Crisis Investing for the Rest of the '90s by Douglas Casey - Excerpts

Crisis Investing for the Rest of the '90s. Douglas Casey. 1995. ISBN-13: 978-0806516127

EXCERPTS

At a minimum we're headed for a financial collapse. A financial collapse does not mean that any real assets disappear. It means that assets change ownership. The buildings, factories, machines, and technology that were created during good times do not vanish just because the stocks, bonds, and bank accounts that represent them are devalued or dishonored. Nor does the desire of people to create and produce vanish when their finances go bad; instead they may become even more motivated.

My belief ... is that when this business cycle peaks and the market distortions and the misallocations of capital forced by the government's intervention in the economy are finally unwound, the consequences will probably reach far beyond the economic sphere.

Why should a depression occur now? A depression could have materialized out of any of the credit crunches in the last three decades, including the financial squeezes of 1962, 1966, 1970, 1974, 1980 and 1982. With each episode inflation went higher, interest rates rose, unemployment increased, and the bankruptcies were bigger. Near bankruptcies (such as Lockheed, New York City, Chrysler, Continental Bank) became more numerous and dangerous and more likely to demand a government rescue. But each time we experienced just a recession that the government ended before the underlying distortions in the economy had been eliminated. And each time the authorities succeeded in preventing a financial collapse, the system became more carelessly confident of government doing so the next time.

The depression of the 1930s was deepened , and was prolonged for years, by Hoover's and Roosevelt's interventionist policies. The Work Projects Administration (WPA), the National Recovery Administration (NRA), the Tennessee Valley Authority (TVA), the Federal Deposit Insurance Corporation (FDIC) and numerous other New Deal creations not only prevented the economy from cleansing itself, they also produced new distortions in the economy. Roosevelt's "solutions" to the depression were almost identical to Hoover's, but Roosevelt's public relations was far superior, enabling him to position himself as the savior of capitalism even while he lengthened the depression.

Socialism is not a serious intellectual challenge. It persists because it expresses so well and underlying set of spiritual and psychological problems. Few reasonable people who have actually looked at the historic results of socialism honestly believe government intervention is the solution to economic problems, rather than the cause. But how someone reacts to economic ideas is much more a question of values and psychology than of intelligence and knowledge.

In fact, most "economists" turn out to be merely political apologists. They prescribe the way they would like the world to work and tailor their theories to help politicians demonstrate the virtue and necessity of their quest for more power.

Politics deals with who decides who gets what, how, why, and when. It deals with how men cooperate with, and compete against, one another in the process not of producing wealth, but of taking it.

Confidence is considered a critical commodity today, because the dollar and the economy itself rest on confidence alone. Yet confidence can vanish like a pile of feathers in a hurricane, once the extent of our problems becomes clear. Confidence in the economy is a very shaky foundation upon which to build your future. I suggest you lose that confidence now and beat the last-minute rush.

Every thinking person must be his own economist, simply because everyone needs a worldview to deal with reality. You can't delegate it to an "expert" any more than you can delegate the formulation of your personal philosophy and ethics to someone else. You need to decide whether we're to experience prosperity or a depression, and how you want to prepare.

A depression is an economic crisis with both danger and opportunity. Everyone will feel the danger, but those who see the opportunity will profit from the crisis. After all, one function of a depression is to return wealth to its rightful owners ... Disaster-caused depressions destroy wealth and make it harder to produce more. Economically caused depressions, through regulations, make it impossible, or at least unprofitable, for the average person to produce wealth.

A real estate collapse doesn't mean the buildings will tumble. But their prices will and their owners may change. A corporation's bankruptcy doesn't mean that the factories or technology it owned will vanish; they will become the property of a different corporation. A government default on its bonds doesn't mean the country (which is not at all the same thing as the government) is bankrupt. It just means that those who held the bonds are poorer and those who otherwise would have been taxed to pay the bonds are richer. In other words, all the real wealth will still be there, but its ownership will change. And some commodities will become more (or less) valuable relative to other commodities.

Because the banks have just taken in billions of dollars, courtesy of the government, they have plenty of money to lend, and at very low rates. "Interest" is the rental price of money, and with money in such ample supply, the price drops. Like any other business with excess capacity, the bankers have a "special" on money.

A recession follows an inflationary boom when the market tries to readjust to normal patterns of supply and demand. It's a painful period when the free market corrects the misallocation of resources encouraged by government inflation. People have more of some consumer products than ever, and there is more plant capacity to produce those products, but few people are as well off as they were before the inflation. They're actually less well off than if the government had only taxed them.

The contraction will be called a recession if the government acts quickly and reinflates the money supply in time to prevent complete collapse. It will be called a depression if the government decides not to act, acts too late, or acts with too little reinflation. In other words, it will be a depression if the government allows the economy to cleanse itself of the distortions that have occurred due to earlier government intervention and inflation; it will be a recession if the government steps in before the liquidation is complete.

At some point, the economy is no longer controlled by individual citizens in the marketplace but by government "planners", who find they have only one of two alternatives: stop "stimulating" and permit a full-scale credit collapse, or continue stimulating until the dollar loses all value and society breaks down. Depending on which they choose, we will have a depression characterized by deflation or by hyperinflation.

"Inflation" occurs when the creation of currency outruns the creation of real wealth it can bid for. It isn't caused by price increases; rather it causes price increases. Inflation is not caused by the butcher, the baker, or the auto maker, although they usually get the blame. On the contrary, by producing real wealth, they fight the effects of inflation. Inflation is the work of the government alone, since government alone controls the creation of dollars.

If taxation is the expropriation of wealth by force, then inflation is its expropriation by fraud.

Money is the means by which all other material goods are valued. It represents, in an objective way, the hours of one's life spent in acquiring it. And if enough money allows one to live life as one wishes, it represents freedom as well. It represents all the good things one hopes to have, do, and provide for others. Money is life concentrated.

Only the rich can afford the legal counsel it takes to weave and dodge through the laws that restrict the masses. The rich can afford the accountants to chart a path through loopholes in the tax law. The rich have the credit to borrow and thereby profit from inflation. The rich can pay to influence how the government distorts the economy, so that the distortions are profitable to them.

Always, and without exception, the most socialistic, or centrally planned, economies have the most unequal distribution of wealth. In those societies the unprincipled become rich, and the rich stay that way, through political power.

At any given moment a fixed amount of capital in the world is available for borrowing. The government is considered the most creditworthy borrower, since it has what amounts to a 100 percent lien on all the wealth in its bailiwick, so it can borrow all it wants, and at the lowest rates. Why should anyone lend to a business, which could go bankrupt, when the government is available? The ultimate result is "crowding out". The potential for real problems first arose in the middle of the 1970s; as of 1991, the government consumed approximately 79 percent of all new credit.

A better term for the underground economy might be the "alternative economy", since "underground" has acquired a somewhat pejorative connotation. The alternative economy, which includes everything from barter of services to the millions who don't file tax returns, obey regulations, or purchase licenses to do business, is simply the untaxed, unregulated free market in action. It runs the way business did in the early part of the century, before the income tax, the Federal Reserve, and most regulatory agencies. In the alternative economy, the sellers earn more, the buyers pay less, and the State is shut out. Everyone wins, except those who are fed by the government.

Being on the wrong side of a bear market is somewhat comparable to the progressive stages of people when they discover they have contracted a terminal disease. First comes denial, then anger and blame, then false hope and grasping at straws, then finally acceptance and resignation. Only then is the market really dead and ready for reincarnation.

Big companies have always had an edge when it comes to manipulating and gaining from the government's regulations and tax rules. In fact, they have often been strong proponents of government intervention, because it can help the established companies stave off new competition. Large corporations have an innate advantage in getting government contracts and otherwise feeding at the public trough. It's much easier for Big Government to deal with Big Business and Big Labor on Big Deals. But the tenor of the times has turned against them; only government has continued to grow, because it alone has the legal power to coerce. Like a cancer, it's reaching its largest size at the very time its host, the Mass Economy, is dying.

Small business is stagnating for several reasons. First, loan capital is tough to come by, even with interest rates very low ... Second, regulatory hassles - everything from sexual harassment liability to making the premises accessible to the handicapped to zero-tolerance environmental policy - have driven the costs, and liability, of doing business beyond the level small outfits can handle ... Third, the associated costs of starting a new business - taxes, license fees, legal fees, medical and other insurance - are far higher than in the past ... All these problems stem from the government. Perversely, they're all likely to get much worse as the malaise of the Greater Depression deepens.

The main reason for shorting stocks is the reason you are in the stock market in the first place: personal profit. There are, of course, risks peculiar to shorting, and I'll cover them below. But on the whole, this is perhaps the single, most-profitable thing you can do in the market year in and year out, in good times and bad.

If "everyone" owns a stock, then all the potential buyers have already bought; and there's only one thing they can do: sell. Perversely, they'll all sell at once.

People invest in mutual funds because they believe the funds relieve them of need to be cautious. They hope the funds will beat the market, which a lot of mutual fund advertising seems to promise. The industry as a whole, however, underperforms the market; that was, you will recall, one of the reasons for the creation of index funds.

When an institution sells, the only likely buyer is another fun; but they'll all be selling together, for the same reasons. That kind of thing can put a market into freefall. Vacuums could develop under stocks with heavy institutional ownership. Their chart patterns would resemble the glide path of an ICBM on re-entry. Index funds will likely lead the way.

Short-term U.S. Treasuries - It's hard to conceive of them defaulting unless there's a domestic revolution or the government loses a major war. That they are redeemable only in paper dollars, which have no intrinsic worth, is beside the point. In today's moving paper fantasy, you must pretend U.S. Treasuries are "good as gold", since they are, by far, the safest way to own dollars.

Bonds should be viewed as vehicles for speculation on the direction of long-term rates, not something for those investors who want safety and capital conservation. They are political footballs that will be passed dozens of times in the years to come by the intellectuals making a game out of "fine tuning" the economy. You can bet that the ball is going to be dropped at some point.

... brokers like to keep things simple rather than risk confusing a customer; they're in sales, not the education business.

Smart places to live might be Nevada or Washington, close to the Oregon border, or in Wyoming, close to the Montana line. You would pay no income tax where you live, but could make all your purchases where no sales tax is levied.

Political jurisdictions compete to provide a favorable environment for corporations. Sound good? It's not, unless you naively think that what's good for management is good for the shareholders. Management prefers jurisdictions where the law keeps the owners from becoming a nuisance. That is why most corporations are headquartered in Delaware; laws in that state make it easy for management to get its way, as opposed to guarding the rights of shareholders. Delaware receives about 20 percent of its budget from the corporation business, and its officials know what side their bread is buttered on.

Most companies subject to takeovers are vulnerable only because their stock price is low relative to their assets. And that happens when the assets are being misallocated and the market has no confidence in management's abilities to correct the error. In fact, a company can usually be acquired only if management owns no more than a token care of stock. And if the managers are not also owners, why should they care what the business is worth, as long as they keep their jobs? Most managers of big corporations own very little stock in them; arguably, that is because they can see it's a poor long-term investment.

Unlike currency, gold cannot lose value because of government mismanagement. On the contrary, it tends to gain value because of government mismanagement.

Gold ... is a matchless crisis hedge. It's the only financial asset that's completely invisible and private. There are no social security numbers stamped on gold coins, and they leave no paper trail when they change hands. Unlike real estate, for instance, a government cannot easily find gold to tax or confiscate. Unlike stocks, gold doesn't represent a value that can be dissipated or mismanaged. Unlike bonds, gold cannot default. And unlike currency, gold cannot be inflated away. There are not many low-risk places for wealth to hide today. But plenty of wealth exists and, as the world's greatest coward, capital will look for a place to hide when things get scary. Gold is the perfect financial asset in times of uncertainty.

The art of investing emphasizes inaction as much as it does action. Success is a long-term proposition, and most of your time should be spent patiently hunting for the fattest prizes, not frenetically chasing after every mangy stray. Given transaction costs and the vagaries of your own mind set, an even-odds bet is inevitably a fool's bet. You want anomalies where risk and reward are heavily weighted in your favor, where the arguments that you'll be right are so compelling that you are almost forced to act.

The most important question about any investment is: What is the downside?

Government quotas, subsidies, supports, taxes, and marketing regulations are the greatest cause of commodities' volatility; they alternatively cause disruptive shortages and wasteful surpluses. Government intervention gives the appearance of stability over the short-run, but at great cost to both the producer and consumer in the long-run. This offers great opportunities to speculators.

Rather than just deregulate, it would be more in character for the powers that be to create the conditions for a famine in order to get prices up to subsidize inefficient farmers. You may think I'm stretching the point. But the U.S. government cause the slaughter and burial of whole herds of livestock, and poured tons of milk in the gutter during the '30s in a futile attempt to raise prices, even while many people couldn't afford to eat.

The world may still be on a honeymoon following the collapse of communism, but it's hardly the end of history. The fundamental cause of war and revolution still exists, namely, politics. And, to a lesser extent, just plain geography.

Most people do not want to hear the bearish argument for real estate, since by far their largest asset is their house. For the average American family a house is much more than a home; it's a combination investment, savings program, tax shelter, and retirement program. A crash in housing prices would be more devaluating than a stock market crash, not only financially but psychologically.

Real estate has traditionally been the most debt-leveraged of all markets. In the United States, few people can buy real estate, and few people can sell, without borrowing money. Getting a mortgage has always been integral to buying a house except for the very rich. The easy availability of cheap mortgages is the most important single reason that real estate prices increased faster than consumer prices from the '50s through the '70s. U.S. real estate prices are built on a pyramid of long-term mortgage money.

You can't hide real estate, which makes it the most taxable of all investments. Many local governments are in deep financial trouble, and property taxes are excellent candidates for "revenue enhancement". Property taxes also suit the envy-driven, tax-the-rich hysteria that is likely to grow as the average person's standard of living declines.

Taxes, like every form of government action, cause distortions and misallocations of capital. Taxes induce people to act in ways they otherwise would not. And, in what will become a desperate quest for revenue, the government will unwind the tax breaks that have favored real estate over many decades. As a result the distortions those breaks caused will also come apart. Artificially high property prices will tumble.

It's one thing to arrive at a conclusion that U.S. property has entered on a long-term bear market. But it is priced in dollars, and it seems an even surer bet that dollars are eventually going to zero. Instead of seeing the mortgage as a means to buy property, it might be a better idea to view a mortgage as a way to short sell the dollar. It's convenient for borrowers, therefore, that the fixed rate mortgage is still available. I don't like the idea of paying interest. I would rather collect it. Nor do I like the idea of being in debt; it limits your options and puts at risk. But fixed-interest debt remains an excellent defense against a collapsing currency.

The speculator provides a public service by offering a bid when otherwise none is available. A speculator simply gives people what they want most of the time. When prices are high and everyone seeks property, he endeavors to keep prices from going even higher by providing a supply. And when prices are low and everyone desperately needs cash, he once again bows to the will of the market. Buying low and selling high is helpful to people when they need cash more than land.

Foreign aid might accurately be described as a transfer from poor people in rich countries to rich people in poor countries.

When going to a place like Mozambique is suggested to most people, their first reaction is they would feel safer in Miami when they want warm weather. But those who buy a dumpy studio apartment in Miami will someday wonder why they didn't go for a large farm on the African coast instead. The reason, of course, is that they are provincial and not very imaginative and probably, alas, belong in Miami.

The failure of Credit Anstalt in Austria, a bank few Americans knew of, sparked the 1929 depression.

Despite recent large sell-offs, Japan's stock and property markets are not cheap. Prices continue to reflect the good times of the last few decades. The next few years will probably be grim enough to shake up price perceptions; views ingrained over many years do not turn on a dime. As with most historic events, Japan's crisis will not bottom out until the collapse of its financial markets is the headline in every magazine and newspaper around the world.

A collapse in Tokyo, therefore, wouldn't just be a story on the evening news; it could be the signal for a worldwide financial and economic catastrophe. There is no rule that says a depression in America has to be made here; everything is imported these days.

Every nation is insufferably nationalistic. Unfortunately, the Japanese and the Americans are two of the worst offenders and believe that anyone who is not one of them is genetically disadvantaged. Moreover, they are radically different cultures, leaving plenty of room for miscommunication, or worse.

The weapons business is the biggest in the world, bigger even than illegal drugs, and the Japanese have almost no participation there. With their tremendous abilities to produce to high standards and innovate, the Japanese should surpass the American, Russian, British, French, and other arms manufacturers as easily as they did the automakers. Arms will, before the end of the decade, be a perfect area to pick up the slack created by dropping consumer goods exports.

As bad as things were in the United States in the '30s, people still had businesses, savings, and farms - and incentives to rebuild. And the system allowed them to start anew. The Russians have none of that. They own little; the state owns everything. And since the state already owns everything, it has nothing to tax.

We're still paying for the Vietnam War, since it was fought with 100 percent borrowed money. $160 billion over about twenty years at about 8 percent compounded is already $640 billion, and growing at about $50 billion a year. The bill for the instant gratification in Iraq will also grow for years.

Military prowess is a poor substitute for the real roots of greatness, or even for economic power, as the Russians have just discovered and as the Germans and Japanese learned in World War II or the Romans found in the late empire. War is the most unpredictable of human activities, has unintended consequences, and can take on a life of its own.

In a just society, law concerns itself with only two matters: contracts (have you done all that you agreed to do?) and torts ( have you encroached upon another's person or property?). There are encompassed by "common law". Common law, determining right and wrong, is based on principles of justice that can be considered universal in societies. That is vastly different from "legislation" or "political law", which is arbitrarily constructed by officials. Legislation mostly deals with what have come to be known as "victimless crimes".

The U.N. Convention against Illicit Traffic in Narcotic Drugs defines money laundering as "the concealment or disguise of the true nature, source, disposition, movement, or ownership of proceeds and includes the movement or conversion of proceeds by electronic transmission." The treaty does not specify that the proceeds need be from any illegal activity; the simple act of protecting your financial privacy leaves you open to sanctions. About seventy nations, including the United States since 1990, are signatories to this treaty, and treaties have the effect of law within the United States.

Some Americans simplistically believe an opposition to the war on drugs amounts to an endorsement of drugs and an unwillingness to see their destructive effects on society eliminated. I see drug use as a debilitating at best and tend to eschew the company of those who use them. But destroying liberty isn't an even remotely acceptable method to discourage drug addiction. Nor is it effective.

Government sponsors untold waste, criminality, and inequality, in every sphere of life it touches, giving little of value in return. Its contributions to the commonweal are wars, pogroms, confiscations, persecutions, taxation, regulation, and inflation. And it's not just some governments of which that's true, although some are clearly much worse than others. It's an inherent characteristic of all government.

Force is the essence of government. But the possession of a monopoly on force almost inevitably requires a territory, and maintaining control of territory is considered the test of a "successful" government. Would any "terrorist" organization be more "legitimate" if it had its own country? Absolutely. Would it be any less vicious or predatory by that fact? No, just as most governments today (the ex-Communist countries and the kleptocracies of the Third World being the best examples), demonstrate. Governments can be much more dangerous than the mobs that gave them birth.

In general, government judicial systems are far more concerned about crimes against the state than crimes against the individual. In China, as the Tiananmen Square revolt demonstrated, the gravest crime consists of agitation for democracy; in the United States, it consists of nonsupport of the government by refusing to pay taxes or obey regulations. And in all cases a show of humility, a respectful attitude, and the renunciation of politically incorrect ideas are required.

In the perverse "real world" of today ... the police, courts, and the military are among the least significant parts of government; moreover, government fails to produce quality products in any other worthwhile area it pursues, such as education. Indeed, its main products are taxation, regulation, inflation, and wealth redistribution, which all eventually destroy their supposed beneficiaries as surely as they do those who are taxed overtly.

Politics is the theory and practice of government. It concerns itself with how force should be applied in controlling people, which is to say, in restricting their freedom. It should be analyzed on that basis.

QUOTATIONS

Bakunin, Michael
Ever since States came into existence, the political world has always been and still continues to be the state for high knavery and unsurpassed brigandage – brigandage and knavery which are held in high honor, since they are ordained by patriotism, by transcendent morality, and by the supreme interest of the State. This explains to us why all the history of ancient and modern States is nothing more than a series of revolting crimes; why present and past kings and ministers of all times and all countries – statesmen, diplomats, bureaucrats, and warriors – if judged from the point of view of simple morality and human justice, deserve a thousand times the gallows or penal servitude. For there is no terror, cruelty, sacrilege, perjury, imposture, infamous transaction, cynical theft, brazen robbery, or foul treason which has not been and is not still being committed daily by representatives of the State.

Lord Byron
Ready money is Aladdin's Lamp.

Edwards, Bo
The Bill of Rights applies to criminal cases. For example, the right to have a lawyer, the right to a trial by jury, and the government must prove its case beyond a reasonable doubt. None of those rights apply in a civil case where the government is bringing a civil forfeiture case against your property.

O'Rourke, P.J.
Every government is a parliament of whores. The trouble is, in a democracy, the whores are us.

Jean-Francois Revel
Authoritarian socialism has failed almost everywhere, but you will not find a single Marxist who will say it has failed because it was wrong or impractical. He will say it has failed because nobody went far enough with it. So failure never proves a myth is wrong.

Nathan Rothschild
Buy when blood is running in the streets.

Paul Samuelson (Nobel laureate, in 1989)
What really counts is results, and there can be no doubt that the Soviet planning system has been a powerful engine for economic growth

Paul Samuelson (Nobel laureate, in 1989)
The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.

Mark Skousen
Taxation is the price we pay for failing to build a civilized society. The higher the tax level, the greater the failure. A centrally planned totalitarian state is a complete failure of civilization, while a totally voluntary society is its ultimate success.

Gore Vidal
Free enterprise ended in the United States a good many years ago. Big oil, big steel, big agriculture avoid the open marketplace.

Building Wealth by Lester C. Thurow - EXCERPTS

Building Wealth: The New Rules for Individuals, Companies, and Nations in a Knowledge-Based Economy. Lester C. Thurow.

EXCERPTS

In the new man-made brainpower industries of the twenty-first century, all of Europe is an also-ran. Nowhere is it an industrial leader.

For in the end, it is productivity growth (the ability to produce more output using fewer inputs) that ultimately drives real wealth creation.

At the end of the twentieth and beginning of the twenty-first centuries, six new technologies – microelectronics, computers, telecommunications, new man-made materials, robotics, and biotechnology – are interacting to create a new and very different economic world.

Knowledge is the new basis for wealth … Exactly how one controls (owns?) knowledge is in fact a central issue in a knowledge-based economy.

Just as the second industrial revolution moved us from local to national economies, so the third industrial revolution is moving us from national economies to a global economy … The existing international institutions – the International Monetary Fund, the World Bank, the United Nations, the World Trade Organization – were not meant to deal with a global economy.

In short, no one is going to set up a global government in the foreseeable future – regardless of whether it is or is not needed. As a result, the world is going to have a global economy without a global government. This means a global economy with no enforceable, agreed-upon set of rules and regulations, no sheriff to enforce codes of acceptable behavior, and no judges and juries to appeal to if one feels that justice is not being done.

In the twentieth century as local economies were replaced by national economies, national governments gained power. They needed to be given the powers necessary to control national economic systems. A global economy reverses this process.

To have great wealth is to have it all. It is not surprising that get-rich-quick books sell, even though the buyers know the books will convey nothing helpful. They are the modern equivalent of alchemy. Neither exists, but it would be so nice if they did that many are willing to suspend their critical faculties and believe in the unbelievable. Fairy tales both sell and give comfort – even when they are know to be fairly tales.

RULE ONE: No one has ever become very rich by saving their money. The rich see opportunities to work and invest in situations where large disequilibriums exist. This was as true for John D. Rockefeller as it is for Bill Gates. In both cases heir lifetime savings constitute a small fraction of their total wealth. Carefully saving one’s money and investing in normal equilibrium situations can make one comfortable in one’s old age but never really wealthy.

Big old firms understand, and often even invent, the new technologies that transform the world, but they have a structural problem that is almost impossible to solve. When new breakthrough technologies come along, old firms must destroy themselves to save themselves. They must cannibalize themselves, but they cannot.

“Entertainment” shopping will be able to compete with electronic shopping or some products, but no one knows which products. Which customers will be willing to pay more if they buy in an entertaining environment and which ones just want to buy at the cheapest possible price? Those who figure it out first will become rich.

Studies show that productivity falls sharply if workers telecommute for more than a day or two per week, but companies save most of their money by not having offices for the telecommuters.

If one takes a wide definition of culture (all leisure activities), culture is the world’s biggest industry.

New technologies mean change. Change means disequilibrium. Disequilibrium conditions create high-return, high-growth opportunities. The winners understand the new technologies, are lucky enough to be in the right place at the right time, and have the skills to take advantage of these new situations. They become rich.

The problem with wealth generated from sociological disequilibriums is that it usually reflects more a transfer of existing wealth rather than a generation of new wealth.

RULE THREE: Business that would grow rapidly with high profit margins must take advantage of technological disequilibriums, exploit developmental disequilibriums, or create sociological disequilibriums. All other activities are slow-growth, low-rate-of-return commodity businesses.

For some unknown reason the third industrial revolution simultaneously created great market wealth and a miserable productivity performance.

If countries attempt to protect their companies in home markets, their companies are increasingly shut out of global markets, and for most big companies global markets are now more important than home markets.

The wealth pyramid begins with social organization. Social organization constitutes the great building stones at the bottom of the pyramid. Think of any of the world’s poorest countries – Haiti, Bangladesh, central Africa, Albania. All are characterized by chaos, disorder, and an inability to organize themselves socially. They cannot maintain public order. They cannot build or repair infrastructure. They cannot organize and staff village schools. They cannot deliver health services.

The Americans invented mass universal public education, were its leaders for a century, and used it to create their twentieth century success. But an educational system that once led the world is no longer world-class. America has to reinvent itself if it doesn’t want falling wages for a poorly skilled bottom two-thirds of its workforce.

With the onset of the third industrial revolution, the ability to rapidly open up the new and close down the old became the central characteristic needed for economic success. The American system was built to open up the new and close down the old. That is what it does best.

Having tried to set up one’s own business, even if one fails, is the mark of a good potential employee – works hard, creative, takes risks, knows how the world works.

Capitalism is a process of creative destruction. The new destroys the old. Both the creation and the destruction are essential to driving the economy forward.

Entrepreneurs are risk takers, organizers, and doers, not usually thinkers and inventors. The characteristics needed to create new knowledge are very different from the characteristics necessary to bring that knowledge into active use.

Sustainable long-run competitive advantage can be had only through an advantage in skills, education, and knowledge. Yet this is precisely where Europe has its greatest competitive advantage. If ratings were given for top to bottom skills, Europe would get the best ratings. It is more creative at the top than Japan and better educated at the bottom than America. Relative to any comparatively sized group in the rest of the world it is the best educated. Europe is a continent rich in human capital. Why, then, is it a laggard when it comes to the creation of wealth?

Western Europe has not solved its unemployment problem because it won’t adopt policies to accelerate growth or to lower wages.

RULE SIX: There are no institutional substitutes for individual entrepreneurial change agents. The entrepreneur winners of the game become wealthy and powerful, but without entrepreneurs, economies become poor and weak. The old will not exit; the new cannot enter.

In the United States, where payroll taxes are low, the underground economy is small. In Western Europe, where payroll taxes are high, the underground economy is large.

Knowledge generates the basic breakthroughs in technology that create the disequilibrium conditions in which high returns and high growth rates are possible.

Creating technological disequilibriums is an art form that not all societies have mastered. Even within creative societies, creativity is not spread equally. American Jews win far more than their proportional share of America’s Nobel Prizes. (But Israelis win almost none.) America’s great research universities are not evenly spread across the country. Every area of America does not have its Silicon Valley or Route 128.

Creativity does not occur when it has to challenge authority. Creativity occurs when there is no authority to challenge – when there is an empty space without order where creativity can grow unmolested. But to many, an empty space without order is chaos – and chaos must be suppressed.

Einstein dropped out of high school at fifteen; renounced his citizenship one year later; lived on the margins socially, economically, and morally; called himself a gypsy and was considered a bohemian by others. His life was in some sense a search for order in disorder, both scientifically and sociologically. Great creativity requires hard facts, wild imagination, and nonlogical jumps forward that are then proved to be right by working backward to known principles. Only the rebellious can do it. Curiosity and the desire to explore can be enhanced. Useful curiosity requires individuals who have mastered the existing body of knowledge but are not paralyzed by it. Enhancing curiosity is what really good graduate education is all about. Societies that value and honor curiosity produce curious people.

The reason manufacturing does most of the R&D spending is that historically it has been impossible to make money on innovations unless one made and sold the products that were the fruits of that new knowledge. Selling knowledge so that others could make the products that came from it has never been a profitable strategy.

To be useful, inventions usually need a well-educated workforce that can absorb the technology and acquire the skills necessary to employ it. If this skill base does not exist, the invention lies unused. This is why well-educated inventors in the developing world often move to the United States. Because their fellow citizens are undereducated, they can’t get their invention to market in their home environment.

While there are obviously individual exceptions, technological breakthroughs aren’t usually made by older researchers who have been looking at the same things in the same ways for long periods of time. New ways are usually conceived by those who haven’t accepted the old ways.

Whatever the process for establishing clear, enforceable property rights, capitalism does not work unless who owns what is clear. The private ownership of productive assets and the ability to appropriate the output that flows from those assets lies at the heart of capitalism. This principle is what gave capitalism its name. To make capitalism function, legally enforceable ownership rights have to be established.

Capitalism cannot deal with pollution because it cannot establish the ownership rights to clean air and water.

The source of any retailer’s future success is apt to be buried in the software of its electronic information and logistics systems rather than in its advertising or the novelty of its products.

Without a clear, workable, enforceable system of intellectual property rights, knowledge-based capitalism is not going to work. No one is going to invest the necessary sums in research and development if they cannot garner the resulting gains.

The prevailing wisdom among those who earn their living within our system of intellectual property protection is that some minor tweaking here and there will fix the problem. Much of this wisdom flows from nothing more profound than the belief that to open up the system to fundamental change would be equivalent to opening Pandora’s box. All can vividly see themselves as potential losers. Few consider the private and public gains that might accrue from a different system. The prevailing wisdom is wrong. The time has come not for marginal changes but for wide-open thinking about designing a new system from the ground up. This is never going to happen if the problem is left to those who make their living operating the current system. They have too many vested interests in preserving it with the fewest possible modifications.

The differentiation must start with distinctions between fundamental advances in knowledge and logical extensions of existing knowledge. Each deserves a different kind of patent.

In nineteenth century capitalism, human skills weren’t seen as that important. Labor was a rented, hired-and-fired, marginal factor of production. Socialism arose as a response to the secondary position of labor in capitalism, promising to give labor a central position in the economic system. This is what gave it its political appeal. Interestingly, just as socialism and communism were dying, technology was elevating humans to a more central position in the productive framework of capitalism. Capitalism was being forced to put human skills and knowledge, rather than machinery, at the heart of its system.

In a global economy where employers arbitrage the world looking for the lowest wages, people’s pay is not based on whether they live in a rich or a poor country but upon their individual skills. The well-educated living in India make something that looks like American wages, while the uneducated living in America make something that looks like Indian wages.

Older workers sell experience and skills of an earlier vintage. Young workers sell newly acquired skills. Experience is just less valuable. Over the past quarter of a century the returns to experience have been going down for every level of education.

In the twenty-first century, no country that wishes to be rich can leave some of its citizens uneducated. This applies to women as well as men. Any society that does not educate women (the Taliban in Afghanistan) is not going to be successful … Successful societies will educate women because they contribute needed talent to the workforce, but they will also do so because uneducated mothers seldom have well-educated sons. A knowledge economy requires two interlocking but very different skill sets. Knowledge creation requires highly educated creative skills at the very top of the skill distribution. Knowledge deployment requires widespread high-quality skills and education in the middle and bottom of the skill distribution. The same country need not lead in both.

Looking at how wages rise as years of education go up, big economic payoffs exist for the first few years of education and the last few years of education, but only very small economic returns accrue per year of education in between these extremes.

An extra year of college education has very little positive effect on earnings if the student does not complete a degree program. From an economic perspective the right advice is “Get a degree or don’t go.”

Publicly financed education spreads the costs across the entire population (not just those with kids) and across each individual’s lifetime. Spread out in this way, the costs don’t seem so overwhelming.

Age discrimination laws can protect older employees against being unfairly dismissed by their old firms, but they cannot get them a good job at a new company. Employers get to decide whom they will hire. In a fast-changing world, older employees too often bring obsolete experience and out-of-date skills. There are always a lot of possible young employees who look better and are better. Older job seekers do not suffer from discrimination. They are objectively economically obsolete.

RULE TEN: The biggest unknown for the individual in a knowledge-based economy is how to have a career in a system where there are not careers.

Under capitalism those who own tools are the decision-makers, and market wealth consists of the ownership of tools and the output that flows from them.

Current consumption expenditures on the health care and pensions of the elderly (over 50 percent of the federal budget now goes to the elderly) are driving investment spending out of the federal budget.

Rising stock market values cannot be used to finance investment in new tools. The money received by those who sell stock must be equal to the money given up by those who buy stock. It is a zero-sum transaction as far as investments are concerned. It generates no new funds for building tools. Only holding consumption below earnings can provide the necessary resources to build tools.

In America, all of our social conditioning is now leading not just toward the primacy of individual consumption but toward the view that nothing else matters at all. Billions are spent advertising the benefits of different consumption goods. Little or nothing is spent advertising the importance of investment goods. When he first came into office in 1992, President Clinton was debating whether his new administration should focus on health care, education, or infrastructure. He chose health care, a form of public consumption, rather than education or infrastructure, both forms of public investment. He did not just make a political mistake. He focused Americans on a consumption problem when he should have focused them on investment problems. Even if he had succeeded in reforming health care, it was the wrong problem to address. He could and should have focused us in a very different direction.

In cities that have developed since the onset of the auto age, population densities simply aren’t high enough to justify the frequency of service that makes mass transit competitive with the auto in cost or time.

Market prices measure what is happening to the relative supplies and demands of natural resources. What has happened to oil is happening across the spectrum of other energy supplies, minerals, and agricultural products. Reductions in demand plus new technologies have created a world where natural resource availability is growing far faster than demand.

It is not possible to have American standards of living at home without at the same time having American production standards at work.

Americans want more than they have, but with marketable wealth of just $1.3 million invested in riskless government bonds, one could have those dreams without ever having to work, without ever touching one’s principal, and at death be able to leave one’s children $1.3 million in wealth.

In all countries, wealth is much more unequally distributed than earnings.

Falling equity in one’s own home is also the principle reason why the wealth of the median household is going down in absolute terms. When it comes to the wealth accumulation of the median family, home equity loans (something first allowed in the mid-1980s) have been a disaster.

Great wealth does not depend on personal savings, but modest wealth does. With lower savings rates in America, less wealth for those with lower savings rates should come as no surprise. Americans have a more unequal distribution of wealth because they have chosen to have more current consumption and less wealth. America’s greater inequality is simply a matter of different tastes.

Acquiring great wealth is best seen as a conditional lottery. Luck is necessary. One does have to be in the right place at the right time. Great wealth is created during times of change – the second and third industrial revolutions. Capitalizing on existing disequilibriums (technological, sociological, or developmental) is the name of the game.

Wealth is created in the financial markets but not by the financial markets. Financial markets capitalize the value of eliminating technological, developmental, or sociological disequilibriums.

With electronic shopping, where products are delivered to the home rather than carried home by the buyer, maybe the profits will be made by the delivery companies (UPS, Federal Express) and not by those that run the Internet stores. For what new, never-before-delivered services will people be willing to pay premium prices? What will have to be done to preserve those premium prices?

In the long run market wealth cannot grow unless productivity grows. Productivity is the putting together of the basic building blocks of the wealth pyramid so that humans with finite lifetimes and limited energy levels can produce ever greater levels of output. New technologies are staffed with new skills organized in new ways using new tools powered by new sources of energy to make new things. The difference between output and input growth is what causes wealth to increase.

Slower rates of growth in the capital-to-labor ratio inevitably mean slower rates of growth in productivity.

The antitrust suit against Microsoft is a dramatic case in point. It illustrates a type of regulatory chaos that doesn’t make sense in a well-ordered society. It’s a suit that would not have been brought in any other country in the world. In a short period of time Microsoft has become the most valuable company in the world, with a dominant global market position. It is precisely the kind of company that every country wants. Anywhere else it would be protected like a crown jewel. Other governments would ask what they could do to help it – not what they could do to hobble it … But such erratic, nonsensical actions reflect a type of regulatory chaos that does create economic space for other firms – even if those other firms are apt to be in other countries. American industry has too much chaos, but too much is clearly better than too little when a country reaches America’s position on the wealth pyramid. A high degree of chaos leads to economic creativity.

Revolutions cannot be organized from the top by those running the old system. Revolutions are always frightening to those with vested interests. Those at the top of any successful system, whether political or industrial, have vested interests.

Leaders are not entrepreneurs. Leaders are the order part of the system. Entrepreneurs are the chaos part of the system. Both are necessary, but neither can play the role of the other. Creativity cannot be organized. It is a product of disorganization. In very successful societies, creativity requires some chaos, but not so much chaos that there is not enough order to use what has been invented.

Large bureaucracies, whether government or private, always have too many vested interests in the old to be pioneers of the new technologies that will destroy the old … Capitalism’s only advantage is that death is easier if big firms are privately owned … Socialism never figured out how to kill its dinosaurs; they just went on using up resources until the system collapsed.

Big companies are where managers of the new companies learn the management skills (make mistakes on other people’s money) that allow them to start up their own companies with fewer mistakes.

Centrally organized economic change is theoretically possible but in practice impossible. The economic losers who already exist are always politically stronger than the potential winners who have yet to come into existence.

Capitalism does not work when assets have to carry debts whose value is greater than the market value of the assets themselves. Capitalism only works when profits can be earned.

If countries cannot do what is necessary, economic stagnation looms over their futures. But the causes of that stagnation are not in the economy. They lie in an unsolved political crisis – an inability to act when action is required – that leads to disastrous economic consequences.

Judges don’t think about what makes sense from the perspective of accelerating technological and economic progress. Their concern is with how new areas of technology can be inserted into the legal framework with the least disruption to existing legal interpretations.

As monopoly power wanes, and social interest in encouraging the development of new intellectual property grows, the balance in our system should shift toward encouraging the production of new knowledge and be less concerned about the distribution of existing knowledge. Tighter or longer-term patents and copyrights are warranted.

If someone cannot think of how a legal right can be enforced, it should not be a legal right.

The system must be able to determine rights and resolve disputes quickly, efficiently, and cheaply. Many of the problems with the current patent system flow from the lack of consistent, predictable, rapid, low-cost determinations about intellectual property rights and a means of quick, cheap dispute resolution.

To accomplish society’s interest in expanding knowledge as rapidly as possible, certain classes of knowledge ought to be in the public domain and freely available to everyone. The use of basic scientific knowledge is central in an era of man-made brainpower industries because it allows breakthrough technologies to be developed.

Because of low salaries, elementary and secondary teachers tend to come from the bottom of the education distribution. Americans are asking people who were not themselves good students to teach others to place a high value on being a good student.

Part of the American workforce will have the skills necessary to take advantage of the new technology-intensive global economy. They’ll march on to economic success, joining a global team and leaving the rest of the American workforce behind. The problem isn’t that this model won’t work. The problem is precisely that it will work … The problems are basically moral. Is one living in a good society if that society knowingly lets a major fraction of its citizens drop out of the first world and effectively become third world wage earners?

Governments can increase investment by spending more of their own funds on infrastructure tool-building … The tax system could be shifted from an income/payroll-based system to a consumption-based one in which citizens are taxed only on what they take out of a system (consumption) and not on what they put into it (tools or work effort).

The returns to capital are up and the returns to labor are down. On a global basis labor is more abundant relative to capital than it is in the developed world. As a consequence the earnings of capitalists grow, and the earnings of labor fall. Similarly the returns to skills are up and the returns to raw unskilled labor are down.