The patchwork of attempts to prop up the financial system has taken on a life of its own - we call it bailout economics. At every step, Adam Smith's "invisible hand" to guide the economy has become less evident. Back in the 18th century, the economist coined the term as a metaphor for the self-regulating nature of free markets. Economic booms and busts are as old as mankind, but each time a crisis occurs, policy makers want to ensure that the same disaster will never happen again. Most of the time, instead of fixing crises, policy makers place the seeds for even greater problems down the road. Others argue the government must not do anything and let the free market take care of things entirely; however, it is important to note that we don't start with a vacuum: we have a complex set of regulations and taxes that influence market behavior. If we are going to change the rules, we must ensure we don't throw out the baby with the bathwater to preserve the benefits of capitalism.

Much of the public outrage is a result of the privatization of gains and socialization of losses. An executive or hedge fund manager makes a lot of money while risky bets pay off, but if bets turn sour and the firm goes bust, he or she walks away with the mess left behind. A libertarian would argue that those who provided capital or credit only have themselves to blame; after all, they were greedy and took a gamble with the executive. But what happens when this executive works for a public company and shareholders have little influence over the compensation packages? One could argue not to invest in this particular firm, but rather another; but what if there is a culture of compensation prevalent throughout a vast number of firms that, in retrospect, look like management was out to raid the firm? What if management raises the stakes so high to be able to blackmail governments into bailouts?

Risk essential to capitalism
As much as many despise the excesses of it, risk taking is essential to economic growth and prosperity. Without risk taking, investments would not take place. Investment decisions are typically a function of confidence that a reward may be achieved at a level of risk within the comfort zone of the investor; this is not limited to stock market investors, but extends to any form of risk taking, including whether to launch a new business or extend a loan. Confidence is a function not just about the potential revenue and expenses of an investment, but also the certainty over these; they are influenced not only by free market forces, but also by government taxes, regulations and changes in policy.

The reason China's savings rate is so high is not simply because the government hasn't handed out credit cards en masse, but foremost because of a lack of investment opportunities. Those with money won't invest if they are discouraged because of excessive or unpredictable taxation; excessive or unpredictable regulation; or a weak legal system where contracts cannot be enforced. While China still has a long road ahead, the Chinese have been working hard to improve the country's investment climate, not just for foreign investments, but also for domestic entrepreneurs. Building trust takes many years; it can be destroyed very quickly.

We don't necessarily need low taxes and regulations to foster investments, but clarity on taxation and regulation. California has been able to attract a lot of investment over the years despite high taxes and a high regulatory burden; the same applies to Europe where many companies thrive despite a high cost of doing business. At the same time, one can never take investor confidence for granted, but one must earn it at all times - this applies to individuals and governments alike.

Limited liability fosters risk taking
Essential components to foster risk taking are the ability to "walk away", be that from a house with a non-recourse mortgage by mailing the key to the bank; or by declaring bankruptcy. Taking advantage of these "circuit breakers" rightfully ruins the credit history of those taking advantage of them. However, that doesn't necessarily stop someone discredited from raising money once again: take John Meriwether, whose Long Term Capital Management hedge fund required a government bailout in 1998. Mr. Meriwether was able to raise money for a new fund, only to once again run into trouble in the most recent credit crisis. This does not mean we endorse running away from a contract or allowing a court outside of bankruptcy proceedings to change the terms on mortgages. In most of the private sector, chapter 11 bankruptcy is required to be able to renegotiate contracts at a tremendous cost to equity holders; in the banking sector, insolvent institutions may be seized by the FDIC. Those are established processes that have matured over 200 years. If those processes are not followed - say the government decides that a court can change the terms of a mortgage because it would otherwise cause hardship on the homeowner - all home owners will have a higher cost of borrowing because the risk of random government intervention will now have to be priced in; it's a risk that's far more difficult to price than credit risk. In our view, banks will only issue mortgages in such an environment if they are willing to carry the mortgages on their books, i.e. they may not be able to sell them off. While some argue that the securitized mortgage market has some flaws, killing off the market entirely is not the way to fix the shortcomings as fewer mortgages at higher costs result.

Failure must not be rewarded
What doesn't work is to reward failure. Taking money from prudent people to give it to the imprudent is a recipe for disaster; or, as the outgoing president of the European Union stated, will put the U.S. on a "road to hell." There are about 8,000 banks in the U.S., most of them sound; however, the government is propping up the largest banks, injecting hundreds of billions of dollars in capital and guarantees. Warren Buffett laments in his letter to shareholders that he cannot compete with businesses that receive government subsidies. The government is not encouraging private sector activity, but replacing private sector activity.

The same applies to homeowners: money is moving from strong hands to weak hands. Worse still, massive subsidies prevent home prices to reflect the purchasing power of buyers. Homeowners who cannot afford their present home are best served by downsizing to a home they can afford. Not only is the re-failure rate of those who get relief on their mortgages very high, homeowners may become slaves of their homes as they are likely to perpetually struggle to make payments and won't have the cash flow for larger expenditures that come with home ownership. If such homeowners downsize, however, they can start rebuilding equity and may eventually be able to afford a larger home.

Work with the market forces, not against them
The cost of the bailouts is staggering, amongst others, because the government is fighting market forces. In the end, however, you cannot print wealth, only currency. When you print money, you destroy a fundamental attribute of currency, namely that it is supposed to be a store of value. If currency is nothing but a government imposed medium of exchange, a flight to hard assets, including gold, may accelerate. Great Inflation may be upon us as both fiscal and monetary policies are forceful, but ineffective. Policies are ineffective because they prevent prices from reaching a market based equilibrium; because the stimulus package is mostly a spending package that is foremost expensive, but otherwise has mixed signals; because money is taken from strong hands to prop up weak hands - be that consumers of financial institutions; because policies remain without clear direction and change unpredictably; because policies don't encourage more sustainable consumer spending; because, in our assessment, the Fed has no exit strategy that is viable - it seems impossible to us the Fed could tighten monetary policy if and when inflation breaks out without causing yet another collapse in economic spending; and finally, the Fed - in our view - wants to have inflation as inflation bails out those with debt. By inducing inflation, fewer homeowners will be "under water" on their mortgages, possibly providing relief. It's a dangerous road to proceed on, and, moreover, runs against the mandate of the Fed.

By the way, when Congressman Ron Paul recently asked Fed Chair Bernanke whether the Fed extends the bust cycles, the Fed Chair responded that the Federal Reserve was created to smoothen the business cycle. Pressed again to clarify whether it wouldn't be preferable to have a short and painful bust followed by more growth, Bernanke did not disagree, but said that it is his job to follow the Fed's mandate.

Initiatives for a more sustainable future
So far, all Congress has been able to come up with are policies to destroy even more wealth or well-intended policies that cause unintended consequences. For the sake of not only the U.S., but the world, we have to move away from bailout economics, from the politics of self-destruction. We don't have all the answers, but what is needed is a discussion that focuses on setting the right incentives.

Some of the key concerns policy makers have is that institutions may be using too much leverage; that their failure may cause uncontrollable ripple effects; that executives do not act in the long-term interest of shareholders. Let us try to address these issues constructively. As we discussed earlier, risk taking is an essential ingredient to achieve a higher standard of living; when used prudently, leverage can be beneficial. To provide incentives, we put forward a couple of proposals:

• Employ tax policy to make leverage less attractive. Merk's Senior Economic Adviser and former President of the St. Louis Federal Reserve William Poole has proposed to eliminate the tax deductibility of interest (for business an individuals) and in return cut the corporate income tax in half. Using 2005 IRS data, this would be approximately revenue neutral for the government. Such a change could be phased in over time.
• Move derivatives onto regulated exchanges whenever possible. Regulated exchanges do not prevent participants from employing substantial leverage, but they ensure there are no systemic risks if a party fails. Derivatives on a regulated exchange are marked to market every day: each party has to post collateral for any contract and that collateral is adjusted on a daily basis depending on market values. Even if a position was ultimately profitable, a participant could get wiped out if during the course of the contract the value showed a substantial loss if closed prematurely. The point here is precisely that institutions must be careful in how much leverage they undertake if regulations require them to post sufficient collateral during the course of the entire contract. Compare this with the status quo: institutions argue that theoretical models about future cash flows are sufficient to calculate the value of derivatives held.
• In many cases, especially for legacy positions, it may not be possible to move derivatives onto an exchange. But instead of relying on a model based on future cash flows, the regulator could insist that firms rely on estimates of current market values and post collateral accordingly with their counterparties. Berkshire Hathaway, Warren Buffet's conglomerate, has always stressed how they avoid engaging in contracts that require the posting of collateral. The firm has always relied on its reputation; however, rating agencies have started to downgrade the debt of even this giant. The point, again, is to provide an incentive for firms to use less leverage. Already the business model of many firms is broken as they rely on huge leverage with low cost of financing. There's a cost associated with moving towards a world that relies less on leverage.

Before going any further, policy makers should abandon their attempts to persuade failed institutions to increase their lending. If policy makers want to have institutions increase their lending, healthy institutions should do so, not bad ones. The government sponsored entities Fannie Mae and Freddie Mac must be phased out. Providing subsidy to home ownership makes home prices more expensive and, as a result, less affordable to subsequent buyers. It's a slow-motion Ponzi-scheme that initiated in the 1930s and blew up last year; the solution is not for the government to force them to increase their lending. Further, large financial institutions must be dismembered, not propped up. To avoid disruptions to the markets, one can look across the Atlantic at the ECB; the ECB has provided unlimited liquidity to the banking system. Such a scheme may produce "zombie banks" - banks that are technically insolvent, but remain afloat. Similarly, one can keep failed large institutions afloat to allow an orderly dismembering. The government indeed tries to encourage institutions to sell off healthy businesses, but does so while micro-managing these firms - we may have only seen the beginning of the political fallout of this approach. Everyone should realize the government must disengage from these institutions as soon as possible. The current path does not achieve this. One more market-based approach is to require healthy capital ratios, then force the bank to raise money or shrink. To make this work, however, there must be the political will to allow these institutions to shrink. Policy makers should not focus on these institutions issuing fewer loans as a result, but instead should focus on incentives for healthy institutions to fill the gap (note that, in our assessment, Fannie and Freddie are not part of the club of healthy institutions).

Board Reform
Boards must be held accountable. The outrage at AIG is directed at employees, whereas it should be directed at the board that hired an executive team that allowed the firm to be run into the ground and is ultimately responsible for compensation packages. How about requiring firms with over $x billion in revenue - whatever number determines a "systemically important firm" - to have a Chief Risk Officer report directly to the board, not the CEO or COO. Many financial firms already have a Chief Compliance Officer that reports directly to the board and it could be an integrated role. The function of this officer would be to ensure that the firm adheres to the risk management plan as approved by the board. There may be no need for the government to restrict the types of risks a firm may take, but a board should approve and supervise processes based on best practices. The risk management guidelines should be publicly available to allow shareholders and other stakeholders to have another tool to gauge the riskiness of a firm. A standardized summary report would also be helpful.

We can improve the system without imposing undue burden or stifling innovation. However, one must return to a system where the risk manager can ax a product and not be overruled by a hotshot money maker - in the "old days" until the early '90s, the general counsel in an investment bank was in many ways more powerful than the bankers, as he or she could veto projects that jeopardized the franchise of a firm. We must return to a more sustainable model and the above is one proposal. There may be others, possibly better ones, but policy makers must start to earn their salaries by coming up with constructive, not destructive proposals.

Executive compensation will, without a doubt, also need reform. One of the unintended consequences of the Clinton administration's imposition of an additional tax on incomes over $1 million was the explosive growth of options being awarded. In our view, tax policy can be used to provide incentives to improve incentives. Tax-incentives can be provided to encourage boards to make compensation based on long-term performance. This isn't always easy at the top executive level as any board hiring an executive from another firm tends to match the value of a compensation package the person is leaving behind. We would like to encourage policy makers not to come to hasty decisions and consider the consequences of any actions before implementing them.

Taxation of capital
Capital should be made more attractive relative to debt; reducing the deductibility of interest expense as discussed earlier is a step in that direction. Shareholders should not be taken for a ride by boards. In our view, policy makers should consider outlawing the re-pricing of options awarded in the past. A firm should award new options if it wants to do so, but rewarding past failure is not in the interest of shareholders. Instead, if firms want to award options, they should consider awarding a modest amount on a monthly basis; the cost averaging would reduce the incentive to change terms retro-actively.

To strengthen shareholders further, policy makers should provide firms with incentives to make dividend payments rather than to buy back their own shares. As the meltdown in the stock market has shown, only a dividend that is distributed is cash an investor can use to re-deploy. Share buybacks may have their place, but, ultimately, a company's value is dependent on the cash returned to the shareholders, not the currency of a stock price a company can gamble with. Reducing or even eliminating the taxation of dividends would go a long way in encouraging investments in firms that create value.

Beyond that, there is a call for the streamlining of regulation. By all means, let us consolidate regulations, but do not create yet another regulator. Moreover, do not give the government the power to seize non-bank institutions that are "systemically important" - that's a power you would expect the Soviet Union to have, not the United States. Instead, provide incentives for more prudent risk management. The next boom and bust will happen - but we don't need to give up all free market principles for the illusion of safety.

In an upcoming analysis, we will expand on the discussion on what governments and individuals can do to seek more sustainable wealth; we believe any reform should focus on incentives: let the free market, not government credit facilities decide where the money flows. We will also resume our discussion on how the U.S. dollar and other currencies may develop as the dynamics amongst policy makers around the globe plays out. We already discussed whether there are any hard currencies left; potential depression currency plays; as well as who may benefit as the world tries to reflate. To be informed as we continue these discussions, subscribe to our newsletter at www.merkfund.com/newsletter.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.