The capitalists will sell us the rope with which we will hang them.
-- Vladimir Ilyich Lenin

These fateful words, uttered nearly a century ago by one of the most notorious figures in world history, could not be more relevant today. As the entire world seems to be turning its back on capitalism, and with it the hard-fought prosperity that capitalism has built during the last 60 plus years since the end of World War II, this is an opportune time to reflect on why we have a capitalist system in the first place.

What are the practical alternatives to it, and what are the implications for investors if we continue to move away from capitalism?

At the most basic level, we have a capitalist system because, in the absence of using markets to determine economic outcomes, the only alternative is the barrel of a gun. This is historical fact. In any society that has turned its back on market forces, the results have been clear: poverty, tyranny and despair.

It would be nice if politicians, intellectuals and bureaucrats could simply get together and figure out the best way to organize society and allocate economic resources, but there is absolutely no evidence that will happen, and there is a mountain of evidence that the more you interfere with the market mechanism, the worse things get.

Is capitalism perfect? Of course not. As the late William F. Buckley, founder of the conservative National Review, said, the worst thing about capitalism is capitalists. I agree with that sentiment. Many capitalists are narrow, greedy and dishonest. This is why it's extremely important to maintain the integrity of a capitalist system by demanding transparency and limiting speculative excesses that create environments ripe for frauds and hucksters.

Unfortunately, under the reign of Greenspan's Federal Reserve, these important safeguards were discarded in favor of a simplistic, extremely naïve, libertarian Ayn Randian philosophy that the market is always right and can always correct itself. Rand worshipped capitalists and capitalism like a religion. While that ideal would be nice to believe, history also tells us it's not realistic. In fact, capitalism naturally runs to extremes of booms and busts. This is the business cycle.

Greenspan and his followers somehow believed they could eliminate this boom-and-bust cycle by printing enormous sums of excess money, keeping interest rates below the rate of inflation and allowing a Wild West, anything-goes environment. Instead, what they have done, and what Greenspan as much as admitted recently in his testimony on Capitol Hill, is wrecked the financial system -- and probably the economy -- of the entire world.

Even worse, they have destroyed the credibility of capitalism as an economic system. The absurdity of this result is that it was actually central planning, in the form of arbitrary decisions by the Federal Reserve, the Treasury and the Securities and Exchange Commission that caused this crisis and have exacerbated it recently.

If interest rates were set by the market, if there were a gold standard and the dollar could not be printed in unlimited amounts, if the Fed and the SEC actually understood what is meant by ensuring transparency and limiting speculative excesses, if the government were not trying to pick winners and losers among financial institutions, we would not be in this mess.

(And what a mess it is. Consider that in the past two months, the market has seen the bankruptcy of Lehman Brothers; government bailouts for Fannie Mae ( FNM), Freddie Mac ( FRE) and AIG ( AIG); the failure of Washington Mutual and its takeover by JPMorgan Chase ( JPM); and the mergers of Wachovia ( WB) with Wells Fargo ( WB) and Merrill Lynch ( MER) with Bank of America ( BAC).)

However, it is also clear that there has been egregious behavior by market players. The right way to handle this bad behavior is to identify the individuals and companies that are responsible and bring them to justice. If frauds were committed, the people and companies that engaged in that behavior need to be punished with financial penalties and possibly jail time.

Senior executives at all of the major Wall Street firms, insurance companies, banks and hedge funds should be investigated and prosecuted vigorously for any misconduct. Unfortunately, the easier thing for politicians to do is to blame the whole system.

The public, for its part, is desperately seeking an easy solution to its economic pain. They say desperate people will believe almost anything, even the ridiculous idea that you can simply redistribute wealth to create prosperity. This has been tried many times in many different societies and has always failed.

Redistributing wealth through the government does four things.

First, it makes everyone worse off financially, except government employees, because the government inevitably spends a lot of money just administering the redistribution with its bureaucracy.

Second, it discourages people whose taxes are going up from producing more income. Despite what certain politicians may tell you, this is a very real and inevitable result of higher marginal income tax rates.

Third, it encourages the beneficiaries of the redistribution to work less and spend more. This creates more inflation, which also makes everyone worse off economically.

Fourth, it encourages special interests and their lobbyists to fight for a piece of that money sent to the government. Because rich interest groups have more money and more lobbyists, the ironic result is that it is often the richest among us who end up getting the biggest slice of the money sent to the government.

If people were thinking clearly, the idea of raising taxes during a severe recession, such as we are experiencing, would be considered ridiculous. However, because it is being presented as "sharing the wealth," everyone seems to think it is OK.

Who would not want to share the wealth? Only greedy capitalists wouldn't want to do that. What the politicians don't tell you is that the best way to actually reduce the tax burden for everyone, except the special interests represented by lobbyists, would be to have a low flat tax rate and eliminate all of the loopholes and credits.

It has been shown in many studies that you could exempt low-income wage earners from any taxes, have a flat tax rate that is far below the current higher marginal tax rates and still collect as much or more revenue due to the elimination of all loopholes and deductions.

In fact, it is the super wealthy and the big corporations that would pay a lot more taxes under this system because they are the largest beneficiaries of tax loopholes. The big losers in all of this would be accountants, tax lawyers, lobbyists and politicians who get to collect enormous fees and huge contributions from special interests in exchange for favorable tax treatment.

If there is a shortfall in revenue from a flat tax, the best way to cover that shortfall would be a sales tax. This would accomplish several very important objectives.

First, it would capture the very large percentage of the economy that doesn't file a tax return. Some estimates put this at nearly 20% of all the income generated in the country.

Second, it would encourage savings over spending, which everyone acknowledges is necessary.

Third, it is much easier and more efficient to collect than an income tax, so there would not be any need for a large bureaucracy to collect it.

What about spending on infrastructure? Can't only the government do that? Doesn't that create a lot of good jobs and necessary public improvements? Yes. Of course it does those things. Although it isn't really true that you need government to have infrastructure projects. Many large projects a re privately financed.

Regardless, government does have a role in this area, but it should be done at the state and local level. The federal government has no business dictating to states and municipalities what infrastructure is or is not needed. Federal money should be made available to the states, which should make a portion of that money available to cities.

Federal infrastructure projects too often become ridiculous "pork barrel" boondoggles, such as the famous "bridge to nowhere." In general, more government spending even beyond infrastructure should be done at the state and local level because states and cities know what they actually need better than politicians and bureaucrats in Washington.

The best way to raise more money for infrastructure is not higher taxes. It is by selling more bonds at the state and local levels. Can we really afford to keep borrowing? Look at interest rates. They are extremely low by historical standards. Why shouldn't we take advantage of that situation to finance projects that will create jobs and make public improvements that will benefit the whole society? Last week was the best week ever for municipal bonds.

With investors fearing stocks and real estate, with cash and Treasuries paying very low yields, it only makes sense that investors would flock to higher yields that are tax exempt.

Municipalities should take advantage of this to move forward with infrastructure projects as well increases in public services. The federal government can help by offering to guarantee municipal bond issues for a certain period of years until we start to come out of this very challenging economic environment.

All of this would be so much better than raising taxes or more federal spending. The federal government should not raise taxes during the worst economic crisis in 80 years. If anything, it should be figuring out how to lower taxes by finding ways to eliminate unnecessary and wasteful federal spending. Medicare would be a good place to start. This is an enormous boondoggle that is a transfer from poor working people to relatively wealthy retirees. Yet, you will never hear a politician talk about cutting Medicare because that is bad politics.

Another area to cut would be corporate welfare, but you also rarely hear about that because the lobbyists pay the politicians to keep quiet about it. Obviously, getting out of Iraq would also save a large sum of money that could be allocated for pro-growth tax reduction or spending initiatives.

The point is that you don't fix an economy by taking money from the pocket of somebody who earned it, funneling it through Washington and sending some of whatever is left into somebody else's pocket who didn't earn it. This is a failed concept.

So what is an investor to do in this environment if things continue in this direction? Buy municipal bonds with relatively short maturities to control for the risk of future inflation and benefit from probably higher tax rates. Buy some gold also to hedge against the potential collapse of the world currency system if people lose faith in the dollar as the reserve currency.

Keep a substantial amount of cash or cash equivalents in order to have liquidity available to take advantage of severely depressed asset prices in stocks, real estate and risky credit products (such as high-yield bonds, convertible debt, leveraged loans, lower-than-AAA-rated commercial mortgage-backed securities, collateralized debt obligations, et. al) as well as to possibly take advantage of much higher short-term interest rates in the future if they become necessary to support the dollar.

Wait until the end of 2009 at the earliest to consider long-term investments in risky asset classes, such as stocks -- except for self-financing, large-cap consumer staples companies -- commercial real estate except for apartments in supply-constrained markets, hedge funds and lower-than-A-rated corporate debt.

Avoid borrowing and using leverage as much as possible unless: it is for something you want to own long term; you are fairly certain of your ability to carry the debt service; and it is financed using long-term, fixed-rate debt.

Avoid any complicated investment strategies or securities that you do not fully understand. The world is moving away from risk, and that movement is only going to get more severe if capitalism remains under attack.

Maybe it's been too long since the Soviet Union collapsed, so people don't remember why we had a Cold War for 50 years. It was exactly because we understood that the government, especially the federal government, should not decide who gets to keep what in our economy. If having a scary enemy to remind us of this very important concept is what it takes, then I would be very happy to bring back the Soviets.

That would be better than having our system slide its way into socialism because the public is too ignorant or too desperate to understand what is happening. Redistributionist economics, as Hayek famously wrote, is the "road to serfdom" because you cannot repeal human nature, even at the barrel of a gun.

It is human nature to expect to be paid for working and taking risk. That is why there will never be a better system than capitalism for creating prosperity, even though it is has many flaws that have been on display for everyone to see recently.
Christopher Grey is a managing partner of Third Wave Partners. He currently has no positions in the stocks mentioned in this article. This article should not be interpreted as personal investment advice or a recommendation to buy or sell any security. Interested readers may contact the writer by e-mailing cg@thirdwavepartners.net or visiting the company's Web site, www.thirdwavepartners.net.