I have written repeatedly on how these actions have distorted the markets, how they are making things worse in an attempt to stop failed enterprises from failing.

It’s hard to say how much money has been thrown away by the US Government alone. I would guess several trillion dollars. The US Government finds itself in the predicted horns of dilemma: they can devalue the dollar and potentially destroy those who would buy their debt. Or, they can finally let the crash happen, and watch several large sections of the economy implode, along with several government backed institutions like Fannie, Freddie, and several government pension funds, and the Fed.

I have always argued that the second option was always the best, because it would happen anyway, and the sooner done, the sooner it could be dealt with. Of course it would have been a lot easier to deal with before when the government hadn’t committed over 12 trillion (yes, trillion) dollars to making things worse. That’s roughly a year’s GDP. I think they’ll be lucky to get half of it back.

A little creative destruction right now would be a nice change from the status quo. At least after an implosion, all the poison would have been worked out the system.

Anyway, the financial crisis never went away. It was simply papered over with ridiculous amounts of printed money and reckless monetisation of bad debt. The semi-socialist states of Europe could not ever sustain their spending levels, and the USA has put itself on the hook for stupid amounts of money over the last year. When the rest of the world craters and the US loses buyers for its debt, we’ll be back to disaster as usual.

I don’t know when that will be, but I think the powers that be are running out of tricks, and places to hide bad debt. I would not be surprised by a ripple of sovereign debt defaults around the world. The ripples may take a long time to reach the USA, but they will come.

The general answer is “when you’ll be better off for having borrowed the money”. I know that sounds inane. Let’s expand a little.

The practical perspective: borrowing boils down into two things: results, and risk.

If we ignore risk, then we need to consider if borrowing money will allow us to make more money, and enough to pay back both the loan and the interest. Borrowing money to buy tools to increase your factory output, or your worker’s efficiency, enough to pay back on the debt and more, is a good use of debt. Borrowing money to aid the borrowing of more money is bad. Borrowing money that depends on the successful borrowing of money in the future to provide results, is probably not good.

This brings us to the other dimension of the equation: risk. What is the chance that borrowing the money will pay off in results, and what is the chance that we’ll not be able to pay back the loan? If we are borrowing money for a risky endeavour, then we should expect to pay more interest, as that is how the lender takes compensation for the added risk.

Pricing risk, and judging the degree of risk in a loan is a difficult task, and one not really solved. The only mathematical tool I know of that I think has much veracity is the Kelly Criterion, which has mostly been ignored by the financial community.

The monetary perspective:

In the monetary perspective, we look at how money and the system as a whole are affected. We still care about individual borrowers, but we are really looking at the effects on everyone that participates in that system.

Borrowing creates money.

When we borrow, we are creating money. A bank generally only has to keep as a reserve a fraction of the money it lends out, so the simple act of borrowing creates money. However, there is no free lunch. That money does not enter the system unless it is actually used, and it is only beneficial if it actually increases the value of the system by being used.

Borrowing moves money from the future to the present.

For the cost of paying interest, borrowing allows us to buy things today that we could only have bought in many years time if we were forced to save the money. A classic example is a 30-year mortgage. A mortgage allows a buyer to get most of the benefits of owning a house 20 or so years before he would otherwise be able to afford the house.

Borrowing integrates risk from the present into the future.

If anything goes wrong during the repayment period on a loan, the borrower may find himself unable to pay. Any unexpected event that limits the ability of a borrower to pay could happen any time during the life of the loan. Generally, borrowers are given very little leeway in making payments late. And, once a borrower is in arrears, the chances are good that the extra load of catching up will make it even more difficult for him to keep up with his payments. These problems pile up over time.

Thus, the act of borrowing carries more risk than simply saving money and spending it when there is enough.

Money is not the same as value, and we shouldn’t create money without creating value to match.

Moving money from the future to the present means little if that money is not used to do something meaningful. The money needs to be used to genuinely increase the value of the world: it has to be used to make something, or be used to make it easier for someone to make something. If not, the borrower has simply paid interest to temporarily create and then destroy money. Money is used to measure the value of things. Creating money without (eventually) creating added value in the world to match that money devalues the money. If there is more money being used to measure the same amount of value, then each bit of money must represent less value.

Paying back a loan destroys money, and defaulting on a loan does so even faster.

When a loan is paid back, the money that was created is given back to the bank. This money cannot be used as a reserve for new loans, and as such it effectively disappears. The exception to this is the interest paid by the borrower. This is in excess to the original loan amount and adds to the amount of money in the system. Because there are multiple banks, and money borrowed is paid to third parties and ends up deposited in banks, further multiplication of money does actually occur, but this is not the case with a single bank.

When a borrower defaults on a loan, and the bank writes it off, the money that was created disappears in one fell swoop, but the bank is forced to make up all of the difference out of money that it was using for reserves. Thus defaulting on a loan destroys far more money than paying back a loan.

Thus, it is only a good idea to borrow (or lend) when the money is used to create more value than is represented by the interest paid on the loan.

If the required value is not created, then the extra money in the system devalues all money, punishing all members of the system holding money. If more value than money is created, money becomes more valuable too, and it becomes harder to borrow money as it is more difficult to pay off existing debts. This is self limiting, and also limited by the fact that if more value is being created than money, someone is undercharging for their product, which doesn’t usually last long.

In order to get to the bottom of all of this, there are a few realities we need to consider:

The government borrows money.

It seems to be a given that the US government will always spend more than it takes in in taxes. I suspect that only when it becomes impossible to borrow will this behaviour stop.

Typically, in recent years, the US Government had to borrow around $2 billion dollars per work day to keep the lights on. However, given all the current shenanigans, the US Government will probably have to borrow around $40 billion dollars a week to keep going. That’s $8 billion dollars a day, or four times the old level of borrowing.

The government borrows money by selling treasuries and paying interest on them.

So the government has to sell $8 billion dollars of treasuries per working day, a feat never before attempted.

Historically, over half of those treasuries have been bought or are owned by Americans.

People think in terms of foreign entities owning US Government debt, but the largest holder of treasuries is the government, followed by private entities in the USA, followed by foreign entities.

As the financial crisis proceeds, fewer treasuries will be bought by foreign entities.

As American demand for foreign goods dries up, and foreign entities have to deal with their own home-grown financial implosions, both the need and the means for buying US Treasuries will decline.

Tax income is imploding.

We are in a deflationary crash; debt is being written off left and right. Companies are failing. People are losing jobs. Unemployment is rising. This all means that tax income is going to crash. No profit means no income tax. Increasing the tax rate will just make companies implode sooner and individuals declare bankruptcy sooner. Tax returns will not increase without a concomitant negative impact on the economy.

Hence, the stimulus bill and other bailout monies will be paid for by selling treasuries.

There will be less money coming in, and spending has gone up drastically. The only way to make up the shortfall is to sell treasuries.

Those treasuries are going to be disproportionally bought by Americans.

Treasuries are seen as being lower risk than most other types of debt. Historically the US Government has been good about paying its debt, mainly because of the industriousness of its people and stability of its culture (and the fact that people who don’t pay their taxes go to jail). In a declining stock market, people are doing to be trying to decide where to store their money where it won’t be destroyed. Banks are shaky, and the stock market is declining. Because of government intervention in bond markets, and a refusal to force companies to be honest about their balance sheets, people are unwilling to buy commercial bonds (basically the equivalent of treasuries, but sold by individual companies that need to borrow money). Thus, they are left with buying US treasuries.

As more money is sucked out of businesses and the stock market, those entities will fail, making investors even more desperate to find safe places for their money.

So, government spending money will come at the expense of businesses and the stock market.

Any increase in the supply of treasuries in the current environment provides an opportunity for investors to pull their money out of the stock market and use it to buy treasuries. This drives the stock market down. This is called a “vicious cycle” or a “positive feedback loop”. This is bad.

Because of their desperation, the investors are willing to take treasuries for relatively low interest payments. This makes the government more willing to sell treasuries. This is also a vicious cycle.

Hence, the stimulus bill will be funded by destroying companies, employment, and the stock market, and will incur interest payments by the government in the future, which will be paid for out of future taxes.

So, the government is going to pay interest for the privilege of destroying commerce, and is then going to use that money to … improve commerce.

All of this ignores the potential problem that eventually nobody will have the money to buy treasuries, at which point interest payments will explode and the US Government will find itself indigent. At that point most entitlements would have to be withdrawn in a matter of months, and hundreds of thousands (if not millions) of civil servants laid off. Unfortunately, a private sector starved of money won’t be able to take up the load.

Tune in Wednesday for the next exciting episode in this series, titled “When is it okay to borrow?”

He has a rather outraged take on what will happen, and it is worth reading. You can find it at http://realestateandhousing2.blogspot.com/2009/02/obama-deal-with-family-b-and-c.html.

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.