Lawson for Congress

The terrorists we must fight are not crouched in caves thousands of miles away.

The terrorists we must fight are threatening us with financial weapons of mass destruction that are destroying our economic system.

As described by Warren Buffet in his 2003 letter to Berkshire Hathaway shareholders, the financial industry has created new types of derivatives that he described as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

As summarized in this BBC article:

Contracts devised by ‘madmen’

“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years” - Warren Buffett

“Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers … which can trigger serious systemic problems.” - Warren Buffett

Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares - without buying the underlying investment

Derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements -, but have quickly become a means of investment in their own right.

Outstanding derivatives contracts - excluding those traded on exchanges such as the International Petroleum Exchange - are worth close to $85 trillion, according to the International Swaps and Derivatives Association.

Some derivatives contracts, Mr Buffett says, appear to have been devised by “madmen”.

He warns that derivatives can push companies onto a “spiral that can lead to a corporate meltdown”, like the demise of the notorious hedge fund Long-Term Capital Management in 1998.

Does any of this sound familiar? It should. We’re living it.

How is Congress reacting to this clear and present danger, which is sitting right across the table from them as it testifies in Washington?

They’re ignorant and scared:

WASHINGTON — It was a room full of people who rarely hold their tongues. But as the Fed chairman, Ben S. Bernanke, laid out the potentially devastating ramifications of the financial crisis before congressional leaders on Thursday night, there was a stunned silence at first.

Mr. Bernanke and Treasury Secretary Henry M. Paulson Jr. had made an urgent and unusual evening visit to Capitol Hill, and they were gathered around a conference table in the offices of House Speaker Nancy Pelosi.

“When you listened to him describe it you gulped,” said Senator Charles E. Schumer, Democrat of New York.

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

How did we get into this situation? This is the endgame for an inherently unstable system that has been forever destined to fail. As I noted in a previous post:

If asked to pick one word to describe why I’m running for Congress, that word is sustainability. Sustainability doesn’t mean stability, it doesn’t mean safety, and it doesn’t mean protection from life’s inevitable uncertainties. Sustainability does mean recognizing and obeying the natural laws that govern of our world.

Every branch of science has certain laws: Objects in motion tend to stay in motion; force equals mass times acceleration; every action has an equal and opposite reaction; energy in a closed system cannot be created or destroyed but merely changed in form; and closed systems tend towards increased entropy are a few good examples.

These laws of motion and conservation of energy are not limited to high school physics class. Every system in nature must obey these underlying principles — including our financial and monetary systems.

Let’s start with Newton’s laws of motion — it’s a short hop from there to defining leverage as the ability to move a large object a short distance using a small force exerted over a long distance. Leverage is a concept in finance, as well — using borrowed money to increase returns based upon small underlying price movements. Just as the car lifted with a hydraulic jack can hurt you if it falls, a small price movement in an imprudently leveraged investment can wipe out a lifetime of savings.

Next consider conservation of energy and open versus closed systems. Since energy within a closed system cannot be created or destroyed, and since closed systems tend towards increasing entropy, every growing system must be open to an external energy source. In this setting, one can immediately see problems with our debt-based monetary system.

What is debt-based monetary system? It’s where money is debt, and every dollar in circulation exists because a bank created it out of nothing based upon someone’s promise to pay it back, with interest.

Our economy is an open system relative to money, which is created and destroyed by banks. Banks create the money through loans — but they only create the amount you borrow. They don’t create the interest that you also promise to repay. Where do you get the interest? You have to earn it, but first it has to be created — yes, by someone else borrowing more money that they promise to repay with still more interest.

In the end, our monetary system is like a game of musical chairs — the banks create money based upon someone’s willingness to borrow, and the bank’s ability to lend. The constant demand for new money to repay interest on existing money compels growth and new money creation at an accelerating rate.

Refer to the chart of America’s total debt, which raises obvious questions about sustainability. Trees do not grow to the sky — and when banks cannot lend, or people are no longer willing to borrow, the music stops. When the music stops, there are more loans outstanding than money to repay, so everyone left standing loses whatever they pledged in exchange for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the room.

Leverage, debt-based money, fractional reserve banking, and interest are fundamental features of our economic system. Our economic history of boom/bust cycles and decisions dominated by short-term gain as opposed to long-term stewardship are fundamental consequences of this underlying system. In short, our system has undesirable consequences and is fundamentally unstable — but it’s working as designed.

Interestingly, now we have the terrorists who created and detonated these weapons holding us hostage. They’re asking us for more power, and to punish us with more debt, only to further enable the corrupt system to which we are hopelessly enslaved in the first place.

In other words, they’ve thrown a massive brick through the window, and are asking us to assume a crippling debt so that we can hire and pay them to “fix” it:

As noted by many, including Kentucky Senator Jim Bunning and Texas Representative Ron Paul, the Federal Reserve and the banking system that controls it are the cause of our systemic risk. Even the Federal Reserve’s own Harvey Rosenblum emphasizes that the Federal Reserve’s job is to create moral hazard, which enables systemic risk:

Rosenblum: The Federal Reserve is in business to create moral hazard. The mere act of being a central banker means that your job description involves creating moral hazard. A central bank is a “lender of last resort,” what more moral hazard can you have than having a lender of last resort that people know, when push can to shove, can be relied upon? The Federal Reserve’s job is to cushion the blow to 300 million American citizens of all the economic shocks that hit out there. What drives me crazy is when I hear people shouting “Moral hazard, moral hazard”… that’s what my job is to do…

Of course, it’s a bit disingenuous to say that the Fed’s job is to “cushion the blow” when the Fed threw the brick that caused the economic shock.

Gary Larson’s classic Far Side cartoon says it all. The Federal Reserve has heaved a gigantic brick through the window of our nation’s economy. Jobs are getting scarce, retirement savings and housing values are declining, and basic necessities are less affordable. Using the current crisis as an opportunity to further empower the Federal Reserve at the expense of the people is not the answer.

We need to restart past conversations, and restore a Constitutional money and banking system that removes moral hazard from the equation entirely. We cannot allow a private monopoly to create money out of nothing to loan to us at interest. The Federal Reserve is welcome to compete in a free market, but accepting private debt-based currency should not be compulsory — it should be voluntary, and other forms of money that facilitate trade and local economic growth should be welcomed.

Alan Greenspan noted that our money system is not a free market — the power over our money is centralized in the hands of the Federal Reserve. That fact, along with the Federal Reserve’s support for the inherently unstable process of fractional reserve banking,  create the bricks that break our windows.

Our founders intended for our money and banking system to be democratized. Our ability to create wealth in our communities is one of our unalienable individual rights. The government is only authorized to establish a level playing field with accurate “weights and measures.” In particular, Congress was given the authority to coin money, and regulate its value — it is not authorized to delegate monopoly authority over our money to a private central bank.

Since 1913, however, our money comes from a monopoly run for the benefit of private banks. The banks have the power to create money through debt, and the people and our governments thus accumulate debt instead of wealth.

So what is Congress going to do? Let’s continue reading about their negotiations with the terrorists:

When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.”

“What you heard last evening,” he added, “is one of those rare moments, certainly rare in my experience here, is Democrats and Republicans deciding we need to work together quickly.”

Although Mr. Schumer, Mr. Dodd and other participants declined to repeat precisely what they were told by Mr. Bernanke and Mr. Paulson, they said the two men described the financial system as effectively bound in a knot that was being pulled tighter and tighter by the day.

“You have the credit lines in America, which are the lifeblood of the economy, frozen.” Mr. Schumer said. “That hasn’t happened before. It’s a brave new world. You are in uncharted territory, but the one thing you do know is you can’t leave them frozen or the economy will just head south at a rapid rate.”

As he spoke, Mr. Schumer swooped his hand, to make the gesture of a plummeting bird. “You know we’d be lucky …” he said as his voice trailed off. “Well, I’ll leave it at that.”

Folks, we’re in trouble. When Republicans and Democrats are both ignorant and scared, we do horrible things.

Don’t believe me? Turn off Faux News and read Roubini. Read Denninger. Read Shedlock. This is not a drill, and our elected representatives need to hear our anger at this unprecedented hostage crisis.

In this setting of ignorance and fear, a proposed “fix” is being circulated that will authorize our government to go further into debt to buy toxic debt from failing banks. Note that the “fix” will not work — it will simply push the system further out of equilibrium. Karl Denninger succinctly dissects it here. Key quote:

The claim is that this is intended to “promote confidence and stability” in the financial markets.

It will do no such thing.

It will instead strike terror into the hearts of investors worldwide who hold any sort of paper, whether it be preferred stock, common stock or debt, in any financial entity that happens to be domiciled in the United States, never mind the potential impact on Treasury yields and the United States sovereign credit rating.

What should Congress do? Follow the Constitution: eliminate the money monopoly that is crippling our country. As I noted here:

Return our money to the people, for starters. Do people want to exchange and transact in gold and silver? Great. Do people want to do business in private local currencies that build self-sufficient communities? Great. Affirm that all barter transactions between individuals are tax-free, and let individuals build wealth by helping each other.

Eliminate fractional reserve banking, eliminate legal tender laws, and eliminate our private money monopoly. Our government can use its sovereign power to create currency that is not based upon debt, and based upon how responsibly our government creates that currency, people can choose to accept it or discount it appropriately.

This idea is not new, it’s in fact how we originally grew into a prosperous nation — colonial scrip. Scrip is fine for domestic trade, and specie or other commodities can be used for international trade. Competition between different money systems keeps people honest, and elimination of fractional reserve banking and fraudulent “deposit insurance” keeps banks honest.

Relentlessly seeking another hit of debt will not cure our unsustainable addiction. The poison is not the cure.

It’s time to look around and reassess our national priorities. Republican, Democrat, Libertarian, Constitution, Green, Unaffiliated, Catholic, Protestant, Jewish, Muslim, Hindu, Atheist, Straight, Gay… none of these labels matter. We are all on the same boat. When the boat hits the iceberg, we all sink or swim together.

It’s time to get off the treadmill of a collapsing debt-based currency and empower local economic growth through an honest, Constitutional money system that will strengthen communities by empowering local producers of real goods and services.

Here’s the bottom line: we may or may not be able to prevent a a misguided bailout. Ultimately, however, self-sufficient communities are the only lasting antidote to the current crisis. There is one thing that Congress could do to provide a safety net that would empower individuals to build self-sufficient communities:

Congress must unambiguously affirm that all voluntary barter transactions between individuals are tax-free.

What do I mean by “barter transactions”? They may be transactions exchanging time for time, time for goods, goods for goods, time for dollars or private barter currencies (paper or specie), or goods for dollars or private barter currencies. The key point is that human individuals (not corporations or other creatures of the legal system) need to be free to create wealth in their communities.

Again, If the banks get bailed out, the people need to be bailed out. People must again have the ability to serve each other as individuals to recreate the wealth that is being destroyed all around us.

It’s time to focus on hometown security, instead of homeland security.

It started last week with the Freddie and Fannie bailout, where our Treasury ignored our national interests and bailed out foreign central banks, PIMCO, and other sophisticated investors. What was wrong with this story? Most importantly, the Treasury offered public funds to guarantee debt that has never had any government guarantee, implicit or explicit:

Read the bold print on that prospectus. Should there be any confusion here? If homeowners start falling into default and not paying their mortgages, and the rate of default exceeds Fannie’s ability to make payments to its lenders, is there any reason to believe that the holders of those mortgages should expect our Treasury to make up the difference?

As Jim Rogers notes, in the wake of our Treasury volunteering our liability for Freddie and Fannie’s debt, we are perfecting the art of welfare for the rich:

While some well-meaning Americans attempt to rationalize this bailout as a “necessary evil,” the unintended consequences are beginning to reverberate. First, our government’s destruction of Freddie and Fannie’s preferred stockholders has closed the door on preferred stock for other at-risk organizations who might have wanted to use that route in attempts to raise capital. As Denninger noted:

If you’re a bank or other financial and need to issue (or have outstanding) preferred stock, you’ve got a problem - a serious problem.  The Federal Government just declared out loud that it will declare that stock essentially worthless any time they think there’s an accounting irregularity, and they will value things as they - not GAAP - sees fit.

Here’s what happened to you if you held just one of the many series of Fannie Mae preferred (the others are all essentially identical)

How about that - $13 to $2.50 in one fell swoop.

That’s an instantaneous 80% loss.

Now think about this from the perspective of, say, Lehman.  You have a capital problem.  You’d like to go out and issue some preferred stock - essentially a junior debt issue, where you pay interest in exchange for money, and perhaps its convertible into common stock at some point in the future.

However, you have a bunch of Level III assets, which might include mortgage bonds - not Agencies, but private-label stuff and commercial real-estate backed.

As a potential buyer of these securities, are you going to take this sort of risk?  Remember, Fannie and Freddie did not file bankruptcy; even in a bankruptcy, you’d likely get something as a preferred stockholder!

But in this case you got essentially nothing as a result of an (arguably) unlawful “taking” of your ownership interest in the firm!

My opinion?  This move just destroyed all preferred stock issues going forward for financials in the United States.

Paulson attempted to argue just the opposite in his press release:

Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing the GSEs so they can better perform their mission, today’s action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

Right. Well-capitalized institutions. That obviously doesn’t include Lehman, which is on the chopping block this weekend.

So now what?

Well, many observers believe that this unwinding of our banking and financial system is just getting started, with damaging consequences. Representatives from the New York Fed and major banks are working this weekend to orchestrate an orderly resolution for Lehman Brothers. Such meetings sound refined and sophisticated, although the situation is best described as a giant game of “chicken,” with our banking system hanging by a thread.

If Lehman fails suddenly, it is likely that its collapse would bring down its trading partners, as well. As Roubini notes:

If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

The potential for a widespread meltdown has brought banks to the table, each eager to avoid a similar fate. However, while banks are collectively motivated by self-preservation, no one individually wants to pay scarce money for Lehman’s questionable assets. So the “chicken” comes in when the banks look (again) to the Treasury and U.S. taxpayer to guarantee their purchase, thus bailing out the system and allow the status quo to continue:

But suitors like Bank of America, worried about the risk of buying an ailing financial institution like Lehman, want the government to step in with a package similar to what was offered to J.P. Morgan when it bought Bear. Then, the federal government agreed to absorb as much as $29 billion in losses. In seeking a Lehman deal, Bank of America Chairman and Chief Executive Kenneth D. Lewis is likely to face a tough sell to investors if he doesn’t secure some federal government backing.

As of this evening, no deal has been reached. Of course, the goal will be to reach a definitive plan by Sunday evening, before Asian markets open. We wouldn’t want to upset the new owners.

What can Americans do about our current predicament?

The first thing we need to do is educate ourselves about how we arrived at this precipice. It’s taken us a long time to get to this point, but the pressures have been gradually building since our current money and banking system were established in 1913.

One must first understand the system itself: a debt-based money system combined with fractional reserve banking. Once one understands how the system works, it becomes clear that our entire economy rests on an unstable foundation — and that the turmoil we’re experiencing is not unexpected. In fact, the system is working exactly as designed. As was noted by Robert Hemphill of the Atlanta Federal Reserve Bank in 1936:

“If all the bank loans were paid, no one would have a bank deposit and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture the tragic absurdity of our hopeless position is almost incredible, but there it is. It (the banking problem) is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.”
- Robert Hemphill, Federal Reserve Bank of Atlanta.

Our money and banking system is the antithesis of a “free market” — it is a private monopoly managed for the benefit of the banking system itself. Are you surprised that inflation has been attacking American families, and that even two jobs are often insufficient to pay for gas, groceries, healthcare, and save for retirement? Are you surprised that our goverment, in attempting to “help,” has taken on a $9.6 trillion national debt with over $50 trillion in long-term liabilities that we cannot afford?

Based upon understanding the system, we shouldn’t be. Again, it’s working exactly as designed — although it’s been pushed past the limits of sustainability, and is nearing tragic absurdity.

It’s time to change the system. Congress unconstitutionally delegated control of our money to the Federal Reserve, a private central bank, in 1913. Congress can, and must, return control of our money to the people.

Today’s New York Times has an Op-Ed piece by Roger Altman, formerly with Lehman Brorthers, Blackstone Group, and the U.S. Treasury, regarding the role of the Federal Reserve in the current financial crisis. This article deserves critical scrutiny by every American. Here are some key excerpts:

SMALL rallies notwithstanding, we are experiencing the most dangerous financial period since the 1930s. In the year since this crisis erupted, huge losses have threatened the solvency of our largest financial institutions. As a result, the Federal Reserve has been forced into increasingly difficult emergency actions, including the rescues of the investment firm Bear Stearns and the mortgage companies Fannie Mae and Freddie Mac, to prevent the entire system from collapsing.

Our entire regulatory system, conceived long ago for a different financial world, must be rebuilt. The next president will have no choice but to undertake this task next year.

The next president must first create a single framework for the major financial borrowers, administered by the Federal Reserve alone.

It usually takes a severe crisis to bring about systemic change. The upside to the punishing turmoil in our financial system is the growing probability that regulatory overhaul is at hand. And that’s good, because without it the Fed might be unable to save the system next time.

I agree with two of Mr. Altman’s key points: our current position is dangerous and unsustainable, and that the regulation of our monetary and financial system, based upon the Federal Reserve’s monopoly of our debt-based currency, must be rebuilt.

I disagree, however, with the assertion that we need to further centralize power in the Federal Reserve. As noted by many, including Kentucky Senator Jim Bunning and Texas Representative Ron Paul, the Federal Reserve and the banking system that controls it are the cause of our systemic risk. Even the Federal Reserve’s own Harvey Rosenblum emphasizes that the Federal Reserve’s job is to create moral hazard, which enables systemic risk:

Rosenblum: The Federal Reserve is in business to create moral hazard. The mere act of being a central banker means that your job description involves creating moral hazard. A central bank is a “lender of last resort,” what more moral hazard can you have than having a lender of last resort that people know, when push can to shove, can be relied upon? The Federal Reserve’s job is to cushion the blow to 300 million American citizens of all the economic shocks that hit out there. What drives me crazy is when I hear people shouting “Moral hazard, moral hazard”… that’s what my job is to do…

Of course, it’s a bit disingenuous to say that the Fed’s job is to “cushion the blow” when the Fed threw the brick that caused the economic shock.

Gary Larson’s classic Far Side cartoon says it all. The Federal Reserve has heaved a gigantic brick through the window of our nation’s economy. Jobs are getting scarce, retirement savings and housing values are declining, and basic necessities are less affordable. Using the current crisis as an opportunity to further empower the Federal Reserve at the expense of the people is not the answer.

We need to restart past conversations, and restore a Constitutional money and banking system that removes moral hazard from the equation entirely. We cannot allow a private monopoly to create money out of nothing to loan to us at interest. The Federal Reserve is welcome to compete in a free market, but accepting private debt-based currency should not be compulsory — it should be voluntary, and other forms of money that facilitate trade and local economic growth should be welcomed.

Alan Greenspan noted that our money system is not a free market — the power over our money is centralized in the hands of the Federal Reserve. That fact, along with the Federal Reserve’s support for the inherently unstable process of fractional reserve banking,  create the bricks that break our windows.

Our founders intended for our money and banking system to be democratized. Our ability to create wealth in our communities is one of our unalienable individual rights. The government is only authorized to establish a level playing field with accurate “weights and measures.” In particular, Congress was given the authority to coin money, and regulate its value — it is not authorized to delegate monopoly authority over our money to a private central bank.

Since 1913, however, our money comes from a monopoly run for the benefit of private banks. The banks have the power to create money through debt, and the people and our governments thus accumulate debt instead of wealth.

Please help us teach David Price the importance of debt-based versus asset-based money, and the importance of returning the power to create wealth to the people.

Headline of the day:

Cops to IndyMac customers: Remain calm or face arrest

Police ordered angry customers lined up outside an IndyMac Bank branch to remain calm or face arrest Tuesday as they tried to pull their money on the second day of the failed institution’s federal takeover.

At least three police squad cars showed up early Tuesday as tensions rose outside the San Fernando Valley branch of Pasadena-based IndyMac.

Federal regulators seized Pasadena-based IndyMac on Friday and reopened the bank Monday under the control of the Federal Deposit Insurance Corporation. Deposits to $100,000 are fully insured by the FDIC.

Let’s try infusing this story with a healthy dose of reality:

Cops to IndyMac customers: Blame the bank, not us

Police ordered angry customers lined up outside an IndyMac Bank branch to study the history of fractional reserve banking lest they repeat the unpleasant experience of losing their retirement savings.

Customers were informed that the bank had caused those deposits to vanish into thin air by lending in excess of their deposits. Customers were further informed that while the bank regrets their loss, the money destroyed was simply debt-based money that the banking system created out of thin air in the first place to be loaned with interest. In other words, “Easy come, easy go.”

Finally, it was noted that bank insolvency is not a theoretical risk, but simply standard operating procedure as all banks operate in a state of regulated insolvency.

Federal regulators seized Pasadena-based IndyMac on Friday and reopened the bank Monday under the control of the Federal Deposit Insurance Corporation. Deposits to $100,000 are fully insured by the FDIC based upon the government’s ability to print more money if the FDIC’s paltry reserves become exhausted.

Back in August of last year, Barack Obama proposed a solution for the subprime crisis, perfectly following the “bubble script“. Nine months later, we’re still on schedule — right up to high-profile government prosecutions of Bear Stearns hedge fund managers and promises of perpetuating but “regulating” a corrupt system in Senator Dodd’s Housing Bill:

The bill calls for a new, independent regulator for Fannie Mae, Freddie Mac and the Federal Home Loan Banks that would have the authority to establish capital standards and “prudential management standards,” as well as to “restrict asset growth and capital distributions for undercapitalized institutions,” among other powers, according to a summary of the bill.

As our markets and economy continue sagging under the weight of our unwinding debt (= credit) bubble, and a weak currency continues to send energy and food costs surging, it should be clear that our monetary, banking, and economic systems are sick.

After my two prior blog posts on the banking and monetary systems, it should also be clear that the problems we face are innate feeatures of a deeply flawed system. Or, as we used to say in the software business, “that’s not a defect — it’s working as designed!”

Things are working so well, in fact, that our banking system itself is propped up by “borrowed reserves” — the Federal Reserve has traded its government bonds, which normally serve as the foundation for our monetary system (don’t ask), for a variety of sketchy “assets” that banks are finding impossible to value. In other words, banks are dodging the bullet of having to accurately value some of their assets based on mortgages, credit card debt, and other consumer loans by “borrowing” the Federal Reserve’s treasury debt and leaving their questionable assets as collateral. As a result, the non-borrowed reserves in our banking system are now negative:

Wow. That’s an odd looking chart. What does that mean?

Nothing, really. It means that we’re living in a grand illusion. Don’t worry, go shopping, and go Celtics. Everything will be just fine.

But what about the mortgage bubble, and subsequent bust?

Do you really want to know? NPR’s This American Life had a fantastic episode a few weeks ago that explains the processes, people, and pathologies involved. It’s a great illustration of our financial system’s inherent instability. If you don’t have time to listen to the entire episode, there is a wonderfully concise and illustrative online slideshow that explains the mortgage mess in colloquial terms (Warning: Rated R for language).

So what now? Will Senator Dodd and other august leaders in Washington be able to stop the Great Credit Unwind, restore stability to our financial markets, prevent foreclosures, and empty California’s tent cities?

Time will tell.

But wait, there’s more. In an Orwellian twist, today we learn that language was inserted into Dodd’s Senate Housing bill that would require small businesses and third party payment processors to report all electronic transactions to the federal government:

Hidden deep in Senator Christopher Dodd’s 630-page Senate housing legislation is a sweeping provision that affects the privacy and operation of nearly all of America’s small businesses. The provision, which was added by the bill’s managers without debate this week, would require the nation’s payment systems to track, aggregate, and report information on nearly every electronic transaction to the federal government.

What? Unconstitutional police state surveillance tactics in a housing “relief bill”? Is the government trying to feed us with one hand, while holding us down with the other?

It appears so.

Liberty is Priceless — support our Congressional campaign, and help us question the system that feeds our addiction and enslavement to perpetually-growing debt. Also, help us bring the Read the Bills Act and One Subject at a Time Act to fruition in Washington.

In a previous post, we discussed the hazards (moral and otherwise) of fractional reserve banking. Once you understand fractional reserve banking, you understand why we need a central bank.

When you have a fractional reserve banking system, each bank is technically insolvent in that it cannot meet all of its depositors’ demands for their money. If all holders of demand deposits came to the bank to withdraw their funds, the run on the bank would force the bank to close down. It’s only the depositor’s confidence that the money will be there that keeps the bank in business.

Since that confidence proves shaky — witness the case of Northen Rock, or even Bear Stearns — the idea of “reserve pooling” gradually arose. The idea is that if an individual bank runs into trouble, other banks can temporarily lend it funds to meet its demands. The endgame for reserve pooling, however, is a single bank that has the power to arbitrarily create money — the central bank.

Our central bank, the Federal Reserve, was commissioned in 1913. It is not federal, and is owned by its member banks. The Federal Reserve interacts with the banking system in a simple but important way — it is the “lender of last resort”. That means that when a bank runs into trouble, the Federal Reserve will be there to bail it out, or orchestrate a merger or other transaction that will prevent collapse of the institution, or the entire system.

How does the Federal Reserve do its job? Today’s Federal Reserve is best known for setting the so-called “Fed Funds Rate“, or the price at which banks borrow money from each other overnight. Why would banks borrow from each other? One reason is to meet reserve requirements. If you own a bank, and make a new car or mortgage loan, you create new money for that loan in your borrower’s demand deposit account. You don’t need to have enough “reserves” in advance to make that loan, however — you can just borrow the necessary reserves in an overnight loan from other banks, and you should expect to pay close to the Federal Reserve’s target rate.

The Federal Reserve manages this interest rate by so-called “open market operations“, where the Federal Reserve buys and sells securities in an effort to keep interest rates close to its target. Right now, the Federal Reserve’s “Fed Funds Rate” is set at 2%. When banks are unwilling to lend to each other, and rates creep upwards, the Federal Reserve will add reserves to drive that interest rate down towards its target. Even if banks don’t have surplus reserves to lend, the Federal Reserve will still work to ensure that banks can borrow reserves at its target rate.

So what’s the problem with this system? Well, let’s take the words “add reserves”. The Fed “adds reserves” by purchasing debt, or providing a loan against debt (called a repurchase agreement, or repo).

When the Federal Reserve purchases debt from our government, or provides a loan against debt for a bank, it pays for that debt in Federal Reserve Notes. Where does the Federal Reserve get its Federal Reserve Notes? Well, the Federal Reserve has the unique ability to create new ones. In other words, the Fed has the ability to write a worthless check, and create new money.

Besides the moral issue of letting our central bank create new money that competes with money you’ve earned for goods and services, does this system really make sense?

No, it does not. Many people believe that in order for a bank to make a loan, someone must have first saved money, and made a deposit. That’s simply not true. When the Federal Reserve sets the interest rate at which banks can borrow to meet their reserve requirements, banks compete to make loans and create new paper money based upon their cost of borrowing, as opposed to the amount of reserves they have on deposit. Practically speaking, banks are limited in the amount of loans they can make based upon capital requirements, not reserve requirements.

In addition to the Federal Reserve’s ability to create money to lend to banks is the Federal Reserve’s ability to create money to give to our government. Our United States Treasury is constantly issuing new debt — we’re a “payday lender” nation whose government is constantly rolling over old debt into new debt, and issuing additional debt to pay for our constant budget deficits. Who buys all this debt?

Lots of people, and lots of institutions, purchase our Treasury’s debt. Many of these investors are overseas. The Federal Reserve also purchases our Treasury’s debt. But when the Federal Reserve purchases our government’s debt, unlike you or me, the Fed can give the Treasury a check with no money in the checking account. While you would be charged with fraud for writing worthless checks, it’s business as usual at the Federal Reserve. The Fed’s “checks” simply create new dollars in the Treasury’s checking account.

Money doesn’t grow on trees any more — it’s even easier than that. The Treasury just needs to sell some bonds, and if there aren’t enough willing purchaser with existing dollars, the Federal Reserve creates new electronic money to make up the difference.

So why do we have inflation? One important factor is the Federal Reserve’s new money competing with your earnings and savings for goods and services. Ultimately, our flawed system makes everyone’s dollar worth less.

While the American worker and saver gets hurt by this arrangement, who benefits?

Consider the banks — banks are protected from failure by a central bank that can create money out of nothing. Furthermore, this perception of “stability” allows banks to create loans out of nothing, backed with minimal reserves, and thus claim an ever-greater share of borrowers’ future income through interest payments. More loans leads to more profits — it’s definitely a winner for the banks.

Consider our government — politicians can make promises that we can’t begin to afford, but our central bank’s ability to create money to buy our government’s debt means that politicians can spend obscene amounts of money without raising taxes. Instead, they simply borrow and print new money. As long as the American public is unaware that government benefits are paid for by newly-printed money, and don’t understand the link with rising prices, this system is tolerated. Even the mainstream media is widely ignorant of how this system works.

But the dynamics are changing. We can no longer ignore gas prices, and grocery bills. We can no longer ignore the future costs that our children face. A speech on May 28 entitled “Storms on the Horizon” by Dallas Federal Reserve President and CEO Richard Fisher (world government fans unite — check out his biography in Spanish!) paints a surprisingly realistic picture:

Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation’s fiscal predicament.

…

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation’s retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker–retiree ratio and leaving today’s workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders—Wilbur Mills was the most credible of them before he succumbed to the pay-as-you-go wiles of Fanne Foxe, the Argentine Firecracker—who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

What do we do about that? How can we begin to “fund” a $99 trillion liability?

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it’s because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

OK, so if we can’t cut spending, and if we can’t increase taxes, are there other options?

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

Mr. Fisher, I wish I could believe you. Based upon the performance of our dollar against other currencies, it appears that we are doing exactly that. In fact, Alan Greenspan was asked about the problem of how we could meet our Social Security obligations back in 2005. His response at the time? “We can guarantee cash, but we cannot guarantee purchasing power!” In other words, we can print the money, but it won’t buy anything.

Odds are, despite Mr. Fisher’s wishes, we keep borrowing and printing. As Mr. Fisher concluded his speech:

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times [3] that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Mr. Fisher, you are correct. We do have the power to prevent this destruction. The cause of this destruction is the system itself. We cannot afford a debt-backed monetary system controlled by a private central bank that creates money out of nothing — thus facilitating unrestrained spending by politicians interested only in their re-election.

Coupling an unstable banking and monetary system with a government that gives favors in exchange for growing its power is a recipe for collapse into tyranny.

I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.

Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.

What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.

Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.

In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:

• Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
• Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.

From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.

You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.

Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.

The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.

From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.

You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:

If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)

This verse is talking about the prohibition of interest in loans to poor fellow believers, also known as usury. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, it’s still important, and acceptable, that the borrower offer collateral — even something as humble as his cloak. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.

As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.

So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.

In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency photocopied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.

For an entertaining description of fractional reserve banking and its interaction with paper money, watch this video:

While this video does an excellent job of showing the problems with our current system, there’s still much discussion to be had on proposed solutions. But we need to begin an honest discussion as we look towards the future.

On a more humorous note, here’s a great video on the Northern Rock bank failure in Great Britain:

Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.

Americans today are slowly being crushed by our currency’s decline. Oil is $110 per barrel, gold is over $1,000 per ounce, and foreign currencies across the board are hitting new record highs against the dollar.

These prices and events are not theoretical concerns. Americans across the board are facing rising prices for food, energy, and manufactured goods. Unfortunately, however, we’re not supposed to talk about the dollar here. In fact, we have such a provincial view of money in the United States that your average American consumer doesn’t even have the ability to save him or herself from a collapsing paper currency. In other countries, however, consumers are much more sophisticated:

In Bolivia, billboards feature George Washington’s image on a $1 bill alongside a bright pink 500 euro note, encouraging savers to turn to the euro to tuck away money earned abroad or sent home in remittances.

“If the dollar’s going down … save it in Euros!!!” say the signs popping up around La Paz for Bolivia’s Banco Bisa.

Just try going down to your local bank and switching your savings account to Euros. Not so much. (You can visit RBC Centura and gain access to Canadian dollars fairly easily, however.)

American consumers shouldn’t feel badly about their lack of knowledge regarding the dollar crisis, however. It turns out that even the White House isn’t allowed to talk about the dollar. Here’s a memorable quote from a recent press conference on March 7 by Dana Perino and Edward Lazear, Chairman of the Council of Economic Advisers:

Q I’d like to follow up on their refusal to talk about the dollar, if I could. I mean, we’re in a kind of a bad situation here, when OPEC says the reason for $105 or $106 a barrel of oil is the falling value of the dollar — and you won’t address that issue. Where do we go to find out who is right?

MS. PERINO: Well, as he just said, the Treasury Secretary is where you go to talk about the dollar. It’s a longstanding policy that predates this administration, and I’m not going to change it today. But Treasury can talk about it.

Q I don’t expect you to change it, but I do expect you to be able to say whether OPEC is completely wrong about this, or whether there is at least something to their claim that the dollar is responsible for the high price of oil right now.

MS. PERINO: Wendell, I’m under strict instructions, and have been from the beginning, to not talk about the dollar, and I’m not going to get fired to satisfy your question. (Laughter.)

That’s funny, all right. It’s funny that the current crisis is cloaked in bureaucratic “secrecy”, and folks aren’t willing to be honest about a crisis of historic proportions.

Today, the Federal Reserve opened up the money spigots to bail out a broke investment bank. Not surprisingly, our currency continues its free-fall against commodities and other currencies. The American worker, saver, and retiree has never been so endangered as in today’s inflationary environment.

For folks who don’t understand why we’re in such danger, here’s the answer: un-Consitutional debt-backed paper money that can be created or destroyed at will by a private central bank. Right now, your salary and savings are being stolen by the rising cost of food, energy, and other necessities just so we can keep a corrupt system solvent.

It’s time for a change, and time for Americans to talk about the dollar again. My favorite quote from this recent post:

I urge all voters to apply this crucial test to their representatives before supporting them.

Make them commit squarely and unequivocally to these questions. Do you believe Congress should exercise its sovereign power as provided in the Constitution of the United States to create money and regulate the value thereof and control the circulating medium in the interest of the whole people? Or do you believe this sovereign power should be transferred to Banks of Issue?

Their answers will prove conclusively whether they are with the people or against them.

Or do you believe that Banking Corporations should issue a credit substitute and through it control the money and circulating medium of exchange of the people of the United States in their own interest?

Watch your presidential candidate carefully and see that he commits himself clearly on this vital question. It will be a true test of his honesty and fitness for office. Admitted ignorance on the monetary issue should not excuse him. The subject is as old as our government, and if he does not know enough about it now to answer these test questions, he is not qualified to fill the position he aspires to, and should not ask your votes.

These words were written in 1912. When’s the last time you considered the nature of money?

Why would Bank of America, the largest bank in the country, agree to purchase Countrywide Financial, one of the nation’s most toxic mortgage lenders?

Four words: Too big to fail.

You see, the name of the game is bailout. Bank of America really has nothing to lose. After making a $2 billion investment when Countrywide was is distress last summer, anteing up additional stock (it was a stock deal, not cash) to purchase Countrywide and become the nation’s largest mortgage lenders was an easy next step. Think about the options from BoA’s perspective:

After watching its initial $2 billion investment decline by $1.3 billion, and seeing its purchase teetering on the brink of insolvency, it could just watch the mortgage lender keel over, and let someone else to pick up the pieces. That’s not too attractive, as BoA’s initial investment would likely be wiped out in the process.

The alternative is simply to buy the company outright. Does BoA need to worry about “calling the bottom” in the housing market? Does BoA need to concern itself with how much further the housing and mortgage market might deteriorate, and what further writedowns might damage the balance sheet of their combined entity?

Nah. Come on, we’re talking about Bank of America! Get it? It’s the biggest bank in the country. Is failure of Bank of America really an option?

Of course not. Which explains this recent article in the New York Times:

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

It all makes sense now, doesn’t it? If you owe $350,000 on a house now valued at $250,000, the government would pay BoA to purchase your loan, and then reset your mortgage down to $250,000 with a reasonable interest rate. You stay in your house, keep paying interest, and BoA is spared the trouble of foreclosing based upon your negative equity.

Even better, since it didn’t cost BoA anything to put that $350,000 in your account when you signed the mortgage in the first place, they still come out ahead when the loan is bought by the government. But how is the government going to buy these troubled mortgages? Read on:

The government would buy the mortgages at their true current value, perhaps through an auction, at what would probably be a big discount from the original loan amount. The mortgage lenders, or the investors who bought mortgage-backed securities, would be free of the bad loans but would still have to book their losses.

But wait… what is “true current value”? What the government is willing to pay in an auction? Who is bidding against the government? Can you even call it an auction if the banks are selling the mortgage to a single buyer? Who will set the price? The banks, of course. After all, we need to make sure BoA’s balance sheet is adequately protected. So then what happens?

Mr. Taylor estimated the government might end up buying $80 billion to $100 billion in mortgages. But he said the government could recoup its money if it was able to buy the mortgages at a proper discount, repackage them and sell them on the open market.

Oh, I see. The government is going to buy mortgages at a discount, repackage them, and sell them on the open market. That process isn’t working now, but after the government prints more money to give to the banks in payment for the at-risk mortgages and resets mortgages at a more tolerable level for the consumer, presumably the government will be able to sell those mortgages.

That is, as long as the broader credit crisis doesn’t cripple the economy, throw the borrower out of his job, and leave him unable to make any mortgage payments.

To whom will the government sell them? Well, the banks. Sounds like they get to play the game, “sell high, buy low”, with the taxpayer paying the difference.

What a great plan. Is there another alternative? Remember, failure is not an option. We bailed out the banking industry in the S&L crisis of the early 1990s. Sounds like we’re lining up to try again.

Even more amusingly, some savvy consumers are beginning to take advantage of this twisted situation in a new and unique way. Since a large number of mortgages are packaged into securities, and since the brokers securitizing these debts have been playing fast and loose with the loan documents in their rush to package up the loans, borrowers are discovering that they can successfully beat foreclosure when the supposed lender is unable to provide the actual loan note itself:

Joe Lents hasn’t made a payment on his $1.5 million mortgage since 2002.

That’s when Washington Mutual Inc. first tried to foreclose on his home in Boca Raton, Florida. The Seattle-based lender failed to prove that it owned Lents’s mortgage note and dropped attempts to take his house. Subsequent efforts to foreclose have stalled because no one has produced the paperwork.

“If you’re going to take my house away from me, you better own the note,” said Lents, 63, the former chief executive officer of a now-defunct voice recognition software company.

Judges in at least five states have stopped foreclosure proceedings because the banks that pool mortgages into securities and the companies that collect monthly payments haven’t been able to prove they own the mortgages. The confusion is another headache for U.S. Treasury Secretary Henry Paulson as he revises rules for packaging mortgages into securities.

So how will this situation turn out? Time will tell, but we desperately need economic and monetary systems that encourage saving and production instead of borrowing and consumption. Do you really think current trends are sustainable?

Lord Josiah Stemp, Director of the Bank of England, 1937:

“The modern banking process manufactures currency out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. If you want to be slaves of the bankers, and pay the cost of your own slavery, then let the banks create currency.”

To paraphrase the title of Rothbard’s classic book, the past few weeks in the markets illustrate the consequences of irrational and frankly treasonous fiscal, monetary, and economic policies. Our groceries have not been getting more expensive, our dollars are worth less. Gasoline is not more valuable, our dollars are less valuable. Our cost of living has not gone up, our salary is worth less.

A friend of mine sent me the following summary, which uses some great analogies. If we’ve not previously considered the importance of a sound currency, we’re getting a lesson right now:

The measuring stick (US $) is 40% shorter than it was 3 years ago. If one is using a shorter measuring stick then everything looks longer and higher as in the case of the stock market. The US has been losing ground vis-à-vis the rest of the world for about 17 years now, which is just after the Berlin Wall came down and most of the super cheap labor, in the often well-educated rest of the world, began to be a factor in the world economy.

Initially it was really good for the US because the cheap imports really kept inflation down. Then more companies began to move production off shore and more “creative destruction” ensued, but inflation & interest rates continued to drop in the ‘90s which is good for just about everything in the economy, especially the stock market and home prices. As more and more dollars were exported for more and more goods, emerging countries began to realize that the wealth transfer would inflate their own currencies and thus make their goods more expensive for their best customer (US) unless they invested those exported dollars back into our capital markets.

Their markets were not very well developed and so those emerging countries, especially in the Pacific Rim, were only too glad put their money back into our capital markets, which meant that their own currency had to be converted back into dollars. That wasn’t a bad deal for them because both our bond and stock markets were in super bull markets in the 90s, especially between late 1994 & 2000.

Now it is a different story, and for the last 4 to 7 years the various economic elements that are relevant have been in a state of flux. First the dot com & tech bubble burst, then we had 9-11, then the S&P went into the worst bear market since the 1970s, then the Fed was afraid of deflation so they dropped Fed Funds to 1%, which was lower than the rate of inflation and represented a negative interest rate.

Along about this time the dollar really began to drop. The S&P 500 was down 50% at its low in 2002 (that is the trading rule that will make you rich, or richer, whatever. Buy when a market is down 50%, just make sure that it will go back up before you do that though. <grins>) but with the 2002 midterm elections coming up everyone was focused on “growing the hell out of government.”

That is a euphemism for fighting terrorism through expansionary, but mostly worthless fiscal policy. Soooo, “Greenspasm” cut Fed Funds to 1%, Bush browbeat Congress into a tax cut, and Congress browbeat Bush into providing full employment though Homeland Security. They were all in a race to see who could stimulate the economy the fastest and the dollar lost big time.

Everyone I talked to about markets (3 people) knew that the dollar would tank and it did. The dollar was sacrificed at the altar of big government and political expediency. The stock market was propped up and made to look higher & better with the shorter measuring stick.

All of that cheap money shot housing prices through the roof in 2005. That was also one of the most predicted things that I have ever seen. Most people don’t think about what happens when an asset class can be leveraged at ten to one or more, like housing, but that kind of leverage plus loose money was one of the main things that led to the stock market crash in 1929 and the housing bubble may do something similar to the economy before it is over.

Meanwhile the dollar is on the back burner politically because only a small percentage of Americans realize or care that the wealth transfer to the rest of the world is on full burner, and many of those who know how to hedge or benefit from the dollar weakness.

The stock market may bounce for a while because it was pretty washed out at the close of trading today but there is a good chance during this quarter it will roll over into a bear market. It has not been totally confirmed yet, which is why it will probably bounce for a little while but I don’t see much of a chance that that it can avoid a major swoon in the first half of 2008. They will find a way, some way, any way to get it up going into the election but it will probably be from a much lower level than it is now. 2009, the first year of the new administration is traditionally the year when all of the built up economic pain is recognized by the politicians and the treatment will really need to be radical and harsh this time.

2009 could be an exceptionally bad year in the stock market.

A final word from Alan Greenspan in 1968:

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.

No equivocation there. I wonder what happened?