According to Ambrose Evans-Pritchard, Japan is quickly turning into developed world’s sickest economy and could soon tip into an uncontrolled downward spiral. Evans-Pritchard reported last week in the Telegraph that Japan is reaching the point of no return where it won’t be able to meet its obligations and could enter a debt death spiral.

While Evans-Pritchard is one of my favorite writers, at the end of the article he comes to the wrong conclusion about what the West should learn from Japan. Evans-Pritchard suggests that too much government spending resulting in too much debt is the root cause of Japan’s problems and that the West needs to take notice and get government spending under control. While Evans-Pritchard is correct that Japan’s debt habit is unsustainable, the country’s debt problems are the result of its population imploding and the fuse finally burning out on its demographic time bomb. The Land of the Rising Sun is in trouble because it suffers from an insular society that discourages immigration and implicitly encourages low birth rates. For the last 50 Japan has been slowly committing demographic seppuku and now the inevitable is taking place, i.e., Japan’s population is crossed the tipping point so that its work force is both relatively old and shrinking and as a nation Japan can’t sustain its standard of living.

On Monday the Wall Street Journal ran an article that described the end of the golden era for oil refiners. It is a great article that, unfortunately, was published many years too late to be considered news. Just as gravity is a force that brings all objects to earth, public policy that destroys the demand for gasoline will hurt the refinery business. Not surprisingly, President Obama’s public policy initiatives that increase car and truck fuel efficiency have the side effect of hurting oil refinery and distribution businesses.

Just to be clear, I am not against the Administration’s effort to increase fuel efficiency in the vehicle fleet. Quite the contrary, it is a matter of national and economic security that we burn less imported fuel. Increasing transportation fuel efficiency is a “must” for the United States. However, I don’t think that it is realistic to believe that the energy industry will act like an old trusted dog that knows when it it time to walk into the woods and die. And it isn’t fair to the refinery and distribution businesses to ask them to effectively subsidize the rest of the economy’s shift to more fuel efficient vehicles and alternate energy without compensation.

The entire debate about the regulation of derivatives contracts takes on a new meaning in light of the OCC’s Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2009. The OCC (Office of the Comptroller of the Currency) publishes all sorts of interesting reports and handbooks that are largely overlooked by the media. And, the Derivatives Report is one of those OCC reports that almost no one seems to look at or care about.

For those readers who don’t know what a derivative is, Wikipedia has a great definition:

The U.S. economy has a long way to go before the economic recovery will be either sustainable or robust. Monetary indicators don’t look good and are once again getting worse. I am concerned that the financial system hasn’t recovered enough for the Federal Reserve to withdraw from its program of quantitative easing.

While most of the large financial institutions seem to be currently stable, abetted by hundreds of billions of dollars of government investment and support, they aren’t strong enough to service the needs of Main Street. Almost all of the monetary and financial indicators point to shrinking lending and constrained credit. The part of the banking sector that supports business and consumer isn’t working and, in many ways, is getting worse. And, the shadow banking system is continuing to disappear and can’t be counted on to pick up the slack of banks.

Have you ever tried to recalculate the finance charges on your credit card bill? I am betting that few Americans know if their bank is overcharging them or not.

I have to confess, for the last 28 years I was one of the people who trusted my bank and didn’t bother to check the interest calculation. After all, in 1966 when I opened my first bank account my mother told me that I could trust my bank and that they would never try to rip me off.

Last week’s late breaking news that the Federal Reserve was following through on its plan to change how it regulates bank compensation is being follow up by this week’s G-20 meeting on how bank compensation curbs can be internationally coordinated among the large economies. Surprisingly, however, the media is acting as if regulating bank compensation is a new issue. It isn’t new at all but rather a problem that they chose to forget about for the summer.

If anyone was wondering what the Federal Reserve and the U.S. government has been thinking, the minutes of the House Financial Services Committee provide the answer. On June 11, 2009, Scott G. Alvarez, General Counsel for the Fed, laid out the compensation plan. Interestingly, his words are almost identical to the breaking news that caused last week’s compensation firestorm.

President Obama’s effort to reform the banking system doesn’t address the system’s biggest problem, which is how consumer credit is underwritten in the United States.

Without exception, no material consumer loan is made in America without the borrower’s credit bureau first being polled by prospective lenders and a credit score used to classify the borrower as good, bad or middle risk. Credit scores are supposed to accurately predict the probability of default by consumers, but in practice, credit scores don’t predict much of anything. Banks blindly rely upon the junk put out by consumer credit rating agencies and are getting burnt by ignoring the most basic rule of underwriting, which is to know their customer. While banks know borrowers' credit scores and information on the credit report, that isn’t the same thing as knowing their customer or things like their customer’s assets, liabilities and earning power.

Two weekends ago Paul Krugman explained in a New York Times Magazine article that many economists can’t forecast the economy because they have a cultish belief in the nearly always wrong efficient market theory. Mr. Krugman’s solution, an academic exorcism where economists renounce their loyalty to the efficient market theory and swear allegiance to neo-Keynesianism, has created quite a stir in the profession and prompted a number of personal and professional attacks on Mr. Krugman. Unfortunately, both Mr. Krugman and the efficient markets believers are both wrong. The theory is correct but the conditions necessary for the efficient markets theory to work don’t exist.

Mr. Krugman suggests that economists missed the Great Recession because they relied upon mathematical models that assume the economy is a series of free and efficient markets and therefore a self correcting predictable economic organism. Mr. Krugman proposes “economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly”. Instead, Mr. Krugman’s solution is to substitute Keynesian models for efficient markets models when he states that “Keynesian economics remains the best framework we have for making sense of recessions and depressions”.

Paul Krugman’s New York Times Magazine article of September 6^th maintains that externalities are the most important factor in market failures, but then never considers whether or not large “externalities” caused the failures of 2007. By ignoring externalities, the usually brilliant Mr. Krugman illustrates why economists didn’t see the market crash and Great Recession. The unintended and unrecognized effects of negative externalities were probably the largest factor that contributed to the summer of 2007crash, yet economists virtually ignore these cultural and sociological phenomena that almost resulted in economic seppuku.

Mr. Krugman wrote a single sentence about externalities when he said “…economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” – costs that people impose on others without paying the price, like traffic congestion or pollution.”

Paul Krugman’s New York Times Magazine article explaining the dismal state of the economics profession is itself an object lesson in what is wrong with the economics profession.

While Mr. Krugman is one of the most talented economists alive, this article isn’t an example of Mr. Krugman at his best. Instead of trying to figure out what is wrong with the training and reward system for economists, Mr. Krugman uses the New York Times article as a chance to implicitly disparage his critics while proposing a solution to the problem which, coincidentally, is to become a believer in his view of economic theory and public policy.

Almost every day I am asked about the economic recovery and whether or not it is sustainable.

People ask because there is a constant barrage of economic predictions by economists that pretend that they know what will happen in the future even thought they still can’t figure out what happened in the past. Listening to economists and TV talking heads it’s clear that while everyone has an opinion, no one really knows if the recovery will take the form of a “W”, “V”, “U”, “V” or “Z” (I am not really sure what a “Z” recovery is but some really confusing economists are predicting it).

Hank Paulson said the unimaginable last week. He testified that he was off skiing when he had his famous telephone call with Ken Lewis where he strong-armed Lewis and Bank of America (BAC) to complete the acquisition of Merrill Lynch (MER). Lewis had previously testified that he thought that Paulson was on a bike ride but as it turns out Lewis was wrong and Paulson corrected the record.

During his testimony Paulson made it clear that in December the United States financial system was teetering on the edge of collapse and that if Bank of America didn’t follow through with its planned acquisition of Merrill Lynch the economy could have been destroyed. According to Paulson it was impossible to underestimate the stakes involved in a bad outcome for Merrill Lynch.