As a follow-up to our earlier article about how tax law affects behavior, we offer this story.

Amazon.com Inc., the world’s largest online retailer, hasn’t charged sales tax in most states since its founding in 1994. And it has taken some extreme measures to keep it that way.

Among them: Staff traveling around the U.S. have been required to first consult a company map that shades each state red, yellow or green, said three people who have worked for the retailer. These people said they needed permission from managers or company lawyers before entering “red” states because a worker’s actions might trigger laws that force Amazon to collect taxes in those states.

Such steps to avoid local levies allow Amazon to undercut in-state retailers by the amount they must add in sales tax, which can exceed 8%.

A close examination of Amazon’s corporate practices, based on interviews with more than a dozen former employees and people who have done business with the Seattle company, as well as a review of corporate documents, indicates that the company believes its sales-tax policy is critical to its performance.

Credit Suisse recently estimated that if Amazon were forced to collect sales taxes in all states, it would lose as much as…

To continue reading about how Amazon battles States over sales tax, go to TaxProf Blog

For example, Amazon.com has thousands of affiliate marketers who sell product through Amazon by placing links from their web sites to the promotional item at Amazon.com. When a consumer makes the purchase, a percentage of the purchase is paid to the web site as a commission for marketing that item. Governor Brown just signed into law a requirement that on-line retailers like Amazon begin collecting sales tax on transaction where a California based affiliate will receive payment. This law will force retailers to set up new systems to collect, track and forward tax revenue to California.

Tax Changes Behavior

Will this change Amazon’s behavior? It already has. All California based affiliate contracts with Amazon were canceled as of today because of this law.

What will that mean to California?
1. Website owners who rely on affiliate revenue will no longer promote Amazon.com since they no longer have an affiliate contract.
2. This will result in less sales and less revenue to California residents who are also affiliates. California will have less income to tax as income tax.
3. While it may be relatively small, it will have a negative impact on business activity and hurt our struggling economy.

I am sure about the facts since Capitalmarketsu.com Magazine is, or rather was, an Amazon affiliate. It won’t mean a great deal to this site since we didn’t sell many books anyway. But, there are many Internet businesses that are the sole business of the owner and they cannot stay in business if they have no affiliate contracts. For  Capitalmarketsu.com Magazine this has been more of an accommodation to our readers and an attempt to monetize to some degree the site and offset the expenses of operating. At the end of this column are the pertinent parts of two letters I received from Amazon detailing this termination and its cause.

Increasing or decreasing taxes does change behavior of both consumers and businesses. Tax policy is, therefore, very important in the process of bringing the United States out of the current extreme slowdown. Our politicians should be looking at the way to use tax policy to increase economic activity, not slow it down. Increased economic activity will result in additional revenue to government through increased sales and income.

For some politicians, the word “revenue” is a euphemism for “higher taxes.” They equate higher taxes with increased revenue, but that isn’t necessarily true. On the other hand, increased economic activity does always result in increased revenue – to the individual family/tax payer and to the government. I wish politicians would quit using deceptive language and speak plainly. When they mean higher taxes, they should say higher taxes. When they say increased revenue they should mean increased revenue.

So much for my soap box.

PC Magazine ran this story today, California Passes Law Forcing Web Retailers to Charge Sales Tax and CNN Money ran this story, Amazon drops California associates to avoid sales tax.

Hello,
For well over a decade, the Amazon Associates Program has worked with thousands of California residents. Unfortunately, a potential new law that may be signed by Governor Brown compels us to terminate this program for California-based participants. It specifically imposes the collection of taxes from consumers on sales by on-line retailers – including but not limited to those referred by California-based marketing affiliates like you – even if those retailers have no physical presence in the state.
We oppose this bill because it is unconstitutional and counterproductive. It is supported by big-box retailers, most of which are based outside California, that seek to harm the affiliate advertising programs of their competitors. Similar legislation in other states has led to job and income losses, and little, if any, new tax revenue. We deeply regret that we must take this action.
As a result, we will terminate contracts with all California residents that are participants in the Amazon Associates Program as of the date (if any) that the California law becomes effective. We will send a follow-up notice to you confirming the termination date if the California law is enacted. In the event that the California law does not become effective before September 30, 2011, we withdraw this notice. As of the termination date, California residents will no longer receive advertising fees for sales referred to Amazon.com, Endless.com, MYHABIT.COM or SmallParts.com. Please be assured that all qualifying advertising fees earned on or before the termination date will be processed and paid in full in accordance with the regular payment schedule…

Regards,
The Amazon Associates Team

Hello,
Unfortunately, Governor Brown has signed into law the bill that we emailed you about earlier today. As a result of this, contracts with all California residents participating in the Amazon Associates Program are terminated effective today, June 29, 2011. Those California residents will no longer receive advertising fees for sales referred to Amazon.com, Endless.com, MYHABIT.COM or SmallParts.com. Please be assured that all qualifying advertising fees earned before today will be processed and paid in full in accordance with the regular payment schedule…
To avoid confusion, we would like to clarify that this development will only impact our ability to offer the Associates Program to California residents and will not affect your ability to purchase from Amazon.com, Endless.com, MYHABIT.COM or SmallParts.com.
We have enjoyed working with you and other California-based participants in the Amazon Associates Program and, if this situation is rectified, would very much welcome the opportunity to re-open our Associates Program to California residents. As mentioned before, we are continuing to work on alternative ways to help California residents monetize their websites and we will be sure to contact you when these become available.
Regards,
The Amazon Associates Team

To change behavior, add or delete a tax.

“When Americans hear the word ‘manufacturing’, they don’t think of the future. They think of the past — and of a present defined by job losses, closed factories and a middle class in peril,” Liveris wrote in his book, which he recently discussed during a visit to Wharton. “This stands in stark contrast to most other parts of the world, where manufacturing conjures thoughts of opportunity, of wealth, of growth, of promise.”

In a speech called, “The State of the Union: A CEO’s Path to a Sustainable Future,” Liveris said he wrote the book and came to Wharton to “get the national conversation going” about manufacturing. Manufacturing, he noted, is no longer about producing textiles and tennis shoes, or smokestacks and steel. Today, when other countries think of manufacturing, they think of advanced manufacturing: “They think semiconductors, solar and photovoltaics. They feel the power of manufacturing. Countries are creating wealth, true value, by investing in highly specialized manufacturing sectors.”

The United States, in contrast, is standing by idly as it loses manufacturing jobs to overseas competitors, according to Liveris. Unless Washington can develop a coherent long-term strategy, the United States will lose not just its factories but its ability to innovate as well, he argued. Government and business need to work together to renew America’s manufacturing industry and secure its future.

Liveris speaks about global manufacturing from first-hand experience: He has worked at Dow for 34 years, and has led the Midland, Mich.-based company for seven. Dow recently committed to developing two new factories in Michigan to build solar shingles and battery packs for electric cars, but many of the company’s other 5,000 products are made elsewhere. Dow employs more than 52,000 people at 214 sites in 37 different countries.

Once a leader in manufacturing, the United States has been hemorrhaging manufacturing jobs for the past decade, Liveris said. Between 2001 and 2010, U.S. companies closed more than 42,000 factories and lost 5.5 million jobs. About a third of the sector has disappeared.

The United States must reverse this trend if it wants to develop a sustainable economy, Liveris stated. Manufacturing is vital to a national economy because it has a high multiplier effect — in other words, it creates supporting jobs outside of the sector. “Manufacturing matters whether I’m in Singapore or Moscow. Manufacturing creates jobs and creates jobs around those jobs.”

To continue reading, go to Dow Chemical’s Andrew Liveris on the Future of Manufacturing — and Making America Competitive Again

The following is adapted from a lecture given at Hillsdale College on February 2, 2010, during a conference on the New Deal co-sponsored by the Center for Constructive Alternatives and the Ludwig von Mises Lecture Series. A version of this lecture was delivered as the Hayek Prize lecture in 2009.

The Monopoly board game originated during the Great Depression. At first its inventor, Charles Darrow, could not interest manufacturers. Parker Brothers turned the game down, citing “52 design errors.” But Darrow produced his own copies of the game, and Parker Brothers finally bought Monopoly. By 1935, the New York Times was reporting that “leading all other board games … is the season’s craze, ‘Monopoly,’ the game of real estate.”

Most of us are familiar with the object of Monopoly: the accumulation of property on which one places houses and hotels, and from which one receives revenue. Many of us have a favorite token. Perennially popular is the top hat, which symbolizes the sort of wealth to which Americans who work hard can aspire. The top hat is a token that has remained in the game, even while others have changed over the decades.

One’s willingness to play Monopoly depends on a few conditions—for instance, a predictable number of “Pay Income Tax” cards. These cards are manageable when you know in advance the amount of money printed on them and how many of them are in the deck. It helps, too, that there are a limited and predictable number of “Go to Jail” cards. This is what Frank Knight of the University of Chicago would call a knowable risk, as opposed to an uncertainty. Likewise, there must be a limited and predictable number of “Chance” cards. In other words, there has to be some certainty that property rights are secure and that the risks to property are few in number and can be managed.

The bank must be dependable, too. There is a fixed supply of Monopoly money and the bank is supposed to follow the rules of the game, exercising little or no independent discretion. If players sit down at the Monopoly board only to discover a bank that overreaches or is too unpredictable or discretionary, we all know what happens. They will walk away from the board. There is no game.

Relevance to the 1930s

How is this game relevant to the Great Depression? We all know the traditional narrative of that event: The stock market crash generated an economic Katrina. One in four was unemployed in the first few years. It resulted from a combination of monetary, banking, credit, international, and consumer confidence factors. The terrible thing about it was the duration of a high level of unemployment, which averaged in the mid teens for the entire decade.

The second thing we usually learn is that the Depression was mysterious—a problem that only experts with doctorates could solve. That is why FDR’s floating advisory group—Felix Frankfurter, Frances Perkins, George Warren, Marriner Eccles and Adolf Berle, among others—was sometimes known as a Brain Trust. The mystery had something to do with a shortage of money, we are told, and in the end, only a Brain Trust’s tinkering with the money supply saved us. The corollary to this view is that the government knows more than American business does about economics.

Another common presumption is that cleaning up Wall Street and getting rid of white-collar criminals helped the nation recover. A second is that property rights may still have mattered during the 1930s, but that they mattered less than government- created jobs, shoring up home-owners, and getting the money supply right. A third is that American democracy was threatened by the rise of a potential plutocracy, and that the Wagner Act of 1935—which lent federal support to labor unions—was thus necessary and proper. Fourth and finally, the traditional view of the 1930s is that action by the government was good, whereas inaction would have been fatal. The economic crisis mandated any kind of action, no matter how far removed it might be from sound monetary policy. Along these lines the humorist Will Rogers wrote in 1933 that if Franklin Roosevelt had “burned down the capital, we would cheer and say, ‘Well at least we got a fire started, anyhow.’”

To put this official version of the 1930s in terms of the Monopoly board: The American economy was failing because there were too many top hats lording it about on the board, trying to establish a plutocracy, and because there was no bank to government became the bank and pulled America back to economic health.

When you go to research the 1930s, however, you find a different story. It is of course true that the early part of the Depression—the years upon which most economists have focused—was an economic Katrina. And a number of New Deal measures provided lasting benefits for the economy. These include the creation of the Securities and Exchange Commission, the push for free trade led by Secretary of State Cordell Hull, and the establishment of the modern mortgage format. But the remaining evidence contradicts the official narrative. Overall, it can be said, government prevented recovery. Herbert Hoover was too active, not too passive—as the old stereotypes suggest— while Roosevelt and his New Deal policies impeded recovery as well, especially during the latter half of the decade.

In short, the prolonged Depression can be put down to government arrogance— arrogance that came at the expense of economic common sense, the rule of law, and respect for property rights.

Arrogance and Discretion

Consider the centerpiece of the New Deal’s first 100 days, the National Recovery Administration (NRA), which was in effect an enormous multisector mechanism calibrated to manage the business cycle through industrial codes that, among other things, regulated prices. The principles on which its codes were based appear risible from the perspective of microeconomics and common sense. They included the idea that prices needed to be pushed up to make recovery possible, whereas competition constrained recovery by driving prices down. They held that big firms in industry— those “too big to fail”—were to write codes for all members of their sector, large and small—which naturally worked to the advantage of those larger firms. As for consumer choice, it was deemed inefficient and an inhibitor of recovery. The absurdity of these principles was overlooked, however, because they were put forth by great minds. One member of the Brain Trust, Ray Moley, described the myopic credentialism of his fellow Brain Truster, Felix Frankfurter, in this way:

The problems of economic life were to Frankfurter matters to be settled in a law office, a court room, or around a big labor-management bargaining table . . . . The government was the protagonist. Its agents were its lawyers and commissioners. The antagonists were big corporate lawyers. In the background were misty principals whom Frankfurter never really knew at first hand . . . . These background figures were owners of the corporations, managers, workers and consumers.

One family that was targeted by NRA bureaucrats was the Schechters, who were wholesale chicken butchers in Brooklyn. The NRA code that aimed to regulate what they did was called The Code of Fair Competition for the Live Poultry Industry of the Metropolitan Area in and about the City of New York. And according to this code, the Schechters did all the wrong things. They paid their butchers too little. They charged prices that were too low. They allowed their customers to pick their own chickens. Worst of all, they sold a sick chicken. As a result of these supposed crimes, they were prosecuted.

The prosecution would have been comic if it were not business tragedy. Imagine the court room scene: On one side stands Walter Lyman Rice, a graduate of Harvard Law School, representing the government. On the other stands a small man in the poultry trade, Louis Spatz, who is afraid of going to jail. Spatz tries to defend his actions. But he barely speaks English, and the prosecutor bullies him. Nevertheless, Spatz is now and then able to articulate, in his simple and common-sense way, how business really works.

Prosecution: But you do not claim to be an expert?
Spatz: No.
Prosecution: On the competitive practices in the live poultry industry?
Spatz: I would want to get paid, if I was an expert.
Prosecution: You are not an expert!
Spatz: I am experienced, but not an expert . . . .
Prosecution: You have not studied agricultural economics?
Spatz: No, sir.
Prosecution: Or any sort of economics?
Spatz: No, sir.
Prosecution: What is your education?
Spatz: None; very little.
Prosecution: None at all?
Spatz: Very little.

Then at one point this everyman sort of pulls himself together.

Prosecution: And you would not endeavor to explain economic consequences of competitive practices?
Spatz: In my business I am the best economist.
Prosecution: What is that?
Spatz: In my business I am the best economizer.
Prosecution: You are the best economizer?
Spatz: Yes, without figuring.
Prosecution: I wish to have that word spelled in the minutes, just as he stated it.
Spatz: I do not know how to spell.

This dialogue matters because little businesses like Schechter Poultry are the natural drivers of recovery, and during the Great Depression they weren’t allowed to do that driving. They weren’t allowed to compete and accumulate wealth—or, in terms of Monopoly, to place a house or hotel on their property. Instead they were sidelined. The Schechter brothers ultimately won their case in the Supreme Court in 1935. But the cost of the lawsuits combined with the Depression did not go away.

Regarding monetary policy, it is clear that there wasn’t enough money in the early 1930s. So Roosevelt was not wrong in trying to reflate. But though his general idea was right, the discretionary aspect of his policy was terrifying. As Henry Morgenthau reports in his diaries, prices were set by the president personally. FDR took the U.S. off the gold standard in April 1933, and by summer he was setting the gold price every morning from his bed. Morgenthau reports that at one point the president ordered the gold price up 21 cents. Why 21, Morgenthau asked. Roosevelt replied, because it’s 3 x 7, and three is a lucky number. “If anyone knew how we set the gold price,” wrote Morgenthau in his diary, “they would be frightened.”

Discretionary policies aimed at cleaning up Wall Street were destructive as well. The New Dealers attacked the wealthy as “money changers” and “Princes of Property.” In 1937, after his re-election, Roosevelt delivered an inaugural address an instrument of “unimagined power” which should be used to “fashion a higher order of things.” This caused business to freeze in its tracks. Companies went on what Roosevelt himself resentfully termed a “capital strike.”

These capital strikers mattered because they were even more important to recovery than the Schechters. Consider the case of Alfred Lee Loomis, who had the kind of mind that could contribute significantly to Gross Domestic Product and job creation. During the First World War, he had improved the design of firearms for the U.S. Army. In the 1920s, he became wealthy through his work in investment banking. He moved in a crowd that was developing a new form of utility company that might finally be able to marshal the capital to bring electricity to the American South. But when Loomis saw that the Roosevelt administration was hauling utilities executives down to Washington for hearings, he shut down his business, retreated to his Tudor house, and ran a kind of private think tank for his own benefit. We have heard a lot about a labor surfeit in the 1930s. Here is a heresy: What if there was a shortage of talent brought on by declarations of class warfare?

Another challenge to the Depression economy was tax increases. While these increases didn’t achieve the social equality at which they aimed, they did significant damage by confiscating too much individual and corporate property. As a result, many individuals and businesses simply reduced or halted production— especially as the New Deal wore on. In the late 1930s, banker Leonard Ayres of the Cleveland Trust Company said in the New York Times: “For nearly a decade now the great majority of corporations have been losing money instead of making it.”

As for big labor, the Wagner Act of 1935 proved to be quite destructive. It brought on drastic changes at factories, including the closed shop—the exclusion of non-union members. Another innovation it helped bring about was the sit-down strike, which threatened the basic property right of factory owners to close their doors. Most importantly, it gave unions the power to demand higher wages—and they did. A wage chart for the 20th century shows that real wages in the 1930s were higher than the trend for the rest of the century. This seems perverse, considering the economic conditions at the time. The result was high paying jobs for a few and high unemployment for everyone else. The reality of overpriced labor can be seen in several stock phrases coming out of the Great Depression—“ Nice work if you can get it,” for example, was the refrain of a Gershwin song performed by Fred Astaire in The Damsel in Distress, a film released in 1937 at the zenith of union power.

To return to the Monopoly board metaphor, the problem in the 1930s was not that there was no bank. It was that  there was too much bank—in the form of the federal government. The government took an arbitrary approach to the money supply and made itself the most powerful player. It shoved everyone else aside so that it could monopolize the board. Benjamin Anderson, a Chase economist at the time, summed it up in a book about the period: “Preceding chapters have explained the Great Depression of 1930 to 1939 as due to the efforts of the governments and very especially the government of the United States to play god.”

Relevance for Today

It is not hard to see some of today’s troubles as a repeat of the errors of the 1930s. There is arrogance up top. The federal government is dilettantish with money and exhibits disregard and even hostility to all other players. It is only as a result of this that economic recovery seems out of reach.

The key to recovery, now as in the 1930s, is to be found in property rights. These rights suffer under our current politics in several ways. The mortgage crisis, for example, arose out of a long-standing erosion of the property rights concept—first on the part of Fannie Mae and Freddie Mac, but also on that of the Federal Reserve. Broadening FDR’s entitlement theories, Congress taught the country that home ownership was a “right.” This fostered a misunderstanding of what property is. The owners didn’t realize what ownership entailed—that is, they didn’t grasp that they were obligated to deliver on the terms of the contract of their mortgage. In the bipartisan enthusiasm for making everyone an owner, our government debased the concept of home ownership.

Property rights are endangered as well by the ongoing assault on contracts generally. A perfect example of this was the treatment of Chrysler bonds during the company’s bankruptcy, where senior secured creditors were ignored, notwithstanding the status of their bonds under bankruptcy law. The current administration made a political decision to subordinate those contracts to union demands. That sent a dangerous signal for the future that U.S. bonds are not trustworthy.

Three other threats to property loom. One is tax increases, such as the coming expiration of the Bush tax cuts. More taxes mean less private property. A second threat is in the area of infrastructure. Stimulus plans tend to emphasize infrastructure— especially roads and railroads. And after the Supreme Court’s Kelo decision of 2005, the federal government will have enormous license to use eminent domain to claim private property for these purposes. Third and finally, there is the worst kind of confiscation of private property: inflation, which excessive government spending necessarily encourages. Many of us sense that inflation is closer than the country thinks.

If the experience of the Great Depression teaches anything, it is that property rights must be firmly established or else we will not have the kind of economic activity that leads to strong recovery. The Monopoly board game reminds us that economic growth isn’t mysterious and inscrutable. Economic growth depends on the impulse of the small businessman and entrepreneur to get back in the game. In order for this to happen, we don’t need a perfect government. All we need is one that is “not too bad,” whose rules are not constantly changing and snuffing out the willingness of these players to take risks. We need a government under which the money supply doesn’t change unpredictably, there are not too many “Go to Jail” cards, and the top hats are confident in the possibility of seeing significant returns on investment.

Recovery won’t happen from the top. But when those at the top step back and create the proper conditions, it will happen down there on the board—one house at a time.

Reprinted by permission from Imprimis, a publication of Hillsdale College.

“All men seek happiness. This is without exception. Whatever different means they employ, they all tend to this end. The cause of some going to war, and of others avoiding it, is the same desire in both, attended with different views. The will never takes the least step but to this object. This is the motive of every action of every man, even of those who hang themselves.”

- Blaise Pascal (1623-1662)

In fact, one financial planning firm took a poll of its clients, asking them what kinds of fun things they had rediscovered while they were tightening their belts.  What they found was that many people were having MORE fun with less money, simply by being creative.

Other advisors are asking similar questions, and reporting the answers so that everybody can see what their friends and neighbors have discovered/rediscovered.  They received answers like: working jigsaw puzzles as a family, or playing board games (like Parcheesi or Scrabble) in the evening, inviting friends over to play cards, taking walks, creating a new flower garden (or, in one case, turning the entire front lawn into a flower garden of spectacular beauty), hiking in the local state park, attending a variety of free seminars, getting more involved in community meetings, having group cookouts where everybody shares the cooking or brings dishes, joining a book club–the original advisory firm now has several hundred suggestions, and counting.

Of course, the lesson is something that we somehow manage to forget from time to time: that the world is full of endless possibilities for fun and pleasure and satisfaction and beauty, and some of the most interesting cost us nothing.  In fact, the shared togetherness of many of the “rediscovered” activities makes them superior to how many people were spending their time before the market dropped.

It would be shame if we learned these important lessons and then let our rediscoveries slip away now that people are feeling a bit wealthier again.  They call these the “simple” pleasures, but there’s nothing simple about being creative and really looking at the beauty and possibilities of the world around us.  It’s possible that we can be thriftier AND enjoy life more if we use our minds and hearts and each other to bring pleasure and fun into our lives.

So, I would like to continue the flow of information and ask you, “What have you ‘rediscovered’ as a way to have fun in a more economical fashion?” Why don’t you respond in the comments section below and share your findings with our other readers?

It’s all About Fiduciary Duty to Your Clients

Everyone who listens to the news, either on the radio or TV, knows that the SEC is going after Goldman Sachs. There are significant problems to be ironed out. If, as is alleged by the SEC, there was criminal activity at Goldman, then someone needs to be treated to some free room and board for a while. That, however, will not resolve what is wrong – and neither will the Obama Financial Regulation legislation in its current form. Ron Rogé has written what is effectively an open letter that expresses this so well and directly that I will just let you read it. Here it is:

By: Ronald W. Rogé, MS, CFP®

April 20, 2010

You undoubtedly know that the SEC has sued Goldman Sachs for fraud.  I have been following the media and government pundits on this topic, and I am beginning to conclude that they just don’t get it.

Yes, I agree that for Goldman Sachs not to disclose to their retail clients that they were betting against the very products they helped create for their institutional clients and then sold those products to their retail clients, is disgraceful and unethical, even if it turns out to be legal.

fiduciary duty and responsibility

Goldman, the SEC, U. S. Congress and the media are missing the entire point about this event, as they argue the very fine details of what’s legal, what’s not.  What they are missing is that a financial advisor has a sacred relationship with his or her clients.  It’s called fiduciary duty and responsibility.

Accepting fiduciary responsibility is the first principle under which all financial regulation should be based.  No exceptions for anyone in the financial services industry.  Sadly, the new financial regulatory bill does not require a fiduciary standard.  The bill authorizes the study, not the implementation of a uniform fiduciary standard.  It will allow situations like Goldman’s to continue to perpetuate and confuse the public, as to who is a fiduciary and who is not a fiduciary.

Jack Bogle, founder of the Vanguard Group is fond of saying; — “You can’t serve two masters at the same time.”  Goldman Sachs, to my knowledge, probably did not act in the best interest of their retail clients, because they are not a fiduciary.  Their real clients are the corporations and institutions for whom they create products, which they then turn around and sell to their retail clients, as they allegedly did with mortgage backed securities, according to the SEC charges.

The problem with financial regulation in the U.S. is that rules for operating are not based on the first principle of being accountable as a fiduciary, for all of your clients all of the time.  The system is also confusing because Registered Investment Advisors (RIA’s are governed by the SEC) are required by law to be a fiduciary, whereas registered representatives of a broker-dealer (Governed by FINRA) are not fiduciaries and their allegiance, by law, is to their broker dealer, not the client.  The only filter a registered representative has to use before selling a product is a suitability test.  Playing these confusing rules of both the SEC and FINRA against one another, like a concert violinist, allowed Bernard Madoff to run his Ponzi scam as long as he did.

Goldman may try and buy their way out of this by paying a big fine and hoping the problem will go away without admitting guilt.  I hope the SEC has the wherewithal to pursue this to a proper and just conclusion.  I think Goldman’s reputation has been damaged, but history shows that they have managed to survive.

We only have one thing in life that we really own, and that’s our reputation.  As Warren Buffet has said, “Your reputation takes a lifetime to build, but only seconds to destroy.”  Goldman may have finally managed to destroy their reputation.

Goldman vs. the SEC is a teaching moment for the financial services industry, U. S. Congress, SEC, the media, and public.  It teaches us that we need a fiduciary standard as the first principle from which all financial regulation flows.  Playing the game of serving two masters at the same time is no longer acceptable behavior.  It’s time for the fiduciary standard to be the first principal from which all financial regulation is created.  Without exceptions!

As a SEC Registered Investment Advisor (RIA), we take our fiduciary duty to our clients seriously, not because it’s the law, but because it’s the right thing to do.  That’s because we answer to an even higher authority, who tells us to live by the Golden Rule — “Do to others as you would have them do to you.”

I could not have said it better myself. It really is all about fiduciary duty.

I am linking you to a short presentation that shows how the VAT works. The most important thing about the VAT that is not underlined in this presentation is the fact that the consumer never actually sees that tax that is embedded in the price of everything he will buy under the VAT regimen. I believe this is why some members of Congress like it so much; no visibility.

First, I believe we should be looking like starving hawks for ways to cut spending rather than raising taxes. But that being said, I also believe in full disclosure. There should be no secrets when it comes to government getting into the pockets of American citizens. The VAT does just the opposite, it attempts to hide the tax from the consumer. Oh yes, I know, anyone willing to look into it carefully can know what is being paid in tax, but the reality is that most won’t do that and everyone will eventually get used to the increase in costs and not realize how much of it is a tax. And, of course, once the VAT is in place, it can be slowly increased and, like the frog in the pot, we won’t realize that we are being boiled alive. As you can tell, I don’t like the VAT. But I promised you a link to a demonstration to how it works, so here it is. How Would a VAT Work?

The content of an investor’s faith includes faith in human nature. Human beings have a natural drive to want to do better for themselves and for the world in which they live. We easily understand the part about bettering ourselves, some would call it greed. For some people, this drive is greed, for others it is an honorable desire to provide for themselves and their loved ones.

The part about bettering the world in which we live may be altruistic or it may simply mean that I want the community in which I live to be more pleasant for my own enjoyment and my own enjoyment is hindered if my neighbors are in poverty and squalor, therefore I want them to do well also. That is part of why people move into “better neighborhoods.”

As an investor, whether I articulate it or not, I am counting on these kinds of forces to continue to be in effect in the corporate world where I invest my money. I count on the fact that the CEO wants to be “a winner” and wants his bonus – either because of his drive to provide for himself and his loved ones or to fulfill his insatiable greed. I also count on the fact that corporate leaders know that in order for their products to sell, they have to be making the community better in some way – or at least it has to be perceived that way, otherwise, consumers will not consume that product.

Economic policies and government programs come and go, but as long as human nature continues to be free to be expressed in commerce, I can invest successfully. This is a basic tenet of the investor’s faith. It doesn’t require religion; it just requires a realistic view of human nature.

This is basic to free market economics and is heresy in the economic theories of socialists or communists. Those economic systems have a different view of human nature.

There are other much more academic parts of the investor’s statement of faith and this magazine is full of those statements that have come from the work of men like Harry Markowitz, Eugene Fama and Ken French and others. Investing is not, in the short run, a sure deal. There are risks (another of the tenets of the investor’s faith) and there are techniques to mitigate risk. Just keep the faith.

Larry P. Arnn, the twelfth president of Hillsdale College, received his B.A. from Arkansas State University and his M.A. and Ph.D. in government from the Claremont Graduate School. From 1977 to 1980, he also studied at the London School of Economics and at Worcester College, Oxford University, where he served as director of research for Martin Gilbert, the official biographer of Winston Churchill. From 1985 until his appointment as president of Hillsdale College in 2000, he was president of the Claremont Institute, an education and research organization based in Southern California. In 1996, he was the founding chairman of the California Civil Rights Initiative, the voter-approved ballot initiative that prohibited racial preferences in state employment, education, and contracting. He sits on the board of directors of several organizations, including the Heritage Foundation, the Army War College, and the Claremont Institute. He is the author of “Liberty and Learning: The Evolution of American Education.”

The following is adapted from speeches delivered in Indianapolis, Indiana, on September 24, and in Pocahontas, Arkansas, on October 19, 2009.

I HAVE BEEN ASKED TO talk today about education and economic development. The standard thing to say on this topic is that the former is vital to the latter. We live in the modern world, so we all have to be highly informed and highly skilled and understand the power of modern science. It is a task of the very first importance to train a workforce that will be able to compete in the global marketplace. That is the standard thing to say, and we hear it said often by education bureaucrats from the federal level on down. And of course it is perfectly true, as far as it goes. But there is more to be said.

The practical point of this standard thing to say is that America needs more technical education—more scientists and mathematicians. And of course we do need scientists and mathematicians. But I like to remind people when they say this that the word “technical” comes from the Greek word “techne,” which means “art.” And Aristotle points out that art is about making, and that the question of what one should make is always superior, in point of order and logic, to the question of how to make it.

What does this mean? Consider one of the greatest scientific achievements of the last century—the development of the atomic bomb. The question of whether to build an atomic bomb, and then the question of whether to drop it on Hiroshima and Nagasaki in order to end World War II without the need of invading and conquering the Japanese mainland, were more important questions—superior in order and logic—to the question of how to make the bomb. The brilliant physicists who accomplished the latter had immense technical training, but that training gave them no special knowledge about those more important questions. Or to put the point in a slightly different and more general way, a technical education can make a person wealthy and famous, but it does not teach that person what is best to do with wealth and fame.

So the first point I would make about education and economics is the importance of liberal arts education, which is the kind of education offered at Hillsdale College. Many think of liberal arts education as a broad education, but in fact it is a high education. We understand things to be arranged in a hierarchy. Hillsdale College has plenty of science and math majors, and our students go on to the very best graduate and professional schools. But whatever their majors, they learn the distinction I just made about questions of greater and lesser significance, and they study how to think about the very greatest ones.

The second point I want to make has to do with politics and education. The greatest example of economic development in human history was in the United States during the 19th century. At the beginning of that century, we were about five million people huddled along the East Coast. By the end of it we had grown at a rate of about 25 percent—much faster than China is growing today—and had settled an entire continent, largely without the help of modern science. To the question of how it was done, I think the short answer is the Homestead Act—the greatest piece of legislation I know. Signed by President Lincoln in 1862, the Homestead Act is short and beautiful—two qualities good legislation should have, and two qualities in which legislation today is utterly lacking.

What the Homestead Act did was to take the western land of the United States—surely one of the greatest assets ever held by any government in history—and give 160-acre plots to anyone with the backbone to live on them and work them. These plots of land were granted regardless of who someone was and with the certainty that no one settling on them could ever vote for this congressman or that. It is one of the greatest impartial acts of legislation in all of human history. It, and things like it, built America and the character of the people who spread across it.

How does this connect to my first point? It connects because the spirit of the Homestead Act, which led to unprecedented economic growth, could not be more different from the spirit of our legislation today. And the key to this difference is the difference between the education our leaders today have had, and the education students get at Hillsdale.

The principle that justified the Homestead Act has two parts, and both are found in the first 15 lines of the Declaration of Independence. The first is the idea of human equality—the idea that it does not matter what race or what family you come from, it only matters what you do—which has been the source of our greatest struggles in an attempt to live up to it. The second is the idea of the “Laws of Nature and of Nature’s God.” At Hillsdale College, we study the Declaration of Independence as the greatest thing of its kind. The signers of the Declaration were risking their lives. There is a beautiful passage at the end of it where they write, “we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.” But the document begins in an opposite mood, because the cause they are willing to die for is not specifically about them at all: “When in the course of human events”—that means not our time, but any time—”it becomes necessary for one people”—that means not our people, but any people—and then this sentence goes on to speak of the “Laws of Nature and of Nature’s God,” laws true always and everywhere.

Understood comprehensively, the Declaration points us to an unalterable law of God, visible in nature, that man is inferior to God and superior to the beasts, such that it is unjust for one human being to rule any other without his consent. And it is this same understanding of human nature on which Madison rests his case in Federalist 51, in explaining why government is both necessary and must be limited:

. . . [W]hat is government itself but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.

This is the understanding that animates legislation like the Homestead Act. And note the humility in it. America’s founders understood themselves to be bound and limited by something higher. And it is precisely this understanding that is missing among our political leadership today. Nearly 20 years ago now, when Clarence Thomas was testifying before the Senate Judiciary Committee during his confirmation hearings, several senators questioned him about the idea of natural law, which seemed to them a foreign and dangerous idea. And why would it seem that way?

These senators have been taught to understand government as a means by which they can do marvelous things, changing society for the better in countless and unlimited ways. And in this light, the old-fashioned idea of natural law—which, as we saw in the passage from Madison, leads to the idea of limited government—becomes simply an impediment to progress.

President Obama is an impressive man, and there is much good to be said about him. But he falls firmly into this newer school of thought. Let me read you a passage from his book, The Audacity of Hope:

Implicit in [the Constitution's] structure, in the very idea of ordered liberty, was a rejection of absolute truth, the infallibility of any idea or ideology or theology or “ism,” any tyrannical consistency that might lock future generations into a single, unalterable course. . . .

One can see immediately the practical results of this in the health care debate. Advocates of one of the latest plans are proud to place the cost at only $900 billion—apparently it takes $1 trillion to impress in this day and age! But consider that, in most of the plans that have advanced in the Congress, people making in the range of $30,000 to $80,000 a year will be forced to pay health insurance costs—or fines of about the same amount—that come to between ten and 20 percent of their income. They will be compelled to buy plans that have certain specific features. There will be an allocation of health care resources as part of the plan. And it will not be legal to buy or sell a plan that does not fit the criteria. Compare the spirit of this legislation with the spirit of the Homestead Act. There is a bullying spirit behind it. And that bullying spirit is becoming ever more pervasive.

The means are already in place for the federal government to control what people say in elections. As a recent example of how it tries this between elections, consider that Henry Waxman—a congressman of some power and influence—sent a letter in August to the CEOs of health care companies asking for schedules of all salaries above a certain amount, and of the conferences they had been to, and how much they cost, and who was there. Was it a coincidence that he wanted this information just as a health care debate was starting up? Could it be that he was trying to intimidate and silence potential opposition? One of the many “czars”—isn’t that an ominous word?—in the Obama administration is Cass Sunstein, the czar of regulatory policy. Mr. Sunstein is a very smart man—a law professor, like the president—but he is on record saying that speech rights should be redistributed by government bureaucrats much as wealth is redistributed through post-New Deal tax and entitlement policy. This is not supposed to be a country where there are czars dealing with things like speech. But it is such a country right now.

The economic policies being proposed these days are very bad. But the principles behind them are worse. They represent a return to the idea that the American Revolution repudiated—the idea that some are equipped by nature or training to manage the lives of others without their consent. I have been making the point lately that people are wrong who accuse the Obama administration of being socialist. I take the president at his word when he says that he has no desire to own the automobile companies. Instead, he wants to control them—and the rest of us as well—through a regulatory apparatus overseen by czars and bureaucrats. And again, his intentions are good. What is bad is the view underlying them of what human beings are. Rather than looking on us as equal beings with a set nature—such that none of us should rule another in the way that God rules man or man rules beast—our political leaders today have been taught to see us as material to be shaped and perfected by experts who have the proper technical training.

It has been close to 100 years now that the majority of people teaching in American colleges and universities have agreed with Woodrow Wilson, one of the founders of the Progressive movement and the first to write explicitly that the Declaration of Independence is obsolete, and that we need to liberate the Constitution from the Declaration’s restraints. This liberation leads to the idea of a “living Constitution,” characterized by constant change or progress. Absolute truth, to the extent that ordinary people still believe in it, obstructs change or progress—which is why President Obama refers to it, in the passage I read, as tyrannical. But if change or progress is the rule, who is to determine what version of change or progress is good? And the logical problem here—as any Hillsdale student could tell you—is that once you deny the existence of absolute truth, the definition of “good” becomes subjective and the only standard of behavior is what we want—”we,” in the political sense, meaning the government or bureaucracy. It reduces politics not to right, but to force. That is why there is this bullying spirit about our government today, and why so many Americans are worried.

It is time for that to stop, and there are two conditions for stopping it. The first is for the ordinary folk of the United States to see in this the despotism that it is, and to rise up and repudiate it. The second thing is longer term, but equally vital: It is to replace leaders who have bad educations with leaders who have good educations. This is our work at Hillsdale College. We aim to recover the meaning of the “Laws of Nature and of Nature’s God” and to place that meaning firmly in the minds and hearts of ambitious young men and women who have the courage to do something with that knowledge. And I swear that we shall not stop pursuing that task.

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Is there such a thing as the “wisdom of Solomon” when it comes to investing? Well, you betcha! And, it has powerful contemporary application. Here it is, Ecclesiastes 11:1-6 (ESV).

1 “Cast your bread upon the waters,
for you will find it after many days.
2 “Give a portion to seven, or even to eight,
for you know not what disaster may happen on earth.
3 “If the clouds are full of rain,
they empty themselves on the earth,
and if a tree falls to the south or to the north,
in the place where the tree falls, there it will lie.
4 “He who observes the wind will not sow,
and he who regards the clouds will not reap.
5 “As you do not know the way the spirit comes to the bones in the womb of a woman with child, so you do not know the work of God who makes everything.
6 “In the morning sow your seed, and at evening withhold not your hand, for you do not know which will prosper, this or that, or whether both alike will be good.”

The first principle in verses one and two is diversification to reduce risk. In Solomon’s case, he was referring to sending “bread”, the wheat and other grains harvested in Israel, on ships to other ports as trade. Sending your grain on a ship was risky but was the most efficient way to participate in trade. Take risk and after many days your profits will come back after the grain is sold.

Now to the diversification part, “Give a portion to seven, or even eight, for you know not what disaster may happen on earth.” Interpretation: Do your shipping on several ships, not just one. If a bad storm comes up on the sea your one ship may go down and you will have lost all (Can anyone spell Enron, Bear-Stearns or Lehman Brothers?). So, spread your shipping across multiple ships and multiple routes and reduce your risk of loss.

Diversification is primarily a way to reduce your risk of loss, not a way to make more profits. However, if you compare the results of a shipper who always spread his risk across several ships versus the merchant who always used only one ship, eventually the diversifier would make more profit. That is because statistically, both will lose a shipment occasionally and the diversifier will only lose part of his crop whereas the non-diversifier will loose 100% of that year’s crops (like Enron, etc.).

Carry this forward to contemporary equity or stock investing and the same principles apply. Diversify broadly and you will reduce the risk of loss and the risk of volatility of returns.

If I construct an equity portfolio of three funds, one with US stocks, one with non-US stocks of companies in mature markets and one with stocks from Emerging Markets and each of these own virtually every publicly traded stock in their respective markets, then I have diversified away every conceivable risk except one; market risk. And, I would own virtually the entire world stock market. Every time someone buys or sells and makes profit, I own a little (very little) piece of that deal.

Principle number two: Risk is everywhere, you can’t escape it.

3 “If the clouds are full of rain,
they empty themselves on the earth,
and if a tree falls to the south or to the north,
in the place where the tree falls, there it will lie.”

When rain comes it may be a nice rain to increase crops or it may be an old fashioned “gully-washer” and wipe out everything in sight. We have no control over this. We can do our best to apply good agricultural principles in how we plant and how we plow but some things are just overcome by the rains.

None of life is free of risk. Regarding investments there is inflation risk, interest-rate risk, company risk, industry risk, country risk, money-manager risk, currency risk, etc. Here a risk, there a risk, everywhere a risk – risk. Old MacDonald had a risk. Sorry… got carried away there.

Proper diversification can eliminate all of these risks except market risk; that is one risk an investor just can’t eliminate.

Principle three: Don’t procrastinate because of risk.

4 “He who observes the wind will not sow,
and he who regards the clouds will not reap.”

The farmer who is always waiting for calm winds before planning seed so it won’t get blown away will never get around to planting his seed and the farmer who is afraid to begin harvesting for fear the clouds will bring rain and cause his crops to rot in the field will never get around to harvesting his crops – no profit.

Does it sound familiar? I can’t invest because:

• Of the war in Iraq/Afghanistan

• Of the credit crisis

• Of the real estate/mortgage crisis

• Of the failure of Lehman Brothers

• Of the failure of Enron, WorldCom and Tyco

• Of the bursting of the tech bubble

• Of the recession

• Of the George W. Bush administration

• Of the Barak Obama administration

• Of the Republicans being in charge

• Of the Democrats being in charge

History is filled with excuses for not investing and accepting the risk of the equity markets and yet, since 1926 the large cap stock market has averaged approximately 10.5% per year. If one was willing to accept more volatility risk and invested in small cap stocks instead, the average return was much greater than 10.5%.

5 “As you do not know the way the spirit comes to the bones in the womb of a woman with child, so you do not know the work of God who makes everything.”

The world is complex and just as we don’t understand everything about the development of a child in the womb, we don’t understand everything about how God oversees the economies of the world and allows for profits to be made fairly consistently over time. If I diversify broadly enough, I don’t have to understand the minutiae of the markets to profit from investing in them. I know God has placed in man the desire to produce, to make profit, the desire to do better for himself and for his family and as long as man has sufficient freedom to pursue those interests, there will be profit, and profit is a good thing (this will be the subject of another article later). Go capitalism!

Principle four: Keep on investing

6 “In the morning sow your seed, and at evening withhold not your hand, for you do not know which will prosper, this or that, or whether both alike will be good.”

The picture here, again, is a farmer in the ancient near east. He is encouraged to sow seed all day long, from morning to night, because he doesn’t know which seed and which part of his fields will have all the right conditions to produce an excellent crop – or if none of it will. This is another way to approach diversification.

Regardless of the great efforts of our finest young MBAs to research the markets and make the best most informed decisions possible, the track record shows that we don’t really know which stocks will perform best or if, as over the past couple of years, none of the seed will do well. This past market decline was characterized by stock market losses in all markets, domestic, international and emerging markets. That was not anticipated and it is unusual. Some have referred to this as a “Black Swan” event. When looking at a flock of swans, you don’t expect to see a black one, but occasionally you will. We did!

So, lets review quickly the Wisdom of Solomon regarding investing.

1. Diversify broadly to reduce risk.
2. Risk is unavoidable. There is no such thing as a risk-free investment.
3. Don’t procrastinate because of risk.
4. Keep on investing.