By Martin Hutchinson
Contributing Editor
Money Morning

In February 2009, I reviewed the operations of the 12 largest U.S. banks, and concluded most of them were sound.

In fact, I told Money Morning readers that the soundest were at that point excellent investment opportunities.

Judging by the performance of the Financial Select Sector SPDR (NYSE: XLF) Exchange-Traded Fund (ETF) since that time, one thing is clear: If you’d followed my advice you would have more than doubled your money.

Yes, the market’s up, too, but not to that degree – so it’s reasonable to say that I feel a quiet satisfaction over my early analysis of that troubled sector.

A Tough Act to Follow

Unfortunately, the U.S. banking-sector outlook for 2010 is not so rosy. Not only would you be buying at roughly double the price of February, but the sector’s prospects are considerably grimmer than they were just a few months back.

I didn’t get everything right in February. You can quibble only slightly with my ratings of banks: For instance, State Street Corp. (NYSE: STT) has been nothing like the solid player I predicted at the time, while Capital One Financial Corp. (NYSE: COF) has had less difficulty with its credit-card portfolio than I expected.

Overall, however, I was mostly right.

What I got wrong was my advice to readers to buy the shares in the top-quality banks: You actually would have fared better by investing in the lousy ones. Instead of the 100% you would have reaped by following my strategy, you could have made roughly 90% by now on Bank of America Corp. (NYSE: BAC), which I had dismissed as a “zombie,” and about 210% on the “walking wounded” Capital One.

And if you’d waited until early March – when true despair ruled – you could have earned even more on the king of the “zombies:” Citigroup Inc. (NYSE: C).

Bad banks turned out to be the better investment than good banks for two reasons:

First, the government has intervened heavily in the banking sector, even since February. The “stress tests” were carefully designed so that everybody would pass, while the public investment in Citigroup was converted from preferred stock into equity on what looked like very favorable terms. Little or nothing has been done to break up the largest banks that had caused the problem; indeed, the only sanction on them has been for a “Pay Czar” to step in and limit the pay of their 25 top executives. Conversely, the good banks like U.S. Bancorp (NYSE: USB) and BB&T Corp (NYSE: BBT) were forced by the threat of state intervention to raise new equity to repay TARP (Troubled Asset Relief Program) money, and to cut their dividends, neither of them things they would have done in a free market.

And second, the other factor helping banks that I did not expect in February was the continuation of very low interest rates and the ongoing federal “stimulus.” The U.S. Federal Reserve has purchased $2 trillion of U.S. Treasuries, mortgage bonds and agency bonds.

The Obama administration has continued its initiatives, too, such as the $8,000 tax subsidy to first-time homebuyers. This has helped bad banks more than good banks, because the housing-loan and mortgage-bond “books” of the bad banks were in far worse shape.

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However, it has enabled all banks to make money simply by borrowing short-term money at a cost close to zero and lending it out to consumers and business at rates often in double digits.

The biggest beneficiary has been Goldman Sachs Group Inc. (NYSE: GS), which has enjoyed a trading bonanza, and which is now intending to pay out record bonuses on the basis of profits made using cheap, taxpayer-provided capital.

No Room for a New Year Encore?

Going forward into 2010, these factors stop being so positive.

First, it’s most unlikely that the Fed will keep interest rates at such low levels in 2010. Commodity and oil prices have soared during 2009 because of the low interest rates, and at some point these escalating prices will translate into real inflationary pressures – even down to the consumer level.

When this happens, interest rates will have to go up. That will have three effects on bank profits – all of them bad.

• First it will reduce the huge trading profits that the likes of Goldman Sachs, Citigroup and Bank of America (which owns Merrill Lynch) have been making.
• Second, it will reduce the profitability of borrowing short-term and lending longer-term – indeed the banks that have invested in bonds with the interest rates un-hedged will even incur capital losses.
• Third, and last, the higher interest rates will tend to reduce the prices of assets such as houses and commercial real estate, thus causing larger bad debts.

The government’s stress test earlier this year was based on a “worst case” U.S. economic scenario of 10.5% unemployment in 2010 and a 29% decline in U.S. house prices from the beginning of 2009.

Housing prices are now showing signs of having bottomed out only about 8%-10% below their December 2008 level. That’s good.

However, the U.S. unemployment rate in October rose by 0.4% to reach 10.2%, and there must be a substantial chance in the new year that the U.S. jobless rate will blow through both the stress test’s hypothetical level of 10.5% and the November 1982 postwar record of 10.8%. Combine that with a possible further decline in home prices if interest rates rise, and investors could be looking at some real trouble for the balance sheets of consumer-oriented banking institutions.

Since unemployment has never risen above 10.8% in the postwar period (and its duration above 10% was only 10 months in the rough 1982-83 downturn) the U.S. consumer-credit system is not “stress-tested” for such high unemployment rates.

Losses could be huge.

Of course, the government will very likely bail out the banks again if they get in more trouble. However, shareholders would probably be pretty badly penalized in that event, since politicians would likely conclude that investors should bear more of the cost for zapping taxpayers twice in two years.

That brings me to the other possibility, of punitive legislation against the banks – or some kind of “insurance premium” on those deemed “too big to fail.” I’m talking about premiums in addition to those that banks already pay to the Federal Deposit Insurance Corp. (FDIC).

There is considerable political momentum behind this: The news of the record Goldman Sachs bonuses and soaring bank remuneration – coming at a time when the Fed is running policies specially designed for U.S. financial institutions to repair their capital and resume ordinary lending – is pretty compelling. It’s not as if the banks were increasing their lending with the money they are being given; bank loans are currently running $600 billion below year-ago levels even as banks have nearly $2 trillion in excess reserves with the Fed.

Personally I would favor a “Tobin tax,” a small tax on each transaction in bond, stock commodity and foreign-exchange markets. This would need to be imposed by global agreement, but could be levied on a country-by-country basis (you don’t want to give global institutions a separate source of revenue, heaven forbid!).

Tobin taxes would fall most heavily on the very big conventional banks, as well as on the trading-oriented investment banks. They would hit especially hard the “fast-trading” business initiatives, in which investment banks profit from their inside knowledge of money flows.

That’s all to the good; the “fast trading” business – and much of trading in general – appears to me to be pure rent extraction in which traders make money without providing anything of value to others. As a veteran banker myself, I can say with certainty that this is not true of most traditional banking and investment banking business, however.

Whatever tax the politicians decide to go with would strike both directly and deeply at bank profitability. If designed badly, this tax could also hurt the relatively innocent regional banks. There is also new talk of breaking up the biggest banks to stop them being “too big to fail” – again probably bad news for shareholders in the short-term.

With markets, loan losses and the government all likely to hurt banks in 2010 – especially in the year’s second half – banks are not a savvy investment play right now.

However, there may come a period – perhaps in late spring – at which the overall stock market sees all the problems and again fails to distinguish properly between the badly run or scamming behemoths, and the valuable and well-run regional franchises.

At that point, selected banks will again be a “Buy.”

Perhaps – as we saw last February – it will even once again be possible to double your money.

After all, risk does have its advantages!

[Editor's Note: Money Morning's "Outlook 2010" series has already provided readers with a forecast for the U.S. economy in the New Year. Watch for future installments addressing the economic outlook for oil prices, the high-tech sector, retailing, housing, foreign investments and other key topics.]

News and Related Story Links:

• Analysis of the U.S. Banking Sector (Part I of II):
  The Top 12 U.S. Banks: From Zombies to Hidden Gems.
• Analysis of the U.S. Banking Sector (Part II of II):
  Fifth Third – A Medium-Sized “Zombie” Bank.
• Money Morning Analysis of the U.S. Banking Sector:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest.
• Money Morning News Analysis:
  Bank Stress Tests: The Results Are in; Now What?
• Wikipedia:
  Tobin Tax.
• Money Morning News Analysis:
  BB&T, Capital One, U.S. Bancorp and KeyCorp Planning Stock Sales to Raise Capital, Repay TARP.
• FDIC.gov:
  Official Web Site.
• Money Morning News:
  Obama Administration Wants New “Pay Czar” and Shareholder Vote to Reign in Executive Compensation.
• Wikipedia:
  Too Big to Fail.
• Money Morning Special Report: First Anniversary of the Financial Crisis:
  Wall Street Back to Business as Obama’s Regulatory Overhaul Loses Momentum.
• Money Morning Market Commentary:
  High Frequency Trading: Wall Street’s New Rent-Seeking Trick.

Volume in the credit default swap market for rich countries has soared and so have credit spreads, according to a recent Financial Times story, while volume in emerging markets CDS has stagnated. In other words, traders are betting against the governments with high budget deficits, like Britain and the United States, as well as against those with high debt levels, like Japan and Italy.

So is there really a substantial chance of a big rich-country default, and what would it look like if it happened?

It’s not obvious which of the “Rich Four” countries would go first.

Japan, for instance, has the highest debt. But Japanese consumers are such great savers that they essentially owe almost all of the debt to themselves.

The country needs fiscal discipline and higher interest rates (to reward Japanese savers properly), but there’s a decent chance Japan will get both, in which case default is unlikely.

Italy has high debt – at about 120% of gross domestic product (GDP) – and not much discipline of any kind. On the other hand, Italy has the best budget position of the four rich countries, with a 2009 deficit forecast at only 5.3% of GDP, according to the Economist.

Italian Prime Minister Silvio Berlusconi is something of a rogue. But unlike his counterparts in Japan, the United States and Great Britain, Berlusconi avoided the tendency for wasteful “stimulus” public spending when the recession was at its worst. Consequently, for as long as he’s in power, Italy is unlikely to default.

Unfortunately, Berlusconi is 73, and his opponents on the “center-left” are far less responsible. That means they are prone to all kinds of economically damaging policies. So Italy isn’t out of the woods.

Britain is in probably the worst shape of the Rich Four. It has the highest budget deficit – at an astounding 14.5% of GDP in 2009 – and very little chance of improvement.

Opposition leader David Cameron has pledged to bring that deficit down, but he’s no Margaret Thatcher, to put it bluntly. And it would probably take another Thatcher – or perhaps even an Attila the Hun – to chop away at Britain’s overgrown public sector, infested as it is with extra costs from the European Union.

Britain also has the problem that its primary industry – financial services – is currently the global economy’s Public Enemy Number One, and therefore seems unlikely to provide the tax revenue or support for London house prices that nation has come to expect. Yes, there are lots of other things Brits can do, but their wage costs will have to come down a long way before they can make money doing them. Meanwhile, default is quite likely, though it’s probably eight years to 10 years in the future, since debt is still well below the levels currently borne by Japan or Italy.

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Then there’s the United States. The U.S. deficit for calendar year 2009 is projected to be 11.9% of GDP. But it looks likely that the U.S. deficit will be even slightly larger in 2010. In addition, the healthcare bill wending its way through Congress is likely to add nearly $200 billion a year to the deficit – starting in 2014 – when its full provisions kick in.

(The official cost is less, because Congress has timed it to include 10 years of income, but only six of expenses.)

On the other hand, U.S. debt should still be only around 100% of GDP even in 2020, which is generally bearable. Thus, if there’s to be a U.S. default, it will be after that date – and probably not until the late 2020s, when the baby boomers are retired but still getting sick, receiving social security and generally chewing up resources.

After careful review, it appears that we’re reasonably safe from a near-term default. On the other hand, however, the odds of an eventual default by one of these four indebted countries is pretty high.

That isn’t good news, even if the defaulting country is not the United States. Bond markets have large exposures to all four countries, and each of them has a large number of multinationals. That means risk premiums worldwide will rise for practically everybody. That, in turn, will make debt financing very difficult to obtain and will probably induce the stock markets to crash again.

In short, investors and consumers worldwide are most likely looking at yet another recession, though this new one that we’re warning about isn’t likely to come our way for some time.

If the United States were to default, the outlook would be a grim one for those of us who live here. If the country defaults on its debt, it won’t be able to pay Social Security or Medicare – at a time when the programs are already in deficit mode, paying out more in benefits than they re taking in.

Hence, either payments to the baby boomers will stop with a sharp jolt, or – alternately (since baby boomers vote) – the U.S. Federal Reserve will be forced to print money in order to make Social Security and Medicare payments. That will result in very nasty inflation. And the country won’t dodge a recession either, since U.S. companies will find it difficult to raise money, the same problem U.S. firms had this year.

Better hope for fiscal discipline to break out worldwide. But I wouldn’t bet the ranch on it.

[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 Market Analysis:
  Investors Can’t Ignore a Rebounding Japan.
• Wikipedia:
  Credit Spreads.
• AgingHipsters.com:
  The Baby Boomer Generation.
• Wikipedia:
  Silvio Berlusconi.
• Investopedia:
  Risk Premium.
• Wikipedia:
  Margaret Thatcher.

By Martin Hutchinson
Contributing Editor
Money Morning

In a Money Morning column last December, I predicted that “commodities may be due for a recovery in 2009.” It’s always nice to be right, but I have to say the move in some commodities has surprised me. Just look at the performance figures for the 12-month period that ended in mid-November.

When it comes to commodities, most of 2010 will be a reasonably close repeat of 2009. You may think that sounds dull – until you look at the accompanying chart (see chart below) and realize just how much more there is to go.

Although the rally started at an admittedly low point in January, by mid-November it was very clear that commodities were once again in a major bull market. A few commodities have been left out – coal, natural gas and many foodstuffs have experienced lackluster performance – but many of the others (such as the metals, in particular) have had an exceptional year.

Three Factors That Will Drive Prices

The reasons for this aren’t hard to find. Three catalysts in particular figure to keep commodities on their upward trajectory.

First, the U.S. Federal Reserve has kept short-term interest rates close to zero all year, and other central banks around the world have pursued similar policies. Even countries that haven’t had significant recessions – such as China – have pursued exceptionally expansionary monetary policies: China’s M2 money supply was up 29.4% in the 12 months through October, far above the country’s economic growth rate for that period.

All that money had to go somewhere. It hasn’t gone into housing – the global housing markets are still bombed out after their earlier excesses. It hasn’t gone much into stocks – they have had a very nice rally, but are still well off their all-time highs.

Instead, all the stimulus money has gone into commodities.

Second, while the rest of the world has been mired in recession, China has had a pretty good year, and so has India. In the third quarter, China’s gross domestic product (GDP) increased 9.5% over the previous year, and India is expected to post a rise of at least 6%. That has caused soaring demand for raw materials, because lifting the 2.5 billion inhabitants of those countries out of poverty generally requires lots of goods you can drop on your foot.

With sales of 11 million cars and light trucks, China leapfrogged the United States this year to become the world’s largest automobile market. China and India show no sign of dropping back into recession. Far from it, in fact.

This escalation in demand is likely to continue. And that will put added pressure on global raw materials supplies. In general, we have plenty of commodities, but opening up new production takes lots of time and money, so rapid demand growth pushes up materials prices.

Third, and last, hedge funds and other speculative investors are piling into commodities. What’s more, they are buying not just futures, but physical commodities. The supply of most commodities is a small fraction of the volume of hedge funds outstanding, meaning that prices could shift quite sharply as supply disruptions occur.

Don’t forget: While a hedge fund buying commodity futures eventually has to roll its position over into the next fund, a hedge fund buying a tanker full of oil or a freighter full of copper ore is tying up part of even higher prices.

Commodities to Play For Maximum Profit

In virtually any market, in terms of which commodities to go for, there are two key factors to consider: genuine industrial demand and speculator interest.

Given current economic backdrop, a third factor must be considered: How quickly can new supplies be brought on stream?

For some commodities – chiefly gold and oil – ramping up on new supplies is a difficult and lengthy process. Gold production has declined by about 2% in the last few years, in spite of rising prices, and most gold ores are in low concentrations – hence ramping up production is very difficult, whatever the price. The same is more or less true for oil, with the added challenge that many of the best potential fields are in countries run by tinpot dictators, who get greedy when the prices rise, and try to push them up further.

At the other extreme, agricultural commodities are unlikely to see much of a bubble – it’s just too easy to farm more land or use better seeds. Price run-ups in agricultural commodities tend to be short-term, caused by bad harvests.

Coal has some upside potential, as does natural gas (to a lesser extent). There is unlikely to be much speculative demand for them, but increasing supply is difficult and demand from China and India is increasing fast.

On balance, the metals are the best bets for upside, together with oil.

U.S. Federal Reserve Chairman Ben Bernanke has said he will keep interest rates around zero “for an extended period.” This fits with his record, which has been consistently to have the lowest interest rates possible while prattling incessantly about non-existent deflation.

With interest rates, the bottom line is that Bernanke is likely to keep them at a low level for far longer than he should. When he eventually does start to raise them, he’ll do so only grudgingly, at first, even as inflation races away. That has to be good for the commodities market.

At some point, this will all reverse. The world’s central bankers will get serious about interest rates, and commodities prices will crash as they did last autumn. However, because the world economy is just staggering out of a deep recession, that’s unlikely to happen before the second half of 2010, and maybe not before the early months of 2011.

So, for at least the first half of the new year, commodities and commodity-related stocks look to provide excellent returns. I’d recommend that individual investors look at the major mining companies involved in metals production, as well as those that mine coal.

Just make sure you use a trailing stop – even a broad one of 30% to 40% – because these stocks are volatile. When the commodities market reverses, it may do so quickly.

[Editor's Note: Commodities plays such as those detailed in today's forecast story are just one type of the "hyper-profitable" investment plays that Martin Hutchinson has uncovered for his Permanent Wealth Investor trading service. There are others - and they're just as potentially lucrative. In a new report, in fact, Hutchinson not only uncovers the very best profit plays available today, he guarantees triple-digit gains. For more information, please click here.]

News and Related Story Links:

• Money Morning Special Report:
  Hedge Funds Take Direct Stakes in Commodities … Should We Be Wary?

• Money Morning News Analysis:
  The Best Ways to Profit From the Growing Pension Fund Crisis.

• Money Morning “Outlook 2010″ Economic Forecast Series:
  Why Gold Will Reach a Record $2,000 in 2010

The Dubai World default is a matter of only $60 billion – mere peanuts when compared to other elements of the global financial crisis. It’s thus of concern only to those silly enough to invest in real estate there (and the European banks foolish enough to finance it.) For the rest of us, it is a useful reminder that sudden collapses don’t really come out of nowhere – they can be foreseen, and smart investors can plan for them.

You see, I did foresee this one, for Money Morning readers – 16 months ago, before the global banking crash. Back in July 2008, I wrote that Dubai’s economy was “more bubble than boom,” that it had “a construction bubble worse than the Florida market and a monetary policy looser than Ben Bernanke’s” and that “its return to earth will be painful and probably not long delayed.”

Let me share with you the signals that flash “red” when a bubble is in progress – and that suggest a crash may well follow. Indeed, you can actually make money in a bubble – if you know what to look for.

Spotting a Bubble

The first sign of a bubble – and the most important thing to consider – is the existence of a major mismatch between the local interest rate and the local inflation rate. If the local long-term interest rate is substantially below the local inflation rate – other than in a really deep depression like one we experienced in the 1930s – then speculation is being subsidized by the financial system.

Take Dubai. Back in July 2008, inflation was 20% and rising. But you could get a home mortgage for 7% per annum. That’s a “real interest rate” of minus 13% per annum.

I don’t think there’s a single market that has had interest rates of negative 10% or lower and not had the market blow up. Britain in 1973 had that problem, and a deep real estate crash followed. Argentina had that problem in 2001 – and the economy collapsed. The German Weimar Republic had that problem in 1919. In that case, the hugely negative real interest rates persisted for four full years.

At the end of that period, Germany ended up with 1 trillion percent inflation – hyperinflation.

A second sign of a bubble is when an economy doesn’t really have much of an underpinning – save for speculation.

The dot-com bubble of 1999 was like that: Even Amazon.com Inc. (Nasdaq: AMZN), and eBay Inc. (Nasdaq: EBAY) – solid and profitable companies now – were loss-making tiddlers back then. And, of course, there were hundreds of other 1999 “success stories” that are no longer with us.

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Likewise, the subprime-mortgage market of 2005 – if one investigated – was fueled by “liar loans” and borrowers with no downpayment and very low “teaser” rates. Lots of people on Wall Street and among the mortgage brokers were making huge amounts of money, but they were selling mortgage products that were often worthless because the borrowers would never be able to repay their debts.

Dubai was like that. It had lots of the characteristics of other “bubble” resort areas – impossibly luxurious hotels, buildings intentionally designed to be the tallest in the world, and floating real estate islands.

At the same time, the Dubai economy had no obvious means of support: There is no oil there, meaning the nation relies on oil revenue from its other partners in the United Arab Emirates (UAE).

Reliable resources don’t have to be tangible, of course: Boston has no oil, but when you go there you can almost hear the throbbing from all the brains in its giant college community; and you can almost feel the money in the New England city’s giant fund-management business. But a big place, with no obvious reason other than real estate speculation for it to grow, will probably eventually crash.

The “Next” Dubai

A bubble can end in a number of ways:

• It can end in an economic collapse and general default, as Dubai has done now or as Argentina did back in 2001.
• It can end in massive hyperinflation, as with Latin America repeatedly in the 1950s through the 1980s and in the Weimar Republic of the 1920s.
• Or it can end in a little bit of both, like Britain in the mid 1970s, where inflation rose to 25% and then gradually came down again. Britain didn’t even have a house price collapse – everybody’s incomes went up more or less with the inflation, and at the end of four years people could afford houses again so prices, which had declined only marginally, started rising once more.

You can make money in a bubble – indeed, it seems a pity not to, when prices zoom up so rapidly. You just have to be clever enough to get out before it bursts. With so much exceptionally cheap money sloshing around the world, there are other bubbles to watch and profit from.

Let’s consider a couple of examples.

India, for one, continues to grow very rapidly – it advanced at an 8.9% clip in the latest quarter. But India has a budget deficit of more than 10% of gross domestic product (GDP) and when money stops being cheap, it will have a tough time.

Commodities and gold are currently in a bubble. Gold – which set yet another record yesterday (Tuesday) – is the classic item for which nothing tangible supports the price. But while money is as cheap as it is, gold will continue its advance.

That means real estate is a lousy bubble investment, because you can’t be sure of selling it when you need to. Stocks and gold, on the other hand, are pretty good profit plays, provided the companies you’re investing in are not too small, so there’s ample liquidity.

But remember, what goes up must come down, and it may do so with a bump. So invest only a modest amount in the next bubble you spot. Otherwise you’ll lose precious capital during the day – and lots of sleep at night.

[Editor's Note: With his July 2008 warning about Dubai, Martin Hutchinson has done it again. Hutchinson also warned Money Morning readers 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 Market Analysis:
  Dubai: More Bubble or More Boom? Time Will Quickly Tell.
• Bloomberg News:
  Dubai Credit Risk Falls Most in 9 Months On Debt Plan.
• Wikipedia:
  Real Interest Rate.
• Money Morning:
  Is it 1932 – or 1923?
• Wikipedia:
  Hyperinflation.
• FreeDictionary.com:
  Tiddler.
• Wikipedia:
  German Weimar Republic.
• Investopedia:
  Liar Loans.
• Wikipedia:
  Inflation in the Weimar Republic of Germany.
• MarketWatch.com:
  Gold futures hit fresh high above $1,200 on weaker dollar.
• Wikipedia:
  United Arab Emirates.

The Shocking New Yield Gap…
And What It Means to Your Wealth

Thank you for registering for this event, airing Tuesday, April 21 at 4:00pm EST

Look in your e-mail for a confirmation and directions on how to attend.

P.S. Martin Hutchinson has uncovered a special group of investments that pay juicy cash sums all year long…starting with $4,201 guaranteed cash by June 4. They’re not income trusts, corporate bonds, or foreign bonds. In fact, remarkably, no one is talking about them. But the deadline to act on these is April 26.

Endless reports in the media have pointed out that this global recession is “worse than anything since the Great Depression.”

To be fair, it’s not even certain yet that this nasty downturn has beaten the mid-1970s downturn, though it probably will. But even if that does happen, by focusing exclusively on the 25% unemployment of the 1930s and the “Grapes of Wrath” Joad family as our inevitable future, we’re ignoring another equally unpleasant potential scenario: The Weimar German hyperinflation of 1923.

The U.S. authorities and those of the G-20 are currently avoiding most of the mistakes that during the period from 1930 to 1932 turned an ordinary recession into the Great Depression. In those years, the U.S. Federal Reserve deflated the money supply by about 30% in real terms. Central bank officials didn’t realize they were doing this; banks kept failing, thus reducing the country’s bank deposits, while the Fed did nothing to offset the money supply shrinkage the bank failures produced.

U.S. President Herbert Hoover raised tariffs via the Smoot-Hawley Tariff Act of 1930, causing world trade to fall by 65%; his huge income tax increase (with the top rate going from 25% to 63%) in 1932 also contributed greatly to the global economic meltdown. All three mistakes have been avoided this time:

• The money supply has expanded rapidly, bringing negative real interest rates almost everywhere except Brazil.
• And fiscal policies have been expansionary and protectionism limited.

The history of the Weimar German inflation was quite different. During World War I, Germany ran moderate inflation, which accelerated in the last year of war and the first years of peace. By 1921, prices in Germany were already 15 times those of 1914.

But it was over the next two years – 1921 to 1923 – that true “Weimar inflation” occurred. By the time it ended in November 1923, the German mark was worth only one-trillionth of what it had been worth back in 1914. The middle classes lost all their savings, but one rich industrialist, Hugo Stinnes, was able though repeated borrowing in rapidly depleting marks to amass an industrial empire that controlled 20% of Germany’s industry.

The German hyperinflation was finally quelled by Chancellor Gustav Stresemann and Reichsbank director Hjalmar Schacht, who in October 1923 announced the replacement of the paper mark by a “Rentenmark” (security mark) worth 1 trillion paper marks and backed by a nominal mortgage over German land assets worth 3.2 billion Rentenmarks.

The mortgage was fictitious, but it created confidence in the Rentenmark and prevented the creation of extra Rentenmarks, so inflation rapidly ceased, while the budget was balanced through so-called “windfall-gains taxes” on debtors whose debts had been extinguished by the previous hyperinflation. Normal business was resumed by Germany, which was able to return to a new gold Reichsmark in July 1924.

Sign up below… and we’ll send you a new investment report for free: “Credit Crisis Report.”

You can debate which was worse, the U.S. Great Depression or the Weimar hyperinflation; there are arguments for both sides. The Great Depression lasted much longer, from 1929 until the United States entered World War II in 1941. On the other hand, the Weimar hyperinflation wiped out the entire savings of the German middle class.

The lack of confidence in the economy, and the overall misery that this produced, meant that the German reaction to the Great Depression that arrived six years later was much more extreme than in the United States – leading to the election in 1933 of Adolf Hitler.

The current policy mix reflects those of Germany during the period between 1919 and 1923.  The Weimar government was unwilling to raise taxes to fund post-war reconstruction and war-reparations payments, and so it ran large budget deficits. It kept interest rates far below inflation, expanding money supply rapidly and raising 50% of government spending through seigniorage (printing money and living off the profits from issuing it).

Even John Maynard Keynes, no monetarist, recognized the problems with this, stating in his 1920 treatise the “Economic Consequences of the Peace” that “the inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance.”

The really chilling parallel is that the United States, Britain and Japan have now taken to funding their budget deficits through seigniorage. In the United States, the Fed is buying $300 billion worth of U.S. Treasury bonds (T-bonds) over a six-month period, a rate of $600 billion per annum, 15% of federal spending of $4 trillion. In Britain, the Bank of England (BOE) is buying 75 billion pounds of gilts over three months. That’s 300 billion pounds per annum, 65% of British government spending of 454 billion pounds. Thus, while the United States is approaching Weimar German policy (50% of spending) quite rapidly, Britain has already overtaken it!

U.S. authorities probably won’t pursue expansionary monetary policies with quite the dogged Germanic persistence that caused the mark to fall to one trillionth of its former value. However, the turnaround needed to stop a Weimar repetition will be very unpleasant, so there will undoubtedly be considerable denial and fudging of the figures as inflation begins to take off (especially if Ben S. “Drop Money From Helicopters” Bernanke is still serving as the head of the U.S. central bank).

As investors, we need to ensure that our money is safe from the inflationist onslaught. Our portfolio should thus currently contain no bonds – even Treasury Inflation Protected Securities (TIPS) are linked to the U.S. consumer price index (CPI), which has been fiddled before and will be again, so will not provide true inflation protection.

Only gold will play its traditional role as a protector of savings against inflationary onslaught. Once policymakers get serious, gold prices will drop, as inflation risks recede. But before that gold prices are likely to shoot much higher, perhaps beyond their 1980 peak of $2,300 in today’s dollars. You have to remember that gold is a thin market, with only $100 billion mined annually, so a surge of hedge funds into the gold market could move the price very quickly indeed.

Two avenues into gold should be attractive, the SPDR Gold Shares ETF (GLD) which invests in gold directly and the more financially solid gold mining companies, such as Barrick Gold Corp. (ABX) and Yamana Gold Inc. (AUY). Since gold has fallen back recently to below $900 an ounce, it may be a good time to buy.

[Editor's Note: When it comes to banking or global economics, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. Fans and followers of Hutchinson's work will soon be able to subscribe to a new product - The Permanent Wealth Investor - that will feature more of his expertise. Watch for The Permanent Wealth Investor to debut in the next week.]

News and Related Story Links:

• Bank of England:
  Official Web Site.
• Wikipedia:
  Hyperinflation.
• Time:
  John Maynard Keynes.
• Wikipedia:
  Weimar German Hyperinflation.
• Bureau of Labor Statistics:
  Consumer Price Index.
• Wikipedia:
  Great Depression.
• Whitehouse.gov:
  Herbert Hoover.
• Wikipedia:
  Smoot-Hawley Tariff Act of 1930.
• Taki’s Magazine:
  Money for Nothing; Ben Bernanke Wants to Throw Money Out of Helicopters.
• Wikipedia:
  Hugo Stinnes.
• Investopedia:
  U.S. Treasury bonds.
• Wikipedia:
  Rentenmark.
• Money Morning Investment Analysis:
  If You Want to Use “TIPS” to Beat Inflation, Follow These Tips.
• Wikipedia:
  Germany’s World War I War-Reparations Payments.
• Investopedia:
  Seigniorage.
• TreasuryDirect.gov:
  Treasury Inflation-Protected Securities (TIPS).

Chilean President Michelle Bachelet rebuked British Prime Minister Gordon Brown last weekend, saying the British economy would have more room for fiscal stimulus now if he had pursued responsible budget policies previously, as Chile has.

It makes you sit up and take notice when you see a Latin American political leader rebuking a British one for financial irresponsibility, but in this case, Bachelet was completely justified. Great Britain, even more so than the United States, was running big budget deficits well before the crash hit.

Meanwhile, Chile prepared for a downturn far better than either Britain or the United States, and is in a correspondingly better position now.

Chile was the first Latin American economy in living memory to implement the free market properly under its dictator-president Augusto Pinochet (1973-90), who early in his rule decided that socialism didn’t work and hired a bunch of advisors from the University of Chicago.

Pinochet privatized Chile’s major companies, and in 1982, Chile became the first country to privatize its social security system. Chile’s democratic governments after 1990 dismantled most of Pinochet’s security apparatus, but they kept a lot of his economic policies, and so Chile has remained notably well run economically.

Bachelet was elected in 2006, on a social democratic platform, and politically has devoted a considerable amount of effort to removing the last vestiges of Pinochet’s rule. However, economically, her rule has been sound with moderate budget deficits and a solid monetary policy.

Most importantly, she realized that copper, Chile’s main export, is highly cyclical. Thus, in the last few years the country has built up an Economic and Social Stabilization Fund, to which copper revenues are committed when prices are high. By January 2009, that fund was worth $19.5 billion, or 10.5% of Gross Domestic Product (GDP). Therefore, Chile’s recent fiscal stimulus of about 2.5% of GDP has been easily affordable.

Chile’s economy grew by 4% to 5% annually during the boom years, respectable but not spectacular. The Chilean economy is expected to grow just 0.4% in 2009, but to rebound to 2.3% growth in 2010, according to the Economist forecasting panel. By the standards of the current miserable world, that’s very good indeed.

Inflation is expected to run at a rate of 3.7% in 2009, and the budget deficit (after stimulus) is expected to reach just 3.5% of GDP. The currency has already dropped, by 23% against the dollar in the last year. Chile’s stock market is down 30% from its October 2007 peak. But because of the country’s relative stability, the market is still not especially cheap, trading at 12.2 times earnings compared to 11.0 times on the Standard & Poor’s 500 Index.

With solid economic performance and little risk of further nasty surprises, Chile seems well worth looking at. What’s more, is there are over a dozen Chilean American Depository Receipt (ADR) issues with full quotation on the New York Stock Exchange

As a small country, Chile has always tried to be as open as possible to foreign investment capital. Some of the most attractive companies include:

• CorpBanca (ADR: BCA): Only Chile’s fifth-largest bank, but it’s most consistently profitable. Trades at 8.5 times earnings currently, but has a dividend yield of 7.8%. Most Chilean banks suffered in the last quarter of 2008 because of the peso’s decline against the dollar, but CorpBanca was properly hedged and avoided this problem.

• Lan Airlines S.A. (ADR: LFL): Normally I’d suggest you were mad to invest in an airline (a business that has lost money worldwide over the entire 106 years since the Wright Brothers took off). However Chile’s long thin shape, remoteness and abundance of mountains make air travel both within the country and internationally a profitable business. LFL is currently on a P/E ratio of 9 times with a 14.8% dividend yield. Not a “widows and orphans” stock but well worth a little investment for the adventurous.

• Madeco SA (ADR: MAD): Manufactures all kinds of household goods and other products based on copper, aluminum and other non-ferrous alloys. Madeco had a special gain in 2008, so its annual earnings were artificially high. But it currently trades at about 6 times 2007 earnings and 40% of book value, with over $200 million in cash. Basically, this is a deep-value asset play.

• Vina Concha y Toro S.A. (ADR: VCO): I can’t help it. I like the product – Chile’s largest wine producer. Chile was the only country in the world whose grapes were not infected by the Great Phylloxera Blight of 1873. Wine snobs therefore claim that Chilean wines, being made with pre-Blight grapes, are the best in the world. The market seems to buy this sales pitch, since the stock trades at 19.6 times earnings with a 0.8% dividend yield, distinctly pricey in these markets. Still, if you don’t buy the stock you should at least try the wine!

News and Related Story Links:

• Money Morning:
  Has Anybody Seen the Bottom Yet?

• Money Morning:
  The Five Most Promising Emerging Market ETFs for 2009

• Chilean Government:
  Michelle Bachelet

• Wikipedia:
  Augusto Pinochet

U.S. President Barack Obama’s firing of General Motors Corp. (GM) Chief Executive Officer G. Richard Wagoner Jr. may be the beginning of the final act of a long and sad drama – the slow death of GM. The company nameplate may soldier on in some form, but it seems increasingly likely that unless Ford Motor Co. (F) can forever avoid government intervention, the once-unique capabilities of the U.S. automotive industry will be forever lost.

In 1970, GM had nearly 60% of the U.S. automobile market, and imports’ share was below 10%. Today GM’s market share is little more than 20%, and imports and domestically produced automobiles of foreign brands) dominate the market.

There are three reasons for GM’s decline, none of them easily reversible:

The first is notorious – GM has a major cost disadvantage: When foreign automakers had no automobile factories on U.S. soil, GM could – and did – allow the United Auto Workers (UAW) union to ramp up costs ad infinitum. Any cost disadvantage that GM thereby acquired compared to foreign brands produced in cheaper-labor economies could be overcome through careful lobbying to provide barriers against excessive imports.

However, the arrival and establishment of foreign-owned manufacturers in America’s less-unionized states – combined with the inexorable aging of GM’s former and current work force, which greatly increased the U.S. automaker’s health and pension costs – shackled GM with an impossible cost disadvantage against its competitors. Some of that disadvantage is now being slowly negotiated away, but without a GM bankruptcy it seems most unlikely that the company’s costs can be brought down to competitive levels.

Second, GM has been bedeviled by government regulation: One great example is the Corporate Average Fuel Economy (CAFÉ) standards introduced in 1975. As a specialist in the traditional large cars that the U.S.-consuming public favored, GM was badly affected by the CAFÉ standards that, by mandating average fuel economy ratings for the entire fleet, enormously benefited Japanese and other makers that specialized in small cars. Eventually, GM and the other U.S. manufacturers found a loophole, and developed the sports utility vehicle (SUV) that, being based on a truck chassis, was not subject to the CAFÉ restrictions. By the time Chrysler, Ford and GM made that discovery, however, the damage – in terms of market share – had been done.

A further round of tighter CAFE restrictions introduced in 2007, this time including SUVs, has once again imposed gigantic development costs on GM, making its entire product range obsolete. A moderate gasoline tax, particularly one introduced over a lengthy period, would have been far less disruptive to the market, and to GM’s operations. It would also probably have achieved rather more in terms of fuel economy and combating global warming. “Cap-and-trade” regulations, as proposed by the Obama administration, will further increase GM’s costs, providing the biggest relative benefits to manufacturers in such low-wage countries as China and India that are not subject to such impositions.

However, the principal threat to GM’s competitive position, one which Wagoner’s departure will intensify, is the “culture war” between the upscale bi-coastal opinion formers and the general U.S. public: In 1970, the standard upscale car for all but the very rich was a Cadillac, a Lincoln, or a Chrysler Imperial. This was as true in New York as it was in Detroit or Dallas; only a small minority of consumers bought top-of-the-line foreign cars, generally with academic pretensions. Equally, for the upper-middle bracket, Buick or Mercury was the choice of the vast majority.

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Today on the East and West coasts, consumer tastes are very different. Saloon Cadillacs and Lincolns are rare; the upscale driver generally chooses a Mercedes, BMW or Lexus. Only among those with families (such as the Obamas) is a large SUV sometimes chosen, although generally an imported one. Buick now sells far more cars in China than in the United States; the traditional Buick or Mercury driver on the East or West coast has migrated almost entirely to import models. Before his presidency, then-Sen. Obama himself drove a Chrysler 300C followed by a Ford Escape hybrid, but one has to guess that his choice of U.S. vehicles was strongly influenced by his political ambitions.

This preference for foreign automobiles is reflected in the media commentary (media bigwigs being almost entirely upscale and bi-coastal). GM and other U.S. manufacturers are persistently accused of “poor management,” although there is little or no evidence given, or discussion of what they might have done better.

Objectively, GM and Ford products perform extremely well in quality surveys, and represent much better value for money than most imported brands, yet without support from opinion-formers they are terminally unfashionable, with the upscale models destined to sell relatively poorly except between Pittsburgh and Boise. Even technological breakthroughs like the Chevy Volt electric car seem unlikely to change this.

President Obama’s decision to get rid of Wagoner reflects this attitude. His announcement was full of denunciations of poor management, with no acknowledgement that overblown union contracts are GM’s No. 1 problem (at least, the No. 1 problem that there is any possibility of solving in the short term). There appears to be little recognition in the Obama administration as a whole that recalcitrant unions and media-induced disdain for GM’s product range were far more important causes of GM’s decline than any shortcomings in Wagoner’s management moves.

Over his eight years as GM’s CEO, Wagoner has done about as well as he could have. He has overseen a considerable and successful restructuring of GM’s operations, together with an extraordinary success story in the Chinese market, where GM has emerged as one of the leading competitors in the world’s fastest-growing car market.

With the Obama administration overseeing GM’s operations, the company will move towards producing the cars that opinion formers want it to produce: cramped, dangerous and uncomfortable, but fuel-efficient or powered by subsidized energy sources. However, the “New GM” will reap little reward for its docility; unless it files for Chapter 11 bankruptcy, it still will have excessive costs, and it will find itself competing in a market crowded with foreign producers, but containing only a minority of the U.S. consuming public.

This is bad news for consumers between Pittsburgh and Boise, and for those on the coasts seeking low-cost, high-comfort transportation, but possibly very good news for Ford, if it can somehow avoid being caught in the government maw. If GM is emasculated by the government and Chrysler is downsized and sold to the small-car-oriented Fiat, Ford will have a huge market to itself, that of U.S. consumers wanting traditional U.S. automotive qualities.

Wagoner doubtless now wishes that in December he had chosen a GM bankruptcy over government aid. In the long run, the U.S. car-consuming public, its automobile industry and the U.S. economy (let alone U.S. taxpayers) may come to share that view.

In closing, let me offer a personal note of disclosure – and a final thought: Being “bi-coastal” but determinedly not “upscale” I drive an ancient Buick.

It’s a wonderful car …

[Editor's Note: When it comes to banking, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. Fans and followers of Hutchinson's work will soon be able to subscribe to a new product that focuses on income investing that will feature more of his - insights and essays. Watch for that to debut in the next two weeks.

For a news/analysis story on General Motor's failure to land federal bailout aid that appears elsewhere in today's issue of Money Morning, please click here.]

News and Related Story Links:

• Money Morning News Analysis:
  CEOs of GM, Peugeot Lose Their Jobs as a Result of Auto Industry’s Great “Global Glut”.
• Wikipedia:
  Corporate Average Fuel Economy.
• Money Morning Election 2008 Investment Research:
  How Investors Can Find ‘Obamanomics’ Profit Plays.
• Wikipedia:
  Chrysler Imperial.
• Money Morning Market Analysis:
  The View From China: Despite the Auto Industry’s Pedal-to-the-Metal Growth, a Safety Play May Offer the Safest Play.
• Money Morning:
  Car Companies Target Customers (And Each Other) in Hotly Contested Asia Battleground.
• Money Morning:
  With an ‘Icky’ First Half for U.S. Vehicle Sales, Toyota and GM Bank on China to Supercharge Sales Growth.

Anyone who has ever visited Japan knows it to be a country where everything works beautifully – and with great efficiency. Right now, however, it’s clear that something has gone horribly wrong there.

Japan’s exports for February were down a shocking 49.4% on a year-over-year basis. The Japanese economy suffered a fourth-quarter decline of 3.2% – twice the decline of its U.S. counterpart – and is expected to drop by a similar amount during the current quarter.

What went wrong? And, for us investors, are the low current prices of Japanese stocks a buying opportunity or a trap?

Partly because of its efficiency and my fondness for sushi, I have always been inclined to favor Japan and Japanese investments. In 1989, it was obvious that the market was overvalued and I said so – in the process alienating several of my friends who thought they had found safe career niches managing investment funds investing in Japan.

In the 1990s, it was obvious that whatever Japanese governments were doing didn’t work, so I welcomed the 2001 arrival of Junichiro Koizumi as prime minister, and from there wrote frequently about Japan’s growth prospects – until last year.

Until August last year, it looked as though I would be right in the long run, even if the Japanese stock market tended to droop. Since September, however, it has all gone wrong; Japan’s economic performance has gone from adequate to truly dreadful.

Pinpointing the date enables us to pinpoint the reason. In September, Japanese Prime Minister Yasuo Fukuda, who had supported Koizumi’s policy of public-spending restraint, resigned and was succeeded by Taro Aso, still of the long-governing Liberal Democrat Party (but from its opposing faction). Aso is an enthusiastic proponent of “stimulus” public spending programs, particularly on public works in rural constituencies. That’s the policy that notably failed to conquer recessionary conditions in the 1990s, leaving Japan with a public debt equal to 160% of gross domestic product (GDP).

Aso has already proposed four stimulus programs, raising Japan’s budget deficit from 3% of GDP in 2007-2008 to an estimated 11% of GDP in 2009-10. The public debt/GDP ratio is rocketing upwards, because of public borrowing and the decline in GDP. Interest rates, which had been rising gently towards normal levels in 2006-08 (though short-term rates had only reached 0.5%), have been reduced to zero again and the Bank of Japan (BOJ) has begun “quantitative easing” – buying up government debt.

Currently, there’s a general agreement among Western politicians that these are the policies to follow. So why haven’t they worked in Japan?

At this point, the London merchant banker in me is irresistibly tempted to snarl: “Because they don’t (expletive-deleted) work in general.”

My own preference is for balanced budgets, low public spending and high interest rates – you may not get much economic growth with those policies, but what you get you’ve earned – without burdening your grandchildren. Even now, some countries – such as Brazil – are following those policies, and doing quite well.

Setting aside the question of whether stimulative policies work in general – within a year or so we shall have tested them exhaustively in the United States and most of the western world – I do think there may be reasons why they work particularly badly in Japan. Japan has traditionally had very high savings rates; it still has a limited Social Security system and an aging population. Low interest rates may well therefore damage demand from consumers living off savings more than they boost demand by helping companies and other borrowers. While low interest rates boost exporting companies, that boost may simply raise the yen exchange rate to a level at which in a recession exports fall catastrophically.

As for budget deficits of 11% of GDP, if you already have a public debt in excess of 160% of GDP, you may well be at the point at which the extra debt and the uncertainty about how you are going to pay it all back eliminate any boost to demand that the budget deficits would normally bring.

It is thus clear that Aso’s policies will work less well in Japan than they would elsewhere. Indeed, they may make matters worse in Japan, even if they would be effective in some other countries.

Japanese voters will have a chance to choose something different at a Diet election due in September or before. The bad news is that, while the opposition Democratic Party of Japan is theoretically pro-market, its leader, Ichiro Ozawa, in practice is a former LDP stalwart, of the faction founded by 1970s’ kingpin Kakuei Tanaka that favored heavy public spending.

Furthermore, many of Ozawa’s supporters, from the former Social Democrat party, also favor heavy public spending, albeit on different things than the LDP barons. In other words, an Ozawa victory may not bring much of a policy change, at least on economics. What’s more, Ozawa himself has now been caught up in a campaign-fund scandal, so even though Aso’s popularity ratings are down to around 10%, the LDP still may win – which would boost Aso at the expense of the free-market Koizumi supporters.

The bottom line: In the election this year, if the Japanese people want the economic policies that seem to work, they will have to be damn clever about it. There are many supporters of free-market policies in both the LDP and the DPJ, but they are not currently represented among the leadership of either party.

Japan remains a country in which everything works beautifully – except the politics. But the country is still worth keeping an eye on, though, because if the politics change, the potential from a Japan with higher interest rates and lower public spending is absolutely gigantic.

[Editor's Note: When it comes to banking, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.

Experiences such as this have imbued Hutchinson with special insights in such areas as banking, the financial markets and fixed-income investing. Just last month, the financial Web site Seeking Alpha named Hutchinson to its "leader board" because of his quickly developing online following. And, in Money Morning, Hutchinson cut through the controversy about the health of the U.S. banking system, analyzed the Top 12 U.S. banks, and told readers which ones were "Zombies" and which ones were "Gems." The article was one Money Morning's most popular pieces of the New Year [If you missed the story, please click here to check it out. The report is free of charge].

Fans and followers of Hutchinson’s work will soon be able to subscribe to a new product that focuses on income investing that will feature more of his – insights and essays. That should debut in about a month or so.

Hutchinson also writes regularly for our monthly newsletter, The Money Map Report, in which he and other Money Morning colleagues also make investment recommendations for subscribers. To find out more about The Money Map Report – including a special offer that includes The New York Times bestseller, “Crash Proof” – please click here.]

For lawmakers who believe that 90% tax rates would be an effective way of punishing the financial malefactors who continue to flourish as the rest of us founder, take careful note: Not only will you punish the innocent as well as the guilty, you could also extinguish the innovative spark we’ll need to eventually make this moribund economy catch fire.

The U.S. House of Representatives voted Thursday to impose a tax rate of 90% on bonuses earned by wage earners of $250,000 or more who are working at banks that received more than $5 billion from the Troubled Assets Relief Program (TARP). The Senate is expected to vote this week on similar legislation, possibly extending the tax to institutions that have received more than $100 million under TARP.

OK, we get it guys: You don’t like American International Group Inc (AIG).

Still, unless you just like 90% tax rates (probably true of about half the House Democratic caucus), you are punishing the innocent along with the guilty. Banks like Wells Fargo & Co. (WFC) and U.S. Bancorp (USB) have received more than $5 billion from TARP, but have yet to record a net annual loss.

The Saga of a (Highly Taxed) British Banker

For those who think taxing the rich at 90% may seem like a good idea, I can give you some practical experience of what happens when you do. Anyone who has paid a 90% tax in the United States is both quite old and quite rich – under the 1954 code, repealed in 1964, you had to be earning over $200,000 to pay tax at 90%, real money in those days, equivalent to over $1.5 million now. However, in Britain, 90% income tax rates lasted until 1979, and kicked in at 20,000 pounds, about $150,000 today. I never quite made that much, being in my 20s then, but I was paying 75% marginally, and it made a HUGE difference to my lifestyle and to those of my fellow bankers.

So, apart from making me feel poor, what did the high marginal rate do for me, as a young merchant banker?

Well, for a start, there were none of these 90-hour weeks you hear about on Wall Street. What the hell would have been the point? We got to the office each morning around 9:45 – not 6 a.m. – and we left at 6 p.m. (5:15 was the “official” quitting time, but we wanted to appear as keen up-and-comers, and figured the extra 45 minutes each day was time well spent).

Our workday was over, but we weren’t exhausted: Every evening, in fact, I’d catch a bus to the British Museum Reading Room, which was open until 9 p.m., and get two-and-a-half hours of work done on my book about great conservatives in British history. Had the book been a best seller (it took me 25 years to find a publisher … although it did get wonderful reviews), the 90% tax rate might have been justified, I suppose, but modest sales was what I saw.

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Then there was lunch. Don’t think now of the quick sandwich at the desk, or even the half-hour at the gym. When merchant bankers did lunch, they did it properly.  All banks had in-house dining rooms, where the food was of excellent quality and the wine was superb. You had to invite a client, of course, but there was no requirement that you ever actually did any business with that client, although usually one would spent five or 10 minutes over a very nice port, discussing the market – just in case.

Some of my colleagues found the wine so superb they were quite incapable of rational thought afterwards … but that’s why lunch started at 1 p.m., and not noon, so the firm got at least an hour or two out of them beforehand. Personally, I loved the haute cuisine, which is why I am the shape I am today – do you think I could sue?

The best lunches were the ones where I got Sir John Colville, one of our directors, to host – he had been Winston Churchill’s private secretary, and as soon as the main course was served and the wine poured, he would begin: “When Winston and I were at Casablanca …”

Lucky if you were back at your desk by 4.30 in the afternoon on those days, I can tell you – but it was worth it.

So if Congress wants to make bankers pay taxes at 90%, that’s what they’ll get: Lots of very good lunches, but not many deals. The bankers will be more dyspeptic, and the economy will be poorer, but what the hell: Civilized conversation and an in-depth knowledge of the better claret vintages will once again be the order of the day on Wall Street.

Why Not Spread the Pain?

It does, however, seem more than a little unfair to restrict the benefits of the 90% tax rate to bankers alone. We could, for example, extend it to members of the U.S. House of Representatives and the U.S. Senate. This wouldn’t be, heaven forbid, on the salaries they earn as congressman and senators – the American public needs their finest efforts during that period. Instead, this new tax rate would levied on the period up through 10 years after they retire from Congress, on the lobbying income they pick up as “beltway bandits.” And here it’s clearly a case of addition by subtraction: The less productivity we get from lobbyists, the better off the country will be.

You could also extend the 90% tax rate to U.S. Treasury Secretary Timothy F. Geithner: Why should he not get the full joy of paying the taxes he imposes (and there’ll be no forgetting about those tax payments this time around, Mr. Treasury Secretary!).

U.S. Federal Reserve Chairman Ben S. Bernanke could pay those higher taxes, too. And if that made him less eager to continue inflating the money supply after his current term ends in January 2010, well, everything has a downside!

Even President Barack Obama might enjoy them. Again, not on his presidential salary – but he’s such a magnificent speaker, and so young, that you have to believe he will break all records for speaking fees once he leaves the White House. Indeed, 90% of his post-presidential earnings for a decade-long stretch might even make a noticeable dent in the budget deficits he will leave us.

So there you have it – a look at what the world might be like with 90% tax rates. If Congress goes ahead and implements them, I have an obvious stock tip, too: Put your money in one of the new tax havens, where relatively low taxes attract investment and entrepreneurship from all over the world – including such global economic powerhouses as France or Sweden!

[Editor's Note: When it comes to banking, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.

Experiences such as this have imbued Hutchinson with special insights in such areas as banking, the financial markets and fixed-income investing. Just last month, the financial Web site Seeking Alpha named Hutchinson to its "leader board" because of his quickly developing online following. And, in Money Morning, Hutchinson cut through the controversy about the health of the U.S. banking system, analyzed the Top 12 U.S. banks, and told readers which ones were "Zombies" and which ones were "Gems." The article was one Money Morning's most popular pieces of the New Year [If you missed the story, please click here to check it out. The report is free of charge].

Fans and followers of Hutchinson’s work will soon be able to subscribe to a new product that focuses on income investing that will feature more of his – insights and essays. That should debut in about a month or so.

Hutchinson also writes regularly for our monthly newsletter, The Money Map Report, in which he and other Money Morning colleagues also make investment recommendations for subscribers. To find out more about The Money Map Report – including a special offer that includes The New York Times bestseller, “Crash Proof” – please click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Timothy Geithner, Career Finance Official, is Obama’s Nominee for Treasury Secretary.
• Academica Press LLC:
  The Great Conservatives.
• The New York Times:
  Sir John Colville, 72, Secretary to Churchill.
• Money Morning News Analysis:
  Could Tax Problems Trip up the Confirmation of the Best Candidate for Treasury Secretary?
• Wikipedia:
  Sir John Colville.
• Money Morning Special Banking Rankings Report:
  The Top 12 U.S. Banks: From Zombies to Hidden Gems.