Archive for July, 2010

Trading Idea: British Pound Sterling (FXB)

Newly minted Prime Minister David Cameron’s new coalition government has made a big splash in the U.K. Announcements of massive cuts in government spending have taken even hard-nosed skeptics like hedge fund manager and London Junto guest Hugh Hendry by surprise. Turns out that the market appreciates fiscal austerity measures a lot more than Britain overpaid  schoolteachers – like the one who took home 283K GBP ($450K) last year. Pretty much since the day the Cameron government took office, the British pound sterling (FXB) has headed in one direction- and that’s straight up. Now, granted, this happened to coincide with a relief rally experienced by the Euro. And  economic  growth in the U.K. economy has been better than expected. But it doesn’t take a lot of imagination to realize that free markets appreciate Hayekian fiscal austerity a lot more than Keynesian stimulus. With the British pound sterling penetrating its long-term 200 day moving average in the past few days, trend following currency traders are already surely on the train.

.Chart forCurrencyShares British Pound Sterling Tr (FXB)


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The “Big Mac” Index for 2010

It’s the 24th year running that the Economist magazine has published its famed Big Mac Index — a tongue-and-cheek way of measuring the purchasing power parity (PPP) — that is, the relative over and undervaluation of the world’s currencies.

According to the theory of purchasing power parity, a dollar should buy the same amount of the same good across all countries. As a result, in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country.

By comparing the cost of Big Macs — a good produced in about 120 countries — the Big Mac Index calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in America as they do abroad. Compare the Big Mac PPP to the market exchange rates, and voilà!… you see which currencies are under or overvalued.

The Big Mac Index: The Currency Lineup Today

Granted, the Big Mac Index is far from perfect. Because of varying labor and input costs, the Index is most valuable when comparing countries at roughly the same stage of development. But for all of its weaknesses, the Big Mac Index has caught on among investors as a shorthanded way of looking at PPP across the world’s economies. The table below — reproduced from the Economist — shows by how much, in Big Mac PPP terms, selected currencies were over or undervalued at the end of July.

Only a handful of currencies are within 5% of their Big Mac PPP value — among them places as far-flung as Uruguay, Turkey, Peru, New Zealand, Japan, Israel, Australia and Costa Rica. At the same time, thanks to depreciating British pound and the euro and appreciating the Japanese yen, the PPP values among the most-traded currencies in the world are about as in line as they have been in recent memory.

As usually has been the case, the most overvalued currencies are in Western Europe. The most undervalued ones are in both Asia and Eastern Europe. Two years ago, the euro was overvalued by a massive 50% compared to the U.S. dollar. After a massive correction in the euro this year, today that figure is down to 16%. A similar fate has befallen the British pound, which is undervalued for the first time in recent memory.

Other European currencies remain strong. The Swiss franc is overvalued by 68% against the dollar. As a group, the Scandinavian currencies are by far the most overvalued currencies in the world. A Big Mac in Oslo, Norway, will cost you twice as much as in the United States, with its currency overvalued by 93%. Sweden has retained its reputation as being expensive, with its currency 76% overvalued. Denmark is Scandinavia’s bargain. Its currency is only 31% overvalued — a substantial drop from last year, as it is de facto linked to the euro.

Asia is the region where those who earn their money in U.S. dollars find a bargain when buying a Big Mac. Although the Japanese yen has risen substantially to hit fair value, the Singapore dollar remains undervalued by 18% and the South Korean won by 24%. The Big Mac Index also makes clear the reasons for the Asian export boom. Hong Kong, Malaysia, the Philippines and Thailand remain about 40% undervalued — though they are more expensive than they were a year ago. The currencies of less well-off Asian countries, such as Indonesia and Thailand, are equally cheap.

The Chinese yuan remains 48% below its PPP rate — the recent “flexibility” of the Chinese government’s approach to the yuan notwithstanding. A Big Mac costs $1.95 in China at current exchange rates versus $3.73 at your local mall in Ohio. No surprise that China’s cheap currency acts as a massive subsidy to Chinese exports.

What about the other BRIC economies besides China? The Big Mac Index omits India altogether. (Because Hindus do not eat beef, India’s version of the Big Mac — the Maharaja Mac — is made of chicken.) Visitors to Moscow — one of the most expensive cities in the world — will be surprised to learn that Big Macs still are 38% cheaper there than in Chicago. The appreciation of the Brazilian real during the past few years has made it 31% overvalued and made Brazil one of the most expensive places on the planet to buy a Big Mac.

Most remarkable is how quickly Eastern Europe’s cost advantages shifted over the past couple of years. Two years ago, a Big Mac cost more in Budapest, Hungary, than it did in London. Today, that position has reversed. In fact, the Baltic countries (Latvia, Lithuania and Estonia) and Poland are almost as cheap as Asia — though Hungary and the Czech Republic remain more in line with Western Europe.

Latin America is a mixed bag. This year, Argentina claimed the title of most undervalued currency in the world (from China), and Mexico is very cheap. At the same time, as noted, booming Brazil has one of the most overvalued currencies in the world.

The Big Mac Index: What to Trade

So, if you were running a currency hedge fund, what would the Big Mac Index tell you to trade? Among the big six of the currencies traded by foreign exchange traders, the Swiss franc is one of the only major currencies much off kilter with its purchasing power parity. But the explosion of new currency ETF offerings affords you an opportunity to bet on some less mainstream currencies as well.

Looking purely at the Big Mac Index, you’d buy the Chinese yuan (CYB) (48% undervalued), the Russian ruble (FXR) (38% undervalued), the South African rand (34% undervalued) and the Mexican peso (FXM) (33% undervalued). You’d sell the Swiss franc (FXF), the Swedish krona (FXS) and the Brazilian real (66%, 78% and 31% overvalued, respectively).

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Portugal: The “PIG” with a Little “P”

“Portugal is not the next Greece!” That’s the battle cry that has attracted the global financial media to this small European country with an economy the size of Colorado. During the past few months, investors have lumped Portugal together with the other PIGSIreland, Greece and Spain — as one of Europe’s most profligate economies that threatens to burst the European Union along its economic seams. The pressure on Portugal is relentless. Just last week, the ratings agency Moody’s slashed Portugal’s debt rating, based on its “deteriorating financial position and weak economic growth prospects.”

Portugal: Booming Economy Gone Bad

Portugal’s star has fallen far during the past decade. When I covered Portugal as part of my beat as a mutual fund manager back in the 1990s, Portugal boasted one of the fastest-growing economies in Europe, with annual growth rates of around 5%. It had launched a successful privatization program; its tourism industry was growing by leaps and bounds; and the whizz-bang gadgetry of its banks and telecoms seemed light-years ahead of the United Kingdom. Membership in the euro in 1999 was a reward for a job well-done, giving Portugal a stable currency, low-interest rates and access to one of the world’s largest trade zones.

That dream unraveled quickly. Much to everyone’s surprise, adopting the euro transformed Portugal from economic hare to also-ran tortoise. Portugal’s gross domestic product (GDP) growth has averaged a barely perceptible 0.8% since 2001 — the second-lowest in the euro-zone after Italy. And instead of converging upon the standards of living of other European countries, Portugal has fallen further behind. Per capita GDP fell from about 80% of the European Union (EU) average in 2000 to just over 70% six years later. In the past 10 years alone, the Czech Republic, Greece, Malta and Slovenia all surpassed Portugal by this measure.

The culprit? Thanks to the euro, the country’s global competitiveness simply collapsed. Between 2000 and 2007, unit labor costs rose 19% — pulling the rug out from its textiles industry, even as China burst on to the global economic scene. To add insult to injury, government finances went awry, and Portugal became the first euro-zone member slapped with an excessive-deficit warning back in 2002.

Portugal: The State of Play

That all said, you can see why the Portuguese get grumpy when investors compare them to Greece. Public debt as a share of GDP — around 80% — is far from Greece’s triple-digit percentage levels of public debt as a share of GDP. And no one has accused Portugal of ever cooking its fiscal books. Nor is Portugal deserving of a comeuppance for a debt-fueled boom that now has gone bust. Portugal never had a boom. And the Portuguese government was cutting back, even as PIGS rivals Spain, Ireland and Greece were riding the wave of housing bubbles and debt-fueled spending.

Nevertheless, the Great Recession hit Portugal hard. Its budget deficit soared from 2.8% of GDP in 2008 to a record 9.3% last year. Not that the government has sat on its hands. Portuguese Prime Minister José Sócrates boasts that Portugal is far ahead of rivals in spending cuts, reducing the number of civil servants by 10% between 2005 and 2009, and cutting the public sector wage bill from 14.8% to below 12% of GDP. More recently, the government also has frozen civil service wages for four years, reduced social spending and cut military spending by 40%. The value-added tax (VAT) increased to 21% and income taxes rose by 1.5%.

Portugal: Grand Plans after a Turnaround

There are signs that Portugal’s economy is turning around. Its growth of 1.1% in Q1 of 2010 was among the highest in the European Union. In the five months through May, fiscal revenue was substantially above target and state spending lower than forecast.

Beyond the current crisis, an optimistic José Sócrates has grand plans for his country, especially in the areas of green energy and education. Already Portugal generated 70% of its  electricityfrom renewable sources early in 2010. The government has launched a national network to recharge electric cars.

Education is also in the government’s sights. Between 2005 and 2008, Portugal increased public investment in research from 0.7% to 1.55% of GDP, overtaking Ireland and Spain. The government is investing €80 million in the first five years of a research program with MIT and exploring similar programs with Carnegie Mellon, the University of Texas at Austin and Harvard Medical School.

Portugal: The “Lusophone” Edge

Portugal has a secret edge that other countries like Hungary, Czech Republic and Greece don’t have. Portugal’s population is only 10.6 million. Yet 223 million people in the world are “lusophones” (Portuguese speakers) — a vestige of the Portuguese Empire. By dint of a common language, a shared legal framework and long-standing business ties, a “lusophone triangle” links Portugal to Brazil and expanding economies like Angola, Mozambique and Capos Verde in Southern Africa.

Although Portugal’s main export markets today remain Spain, Germany and France, trade links with Portuguese-speaking Africa and Brazil are soaring. Portugal’s exports to non-EU countries have risen from 15% of the total to more than 27% over the past decade. Up to 10,000 Portuguese companies are doing business with lusophone Africa. They have invested more than $1 billion in Angola over the past three years alone, as Angola has become both Portugal’s fourth-biggest export market, and home to 100,000 Portuguese. No wonder TAP-Air Portugal, the national airline, runs 20 direct flights from Lisbon to Luanda, Angola, every week.

A bigger opportunity than lusophone Africa is Brazil, home to 192 million of the world’s Portuguese speakers. Portuguese banking giant Banco Espírito Santo has a 7% shareholding in Brazil’s Bradesco bank and operates its own investment bank there. Portugal Telecom (PT) is battling with Spain’s Telefónica over control of Vivo, Brazil’s largest mobile phone operator.

With all of its advantages — culture of reasonable fiscal discipline, its close links to other lusophone nations, and an enlightened government policy toward education, it seems surprising that Portugal was never a bigger economic success than it has been. But with its economy having screeched to a halt after adopting the euro in 1999, Portugal offers a poignant lesson to other small countries: “Be careful of what you wish for.”

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Ireland: Test Case for PIGS Austerity

For much of the 20th century, Ireland had been the country from the wrong side of the economic railroad tracks. In 1988, Britain’s Economist magazine predicted that Ireland was heading for catastrophe — stuck in a downward spiral of high unemployment, slow growth, high inflation, heavy taxation and crushing public debt. Yet within a decade, Ireland had transformed itself into the “Celtic Tiger” — a country from Old Europe that successfully joined Asia-style growth rates with low unemployment, inflation and taxes — and a public balance sheet that was the envy of tax-and-spend European welfare states. While Germany, France and Italy struggled with slow growth economies bordering on stagnation, Ireland had transformed itself from an economic also-ran into the European Union’s second-richest country.

Then the Irish story unraveled with remarkable swiftness. Ireland was the first country in the euro-zone to slide into recession in 2008, with its gross domestic product (GDP) declining more than 14% in two years by the end of 2009. Ireland also is an ongoing case study of what it means to pursue a path of austerity in response to economic crisis, in contrast to the relentless onslaught of Keynesian stimulus packages being implemented by governments ranging from the United States to China.

The Boom

During the boom, Ireland’s economic transformation ranked up there with the best of the Asian Tigers. Twenty years ago, Irish GDP per person was about two-thirds of the EU average. Between 1993 and 1998, Ireland’s GDP increased by 45%, with annual rates of growth approaching 10%. House prices soared as shopping malls appeared on the outskirts of Ireland’s newly vibrant cities. By 2003, Ireland’s GDP was a third higher than the EU average. Unemployment fell from 17% in 1987 to 4%. Government debt shrank from 112% of GDP to 33%.

Thanks to a low corporate tax rate of 12.5%, Ireland attracted a huge amount of foreign direct investment (FDI). At its peak, Ireland boasted 1,100 multinational companies, which exported goods worth some $60 billion, accounting for a whopping 87% of Ireland’s total exports. Nine of the world’s top ten drug companies operated in Ireland. One-third of all personal computers sold in Europe were manufactured in Ireland. Ireland also was the world’s biggest software exporter, ahead of the United States. Ireland had become a European country that Americans could relate to: English-speaking, entrepreneurial and successful.

The Bust

Thanks to a deadly cocktail of a world-beating property boom, combined with unrestrained government spending, the boom veered out of control. The price of an average house soared by more than 350% between 1997 and 2006. The price of an acre of un-zoned land rose from 5,000 to 35,000 euros in rural Ireland in seven years. Between 2004 and 2008, banks in Ireland issued $50 billion in mortgages — the equivalent of banks in a country the size of the United States issuing mortgages of $2.8 trillion.

Flush with cash, the government went on a spending binge. From 1997 to 2008, investment in Ireland’s health service went up five-fold. Public-sector employment soared, even as pay doubled. Infrastructure projects were started across the country, but invariably completed spectacularly over budget.

The Irish economy unraveled with remarkable swiftness. Soaring labor costs forced Dell to pull up stakes and move 1,900 jobs to Poland. The collapse of the iconic Waterford Crystal brand quickly followed. Anglo Irish, the most aggressive lender of the past 20 years, was nationalized as property values halved. Tax revenues in 2008 were the worst on record as the economy collapsed. The government’s budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3% of its GDP last year — worse than Greece.

The Bitter Taste of Austerity Medicine

The Irish government’s response was both swift and harsh. Irish Premier Brian Cowen launched what many called the biggest assault ever seen on the public services of a modern Western state. The government raised taxes, even as it cut salaries in the public sector by up to 20%. But public finances are hardly flush. The government plans to cut its deficit to less than 3% of GDP by the end of 2014. But for now, the OECD forecasts Ireland’s deficit at 11.7% of GDP in 2010 and 10.8% in 2011.

Ireland is a living, breathing test case of the austerity measures that are causing taxpayers and workers to take to the streets with pitchforks across the globe. Keynesian acolyte Paul Krugman argues that Ireland’s current woes offer a glimpse into the consequences of fiscal austerity in the United States. On its face, it’s a sad irony that rather than being rewarded for swallowing the bitter cod-liver oil medicine of austerity, Ireland is grouped right alongside the other PIGS — Portugal, Greece and Spain. The Irish government’s heroic efforts notwithstanding, Ireland still pays three percentage points more than Germany on its benchmark bonds.

Ireland’s downturn has been almost certainly sharper and its recovery has been delayed compared to what it would have been had its government gone on a U.S.-style spending spree. That said, Ireland’s economy already may have turned the corner. Ireland’s economy expanded for the first time in more than two years in the first quarter by 2.7%, and is expected to grow as much as 1.5% this year. This is an improvement over an earlier prediction of 0.5% and marks the first full-year expansion since 2007. Ireland’s unemployment rate today stands at 13.4%, the highest since September 1994. But this is substantially less than the 16% projected for 2010 last year. Overall, Ireland is quietly starting to outperform the most pessimistic projections.

While Keynesians like Krugman argue against the dangers of the United States becoming the “next Ireland,” the reality is that Ireland’s austerity efforts have kept it from becoming the “next Greece.” And the markets now seem to agree. While Ireland pays three percentage points more than Germany for its bonds, for Greece, that number is closer to seven percentage points higher.

Harvard economist Ken Rogoff, co-author of the bestseller “This Time Is Different” points out: “If you want to escape default, the Irish path is the only way to go. But the Ireland experience points to the profound challenges that the current strategy implies.” The lesson? After a boom, the economic pied piper must be paid somehow.

And it’s better to pay him today than tomorrow.

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Spain: The Biggest PIG(S) in Europe

Despite having freed itself from the yoke of fascist dictatorship only 35 years ago, Spain is probably Europe’s top economic success story of the past generation. Since then, this country of 45-million people has transformed itself into the world’s second-most-popular tourist destination, the world’s sixth-largest car manufacturer, and eighth-largest economy in the developed world. More recently, Spain has hit the headlines as one of Europe’s PIGS — the continent’s poster children for debt-fueled binges and fiscal profligacy. This negative sentiment has hit Spain hard, and its stock market has been among the worst performing in the world in 2010, close on the heels of China and Greece.

From Economic Boom…

As one of Europe’s best-performing economies over the past 30 years, Spain’s “siesta-and-fiesta” reputation is long outdated. Modern Spain was born with the death of dictator General Franco in 1975, which led to the re-establishment of parliamentary democracy and a new constitution three years later. Over the past 20 years or so, Spain’s economic performance has matched that of the United States — its economy expanding at 3.6% a year between 1994 and 2007. During that same period, unemployment in Spain fell from 24% to 8%, even as some five million immigrants entered its labor force. When Spain joined the forerunner of the European Union (E.U.) in 1986, its per capita income was only 68% of the average. By 2007, this figure rose to 90%. As a result, the average Spaniard now has a higher standard of living than the average Italian. And thanks in part to generous E.U. transfers, Spain soon will boast Europe’s most extensive high-speed rail network.

For all of its economic achievements, mention Spain at a cocktail party in London or Berlin, and the conversation inevitably turns to real estate. A few years ago, it was the real estate boom, when Spain was building more than triple the number of units annually as a much-larger Britain. Today, it’s all about the ensuing real estate bust, as asking prices for apartments along Spain’s Costa del Sol have fallen off of a cliff, and more than 800,000 apartments are awaiting buyers.

To Economic Bust…

Spain’s transformation from Europe’s top economic success story to new “sick man of Europe” happened almost overnight. Although most other E.U. countries climbed out of recession by Q3 of 2009, Spain’s economy never stopped shrinking. The International Monetary Fund (IMF) is forecasting that Spain’s economy will continue to contract in 2010 by 0.4% after a drop of 3.6% last year. Standard & Poor’s projects that real GDP growth in Spain will average an anemic 0.7% annually between now and 2016.

Why the sudden pessimism about Spain? Exacerbated by an over-reliance on the property boom, Spain’s 20% unemployment rate is second only to Latvia’s in the European Union. And close to a million newly unemployed are largely unskilled construction workers, whose jobs may never come back. Spain’s dysfunctional labor system makes things even worse. Half of Spain’s — mostly older — workers are on permanent contracts that make them extremely hard (and costly) to fire. Meanwhile, young workers scrape by on short-term contracts. On the one hand, this gives companies flexibility. On the other, they have no incentive to train younger workers. Throw in the effects of the credit crunch, and many companies are between a rock and hard place. Companies can’t afford to fire workers to cut costs, and they have no access to credit to expand business in an already tepid consumer market.

But Not the Next Greece

Spain’s fall from a poster child for European growth to potentially the “Next Greece” has been swift and sudden. Investor nervousness means Spanish banks and companies are having a harder time raising funds. The spread on yields between Spanish and German sovereign bonds — a key measure of perceived risk — has been rising.

Most Spaniards feel this is eminently unfair. After all, before 2008, Spain was a model of fiscal probity. Nor does Spain have a record of fiscal profligacy like Greece. As recently as 2007, Spain was running a fiscal surplus. And even if Spain’s 2009 fiscal deficit hit a Greece-like 11% of GDP, its overall government debt has hardly hit crisis levels. Spain’s ratio of government debt to GDP of 63% is much lower than either of the other PIGS, Portugal’s 87% or Greece’s 120%. Spain’s debt, in fact, is lower than either that of Germany or France.

Nor is Spain resting on its laurels. Prime Minister Jose Luis Rodriguez Zapatero has moved quickly to cut expenditures to cut the fiscal deficit to 3% of GDP by 2013. These include austerity measures worth a total of €15 billion ($17.88 billion) this year and next year, including a 5% cut in public-sector wages and a freeze in pensions in 2010. The government also recently approved a labor reform bill to make the labor market more flexible. The Spanish central bank also is proposing new rules that aim to force lenders to work out nonperforming loans promptly. A dozen of Spain’s 45 savings banks are racing to restructure before a deadline on bank bailouts set by the European Commission  expires.

Spain’s efforts just might be paying off. Just last week, Spain sold more than $4 billion in bonds in spite of warnings that it was on the verge of losing its triple-A credit rating. Skeptics still worry about the level of Spain’s private-sector debt — estimated at anywhere between 178% and 232%. But Barclays Capital argues that Spain overall is less vulnerable to a debt crisis than rival PIGS, Greece and Portugal, as well as non-PIG Ireland.

Spain’s biggest problem may be the sudden and unpredictable jump in risk aversion, rather than its unwillingness to face the fiscal music.

If the PIGS are ever to fly again, Spain will be among the leaders of the pack.

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The World’s Most (Un)popular Economist

“The curious task of economics is to demonstrate to men how little they really know about what they can imagine they can design.”

–F.A. Hayek

Over the last few weeks, a little-known Austrian economist named Friedrich von Hayek has received more press than he has in the last 65 years. Thanks to the promotion of Hayek’s “The Road to Serfdom” by political shock jock Glenn Beck, this 1944 bestseller briefly became the number-one best seller on George Mason University professor Russ Roberts also has produced a rap video, “Fear the Boom and Bust,” that pits Hayek against arch rival John Maynard Keynes and has become a viral hit on YouTube. You almost can see the ghost of Friedrich Hayek smiling as failed Keynesian fiscal stimulus programs give way to government austerity programs across the globe.

Unlike most one-trick pony economists, Hayek was a polymath who wore many hats. Nor was Hayek as obscure as the mainstream economics profession has made him out to be. After all, he collected a Nobel Prize for Economics (actually, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) in only the sixth year of its existence in 1974. His name is more recognized than all but a few former winners. And Hayek’s “The Road to Serfdom” — by far his most popular book — was widely read and cited among British members of parliament during the Thatcher era.

Hayek the Economist

Plucked from the bush leagues of Austrian academia to fill a prestigious chair at the London School of Economics in the 1930s, Hayek initially was feted as the intellectual rival to John Maynard Keynes at Cambridge. Much like today, in the 1930s, the global economy was recovering from a credit-fueled depression. Keynes argued that increased government spending that boosts aggregate demand was a key to getting the economy back on track. Even building empty cities — as the Chinese have done recently — keeps the economy from grinding to a screeching halt.

Hayek argued that paying people to build pointless projects is simply wasteful. And throwing fuel on the fire by loosening monetary policy — as the Fed has done — simply kicks the can down the road and postpones the inevitably painful adjustments needed to heal the economy.

Hayek’s solution? Leave things to work themselves out and not print money in a vain attempt to fix what ails the economy. That was not a solution that won Hayek a lot of friends. After all, people want the government to “do something.” It is no surprise, then, that Hayek lost his debate with Keynes, and his professional star fell as suddenly as it rose. Truth be told, Hayek’s rivalry with Keynes was also a clash of personal styles. Keynes was flamboyant and cool, effortlessly brilliant. Hayek, in contrast, gave the impression of a nerdy, rambling ninny.

Hayek the Political Philosopher

Shunted aside by the mainstream academic profession, Hayek wrote “The Road to Serfdom” as a warning to post-war Western governments about the perils of collectivism. He pointed out that, despite fighting on opposite sides of World War II, Hitler’s National Socialists and Stalin’s Communists shared a disdain for individual liberty. In an economy where government plays a big role, the state inevitably infringes on what you do, what you read in the media, and what your children study in school. Economic control morphs into political control. Think of China today, where 300 top Communist party members control the fate of one quarter of humanity — and all but a few hundred of the 11,500 or so Chinese who have a net worth of $20 million or more, are somehow connected to the party.

“The Road to Serfdom’s” popularity sealed Hayek’s fate as a non-economist. Even the University of Chicago, a stronghold of free-market theory — which Hayek joined in 1950 — refused to give him a post in economics, exiling him instead to its recently created “Committee on Social Thought.”

Hayek the Psychologist

Power corrupts and absolute power corrupts absolutely.

–Lord Acton

Permeating Hayek’s work is an important point about human psychology. Politics attracts narcissists more than policy wonks with noble intentions. This leads those in power to develop distorted perceptions about their own importance. Whether it’s the pharaohs of Egypt who declared themselves gods or Adolf Hitler who launched the Thousand Year Reich (1933-1945), politicians with too much power tend to go cuckoo.

More menacingly, the veneer of civilized behavior that separates us from AK-47-toting freedom fighters is thinner than we think. Consider the results of the Stanford Prison Experiment — where Stanford professors arbitrarily  designated certain students “prisoners” or “guards” in a mock concentration camp. The experiment was stopped early because “guards” soon began to inflict humiliating treatment on the “prisoners.” The lesson? Give even educated, psychologically healthy people too much power, and bad things can happen very quickly.

Hayek the Philosopher

Hayek also makes a point about the limits of our knowledge. Recommendations made by the McKinsey consulting firm by people who were straight-A students in school, but never even ran a pizza shop, rarely pan out as advertised. After all, it was Nobel Prize-winning finance theory that gave Wall Street the misplaced confidence to leverage itself as much as it did.

Hayek’s conclusion? You can’t solve complex policy problems by shoehorning them into complex-looking mathematical equations as economists would have you believe. Perhaps being smart is acknowledging that the world is more complicated than what you can jam into a 20-page PowerPoint presentation. And just because you can conceive of an ideal world, it doesn’t mean all you need to do is to appoint a Czar or an expert commission to make it come true.

Hayek’s Lessons

You see Hayek’s lessons permeate every nook and cranny of today’s policy debates. Government spending can’t bootstrap an over-leveraged economy. You can’t borrow your way to prosperity. Beware of the long arm of “well-intentioned” government policies. The idea of a country’s leader shaking down a private company for $20 billion in damages, based on his arbitrary assessment of what is “just,” is what you expect to see Vladimir Putin do in Russia, not the President of United States do stateside to one of the world’s biggest companies. (Constitutional “due process” anyone?) Finally, reality is complex, and we are a lot less smart than we think.

But perhaps some of Hayek’s lessons are finally sinking in. In a rare admission of his own frustration at confronting a problem the government can’t solve, President Obama recently said of the BP oil spill: “I can’t just swim down there and suck out the oil with a straw.”

Welcome to reality, Mr. President. Welcome to the world of Friedrich Hayek.