The tax is gaining plenty of support across Europe – with the United Kingdom being the most prominent holdout, which is ironic, because they have been doing something similar for decades.

But support isn’t coming only for the reason Sarkozy mentioned – namely, that the tax will help cut the deficit.  That may be the selling point for voters, and it may even be the reason he feels it will resonate with voters in other countries – especially those without major financial centers – but the reasons being kicked around the halls of the European Commission, the IMF  and Washington, DC, are a bit more nuanced.  The more common argument is that a transaction tax will be used not to reduce the deficit, but to both fund stronger regulation of the financial system, reduce speculation and to act as a sort of down-payment against the next big debacle.

Former JP Morgan Managing Director John Fullerton is one of a handful of finance professionals who have come out in favor of the tax, which he concedes may make the financial system less efficient, but which he says will make it more resilient.

“Efficiency is the ability of a system to grow and expand and process throughput,” he told us in an article to be published later this week. “While resiliency is the ability of a system to recover from a shock.”

It’s an argument he’s made before, and it’s one we will be exploring in an upcoming online Futures exclusive, tentatively slated for publication later this week, and tentatively titled “Is a financial transaction tax the market’s salvation?”

According to Bloomberg, the decision came after a fourth quarter that some analysts predicted was the worst for investment banking and trading since the financial crisis in 2008. Last year companywide compensation and benefits rose 6% to $12.7 billion as revenue climbed 13%.

This is the latest news of how the financial crisis is beginning to catch up with Wall Street. Last year we heard announcements from UBS, Citigroup, Morgan Stanley and others that they are planning significant layoffs.

What’s your take on bonuses at investment banks? Will we see more caps in the future, or will investment banks have to become more stingy in other areas?

This morning I woke to the news that UBS, the giant global bank of Switzerland, suffered a $2 billion plus loss, allegedly because of a rogue trader on its London equities desk. If true, apparently UBS management didn’t get the memo on Barings or Société Générale, both of which suffered huge losses because of rogue traders and, in some ways more disturbing, bad oversight of traders.

News like this can lead the public to think all traders are rogues. That’s not the case. Fraudulent trading may cause these extreme losses, but bad trading can lose even more, and usually it’s cock-eyed executives with poor risk management that cause the most losses.

This month’s issue is packed with interesting stories of traders who come from the corporate world. Case in point is our Futures interview with Larry McDonald, who was head of the convertible bond trading desk at Lehman Brothers (see “Larry McDonald: Inside the fall of Lehman,” by Managing Editor Daniel P. Collins). McDonald wrote a book, “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers,” providing his view of how a combination of senior management blindness and/or greed mixed with government policy led to Lehman’s end. With the three-year anniversary of that failure just passed, and with markets still roiling, we believe his story is one to hear.

McDonald says he worked with senior managers to warn the upper echelon about the problems in the real estate market and that Lehman’s risk was too concentrated, but to no avail. And we all know what happened. Did Lehman’s end have the wake-up effect then-Secretary of Treasury Hank Paulson thought it would? McDonald says that letting Lehman fail made things worse. He now has moved on to Newedge.

Having lived through somewhat of a similar tale is the subject of our Trader Profile, Jean Mrha Beach (see “Beach: Building a new business,” by Dan Collins). Beach started her own commodity trading advisor (CTA) in 2010, but has years of corporate trading experience. Most recently she was heading up trading and risk management for Tyson Foods, but prior to that she was head trader of Enron’s daily swap and options book for natural gas and then moved over to run Enron’s broadband and upstream product units. She notes how, working at a commercial firm like Tyson Foods, “you get a perspective of how commercial end-users think.” And while at Enron, she learned “how to get information out of the market and how to trade off of that information into hopefully a profitable position.” She is using those same techniques to trade today.

One of our hot new trader selections, Randall Cleland, now runs CTA Tanyard Creek Capital (see “Tanyard: Bringing home the bacon,” by Dan Collins). Cleland got a master’s in agricultural applied economics from the University of Georgia, and upon graduation went to work for Sara Lee. His basic job was to buy meat (bacon) as well as help customers with forecasting and forward pricing. He even traded pork bellies at the Chicago Mercantile Exchange for awhile, but went back to Sara Lee to run its hedging desk. He says he learned a lot about how to get information on the market from the corporate position but became frustrated that he couldn’t use it. Eventually he opened his CTA to take advantage of that market information in the livestock market.

At least two of these traders lived through a rough corporate downfall, not of their doing, but still managed to retain the correct lessons learned from those days: Diversify risk, use market information to your advantage and don’t over-trade.

Looking forward, this next couple of years don’t look very promising, either. Based on issues plaguing world economies now, Capital Economics analysts covered topics such as austerity vs. default and other options, the continued viability of the euro, how the United States stacks up against Europe and the state of emerging markets. For now, let’s look at the options for getting out of a recession and watch for future blogs on the other topics.

Of the options to get out of a recession, austerity seems to be the newest buzz word for politicians that like to equate running a country with running a home. While it makes sense in the one setting to not spend more than is coming in, the problem is that to get out of a recession, someone has to spend more. And that’s probably not going to be consumers, at least not right away. Further, there are other consequences if a government reduces expenditures, namely that money is no longer going into anyone’s checking account causing even less spending. See where this is going?

If austerity alone won’t do the trick, perhaps defaulting on the debt is the way to go. In the past, some countries have done very well by defaulting and then restructuring, Argentina is a great example. The key to that, though, has always been to default to foreigners only because defaulting on domestic debt transfers the problem from governments to domestic citizens. In today’s world, though, it is a global economy and as such there are no real foreigners anymore because everything is so interconnected. So, any default would be likely to see the banking crisis reemerge.

Inflation is another way out of a crisis, but ultimately that’s just “default by the back door.” By increasing monetary supply so that it takes more money to achieve the same results, past debts are “paid” at a lower cost. Of course, this method achieves debt reduction gradually and spreads the cost fairly widely across society. There are other risks to this strategy, too. Bond yields rise dramatically and it can be difficult to keep inflation under control. Not to mention, bringing inflation back down again requires a recession.

The last way out of a financial crisis is through growth. That growth, usually has to start with government spending. This is arguably the most painless way, but it takes confidence and patience to see it through, and it still requires some form of fiscal restraint. Growth could be strengthened by a number of things including stronger currencies in Asia, particularly China, lower commodity prices or relief from the European debt crisis.

So, how do we escape the current economic crisis? Bootle says the best way is fiscal restraint combined with economic growth. Unfortunately, he adds that few countries can manage that combination. Bootle’s outlook, then? “The world faces a toxic mixture of austerity and default, currency instability and depression.” Sounds just swell.

The day after the infamous downgrade of the U.S. credit rating by Standard & Poor’s, I had lunch with a long-time friend who has taught me much about the markets. I noted I was annoyed by what the agency had done and said people should dump McGraw Hill stock. She was more sanguine and said that S&P probably wanted to show some independence after the financial crisis of 2008 and its part in it. My response: Helluva time to show some spine.

And bad spine at that. As I read the S&P report and its sovereign committee’s reasoning behind it — in summary, Washington is broken — I admit to agreeing with some of the points. But as others have said, it should be the numbers, not the politics, that S&P is judging. Further, when a credit agency has been as much debased as S&P, its decision, to quote CME Chairman Terry Duffy, was “a joke.”

Although many talking heads attributed the following week’s whipsaw stock market fluctuations to the downgrade, the action didn’t have much impact. After all, two other credit rating agencies kept America at AAA. Perhaps even better proof of this and a bit of irony: U.S. Treasuries rallied, showing where people put their money in volatile times. Stocks were dumped and U.S. bonds were bought despite record low yields, which as the Financial Times noted: “Take inflation into account and the yield on U.S. government bonds maturing in the next 10 years is negative.”

Turns out the market swoon was due to several factors, both fundamental and technical, but a key theme was the continued instability of Europe: Riots in London, French banks under pressure and possible debt contagion spreading beyond Greece — still.

On the currency front, the Swiss franc and Japanese yen rallied, taking over the U.S. dollar’s share as a safe haven, while the dollar weakened but stayed within its channel. China seemed unmoved and unworried about America paying its debts but was disturbed by the public display of dislike our policy makers had for each other. Of course China would say that, but even I’m a bit disturbed by not so much the display, but the foolish stubbornness of certain political factions that choose fiction over fact every time.

The trouble is, all these dramas take away from what really is needed: Employment stimulus. Perhaps it was some good news that bolstered some of the market, including a rise in nonfarm payroll, up 117,000 in July, and unemployment claims that had dropped below 400,000 for the first time in four months. For a market desperate for some good news — especially on jobs — this helped support a rally.

In “Currencies outlook: Winning the ugly contest,” by Assistant Editor Michael McFarlin, analysts note a key concern is that as we move away from a stimulus environment and settle into a period of austerity, we could find ourselves, and the U.S. dollar, in a deeper funk. One analyst even suggested the need for a third quantitative easing package.

One thing confuses me in the discussion about spending cuts and holding the line on taxes. Our tax rates haven’t been this low since 1950. Due to deductions, income, etc., about 47% of Americans don’t pay any federal income tax. And yet, when Bill Clinton pushed through a deficit reduction program in 1993 that in fact increased taxes on the more affluent, we went through the longest economic expansion in our history. So if it’s true that “Reagan proved deficits don’t matter,” as Dick Cheney said, why aren’t we following the same road that led us to the prosperity and growth of the 1990s and even would have gotten a AAA rating from S&P?

But no one is going to want to pay more in taxes just because Warren Buffett says so. The important point he made is that he is in the business of making money, the business of investing — perhaps the best of the best at this — and he says, tax policy doesn’t affect the way he and most of his competitors pursue their craft.

He notes, “Back in the 1980s and 1990s, tax rates for the rich were far higher, and my percentage rate was in the middle of the pack. According to a theory I sometimes hear, I should have thrown a fit and refused to invest because of the elevated tax rates on capital gains and dividends. I didn’t refuse, nor did others.”

To add emphasis, he states, “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9% in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

Many people will dismiss Buffett because of politics or his age — in fact they already are — but this is not some liberal Hollywood star making this point, this is arguably the greatest capitalist of our time. And he is saying the tax rate does not dictate his investment plans, which is an argument made so often many presume it to be true.

He next attacked the job creation argument. How raising rates on the rich would stop job creation. “And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation,” Buffett states.

A little over a year ago I attended a forum on the debt crisis at the University of Chicago sponsored by the MacArthur foundation entitled, “America’s Fiscal Futures: Making Difficult Choices.”

It was based on the report, “Choosing the Nation’s Fiscal Future,” which was produced by a committee put together by the MacArthur Foundation and chaired Dr. John Palmer and Rudolph Penner.

The point was to bring experts together to come up with a plan to cap the debt to GDP ratio to 60% by 2022, an area which was viewed as a danger level.

They developed a couple of models to do this but the conclusion by the chairs of the committee was simple, there was no way to do this simply by raising taxes or simply by cutting spending. Tax increases would be too high and budget cuts too deep. It had to be some combination of the two.

Since then a portion of the Republican party backed by Tea Party activists have managed to take one side of the equation completely off of the table despite their claim that their focus was on deficit reduction.

If this is indeed your top priority, then you really can’t start by taking potential solutions off of the table. That fails the smell test.

As we pointed out last December when a compromise was reached to extend the Bush tax cuts as well as unemployment benefits, neither side appeared to be serious about the deficit. Both sides compromised to keep what was important to them: for the GOP it was to retain the Bush tax cuts for people earning more than $250,000 (they threatened to not extend the cuts to all if the Democrats attempted to simply end them for the top earners) and for the President it was extending unemployment benefits out 99 weeks. What both sides were willing to give up was deficit reduction.

We all now know that those sorts of compromises are destructive to the long-term health of the United States.

Buffett’s piece reiterates that fact  noting the need to pare down “future promises,” but also notes that the dire consequences often attached to any sort of revenue increase simply are not true.

At a recent Republican debate, all of the GOP contenders for the 2012 nomination affirmed that they would not raise revenue (taxes) even if it was accompanied by budget cuts 10x the size of the revenue increase. Perhaps they should consult with America’s most successful investor.

Despite the debt ceiling debate, 79% of organizations that held Treasury securities during that time did not alter their holdings. Almost 13% slightly decreased, significantly decreased or completely liquidated U.S. Treasury holdings during this time. However, of those that held on to U.S. Treasuries, 15% indicated they do not plan on adding to those holdings.

So what do these pros believe the key short-term impact of the downgrade? Although 60% don’t believe it will have any impact, 26% believe it will increase the cost of debt financing, 20% believe it will increase the cost of bank credit, 10% believe it will reduce bank credit availability and reduce access to debt financing. Finally, 7% believe it will increase the cost of raising equity and reduce ability to raise equity.

Long term, 75% don’t believe this downgrade will have any impact, although 24% believe it makes the U.S. less attractive for investment, which could impact hiring and capital investment in the United States by these firms.

The Fed is telling us that it will maintain a zero interest rate policy—the same emergency policy that has been with us since December 2008 — for nearly two more years. 

Fed Fund futures had only priced in a 25 basis point increase in its June 2013 contract prior to the announcement so this shouldn’t have been than much of a shock. But I have to admit it shocked me.

Perhaps if they announced a third round of quantitative easing (QE3) it would have seemed too much of a reaction to the recent Standard & Poor’s downgrade of U.S. credit. And the market doesn’t seem afraid of U.S. credit as 10-year Treasury note futures rallied to all time highs (record low yields) so there is no immediate need for the Fed to starting buying up more Treasuries (see chart below). But it needed to acknowledge the recent weakness in the economy and at least appear to be taking some action.

It did, however, leave the door open for QE3: “The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.”

We have been critical of the Fed who have appeared to be talking out of both sides of its mouth during this crisis. At one point claiming the economy is improving and at the same time keeping rates at zero.

There was no confusion here as the outlook was grim.

More confusing is the market’s reaction. Equities where on their way to a pretty strong rebound when the announcement caused equities to tank to new lows. Then just as quickly they rebounded to close on their highs.

While this type of whipsaw reaction is seen during Fed auctions, the results of which are sometimes hard to read, their statement was pretty straight forward. It was either good news or bad news. I began wondering if conspiracy theorists would start to bring up the mysterious, “Plunge Protection Team”.

The market reaction was so weird it caused Andrew Wilkinson to write today: “The equity market’s strongest rally in several years is about as misplaced as had parents thrown a celebratory party for an eighth-grader after hearing their child would spend the next two years at the same grade level.”

I think Andrew is looking at the whole more than the parts. Remember the initial reaction was extremely negative. What happened next is a mystery to me as well, though I think it is related to the perma-bull mentality that is still rampant in the equity brokerage world. The internet was full of analysis from this space claiming we are at an historic buying opportunity. And yesterday’s S&P low represented a 20% drop in the index over one month. Surely the market was oversold and there is a portion of the investing world looking to buy a major bottom, and every serious downturn produces claims that this is a major bottom. Also, whether or not you subscribe to the PPT conspiracy theory, there is ample proof that the Fed will take action to attempt to prop up equity markets.

There have been numerous comparisons about what is going on in the U.S. economy with the Japanese lost decade (now decades). With the projection of a five-year period of zero interest rates, no time has that comparison been more apt.

 I have to admit I found that amusing. You see, I had just posted a chart on our web site indicating how some significant technical support areas had been breached on the Dow Jones Industrial Average. I had been having a conversation with one of our contributors about this and he had indicated earlier in the week that the market could be facing a turning point.

Jeff Greenblatt (aka Fibonacciman) had noted on Monday, “Last week, it appeared we could be setting up for an inversion of the 610 trading day cycle to the March 2009 Haines Bottom. That window kicks in at the end of this week….  I remarked to my client base that we started getting that ‘end of world’ feel to things. It seemed like we were having a smaller version of 2008 all over again. … there has always been and now can’t be ruled out a chance we could have a market top as a result of all this on day 610.”

Actually it looks like the market topped on July 21 when it failed to take out a top from two weeks earlier and began its current slide. A slide that pushed the indexes up against significant trendlines that were subsequently breached. The point being there was some significant technical validation in yesterday’s move.

However what amused me harkens back to Geithner’s nomination. Jeff is an ardent technician who has pointed out in articles in Futures and at numerous conferences, that most important market reversals can be predicted through the study of technicals, more specifically market cycles.

He has pointed out that often we look to the newswires for reasons but even when the reason seems legitimate, like the Lehman Bros. bankruptcy, TARP vote, Japanese tsunami etc. there is a corresponding technical cyclical reason for a major price reversal.

Sometimes the news event seems paramount and at other times it seems a stretch as when in November of 2008 the pundits attributed a market bottom and subsequent rally to President Elect Obama naming Timothy Geithner Treasury Secretary. Really; that is what turned around the market?

At the time, Greenblatt had detected a significant technical top in the U.S. dollar, which he attributed to setting a floor in equities. The dollar and equities have been negatively correlated (look at yesterday’s action) especially in the last decade.

The Geithner story from 2008 illustrated just how silly the business media can be in trying to tie a market move to a particular item in the news. Now yesterday’s story was partly tongue in cheek but I guess it is only fair to blame yesterday’s carnage on the chance Tim Geithner will be staying at Treasury.

The scary thing is just how easily some of us can accept such dubious cause/affect assumptions. I am sure over the weekend you will hear blame being tossed around for what happened in the markets. It was the Tea Party? It was the President. It was the failure to extract deeper budget cuts. It was the cuts.

Perhaps it was technical.