This graphic from Stratfor just about sums up Europe's dilemma. Or should that read Germany's dilemma. As a student of German history I've long believed Germany was the key to the course of European history. But who would have imagined that to unfold to this extent? And who will exploit this crisis most? China? Russia?

Frank says "he is concerned that the process is undemocratic because the regional Fed presidents are not elected or appointed by elected representatives, and he believes that regional Fed presidents are overly likely to focus on guarding against inflation at the expense of more adequately tackling the country's unemployment crisis." (US News and World Report)

Basically, he wants the Fed to be subservient to the politicians. Under his proposal, the FOMC could lose what independence it has in a short time. This is part of a strain of thought that suggests that the decisions that affect all of us should be made by a few elite people who purport to understand what is going on, which coincidentally are government insiders and the academics who foster their agendas.

How did Weimar and other hyperinflation incidents occur? When power was in the hands of a few well-intentioned elites who did not understand the long-term consequences, or were acting in self-interest without transparency or any check on their decisions. The Fed is designed to be a system of checks and balances, with no one president getting to appoint all the governors (they have 14-year terms), in order to try to remove the process as much as possible from political interference. That does not mean they will make the right decisions, but in this I agree with the alarmists: history suggests that without some constraint (gold standards as an example) hyperinflations may occur."

Students of history will understand that we Americans make a lot of our economic decisions with a great sensitivity to the trauma of the Great Depression. Germans, on the other hand, have a a tremendous sensitivity to unemployment and hyperinflation. Governments are historically fond of inflating their way out of debt problems. This also amounts to a confiscation of wealth from private citizens! Citizens....resurrectio!

So how have economies historical "righted" themselves from debt levels of this magnitude? There have been three primary elements:

1. High Growth

2. High Inflation

3. Financial Repression

High growth is, I think, self-explanatory. And while that is true, policy makers seem befuddled as to precisely what steps to take in order to achieve such growth. In the U.S., we appear to be in a tug of war between "government does it best" advocates and "the private sector does it best" advocates. I suspect that means a blend of the two is what is needed.

High inflation is also self-explanatory. The U.S. government tells us we don't have meaningful inflation in our economy. Can I see a show of hands of those who think otherwise? I thought so!

Financial repression is, I believe, the least understood of the three paths to debt salvation. Wikipedia defines financial repression as "a term used to describe several measures which governments employ to channel funds to themselves which in a deregulated market would go elsewhere." I highly recommend a quick read of the Wikipedia entry as financial repression is certainly underway as defined there.

On a more basic level, financial repression will punish savers. Case in point, if you've been fiscally responsible and saved over the years, what are your fixed income options today? What rates are being offered? Are the real rates a positive return after taxes and inflation? One of the key tools of financial repression is explicit capping of interest rates on government debt. Didn't the Federal Reserve announce just last week that they would be keeping rates low for the next two years? That certainly sounds like interest rate control to me.

Financial repression is simply another form of taxation without the political heat. I fear this will be a feature of our economy for many years to come and investors should prepare themselves for this. I believe a cornerstone strategy for any portfolio should be to seek higher interest rates in private debt markets with instruments backed by real assets as an inflation hedge.

Last week's wild market ride sparked more than one conversation about not only recent market action, but the markets and returns since this bear market cycle began in 2000. Watching gut-wrenching declines, punctuated by seemingly strong rebounds, only to be followed by more steep declines, prompted me to visit one of my favorite risk management topics: the importance of minimizing losses when investing.

"In order to make money, you must first not lose money" George Soros

No matter your investment style or approach, being mindful of what's referred to as "drawdowns from peak" is very important That's a fancy way of saying losing money relative to how much your portfolio has grown to over time. 

Say your portfolio started at $100,000, grew to $500,000 then subsequently declined to $300,000. Are you up $200,000 or down $200,000? When examined from the perspective of drawdown from peak, you're down $200,000. I prefer this method of determing progress in wealth management.

"You cannot get ahead while you are getting even." Dick Armey

After steep market declines, investors often underestimate what it takes just to get back to even. The following chart illustrates how advances required to get back to even grow geometrically as it relates to losses:

The periodic deep declines in the S&P 500 since the beginning of this secular bear market, which I believe began in 2000, have challenged investors to stay the course and certainly required iron nerves to give their portfolios the opportunity to get to "even." So how has that worked out?

From January 1, 2000 through today, it's been quite a harrowing ride to be invested in the S&P 500. The statistics below show just how frustrating the experience has been. Choose your method for risk management and stick to your discipline!

1. Term limits: 12 years for all members of congress.
2. Balanced budget
3. Line Item Veto for the President
4. A 2/3 majority of states required to raise the debt ceiling.
5. The ability to repeal an act of congress with 2/3 of states' approval

He went on to say that of the two methods provided for in the US constitution to enact amendments, only one has ever been used. The second, an article 5 convention, should, in his opinion, be called for. Such a convention would allow the states, with a 3/4 majority to propose and approve the five amendments listed above.

Great outside the box thinking and kudos to Senator Wentworth.

To be sure, we have plenty of challenges in the US economy:

1. GDP growth reduced to near 0%
2. negative real consumer spending the past two quarters
3. the economy flirting with a double dip recession
4. an S&P downgrade of the U.S. credit rating
5. weak national housing market
6. weak consumer balance sheets (too much debt)
7. weak construction demand (a key driver in most recoveries)
8. unemployment above 9%.

And that's just the US! Add Europe's woes to the picture, which many contend are far worse, and, well, you get the picture! The result has been panic type moves based on investor fear that unfolds as they witness political leadership which looks dysfunctional.

But there are four good reasons to not panic and sell, and perhaps some great reasons to consider increasing equity exposure in portfolios:

1. Valuations. US corporations are putting up great earnings numbers and have exceptionally strong balance sheets even relative to better economic times. There are many ways to value markets, P/E ratios etc. Do your homework and decide if you think US stocks represent a great buying opportunity.
2. Emerging markets. Rapidly growing emerging economies are also a big part of the US corporate profit picture. We're players globally, not just at home.
3. Deleveraging. The process that began in 2008 continues and household balance sheets are in fact improving. Yes, more progress is needed but progress has occurred!
4. Housing. Working off excess housing inventory remains a challenge, but affordability of housing is at an all time high. New permits are running at half the household formation numbers indicating absorption of housing at a decent clip. If we can just get the jobs engine going, a real improvement could be just ahead.

I'll add one final observation drawn from years of personal experience observing and trading markets. Check your own pulse. If you're anxious and nervous, others likely are too. It can pay handsomely to do the exact opposite of what you FEEL like doing. As John Templeton once said, the best time to buy is when there's blood in the streets.

Perhaps this time it IS different. Perhaps we have capital markets pushing politicians to craft real solutions and to do what's needed to get the US economy back on track and headed in the right direction!

Jonathon Avidor of the Northwestern University School of Law and the Kellogg School of Management recently published a timely paper that contained a thorough survey of the leading academic ideas regarding preconditions for encouraging innovation in a nation's economy  by examining the preconditions for Israeli innovation over a 30 year period. His review considered: public R&D grants, human capital acquisition, intellectual property rights, financial reforms, venture capital policy and cultural factors.

The paper also lends fresh empirical support to the notion that these factors can be emulated and distinguished by other governments and organizations (ie. deliberate policy-making or responses to market indicators) and can be distinguished from those which resulted from historical chance (ie. luck). Key public policy lessons and limitations of innovation policy were also discussed.

I'll summarize the conclusions of the paper as follows:

The emergence of an innovation economy requires proper alignment of key factors:

1. economic incentives,

2. access to financial capital,

3. skilled human capital, and

4. unrestricted access to information.

And here's a key point: "Over a 30 year period, Israel created or acquired these necessary building blocks through a combination of focused R&D policies, immigration dynamics, robust education and military training infrastructure, financial reforms, venture capital policy and cultural factors."

Further: "...intelligent policy-making in pursuit of strategic objectives and responses to market conditions combined to play a crucial role in combating market failures and promoting innovation. As a result, important lessons can be learned from the Israeli experience in acquiring each of the four required factors for building an innovation economy."

Israel created proper economic incentives for innovation by: 

1. reducing the cost of capital through financial reforms and direct R&D support, leading to an increase in the expected value of innovation to inventors; 
2. increasing the appropriability of inventions by strengthening local intellectual property protections and foreign reciprocity, effectively increasing the expected value of innovation to inventors; and 
3. increasing the probability of success by providing resources for new entrepreneurs, further increasing the expected value of innovation to inventors.  

Israel developed adequate access to financial capital by:

1. providing direct R&D grants to industry in a horizontal and neutral, market-led fashion in order to bridge the funding gap caused by information asymmetries, leading to the development of a critical mass of technological advancements and startups; and
2. building a venture capital industry to provide growth capital and management expertise for startups which have reached the marketing/growth stage.

Israel acquired and developed sufficient human capital by: 

1. building a large network of academic institutions that were responsive to industrial needs; 
2. encouraging immigration of skilled engineers and scientists to increase the pool of qualified innovators (perhaps benefitting from a bit of historical luck);
3. and facilitating an efficient military-civilian transfer of skills and know-how.

And finally, Israel provided adequate access to information by: 

1. sponsoring knowledge intermediaries, conferences, consortiums between industry and academia, foreign participation in pre-competitive knowledge generation and comprehensive databases with shared information; and 
2. facilitating an efficient military-civilian transfer of knowledge and technological progress.

1. Non-correlation to stock and bond markets

Non-correlation simply refers to the fact that real estate does not fluctuate in value in tandem with stock and bond markets. True, bond yield movements (an inverse relationship to price) can impact real estate prices as they provide benchmarks for bank lending rates. However, there is not a 1:1 correlation to those markets and this is where commercial real estate can provide enhanced diversification as an alternative asset class. It can provide a hedge against declining asset prices and represents a longer term "support" to capital values.

2. Income

Businesses and retail tenants can generate income for you from leases. After operational expenses and the mortgage are paid, there hopefully is residual cash flow to you, the owner.

3. Depreciation

Depreciation represents a tax write-off of some or all of your income which reduces your overall income tax burden.

4. Equity Growth

As your mortgage balance is reduced, this represents an accumulation of equity for you. The tenants in your property pay down your loan for you.

5. Appreciation

Overall appreciation of your property occurs as rental income goes up, as the market assigns a highler value to your property income and as the value of the land goes up. Particularly in an inflationary environment, commercial property can provide an excellent hedge as rental income will rise with inflation.

6. Leverage

Although bank credit is tough to access in today's market, traditionally leverage means you can borrow a substantial amount of your purchase price to buy the property. Leverage allows you to control a large property for a small percentage of the value. For example, if you buy a property for $4, you may borrow $3 and add $1 of your own. If the value of the property goes up to $5 (a 25% increase,) and you sell it, $3 goes to the bank and $2 goes to you. That's a 100% rate of return to you on a 25% increase in value of the underlying property. That's a very simplistic example...but you get the point!

Consider commercial real estate as an alternative asset class to stock and bond markets. It can be a valuable component of your overall asset allocation strategy.

-Ben Bernanke, April 27, 2011

Those of us buying screws, nails, sheetrock and other primary construction materials know that the "additional inflation risk" has already come to roost. I believe inflation is being significantly under reported and maintain that of the three options to attack the Federal deficit, raising taxes, cutting spending or inflating our way out of the problem, our leadership will choose inflation. It's the most politically expedient and, of course, the most cowardly. It's also a transfer of wealth from you and I due to poor leadership!