I never thought they would be this aggressively stupid.

The government has now made promises to the tune of 8 Trillion dollars (that’s eight followed by twelve zeros, BTW). That’s roughly $25000 for every man, woman, and child in the USA, on top of any other government and personal debt.

That excludes the most recent bailout of Citigroup.

Don’t let anyone fool you. None of this is going to be making the taxpayer any money. If it does, it will be because the money is worthless.

And now it’s time for a rant:

This is all done in the name of “saving the system”. I was born in Zimbabwe and I’ve seen some interesting things; I still have family there who write me some very interesting emails. When “the system” fails, people usually scratch their heads and figure something out. The entire “ATMs will stop working and people will riot” line of argument gets right up my nose. ATMs will stop working and people will figure something out, mainly because rioting while someone else figures it out costs you money.

If rioting gets you a free TV, some people will riot, probably with friends because decent TVs are really big nowadays. So, I would suggest that TV’s not be made available to rioters, or that someone try real hard to get them back. Other than that, I don’t see a big riot problem down the line. If the government is afraid banks are going to fail, it should investigate what forms of credit would keep services and transport of food going, set up a facility to provide that credit, and cut the banks loose. The implosion would be huge, and short. The rush by small and sensible banks to take over their customers and business niche will be worse than opening time on Black Friday at Walmart.

“But letters of credit will fail!” I hear. Letters of credit are failing now. Some stuff will become unavailable. The rest will become available in other ways because people will figure it out. Why? Because they like making money, and you make money by selling stuff. The worse things get, the more enthusiastic they will get at figuring it out.

The one thing you can guarantee about a deflationary crash is that it has a bottom. A deflationary crash is what happens when a massive amount of debt is destroyed when people are forced to default. They don’t pay because, you know, they can’t. You can put lipstick on that, but you can’t get broke people to borrow more money. They might have taken a while to realise they are broke, but when they get there, they figure it out how not make it worse. Giving the banks money to lend, just after they’ve had their hand burnt by stupid lending, is asinine.

Attempting to stop a deflationary crash is stupid. It’s going to stop when bad debt is written off. You can try to obfuscate that, or you can try to help get it out of the way. Stagflation does not have a time limit. Long term zero-percent inflation with oodles of pretend-not-bad-debt hanging around has no time limit (ask Japan). Debt disappearing because it can’t be paid and has to be written off has a limit. Worst case, when there is no more debt, but probably significantly before that.

In the meantime the US government is spending like a drunk sailor in Vegas, as we go into a time when people won’t be able to pay their taxes, or won’t have any taxes, because you don’t pay taxes when you don’t have income.

In the meantime, President-Elect Obama is talking about deficit spending much more than usual for the first two years of his term to stimulate the economy. That level of imbecility is going to require an entire post of its own. I don’t know where to begin.

Anyway, Ben Bittrolff has the numbers at The Financial Ninja

The last few weeks have been filled with government announcements that they will guarantee one form of debt, or another. They think they are helping, but in fact they are doing two things:

• They are destroying otherwise healthy parts of the world financial system.
• They are putting other governments in a position where they have no choice but to do the same thing.

Generally, big governments are considered a good credit risk. For example, people generally assume that if they lend to the US Government, they will be paid back. So, imagine an otherwise normally functioning market in today’s panicky times, in which various forms are debt are bought and sold. The government announces that they will be guaranteeing a particular form of debt.

At that point, rational market participators sit back and consider their options. They can continue trading in the debt they are used to, but these are tricky times, and the government guaranteed debt is safer.

So, they very quickly move their money in the guaranteed debt. Besides meaning that a government is now on the hook for much more debt than they thought, this also means that otherwise healthy debt is suddenly difficult to sell.

The government backstop stole buyers away from similar debt. At that point the market for that other debt is distressed, and previously healthy entities start teetering. In desperation, governments announce they will backstop the newly distressed market. This then causes money to be sucked out of some other market, and that market becomes distressed.

In the end, everything is distressed, and the government is backstopping everything.

But, governments don’t have infinite resources. At some point they either refuse to guarantee something, or they default on their own debt. And then, a much larger problem that they have created unravelles in a way out of anyone’s control.

(For one example of what I am talking about, have a look at what Mr Practical has to say at Minyanville.)

I have already pointed out that the root of the problem is that many companies are functionally bankrupt because they are holding debt that has no value. They do not want to admit they are bankrupt. The powers that be are so afraid of a system collapse that they are not willing to force companies to come clean. I personally think that they are making a system collapse much likelier with their current actions. More on that in another post.

The current claim is that “the markets are frozen up and need more liquidity”. This is a load of bunk. What is actually going on is that a lot of people without enough money are trying to pretend they have money, and the Federal Reserve Bank (”The Fed”) is trying to help them do it. The Fed is doing this by making huge short term loans.

Here’s how it is done:

The Fed dumps a ton of money into the market, as loans. Companies take those loans, and try to pass the money around as fast as possible, to prove to any doubters that they aren’t bankrupt, and then give the money back to the Fed.

It’s a bit like a man with $1 that owes five people $20 each. He can borrow $9 for a day, and then rush around showing the $10 he now has to those people, and tell them that he has almost made back the money he needs to pay them back, and he’ll pay them back next week for sure.

If he’s lucky, he might be able to make a little money from that $10 and add it to what he has after he gives the $9 back.

Will it work?

Sure. For a while.

Have a look at this:

http://www.dailymail.co.uk/sciencetech/article-1079963/The-new-Concorde-Supersonic-jet-London-New-York-just-hours.html

That’s the Aeiron Business Jet. Pretty huh? Not only is it pretty, it’s ground breaking.

Aeiron have figured out how to defeat the formation of a shockwave at supersonic speeds (they call their design technique “Supersonic Natural Laminar Flow”). This is a big deal for two reasons:

1. It takes a lot of energy to make that sonic boom. By stopping its formation, you save lots of fuel. This means supersonic air travel might just become affordable for the man on the street in the future.
2. The sonic boom is very disruptive, being loud and damaging, meaning that it is illegal to fly supersonic over US land. That could change in the future if there is a really quiet supersonic plane, ALSO meaning we could all be travelling from A to B at supersonic speeds in the future.

I have family all over the world. Being able to do those long trips at faster than the speed of sound would be great. And, I’m an engineering geek, and it’s just cool.

The root of the problem is counterfeit money. I’m sure that’s a statement worthy of a double take for most people, but it is true.

In today’s world, there is not very much difference between debt/credit and money. If you write a check to someone saying your bank owes them $100, that’s pretty similar to giving them a $100 bill. Businesses buy and sell debt like they buy or sell anything else.

Now, a relatively easy way to make money is to convince someone that some debt is good, and sell them the debt. If you know the debt is bad, this is really a form of counterfeiting. For those interested, here’s another take on the problem.

An everyday example of counterfeiting debt is writing a bad check.

Now there are three forms of debt we care about:

• Debt that will be paid back, or good debt.
• Debt that is good debt now, but will go bad later.
• Debt that is bad now.

And they directly correspond to:

• Money.
• Counterfeit money that will magically become worthless in the future.
• Counterfeit money that people realise is counterfeit, and won’t accept.

The housing boom, mortgage backed securities, credit default swaps, etc. was all about making counterfeit money, whether it be intentional or unintentional. Mostly, it was in some grey area really close to “intentional”. Now, those same institutions dealing in this counterfeit money have been caught by their own creation.

That was the root of the problem.

The problem now is that lots of institutions are now holding counterfeit money that has turned bad, and they do not want to admit that they are bankrupt. Similarly, they are afraid to do business with other institutions, because they suspect those institutions have the same problem. They like to claim that they can’t sell their debt at the correct price, and that their “assets are illiquid”. That is not true, if they were willing to sell those assets for what they were worth, they would sell like hotcakes.

Any bailout attempt that does not force businesses to come clean about how much counterfeit money they hold is doomed to failure. Markets will be frozen until trust is restored, and trust will be restored when institutions are forced to come clean, and not a second sooner.

Authorities are trying to paper over the problem by providing “liquidity”; that is, lending money for short periods to those in trouble. This is a fool’s errand, as I will cover in another post.

Well, I think the financial crisis is about ready to really get started.

So far, every government response to the crisis has been to make it worse, along with taking on debt. Taking on debt during extreme deflation is a slow way to commit suicide.

The US Government will probably need to sell around 3 Trillion dollars of treasuries this fiscal year, because of all the debt the government has taken on trying to fix this.

That’s far more than has ever been attempted before, and they’re going to be trying to do it in a panicky environment where people don’t have cash to spare to buy treasuries.

When everyone figures out the numbers, all hell will break loose.

Europe is in a worse place than the USA. The chances are that the moment of truth will start in Europe, and drag down the USA with it.

If you are in stocks, get out NOW.

If you are thinking of buying something big or expensive, DON’T.

Don’t listen to anyone who claims that we have found the bottom for at least another year. In a year, I’ll probably say the same thing.

I don’t see any place to hide. Deflation kills everything but cash. Every government in the world is frantically doing its best to destroy cash, too, and their actions force other governments to join them in a race to the bottom or perish first.

The only way to fix this would be to force massive defaulting of debt. There is no way politicians are going to walk out onto the stage and announce procedures that will overnight kill 20% of companies out there and force millions into foreclosure, and guarantee 30% unemployment. The alternative is worse for all of us, but there is no upside for a politician for being known as the person who forced a hard crash to forestall a bigger crash that he claims was around the corner, and that he can’t prove will happen.

Wow. This is happening a lot quicker than I thought it would.

And the answer iiiiss: “F.D.R!”

I am quite scared for the short term future of the USA. I look at the potential presidents we could end up with, and I am faced with either ignorance or mal-education, or both. Let’s hope the results below are rubbed in their faces before they decide to “fix” anything.

For more have a look at: http://newsroom.ucla.edu/portal/ucla/FDR-s-Policies-Prolonged-Depression-5409.aspx?RelNum=5409

This is bad, because letters of credit are used as part of shipping goods around the world and within countries.

When letters of credit start failing, goods stop moving. Imagine not being able to buy food at your local store because it is empty, and not being able to drive to another because the gas station is also empty.

That is the logical end point for what is happening now.

Let us hope that the desire to make money keeps enough credit going that everyday life is not too badly impacted.

For more information, see:

http://www.nakedcapitalism.com/2008/10/international-trade-seizing-up-due-to.html

A credit default swap is a bet on some outcome. It can be legitimately used as a form of insurance against a negative outcome. For example, it was possible to buy a credit default swap as insurance against a piece of debt defaulting. In other words, “I’ll pay you a premium now, and if that debt over there becomes bad, you pay me the money I would otherwise have lost”.

Unscrupulous dealers bought credit default swaps on risky debt, so that they might sell that debt to other people as “good” debt. Unscrupulous insurers sold the insurance on the debt, thinking that they would simply refuse to pay if too much debt went bad. Some honest insurers sold legitimate swaps, but they we not aware of how risky the debt was that they insured.

Regardless of how honest people were when the transactions were made, when enough debt defaults, it is simply not possible for the insurers to pay without going bankrupt. And, everyone insured everyone else. So, in the end, the swaps neatly tied together a large number of companies in a net that insured that if enough parts of the net went down, the rest of the net would be dragged down with them.

In the context of the current crisis, the real problem with credit default swaps is that they tie all the dominoes together in a non-obvious way. Dominoes no longer need to be next to each other for a collapse to spread through the system.

For more context and background, this article is pretty good: http://www.newsweek.com/id/161199

So whatever happens, we’re going to hurt a lot?

Yes. It’s going to hurt. A deflationary crash would be quick, and extreme. People who watch too many Hollywood movies think this means blood in the streets, but it really just means a lot of hard working people will be on the streets trying to find a way to be productive. People who would rather cry to the government for help than work will be screaming blue murder and politicians will be trying to prove they can help by doing something. If they give in and do anything that forces the US Government to borrow, they could make things worse or just make the crash last longer.

An inflationary crash means that we’ll have many living-dead companies, and many people just on the edge of bankruptcy. House prices will still crash as it will be impossible to borrow money to buy them, and impossible to pay the interest on a mortgage if people do buy them. The government will constantly be borrowing more and more to try and make the problem go away. If it borrows too fast, the entire economy crashes as the US Government defaults on its debt. If it borrows at just the right rate, the inflationary crash lasts ten or twenty years.

Is there anything the government can do to make it less awful?

Yes. The primary problem is that nobody is willing to deal with anyone else, because they don’t know who is hiding bankruptcy. A realistic government solution would break down into three parts:

1. Make it possible to figure out who should be bankrupt. This can be done by changing reporting requirements in quarterly reports, and sending the SEC at any signs of fraud.
2. Set up a system to put a company in a special state where PRIVATE individuals and companies can invest their money to bail out a company if they think it will be worth saving. This would be done by wiping out all current shares and bonds and issuing new shares based on the debt of the company (this is called an debt/equity swap). People buying the shares would be buying the mixed good and bad debt of the company, but they would be buying it at the price they think is worth paying, so they can pay far less than full face value. Investors would make a lot of money if they choose correctly, and lose it if they choose poorly, but it would at least be real money already in the system.  There is far more private money out there than government money, it’s just that private entities don’t know where it’s safe to put it.
3. The government needs to stop spending money, stop borrowing money, and cannot use any of its money to convert fairy money to real money or to insure bad debt.

If the government did this, there would be a deflationary crash, but it would be as short as possible, and the economic growth after the crash would be phenomenal.

I doubt this will happen though, as politicians would be (rightly) afraid of being thrown out of office because they let their constituents hurt so much. I doubt they would have the strength to do the right thing.

Shouldn’t people be going to jail for this?

Yes.

I think you can see that in my opinion, a deflationary crash is the best way for us to go, and we have to stop the US Government from borrowing any more money than it already is. The government will probably attempt to inflate out of the problem, and potentially blow itself up in the process. If it doesn’t blow up, it will probably fail in stopping the deflationary crash (because they can’t inflate fast enough), but the crash will hurt more and last longer as people will have a higher tax burden.

The only place I think it would be worth allowing some government debt is in covering FDIC insured deposits in banks. Exposure there is fairly limited compared to trying to save the roughly 60 trillion dollar debt markets, and it will largely protect innocent bystanders from much of the carnage as banks are forced to come clean about their finances and get shut down.

Other than that, the government needs to conserve its powder, and restore trust by forcing companies to tell the truth about their finances. The economy will be frozen as long as businesses are afraid that they will be paid with counterfeit money.