WHY THE RECOVERY FEELS BAD

What if Ted Kennedy told Fox News tomorrow that he had changed his mind and had decided to become a tea-sipping, tax-cutting Republican? You'd be shocked. Then suppose a week later Strom Thurmond jumped up to a microphone and said (from under his saucy new Ché beret) that he, too, had had a change of heart. He'd decided he wanted to live out his days as a pro-Castro liberal. Well, there'd be chaos. "What in blazes is happening to America?" you might wonder.

This is how I'm beginning to feel about the amalgamated conundrums known as the U.S. economy. The best quarter in two years--5.8% GDP growth in Q1--is met with Bronx cheers of disbelief by CEOs everywhere. Stocks run for a day or a week, then they pot. Two steps up, three down. This is not the way things are supposed to go after 11 interest rate cuts, a tax cut, a productivity bounce and a boom quarter.

So frets the Federal Reserve's chief inflation hawk, J. Alfred Broaddus Jr. Meditating upon these oddities, Broaddus has completely flipped. The career inflation-fighter says inflation is a slain beast. The monster is deflation. Fed colleagues are shocked by Broaddus' change of thought.

But wait. It gets nuttier. Brian Wesbury, last year's top economic forecaster--and a bull who sees an 11,000 Dow and a 2500 Nasdaq this year--has decided to pull a Broaddus himself. Only Wesbury has gone from ... dove to hawk! "What is spooking the market," he yells through my car phone one day last month, "is inflation." Inflation? I pull over. I can't drive anymore. I am shocked and confused.

There is a shred of comfort in this confusion. If smart guys like Broaddus and Wesbury are switching jerseys to figure out what ails the U.S. economy in 2002, then anybody's guess is good--mine included. So here goes:

? The recession of 2001-02, I think, has reached its third act. Act I: a tech bust that sucked $4 trillion out of the stock market and left the largest inventory overhang in history. Act II: Sept. 11, of course. Act III: Enron and sleazy accountants. But this is good news. Accounting scandals are so boring that it means we must be near the play's end.

? The stench from the accounting scandals will take another quarter to dissipate. What is happening now, CFOs tell me, is that public companies are on a migratory path to more conservative accounting. Numbers stated conservatively, of course, look awful at first. Recall how January's optimism fell victim to April's numbers? That was accounting. After a quarter of pain, expectations will be set low again--low enough to beat.

? The tech inventory overhang is over, too. But this happy news is offset by the fact that CFOs are freezing new tech expenditures right and left. How long will this CFO lockdown last? Good question--but irrelevant. Tech needs to come up with new killer apps that are so darn cool they will blow their way past CFOs.

? The overhang of bubble business models is not over. Soon it will be. The necessary triggering event will be a big telecom bankruptcy or two to clear the field. Let us also pray for the death of a hundred or so me-too venture capital firms in Silicon Valley that never funded anything more durable than Webvan. Only then will the VC field clear and its $60 billion jump off the sidelines.

? Last year's Bush tax cuts are weak tea. They do not offset weightier "taxes," such as: the costs of post-Sept. 11 security, which affect travel, buildings and computer networks. Then there is exploding litigation; fading free trade, wounded by a thousand cuts in Washington and Brussels; and new pork, as exemplified by last month's $190 billion farm welfare bill. One cut at a time, the U.S. economy is being bled by legislation, regulation, litigation--taxes, no matter how they're labeled. Atlas sags.

? The biggest boom snuffer of all may be the threat to interstate commerce posed by state attorneys general, such as New York's Eliot Spitzer in his reckless pursuit of Merrill Lynch.

What is to be done? Where to start? How about with some deep, offsetting tax cuts, starting with capital gains, to motivate entrepreneurs and investors? How about with an end to the Fed's seesawing, and a promise of lasting price stability? How about with the Bush Administration's standing up for free trade and standing down the power-mad state AGs? How about with Michael Powell's breaking some eggs at the FCC? How about with the Supreme Court's choosing Silicon Valley over Hollywood in matters of digital copyright? How about with the Valley's returning the favor by inventing some new products as cool and profound as the PC and Web browsers?

Visit Rich Karlgaard's home page at www.forbes.com/karlgaard or email him at publisher@forbes.com.

I like that last line - here's a pike if you need one ...

Broaddus (worried about deflation) and Wesbury (worried about inflation) aren't really disagreeing. What may be holding back investors now (well one of the things) is fear of inflation, following the Feds efforts to reinflate the economy. But, I predict, perhaps after just enough of a wiff of inflation to fake us out, that deflation will be the big problem.

This might come from the baby boomers reaching "maturity". In our youth, we contributed our part to a nice rip of inflation. In our mid years, to one of the most productive booms in American history. Now we are starting to get a little more careful with money. In the same vein, we have accumulated too much debt, so we start paying it down. Layoffs and unemployment are for the first time in a decade not entirely out of our concern. Reduced personal spending, reduced corporate investment still coming off the recent dot.com bubble. Finally a weakening dollar, that contributes to reduced foreign investment in America. Continued stock market weakness -- though with some deliciously large bear traps ahead. Real estate prices, for luxury homes and office space begin to fall (at least in Silicon Valley, where I live, I'd wager a pretty penny on this one).

Perhaps a better way to understand inflation and deflation is not to look at whether prices are going up or down, but to look at the velocity of wealth. How fast is wealth changing hands? Actually, look at the change in that velocity - so I should say that:

Inflation is defined by accelerating wealth transfer; Deflation by decelerating wealth

The next decade will be dominated by deflation (as the last already has in Japan).

Like armchair generals, today's economists are all trying to fight and predict the last war.

And they've totally botched it up. They look at the Tech bubble, internet crash, and low unemployment and reach diametrically opposed conclusions among themselves.

No wonder they're confused.

But you don't have to be.

It's all rather simple, actually.

Corporate America is shifting back from large mega-conglomerates to small businesses. Sure, we hear of massive coporate layoffs every day, but we've still got low unemployment.

Why is that? Because small businesses are hiring people as fast or faster than big businesses are letting them go.

Why the shift, and why now?

Technology. 50 years ago a CEO needed a pool of typists just to generate his daily memo's and press announcements. Today's CEO emails a quick note to a few people for review, it gets modified, and then emailed to the right staff or news agency. Hence, no more office pools of typists are needed, so typists got laid off.

And fewer managers are needed, too. Technology permits one manager to email far more people, and faster, than the old ways of moving paper to underlings. So middle managers are getting laid off.

High level software (CASD) permits fewer programmers to code more and better software (and faster hardware makes the bloatware run faster, too). So programmers are getting laid off. Let's face it, you don't have to have twenty Java coders to build a business web page anymore.

The other side of this technology shift is that small companies can do what the larger companies can do. When you hit a web page, you usually have no clue how large the business might be that is behind it. The Internet has therefor leveled the playing field for on-line ventures. Voicemail, email, corporate web pages, on-line purchases, cell-phones, call-forwarding, bandwidth; these aren't restricted to the domain of mega-corporations any longer. Now even the smallest firm can have it all, appear professional, and serve their customers.

As for the stock market, what we are witnessing is a gradual realignment of investment mentalities. Gone are the days when the "greater fool" could be depened upon to pay you more for your tech stock than what you paid for it. Investors are now very skeptical of corporate accounting books, and they are selling off the stocks of high P/E firms as well as selling off the stocks of companies with less than fully visible accounting procedures.

Where is the money going? Into real estate. Into metals. Into dividend stocks (you can't fake the cash that has to be paid out to shareholders for dividends). Into small businesses. Into art.

So who is going to feel bad in this recovery? People who still cling to the old ways of buying tech stocks regardless of their P/E's. People who think that buying into a big firm is a "flight to quality." People who look for jobs only at the Fortune 500. People who think that "layoffs" at big companies are bad things (what, they'd rather see the company go out of business and wind up laying off everyone).

Just look around you. The people who scream gloom and doom, the people who claim that disaster lurks just around the corner, the people who point to layoffs and cry that the sky is falling, the people who claim that you just can't make money in the stock market anymore; well, those are the people who haven't seen that the world has changed for the better.

Businesses are more productive. Salaries are up. Unemployment is low. Interest rates are low. Inflation is low. In short, Life Is Good.

But life is also quite a bit different than it was just 5 or 10 years ago, so have pity on the poor slobs who haven't quite caught on to all of the changes that we see in our lives now.

Recommended reading for the hard cases: Future Shock.

Insurance is merely "peace of mind."

Businesses can always self-insure themselves (i.e. do without third-party insurance altogether) and still operate, but the reason that they do NOT self-insure is fear.

The more that people/companies fear things (e.g. lawsuits, global unrest, currency crisis, et al), the more willing they become to pay higher rates for "peace of mind."

And insurance companies, sensing the fear in air, can get away with charging higher premiums.

In today's climate, it's only natural that insurance would be more expensive. We're seeing a shift in business from large corporations towards smaller ones. Lawsuits are out of control. We've got a global war on terror, a banking crisis in Japan and Argentina, a new currency altogether in Europe, massive shifts in military alliances (hey, Russia is now in NATO!), and the "greater fool" investment mania is heading towards the endgame.

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