Category Archives: Monetary Issues

Quote Of The Day

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
Ludwig Von Mises

After Great Depression I, a well-known economist was quoted* to say “We are all Keynesians now.”

Perhaps the refrain after Great Depression II will be “We are all Austrians now”?

Hat Tip: to herd or not to herd
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Oil — Where Is It Going? Up, Up And Away!

Last week, I posted about my belief that oil has currently dropped to a price level that is damaging to the long-term stability of the oil market, and that while it seems wonderful right now, it won’t last.

Today we find a bit of evidence that may only support this point:

The $25 low-end estimate [Francisco] Blanch recites is based upon a furthering destruction of Chinese and other emerging-market growth in 2009, and it is astounding if it turns out to be true.

We have witnessed the perfect storm of declining commodity pricing in the last six months — a tsunami of credit tightening, capital withdrawal on a massive scale, dollar strength, weakening emerging-market growth and finally a deflationary spiral that seems to never be ending.

The oil markets, if they represent perfect efficiency as the equity markets normally do, would indicate either that Francisco is very, very wrong with his oil predictions or that we are in for far deeper problems with the rest of our economy. Far-forward contracts of oil are trading at a premium to front months rarely seen before in my history of trading the stuff and in a way that looks unbelievable to other longtime participants.

As I write this piece, January crude is trading for delivery later this month at $43.40 a barrel. Amazingly, January crude for delivery in December of 2009 is trading at $57.50 a barrel, a premium of more than 32%. This premium (contango) nature of the markets has rarely been so great and would allow for a riskless trade. One could buy crude oil for delivery this month, store it and sell next January’s contract for delivery 12 months later. With margin, storage and financing costs, you’d still clear a healthy 11% profit.

Now, I’m a big fan of futures markets. However, futures markets don’t represent truth, they represent an aggregate of belief — and are often trustworthy because it’s belief backed up with money. As such, futures markets tend to be extremely accurate when correct. When wrong, though, they’re often spectacularly wrong, because when groupthink takes over, belief becomes decoupled with reason. This could be easily seen in the housing market, houses representing a similar case to a futures market (i.e. you buy and hold, betting the price in the long-term future will continue to rise, and then even more so recently with house “flippers” speculating on near-term future prices), where the belief that it will simply keep going up only enhances the height it reaches before the inevitable crash.

But I don’t think that is the case here. The pundits are all asking “how low will oil go.” The futures market says it’s headed up. If the futures traders were trading these contracts at $25/bbl, I’d call it groupthink, the belief that things are just going to spiral down worse out of control. But they’re not, they’re exercising a contrarian point with the $57/bbl price. When pundits and futures traders disagree, I know who I’m more likely to trust.

I think what we’re seeing here is a confluence of unintended consequences that many people only purport to understand. Extremely complex are markets making moves that appear contrary to “normal” behavior, and thus everything is becoming very unpredictable. Bailouts here, money-printing there, and debt deflation out of left field have all thrown markets out of whack. It’s going to take time to sort this out, but the oil futures traders are assuming that when it finally happens, we’re more likely to be at $57+/bbl than $25/bbl.

They [and I] may be wrong… When dealing with such complex systems, it’s hard to gauge all the inputs and outputs and every relationship between them. But when you take the prospective theories about what’s going on, I think the plausibility of demand destruction creating a 70% downward move in prices is in question. I think the belief that this is a strong dollar / credit crunch issue is a lot more plausible, and with all the money-printing going on worldwide, I don’t see how anyone can reasonably predict $25/bbl oil.

Oil Is Too Cheap

No, not for the reason these guys think:

Venezuela will back repeated cuts in OPEC oil production until prices stabilize, Oil Minister Rafael Ramirez says, and Russia is proposing closer cooperation with the oil cartel.

Ramirez said Wednesday that his country will back a proposed 1 million barrel per day cut when OPEC meets Saturday in Cairo. If that doesn’t halt the price slide, “We will keep cutting until the market stabilizes,” he said during a visit by Russian President Dmitry Medvedev.

Oil prices fell below $54 a barrel Thursday as dismal U.S. economic data and rising crude inventories outweighed the possibility of production cuts by OPEC and non-member Russia.

Russia, the largest oil producer outside OPEC, produces around 11 percent of the world’s oil and it could be eager to seek new customers to shore up its suffering economy. OPEC output is estimated at about 31.5 million barrels a day — about 40 percent of daily world demand.

Venezuela’s President Hugo Chavez has said OPEC should work to keep global oil prices in a “band between $80 and $100.”

I normally explain price moves using conventional terms of supply and demand. In this case, though, the rules are somewhat different*. There is certainly some demand destruction that has reduced the price of crude oil, but I hardly think it’s a large enough change to move from $147/barrel to $50/barrel oil. At this point, the price of oil seems artificially low, considering the fact that fundamental supply and demand forces haven’t changed.

Yet the response from OPEC, Venezuela, and the big oil companies is the same as if the price decline was natural — they reduce production. This is not only true of the state-owned oil companies, but areas such as Canadian tar sands and some of the more difficult offshore fields have stopped production or shelved new exploration projects. This only makes sense, of course, as the marginal cost of production of many of these projects is well over $50/barrel, and they don’t want to lose money.

This causes a major problem for two reasons, assuming that the fundamentals haven’t changed:

  • It takes supply offline in the short-term, and due to the nature of drilling, shutting down existing fields may reduce the ability to pump oil from those fields in the future. I.e. if a field is pumping 500,000 bbl/day before being shut down, it may only reopen with the capacity to produce 460,000 bbl/day. Thus, taking oil offline in the short term reduces potential oil recovery in the long term.
  • Reduction of exploration projects reduces oil supply in the future. While this may only push out exploration projects 2-3 years, current IEA projections of decline suggest that we should be searching for oil right now — and fast.

What does this mean for future oil prices? They’re going to go up, and they may be going up faster than before. This isn’t a return to the norm, this is the swinging of a seesaw. We’re at a low point right now, but an 800-lb gorilla just got on the other side.

Of course, to hear that oil prices are too cheap is not a common theme these days, as here in California gas has dropped under the $2/gallon mark. From a personal level, of course, I’m enjoying the reprieve. But now may simply be the best time to jump out and buy yourself a gas-saving auto, because these prices will not last.
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Financial Armageddon Follow-Up

Back in March of 2007, I posted this:

So here’s what I see. The slowdown in the subprime mortgage and building industries will increasingly push the default and foreclosure rate up. As a result, the mortgage-backed securities market and other housing-based stocks, which are reaching insane levels of “irrational exuberance” and are often highly leveraged (particularly derivatives), will crater, increasing the pressure. I think recession is on the way, and perhaps worse.

The above doesn’t sound very pretty. I don’t see any way out of it, though. The problem occurs with what happens after this, which is where it has the potentially to get really ugly. As I said, what I wrote above is what I predict. What sits below is a worst-case assumption of what might happen.

After the 2001 recession, when the government was coming off small surpluses, we had very low interest rates, and the political will to cut taxes, we were able to protect against a major economic crisis. We don’t have the same situation now. The government is running enormous deficits (and has added several trillion to the debt), the politicians are debating raising taxes, and interest rates likely won’t be able to hit the rock-bottom levels we had in 2002.

What does this mean? I don’t think we can spend our way out of this. I don’t see any way for us to have liquidity in a stagnant housing market and a tight credit market. In a tighter credit market, with rising interest rates, the cost of borrowing to cover deficit spending will not be feasible for the government. I don’t see an engine for economic growth appearing to cover the recession. There’s only one way for this liquidity to arrive, and that’s for the government to print money. Loads and loads of money. Helicopter drops of money. And the result is stagflation. This is quite possibly the worst thing our government can do, but I don’t trust any politicians to take the tough medicine– I expect them to print money.

Further, if things get bad, you can expect a quick increase in the level of socialism in this country. In an effort to placate both American big business and American voters, you’ll see the government take over health care. As a result of the inflation government will cause, you’ll quickly see them try to institute price controls and wage controls, like the 1970’s. All the while, they’ll blame scapegoats like outsourcing companies, while their own inflationary policies are causing the problem.

It looks like most of my nightmare scenario is already coming true.

I was wrong on a few things, of course. I suggested that the Fed wouldn’t be able to cut rates. What I didn’t expect was that credit markets wouldn’t simply tighten, but would disappear completely, making the enormous rate cuts ineffective. I chalk that up to some lack of understanding that I had on monetary issues, that I [hopefully] have significantly improved in the last year and a half.

Then, I talked about inflation. I have to temper that. We’re not going to see inflation. We’re either going to see a deflationary crash, or a hyperinflationary depression. I just don’t see us having a smooth way out of this one.

But one thing about sitting where I do today and looking back on that struck me… I was a lot more optimistic then than I am now!

We’re screwed, folks. There are going to be economics textbooks written about what we’re going through — assuming we don’t all go Mad Max instead.

Credit Crisis News — Pay Attention This Weekend

Over the last few months, I’ve been trying to devote time to the credit crisis and bailout. Unfortunately, the news cycle is often so short that it’s difficult to keep up. Today I was lucky to be able to catch the bailout modification. With the busy times ahead, though, there’s something that needs to be monitored very, very closely:

The Group of 20 nations is prepared to act “urgently” to bolster growth and called on governments to cut interest rates and raise spending as the world’s leading industrialized economies battle the threat of a recession.

“We stand ready to urgently take forward work and actions agreed by our leaders to restore and maintain financial stability and support global growth,” the group said in a statement released yesterday following a meeting in Sao Paulo. “Countries must use all their policy flexibility, consistent with their circumstances, to support sustainable growth.”

Those measures include “monetary and fiscal policy,” it said.

The G20 nations will be at a summit in Washington beginning this Saturday.

Something tells me that nothing good for us “plebes” will come of this. We’ll end up paying dearly for this.

They Don’t Know What They’re Doing

For anyone who thinks this “bailout” is any more than a haphazard guess about what the market needs to remain mobile, here’s your answer… They’ve changed their minds — again:

An already disheartened Wall Street turned sharply lower Wednesday after Treasury Secretary Henry Paulson said the government won’t buy banks’ soured mortgage assets after all, disappointing investors who hoped to see the bad debt wiped off companies’ books. The Dow Jones industrials fell more than 270 points, and all the major indexes dropped more than 2 percent as the market retreated for a third straight session.

Paulson said the government’s $700 billion financial rescue package will not purchase troubled assets from banks as originally planned. He said that plan would have taken too much time, and that the Treasury instead will rely on buying stakes in banks and encouraging them to resume more normal lending.

While the market had been pleased by the government’s decision weeks ago to buy banks’ stock, investors still hoped to see the financial industry relieved of the burden of the mortgage assets whose decline in value helped set off the nation’s financial crisis.

Paulson also announced a new goal for the program to support financial markets which supply consumer credit in such areas as credit card debt, auto loans and student loans. He said “with a stronger capital base, our banks will be more confident” to support economic activity.

Now I understand why his initial proposal desired a lack of oversight on his powers… He had no clue what was going on and wanted free reign to change his plans in mid-stream. Now he’s decided to throw money at the credit card and auto loan companies, because he’s worried that lagging consumer spending will be the next domino.

Perhaps to say that he has no clue what’s going on isn’t fair. He probably knows exactly what’s going on — he just can’t tell us, or we’ll realize that the whole system is in danger. As an unnamed banker reportedly said in Aug’07, “the deleveraging will not be denied.” I think our government is scared shitless. Right now Paulson, Bernanke, the ECB, and financial movers the world over are trying to keep a burst bubble inflated, and the only way they know how is to pump air in, because they can’t fix the hole.

Just when will the world realize that the emporer has no clothes?

Third Party Debate

The City Club of Cleveland extended an invitation to the top six presidential candidates*. Of the six candidates, Libertarian Party candidate Bob Barr, Constitution Party candidate Chuck Baldwin, and independent candidate Ralph Nader participated; Democrat Barack Obama, Republican John McCain, and Green Party candidate Cynthia McKinney were no-shows.

Unlike the debates we have already seen in this cycle, the candidates in this debate actually debated the issues!

*The candidates who could theoretically receive the requisite electoral vote to win the presidency

A Tale Of Two Bubbles

Today’s Wall Street Journal notes that the world’s financial problems go well beyond a credit crisis:

The original bubble was in housing prices and mortgage-related assets, which the Federal Reserve helped to create with its negative real interest rates from 2002 into 2005. This was Alan Greenspan’s tragic mistake, not that the former Fed chief will acknowledge it. Testifying before Congress yesterday, Mr. Greenspan pinned the crisis on mortgage securitizers, risk modelers and lending institutions, thus contributing to the Washington narrative that government had little to do with it. The Fed’s monetary policy apparently gets a pass. The media and Members of Congress will use Mr. Greenspan’s testimony to impugn the very free market principles that the former Ayn Rand protégé has spent his life promoting. It was a painful spectacle to watch.

As for the second bubble, this one began in August 2007 with the onset of the credit panic. This is Ben Bernanke’s creation. The Fed chose to confront the credit crunch as if it were mainly a problem of too little liquidity, not fear of insolvency. To that end it flooded the economy with money, while taking short-term interest rates down to 2% from 5.25% in seven months. The panic only got worse, and this September’s stampede finally led the Treasury and Fed to address the solvency problem by supplying public capital and numerous guarantees to the financial system.

But, in the process, the Federal Reserve had created a monetary/commodity price bubble that is clearly reflected in these two charts:


As the Journal points out, the consequence of this monetary bubble is that it has left us, and the rest of the world in a much weaker position to respond to the credit crisis that, even today, continues to rampage it’s way through the financial system. And yet, both major political parties, and both major-party candidates, continue to ignore reality, as the Journal points out:

As Congress plumbs the causes of our current mess, the main one is hiding in plain sight: Reckless monetary policy that did so much to create the credit mania and then compounded the felony with a commodity bubble and run on the dollar whose damage is now becoming apparent. The American people intuitively understand what’s been done to them, which is why they are so angry. If the next President ignores the monetary roots of our troubles, he is courting the same fate as George W. Bush.

Monetary policy isn’t fun, it isn’t sexy, it doesn’t make for cute soundbites or 30 second television commercials, but it’s important and it’s been ignored for far too long. Unless we start paying attention to it soon, the Bush years may start looking like the good old days.

Don’t Forget to Study Before the Final!

I just received my mail-in ballot a week or so ago. The ballot, with multiple choices with arrows to be filled out next to each choice, reminds me of taking standardized tests back in the day. Some tests were easier than others but I knew that if I did not study, one of two things could happen: (1) I could get lucky and answer enough of the questions correctly to pass or (2) I could possibly fail.

In a way, the general election is a final exam. Whether one “passes” the exam or not depends on whether s/he votes according to his or her principles. In order to increase your chances of voting according to your principles, you must study.

I am disgusted with the Republican and Democrat parties. When going over my ballot, my first instinct was to vote Libertarian in every race with a Libertarian candidate. I had studied all of the ballot measures and was satisfied that I could make intelligent choices there, but I hadn’t researched the candidates below the presidential level*. In the U.S. House race, I found three choices: the incumbent Diana DeGette (D), George Lilly (R), and Martin Buchanan (L). I knew that DeGette supported the bailout so she was never an option. Buchanan is a Libertarian and his positions he posted on his website are indeed Libertarian.

So why not just support the Libertarian you ask?

Regardless of how much I despise the Republican and Democrat parties, I make an effort to learn about the individual candidates and their positions before making a choice. Much to my delight and surprise, I found the Republican, George Lilly to be a “Ron Paul Republican.” I knew that there were such individuals running in this election but I never thought I would have had an opportunity to vote for one!

Now, I know that an endorsement from Ron Paul is not necessarily all it’s cracked up to be but take a look at Lilly’s positions posted on his website:

Please join me in RESTORING the Constitution, and together, let’s:

1. RESTORE the economy — free up business from onerous outdated regulations.

2. RESTORE proper use of the military (136 nations have U.S. military presence.)

3. RESTORE integrity to the treaty process to protect America’s interests first.

4. RESTORE individual privacy and say “no” to the Real I.D. Act.

5. RESTORE high quality medical care at affordable prices.

6. RESTORE checks & balances — the executive branch has gotten too powerful.

7. RESTORE integrity in the campaign financing process.

8. RESTORE integrity to the dollar — re-institute the gold standard. Watch this YouTube video!

9. RESTORE integrity to the tax system — rein in the I.R.S.

10. RESTORE and retain rights to unregulated health supplements & the Internet.

The following will be my top priorities in Congress:

1. Create a level playing field for Americans who receive the benefit of Workmen’s Compensation, mandatory health insurance, retirement benefits, taxes, OSHA, EPA etc. and calculate that into the cost of the products manufactured so that any foreign country not providing the same benefits to their employees would have to pay a tariff on their imported products to equal that amount.

2. Support a bill that calls for a single subject on all spending bills.

3. Oppose unconstitutional spending in the form of corporate subsidies.

4. Oppose unconstitutional spending in the area of education so that “No (every) Child Left Behind” is abolished.

5. Hold the Federal Reserve to account for their corruption of the dollar which has driven up the price of everything way beyond what any normal person can even consider affording!

While I have some concern about his #1 priority being a little on the protectionist side, I certainly applaud his willingness to stand up for the Constitution and against big government**. He’s not purely libertarian but in my estimation, he’s at least as libertarian as Ron Paul.

Having learned about George Lilly’s positions, most of which I agree with, I am very glad I had taken the time to make an informed choice. Now my choice was between the Ron Paul Republican and the Libertarian. Who should I choose?

Most things being equal, I decided to support Lilly. As a practical matter, the Republican Lilly would have a much better chance of unseating DeGette than the Libertarian Buchanan. I have not seen any polls regarding the District 1 race, but I suspect that in a district which seems to worship the ground Barack Obama walks on, DeGette will be difficult if not impossible to beat. If most of the libertarian vote goes to Buchanan, we’ll almost certainly re-elect a tax and spend Democrat to another term.

This is why I urge everyone to study each race before casting a vote***. Put emotions aside and “think the vote.” Though the electorate as a whole may fail the exam, we should each make the effort to pass individually.
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Inflation Fears Ease — So Watch Out!

As I’ve pointed out before, the extreme leverage increases in our economy created a false inflation, and the de-leveraging is an inherently deflationary process.

There are signs that this false inflation is easing, and possibly even heading into a deflationary curve.

Consumer prices were flat in September as retreating costs for gasoline, clothes and new cars helped to offset rising prices for food, medical care and other things.

The new reading on the Consumer Price Index, the government’s most closely watched inflation barometer, came after prices actually dipped by 0.1 percent in August, the Labor Department reported Thursday.

In the inflation report, when energy and food products are stripped out, “core” prices inched up by just 0.1 percent in September, an improvement from a 0.2 percent advance in August.

The latest showing on inflation was better than economists expected. They were forecasting a 0.1 percent increase in overall prices and a 0.2 percent rise minus energy and food.

I’ve been watching locally as gas prices here in Orange County have dropped, from the $4.50/gallon range at the high points down into the $3.35/gallon range this morning. As they tend to lag the price of oil, they could drop even further. The [impending or currently existing] recession is eating into demand for most consumer goods, which puts downward pressure on prices for those as well.

Food is holding steady, but if we can get some pressure in Washington to end our silly corn ethanol program (only possible if Congressional Democrats try to punish their Midwestern Republican opponents), it could reduce prices there as well.

So why do I say watch out?

With the economy in for a period of weakness that could extend well into next year, inflation should also moderate, Bernanke and other Fed officials predict. Tamer inflation would give the Fed more leeway to slice rates again or at least keep them at low levels for some time.

“The rapidly disappearing inflation threat is providing the Federal Reserve full latitude to move to an easing bias on rates to combat the recession as well as the ongoing financial crisis,” said Brian Bethune, economist at Global Insight.

Many economists believe there’s a strong chance the Fed will lower rates at its next regularly scheduled meeting later this month. In an unprecedented assault on the financial crisis, the Fed and other major central banks together reduced rates last week. The Fed’s main rate dropped to 1.50 percent, from 2 percent.

He says this coming off a 2-week bender where the Fed, the Treasury, and our elected officials have pledged to throw liquidity at the problem to “unfreeze” this market. Now, there’s a chance that our super-intelligent always-prudent benevolent masters in Washington may lay down exactly the right amount of liquidity to forestall deflation, get markets moving, and not create inflation of their own… Yeah, that’s about as likely to happen as France adopting a 55-hour work week.

Much more likely is the scenario where our government throws dollar after dollar, rate cut after rate cut, and stimulus package after stimulus package at the problem until they see movement. After all, now that they know inflation fears are “disappearing”, they know that they have “full latitude” to act. Once they begin to see movement, they’ll finally realize that all those free dollars had a lag period and that they’ve overreached. We’ll have “booming growth” on paper as the value of our money erodes.

Sadly, only the few of us who know that these cycles are induced by a loose monetary system— those of us who saw this problem coming 2+ years ago— will accurately diagnose that the apparent growth is a chimera. And as usual, nobody will listen until it’s too late. They’ll blame the guy in office, and get ready to elect their next savior politician to take care of them. “Pay no attention to the man behind the curtain! All hail the Wizard!”

Pretty Soon You’re Talkin’ Real Money!

$700B here, $900B there, and now another $250B on top!

The government put itself four-square into the country’s banking business Tuesday, resorting to what President Bush conceded was the unwelcome choice of buying into the system to loosen paralyzed channels of credit.

The president said the decision to buy shares in the nation’s leading banks — a kind of federal intervention not seen since the Depression era — was “not intended to take over the free market but to preserve it.”

Translation: We already broke it, now we have to buy it.

Said Paulson: “Government owning a stake in any private U.S. company is objectionable to most Americans — me included. Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable.”

Nine major banks will participate initially, including all of the country’s largest institutions. The first bank to take advantage of the new program was Bank of New York Mellon which announced Tuesday that it would sell $3 billion in preferred shares to the Treasury.

Some of the nation’s largest banks had to be pressured by to participate by Paulson, who wanted healthy institutions that did not necessarily need capital from the government to go first as a way of removing any stigma that might be associated with banks getting bailouts.

(emphasis added) Don’t you love it? It’s objectionable to Paulson, and to the American public, and even to the banks themselves. But they have to do it anyway.

A person I know who works in the finance industry said it best: I’m not sure what to think any more. There are a lot of comparisons to 1929, except the government at that time didn’t have the capability to throw any liquiditity in the markets.”

Yep, we’re in pretty much unchartered territory here. We’re taking a situation with echoes of 1929 and throwing so much liquidity at it that we’re not sure what’s going to happen. Nobody knows what to think right now, and that’s pretty damn scary. That Paulson and Bush think they can actually manage the situation is even worse. This really could be the end of America’s financial position in the world.

UPDATE: It has been mentioned elsewhere (and alluded to in the article) that this $250B is part of the $700B bailout money. This appears to be true. So now we have a huge run-up in bank stock prices, because investors know there is a ready buyer about to toss $125B immediately into the 9 biggest banks. Great!

No Repeat Of The 1930s Here!

Yep… Worried of a liquidity crunch similar to that in the early 1930s, there’s been quite a bit of movement in the last week. Starting with last Friday’s $700B Treasury bailout of toxic debt, followed by yesterday’s $900B+ short-term lending backstop, markets still weren’t assuaged.

So what happened? A big drop from the Fed in short-term interest rates, to nearly the lowest levels since 2003. And this isn’t just an American move, this is worldwide:

The Federal Reserve, the European Central Bank and other central banks from Britain and Switzerland to Canada and China announced rate reductions within seconds of one another. The British government separately announced a plan to pump billions of pounds into the country’s leading banks as part of a plan that would result in considerably greater government influence over the financial sector there.

The Fed said in a statement that, because of weakening economic activity, it had cut the Federal funds target rate by half a percentage point, to 1.5 percent. It also cut its discount rate by the same amount. The vote was unanimous.

So don’t worry. We’re not going to have a depression caused by lack of liquidity. We’ll have all the problems attendant with too much liquidity instead.

Want an example? As I’ve pointed out before, the unwinding of leverage is an inherently deflationary process. Gold, in its retreat from highs during July as that credit crunch started setting in, dropped from a high very near $1000/ounce to about $840 an ounce late last week. With the news of the bailout, the short-term lending program, and the rate cuts, it has since rocketed back up over $900. I have a feeling it’s headed farther up in the very near term.

Fed Opens Spigot With Up To $900B $1.3T More

With the reverberations of the Congressional fight over the $700B bailout still shaking Capitol Hill, the lingering question has been whether that $700B would be enough to do any good.

Nope. They’ll need at least double that. And Congress isn’t voting on this plan:

The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debt in a dramatic effort to break through a credit clog that is imperiling the economy.

The Federal Reserve, invoking Depression-era emergency powers, will buy commercial paper, a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they’ll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

And lest anyone be confused, this is not what went through Congress on Friday:

The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday.

Bernanke, a student of the Depression, took one lesson away from the 1930s. Never let liquidity dry up. He’s going to inject so much grease in the system that it will be FORCED away from seizure. What remains to be seen, though, is if that grease will cause it to spin right off the axle.

The current credit crunch is a largely deflationary phenomenon. Too much leverage existed in the system, and with our fractional reserve lending system, that led to too much money floating around.

The healthy way to let leverage unwind is to allow that fake wealth to evaporate. However, this is a very painful exercise. Leverage-induced inflation sends false signals to the market suggesting that natural demand for certain products (housing in this case) is increasing, and jobs and companies spring up to meet that demand. As the leverage unwinds, the money dries up, and people in those sectors are left out of a job looking for something to do.

The unhealthy way to unwind leverage is to flood the market with enough liquidity that the base of the lever expands. If you’re leveraged at 20-1, and the government steps in and loans you new capital while buying your bad assets, you can increase your capitalization and may only be levered at 10-1 while your actual holdings haven’t decreased. This is what the government is trying to do. The danger, of course, is that the new money injected into the system just adds to the leverage, and we end up in a hyperinflationary depression.

Many people I’ve spoken to who are involved in financial matters are saying things like “I’ve never seen anything like this before. The market is acting in completely unprecedented ways.” At the same time, we have a government that is so desperate to stave off another 1930s depression that they’ll sacrifice any sense of fiscal discipline or monetary stability. It sure is going to get interesting!

Just What Was The Administration Threatening Recalcitrant Representatives With? Martial Law?!?

I hope that Representative Sherman is the victim of a bad game of “telephone”. If he is not, if the administration really did threaten to impose martial law if the bill weren’t passed, then the time has come for us to cast out the vipers in Washington D.C.

Hat tip to The Crossed Pond and Dispatches from the Culture Wars

I am an anarcho-capitalist living just west of Boston Massachussetts. I am married, have two children, and am trying to start my own computer consulting company.

Thoughts On The Bailout

A few days ago, I tried to explain, in layman’s terms, how we ended up in this financial mess. I had this to say about the bailout:

We can debate whether or not this bailout should or shouldn’t occur (for the record, I’m against it), but in an election year, there’s nothing that’s going to derail this monster.

And it looks like today’s news proves that analysis correct momentarily premature. It’s clearly not in “stick a fork in it” stage yet, and you know that round 2 is on its way and will not be deterred.

So there’s still time to call it a stupid decision. I don’t have the time to devote to that today, so I’ll turn you over to the ever-talented Warren Meyer of Coyote Blog, who skewers the bailout plan. As they say, read the whole thing.

The Global Financial Margin Call


4. the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own liability for any loss.

For an investor, margin is a blessing and a curse. When you’re trading on margin, your returns can be very high, but it only takes small losses to wipe you out completely. It’s the problem of leverage. If you invest $1000 but your brokerage is giving you 5-to-1 margin, you effectively invest $5000 instead of $1000. Thus, a 20% return nets you $1000 profit instead of $200. But it’s a problem in the opposite direction too. A 20% loss loses you $1000. You now have a $4000 loan from the brokerage, and the total position of your holdings– if liquidated to pay off your loan in a margin call– will leave your position wiped out.

Margin, for an individual brokerage and an individual investor, can be a very useful tool. Yes, it’s a big risk, but it carries big rewards. It allows the investor to play a large position with a limited exposure, and allows the brokerage to make very liquid loans when they have excess capital.

When margin requirements get very loose, though, and the practice becomes widespread, it becomes scary. Gains happen quickly, as the money moving in the market gain velocity. Losses are worse. If a brokerage has a lot of investors working on margin, a bear market may force them to initiate a margin call on a lot of investors, and their exit of the market can further reduce demand and drive down prices. Thus, each brokerage is in a race to exit the market, and the market crashes — as we saw in 1929.

Leverage is not a bad thing. Without leverage, most people couldn’t afford a house. We don’t save the full price of the house, we save a modest down payment, borrow the rest, and then watch as our 10% down payment reaps the rewards of 100% of the gains of the house price. In a down market, because houses rarely drop more than 10% or 20% in a down market, it’s rare that a price will drop enough in a short period of time to liquidate our down payment…

Enter subprime and alt-A. When lending standards decline, offering houses to people with no money down, the leverage becomes nearly infinite. If I can buy a $400K house with no down payment– only covering closing costs– I now have the ability to make a huge reward with very little risk of my own. It doesn’t take a 10% drop in housing prices for me to be underwater on my investment, but a 10% increase on that house is $40K in profit.

Leverage increases the rate of gain as well as loss. When subprime lending became widespread, everyone was buying on margin and bidding up the prices of homes to obscene levels. The market was crowded not only by homeowners, but by speculators looking to “flip” houses for a quick profit. The rapidly escalating prices was a false signal to homebuilders, who believed that demand had shot up and tried to build houses to meet the demand. The market went up with no signs of stopping — and then it stopped.

As all bubbles do, eventually the perma-bulls have nobody to sell assets to except other perma-bulls. The market can go nowhere but down. At that point, everyone who is leveraged is in big, big trouble. In this case, the market was leveraged top to bottom, and we’re looking at a financial catastrophe unlike few people today living have ever seen.

I said we were leveraged top to bottom, but so far I’ve only spoken about the homebuyers and lenders. It goes far deeper than that. Investors lending out their own money have a responsibility to ensure that they’re lending to creditworthy borrowers. Even if it’s not “their own” money, they usually have to carry those profits and losses on their own balance sheet, and thus it’s their responsibility (often with their job on the line) to ensure the money is handled responsibly. But in this case, the incentive of the lenders was to “churn” loans, because every loan was carried by someone else. The loans were packaged into CDOs– Collateralized Debt Obligations– securities grouping these toxic loans into equities sold to institutional investors who were far more liquid than the banks or the homebuyers.

Even worse, many of those institutional investors were working on their own version of margin, CDSs– Credit Default Swaps. A CDS is an insurance policy against default. If I buy $1B worth of securities, with a worry about losing my entire position in a big default, I can insure my position against default for a much smaller amount. I can then assume that my $1B investment is no longer “exposed”, and go out making another billion dollar investment as if the first billion doesn’t even exist. I’m covered — as long as my counterparty selling me the CDS can remain solvent.

So everyone’s leveraged to the max, top to bottom. How did it get this way? This post isn’t intended to assign blame, but as I’m sure many of you know, I think the government deserves quite a bit of responsibility for its easy-money policies, Fannie and Freddie, and the CRA. Then, of course, there were a lot of investors who got swept up in the “good times” thinking nothing could go wrong, and many of their technical investing brethren who assumed that the new CDO and CDS products would work to improve stability instead of just allowing the bubble to reach historic proportions before bursting. And there’s the old-fashioned greed, by lenders who want to refinance everyone they meet and homebuyers who either bought more than they could afford or treated their homes like ATMs. This one’s big enough that there’s plenty of blame to go around.

So what’s happening now? The global financial margin call. This leverage has to unwind, and the way that happens is going to cause a lot of pain no matter what happens. It would have been easier if everyone just held on through the crisis. But these financial institutions are in a prisoner’s dilemma writ large; if none of them write down the assets and try to de-leverage, they’re all able to weather the storm, but if any of them de-leverage, the firms to do it first get off the lightest. Plus, with mark-to-market rules forcing them to write down the losses, they’re hand is forced. We’re at the point where everyone’s in the process of trying to get out, and the whole system is nearly ready to come crashing down.

And why is the government stepping in? Because the credit markets are frozen. An institutional investor isn’t going to take a big risk right now if they can’t hedge that risk. They’d love to use a CDS to protect themselves, but nobody believes the counterparty selling a CDS is solvent enough to live up to its obligations. AIG is a perfect example. As the largest holder of these CDS contracts, there was no way they could effectively live up to their counterparty obligations, and allowing them to fail would unravel the whole egg in a very fast manner. Thus, the government stepped in and said that nobody has to worry, because if push comes to shove, the US Treasury will be that counterparty. And nothing’s more trustworthy than the US Dollar and the US Treasury, right?

There’s an old adage when it comes to economics: “If you owe the bank $5,000, that’s your problem. If you owe the banks $100,000,000, that’s the bank’s problem.” The problem with being “too big to fail” is that failing hurts the people you owe a lot more than it hurts you. This is where the bailout is coming from, because companies like AIG will cause so much havoc when they fail that we can barely understand the potential implications.

We can debate whether or not this bailout should or shouldn’t occur (for the record, I’m against it), but in an election year, there’s nothing that’s going to derail this monster. What’s important right now is to understand the potential implications. So here’s the possibilities:

Best Case: The whole point of the government intervention isn’t really to fix the situation. This situation can’t be “fixed” in that sense. The system is over-leveraged, and that has to work itself out. The issue is that if it occurs quickly, we’ll have a level of pain that this country is not ready for. If it occurs slowly, we might have a protracted recession and a dull nagging ache, but eventually the economy will grow its way out of the mess. We’re talking a 5-15 year process, but they may stave off double-digit unemployment and bread lines.

Worst Case: Government doesn’t solve the problem, and we still go into a depression. In order to get out of it, and to try to keep the economy moving, they inflate the dollar to try to give the appearance of growth, but America doesn’t buy it. The world abandons the dollar as a reserve currency, and we enter a hyperinflationary depression along the lines of 1920’s Germany.

Even the best case is not good, but the worst case is downright terrifying. But whether or not you support this bailout, I hope this post explains the underlying causes and issues at stake here. We’re in uncharted territory, and the Sword of Damocles is dangling just above. No politician wants to let that sword fall, but there’s a distinct chance that their intervention will destroy us first.

Just Say No To The Bailout From Hell

While the rest of the politcal class debates the wisdom of John McCain’s non-supension suspension of his campaign, Libertarian Party Presidential Candidate Bob Barr seems to be one of only a handful of people out there saying we need to look at the bailout itself:

In the name of restoring economic confidence, the Bush administration is demanding unlimited authority to implement a massive financial bailout. The Secretary of the Treasury would become an economic dictator, empowered to re-engineer the economy as he sees fit. These powers fit Kim Jong-il’s North Korea, not the American republic.

The economy is in trouble, but the wrong policy could make things much worse. With the public deeply divided over the proposed bailout, and the future structure of our economy at stake, Congress must stop and take a deep breath before rushing such a far-reaching plan into law.


The federal government cannot eliminate financial losses and should not attempt to do so. It can only shift the burden — in this case from irresponsible borrowers, lenders and investors — to taxpayers. Keeping the walking dead on economic life support will only slow down necessary adjustments. The federal government’s principal responsibility at a time of financial stress should be to maintain liquidity for use by otherwise sound institutions.

Congress certainly should reject an unrestricted, economy-wide purchase of mortgages and mortgage-backed securities, as well as “other financial instruments” at the Treasury’s discretion. Interest groups already are lining up with their hands outstretched, including mortgage lenders and insurance companies, municipalities and foreign banks. The congressional Democrats even want to include home heating assistance and another wasteful “stimulus” package.

If the administration believes there are financial institutions so critical that their failure would put the entire economy at risk, then the president should identify those institutions and make the case for aiding them to Congress and, more important, to the American people.


“My first instinct was to let the market work, until I realized, while being briefed by the experts, how significant this problem became,” lamented President George W. Bush. So, he would turn capitalism into a government-protected enterprise and Uncle Sam into an ATM machine for economic failures. Congress must say, “No.” Why should we, the taxpayer, believe the people who got us into this mess when they say bailing them out is the only solution?

Despite his flaws as a candidate, Barr is, of course, quite correct about all of this.

Here he is talking about the bailout on CNN earlier today:

We all know what will happen here. Compromise will be reached in Congress and another $ 700 billion of taxpayer wealth will be wasted in an effort to keep a system that can barely sustain itself at this point in operation.

It might even work, temporarily.

At some point, though, we’re going to run out of tricks like this and then where will we be ?

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