that most of the people running companies today are motivated and pay is a small portion of the motivation,” Mr. Sinegal said. So why so much pressure for ever higher pay? “Because everyone else is getting it. It is as simple as that. If somehow a proclamation were made that C.E.O.’s could only make a maximum of $300,000 a year, you would not have any shortage of very qualified men and women seeking the jobs.”

“Carnegie made it abundantly clear that the centerpiece of his gospel of wealth philosophy was that individuals do not create wealth by themselves,” said David Nasaw, a historian at City University of New York and the author of Andrew Carnegie. “The creator of wealth in his view was the community, and individuals like himself were trustees of that wealth.” Repaying the community did not mean for Carnegie raising the wages of his steelworkers. Quite the contrary, he sometimes cut wages and, in doing so, presided over violent antiunion actions.

Carnegie did not concern himself with income inequality. His whole focus was philanthropy. He favored a confiscatory estate tax for those who failed to arrange to return, before their deaths, the fortunes the community had made possible. And today dozens of libraries, cultural centers, museums and foundations bear Carnegie’s name.

WHEN BAD DEBTS ATTACKS

Just how hard is it to beat deflation, that horror of falling wages and prices ...?

Ben Bernanke has his helicopter ready. John Maynard Keynes proposed burying bottles of cash in coal mines. And the Japanese government ... how can the Ministry of Finance in Tokyo dish out enough free money to put an end to deflation, that horror of falling prices and wages? “Envelopes containing ¥10,000 bills ($82) and well-wishing notes have been discovered in municipal toilets across Japan,” reports the Associated Press, “baffling civil servants and triggering a nationwide hunt.”

The anonymous well-wisher has left money in men’s rooms in 15 prefectures in the last month. Each package of cash comes with a handwritten note: “Please make use of this money for your self-enrichment.” After studying the handwriting, the authorities are seeking an elderly gentleman or men – and do we really need any more proof that this free money comes as a gift from the Ministry of Finance (MoF)?

After a decade of falling incomes, such desperate remedies might just start to appeal to any government. As crazy reflation schemes go, it is no more bizarre than throwing freshly-printed dollars out of a chopper or burying old bottles stuffed full of cash in disused mine shafts. What is more, all the Japanese “drops” have so far been made in government buildings. But this scheme has not worked. According to a report in Le Figaro, all the free cash has been handed straight to the police! That is the trouble with a genuine currency slump. You cannot even give money away when the whole country is bent on destroying its value.

The MoF printed and spent $400 billion selling the Yen between 2000 and 2004. Since it gave up, the entire Nippon nation has begun selling the Yen on margin. Forex account balances in Japan have risen by nearly two-thirds from last summer to total ¥613 billion – nearly $5 billion. “Leveraging typically makes their positions 10 to 30 times larger,” says the Financial Times, and what the MoF struggled to achieve with $400 billion of short sales, private investors are now doing with a quick click of a mouse. Total Yen sales by private individuals in Japan outweighed the volume of professional betting against the Yen recorded at the Chicago Mercantile Exchange by the end of last month.

Mr. and Mrs.Watanabe’s profits from selling the Yen might just be a taste of the short-sale gains yet to come ... or so everyone thinks. And whether you are game to join in the world’s biggest ever “one-way bet” or not, the Yen’s ongoing decline at least shows just how debased all currencies have become over the last three and a half decades. The collapse in Japan’s interest rates only served to put a ceiling at ¥84 per dollar. Fresh out of interest-rate fire-power by the end of 2001, the Bank of Japan then had to actively sell Yen to cap its currency at ¥102 per dollar in late 2004. Put another way, destroying the Yen by destroying its yield proved mighty tough with Bernanke and Greenspan in charge at the Fed. And with $686 billion in excess foreign currency reserves now stacked up today, perhaps the only route left to beating Japan’s 10-year deflation really is to leave banknotes in rest rooms.

Ben Bernanke’s famous speech was entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”. Speaking as the tech stock crash leached into consumer spending in late 2002, the current Fed chairman tipped his hat to Milton Friedman’s idea of “money dropped from a helicopter” to stimulate an ailing economy. Bernanke’s speech bears revisiting now that U.S. retail sales are tanking once more – driven this time by the collapse in home sales and prices. “... under a paper-money system, a determined government can always generate higher spending and hence positive inflation,” the speach concluded.

Neither Friedman nor Keynes got to put their reflationary plans into action, of course. To date, Japan has failed with its make-work programs and free money gifts, too. But Bernanke sat at Alan Greenspan’s right hand while the Fed Funds rate was slashed from 6.0% to 1.75% in 2001 – and then cut again to an “emergency” rate of 1.0% by June 2003. The Nasdaq turned higher. Home prices soared. And despite 17 hikes in the official cost of dollars since then, there has also been a surge in that “quantitative easing” known as trading on margin. According to the latest NYSE data, margin debt jumped 11% to $353 billion in May, up from below $318 billion in April. And this is before the U.S. slips into recession, and lenders stop lending for fear of bad debts.

Just how much speculation will the Great American public indulge in when rates slide again and we are all urged to hold hands and gear up in the markets? The Japanese Yen began its slide from near all-time record highs. The dollar, in contrast, has already sunk to a near-three decade low on its Trade-Weighted Index. “The arrival of Japanese households as major investors seems to have affected foreign-exchange markets,” said Bank of Tokyo board-member Kiyohiko Nishimura earlier this month. “The gnomes of Zurich were accused in their day of destabilizing markets. The housewives of Tokyo are apparently acting to stabilize them.”

Nishimura might just be right, if by “stabilize” he means “destroy the Yen’s purchasing power.” Which he does. Deflation in the classical sense defines a shrinking supply of money. On the ground it means falling asset prices, lower wages, and the loss of all pricing power for business and industry. Make the currency worth less, therefore, and deflation is cured. Make it utterly worthless, however, and the trouble will have only just started.

Priced against gold, there could be a whole heap of ruin left in the Japanese Yen. Indeed, the greatest achievement of Japan’s near-zero interest rates so far has been a bull market in gold for retail investors sick of earning next-to-nothing on their cash. In the economy, however, total cash earnings for Japanese workers have barely risen over the last 13 years. The Cabinet Office said this week that Japanese consumer confidence fell in June, the third monthly decline on the run, giving the lowest score since December 2004. This is what a real credit crunch looks like, a gut-hollowing time after asset prices collapse and near-zero interest rates cannot cancel repeats of When Bad Debts Attack on TV.

How to encourage fresh lending, fresh spending and growth? You can make money free, but you cannot force banks to lend it. “Bank loans for start-ups still require personal guarantors,” notes Ken Worsley for JapanEconomyNews.com. “Great risk management for the banks, bad for start-ups and innovation. On September 29, 2006, the Prime Minister told the Diet that he would urge banks to do away with this in order to encourage entrepreneurship, but nothing has actually happened.”

Now the world’s largest economy is settling down to its own version of When Bad Debts Attack, with U.S. home-owners, investment banks and retirement funds all fighting to take the lead role. Buy the Yen if you dare. Back the Euro if you must. Bet against all currency values – and buy gold – if you think the collapse of the dollar can only cause trouble.

If only Bank of Japan Governor Fukui was Dr. Who.

One of the blessings, or curses, of long international flights is the opportunity to catch movies you ordinarily might avoid. Japan’s comedy Bubble Fiction is a case in point. It is the tale of a befuddled 20-year-old woman who travels back in time on an important mission for the Finance Ministry. Roger Ebert would probably trash it and the folks at Cannes would not be impressed. Think Doctor Who meets Wall Street with a bit of Bridget Jones’ tossed in.

Yet the idea of traveling back in time to 1990 to avert Japan’s lost decade proved oddly thought-provoking. What if policy makers could go back and fix their biggest screw-ups? What if officials could stop the Japanese miracle from spiraling into a deflationary nightmare? What if then-Bank of Japan Governor Yasushi Mieno revisited December 1989 and changed his decision to boost short-term interest rates so rapidly?

It is tempting to apply the economic-policy time machine elsewhere. Former Federal Reserve Chairman Alan Greenspan might like to return to December 1996 and do more than just make ambiguous warnings about “irrational exuberance”. Thai officials might want to go back to July 1997 and play their baht devaluation a bit differently. John Meriwether of Long-Term Capital Management could go back to 1998 and make money from Russia’s devaluation and bond default.

Someday, if Japanese officials really are able to travel back in time, early 1999 should be among their first destinations. It was then that BoJ Governor Masaru Hayami cut rates to zero. That single event has arguably had a bigger impact on global markets than any policy decision of the last decade. From New Zealand to Poland and from Zimbabwe to Peru, policy makers are experiencing economic-control problems. Asset markets are moving in ways that fundamentals and highly paid analysts cannot explain. One source of the growing number of conundrums around the globe is Japanese money.

Those of us paid in yen are not happy about the currency’s 5.6% drop during the past 12 months. It can make cities such as Sao Paulo and Kuala Lumpur feel more like New York or Paris, in terms of living costs. Yet for global investors, cheap Japanese financing is the key to prosperity.

In a new book, Client State: Japan in the American Embrace, Gavan McCormack argues that the U.S. uses Japan as an automated-teller machine, and he has a point. Keen on becoming the Britain of Asia, Japan even ignored its pacifist constitution and sent troops to Iraq. Japan helps finance U.S. interests around the world, yet its views are often unsolicited in Washington, or ignored. Japan also has become an ATM in global markets via the so-called yen-carry trade. Borrowing cheaply in yen and investing those funds in higher-yielding assets overseas has become a one-way bet, and a steadily growing one. It is flooding economies from Thailand to South Africa to Chile with liquidity, feeding bubbles virtually everywhere.

Bubble Machine

When current BoJ Governor Toshihiko Fukui talks about raising rates, he cites the risk of bubbles in Japan. Yet it is too late. Japan’s ultra-loose monetary policy already is doing that globally. Japan is not exactly encouraging the yen-carry trade. And just as former U.S. House Speaker Tip O’Neill said about all politics being local, central bankers tend to think globally and act locally. The BoJ has done that in a bid to end deflation.

Yet Fukui, who has run the BoJ since March 2003, could have gone in one of two directions: ending deflation once and for all or normalizing interest rates. Fukui has succeeded in neither and the yen’s weakness is a side effect of confusion in markets about the BoJ’s goals.

History may look even less kindly on this period than the BoJ’s efforts to prick Japan’s asset bubble in the late 1980s and early 1990s. The odds favor the yen-carry trade blowing up at some point, just as it did in 1998. Back then, Russia’s debt default and resulting market turmoil saw the yen surge 20% in less than two months, devastating the carry trade. Today, the number of trades and the amount of leverage involving yen borrowings are far greater than in the late 1990s. Add in a rapid increase in the number of hedge funds since then and the size of imbalances – U.S. deficits, China’s undervalued currency and free Japanese money – and you have a perfect recipe for global shocks.

When things go awry, and they will, some Japanese officials will be wishing they had a Doctor Who. Or, at least a good place to hide.

CONVERGENCE AND DIVERGENCE

The last few years offer many conundrums. Some are widely debated, others go unmentioned. This article seeks to highlight an unmentioned attribute of the recent period. Globalization has been producing growing economic integration and interdependence. At the same time, political circumstances are divergent. Electorates, national moods and rhetoric have been increasingly nationalistic as fortunes converge and correlate. Rising tensions and tariff threats emerge from governments as financial flows and business deals spill across borders. Governments can not even get along well enough to agree on the next round of economic integration regulation. The Doha Round negotiations of The World Trade Organization (WTO) talks are defined by setback, standstill and rancor. Our international economies are moving toward integration and move increasingly in lock step. Meanwhile, political understandings and discussions are increasingly narrow and hostile. At some point international politics and economics must move toward convergence.

The U.S. is fundamentally dependent on the rest of the world and the present financial and trade architecture. America imports 64% of the world’s saving and increasing portions of her food, energy, appliances, clothing, toys, vehicles and inputs to production. Foreign nationals, funds, firms and governments have been literally supporting U.S. households, firms and the government with credit. At present 52% of marketable U.S. Treasury debt obligations are foreign owned. Over $1 in $3 lent to Uncle Sam is lent by a foreign government, 35% of marketable U.S. Treasuries are owned by foreign government institutions. Foreign entities own 20% of U.S. corporate bonds and 14% of U.S. equities. You would never know it from the political rhetoric and debate. The SEC is presently terror-bating numerous firms – disproportionately foreign – on its official website. America is fast becoming the worst offender in terms of political policy, statements and actions that ignore interdependence and offer nasty hyperbole. Real tensions with Russia have blossomed into a cold war light as pundits and politicians just can not seem to fathom divergent opinion. Deal blocking against Middle Eastern and East Asian firms continues as our private equity firms, hedge funds and investment advisors look offshore for growth opportunities. Massive tariffs against Chinese goods are regularly debated in Congress. Some are beginning to refer to rumblings and restrictions with China as a trade war.

Leading American politicians, pundits and business leaders preach to the world about free trade and unfettered market efficiency. Economic futures are woven together all over the world. Political goings on and opinion polls suggest distrust and divergence on subjects of policy conduct and foreign affairs. Angry accusation, disengagement and growing isolationism define American attitudes to the rest of the world. Hostility to foreign “plots”, firms, agendas and ideas is not unique to America. No one mentions, notices or cares that we are wholly interdependent on these “nefarious” foreign elements for an increasing share of our goods, export markets and financing. We are buying ever more of their stuff, borrowing their money and pouring our wealth into their assets. However, they are not to be trusted! This is not just an American phenomenon.

The depth of American anger and distrust at foreign action is high. Sadly, resentment seems to be broadly growing. Global opinion of the U.S. is extremely poor. Foreign conceptions of the U.S. and especially of America’s foreign policy, is highly negative. Strong majorities in 65% of 47 surveyed countries believe the U.S. does not consider their country when making foreign policy decisions. Americas are suspicious of and hostile toward traditional allies and rising regional powers. While the Iraq War and Global Terror War contribute significantly, the depth and breadth of negative opinion signal a bigger problem. The U.S. is not alone. Chinese, Japanese, Korean, Russian, Indian, Pakistani, EU, Middle East and South American citizens view each other with significant suspicion. Foreign suspicions of the U.S. and of each other define the day. All of this is increasing alongside growing mutual economic dependence.

We see this rising in another form in immigration debates. Anger and xenophobia blend in a heady mix as nations debate immigration policy. This has been a feature of European political debate and has surged in the U.S. The scope, scale and import of immigrant labor in the U.S. economy is absent from a debate waged purely on theoretical and moral terms. Morality surely deserves a seat at the table in this discussion. Thus far, reality has not been invited to the meeting. Economic integration of immigrants is high and rising, the political debates and policy suggestions operate as though this was not true. The politics and economics of immigration are distant and diverging. They must converge.

Across the industrialized world passions rage about outsourcing. There are good reasons for concern. Public perceptions of risk level and extent can easily be shown to be extremely exaggerated. Politicians grandstand and laws to protect domestic production are discussed. Policy has yet to actually be changed. Lost in these debates is the massive investment by firms, households and institutional investors in the developing world. Our firms and investors believe in and increasingly bet on far more rapid and robust growth in emerging markets. This means reallocation of position in the global economy, rising employment and shifts in design, finance, production, marketing, advertizing and tastes. In short, it means increased outsourcing and in-sourcing. We have battered down the protectionist walls to developing nations and mandated openness. Our economies are built on integration. Politically we see these developments as threats and debate if we should allow them to happen. We have and continue to organize our economy to insure these developments occur. No one is seriously challenging that organization. There is a serious disconnect!

Forward movement requires that this gap be bridged. There are two basic ways to lessen the distance between political and economic realities. Economic integration can reverse trajectory or political integration can be embraced. No doubt, some mixture will occur. The nature and mix of accommodation will play a huge shaping role in the economic and political realities of the medium to long term global situation. Our concern has been growing as the distance between political and economic courses increases. This is one conundrum that is ignored at great peril.

HOW HIGH CAN CRUDE OIL FLY?

In London, the price of North Sea Brent, the benchmark for two-thirds of the world’s oil, touched an all-time high of $78.40 per barrel, with no sense of alarm at the world’s top central banks. Regarded as a key indicator of global inflation, central bankers are sitting in stone-faced silence about the surge in crude oil, and that has been good news for bullish speculators in gold and energy shares.

After all, higher interest rates will not produce one extra barrel of oil. When asked about the high price of crude oil on July 10th, Fed chief Ben “helicopter” Bernanke replied, “Inflation is less responsive than it used to be to changes in oil prices and other supply shocks. If inflation expectations are well anchored, changes in energy and food prices should have relatively little influence on ‘core’ inflation.”

Crude oil has been on a wild roller coaster ride for the past 18-months, gyrating within a wide range, between a low of $50 per barrel and a high of $78l, and dragging global oil company shares along for the ride. With the Dow Jones Industrials hyperinflating to the 14,000 level, and oblivious to record high oil prices, why should U.S. central bankers rock the boat with higher interest rates?

In today’s world of 20-second sound bites, and information overloaded with lots of static and noise, it is easy to lose one’s historical perspective on the markets. The starting point for the latest 6-month rally in North Sea Brent was from the depths of despair, at $51 per barrel. So after a 50% increase in oil prices, traders are asking just how high can crude oil fly, or does a big tumble lie ahead for the second half of 2007?

A year ago, once it became apparent that Israeli PM Ehud Olmert could not engineer a crushing defeat of Hizbollah, the U.S. and other Western powers asked for a UN cease fire, which ushered in a huge slide in the crude oil market. Few operators in the crude oil market could have imagined that North Sea Brent would tumble by $27 to $51. But behind the scenes, the OPEC cartel kept its oil output steady at 28 million barrels per day, near a 25-year high, greasing the skids in crude oil and aiming for a “reasonable target” of $60 per barrel. But the price kept falling. Since hitting rock bottom at $51, the pendulum has swung the other way, climbing upward to record highs of $78.40.

Global demand for crude oil is led by China and its 11% economic growth rate. China’s crude oil imports were up 20% in June from a year earlier to 14.1 million tons. In the first half of this year, China’s oil imports rose 11.2%. China has become Iran’s biggest customer, buying 15% or 335,000 bpd of Iran’s oil exports last year. And Beijing uses its UN veto to blunt Washington’s drive to squeeze Iran’s oil industry and economy.

Iran’s Ayatollah Khamenei and his sidekick, Mahmoud Ahmadinejad, are making all the right moves in their quest of nuclear invincibility. Spinning European diplomats in an endless circle by dangling a few multi-billion oil and construction contracts is a simple trick. But keeping the Washington neo-cons at bay, with the U.S. army perched on Iran’s eastern, southern, and western borders is no small feat. After four years of fruitless negotiations with the Europeans, IAEA chief Mohamed El-Baradei says Iran has become a “master of uranium enrichment,” and has reached “the point of no return,” in acquiring the technology to build a nuclear bomb. That is reinflating the “Iranian war” premium into global oil prices. At the same time, Tehran is turning U.S. public opinion against the war in Iraq, as it supports the anti-U.S. insurgency in Iraq with money and weapons.

But Saudi king Abdullah is already several steps ahead of public opinion. On March 3rd 2007, King Abdullah of decided to hedge against the possibility of an early withdrawal from Iraq, by inviting Iranian hard-line president Mahmoud Ahmadinejad to an extraordinary meeting, promising a thaw in relations between the two regional petro-powers. The price of lasting Iranian friendship with Riyadh might be the removal of the U.S. military from the Persian Gulf region. At risk are Iraq’s 113 billion barrels of proven oil reserves and 200 billion barrels of probable reserves in the western half of the country. In the eyes of American neo-cons, Sunni Saudi Arabia, Egypt, Jordan and the small Gulf monarchies are all threatened by the emergence of a super-confident Iran, intent on acquiring nuclear weapons, and dominating a region that contains 2/3’s of the world’s oil reserves.

Ahmadinejad received his booty a few weeks later, when Saudi Arabia, notified oil refiners in Japan, South Korea, Taiwan and China that it would cut its oil exports by 10% for April. Saudi Arabia’s oil production cutbacks helped push North Sea Brent above $60 per barrel, boosting Iran’s oil income, and turning Iran’s national budget away from a possible deficit and back into a surplus.

Iran demands payment for oil in Euros and Japanese Yen.

While the price of Iranian oil is still quoted in U.S. dollars, Hojjatollah Ghanimifard, chief of the National Iranian Oil Company (NIOC), says roughly 70% of Iran’s oil income is now paid in currencies besides the U.S. dollar. Not since Saddam Hussein in November 2000, has an OPEC member dared to ask for payment of oil in a currency other than the U.S. dollar. Saddam converted $10 billion of his currency reserves to Euros, and was ousted from power 2 1/2 years later.

Since then, the Euro has emerged to challenge the U.S. dollar’s hegemony in world trade, and is the second most held currency by central banks. The GDP of the Euro zone is roughly the same as that of the U.S., and its population is 60% bigger. Furthermore, the Euro zone’s external accounts are much better balanced, with a current account deficit of only €3.2 billion ($4.2 billion) over the past 12-months, compared to an $833 billion U.S. deficit. 60% of OPEC’s oil sales are sold to Europe, so it would make economic sense for OPEC to ask for Euros in exchange for its oil. But the House of Saud needs a buffer against its Shiite enemies in southern Iraq and Iran, which it receives from U.S. military. Thus, the Arab Oil kingdoms are still sticking with the U.S. dollar, and recycle much of their petrodollars into U.S. Treasuries through their London brokers.

Now in a very interesting turn of events, Ayatollah Khamenei is demanding that Tokyo pay for its Iranian oil imports in Japanese yen, rather than U.S. dollars. The request is believed to be part of Tehran’s fear of a possible seizure of its assets by the U.S. government amid tensions over its nuclear weapons program. So far, the dollar has shown little reaction to the Ayatollah’s latest gambit, holding steady above 122-yen.

Perhaps, the only way to prevent Iran from acquiring nuclear weapons, short of a military attack, is the imposition of tough economic sanctions. The United States is prohibiting U.S. banks from dealing with Iran’s Bank Sepah, with $10 billion in assets, and Bank Saderat with $18 billion. But Bank Sepah International is able to skirt around the restrictions through it offices in London, Paris, Frankfurt, and Rome. Washington has begged European companies and governments to break commercial and financial relations with Iran, but so far, has failed to make any progress.

The U.S. administration is particularly targeting loans made by European governments to Iran. European companies that export machinery, industrial equipment and commodities, Iran get loans from European banks and then receive European government guarantees for the loans on the ground that such transactions are risky in nature. Germany’s Chamber of Commerce said on September 1, 2006, “Economic sanctions against Iran would solve none of the political problems. But the German economy would be hard hit in an important growing market, and would jeopardize more than 10,000 German jobs.” So it would be very difficult for the US State department to gain European approval for tough sanctions.

Perhaps the most effective means of punishing Iran would be to cutoff Tehran from the Euro for its oil. California Democrat Tom Lantos aims to put an end to Europe’s cozy business dealings with the Ayatollah. Legislation aiming to punish foreign companies that do business with took a big step forward on June 26th. The foreign affairs panel of the House passed a proposed law, 37 votes to one, to curtail the president’s ability to waive sanctions against foreign companies doing business with Iran. It also provides increased congressional oversight regarding the way the administration implements the legislation. “Until now, abusing its waiver authority and other flexibility in the law, the Executive Branch has never sanctioned any foreign oil company that invested in Iran. Those days for the foreign oil industry are over. The corporate barons running giant oil companies, who have cravenly turned a blind eye to Iran’s development of nuclear weapons, have come to assume that the Iran Sanctions Act will never be implemented. This charade will now come to a long-overdue end,” Lantos declared.

Iran aligned with “Axis of Oil”, counterweight to U.S. military.

Washington is saber rattling in the Persian Gulf, sending the USS Enterprise to join the USS Stennis and the USS Nimitz naval carriers, building up the largest sea, air, marine concentration the U.S. has ever deployed opposite Iran. Washington is also considering deploying the fourth U.S. carrier to the Red Sea opposite the Saudi Arabian western coast to secure the Gulf of Aqaba and the Suez Canal. But Iran has taken delivery of four submarines from North Korea, and may be mobilized near the Strait of Hormuz and pose threats to U.S. naval vessels.

Tehran has aligned itself with the “Axis of Oil” including Russia and Venezuela, comprising the world’s 2nd, 4th, and 8th largest oil exporters. Chavez has threatened to cutoff oil exports to the U.S. if Bush decides to attack Iran’s nuclear facilities. On July 2nd, Venezuela’s fiercely anti-U.S. President Hugo Chavez held talks with his “ideological brother” Mahmoud Ahmadinejad, on the last leg of a tour of nations at loggerheads with Washington. Last month, Chavez, pushed Exxon Mobil and Conoco Philips out of his country as part of his self-styled socialist revolution. “The United States’ empire is the greatest threat that exists in the world today,” Chavez told Iran’s hard-line Kayhan daily.

Last month, in an effort to ward off a possible U.S.-led embargo of gasoline to Iran, The Supreme Leader of the Islamic Revolution, Ayatollah Ali Khamenei, ordered the rationing of gasoline, which is expected to reduce imports by $4 billion per year. “Our enemies have confessed, that if gasoline consumption is contained and reduced, Iran will become invincible,” Ahmadinejad declared.

Washington has imposed an arms embargo against Venezuela, but Russia and Venezuela have signed arms deals worth $3 billion over the past 18 months. “I am determined to expand relations with Russia,” Chavez told Russian kingpin Vladimir Putin last month, adding that his determination stemmed from their shared vision of the global order. “We must defeat imperial hegemony that is imposed on us or we head toward barbarism, we either defeat imperialism or imperialism destroys the world. The empire must understand that it cannot dominate the world.” Chavez fears the possibility that American soldiers would invade Venezuela to seize control of the South American nation’s immense oil reserves.

Federal Reserve ignores higher energy and food prices.

Since crude oil is denominated in U.S. dollars outside of Iran and Russia, the Fed has a special role to play in protecting the purchasing power of the dollar, and to prevent an upward spiral in global inflation. However, on July 10th, Bernanke appeared to firmly endorse the his long-standing practice of ignoring swings in food and energy in setting monetary policy. Bernanke went a step further and said that the M3 money supply did not have a “special role in the formulation of U.S. monetary policy. Our experience has been that financial innovation and other factors have tended to create a relatively weak relationship in the short run between money and inflation and money and output,” he told the National Bureau of Economic Research.

Back in February 2006, Texas Representative Ron Paul asked Bernanke if the Fed would reconsider publishing the M3 money supply. Bernanke replied, “The reason for the planned cessation is that the Fed staff had not found M3 as a useful indicator of monetary policy. Therefore, in order to reduce the reporting costs to financial institutions, the Fed had decided to drop the calculation and publication of M3.” (Could Bernanke print an extra few million dollars to cover the cost?) It is not surprising, because since Bernanke took over the Febd’s helm, M3’s growth rate has expanded rapidly to a 13% annualized clip, just shy of a 30-year high, and up from 8% in March 2006. Much like the ECB, the Fed is expanding the M3 money supply to immunize the U.S. economy and stock market from sharply higher prices of crude oil.

The rapid expansion of the US money supply has sent the U.S. dollar to its lowest level in 26-years against the British pound, an 18-year low against the Australian dollar, a 30-year low against the Canadian dollar, and an all-time low against the Euro. So oil exporters are quick to dump the U.S. dollar and convert into appreciating currencies after initially accepting payment in the greenback.

A weaker U.S. dollar, double-digit growth of the money supply, and sharply higher oil and food prices is a prescription for higher inflation. According to the IMF, food prices are 23% higher around the globe than 18-months ago, largely due to stronger demand for agricultural commodities to make ethanol and other bio-fuel substitutes for crude oil. The price of a bushel of corn is up about 50% since spring of last year, and has led to rising costs for other foods and meats, because corn is an essential part of the U.S. food-supply chain. Other pressures driving up the price of food include higher fuel costs, from surcharges passed along for transportation.

Soybean prices rose to their highest level since 2004, climbing above $9 per bushel and up 54% since October, tracking trend in crude oil prices, as demand for bio-fuels fuels boosted demand for vegetable oils. Soybean prices also rose on speculation that increasing use of ethanol made from corn in the U.S. will require farmers to switch more acreage from soybeans to corn next year. Rising demand for bio-fuel helped send soybean oil to a 23-year high.

Of course, Bernanke’s sleight of hand is backed up heavily doctored inflation statistics, conjured up by government apparatchniks. The mainstream media relays the inflation propaganda to the public, with a stamp of approval from Wall Street economists. But with a hyperinflating stock market in the background, savers in the U.S. bond markets are the big losers from Bernanke’s money printing operations.

The International Energy Agency is begging the Arab Oil kingdoms to dip into their spare capacity and open the oil taps wider to lower oil prices. But on July 16th, Libyan oil chief Shokri Ghanem rejected the call for higher output. “There is no shortage of oil, but there are refining bottlenecks, panic in the market, speculation, and the political situation in the Middle East. No one is saying there is no oil in the market,” he said.

Arab oil exporters are paid in inflated U.S. dollars, which are losing their purchasing power against the Euro and British pound. Arab oil kingdoms are keeping a tight lid on the oil supply to buoy prices, to offset the Fed’s devaluation of the U.S. currency. It is a vicious cycle that does not end, until Helicopter Ben and his reckless cohorts in Asia and Europe, tighten up on the money supply.

CORN ON CORN ACTION SIGNALS FORTHCOMING BUST IN ETHANOL

American-style ethanol production is a strange kind of success story. It is not exactly profitable, nor exactly energy-efficient, nor exactly agronomically prudent ... and yet it consumes one quarter of the entire American corn crop.

The success of corn-based ethanol production in the U.S. relies on large government subsidies, as well as on hefty tariffs against Brazilian imports. Furthermore, ethanol production consumes about as much energy as it delivers, if not more. And making the stuff requires prodigious amounts of water and corn. The rapidly shrinking Ogallala Aquifer provides most of the water. The degrading soils of the Midwest provide the corn.

We have no idea how much longer this bizarre combination of governmental coddling and dubious resource management can masquerade as an “energy solution”. But when the mask does finally come off, we that a lot of investors – and farmers – will wish they had never heard of ethanol.

As things stand today, ethanol production diverts one quarter of the U.S. corn crop from dinner tables and feed lots to gas tanks, in the process boosting the prices of corn and numerous food products that rely on corn. Ethanol production, therefore, has fueled an agricultural gold rush. Everyone wants to grow those golden ears of corn that sometimes fetch $4.00 a bushel. This newfound love for corn crops would be fine if the nation’s soils could tolerate it. Experience suggests otherwise, but many farmers are shunning traditional crop-rotation practices in favor of continuous corn planting. Farmland soils will likely suffer as a result. Therefore, to ethanol’s lengthy list of drawbacks, you can add soil degradation.

Ethanol may not be much of a long-term energy solution, but it has been one heck of a short-term solution for farming profitability. Because ethanol production is booming, so is demand for corn. Rising demand means rising prices, which makes corn farmers very happy. Maybe too happy. Corn farming has become so enticing, that many farmers are ignoring the age-old imperative to rotate their corn crops with soybeans. Corn on corn is the new craze in grain-growing country.

Farmers know that they must practice crop rotation to maintain the fertility of their soil. But with the price of corn rising and the allure of a corn goldmine, some farmers are throwing caution and common sense to the wind. By planting corn on corn and not using proper rotation practices, farmers will almost inevitably face the prospect of growing corn in nutrient-deficient clay. Soil deterioration is a perennial condition in the Corn Belt.

For example, for about the last 20 years, much of eastern South Dakota’s farmland has seen consistent healthy crop rotations. A typical rotation would alternate corn crops with soybean crops. Many of the farmers I met of my farm tours through the Midwest this spring and summer were worried that corn on corn is becoming too popular, especially with young farmers. During my trip, I even saw flyers in the local Walmart for farmer workshops about how to manage a continuous corn planting system.

SDSU economist Thomas Dobbs writes in a recent publication that he worries about the loss of biological diversity on the farm, “I have been concerned for a long time, even about the corn-soybean rotation not being ecologically sound. But corn on corn is much worse. I think this is a real step backwards.” Make no mistake. Many experts say crop rotation is vital, no matter what the flyer at Wal-Mart says. Rotation serves several ecological and agronomic purposes. It makes it harder for diseases, weeds and insect pests to persist. The right rotation also builds soil fertility. Soybeans are a natural partner to corn because they capture nitrogen from the atmosphere, leaving more in the soil for the next year’s crop.

Some farmers and scientists disagree, saying that with new technology corn on corn is very possible to do effectively. I hope the corn on corn people are right. But I have my doubts. When farmers start ignoring centuries of wisdom, just for the sake of cashing in on next autumn’s corn price, something must be very wrong. Probably, what is wrong is ethanol itself. This boom is probably going to go bust, even with government subsidies.

Put it this way: the insiders are selling to the outsiders. One Minnesota farmer I spoke with on my trip, said that back when he and his fellow farmers built a co-op ethanol plant a few years back, the costs were half of what they are now, maybe even less. But now, a bunch of private-equity boys have come to town and funded new ethanol plants. “Many of us farmers just don’t see how these new ethanol plants will ever turn a profit,” my source said. The larger the ethanol boom grows, the more obvious ethanol’s limitations become. Ethanol is not an energy solution, it is an energy speculation. It is a massive national speculation that is distorting the economics of numerous industries, while also promoting imprudent farming practices.

Sticking with my theme of funny farming, let us talk about the acreage rental market. Yikes. $275 an acre is obscene. That, however, is the going rate in several corn-growing regions. But many farmers are paying these unreasonable rents anyway, all in the hope of cashing in on high corn prices. On my last farm tour in June, all the farmers I met with, from Minnesota to Wisconsin to Iowa, owned their properties outright. So they were the ones doing the renting – often to younger farmers and smaller operations. All the farmers I met said the same thing. “I don’t know how these smaller guys will pay the rent.”

And rent is not the only sky-high cost that farmers are facing. Look at some of these input costs. Fertilizer is soaring, seed at the elevator, storage, transport, irrigation, fuel, etc. Then pile on top of that huge increases in rent for some farmers and the fact of the matter is they simply do not have any more blood to give. All of that expense is mounting and the only hope is for every farmer to have a perfectly harvested crop and fetch the highest market price, the chances of that in any year are slim to none.

It looks to me like corn on corn action is getting a little out of control. Which is just one more sign that the Ethanol boom might be nearing the bust stage.

A SINGLE WAY TO PLAY BOTH GREEN AND DIRTY ELECTRICITY GENERATION

As CO₂ cap legislations are passed, like the one the Governator just passed in California, we will begin to see more nuclear power plants, as well as renewable forms of energy production. This will have massive ramifications for the world energy market – and by the end of this article, you will have some concrete information on how to profit from this huge change in the energy paradigm.

All of this news on carbon caps and clean energy laws is nothing new to you, so I will not bore you with legislation details. I can promise you that although I am all for renewable energy, we have not seen the end of the carbon fuels era. Instead, we have somewhat of an overlap with making the transition between green/nuclear energy and carbon-based energy. It is this transition that presents itself with an awesome opportunity – a hidden market that allows you to play all of these forms of energy with one single play.

The carbon cap that Gov. Schwarzenegger passed has eliminated 15 carbon-based power plants in the surrounding states that were set to come online and supply energy to the California power grid. It just was not going to be economical for them to complete production anymore. This is a huge development for energy markets. The power supply has to come from somewhere, or we can expect to see massive brown- and blackouts. According to the governor’s new legislation, this energy WILL BE green. But how green?

There are still technological limitations with green energy created from the Earth’s natural forces. Solar is only operational during the day and when overcast is limited. Wind is not always around to keep the mills turning. Geothermal, good as it is, has been slow in grabbing the public’s attention. Hydropower is strictly limited by geography. Nuclear energ has become the center of attention recently. It is a cost-effective form of energy with virtually no carbon emissions. But it, too, has its drawbacks to keep it from being a universally accepted power source: the disposal of used fuel rods, general safety worries, and an overall negative political image. So our coal, oil, and natural gas power plants are not going anywhere.

So which carbon-based power plants are cleaner and more efficient? Honestly, I do not really know. Coal liquefaction and other clean-coal technology make it cleaner to burn, but less economical. The coal lobby is working hard in Washington. Natural gas is also a cleaner-burning fuel source, but how long will natural gas prices remain moderate? As for oil, the whole story of Peak Oil is beginning to be more common talk around the local watering holes. It seems that greener power might just cost more green dollars.

So I am not going to say that one form of power is better than another. What I do know is that it will be a combination of all these forms of energy that will keep the lights going. That is definite. As an investor myself, the point that I am trying to uncover is how to protect my investments. And that is what is brought me to this conclusion ...

There is one market that allows you to take advantage of the growing demand in ALL of these forms of energy. The name of the game is molybdenum, or just moly, for short. This metal has several interesting characteristics that make its usage integral to several forms of energy creation. Moly has the sixth highest melting point of any element. It is highly corrosive resistant and does not expand, contract, harden, or soften under extreme temperature changes. Moly is used in making stainless steel, hence the corrosion resistance and life span of your shiny ratchet set. Moly is added to steel and cast iron to make metal alloys and superalloys that are much greater in strength. It can be found in anything from airplanes and cars to construction beams and filaments.

This metal has tons of application and, better yet, is used in almost every aspect in the world of energy. It can be found in almost every modern oil and gas drill. It is used to extract and transport coal. The corrosion resistance, combined with temperature insensitivity, makes moly very important in the production of oil and natural gas pipelines. Molybdenum is also used as a hydroproccessing catalyst in petroleum production. Molybdenum can be found in every modern turbine used in a power plant. Moly is the only way you can play these markets all at once.

SOMETIMES IT IS NOT JUST A CYCLE

The rise in commodity prices may not simply be cyclical.

The market and media view about the mining giant Rio Tinto’s $44 billion bid for the Canadian aluminum company Alcan is that the buyer overpaid. It is generally believed that commodity prices are close to the top of the cycle, so Alcan earnings can be expected to decline going forward. Certainly Alcoa, the other bidder for Alcan, seems to think so. It has terminated its own lower bid. However, the market may be wrong. There are factors which suggest that the rise in commodity prices may not simply be cyclical, but will instead be an important feature of a new and more difficult world.

The theory that commodity prices are simply in a cyclical upswing is at first sight highly plausible. The Fed has been printing money like confetti since 1995, and other central banks have since joined it, allowing the world’s supply of foreign exchange reserves to soar to a total of $5.82 trillion, 11.8% of Gross World Product, compared with $1.6 trillion, 5.4% of Gross World Product in 1997. While consumer price inflation has remained under control, it is reasonable to suppose that such a gigantic increase in money supply would produce price rises in assets, housing and commodities. Naturally, in the cyclical theory, once the world’s central banks come to their senses, and resume their traditional role of fighting inflation, commodity prices will drop back as they did after 1973.

There is just one nagging factor. Consumer price inflation should not have remained under control with such a huge increase in the world’s money supply. Indeed, world consumer prices in dollar terms should have roughly trebled in the last decade, fueled by the increase in the money supply. Thus the simple cyclical theory cannot be correct. Something else must be going on.

Examination of the technological and economic changes of the last decade immediately suggest two possible causes of the mismatch: the emergence of China and India from their half-millenial slumber into rapid growth, and the world telecommunications revolution of cellphones and the Internet, which has allowed international product sourcing to be carried out much more efficiently. It is clear upon examination that the Internet/communications revolution in international sourcing is similar to the railroad/refrigeration revolution of the 1880s. Rather than introducing new products to our daily lives, as did electricity and the automobile, it has revolutionized the cost structures of existing products, as with farm products in the earlier period. Thus if money supply had been held constant, as it was with the 1880s Gold Standard, consumer prices would have declined steadily.

That explains the lack of consumer price inflation in the last decade. It also suggests that the Internet/communications inflation-suppressing effect is likely to prove temporary, as costs in the outsourcee countries rise and the market equilibrates to the new production and consumption patterns. Just as the railroads/refrigeration revolution condemned British agriculture to a decline lasting half a century, so the Internet revolution is hollowing out many Western industries, while producing new classes of productive consumers in India, China and elsewhere, who for the first time have enough money to live at above the subsistence level.

In Western countries, the last decades have seen a massive move towards services and away from products you can “drop on your foot”. Naturally, since most commentators on the world economy live in Western countries, they have tended to take this de-materialization of output as part of the natural order of things, and to suppose that commodity prices were in overall long term decline, as usage increased little if at all while extraction techniques improved and recycling became more widespread. However in poor and emerging countries, the pattern of demand is very different. While some modern lightweight goods, such as software and cellphones, spread rapidly to poor countries, much of the demand in emerging markets is for goods that are already plentiful in the West.

For example, Chinese consumers purchased over 7 million vehicles in 2006, and demand is increasing by around 20% per annum. Since China’s population is four times that of the U.S., a China with Western living standards would have automobile demand, not perhaps of 4 times US demand, but at least of 2-3 times. Similarly India has a population of 3.5 times that of the U.S. There, annual automobile demand is still only around 2 million vehicles, but it is increasing rapidly and there is no reason to suppose it will not follow the same path as China. There is no way to manufacture automobiles without using several thousand pounds of commodities of one type or another. Furthermore, they create their own demand, for oil obviously, but also for roads, shopping centers and other modern suburban paraphernalia, all of which is highly physical and requires substantial commodity inputs to satisfy.

It therefore follows that the Internet/communications revolution, by spreading purchasing power from a small group of rich country inhabitants to a much larger group of emerging markets citizens, has reversed the trend so clear in 1950-90 of shrinking commodity intensity in Gross World Product. As well as providing rich Westerners with ever more complicated gadgets of minute size, this new economy is also providing a numerically much larger group with the chunkier products (think furniture, for example) for which Western demand was already more or less saturated.

In services too, the trend is by no means wholly towards resource downsizing. While hedge funds consume directly no more of the world’s resources than the merchant banks and mutual funds they replaced (though being more expensive, they create product demand among their overpaid staff) that is not true of other services, especially air travel and vacation expenses, which tend to expand more rapidly than GDP. When characters on the down-market Yorkshire farming soap opera Emmerdale Farm vacation in Antigua, huge social change has occurred. Their journey to Antigua uses far more of the world’s commodity resources than their grandparents’ 1957 week in Blackpool. The transition of wealth to emerging market countries will only increase this resource-intensive demand further.

Thus the commodity boom we have seen over the last 5 years is probably not simply a cyclical phenomenon, but a long term trend. Commodity prices will dip once the world’s central bankers come to their senses and stop creating excess money, but the dip, not the recent rise, is likely to prove temporary. For oil and most minerals, increasing production will cause demand to move towards the more costly sources, and those in the less reliable countries. This will provide a bonanza for the likes of Russia’s Vladimir Putin, Venezuela’s Hugo Chavez and Iran’s Mahmoud Ahmedinejad. It will also cause a secular rising trend in inflation (when measured properly) which will prove as impervious to monetary policy as has the deflation caused by the Internet/communications bonanza.

Since Alcan produces a commodity, aluminum, that is basic to modern civilization, and sources much of its power needs from cheap Canadian hydro-electricity, it may be exceptionally well placed to take advantage of a secular rising trend in commodity demand and prices. Far from overpaying, Rio Tinto may be buying intelligently early into a trend that will shape the long term future. Oil companies that appear prepared to abase themselves more or less ad infinitum before the grand larceny of Putin and Chavez may also be seeing the future more clearly than the rest of us.

However, if Rio Tinto and the oil majors are right, most of the acquirers at premium prices in non-commodity fields are wrong. A world of high commodity prices is one in which the U.S., the EU and other “advanced” powers have a lower share of the world’s economic strength, with lower growth, lower living standards and much higher inflation than in the recent past. Far from rising 283 points to close to 14,000 to celebrate the Rio Tinto deal therefore, the Dow should have plummeted to a level more in line with the 5,000 that would reflect its long term historical trend – or even somewhat lower, reflecting the secular deterioration in U.S. economic prospects.