Geithner vs. Krugman

The implosion of the private credit system--the product of inadequate regulation and easy money--has blown a huge whole in our monetary system. That damage has been done is no news; what is remarkable is the scale of the massive bailout, which includes funds issued by the Federal Reserve, which borrows on Treasuries issued it on behalf of the government.

Everyone agrees something needs to be done. In crafting a workable solution, two opposing camps have formed, one with Nobel-prize winning economist Paul Krugman, and Obama and Geithner on the other.

Geithner and New York Times columnist Paul Krugman entered into a war of words last week. Krugman is calling Geithner's plan "cash for trash." In the New York Times Monday, Krugman quoted an article by Simon Johnson in The Atlantic magazine:

...elite business interests--financiers, in the case of the U.S. --played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed..."

Krugman writes that Johnson sees "America's current difficulties as 'shockingly reminiscent' of crisis in places like Russia and Argentina--including the key role played by crony capitalism."

Krugman and Johnson could have been repeating what I've been saying on this very blog weeks before the mainstream regurgitated this "news" that the crisis and its solution have been tainted by corporate influence over the political and regulatory processes. I even brought up Michael Hudson's article, "The Oligarch's Escape Plan," which outlines similarities between the Russian oligarchs and the way the bailout was being handled.

Some would say the banking industry is, and was, still being represented by the Federal Reserve in the person of ex-Fed governor of New York, Geithner. Can we trust our gut, common sense, and what Krugman says? Or do we believe Geithner--who was and is part of the same system that directly contributed to the crisis?

On TV, the case Geithner makes for the bailout is logical, and sounds like it might work. Yes, adding more capital allows the financial entities to lend more. But will consumers spend? Our economy depends on ongoing borrowing by consumers--Americans are saving instead. Can increased government spending replace consumption that's declined?

While Geithner's plan may be credible on an intellectual level, my gut tells me he can't be trusted. Apparently most Americans agree with me. Over 50% believe the bailout should end, which indicates political momentum is against Geithner's proposition, that the Treasury needs to buy up the so-called toxic assets, or begin a public-private partnership to liquidate the securities. Obama has wrapped a lot of political capital up in the bailout.

Why are people like Geithner so worried? The answer to this question comes in the under-publicized truth that the banks are under-capitalized--having been allowed to double down on their reserves, in what would have been impossible had banking laws and regulations not been tampered with. Subsequent to lending themselves and each other too much, they then bundled financial products into derivatives, swaps, futures, and other overly complicated, hard- or impossible-to-value debt instrument which of course provided huge short-term profits.

Making these assets toxic is the fact many of these securities have Credit Default Swaps--a type of insurance against default--attached to them. Should the value of these debt securities crash, the CDSs will kick in, and incur huge payments on the issuer of the CDSs, who happen to be the same banks and financial companies whose balance sheets positions have deteriorated.

As the financial entities issuing CDSs are all interdependent, should CDS issued by one company not be payable, all CDSs could quickly become worthless.

We can't summarily write off the CDSs, as they're part of a contract. Or can we? Congress did end up taxing AIG retention bonuses, so maybe CDSs can simply be retroactively annulled. Then the markets could discount the underlying security as if the CDS weren't there. Better to take the damage upfront.

Geithner does seem to realize the need to allow the market for these securities to function with a minimum of intervention. At least Geithner is wise enough to know that the market is a far better source for evaluating the worth of the securities than any government agency. He's wise to let private sector professionals determine what constitutes fair value. So why doesn't he just leave the sector alone?

Well, as I said above, the banks are exposed to double jeopardy on paying the CDS attached to the Collateralized Debt Obligations and other debt. They owe each other vast sums and once one bank defaults, they all could. Should a ripple effect begin it's possible all the cherished big names on Wall Street might actually owe more than they can pay. Already derivatives holdings and obligations far exceed the depositor base--JPMorganChase has some $90 trillion or so.

If a collapse were to occur, would banks simply raid depositors' accounts, causing a run on the FDIC? As I said in my last post, libertarians view the FDIC bank guarantees as a moral hazard that encourages risk-taking.

CDSs have discouraged many of the debt securities from being sold. Why buy something for 80 cents on the value if the CDSs kick in at 70 cents? The only reason buyers would pay more for a CDS-insured debt security is if they think the insuring company--often the same as the one issuing the security--can cover the cost of default.

Government buying up of the CDS-insured debt, at above-market prices, shows a lack of confidence in the ability of the issuers of the CDS to pay in the event of default on the underlying security.

Now Geithner is trapped between letting free markets set prices and setting the prices itself. The worth of these securities can't be determined very well under contrived circumstances, where government guarantees and loss stopping prop up prices.

No one in the private sector wants to make a mistake or take losses when the government will subsidize the losses to some degree should they be incurred. The intent of the bailout to subsidize losses on behalf of private banks encourages gaming the system, by selling the worst debt to the government or through a market it supports.

Successful government intervention will require ongoing interventions as a self-fulfilling prophecy for as long as the government is actively participating. No government involvement in pricing can be good over the longer term: it's like setting bread prices in a communist bakery; they might be good for consumers, but no one wants to supply the wheat at such low prices so the shelves go empty.

Constant meddling hinders free market activity, reducing prices as the result of a massive injection of risk, which accompanies any market subject to political control.

Whatever excess profits might have been lost to regulatory burdens that could have been imposed but weren't far exceed the tens of trillions in home and stock equity losses. Hard-core market fundamentalists like Larry Kudlow have to eat their own words as the bailout costs incur huge deficits that must be remedies by higher taxes, or inflation, sooner or later. Worse, Kudlow and others who view regulatory burdens as an impediment now have to depend on the political consensus in Washington to keep the bailout, and prospects for a recovery alive.

In my opinion, the financial system is simply too unstable right now to support a recovery. Until we can stabilize our dollar and our federal spending, we can't expect a sustained recovery. And as I've said, until we tackle the inherent instabilities in our monetary system--like the creation of private credit and derivatives--we can't restore our financial system which is the backbone of our economy in the post-industrial age.

I'd reiterate that the bailout intends to re-inflate the debt bubble. The banks and Federal Reserve are clearly the main players in this effort. Not only did they issue the most toxic debt, they also are on the hook for Credit Default Swaps if borrowers default on the underlying securities.

Last fall's hurried rush to flow so much money to the banks and companies like AIG demonstrates how fearful top officials were by the prospect of system-wide defaults. It bears mentioning that subprime mortgages only compromise 2% of Mortgage Backed Securities. Larger by many multiples are risk obligations on the Collateralized Debt Obligations and other forms of derivatives unrelated to subprime.

So the bailout isn't really about bad mortgages, it's about preventing the banking system from collapsing as a consequence of its greed. The CDOs and CDSs brought in huge profits for people like former Treasury Secretary Paulson, who made over $300 million while heading Goldman Sachs, a major recipient of bailout funds.

Managing perception

Hitler said that the big lie was more easily sold to the public than the little lie. The big lie is clearly the idea that it will be worse for us all if we don't submit to the administration and its call for bailout funds.

There's an entire perception management effort afoot. By controlling what Americans hear about regulatory breakdowns, the easier it is to convince the American people about necessity of the bailout, how it's administered, and its size.

Over-selling the plan diminishes its credibility, so I hope Geithner has been working on smoother delivery of his message. Geithner's delicate treatment of perception shows how the credit crisis is also a crisis of confidence. However, the more effort is expended to create confidence in the system, the more circumspect it becomes.

It's important not to let the American people see what really happened. It's possible that the spigots of federal money creation expended to re-inflate the bubble could still be turned off, which would mean that Federal Reserve would have to go it alone. Already, they've issued billions in debt based on unprecedented backstopping of toxic debt.

By instigating the crisis through easy money policies and a lack of regulatory oversight, the federal government is now compelled to mask its role in failing to reign in the banks. So complicit our government has been that it was actually sued by former Governor of New York Elliott Spitzer for failing to control shady behavior by mortgage lenders.

Who knows how effective the government will be in covering up the regulatory failure and easy money policies that precipitated the crisis. One key factor in holding people responsible is Americans' willingness to stay informed and participate politically. Many are apathetic, believing neither party represents their interests.

Skepticism doesn't justify disengagement from the political process, it should precipitate greater involvement. Thomas Jefferson said eternal vigilance is the price of liberty.

The disconnect between the cause of the regulatory failure and the clean-up also exploits American's very limited understanding of finance. If Americans knew that the dismantling of Glass Steagall directly led to the crisis we're experiencing today, they'd be outraged at their representatives, and reject the two-party political status quo entirely. It was Democrats that helped pass the Financial Modernization Act in 1999 that gutted Glass Steagall. These key changes in regulations and the law came as the direct result of the banking industry's lobbying efforts.

The elite are surely gambling on Americans never learning enough about the origins of the crisis to do anything about it. As long as Americans are fundamentally ignorant as to the causes of the economic crisis, they're easy prey to any insider actions that attempt to compensate private sector investors for their losses in risky derivatives. Unless Americans catch on to the need to rebuild a regulatory framework, abuses of the monetary system by the Federal Reserve and its member banks will continue.

According to plan?

Some conspiracists have gone so far as to suggest that the dumbing down of America is attributable to an pre-planned agenda by the uberclass Bilderberger/Trilateral Commission elite bent on making the "sheople" easier to manage, less able to understand the failures that led to the problems of their making. Once conditioned not to think or question authority, we're susceptible to a repeat, another abuse of the public trust and draining of public coffers.

Whether or not an evil organization is bent on world domination, we Americans are dumbed down in economic matters and thereby allow those in charge to design a solution that benefits the elite at the expense of the general public. We trust blindly, out of ignorance.

A theory that accompanies the dumbing down one is often that of financial exploitation: turn the people into peasants, then bilk them for all they have. Yet in the most recent financial crisis, we see the beggar-thy-neighbior policies typical of capitalism-on-steroids have really been used in competition between rich people for each other' money, as the Madoff case demonstrates.

Yet the investor class can't tolerate so much exploitation of the system, even if that system invariably leaves them better off. Short of a steady regulatory climate, no structure is stable enough to allow the systematic looting of the new peasantry, although I guess emptying the Treasury is the next best thing. Plundering public resources for the benefit of the wealthy class could continue until the dumbed down can somehow summon up the wits to wake up from their slumber and confront the investor class, pitchforks in hand, ready to storm the castle gates, or the mansions on the Upper East Side as in Gangs of New York.

The fact remains that the uber-capitalists who gamed the system are now reaping huge rewards for investing in a class of debt securities that the for-profit banking industry created, or their losses are being limited by government intervention.

Getting my bailout

If we've dumbed down, I guess it's time to capitalize on the ignorance of the masses.

Hey well if the banking industry can get away with it, why not me? Well, unfortunately for the Detroit auto industry, controlling the flow of government bailout expenditures is no easy task, even if you are a vital-for-national-security industry like automobiles, one that hardly as expendable as banking, which appears to be little more than shoving piles of money around. Now making steel and making cars, that was real work back in the day America was a real man's country.

In keeping with this exploitation theme (isn't this what unrestricted free-market capitalism ends up being about, how to get yours?) I came across a good post in businessinsider.com, "Five ways to scam the bailout". One commentator, Mark Meyers, had this to say about the bailout plan:

It's an elegant stock manipulation engine. First my hedge fund buys ten million shares of Citigroup at $2.50. Then I go in with the government on a hundred million in toxic assets, risking 3 million of my own money and paying whatever I have to pay. I assume other hedge funds are thinking along the lines I am and so are also buying this stuff. As the toxic assets are removed from Citi's balance sheet, the stock price inevitably goes up. I sell my ten million shares at $3, covering 100% of my potential loss on the toxic assets and pocketing 2 million in additional profit. If the toxic assets appreciate, I split the profit with the government. If they don't, it's not my problem. And Geithner is happy, because he and I have started to re-inflate the bubble. Through market manipulation, we've once again created value where there isn't any. On Monday, when Geithner announced the plan, Citi gained 41%, so it's already working. Of course, it won't be long before we're bailing out the FDIC.

Not so sure how good the bet on Citigroup stock will be long-term, but maybe the kind of people who benefit from bailout activities are only in it for the quick money.

Lower down the post, a comment by brian also offers a more technical explanation of how CDOs (Collateralized Debt Obligations) are bundled and sold which you may want to see.

I admit to my own perplexity at the complexity of the derivatives market and how much I learn from posts like brian's, coming well after the point I thought I knew how they worked. Despite my lack of knowledge about derivatives, I do know enough about how they work to recognize their dangers. If anything, all the surprises that I get in my protracted derivatives learning experience should send red flags up.

Credit Default Swaps and other Structured Investment Vehicles compromise a large portion of the systemic risk remaining. Mortgage foreclosures are a serious problem indeed, with ripple effects, but their problem is largely in how to value them once they're bundled and resold.

When an issuer of Mortgage-Backed Security bundles mortgages which are then sold, the connection between the debt security and its collateral are greatly distanced. By bundling and re-selling mortgage-backed securities, the banks have managed to disconnect assets from their debt security. A single MBS tranch could contain a thousand houses.

By piling on tranches of debt, at different levels of risk, the value of the underlying mortgage is obscured. Yes, the tranch system does allow for classification of risk, as brian explains in his post. But the process of securitizing the debt, and mixing mortgages into a single security is inherently unstable.

The market for that kind of debt was created under the false presumption that Credit Default Swaps, a type of insurance--or insurance fraud depending on your view of how collectable they truly are--, could cover the consequences of a default or, worse, systemic collapse throughout the credit markets.

* * *

As much as we'd like to vilify Geithner, or even Obama, I've argued that it's not so much the individuals responsible but more the political system, which supports corporate patronage. At its core is a re-election scheme that repeats the injustice of cash exchanged for influence. Winning politicians bestow regulatory and legal changes that reward corporate benefactors that contributed to their campaigns.

There is however a price to pay. The more that the political system intrudes into the economy, the more subjected to the ebb and flow of political control our economy becomes.

The more the Federal Government spends, the more vulnerable our overall economy becomes. Government spending always creates inefficiency in the private sector, as the Federal trough makes for far easier slurping than making money the old fashioned way. If more and more Americans get their incomes from the government, it's inevitable that there will be more taxes, or that the currency will simply be over-produced, causing monetary inflation. Tax burdens are already at record levels, surely they can't go up any more.

Government spending has an Achilles Heel: it fosters dependency on federal spending among the recipients, which include corporations receiving contract revenue, citizens employed by government, and direct beneficiaries. The increased spending and aura of entitlement it spawns reflect political pressure on incumbents to keep the money train flowing.

Military spending exemplifies governmental inefficiency. Now if the US were to suddenly cut off war spending, an amount of over $400 million PER DAY, JUST FOR IRAQ, we'd see the recipients of that military spending experience an overdue contraction. Now if you're think that money we spend on our military is spent efficiently, consider that over 40% of the Pentagon's budget flows to private contractors.

In economics, eventually the consequence of an imbalance will have an effect somewhere else, disrupting or redirecting supply and demand. Ultimately the war spending sends cash to companies that are less efficient than those that must compete in the private sector. Government contracts become a crutch--crucial in keeping employment from dropping even more.

Now in Keynesian terms, the government should be spending more in down times. But Keynes also stated that government should be saving, or lowering debt, in good times. Well, unless the period from about 1999 on can be considered bad times, we have a Republican-led Congress and Presidency responsible for the largest expansion of Federal Spending ever. Their constant prattling about lower taxes flies in the face of their track record on government expansion.

Not only did we not retire debt during the good times, Clinton plundered from Social Security, though he did manage to avoid creating the warfare state that our present economy seems dependent upon.

Government deficit financing requires constant search for more and more investment capital. Foreigners have long filled this need, but the appetite for cash is simply too large to fill. The Fed's reckless lending of Treasuries for trash has hardly made this problem easier.

People tend to flock to the safest debt during times of great uncertainty. These are US Treasuries, which the Fed has in abundance. Unfortunately, the more unstable the overall market for debt, the more attractive Treasuries become, and the more are bought, creating what economists call "crowding out," where lending to the government drives out lending to private sector companies, driving up their costs of borrowing.

Building a bigger trough will mean weakening our fiscal situation, and lead to less borrowing and slower growth in the private sector. And as market conditions contract with higher borrowing costs--as the recession can't be stopped through the power of Federal spending alone--tax revenues dip and even more borrowing is required.

Eventually the Federal Reserve will start spending trillions to buy up the Treasury debt simply because no other investor will. Now while this might inflate the price of Treasuries, the supply of money will actually go up...way up. This is monetary inflation, where increasing prices come not as the result of too much wages being paid to wage-earners or money being spent by consumers, but rather from too many dollars being spent by government, which enter the credit system via the Fed (see last week's article by Chang for more on the Repurchase Market which finances the Fed's activities.)

Now there has been a shadow banking system created which has expanded the de facto money supply. I heard that the amount of this money being lent and traded based on swaps, repurchase agreements, and other forms of derivatives exceeds the supply of public money. The creation of a vast private credit bubble based on debt securities has changed fundamentally the variables which economists must study when evaluating the supply of money.

It's no coincidence that financial companies constitute some 40% of our GNP. In actuality these people make nothing. Yes they do provide loans in the retail banking market, but essentially they are moving piles of money around. Through a lack of regulation, they were able to create a shadow banking system which generated vast profits for insiders.

Of course the economic consequences of this free-market capitalism have "come home to roost," to borrow the words of former Obama pastor, Rev. Jeremiah White. Private credit money evaporated, and with it our entire monetary system has been shaken to its core. Unless we gut the shadow banking system, and reinstitute Glass Steagall, we're likely to see the effects of more uber-class control over our monetary and financial system.

Judging by how far the Obama administration and Congress appear willing to go to protect the banking system from its own malfeasance, the financial companies lobbying has paid handsome dividends. The scale of the public borrowing which we've undertaken shows just how far our government is willing to go to save the banks.

Our Treasury drained, and our ability to borrow in the future greatly diminished, the long-term interest of the people are being sacrificed. Increased self-reliance could emerge as a result or we could simply see more government, acting as a surrogate employer, displacing investment and jobs typically generated within the private sector.

Ironically, in trying to save the banking system, we could be destroying the value of our money. So much excess borrowing to prop up the failed shadow banking system could make dollars too plentiful and thus cheapen their worth. While exports could rise, we have little left of our manufacturing base to exploit the comparative advantage of a weak dollar. Besides, other nations appear to be suffering from weakening currencies so American exports might not be any cheaper in those countries.

Obama may be able to straighten out the bankers, but in the end it'll be the private market--the one for investment capital--that'll shake out the bad debt and punish those who own it. Should the Federal Government intervene, or allow its fiscal authority to be undermined to support a broader intervention, the reordering of the banking system will be much slower in coming. And no, just because regulations cut some profits doesn't mean they should be discarded. This crisis proves that the costs to everyone--rich and poor alike--will likely be far higher if insiders aren't held accountable.

Sources

http://www.huffingtonpost.com/2009/03/29/geithnerkrugman-feud-come_n_180477.html
The lower video--Geithner's Meet the Press appearance--contains a lot more hard information than the thin soup offered by the ABC panel in the video above.

http://www.huffingtonpost.com/arianna-huffington/geithner-unable-to-escape_b_178006.html
Follow-up by Arianna herself. She brings up Obama's comment on Jay Leno that Geithner had been doing a great job, just like Bush said of FEMA director "heckuva job Brownie" during Katrina. Arianna was also on CNN's Larry King Friday night.

///

Politics corrupt our Money and the Economy

Monica Goodling has reemerged in the news as the extent of politicization becomes known. Goodling was a young attorney granted responsibility over decisions concerning the hiring of assistant US attorneys. As it turns out, screening prosecutors according to political litmus tests is actually illegal under federal law.

Now, with only six months left in Bush's terrible reign, the corporate media appears willing to confront some of the many injustices committed by the regime. Goodling represents but one example of outright lawless conduct by Bush appointees. She could join a long roster alongside Brown's FEMA, the FCC, the FDA, the EPA, and countless other federal organs converted into outposts of Bushism throughout our federal government.

Many of political appointees overseeing these departments got their start in the industries they've been appointed to regulate. Combines with the Chicago School of Economics principle that government regulation is a inhibitor for business growth, regulatory efforts have been systematically gutted. The results are thoroughly predictable: speculative frenzy in the oil markets, pharmaceutical crises, food supply issues, formaldehyde-laced trailers, increased pollution, and the formation of media cartels/squeezing out of independent media (have you been watching TV recently?)

The total costs of repair and recovery from inadequate federal oversight will far exceed the benefits of de-regulation. In typical short-sighted greed, the desire to enrich the few--not coincidentally those who've given the most money to the regime--comes at the expense of the many, who will bear higher costs and taxes.

I found a good opinion piece by Tim Rutten in The Los Angeles Times about the horrible partisanship that pervades our federal government. {Hmm, why is that the word "our" seems so out of place when referring to the government?}
Here is my post as I would have entered it, had the comment period not ended. [Bloggers Beware: While I received a pop-up declaring my comment to be too long, I received no message to warn me that my comment would not be posted, simpy that it had been received.] I refer to the news because one comment had said how Rutten's article contains nothing new. I disagreed, considering how whistleblowers have emerged--at great personal cost--to add whole new dimensions to the original story, which was poorly covered anyway.
~start comment~
The news is how insiders gave up any chance of advancement to preserve the rule of law and judicial oversight of the military justice system.
The only reason this story might not seem to be news is that the MSM has not reported it, while the truth has been out there for some time. Media mogul owners have kept the public in the dark to pursue an Israel-friendly Middle east policy, which is coordinated with Republican Christian fundamentalist zealots like Goodling.

There's a place in my heart for all the people who've fought the administration's efforts to militarize our foreign policy and circumvent limits on Executive Branch power. "South Americanization" of our judicial and military systems, by creating a system of political litmus testing for appointees, alongside show trials of dissidents and targetted racial subgroups, threatens the rule of law and the effectiveness of our military. Prisoner abuse continues in the Al Arian case, so this isn't over by a longshot."
~end comment~
I heard the term "South Americanization" applied in reference to the Bush regime--or "junta," also a good word--several years ago. The idea is that the ruling government utilizes it largely unrestricted authority to maintain power, crush dissent, and enrich itself, typically at the expense of the peasantry.

The real objective of South Americanization is economic. Whatever political steps are taken are meant to stabilize the nation for the purposes of economic exploitation of its resources for the benefit of the ruling aristocracy.

Also, South America has so greatly transformed itself in places like Bolivian and Brazil that the trappings of old dictatorships are barely visible anymore. For this reason "South Americanization" is an unfitting and dated stereotype. Still, the image of this kind of government is probably the easiest for most Americans to grasp.

Now in America in the past eight years, we've seen the aggrandizement of the wealthiest Americans. Tax rates fell and with them any hope of balancing the budget.
Rather than complain about taxes being a bad thing, Americans need to understand why they pay taxes, and why taxes seem to invariably march up.

Primer on Money and Taxes

Understanding how much Americans pay in taxes is vital to understanding politics. People who earn their wages--as opposed to those who invest and sell, or collect bond interest, or dividends--pay a much higher percentage of their income. This is in large part due to social security, which hits the first 80,000 dollars of income or so with a net 8% (or so) tax rate, plus about a 1/2% Medicare rate. Your employer--which could be you--must kick in another 8+%, and match your contribution to Medicare.

For the rich, a portion of whom make many times the 80,000 or so, their total tax rate is lower because they don't have to pay social security tax rates on any income beyond the cap. Recently, the cap on maximum income on which Medicare is assessed was eliminated. This did mean that the rich would have to pay more--assuming they still earn the bulk of their income from wages, which they do not. I can assure you John McCain's wife Cindy did not acccumulate her $100 million plus net worth by working for it. Now there are some rich who make a lot in salary, but the vast majority of income comes from investments and the sale of stock.

Lacking the financial resources to put to work in the market, more and more Americans have to put themselves on the market. It wasn't always that way--holding a conventional job is a relatively recent concept. Before the late 1800's, most Americans had an area of specialization which they practiced as an independent businessperson, or were apprenticed to some craft. Rather than be paid by a salary, many junior people received services in kind, or room and board.

Then around 1913, the Federal Reserve monster was created, and later the IRS. With the creation of a private banking cartel, money needed to continually flow into government coffers. Otherwise the government wouldn't be able to pay for things like wars and the later New Deal programs. By 1971, the government was spending so much (Vietnam and the War on Poverty) that federal reserves gold and silver were found unable to back up our currency. We went to a pure fiat money system. A fiat money system is essentially a declaration by the government that the private sector will set prices according to the dollar, and that the dollars people take are secure based simply on the promise that the government will pay.

In reality the dollar is simple paper and ink. It has no intrinsic value, except perhaps as emergency firestarter, or wallpaper, or lampshades. Surely everyone's seen the Confederate bank notes that are sold as novelties. What gives the dollar value is its acceptance. That acceptance in turn is legally binding--everyone must take it. This forces the money to circulate, and facilitate spending, saving, and investment that the economy needs--all good things, in moderation.

The amount of money in circulation determines how much the money is worth. If the U.S. Treasury were to print up $1,000 bills andd throw them out of a helicopter, then all that hard-earned twenties and fifties in your wallet wouldn't be worth nearly as much. Theoretically, there's nothing to keep the government from doing this except for the Federal Reserve. The Federal Reserve is a private corporation which loans money to large banks and establishes the interest rates charged, which in turn shapes how much interest banks will charge its borrowers.

The Federal Funds rate is important because it establishes the value of money. This could only work in a fiat monetary system, where the only thing keeping spending under control is the cost of financing debt--an amount determined by the prevailing interest rates (modified by the credit risk of the individual borrower.)

In an awkward twist, debt has become money--the actual Federal Reserve Notes represent an IOU by the Federal Reserve to pay you. Essentially our money is a marker, representing no more or less than the borrower's ability to repay. If you have more dollars, you have more of someone else's debt. The whole money system is founded on nothing more than a promise to pay. And even worse, the government can't pay you for the dollars, should you bang at the door of the US Mint. The government has few liquid assets; yes, it can buy things, but only with pieces of paper that represent nothing of direct value.

The reason that understanding our money system is so important is that all fiat money systems in history have failed. Of course there are the periodic crises that can hit, and make spending, investing, and accumulating money harder. But the dollar has a built-in self-destruct switch that could at some point go off, tripped by nothing more complicated than simply printing and loaning too much money.

Once too many dollars get into the system, the value of outstanding dollars--as well as the value of loans, debt, savings accounts, and paper-based investments--decreases. The bankers know this--more than any other industry, they understand how inflation and its Mr. Hyde--hyperinflation--can destroy their loan balances which are their primary source of future income. In an inflationary scenario, banks are forced to raise interest rates to keep their profits up, in real terms.

Representing banks (and not you), the Fed swings into action and makes borrowing money more expensive. With loans harder to get, and less desirable to hold because of their higher rates, business activity slows down. This will reduce demand for money and cool down the urge to borrow and spend which seems to be the root of our consumerist culture. After a while, the higher interest rates encourage savings (not necessarily investment.) Why put money at risk when you can make vasst sums of interest in a federally insured CD? Businesses probably don't have much of a challenge growing when they can borrow at low rates, but the more expensive the borrowing, the harder it is to achieve a larger rate of return, especially considering the rising interest rates will be slowing down overall business activity throughout the economy.

There is however another major consideration in confronting inflation: the amount of dollars already out in circulation. Working in conjunction with low interest rates, Bush's government has tripled the money supply since entering office. In other words, already in place is the inflationary pretext: too many dollars.

The best measure of real inflation is not the government's stated rates, but the price of oil and commodities, things which people must have, and must continue to spend paper dollars on. It's no coincidence that prices have risen if we consider the expansion of the money supply. Why should the holders and producers of real things like silver, wheat, and oil sell their stuff for the same amount of dollars if the number of dollars out there has tripled? The growth in the supply of money has an inverse relationship (1/x) with the value of that money. If the money supply triples, a dollar buys one third of what it did before.

Now, it's worth understanding that having a lot of money out there isn't as big of a threat as having that money in circulation. Vast quantities of dollars go abroad to pay for oil. In a long standing quid pro quo with oil producers in the Middle East, the dollars stay overseas. With the exception of military hardware purchases and overseas shopping sprees by Saudi princes and their posses, the dollars sent overseas for oil stay overseas. The US domestic economy doesn't have the additional money to contend with, so there's not as much upward pressure on prices. Now should that money come flooding back into the US , there'd be runaway inflation overnight, but the shieks and all them don't want that, any more than anyone else holding large amounts of dollars overseas like the Chinese.

Housing market making

Of course the Feds need to maintain the dollar's value, so they prop it up with interest rates, but there's another agenda at work: to stimulate home prices and building. So the Fed keeps interest rates low. Over time, the sheer quantity of dollars created out of thin air, and loaned through the banks, makes existing dollars worth less. The only way home prices can be kept up is by limiting supply, which is the antithesis of the federal goal of increasing home ownership.

A lot of very good articles on the housing bubble are available throughout the Web that can educate people to the dangers of cheap money. The biggest risk going forward is that housing values fall even more, which would further depress the housing industry, which is an important sector of the economy largely because it is actually making something, not just pushing piles of money around or importing Chinese-made stuff. If Americans find themselves in houses worth a fraction of the outstanding mortgage balance, they'll surely be tempted to just walk out. So how to encourage home ownership even as the home values fall? One method is to make housing values fall to the point that they're attractive, but that hurts these people who are just barely holding on.

The Bushite solution (with a lot of Democratic support) has been to converted bundles of mortgages into AAA Federal debt, not exactly a winning proposition for the taxpayer, but one that alleviates strain on the banking industry, the one that helped get us into the mess (alongside speculative fever and mortgage fraud.)

Peter Schiff is one of the people who've been talking about the housing crisis before it'd been accepted as a crisis. There's an eight-part youtube video from a November 2006 speech he gave, in front of a group of mortgage bankers no less. Dedicated as I am, I went through all eight, and they're required viewing for anyone who believes the mortgage crisis could have been avoided (and therefore understand the scope of the impact of a corrupted regulatory environment.)

In Part IV, Schiff talked about the process behind fraudulent loans "...lenders don't want to make loans...they don't care if they're ever repaid because they're not gonna own the loan..." Mortgages were sold within a few days, so the originators had little fear as to the long-term credit worthiness of the borrower. Also they were paid (an essential element in understand how the financial industry operates) for making loans, not for finding qualified buyers, as were the appraisers, who counted on mortgage companies for their pay.

Schiff continues: "nowadays people don't own homes, they are renting them from banks...they have interest only loans, negative amortization where they go deeper and deeper in debt every year..." I remember from my days working in the field of personal finance from an experience mortgage originator about all the balloon loans and other crap that people were doing at the time--the late 1990s. This moral hazard--both on the part of lenders and house buyers--was clearly the result of a speculative frenzy combined with plenty of low-interest money.

Schiff's skills as a economic prophet are really quite amazing. Here's what he said in 2006 (from part V): "people are going to be completely amazed at the prices that their houses are going to be selling for..." He also said " you're going to have a lot of foreclosures...developers going bankrupt." A regional builder, Davis Homes, went bankrupt a few weeks ago here in Indiana. Foreclosures have hit a rate unequalled since the Great Depression.

With so many of his predictions accurate, it's the next part of Schiff's speech that should frighten us: "once the bubble bursts, cutting interest rates isn't going to stop it." The scary part here is that Schiff is referring to the inability of any monetary policy to make a difference. While the ultra low rates might have formerly encouraged home loans, the opposite doesn't hold true: making money more expensive won't cure the crisis. The loans have already been made.

With 10% interest rates possible, Schiff ponders, "what would happen to Fannie Mae and Freddie Mac, would they still be around?" He goes on to say a 5% loss would wipe them out. Now the Feds have stepped in, essentially printing money to bail out these two GSEs (government supported entities.) Together, the two quasi-private companies control a majority of all home loans, so the government is becoming the lender not only of last resort, but first as well.

Just what does so much ownership of mortgages mean? Well, for one the losses for defaults will be borne by the public, out of the Treasury. Also, we know that the government will probably lose huge sums trying to prop up the unrealistic price levels, as to prevent a further deterioration. There are two reasons for this: first, as the leading holder of residential mortgages, the Feds will have much already invested, and thus much to lose. Also, the large political influence that the housing sector and real estate developers wield means that federal monies will continue to support more house-building, which will delay the much-needed correction, one which began but was aborted when the Fed began giving AAA Treasuries away in exchange for mortgage-backed securities.

Schiff's speech went on to focus on the next inevitable consequence--one which we have yet to see, but is almost guaranteed, inflation. "Governments create inflation by creating money. As these entities like Fannie Mae, like Freddie Mac go bankrupt, the incentive to monetize that...and the pressure for the politicians to print enough money to make good these promises [to cover their debts] is tremendous. It's the same type of incentive that the Argentines faced, like the Germans faced...Wiemar Republic...that led to the inflation."

This last part is a real doozy as Schiff is spelling out the future we face. The problem with inflation is not rooted in economics, though it surely manifests there. The biggest problem with inflation is that it is political meddling that creates it. The government has a political goal like increasing home ownership and so it pushes it to the point the broader economy is endangered. Such is the dark nature of the political economy, especially one dominated by cronyism.

Blame has been put on Greenspan for keeping rates too low, possibly to help George Bush get reelected in 2004. Clearly the partisanship in government is particularly dangerous, whether in the selection of federal prosecutors or conspiring with cronies. When government meddles in the private sector, all the benefits and promises of the free market are erased. To function effectively, markets need as little intervention as possible. Ironic it is that the supporting cast for free marketism has flip-flopped on the role of govenrment, and sees the Federal money as the panacea for all the troubles that unregulated capitalism-on-steroids has created.

Fitting indeed would it be for investor-class capitalism to die on the vine of inflation, emerging from the unremitting influence of financial sector players concerned about the losses they face in their mortgage portfolios. These advocates of unrestrained super-capitalism should die a second death from the inflation that the Federal response is creating. Instead, inflation will hit wage-earners and the retired hardest, which makes the unholy alliance between the investor class and government all the more diabolical when supported by a willingness to inflate. The banks are hurting though, despite the best efforts of their friends in government, so the rich will not be unspared the suffering of inflation, but will suffer less, a lot less, as they have had eight years now to rack up huge stashes of undertaxed wealth.

Correction/Addition

Last week, I struggled to find the source of this tidbit. John Browne's market commentary at europac.net (a site shared with Peter Schiff) helped me find the source of my reference to "socialization of losses and the privatization of profits." Turns out it the reference was in the Wall Street Journal, which I had searched last week, but to no avail.

When the Treasury/Fed team moved to rescue Bear Stearns and, more recently, Fannie Mae and Freddy Mac, the $5 trillion-plus burden of risk was neatly transferred to the American citizen. This week, the Wall Street Journal commented on Nouriel Roubini, the New York University economist. He aptly observed that it was “the price of a system that privatizes profit and socializes losses.” People could be excused for protesting strongly against such political policies as outrageously un-American."

The preceding quote is from July 23rd's "No Bottom Yet For Flailing Financial," here.

Bonus Essay
"On the outside looking in"

I've been perusing the comments at commondreams.org, a favorite site of mine despite a filter there that prevents the posting of any link to whatreallyhappened.com, another favorite site of mine. The filter is actually the product of WordPress, which hosts the /wordpress.com blogs. Why the people at wordpress would deny Mike Rivero at wrh any linkage is hard to understand, and makes me suspicious, rightfully so. Whatreallyhappened posts some controversial material, like the pictures of WTC girders cut at a 45 degree angle, but for a blog host to act as gatekeeper is outright censorship.

Where I can, I've started playing something of a cheerleader role, in part due to the fact that so many comments are so very perceptive. I guess one consequence of such atrocious mainstream media coverage is that curious people--who tend by no coincidence to be brighter than average--must turn elsewhere for the answers to questions about our world.

Having taught briefly, I do carry some of the teacher bug in me. Perhaps the drive to educate others fulfills my desire to be heard, to be listened to, to make an impact in the lives of others. I can labor endlessly with a narrow field of readers and reach fewer people than I could in one day of teaching.

Back when I was selling insurance, yes I did that--people really do need it--successful people would be brought before us less successful salespeople. They would constantly talk about results. A "results-oriented mindset" was something we should cultivate to be successful, or so we were told. Our sales managers were keenly focused on motivation, which depends on one's level of confidence.

In the field of sales confidence is vital in believing what you offer has value to the customer. Modeling the desired behaviors has been proven to be the most effective method for imparting successful habits. In sales training, this means successful people demonstrate their belief level, and give examples of how successful they've been in order to show the value of confidence.

Their success is meant to be the model which you can follow. Oftentimes, this is packaged as "servant leadership," the idea that those in charge are doing so to help those below them. While it's obvious you need to help others while on your way up, someone also said, "it's important to be nice on the way up, because you might meet them again on your way down."

Nurtured by proto-sales motivational types, leading-by-example can easily be taken too far. The little people may actually believe that they can do great things, and in altering their attitude great things can be achieved. Or maybe not. The mind does have an amazing capacity for self-delusion, and can convince itself of the inevitability of some result when every available fact, considered objectively, indicates to the contrary. Even this writer has made a Greatest Investor in the World mistake; that self-deception that allows you to play your hand out instead of folding. Easy it is to convince youself that your mistake isn't a mistake.

The typical motivator's leadership-by-example fails to work in a number of areas, essentially overwhelming the ability of the mind to suspend disbelief. At some point it dawns on you that you, the less successful salesperson, quite simply aren't the same as them. You aren't as pretty. Your nails aren't as neatly manicured, nor your car as brightly polished. Deep down inside, you may not be as devoted. Doing as the role model does never seems to get you what you want. Yes, you may be motivated, but what works for him probably won't work for you, as you are really quite different. Nor can you mold yourself into a replica, although some might try this and succeed, up to a point.

Of course motivational speakers talk all the time about reinventing yourself, and anyone who's ever gone through any serious changes knows the necessity for change, and its transformative benefits. Still, the exemplary leader's example of what you should do isn't feasible if it requires becoming someone you aren't, or will most likely never become.

The same capacity for mass delusion exists in politics. You have to wonder how Republicans can believe the what Bush has done will be good for their party come next election. 2006 saw some worst defeats for the Republicans in their history--how can they honestly believe that staying the course is good for their political future? I'm reminded of successful Republican candidates like Florida governor Charlie Crist who failed to show up at a scheduled rally alongside President Bush in 2004. I've also heard rumors that outgoing President Bush won't be allowed to make an appearance at the upcoming GOP National Convention.

What role models do we have in America today? Sports and celebrities take the leadership position. Tiger Woods is the first billionaire athlete. A billion dollars! To be paid simply for hitting a ball across the grass? Unbelievable but true. Sure, the person Tiger is about a lot more than golf, as much as quitting it might mean to George Bush. But Tiger Woods doesn't get paid because he's a nice guy, he gets paid to endorse commercial logos while winning golf tournaments.

Those who fail, deserve to

Under our current brand of capitalism, we are told that success is a choice, and that those who fail do so as the result of a lack of effort, or conviction. Those that lose under the present economic system are treated as if something were matter with them, as if their depreciated economic status were deserved and just. This is like the king in the castle scolding the serfs for their laziness as he sits back, content to tax the fruits of their toil in the fields, growing wealthier on their backs.

Like the aristocrats of the medieval period, the ruling elite, like Bush, who've started with a silver spoon in their mouth, tell the little folk that their success is the product of superior talent, intellect, and effort. Hardly, to borrow the lyrics from Pink's "Dear Mr. President", hard work is being pregnant and working for minimum wage.

It's as if Americans aren't aware of how little social mobility they now have in their country. Social mobility is defined as the likelihood that your standard of living and accumulation of wealth will exceed that of your parents.

Americans have always had a problem dealing with class. We don't want to publicly admit that we have such a huge gap in the opportunities available for some, while we have an almost certain path to success, a it is presently defined in American society, as the ritual accumulation of material goods through the steady accumulation of monetary capital. I believe we've forgotten the value of social capital in this country. We Americans, and the countless millions who seek to imitate our lifestyle, seek to accumulate money so we can buy the things we want, to live better, and in greater security. These things in themselves are no crime, but in the collective pursuit of these riches we exert far too much physical demand on the earth and its finite resoruces. This is where the doctrine of sustainability enters the picture: we must live within our means financially just as we must replace the exhaustion of the finite with the replenishment of the resources we use as we go.

Fitting a punishment it would be for Americans to suffer from the scarcity of financial capital as just moral recompense for the sin of gratifying ourselves, vampiric, as we consume 25% of the world's resources being but 5% of its population. Leadership by example can't work if we are to be the model that the rest of the world chooses as it looks to secure its future in a world with far less physical abundance than the US.

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