Preface. Bonner & Wiggins at the dailyreckoning called the 2008 housing crash in 2002 and the 2000 dot.com crash in 1999. They’ve got a lot right, a lot wrong, and are always entertaining to read. A few random excerpts are below.

As I realized how much the world depended on energy, not money, I grew less interested in the economy, and on investing, though this knowledge did allow me to invest so well I retired at 50 thanks to the dailyreckoning, the automaticearth and other fringe economic news advice.

But at some point money will be worth nothing, energy everything since our bodies and everything else depends on it. Life itself.  In peak oil circles it was called the money/energy transition. So I stopped reading this and other economic newsletters years ago.  The dailyreckoning was mainly  about trying to talk readers into buying precious metals. Which I might have done if I had grandchildren likely to make it through the bottleneck ahead when everything settles down after collapse, but I don’t, and during collapse the local gangs are likely to raid your house, especially if you spend your silver or gold anywhere during the crisis.

Alice Friedemann  www.energyskeptic.com  Author of Life After Fossil Fuels: A Reality Check on Alternative Energy; When Trucks Stop Running: Energy and the Future of Transportation”, Barriers to Making Algal Biofuels, & “Crunch! Whole Grain Artisan Chips and Crackers”.  Women in ecology  Podcasts: WGBH, Jore, Planet: Critical, Crazy Town, Collapse Chronicles, Derrick Jensen, Practical Prepping, Kunstler 253 &278, Peak Prosperity,  Index of best energyskeptic posts

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Bill Bonner.  2017. A Gold bug goes bad, volume 4 issue 2.

In monetary terms, Alan Greenspan really was the most important person of this whole bubble era. What I refer to as the “bubble era” is loosely the period since 1971 until the debt bubble blows up (which hasn’t happened yet), and more precisely, the period after Paul Volcker had wrung inflation expectations out of the U.S. economy. Mr. Greenspan, Volcker’s successor, took over at the Fed in August 1987. He left it in January of 2006. During those 19 years, the U.S. economy changed in fundamental ways, some obvious, some not so obvious. In the first category, interest rates fell from 7.4% to 4.5%, using the 10-year Treasury note as a measure. More remarkable was that they were poised to fall even further… down to a low of 1.38% in July of this past year.

That downward trend of yields began in 1980. So it’s been going on now for 37 years. And this is about the fifth time I thought I saw the bottom. But who knows?

If you wanted something – land, slaves, women – you had to take it from someone else. And then you could force him to pay tribute! These were zero-sum exchanges. They had to be; there was very little wealth creation.

Also in the category of the obvious, the stock market rose from Dow 2,680 in January 1986 to 10,865 the day Greenspan left his desk at the Fed. These two things together – stocks and bonds; we won’t even bother with real estate – represented a gain of $37 trillion in capital value to the investment-owning classes.

Everyone considered this a positive development. Dr. Greenspan was celebrated as early as 1999 on the cover of Time magazine as the central figure in the “Committee to Save the World” for his role in protecting this wealth. The following year, famed author Bob Woodward’s book celebrated him as “The Maestro.” And Sebastian Mallaby, another celebrated author, still refers to him as “The Man Who Knew.

But where did the money come from? That $37 trillion of stock and bond wealth? U.S. GDP rose during the same period, from $5 trillion to $10 trillion, but that was only half as fast as the stock market. In other words, the “wealth” represented in the equity and fixed income markets couldn’t have come from new Main Street output. Instead, it must have come from the money system itself, over which Dr. Greenspan presided.

Before the invention of portable, modern money, property rights, and capitalism, the best (and often the only) way to get ahead was by violence.

Here at The Bill Bonner Letter, we hope to be a consistent and coherent critic of the use of force in markets. We don’t know if stocks are going up or down. We don’t know how many people will buy the Tesla. We don’t know when the Chinese “red-bubble” economy will blow up. But we know – from both theory and observation – that trying to control or manage economies doesn’t work. And we are nearly the only people in the world who are free to say so. All depend on cheap money. And all will fight tooth and nail to preserve this debt-financing system… Big corporations, governments, think tanks, Wall Street – all of them depend too heavily on the fake, post-1971 dollar and central bank manipulation. They can’t tell the truth. They’re paid not to see it and, if they catch a glimpse out of the corner of their eye, not to say anything.

An Empire of Debt

We have a pernicious and corrupt financial system. It is used by honest industry and commerce. But it also finances a political system, which has grown much larger and more aggressive in the fake-money era. What we wanted to know from Dr. Greenspan was to what extent the financial system is now hostage to the political system it financed.

Is it still possible today, we asked, for the central bank to navigate us out of this bubble by leading and managing a debt deflation? If not, what happens?

Last year, the empire conducted military operations in 118 different countries. It dropped 26,171 bombs last year.

And when you aggregate the costs of all foreign and security operations, it spent about $1 trillion in the 12-month period. That’s the cost of empire.

In the U.S. alone… the Bush-Obama administrations have exploded the national debt to $20 trillion.

The U.S. spends about $3.50 for every $1 of GDP. And since 2007, the economy has added $10 trillion in debt, and only $4.5 trillion in GDP. This is a formula for disaster. Not necessarily tomorrow. But eventually.

While Alan Greenspan was chairman of the Federal Reserve, total world debt rose from 13% of GDP to 109%. This was the real explanation for the “conundrum” that Greenspan saw in mid-2004 to mid-2006. He raised rates, but U.S. bond yields continued to go down. When asked by Congress about it, the Fed chairman was lost.

But what was really happening, as former IMF consultant Richard Duncan explained to Dr. Greenspan, was that foreign central banks in the trade surplus countries printed trillions worth of their own currencies and used that new money to buy U.S. dollars.

They did this to hold down the value of their currencies in order to protect their low-wage trade advantage. Those central banks then invested the trillions of U.S. dollars that they had acquired into U.S Treasury’s. That pushed up the price of those bonds and drove down their yields, causing the Fed to lose control over U.S. interest rates and over the U.S. economy as a whole, and made it impossible for them to contain the property bubble that imploded in 2007.

Greenspan, and later his successor Bernanke, misidentified the phenomenon as a “glut of savings.” This led them to miss the solution, too… and let the credit bubble get bigger and bigger.

My hypothesis, which I put to Alan Greenspan in question form, is that the Age of “Tall Paul” Volcker… when the Fed could actually still control the monetary beast it had created… is over. Politically, it is not possible to manage a debt deflation. Not when you have three times as much debt as GDP.

Before 1971, our money was asset-based, linked at a fixed rate to gold. Now it’s debt-based, linked only to a promise to pay. With what? More paper, of course.

While Greenspan was helping to create a credit bubble, another kind of bubble was forming. During the Greenspan Fed era, 25,000 pages were added to the Federal Register, and the amount of money spent on lobbying went from an estimated $200 million in 1986 to $2.6 billion in 2006.

Government power was always restrained by real money. Roman emperors had to work the silver mines of Iberia night and day to get the money they needed. Then, when it wasn’t enough, they “clipped the coins” to reduce the silver content. Later the kings of Europe had to rely on moneylenders to get the cash they needed.

And finally, modern democracies had to get their money from the hard work and economies of the voters. Wars were frequent and endemic. Often, they only ceased when the combatants ran out of money. Over the course of the centuries, the lack of money probably spared millions of lives.

By the way, I strongly recommend George Gilder’s The Scandal of Money. Gilder shows that money is more than just, well, money. With it comes a basic sense of fairness. If you work all your life and manage to save a thousand dollars, it is fundamentally unfair for some hot shot in Lower Manhattan to get a thousand dollars for nothing, simply because he is wired into the new money system. It was the voters’ sense of unfairness – not money itself – that got Donald Trump elected.

Phony, debt-backed money is fundamentally unfair and unreliable. It distorts prices, misleads investors, depletes and devalues real savings, redistributes rather than adds wealth, and generally increases waste and mal-investment throughout the economy.

But that limitation was removed in 1971. The new money was different. It didn’t come from the mines or the economy or from savings deposited in banks. And it put money at the beck and call of politics as never before. It enabled a large growth in what former congressional policy analyst Mike Lofgren calls the Deep State… or I call the Parasitocracy… or others know as the Establishment Elite or the permanent government.

From a fair economy where the rewards went primarily to those who added wealth to the system… people who made cars or mattresses or kitchen appliances… the U.S. system was corrupted into a system that rewarded, first and foremost, the people who added more fake money and more debt. people who owned stocks were about seven times richer at the end of Dr. Greenspan’s term than at the beginning of it, an increase of about $17 trillion in capitalization.

But they had not created more wealth. Where did the extra stock market wealth come from? The answer: from the same source as the new credit-backed money – from nowhere.

If you want to blame someone for this, you can blame Alan Greenspan. He didn’t create it. But he yielded to it readily. It was he who began the pattern of supporting stock prices by backstopping the markets with easy money – as early as 1998, when the infamous hedge fund Long-Term Capital Management collapsed in spectacular fashion.

World debt is now approaching $225 trillion, not counting the off-the-books financial obligations of sovereign governments, which would probably add another $200 trillion to the total.

In a 21st-century democracy today, voters would never tolerate sharp swings in the business cycle. Nor would a modern democracy permit the kind of flexibility in labor rates that you would need to allow for downside adjustments. Wages are too sticky to adjust to a deflationary shock. Government budgets, and its payments to the old, the sick, the needy, and the vast elite of the Deep State, are even stickier. Even in a depression, it’s almost impossible to bring them down. In fact, the tendency is to try to raise them up… in some form of countercyclical stimulus.

We’ve seen that centralized control can last a long time. In extreme versions it lasted 30 years in China and 70 years in the Soviet Union. Less extreme versions – that is, with less politics – can presumably last much longer. We’ve seen, too, that these systems can create the kind of stability that Minsky described. But what we haven’t seen is that they can somehow correct or erase the imbalances and excesses that they create.

The idea is that, as much as it might be inefficient from an economic standpoint, we nevertheless live in a world of seat belts, airbags, and safety nets (stability), which the public craves far more than it craves economic progress (liberty).

On this second point, Reagan’s former budget advisor, David Stockman, challenged him. The original Fed authorization was for a central bank that would have the power to step in and buy securities, but only of solvent institutions. That is, it was meant to stop “irrational” runs on the banking system. But the current Fed goes way beyond that, meddling in equity and fixed-income markets on a scale that would have been unimaginable to Carter Glass, who created it.

How does this debt bubble get corrected under the watchful eye of central bankers? Having allowed the debt bubble to expand to such an extraordinary size, are the authorities now going to prick it?

And what will they do when the howls of despair reach them? Will they fill their ears with wax and stay the course through a very painful correction, when stocks get cut in half… and don’t recover? Will they, like Paul Volcker, who received death threats as he fought to bring inflation under control, ignore the political pressure?

If my hypothesis is right, the Volcker role is no longer an option. The authorities can no longer take the kind of action that they’d need to take to correct credit excesses. The debt-money system has put too much money into too many pockets of too many powerful people. The Deep State needs it. It depends on it. It controls it. And it won’t give it up.

What’s more, it has raised the price of a correction far beyond anything the political authorities can afford to pay. In 1978, when Paul Volcker went to Washington to tame inflation, world debt totaled only $3 trillion. Today, it is 70 times as much…

Making a bubble bigger doesn’t make it go away. In a properly functioning economy, corrections come occasionally, like showers during a beach holiday. But, in trying to protect the public from these passing storms, the authorities invite a hurricane.

And isn’t the role of a small panic… with its “irrational” reactions and extraordinary pricing… to immunize investors against a big one? In other words, couldn’t the irrationality central banks aim to guard against actually have a very rational and important purpose?

Without the small, periodic crises – left to run their courses and immunize investors against further risk-taking – big crises develop for which central bankers have no solution. That’s the key point here. Yes, we’ve had several of these small, periodic crises over the last four-plus decades, but the feds haven’t let a single one of them run its natural course.

It is now a political matter. And politics is force, not persuasion. The system of constantly expanding debt has served the Deep State, the people who really control the U.S. government and its financial system. They won’t let it go. They can’t afford to. No Volcker can stand up to them. There are no longer any policy decisions to make. Like real love, a fake-money system has to run its course.

January 25, 2017 A Conversation With “The Maestro

It is certainly true that, ultimately, historically fiat currencies have always ultimately ruined the economies who basically worked with them. I’m sure your colleagues from South America went through enough of 5,000 or 20,000 annual rate inflation, and it disabled society fundamentally. That has never happened in a system which gold was the medium of exchange.

Chris: Do you think that in our democracies the financial authorities are willing to let corrections happen? And if they aren’t willing to let corrections happen, what are the consequences for our societies?

Dr. Greenspan: In the short-term, if you have a breakdown like 2008, the maximum short-term probability of coming through it is to basically buy up the whole system. Since the central bank can print as much as it needs to, there is no limit. So you can stop any crisis cold merely by just buying up everything. The trouble is, what do you do then? If there is that sort of action taken several times, you engender a degree of uncertainty in the marketplace, which essentially destroys the viability of the structure.

Very obviously, in the last eight years, we’ve gone into a stagnation, which incidentally has pretty much been for the last 10 years worldwide. That stagnation has led to an extraordinary collapse in the growth of output per hour, which meant that standards of living were freezing at very low levels.

In all human history, whenever you get a situation where the population feels deprived one way or another and things aren’t going well, it begins to revolt.

The revolt here is Brexit… Scotland… Italy. I can go through a whole series of things, which are just now beginning to brew. The problem I have with democracy is that 51% can legally annihilate the other 49%, so a pure democracy is never what the American system has been. It’s always been a constitutional representation of government. Going evermore from where we are now to more and more democracy is not working for us.

Donald Trump would not have arisen if output per hour instead of being on average half a percent per year for five to eight years. If that didn’t happen, Donald Trump would not be president of the United States.

Jim: I would also argue it wouldn’t have happened if interest rates had been above zero as well. The reason for saying that is that when I look at the results of Brexit and Trump, everybody blames Brexit on immigration in the UK. Yet most of the people who voted for Brexit don’t work. They don’t have a problem with immigrants taking their jobs, but they have a problem with having to save more and more every year in order to eke out an existence.

I really want to ask you about your insight into the thinking of central bankers and the policymaking that’s been going on for the last eight years when we’ve had extraordinary monetary policy… from zero interest rates to negative interest rates… to quantitative easing… to qualitative easing… all of which I call “institutionalized theft.

I want to ask you about institutionalized theft. Do central bankers think about the consequences of their actions for households and consumers who have saved all their life… who have expected a compounding effect in their savings? But they’re now expected to assume no compound interest… no increase in savings. They get to the end of their working days, and what they’re faced with is nothing

Dr. Greenspan: Let me tell you. There’s one thing that bothers me considerably, which nobody makes any mention of: There is in the European Central Bank a mechanism as it exists of necessity where the European Central Bank is made up of the central banks of the euro area, and there’s a thing called TARGET 2.  TARGET 2,at this particular stage, is turning out to be an extraordinarily large transfer from Bundesbank [the German Federal Bank] to essentially Italy and Spain and, most recently, the European Central Bank. That means the Bundesbank is lending money to the European Central Bank, and the question is its big numbers…

We’re talking 700 billion… 800 billion euros. This can’t go on indefinitely because, at some point, somebody’s going to have the courage to move Greece out. Greece is in the ECB [European Central Bank] by accident. They came in under false pretenses, and the government immediately following the government that got Greece fraudulently into the ECB said the numbers were all wrong. If they were actually the numbers used, they would not have been in. But nonetheless, they let them stay. That was a terrible mistake. The Greek personal savings rate right now is minus 20%. You cannot run an economy at minus 20% savings rate.

Something is going to happen there. My view is it’s either going to be Greece or it conceivably could be Italy. The funny part of it is that the second-largest contributor to the net flow in lending to Spain and Italy is Luxembourg. They’ve got some steel, and they’ve got a few other things, and they’ve got some banks, but it is extraordinary what is going on in this system while the total assets of the European Central Bank continue to go straight up. What would happen if there was a default of the euro?

In the United States, if the Federal Reserve went into default, the U.S. Treasury would bail it out. But there is no comparable vehicle to help the European system.

At some point, somebody’s going to say, “I don’t want to accept euros.” that there were five or six recessions between 1870 and 1913. They were all short-lived and they happened because banks got, as you use this great phrase, “over-loaned.” There was a limited supply of gold, the credit expansion stopped, the economy adjusted, and then things moved along. During that period – which you would never know from listening to the debate today – real GDP grew by 4.2% a year for 43 years running. Even if you take all the immigration out, that was 2.6% on a per-capita basis. That compares to 0.4% in the years since 2007 – the reason we have Trump.

David: In other words, I’m saying if it’s too radical to say “abolish the Fed, end the Fed”… why not go back to Carter Glass’ banker’s bank (Carter Glass is a great icon, at least in the modern world, because everybody thinks Glass-Steagall should have been maintained, whether true or not), put the Fed out of the activist money-management targeting, interest rate targeting, yield curve managing of the stock market supporting business, and simply let the market drive, market clear interest rates, which we desperately need? The most important price in capitalism is the cost of money and debt. The whole idea of the Fed is to control the cost of money and debt, so it’s not capitalism. That’s what I learned from your essay, and I’ve been wanting to catch up with you for a long time to find out why I’m wrong for my conclusions.

Dr. Greenspan: The problem, David, today is that you would need a majority of both houses of Congress to get an act which was sufficiently solid to enforce that. Remember that the original Federal Reserve Act had gold requirements for the currency and for other things. The issue is so long as you have this fiat money premium, which I was discussing before, namely human beings are willing to take worthless money in exchange for goods until they learn better.

The basic problems are you get bubbles because human nature is what it is. People get euphoric. We know by experience that fear is a far more formidable force in human activity than euphoria, and as a result, for example, recessions go down far more sharply than recoveries. The stock market behaves exactly the same way so that you’ve got these very odd patterns.

Mike Lofgren: Okay, I’m the odd man out. I’m not an Austrian economist and I have no unrequited love for the barbarous metal, but I did see the sausage factory in Congress. In the late ‘90s, we had a good deal of financial deregulation along with the repeal of the Glass-Steagall Commodity Futures Modernization Act, followed by roughly two trillion in tax cuts under the Bush administration. My question is: Trump is proposing tax cuts roughly three times the size and he wants to get rid of Dodd-Frank, which he says is strangling the economy.

Dr. Greenspan: I agree with him on this.

Mike: Are we setting ourselves up for another asset bubble on top and, if not, why aren’t we?

Dr. Greenspan: Because it’s not going to happen that way.  Can you imagine what they’re going to be staring at in February when they start looking at the budget numbers? The issue isn’t going to be “Do you have a big tax cut?” but “Do you have a big tax increase?” None of that is going to happen, but I think the real danger here is the fact that we’ve allowed this issue of a huge amount of entitlements to rise as we age and to keep adding to them. One of the things that the Bush administration did was to have a huge increase in the number in Social Security. No source of revenues.

If you’re going to have this sort of fiscal policy, we’re at the edge of some fairly questionable issues of what happens. This is a non-sustainable outlook. don’t see where we go from here. I’ve listened to the debates. The word “entitlement” never came up once, and the reason is entitlements are the third rail of American politics. If you’re running for office and you mention them, you lose. How are you going to run government on that? I do not know.

 

December 22 2011.   The Great Correction   by Bill Bonner

What if growth itself were being corrected?

What if the entire period from the invention of the steam engine to the invention of the internet were not the normal thing, but the abnormal thing? What if the “lost decade” we have just gone through is actually the mean…the usual…the normal thing? And what if — after nearly 3 centuries — we have just now reverted to it?

Until about two weeks ago, we thought human beings had only existed for 100,000 years. Now, archeologists are guessing that we’ve been around as a species for twice as long.

You know what that means? It means that our mean rate of growth — already negligible — is actually only about half what we thought it was. In other words, it took not 99,700 years for humans to invent the steam engine, but 199,700. And now, what if we are not going on to something new, but back to something old? What if the New Age is really more like the Old Age…where growth and progress were unknown.

Let’s see, the typical person in 1750 lived better than the typical person in say 100,000 BC. The person in 100,000 BC lived in a cave or maybe a wigwam. The typical person in 1750 lived in a hovel. There were some great houses too, of course. By the 18th century, humans had been building with arches and columns…and domes…dressed stone with elaborate decoration…for thousands of years. But most people had no access to those monuments. They lived in whatever they could put together — usually of wood or mud.

They lived on what they could grow…with their own hands, or with the help of domesticated draft animals. They hunted wild animals…or got their calories from their own herds and flocks.

The person from 100,000 BC was a hunter-gatherer. But his life was not all bad. At least he got plenty of fresh air and didn’t get caught in traffic jambs or have to watch television.

But the progress between 200,000 BC, when mankind is now thought to have emerged…to 1765, when Watt produced his first engine…was extremely slow. In any given year, it was nearly negligible…imperceptible. Over thousands of years there was little progress of any sort, which was reflected in static human populations with static levels of well-being.

Then, after 1765, progress took off like a rocket. Over the next 200 years, the lives of people in the developed countries, and the human population, generally, changed completely.

It took 199,700 years for the human population to go from zero to 125 million. But over the next 250 years it added about 6 billion people. Every five years, approximately, it added the equivalent of the entire world’s population in 1750.

“Progress” made it possible. People had much more to eat. Better sanitation. Better transportation (which eliminated famines, by making it possible to ship large quantities of food into areas where crops had failed). The last major famine in Western Europe occurred in the 18th century when crops failed. After that, the famines in the developed world at least have been intentional — caused largely by government policies.

Progress abolished hunger. It permitted huge increases in population. And it brought rising real wages and rising standards of living.

By the late 20th century, people took progress and GDP growth for granted. Governments went into debt, depending on future growth to pull them out. So did corporations and households.

Everyone counted on growth. Spending and tax policies were based on encouraging growth. The enormous growth in government itself was made possible by economic growth. After all, as we’ve seen in our Theory of Government, beyond the essentials, government is either parasitic or superfluous. The richer the host economy, the more government you get.

Today, there is hardly a stock, bond, municipal plan, government budget, student loan, retirement program, housing development, business plan, political campaign, health care program or insurance company that doesn’t rely on growth. Everybody expects growth to resume…after we have put this crisis behind us.

Growth is normal, they believe.

But what if it isn’t normal? What if it was a once-in-a-centi-millenium event, made possible by cheap energy?

 

Bill Bonner on Inflation and Derivatives

Inflation is an increase in the supply of money plus credit relative to available goods and services. In times of speculative mania, when people no longer care what they pay for something on the grounds that someone else will always pay more, and money is being created with abandon in order to satisfy the acquisitive impulse, credit hyper-expansion constitutes inflation on a massive scale.

Expansion is the only reality many of us have known, hence it is no wonder we imagine it can be a permanent condition.

Derivative definition:
Imagine a man who makes his living digging ditches. He may hire himself out at a daily rate of $25. The old capitalists would have paid no attention to him – he is just one of millions of small entrepreneurs getting by in life.

But today’s financial hustlers will spot the opportunity. Let’s take him public, they will say. We’ll raise his daily rate to $30…pay him his $25…and the rest will be our “profit.” We’ll sell shares to the public at a P/E of 20…let’s see, 20 x $5 x 250 days per year = $25,000. All of a sudden, the ditch digger has a capital value of $25,000.

Then, they borrow $20,000 from a hedge fund…and pay it to themselves for structuring the deal. Now, the hustler has $20,000 in his pocket; the hedge fund has a high-yield bond worth $20,000; the shareholders have $25,000 worth of stock; and the poor man is still digging his ditches.

Then, an even more ambitious wheeler-dealer will come along and decide to “roll up” the whole industry – bringing the ditch diggers together into a multi-national consortium. Now they can all do cross-border transactions…including derivatives.

And now ditch-digging is a major business, suitable for large investors…with more investment coverage and a higher P/E ratio. Soon all the world’s banks, pension funds, insurance companies, and hedge funds have some of the ditch digging paper – debt or equity – and billions in fees and commissions have been squeezed out of ditches by the financial industry.

That, patient reader, is the way (the world-over) that industries and assets are now being bought, sold, refinanced, leveraged, re-jigged and resold. In the old days, companies went to investors or to banks for capital and cultivated a relationship with them that was long and fruitful.

Now, it’s all wham-bam-thank-you-ma’am capitalism. Inquiring capitalists now only want to know one thing – how fast can we do this deal? How many points can we get out of it and how much leverage can we get? And whom can we dump it on, when we’re done?

As John Rubino wrote, credit gains ‘moneyness’ as during periods of ponzi finance, creating excess claims to underlying real wealth:

As the global economy expanded without a hic-up, more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money.

Thus mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid….credit gained “moneyness,” which sent the effective global money supply through the roof.

This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.

June 2008 In the war between inflation and deflation, Friday was a bloody day.

It began with a shot from the Labor Department; unemployment registered its biggest increase since 1986 – from 5% to 5.5%. Then, all Hell broke loose.

Immediately, investors figured that there was no way the Bernanke Fed could follow through on its half-promise to give up the fight against deflation and begin fighting inflation, alongside the European Central Bank. Central banks do not increase rates when unemployment is rising. At least, that’s the ways it’s gone for a long time.

The Fed, we remind new readers, has a “dual mandate.” It is supposed to do two contradictory and incompatible things at once – protect the dollar (guard against inflation)…and maintain full employment (guard against deflation). The two are mortal enemies. Generally, lower rates help stimulate employment; but higher rates are the way to protect the dollar. Of course, in the period known as the Great Moderation, it didn’t matter. The feds could stimulate employment all they wanted and not worry about inflation. Meanwhile, the Chinese were protecting the dollar by exporting cheaper and cheaper goods to the United States.

Now, the inflation rate in China is 8.5%…labor costs are rising…energy and raw materials prices are soaring; the poor Chinese have no choice. They’re exporting price increases…not price cuts. All of a sudden, the war is on!

Yesterday, amid the smoke and dust of the battle, in rode the ‘crude oil vigilantes,’ guns blazing. The news from the Labor Department seems to have set them off, but they seemed to be itching for a fight anyway. Soon, they had driven up the price of oil more in one day than ever before. A barrel of crude rose $11. To put that in perspective, that’s about the whole price of oil 10 years ago. At the end of the day, the oil price was at a new record high: $139.

As we’ve been saying, there is no clear winner in the battle between inflation and deflation. There is just a clear loser – the U.S. householder. He gets blasted no matter which way he goes. Higher unemployment means lower earnings. And a higher oil price means higher consumer prices. And don’t forget the falling housing market. His earnings and his major asset go down; his cost of living goes up. Heck, even Ed McMahon says the bank is trying to take his house – and he’s got a lot of company. Aretha Franklin and Michael Jackson are said to be facing foreclosure as well.

Lately, most of the news has been about inflation. The threat of recession was thought to be past. The oil price has been setting records…and we’re getting more and more consumer inflation-sighting reports from all over the world.

“Inflation is biggest threat to global economy,” a Bloomberg poll of business executives discovered.

But last week, according to the Wall Street Journal , “recession fears [were] reignited.”

Adding to deflation’s firepower last week was an announcement by the European Central Bank on Thursday. Unlike the Fed, the ECB only has one job – to protect the euro. And when the inflation numbers in Europe came out higher than hoped – remember, inflation is now a globalized phenomenon – Jean Claude Trichet, head of the ECB, stepped forward to tell the world to get ready for higher rates. This, of course, had the effect you’d expect – the dollar fell, which puts additional pressure on the Bernanke forces, who had hoped to be able to talk the dollar up.

Of course, everyone knows you can’t fight inflation and fight deflation at the same time. And everyone knows that when push comes to shove, the Fed will throw its weight in inflation’s direction. That is, when its back is to the wall, the Fed will lash out at deflation…and let the dollar go whither it wants – down.

How much difference it makes is open to question. Because, when the shooting really starts, the Fed’s policy changes often get lost in the fog of war. Even as the Fed was being pushed towards the wall…so close it could scratch its back on the aluminum siding…investors sold off stocks. You might have thought that the prospect of lower rates would be good for stocks. But now, with the crude oil vigilantes in the saddle, investors know that being soft on inflation is no guarantee of lower rates and a growing economy. Instead, they’ve come to see that higher oil prices…and higher prices generally…shoot so many holes in consumers’ budgets, the economy goes into decline anyway.

*** Stocks sold off on Friday, sending the Dow reeling by 394 points. The banks were hit hard. You’ll recall that everyone thought the banks had seen the worst back in March, after Bear Stearns collapsed. Investors expected the banks to lead the following rally.

But once a bubble pops, the hot air goes elsewhere. Instead of going into the financial sector, now it’s going into prices for oil and commodities. Not only did oil hit a record on Friday, by the way, so did corn – at $6.50 a bushel.

The banks have been almost cut in half since last year’s high. You’ll recall that they were “adding value” by “allocating capital more efficiently” than their predecessors. Well, for some reason, they don’t seem to be allocating capital very efficiently anymore. All the value they added to their own shares, ever since the merger and acquisition boom of the late ’90s, has now been wiped out.

Aren’t there some good bargains in the financial sector, thanks to the collapse of share prices? Yes, almost certainly…just as there were some good buys on the NASDAQ after the collapse of the dotcoms…and good buys in tulip bulbs after the blowup of the bubble in the 17th century. But don’t expect to see the whole sector reflate anytime soon. Now, it’s on to the NEXT bubble…

*** It looks to us as though the next bubble is in oil and commodities.

August 2008

We suggested a possible plot outline yesterday:

Boy meets girl. Boy and girl go on spending spree. Wall Street and Washington collude to cause them to spend more than they could afford and to go much further into debt than they should. Boy and girl can’t pay their debts; they’re losing their houses. The moneybags who lent to them are going bust.

Meredith Whitney, one of the few professional analysts who foresaw the subprime crisis, says that the downturn will be more severe than people yet realize. One in ten households overextended itself in the bubble period, she points out. Bankruptcy, default, and foreclosure rates will inevitably worsen as these Jacks and Jills roll down the hill.

Anyone waiting for the financial industry to return to the glory days of 2006 may have a long wait. As a credit-fueled boom turns into a bubble, it takes more and more lending to produce an additional increment of GDP growth. In the real boom years after WWII, it took about $1.40 worth of credit to produce $1 worth of GDP growth. The ratio rose sharply after the Reagan Revolution…and now stands at about $6 of credit to every extra dollar of GDP. Of course, that is why Wall Street made so much money – it was selling credit. But it’s also why that story is history; that show is over. As the cost of growth – in terms of credit – rises, so does the cost in terms of debt service. Even at 5%, the cost of $6 of credit is 30 cents per year. If it produces $1 of GDP growth, that extra output would need a 30% profit margin to break even. Not very likely.

And the good news just continues to pour in from the housing sector. RealtyTrac reported this morning that bank seizures of U.S. homes have risen 184% since the group began tracking this data in 2005. Banks have repossessed close to 3 times the amount of homes in the United States, when compared to last year’s stats.

One in four houses sold in America today is sold at a loss, says a report on CNNMoney. That totes up to a lot of losses for the whole financial chain…the homeowner, the mortgage company, the builder, the real estate agent, and the investor who bought a mortgage-backed security.

Remember, if big emerging economies can continue to grow, it will keep the pressure on prices for raw materials. This then makes the situation worse for Americans; they pay more for food and fuel…even as their incomes and assets fall in price.

Roubini notes that 72% of GDP is attributable to consumer spending and that the consumer has no money. The feds handed out billions in ‘tax rebates;’ even so, retail sales in June increased only 0.1%. Most of the money was used to pay down debt…or just to keep up with higher-priced food and fuel. Consumer debt was 100% of disposable income in 2000; now it’s 140%. Bankruptcies are up 30%.

And the economy is still, officially, growing! You can imagine what would happen in a real downturn. Today, a severe, drawn-out recession would be devastating for millions of people. They would lose their jobs and their homes. Naturally, they would expect the government to “do something.”

Sep 25, 2008 Daily Reckoning

Here come da judge…

Oh Dear Reader, it may be a cruel, cruel world for some…but it’s a delight to us!

Little by little, gradually, haltingly…the commentators are putting two and two together. In just four days, global stock markets lost more than $3 trillion. Then, the fellows who saw no danger at all – Greenspan, Bernanke and Paulson – suddenly insisted that if immediate action were not taken the world’s whole financial system would implode! Meltdown! Collapse!

What did that mean, exactly? They didn’t say. But it sounded like big trouble. And people want to avoid trouble at all costs – especially if the costs can be laid on someone else.

“The private market has screwed itself up,” explained Representative Barney Frank “and they need the government to come help them unscrew it.”

(He left out the extenuating circumstance that the U.S. money supply, the shortest term lending rates, Fannie Mae, Freddie Mac, the Fed, the Federal Housing Administration, the SEC…and a whole plethora of agencies, commissions and meddlers…as well as one out of every 4 dollars spent…were all under government control all along!)

And so, Bernanke, Paulson, et al took the witness stand yesterday. They clearly had some explaining to do. But the more they explained…the more we didn’t understand. If government were capable of understanding and fixing the problem…how come it didn’t see it coming in the first place? How come it let it happen?

But this morning, we put aside the question of whether the government will unscrew things or screw them up even worse – as it usually does. Instead, we come back to the issue of who will bear the ultimate cost of bailing out Wall Street. No one knows the answer. And no one seems to feel bothered by it – even though the cost will rise to about $2,000 per family. But no one is complaining about the cost.

There’s “bipartisan outrage” in Congress, reports the Washington Post . But it’s not about the money. Instead, some argue that Wall Street fat cats getting away with murder. Others want an even bigger bailout – one for the homeowners, too. And others just want to rant and moan for the benefit of the voters back home.

But here at the Daily Reckoning mobile headquarters, we are like an old detective with a new clue. As to the issue of who will benefit from the bail out, we have no further questions, your honor. We know the answer already – it will be the usual collection of parasites and chiselers with good lobbyists in Washington. As to the question of who will pay for it, we want a lab report on the blood samples…and a fingerprint match.

The measure includes a provision in which the public debt is raised to over $11 trillion. This will put it at about 85% of US GDP. We recall from a couple weeks ago that Louis 16th lost his head after France’s debt rose to about 80% of GDP. The problem is, when you get to that level of debt, lenders balk and the borrower runs room to maneuver. In the modern world, that probably means higher interest rates…and what was once unthinkable, a downgrade of America’s debt rating from AAA to something less than that – and possibly junk.

This would be accompanied by a sell-off in the dollar too. In this regard, here comes an insight from the democratically elected president of Iran:

“The world,” explained Iranian President Mahmoud Ahmadinejad, “no longer has the capacity to absorb fake U.S. dollars.”

Of course, that is exactly what we’re about to find out. Mr. Ahmadinejad has rushed to judgment. We’ll let the court take its time. But we have a feeling that the Iranian president is right about the ultimate verdict.

“If the U.S. government were a publicly traded stock,” writes expert witness Chris Mayer, “the dollar would be its shares and the value of the dollar its share price…. And this huge increase in money supply is like a massive offering of stock, which dilutes the value of the shares everyone else holds. (Assets stay the same, just a lot more claims on them).

“The bailout tab so far could top $1.6 trillion – assuming the new $700 bill happens. Consider that M1 money supply – cash in circulation – only totals $1.39 trillion… Consider that M2 – including certificate of deposits and such – is only $7.72 trillion.”

Economists will tell you that this increase in the supply of “money” is just what the world needs. Deflation is acting like the hair dryer from Hell – liquidity is evaporating fast. The feds are trying to put it back.

The feds giveth; the markets taketh. Hallelujah. Hallelujah. Currently, the markets are taking away more than the feds are putting back. But as to who is going to prevail…who will pay court costs…and who’s going to jail…the jury is still out.

 

Daily Reckoning Sep 26, 2008

Garrison Keillor:

“[T]hat’s why we need government regulators. Gimlet-eyed men with steel-rim glasses and crepe-soled shoes who check the numbers and have the power to say, ‘This is a scam and a hustle and you either cease and desist or you spend a few years in a minimum-security federal facility playing backgammon.’”

Out on the prairie, one can imagine all sorts of things. But it’s not as if there were no bureaucrats on the job between 2000 and 2007. How does one imagine that these same regulators, who missed the biggest bamboozle in market history, are now going to be able to clean it up?

How does a bureaucrat – charged with protecting the public’s money – recognize a scam more readily than an investor whose own money is on the line? What information does he have that is not available to the public? What theory does he follow that is unknown to investors? What meat does he eat…what wine does he drink…that prevents him from falling prey to from the delusions and temptations to which all flesh is heir?

This is what Hayek termed the “fatal conceit,” that public officials – armed with the power to force people do to what they say – will do a better job of running things than people can do for themselves.

Apparently, neither the masters of the universe on Wall Street, nor the geniuses at the rating agencies, nor the saints at the SEC…and certainly not the poor lumpeninvestor… understood what was going on. None had gimlet eyes. Instead, all their eyes bulged with admiration at the financial engineers’ handiwork…and with greed at how much money they could make.

And now we find, on page one of today’s International Herald Tribune , the bureaucrats’ practical challenge. “What’s this stuff worth?” The Paulson plan puts $700 billion in the hand of GS14s, clerks, hacks and appointees. What are they supposed to do with it? Buy “assets” that Wall Street wants to dump.

How are they supposed to know what it is worth? If they pay too much, the government takes a big loss. If they pay too little, at least according to the dim light coming from the Christmas treers, it won’t bail out Wall Street enough and the economy is likely to sink into recession.

“The reality is that we are not going to know what the right price is for years,” the IHT quotes a portfolio manager.

Isn’t it amazing how fast things change, dear reader? Only a few months ago every portfolio manager in the world would have deferred to the market. What’s something worth? Exactly what willing buyers will pay for it! Not a penny more. Not a penny less.

But now we have a whole new theory…that the value of a financial asset is somehow unknowable…it is like the face of God…or the meaning of “is” – it floats in the ether; it plays cards with Jimmy Hoffa. According to this theory, the value of an asset is determined not by what willing buyers will pay for it…there is no such thing as a ‘market price.’ Instead, values are metaphysical…determined by what willing buyers MIGHT pay for years from now…if everything goes to plan.

Henry Paulson says that the government might even make a profit. How might this occur? Well, the bureaucrats might turn out to be shrewder than the Wall Street pros. Prices set by bureaucrats (with money that doesn’t belong to them) will be better than those set by willing buyers and sellers!

According to this new theory, the sellers don’t know what gems they are tossing out. You’ve heard of casting pearls before swine. According to the new theory, the pigs on Wall Street are casting out the pearls! And those canny bureaucrats are grabbing them up!

Now, get this… “the recent turmoil on Wall Street may be followed by a $900 billion aftershock as bank debt comes due next year…”

Oh happy day for the public sector…that great untapped reserve of investment wisdom…. Here comes more opportunity to buy up those pearls that the swine on Wall Street don’t want.

Now things are going to get interesting. Add another trillion-dollar bill to Christmas tree…only months after they Christmas treed the last one. Turn on lights! We can hardly wait to see what this new Christmas treed-up world looks like.

*** At least one person had something smart to say this week. Would you believe it, George W. Bush must have picked up the wrong speech on his way out of the door to the Capital. When he spoke on the debt crisis, his speechwriter actually seemed to know what he was talking about:

“First, how did our economy reach this point?

“Well, most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions – along with low interest rates – made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition – some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.

“Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit – combined with the faulty assumption that home values would continue to rise – led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

“Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected – along with mortgage payments they could not afford. As a result, many mortgage holders began to default.

“These widespread defaults had effects far beyond the housing market. See, in today’s mortgage industry, home loans are often packaged together, and converted into financial products called “mortgage-backed securities.” These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

“The decline in the housing market set off a domino effect across our economy…”

Our president was on solid ground. He sounded as though he had been reading The Daily Reckoning , commented colleague Dan Denning. But then he stepped into the mush, claiming – along with everyone else – that a bailout is needed to put the economy back on its feet.

 

Sep 24 Rude Awakening A Violation of Public Trust
By Tim McCormack, A professional investor from Santa Barbara, CA

There is nothing wrong with Government coming to the rescue of financial institutions where mismanagement has caused risk of failure in a way that jeopardizes the stability of the entire financial system.   What is wrong, and is both a violation of public trust and a display of professional incompetence, is to contribute taxpayer money in a way that enriches management and the owners of these mismanaged companies rather than the taxpayers.

Additionally, it is also a violation of public trust when government officials deliberately manipulate markets on behalf of certain market participants at the expense of others.  The recent market manipulation executed by the US Securities and Exchange Commission by banning short selling of financial stocks is all the more outrageous due to that fact that it was specifically designed to enrich the very individuals who mismanaged their companies into near bankruptcy, and who are the underlying root cause of the larger systemic financial crisis by manufacturing, distributing, and inventorying toxic debt.

It is now well known that these financial firms manufactured, distributed, and inventoried near-fraudulent debt (financial widgets) at 30:1 leverage.  Investors do not want these widgets at the current offer price, and if the widgets were priced and offered at a realistic market clearing price, it would likely bankrupt the vendors.

Hank Paulson (in concert with Ben Bernanke and Christopher Cox) has just orchestrated a plan that provides huge sums of taxpayer money to his old colleagues and buddies at Goldman Sachs, along with various others, including Morgan Stanley, to purchase the  unwanted widgets in a manner that directly enriches the management and shareholders of these nearly bankrupt companies.  Rather than demanding that taxpayers be rewarded with any profits of the rescue, as just occurred with AIG, this latest proposal appears deliberately struck to stick taxpayers with the downside, while management, creditors and shareholders of these firms instantly reap tens of billions in stock and bond appreciation.

Such actions cross the line not only into the arena of professional incompetence and negligence, but steps right up to the line where an open society stares official tyranny in the face.

These government officials could have rescued the financial system in a way aligned with their core responsibilities to the American taxpayer.  If they had done so, as they did with AIG, they would deserve a pat on the back.  They chose a different path. Rather than rescue the financial system in a responsible way, they have rescued their rich buddies that created the mess and left the taxpayer holding the bag.  The American people deserve better.

Additionally, the same Gang of Three government officials simultaneously executed a massive market manipulation specifically designed to further enrich their Wall Street cronies — the very same individuals who mismanaged and nearly bankrupted these firms — by banning the short selling of financial stocks.

The management of these mismanaged companies — including John Mack, of Morgan Stanley, Richard Fuld, of Lehman Bros, and before them senior executives of Bear Stearns — have loudly spread rumors that the decline in their stock was caused by rumor-mongering and improper short-selling without offering an iota of evidence.  Zero evidence has been presented to back up these allegations.

The market manipulation executed by Cox last week occurred without offering a single shred of evidence of the alleged improprieties. This behavior is eerily similar to the allegations of WMD in Iraq made by others in the Bush administration while absent of evidence.  The administration at least went to the trouble of manufacturing evidence to support its claims that Iraq had weapons of mass destruction.

Worse, was their professional incompetence in responding to the impending Lehman and AIG bankruptcies over the weekend of Sep. 13-14, and on Monday, Sep. 15.  Their behavior and public announcements greatly intensified the crisis, and seriously elevated the systemic risk in global financial markets.

Some background on this issue is helpful.  Financial professionals have always feared the “domino effect” of the failure of one large financial firm taking down many others through counterparty exposures.   Since the failure of Bear Stearns and Northern Rock, market participants have had the clear impression that Government officials in the US and UK were not going to let this happen.

On Sept 13-15, the Gang of Three sent dramatically different signals into the market.  Their abandonment of Lehman and AIG had dramatic negative consequences. At a press conference on Sep. 15, Paulson clearly said, in paraphrase, that “while the Government is concerned about the health and stability of the markets, it would not act to save these firms.”

This news changed the landscape. Now, the domino effect not only seemed possible, it appeared imminent and all eyes were on the insurance giant AIG.  Global stock markets reacted instantly, and rationally, as investors fled financial stocks generally, and the stocks of riskier financial firms (like Morgan Stanley and Goldman Sachs) in particular.

Rather than pouring water on the fire, Paulson pumped gasoline in a move that will now cost the US taxpayer several hundred billion dollars more than if proper actions had been taken in a timely fashion.  Yet, after the dramatic global selloff, the AIG fire was doused in government water, but the global fire had become an inferno.

Rather than admitting to this blunder and learning from it, those who committed the blunder are now attempting to divert blame and attention to short sellers. Credit should be given where credit is due. The SEC is now complicit in falsely pointing the blame for the near-demise of these financial institutions at short sellers (a convenient scapegoat) in what appears to be a blatant attempt to divert attention from:

1.             The real cause of the demise of these firms: mismanagement, in applying 30:1 leverage  to volatile illiquid mortgage assets that these firms manufactured, distributed, and inventoried;

2.             The failure of regulatory oversight, in allowing these firms to use 30:1 leverage on collateral known to occasionally suffer 30% to 50% downside fluctuations (real estate);

3.             The failure to respond properly to the fires at Lehman and AIG; and

4.             The real reason for the SEC market manipulation: to artificially inflate the share prices of distressed companies in a way that enriches management and shareholders, and simultaneously strengthens the company balance sheet (the new riches coming at the direct expense of innocent market participants, at the direct expense their financial competitors who were prudent in avoiding overexposure to leveraged toxic debt, and at the expense of free market principles).

Absent evidence of wrong-doing, the SEC is complicit in spreading lies and rumors, and engaging in market manipulation on behalf of their wealthy buddies.  To date, rather than asking pointed questions, the press has bought the story and is guilty of rebroadcasting it rather than questioning its validity. With no evidence of improper short selling the most rational explanation for stock price declines is that natural investors (from mutual funds, pension funds, retail investors, etc) were selling or hedging long positions due to lack of confidence in these firms, and due to the new risks that sprang into existence by the reversal of position taken by US regulators.

While the SEC says that it is opposed to market manipulation, it has just engaged in market manipulation of the highest order on behalf of John Mack at Morgan Stanley and the gang at Goldman Sachs.  This market manipulation has instantly resulted in the management and owners of these two firms receiving tens of billions of upside stock profits (and hundreds of billions among the 799 financial stocks) in just two days.

The SEC should be held accountable to defend its WMD claim with evidence that was in its possession at the time it manipulated these markets.  It should not be allowed to manufacture an after-the-fact witch-hunt.  Key questions are: What evidence was in the hands of the SEC regarding both mismanagement and short-selling at the time that this market manipulation occurred?  Also:  Were government officials at the SEC, Treasury and/or the Federal Reserve (specifically Cox, Paulson, and Bernanke) speaking with market participants who would be enriched by the market manipulation just prior to the manipulation? If so, what was the nature of these communications?

When small businesses take risks that don’t work out, they fail.  Farmers, bakers and widget-makers are not enriched by government for their failure.

Goldman Sachs is known as one of the most opportunistic and predatory firms on the street.  When Goldman identifies companies in distress it has a long history of rushing in and providing assets in return for majority equity stakes, rightly earning the upside for this risk ahead of the existing management or owners.  Hank Paulson was the direct recipient of this behavior while CEO at Goldman and it is important to note that he was able to sell more than $500 million in Goldman stock, tax-free, when he accepted the job as Secretary of the Treasury.  Now that Goldman is in distress (and Paulson is employed by US taxpayers), Paulson wants to hand Goldman taxpayer money without demanding a controlling equity stake from Goldman Sachs in return.  Who does Paulson work for?  This is not rocket science.

No private company or public company would stand for similar behavior of their directors risking shareholder assets in ways that deliberately benefited others at shareholder expense.  Such behavior would be rewarded with immediate dismissal for dereliction of duty and personal lawsuits seeking damages for negligent behavior.

Rather than getting an honest explanation about what has just occurred, the American people are now being sold a story manufactured by government officials who have been complicit in this irresponsible behavior.  The open question remains: Are the American people gullible enough to buy it?

 

November 2008

Yes, the financial hotshots did all these things.  And more.  They sold the world on ‘finance,’ rather than making and selling things.  Then, it was off to the races.  Everybody wanted to bet.  Perfecta, place bets, odds-on…double or nothing.  Of course, investors would have been better off at the race track.  The track takes about 20%.  In the financial races, Wall Street took 50% to 80% of all the profits.

Before 1987, only about one of every 10 dollars of corporate profits made its way to the financial industry – in payment for arranging financing, banking and other services.  By the end of the bubble years, the cost of ‘finance’ had grown to more than 3 out of every 10 dollars.  Total profits in the United States reached about $6 trillion last year; about $2 trillion was Wall Street’s share.  What happened to this money?  Other industries use profits to build factors and create jobs.  But the financial industry paid it out in salaries and bonuses – as much as $10 trillion during the whole Bubble Period.  And now that the sector finds itself a few trillion short, it waits for the government to open its purse.

But Wall Street’s critics have missed the point.  Yes, the financial industry exaggerates.  But so does the whole financial world.  Both coming and going.  It’s madness on the way up; madness on the way down.  Investors pay too much for “finance” when the going is good.  And then, when the going isn’t so good, they regret it.  This regret doesn’t mean the system is in need of repair; instead, it means it is working.

The financial industry was just doing what it always does – separating fools from their money.  What was extraordinary about the Bubble Years was that there were so many of them.  There is always smart money in a marketplace…and dumb money.  But in 2007 there were trillions of dollars so retarded they practically cried out for court-ordered sterilization.   What other kind of money would pay Alan Fishman $19 million for 3 weeks work helping Washington Mutual go bust?

Whence cometh this dumb money?  And here we find more worthy villains.  For here we find the theoreticians, the ideologues…and the regulators, themselves, who now offer to save capitalism from itself.  Here is where we find the bogus statistics, the claptrap theories and the swindle science.  Here is where we find  the former head of the Princeton economics department, too, Ben Bernanke… and both Hank Paulson and his replacement, Tim Geithner.  Here, we find the intellectuals and the regulators – notably, the SEC – who told the world that the playing field was level…when everyone could see that it was an uphill slog for the private investor.

“Six Nobel prizes were handed out to people whose work was nothing but BS,” says Nassim Taleb, author of The Black Swan.  “They convinced the financial world that it had nothing to fear.”

All the BS followed from two frauds.  First, that economic man had a brain but not a heart.  He was supposed to always act logically and never emotionally.  But there’s the rub, right there; they had the wrong guy.  The second was that you could predict the future simply by looking at the recent past.    If the geniuses had looked back to the fall of Rome, they would have seen property prices in decline for the next 1000 years.  If they had looked back 700 or even 100 years…they would have seen wars, plagues, famines, bankruptcies, hyperinflation, crashes, and depressions galore.  Instead, they looked back only a few years and found nothing not to like.

If they had just looked back 10 years, says Taleb, they would have seen that their “value at risk” models didn’t work.  The math was put to the test in the LongTerm Capital Management crisis…and failed.  Their models went sour faster than milk.  Things they said wouldn’t happen in a trillion years actually happened while Bill Clinton was in still in office.

In the real world, Taleb explains, things are stable for a long time.  Then, they blow up.  Then, all the theories and regulators prove worthless. These blow ups are inevitable, but unpredictable…and too rare to be modeled or predicted statistically.  “And they are almost always much worse than you expect.”