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The United States prides itself on being the home of free market capitalism, governed by the rule of law. However, the rapidly developing capital market crisis demonstrates once again that, faced with a systemic crisis, rules and ideology take second place to pragmatism. A similar incident happened on 15 August 1971 when Nixon arbitrarily ditched the solemn US international pledge to honour the Bretton Woods Agreements making the dollar convertible into gold at US$35 an ounce. Cynics might say that the US lives by the Gold Rule: he who has the gold makes the rules.

Hence, the unprecedented developments in which the free market took second place to untrammelled state socialism as the national debt was effectively doubled in the blink of an eye as Fannie Mae and Freddie Mac with their $5 trillion indebtedness were nationalised, to be followed in rapid succession by the bankruptcy of Lehman Brothers and the nationalisation of the world's largest insurance company AIG at a cost of $85 billion. Merrill Lynch was forced into a shotgun marriage and the last two major investment banks were forced to convert to commercial banks to stay in business and get the support of the Federal Reserve Board. Then Washington Mutual, the fourth largest bank was closed down and Wachovia, that two weeks earlier was touted as the saviour of Merrill Lynch, was folded into Citicorp. Finally, in an effort to solve a systemic crisis, there is the unprecedented proposal to use $700 billion of taxpayer funds to buy the toxic debt of a banking system bordering on bankruptcy.

This has created an emotional political firestorm, not seen since the 1930s, since the middle and working classes feel they are being asked to bail out the banker 'fat cats' who are seen as having created the problem whilst ordinary wage earners are losing their jobs and having their houses foreclosed. Of course, the story is in reality more complicated and longer standing involving a failure of government to understand and regulate adequately a fast changing industry, but it is equally a story about failed political will, ideology, rampant greed and corruption.

The House of Representatives, all of whom face re-election in 5 weeks times spectacularly rejected the bill the first time it was presented to them on Monday 29 September, an almost unprecedented slap in the face for the failed Administration of George Bush. But after the markets tumbled 7 percent in an hour's trading in the after math of the vote it seems likely a modified version will pass the Congress shortly.

It is said that success has many fathers and failure none. It is the inverse with the present situation: failure has many fathers; in banking, regulation and policy. However, the time for recriminations is later. The task now is to contain the evolving firestorm and minimise the severe global fallout that could be very destabilising in the extreme.

At the heart of the matter is the incredible growth of debt and leverage in the financial markets since deregulation set in about 30 years ago but which went into overdrive in the past ten years. Derivatives scarcely existed 15 years ago; today they total between $600 trillion and a quadrillion- that's 1000 trillion or 10 to the power 15. By comparison the world's GDP is less than $60 trillion and the capitalisation of all the world's stock markets is less than $50 trillion.

Even worse are the opaque and unregulated $60 trillion over the counter derivatives in areas such as credit default swaps related to the US mortgage fiasco. In the prophetic words of Warren Buffett they have proven to be weapons of wealth destruction on an unprecedented scale.

Scale of the problem

The US banking system is facing a solvency problem on a scale approximately as serious relative to its economy as the Asian crisis was to the region eleven years ago or the Japanese crisis of the 1990s. But because of its position in the world, its impact on the global economy is far greater.

No one has a good handle on the numbers yet. The IMF originally estimated about $1 trillion in losses and now says that will be too low. Nouriel Roubini has estimated eventual losses of over $2 trillion and Marc Faber of the order of $5 trillion. This compares with a US GDP of $14 trillion. If that is true then the $700 billion 'bailout package' may just be a down payment on the final cost.

The US budget deficit for the year beginning October 2008 seems likely to more than double and exceed $1 trillion - maybe even reaching 10 percent of GDP - and financing this could put severe pressure on the dollar since, unlike Japan and the rest of Asia, the US has a miserable savings rate and is dependent on borrowing from abroad, primarily the Middle East and Asian central banks and sovereign wealth funds to finance its twin deficits.

The potential therefore certainly exists for the financing of these deficits to be inflationary in the medium term and cause further weakness, possibly severe, in the dollar. The diversification of international reserves that has been underway since the creation of the Euro will probably gather pace. This should also be a catalyst to encourage Asian nations to step up their efforts to coordinate their currency exchange rates.

Will the programme work?

There is no certainty that the measures as proposed will work but it is reasonable to presume there will be pragmatism in its execution and any necessary adjustments will be made along the way. The political will is probably there now and it would seem quite likely that the US government may need to take an equity position in some of these institutions until their health can be restored.

The result of this catastrophe will be a period of recession, possibly global, followed by an extended period of lower growth, accompanied by a much stronger regulatory regime for the financial sector that will have to operate with reduced leverage. Bank profits in the US and Europe will be smaller moving forward as they are forced to operate with lower levels of risk.

Global Contagion

The cancer has now spread to the European banking system and daily bailouts, mergers and partial nationalisations are becoming the order of the day. Some European banks are affected because they have bought large tranches of these toxic US products whilst others, such as the UK, Ireland and Spain are affected by weak national housing markets. The Scandinavian banks are affected by their large exposure to the weak markets in the Baltics and Eastern Europe. In addition, the European Central Bank is untested in a regional banking crisis and indeed does not have either an institutional ability or authority to act at present.

The Asian economies and their banks are better placed to withstand America's problems. Lower economic growth rates in the region are inevitable but they have the ability to increase domestic demand to make up for flagging exports. At the same time, the banks have only recently recovered from the stresses of the 1997-2002 crisis period and, as a consequence, avoided much of the stupidity that consumed Western institutions during the recent housing and derivative boom. They can also see that much of the lecturing they endured about crony capitalism was sheer hypocrisy when the shoe was on the other foot.

Other consequences of the crisis

The US budget is already under pressure at a time that demographics were about to explode it in any case. The crisis will put further extreme pressures on the budget and will probably force it to moderate its international ambitions in areas such as foreign assistance and military adventurism. The election of a new president will also have to be monitored closely, since he will be under pressure for more protectionist policies.

We must hope that the lessons of the 1930s are well enough understood and remembered. The world and the markets have some very challenging times ahead. But, as is well known, the Chinese symbol for crisis is in two parts: one symbolises danger the other opportunity. Out of this crisis will rise opportunities and some brave and liquid future Warren Buffett's will profit from the misery. Others, should be careful, not panic, invest in quality assets globally and never forget there is one asset that is no one else's liability - gold. Its day is upon us as the ultimate insurance policy.

_____

© 2008 William Thomson

ABOUT THE AUTHOR

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Posted in Guest Commentary, Banking Crisis, William Thomson

This time last week, the biggest bailout in the history of the world seemed to be a fait accompli. Last weekend, the Fed Chairman and the Secretary of the Treasury had harsh words of doom and gloom for Congressional leaders, with the rest of the administration parroting along, and by last Monday it seemed both parties were about to fall in line and vote our Republic away by socializing the banking industry through this bailout.

Foolish business behavior was about to be rewarded, and propped up a little longer, the bubble blown a little bigger, and our coming Depression made that much greater, but then something happened on the way to the House floor.

Citizens made their voices heard.

The real story behind the story in Congress this week was the thousands of calls and emails sent to Representatives, clogging up inboxes and even slowing down the House internet system. Slowly, like the Titanic turning around, sentiments on the Hill shifted, and we heard Congressmen capitulating and changing their tune a little, desperately trying to find ways to salvage the bailout without completely enraging their constituencies.

Now we hear about taxpayer protections, about golden parachutes, and about other nuances that hardly cover up the fact that we would be creating more money out of thin air and further devaluing the dollar! The problem is not HOW the government is spending this money; it's the fact that the government is spending this money. We don't have it. We are already nearly $10 trillion in debt, not including unfunded liabilities. We already spend about $1 trillion a year we don't have on our overseas empire. Now nearly $1 trillion more is somehow supposed to magically appear and solve all our problems! No - creating more money might delay the inevitable for some well-connected banks on Wall Street, but in a few weeks we will find ourselves right back in this same position, but much poorer.

The unfortunate thing is that we've already spent at least $700 billion on other bailouts that did not solve the problem. And while all this negotiation was taking place, the auto industry was quietly bailed out, with no controversy, no discussion, to the tune of $25 billion.

Inevitably, it appears Congress will call their constituents' bluff and the bailout will pass, because that is the habit Wall Street and Washington have fallen into. People are right to be concerned about our financial future. I've been talking for 30 some years about reasons we need to be concerned and change our ways. We find ourselves now in a position of no good options, and no silver bullets. But the worst thing we can do is to compound our problems by intensifying the mistakes of the past. We do have tough economic times ahead, no doubt, no matter what we do, even if we do nothing. The question, is will we have the courage to take our medicine now and get it over with, or will we prolong the misery for many years to come? I'm less and less optimistic about the answer to that question.

_____

© 2008 Ron Paul

ABOUT THE AUTHOR

Congressman Ron Paul of Texas enjoys a national reputation as the premier advocate for liberty in politics today. Dr. Paul is the leading spokesman in Washington for limited constitutional government, low taxes, free markets, and a return to sound monetary policies based on commodity-backed currency.

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Posted in Guest Commentary, Banking Crisis, Ron Paul

Many sage commenters have claimed the bailout plan is a bad idea. It's been described as "Socializing Risks while Privatizing Profits." True enough, but that description apparently doesn't carry much weight, especially since the term "socialization" doesn't bother many people these days. Other folks say that the free market has failed, and new regulations are needed - but they don't satisfactorily explain why the existing regulations weren't enough - after all, we had plenty of them. Closest to the mark are those who say the plan "threatens the dollar" but even they don't explain what that means.

Bailout proponents have sympathized with all the above, but they still say we must have the bailout to prevent a financial meltdown, or "systemic risk" to our financial system. Theirs is a potentially fatal misunderstanding. The main risk from doing nothing is that many banks and financial concerns will take huge losses and maybe even go bankrupt, possibly all of them. That, we are told, is the systemic risk, which must be prevented at all costs. I don't agree at all. It is the very costs of prevention that are the real risk.

Although the more savvy observers are pointing to the lurking problems with derivatives, particularly the 62 trillion in credit default swaps, it seems to me that if these derivatives were to become worthless, the threat to the real economy is overstated, unless they were somehow transformed into claims on goods and services. Unfortunately, that is exactly the process that is well underway, with mortgage-backed securities and other worthless or illiquid paper being traded for, or used as collateral for loans of, liquid instruments - cash for trash - some have called it. This is, of course, the huge underwater portion of the iceberg that the government hasn't even acknowledged yet; but I'd like to step back and look at the whole mess from yet another angle.

The primary misconception I'd like to focus on is the underlying assumption that our financial institutions essentially ARE our economy, and that it cannot function without them. We are told that without this bailout we may suffer another Great Depression. What our limited imaginations cannot conceive is that risks exist that are far greater than that. Recall, we were given the Fed in 1913, ostensibly to prevent bank failures like the panic of 1907. Of course, within 20 years we had even more bank failures, followed by massive government intervention. Contrary to popular belief, that intervention fixed nothing and made things worse. By contrast, the 1907 crisis, during the gold standard era, and prior to the Fed's existence, lasted only two years.

Also contrary to popular belief, there was no real systemic risk either in 1907 or during the Great Depression. The linchpin of any economic system is the quality of the money; and unlike now, the dollar was never at risk then - it actually gained purchasing power during the Depression. This notion that our entire economy depends on financial institutions is a myth promoted by bankers and their enablers. The main support for this myth is the claim that producers are dependent on the financial institutions for the credit they need, and without a ready supply of that credit, the entire real economy may grind to a halt along with the financial economy.

If we would just stop and think about it for a second, this should not be the case at all, because whether banks fail or not, nothing has really happened to producers' ability to produce, because they still have their factories, tools, skills, and inventory. Also, bank failures do not really affect the needs of real people for those goods. Yes, banks and financial institutions are a bigger part of the economy than they used to be; and producers and consumers are more dependent on them than they used to be. However, history reminds us that this outsized role for financial institutions was not needed for a healthy economy in the past, and it isn't needed now either.

Here is where Antal Fekete's and Bill Koures' research on the mostly-forgotten Real Bills Doctrine re-enters the picture. They are the missing link in this discussion of how and why these modern financial institutions have attained such a large and, we are now told, indispensable role in funding our real economy. Now, what we are really seeing with this crisis is not just the results of abandoning the gold standard itself, but also the results of the deliberate usurpation of the complementary role that Real Bills of exchange were playing in our pre-Fed economy. The central banking community didn't like these bills of exchange because they were, as Koures points out, an emergent market phenomenon.

They evolved, without being planned, independent of the control of bankers, to supplement the gold standard as a means of funding the production of consumer goods. This was unacceptable to the bankers and their statist supporters, who desired central control of the money supply, and central control of the economy. So, as a result, first the discounting of the bills of exchange was taken over by the central bank through the "discount window" and then the bills themselves were systematically discredited, and bank lending to support all goods production was substituted in their place. Now, at long last, despite all the years of delay, despite the spreading of their false doctrine of fiat money and central banking all over the globe - the inevitable results are clear.

Central banks and their debt-based fiat money simply cannot properly fund production for a stable real economy. Their methods are too crude, and do not allow for the proper transmission of supply and demand signals between producer and consumer. They can only suck a society and a government into debt so deeply that they cannot get out. That is where we are, and why. This crisis is nothing more than the preordained failure of their attempt to substitute central planning for the free market. Central banks have usurped control over aspects of the economy that were none of their business - aspects that the free market was already handling - and they have totally blown it.

And, of course, like all statists, they won't admit their failures, and instead blame the results of their system instead of the system itself. That's why they focus on secondary effects such as the "housing boom" and "reckless lending" and even "insufficient oversight," instead of the root of the problem. As they twist and squirm, looking for excuses, they desperately want to keep their flawed process going instead of ending it. This cannot be done without infecting and destroying more and more of the real economy by more central control, and by debasing the currency in order to bail them out from the consequences of their failed ideology.

To get out of their trap, all we need to do is remember that the real engines of economic prosperity are and always have been the producers of real goods and services, and the people at-large, and that all these engines have ever really needed is a stable currency to conduct their business in. Ironically, currency stability has never been a concern of big-government central bank defenders and enablers and that stability is exactly what this desperate, ill-conceived bailout is putting at serious risk. By attempting to get themselves out of the frying pan, they are willing to throw our entire society into the deadly fire of currency debasement.

What is the real meaning of currency risk, and why are we subject to it now? As to the former, in Weimar Germany the entire society was turned upside down, with life savings destroyed, putting rampaging gangs of youths on an equal economic footing with solid German citizens who had worked and saved their whole lives. The resulting chaos cleared the way for Hitler as no other economic crisis ever could. The same thing is happening in Zimbabwe now, with London School of Economics graduate Robert Mugabe presiding over the whole thing. Never mind the financial sector; their entire economy is in ruins.

The reason we are at risk is that 95 years of central banking and debt-based currency have left us with a ten trillion dollar national debt; 99 trillion of unfunded obligations; no national savings; and leaders who do not acknowledge the foregoing facts. We continue to require 60 billion dollars a month in outside funding. Another little-understood complication is that there are trillions more dollars around the world, both piled up in central bank "reserves" and in the hands of the world community for many purposes, most notably the purchase of oil, which the Bretton Woods agreement required.

These conditions already cry out for higher interest rates, and funding this bailout will force our creditors to finally demand them. Also, if the government admits to 700 billion now, history tells us the real amount will be far greater. Remember, talk of "spending" by Congress ignores the fact that our government has no money. Any money we need, we must borrow. Alternatively, we could just print up the money we need, but either way the dollar will be devalued. But that's just the beginning. If foreign creditors get the idea that their holdings are at serious risk, they will liquidate those holdings quickly, greatly compounding the devaluation. Rumblings in the foreign press indicate they are finally figuring this out.

In sum, no matter how badly the government may want to make the mistake of propping up housing prices, they cannot be maintained at current levels in a high-interest-rate environment. Unfortunately, the inflationary consequences of borrowing the trillions actually required will discourage creditors from further lending and also encourage the repatriation of foreign-held dollars before they lose their value. Both of these results will necessarily drive up interest rates - thereby canceling out the intended effects of the bailout. In fact, these factors will do much more than cancel out the bailout; they will reverse it with a terrible vengeance. Once that process begins in earnest, the velocity of money will increase so much that hyperinflation will be inevitable.

Currency risk is the worst systemic risk of all, dwarfing the pain of any depression we have ever experienced. And we're making it happen.

_____

© 2008 Tom deSabla

ABOUT THE AUTHOR

Tom deSabla is the host of the Tom deSabla Radio Show.

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Posted in Economic Theory, Guest Commentary, Government Policy, Banking Crisis, Tom deSabla

No one will deny that last week was one of the most tumultuous in history. The streets red with blood... the bodies of the dead and dying strewn about where they fell. You already know the names: Lehman, Merrill, AIG. Fannie and Freddie.

But none of this happened by accident.

The warning signs have been all around us for years.

Bud Conrad, chief economist at Casey Research, wrote about the beginnings of our current problems back in March of 2007... before most people were even aware of the storms brewing just over the horizon.

I actually wish that his analysis had been flawed.

I also wish that the government officials had been right who have consistently claimed since then that the subprime crisis was contained and the markets would rebound in the second half of the year.

Unfortunately, this is not the case.

The Fed's recent attempts at quick fixes have not worked, and current events are reinforcing what Bud Conrad prognosticated almost two years ago: that this is much more than a normal cyclical correction. This is a disaster of biblical proportions.

As the Fed and the Treasury continue to intervene in the market, they continue to lose ground and credibility, caught between a sharp recession and strong inflationary pressures. In an effort to bail out the financial sector, they have no choice but to start injecting hundreds of billions in liquidity into a contracting market place.

This will contribute to the creation of a stagflation period that will make the '70s look like a tea party.

The Fed's never-ending injection of liquidity into the market has, and will continue to, devalue the dollar.

Ordinarily, a country threatened with currency collapse would lean toward tight money, perhaps contracting its domestic money supply. That would push interest rates upward and compensate foreigners for holding on to the currency despite the depreciation risk. And it would soften that risk.

But this time, things aren't ordinary... there is a difference that has turned what might otherwise be a disturbance into a disaster: the U.S. economy's inability to endure high interest rates.

Because of the corrections taking place now in the grossly distorted U.S. housing, commercial real estate, and personal credit markets, raising interest rates to protect the dollar would prove as calamitous as not raising interest rates.

The housing bubble fueled a blockbuster business in first mortgages, and then home equity loans. Homeowners drew down their equity to splurge on consumer goods, including shiploads of imports.

The relative attractiveness of U.S. financial instruments kept the game going into overtime. The foreigners who received all those U.S. dollars put them back into U.S. Treasury bills and other dollar-denominated instruments, thereby underwriting low interest rates for all U.S. borrowers.

The net result? Foreigners funded our housing boom. The amount of mortgage growth annually matched the amount of trade deficit, which foreigners dutifully invested back into the U.S.

And subprime lending was no mere sideshow. It was big business. In 2005, it accounted for 25% of all new mortgages - about $600 billion of high-risk paper, most of it with adjustable interest rates.

The collapse of the subprime market soon spread into other mortgage sectors... and the derivatives created on top of all those subprime mortgages made everything much worse. Given that the annual GDP of the U.S. economy is just $13 trillion, the $250 trillion in derivatives should have been seen as an accident waiting to happen.

Foreign reinvestment is part of the system of U.S. debt, and we are already seeing a significant impact, as depicted in the chart below.

As foreign investors watched the collapse of the U.S. housing markets, and the relative values of their debts began to sink, they quickly moved out of U.S. debt, particularly Fannie/Freddie obligations.

This massive exodus of foreign cash out of the debt of Fannie/Freddie prompted the biggest stock market fall since the days just after 9/11. On September 15, 2008, Treasury Secretary Paulson injected the biggest amount of daily liquidity since 2001, a whopping $70 billion in just one day.

And now the government is proposing an additional infusion of approximately $1 trillion. More than the total cost of the Iraq War.

To put this amount into perspective: if you had spent $1,000,000 a day, from the birth of Christ until today, you would have only spent about 732 billion dollars.

It's going to be interesting to see what happens to our markets if that proposal goes through.

_____

© 2008 Oliver Garret

ABOUT THE AUTHOR

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Posted in Guest Commentary, Banking Crisis, Oliver Garret

The Financial Structure that fueled myriad Credit Bubbles, asset Bubbles, economic Bubbles and overliquefied the entire world is today no longer viable. Wall Street finance is at this point an unmitigated bust, with a few of the "holdout" sectors (i.e. the Credit default market and the hedge fund community) now succumbing. The great Financial Alchemy of transforming endless risky loans into perceived safe and liquid "money"-like instruments has run its historic course. And with risky loans - household, financial sector, business, municipal and speculator - having come to play such a prominent role in the nature of spending and "output", the near elimination of risky lending will prove a momentous financial and economic development. The U.S. Bubble economy is today in dire straits.

We've reached the point where it has become difficult to secure new borrowing unless one is of quite sound Credit standing. This is the case for individuals seeking to buy automobiles and homes; to afford myriad discretionary and luxury goods and services; to finance educations; or to make the types of big ticket purchases that had been bolstering our Bubble Economy. Lenders are now moving aggressively to cut home equity and Credit card lines. And, importantly, recent developments have significantly tightened Credit Availability for businesses of all sizes. Securitization markets have been largely shut down for awhile now. Now acute stress has incapacitated the money markets.

Unless some dramatic development reverses the current course, it will not be long before a self-reinforcing cycle of company payroll and spending cutbacks takes hold. At the same time, the municipal bond market is in disarray. The economic impact from major cutbacks in state and local government spending will be significant. Today's finance-related economic headwinds are Cat-4 (and gaining) Hurricane Systemic Credit Seizure, compared to last year's Tropical Storm Subprime. Federal Reserve-dictated interest rates are extremely low - and the Fed and global central bankers have injected unfathomable amounts of liquidity - yet Credit Conditions have turned the tightest they've been in decades.

The Lehman bankruptcy marked a major inflection point in the confidence of contemporary "money." It was a decisive blow against trust in various money market instruments - the very foundation of our monetary system. "Money" has now tightened significantly for virtually all players that had previously enjoyed cheap short-term financings. This list certainly includes the hedge fund community.

The Lehman bankruptcy also marked a major inflection point in confidence for the various "daisy chain" players involved in intermediating risky loans into contemporary "money." The market was convinced Lehman was "too big to fail." Its failure inflicted thousands of market participants with losses - from Primary Reserve Money Fund investors caught with short-term Lehman paper to holders of Lehman's long-term bonds. Investors all over the world were impacted. The hedge fund community suffered mightily. The status of hundreds of billions of derivatives and counterparty obligations was suddenly up in the air or in the hands of the bankruptcy court. And, importantly, huge losses were suffered in the Credit Default Swap marketplace - the marrow of one of history's most spectacular speculative manias.

Trying to add a bit of simplicity to the Complexity of a Credit Market Breakdown, I'll say the Lehman collapse marked a critical inflection point in at least five major respects: First, the Crisis of Confidence jumped the "firebreak" from risk assets to contemporary "money," shattering trust in various facets of contemporary finance that was forged over decades. Second, it required the marketplace to reexamine exposures to various direct and indirect counterparty risks, a terminal blow for derivatives markets. Third, it pushed the Credit default swap marketplace into full-fledged dislocation and instigated a long-overdue regulator onslaught. Fourth, it decisively burst the "leveraged speculating community"/hedge fund Bubble. This has ushered in another round of problematic de-leveraging and accelerated the reversal of "Ponzi Finance" dynamics. Fifth, it instilled global fear with respect to the risks of participating in the inter-bank lending market with American institutions.

Basically, the Lehman collapse marked the end of "Wall Street" risk intermediation as a significant component of system financial intermediation. Going forward, Credit growth will be chiefly generated by the banking system, supported by various forms of government backing (Fed, FDIC, Washington bailouts/recapitalizations, etc.), the government-operated GSEs, and various forms of federal government debt issuance. Importantly, this new financial structure will ensure minimal risky lending as well as significantly reduced risk-taking. And from a global perspective, I believe newfound fears of lending to the American financial sector marks the beginning of the end of our economy's capacity for trading new financial claims for imports of energy and goods.

Over time the Changed Financial Landscape will have a profound impact on the underlying economic structure. Our economy will have no alternative than to get by on less Credit, less risk intermediation, and fewer imports. In the near-term, the effects will be a rapid and pronounced slowdown of our economy's "output." And while we'll only know over time, I'd bet this new financial structure will allocate much less finance to entrepreneurial activities, productive endeavors and the asset markets - while at the same time providing ample (government-directed) purchasing power to ensure stubborn consumer price inflation.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

_____

© 2008 Doug Noland

ABOUT THE AUTHOR

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.

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Posted in Current Events, Guest Commentary, Banking Crisis, Doug Noland