Monty Pelerin's World

Economics, Finance and Politics Through The Prism of Classical Liberalism

January 2010 - Posts

Fannie and Freddie, Not Financial Sector to Blame

Fannie and Freddie, Not Financial Sector to Blame

Corruption, Ineptness and Duplicity — The Description of  Washington, DC

For anyone still under the delusion that the government is actually a neutral referee or that we will get out of this crisis in any reasonable time or manner, the following is an absolute must-read.

The financial sector has been the scapegoat for much of our economic problems. They are hardly innocent and probably are a key part of the oligarchy that run the country. It would be nice if we saw criminal investigations into their activities which would result in many going to jail. That will not happen because it would implicate too many politicians and/or cut off their cash supply.

Now we have indications that the role of the financial sector may have been smaller than first assumed. Not that they are innocent by any means, but that the crisis could not have attained anywhere near the size it did without direct complicity by government agencies, specifically the GSEs. An investigation here is not likely either because it would be even more dangerous to the politicians involved.

Based on the allegations of Edward Pinto as reported in the Wall Street Journal, Zerohedge concludes: “… it seems almost beyond question that the policies (or policy malfeasance) of Fannie and Freddie, and not the actions of large banks or firms like AIG are the proximate cause of not just the credit crisis, but also the continuing multi-act, multi-bailout farce that continues to be passed off to the public as necessary ’stimulus’.”

Below is the entire Zerohedge post by Marla Singer and some amazing claims and observations (emboldening added):

Origins of an American Kleptocracy

Marla Singer's picture
Submitted by Marla Singer on 01/01/2010 22:20 -0500
Some days ago we wondered aloud at the blank check extended to Fannie and Freddie along with the suspiciously convenient timing of those announcements on Christmas Day.  Back then we wondered if we had been told the entire story.  To wit:

So.  Let us summarize:

We do not expect the GSEs to grow their portfolios at all, so we are fixing the bloated portfolio problem by easing the portfolio caps to permit a quarter trillion dollar expansion thereof.

We do not expect either of the GSEs to need more help from the Treasury, so we are responding to the underutilized $400 billion “lifeline” the GSEs have with the Treasury ($111 of which is currently used) by expanding it to… infinity.

Oh, and though they have collectively lost nearly $200 billion, we are paying the CEOs around $6 million each.

Great work team!  It’s already almost 11:00.  Let’s go to lunch.

The other shoe having now dropped, Bloomberg has joined in our skepticism:

Taxpayer losses from supporting Fannie Mae and Freddie Mac will top $400 billion, according to Peter Wallison, a former general counsel at the Treasury who is now a fellow at the American Enterprise Institute.

“The situation is they are losing gobs of money, up to $400 billion in mortgages,” Wallison said in a Bloomberg Television interview. The Treasury Department recognized last week that losses will be more than $400 billion when it raised its limit on federal support for the two government-sponsored enterprises, he said.

Wallison continues:

“It was always safe to buy these notes,” he said. The U.S. government was always going to stand behind them. They’re as good as Treasury notes.”

We are no longer sure this is the most inspiring comparison. Wallison also chimes in via the Wall Street Journal and points to a darker vein shot through the GSE story:

New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A.

In general, a subprime mortgage refers to the credit of the borrower. A FICO score of less than 660 is the dividing line between prime and subprime, but Fannie and Freddie were reporting these mortgages as prime, according to Mr. Pinto. Fannie has admitted this in a third-quarter 10-Q report in 2008.

But because of Fannie and Freddie’s mislabeling, there were millions more high-risk loans outstanding. That meant default rates as well as the actual losses after foreclosure were going to be outside all prior experience. When these rates began to show up early in 2007, it was apparent something was seriously wrong with assumptions on which AAA ratings had been based.

Losses, it was now certain, would invade the AAA tranches of the mortgage-backed securities outstanding. Investors, having lost confidence in the ratings, fled the MBS market and ultimately the market for all asset-backed securities. They have not yet returned.

It has become conventional wisdom, perhaps even cliche, to pin the origins of the credit crisis on the big banks or, AIG or even the practice of financial modeling.  Certainly, these actors have received the most play in the media, and have now endured the focus of populist ire for more than a year.  We now think that the analysis leading commentators to focus blame on these entities is fatally flawed.

We have seen no credible data that any of the large banks or other underwriters of mortgage backed securities (“MBSs”) or collaterized debt obligations (“CDOs”) or firms like AIG selling protection on same actually misrepresented the character of underlying collateral.  This is in direct contrast to the allegations of Edward Pinto as printed by the Wall Street Journal.  If Pinto is correct such that the mis-marking of mortgages by the GSEs and the discovery thereof destroyed confidence in the accuracy of ratings in mortgage backed securities and their derivatives (and it seems probable to suspect that he is) then it seems almost beyond question that the policies (or policy malfeasance) of Fannie and Freddie, and not the actions of large banks or firms like AIG are the proximate cause of not just the credit crisis, but also the continuing multi-act, multi-bailout farce that continues to be passed off to the public as necessary “stimulus.”

It takes only a cursory examination to suspect that misdirection plays a key part in the latest act of the ongoing crisis theater of the absurd. Misdirection to distract attention from the key complicity of GSEs in the crisis.  Misdirection to deflect scrutiny away from the political personalities from both sides of the aisle responsible.  Misdirection to conceal what could only be described as the most damaging acts of accounting and securities fraud in the history of accounting, securities or fraud.

Precious few assumptions are required to come to conclusions laying responsibility for the largest economic disaster in recent memory at the feet of the GSEs.

First, that the GSEs had substantial influence over the mortgage market.

This is a no-brainer with the GSEs either holding or guaranteeing 51% of outstanding home mortgage debt in 2003.  To put this in perspective, that figure was around 33% of the GDP of the entire United States in 2003.  Read that last line again.  Anyone wishing to play in the market had to compete with the rates set by Fannie and Freddie.

Second, that the GSEs artificially depressed rates (read: underpriced risk).

This is equally trivial to find given that this precise mandate has been the express purpose of the GSEs since at least 1993.  The GSEs were not tasked with increasing the capacity for mortgage lending.  They were tasked with making loans “affordable.”  They used a number of tools to do so, but the key elements were acting as a proxy for quasi-government guarantees and bundling mortgages into risk tiers to act as a sort of clearing house for securitization pools.  It is often said that providing a guarantee (particularly governmental) reduces risk.  This is, of course, a fantasy.  All that explicitly or implicitly tax dollar backed guarantees do is socialize risk.  However, they manage to do so without requiring consolidation of the resulting liabilities on the government’s balance sheet.  Convenient that, yes?  A guarantee is a subsidy.  Period.  Failing to understand this is what permitted the political class to mislead the American public into thinking that cheap loans for everything from housing to small businesses to education (the next fiscal disaster on the horizon) come with no cost.  (Or that cheap debt wouldn’t pump up the price of everything from education to housing).  Today’s pundits seem to enjoy blaming “moral hazard” (by which they mean “corporate moral hazard”) for the crisis.  Oddly, government guarantees, particularly those that everyone assumes will be costless, are not typically part of this definition.

These assumptions, on their own should be sufficient to indict the GSEs, the totally unqualified and unaccountable recipients of political payoffs who occupied the executive offices of these fiscal singularities1 and their other supporters (including the voters who continued year after year to return these jokers to public office) on charges of gross negligence.

If, as Pinto suggests, we add purposeful misrepresentation of underlying collateral to the mix three things become apparent:

First, absent some intervening criminal act by actors farther downstream (and we may yet find some), we have isolated absolutely the cause of all that followed.

Second, it becomes quite easy to construct a criminal case for literally millions of counts of accounting, securities, wire and mail fraud against the GSEs.  To the extent executives at Fannie and Freddie signed off on financial statements disclosing the portion of their balance sheets that held “AAA” securities and these had been purposefully misidentified we should be exploring prosecution for violations under e.g., Sarbanes-Oxley.  (Given, however, Rham Emanuel’s involvement in Freddie and Fannie, we aren’t holding our breath).

Third, given the presence of blatant government price fixing in more than a third of the entire economy, the United States hasn’t been anything like a “free market” since before 2003.

It should shock you that literally a third of the U.S. economy should become a playground for the social experiments of any political group of any party affiliation.

It probably will not shock you (since you are reading Zero Hedge) to find what may be the largest example of securities fraud ever directly connected to elected officials of the United States and their cronies.

Taking a step back, it should shock you that power over literally a third of the U.S. economy should ever have been allowed to become concentrated in two entities with blatantly socialist aims and under the control of executives with no relevant qualifications of any note other than loose purse strings on their political contribution satchels.

What should grip readers with even more substantial alarm is the combination of blank checking for Fannie and Freddie backstops, and the shifty manner in which these disclosures were made.  Is it possible anymore to doubt that the administration simply lied through its teeth while promising us it expects no need of increased credit lines for the GSEs while simultaneously expanding same literally to infinity?

Given that Fannie, Freddie and the FHA have now taken up the mandate of supporting housing prices at any cost (to the taxpayer via endless bailouts and unlimited credit) is it possible in any way to credit the current “upturn” to fundamentals?  When we factor in similar capture of the FDIC and the like, where does this leave us, exactly?

Permit us to ask a few questions:

1.  Why are Fannie and Freddie still operating in any way whatsoever?

2.  Given that their credibility for reliable (or even remotely non-fiction) financial disclosure nears complete obliteration, who is likely to buy anything from these entities in the future?  (If you said “The Fed” you may advance to the bonus round).  Surely the conflict of interest implicit in government ownership does nothing to improve the situation.  Perhaps the news that the Fed plans to issue securities to shrink its balance sheet and reverse “quantitative easing” describes an attempt to securitize the tattered reputation of the GSEs?  Will the Fed simply aggregate its balance sheet and issue tranches?  Does that make the Fed simple the collateralized debt obligation (“CDO”) of last resort?  Who will do the rating?  Who will be writing protection on CDO Fed Tranch A-1 (AAA)?

3.  Given that neither entity is currently monitored by an Inspector General (despite what used to be statutory language so mandating) and both entities are completely captured by the current administration, how can it be anything other than insanity to expect any result from these entities other than the formation (or expansion) of a ravenous fiscal black hole?

4.  Given increasing government control beyond Fannie and Freddie that now extends far beyond 33% of GDP, what can we expect if we continue to permit political parties of any stripe to exercise command and control influence over what is now probably a simple majority of our economy?

There was a time when we hoped that the United States would learn its lesson with respect to permitting political control over large swaths of private markets.  Today that time seems very long ago, and somewhat naive.

Perhaps we are being too harsh on the likes of Barney Frank and other GSE proponents.  Adopting a slighty more relativistic economic morality, we might count Frank as one of the greatest legislators of all time.  Consider:

To the extent Mr. Frank and his ilk self-identify as advocates for low-cost housing for those ill-able to afford it, or beset by poor credit, the last 20 years have represented the largest single wealth transfer (composed primarily of real estate and flat screen TVs) to that sector known to us.  Not only that, but given the de facto nationalization of MBS portfolios (we’ll give you three guesses who have been the largest MBS buyers over the last several quarters) the GSEs and their supporters have managed to get taxpayers to pay for it all.  Of course, had they simply proposed such a measure in Congress it would have been laughed from the chamber.  And yet, it almost seems as if these individuals simply wrote a multi-trillion dollar check to their constituents that happened to be drawn on the United States Treasury.

It almost seems this way because it was this way.

  • 1. Just consider Fannie Mae’s torrid leadership history: James A. Johnson (Fannie CEO 1991-1998, Democratic luminary, Obama fundraiser, John Kerry vice presidential selection committee chair, $21 million in Fannie compensation). Franklin Raines (Fannie CEO 1999-2004, Clinton’s Director Office of Management and Budget, $90 million+ in Fannie compensation later the subject of a civil suit) Daniel Mudd (Fannie CEO 2005-2008, $80 million in Fannie compensation) Herbert M. Allison (Fannie CEO 2008-2009, National Finance Chair, John McCain Campaign).  Freddie’s record is no better.
  • Some Recovery

    Some Recovery

    Sucker Born Every Minute

    Below is a graph from the US Treasury Department. It tracks the rolling 12-month growth rates of taxes received. There are two points to be made:

    • Two of the three categories are down 30%; the other is down about 8%.
    • There is no indication that these figures have stopped going down.

    The government is telling us that the recession is over. Forecasts for the 4th quarter GDP run as high as 5%

    At best, this is surreal mathematics, probably unsaleable to a sixth grader (in private school). At worst, it is outright duplicity on the part of the government.

    Simply put, there can be no recovery without private sector growth. The chart below clearly shows the private sector is not growing but continuing to shrink!

    I have maintained in several posts that we are nearing an end point where the economy, government, the currency or a combination of the three occurs. If some of us can see this, surely many inside the government know it. After all, they are supposed to be smarter and certainly have access to better data. Because there are no options or ways out of what must happen, I have likened the government to a cornered, wounded animal that is willing to do ANYTHING to survive. Lying to the public is probably the least harmful thing they can do.

    Two posts earlier today dealt with other data published by the government that make no sense, at least with respect to an economic recovery. These are Unemployment and Market Manipulation?

    “Free” Booze for State Alcoholics

    “Free” Booze for State Alcoholics

    … the stimulus was akin to providing a gift of booze to a recovering alcoholic.

    The states continue to go deeper into fiscal holes. The Wall Street Journal reported today:

    The combined deficits of the states for 2010 and 2011 could hit $260 billion, according to a survey by the liberal Center on Budget and Policy Priorities. Ten states have a deficit, relative to the size of their expenditures, as bleak as that of near-bankrupt California. The Golden State starts the year another $6 billion in arrears despite a large income and sales tax hike last year. New York is literally down to its last dollar. Revenues are down, to be sure, but in several ways the stimulus has also made things worse.

    Federal bailouts for states merely enabled them to continue their profligate ways. The stimulus was akin to providing a gift of booze to a recovering alcoholic. Instead of downsizing, many states used the funding to expand programs that cannot be supported in the future:

    … the stimulus enticed state lawmakers to spend on new programs rather than adjusting to lean times. They added health and welfare benefits and child care programs. Now they have to pay for those additions with their own state’s money.

    In typical Washington fashion, the Federal funds came with strings attached. Prohibitions prevented states from using the funds wisely and restructuring. In effect, the recovering alcoholic was ordered by law to drink the booze:

    Many environmental grants have matching requirements, so to get a federal dollar, states and cities had to spend a dollar even when they were facing huge deficits. The new construction projects built with federal funds also have federal Davis-Bacon wage requirements that raise state building costs to pay inflated union salaries.

    … at the behest of the public employee unions, Congress imposed “maintenance of effort” spending requirements on states. These federal laws prohibit state legislatures from cutting spending on 15 programs, from road building to welfare, if the state took even a dollar of stimulus cash for these purposes.

    Distortions and mal-incentives are omnipresent whenever Washington intervenes in either the private or public sector. Political motivations always produce attached strings, in the form of laws or mandates designed to preclude rational economic behavior. Chicanery, not common sense, rules. It is only taxpayer money. Why worry about spending it wisely?

    In a post on How’s all that Stimulus cash working out for the states?, Rick Moran describes the real motivation:

    Remember – it’s not about the economy. It’s about control. The federal government wants to emasculate the states, making them beggars and wholly dependent on Washington.

    In a post, Political Cannibalism Democrat Style, the problem of state funding was discussed. Ironically, the states with the biggest deficits are hard-core Democrat states. In coming elections their needs will continue to be huge. Political considerations will dictate that monies be re-directed away from them to uncommitted states, where votes can be mined. The prospect of bitter internecine feuds should be enticing for all political observers. Will Democrats end up eating their own? Is it possible that the 2010 and 2012 election cycles are so vicious as to destroy the party?

    On top of all this political intrigue and whining is the prospect of the Federal Government running out of money. Politicians with unbounded appetites are about to find out that they too are subject to finite resources. While many believe they can legislate away such basic laws as the Law of Gravity, others are starting to understand the extent of the predicament.

    Perhaps someone in Hollywood should consider this unfolding Washington drama as the basis for a new reality show.

    More Good Intentions Gone Awry

    More Good Intentions Gone Awry

    Just another example of how good intentions mean nothing! When people speak of “good intentions” they are talking about a failed program. Almost every government program, upon evaluation, includes the phrase “good intentions” or its equivalent.

    A reasonable rule of thumb regarding government programs is to identify the objective and then predict just the opposite to result. The law of “unintended consequences” was invented to rationalize government failure. The following article is from American Thinker.

    Big Surprise: Mortgage bailout program hurting rather than helping say experts

    Rick Moran

    Before Obama is out of office, the four most overused words in the English language are going to be…

    “I told ya so:”

    The Obama administration’s $75 billion program to protect homeowners from foreclosure has been widely pronounced a disappointment, and some economists and real estate experts now contend it has done more harm than good.

    Since President Obama announced the program in February, it has lowered mortgage payments on a trial basis for hundreds of thousands of people but has largely failed to provide permanent relief. Critics increasingly argue that the program, Making Home Affordable, has raised false hopes among people who simply cannot afford their homes.As a result, desperate homeowners have sent payments to banks in often-futile efforts to keep their homes, which some see as wasting dollars they could have saved in preparation for moving to cheaper rental residences. Some borrowers have seen their credit tarnished while falsely assuming that loan modifications involved no negative reports to credit agencies.

    Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.


    Omigod. It appears that Peter Goodman of the New York Times has discovered the free market! That last paragraph that describes what must happen before a housing recovery can occur must have been used by conservatives a hundred times before this idiotic bailout package was passed.

    And the Treasury Department is still fiddling with the program, trying to get it to work. With more than 50% of people who got their mortgages adjusted once again finding themselves more than 90 days behind, this boondoggle will keep the housing sector depressed for years to come. There will be no recovery until individuals and banks pay the price for their greed and stupidity. That’s how capitalism works and no one has found a go around for it yet.

    Key to Investment Success — Inflation or Deflation?

    Key to Investment Success — Inflation or Deflation?

    Inflation or Deflation?

    For investors, the critical question is are we headed toward Inflation or Deflation. How you answer this question and prepare for what you believe is coming, will be the single most important factor in your investment outcomes over the next five or so years.

    There are plenty of smart people on both sides of this argument. Listen to their positions and rationale and then make up your own mind.

    Saturday, December 26, 2009

    Part 1: The Deflationists

    RealPlayer WinAmp Windows Media MP3

    Robert Prechter, author and CEO of Elliott Wave International (September 5, 2009)
    Harry Dent, author of The Great Depression Ahead: How to Prosper in the Debt Crisis of 2010–2012 (September 26, 2009)

    Part 2: The Inflationists

    RealPlayer WinAmp Windows Media MP3

    Peter Schiff,  President of Euro Pacific Capital (September 12, 2009)
    Marc Faber, Editor of The Gloom, Boom & Doom Report (September 19, 2009)

    Part 3a: The Inflation/Deflation Debate

    RealPlayer WinAmp Windows Media MP3

    Daniel R. Amerman, CFA, author, speaker, consultant & Michael (Mish)Shedlock, “professor” at Minyanville (September 19, 2009)

    Part 3b: Inflation/Deflation: Summary & Conclusion

    Your Grandchildren's Future

    Welcome the future. If you have any questions regarding how current economic and social policies will work, look at the following video. While this one focuses on Detroit, other cities could have been the setting. Perhaps none quite as dramatic, but wait a few years!

    http://www.youtube.com/watch?v=1hhJ_49leBw

    America’s Bucket List

    America’s Bucket List

    Jim H. Ainsworth wrote a timely and appropriate article in American Thinker entitled A Bucket List for America. Unlike the movie, Ainsworth explains that his bucket list is to prevent America from dying. Here is his thoughtful list:

    1. Truth — the unvarnished, non-manipulative, forthcoming kind — is no longer a stranger inside the Beltway.
    2. Contracts are once again honored, words kept, and the government stops invalidating valid contracts.
    3. The government gets off small businesses’ backs and allows them to create real jobs.
    4. People go back to saving for home down payments and making sacrifices in order to own homes. Those who will not save or sacrifice go back to renting.
    5. Soldiers are no longer prosecuted for bloodying terrorist lips. They are no longer accused of murder (without evidence) by members of Congress.
    6. Soldiers become more important than politics or a socialist agenda.
    7. Rules of engagement are changed to allow our soldiers to fight to win and come home.
    8. The government stops “helping” the economy by creating jobs that must be paid for by the real job-creators.
    9. Failure is once again punished in the marketplace instead of rewarded in Washington. That will scale back unreasonable pay more than any pay czar ever could.
    10. The president mistakenly appoints several cabinet members (maybe a czar or two) who have solid private-sector experience. (He would never do it on purpose.)
    11. Voters begin the process of enacting a constitutional amendment for term limits. Until said amendment passes, they require every candidate to sign a binding personal services contract to serve no longer than three terms in the House or two terms in the Senate. Heavy penalties would apply to transgressors.
    12. Viable candidates with private-sector experience come forward to run for Congress. Any party? Anyone?
    13. American voters learn the difference between eloquence and intelligence, education and experience, and charm and leadership.
    14. Too-big-to-fail businesses are allowed to fail or become smaller. (Guess which one they will choose.)
    15. Voters wake up from a prolonged slumber and become an informed citizenry once again.
    16. Legislative and executive branches of government learn that you cannot tax your way out of massive debt.
    17. Taxpayers begin to starve the beast that has been created in Washington.
    18. Freedom and national security are longer sacrificed on the altars of social justice, diversity, and tolerance.
    19. We negotiate with terrorist and dictator regimes from a position of strength, not one of appeasement and apology.
    20. Marxist voter-manipulation groups like ACORN lose taxpayer funding permanently, not just temporarily.
    21. Political correctness is rudely swept out of the halls of Congress, out of airports, out of classrooms, and out of businesses so that leaders can govern, business leaders can run businesses, security forces can target terrorists instead of luggage, and teachers can teach.
    22. Lawyers and politicians are removed from doctors’ offices, hospitals, and our health care delivery system.
    23. Current politicians with no private-sector experience or scientific background stop believing that they are smart enough to run the American economy or change the weather. (Okay, that’s right up there with “when pigs fly.”)

    I have a few suggestions to add to the Ainsworth list:

    1. Abolish the Federal Reserve and ensure that whatever (preferably nothing) replaced it had no power to print or increase the money supply. Additional banking changes, too technical to outline here, would accompany this recommendation.

    2. Impose spending limits on Washington, DC in the form of percentage of last year’s GDP. Start at 20% and decrease the percentage by 1% every two years until it reduced to 10%. Then review it to consider taking it even lower. With this limit, I could care less about taxes or deficits.

    3. If the spending limit was exceeded “slightly,” congressional pay would be decreased 20%; if exceeded more than 10% but less than 20%, pay would be decreased 50%. If exceeded by 20%, an immediate special election to replace all sitting senators and congressman would be held. There would be no exceptions for war or any other “crises” for this rule. Build up “rainy day” funds are risk the penalties.

    4. Announce immediate forensic audits for all sitting politicians. These audits would reconcile the net worth at the time they first announced for office until today. Politicians would be given the option to resign office without undergoing the audit with no further ado. Those who stood for audit and were found to have committed illegal acts would be prosecuted to the full extent of the law. Future politicians would have to stand for such audits every four years.

    HAPPY NEW YEAR, NOW GO TO THE BOMB SHELTER

    HAPPY NEW YEAR, NOW GO TO THE BOMB SHELTER

    Stock your bunker. 2010 is apt to be ground zero for financial markets.

    Sixty years later, a bomb-shelter strategy once again seems in order. But this time it will used for financial as opposed to physical protection. The year 2010 is likely to be the pivotal year where pundits stop referring to the recession and begin openly talking about a Depression.

    Our economic problem is rather simple, at least to describe. There is too much debt relative to income and/or wealth. Below is a single graph that depicts the condition of our economy. It shows total debt of the US as a percentage of GDP from 1870 forward. The debt figure includes all private and public debt. It does not include liabilities associated with unfunded government mandates like Social Security and Medicare. (Note: according to the US trustees of these funds, the present value of the liabilities is about $106 Trillion. Including them, would boost the ratio below to nearly 1,000%.)

    The amount of debt relative to GDP is staggering from an historical perspective. Several points are worth making about the graph:

    • The long-term “norm” for the ratio appears to be around 150%. The red lines band the “norm” at 130 and 170%, respectively.
    • Other than the two boom periods that commenced in the 1920s and the 1980s, the ratio never exceeded the upper band.
    • Each cross resulted in enormous credit-driven booms. The first ended in the Great Depression. The second will produce a similar, if not bigger bust (we are merely at the beginning of this event).
    • The credit expansion that led to the Great Depression was not nearly as overextended as the current expansion.
    • Peak credit occurred after the Depression began. Government spending and the shrinkage in GDP continued to drive the ratio up early in the Depression.
    • Since this graph was published, today’s ratio has grown to near 380%, about double the level when the US entered the Depression.
    • While it appears as though current private borrowing may have peaked, funding enormous government deficits continues to drive the ratio up, as does GDP shrinkage.

    No economic theory rationalizes a proper “norm,” yet intuitively we know such a number exists. Debt must not exceed some percentage of income, else it cannot be serviced. Equivalent conceptual ratios for individuals and businesses have been used by the banking industry as lending criteria for more than a century. For various reasons, banks neglected these guidelines over the past couple of decades, contributing greatly to the credit bubble.

    The government has decided that the cure for too much debt is more debt. This solution cannot work, especially when credit is already so overextended. Income and wealth cannot support present debt levels. Credit will adjust back to the mean, regardless of what the government attempts. Whether this is via orderly payment or via default, the reduction in debt is inevitable.

    Ludwig von Mises addressed the limits of credit in The Theory of Money and Credit, originally published in 1912. As he expressed in later work:

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

    In 2009 it was not possible to finance US capital requirements through conventional markets. Only via the Fed’s explicit (and surreptitious) Quantitative Easing was the government able to fund its 2009 deficits. Discussing 2009, Zerohedge stated:

    There was a huge credit and liquidity crunch, and then there was Quantitative Easing. The last is the Fed’s equivalent of band-aiding a zombied and ponzied corpse, better known as the US economy. It worked for a while, but now the zombie is about to go back into critical, followed by comatose, and lastly, undead (and 401(k)-depleting) condition.

    Zerohedge estimated that demand (financing) for US fixed income securities must increase 11-fold in order to fund capital needs in 2010. Continued shrinkage in foreign participation in US fixed income markets makes that increase impossible.

    There are only three possibilities with respect to meeting 2010 funding needs:

    1. The Fed continues its QE beyond their planned cessation in March 2010.
    2. The Fed raises interest rates to levels that would attract the capital necessary to fund government operations via conventional credit markets.
    3. No Fed action is taken. That would cause the government to default on some of its obligations.

    None of these alternatives are attractive. The unpalatable choices arise from prior Fed and governmental policies. To avoid recessions over the past fifty years, the government abused and then finally exhausted all reasonable options. After years of mismanagement, the government is in a quandary of its own making, and from which there is no escape.

    All alternatives will be very painful; none offer the possibility of a traditional recovery. No matter what alternative is chosen, the country cannot avoid a Depression. At this point, “do no further harm” should guide policy.

    Of the three alternatives, what is best economically is worst politically. This natural conflict between good economics and good politics is not unusual. Economically, the country would be harmed least by implementing alternative 2. From a political standpoint, alternatives 2 and 3 are probably unacceptable. Thus, it is likely that alternative 1 will be used. Again! It is precisely the continual overuse of this alternative that led to the current, sad state.

    Alternative 1 cannot work. It will not avoid a Depression. Worse, it will likely result in hyperinflation. Thus, we likely end up with the worst of all worlds. In a hyperinflation, money will cease to be a medium of exchange. Markets will cease to work, except on a barter basis. The middle class will be wiped out. Their savings will become worthless along with the dollar. The end will be as Mises warned so many years ago.

    The possibility of losing our form of government is a real risk under any of the alternatives. So is civil unrest and strife. All are probably more likely under alternative 1 because of the corrosive effects of high inflation combined with a Depression.

    Beware of the turn of the calendar. Things are going to get interesting, and probably very quickly.

    Happy New Year, and stay close to your financial bomb shelter.

    This article appeared originally in American Thinker.

    More Posts « Previous page