In his latest NYT column, Floyd Norris joins a rising tide of pundits in pushing for higher inflation. There are two main lines of argument for higher inflation. Firstly, the economy is too leveraged, many people have underwater mortgages and cannot spend, therefore decreasing the real debt burden will boost the economy. Secondly, deflation is bad for the economy, therefore inflation must be good. The premises of both lines of argument are true, but the conclusion may well be false.

The fundamental problem is a failure to consider the costs of inflation alongside the benefits. Yes, increasing inflation will likely lead to an uptick in real estate prices, which may lead to fewer underwater mortgages. But will this really lead to a recovery in consumption? What other effects might inflation lead to? Do you really think rich asset holders simply sit tight and let the central bank erode away their wealth? The most benign effect of inflation will be to raise home prices. There are a variety of other much more adverse side effects. For example, rich investors can snap up farmland as an inflation hedge, and then demand increasing farm rents to offset inflation erosion, resulting in rising food prices. Wages, I expect, has no chance of rising with the current sky-high unemployment rate, which would result in lower- and middle-income classes getting squeezed, and maybe abandoning all other discretionary luxury purchases. There could be increased capital flight from the US, leading to a decrease in productive investment. By pushing investors into deploying their cash, the economy as a whole may see all their real assets further concentrated in the hands of the moneyed classes, which can then just sit on their assets and demand rents from the rest of the economy. On balance, I think that the possible distortions brought on by inflation will probably outweigh the benefits. Paul Krugman has also recently pointed out that there is good inflation, and then there is bad inflation. It is far from clear what type of inflation will be stoked if one just prints more money.)

In a modern efficient capitalist economy, financial factors, such as an appropriate amount of money in circulation and a financial sector that allocates capital rationally, cannot in and of itself CREATE economic growth. At some point, capital flow is as lubricated as can be, and increasing the size of the financial sector past that point just creates a source of instability. Simply printing money will just cause people to shuffle money around the various asset classes without actually increasing the stock of economic assets. What we need now is joint financial-government action, with the central bank keeping interest rates low so that the government can borrow cheaply and invest in increasing the stock of economic assets, and the central bank also printing money to match the increased stock of economic assets so that deflation doesn’t occur. Avoiding deflation is critical, but that does not mean that one should advocate for inflation. In other words, it is time for the government to step up.

As the price of gold continues its ascent, and the world economic powers endeavor to outdo each other in printing fiat money, I find myself in a similar situation as value investors were in the late 1990s. Then, in the middle of the technological boom, value investors found that the stocks they cherished were spat upon by the market, and tech stocks which have no real earnings soar to great heights. Similarly, gold, with negative cash flow and no real productive value, will likely boom in the near future. I find myself sorely tempted to join the ride.

The most convincing bull case for gold is that gold can once again become a reserve currency in an era when all paper currencies are being devalued (industrial and jewelry demand for gold pales in comparison). Indeed, anecdotal reports are that many central banks around the world have begun to slow their gold sales, and may in fact be buying gold again. And of course, gold is a classic inflation hedge. The last time gold reached a peak in price is in the late 1970s, near the end of the inflationary era (see the very informative figure from the St Louis Fed). Many pundits have already pointed out that, when adjusted for inflation, gold prices are nowhere near its 1970s peak, although gold is currently at its peak based on nominal dollar pricing. However, if you look at the relationship between gold and other commodities such as oil and wheat, it is clear that gold is expensive relative to these commodities. In fact, it would make more sense for surplus nations such as China and Germany to stockpile commodities which they can use in the future, such as oil and uranium, rather than stockpile gold, or worse, paper currency that is losing value.

Due to the difficulty of valuing gold, a position in gold is necessarily a speculative play and must be constantly monitored. My preference is to look for commodity-related stocks that are undervalued as a hedge against currency devaluation. There are other methods, of course, such as Seth Klarman’s deep out-of-money options on Treasuries which will pay out only if Treasury yields spike (which will occur in a hyperinflation scenario, either as a result of a bond buyers’ strike, or the Fed increasing rates to rein in inflation). And of course, as per my previous post, I am still looking into Japanese stocks, which is expected to benefit from an inflationary environment. Failing to find some suitable hedge, I might initiate a small GLD position with a 10% trailing stop. This is not my normal procedure, as most of my positions are somewhat illiquid and 10% swings are commonplace. However, since I cannot value gold, a trailing stop would have to do.

At a time when central banks all over the world are pumping money into their economies, record amounts of cash are being sunk into a shiny hard rock. This rock cannot be consumed, has minimal industrial uses, and has negative cash flow due to storage and security costs. Nonetheless, gold serves as a currency of last resort, and the huge sums flowing into gold threatens to drain liquidity from the economy at the very moment when it is most required.

Of course, for every buyer of gold, there must be a seller. Gold miners and European central banks are traditionally net sellers of gold. Miners are likely to reinvest the cash in more mining equipment and gold exploration projects, which in my view, is a largely non-productive investment that does not increase the welfare of society. A society with more gold merely incurs more storage and security costs. Central banks tend to sell gold to raise foreign currency (or in the case of European banks, to raise euros) with which to repay bonds, which recycles the cash back into the economy, and so is more innocuous. Still, the silver lining is that central banks have no limits in quantitative easing, and can always print more money to counteract the “gold drag” on the economy.

Gold is likely to continue its climb as European central banks tamp down on their gold sales, and gold miners cannot possibly keep up with the surging demand. Central banks are trying very hard to fight deflation and pump a little inflation into the economy, which will encourage people to stop hoarding cash and start spending. When that happens, gold is likely to appreciate still further, since it is a traditional hedge against inflation. Gold bugs are rejoicing, while gold skeptics point in vain to the many other productive hard assets and excellent companies with pricing power that are likely to keep their value with inflation. I, for one, find it difficult to value gold, and would not be able to sleep at night if I invested in gold, and so prefer to head towards the contrarian camp and invest in things I understand.

Much media hay has been made over the astonishing foreclosure rate in August, as lenders took back the greatest number of homes in a month since records have been kept. Some of the language used in these articles evoked imagery of hurricanes sweeping across the nation and destroying vast stores of wealth in the form of houses. Breathless references were made to the large number of underwater mortgages (currently estimated at 25% of all outstanding mortgages), and how that ensures that housing prices will fall for months to come, and how the country will be dragged into ruin as a result. Clearly, the economic education of many journalists leaves much to be desired.

Let’s get this straight. Foreclosures and declining housing prices DO NOT destroy wealth. The amount of goods available for consumption has not declined because housing prices have declined. Declining housing prices merely redistributes existing wealth in the country, from current homeowners, to future homeowners. While current homeowners feel (and are) poorer, future homeowners pick up a bargain home and have more disposable cash. This transfer of wealth should work out to an economic wash.

Despite the above reasoning, most economists agree that large declines in housing prices are bad because of two externalities. Firstly, if the number of current homeowners exceed the number of future homeowners (which it does in the US, with an estimated home ownership rate of 60-70%), the psychological impact of declining wealth among economic winners is likely to be swamp that of increasing wealth among economic winners, both because the winners are in majority, and because the pain of economic loss is felt more keenly than the pain of economic gain. In other words, poorer current homeowners become gloomy and stop spending, and this gloomy mood infects the richer future homeowners, who also reduce their spending. This is the “wealth effect” that many journalists refer to, except that most do not point out that this is a psychological effect rather than an actual economic reduction in wealth. And psychology, as most veteran value investors know, can and often do turn on a dime.

Secondly, large declines in housing prices lead to huge losses for banks, causing them to run short of cash required for extending new loans, thereby depriving the economy of credit. This is probably an appropriate end for banks, since it was their reckless assumption that housing prices will keep rising that got us into this mess. And there is an easy solution for this side-effect of house price declines; the government could and should backstop the banks, perhaps easing the required regulatory capital ratios (i.e. regulatory forbearance), or just bailing the banks out, as it has done before. However, there is a political problem in bailing out unpopular banks; it is much more politically appealing to bail out the homeowners, thereby achieving an indirect bailout of the banks anyway.

Still, nearly all the scenarios that can play out due to housing declines do not result in an actual destruction of economic wealth. The rate of economic expansion in the US may be reduced for a few years due to psychological effects and a reduction in investment opportunities and credit, but overall, when all the dust has settled, existing wealth in the country will have been somewhat redistributed, but life will go on.

The latest banking rescue has been widely panned by the punditry, with even Krugman voicing his dismay, yet was warmly received by the markets. The pundits are correct : this plan will not rescue the bad banks. Instead, the new plan will grease the flow of credit into the real economy, and lift all banks, both good and bad, along with the entire economy. In fact, I think that the new plan is a piece of genius. It finally rewards the good guys instead of the bad ones.

From the viewpoint of rescuing banks, the plan looks like a failure. It will accelerate price discovery of loans, which may cause the balance sheets of weak banks to actually deteriorate rather than improve. Banks will not tender their loans for sale if they know that the loans will fetch prices lower than their marked down value. The bad loans will stay on the books of the bad banks. What will come off the books of the banks are the good loans, those that are likely to perform well, but have been lumped together with the bad apples and now are stuck on the balance sheets of the good banks. By getting those loans off their balance sheets, the good banks will be able to do what they do well, assess credit risks and make more loans to good risks. The net effect will be an extension of credit to the economy, but in an intelligent manner, by making use of the expertise of the good bankers.

Under this plan, two groups will make out like bandits. The first group are the good banks which will be able to securitize and unload their good loans onto the markets, enabling them to make more loans. The second group are the investors in those securitized loans, who will be getting a huge government-sponsored loan on intrinsically profitable loans, leveraging their profit many times. To me, this is a refreshing change. Rather then rewarding the bad bankers who could not differentiate good credit risks from bad ones, and rewarding investors who relied on leverage to obtain eye-popping gains, the government is finally rewarding the good bankers who knew good from bad risks, and the conservative investors who did not rely on leverage and kept their powder dry.

Part of the reason why the plan has been so roundly criticized by bloggers is that the favored solution has been outright nationalization. The previous solution of extending government guarantees to loans on the books of the banks has a negative effect on the economy. It does not make the banks in question healthy enough to lend again. Instead, it is effectively a tax on the good banks to throw at the bad banks, since the bad banks are in business only because of the government guarantees. Nationalization is a possible way out of the impasse. Certainly, a nationalized bank can be made lend again, relying on the balance sheet of the government. However, this is also a tax on the good banks, because depositors and investors will prefer dealing with the government over private parties. The new Geithner plan suggests a third way out that avoids nationalization and is economically beneficial. Pump so much money into the good banks that they can now take over the bad banks. Although a bank such as Citigroup (and perhaps Bank of America) looks too large to be sold to any group, if the current plan manages to pump enough money into the good banks, there is hope that a conglomerate of the good banks can absorb a sufficient portion of Citigroup’s assets to finally solve the problem. It may seem unlikely now, but then again, mega-banks such as Wachovia, Merrill Lynch and Wachovia once looked too big to be taken over too.

The final criticism of the current Geithner plan is that it is too punitive on the taxpayer, who stand to lose too much. However, the bad loans have already been made and the losses have already been incurred. When the decision was made that bad banks cannot be allowed to collapse, it is just a matter of determining the combination of parties who should be made to shoulder the losses. Due to the magnitude of the losses, realistically speaking, the taxpayer has to shoulder the lion’s share. The only question is what mechanism to use to shift the losses onto the taxpayer. We can extend government guarantees to loans, nationalize banks, or pay private investors to absorb the losses. It seems to me that the last way is the only way which rewards the good guys, and are the least objectionable.

The blogosphere is awash with opinions about whether banks should be nationalized, and whether an aggregator bank to hold bad debt is a good idea. Much of the heated debate about the mechanics of a rescue is about the technical details of the rescue, devoting little time to the fundamental normative question : who should shoulder the debt losses, and in what proportion? Once that question has been settled, many mechanisms exist to achieve the desired distribution of losses.

Losses suffered by the banks can be apportioned among the following stakeholders : taxpayers, bank management, shareholders, debt-holders, and depositors. For taxpayers and depositors, the answer is clear cut. Taxpayers will shoulder the majority of the losses because the government is the only entity with sufficient funds to fill the hole. Depositors should not sustain any losses whatsoever because they were not at fault, and sharing losses with depositors will cause an immediate bank run on all banks. As for management, while the public overwhelmingly favors punishing management, perhaps by firing current management and clawing back compensation paid to past management, the actual financial impact on the banking crisis will be negligible regardless of the course of action. The money that can be recouped from management is miniscule compared to the scope of the problem. The last two classes of stakeholders poses the most acute moral questions. Are shareholders responsible for the crisis because of the pressure they exerted on management for profits? Should debt-holders have performed better due diligence before lending money to banks? Should they be completely wiped out to reinstate moral hazard, or will completely crushing them scare private investors away from bank stock and debt at the precise time when banks need capital? There are no easy or correct answers to these questions, as they are essentially value judgements. Nevertheless, serious debate about these questions should be undertaken.

Once it has been decided how to divide the losses, many mechanisms exist to do so. Outright nationalization will completely wipe out shareholders, with the option of also causing pain on debt-holders should the government choose not to honor unsecured debt. An aggregator bank that purchases bad debt at prices far above market prices will essentially preserve both shareholders and debt-holders at the expense of taxpayers. Alternatively, the aggregator bank can demand a large haircut to acquire the bad debt, essentially socking it to both shareholders and debt-holders, or demand warrants or senior debt, which will again harm shareholders and debt-holders respectively. The possibilities and variations are almost endless. My gut feeling is that the Obama administration will go with the aggregator bank approach, because that is the most flexible, allowing the government to purchase various amounts of debt and inflict various levels of pain on stakeholders.

A New York Times article today rehashes the conventional myths about deficit spending : that it is inflationary and dangerous, and that its use in extremis today must be carefully reversed in the future, lest it lead to foreign countries dumping US Treasuries and causing a cataclysmic increase in the US interest rate. The author seems to think that, because reckless borrowing and spending by Americans precipitated the current crisis, more borrowing and spending on a larger scale by the US government cannot possibly be the cure. In doing so, the author displays more than a few misconceptions about economics (such as confusing micro and macroeconomics), and contributes to the economic illiteracy of the reading public. Firstly, deficit spending is not intrinsically inflationary. Secondly, even if all foreign countries simultaneously dump all of their Treasuries, the interest rate will not rise an iota if the Fed doesn’t want it to rise.

Inflation occurs when the monetary base grows faster than the amount of goods and services in the economy. Deficit spending, applied to boost consumption, will result in inflation because the amount of goods and services in the economy is unchanged while the monetary base is increased. On the other hand, deficit spending applied to boost production will increase the amount of goods and services, and is not necessarily inflationary. It is true that traditional Keynesian macroeconomics theory calls for the use of deficit spending to boost “aggregate demand”, but I am convinced that the theory thus applied will fail, as Japan has illustrated with its failed fiscal policy to boost consumption in the 1990s. The only thing that pro-consumption fiscal policy has going for it is its speed of effect; it is easy to boost consumption quickly, it is much harder to boost production quickly. However, the infrastructure projects currently envisioned by the Obama administration is in many ways the best of both worlds. Infrastructure improvements take time to impact production levels, but their immediate effect is to employ large numbers of people who will boost demand right now, when prices are falling due to deflation. Hopefully, by the time the economy recovers to the point that inflation is a concern, the productive nature of the infrastructure investments will kick in and help limit inflation. Also, boosting domestic production will reduce US reliance on imports, which will make it less important if foreign countries stop buying US bonds. Lastly, the Fed can print money to buy up any amount of Treasuries dumped in the open market, sharply limiting any effects on the interest rate, and can in fact substitute for any drop in foreign demand for US bonds. In general, the media should pay less attention on the total amount of stimulus spending, and more attention on how the money will be spent.

How can the stimulus money be productively spent? Three major areas occur to me, energy infrastructure, internet infrastructure, and education. Currently, US cities along the coasts burn oil and coal to generate electricity, while further inland, electricity can be generated cheaply from renewable resources such as wind generators and dams, prompting energy-intensive industries such as data centers and aluminum and steel mini-mills to relocate to those locations. Electricity transmission lines are regulated and maintained at a state level in piecemeal fashion by the electricity producers themselves, who understandably are not going to commission the construction of inter-state transmission lines which will disrupt their local monopoly. The government can step in to construct a cohesive national electricity transmission network, which will equilibrate electricity prices throughout the US, and probably reduce America’s reliance on imported oil for electricity generation. A similar failure of market forces is occurring in internet infrastructure, where the US lags many other countries in broadband penetration. Lastly, education is a silver bullet which, in addition to adding to human capital, has many beneficial social benefits such as lowering the crime rate and facilitating better political decisions. Unfortunately, an unnecessarily large number of young Americans drop out of the education system every year, and in general, Americans are under-educated, especially in math and sciences, to the point that the US computer and biotechnology industries require a large influx of highly trained foreigners annually for them to function. A lot can be done to change this situation. Many countries require teachers to pass stringent exams and be licensed. In return for a large increase in pay, American teachers should be required to pass both written and practical licensing exams, similar to the licensing process that medical doctors go through. Statistical tracking of student achievement should be vastly expanded and standardized at the federal level, so as to properly measure the ability of teachers and the improvement of students. A new initiative to expand educational research among social scientists should be considered. Schools should be safe and palatial, with facilities to accommodate students who need a refuge from their turbulent family life after school hours. Meals should be provided free and on a need-blind basis. While I realize that many of the proposals above are not politically realistic, the achievement of at least some of them will go a long way towards boosting the future productivity of the USA.

How can the stimulus money be mis-spent? The Obama administration is unlikely to use another tax rebate to boost consumption. Japan’s experience with issuing shopping vouchers to citizens has shown that when companies recognize that the demand boost is a temporary phenomenon, they do not hire people or expand production. Another tax rebate is likely to be saved, or be used to buy imported goods, and hence will not stimulate the US economy by much. A more likely scenario is a government subsidy for house purchases or refinancing, perhaps by issuing government backed housing loans at a below-market interest rate. This development would be troubling to me, as I frown on consumption-boosting stimulus efforts. In my opinion, the government should not be trying to influence consumption patterns through its policies. US politicians seem to have a penchant for promoting house ownership, believing that somehow this will give people a stake in the economy and help them save up for the future. In practice, owning a house makes little sense for someone who may move in a couple of years, as the transaction costs involved are huge and will likely eat up any capital gains. In fact, excessively high home ownership levels make it difficult for people to move to where jobs are, making the labor market more inflexible. Businesses routinely operate with long-term operating leases on buildings and properties without the need to own them outright, even though it can be argued that a business is more likely to have a permanent presence in a certain location compared to a person. Still, the government will be sorely tempted to try and stabilize the balance sheets of banks and the psyche of the American public through targeted inflation of housing values.

In short, there is good deficit spending, and bad deficit spending. The US government should concentrate on getting the most productive bang-for-the-buck with the stimulus money, and immediately start all currently feasible productive infrastructure projects. Everything else is just noise, including predictions of pending inflationary doom and reactions of foreign governments. If the government invests the stimulus money correctly, the other side-effects will sort themselves out.

Nowadays, every stock seems to be trading not based on their fundamentals, but based on the fear that the economy will sink into a depression. If indeed this fear proves to be true, then buying stocks now would be a mistake. In the Great Depression of the 1930s, US GDP shrunk by 27%, pushing the unemployment rate up to 25%. Deflation rates of up to 27% caused consumers to defer consumption and conserve cash at all costs. The situation was aggravated by policy missteps by the federal government, including a call by Herbert Hoover for citizens to tighten their belts, and the passing of the protectionist Smoot-Hawley Tariff Act, which caused retaliatory measures by other countries causing US exports to drop by 66%. In the face of the deep economic malaise, the US stock market sunk by more than 80%, and remained at those levels for almost a decade, until the forced expenditures caused by World War 2 ended the Great Depression.

To find out where we’re headed, its important to see where we are today. The US economy has begun to shrink at an annual rate of 0.3%, and unemployment has edged up to 6.1%. Inflation is running at 4%, but will fall in the near future as the price of oil and other commodities have plunged in the face of weak global demand. Similarly, US exports, which had been growing by 15% until recently, will probably decline as world demand decreases. Government mistakes in the form of allowing Lehman to fail has sparked a financial crisis which is only now coming under control. The Fed has aggressively lowered interest rates down to 1%, and the Treasury has injected capital into banks, but banks are not lending at any price, since there is spare capacity in nearly every business sector, and banks do not know how high default rates will rise, and therefore prefer to keep the excess capital in case they need it in the future. Massive deleveraging and capital flight to cash on a global scale have sparked economic crises in multiple countries, further threatening global demand.

The key now is in boosting demand. Without adequate demand, there will be spare capacity in the economy, with excess resources going unused (spare land going unused, spare labor in the form of a high unemployment rate, and spare capital in the form of cash sitting in bank accounts and under mattresses). Monetary stimulus has reached its limit; it is time for the federal government to step up with fiscal stimulus to boost demand. This stimulus should be channeled towards productive purposes (e.g. building wind farms to wean the US off oil imports, building a national broadband system etc.) instead of more consumption (e.g. shopping vouchers for citizens). During the 1980s, the Japanese government issued multiple tax credits and started many “bridge-to-nowhere” infrastructure projects in trying to jump-start the Japanese economy from a deflationary spiral, but they failed because people saw that these measures all had a temporary effect which would fade once the extra one-time demand ceased, and resisted investing in new factories. Only when it is clear that the new measures will result in permanent new demand (e.g. by shifting demand for foreign oil into demand for domestic wind power, resulting in permanent new jobs in the US) will the private sector be willing to invest its own capital into the economy.

What will happen in the future? In the worst case scenario, the US may endure a Japan-style lost decade. The Fed cuts rates to zero without increasing lending, and deflation causes people to avoid taking on debt (which costs more to repay in a deflationary environment) and to defer consumption (goods get cheaper with time). The economy stabilizes at a level of lower consumption, with 15-20% unemployment rate and lower living standards, and the stock market stays depressed. In the best case scenario, the US government incurs large deficits to spur productive investments in infrastructure, education and technology. It pays for this deficit by issuing Treasury bonds on a large scale, and the Fed holds the interest rate of these bonds at a measly 1% by buying up excess bonds on the open market (i.e. by printing money). Foreigner creditors take a look at the deteriorating balance sheet of the US government and the burgeoning inflation, and decide that rather than hold Treasury bonds that are losing value, they would rather buy USD-denominated assets, such as stocks and real estate. The housing and stock markets recover, and US consumers feel richer again and start spending. The increasing inflation discourages people from holding cash, and demand recovers.

It may seem like heresy to advocate for higher inflation, since inflation works against savers and investors (like myself), and benefits debtors (like the idiots who took out loans they could not afford). However, on a macroeconomic basis, it is reality that the US is a country with a negative savings rate, and that we have depended on foreign countries to fund our consumption for nearly a decade. I see moderate inflation as a fair way to spread the pain between debtors and creditors, who share responsibility for past excesses and the current situation. Inflation erodes the value of the huge pile of Treasuries held by foreign creditors, causing them pain, and also makes future consumption more expensive, causing US consumers pain. In the short term, the US loses a chunk of its productive assets to the hands of foreign government as the price for past consumption, and in return the US economy regains its footing and continues to be the most innovative economy in the world, generating new productive assets (ideas, companies, technology) at a rapid clip.

The key to an economic recovery therefore now rests almost entirely upon government policy (as well as policies by foreign governments). This is the key reason why stock markets are so volatile at this time; the current administration is genetically opposed to government intervention and vaciliates from policy to policy, while the capabilities of the future government is not yet clear. At no time in recent history has government leadership been as important as it is today.

Hank Paulson’s refusal to rescue Lehman has been a rude shock to bond holders. Until last Sunday, the main losers in the financial crisis has been equity holders, while bond holders have seen their assets protected by the government. As a result, Treasury yields plunged to new lows on Monday as bond investors fled bank and commercial bonds and flooded into the safety of government bonds. To restore stability in the credit markets, the Fed had to inject massive amounts of liquidity to maintain the target Fed funds rate, as well as agree to backstop AIG with $85 billion of loans. It remains to be seen whether these actions will work.

The latest panic in the credit markets, caused in my opinion by the mis-steps of the Treasury, has considerably darkened the prospects for the recovery of the US economy. Bond investors are by nature extremely risk-averse, and any uncertainty will cause panic; Paulson, with his years of experience in the financial world, should have known this. Now, US companies and banks have effectively lost the ability to issue bonds and incur additional debt. New initiatives for growth will go unfunded. Companies with existing debt which need to be refinanced will likely be unable to do so, and will go bankrupt. Banks will seize every opportunity to terminate credit lines to preserve their own capital. All this adds up to more people being laid off, the economy sliding further into recession, and a massive decline in the stock market.

Investors who had made ill-considered investments in risky subprime mortgages should not be rescued. However, the government has failed to clearly specify its criteria for rescue, and has chosen to haphazardly mount rescues on an ad-hoc basis. As a result, otherwise sound bonds, such as those backed by student loans and commercial bonds, have also became risky in the short term as bond holders flee the entire bond market. In other words, the government has failed to contain the crisis to the subprime mortgage sector, and contagion of healthy bonds has begun. In order to salvage the situation, the government needs to formulate a clear industry-wide criteria for rescues. In addition, the Fed must apply monetary stimulus and tolerate a short-term period of increased inflation, which will stimulate exports, reduce the current account deficit, and hasten the bottoming of housing prices (in real terms).

Recently, the technology component of my portfolio has reached 15-20%, invested in companies with dominant market shares and minimal debt (DELL, INTC, NVDA and CYMI). The entire tech sector has been in slump in recent months due to a combination of the saturation of the desktop market in the US, and the flop of Windows Vista. I believe that the tech sector will pull out of this slump soon, driven by demand for computers from the fast rising Asian economies (China and India).

This investment thesis may appear to be a rather risky one at first glance. After all, economic growth has slowed dramatically in the US and Europe, and as the Asian economies are heavily weighted towards export to the Western economies, there is widespread consensus that these economies will also slow. However, in recent years, a middle class has emerged in the Asian economies, especially in China. Despite the recent drop in the Chinese stock and real estate markets, the newly-minted middle class still has wealth unimaginable just a generation ago. To combat an impending slowdown due to the malaise in the western economies, the Chinese government is likely to attempt to stoke consumerism among the middle class to boost domestic demand, to promote the development of a more service-based economy, as well as to move up the value chain in the goods it produces. All these trends will boost demands for computers. In fact, I see computers as the single most productive investment that can be made by the Chinese economy. Rather than hold onto depreciating US Treasuries and bonds, the Chinese government can embark on a program to massively upgrade the technological and educational infrastructure of the country. In order to give birth to the future Googles and Microsofts, China needs an educated and technologically savvy population. Even among the middle class, only 20-30% of households now own a computer. In support of this view, Lenovo has recently announced that its quarterly profit has risen 65%, driven mainly by demand in China and the emerging economies.

In the future, I see companies such as Dell, Intel and Nvidia as being more like Coke and McDonald’s, deriving the bulk of their profits from outside the United States. Already, Dell’s international sales has outstripped its domestic sales. Furthermore, even within the US, hardware and software upgrades cannot be indefinitely postponed. At some point, demand will recover. Here, again, timing is the bugbear. However, given the excellent financial positions of the companies I’ve chosen, I expect them to outlast even a protracted domestic recession.