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The Jehoshua Novels


Peak Money Arrives

The world is running out of money. If money is credit, and credit relies on confidence, there is not enough confidence in the financial system to supply the world with the money it needs. Since the initial credit crisis struck in 2008, credit and money have been withdrawn from the system in such staggering amounts that international trade can no longer grow. The world’s central banks are playing a rear guard action by acting as lender of last resort to banks that no longer trust each other and have stopped lending in the interbank market. As liquidity flows out from the system, the rottenness that has corrupted the foundations of global finance is now exposed for all to see.

This was especially evident in the bankruptcy of MF Global, when the unthinkable happened ”“ innocent bystanders on the Chicago Mercantile Exchange were stuck with over $1.0 billion in losses that should otherwise have been allocated to MF Global’s lenders. For over 100 years the futures exchanges have bragged that no customer on an exchange has lost money due to a broker-dealer’s default. No longer. This is how confidence is lost in the financial system ”“ investors are surprised by large losses from institutions or products thought to be impregnable.

When confidence in the financial system is lost, people don’t trust their money to banks nor to the financial markets. Banks in turn don’t trust their money to anybody but the safest of risks. You then have the making of a large-scale financial collapse, particularly at a time like this, when the world’s economy is heavily dependent on ever-increasing amounts of debt. Since the new debt is essential to repaying the old debt, old debts turn into a default, and as one default leads to another, an economic depression ensues. Credit becomes scarce, and so money disappears. This is the inflection point at which we are poised entering 2012. The question is: How will this play out?

HOW WE GOT HERE

It is important to understand the makings of this crisis. How did the global economy get to such a stage?

We start with the concept of fiat money. Money has traditionally had a store of value. Coins were made of gold or silver or copper ”“ metals that gave the coin itself intrinsic value. Paper currency was exchangeable for these metals, so paper currency also had intrinsic value. This system disappeared in the 1930s in the US when citizens could no longer exchange their paper currency for gold or silver. Coins themselves were no longer made of gold or silver, but of baser currencies with hardly any intrinsic value. The whole system is described as ”œfiat money”, or in other terms, pretend money.

Under a fiat money system, paper currency is only as good as the government’s reputation for prudent behavior. The citizens of the country, and foreigners as well, have to be willing to accept the currency as a medium of exchange for goods and services, which means they need to believe that government will keep its own budget under control, that banks and financial markets will be properly regulated, that the central bank will control the money supply so that the currency is not debased by inflation, that private debts will be honored by law, and that bankruptcies will be adjudicated in courts so that both debtors and creditors are treated fairly. If these things are done properly and consistently, a fiat money system can work. People retain the confidence necessary to accept mere pieces of paper, and electronic money transfers, as forms of exchange for commerce and trade.

It is not easy for a government to do all the things necessary to develop confidence in its fiat currency. One of the things that distinguishes developed countries from emerging markets countries is that developed countries, such as the U.S. and Canada, the major countries in Europe, Japan, and Australia, did what was necessary to establish confidence in their paper currencies. They had stable and prudent governments, their central banks were run independently of the politicians and were able to keep money supply under control, the financial system was well-regulated, and laws were in place and enforced which governed debts and bankruptcy.

Just as it takes time to establish this confidence, it takes time to lose it. The pillars of confidence have to be undermined one by one, and systematically, and most people don’t notice the deterioration until it is too late. At some point, often within a few days or a few weeks, trust in a currency is lost. Bank runs begin to take place, financial markets freeze up, and suddenly the currency is no longer freely accepted domestically or internationally. This is represented by investors demanding much higher interest rates to hold the currency, and a much lower foreign exchange rate in order to buy it.

This is the core of the problem with the international financial system and the global economy. People are losing confidence in their leaders, in their government, in their legal system, and with the companies that employ them. Individuals and companies are taking defensive actions, including reducing their debts if possible, cutting expenses, halting plans for expansion, and shifting their investments to the safest possible instruments. The expansionary credit cycle we are all used to since World War II has been contracting for three years now, and the downwards spiral is tightening, with events picking up speed.

What most people do not realize is that the downward momentum can no longer be stopped. Governments can slow momentum down, but the ball continues to roll down the incline of the funnel and eventually picks up speed again. That is exactly what has been happening since the 2008 credit crisis hit, and governments are now almost out of ammunition to slow the momentum. Dangerous events are occurring more frequently, and the global economy is now destined to deteriorate rapidly until a massive global crash occurs. At the bottom, no one will have any money. You’ll hear that phrase over and over. It will mean that credit will be very scarce, and cash in only the safest of currencies will be used to purchase things. Unfortunately few people will have cash, and mass privation will be the order of the day. To see why this situation can no longer be stopped, we need to go down the societal pillars that support the fiat money system, and show how these have been irrevocably debauched. This will necessarily be a U.S.-centric analysis, not just because the United States manages the reserve currency of the world, but because the U.S. is the country that backstops the global financial system. It is the one country that is supposed to come to the rescue of any other country, by virtue of its economic power, its financial strength, and its prudence. It no longer has these qualities, which is a basic reason why the global financial system has nothing to support it.

WHY THE COLLAPSE OF THE GLOBAL FINANCIAL SYSTEM CANNOT BE AVOIDED

Debts Which Cannot Be Repaid

The United States spent most of the 20th century building confidence in its currency, so that by the end of World War II it was positioned to replace the U.K. as the reserve currency of the world. It then proceeded ever so slowly to undermine its position, in part because it had taken on the burden of a military superpower. The Soviet Union was not able to sustain this burden and collapsed politically, economically, and militarily in 1991. The United States carried on as the sole ”œhyperpower”, expanding its military capabilities to unbelievable levels, so that its defense budget now consumes over 1/3 of all government spending, and exceeds the military spending of all other countries combined.

Since the credit crisis hit in 2008, the US budget deficit has exploded, bringing total government debt from around $9 trillion to over $15 trillion this year. The US is adding $100 billion to its debt each month. An agreement by Congress and the administration to reduce the debt, which came about only after the US lost its AAA rating, actually does no such thing. The agreement lowers the rate of growth in the annual deficit, and then only over 10 years, with the savings back-loaded in the later years. Even this feeble effort may not come to pass, as the bipartisan committee responsible for recommending budget cuts cannot reach agreement. A set of draconian budget cuts are scheduled to take place if there is no agreement, but already Congressional leaders are calling for suspension of these cutbacks. In particular, Republicans are crying that scheduled defense cuts will expose the nation to terrorist attacks.

Anytime anyone in Congress suggests tackling the Defense Department’s gargantuan budgets, that person is charged with being ”œweak on defense.” These scare tactics have worked for 30 years, allowing the military budget to enjoy compound growth over that time near 10%. It is this sort of growth rate in military spending that bankrupted the Soviet Union, siphoning off dearly-needed investments in the domestic economy. A similar process is well underway in the U.S. The United States has lost its leading position in computer technology, automobiles, aircraft manufacturing, machine tools, consumer and industrial electronics, textiles, and a host of other technologies. It leads the world, however, in armaments technology and arms shipments to other countries.

The military-industrial-Congressional lobbying machine is the most powerful political force in the country. Any serious cutbacks in military spending would hit not just the weapons manufacturers, but hundreds of consulting firms that feed off lucrative contracts with the Pentagon. Virtually every Congressional district in the country would experience a loss of jobs if the Defense Department budget was cut in any meaningful way. This is why there is no political will to tackle this problem. A similar situation exists with the health care industry, which has enjoyed a 9% compound annual growth rate in costs over three decades. The powerful lobby that supports this industry has made any real changes impossible; even the Obama health plan much derided by the Republicans still protects the health care industry’s profit. Wherever you see compound growth rates of 5% – 10% per annum in the US economy, you are sure to see active federal government subsidies for that industry. A case in point is the success of the higher education industry in pushing through nearly double-digit increases in college tuition for several decades now. This would not be possible if the federal government did not guarantee most of the student loans required to pay for these increases.

Do not expect Congress or the administration to deal seriously with the US fiscal crisis; there is no political support for serious action on this problem, despite the bleatings of politicians about ”œout of control spending.” When they say that, they are always talking about some other politician’s out of control spending. The only government cuts the US is likely to see in the immediate future are in municipalities and states, which are not allowed to run budget deficits. Here, the cutbacks are becoming increasingly vicious, because tax revenues have not bounced back to their 2008 levels.

The United States deficit ballooned under President Obama because he chose to bail out the banks, and he has spent trillions of dollars supporting the unemployed and the growing ranks of poor people. He also decided not to allow the Bush tax cuts to expire. He was able to get away with nearly doubling the government debt because the financial markets are not penalizing the US with high interest rates, as they are nearly every other country. Italy this past year saw its long term funding rate jump from 2% to 7%, forcing the government to concentrate its funding on the short end of the yield curve.

Italy is not alone. The US and most other major countries have pushed their funding activity in the five year and under maturities. This is a sign of weakness, especially in cases like the US which has a central bank following a zero interest rate policy. Japan has long since been on this path, and it leads to a trap: government borrowing continues to grow when the cost of money is 2% or less, but after a certain point the country becomes addicted to low interest rates. It simply cannot afford to pay higher rates to the market because the cost of interest payments on its debt would wipe out a substantial part of its domestic spending. In the case of the US, a 4% average rate on its debt, versus the 2% it is now paying, would require serious reductions in its defense budget, social security programs, and corporate subsidies to the health care and other industries.

Country after country is falling into this trap. The IMF calculates that total global government debt rose from $21.9 trillion in 2007, to $34.4 trillion this past year, with most of the increase in debt occurring in the developed countries. By the end of 2011, the ratio of debt to GDP in developed countries was 80% (and much higher in countries like Japan, Italy, the UK, and the US). In emerging markets countries, this ratio ended last year at 28%. This is exactly the reverse of the situation for the post-war period, when it was the emerging markets countries which were profligate spenders and chronically falling into default.

These calculations only include federal government debt. If you throw in all other state and municipal debt, individual debt, and corporate debt, the situation becomes positively alarming in many countries. The US, which has run a chronic annual international trade and finance debt of over $500 billion for years, has a total debt to GDP ratio approaching 300%. There is no occasion of any nation sustaining such a debt burden for more than a few years, which tells us that the US is already on the spiral downwards towards a deflationary collapse where debts of all kinds are to be repudiated through default or restructuring. Many European countries are ahead of the US on this downward spiral, but the fact that the linchpin of the global financial system ”“ the supposedly prudent overseer of everyone else ”“ has now joined them tells us that this system is heading for a collapse. As we’ve shown here, there is no political or other impetus that can prevent this from happening.

Free Market Capitalism Allows the Banks to Destroy Themselves While the Regulators Do Nothing

When the George W. Bush administration took office in 2000, there was a deliberate attempt to deregulate the US economy. This effort was led by Dick Cheney, and involved the wholesale firing of career regulators in the Securities and Exchange Commission, the Office of the Comptroller of the Currency, and the Commodities Future Trading Commission. The Federal Reserve, while an independent body, undertook the same initiatives under pressure from the administration and Congress, though Fed Chairman Alan Greenspan needed little prodding; he had long favored the policy that the markets work best when they regulate themselves.

In a remarkably short period of time, the US financial system destroyed itself, largely by encouraging the development of something called ”œshadow banking.” The big commercial banks had long been constrained by regulations requiring them to hold at least 8% capital against their risk assets, but by 2000 the Fed allowed these banks to get around these rules by quietly parking hundreds of billions of dollars of such assets in off-balance-sheet subsidiaries. Publicly, it appeared as if these subsidiaries were ”œbankruptcy remote”, but when they became functionally insolvent, their owners were forced to bring all these assets back on their balance sheet. This is one of the principal reasons Citigroup and Bank of America had to be rescued in 2008 and put on government life support.

Regulators were equally asleep when it came to overseeing the housing bubble. For the longest time, until the collapse of the market began in 2006, regulators denied there was any housing bubble. The Federal Reserve kept silent when commercial banks began buying mortgages with deplorable credit quality ”“ loans where the originating bank falsified the borrower’s income, accepted inflated property appraisals, and tolerated two or more second mortgages on the same property. The Fed seemed to display the same insouciance as the banks when it came to the collapse of credit standards in the mortgage market: everything was fine, because the loans were being packaged into securities and sold to investors. Let them worry about possible credit losses. The result has been potentially crippling law suits against the big banks from investors seeking hundreds of billions of dollars in damages for fraud.

The Federal Reserve has not been alone in its ineptness. Regulators in the UK, Canada, Australia, South Africa, Ireland, Spain, and many other countries allowed housing bubbles to explode in their domestic markets. When Greece’s debt problems first surfaced, it was revealed that Goldman Sachs conspired with the Greek government to use foreign exchange derivatives as a means of expanding Greek debt without drawing the attention of EU officials. What is interesting about this incident is that the EU did an investigation, confirmed the basic facts, but then refused to release the report to the public. Speculation persists as to which other countries used the same trickery.

This is one of many instances where the regulators have hidden facts from the public about potential corruption and malfeasance. The Federal Reserve refused to release details regarding several of its bank lending programs set up after the 2008 crisis. It eventually forced a lawsuit up to the Supreme Court, and lost its case. The information ultimately has shown how crony capitalism works in the United States. The Fed’s lending programs were open to domestic and foreign banks, to the executives of these banks, and even to the wives and friends of some of these executives.

One would think the collapse of the housing bubble would chastise the Fed and cause it to redouble its regulatory efforts on the banks. Nothing of the sort happened. The Fed allowed the big banks to put in place foreclosure mills, complete with robo-signing executives attesting to the facts behind up to 10,000 mortgages a day which they could not possibly have examined. It is unclear how much damage has been done to the US housing market, but courts are finding that the banks have most likely destroyed the legal foundations that underpin property rights in America, by failing to properly register mortgage transfers with county recorders of deeds. Not one regulator in the US has shown the slightest interest in this problem or willingness to force the banks to correct it.

Why the regulators have taken such a lax attitude toward the banks, even after all types of criminal behavior have surfaced, has surprised even industry insiders. The general public tends to blend the banks and the regulators together as part of a corrupt financial system designed to extract profit from its customers while enriching its executives. Some evidence of this exists when looking at the revolving door phenomenon between the industry and the regulators ”“ especially the practice of hiring Goldman Sachs executives as senior regulators. The Occupy Wall Street protestors seemed to have this in mind when they displayed equal disdain for the banks and their government overseers.

Regulators are certainly not unmindful of their public reputations, which is part and parcel of the confidence necessary to run a fiat money system. A more generous interpretation of their laissez-faire attitude suggests that the regulators understand that the Too Big To Fail banks are now too big to manage, to regulate property, and to break up easily. Moreover, many of them are close to insolvency if they were forced to liquidate their bad assets on the open market. Consequently regulators do everything not to make the situation of these banks worse, in the hope that over time their problems will get sorted out.

That, unfortunately, is a vain hope. Time has already run out for the big banks. They are on the same slippery slope as government, and they will be forced ultimately to take their losses on mortgage securities, on failed securitization programs, on destruction of property rights, and on their holdings of sovereign debt.

Time has run out as well for the central banks. Their ability to use their balance sheets to prop up the commercial banks is almost at an end. The most recent bank rescue, occurring after the collapse of MF Global, involved the Federal Reserve increasing its swap lines to various other central banks, and lower the cost of borrowing. This move took place under great secrecy, and the announcement gave little information. Only after the fact have we been able to look at the expansion of the Federal Reserve balance sheet, and the borrowing done by the other central banks, to see that this rescue was necessitated by a further dramatic shrinking of the international market for bank loans to each other. Reports were circulating a week before this announcement that some major Too Big To Fail banks in Europe were completely shut off from interbank lending ”“ nobody trusted them anymore, which is to say they were viewed as insolvent given how the market was now pricing government debt from Italy and Spain. The European central banks themselves did not have enough liquidity in their own currency or dollars to prop up these banks ”“ hence the Fed rescue. In short, we are back to where we were at the height of the 2008 crisis, when the Fed was the only institution able to lend money to any financial institution, central bank or otherwise. Only now, the situation is permanent.

One other important thing to note about this development is that the Fed’s rescue program is yet more expansion of the monetary base in dollars, which under normal circumstances would lead to a serious inflation problem. Many astute observers look at this explosion in monetary reserves in the US and see hyperinflation as a result. Certainly the price of gold, up from $900 in 2008 to a peak of $1900 last year, suggests that investors are losing faith in the dollar and are seeking the only hard financial asset available. The reason an inflationary result has not occurred is that these reserves are sitting on commercial bank balance sheets rather than being pumped into the economy in the form of loans. It is as if the banks are waiting for the moment when these reserves will have to be used to cover losses that have rendered the big banks insolvent.

The Rule of Law is Trampled

We have already seen how the banks have engaged in fraudulent activity, literally stealing people’s homes out from under them by processing fake foreclosure documents through the courts. No serious retribution has been extracted from the banks for these crimes ”“ certainly not from the regulators, and not from the Obama administration. There is some evidence that a few state attorneys general are doing the hard work necessary to investigate these crimes and demand justice for homeowners. At this stage, though, the impression left with the general public is that the rule of law has been knowingly and aggressively compromised by the banks and the regulators as their stewards.

Investors have been aware of these failings, but have been more concerned about the safety and fairness of the financial markets. This was especially evident in May of 2010 when the Flash Crash in the US markets showed investors how exposed they were to sudden, large losses on their stock holdings. Very little was done by the SEC to correct these problems, which were shown to be related to the practice of High Frequency Trading, which involves firms like hedge funds submitting thousands of trades per microsecond, most of which are cancelled before they can be acted upon. The purpose of such trading appears to be to profit from the price moves which occur when so many transactions hit the wire, and hedge funds have arranged to locate their computers directly on the floor of the exchanges to minimize the time necessary to process their trades. Private investors, of course, don’t get such privileges, but they pay an incremental tax, as it were, on each trade, to the hedge funds that do have such privileges.

This is part of the reason money has been leaving mutual funds and hedge funds steadily for three years now. 2011 was no exception; mutual fund withdrawals from small investors exceeded inflows for all but one week during the year. To the extent the small investor has been willing to stay in the markets, they have concentrated on futures contracts in commodities, especially gold, which has been seen as a safe haven from the problems in equities.

There is, alas, no refuge for the small investor anymore. The MF Global collapse on October 31 affected one of the largest broker-dealers specializing in commodities. Tens of thousands of small investors used this firm to buy futures contracts on the Chicago Mercantile Exchange. When the bankruptcy was announced, it was discovered that MF Global was missing $600 million in customer assets that were on its books; the number was later doubled to a $1.2 billion loss. What happened in response to this loss will go down in the history books as one of those events which precipitated the end game in this long road to financial Armageddon.

Normally, customer accounts held by brokers are sacrosanct. They are to be completely segregated from the broker’s own assets, so that in a bankruptcy they can be protected and transferred to a solvent broker. In the history of the Chicago Mercantile Exchange, this has always happened with a broker bankruptcy, which is why the firm touted the fact that no individual investor ever lost a penny on the exchange from a broker bankruptcy.

Exactly what happened at the CME is still uncertain. There are reports that a week before the bankruptcy, MF Global was deliberately using segregated customer monies to pay margin calls on its own trading positions. The margin was being demanded by big New York banks in particular, which were looking to obtain collateral as protection for hundreds of millions of dollars of losses owed to them by MF Global on their holdings of European government bonds. There is nothing illegal about banks demanding margin from their customers; what is illegal is how MF Global raised the cash to meet these margin calls, and whether any of the receiving banks knew whether this was money coming from segregated customer accounts.

At the announcement of the bankruptcy, the CME discovered customer assets were missing, ultimately to the amount of $1.2 billion. It could have ”œpassed the hat” to its surviving broker-dealers and raised the missing amount, but it chose not to do so. It could have used some of its $600 million of reserves to cover these losses, but has so far suggested using only a portion of that amount. No doubt the CME will argue that this is a special case: one of its broker-dealers deliberately deceived the exchange by fraudulently transferring segregated customer money to third parties. The CME has also suggested that New York bankruptcy law supersedes CME rules and regulations, and that it is somehow helpless to provide full restitution to individual customers of MF Global. Conveniently, now that the situation is in bankruptcy court, it benefits the big New York banks that grabbed on to MF Global assets before the bankruptcy occurred.

To make this situation worse, the CME froze the accounts of MF Global customers, informed them that their assets were missing, demanded margin from them on any open positions which had lost value, and prevented them from selling any of their positions to raise this margin. Those customers who held gold in warehouses backed by certificates of ownership have also discovered that the bankruptcy trustee has confiscated the gold and held it for the benefit of the MF Global estate.

The result of the actions taken by the CME, and all the uncertainty surrounding the MF Global bankruptcy, have destroyed forever the sense of security investors have had dealing in futures contracts in the US. Several brokers have publicly advised their clients to close out all accounts on all futures exchanges, because their money is not safe. This is being held up as an example, once again, of how the system works in favor of the banks and other big players, and against the individual.

One other item of importance from this debacle needs mentioning. There is now some evidence that MF Global was re-hypothecating its customer margin accounts. To hypothecate is to legally grant a lender rights to certain assets you have given up as collateral. Margin is nothing more than collateral, consisting of your investment money you have sent to a broker, plus or minus any gains or losses you may have on your investments. The broker, in their contract with investors, establishes their right to pledge this margin money to third parties, on its own behalf, as if it owned these assets outright, to cover any loans and trading positions it has taken from these third parties. This is called re-hypothecation, and is a legal practice under US regulations, though there are limits to how much can be re-hypothecated in any one customer account.

MF Global had made a very large bet on European government bonds, and didn’t want to be restricted by the US limits on re-hypothecation, so it notified its customers that it was transferring their accounts to MF Global’s subsidiary in London, since England has no limits on re-hypothecation. This meant a single customer account could be pledged as collateral multiple times to different banks. MF Global did not notify its customers that it intended to use their margin as its own collateral for its own trading activity.

The result was that MF Global was able to use customer margin multiple times with different bank lenders. This is the practice of using leverage to boost a firm’s profits, but leverage also increases a firm’s vulnerability to market losses. MF Global may have taken $1.2 billion in customer margin and pledged it as collateral to five different lenders, allowing it to create a position in European government bonds worth $5.0 billion. When these bonds sunk in value on the markets, the lenders watched their margin cushion shrink to the point where contractually they had to call for more margin from MF Global. At first MF Global was able to comply, but when five lenders are seeking more collateral from a firm that has little cash cushion in the first place, and when losses on the bond positions are mounting, a mad scramble takes place among the banks to seize whatever assets MF Global has, at the same time liquidating their trading positions to prevent any further losses.

Some lucky banks may have been holding on to the margin accounts that MF Global controlled (MF Global was not a bank and so could not itself maintain margin deposits). These banks might have requested permission to seize the margin accounts, or they may be done so unilaterally and risked the consequences afterward (the party holding on to cash in a bankruptcy is always in a superior position). However it happened, thousands of individual investors were absolute pawns in a brutal game of self-protection played by the big banks.

It cannot be overestimated how serious a blow this is to investor confidence in the US markets. Hedge funds and mutual funds are already reacting. They have instructed their bank lenders that they want to close their broker accounts with these banks unless the banks redo their legal contract and throw out their right to re-hypothecate. These same funds are also demanding to see exactly where their money is kept, and they want assurances from these depositaries that their money is at all times segregated and kept out of the control of the broker.

This is going to kill a very lucrative business for the broker-dealers, including the Too Big To Fail banks, which all maintain broker-dealer subsidiaries. JP Morgan Chase, for example, re-hypothecates over half a billion dollars of customer margin money. Nobody knows how many times over the same dollars are re-hypothecated by these banks, but it is certainly more than once. This is all part of the shadow banking system ”“ lending and leverage done outside of the public eye between financial firms, with the investors told nothing of how their margin accounts are being used.

The collapse of MF Global exposed re-hypothecation and its dangerous effects, and because of this, banks and other large financial firms are now forced to downscale yet another aspect of the shadow banking system. This sudden reduction in re-hypothecation was clearly behind the further collapse of interbank lending in November, which ultimately forced the Federal Reserve to step up and increase its swap lending lines to other central banks. Nothing in that respect has changed since 2008; the Fed is still acting as lender of last resort to the world, in a hopeless attempt to keep liquidity flowing in the global financial system.

THE END GAME

We now have almost all the cards on the table for everyone to see. It should be obvious to any observer that a debt implosion process is already underway. It started in the banking system, and has now infested major governments around the world. We see that the major central banks will do nothing to clean up the banks they regulate, and in fact they will do everything possible to keep hidden the true extent of the problems. We see how the legal system has been compromised in so many ways, usually so that the banks can benefit from whatever turmoil may occur, much of which they themselves caused. We see that the individual is a hapless tool in this system, subject to losses arising out of nowhere from products and institutions that everyone had thought were of the highest and safest quality.

The globe financial system is at a dangerous moment. Confidence has been ebbing for three years, and distrust in the system is now building at a rapid pace. The distrust now extends to the major financial players themselves. They won’t lend to each other. They will grab any assets they can at the first hint some institution may be in trouble. They will completely ignore legal contracts if they have to, just as they will throw away 100 years of tradition and ruin the reputation of an entire market in order to protect their own institution. They will run to their government at the first sign of trouble, and they expect the taxpayer to bail them out without any questions asked, and often without any public knowledge that a bailout has taken place. They fully rely on their regulators to hide their true condition from the public. They continue to believe they are entitled to exorbitantly high earnings and bonuses, so they find one fee after another to charge their customers, and they notify their clients of these fees in the dead of night through tiny legal print sent in innocuous form letters. The system of cooperation among banks that was the basis for all interbank lending has dissolved, and the central banks are left to cooperate among themselves, if possible, in order to maintain a thin thread of global sanity to a crumbling financial structure.

We also know how the final collapse is likely to come about. Financial crises almost always arise from a credit event ”“ usually a surprise announcement of financial trouble facing a major bank or firm. It can also be a surprise bankruptcy. The sector most likely to be the source of such a problem this time is the hedge fund industry, because it remains as highly leveraged as it was in 2008 before the crisis hit. Furthermore, the lifeline of hedge fund investing is credit extended by banks, and that credit is now drying up. The hedge funds themselves are beginning to pull back on their investing, in order to reduce their leverage and reliance on bank lending. This has led to damage in some markets ”“ gold for example, a favorite safe-haven for the hedge funds, has seen a big sell off in recent months as positions are closed.

We can’t discount the possibility that a bank failure will trigger the next crisis. Many banks in Europe are just a step away from being on full-time life support from their central bank. All it takes to shock the market would be the announcement that a major bank requested it be nationalized in order to continue to function. This is tantamount to bankruptcy for a financial institution.

A third possibility is an exogenous shock to the system, such as a political crisis or natural catastrophe. The Straits of Hormuz conflict with Iran that is now underway is a good example of something that could get out of hand quickly, driving oil to $140/bbl, and tanking markets around the world (except possibly for gold). Yet another candidate for an exogenous shock is China, which is now at the first stages of an implosion of its housing bubble. This bubble is far and away the most dangerous of them all, dwarfing any other housing bubble in size, and in the exposure Chinese investors have through leverage that resides in a shadow banking system beyond government control. Compounding this situation are two other problems: domestic inflation that has now infiltrated the wage cycle and is destroying corporate margins, and the collapse of China’s export markets as more and more Western consumers are unable to borrow in order to continue to purchase cheap Chinese products.

Whatever the shock is, there will be a frantic race by institutions and investors to protect themselves. They will want to get out of their speculative contracts, unless they are short assets, and they will want the safety of cash. These types of panics inevitably bring out more surprises in the nature of bankruptcies of firms caught the wrong way in the market. As bankruptcies mount, the big banks will be brought into a maelstrom of defaults by their customers, chiefly financial firms, but increasingly individuals and even corporations.

Multinational corporations have been preparing for a financial collapse by stockpiling cash, which is at record high levels for companies. What is not appreciated is that many of these corporations have borrowed the cash they are stockpiling; they have not been generating much cash from their operating business. Since so many companies have such high leverage themselves (high debt to equity) that they are considered as junk debt by the ratings agencies, these firms will be very exposed to a financial collapse. They will be starved of credit by the banks and the markets, and since they won’t be able to roll over their debt into new loans, they will hit a wall when their debt comes due.

The equity markets are unprepared for an increase in corporate bankruptcies. Most S&P 500 companies are trading at multiples that were common in the 1990s, when the markets and the global economy were soaring. They are enjoying record earnings because they are able to continue to reduce expenses, and many companies have figured out ways to extricate themselves entirely from paying taxes. The average corporate tax burden for a large US company today is a fraction of what it was 30 years ago. All of these beneficial conditions are coming to an end. Credit in a financial implosion is going to be very scarce, and the majority of companies today are so highly leveraged they will have difficulty surviving without additional credit. Corporate margins are already being compressed, and this earnings season confirmed that revenues will continue to flat-line while expenses increase. Then there is the tax benefits that accrue to companies. These favors from Congress are under more scrutiny than ever before, and as federal tax revenues collapse with the rest of the economy, Congress will have no choice but to go after corporate income in a big way.

If you think this is fanciful, spend a week or two following the stock market in the US. The New York Stock Exchange is positively fixated on what is happening with global finance, with the banks, with the European debt situation, and with the Federal Reserve. It is all about continuation of the liquidity ”“ meaning availability of credit and debt ”“ that has fed the global financial expansion since the 1980s when Ronald Reagan first began adding significantly to the budget deficit. When it looks like more liquidity is on its way, the stock market soars. It drops back down when some official says government is running out of ways to keep liquidity flowing. It is in that sense all very simple: the stock market knows exactly what is at stake here if the game of incessant expansion of debt is brought to a halt.

What is at stake for the Dow Jones index is a very quick fall back to its 2009 low of 6,600 if the central banks can no longer hold the system together. The assertion of this article is that they cannot do so, and therefore the Dow at 6,600 is only a resting point for a much greater collapse, with an initial stopping off point near 3,600 to 4,000. A final resting point is likely to be closer to Dow 1,000.

Of course that sounds ridiculous at the moment, but it sounded much more preposterous ten years ago when we first started talking about the possibility. To get to Dow 1,000 we need corporate profitability to collapse almost completely. We’ve already shown how corporations are more exposed to an economic crisis than most think, because so many companies are now highly leveraged. What takes the stock market down much further is a drying up of business altogether.

This is happening already in Greece. Leaders of industry in Greece are reporting that ”œno business is being done.” Trade has come to a halt, at the retail as well as the wholesale level. Even trade receivables are no longer being accepted for finance. Credit has gone out of the system, and the average Greek citizen has been pulling their euros out of Greek banks for over a year now. People are literally scrounging for food and medicine, and a barter system has arisen to help people trade goods and services without the use of money. Greece is in a classic depression, and whatever credit it is reluctantly given by the EU or the IMF is merely to pay debts back to the banks so that they themselves won’t go bankrupt.

Greece is small doings compared to Italy, which is the third largest debtor in Europe, and close to the US and Japan in its debt/GDP ratio. Greece’s problems are about to extend to Italy, and then travel from there quite rapidly throughout Europe and eventually to Japan and the US. This is when corporations will be dragged into the whirlpool; when ”œno business is being done.” The big banks will be severely compromised if not already wards of the state. The central banks will have no way to push more debt into the system, and bankruptcies will mount higher and higher as the debt overhang is finally dealt with by the market.

What is the timing for all of this? A logical start for the point of recognition ”“ the moment when everyone realizes the system cannot be saved ”“ is 2012. The central banks can forestall that moment, with one or possibly two more renditions of Quantitative Easing. In fact, Europe is already working on its version of this program, for an amount anywhere from €500 billion to €1.0 trillion. The Federal Reserve can opt for QE3, which might involve purchasing more mortgage-backed securities from the banks. What the market has discovered, however, is that each successive version of Quantitative Easing carries less of an economic punch than its predecessor. The US is rapidly approaching the point of little or no return for QE3; in fact, such a program may be counterproductive if it brings about any of the inflationary problems we saw with QE2. Consequently, these programs will be the last gasp of the fiat money system. They can forestall collapse until next year, but they cannot stop it.

The way down the deflationary funnel will occur in lurches rather than smoothly. Economic conditions may improve from time to time. Crises will ebb for a period. The governments will appear to be back in control again. These will be false hopes. It is going to take three or more years to take a real hatchet to the mountain of debts that needs to be pared to manageable proportions ”“ to the point where those who have debt can pay interest on time without a great financial strain on themselves.

Some people will prosper during this period. There are always ways to make money. Sadly some will profit from other’s misery. But there will be legitimate ways to help people, and survivors, be they retailers or large multinationals, will be those who can operate with a much lower cost base, and deliver goods and services at prices much reduced from current levels. As you can see, survivability for corporations means woe for today’s workers, who will be exposed to further rounds of layoffs. Millions more will join the unemployed, and effective unemployment in the US will exceed 25% and may go much higher (measured on a BLS U.6 basis).

The most pressing social problem all countries will face will be feeding and housing the millions of unemployed. Make-work programs may be helpful, but meeting fundamental human needs, and keeping families together, will become matters of urgency for governments. In the US, this will require a major upheaval in the political order, for both parties, and the political test for any country will be whether it uses government for humanitarian purposes to help its own people, or whether it emphasizes ”œself-reliance” on the North Korean model, where mass starvation is not a problem for government to address. Going down that path will require governments to replicate North Korea’s policy of social and political isolation, with complete domination by the government of all information.

To the extent capitalism survives this crisis, there will be an economic recovery in 2017 or sometime thereafter. The economy will not only look better, it will be better, after years of false starts and promises. Opportunities will begin to abound, as long as new social, political, and economic structures are being put into place to address the problems that got us here. The solution will not necessarily involve replacing fiat money with a gold standard. The gold standard had its own serious drawbacks, including a tendency to cause a rolling series of depressions, not just recessions. But if fiat money is going to stay, what will be needed is discipline ”“ a system of government where leaders are willing to make hard decisions when malpractices and imbalances begin to show up in the economy. That will be the test for American society and other countries. Discipline means that unfettered market capitalism will not be tolerated. This will be especially challenging for the United States, a country where ultra-individualism is honored, and where one political party has bought into an Ayn Rand philosophy of government-loathing. Unless the US can have a serious discussion of what government means, what it can accomplish, and where the limits are to be placed on the free market; unless the US jettisons the Reaganite dogma that government is bad and the markets are always good; unless these things happen, the US will not be participating in the global economic recovery that will follow the next few years of tribulation.

19 comments to Peak Money Arrives

  • maqmigh

    Around August, IIRC.

  • Numerian

    You are right, though, that the first major credit problems surfaced in 2007. You can also go back to 2006 when the housing market stalled. There were some small-scale bankruptcies with mortgage brokers that should have told the regulators that problems had gotten out of hand.

  • Don

    Best, easiest to understand and most comprehensive account of the situation to date.

    My only quibble concerns the last paragraph.

    To the extent capitalism survives this crisis, there will be an economic recovery in 2017 or sometime thereafter….

    I don’t know, but I suspect the United States will not survive this intact.

    At some point a terrible war and its afteraffects will likely rearrange the world as we know it.

    The plan will call for further centralization while the forces of nature (entropy) will work in the opposite direction.

    We (or someone) shall see.

    I did inhale.

  • Entropos

    I feel like I just read a rational, un-hysterical, jargon-free and condensed version of ZeroHedge-2011.
    Thank you for writing something accessible that I can share with my friends and family.

  • dude

    I enjoy reading Numerian’s posts. This one kicks off 2012 so nicely.

    For anyone who thinks 2012 marks the “end of the world”, Numerian has dispatched that notion completely by marking 2008 as the real date of our ongoing demise.

    And he has support in many unexpected places.

    I was reading the local paper about how one skeptic was trashing Twenty-Twelvers. He noted the history of Dionysius the Small, a monk who gave us revisions to the Julian calendar, and the terms “A.D.” and “B.C.” which much of the world has been using for centuries to mark time.

    Long story short: Dionysius erred. He was off by 4 years using his own Biblican standards as he tried to match the Biblica1 scripture to chronology.

    This from http://www.webexhibits.org/calendars/year-history.html:

    “Was Jesus born in the year 0?

    No.

    There are two reasons for this:

    There is no year 0.

    Jesus was born before 4 B.C.E.

    The concept of a year “zero” is a modern myth (but a very popular one). In our calendar, C.E. 1 follows immediately after 1 B.C.E. with no intervening year zero. So a person who was born in 10 B.C.E. and died in C.E. 10, would have died at the age of 19, not 20.

    Furthermore, as described in section 2.14, our year reckoning was established by Dionysius Exiguus in the 6th century. Dionysius let the year C.E. 1 start one week after what he believed to be Jesus’ birthday. But Dionysius’ calculations were wrong. The Gospel of Matthew tells us that Jesus was born under the reign of king Herod the Great, who died in 4 B.C.E.. It is likely that Jesus was actually born around 7 B.C.E.. The date of his birth is unknown; it may or may not be 25 December.”

    I hope you find this amusing.

  • Joaquin

    Great post Numerian.

  • dk

    First let me thank you for providing a clear explanation of what happened at MF Global & the CME. These financial crises seem to increase my vocabulary every time, but the first reports are difficult to understand because of the jargon and I just tend to glaze over. Now I have a foothold for deeper investigation, and hopefully understanding.

    However, I’m seriously confused that London can have no limits on re-hypothecation and yet London based subsidiaries can trade on the CME, and then expect the CME to cover losses when the CME operates under US laws?
    And the banks that lent to the London subsidiary, under London’s regulations, or lack thereof; are actually US banks? WTH? It smells like AIG Financial again. Like some sort of international regulatory arbitrage, that ought to illegal under the Basel accords or something like them.

    I recently met someone that worked at MF Global in Chicago (and is now unemployed), and the most I could get from them was that someone in NY got caught while trying to put the money back into customer accounts, presumably to hide some wrong doing. Of course, I have no idea what their level of understanding is either. It’s unlikely, but they could be more confused than me.

    And lastly, I’d like to thank you for this tour de force of doom, but somehow I feel like ignorance might have been more blissful :)
    But I will print it out to share with others, after I buy more blankets of cynicism to hide under.

  • Lex

    Of course, he was the son of God and all that, so maybe the Big G thought the date would be just right. Otherwise, it’s Christian mythology overlaying itself on all the other Solstice/Solar traditions and deities that came before Jesus.

    However, having him born on the 25th does provide a handy, religious continuity through human history. So far as i know, Jesus never associated himself with evergreen trees, but by being born on the 25th we get to keep bringing those signs of resilient life into our homes during the coldest, darkest moment of the year.

  • Kurt

    Numerian, this piece really helped me understand the relationships among the components of the financial crisis. Thank you for writing and posting it. I’m going to share it with many others.

    There’s a question that’s been in the back of my mind for a couple of years now. You might say the back of my mind is where it should have stayed, but nevertheless I want to ask it here, because I think you would be able to provide a grounded and understandable answer.

    Keep in mind, I’m not an economist.

    Setting aside consideration of how credit is granted, and how money is created by banks though the extension of credit, and how in the worst cases credit is extended to too many borrowers based on money and assets that are leveraged beyond belief by the banks… Setting all of that aside, isn’t the real definition of a prosperous economy simply the condition in which individuals and groups provide goods and services to other individuals and groups in an efficient, cyclical fashion? And in that system, what is “money” except a promise by one party to another to provide goods or services (or something of equal value) at some point in the future?

    If that definition works, then the financial crisis and the depression that results from it are really just organizational problems. The institutions that are supposed to serve as the conduits of those promissory relationships we call money are failing to achieve throughput. The criss-crossing web of debt relationships among those institutions has reached a point where it is causing the whole system to seize up.

    Would we have this problem if banks were operated as public utilities? (In that scenario I can imagine banks being limited to just three functions — providing clients with a means of saving money, extending credit to borrowers, and facilitating financial transactions.) If they were public institutions, they would not be rent-seeking.

    What would happen if the executives in the leading economies DID nationalize the banks overnight, untangled the criss-crossing web of debts, and rendered most of those debts (the big ones) irrelevant (either by saying they simply wouldn’t be paid or by showing that they more-or-less balanced out against other debts)? And what if, on the following morning — or whenever they could sort it out — they opened the doors of the new and much-simplified banks to provide basic financial services to businesses and the public? If we cut away the dysfunctional and debt-paralyzed parts of the financial system and cauterized the whole mess quickly, would we still be in a depression?

  • Numerian

    When I joined banking, a long long time ago, US interest rates were fixed. The government decided the maximum rate on deposits. The banks got a guaranteed spread, and it was their job to protect that spread by making prudent loans. This system was not sustainable when inflation broke open in the US during the 1970s, so I don’t know that we can go back to this exactly. We can, however, look at your three functions, which I will word slightly differently: acting as a depositary, making loans, and managing the payment system. This should be the core of modern banking. There is certainly room in this construct for banks to offer asset management services, cash management products, and even derivatives and other trading products if they are restricted in the way Paul Volcker recommends. What banks should not do is own a brokerage business. We need to go back to the Glass-Steagall restrictions that worked so well in the past.

    This is radically different banking than we have now, and it will mean that banks as utilities will have to get used to 5% – 8% returns on equity, rather than 15% – 20%. No one should be getting million dollar bonuses.

    There is room for businesses which want to speculate and pay their executives million dollar bonuses. They just can’t be banks, and they should have zero expectation of ever getting any help from the Fed. This is, unfortunately, one of the bad consequences of the 2008 rescue packages by the Fed. They gave Goldman Sachs a banking franchise overnight just for nothing. In my day in banking, Goldman Sachs would have sold their soul to get direct access to the Fed. Of course, in the end, maybe they did.

  • Numerian

    If one regulator out there wants to lower their standards, or have none at all, it makes life very tough for all the other regulators. Banks will find their way to running business through the most friendly environment. This is how we have so much eurodollar deposit business running through the Cayman Islands, where all a bank needs is a paper license and a nameplate on an office door (no employees necessary).

    Of course, if the CME had given this any thought, they would have looked into the possibility of regulatory arbitrage, and found a way to forbid their broker-dealers from shifting client accounts legally to such domiciles. I guess they just weren’t that concerned about the problem, though to absolve them somewhat, very few people paid attention to or even heard of re-hypothecation until a month ago.

  • Zman1527

    Couldn’t resist. Great post and analysis Numerian and many thanks for putting it out there for all to read.

    Twould be very interesting to hear your views on:

    1. How to survive the coming sheisstorm?

    2. What we need to change as a nation to come out the other side in good shape?

  • steeleweed

    – from Nightmare With Angels

    You will not be saved by General Motors or the prefabricated house.
    You will not be saved by dialectic materialism or the Lambeth Conference.
    You will not be saved by Vitamin D or the expanding universe.
    In fact, you will not be saved.

    – from Litany For Dictatorships

    We thought, because we had power, we had wisdom.
    We thought the long train would run to the end of time.
    We thought the light would increase.
    Now the long train stands derailed and the bandits loot it.


  • Bolo

    that we’re in big trouble and its probably going to get much worse before its getting better. However, I think you overemphasize the problems with the US federal debt and somewhat under-emphasize the problem with private debt. If the federal government were to balance its budget we’d face an absolute catastrophe right now. The government needs to increase spending (intelligently, on jobs and retooling the US economy and infrastructure) while simultaneously fixing the other problems that you outline above–rule of law and regulation. The fiat monetary system gives it the flexibility to do this. US government debt can be and will be repaid–this is why the markets haven’t raised rates on the US but have done so on Euro-using countries, as you note. There is a real risk with the Euro countries defaulting on their debt because they are in a fundamentally different arrangement than the US. The high budget deficits are a symptom of the problem, not the cause.

    The cause is a slack economy created by a hugely overleveraged private sector that faced a sudden contraction of demand brought about by the popping of an asset bubble that was created by a criminal financial environment run by Wall Street and allowed to fester through government inaction and deregulation brought about by a pernicious ideology which maintained that banks and corporations can be trusted to be honest, self-regulating, rational entities. That, and the banks and corporations paid off a lot of people in high places to at least pretend to believe or look the other way.

    The public debt can be paid and simply will be paid–there is no real constraint stopping this from happening other than some arbitrary rules that Congress has enacted.

    For some additional comment, I have a couple links if people are interested in reading them:

    The Debtwatch Manifesto: Outlines a plan for a modern debt jubilee, taming the financial sector, etc. Definitely a good read!

    Historically High Budget Deficits Will Be Required for the Next Decade: The private sector debt is so unsustainable right now that the only actors that are capable of spending to fill the gap are governments. Governments such as the US (but not those using the Euro) are not constrained by balanced budgets and in the current situation balanced budgets would be extremely detrimental.

    The Age Economic Survey: Steve Keen’s answers to this survey. Basically, private debt is completely out of whack and needs to be reduced and government spending is the only thing that can fill the gap.

    Debt Britannia: Some more exploration of the above issues, focusing mostly on the UK and somewhat on the US. The UK is screwed, by the way–a 950% debt to GDP ratio for its private sector, most of which is financial.

    Of course, things could get very bad if we decide that the government needs to balance its budget and slash spending. The current plan, which does not involve this, leads us to a Bright Depression much like Japan has suffered through. Steve Keen (linked above) estimates that we’ll need until about 2027 to deleverage and start rebounding. Cutting the budget and radically reducing spending would just crash everything, leading to what I’d call a Greater Depression–probably more horrible than the last one. The only solution I can see is to strategically increase government spending and support, institute a private sector debt jubilee (Keen’s suggestion linked above seems like a good start), and basically cram down on the financial sector with ironclad rules to stop criminal behavior.

  • steeleweed

    Re Keen’s suggestion: Putting money into private accounts ‘on the condition that it go to pay off debt’ could be tricky. What if consumers didn’t use the funds to pay off/down debt? Since the major consumer debt is housing and such a huge proportion are ‘under water’, it makes more sense to have the money pay down mortgages to match the market value of real estate. This frees up consumer capital and resets the housing market ‘thermostat’. Right now, that mortgage debt is not really doing anyone any good – the banks are faking assets by refusing to ‘mark to market’, mortgagees are throwing good money after bad and have no incentive/ability to spend elsewhere.


    It is worth remembering that the Founding Fathers were all traitors.

  • nihil obstet

    In my day in banking, Goldman Sachs would have sold their soul to get direct access to the Fed. Of course, in the end, maybe they did. — No, they bought Congress’s soul.

    A matter that strikes me as turning into a more and more serious problem is the transition of commercial transactions from physical payment with checks or cash to electronic payment, and leaving this whole currency system with the banks. This enables private companies to levy what is in effect a tax on use of currency. I can see leaving credit cards with private entities — there is the extension of debt issue — but I do think a government-run or closely regulated bank should be available to all citizens for direct deposit and use of debit cards.

  • dk

    coupled w/ banking consolidation, liquidation, and the fees bank now charge on small accounts, plus the processing fees certain banks get from food stamp cards, FEMA, etc; you’d think it would be an anti-trust suit waiting to happen.

    but no, 4 banks are apparently enough. hey, maybe if it continues to consolidate, then 1 big bank would be easier to nationalize!

  • Bolo

    Like I said, his suggestion is a good start.

    Our options are to either (1) keep the economy idling and just waste our lives and resources (Obama/Romney style), (2) cut cut cut!, then watch it all crash down (Ron Paul style), or (3) actually do something constructive to try to fix and change the system now so we can have a brighter future (no politician on the national stage will do this).

    It really looks like we’re just choosing between (1) and (2) right now. (2) sounds like it will be over quicker, but I question whether we’ll be able to recover from it or whether we’ll even want to. The economics and ideologies espoused by the people who want (2) (as opposed to those who simply see it as the ‘best’ option out of a range of terrible choices) will not lead us out of the collapse. They’ll only lead us into it.

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