CHINA

Fed's mixed blessing

Has Bernanke's success in calming markets clouded investors' view of the long road ahead?

NEW YORK (Fortune) -- For a guy who supposedly has lost his credibility, Fed chief Ben Bernanke has been surprisingly effective in soothing stressed-out financial markets - maybe a little too effective.

Since the credit crisis began unfolding last summer, Bernanke has taken brickbats from all angles. When the Fed held interest rates steady back in August, some critics claimed Bernanke was "behind the curve" and that his failure to act quickly would lead to a deep recession. Once the Fed began cutting interest rates starting in September, others warned that the Fed was overreacting and risked fueling inflation with its monetary laxity. When the New York Fed led a rescue of Bear Stearns (BSC, Fortune 500), and the Fed began lending more freely to financial firms to prevent another bank run, there were doubts about the prudence of the decision to make loans using riskier nongovernment securities as collateral.

Yet for all the questions about the Fed's on-the-fly policymaking, Bernanke seems to have succeeded in calming down the markets. Stocks have rallied off their mid-March panic lows, and the spreads between risk-free Treasuries and private investments have narrowed sharply. "The Fed has been very creative," says Jeff Miller, CEO of investment adviser New Arc Investments in Naperville, Ill. He credits the Fed's rate cuts and its expanded lending to banks as having "stopped the spiral" of financial-sector problems that threatened to deliver a shock to an already slowing economy.

The question now is whether investors have taken too much comfort in the Fed's ability to keep markets functioning. While the Fed's willingness to lend to financial institutions should prevent another Bear Stearns-like calamity, some observers believe the last two months' rally reflects a rosier view of the markets and the economy than is warranted.

"A lot of complacency has come back into the market," says David Merkel, chief economist at broker-dealer Finacorp Securities. He points to the narrowing spread between the yields on two-year Treasury notes and A2/P2 commercial paper, the short-term borrowings of corporations deemed a satisfactory risk by Standard & Poor's and Moody's.

That spread was 190 basis points in March, as investors were fleeing privately issued debt ahead of the near collapse of Bear Stearns, and as much as 260 points back in December, shortly before Bank of America (BAC, Fortune 500) agreed to buy distressed mortgage lender Countrywide (CFC, Fortune 500). This week, the spread was 46 basis points, Merkel says. That means roughly that companies with low-A to high-triple-B credit ratings can borrow in the market for 90 days at about 3% - what he terms a relatively attractive rate.

The spread has narrowed even as the U.S. has continued to add jobs at an anemic rate while losing high-paying manufacturing jobs. At the same time oil prices have surged. The minutes of the Federal Reserve's April 29-30 meeting notes that recent economic data "continued to suggest that a substantial softening in economic activity was under way." The Fed said members of the Federal Open Market Committee expect a contraction in U.S. gross domestic product in the first half of 2008, with only modest growth returning in the second half as consumers cash and spend the fiscal stimulus checks the government started sending out this spring.

Yet even with sharp selloffs Tuesday and Wednesday inspired by the surge of crude oil past $130 a barrel, the S&P 500 is up 10% off its Bear Stearns-inspired lows on St. Patrick's Day.

"The euphoria in the equity market has been breathtaking in the past few months," Merrill Lynch economist David Rosenberg wrote in a report Monday. "Are we believers that this is sustainable? The answer is no."

He compares the recent run-up in stocks to a rally that followed the Sept. 11, 2001, terrorist attacks. Back then the S&P 500 jumped 21% during the six months that ended in March 2002, but the gains didn't last for long. The blue-chip index proceeded to lose a third of its value before it bottomed out in October 2002, as hopes for a quick economic recovery were dashed.

Rosenberg says expectations that the Fed will raise rates before the end of the year - investors in the Chicago Board of Trade futures market are putting a 57% chance on a 25-basis-point rise - are similarly misguided. The economist, who has said he expects to see the Fed's overnight lending target fall to 1% from the current 2% over the next year and a half, notes that the futures market priced in a sharp rise in the fed funds rate back in early 2002, only to see the Fed resume its rate cutting later that year as a rebound failed to materialize.

That's not to say all is doom and gloom. The U.S. has so far avoided an official recession even in the face of the housing bust, the surge in energy prices and the near collapse of a major investment bank. Other big economies continue to grow, if at a slower clip, boosting U.S. exports. Big financial firms have managed to raise billions of dollars in capital to offset some of the damage they endured during the past year.

But there's reason to believe there's more pain ahead. Merkel says he believes the overhang of unsold houses will keep housing and mortgage securities markets under pressure for at least another year. He also says history shows the slowing economy will likely lead to a spike in defaults among lower-rated corporate borrowers. Retailer Linens N Things was a recent casualty of the slowing economy and a hefty debt load, but it won't be the last. "We're not through that part of the typical credit cycle" yet, he says.

"I think the safety level is overdiscounted right now," Merkel adds. "People are pretty happy."

Taxes Matter, but the Dollar Matters More

By John Tamny

The proper level of taxation has predictably emerged as a major presidential campaign issue. The irony here is that stock-market returns since the 1950s show that the dollar’s stability and its direction trump taxes as the greatest indicator of our long-term economic prospects. So while tax rates matter a great deal, the discussion has occurred at the expense of any commentary on the dollar.

On the tax front, the major candidates of each party have staked out familiar positions. Thought by many in his party to be wobbly on taxes, presumptive GOP nominee John McCain has seemingly gotten “religion” on the issue and professed a desire to make permanent the 2003 reductions on income and capital gains.

As for the Democrats, both Barack Obama and Hillary Clinton have made plain their desire to sunset the 2003 legislation. In revealing their preference for a 2010 repeal of the 2003 reductions, both make the explicit point that they would like to see rates settle back to levels seen in the 1990s.

Sadly, the dollar's fall this decade has not generated any kind of campaign comment from either side. Oddly enough, both John McCain and Hillary Clinton support a federal gas-tax holiday for the summer, but it should be said that this gimmick is perhaps the primary campaign’s ultimate non-sequitur. To endorse an 18 cent per gallon tax cut on gasoline is to miss the point almost completely. Pump prices aren’t high due to federal taxes, but instead are reaching nosebleed levels thanks to a collapsing dollar.

If it’s agreed that stock-market returns at the very least indicate long-term economic optimism, the dollar’s fall should be issue #1 for candidates on both sides. While rates of taxation should never be ignored, it’s forgotten that inflation is but another form of taxation, albeit a somewhat hidden one. Just as high tax rates erode the value of paychecks and investments, so does inflation. And when stock-market returns over the last sixty years are considered, it becomes apparent that all three presidential candidates have taken their eyes off the ball. In short, it’s the dollar, stupid.

In his 1984 book, Losing Ground, Charles Murray wrote that the “average annual growth rate from 1953 to 1959 was 2.7 percent, noticeably lower than the average annual growth of 3.2 percent from 1970 to 1979.” Allowing for the certainty that government measures of economic activity are frequently misleading, Murray’s numbers would surely surprise economic historians who’ve characterized the ’50s as a period of economic revival in contrast with the stagnant, malaise-ridden ’70s. It should also be recalled that while it was nominally high in both decades, the top marginal tax rate was 91 percent in the ’50s against 71 percent in the ’70s.

The major difference between the two decades was not, however, in levels of taxation. Instead, the larger factor involved the dollar, whereby the U.S. economy in the ’50s benefited from a stable greenback measured as 1/35th of an ounce of gold. Conversely, thanks to President Nixon’s decision to sever the dollar/gold link in 1971, the dollar lacked definition afterward and proceeded to collapse. Despite the higher rates of growth that were achieved in the ’70s relative to the ’50s, the S&P 500 rose a mere 17 percent in that decade against a 255 percent return in the 1950s. High capital-gains rates were surely a factor in the ’70s underperformance, but with inflation a certain tax itself, the falling dollar (as evidenced by market returns in the present decade) to some degree made the tax penalty on investment irrelevant.

To show that levels of taxation surely matter, the reduction of the top rate from 91 percent to 71 percent in 1964 ignited impressive economic growth that was partially responsible for stocks reaching all-time highs in 1966. Still, many a commentator has noted that U.S. shares did not permanently pass those highs again until 1982. Sure enough, while the ’64 reduction in the tax wedge kept the economy buoyant, markets started to price in the likelihood that U.S. monetary authorities were growing increasingly impatient with the Bretton Woods system of fixed exchange rates.

This first showed up in private markets where gold traded far above the Bretton Woods $35/ounce fix, and later in government measures of inflation. By the end of 1968, consumer price inflation rose to 4.7 percent. So despite the pro-growth tax cuts passed after John F. Kennedy’s assassination, stock market returns greatly lagged those achieved in the ’50s. The S&P 500 ultimately rose a mere 54 percent in the ’60s due to inflationary monetary policy that stopped the mid-60s rally in its tracks.

A stronger dollar, 1980-2001. When we look at the ’80s, gold’s free fall from a high of $850 in January of 1980 was doubtless rooted in the approaching election of a president who preferred lower marginal rates and a return to the gold standard. And despite a needless recession caused by Fed policy that joined monetarism with Phillips Curve austerity, the ’80s economic revival occurred in concert with a strong dollar and S&P 500 returns of 121 percent during the Reagan years.

Moving to Bill Clinton’s election in 1992, the dollar sagged early on in the face of marginal rate increases combined with a renewed protectionist sentiment. In her 1995 book American Trade Policy: A Tragedy in the Making, Anne Krueger noted that by 1994, “bilateral trading relations with Japan had deteriorated under the Clinton Administration’s pressure for ‘quantitative targets.’” The latter policy helped drive the dollar to an all-time low versus the yen of 80/1.

Importantly, dollar policy changed not long after. Robert Rubin took over from Lloyd Bentsen at Treasury, and as economists Ronald McKinnon and Kenichi Ohno wrote in their 1997 book, Dollar and Yen, amidst the dollar’s rise from 80 to 113 yen by 1996, not once “did a responsible official in the American government complain that the dollar was too high.” With dollar policy sound, the 1993 tax increases were less biting given the tax “cut” achieved by a rising dollar. And while many credibly argue that the dollar rose into deflationary territory by the late ’90s, stocks soared with Rubin at Treasury; the S&P 500 rising 208 percent during Clinton’s presidency. The 1997 capital gains cuts surely helped the ’90s equity boom, though the rally’s origins predate any market knowledge of a capital gains reduction.

Bush, the dollar and the 2008 campaign. Many commentators with GOP leanings point to a “Bush Boom” that began with the 2003 income and capital gains reductions. Commentators with Democratic Party leanings point to a period of even greater economic growth that occurred amidst higher rates of taxation during the ’90s. Both sides perhaps downplay the greater story.

For GOP partisans to laud the economy’s performance under George W. Bush, they would have to ignore the basic truth that inflation is a taxing enemy of prosperity. S&P 500 returns during the Bush presidency of 3.6 percent compare poorly with the 30 percent return achieved during the charitably abysmal Carter years. And if they’re sanguine about 5 percent unemployment and recent GDP growth of .6 percent, they would also have to acknowledge that in GDP terms the economy grew every year of Carter’s presidency alongside the highest percentage job growth of any post-WWII president.

Democratic partisans would first have to admit that levels of taxation do matter. No credible candidate has suggested bringing tax rates back up to those experienced during the ’70s. They would also have to shed a rising protectionist instinct that has harmed the dollar, and if continued, would quickly discredit any tax plan brought forth under a Democratic administration. And for those who still believe that the Clinton tax increases helped the economy by bringing down interest rates, they should be reminded that the 30-year Treasury was yielding 5.8% when the Clinton tax increases passed in ’93 versus an 8% yield by 1994.

So while the broad policy goal should be one of bringing down tax rates across the board, the simpler reality is that with equities serving as a measure of long-term economic optimism, the U.S. economy has done well under all manner of tax regimes since World War II. What historical equity returns show is that dollar debasement is the one policy the stock market can’t withstand.

Today's Republicans talk up tax cuts, while Democrats talk up tax increases. Judging by equity returns, both sides ignore the dollar at their peril.

Middle Class Jitters

By Robert Samuelson

WASHINGTON -- We middle-class Americans are in a funk. "The overarching economic narrative of the 2008 campaign is the idea that life for the middle class has grown more difficult," writes Paul Taylor of the Pew Research Center, which recently published a massive report on middle-class anxieties. By its survey, more than half of Americans believe they either have not moved ahead in the past five years (25 percent) or have fallen behind (31 percent). Pew pronounces this "the most downbeat short-term assessment of personal progress in nearly half a century."

It's not that Americans have lost their optimism. About two-thirds say they have higher living standards than their parents did at the same age, and by a 2-1 margin they expect their children to live better than they do. But there's an underlying disenchantment that seems to predate today's higher oil prices, falling home values and declining employment.

"When my college-educated, gainfully employed thirty-something friends and I get together, we talk about money," writes Nan Mooney in her new book, "(Not) Keeping Up With Our Parents." "We talk about our inadequate health insurance and whether we can afford it, about how to juggle credit card payments and crushing student loans. ... This wasn't the life I'd expected."

Part of the deceptive sense of falling behind reflects the elastic nature of being middle class. According to Pew, 70 percent of households now have two or more cars, and a similar share has satellite or cable TV; 66 percent have high-speed Internet; 42 percent already have flat-panel TVs. Thirty years ago, no one's parents had this inventory. More students go to college and graduate school, so more have debt. Health care is expensive in part because modern medicine can do so much. Someone has to pay. One in 10 households now has a vacation home.

"Progress" keeps draining our pocketbooks. Pew finds that four-fifths of Americans find it hard to maintain middle-class lifestyles; in 1986, two-thirds did. But today's middle-class anxieties transcend the well-advertised "squeeze" on incomes. The deeper source of disquiet, I think, lies elsewhere. Middle-class families value predictability, order and security, and these reassuring qualities have eroded. People worry about rising living expenses; but what really upsets them is the possibility that their incomes or fringe benefits -- pensions, health and disability insurance -- might vanish.

Paradoxically, "the lives of individual Americans have grown simultaneously more prosperous and more precarious," writes Peter Gosselin in his new book, "High Wire." Gosselin, a Los Angeles Times reporter, has provided the most thorough account of this phenomenon to date. As he shows, the chances of being hit by a life-altering event (a long spell of unemployment, divorce, a big decline in work hours for one spouse) have declined slightly since the inflation-plagued 1970s and early 1980s.

But the consequences of setbacks have grown, he finds. The share of families suffering a 50 percent loss of income with a spell of unemployment rose from 17 percent to almost 26 percent. Fear of these setbacks has also climbed up the social ladder: not just factory workers and low-paid service employees but also managers and engineers. Companies downsize. Older workers exit in buyouts. Companies raise health-insurance premiums. The reliable "defined benefit" pension (which paid a fixed monthly amount) has given way to the riskier 401(k) -- vulnerable to bad investment decisions and sinking stocks. Corporate protections have weakened, as Gosselin notes.

One result is that bad economic news packs greater psychological punch than it once did, because more people identify with the victims. Change isn't just something that happens to them; it could happen to us. People worry even if they hold well-paying jobs.

We are losing our sense of entitlement. Under the implied social contract, people who "played by the rules" (to use a phrase popularized by Bill Clinton) deserved modest middle-class guarantees: a steady job, rising income and protection against random misfortune (sickness, disability, job loss, accidents). There was a belief that diligence and responsibility were their own rewards.

It's worth noting that this imagined entitlement never universally existed. From 1975 to 1984, unemployment averaged 7.7 percent (today's: 5 percent). The now venerated defined-benefit pensions sometimes weren't fully funded (so that promised benefits weren't always paid) or were funded at the expense of the next generation. Today's retired and well-pensioned autoworkers have condemned those who followed to lower-paid jobs or no jobs at all.

Almost all Americans consider themselves middle class. In the Pew survey, 53 percent put themselves in the "middle class" and 19 percent each in the "upper middle" and "lower middle" classes. But the prevalence of middle-class ambitions and values creates a vexing contradiction: The advances in living standards that Americans expect require a flexible and competitive economy that weakens the security and stability that Americans also expect.

McCain Won't Play by Obama's Rules

By Robert Novak

WASHINGTON, D.C. -- When one of the Democratic Party's most astute strategists this week criticized John McCain for attacking Barack Obama's desire to engage Iran's President Mahmoud Ahmadinejad, I asked what the Republican presidential candidate ought to talk about in this campaign. "Health care and the economy," he replied. That is a sure formula for Democratic victory, but it is one that McCain's campaign rejects.

Obama embraced that formula once it became clear that he would best Hillary Clinton for the Democratic nomination. He began pounding McCain for seeking the third term of George W. Bush. At the same time, Obama implores McCain in the interest of "one nation" and "one people" not to attack him. The shorthand, widely repeated by the news media, is that the Republican candidate must not "Swift boat" Obama. That amounts to unilateral political disarmament by McCain.

McCain is not about to disarm. His campaign has no intention of fighting this battle on Democratic turf. During the more than five months ahead, Republicans will explore the mindset of this young man who is a stranger to most Americans. That includes his association with the Chicago leftist William Ayers, who has remained unrepentant about his violent role as a 1960s radical. This will not be popular with McCain's erstwhile admirers in the mainstream news media, but America has not heard the last of Bill Ayers in this campaign.

Indicating what lies ahead is the McCain campaign's plan to bring in Tim Griffin, a protege of Karl Rove, who is a leading practitioner of opposition research -- digging up derogatory information about opponents. Although final arrangements have not been pinned down, Griffin would work at the Republican National Committee, as he did in Bush's 2004 re-election campaign.

It is an article of Democratic faith that John Kerry would have been elected president had not Republicans undermined public confidence in his leadership and integrity by assailing his performance as a Swift boat commander in Vietnam. McCain, idolized by much of the news media in 2000 as the potential Bush slayer, is now stigmatized as adopting not only his former intraparty adversary's policies but also his tactics.

Simultaneously, with Clinton no longer around to worry about, Obama deplores "the failed policies that John McCain wants to double down on." He is relentless in pressing home that point. Last Saturday, in Roseburg, Ore.: "If you agree we've had a great foreign policy over the last four or eight years, then you should vote for John McCain. ... (He) wants to give you the failed Bush health-care policy for another four years." On Monday, in Billings, Mont.: "John McCain has decided to run for George Bush's third term."

While on this attack, Obama rails against any responsive fire from McCain. He has lashed out against criticism of his declared willingness to sit down with Ahmadinejad and Cuba's Raul Castro. McCain's strategists are infuriated by prestigious political reporters and commentators whom they see supporting Obama's position. Time columnist Joe Klein turned up in Savannah, Ga., Monday for McCain's press conference, declaring that McCain had misrepresented Obama as proposing unconditional talks with the Iranian president. After asserting that "I've done some research" and "also checked with the Obama campaign," Klein said Obama "never mentioned Ahmadinejad directly by name. He did say he would negotiate with the leaders."

In fact, Obama has repeatedly been questioned specifically about Ahmadinejad. At a press conference in New York last September, Obama was asked whether he still would meet with Ahmadinejad. He replied: "Yeah ... I find many of President Ahmadinejad's statements odious. ... But we should never fear to negotiate." In November on NBC's "Meet the Press," he defended "a conversation with somebody like Ahmadinejad."

The debate over such "a conversation" was heightened by Bush's speech last week to the Israeli Knesset, suggesting "appeasement" by Obama. The White House has privately informed the McCain campaign it had no intention of leaping into presidential politics, but Obama's defensive response enabled him again to link McCain with Bush. Although the Republican candidate would like the unpopular president to get offstage politically, McCain is not about to run a campaign about health care mandates and home foreclosures.

Change You Can't Believe In

President Bush vetoed the $300 billion farm bill yesterday, and a bipartisan throng in the House promptly voted to override. The Senate is expected to follow shortly. Every one of these Congressional worthies purports to be an advocate of "change."

Yet you couldn't write a piece of legislation that more thoroughly represents the Beltway status quo than this one. In every way imaginable, and even a few more, it repeats and compounds the spendthrift errors of previous farm bills.

Since the last farm bill in 2002, the price of cotton is up 105%, soybeans 164%, corn 169% and wheat 256%. Yet when Mr. Bush proposed the genuine change of limiting farm welfare to those earning less than $200,000 a year, he was laughed out of town. The bill purports to limit subsidies to those earning a mere $750,000, but loopholes and spousal qualifications make it closer to $2.5 million. As Barack Obama likes to say, it's time Washington worked for "the middle class," which apparently includes millionaire corn and sugar farmers.

Another purported change is the arrival of "fiscal discipline," in Nancy Pelosi's favorite phrase from the 2006 campaign. Yet it turns out this farm extravaganza may bust federal budget targets even more than we thought a week ago. That's because the new price supports – the guaranteed floor payments farmers receive for their crops – have been raised to match this year's record prices.

The USDA reports that if crop prices fall from these highs to their norm over the next five years, farm payments will surge. For example, if corn prices return to $3.25 a bushel from today's $6, farmers would get $10 billion a year in support payments. If bean prices fall to their norm, they'd get $4 billion. Thus, if farm prices stay high, consumers face higher grocery bills and farmers get rich. If farm prices fall, taxpayers kick in the difference and farmers still get rich.

Sugar producers also make out like Beltway bandits, receiving the difference between the world price of sugar, which is now $12 per pound, and the guaranteed price of about $21 per pound. That's a roughly 75% subsidy for already wealthy cane growers and a nice payoff for the $3 million they contribute to House candidates each year.

All of this is a status quo that both political parties can believe in. More than a few liberal Democrats are privately embarrassed by this corporate welfare spectacle. But they've been mollified by Speaker Pelosi, who spent the last week assuring her left that the bill also includes another $10.4 billion for food stamps and nutrition programs. This entitlement expansion comes only days after the Congressional Budget Office reported that paying the bills for existing entitlements could require tax rates to climb to 80% in the future. Yes we can!

House Republicans are equally as complicit, despite their claims of having found fiscal religion after 2006. About half of them voted to override a Republican President. GOP leaders refused to whip against the bill, and two of them – Roy Blunt of Missouri and Adam Putnam of Florida – even voted for it. These are the same House Republicans who last week unveiled their new slogan, "The Change You Deserve."

Which brings us to Mr. Obama, who says he supported the bill though he wasn't around to vote for it. One of the Illinois Senator's major campaign themes is that he has no truck with corporate lobbyists, but the farm bill is the ultimate lobbyist triumph. Every special interest gets massaged. Just as Mr. Bush bent too far to GOP spending in his first term, Mr. Obama's farm bill support suggests he'd bow to the Pelosi Democrats on Capitol Hill.

To his credit, John McCain opposes the bill, and this week he gave a speech attacking it. Yet he's also missed an opportunity to make his opposition part of a larger case that he represents change from both parties in Washington. He could also turn the tables on Mr. Obama's claim that he better represents middle-class taxpayers. Failing that kind of campaign, the farm bill suggests that the only real change coming to Washington is more of what's in taxpayer pockets.

CHINA

China and the Development Myth

by D.W. MacKenzie

Advocates of government planning often cite China as an example of economic success. China supposedly achieved success by adopting a mixed economy.

According to Joseph Stiglitz, the Chinese government has avoided the deficiencies of capitalism and communism by allowing a limited amount of private competition, while also retaining strong governmental controls over investment.

According to Noam Chomsky, the Chinese government is "the most interventionist and price-distorting government of all." Chinese success in recent decades proves that government planning is a better path. Countries that follow the "free-trade" neoliberal path will lag behind while regulated economies, like China, come to dominate the global economy.

Ha Joon Chang points out that Western industrialized nations rejected free trade during the early stages of development. Poorer nations need government to plan economic development strategically. Jeff Sachs lauds the modest nature of Chinese reforms. In order to realize vigorous economic development, market forces must be introduced gradually, and government controls must remain intact.

Part of what the anti–free market crowd says is actually true. The Chinese government dumped its overtly socialist policies many years ago. The Chinese now have a limited amount of free enterprise and private competition. The Chinese government even sought advice from Milton Friedman. Friedman went to China in 1980, 1988, and 1993. But the Chinese did not act upon all of Friedman's advice. The Chinese government retains strict control over Chinese markets. As of 2008, China ranked the 126th freest economy, in the "mostly unfree" category of the most recent Index of Economic Freedom.

The proof of Chinese success supposedly lies in its GDP statistics. The Chinese have reported astounding economic growth since 1978. The Chinese growth rate has been reported in double digits for many of the past thirty years. Chinese GDP nearly caught up to the United States during this time. At the reported rate of growth Chinese GDP will exceed American GDP in 2012. China has a much larger population, so its reported per capita GDP is still well below that of the United States. Yet, such rapid growth would appear to make China the example to follow for industrializing nations, especially those that are transitioning out of some form of state socialism.

Chinese GDP statistics seem to support the case for government regulation of markets, but there is a problem with these data. The problem with the statistics that the Chinese have reported on GDP is that they are exaggerated. At the end of last year the World Bank published a report on Chinese GDP. World Bank economists used the standard method of Purchasing Power Parity to measure Chinese GDP in terms of US dollars. The result of this study is that Chinese GDP is lower than previously believed.

While it had been thought that China had passed the ten-trillion mark, Chinese GDP is closer to six trillion. Chinese GDP was overestimated by 40%. Chinese GDP is actually half of American GDP, and Chinese per capital GDP is still very low, on average. While it had been thought that 100 million Chinese live on less than one dollar per day, there are actually 300 million Chinese living on less than one dollar per day.

Some economists have suspected that the Chinese statistics were too high since long before the World Bank report was published. University of Pittsburgh economist Thomas Rawski came out with a report in 2001 that exposed some of the problems with the Chinese statistics. Chinese GDP has grown since the abandonment of communism in 1978. However, its growth rate is perhaps half of what it was thought to be. Consequently, the enthusiasm of Stiglitz and Chomsky (among others) regarding the Chinese model of economic regulation is unfounded.

This is not the first time that opponents of freedom have been duped by exaggerated statistics regarding the performance of planned economies. During the Cold War, many scholars and media figures pushed the idea that the Soviet economy was outperforming its Western capitalist counterparts. The official statistics from the Soviet Union were impressive — and fictitious.

Economist Warren Nutter exposed the inflated nature of Soviet statistics in 1958. Yet many prominent antifreedom economists (e.g., JK Galbraith, Lester Thurow, Paul Samuelson) held to the phony statistics on the Soviet economy right until that horrible system collapsed. Unfortunately, too little has changed. Some people accept phony inflated statistics from nations like China's GDP all too easily.

Of course, the Chinese example differs from the Soviet example. China adopted modest market reforms, and reported rapid economic development. China's economic progress is actually in line with the nature of its reforms. Modest reforms have produced modest growth. The evidence on China's GDP might suggest that Chinese reforms did not go far enough, but we cannot rely on data alone. We can see the strength of the case for economic freedom even more clearly through proper economic theorizing. Free-market economists like Friedrich Hayek and Ludwig von Mises arrived at the proper conclusions regarding socialism and interventionism long before the evidence on modern state planning was in. Now that theory and history have rendered their verdicts, we should set these matters to rest.

The Fed and the Mortgage 'Crisis'

By WILLIAM M. ISAAC

The meltdown in the subprime mortgage market has caused a great deal of turmoil in the financial markets and hardship for individual homeowners and financial institutions. It prompted the Federal Reserve to take unprecedented actions to support the markets, one of which raises very difficult public policy issues.

I will return to the Federal Reserve, but first I will make some general comments. I believe that too much is being made of the current problems in the financial and real estate markets. This is probably due to three things: 1) a 24/7 news cycle; 2) a hotly contested presidential election in which roughly half of the population wants us to feel angst; and 3) we are spoiled by 25 years of unprecedented prosperity.

Martin Kozlowski

We have been told in headlines that we are in the midst of the worst banking crisis since the Great Depression. If there is a banking crisis, I have seen no evidence of it.

I can count on my fingers and toes every sizable bank about which I have had any concern during the past year. In the early 1980s, when I was chairman of the Federal Deposit Insurance Corp., it was far easier to count the major banks that were not in trouble. Virtually every major bank in the country would have failed in 1984 had a couple of developing countries renounced their debts, which the FDIC considered a distinct possibility.

The U.S. suffered through more than 3,000 bank and thrift failures during the 1980s and early 1990s, and still had 1,430 banks on the problem list at year-end 1991. I'm sure the problem bank list will grow during the next year, but it totaled only 76 at last count. Banks continue to have incredible access to the capital markets, and over 99% of all banks are considered "well capitalized" by the regulators.

When the headlines are not focused on the "banking crisis," they are fixated on the dramatic decline in home prices – more than 20% from peak levels in some major markets. At the risk of being politically incorrect, I'm not sure why we are upset about a 20%-off sale in housing.

After years of double-digit increases, housing prices in the city in which I live, Sarasota, Fla., jumped an astonishing 35% in 2005 – an unsustainable rate of increase that was pushing housing prices beyond the reach of far too many people. We really needed our housing markets to cool down quite substantially.

Millions of people – particularly the young – will benefit from a significant reduction in housing prices. While those who purchased homes in the past couple of years are unhappy if their investment is under water, the housing markets will be back for those who are able to hang on – with help from their lenders where appropriate. Congress's $300 billion "rescue" plan notwithstanding, the good news is that we have a lot of housing stock at more affordable prices for our growing population.

I don't mean to minimize the economic devastation for individuals or firms caught up in declining asset values if they don't have the financial resources to weather the storm. The last time it happened in a major way was in 2000 when the Nasdaq average took a breathtaking plunge from 5,000 to just over 1,000. That had a terrible impact on a lot of people, but we made it through it as a nation with little disruption.

This brings me back to the Federal Reserve. We had a major crisis of confidence in the financial markets, due in significant part to a loss of faith in the rating agencies and others, especially with respect to mortgage-backed securities. No one knew how big the problems were or even where they resided, so the mortgage securitization markets closed down, and financial firms stopped lending to each other.

The problems were exacerbated greatly by "mark-to-market" accounting, which required financial firms to write down their assets to fire-sale prices in the absence of a functioning market. Bank balance sheets ballooned due to the inability to sell assets at the same time accounting rules drained capital. This required banks to slow lending when loans were most needed.

The Fed displayed ingenuity and persistence on a variety of fronts in its efforts to help end the crisis in confidence. While some argue it waited too long, the Fed cut rates aggressively. It also developed and refined a unique auction process to put tens of billions of dollars of cash into the hands of the banks.

A seminal moment for the Fed came on March 14 when it extended a $30 billion nonrecourse loan to JPMorgan Chase so that it could in turn lend the money to investment bank Bear Stearns, which was suffering a liquidity crisis. Two days later JPMorgan Chase purchased Bear Stearns with considerable financial assistance from the Fed.

The rescue of Bear Stearns was a strong statement by the government that it would do everything in its power to restore sanity to the markets. Having been at the helm of the FDIC when Continental Illinois was rescued in 1984 by a very unusual and high profile transaction, I can appreciate what the Fed did. As part of an interim rescue package, the FDIC made a $2 billion subordinated loan to Continental Illinois. The Fed and the largest banks in the country also agreed to provide close to $20 billion of liquidity to the bank to prevent it from failing.

Now we are left with the aftermath of the Bear Stearns rescue. The transaction marks a vast expansion of the federal safety net. The safety net (i.e., the Fed discount window and the FDIC fund) has been paid for exclusively by insured banks, which are highly regulated. Among the questions raised by the Bear Stearns rescue is whether investment banks will now be required to support the safety net and be regulated like banks. If so, will they be able to maintain their creativity and competitiveness?

Bear Stearns also marks the first time the Fed has taken meaningful financial risk in facilitating a takeover. This is by far the most troubling aspect of the Fed's rescue effort. If the Fed had simply provided liquidity to Bear Stearns through JPMorgan Chase, I suspect there would be fewer critics of the transaction.

Do we want the Fed underwriting takeovers of failing firms? Are we willing to allow that to happen without a competitive bidding process, which is routinely used when insured banks fail? Would we want the Fed to rescue an insurance company? How about an auto company? In short, what are the rules going forward?

I'm delighted the liquidity crisis has eased, and I believe the Fed had a big hand in that. But I'm deeply troubled by the precedent that has been set and the implications for our financial system.

It might be possible to stuff the genie back into the bottle by restricting the Fed's powers to engage in Bear Stearns-type transactions. Under current law, the FDIC cannot engage in an open-bank rescue package like the one that saved Continental Illinois without receiving a recommendation from the secretary of the Treasury (after consultation with the president), and without receiving approval from two-thirds of the FDIC's board and the board of governors of the Federal Reserve.

It's time for a good debate about the authority and role of our central bank, just as we had about the FDIC in the wake of the Continental Illinois rescue.

Mr. Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985, is chairman of the Washington financial services consulting firm The Secura Group of LECG.

Hillary's Concession Speech

For those who can't handle the suspense, we fast-forward the campaign to June 2, in Sioux Falls, South Dakota. A wire-service reporter, who has covered the Clinton campaign for 17 months, files this story:

Sen. Hillary Clinton of New York has decided to end her historic quest for the Democratic presidential nomination. The decision comes one day before the South Dakota and Montana primaries, and a day after she received an extraordinary petition from senior members of the Democratic Party.

Wonder Land columnist Dan Henninger speaks to Kelsey Hubbard about Hillary Clinton's inevitable concession speech, as well as her future in the Democratic Party. (May 22)

The petition, asking her to withdraw, was signed by every Democratic member of Congress, every Democratic governor, all current and former elected Democratic officials still living, the trustees of the estate of Martin Luther King Jr., and all but one member of the New York Times editorial board. The superdelegates remained undecided.

A draft of Mrs. Clinton's concession speech was obtained from persons close to the campaign. It is to be delivered tomorrow evening in South Dakota at the Sheraton Sioux Falls convention center.

Text of draft:

Thank you, thank you very much. (Pause). Thank you! Yes. Oh, yes! Thank you all so much!

Let me just begin by congratulating Sen. Obama (pause for screams of "No!") on obtaining the presidential nomination of the Democratic Party. For the past six months, Sen. Obama and I have traveled to every state of this great country. He will be the party's standard-bearer in November. I wish him only the best.

This has been the most gratifying experience of my life. Together, we sent a message into this political system that will not be forgotten. (Pause for cheers.) That's right. You will not be forgotten. Your hopes, your needs, your dreams. [Shout this line]: They know about them now, don't they? (Pause for cheers.)

Wherever we went – at an auto factory in Lordstown, Ohio; at Bronko's Bar in Indiana (yup Crown Royal!); at a day-care center for single moms in Altoona – wherever we went, you told me how politics was failing you, and I ran to see that the American system would finally work for you. Some day it will! That's my promise. Some day it will!

AP

We came up a little short. (Pause for booing.) But boy, we came close. Or should I say: Boys and girls, we came close! (Pause to smile.)

Let me take this final opportunity in 2008 to thank the great states whose wonderful people voted to support my candidacy.

Our victories began in the legendary primary state of New Hampshire. Then the voters supported this Democrat in Nevada, Tennessee and Oklahoma. Then Super Tuesday arrived, and oh what a day to remember it was: New York, California, New Jersey, Massachusetts – what an honor to win the support of states that carry so much weight in the history of our party's presidential successes.

The media said we were losing, which – let's be honest – meant You were losing. But as I traveled this great land, I listened to you, and what I heard you say was: Keep going! Keep fighting! And we did!

We took our fight to Ohio, a state so vital to the Democratic cause. And we won. (Cheers.) To Texas. And we won. To Rhode Island! To Pennsylvania! I will never forget Pennsylvania! And we won! (Pause for crowd to begin chant: "And we won!")

In Indiana, the industrial heartland took us to their heart, and we won't forget that. West Virginia – a state I will always associate with the historic primary victory of John F. Kennedy – honored me with 67% of its vote. In Puerto Rico we deepened our ties to the Hispanic community, as in New Mexico. Kentucky – the media wrote you off as "meaningless." You will never be meaningless to me. We will not forget you. Ever!

And yes, that includes Florida and Michigan. You will always count with me. You know, there's a reason they call them battleground states. You need a fighter to win them, and together we battled to victory! (Pause/cheers.)

Politics can be hard on lifelong relationships. We understand that. But let me thank just a few old friends who stood by me: the American Federation of State, County and Municipal Employees, the Painters and Allied Trades Union, the Amalgamated Transit Union, the International Association of Machinists and Aerospace Workers, the International Bricklayers Union. My friends, we will not forget you. (Don't smile.)

I'm proud to be the first woman to almost win a presidential nomination. I think women belong in the Democratic Party. Don't you?

Some in the media said our primary victories were divisive. Really? We remember when these voters were called Reagan Democrats and voted Republican. I guess now they'd have to be called Hillary Democrats! My hope this fall is that they'll be Obama Democrats.

Some will ask if I think Sen. Obama can win. It is my honest intention to attend the inauguration of President Barack Obama in January 2009 (pause for scattered boos). He's going to make us proud this November. It will also forever be my intention to stand and fight for the future of the Democratic Party and the people of America. Your hopes. Your needs. Your dreams. Thank you, thank you, thank you!

Huelga! Argentine Farmers Back on Strike

Call it populism that isn't particularly, well, po-pu-lar. While India has decided to shut down futures trading of in-demand agricultural commodities to show the public it is "doing something" about the high prices of food at home, the Peronist government of Argentinian President Cristina Fernandez de Kirchner has raised export tariffs in a bid to keep the locals well-supplied with increasingly scarce agricultural produce. The problem is that the farmers whose livelihoods have been adversely affected by this tariff are none to happy, as are many middle class folks who Kirchner needs the support of. The decision to raise tariffs was accompanied by massive rioting in Argentina by affected farmers. As is usually the case in Argentina, large-scale disturbances ensued. In this instance, routes were cut off to neighbouring countries which are usually destinations of Argentinean produce until the elevated tariffs were put into effect. If you want more of a background, consult this TIME article, from which I draw the snippet below:

At the core of the discontent was a decision by Fernandez three weeks ago to raise export taxes for soy from 35% to 44% though a sliding scale of tariffs. Other observers have called the soy tax and efforts to ban exports of some farm products as misguided attempts to retain the supply of basic goods in Argentina. The government's argument is that the large-scale export of products like soy cause local shortages and drive up the price of food in Argentina.

The protesting farmers (the organizers claim as many as 150,000 took part) blocked international routes used for trade with neighboring Brazil, Paraguay and Chile, leading the government to threaten police action to clear the roads if necessary. The strike forced many supermarkets and butchers to close their meat counters, a dramatic move in a land famous for its abundant and tasty beef. Fruit and vegetable prices rose and exports of cereals and oils have also been affected.

A 30-day truce ended at the start of the month. With more than half of all export revenues coming from agricultural exports which are now at a standstill, things aren't looking up for Argentina's economy. The main agricultural producers in the country want nothing less than the removal of the additional tariffs, but Kirchner won't back down from the redistributive ploy. The result is that the farmers have gone back to good ol' "industrial action," as per the British euphemism. From Reuters:

Thousands of farmers lined Argentina's highways on Thursday in fresh protests to disrupt key grains exports and pressure the government to cut agricultural taxes. Farmers launched the eight-day strike after breaking off weeks of talks with the government, complaining that President Cristina Fernandez had refused to modify a new system of export taxes that triggered a three-week strike in March.

"They wanted to trample all over us, but they couldn't do it," said Alfredo De Angeli, a farm leader in Entre Rios province who became well-known for his fiery speeches during the first strike. The Entre Rios town of Gualeguaychu, some 125 miles (200 km) from Buenos Aires, has become the focus of farm protests. Argentina is one of the world's top suppliers of corn, wheat and soy, and the protests have pushed up soy prices on world markets.

Argentina's peso currency slipped as investors concerned over a prolonged conflict sought refuge in dollars [!], and the local currency is now languishing close to a five-year low. Bonds and stocks were also jittery.

Traders at Argentina's main grains market in Rosario said they had no orders. Farmers plan to hold back products from soy crushers and exporters through May 15. But they have ruled out a repeat of the roadblocks that caused food shortages during March's strike, when the government accused them of trying to hurt ordinary Argentines.

Fernandez's leftist government has offered a tax rebate and transportation subsidies for small producers to cushion the effect of the new taxes, but farmers said they will not go back to negotiations unless she suspends the measure. The sliding-scale tax system pins export taxes to international prices, raising levies on soybeans to about 40 percent at current prices from the previous fixed rate of 35 percent. "When they don't have any more cash from exports, that's when they'll have to sit down to talk," said one farmer in Gualeguaychu who declined to give his name.

Argentina's vast fertile farmlands make it the world's No. 2 corn exporter, the third-biggest soy supplier and the No. 4 provider of wheat and beef. The conflict with the farming community has landed Fernandez with her biggest challenge since taking office five months ago. Top officials criticized the new wave of protests. "It's a hugely irresponsible decision that makes no sense at all. It's just about defending the interests of one sector and not about the general interest," said Interior Minister Florencio Randazzo.

Fernandez has refused to scrap the sliding-scale tax system and she defends high export taxes on farm goods as a way to redistribute wealth and combat inflation in a country where a quarter of the population lives in poverty. Soy exports earned the country $13.47 billion last year while sales of farm goods abroad accounted for 52 percent of total Argentine exports, totaling $29.13 billion.

What are these farmer doing with all that agricultural produce in the meantime now that they are unwilling to cooperate? Socialists would say they are "hoarding"; these farmers would say they are "protecting their interests." Mercopress has an interesting article on how farmers are using ginormous silos to keep the non-exported grains away from unwelcome parties. Will they succeed in starving the government of revenues from export tariffs? It will be interesting to watch, to say the least:

The extended Argentine farmers/government conflict, which was triggered in early March when the new sliding export taxes system was announced, and its renewed eight days of protest, have left an estimated 44 million tons of grains and oil seeds unsold, valued in approximately 12 billion US dollars, according to market analysts interviewed by the Buenos Aires press. The 44 million unsold tons are equivalent to 45% of the 2007/08 harvest which is forecasted to be Argentina’s second record with 96.8 million tons equivalent to 25 billion US dollars.

Non exported grains will inevitably have an impact for the Argentine government coffers since it will have limited access to collecting the controversial export tax if farmers hold on to their crops. This is particularly true since farmers apparently with the help of plastic silos can store such huge volumes of grains.

According to Gustavo Lopez from Agritrend, of the 44 million tons, 75% is soy. Argentina still has to ship overseas an estimated 32 million tons of soy, (some of it already sold but with no price agreed) which at current local prices is equivalent to 9 billion US dollars. The country’s total soy crop is expected to reach 48 million tons of which 14 million still are waiting to be harvested.

Ricardo Baccarin from Panagricola argues that given the current uncertainty in the grains market, and situation, farmers are holding on to their soy crops “which is the most valuable.They’ve decided to sell what they need to face current expenditures and the rest they are holding on to; we could be facing a historic year in so far as crop retention is concerned”, added Baccarin.

Normally at this time of the year daily transactions in the area of Rosario (Argentina’s main soy bean hub) “are in the range of 100 to 200.000 tons of soy, but currently it’s down to 10 to 30.000 tons”. Lopez revealed that an estimated 51 million tons of the current crop have been commercialized, and even when soy beans retention is as high as 75%, “most of corn and wheat has been traded. Of the 16 million tons of wheat possibly 4.2 million tons remain unsold”.

Regarding corn, of a crop of 21 million tons, 10.4 million tons have been traded and exporters have registered sales for 10.7 million tons. Argentina’s domestic consumption is 7.8 million tons. Nevertheless grain traders are fearful because last year the Kirchner administration clamped exports when the overseas registry reached 10.5 million tons. Lopez says that 25 million tons, (14 million of soy and 11 million of corn, sorghum and others) still have to be harvested.

And how do farmers store such huge volumes? Apparently plastic portable silos with minimum units of 200 tons and which can stand a whole year has become the most common resource in current circumstances. “The plastic silos are a good strategy for tough moments and uncertainty” said representatives from a company which specializes in selling these products. Apparently business has been booming and sales of plastic silos could store well above 40 million tons. “That’s where most of the crop should be now”, added Lopez.

This also means a huge improvement from the 2003/04 harvest when plastic silos helped store 12 million tons. Companies admitted this has become a “90 million US dollars business per crop”. Provincial authorities’ sources from Cordoba estimated that Argentine farmers could be holding on to grains and oil seeds valued at almost 20 billion US dollars [!]