Ride out Wall Street's hurricane

When hurricanes hit land, they generally weaken. Not so on Wall Street. Since the gigantic financial storm I call Hurricane Central hit a year ago, it has only grown in size and intensity. This week we saw how destructive its power had become.

Even the mightiest oaks have fallen: Countrywide Financial, Bear Stearns, Fannie Mae, and Freddie Mac.

The latest victim, Lehman Brothers, resulted in the largest bankruptcy in history on Monday. Hurricane Central even toppled the "Bull" on Wall Street. Merrill Lynch, the country's No. 1 brokerage firm, was bought out by Bank of America in a fire sale. These are times that try investors' souls.

With the US and global economy slowing down, real estate still in a tailspin, and credit conditions tightening, Hurricane Central is traveling a wide path, wreaking havoc wherever it goes, and no one knows for sure where it will hit next. (Could it be the insurance companies?)

But one thing is near-certain: Hurricane Central's storm surge will flood Main Street. Aside from putting the economy into a tailspin, it could put taxpayers on the hook for billions in new liabilities and bailouts.

Despite unprecedented bailouts, tax rebates, record federal deficits, and easing of monetary policy, Washington's financial FEMA (known as the Federal Reserve) seems to be at a loss on how to tame it. One week, the markets appear to have stabilized, the next week, we see that we were only in the eye of the hurricane, and the destructive winds have come back with a vengeance.

What caused this dramatic typhoon, when will it end, and what should investors do to minimize their exposure?

Are greedy capitalists to blame?

Many pundits – and, sadly, most politicians and voters – blame it on the "inherent instability" and "animal spirits" of greedy capitalists stirring up the financial waters with their excessive speculation and leverage in enticing new but unregulated financial instruments, such as subprime ARMs (adjustable rate mortgages), CMOs (collateralized mortgage obligations) and CDOs (collateralized debt obligations).

More astute observers will examine the perverse role of Washington in destabilizing a fragile global financial economy. The evidence is growing that governments both here and abroad attempted to heat up the economy through easy money, beyond the natural capacity of technology, saving, and capital formation. Now we are witnessing the unintended and dangerous consequences of their contrived agenda.

To encourage broader homeownership, did not Congress amend the Community Reinvestment Act in 1995 to require commercial and mortgage banks to lend to high-risk borrowers? Banks that failed to comply were hit with fines and faced rejection when they requested mergers and branch expansions. Suddenly the subprime mortgage business boomed, and Countrywide Financial became its poster child.

Furthermore, to encourage homeownership, did not the federal government offer an implicit guarantee to cover the performance of mortgage-securities giants Fannie Mae and Freddie Mac? The result was corporate abuse and a systematic easy-money policy that lasted for more than a decade in real estate. Like all artificial inflationary policies, the overheated property market led inevitably to widespread turbulence.

Recently the quasi-private Financial Accounting Standards Board imposed "mark-to-market" accounting regulations on financial institutions, forcing mortgages and other loans to be written down to zero simply because they couldn't be sold, even if they were still being paid by customers. As a result, we've seen financial tornadoes causing institutions to be downgraded and, in some cases, completely collapse.

Fearing Japanese-style doldrums, the Fed under Alan Greenspan reduced the short-term interest rate to 1 percent in 2004, far below the natural rate, causing a dangerous increase in irresponsible lending patterns, overleverage of capital investment, and speculative heat waves in real estate (subprime ARMs skyrocketed), corporate bonds, and other assets. That modus operandi extended beyond our borders. To artificially heat up their economies, central banks in developing countries (especially Russia, China, and India) deliberately inflated their money supply at alarming rates.

But there's no eternal spring, not even in monetary macroeconomics. The resulting inflationary boom in real estate and other assets created a structural imbalance in the US and global economy. It was inevitable that the storm would release its electrical power, with heavy bolts of lightning striking at will.

At the height of its prowess, Fannie Mae had leveraged its equity 40 to 1, the highest leverage ratio in its history. When the real estate boom ended, the leverage collapsed, the insanity ended, and the government was forced to take it over, or risk a global nightmare.

If any among us can sincerely say, "I told you so," it's the economists who belong to the "Austrian school." For years, they've warned about the risks inherent in artificially stimulating the economy by cutting interest rates below the natural rate and inflating the money supply. As they emphasize, inflation is never neutral in its effects. It can cause an unsustainable surge, destabilize the economy in unexpected ways, and threaten a wholesale depression and crash on Wall Street.

For all the complexity of today's economy, the century-old Austrian theory of the business cycle – in bumper-sticker form: monetary manipulation makes a mess – offers the best explanation of what's going on.

Needed: presidential courage

Both major presidential candidates, Barack Obama and John McCain, are promising "change." Whoever is elected president faces a daunting task in taming the financial whirlwinds. Daunting, not because the solution is hard, but because the political courage it requires is almost impossible.

The new financial model should be based upon principles of sound economics: instead of a fluctuating monetary policy (easy money followed by tight money, cutting rates, then raising them), the Fed and other central banks must ensure stable money. The price of gold is a good way to measure their success in providing monetary stability and genuine growth.

Some regulations need to be abandoned or changed, such as the "mark-to-market" accounting rules. Also, private equity companies should be allowed to buy substantial positions in banks (more than the current 25 percent) without being regulated as a bank. The greatest threat now is that Hurricane Central will result in more controls, not unlike the passage of the draconian – and economically hurtful – Sarbanes-Oxley law following the collapse of Enron and WorldCom in 2002.

Finally, the federal government should not be too eager to come to the rescue of every major corporation or bank. When the state socializes losses, it creates what economists call "moral hazard," which encourages businesses and banking institutions to take on excessive risk in their ventures, knowing that the government will cover up their mistakes. Government guarantees, including insurance on bank deposits and brokerage accounts, can be costly, encouraging irresponsible behavior in the future.

This week the Bush administration made the right decision in refusing to guarantee Lehman Brothers. In 1990, the giant investment banking firm Drexel Burnham Lambert was allowed to go under, and the economy survived and later prospered. It's an important lesson.

It would also help if the new president would preserve the 15 percent tax break for dividends and long-term capital gains, and reduce the corporate income tax, following the trend in Europe and Asia. These measures would help strengthen the dollar and create jobs.

These are real changes. While waiting for them to be instituted, investors should ride out the storm by investing conservatively, being well diversified both here and abroad, and holding a haven in cash and gold.

• Mark Skousen is editor of "Forecasts & Strategies" market newsletter, producer of the annual FreedomFest conference, and author of "EconoPower: How a New Generation of Economists is Transforming the World."