This brief post is a follow-up to an earlier one and begins with the following excerpt from a Reuter’s story posted on May 23:

Stocks dropped on Thursday, with the S&P 500 on pace for its first back-to-back daily drop in a month amid investor concerns the U.S. Federal Reserve’s stimulus may be scaled back sooner than hoped and after weak data in China.The S&P 500 had posted its biggest decline in three weeks on Wednesday after minutes from the latest U.S. Federal Reserve meeting showed some officials were open to tapering large-scale asset purchases as early as at the June meeting. The minutes came in the wake of comments earlier in the session by Fed Chairman Ben Bernanke, who said the Fed could scale back the pace of its bond purchases at one of the “next few meetings” if the economic recovery looked set to maintain forward momentum…In a bright spot, the number of Americans filing new claims for unemployment benefits dropped 23,000 to a seasonally adjusted 340,000, slightly better than expectations for a decline to 345,000, a report showed.

Most Americans either won’t read the Reuter’s story or will be unable to decipher it, so I’ll provide a clearer interpretation:

Even with a slight improvement in unemployment data, stocks dropped late Wednesday and early Thursday after Federal Reserve Chairman Ben Bernanke hinted that the Fed might stop printing $85 billion each month to prop up the economy.

If you think the market rally is primarily due to some sort of economic recovery, think again. Of course, stock prices are affected by a number of factors and it’s fair to say that the economy has seen some marginal improvement in the last few months. However, this market response was triggered by a mere suggestion that the Fed might cut back it’s $85 billion month bond-buying program and is evidence that the recent rally is Fed-driven. Big investors are counting on an ongoing Fed subsidy. Just imagine where stock prices would be if the Fed had stayed on the sidelines from the beginning. Imagine the economic hit the economy will take when these billions begin to circulate throughout the economy.

Greg Lukianoff wrote an interesting op ed in today’s Wall Street Journal. It deserves serious attention because it illustrates the complex web of government control within higher education.

The U.S. Departments of Education and Justice recently investigated the mishandling of sexual assault cases at the University of Montana, determining that the school failed to comply with the Civil Rights Act of 1964 and Title IX of the Education Amendments of 1972. A joint letter from the departments announced a “resolution agreement” with the university, but it extends well beyond Montana. The document, touted as a “blueprint for colleges and universities across the country,” expands the notion of sexual harassment from “objectively offensive” behavior to include all “unwelcome conduct of a sexual nature,” including speech. Put another way, students have a right not to be offended by what they hear on campus.

There is an obvious problem with this ruling. Not only should professors and students refrain from harassing speech, but they must also refrain from any speech that might be perceived as harassing. This clearly violates the first amendment, creating a chilling effect on speech with no clear standard concerning what is acceptable.

But what empowers the federal government to issue such a directive concerning speech on college campuses in the first place? You need only follow the money trail to get the answer. Federal financial aid—including both grants and loans—is an essential part of almost every college’s revenue stream. Choose not to accept it and you most students will be at a financial disadvantage if they attend your school. Choose to accept it and you get the unwanted oversight as well. For this reason, only a handful of colleges (Hillsdale and Grove City College are two of them) reject federal aid for their students.

This is truly the devil’s dilemma. Tax revenues—present and future—are confiscated every year to provide financial aid. The federal government issues $112 billion in student loans in 2012 alone. Like the system or not, all of us must pay for it, and opting out is costly to say the least. It’s like paying to send your kids to private schools after you’ve already been taxed to pay for public schools. Technically, we can choose to avoid government intrusion in education, but the system requires us to overpay to exercise the choice.

The fundamental problem here is the federal control of activities over which it should have none, in this instance student financial aid. The Feds took over the program from banks in 2010, ostensibly to run it more efficiently. But the greater the role the federal government plays in financial aid, the more control it has over what happens on college campuses. The University of Montana case illustrates the type of overreach that occurs when the Feds have too much power.

It should go without saying that I favor and attempt to model civil discourse on my college campus, and insulting or harassing behavior is inappropriate. Nonetheless, we need more speech on college campuses, not less. Any steps the federal government takes to restrict speech on campus will inevitably limit the robust exchange of ideas, shortchanging students as a result.

Andrew Wilkow and I recently discussed Paul Krugman’s piece in the New York Times. The left-leaning economist called for more inflation as a cure for the nation’s economic ills. My comments on the show generated a lot of email so I am following up with a blog post.

Before we get to Krugman, let’s start with a few definitions. In a classic sense, INFLATION occurs when the money supply expands and DEFLATION occurs when it contracts. More money in circulation means that each dollar is worth less, so inflation typically translates into higher prices, sooner or later. Today, the word INFLATION is often used when we are really referring to PRICE INFLATION—an increase in a market basket of goods and services—but there is always a lag between expansion of the money supply and price hikes. The Fed has expanded the money supply recently, which means that prices down the road will be higher than they otherwise would have been. This to be an economic certainty, although we don’t know when prices will rise, by how much, and to what extent some of the change could be mitigated by deflationary pressure. As Milton Friedman put it, “[price] inflation is always and everywhere a monetary phenomenon.”

We can illustrate this with a simple example. Consider a small island economy where everyone agreed to use a certain type of shell as money, and 1,000 shells were in circulation. A coconut costs 2 shells and a pineapple costs 1 shell based on scarcity, preferences for each, difficulty in harvesting, and other market factors. Suppose that I uncovered a box of 1,000 additional shells buried by previous inhabitants. The money supply would double at that time and I’d be relatively rich, but prices would not change immediately, especially if nobody else knew of my discovery. As I began to spend these shells, however, the total number in circulation would rise, providing others with extra shells to make more purchases of their own. This increase in demand would enable sellers to raise prices. Eventually—when all of the additional 1,000 shells are in circulation—prices would rise proportionately to the increase in the money supply. A coconut would cost 4 shells and a pineapple would cost 2 shells. If this were not true, then economies could prosper by simply printing more money. It’s been tried before, but has never succeeded.

Interestingly, and contrary to common belief, inflation doesn’t occur naturally. In fact, without expansion of the money supply, many prices would decline as innovation and technology enable us to produce more for less.  Keynesian economists like Krugman like to see modest inflation. Their greatest fear is deflation. When prices are falling, they argue that consumers are more likely to hold on to their money in hopes of cheaper and better prices in the future. This would reduce demand even further and lead to greater unemployment, more deflation, and a downward spiral. Hence, government must intervene to keep demand rising.

But this argument is shortsighted. It fails to consider adjustment mechanisms already built into the market. Computers get better and cheaper every year, but this fact doesn’t keep us from buying one. If deflation automatically creates a downward spiral, then why doesn’t inflation automatically create an upward spiral?

The key point here is that promoting inflation is, by definition, consistent with central economic planning. Deflation empowers the holder of money because his spending power increases automatically. Inflation—particularly accompanied by a Fed that keeps interest rates artificially low—empowers the government because those who have money must either spend it or put it at risk (typically in the stock market) to avoid losing value. This is financial manipulation; it punishes savings and places individual wealth at the mercy of the central planners.

Andrew Wilkow and I had an interesting discussion on his show Thursday about the global flight of capital. I want to address this on the blog and explain why it’s relevant to all of us.

It’s very simple. People flee persecution, and so does money. It finds its way to places where it is less likely to be confiscated. Money doesn’t like political and social risk, and it likes its privacy.

Historically, Switzerland has scored well on all three fronts in terms of foreign capital—taxation, risk, and privacy. Recently, however, the US and other European governments have threatened to sue Swiss banks for allegedly helping wealthy clients avoid taxation in their host countries. To avoid legal battles, these banks have agreed to share their financial information with the host governments…so much for privacy. Moreover, Switzerland is slated to raise taxes on foreigners in 2016. This is where Singapore comes in.

While Singapore has serious issues with certain personal liberty, it’s an attractive place for commerce and foreign capital. Singapore’s highest income tax rate is 20%. Its highest corporate rate is 17%. There are no tax on capital gains and no death taxes.

Many refer to Singapore as the “Switzerland of Asia.” Indeed, banks in Singapore are enjoying an influx of capital not only from individuals in Asian countries in like China, Indonesia and Malaysia, but also from those in the West. The Swiss still hold about a third of the funds controlled by wealth management firms, but that percentage is declining. Singapore’s share of the wealth management pie is still far behind Switzerland, but the nation is on track to become the new Switzerland for the entire world in the next decade.

There is a lesson here. Creating a less friendly environment for capital will cost the Swiss dearly. Even with higher tax rates, government receipts will likely decline over the long term as money seeks greener pastures. Singapore and other capital-friendly nations will reap the benefits. All things equal, capital always finds the best returns.

On a global level, Marxists campaign for global taxes and other regulations because they would restrict the ability of nations like Singapore to develop more attractive policies. You can only avoid a global tax if you leave the globe. From an American perspective, what we are witnessing in capital flight is further evidence that higher taxes and regulations not only stymie business activity but also fail to raise the revenue politicians seek in the first place. As long as individuals and firms are relatively free to make their own decisions, they will conduct their affairs in the most competitive nations. The U.S. could become the new Switzerland with the right policies, but we have a long way to go.

I’ve received several emails lately that cite the stock market’s recent surge as evidence of the long awaited economic rebound. Is this a valid argument? Not necessarily…Here’s why.

Stock prices are based on a number of factors that are indirectly related to the economy. In theory, a stock’s value should reflect the expected short- and long-term earnings of a firm, but many investors buy stocks simply because they believe their value will rise more than other investments. Put another way, I might not like GM as a long-term investment but I might purchase the stock if I believe others will do so, which would drive up the value of my investment in the short run.

Others might invest in the stock market if they don’t like the available alternatives. After increases in gold and silver prices for the last several year, many investors have pulled back for the time being. The Fed also manipulates the stock market, and has recently sold naked shorts of gold to both drive the price down and profit from the decline. With the Fed keeping interest rates (artificially) close to zero, fixed term investments offer returns below the expected rate of inflation, prompting even conservative investors to buy more equities.

My point here is that the stock market is driven by many factors and should be considered one indicator of an economy’s health. In my view, the U.S. economy is in a holding pattern, and many companies are beginning to adjust to the new normal of increased regulation, government influence, and Obamacare. This, combined with economic weakness in many other countries, has primed the stock market as well. Many firms appear to be sidestepping increased hiring costs by getting by with fewer employees, which is why the U.S. workforce is shrinking.

A modest rebound is not out of the question, but my long-term outlook for the economy remains grim. Trillion-dollar deficits are expected for some time and many in Washington are still calling for more taxes and government spending. Entitlements are out of control and any serious reform is unlikely to pass while Obama is in office. Even with some gains in the stock market, another financial crisis is inevitable if we don’t change course. The only question is when.

The Bank of Japan followed the US Federal Reserve and other central banks, unveiling its own package of easy-money policies on Thursday. By doubling its holdings of government bonds and the amount of yen circulating in the economy, the Bank of Japan is essentially printing money to create inflation and drive down the value of the yen relative to other global currencies. The value of the yen has already declined substantially since November 2012 in anticipation of such a move. A US dollar buys 97 yen today compared to about 80 5 months ago, resulting in a yen-to-dollar depreciation of over 20%.

The Keynesian thinking is that a weak currency boosts an economy by making exports cheaper and raising the price of imports, thereby encouraging citizens to buy goods produced domestically. A central bank’s easy-money intervention accomplishes this goal, thereby devaluing the currency and creating inflation. These facts are not disputed. As noted in a recent Fed letter, “Surprise unconventional policy easing has pushed down the value of the dollar roughly as much as similar surprise downward moves in the federal funds rate did before the crisis” (see www.efxnews.com/story/18074/sf-fed-paper-dollar-has-been-victim-fed-unconventional-monetary-policy).

The arguments of Paul Krugman and other Keynesians notwithstanding, a devalued currency doesn’t help a nation in the long run. The inflation it causes is an indirect tax on wealth and devaluation expectations scare potential investors. But what happens if all developed nations seek to devalue their own currencies? The result would be a currency war. This is a serious possibility, as Japan is simply joining a lost list of nations–including the US–that have already gone down this road.

The answer is not very complicated. If every nation devalues its own currency, then no nation will obtain any short run relative trade advantage because the devaluations cancel each other out. Such a combination of independent central bank actions would have the same effect as a coordinated global currency devaluation. Some economists and politicians might actually like to see this, as it would decrease the value of government debt at the expense of inflation and current cash holdings, including those at corporations and in retirement accounts. Any currency devaluation steals from those who hold wealth by reducing the purchasing power of their cash holdings.

Japan’s move will encourage other central banks to follow suit, and an impending global currency devaluation would have a devastating effect on the US economy. Interest rates would rise because investors will demand higher returns on government debt. At current debt levels, a 3% hike in the interest rate would increase our annual interest payments by about $500 billion. Faced with rising inflation, the Fed would be forced to raise interest rates, which have been kept at artificially low levels to prime the economy and prop up the housing market. While the full effects of these currency devaluations will not be felt immediately, they–like most Keynesian policies–will kill us in the long run.

Negotiators reached a last-minute deal earlier today to stave off the Eurozone’s first eviction. While the arrangement does not include the direct confiscation of deposits, it is not without its flaws. Complete details are not yet available, but the agreement includes the closure of the country’s second largest bank, resulting in substantial losses for those with (uninsured) deposits over 100,000 Euros (~128,000 USD).

This story isn’t over yet, but there are some obvious lessons that can already be identified:

1. Uncontrolled debt will take it’s toll, sooner or later. The later it comes, the fewer and more severe the options. Cyprus probably got a better deal that was originally proposed, but the pain is real and will be felt for years to come.
2. When resolving a financial crisis, the government will always attempt to transfer as much of the pain to the more productive as possible because lower income earners are higher in number and more willing to protest/riot. However, the wealthiest often survive because they are well represented in the governing class. Notice that the original bank levy proposal only addressed bank deposits, not stocks, bonds and property more likely to be held by the wealthiest Cypriots. The demonized “top 1%” in Cyprus do not have most of their assets in banks anyway. In the end, the biggest hit is always felt by the middle class.
3. Government access to private information should be limited, whether we’re talking about bank accounts, medical records, or gun registrations. The government can attempt to do just about anything in a “national emergency.”
4. As George Washington advised, nations should avoid as many foreign entanglements as possible. Countries like Germany and France are learning this lesson in the economic realm. Financial collectivism among nations always transfers wealth to the weaker countries and risk to the stronger ones.
5. Individuals should consider holding as much wealth as possible in assets less susceptible to easy government confiscation, such as precious metals or property. Bank and retirement accounts are easy prey.
6. If you live in a troubled EU nation (particularly Cyprus, Portugal, Spain, Greece, or Ireland), limit the amount of money you keep in local banks. “Government insurance” is only as strong as the integrity of government officials. The next attempt at bank deposit confiscation might be successful.
7. If something happens in the EU, it’s not far-fetched to think it can happen in the US. At the end of the day, the Constitution won’t protect us without a cadre of elected officials willing to defend it.

The EU’s bailout of Cyprus took a chilling turn over the weekend when it required (more or less) the Cyprian government to confiscate a minimum of 6.75% of deposits in Cyprian banks as part of the deal. The confiscation rate is 9.9% of balances above 100,000 Euros, resulting in a total seizure of $5.8 billion Euros (7.6 billion US dollars). Put another way, the government is taxing wealth to pay its debts. Considering that Cyprus is an EU nation and not a despot-run third world country, this move should send chills down the spine of every American that doesn’t believe a similar measure could actually happen here at some point.

To be fair, there is some context worth noting. In short, several EU countries like Germany are tired to footing the bailout bill for less responsible countries. They are pressuring countries receiving the aid to experience more of the immediate pain. This is understandable–to a point.

But the larger lesson here is simple. Sooner or later, a nation that cannot pay its debt must seize the wealth of its citizens directly through taxes or indirectly through currency devaluation, or go bankrupt. What makes the Cyprian wealth tax so scary is that the government is simply taking the money. At least tax increases and government budgets can be widely debated before being passed into law. What’s happening in Cyprus is a confiscation of wealth in the dark of night. They’re calling it a “one time” tax, but only fools believe it can’t happen again, or in other nations.

Could a similar move occur in the U.S.? Consider the fact that individual 401(k) plans contain about $4 trillion in balances. A “one time” 9.9% tax could generate about $400 billion in revenues right away. The left might see this as “fair” because it steals only from the “rich” who could “afford” to put away money for retirement in the first place.

To be clear, the U.S. and Cyprus are not in the same financial situation. But while Cyprus is further down the road, we are traveling along the same highway. Given ongoing $1 trillion deficits and a burgeoning national debt, a spike of inflation would put the U.S. treasury into a serious quandary. The available options will be limited when this happens, including some many Americans never expected to be on the table.

As for Cyprus, stay tuned…Some are proposing alternative bank deposit levies with lower rates for balances under 100,000 Euros and higher rates for balances above 100,000 Euros. In the end, most of the pain will be felt by those who are most productive.

The Swiss have taken another step to control executive pay. The drumbeat for similar action in the U.S. continues (see http://online.wsj.com/article/SB10001424127887324678604578338171658493636.html). Don’t be surprised if the President follows suit as part of his ongoing anti-corporate agenda.

I don’t expect Obama or the Democrats to propose a strict pay limit, however. Proponents of government pay controls rarely seek to limit compensation directly, lest they appear harsh and unreasonable. They prefer indirect approaches, such as requiring firms to pay an extra tax for salaries above a level deemed “fair” by the government elite, or prohibiting certain types of bonuses or benefits, or allowing shareholders to vote on pay levels set by their elected representatives (the board). Such proposals sound like reasonable compromises to uninformed voters, but they achieve the same ends–government control of free enterprise.

The case for regulating CEO pay is a weak one. Most typical left-leaning voters struggle to move beyond the notion that high pay for executives “just isn’t right.” When pressed for a more substantive response, pundits and academics often couch their arguments in intellectual jargon or vague philosophies, such as a demand for “distributive justice” (i.e., the market isn’t fair in determining who gets what so the government must step in), or the greater need for these extra funds in areas such as poverty alleviation and education, or the notion that an executive should only make X times what the lowest paid worker in the firm makes. Of course, these arguments fall apart under scrutiny. If the government is more effective than the private sector at resource allocation, then why are nations like North Korea, Cuba, and Venezuela failing economically? Posing rational questions like this do little to sway public opinion because the anti-CEO rhetoric is based in the emotion of greed.

All of us might agree that a CEO doesn’t “need” $50 million to live a good life, but that is not the point. Private property should be private. It’s not the government’s business how much a CEO earns, even if it does appear to be too high. If you own shares in a company and don’t like the executive pay levels, then you can elect a new board to represent your interests or sell your shares. If you’re not a shareholder, then you can choose not to buy the company’s products or services. Otherwise, it’s not your business.

Unfortunately, most Americans have accepted the idea that private property is not necessarily private if society (AKA, government) objects. Whether it’s wealth redistribution or the abuse of eminent domain, they seem to willing to negotiate what is really private, especially when the property in question belongs to someone else. Government regulation of individual compensation levels is just another step in that direction.

The sequester has already been analyzed to the hilt but 2 points are worth underscoring.

First, the spending cuts–which are only decreases in increases–amount to only $85 billion compared to a $3.6 trillion budget. If the President is correct and these types of cuts will be devastating to our way of life, then how will it ever be possible to balance the budget? $85 billion is less than 10% of the 2012 deficit. The Democrats tell us that all of this can happen in the future after the economy improves, but not if the first $85 would result in cuts to first responders, the release of prisoners, and fewer teachers. The retort to the President is simple: If there is nowhere to cut even $85 billion from the budget, then how will we ever achieve anything close to a balanced budget short of massive tax increases?

Second, the administration’s top economic advisor is claiming that 750,000 jobs will be lost as a result of the cuts. If $85 billion in government spending equates to 750,000 jobs, then the original stimulus bill currently valued at $831 billion would have added over 7 million jobs, thereby cutting unemployment in half. And this doesn’t include various other stimulus packages. Why isn’t the media questioning the Keynesian logic that underscores this claim? Do we really need to spend money we don’t have just to keep the official unemployment rate at around 9%? Is this the best argument the administration can make?

These mandatory “cuts” are only the beginning of what must happen before we can restore fiscal sanity. Let’s hope the Republicans don’t cave.