Would you lend money right now to the government of Dubai?

To most ordinary investors the question may sound crazy. The Gulf emirate, after all, has just sparked a panic after Dubai World, a separate but government-controlled conglomerate, announced it needed to renegotiate terms on at least some of its $59 billion debt.

At times like this, members of the investing public understand why emerging market bonds—those issued by developing countries—are usually described as high-risk assets.

But the question to ask is not how much risk you’re willing to stomach, but how much you might be paid to take that risk. During the past 15 years we’ve had plenty of emerging-market crises, including the Asian Tigers collapse in 1997, the SARS panic in 2003, and of course last year’s financial crisis. And don’t forget, the Russian government actually defaulted on its bonds in 1998.

Nonetheless, emerging-market bonds overall have proved very good, though volatile, investments. Investors have endured some stomach-churning drops during the crises, but someone who held a broad basket of those bonds in a mutual fund, which reduces your exposure to individual issuers, has done well.

Consider the performance of the Morgan Stanley Emerging Markets Debt Fund , which invests in these types of bonds.

If you had invested $100 in this fund 15 years ago and just left it there, reinvesting your dividends, you’d have nearly $500 today. That’s about twice what you’d have if you had put the same amount in a typical basket of conservative U.S. corporate or Treasury bonds over the same time.

For most of that time, emerging-market bonds were cheap, because most investors were afraid to own them. So the investors who did reaped big rewards. Whether that is still the case is another matter. Emerging markets bonds are no longer anywhere near as cheap as they were.

One good measure of a bond’s value is the yield. As prices fall, the yields rise. At times—such as in 1998, and again in 2008—the annual yield on Barclays Capital’s emerging markets bond index has been well into the double-digits.

In the case of Dubai, there is little reason at the moment to believe the state would default on its own sovereign bonds. To allow such a default would be a monumental act of folly on behalf of the oil-rich United Arab Emirates, of which Dubai is a part. (Remember, Dubai World, the conglomerate that just defaulted on its debt, is owned by the government but is a separate entity.)

Thanks to this weekend’s panic, some Dubai government bonds, which come due in five years now yield about 9%.

They could be a bargain. But Dubai bonds are hard for individual investors to own, because they are traded over the counter and volumes are thin. So these are an investment for sophisticated investors only. Middle Eastern countries account for very little of the global inventory of emerging-market debt. (The bulk of the market is comprised of bonds issued by big countries like Brazil and Russia.)

The more relevant question for the individual investor is whether now’s a good time to buy shares in an emerging-market bond fund.

If the Dubai affair had caused a wider panic, the answer would probably be yes. But it hasn’t, at least not yet. Emerging-market bonds in general have boomed this year, sending the yield on the Barclays index down to about 6.6%. That’s nearly as low as it was two years ago, just before the big crash.

Abby McKenna, who runs the Morgan Stanley fund , sees a few opportunities right now. She’s been buying certain bonds issued by Brazil, Mexico and Indonesia, and says she’s found better values in bonds issued in local currencies rather than in U.S. dollars. Her fund, a closed-end one that trades on the stock market, has a distribution yield of 8.1%.

One reason: Right now the shares sell for about 10% less than the underlying value of the investments. For anyone with money to invest right now, that sort of discount has to help your odds.

But even better opportunities will doubtless come whenever the next big panic strikes and experts start hollering at investors to avoid emerging-market risk.

Maybe I’m naïve, but I’m feeling optimistic about the climate talks starting in Copenhagen on Monday. President Obama now plans to address the conference on its last day, which suggests that the White House expects real progress. It’s also encouraging to see developing countries — including China, the world’s largest emitter of carbon dioxide — agreeing, at least in principle, that they need to be part of the solution.

Of course, if things go well in Copenhagen, the usual suspects will go wild. We’ll hear cries that the whole notion of global warming is a hoax perpetrated by a vast scientific conspiracy, as demonstrated by stolen e-mail messages that show — well, actually all they show is that scientists are human, but never mind. We’ll also, however, hear cries that climate-change policies will destroy jobs and growth.

The truth, however, is that cutting greenhouse gas emissions is affordable as well as essential. Serious studies say that we can achieve sharp reductions in emissions with only a small impact on the economy’s growth. And the depressed economy is no reason to wait — on the contrary, an agreement in Copenhagen would probably help the economy recover.

Why should you believe that cutting emissions is affordable? First, because financial incentives work.

Action on climate, if it happens, will take the form of “cap and trade”: businesses won’t be told what to produce or how, but they will have to buy permits to cover their emissions of carbon dioxide and other greenhouse gases. So they’ll be able to increase their profits if they can burn less carbon — and there’s every reason to believe that they’ll be clever and creative about finding ways to do just that.

As a recent study by McKinsey & Company showed, there are many ways to reduce emissions at relatively low cost: improved insulation; more efficient appliances; more fuel-efficient cars and trucks; greater use of solar, wind and nuclear power; and much, much more. And you can be sure that given the right incentives, people would find many tricks the study missed.

The truth is that conservatives who predict economic doom if we try to fight climate change are betraying their own principles. They claim to believe that capitalism is infinitely adaptable, that the magic of the marketplace can deal with any problem. But for some reason they insist that cap and trade — a system specifically designed to bring the power of market incentives to bear on environmental problems — can’t work.

Well, they’re wrong — again. For we’ve been here before.

The acid rain controversy of the 1980s was in many respects a dress rehearsal for today’s fight over climate change. Then as now, right-wing ideologues denied the science. Then as now, industry groups claimed that any attempt to limit emissions would inflict grievous economic harm.

But in 1990 the United States went ahead anyway with a cap-and-trade system for sulfur dioxide. And guess what. It worked, delivering a sharp reduction in pollution at lower-than-predicted cost.

Curbing greenhouse gases will be a much bigger and more complex task — but we’re likely to be surprised at how easy it is once we get started.

The Congressional Budget Office has estimated that by 2050 the emissions limits in recent proposed legislation would reduce real G.D.P. by between 1 percent and 3.5 percent from what it would otherwise have been. If we split the difference, that says that emissions limits would slow the economy’s annual growth over the next 40 years by around one-twentieth of a percentage point — from 2.37 percent to 2.32 percent.

That’s not much. Yet if the acid rain experience is any guide, the true cost is likely to be even lower.

Still, should we be starting a project like this when the economy is depressed? Yes, we should — in fact, this is an especially good time to act, because the prospect of climate-change legislation could spur more investment spending.

Consider, for example, the case of investment in office buildings. Right now, with vacancy rates soaring and rents plunging, there’s not much reason to start new buildings. But suppose that a corporation that already owns buildings learns that over the next few years there will be growing incentives to make those buildings more energy-efficient. Then it might well decide to start the retrofitting now, when construction workers are easy to find and material prices are low.

The same logic would apply to many parts of the economy, so that climate change legislation would probably mean more investment over all. And more investment spending is exactly what the economy needs.

So let’s hope my optimism about Copenhagen is justified. A deal there would save the planet at a price we can easily afford — and it would actually help us in our current economic predicament.

Measuring The Fiscal Costs Of Not Fixing The Financial System

Posted: 05 Dec 2009 06:30 AM PST

This post is a slightly edited version of remarks prepared for delivery at Unwinding Public Interventions in the Financial Sector: Preconditions and Practical Considerations, IMF High-Level Conference, Thursday, December 3, 2009, Washington D.C.  I participated in Session 2: Managing Fiscal Risks—Public Finance Aspects of Unwinding.

The Problem

1)      The underlying fiscal problems of the U.S. have significantly worsened as a direct result of how the financial crisis of 2008-09 was handled.

2)      The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions.  A large number of these institutions have failed so far this year, without causing major disruption to the economy.

3)      The U.S. does not yet have a similarly effective way to deal with the insolvency of large financial institutions.  The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table.  In fact, our underlying banking system problems are likely to become much worse.

4)      The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.  However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.  The prospect of such disruption, they reason, would induce the government to provide various forms of bailout.  They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.

5)      Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”  The implication is repeated bailout and fiscal stimulus-led recovery programs.

6)      The implementation of the Troubled Asset Relief Program (TARP) exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.”  This lowers their funding costs, enabling them to borrow more and to take more risk.  The consequences include a contingent fiscal liability – both for specific bank rescue measures and, on a larger scale, the fiscal stimulus needed to offset a potential future credit crisis.

7)      U.S. national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”.)  Privately held net government debt will increase from around 40 percent of GDP to the 70-80 percent of GDP.

     If any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF.  Yet this is the approach that the U.S. has implemented.

9)      At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.   Again, this is the problem in the U.S. looking forward.

10)  The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard.  Very few outside observers – other than at the largest banks – find this convincing.

Towards a Solution

1)      As legislation on restructuring the banking industry moves forward, attention on Capitol Hill is increasingly drawn to the issue of bank size. Should our biggest banks be made smaller?

2)      There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits.  This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

3)      This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

4)      Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy.  Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

5)      What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

6)      A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio.  On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

7)      A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades).

     Indeed, the whole world would soon realize that our banks are more competitive and offer better pricing than others.

9)      If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, the U.S. should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.

10)  Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand — by showing that they are installing such a hard size cap rule without exception.

11)  The litmus test is simple.  Does Goldman Sachs continue to grow, and continue to be regarded as almost as good a risk as the United States government (Goldman’s Credit Default Swap spread is currently around only 70 basis points above that of the United States), because it has demonstrated it is too big to fail? Or, will the government impose a cap on the size of such institutions and require Goldman Sachs to find sensible ways to break itself into pieces – becoming small enough so that it will not be bailed out again next time?

In the Absence of Real Reform

1)      Real progress towards reducing the risks inherent in the U.S. financial system is unlikely.  As long as there are financial institutions that are Too Big To Fail, we face a potential fiscal cost.  We should recognize this in our government budget and balance sheet accounting.

2)      The overriding principle behind IMF fiscal assessments is the need to capture true total fiscal costs.  Best practice for the U.S. needs to reflect this approach.

3)      All subsidies and taxation – including the entire cost of supporting the continued existence of large banks – should be reflected transparently in the budget and subjected to the prioritization of the budgetary process.

4)      Our current accounting for guarantees and governments’ assumption of other contingent liabilities create the impression that government actions to support the banking system are costless. This is a dangerous illusion – as seen in the recent increase in US federal government deficit and debt.

5)      If we don’t recognize these costs explicitly, we run the risk of taking on ever more contingent liability.  If the financial system reaches the point where its failure cannot be offset by fiscal (and monetary) stimulus, then a Second Great Depression threatens.

6)      Next time, we cannot be certain that the available size of fiscal stimulus – either in the US or worldwide – will match the negative shock to demand caused by the credit crisis.  Either we will already have too much debt or we will be constrained by the consequences of taking on even more debt.  Or – just as in 1930 – the financial decelerator will simply be too large to be offset by any feasible fiscal measures.

By Simon Johnson

John Mauldin coined the incredibly popular phrase, “Muddle Through Economy.” If the next few years continue to drag along as we rebuild from the greatest credit bubble in history, then John’s term may become the catch phrase used by every financial journalist and economist in the land.

John is a passionate traveler with business partners all over the world. He also puts out a free newsletter to over one million people worldwide. This reach of friends and travels give John an excellent macro view of the world economy. Further, his multidisciplinary interests offer some unique insights into economics and human behavior.

I had a chance to catch up with John and talk about his experiences as an economist, his perspective on which countries will grow the fastest in the coming decades, how he sees demographics affecting the world, and a bonus question from one of our 1400 Twitter followers …

Damien Hoffman: John, was economics part of your schooling or a passion of yours right from the start?

John: I had a triple major in college, one of them being economics and history. So I’ve always been fascinated by history, economics, and finance. The markets are a big puzzle to me and I’m a puzzle addict. So it feeds my addiction. I started reading the Austrian economists first, in the early ’80s as I entered the investment world. That was my real introduction to economics. Over time, if you stay around long enough and read enough, you can pick up all the other schools of thought, like I did.

Damien: Based on some of your newsletters, I can see you are also interested in anthropology via the studies of the generations. These are major themes for investors to trade, because they’re based on slow-moving macro phenomena. Can you share what interests you about this particular framework?

John: That’s a good question and a difficult one. This topic covers a book I’m trying to write. I don’t know if I’m ever going to get it done, but it’s called The Millennium Wave. It’s about what the world is going to look like in twenty years. My basic thesis is, we’re going to see a pace of change that far exceeds anything human beings have experienced since the dawn of man. Furthermore, in terms of technology, that change is going to accelerate. We’re going to have multiple waves of technological change. It would be as if electricity, the steam engine, and the automobile all showed up at the same time. Boom!

We’re going to see massive technological revolutions. However, as human beings, our psychology was developed on African savannas, dodging lions and chasing antelopes. So we have a much slower rhythm to us. We’re not paced for change. Therefore, we’re going to have a backdrop of slow-moving generational changes.

Demographic changes are predictable: we know how many people are going to be here in forty years because they’re already born. We know how many forty-year-olds we’ll have in forty years because they’re already born. So, we can see these changes coming at us.

If you’re Japan, you’re walking into a demographic nightmare. Russia is a demographic train wreck. And it’s not going to be but a few decades, in the grand scheme of things, until Iran will have more people than Russia. That’s got to be fit into your equations. You’ve got to look at these large, broad changes that are happening.

In the US, we’re going to be running into the freight train of Medicare and Social Security. There’s just not any way to get around it. We’re going to have to make tough generational decisions about how to handle that. And how we handle it is going to have enormous implications for our economy. If we handle it the way it’s likely to be handled – which is by raising taxes – then we have said we’re making a decision, conscious or not, that we’re going to become Europe. That means high residual unemployment and difficult, slower growth of individual opportunities.

There are other large changes when you talk about the demographic issues. Europe would have to take massive numbers of immigrants in order to support their system. They’re just not prepared for that. Neither is Japan. The US is blessed with a world population that wants to come here and are not very culturally different from us – especially the Hispanic populations. We’re going to need those immigrants. I think that one of the most economically suicidal things we’re doing today is trying to figure out how to close the borders. We need to be doing the opposite. We need to figure out how to open the borders. It needs to be a more rational policy than we have now. Again, you have to put those things into the financial equations.

We also have the fast-moving things such as the growth of biotech and the complete retooling of our telecommunications network over the next ten years. The way we communicate with each other and the way we receive information is also going to be significantly different in the next ten years. There will still be human beings talking, but how we sort through and assess information is going to be different. There are going to be winners and losers in that competition.

I do a lot of biotech research to determine where it’s going. For instance, you could construct an investment play where you are long life insurance companies and short annuity insurance companies, because we’re going to live much longer than any of the actuaries would tell us. That means life insurance companies aren’t going to have to pay, while annuity companies are going to have to pay longer. That trade is probably not ready to happen yet. But when the perception kicks in, that’s going to be a very good trade.

The new medical devices and therapies that are coming along are going to be transformational. I think about what kind of impact that will have on societies and generations – what John Howe and Richard Strauss call “the Fourth Turning,” which we’re in the middle of. All of these things have an impact on the way I think.

Damien: Keeping on a similar topic but shifting over into a different part of the logic tree, let’s talk about one of your passions: traveling. You kind of touched on which markets have a lot of trouble, but which markets will out-perform in the next decade?

John: If I’m picking regions, I would be an emerging market fan over the developed world, simply because the developed world, especially old Europe, is going to be running into such major underfunding problems in their pensions and healthcare. That’s going to put constraints on them and on their growth. Developing countries don’t have that problem. I’m not as much a China fan as an India fan. I like Brazil. I like Canada, Australia, and New Zealand. I know that Australia wouldn’t be an emerging market, but they sell the resources and the tools to the emerging markets.

Damien: Is there a specific reason why you prefer India over China? If you were going to have a conversation with Jim Rogers, who favors China, what would you say to him?

John: We’ve had a lot of conversations over time, but not that one. I think India is eventually going to get its act together. I think there’s more upside there. I think China is still trying to absorb 24 million new people into their markets annually. They’ve got major demographic issues. I’m talking about the next two decades. China may still be better than India in ten years, but I think India is the favorite over time, because they have natural resources, smart people, and better technology. But who knows. Governments can always alter the course by doing stupid things.

Damien: That’s inevitable.

John: Exactly. Government is the wild card. For example, Japan just elected a very left-of-center government. One that’s far more left of center than Obama. If interest rates were to rise by 1%, it would cut into their budgets by at least 25% or 30%. I think Japan is going to be a basket case ten years from now.

Damien: That’s interesting, because one of your letters sparked a conversation with my friend Andy Glatstein about the life cycle of empires. Thinking about the Roman Empire, the Iberian Peninsula, the British Empire, and the US after WWII, it seems our predecessors in the Western line of empires have a life-cycle. It started with entrepreneurism and ambition, exploring and conquering, then reached some sort of stability point that included a decent standard of living for the masses. However, ultimately the economy sort tripped over itself and all these former empires had major issues. If today you look at Italy, Spain, Portugal, and Britain, they’ve all moved in a similar direction. Is this the fate of the US?

John: We’re in the process of having that debate as we speak. It’s not clear how we’re going to answer that. We’re going to have to raise taxes when we hit the Medicare crisis in the next decade. No question about it. If we use that tax increase now, it will be hard to cut later. If we save the tax increases and hold our spending down, then we’ll be able to handle the Medicare crisis. It’s not clear which of two directions we’re going to take right now. We’re probably going to raise taxes and kick the ball down the road. It will have some very serious consequences in the middle of the next decade. We will probably be forced to implement a VAT tax, which is one more way to slow things down.

Damien: Switching topics, can you explain why Wall Street economists tend to be permabulls or permabears?

John: Mostly because their job descriptions create agendas. There are very few like David Rosenberg who feel they have the independence they need. Also, a lot of them are traditionally trained. So, they’re trained to create tools, and they think economics is a science. It’s not. It’s an art. And quite frankly, when you treat it as an art form you have a better chance of getting the numbers right.

Damien: Can you explain what you mean by that?

John: All of the economic models are created on past performance. For instance, right now the economic idea du jour is what the recovery will look like. So, economists go back and average the eight post-war recessions and say, “Look, this is what the average was and this is how it responded.” Well, making a prediction based on that only works as well as the underlying fundamentals of the recession.

This is a deleveraging, deflationary, asset-bubble-bursting recession. We’re going to lose 8-10 million jobs. We’re back to where we were in early 2000 in terms of jobs. Over the next five years, just to keep up with population growth, we must create another nine million jobs. Plus, we’ve got another almost five million people who are underemployed. And the Census Bureau took 450,000 people off this year because they said, “They’re no longer looking for jobs, and since they’re not looking for jobs they’re not unemployed.” That is a fascinating way of looking at it! Last month you were looking for a job and now you’re so discouraged you’re not looking for a job, so we’re not going to count you as unemployed. That’s a patently silly idea!

Damien: That’s absurd.

John: Right, it is absurd. Over the next five years we’re going to have to create something like 17-20 million jobs to get back to 4-5% unemployment. That’s a staggering number of jobs. That’s something like a 15% growth in the number of jobs over five years. You’d need real GDP growth of 15% to make that happen. What is the likelihood of total real GDP growth of 15% for the next five years?

Damien: Less than 0%. [Laughing]

John: I think we’re going to be lucky to have GDP growth of 8-10%. So there’s going to be a real shortfall with jobs. Unemployment is going to stay stubbornly high for the next five years unless something comes out of the clear blue – which is always possible. Somebody could invent a new energy source or we could start retooling our telecom systems – something like that.

Damien: Are those the technological catalysts that will bring us the next economic expansion?

John: Yes. Remember, in the late 1970s we were in an economic malaise. The Japanese were kicking our butts, inflation was high, and the market was in the doldrums. It was not a fun time. Yet the correct answer to the question “Where are the new jobs going to come from” was: I don’t know, but they will. Because that’s what happens in free-market societies. That’s why I’m an optimist. Even looking at all the data and all the problems, I’m saying that 130 million families will figure out what to do to make their lives better. Some of them will sit around and wait for the government to do it, but a lot of people will do it themselves. It’s like the two vultures sitting on the cactus, and one of them looks at the other and says, “Patience? Hell, let’s go kill something.”

Damien: As my regular readers know, that relates to one of my favorite quotes: “Desperation is the mother of ingenuity.”

John: Precisely. Most people will go out and try to figure out something to do. That’s just what we do as a country. It’s part of our particular genius. We’re going to be helped along by some major technological and scientific breakthroughs. I’m an optimist in that regard.

Damien: John, sometimes there are so many variables to think about and so much information it can lead to paralysis by analysis or even worse. Where do you draw the line while informing your investment decisions, when markets diverge from economic reality?

John: You’ve gotta look at why markets are diverging from economic reality. You have to ask yourself, “Do I need to reassess?” You must constantly question yourself and sift through the data.

Right now we’re at a place I call the Statistical Recovery. We’re going to see a recovery in the math, but it’s not going to feel like one in the real world. It’s probably going to be the middle of next year before we see job growth and reduced unemployment. If we’re not seeing job growth, if we’re not seeing income growth, if we’re not seeing a drop-off in foreclosures, if we’re not seeing a rise in consumer credit and consumer confidence, if we’re not seeing a lot of things of that nature, it won’t feel like a recovery.

Economists can say, “Look at these numbers! The numbers are good!” But in the real world you may say, “I’m still not getting the hours I want. I haven’t seen a revival of people coming into my store. Sales are still down 10%.” If that’s the case, then it doesn’t feel like a recovery.

That’s where I think we’re going to be. But that’s part of the process of going to the New Normal. We’re having to rationalize our entire economy, our world economy, which was built around ever-increasing amounts of leverage. And that leverage bubble has burst. The genie is not going back into the bottle. The psyche of the American consumer has been permanently scarred. And we’re going to get to a new level of economic activity that’s going to assume 7%, 8%, or 9% savings. We will see less credit. We’re watching unprecedented amounts of credit-card debt being paid off. That’s never happened in America. That’s positively un-American. Yet, we are. Because what happens? People are saying, “Maybe this leverage and debt thing is not so good. Let’s get more conservative.” It’s the new frugal.

All we did with this “Cash for Clunkers” thing was move cars forward that would have been bought later. You’re not increasing sales down the road. Yeah, you’re taking cars off the road and spare parts and stuff, but I think it’s kind of a silly investment in dollars. But, what’s $3 billion when we’re wasting a trillion here and a trillion there? Still, it’s disappointing.

Damien: Speaking of disappointment, I’m in my early thirties, and when I think about these trillions of dollars being thrown around I say, “I’ve been out of college a decade. We’ve had two bubbles and two collapses. It’s been a completely volatile employment and investment market. A completely volatile social environment. And, to top it all off, we’re kicked in the butt with all of this debt.” My peers look ahead and see our parents getting older and the cost to society. What do you say to our generation? Will we be the forgotten generation which toils our way through it and pays for the problems created before us, to repave the road for those behind us?

John: I tell you, I’m sorry. That’s what you’re going to have to do. You’re going to have to move the ball forward with an extra twenty pounds on your back. That’s just the way life is. I don’t think it’s only your generation in your thirties. I think it’s my kids in their twenties who are going to be dealing with it as well.

We’ve made some generationally bad choices, with unintended consequences. And now we’re going to have to deal with them. It just makes moving forward in the economic environment tougher. You play the hand that’s dealt to you.

You can’t wish, “I would have been better with 35% taxes.” I know that my tax bracket is going to go into the mid-40s at a minimum. Would I be happier and have more money to invest if I had a tax bracket in the mid-30s? Yeah. But that’s just not the hand that was dealt. So, I have to figure out how to move forward with my taxes. When they add the VAT tax in the middle of the next decade, my effective taxes will run into the 55%-60% range. That’s just the way it is. I can either crawl into some hole or go to another country, or just move on and make the best of the hand I’ve been dealt. I choose the latter.

Damien: John, we chose a question from one of our 1400 Twitter followers: Can you be very successful and still live a fulfilling family life without being obsessed with work?

John: I’m partly obsessed with work. But you have to take time for family. You can’t ignore it. It’s easier for me now; I’ve only got one left at home.

The most fulfilling part of my life is my seven kids. We adopted five, so it’s a colorful family. We all get along. It’s the one great pleasure of my life — the best pleasure of my life: my kids, and now grandkids.

Damien: What advice do you have for your grandkids if one day they read this and aspire to follow in your footsteps?

John: That’s a tough question, because I took the Yogi Berra path of career guidance: you come to the fork in the road and you take it. I am as surprised to be where I am today as anybody. I have partners around the world that take the leads we get and do sales and research on funds. Besides writing and trying to figure out the world of economics, my real job is to make sure I have the best partners, who are in the right spot to help readers find the appropriate investment ideas for them. That is not as easy as it sounds, because the majority of potential partners are either traditional money managers (which I am not) or have constraints because of their situation.

People ask me what I’d do if I retired. I’d read, write, travel, speak, and enjoy myself – that’s what I’m doing now! So, I don’t know if retirement is in my path. But for a young person starting now, looking at what I do, I’d say the first thing you have to do is start writing. It’s a craft. I didn’t start out writing top-quality work. When I look back on letters I wrote early on, I think, “My goodness that’s sloppy.” I’ve improved over time, over the decades.

One of the people who helped me learn how to write was my first publisher. I tried to copy his writing style. He had a particularly friendly, easy-to-understand writing style. I’ve long since developed my own style, but I am still grounded in that foundation. I tell people, “If you want to be a writer, find a writer you like and try to imitate him.” I have a certain style, a certain voice when I write. It’s not better than anybody else’s. Sometimes I go back and think, “I don’t particularly like that.” But it’s my voice and I’m comfortable with it.

Second, don’t be too hung up on knowing everything or thinking that you’ve got to have it all figured out. You won’t. You’ll never figure it all out. Economics is an art form. The goal is to kind of be in the middle of the lane and not end up in the ditch somewhere. Don’t think you’re going to be there by the time you’re 30 or 35. It takes time to reason, read, and mature.

Third, early in your career you should be reading more books and analyzing less data. Information is less important than theory and a grasp of the basics. You need to understand what the difference is between John Maynard Keynes and Irving Fisher and von Mises. If you don’t understand what they’re writing, if you can’t get your head around their concepts, data isn’t going to help you.

So, you’ve got to have a handle on how the big stuff works and what the theories are. But none of the theories have independently proven to be particularly adept at describing the problems we have. So, you’ve got to figure out how to blend them and weave them.

If you cling to one perspective, you are going to run into a wall. And you’re going to run into a wall at one of the most embarrassing times. It can be a career-ending event. I’ve been wrong. It’s easy to go back through my letters and say, “John, what were you thinking?” But on average, I’ve been more right than wrong. I often joke that I am often wrong, but seldom in doubt. But I never get married to a position. I constantly test my views. Constantly. It’s important to get the big things right and understand the big picture while not focusing too much on the little details.

Damien: John, thanks for that advice and thanks for indulging my curiosities this afternoon.

John: My pleasure. You asked some very interesting questions.

New York, London, Monaco, and Zurich

Today was a great (and going to be a long) day. I started off with a couple of interviews on Yahoo Tech Ticker with Henry Blodgett, had a few meetings, and then went to Henry Blodget’s office at Business Insider, where we did three more quick (and different) interviews. He is doing something quite intriguing. I walked in, and there were a dozen 20- and 30-something kids working intently at screens, crammed into a room not as big as my bedroom. In less than two years, he is getting two million unique visitors to come to his web site each month.

It made me feel like such an old lion. Tiffani and I have been giving a lot of thought as to how we should manage the business over the next two years. How do we adapt to a world that is changing so fast?

Zip to two million in two years? Interestingly, as we talked business at a long lunch, I wondered if I should write more, as there are so many blogs that hit us each day, and the number seems to be growing. He disagreed. He emphasized that I should not change my model. “You are the one guy I read each week who is above the fray. You see through the day-to-day noise. You come and tell me what was important and make me think. For you, less is more. Don’t change.” Maybe the old lion still has some teeth.

And speaking of old lions, I later visited with Art Cashin and the Friday evening gathering of the Friends of Fermentation, at Bobby Vann’s across from the exchange, at the close of the trading day. What a pleasure. Art is one of the world’s great market savants, full of wisdom and the greatest stories, and a true friend. There is never enough time to spend with him.

And when I hit the send button, I will go to Festivus with Todd Harrison and the crowd from Minyanville. That is always a great party and a worthy cause. Tomorrow night we see Gods of Carnage with Barry and Toni Habib, and then back on Sunday. And then home until the middle of January, when I go to London, Monaco, and Zurich.

But the most important news is that yesterday the doctor told Tiffani she may be getting ready to have my new granddaughter a little early. It is going to be a great Christmas.

Have a great week, and remember to make sure you have some fun on the way. And spend more times with friends. That is the best dividends you will ever get.

Your having fun in New York analyst,

John Mauldin

John@FrontLineThoughts.com

By Jon Hilsenrath

To mark this week’s focus on the dismal state of the U.S. job market, check out the following chart, which shows the trajectory of private sector U.S. employment since 1998. It tells a story of a lost decade for U.S. workers.

The U.S. now produces fewer private sector jobs than it did a decade ago. This been the case since August, and it’s getting worse. In October, private sector companies employed 108.401 million U.S. workers, a million fewer than in October 1999, when they employed 109.487 million. Not since the Labor Department began tracking payroll employment in 1939 has there been such a stretch with no net job gains.

The problem resonates with President Barack Obama, who is holding a jobs summit on Thursday with executives, economists and union leaders, and with the Labor Department getting ready to tee up its November jobs report on Friday.

With the economy recovering from last year’s shock, private sector firms might start hiring again. But it likely will take months if not years to make up this gap.

How to explain the gap? One obvious answer is that the U.S. has suffered through two recessions during this stretch. The first, in 2001, was short and mild but included more than two years of job cuts. The second one starting in 2007 has been long and brutal. The other answer is that the U.S. has enjoyed a big burst of productivity growth during this stretch — which means firms are producing more with fewer workers. In the long-run this is supposed to be a good development because it leads to profit and income gains. But the short-term costs are looking increasingly more debilitating.

It’s worth nothing that overall employment is higher than it was a decade ago, but that’s only because the government has produced two million additional jobs during that stretch. You can expect both sides of Washington’s political spectrum to spin the lost decade for jobs in their own direction. Republicans will use it to blast Mr. Obama’s big government approach — though it’s worth remembering that most of these jobs were lost when a Republican controlled the White House. Democrats will use the data to demonstrate the benefits of a helping government hand in down economic times. The labor market would indeed be worse if it weren’t for those two million extra government jobs. But this hardly seems like the path to prosperity.

Health care reform hangs in the balance. Its fate rests with a handful of “centrist” senators — senators who claim to be mainly worried about whether the proposed legislation is fiscally responsible.

But if they’re really concerned with fiscal responsibility, they shouldn’t be worried about what would happen if health reform passes. They should, instead, be worried about what would happen if it doesn’t pass. For America can’t get control of its budget without controlling health care costs — and this is our last, best chance to deal with these costs in a rational way.

Some background: Long-term fiscal projections for the United States paint a grim picture. Unless there are major policy changes, expenditure will consistently grow faster than revenue, eventually leading to a debt crisis.

What’s behind these projections? An aging population, which will raise the cost of Social Security, is part of the story. But the main driver of future deficits is the ever-rising cost of Medicare and Medicaid. If health care costs rise in the future as they have in the past, fiscal catastrophe awaits.

You might think, given this picture, that extending coverage to those who would otherwise be uninsured would exacerbate the problem. But you’d be wrong, for two reasons.

First, the uninsured in America are, on average, relatively young and healthy; covering them wouldn’t raise overall health care costs very much.

Second, the proposed health care reform links the expansion of coverage to serious cost-control measures for Medicare. Think of it as a grand bargain: coverage for (almost) everyone, tied to an effort to ensure that health care dollars are well spent.

Are we talking about real savings, or just window dressing? Well, the health care economists I respect are seriously impressed by the cost-control measures in the Senate bill, which include efforts to improve incentives for cost-effective care, the use of medical research to guide doctors toward treatments that actually work, and more. This is “the best effort anyone has made,” says Jonathan Gruber of the Massachusetts Institute of Technology. A letter signed by 23 prominent health care experts — including Mark McClellan, who headed Medicare under the Bush administration — declares that the bill’s cost-control measures “will reduce long-term deficits.”

The fact that we’re seeing the first really serious attempt to control health care costs as part of a bill that tries to cover the uninsured seems to confirm what would-be reformers have been saying for years: The path to cost control runs through universality. We can only tackle out-of-control costs as part of a deal that also provides Americans with the security of guaranteed health care.

That observation in itself should make anyone concerned with fiscal responsibility support this reform. Over the next decade, the Congressional Budget Office has concluded, the proposed legislation would reduce, not increase, the budget deficit. And by giving us a chance, finally, to rein in the ever-growing spending of Medicare, it would greatly improve our long-run fiscal prospects.

But there’s another reason failure to pass reform would be devastating — namely, the nature of the opposition.

The Republican campaign against health care reform has rested in part on the traditional arguments, arguments that go back to the days when Ronald Reagan was trying to scare Americans into opposing Medicare — denunciations of “socialized medicine,” claims that universal health coverage is the road to tyranny, etc.

But in the closing rounds of the health care fight, the G.O.P. has focused more and more on an effort to demonize cost-control efforts. The Senate bill would impose “draconian cuts” on Medicare, says Senator John McCain, who proposed much deeper cuts just last year as part of his presidential campaign. “If you’re a senior and you’re on Medicare, you better be afraid of this bill,” says Senator Tom Coburn.

If these tactics work, and health reform fails, think of the message this would convey: It would signal that any effort to deal with the biggest budget problem we face will be successfully played by political opponents as an attack on older Americans. It would be a long time before anyone was willing to take on the challenge again; remember that after the failure of the Clinton effort, it was 16 years before the next try at health reform.

That’s why anyone who is truly concerned about fiscal policy should be anxious to see health reform succeed. If it fails, the demagogues will have won, and we probably won’t deal with our biggest fiscal problem until we’re forced into action by a nasty debt crisis.

So to the centrists still sitting on the fence over health reform: If you care about fiscal responsibility, you better be afraid of what will happen if reform fails.

Some Questions For Mr. Bernanke

Posted: 03 Dec 2009 04:55 AM PST

On Thursday, Ben Bernanke will appear before the Senate Banking Committee, to begin his reconfirmation process as chairman of the Federal Reserve Board.

Based on committee members’ public statements, Bernanke already appears to have enough votes on his side.  But Thursday’s hearing and the subsequent floor debate are an important opportunity for senators to raise important issues about how the Fed will operate moving forward.

This is more than a ritual.  Questioning (the monetary) authority and politely insisting on a coherent answer is an important part of our political governance structure – and something that was sorely lacking during the Greenspan era.

There are three possible lines of enquiry that could draw Mr. Bernanke out.  These questions could be separate or part of a sequence:

1. Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the UK and the US) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macroeconomy over time.  What can be done to break this loop?

2. Senator Aldrich and the National Monetary Commission explicitly sought to establish a bailout mechanism that would replace the role played by JP Morgan in saving the financial system during the panic of 1907, and Aldrich saw the creation of the Federal Reserve in 1913 as the lynchpin of that system.  But this approach has a fatal flaw.  As we saw in the 1920s, a lightly regulated financial sector can produce a boom, based on a high degree of debt, that causes major disruption when it crashes and leads to a Great Depression — even if the major banks are (initially) saved.  How should we modify the Aldrich system to remove such risks?

3. Mervyn King, governor of the Bank of England, argued in his recent Edinburgh speech that re-regulating the financial system will not effectively reduce its risks.  And history suggests that Big Finance always gets ahead of even the most able regulators.  Governor King insists instead that the largest banks should be broken up, so they are no longer “too big to fail.”  Paul Volcker and Alan Greenspan, in recent statements, have supported the same broad approach.  Can you explain why you differ from Mervyn King, Paul Volcker, and Alan Greenspan on this policy prescription?

In the history books, the Bernanke era at the Fed will be divided into three parts.  Through September 2008, Bernanke operated in the shadow of the Greenspan legacy: laissez-faire with regard to bank regulation, taken to the point of absurdity.

In the second phase, once the global financial crisis broke in earnest, Bernanke moved with alacrity to rescue the financial system.  History will likely judge him as too generous to the bankers at the center of the mess, but the real point person on bank-by-bank bailouts was NY Fed President/Treasury Secretary Tim Geithner.  Bernanke will be reappointed because our Worst Crash did not turn (yet) into a Great Depression.

The third phase is for Mr. Bernanke to decide.  Will he become a great reformer, like Marriner S. Eccles in the 1930s, leading the charge to rein in the damage that investment banking, writ large, could cause? Or will his legacy be closer to that of George L. Harrison, head of the New York Fed as the stock market crashed in 1929.  Harrison led vigorous efforts – sometimes stretching his legal authority to its limits – to save big banks and by the fall of 1930 was congratulating himself that no major financial institutions had failed.  At that point, Harrison thought his work was substantially done; sadly, he was very wrong.

By Simon Johnson

ANNANDALE, Va. (MarketWatch) — The many advisers who are worried about the market’s low trading volume remind me of cowboys patrolling their camps at night: They worry that, when it gets too quiet, trouble must be brewing.

And it indeed has been growing increasingly quiet of late: NYSE average daily volume during November, for example, was lower than it was in October. And October’s average daily volume was, in turn, lower than it was in September.

In fact, NYSE average daily volume in November was 20% below its average for the entire rally from the March 9 low through the end of October.

Period NYSE daily average volume

November 1.11 billion

November through 11/20 1.16 billion

October 1.31 billion

September 1.36 billion

Mar. 9 through Oct. 31 1.39 billion

Note carefully, furthermore, that November’s low volume wasn’t caused by traders taking the Thanksgiving week off. Average daily volume was low even for the period through Nov. 20, the Friday before Thanksgiving.

Is this trend of lower and lower volume a source of concern? Is it becoming dangerously quiet out there?

“Yes” is the answer from many of the advisers I monitor, on the oft-quoted technical theory that “price follows volume.”

Not everyone agrees, however. In a communication sent to clients earlier this week, Ned Davis, president of Ned Davis Research, argued that, while the trend towards lower volume is something that deserves close attention, it is not yet a reason to give up on the rally.

For example, Davis pointed out, it is entirely normal for volume to back off during the earliest stages of a new bull market, since during the panic selling that typically takes place at a bear market bottom, there usually is extraordinarily high volume.

This was certainly the case for the stock market at the March 9 lows, by the way. Average daily trading volume over the week leading up to the low, for example, was 1.77 billion — 30% more than the average daily volume since then.

To be sure, lower volume becomes increasingly a source of concern as the length of time since the bottom grows. Even so, Davis argues, it doesn’t have to be bearish — provided that most of the volume that does remain is concentrated in stocks that are rising. And that has been the case throughout this rally.

Are there are flies in the ointment? Of course; there always are.

One, according to Davis: Demand for stocks, as evidenced by advancing volume, peaked two months ago — suggesting a “tiring uptrend.”

The bottom line? The technical picture would improve if the trend of trading volume were to reverse and start rising again — and especially so if it is concentrated in advancing stocks.

But recent volumes trends, in and of themselves, do not appear to have immediately doomed the rally.

Stocks are in a final sprint toward the end of 2009.

After nine months of favorable market conditions, equity investors face a further month before they can declare victory in 2009. The flip of the calendar may be arbitrary, but the full year is the standard by which mutual funds, hedge funds, and other stock investors are judged on their performance.

Investors could be forgiven for wishing that 2009 would end placidly and profitably. But there’s one thing that the past couple of years have taught us about the market: Expect the unexpected. Dubai’s debt troubles, which came to a head on Nov. 25, when the emirate’s investing arm said it was seeking to delay payments on $59 billion in debt, disrupted a growing confidence among investors. Until the news broke over the Thanksgiving holiday, it looked as if markets might glide easily toward the new year.

It has been a quiet couple of months on Wall Street. “We are seeing some signs of normalcy,” says Erik Davidson, managing director of investments for Wells Fargo Private Bank.

Since the end of September, the broad Standard & Poor’s index of 500 stocks  is up 3.3%. Volatility is down. Although the market has risen and fallen day by day, the ride has not been bumpy. From its October starting point, the S&P 500 has never varied by more than 5% to the upside or 3% to the downside.

The S&P 500 has jumped 60% since its low in March. The turbulence in Dubai spread quickly because it raised questions about two important pillars of that rally — improving strength in the financial sector and credit markets and the resilience of the global economy, particularly in emerging markets.

Dubai’s woes: Just a local issue?

The true depths of Dubai’s financial difficulties remain unclear. Investors appeared concerned but not overly alarmed. At one point on Nov. 27, the S&P 500 had dipped 2.4%, but the stocks battled back and the index closed down 1.7%.

Market participants’ worries may have been eased by assertions that Dubai’s problems were a local issue. “The current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism, and services,” Brown Brothers Harriman currency strategist Win Thin wrote on Nov. 27. They “are particularly unique to Dubai and should not have wider implications for [risk to other emerging market sovereign debt].”

But many questions remain unanswered. UBS  analyst Saud Masud suggested one explanation of Dubai’s surprise move to postpone debt: Its debt may be higher than the $80 to $90 billion that many assume. But, Masud says, the restructuring of “Dubai Inc.” could have positive benefits. “While this process will be painful and will take time, it should put Dubai on a sounder footing medium term,” Masud wrote on Nov. 26.

Experienced investors know that news such as that from Dubai can easily jeopardize the market’s recovery. There is always the danger of an “exogenous shock” — whether it’s a geopolitical event or a market surprise — that could send investors fleeing risk toward safer investments. “There is always the danger of a correction,” says Quincy Krosby, Prudential Financial market strategist. “That can happen any time at any place.”

The dreaded “double-dip” recession

At the moment, the most disruptive scenario could be a rapid strengthening of the U.S. dollar, Krosby says. That could unwind the so-called “carry trade,” in which investors have been taking advantage of low U.S. interest rates to borrow and then buy risky assets both in the U.S. and abroad.

Despite the threats, investors still have reason to hope that the year will end quietly. Economic data have steadily improved, a trend that should continue for a while. “All the economic data [point] to continued growth,” says Peter Cardillo, chief market economist at Avalon Partners. He is increasingly confident that the U.S. can avoid a “double-dip” recession.

One test could be how willing U.S. consumers are to spend this holiday season, which officially began on Nov. 27’s so-called “Black Friday.” Stifel Nicholas  analysts visited retailers on Nov. 27 and offered initially positive reviews. “We believe sales are meeting or exceeding [the] plan for Black Friday,” they said.

For holiday spending, “expectations are set so low,” says Davidson of Wells Fargo. “If anything, the surprise of the holiday season could be to the upside.”

So far in 2009, the Dow Jones industrial average  has advanced 17.5%, while the S&P 500 has risen 21% and the tech-heavy Nasdaq composite  is up 35.6%. As Davidson notes, the S&P 500 is now almost perfectly halfway between its October 2007 peak of 1,565 and its March 2009 low of 676.53.

As investors waver between optimism and pessimism, the question they must answer in the months to come is whether that means the market is half-full or half-empty.

OP-ED COLUMNIST

This I Believe

By THOMAS L. FRIEDMAN

Published: December 1, 2009

Let me start with the bottom line and then tell you how I got there: I can’t agree with President Obama’s decision to escalate in Afghanistan. I’d prefer a minimalist approach, working with tribal leaders the way we did to overthrow the Taliban regime in the first place. Given our need for nation-building at home right now, I am ready to live with a little less security and a little-less-perfect Afghanistan.

I recognize that there are legitimate arguments on the other side. At a lunch on Tuesday for opinion writers, the president lucidly argued that opting for a surge now to help Afghans rebuild their army and state into something decent — to win the allegiance of the Afghan people — offered the only hope of creating an “inflection point,” a game changer, to bring long-term stability to that region. May it be so. What makes me wary about this plan is how many moving parts there are — Afghans, Pakistanis and NATO allies all have to behave forever differently for this to work.

But here is the broader context in which I assess all this: My own foreign policy thinking since 9/11 has been based on four pillars:

1. The Warren Buffett principle: Everything I’ve ever gotten in life is largely due to the fact that I was born in this country, America, at this time with these opportunities for its citizens. It is the primary obligation of our generation to turn over a similar America to our kids.

2. Many big bad things happen in the world without America, but not a lot of big good things. If we become weak and enfeebled by economic decline and debt, as we slowly are, America may not be able to play its historic stabilizing role in the world. If you didn’t like a world of too-strong-America, you will really not like a world of too-weak-America — where China, Russia and Iran set more of the rules.

3. The context within which people live their lives shapes everything — from their political outlook to their religious one. The reason there are so many frustrated and angry people in the Arab-Muslim world, lashing out first at their own governments and secondarily at us — and volunteering for “martyrdom” — is because of the context within which they live their lives. That was best summarized by the U.N.’s Arab Human Development reports as a context dominated by three deficits: a deficit of freedom, a deficit of education and a deficit of women’s empowerment. The reason India, with the world’s second-largest population of Muslims, has a thriving Muslim minority (albeit with grievances but with no prisoners in Guantánamo Bay) is because of the context of pluralism and democracy it has built at home.

4. One of the main reasons the Arab-Muslim world has been so resistant to internally driven political reform is because vast oil reserves allow its regimes to become permanently ensconced in power, by just capturing the oil tap, and then using the money to fund vast security and intelligence networks that quash any popular movement. Look at Iran.

Hence, post-9/11 I advocated that our politicians find sufficient courage to hike gasoline taxes and seriously commit ourselves to developing alternatives to oil. Economists agree that this would ultimately bring down the global price, and slowly deprive these regimes of the sole funding source that allows them to maintain their authoritarian societies. People do not change when we tell them they should; they change when their context tells them they must.

To me, the most important reason for the Iraq war was never W.M.D. It was to see if we could partner with Iraqis to help them build something that does not exist in the modern Arab world: a state, a context, where the constituent communities — Shiites, Sunnis and Kurds — write their own social contract for how to live together without an iron fist from above. Iraq has proved staggeringly expensive and hugely painful. The mistakes we made should humble anyone about nation-building in Afghanistan. It does me.

Still, the Iraq war may give birth to something important — if Iraqis can find that self-sustaining formula to live together. Alas, that is still in doubt. If they can, the model would have a huge impact on the Arab world. Baghdad is a great Arab capital. If Iraqis fail, it’s religious strife, economic decline and authoritarianism as far as the eye can see — the witch’s brew that spawns terrorists.

Iraq was about “the war on terrorism.” The Afghanistan invasion, for me, was about the “war on terrorists.” To me, it was about getting bin Laden and depriving Al Qaeda of a sanctuary — period. I never thought we could make Afghanistan into Norway — and even if we did, it would not resonate beyond its borders the way Iraq might.

To now make Afghanistan part of the “war on terrorism” — i.e., another nation-building project — is not crazy. It is just too expensive, when balanced against our needs for nation-building in America, so that we will have the strength to play our broader global role. Hence, my desire to keep our presence in Afghanistan limited. That is what I believe. That is why I believe it.