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Sunday, February 22, 2009

Problems no bailout can solve

Last post, I discussed the creation of private credit money. This is the expansion of balance sheets primarily in banks and large hedge funds, that buy and sell each other's future debt obligations.

If a retail store, for instance, created a pre-paid gift card for use at its stores, it's actually in the money-creation business. The gift card represents no store of value--it is but a promise to receive merchandise, surrendered for an upfront cost. The benefit to the issuer is that they can increase sales, but more importantly, that they can get tomorrow's sales today.

The federal government maintains a monopoly on the issuance of money, although technically we don't carry our government's money around in our pockets. What we have--and you'll see quite clearly if you care to look--are Federal Reserve notes. The Federal Reserve is a central bank that operates on a number of principles meant to reassure the public and maintain the orderly flow of money to its principal users: the banks.

Money created outside this system is referred to as private money. Private money can only exist in the form of credit money. When a private company issues substitute currency, the government clamps down hard, as they did with the Liberty Dollar, a silver coin instrument. SIlver deposits held by the company were seized; these asset secured the value of the Liberty dollar--tying it something far more tangible and value than a simple promise to pay.

Money is only a measure of value because it retains its value. Once money starts to lose its ability to by things, or as much as it once could, people lose confidence in it. If for instance, the retailer who issues a gift card is about to go bankrupt--as many issuers of these cards have--the present value of the cards goes way down. People simply aren't willing to put their trust in the "currency"--in this case private credit.

To restore the value of our currency we need to shrink the size of our debt, which is in fact our new money--issued privately or by our government.

Short of a silver- or commodity-based currency, the value of our money reflects the level of confidence people have in its future purchasing power. Obviously, once the Liberty Dollar's depository based was raided and drained, would-be recipients and holders of Liberty Dollar certificates assessed the worth of the currency based on the promise that the company could get the silver back from the Feds.

Ironically, lower denominations of the paper certificates are actually worth their their stated value on sale at E-bay! The certificates are well printed, of decent quality and stand a better chance of one day being worth something more than an IOU from a company that never tried to tie the value of their credit money--whether in the form of a gift card or some other form of debt-- to any real asset like silver.

The debt must be eventually repaid or increasing amounts of new debt issued to allow the expansion of the economy, which depends on borrowing more, constantly more. Eventually, the dollar will collapse in purchasing power, as money is a commodity--the more of it there is, the less it is worth.

Real consequences

The dollar will eventually plummet. This scenario encourages people to invest in real assets, like certain kinds of real estate and precious metals.

The upside is that we will be forced to live within our means. The downside is that the imminent demise of the present day Federal Reserve/fractional reserve banking system, the consumer lending system (Schechter's In Debt We Trust), will result in radical economic uncertainty. I wouldn't expect a Mad Max-type scenario, nor a Children of Men, but the consequences of the debasement of our currency will be catastrophic in several ways, perhaps the greatest of which will be a loss of trust in the markets.

There's some silver lining in the collapse of credit. By allowing some debts to dissolve, be written off, we actually remove the overabundance of loans to shrink.

If all the private lending won't be repaid, it represents a loss of credit, money that never entered circulation. That would be a deflationary impact and prices would drop. If indeed private lending is the source of inflation, the destruction of private credit represents a contraction of the money supply.

Of course, the public will have to accept the new economic realities, already made clear in the slow death of the Big Three and huge loss of manufacturing jobs.

The consequences of the credit collapse include a crumbling dollar. We take the promise that our dollars will be worth something purely on trust. Jim Rodgers, now based in Singapore, has for years been criticizing the credibility of the dollar as the debt base grows, and the US economy weakens. Even in the peak of economic expansion, skeptics like Rodgers forecast that the dollar would weaken and drew down dollar holdings.

Will the Chinese and Japanese similarly sell off their dollar-denominated holdings? They run the risk of decimating the value of their investment portfolios, along with the majority of nations which hold our currency.

It may in fact be easier to maintain the dollar's position as the international reserve currency than try to settle on another. Holding a basket of different currencies likely raises the complexity of international exchange--easier it is to convert any currency to dollars, even if they are rapidly devaluing.

Another factor in the dollar's favor is the relative collapse of the European economy. They are no less vulnerable to the rise of Asia as the world's manufacturing hub. The Europeans rely on a heavily subsidized manufacturing base, to protect them from cheaper imports. In the same way, the US will choose between letting in cars built in China, or protecting domestic automobile industries.

Who dun it?

I don't think we can delve deeper and often enough into the causes of the current meltdown. Why? On one level there's the very obvious benefit of avoiding another catastrophe. Major complaints against TARP, the stimulus, and government relief so far focus on the size of the debt bubble created.

Another reason to understand the causes of the current crisis is to create an effective solution for the current situation based on its root causes, no matter where the truth may take us, or the response it may bely.

Warren Buffett has attributed today's credit crisis to nothing more than a massive scheme of insurance frauds. The credit defaults swaps pretended to insure the risk of a creditor default but in fact provided nothing more than a false sense of security. The insurers were typically the same people who owned the derivatives which were being insured, perhaps one party removed. In other words, it'd be like the holders of hurricane insurance owning each others buildings. Should a hurricane come, it will damage or destroy the buildings and bankrupt the insurers, unless they've managed to off-load the risk, packaging it as insurance, then selling it to a third party.

Writing in OpEdNews, Steven Lesh explains:
"...banks, working in conjunction with Wall Street, were creating credit, i.e. '-money', far in excess of the needs of the real, main street economy."

As Lesh explains, privately-held debt includes credit cards and home loans made by private banks. It's important to understand that a bank doesn't reduce some of the cash in the vault when it makes a loan. With a few clicks of a mouse, your mortgage comes into existence. Now if the bank needs cash, it will have to produce it--that's where the Fed comes in, distributing cash to charter Federal Banks, who in turn lend it to your garden-variety retail bank down the street, should the need for physical cash outstrip the bank's supply.

If an over-expansion of private credit were the reason for the crash, does it make sense to create a new debt bubble--constituted with reams of new Treasury lending?

Another reason to understand the cause is to figure out how to repair the damage. The regulatory environment needs to regenerate. Without a repeal of the Graham Leech Bill, which in turn repealed Glass Steagal, banks will be allowed to continue to dabble in the credit markets, both at the retail level and in investment banking.

This toxic mix contributed to the Great Depression, by allowing banks to borrow to allow over-leveraged customers to play the stock market. When the market fell, so too did the balance sheets of the banks, as their investment activities had tied their fate to that of equities.

A fire wall needs to be constructed between the high-flying speculation typical of the Wall Street and banks' primary function to lend to the public. Until regulations can be restored, the risk profile will remain exceptionally high. No wonder stockholders now shun the industry.

Too much fast cash came from bundling exotic derivatives; retail banks are traditionally conservative. The solution will require change at the structural level, rather than innovation as has been suggested. When asked about the role of innovation in resolving the crisis, Paul Volcker said the greatest innovation of the last 20-30 years has been the ATM. That comment really embodies the true conservatism of the banking industry, at least defined in its traditional role in the economy.

Now, the stodgy banking mentality reasserts itself, refusing to change or admit its role in the crisis. Also, a bunker-type mentality maintains the gross moral hazard that banks are too big too fail, too important to the economy not to be helped.

Now the financial services industry is fighting any change or accountability. The banks gave lucrative bonuses, even as the results of the poor management manifest themselves. As far as I know, none of the major banks have had a change at the top, despite their atrocious performance.

Going into this crisis, and even into the remedy phase, the banking industry has received preferential treatment. Under Bush and to a lesser degree Clinton, the authorities saw viewed regulations as an obstruction to growth, rather than a way to keep banks from practicing risky behaviors. With far too many close ties between the private sector and those responsible for regulating them, capitalism-on-steriods dominated the earlier part of this decade.

Under the Friedmanian/neo-conservative mantra that regulation is bad, our government systematically dismantled the regulatory element. The swing toward laissez faire capitalism allowed the investor class to reap untold billions. The long-term costs to the economy are emerging now, some years removed from their cause.

At the end of Clinton and during the Bush years, our government undermined post-Depression rules. Congress repealed laws in order to provide Wall Street with great profits. Changes to long-standing regulations greatly eased margin requirements. This meant banks could borrow more; speculation appealed to their short-term profits, pleasing the industry. Meanwhile the Fed, steered by the political goals of the Bush White House, added too much liquidity, at too low interest rates.

The banks lent too much, in part to stimulate "home ownership," a political objective which could equally be called home indebtedness. Lending more, the banks could make more profits, so they hired only those appraisers who'd come up with inflated values, according to Peter Schiff in a 2006 speech to mortgage brokers in Southern California. (See the excellent Part 4 here on youtube.com.)

Last week CNBC reporter Rick Santelli blamed the people who over-leveraged themselves for getting bailout help, while the hard-working stiffs down on the floor of the NYSE pay off their mortgages. Reaction to the outburst has been far-reaching; the White House even criticized Santelli (see the AP article in themorningcall.com, and YouTube clip.)

Perhaps if banks hadn't been so eager to lend, the loans wouldn't have been made. I think it was clear by mid-2007 or so that the great credit expansion had ended, unless of course you live in a bubble or actually believe what people in Washington were saying about the economy. So out of touch were people like McCain that they talked about the economy's strength days before mayhem in the markets. A creature of his industry, Paulson talked up the US banking system even as it was collapsing.

Home equity lost touch with reality. Price levels were set based not on a house's real market value, but instead the limit to which homeowners were able to borrow. Prices lost touch with reality when they were climbing too fast, and beyond demand.

The main problem now is that the banks are avoiding writing off their bad loans...for good reason. The total amount of derivates--CDO's, Credit Defaults Swaps, Mortgage-Backed Securities, etc.--held by US banks is well over $150 trillion. With all the banks owing each other, they've managed to tangle themselves into a massive web of co-dependency. Should one major bank or financial entity be unable to pay its creditors, the ripple effect puts the whole system at risk.

Already over $9 trillion in public debt has been created as a means of limiting a credit collapse. Much of these funds have been offered through Federal Reserve discount windows, which allow "cash for trash" transactions where the toxic debt is off-loaded in exchange for US Treasuries. In this way, those who hold the most bad debt gain the most, reinforcing the bad habits which led to the issuance and accumulation of such risky assets.

Is the Federal government really interested in change? Judging by the way Geithner and the new administration is distributing TARP and associated bailout funds, the interests of the banks are being protected far more than the public's.

Our Treasury Department is led by and the Fed controlled by people who've come up through the financial system, so they continue to represent that constituency. Any potential solution will be screened for its ability to protect the banks. Sheltering the banks could extend the contraction, like Japan in the 90s.

If change were really on the horizon, we'd hear a lot more about structural reforms--changing the system. Japanese politicians were always calling for "structural reforms," from about 1992 on.

I'd had the personal experience of trying to find work in Japan in the beginning of that decade-long slump, so I know firsthand just how important bank solvency is to the economy. Without resolving the bad debts on the balance sheets of Japanese banks, little could be done to stimulate the overall economy.

The Japanese sought to mitigate the effect of bad loans by allowing banks to keep those "liabilities on their books, despite the fact they were un-collectable. Like the US, Japan began buying bank stocks, to encourage the increase of lending to head off what was a well-established recession by 1993.

Our government's current approach to resolving the crisis is like that taken by the Japanese during their Lost Decade. Last week, the New York Times offered a good look back at the misguided efforts to manage their financial crisis in an article "In Japan's Stagnant Decade, Cautionary Tales for America" (link.)

The Japanese Lost Decade provides a supreme example of the sheer momentum of doing as one has despite the lack of any positive result. Like Japan, it seems we're doomed to prop up our failed banks, or nationalize them, and absorb all the losses that way, or by the hidden, perverse Fed methodology of exchanging good Treasury bonds for toxic debt securities.

Nationalization is being debated, but that would only mean that the taxpayers will have to bailout the full extent of the banks' hard- or impossible-to-price derivatives. Surely there's a role for government, at the very least it should oversee the banks, to protect the public from the self-inflicted damage cause by the greed of that industry. Excess greed played a huge role in the Depression, which ended with the creation of Glass-Steagal and other regulatory efforts, alongside a number of new agencies.

Paradoxically, it was the repeal or lack of enforcement of those laws and regulations that lead to the current crisis. I'd say it's in the nature of the world's wealthiest to pursue ever more money, never getting enough, hampered only by the strength of our regulatory controls, which they of course see as an impediment to accumulating even more money.

We may not be able to solve the crisis from the inside out. The more our decision-makers rely on people like Bernanke and Geithner, the more disappointing any potential solution. These are the people who directly contributed to the crisis, by pushing for "financial modernization," a modern euphemism for the greed of old.

In the end, we see the changes and destruction of the regulatory element as nothing more than a lobbying drive towards greater profitability for the financial services industry. It's no coincidence that the banking industry, now and then, is represented better in Washington than anywhere else.

Just as in Japan, systemic reform is being ignored in favor of continual layering of band-aids, typically in the form of adding liquidity or more debt to a system already reeling in it.

Rather than confront the real problem--the banks' mistake in lending too much and refusing to write it down--government focuses on face-saving and protecting bank shareholders. At least we're beginning to see real ownership of the banks who've received so much bailout. Nationalization might allow taxpayers a better deal, but not if the money they've thrown in has reduced the consequences of a credit collapse. If private shareholders don't want to hold banks now, it's a safe bet taxpayers should, either, unless of course the banks are too important to fail.

How much more will the banks demand, and get from Congress and the Fed? If indeed they are going to go under--it looks like AIG, recipient of well over $100 billion is about to--the money plowed into them is a pure waste.

Any potential solution is but a effort to drain Federal coffers to support the banking industry's losses, their bad loans and derivatives. Until we hear talk of limiting the issuance of private credit money, limiting our economy's over-reliance on the issuance of debt, private or public, no real change will be forthcoming. Until we see that a federal effort to prevent a re-occurance of the behaviors which led to the credit collapse, we need to be skeptical of anything posing as a "solution."

Corporate bankruptcies are design for this situations and we may all be better off just letting them all fail. Look at the billions being thrown into the never-ending money pit that the Big Three have become, not to mention financial companies.

The real recession

Rather than focus on how bad we have it, our nation needs to understand the source of its economic problems. First, we need to manage expectations. A house appreciating at 15% or more will eventually stop appreciating. Employment never stays at 4%.

Rather than look at the present recession as the unforeseen collapse it may in fact be, we should look at it as the end of a long trend of inflated growth, excess capital, and poor, lazy regulatory enforcement.

A contraction of the economy is inevitable, when growth rates become unsustainable, as they have in the past expansion. While the loss of jobs is horrible, it's not so bad if you're insulated from the economy, but few are. Unless you were counting on getting some equity, or credit, in order to borrow more, the housing price drop needn't result in hardship in the long-term, if you live within your means. Still the ripple effects could jeopardize jobs--housing prices will fall, creating negative equity, encouraging greater divestment. Then again, many people had no business buying homes at the prices they did. The drop in those prices will bring house prices closer in line to their true wealth, where they will be bought. But people are worried: rightfully so.

Personal bankruptcy is a viable option, or at least it is when times are tough. A few years back, the Republicans, alongside Joe Biden, who was representing Delaware's credit card companies, changed the bankruptcy law. Bankruptcy is a legal right well understood by our Founders and the Constitution. Without the right to purge ourselves of debt, for reasonable reason, we can avoid a state of permanent debt enslavement.

About their over-consumption, or the debt trap they've entered, Americans remain largely ignorant, or perhaps unwilling to recognize the scope of the problem. The lack of fundamental knowledge of course makes Americans malleable and vulnerable to predation by the financial services industry as consumers.

Americans lack understanding into the roots of the crisis. Therefore insufficient momentum exists to overcome the sheer inertia of the Washington establishment. Even with the consequences of greed so devastating, Americans appear unable to confront the political status quo, much less replace it with a better system.

Without an informed population, no broad-based popular effort to reform our monetary system exists. Without active voters, exercising true choice, not between a lesser of two evils, but between different visions for America that go beyond the Washington consensus.

The consensus is stagnant, a fixed point in the future. Worse it looks behind us, to our past. It's afraid of change, fearing it even more than the consequences of failing solutions. The consensus dictates a go slow response, at least on the level of structural reforms.

Throwing a lot of cash at the problem is easier than seeing why it happened, or confronting the special interests and industries that dominate our government.

The status quo and politicians are simply too intertwined to allow for real political change. The system violently rejects any attempt to change it from within. This could bode poorly for Obama's compromise-oriented approach, choosing Washington insiders to staff his administration.

I can't believe that the Fed will ever attempt to limit its powers. The Fed has a charter but has begun to lend money out quite independent of our government, at its own discretion, to companies both under the TARP plan and others which haven't been approved by Congress, providing to date some $9 trillion more or less beyond the accountability of any single regulatory authority.

The expanded Executive sees the Fed as a mean sof expanding its authority over the political economy. This strategy would lower interest rates hoping to stimulate growth, which is a surefire recipe for reelection. Raising rates might help stifle inflation, as it did in the early Eighties, but under Greenspan fighting inflation was less important than under Volcker, who jacked rates up just in time for Reagan to defeat Carter.

Future White Houses may be quite limited in how they can deal with the Fed. The Federal Reserve should expedite economic policies of the President, but also avoid becoming too intertwined with one party, as Greenspan did with the Republicans. In the case of Bush, which held the goal of increasing "home ownership," the Fed reduced interest rates and flooded the system with liquidity. These things also had unintended consequences, like a mammoth growth in the money supply. Both issues like that were beyond the time horizon, well past the next election cycle.

It's debatable how much control future Presidents will have over the Federal Reserve because of its level of indebtedness and a lack of effectiveness. Clearly Presidents rise or fall based on the economy. Changing interest rates to stimulate the economy isn't going to cut it, when they're already at almost zero. The Chairman of the Fed is appointed by the President, the tiny body represents the interests of the banking industry. Now that the banking industry is facing a crisis of its own making, it will seek to mitigate the impact of the crisis. This might mean that the interest of the bankers and President could diverge.

It's hard to know the true culprits or separate them from the Washington establishment. A war of public perception is underway, with banks and our government eager to redirect criticism away from the true cause of the problems: its inability to regulate. Already, we've seen much attention deflects on subprime borrowers, the Red Herrings of the banking collapse. Subprime debt constitutes a tiny percentage of outstanding derivatives.

A propaganda war simmers beneath the veneer of our corporate mass media. The American people simply aren't learning things they should. It's much like the run-up to Iraq and all the lies spewed and truths denied except this time we don't know how bad things are, to keep Americans afraid, under-informed, and incapable of acting in their own best interest.

Apparently the gears of the government bureaucracy grind slowly, when they choose to. It wasn't until after the Election that our government admitted we'd been in a recession. Then, we were told that we'd been in recession since December of 2007, I learned today. Previously, I thought it'd been later--it's as if the start date gets constantly revised backward.

How convenient--and typical--of the bureaucracy to hold off on their pronouncement until it became politically permissible to do so after the Election. Then just as expected, we can count on the incoming administration to tell us just how long ago the recession started, which of course allows them to blame the current situation on their predecessor. Can we trust our government and media to tell us the truth?

The real bad guys

Shameless, today's recently unmasked white collar villains would make yesterday's Martha Stewart and Charles Keating look like saints. The Madoff and now Stanford cases demonstrate widespread fraud on a unprecedented scale.

The raw size of the frauds testifies to the lack of due diligence practiced not only by the regulatory authorities like the SEC, but the purchasers as well. Many Madoff investors were hedge fund managers, or administrators of fund-of-funds. Average shareholders received statements that appeared legitimate.

Maintaining credibility in the system must be based on the strength of the compliance effort. If the rules aren't enforced, fraud is certain.

Madoff and other scandals have exposed a legendary scale of corruption in the financial services industry. The damages caused and reputation damage to the industry justify an immediate restoration of the regulatory environment. Instantly justifying themselves, a reinvigorated regulatory effort will expose even more fraud and instantly justify whatever costs are involved.

Given time, trust between investor and financial intermediary can be restored. The bank's losses, Madoff, whatever, all those costs are known and can be replaced. The loss of faith and confidence in our stock market might be bigger. Irreplaceable could be the damage cause by the dissolution of public trust in our banking and monetary systems.

The size of the rackets hints at a much larger and more established syndicate at work. Were Madoff and the others receiving protection? We may never know the true relationships between corporations and their hidden benefactors in government. We can however assume the worst; if Enron was George Bush single largest contributor in 2000, then it's a good bet they were getting something back for their money. Corruption of this scale can only occur with the tacit cooperation of people at the highest levels of our government.

whatreallyhappened linked to a great Counterpunch article by Michael Hudson, The Oligarch's Escape Plan. This article blew me away as it outlined in full detail an Illuminati-style plan to shelter the banks from their irresponsible lending, transfer those liabilities to the US Treasury, expatriate profits abroad, then come in and buy depressed assets for pennies on the dollar.

An agenda to cash in on the bailout is afoot. Financial institutions like banks and hedge funds will clearly try to maximize their own profits, perhaps by buying toxic assets than exchanging them through the Fed's discount windows, a practice that's most assuredly going on. This subsidizes the profits of speculators on junk debt, by rewarding them with ultra-low risk Treasuries at prices far above those in the market.

Greed will grow to proportions of legend if those who contributed to the crisis can profit from a cure. Geithner and others have recently expressed hope that the private sector will get involved in buying more toxic debt. It's even possible that some firms are holding toxic debt in order to sell to the Treasury under one of its new programs. If prices for the debt will be a fraction of their selling price to the Treasury, as the initial TARP plans involved, a good deal of cash could be made buying trash then trading it in.

According to the Washington Post, two founders of the Carlyle group claimed that there's "a role for private equity in the bank bailout and that there's money to be made."

Carlyle Group represents Big Daddy Bush, James Baker, and the Saudi sheiks. The organization uses its authority with governments to maximize profits. In short, it's a hedge fund for the powerful designed to make as much money from peddling the influence of present and past politicians through a crony network involved in arms dealing, infrastructure projects, energy peddling and the like.

Tactics and behavior of the Carlyle are highly predatorial in the sense they aim to exploit the natural resources and vulnerability of smaller client states. The system for destabilizing an economy is really quite simple.

This model originated at the International Monetary Fund, as it overextended foreign credit to numerous nations like Argentina and Chile, then forced them to pay it back at high rates of interest.

In this kind of scheme, benefits to the foreign investors come after their foreign currency reserves have been depleted and the poor victim is forced to borrow huge sums, with repayment required in dollars, or pounds. Once the exchange rate collapses, foreign lenders step back in, buying up the country's debt at ultra-low prices. Or they might demand that the victim offer high-value collateral, typically energy reserves or public assets, on the grounds the lending has become more risky. It's the meddling that makes economic destabilization a certainty. Foreign currency reserves are emptied, exchange rates soften, or the size of the debt payments become too much for the target economy to handle.

Austerity measures are then demanded of the country in order to qualify them for the new loans which must be extended in order to pay off the country's debt load, which expanded as its currency crashed. Public services are curtailed, and the client government is typically forced to sell off public assets, privatizing formerly low- or no-cost services provided to the people.

Perhaps the best example of this model was the Soviet Union. Under Communism, all assets had been state-owned, but then politicians were given control over State industries, to sell or distribute among themselves as they wished. Political control translated into economic control. The oligarchs who emerged made billions by using their influence over the political process to take ownership of profitable State industries (while leaving weaker, less profitable entities to die off.)

The turbulence generated by volatility, which in turn is generated by weak or inadequate government services. The economic failure rationalizes greater privatization. This is Naomi Klein's shock capitalism: create the crisis, then use it as an excuse to replace public functions with private. Recently Paul Krugman called it "lemon socialism," where taxpayers are forced to fund any potential recovery, should it come. Whatever potential benefits end up in the hands of insiders, cronies, and those with the most political influence in the capital.

If the economy gets too bad, it's possible that the targetted government will be unable to manage popular resistance to the economic shock therapy. We saw this radicalization like this during the Great Depression. Right now, riots are occurring all over Europe, in Ireland a few days ago and Latvia quite forcefully a few weeks back. Fears of a "summer of rage" are rising throughout England and Europe.

As creatures of the status quo, politicians will try to preserve their power and authority, and crack down on dissent, rather than re-evaluate the viability of the system. Funded by moneyed interests, laissez faire capitalism will always be praised and toted as the solution rather than the cause of such violent economic swings.

A new more gentler model of capitalism could be created. At the very least single-payer health care could emerge. It could well be that the lack of government-sponsored health care has undermined our manufacturing base. Perhaps instead of direct bailouts, our government could provide free health care to the Big Three. This benefit, amounting to $1,500 for the cost of every vehicle it manufactures, would put Detroit on a level playing field, and improve the competitiveness of US-based manufactured goods.

Instead, politicians will use economic crises to assume more power and control for the state, which is their source of authority and through the peddling of influence, money for reelection. Two types of politicians can emerge: those that try to appease the people, like demagogues, or those who throttle dissent, dictators. Economic destabilization often becomes part of the rationale for seizing power, like Hitler did during the Great Depression.

A great vehicle for Right-wing social experimentation, many of the architects of today's bailout are tied to Milton Friedman's naked capitalism free market approach characterized by massive privatization. The more modern equivalent is the post-Russian model, where oligarchs and corporations grew to dominate the transition, enriching themselves on the opportunity created by political destabilization.

Often little pretext can be given, when powerful forces decide to intervene. Led by a leftist Allende, Chile in 1973 was a peaceful and productive place until the CIA decided to meddle. The brutal Pinochet took over and purged all left-leaning people and "market reforms" were instituted. In time Chile recovered, but the US intervention exposed the intent and methodologies of the landed money elite.

Hudson's article raises the possibility that we in the United States are approaching the point of being post-Sovietized, where public assets will rapidly decline in value. The political crisis then becomes an economic opportunity.
Simon Johnson, former Chief Economist of the IMF is interviewed by Bill Moyers. This drew my attention:
Simon Johnson: I think I'm signaling something a little bit shocking to Americans, and to myself, actually. Which is the situation we find ourselves in at this moment, this week, is very strongly reminiscent of the situations we've seen many times in other places...But they're places we don't like to think of ourselves as being similar to. They're emerging markets. It's Russia or Indonesia or a Thailand type situation, or Korea. That's not comfortable. America is different. America is special. America is rich. And, yet, we've somehow find ourselves in the grip of the same sort of crisis and the same sort of oligarchs.

Should a post-Soviet model be sought, key decision-makers will act in the best interest of the wealthy. The top income brackets in the US saw their control over the American economy and their net worth explode even as the average American's net worth crumbled. The net result of George Bush's tax credits has been to empower this capitalist class at the expense of the public, destroy the value of our money and transfer vast sums from the middle classes to the rich, who grow richer.

WIll--or is it 'can'--any product of the Washington establishment fend off the influence of the investor class and protect the middle class? Only an outsider could threaten the status quo, which is the continuation of a credit money system that will eventually fail. So exclusive is our political system or, more specifically, the vetting process the selects and annoit those in power, that no true reformer could ever get through.

Moyers explains the situation in his interview with Johnson:
"Geithner has hired as his chief-of-staff, the lobbyist from Goldman Sachs. The new deputy secretary of state was, until last year, a CEO of Citigroup. Another CFO from Citigroup is now assistant to the president, and deputy national security advisor for International Economic Affairs. And one of his deputies also came from Citigroup. One new member of the president's Economic Recovery Advisory Board comes from UBS, which is being investigated for helping rich clients evade taxes."

From Bloomberg comes this article about a potential sweetheart deal for the hedge funds. Privatizing the solution is a great way to shuffle more money into the hands of financial industry insiders, including many of the same people who helpd cause it.

Boris Yeltsin was too much of a populist for the oligarch's liking. Obama on the other hand seems to be the quintessential outsider, with a powerful combination of smarts and compromise, which will potentially allow great achievements. Nonetheless structural reform may not be possible.

We need fundamental change in our money system.


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Tuesday, February 10, 2009

Credit system feeds derivatives monster

Credit system feeds derivatives monster

Tim Geithner's plan hit the street today. As of midday, Wall Street has taken the news badly.

Geithner said credit isn't available, but is this really such a bad thing? The contraction of credit is a natural response to over-lending, which appears not to be as big of a menace to government as it has been to the banks who actually have to account to shareholders. Our government appears to have lost any sense of responsibility in preventing a worsening deficit. Over the long-term our existing debt, combined with the borrowing that will surely come, renders our currency valueless.

The damage caused by a lack of credit is lost opportunity, or a consideration of future value created only in the imagination. In other words, what we will lose, we never really had. Losing anticipated growth and revenue isn't the same as losing real profits unless of course future debt is commoditized, turned into its present value. If money doesn't represent an asset, but rather a debt or future repayment, it will lose value when the chance of repayment drops.

The crisis we face today emerged because we've changed the way we spend money. Rather than represent a fiat currency whose quantity can be changed at will, unprecedented growth in private lending has created a massive unwieldy beast, a mammoth mountain of derivatives.

The Fed can only react to the overabundance of derivatives and instruments out there, which has created a de facto equivalent of currency. Neoclassical economists like Geithner and Bernanke believe they can increase the flow of money by increasing its release through TARP. And in Obama's stimulus bill we see the same thinking: government spending more (especially when people stop to spend) will thereby make more money available.

What if the credit money supply has dwarfed the supply of real money? After all, so much of the banks' lending is based on simple computer entires. If it's really grown, it might take trillions to compensate for the collapse. This could explain the unprecedented amounts that are being proposed. If there are perhaps 10 dollars in derivates for every one in circulation (part of the M1 money supply perhaps), repairing the crisis might require tens times as much.

Now Bernanke is clearly familiar with Keynesian approach; the devaluation of money since the last Depression shows just how much of its purchasing power it has lost over time. So, if the economy in inflation-adjusted terms were now ten times bigger, we'll probably need a New Deal times ten! I'm guessing spending (and not just on TARP and banks either, but real money going to real working people) could go to $10 trillion easy. Say hello to my little friend, inflation.

Another angle: maybe the response to the Great Depression was limited by the fact that our currency was backed by gold. With our unbound fiat currency, no such limitation exist on the issuance of new money today. At least New Deal problem-solvers could claim they hadn't decimated the purchasing power of our currency--an achievement that today's government policymakers will be lucky to prevent.

Looking at Keen's article in nakedcapitalism.com, I would guess the number of derivatives well beyond $150 trillion. Therefore to make a commensurate impact on stabilizing such a huge amount would require many spending on a scale perhaps hundreds of times larger than any precedent.

Unhinged, the US money supply--expressed in its broadest form M3, a statistic the US government stopped tracking a few years ago--the number of "dollars" out there grew by many multiples. Readers won't be surprised to hear that it was the Federal Reserve's loose money policy that led to the bubble, nor that Bush's political agenda to increase home ownership, in turn increased the velocity of money.

Velocity is as relevant to inflation as quantity. As long as the mammoth mountain of derivatives can be supported by the issuance of more debt, everything stays stable. The status quo is therefore a constant and growing expansion of "money," which we all know is not in effect money but rather a computer ledger entry, perhaps in the back halls of some faraway sovereign bank. As long as the sheiks let the money pile up--to pay for the oil--and the Chinese continue to purchase our bonds, the monster stays satisfied.

Should something go wrong, say sub-prime securities go bust, the effects can be cascading and damage the entire system. This explains why Bernanke testified in Congress that the Bear Sterns bailout was so needed--to prevent all the creditors under debt mountain from getting crushed by its weight. The systemic risk also explains how CItigroup was able to fandangle so many billions out of the Saudi sheiks shortly before its disastrous stock price collapse. If we don't pour more money in, the monster will consume everything, or so they could say.

The US monetary system has entered a crisis point because rather than base our money on asset, we've based it on credit. I read a good article by Steve Keen (link above) on the evolution of credit money. Ron Paul and people like Peter Schiff and Roubini have been on this point for years. Rather than assume that the Fed can control the money supply by issuing more debt, economists need to realize the supply of Federally-issued debt is but one small piece of all monetary equivalents out there.

Fair valuation

The sheer quantity of derivatives astounds. As one example, JP Morgan has derivatives in the sum of $90 trillion!

We don't yet know how to value those assets--a big reason why the banks' share prices struggle. More than mistakes, the stock market detests uncertainty. Until potential investors have measuring tools and transparency by which they can assess the worth of an enterprise, they will stay away and the stock price languish unless, of course, some entity indifferent to profit or loss--our government perhaps?--comes in and starts to plow money into them, regardless of their investment worthiness.

This is precisely how the first round of TARP "worked" and at least Geithner has the sense to stop trying to subsidize the banks' share prices. The private hand of market which Republican disciples of laissez faire capitalism praised, will do its job to make banks attractive by lowering their stock price. At no point, has the opacity of TARP helped, but rather hindered the fair valuation of the banks (unless of course they'd become worthless.)

The lack of transparency masked some of the dealings of our government in Act One of TARP, back under the Bushites. Obama may offer a change on this front of incalculable benefit. Despite their self-presumed defenders of the free market system, our last Republican administration actually prodded this whole collapse along, by keeping their activities secret. Investors likely fled the financial stocks because they couldn't find out what would happen.

Banks have always been prone to secrecy, and they often use their political influence to keep their dealigns secret. The industry may also be prone to an overabundance of caution, particularly when investor confidence is involved. If the slightest risk of financial insolvency should lead to the slightest stir of market innuendo, banks will be the first to attempt to quash it.

More than protecting the assets of the bank, banking is concerned about perception, or the concept that investor money is safe. The roots of this paranoia lie in the history of banking; nervous depositors have routinely made based runs on their banks based on hysteria. Public confidence is therefore vital, and the safeguarding of it abandoned reluctantly, or not at all if the administration and banking industry are as tightly bound as they were under Bush and the GOP.

Transparency is a vital part of appealing to investors, and Geithner appears committed to getting banks finances into the public view.

Government solution or more problems?

Like me, Geithner spent some time in Tokyo during the Nineties, where he saw firsthand how government intervention to prop up the economy could backfire. The Japanese poured huge loans into the banking industry. This created moral hazard because the bankers who held massive amounts of bad loans kept those loans on their balance sheets, rather than writing them off. Knowing they could count on government money, the Japanese banks were reluctant to act and disinclined to change, and proceeded to feed even more money to the recalcitrant borrowers.

Sure credit can flow out of the banks, given enough government assistance. But as Geithner admitted, government doesn't run banks very well. So at least he knows the limitations of government lending to the banks. This of course doesn't mean that he can afford to let the banks fail, but neither can he let the status quo maintain itself, creating a "Lost Decade" like the Japanese.

Unfortunately we have a heckuva lot of status quo to get through before the problem can be conquered. The issue as it turns out is derivates, a form of private credit money created when financial institutions buy or sell rights to future income. See, rather than just wait around til the checks come, the banks got cute and started selling each other IOUs, to jack up short-term profits. To make matters worse, these derivatives came with insurance, called Credit Default Swaps, that insured the holder of the derivative in the event of a loss.

The holders of the derivatives packaged their IOUs with the insurance, then sold them to other banks. Eventually, everyone was in the business of both issuing derivatives and insuring them, an unanticipated consequences of the Financial Modernization Act in 1999, which mergers brokerages and banks. Profits zoomed, particularly on the backs of mortgage-backed securities, including subprime, alongside complicated Structured Investment Vehicles (SIVs).

Naturally when the sub-prime market blew, so did the value of the mortgages on which the derivatives were built. The insurance that was supposed to protect the holders of the bundled mortgages turned out to be worthless on account of the fact it had been issued too broadly, and inadequately capitalized in the event of market-wide failure.

In short, greed led us to where we are. Trying to squeeze additional profits out of the bottom end of the mortgage market led to the broader collapse in the derivatives markets. Now with well over $100 trillion in derivatives, the issue is becoming how to get out of even bigger collapses.

The first step needs to be better regulation. Banks and brokerages should be denied the right to bundle mortgage-backed securities or sell in derivatives whose values can't be rigorously tracked at any given time. Without knowing the value of a security, it can't be sold, creating an illiquid asset. The lack of transparency can be attributed to the banks' general distaste in exposing the scope of their derivatives trading.

Everything rises or falls based on leadership

A wise businessperson who helped mentor me said that the first act of a qualified CEO moving into a distressed situation should be to fire those in charge, since they got them into the situation. While of course this approach is something of a
mischaracterization--the CEO might not have caused the problem--it does help simplify things. And simplifying things is exactly what the banking industry needs.

Unfortunately, Obama elected to put many of the people who held leadership roles in regulating the banking industry--like Bernanke and Geithner, former head of the New York Fed--into the top positions responsible for overseeing the recovery. Not gonna work. The vested interests that helped push profitability to new heights using innovative derivative trading schemes will be the last ones to admit they'd made mistakes, especially when the scope of their failures is so epic.

Again it's a matter of leadership. The Federal Reserve/banking industry's Old Guard has been responsible for creating the mess. A good new CEO fundamentally understands the need for change. New wineskins for new wine, that kind of thing. Until the people who got us into this mess are identified, ostracized, and punished, no new solutions will likely work.

I've said that Obama has been inclined to work with the Washington establishment in order to achieve change from within. While a noble, conciliatory gesture, this approach may not really expedite much. And as I've also said, the President needs to be able to achieve change on a rapid basis, cut through all the bureaucratic inertia and partisan bickering. While a "I'm the President--do it now" approach might not appeal to the intellect of the professor-turned-President, he needs to wield his authority decisively, and toss out anyone affiliated with the creation of the derivatives mess. Until then, his leadership will be inundated with Bush leftovers, and consensus picks who don't really have change anywhere on their agenda.

At the same time, Obama need not bring in total outsiders. There have to be hundreds of highly qualified economists better able to manage this crisis than Geithner and Bernanke. I for one nominate my International Finance professor at Thunderbird, John Mathis, chief economist at Continental Bank before its collapse. He exemplifies the kind of dignity we need back at the top, someone of integrity and respect that comes from outside the Washington establishment.

Until we get qualified people at the top, we'll be unlikely to engineer much of a solution. The vested interests are well simply too well vested. The Establishment politics are too infested with self-dealing and protecting reputations/covering up mistakes to purge the wrong-doers. Yes, some sacrificial cows like Lehman Brother's CEO Fuld will be brought forth, but those responsible for the greedy practices and abandonment of regulatory standards are too well intertwined with the establishment to present any real solution which has at its heart the need for change in the way banks do business.

Much of this problems has come out of the Reagan myth that deregulation is good for business. When we dropped the laws that kept brokerages and banks apart we created massive new money-making opportunities. Yet we also allowed the banking system to take unprecedented risks and over-leverage themselves to the point the derivatives they owe or are owed exceed by many multiples their depository base.

The solution has been decoupled from the cause and thereby distorts the alternatives available.

Heart of the problem

Defining the problem has been at the root of the solution. Geithner and Bernanke define their mission as one of restoring the credit markets, and getting credit to flow. To wit they pour trillions into the coffers of private lenders. Some of that money in turn goes to buy regional banks, consolidating the industry and eliminating competition. Meanwhile investment banks pour billions in bonuses away, as if 2008 had been a banner year for the industry.

It's as if a public health policy person were to say that the problem was AIDS. I might say, "no, it's an absence of safe sex." While the health bureaucrat might deal the the effects of getting AIDS, they fail to understand its cause and can do little to stop its spread. I, on the other hand, would confront the cause straight away--unprotected sex.

Geithner and Bernanke are now saying they must deal with the shortage of credit--the disease. I would say the locking up of the credit markets is simply the manifestation of an overextended credit system--the cause. Now the chief difference is in the application of relief: in my definition it would be to stop the over-expansion of lending; in the neoclassical view held by our government, it would be to lend more. [Ultimately the process of lending can be achieved both through Federal Reserve lending and through government borrowing, since to pay for any stimulus, we must borrow.]

Can the creation of more debt lead to a solution? While treating AIDS patients is clearly humane, does that stop the spread of the disease? We need to define the proper problem in order to craft the appropriate solution. As long as our government presumes the problem to be a lack of credit money, how can we cut down on how much we borrow, and thereby keep the mountain of debt from getting even bigger, a plague for the next generation.

Debt has a nasty habit of seeming quite manageable but in fact worsening almost imperceptibly over time until the day it sneaks right up on you. Take my word for it--I've been there. If you're relying on debt to fund your day-to-day existence, the pain will be that much greater when the credit runs out.

As a nation we've become credit junkies. As it probably should, the day has approached when our credit has run dry--we simply can't borrow any more. We do however have a completely indefensible target--using the credit of our unborn children. By borrowing way beyond our ability to repay we can get through our time here on this earth, albeit at the cost of untold years of toil by our descendants, carrying the burden of our unpaid taxes.

Yes, the deficits we run are that straightforward--damaging, and emblematic of where we stand as a people. Myopic, we've chosen the looking glass and ignored the debt crisis that we are brewing for the next generation and those unborn.

Easier it is to deny the scope of our debt than to face it down. Easier it is to believe that the problems of today eclipse those in the distant future, forseeable though they may be.

Harder we must all try to understand the scale of our momentous debt problem. Without understanding that the growth of debt is the cause of our problems, we continue to rely on more borrowing to sustain our way of life, one forged not with the fruits of labors but rather with spending money we never had or made, for things we didn't make, or sell abroad.

If we keep feeding the debt monster it will only grow hungrier. We must terminate our ever-worsening dependency on credit, whatever the cost. Real economic growth can't come from cheap money; we can't build economic strength based solely on IOUs and promises to pay. Now more than ever we need a economic cornerstone based on vital economic truth and justice, to confront the problems of our age, not leave them for others to clean up.


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