The Bush administration had cut taxes, then indulged itself in new entitlement programs and an expensive Middle Eastern foreign policy, with military operations in Iraq and Afghanistan. On top of the $413 billion deficit that this caused in the fiscal 2008 budget year, there were then the various bailouts, which were only free if you don't count the ones like American International Group Inc. (NYSE: AIG), Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), that actually cost serious money.

That meant the U.S. capital market was already stressed at the beginning of 2009. Yes, foreign money had flooded into U.S. Treasury bonds as a "safe haven," but it was obvious that that "hot money" would flood out again as soon as it found something better to invest in - which it did, in the 2009-10 gold-and-commodities bubble.

So the deficits that stimulus produced prolonged the period of stress far beyond the trough in the economy. That trough occurred about May 2009, before any stimulus expenditures had time to kick in. Instead of lessening the recession, the deficits that the stimulus caused were to hinder the recovery, through a process known as "crowding out."

There is after all only so much investment capital to go around. Currently, the U.S. Treasury Department is taking far more of it than it should, and mortgage bonds are being propped up artificially with another $1 trillion of government guaranteed paper being issued in 2009. Meanwhile, U.S. Federal Reserve Chairman Ben S. Bernanke's monetary stimulus - while ensuring plenty of liquidity - is keeping short-term interest rates artificially low.

If the banks can borrow at less than 1% in the short-term inter-bank market, and get nearly 4% on Treasuries, or 5% on government-guaranteed mortgage bonds, why should they ever bother doing anything else? Leverage that 3%-4% risk-free return 15 times, and you're talking about a 40%-50% return on capital, enough to pay everybody's bonuses and keep the shareholders happy.

Of course, it's not really risk-free; when Treasury bond yields rise, the banks will have a capital loss, but hey - Bernanke says rates will be ultra-low for an "extended period," so banks should be able to extract at least one more year's bonus out of it, probably.

Small-business lending is difficult. You have to analyze the company's balance sheet and income statement properly, then make a judgment on whether or not the small businessman is both competent and honest. There are many easier ways to make money, particularly in a recession, when small businesses tend to go bust. And in this recession, Messrs Obama and Bernanke have given bankers a much easier way to "earn" their bonuses.

You can see the result of this in two places. First, in the Senior Loan Officer Survey published by the Fed last week, it was reported that small business defaults had continued rising, while demand for loans was low.

Before you jump to the conclusion that low loan demand means there isn't a problem, consider that banks have tightened lending standards to an unprecedented degree over the past year, and have not begun to loosen them. If you're an intelligent small business owner, you therefore don't bother applying for a loan, because you know you won't get it. The senior loan officers sit in their plush offices, playing with their paper clips and reporting to the Fed that there is no demand for loans, while small businesses are left out in the cold (and snow), deprived of the funding they need, and collapsing in droves.

You can also see the result of this - demonstrated quantitatively - in the Fed's weekly report H8 "Assets and Liabilities of Commercial Banks." Overall, bank credit (including bonds) declined by about 5% between December 2008 and Jan. 27, 2010, as banks downsized their balance sheets. However, bank holdings of Treasury and agency securities (mostly housing-related) rose by 18% over the same period - very easy money, as I said. Overall loan volume dropped by 9%, but real estate loans (including lots of government-guaranteed home mortgages) dropped by only 2%. Consumer loans dropped by 8%, but the big drop was in commercial and industrial loans, which fell fully 20% during the period. These loans, which are the main purpose of banking, were a mere 17.3% of bank credit in December 2008, but fell to 14.6% of bank credit in late January.

The banks aren't evil; they're just following the normal, free-market imperative to make a juicy living with the least effort possible. But government borrowing and prolonged ultra-low interest rates are making it too easy for them to starve the small business sector, the main creator of jobs and the main source of innovation in the economy.

This recovery is thus not going to be a healthy one. And Americans will pay the costs of the misguided "stimulus" for a decade or more, in fewer jobs and a less dynamic economy.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock-market rebound that started in mid-March, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please just click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Fed Gambles on Low Inflation and a Stable Housing Market
  
• Federal Reserve:
  Assets and Liabilities of Commercial Banks in the U.S. (H8)
  
• Wikipedia:
  The Crowding Out Effect
  
• Federal Reserve:
  Ben S. Bernanke
  
• Wikipedia:
  Risk-Free Return
  
• Federal Reserve:
  Senior Loan Officer Survey
  
• Wikipedia:
  Agency Debt
  
• Wikipedia:
  John Maynard Keynes
  
• Money Morning:
  As Greece's Woes Demonstrate, the Fuse Has Been Lit on the Global Debt Bomb

For one thing, the Indian government - which tends to run budget deficits even in the best of economic times - engaged in substantial fiscal "stimulus" in 2009, an election year. And while the central-government-budget deficit appears tolerable at 8% of gross domestic product (GDP), provincial governments also run budget deficits - in amounts equal to an additional 4%-5% of GDP.

With a consolidated budget deficit of 12%-13% of GDP, India's fiscal position is up there with such international bad actors as Greece, Britain and Ireland. And it's substantially worse than the U.S. position. India's saving grace may be the fact that its public debt level is relatively low at around 60% of GDP, and is largely domestically held, primarily in the banking system, much of which is state controlled.

That pinpoints a problem. Since investors around the world have become worried about Greece, there's every chance that they'll one day become just as worried about India.

India does not have the overwhelming domestic savings flow that allows China to be fairly free and easy about public spending. So if India's budget deficit gets too high it relies on foreign financing - both debt and equity - to bridge the gap. While the Indian growth rate is so high and observers generally so bullish, that is not much of a problem. But any slowdown in growth could widen the budget deficit still further and cause a crisis of confidence.

Another problem is inflation. India undertook monetary - as well as fiscal - stimulus in 2009. The Reserve Bank of India lowered its repo rate to 4.75%, which may not appear all that low except that India's inflation rate ran at 10.7% in 2009. The upshot: Real interest rates are sharply negative.

As in the United States, this has done wonders for the stock market, but it has also created a bubble-like atmosphere for investments that is rapidly widening the country's current account deficit and stimulating inflation. Since food prices are currently rising at a rate of 17% per annum, because of the drought, the effect on India's poor is severe. The effect of rising food prices on the budget is almost equally severe because of India's wide range of subsidies on food products.

Markets sense the problems ahead. The Bombay Sensex Index has not again approached its January 2008 level of 21,000; its most recent peak - at 17,686 - was reached in December 2009. Since then, the index has dropped roughly 10%. But even at that reduced level, as I remarked earlier, India's stock market is hardly a bargain.

It appears that India is headed for the economic equivalent of a one-two punch - a simultaneous monetary crisis and fiscal crisis. Inflation will get uncomfortably high while the government struggles to fund its budget deficit and "crowds out" small- and medium-sized business borrowing while doing so. A period of government-spending austerity would alleviate both problems, but is pretty unlikely as the currently governing Congress Party has a history of heavy public spending constrained only with difficulty. Either way, there is likely to be a period of considerable retrenchment among India's business and consumers.

Given this prognostication, a heavy capital investor such as Tata Motors Ltd. (NYSE ADR: TTM) should be avoided, in spite of that company's recent remarkable recovery from 2008 difficulties that stemmed from a lack of available capital.

Look, instead, at such non-capital-intensive exporters (the exchange rate is likely to remain relatively weak) as the software company Infosys Technologies Ltd. (Nasdaq ADR: INFY) or the drug company Dr. Reddy's Laboratories Ltd. (NYSE ADR: RDY).

Both stocks are currently somewhat expensive: Infosys is trading at 23 times the consensus forward earnings estimate for the year that ends in March, while Dr. Reddy's is trading at 20 times the consensus earnings estimate for the current year. However, both companies should be bought for their long-term-growth potential, plus the possibility of additional profits from a manufacturing base linked to a weak rupee.

Nevertheless, at some point India is likely to run into crisis. That's when you should buy the market, because the long-term-growth prognosis is unquestionably positive.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

During the stock-market rebound that started in mid-March, Hutchinson's calls on gold, commodities and high-yielding dividend stocks made winners of investors who took his advice.

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and specially designated "Alpha-Bulldog" stocks into winning portfolios.

To find out more about The Permanent Wealth Investor, please just click here.]

News and Related Story Links:

• MoneyControl.com:
  India FY10 GDP may grow at 7.2%: Govt
  
• Money(Qualcomm):
  G7 confident EU can solve Greek debt problems
  
• Wikipedia:
  Real Interest Rates
  
• Investopedia:
  Current Account Deficit
  
• Bombay Sensex Index (BSE):
  Official Web Site
  
• Wikipedia:
  Crowding Out
  
• Wikipedia:
  India Congress Party

In 2011, most of the extra spending seems to be devoted to a jobs program and to additional defense expenditures for the wars in Iraq and Afghanistan. It's somewhat disheartening to see that the administration can't project more progress on the budget-deficit issue during the next few years.

After all, the Obama budget even assumes that we'll be helped along by a robust economic recovery.

The lowest projected deficit in the next decade is a $706 billion shortfall forecast for the fiscal year that ends in September 2014. That doesn't sound too bad in the context of the 2009-2011 figures, but it's almost $300 billion larger than the highest federal-budget deficit in human history before 2009.

The most alarming trend of all appears if you compare the current budget with what had been projected for the fiscal 2002 budget, a forecast made in February 2001 by U.S. President George W. Bush, who was in his first year in office. As is the practice today, budget projections back then were made in 10-year increments. So it's worth comparing the spending projections for 2011 made by the Bush administration with what's actually been put into the budget.

Our finding: The February 2001 projections were hugely too optimistic; current spending is fully 41% higher than what had been projected at that time.

That has two implications. First, it shows that budgetary control by both parties since 2001 has been utterly lousy (the Republicans controlled the presidency and the U.S. House of Representatives for the 2002 through 2007 budgets, but spending still soared). Second, it shows that out-year projections a decade into the future are often ludicrously over-optimistic.

The implications for the current budget are ominous. If 2020 spending exceeds current projections to the same degree that current spending exceeds the projections made back in 2001, then spending will amount to 33.4% of 2020 gross domestic product (GDP). Add in state and local spending, and total U.S. public expenditure would exceed 50% of GDP, close to that of the worst European countries: France and Sweden.

What's more, since 2020 revenue is projected at only 19.6% of GDP, taxes would have to go up by 70% from currently projected levels to make the budget balance.

Yikes! Even if we introduced a federal Value Added Tax to try to meet that deficit, it would have to be set at an impossibly high rate.

The current budgetary shambles is the fault of two presidential administrations, and both parties in Congress. They have wrecked what back in 2001 was a perfectly solid U.S. budgetary position.

If U.S. budgetary problems continue on their current path, our elected officials in Washington will completely destroy the U.S. financial position in the next decade, and will lead the nation into bankruptcy.

We need an immediate improvement in politician behavior on both sides of the aisle.

Otherwise, it will be too late.

News and Related Story Links:

• U.S. News & World Report:
  Peter Roff: Obama's Not-So-Secret Plan to Raise Taxes
  
• WGRZ.com:
  Obama Wants to Extend President Bush's Tax Cuts
  
• Money Morning:
  Obama's Budget Adds $1 Trillion in Taxes, Balloons Federal Deficit
  
• Congressional Budget Office:
  Official Web Site
  
• SFGate.com (San Francisco Chronicle):
  Many now paying AMT won't feel Obama tax hikes
  
• Wikipedia:
  Alternative Minimum Tax
  
• WhiteHouse.gov:
  George W. Bush
  
• WhiteHouse.gov:
  Barack Obama
  
• American Tax Policy Institute:
  Designing a Federal VAT: Summary and Recommendations

Productivity growth is damned important to investors. Countries with high productivity growth - like China and most of East Asia - become steadily more muscular exporters. Thus, companies from those countries tend to enjoy a growth in market share and profitability that can provide truly stellar returns for investors. Conversely, companies from countries with inferior productivity growth (Italy and Mexico come to mind) tend to find that life as an exporter becomes steadily more difficult: Their costs soar and profits drop at a faster pace than any of their rivals.There's a clear lesson here: If you're looking for profits, put your money where the productivity growth is healthiest.

That's why last year's heavy U.S. layoffs - in the long run - may end up being good news. U.S. gross domestic product (GDP) declined by about 2.5% during the year, according to Conference Board estimates. However, U.S. employment declined by 3.6% and hours worked declined by 1.5%, so the labor input to U.S. production declined by 5.0% (after rounding). If the input declines 5% and the output declines by only 2.5%, productivity has risen by 2.5%. It's the most painful form of productivity growth in the known universe, but it's still real growth.

The wimps in Europe didn't do nearly as well. The output of the Eurozone (the 15 countries that use the euro) dropped, too, by 4.1%. But the region's employment dropped only 1.9% and its hours worked fell1.2%, so productivity fell by 1%. In Japan, output dropped more sharply - by 5.6% - but productivity rose by 0.3% as employment and hours worked dropped sharply. So overall, during the year, the United Statesbecame 3.5% more competitive against the Eurozone, and 2.2% more competitive against Japan.

Overall, global productivity fell by 1% during 2009. Although this was the first such drop since 1991, last year's decline was larger than the 0.1% fall that took place that year. Productivity dropped in rich countries, but rose sharply in some emerging markets. China, of course, was the leader, with productivity surging 8.2%., while India's productivity increased a healthy 3.9%. As for the other two "BRIC" countries: Brazil experienced a disappointing 1.5% increase, while Russia's productivity fell 3.6% (it's a good thing Russia has oil and nukes ... otherwise nobody would take it seriously).

Of course, a single year's figures don't mean a whole lot; it's the long-term trend that counts. Over the long term, emerging-market productivity is growing much faster than rich-country productivity. And that makes sense as newly capitalist markets start to learn and even embrace Western business techniques and catch up with our living standards. That means Western countries, particularly those with relatively poor productivity growth, will feel the chill of competition from China and other emerging markets in years to come. Italy, in particular, has done notably worse than other European countries ever since 1995, and is now suffering from its un-competitiveness. Mexico, too, which as a relatively poor country should be growing productivity at emerging-market rates. But it is notably failing to do so, and instead is experiencing even slower productivity growth than Western Europe.

Over this longer term, the United States' record is good, but not stellar. In 1995-2005, the country saw its productivity advance at a pace that was only a little faster than that of Europe - or at roughly the same rate as Japan.

The lesson we learn here: The so-called "productivity miracle" of the late 1990s so beloved by former U.S. Federal Reserve Chairman Alan Greenspan was mostly hype.

Since 2005, EU productivity growth has slowed somewhat, except in some of the more-dynamic economies of Eastern Europe.Overall, however, there's no reason to expect Western European productivity to expand more rapidly in the recovery than U.S. productivity, so the lead taken by the United States in the recession may persist.

That's good news for U.S. investors. As for those in Europe, Asia and elsewhere who are prophesizing the "inevitable" U.S. decline? Well, we can only say that there's no sign of it yet!

News and Related Story Links:

• Money Morning News Analysis:
  Latest Unemployment Numbers Prove There's No Easy Way Out of a "Jobless Recovery"
  
• The Conference Board:
  Official Web Site
  
• MSNBC.com:
  Obama: 'Road to recovery is never straight'

Politically, Volcker isn't quite my cup of tea, either. I was a young banker in New York in the early 1980s, so I saw firsthand the heroic effort he made to finally stuff inflation back in its box. I also saw - and heard - just how unpopular that effort was with many in the banking community and around the country: The whining at the weekly bank economics meetings was very shrill, indeed.

If you're Fed chairman, you like to be popular with Wall Street - as Alan Greenspan and Ben Bernanke have incessantly demonstrated. So Volcker's ability to stick to the policy he knew was right while Wall Street institutions muttered and grumbled and dragged their feet was very impressive. So it's not surprising that nearly 30 years later he's come up with a banking reform plan that I agree with.

But here's the thing: I would go even further.

There are three things wrong with modern Wall Street.

First, it wouldn't recognize good risk management if it fell across it in the Street. The "value-at-risk" (VaR) system, which most investment houses still use, is completely hopeless. It tells you that 99% of the time your losses will be less than "X." However, it completely ignores the other 1% of the potential results. Naturally, the traders got wise to its faults, and so have invented endless pathological risks that behave well 99% of the time, thus keeping VaR happy.

But that "other 1%" is quite capable of wiping out an entire continent.

Credit default dwaps (CDS) are the most notorious of the instruments that can cause such a financial wipeout, but there are others. And while 1% may not sound like much, 100 trading days is just five months, 100 10-day periods (the suggested unit) are only four years, and even 100 months is 8 1/3 years. So a system that blows apart every four or eight years is going to get damned expensive in bailout costs.

The Volcker plan wouldn't improve Wall Street's pathetic risk management capability, but it would at least quarantine the riskiest bits of the system from the parts that get deposit insurance.

The second problem with Wall Street is that the behemoths are far too big, meaning if they get in trouble they have to be rescued. There seems to be an upper limit of about $300 billion in assets, the point at which banks become unstable.

But if you look at total assets of all the banks and investment banks today, there are six above $1 trillion: Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), JP Morgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Wells Fargo Co. (NYSE: WFC). Then there's a humongous gap before you get to the next two banks, PNC Financial Services (NYSE: PNC) and U.S. Bancorp (NYSE: USB), at about $300 billion.

Everything that was in between those two sizes either went bust or was absorbed by another bank in 2008. The Bear Stearns Cos., Washington Mutual, Lehman Brothers Holdings Inc. (OTC: LEHMQ), Merrill Lynch, and Wachovia all had total assets between $300 billion and $1 trillion; Countrywide Financial Corp. was just a little smaller.

Breaking the behemoths up into $300 billion chunks, as the Volcker plan suggests, would thus make the system much more stable. A Goldman Sachs slimmed down from all its hedge fund activities - with capital of $20 billion and assets of $300 billion - would still be highly profitable and could likely provide much better client service, since it would face fewer conflicts of interest.

The third, and greatest, problem with Wall Street - which the Volcker plan doesn't address - is its dominance by trading. Trading is necessary to provide liquidity, but through the explosion of derivatives and the rise of computerized "fast trading," Wall Street's operations have become "rent seeking." Trading operations scoop wealth out of the economy without giving any useful service in return. That's how Wall Street bonuses got so huge; in times of cheap money like the present, the profitability of a trading business with a substantial market share goes through the roof.

Most of those profits depend on insider information - not insider information about company activities (the use of which would be illegal) -- but insider information about trading flows (where the money's coming from and where it's going). Traders have always used this; you can't make it illegal. However, in a world where trading volume has zoomed skyward, insider information about money flows has become exceedingly valuable. What's more, unlike in most businesses, greater market share provides you with exponentially higher profits - it's more than twice as valuable to control 20% of the trading as to control 10%.

The Volcker plan does nothing about this. The best solution would be an ad valorem transactions tax, a "Tobin tax" of, say, 0.05% on every trade. This wouldn't add much cost to legitimate investing, but it would make the "fast trading," scooping a few cents per share on millions of trades a day, completely unprofitable. That in turn would return Wall Street to banking and corporate finance (arranging deals and raising capital) the businesses that actually have a value for the economy.

Still, two out of three ain't bad. Give the plan a thumbs up, and hope that the lobbyists don't succeed in killing it.

News and Related Story Links:

• Money Morning:
  When it Comes to Naming Wall Street's Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill
  
• Money Morning:
  High Frequency Trading: Wall Street's New Rent-Seeking Trick
  
• Wikipedia:
  Value at Risk