In Response to Pater Tenebrarum's Economic and Monetary Conditions in the US

http://www.acting-man.com/?p=5725&cpage=1#comment-407
You wrote plenty here Pater. The main deflationary force would hit financial assets if they allowed it to actually occur. The value of money, whether it be gold, silver or paper is in its payment of debt, something you mentioned far exceeded the money supply. The debt in the banking system includes the capital of banks which comes at the front of the line, as it is the imaginary amount on the credit side which stands between the deposits liabilities of banks and their inability to pay them. Reserves or not, the banks have no capacity to make loans and create deposits in what would be a good faith, conscionable manner. That is to be surety of what one cannot be surety of is fraud on its face.

I appreciate the comments about the currency being a reduction of reserves. The reserves were reduced when the currency was drawn. You might note how much total reserves were supposed to be in the banking system when this mess began. It was hardly above the amount of currency. Do you think the banks were sitting on $800 billion in currency and drawing no interest or do you believe the logical, that the reserves as described by most people were already out of the banking system? I believe this to be key as to what we have seen over the past few years and the true nature of the credit crunch, the circulation of liabilities of bankrupts in lieu of cash.

The true inflation in the system has manifested itself in high asset valuations and high corporate profits. The stock market, at least the stocks evidenced by the SPX, pays a 2% dividend roughly. No only would these dividends deflate in a deflation, but the credit expansion that has created this excess value would cease as well and the result would be a liquidation of value. I believe this to eventually be an inevitable situation that is merely being postponed. I can see a 50% reduction in dividends and a move to the historical 3% dividend peak value, meaning peak value of the SPX falls by 2/3. Normal value, a dividend yield in the 4.5% range would reduce value over 80% and the entire pension fraud would be exposed.

Where is the currency? Banks don’t put out currency for the hell of it. People are holding it here and around the world because some of us have enough sense to know the banks are broke. The illegitimate debts of banks that have circulated for years have been replaced by the QE. This round of QE merely states that they need more cash to allow bankrupts to write bad checks and little else. If you marked to market the assets of the big 4 US financials, I doubt any of them would be solvent. This factor not only allows the fraud to continue, but it allows the banks that receive the excess reserves an avenue that doesn’t include lending the cash back to the bankrupts. Remember, if you examine the amount of cash, it is clear there were no reserves whatsoever left in the banking system when this mess started.

The system of debt, credit and banking is so paradoxical that it is impossible to predict what will happen. But, in general, all debts must be paid, extended or defaulted. It is cold outside and people can’t pay their rent. Gasoline is going up without demand and I suspect it is the use of excess credit directly. Credit is being used to game the system and support unsupportable liabilities.

There can’t be a true recovery until there is a transfer if cash flow to the lower half of the income structure and a liquidation of debt. Debt is as much a part of the money supply as the deposits and currency are, the absolute paradox of the system. The true debts of a system cannot exceed the true assets. Thus, we have a pension system that is supposed to pay $X per month to its beneficiaries. If the assets, which ware debts of others, whether it be claims on the profits of corporations through stocks or bonds or mortgages, cannot pay the beneficiaries, the income doesn’t exist. A collapse of this system either leaves the retiree with nothing or a fraction of what he thought and planned he would get or place a debt on the system that probably cannot be paid. There not only is a difficulty in liquidating such liabilities, but a reluctance to allow liquidation to occur. This gives the meaning of the term “This note is legal Tender for all Debts Public and Private”, which is the only thing that keeps this stuff worth more than the ink on the paper.

There is nothing more powerful in this system than the dual columns of liabilities on the bank ledger. There are liabilities of the bank and liabilities to the bank. Most people look at these as assets and liabilities, but due to the nature of the entity, banking rests on the performance of both the debits and the credits. This is because the validity of either rests on the other. XYZ corporation can have plant and equipment on one side and debts and shareholder equity on the other and the only connection is that the plant and equipment must generate enough cash flow to pay the debts. Banking, the very existence of the cash comes from the debts and the debts can only be paid by the cash or through default.

Bernanke can do QE, but the cash still belongs to someone. The holder of the debt securities only changes hands. I believe you touch on this, that if the cash goes to a welfare recipient, it ends up in the till of a retailer who has sold his goods and services. Thus, indirectly the government owes the retailer for what he sold. The bank, instead of holding a debt instrument, holds reserves. The bank either acquires a new debt instrument or makes a new loan. If they make a new loan, they have in essence created a new bank liability and thus they are liable for 2 such accounts. The banker can also use the money to acquire commodities and other assets, but in doing so they also create a new liability and their balance sheet becomes more intangible in value, as the value of what they have purchased is less definite.

When we used gold, there was gold and bank credit. Gold was a limiting factor and that was all it was. The majority of money in circulation was bank credit, not gold and the system was insolvent immediately upon the extension of credit beyond the supply of gold. Nothing has changed in banking but the limitations and the willingness of the government to cover up the insolvency to the point that entire countries go broke covering up their banks insolvencies. This has allowed the creation of a series of IOU’s to the point those that created the debts that cannot be paid on both sides of the ledgers and are essentially bankrupts are calling the tune. I suspect QE is nothing more than a plan to allow the big banks to write bad checks until the system is looted to the point that all the debts are owed to them instead of to the people. Once one side has all the credits and the other side all the debts, game is up.

The entire system is a system of bank credit and until it can be seen as such, it cannot be understood. Watching the CPI or any other indicator bears little sense as to what is truly occurring. What is occurring is a widening gulf between what is owed and what can be paid. What is owed is so much beyond what can be paid that the debt value of currency either has to increase or collapse. I believe both will occur, but collapse only after increase. I think we will know when to move when assets represented by the SPX move to a price above fair value, which I contend is a dividend yield of 5% or higher.

The Case for Impeaching Ben Bernanke

The recent act of $600 billion in further Quantitative Easing has created another celebration in the stock and commodities market and why shouldn't it?  The Fed has come out and indicated it was going to support all the speculation the banks could bring into these markets, paving the way for more liquidation of public positions and more paying of massive bonuses to Wall Street players.  The problem is that the bubbles have already burst and it has been shown repeatedly that making money for insiders under fictional values has done nothing for the common American, nor has it increased their purchasing power.  When the end of the bubble comes, we are stuck with the collapse of former high flying entities and harm to the economy at large.  Yet, the Fed is either blind to this fact or it is engaged in conspiracy of sort against the American economy in support of otherwise bankrupt bankers and institutions.  All the while, the prime players suck more compensation out of a broken system, leaving the losses for the economy at large and Americans in general to absorb.

The real holders of the capital in the United States are being penalized to the extent their income from savings suffers or to the extent that they suffer future losses that are sure to come once the commodity corners collapse or the junk bonds seek their proper value of zero.  Also, common Americans are being sent a bill for these corners and manipulation through higher temporary prices for any commodity or good that can be squeezed by these corners.  Bernanke has done nothing more than add additional funds for bankrupts to push prices for common Americans upward, allowing the speculators to play at little or no current cost.  The delusion that one can finance something forever at zero throws out the level of debt that eventually has to be liquidated.  But, in the short term, the corners can push up the prices of what they hold and extract from the economy a toll.  The goal is to extract a fee from the use of everything from housing to food by a group that does absolutely nothing in the long term to create additional or current supply.  This stealing on the margin cannot go on without cooperation from the banking system.  Very little money of the players is at risk and the bills for failure after a temporary success will fall on the taxpayer.

The lower the return on pension assets, the more money is needed to fund pensions.  A person who has saved money all their lives will find their savings to be insufficient once interest rates are cut to zero or the risk of seeking artificial returns hits the assets.  The mortgage bubble is merely the first layer of loss that will eventually show up in stocks, junk bonds and other alternative investments.

The biggest crime of all is the front Bernanke is providing for the big banks at the expense of their depositors. The big banks are insolvent, but the Federal Reserve money allows them to continue to write hot checks to continue the frauds they have perpetuated in the past and the new ones they are engaged in the present.  For every liability on the books of the banks in the form of deposits and bonds, there is a corresponding asset.  Calling the asset cash doesn't further increase the capacity of the banks to make their other assets good.  At best they get to play more speculative games, attempt to draw more interest out of an over-indebted world and pay their management and key employees more bonuses based on temporary gains that will turn to losses.

The point is the depositors own the big banks, not the bankers or the shareholders and the actions of Bernanke are designed, not to re-establish the banks, but to allow the bankers to resume looting their depositors.  When this all collapses, which it will, the depositors will get the bill.  There won't be a bailout, but instead a debt that only the depositors can pay to themselves.  In the meantime, speculative US credit is flowing around the world to produce more bubbles for the bankers to exploit for profits that will turn to losses.

If this was indeed a program to rescue the US economy, it wouldn't be the crime that I propose it is.  I contend that there were no reserves in the banking system when this mess began, only cashed checks and interbank credit based on the creditworthiness of the banks.  Minsky wrote in the 1980's that the assets to produce new money had been gone since the 1970's and the banks were using financial gadgets to balance their books.  These gadgets were no better than the solvency of the banks themselves.

We don't have a liquidity problem, but a solvency problem in banking.  Bernanke seems to think he can invent capital by providing credit, but at best he is taking the best assets out of the system and doing nothing to restore the balance sheets.  This provision of false solvency is making the problem worse, because the banks aren't earning what they claim to be earning, but instead are hiding losses behind this liquidity.  In the meantime he is providing a means of capital flight from the United States in search of speculative profits that will disappear as Eugene the Jeep disappeared in Popeye cartoons.

So, it is this aiding and abetting of continued criminal fraud, the looting of depositors to support continued criminal activity and the creation of another asset bubble that only a few will profit from and scores will sustain massive and in some cases, total losses that I propose Mr. Bernanke be impeached.  Acting in a capacity to continue fraud in action and to convert the property of one to another is a crime.  This act is far from covert, but is being done in front of God and everyone.  The future of the United States depends on the United States government moving to prevent such activity, not to support it.  The future of the American middle class should not be sacrificed on the altar of central bank schemes to protect bankers and their ill-gotten wealth.

It may spiral out of control

http://mannfm11.blogspot.com/2010/08/housing-bubble-post-3-years-afterwards.html

If you look on the bottom of this post Mish, you will see I beat you to the point on your article "The Worst is Yet to Come". In fact, I wrote a post called the Worst is Yet to Come that also was posted on this Chinese website.

In any case, I did my studies and I came to the same conclusion, 3 million extra homes built roughly. I used data that came out of the government and I couldn't tell you where because the links didn't come out.
The 1970's should have been near the peak in housing. The data I had only went through 2004, but I know that 2005 and 2006 were even higher because I was looking at Calculated Risk's site with all his good graphs.

If you figure 3 million extra homes, plus changing demographics and figure the government is going to cause another 400K a year to be built, we are looking at a 10 year oversupply. A 3% to 5% decline out of this is a joke, because debt is deflating and housing debt is a big part of it.

Another thing that is a lie is that current existing home sales are at an all time record. The NAR is a pack of liars who began keeping their own statistics in 2000. Home sales in 1981 dropped to 2 million and they weren't much higher in 1982. In fact, 4 million was the all time high prior to 1997.

We had a deflation in the 1980's, but it was bailed out by steadily falling interest rates and a speculative trend that supported home prices in a lot of areas. DFW had a hell of a housing bust, as it was one of the bright economic spots in the country in the early 1980's and everyone moved in to build. 200K units were built in 1983/1984 and the market suffered for 8 years, despite a growing population.

Home construction probably didn't fall to a reasonable level until early 2008, so we are only 2.5 years into this mess. Once people realize the bust has hit housing, there will be fewer piling in to get a bargain. Real estate in Japan fell 90% in some places, despite their government and central bank doing roughly the same as Obama and the Fed. DFW has a growing population or I doubt the bust would have ended prior to 2000.

We own lower end rental property, mostly in Plano, Tx. I can see the inventory building up in a lot of older areas. Plano has blue ribbon schools, so it is still a stable price area and land is running out quickly. But, we had the telecom bust in 2001, which took to top out of the market here. But, in 2007, SFR construction was running just short of 50,000 units a year. There is a huge inventory homes in the subdivisions I go through and we are at the end. Foreclosures here were running high before the bust hit and have declined significantly during the tax credit time.

Credit quality of renters has been bad for some time, probably because the subprime mortgage boom took so many of the good renters out of the market. But what is going on now is I can see that people are having trouble paying their rent. In the meantime, speculators have bought piles of houses from lenders and distressed sellers. So, there has been an outlet for inventory at the right price for awhile. I have to believe this is about to be saturated.

I get conflicting information. One of my mothers friends, who likes to think he is the second coming of Warren Buffet says he has been told they are selling all the strip centers they can sell here. I suspected they were merely getting new names on the line for expiring loans, but I also suspect someone is lying. I have a friend that is going to law school at age 44, but he made his living building apartment projects. He says there is no work out there and not much in the way of willing buyers. There was a lot of California money came in under 1031 exchanges tha bought properties at 4% cap rates when you could get 5% on 10 year treasuries. That is not only a huge bet on inflation, but a huge bet on occupancy as well. With vacancy, taxes, insurance and maintenance, returns that low can vanish and turn negative quickly. Whether these projects were leveraged or not, I don't know, but I do know I heard some high land price quotes floating around in the middle part of the decade.

My friend that built apartments told me in 2007 that guys he knew in the real estate business who never sold anything were selling out then. Not many people live long enough to go through a cyclical real estate bust or a bear stock market and those that have and made it to the other side, don't generally get caught twice. It costs a lot of money to sell real estate, not to mention the capital gains taxes, but it costs even more to get caught in a bust. The housing boom I mentioned in the 1980's, saw the demise of a lot of properties that were producing good income prior. They had to tear the stuff down because they couldn't rent it. The same was true of commercial with landmarks like the Republic National Bank Complex and several other big buildings being mothballed and sold at bargain prices. The Republic National Bank complex was around 2 million square feet and I recall it sold for $7 million, due in part to the asbestos removal that would need to be done. But it wasn't 5 years earlier the site would have cost that.

I have thought about this and I believe the first thing that needs to be done is the GSE's refuse to finance any houses started after today. This would force people to get private financing before they built and would restrict supply. The tragedy is that we are going to lose a generation of skilled construction workers, but we are going to lose them anyhow. Many will have to go back to Mexico and that will leave the work to the remaining skilled Americans. But, there will be a dearth of labor for this purpose when the time comes, which it will.

But, the problem is even deeper, as we now have a credit problem. Witness Japan devaluing the yen. This was more than trade problems, as the Japanese were using treasuries, which are the credit of the United States to creat yen. The world has been using the dollar and the US government to expand their credit base for over 50 years now and the credit game is running out. American housing and the resulting bubble was the last credit boom of this long cycle. The lower housing goes, the less credit will be created out of equity. This is not only how deflation works, but inflation as well. The housing bubble created its own fuel, as even resales freed credit to be used to fund bank accounts and buy goods and services and other assets, including housing. This phenomenon has reversed, not because people don't want to push it forward, but because it has reversed. This doesn't make sense I know, but the mere reversal is all that is needed to keep the reversal going. This happens because the growth in credit was propelled on itself and not by any specific act. The reversal removes the fuel that was driving it the last mile.

The chicken or the egg theory is a tough one, but I believe the entire inflation we have seen over the past started with the build up of cash balances out of the 1970's housing bubble. Homes doubled here in 3 years back in the late 1970's and there was land everywhere. Those cash balances went into the 1980's where they drew mid teens interest for 3 years and the high single digits for the remainder of the decade. This then fueled not only the stock market, but the next real estate boom when rates fell. Lower payments made houses more affordable to more people and more house affordable to those that already had one. The GSE's complied by reducing down payments to the point that double contracting became legal.

I recall selling a house for a young kid when I first graduated collee in 1979 who was able to get back every dime he put into it, including payments. He had only lived there a couple of years and the appreciation paid the sales expense as well. He took the money and moved to Oklahoma to go to college.

In reading Steve Keen's recent stuff, it is clear we have a huge vaccuum under asset prices around the world. Cash balances might seem high, but we are talking around 1/2 the GDP, which falls under the old 6 months in liquid assets theory. It isn't the existence of cash that drives asset inflation, but the increase in it. What lies under this cash is a lot of bad assets, which will not only consume the capital of intermediaries, but cause the reduction in the money supply as well. There can't be any more cash than there is assets behind the cash and the mere liquidation of the bad collateral will serve to consume the excess.

So with housing we will reach the ultimate paradox, the low down payments that have supported housing and the need for security in lending that will eliminate the low down payments. As cash gets more dear, there will be even fewer people with even a low downpayment.

Housing Bubble Post 3 years afterwards

There is more coming, as the adjustment is going to go on for awhile. Here is an analysis I did at Prudent Bear in July 2007 that I found on a site in China.




There is bad information out there. It has people looking for a bottom when there is no bottom in sight. I don't think the prosperity of the USA suddenly went to such new heights that old data about new homes sales has become irrelevant. In fact, I believe that the prosperity of the average Joe has in fact declined over the past 20 years, 30 years and 40 years.



I wrote some on this Friday, as I was kind of stunned when I saw some posted links for data. Here is one that is official, at least as official as they get.



Official New home sales



There isn't a new paradigm, a new source of population or a new source of permanent prosperity. Then why is there a new source of wealth to purchase a significantly increased number of homes? This isn't a market where people are suddenly demanding and buying cracker boxes, where they are economizing and doing less actual building, but the opposite. Thus, we are looking at a demand curve that is to the extreme.



Priorto 1997, new home sales had topped 800,000 units twice, both in the1970's, 1977 and 1978. I was in college, but I worked in the residential business during the summer in the family office during that time. You couldn't list a house and keep a sign in the yard if the house was decent and the price was close to right during that time. Thus we had a national mania going on, where the average price nationwide was going up double digits. There was reason for the peak inthe late 1970's, as speculation for inflation hedges and the post war population boom were all coming together to shift demand for everything outward.



That is not the case today. Beginning in 1996, new home sales have been at least 757,000 units, a number topped only the 2times I mentioned above. This will be 12 straight years we have had new home sales that will be at a minimum among the top 14 years all time. Every year since 1998 beat the all time high established previous to1998. The depressed sales reported last month beat the all time prior to 1998 sales pace. Last year made 9 straight years where the pre bubble all time high in sales had been exceeded. There is no reason for it in any shape, form or fashion?



Why am I writing this? You might read this, then read on.



Market goes up on higher than expected new home sales, denver post



Here you see the annual sales pace reported in July is 820,000 on an annual basis. If you refer back to the government data, you find 820,000 units annually still exceeds the pre 1998 all time high. We have a market that is broken, not just a subprime crisis or a housing glut. You might see how the sales figures always went down when the market had problems in prior years. I mean it went down to the 450,000 to 600,000 range.There hasn't been this type adjustment at any time during the past 12 or so years. (no recession adjustment in supply)



Total sales in the 1970's was 6.552 million units. That is an annual average of 655,200 homes. The last time we saw a year that low as 1992. Remember, the 1970's was a houing boom era with skyrocketing wages and artificially low interest rates for most of the decade.(not to mention a huge new home buying population) From 1963 to 1969, there were 3.586 million units built.That averages out over the 7 years to 512,300 annually. The 1960's were the last really prosperous decade the US has seen in all facets of the economy. This is to demonstrate the sales in the 1970's were high and not low.



Now we might use the pent up demand argument for bad times in the 1980's. Can we? We might make an arugment for that, but the population trend in the 1980's was downward, not upward and the economy was bad the entire decade with high interest rates. Sales in the 1980's were 6,090,000 units for an annual average of 609,000, not that much less than the 1970's and far above the 1960's, a prosperous,low interest rate, under 4% unemployment decade.



What have we seen over the past 10 years? Well the data I have here doesn't bring us up to current, so I will use the last 10 years on this sheet then make some assumptions for the years from 2000-2006 for a 7 year average.



Taking the years 1995 to 2004, the ending 10 years of data on this report, I add it up to 9.041 million units sold. That is an annual sales rate of 904,100 homes. If you compare that to prior data, you find the 10 year average is in excess of any year prior to 1998, 1977's record sales of 819,000 units. The sales in the above report are also in excess of the 819,000 unit record prior to 1998. Total sales in this period exceeded the 1970's decade record by some 2,489,000 units. This is cutting the game off at 2004 and starting the count in 1995.



If I assumethat sales in 2005 and 2006 matched those of 2003, the sales for 7 years in the 2000's is 7.219 million units for an annual average of 1.031 million units annually. Now I think if I took the time, I wouldfind the sum of sales in 2005 and 2006 (combined) was greater than 2 times the sales in 2004, but this is for expedition of time. (not to be entirely accurate with exact figures. We know now the sales in 2005 and 2006 were record level)



The point here is the market continues to feed an excess supply at current prices. Maybe new home sales plummet or more likely the supply of pre-owned homes keeps spiraling upward. Eventually both occur and foreclosure numbers go through the roof.



I think there is a lot going on that not anyone is going to mention.(the people on CNBC are going to play blind). I think the Fed and Wall Street are riding this game as far as it can go, hoping something straightens it out while they aren't looking. I guess you could justify sales this high if it was merely population of the country projected outward, but the number of prosperous people in the US isn't increasing at anywhere this fast a pace. Maybe it is accounting for the abandoned homes in the midwest and other declining areas, but I doubt the decline in the rust belt is on any faster pace than it was during the 1980's.There is nothing to justify a sales rate 70% higher than the 1980's.This is 2007, not 1907 in the US.



The point here is that either sales drop to a level that I doubt the economy can stand up to or the problem gets worse. The problem isn't that sales aren't high enough on new homes. The problem is they are too high and they have been too high for a decade or more. At least they have been too high since 1996, which is now counting up to 12 straight years. Apparently, 2 million or so units too high if the economic history and prior demand are any good?



The bubble will have absolutely burst when you can't give a house away. It will be like dotcom. Problem is dotcom has come back, but we aren't seeing so much of the new supply in dotcom.Instead it is the few that made it plus Google for the most part and its inflation adjusted value I would venture is less than it was in 2000. I think we will find the same thing in housing come 2015. There are too many units out there and too many units being put out there to allow the market to clear itself.



http://blog.wenxuecity.com/archives.php?date=200708&blogID=22358

see about 20% down the page.

________________________________________________________________________________

I think the reader has to read between the lines of what I wrote here. It has turned out to be 100% accurate, as we are now stuck with massive supply and a market that cannot absorb even record low sales. History indicated that to 2007, the market constructed 3 million more homes than would normally be demanded. I date the housing bubble to the mid 1990's and Doug Noland wrote plenty on FNMA long before it because a problem noticed by most. So, out to 2007 we have a realistic market for 700K units a year and a industry that constructs 300K a year, we have a surplus that will take 7 years to absorb. This gives us 2014, provided nothing changes. Of course, we are going to hear on CNBS that there is going to be a housing shortage at any time now. They aren't counting on the shrinkage in demand that is going to come with a depression, fewer children, fewer illegal aliens, etc. I don't buy that demand should be higher in the 2000's by a significant number than the 1970's because the boomer generation was the rabbit through the snake and everything since has been mouse sized.



I have wondered where this was and I think it is pertinent to the HOA post because we are going to see the HOA stuff come to pieces as we go forward. We are also going to see the acts to restore demand fall by the wayside because real demand was never as high as what they are trying to restore. The US needs to cut its losses and get past this mess instead of following the advice of Bill Gross and other mortgage paper pimps.

Shiller stock data revisited.

I did a sizable study on historical pricing from data posted by Robert Shiller on his website at Yale. The market from 1991 on does not even belong in the mix of data, save the fact that it actually occurred. In this vein, there is no prior data to support owning stocks at the prices we have seen since and the data since 2000 proves this out. http://www.econ.yale.edu/~shiller/data.htm
That said, the data I have read over the years uses 2 base years, 1926, which was prior to the 1926-1929 bubble and 1950, which was the beginning of the post war bull market and had dividend yields at near record highs. To move the market merely to a normal yield would have meant a near immediate double.

The 1929 and 1966 peak in the SPX provided for 3% dividend yields on the broad SPX. The 29 market preceeded deflation and the 66 market preceeded about 20 years of high inflation, yet the peaks of each weren't permanently to date exceeded for near 25 years for the 29 market and about 15 for the 66 market, where the CPI more than doubled.

The dividend yield in March 2000 was 1.16% and dividends were 16.76. Dividends March 2010 were 21.91 and the yield was 1.90. I bring this up for 2 reasons. One is to show the most recent yield and the other to show what growth might have occurred from the top. Reducing this factor for a 10 year compound growth rate gives a growth rate of 5.06% added to the 1.16% dividend rate for a total return of 6.23. In order for that return to have actually occurred, the SPX would have to be priced currently at 2364. As we can see, this is a pipe dream price.

For the great unwashed, the above data tells me that if the dividend yield on the SPX was 6.23%  March 2000, the price today would be the same as it was in 2000.  I might note that the 10 year treasury yield was in this ballpark, so the performance on treasuries exceeded stocks.  There is a formula that used to be taught in finance schools when they taught finance that for stocks P=D/(k-g).  I believe the past 10 years is a better than average growth rate for 2 reasons.  One, that dividends were given preferrential tax treatment since 2002 and the other, that we were in a massive credit bubble, which in itself inflates cash flow to corporations.  Decades were dividends grow more than 1% more than inflation are the exception rather than the rule.  The official compound CPI for the 10 year period was 2.43%, so we had a real rate of return on stocks of 6.23% minus 2.43% or 3.8%.  In normal times, this is about what one would expect on a AAA bond, a far superior security to all but a handful of stocks. 
 
That given, if the performance of the last 10 years was to be expected, we would have a return of 1.90% plus  5.06%, or 6.96%.  This is hardly the 9% preached and being that inflation makes up 2.43% of the return, we have an expected real rate of return of 4.53%.  Plus, if we normalize stocks for what they really are, instruments with an open end life, one has to realize the return can't be compared to an instrument like the 10 year treasury, but instead to maybe a 50 year bond. 
 
The bulls will tell you that this doesn't count buybacks, but the SPX is adjusted for buybacks and the price return on holding stocks is still negative.  What they don't bring up is the stocks that go to zero and we have had some big ones since 2000.  AIG, FNM, FRE, WCOM, ENE, LEH, BS and GM to name a few.  Also, shareholders have lost an apparent 75% of Citi.  I must also note that buybacks have been used more to compensate management than to actually shrink the number of shares in the company. 
 
I will go farther.  Historical growth rates are much closer to 1% on real terms than 2.63% we saw over the past 10 years.  Credit bubbles don't go on forever and taxes on dividends can only be reduced a little.  If you take a 100 year sample on the Shiller data, it reveals a compound inflation rate of 3.14% and a dividend growth rate of 3.97%.  This gives us a real growth rate in the range of .83% and I believe we are at the end of a rapid real growth rate for dividends that has skewed this number upward. 
 
The buy and hold crowd will sell you diversification of the SPX.  Then we have the stock picker crowd, which on a small scale can occasionally beat the SPX, but long term the SPX gives a fairly strong sample of what the whole scale of stocks return.  Thus going back to the formula P=D/(k-g) we can add the numbers.  Lets take the 9% history claimed for stocks.  This would give us P=21.91/(.09-.04)  (I rounded 3.97% to 4% to give a simple example, which will actually slightly inflate the price).  This gives us a 20 times dividend multiple for the past 100 year average, so the proper long term price on the SPX should be 21.91 times 20 or 438.20.  
 
There can be a million and one arguments, the best probably relating to the massive amount of stock that has been repurchased over the past 10 years or the PE's, but stocks are based on long term yield, contrary to anything to the contrary.  Long term gains in stocks are largely inflation and really mean little.  PE's are fleeting and I believe based more on inflation than actual performance, not to forget the nonsense accounting that has been adopted over the past 20 years or so.  In 2003, the same analysis came up with a price estimate of 370, so the analysis is fairly stable, even if it missed the price by a long shot.  Remember, we are in a debt bubble and the next 10 years will likely be worse on a real basis than the past 10, 20, 30 or maybe 100 years.  Earnings on the SPX basically went to zero in the first quarter of 2009 and were only rescued by allowed accounting fraud, massive deficit spending and Ben Bernanke money manipulation.  Even if we threw in another 10 points for dividends due to stock buybacks, it would only increase the reasonable value on the index by 200 points to 638.20. 
 
I do believe Shiller has a reasonable valuation model in the PE/10 calculation for normal times.  At present we have seen dividends shrink from a peak of 28.85 in September 2008 to the current 21.91, thus the valuation of stocks is currently on a downtrend, not an uptrend.  This number as of March 2010 hasn't quit falling.  Earnings peaked at 84.92 in June 2007 and the worsening data since will soon reverse the earnings factor that goes into this function. 
 
There are 2 things that cannot be overlooked.  One is the fact we are in a credit bubble and the trend has apparently reversed.  This will serve over time to dry up money as time goes on and destroy not only the fodder for driving stock prices, but the material that makes earnings and dividends possible in the first place.  Despite the reported reversal in earnings, dividends have shown no hint of ceasing their decline.  The repercusions will be huge. 
 
In short, if stocks don't resume a long term trend upward, then we have massive problems in the area of retirement income in the form of 401K's and defined benefit pension pools.  My best guess is we are not likely to see a sustained price on stocks above the current 1075 for the next 10 years, which means the actuarial estimates for returns in pensions are going to prove excessive.  Maybe we get another bull, but we will eventually have to cross the bridge again as stocks will return to this price level and quite likely lower.  The Nikkei, a modern day marker of what will be seen in a deflated debt bubble resides now at 25% of its 1990 peak.  We are nearing the 21st anniversary of that peak.  Our peak was just short of 1600 and we are only 10 years into what is sure to be a long bear.  75% is just short of 400 on the SPX, which is reflected in my numbers above.  But, Japan has hit even lower prices in the interim and it has already tried the reflationary tactics that are being tried now in the US.  They didn't work there and I doubt they will work here.  The same problem is now here that trapped the Japanese, peak home prices which have now drained the equity out of housing necessary to sustain consumer spending and to some extent, fund retirement.  When it sinks into middle aged Americans that they can no longer depend on their homes to fund their spending and retirement and stocks to provide excessive teturns, we will see a permanent decline in spending for a good generation.  What created the stock bubble in the first place will be gone. 
 
Some will say that Asia will bail us out.  What isn't realized by most is the huge credit bubble already present n Asia, not to mention the low wages paid, which will never replace western demand for goods and commodities.  I highly doubt Asia can move their household incomes to a level that would replace western demand, not to mention the huge investment bubble demand already present.  Contrary to popular belief, the Fed is not printing money for the public at large, but replacing bank liquidity that can no longer be manufactured by financial innovation in the financial industry.  We are more at threat of that system breaking down than it gaining its legs and manufacturing a new steam of credit for expansion and consumer demand.  As we deflate, stock earnings will disappear like water on a noontime summer sidewalk in Phoenix.

The Monetary Game Still Means Deflation

John, I guess I am going to have to watch these. Things are starting to get crazy, as California is looking at ending welfare. Time to arm the citizens of California and open the borders so those getting aid can go back home maybe. Looks as if Arizona can't police its own borders, there is nothing left to do but cut off aid to all people getting it, lest it bankrupt the states. We have a president that is aiming at spending us to peonage to support those that are going to be holding the middle class of the US in peonage, namely the connected wealthy, by putting debt on our tab to send to those that really need it, but having the proceeds flow to those that hold the debts in the first place. We are clearly seeing a struggle for the survival of the US middle class in the midst of this transfer of future income.




In the meantime, I have recently read a couple of articles of interest. One is some very solid theory by Steve Keen, neo-keynesian economist of Australia, who seems to understand this mess as well as anyone out there, in an article dated January 31, 2009. http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/#comment-23918, Keen blows holes right through the theory being used by Ben Bernanke and finishes the article by saying "Having failed to understand the mechanism of money creation in a credit money world, and failed to understand how that mechanism goes into reverse during a financial crisis, neoclassical economics may end up doing what by accident what Marx failed to achieve by deliberate action, and bring capitalism to its knees". This is directed at Bernanke and what Marx called the Roving Caviliers of Credit.



On the contrary, Ambros Evans Pritchard has this article: http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7857595/RBS-tells-clients-to-prepare-for-monster-money-printing-by-the-Federal-Reserve.htmlIn it, he claims RBS is telling clients Bernanke is about to double the QE to $5 trillion. If you read Keen, you will realize that Bernanke is hastening deflation, while at the same time filling the banks with money to speculate on the stock market and other stuff. One of the problems in Japan has been the banks are stuck in the stock market and can't liquidate to get back into the game of lending. Also, the US bubble was so large that the excess demand created by credit was 30% of GDP and roughly 22% of aggregate demand. Bernanke is ignorant of the fact that the Fed did in the early 30's what he accuses them of not doing and it did no good, because fiat money has very little to do with money in general in the US and instead the credit inside the banking system is the game. Of course, the procedure of buying debt with money isn't any different in general than a bank buying the same debt with money. As you have said in the GD mold, the PTB are going to go over the falls in a barrel to attempt to keep their errors of the past from being laid bare.



Here is a link to a Bank of International Settlement study dated March 2009. Much of it is beyond my comprehension, but the gist of the study is pretty easy to understand, "that there isnt' enough dollars in the world to satisfy the liabilities of international lenders. This clues me into the idea that Bernanke actually bought securities off European banks to solve the big problem funding these liabilities. You might recall all the talk about the TED spread when the mess was really hot. In this article it is pretty easy to see how big a mess this $31 trillion ball of wax is and probably how big a part the failure of Lehman had in depriving the market of all the derivative fake money that is assumed to be out there through these trades. http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf



All this adds up to why this is such an impossible situation and why we are going to see a crash. Ones attention has to move from the idea of money to the idea of liabilities in general. I read an interesting writing by a guy named Lysander Spooner, who lived up in your area back in the 1800's. Of all the things I have read about money, this is one of the more eye opening ideas I have read. I had written over and over again that "This Note is Legal Tender, for all Debts, Public and Private" was the essense of the US currency and what gave it value. Whereas I had argued deflation online for the past 9 years with a bunch of gold bugs, I would bring this phrase up in my writings. It was my understanding that what would cause deflation was the shortage of money, created out of debt itself, to satisfy contracts. As borrowing ran its course, we would be left with contractural liabilities that couldn't be paid once the supply of credit slowed. http://lysanderspooner.org/node/20



Here is the key paragraph of what I believe to be one of the great intellectual pieces ever written on American money: "But it will be said that Congress are authorized “to coin money, and regulate the value thereof, and of foreign coins.” This is true-but its obvious meaning is, that Congress shall fix the value of each kind or piece of coin, relatively with the other kinds or pieces, - that they shall, for instance, decide what weight and fineness in a silver coin, shall con­stitute it equal in value to a gold coin of a certain weight and fineness. It means that they shall have power to declare that a dollar of silver shall be equal in value to a dollar of gold, and that they shall decide what weight and fineness of each of these metals shall constitute the dollar, or unit of reference. Congress, then, have power to fix the val­ue of the different coins, relatively with each other - or to make them, respectively, standards of each other’s value. But they have no power to make them “standards of the value” of anything else, than each other - or to fix their value relatively with anything, but each other. Nobody will pretend that Congress have power to fix the value of coin relatively with wheat, oats or hay-that they have power to say that a dollar shall be equal in value to a bushel, a peck, or even a pint, of wheat or oats. And it is only in the single case of a “tender in payment of debts,” that the legal value of the coins, relatively with each other, can be set up. In all other cases individuals are at perfect liberty to give more or less for any one of the coins than they would for any others of the same legal value."



Spooner later became an early anarchist, as he recognized the corruption of organized government and how it set up favorites in the economy and despite the constitution, passed laws to the contrary. The nature of the piece was "The Constitution of the United States, (Art. 1, Sec. 10,) declares that “No State shall pass any law impairing the obligation of contracts.”" In it, he also said that gold and silver were commodities and that their value fluctuated and were no more stable than the other commodities out there. Thus, with India and China and their roughly 2.5 billion or so people between them having a desire to wear gold rings and other jewelry, there is a high demand to melt down gold and make jewelry. India has historically been a hoarder of silver. They also have their own debt bubble, as does China. Demand around the world is being financed by credit that has a limit. We are certain to see the end of this run soon, to be followed by a collapse in demand for all commodities and a liquidation of positions in these metals due to weak markets. In the meantime, tender for payments of debt, debts to banks and debts owed by banks (both sides of the ledger are liabilies, but the liabilities of the banks are of stated amount, while the value of their assets are not stable) become harder to satisfy.



I think these 4 links put together the idea of what we are looking at, as the entire idea behind the establishment solution to this problem, one that has already failed in Japan, is going to fail. This is going to be a conflict that literally rips the world apart, as maybe China can't collect from the US, as people opposed to the welfare state begin to realize their own pensions, 401K's, bonds and other assets can't be saved. I have thought this situation over and over and the only thing I can see that would work is a declared bankruptcy for everyone that would result in a lower price structure, a legal liquidation of debt and at least some portion of all assets being saved to allow for some kind of retirement. Otherwise I think it could all go up in thin air, the last being the currency, should the various governments survive. We have the making of civil and international strife that few can comprehend and little willingness to make adjustments to shorten the disaster that is certain to come.

Double or Nothing

I wrote this post in 3 pieces on Mish Shedlocks Blog. http://globaleconomicanalysis.blogspot.com/2010/06/europe-slams-obamas-stimulus-plan.htmlMish is a daily read for me and a brilliant writer. Needless to say, I agree with about 80% of his reasoning, but I do disagree in part. This current economic collapse is one of paradoxes and I believe one that is going to need some real maneuvering by government to not turn into a total collapse. What government is doing at the present in the US is courting disaster. It is nothing less than what was done in Japan, which has lead to a near destruction of their economy in a time when the world at large had sustained sizable growth. There was a reluctance to call a spade a spade and declare much of the financial system in Japan insolvent. Debt could have been wiped out in bankruptcy, the losses taken and the economy started anew, while the US was inflating a huge debt bubble of its own. There isn't a country that can counterbalance the US deflating and it appears Europe is joining the US in this deflation, while China, Australia, Canada and a few others have created their own deb bubbles. I believe I covered some good bases in this series of posts (series because the software at Mish's doesn't accomodate my novels), though I didn't go into detail. In short, I fell we need a plan, not a plan to throw money at the problem, but a plan to clear out the debt, take the losses and in the meantime buy time. The governments of the world are trying to spend us to prosperity and that isn't going to work, as it will destroy the private sector, where all the ideas that work are. But, I believe government could buy some time and it is clear we are looking at economic disaster of epic proportions which will need assistance, else hundreds of thousands or even millions starve in countries where starvation is currently almost non-existant. The situation is so paradoxical that very few understand it. Here is the post.

“I am amazed how little vision most involved have in what causes depressions. Even the guys I read like Mish and Denninger get off track and to say I don't get off track myself would be a lie. The entire matter is so paradoxical that no party is 100% wrong and I doubt any are more then 75% right. I even read where Robert Prechter said that banks had loaned out every penny of deposits, which is in fact true, but only in the reverse, as all deposits are created by lending this day and time. The problem is they have loaned more than deposits and since deposits and currency is all the money there is in the system, as liquid assets, the excess over deposits can't be collected.

In a commercial banking system, all growth that is measured by the nonsense measurements they call GDP is created out of new debt. Absent new debt to create new money, the compound interest equattion swallows itself. With this action, the market value of all marginal assets goes in the tank and with it the credit for these outfits to exist. GM blew a fuse in a hurry. So did some outfits that didn't appear on the face to be marginal and now the countries that are marginal are blowing fuses as well.

Krugman can make his case because he fails to see that the stimulus doesn't fix anything, but is more akin to putting makeup on skin cancer. The cancer is still there, but it is covered up. The fallacy is the cancer is gone and comes back with the removal of the makeup, but if you keep the makeup on long enough, the patient still dies.

Great care has been used to cover up the fact that the problem revolves around debt. Why is it the Rockefeller controlled education system failed to teach anything about debt in the field of economics? The U of Chicago was JDR's baby and who should arise out of this outfit but Samuelson and Friedman? Both of these lines of reasoning run down the line of give the patient another drink and his hangover will go away. They fail to recognize that the organs inside will continue to rot.

The current system is more akin to the gambling game where the loser gets to go double or nothing until he wins. Except only 1 loser gets to do this, while the other pays up. How do we up the ante and go double or nothing again? In the case of the banks, they are insolvent and can't really produce the money to pay the depositors. In the case of the borrowers, they can't pay the banks, because the banks can't produce the money. Both of these outfits are being supported at the expense or benefit, which there are 2 sides of this equation of the depositors and other holders of financial assets. The game of double or nothing has to go on or everyone loses, as the losers of the bets, the debtors can't pay and the creditors can ride on as long as the pretense is they can pay.

The best we can do is buy time and that is what stimulus does. But, stimulus can't be the plan and neither can the actions of the Fed, because the plan leads to more debt and more pretend double or nothing. Anyone who has ever done double or nothing on a bet knows it was done because the loser couldn't pay in the first place after the second or third loss. The problem here is the loser isn't ever going to win to clear the debt.

There are too many things that the establishment needs to happen which can't. One is that prices remain high. We are looking at a pension system that is based on the stock market. Pull out the stimulus and the numbers attached to stocks goes down and with it the pension model collapses. Manufacturers and retailers need price supports to maintain profits, banks need additional credit to keep the system at least appearing to be solvent. The counter side of this is if the debt is reduced, prices go down, not up. Also, the backbone of the political and monetary structures go away.

The Goldman report is flawed as well, not because it can't be true, but because what they studied has never been done at the end of a bubble. Never as in their history. What this tells me is Goldman has probably already set up a trade to make a killing out of a collapse, as I have not read where they put out an honest report to the public for nothing. Again, I am not supporting stimulus, because at this point it is at best rearranging the chairs on the deck of a sinking ship. I would venture that private credit has always pulled the economy out of a spin and the result has been more government revenues and falling expenses related to recession

The point of all of this is what is the final solution. Regardless of the flaws of government stimulus and monetary policy, the question arises as to how we collapse and survive? I happen to believe that the history of keynesian and monetarism solutions has placed us on this edge of disaster where we sit today. The plan has to have an exit that doesn't contain the delusion we are going to have a normal recovery. We won't and it won't be because they quit doing the flawed ideas taught in the Chicago school. It will be because it is just time for a depression. The only way we go forward is if China raises wages 1000% and we give Chinese consumers credit cards and thus collateralize the future earnings of a billion new people. Even then, it would be necessary for the rest of the world to reduce their debt by a corresponding amount. This isn't going to happen, because the compound interest equation won't allow it.

It is hard to get new debt out there when the people with brains know there is going to be a haircut against cash. If people understood that failing to take the tax credit for buying a house would allow them to buy the same house maybe $20,000 cheaper in 2 years, while taking the credit puts them in debt by a like amount, the tax credit would have never been utillized. But, the asset bubble is the end game of a debt bubble that has lost its capacity to drive commodity and labor prices, because so much of the new debt is geared, not to consumption as assumed, but toward servicing the compound interest equation itself. This system of double or nothing cannot amount to a real gain, only the delusion one is going to collect what they already own and the other person cannot pay.

The real solution is that FNMA paper is worth maybe 50 cents on the dollar. The stock market is maybe worth a dime on the dollar. I am using these 2 as examples for the broad field of assets. This shows the real depth of the problem, as those in favor of austerity might change their minds when they see their pensions, their financial holdings, the price of their homes and other things go down the drain. They fail to see that collecting on these assets at anywhere near par is impossible, but they are going to insist government make an effort. Most have already compounded double or nothing several times and spent the change. But, remember the debtors can't pay

So, Pension fund yields going to be 8%?

I got on this subject the last time around the tub in 2003. I read a lot, saw the projections then and did a total compound analysis on the data on the market Robert Shiller posts on his site monthly. http://www.econ.yale.edu/~shiller/data.htm . This could get really long, so I might move it to my blog.

Firat of all, I believe the Fed at that time estimated underfunding at $400 billion, but underfunding was marked at 90% of full funding and the use of actuarial returns of 8% to 9%. I believe 10 year treasuries were in the 4% range at the time, so any assumption of returns 4% to 5% over risk free would in itself be on shaky ground. I might add that it is difficult for the true, sustainable monetary base to grow in excess of risk free rates, which adds fuel to the fire.

To demonstrate the truth revealed in Shillers data, one must suspend from the nonsense about growth fundementals and get down to real facts. The first proposition, contrary to argument, is that the stock market is nothing more than a discount of a future stream of income known as dividends. Earnings is about nonsense, timing of losses, control fraud and other matters, but the dividend check goes in the bank. One could propose the companies have a salvage value, but once a company goes broke, shareholders are generally wiped out. That idea is for bond holders.

To make matters simple, I am going to use a 40 year holding period, March 1970 to March 2010. This will eliminate some noise, even though valuations are inflated today. To equate the matter, one has to either adjust the price in 1970 upward to reflect the current dividend rate or adjust the most recent downward. Many of you will wonder why, because it has been preached that dividends don't matter, only capital gains matter. This is nonsense, because the company's profits have to be liquidated in some fashion and without dividends over time, the company has no financial value.

Through careful though, I have deduced that the dividend is the basis of growth over time, thus has little present relation to inflation or anything else, including growth prospects. The market can't see 40 years, only what the current mania or downturn reflects. Inflation and the risk premium is reflected in the growth rate, so we could have a relatively low dividend and higher inflation or a high dividend and low inflation. History of these prices have provided us with both situations. IN any case, I am going to make the price of the 1970 market equal the value of what the dividend yield is now on the dividend of 1970. Then I am going to find the 40 year inflation rate based on the CPI and adjust the 1970 price up to today CPI. The division of the current price by the 1970 price should provide the compounded factor of growth over inflation. This should provide 3 rates, the inflation rate, the real growth rate and the dividend rate. The dividend rate will be what the current yield is. An easier way to do this and probably more accurate as well, as adding the compound inflation factor and the compound real growth factor will overstate the return slightly.

The price of the SPX in March 1970 was 88.65, the CPI was 38.20 and the dividend was 3.17. That gives us a dividend yield of 3.58%. The March 2010 SPX price was 1152.05, the CPI 217.63 and the dividend 21.91. This gives us a dividend yield of 1.902%. To adjust the 1970 price to current valuation would require the division of 3.17 by .01902, which gives a yield adjusted price of 166.68. I could do the reverse and divide the current dividend by the yield 40 years ago, which would provide a current price of 612.01. You might note this price is below the bottom price of 666 and I might add that a price that provides a 3.58% yield has been historically a high price to boot.

The CPI factor is 217.63/38.20. This equals 5.697, meaning it takes $5.70 to make a 1970 dollar. If I take the yield adjusted price of the SPX from 1970, 166.68 and adjust by the CPI, the current back inflation/dividend adjusted price from 1970 would be 949.59. This would be the current price if everything merely followed inflation. By being in the stock market from 1970 using the current dividend yield you would have made a compound 1158.05/949.59 or 1.2132 times your original investment. Subtracting 1, we have a total real growth in dividends of 21.95% over 40 years. I won't get exact in the compound factor, but simple math of 21.32% divided by 40 years gives us roughly 1/2%.

One might wonder, why the practice. What this series of calculations reveal is the real long term return on stocks is dividends plus inflation plus around 1/2%. Without going into the math directly I will add that I developed a longer term model, I believe from the January 1926 base that so many academic studies use. It it, I deduced that dividend plus real growth should equal around 6%. This would give the 9% return so talked about when adding a 3% inflation rate. As one might be able to see, real growth has fallen short of that model and if we adjusted the stock market to reflect 6% growth plus dividends, we would arrive at a price of 21.91/.055 or 398.36. Though this sounds shocking, an adjustment of stock prices to this model is 100% sure to happen at sometime in the next 10 years and the only factor is going to be what the CPI factor is at the time.

So, what have stocks, under this model made over the past 40 years? 1.902% plus (1152.05/166.68)^1/40. I will make an estimate on the 40 year factor of 6.91174. Dividing this number by 1.0495 forty times gives 1.00066 making the after inflation return 4.95%. This gives an adjusted 40 year return on the SPX of 6.852%. I might add the inflation rate or the 40 year factor for 5.697. This is somewhere between 4.44% and 4.45%, meaning we are looking at a long term yield adjusted return in stocks of inflation plus 1.902% plus 1/2%. For anyone who has ever studied finance, you know the risk free return is 3% and we are looking at stock returns in the 2.4% range. The theoretical return on treasuries has beaten stocks.

What this tells me is we aren't looking at 8% returns out of the market, but something on the order of inflation plus 2.4%. This would be fact if we are going to get a long term inflation rate of 5.6%, but can anyone fathom financing the pile of debt in the US or for that matter, the dollar denominated debt around the world at 10%? We are more likely to adjust downward to somewhere between the 391 I mentioned and the low 600's on the SPX. That is if the credit system holds up.

Do the Depositors Own the Banks?

All the money is all the money. The money in the US is nothing more than the base of collectable assets in the banking system. It isn't the money printed by the Fed or any of that stuff we seem to be told, but this base of collectable assets. The limitation is the amount of money in the accounts cannot be more than the collectable assets on the balance sheet and visa versa, though the imbalance can exist for awhile in the direction that the collectable assets can exceed the money supply, but that the difference is what is perceived as bank capital. Thus bank capital is the collectable assets of the bank or banking system minus the deposit liabilities. If the banks collectable assets are less than the deposit liabilities, the capital has to lie in the deposits and not in the capital accounts of the banks.

The current attempts we are experiencing are to deny this fact and through time and slight of hand, convert the deposit liabilities into bank assets. Thus, we are having government issue plenty of debt which can only be paid by bank deposits, which when bought by banks through government slight of hand serve over a period of time to make the depositors liable to the banks. The purpose of the Fed isn't to give you and I money, but to redeem or liquidy bank assets so the banks can pay each other and for the minimal purposes of you and I having $100 bills we can draw from the banking system as liquidated settlement of our accounts in whole or in part. Even this is limited, as the government always wants to know where you got more than a few thousand dollars.

Everyone is going to have to take a haircut. The question is how large. It appears to me the bankers are getting an opportunity to lessen their haircut while transferring the haircut to their depositors. See, so much of the money in accounts at this time is defacto bank capital, as the truth of the matter is money in accounts does not belong to the insolvents that owe the banking system and thus the debts cannot be paid. The amount of non-self liquidating debt has reached the point beyond critical and the capacity to create new debt at a pace that would result in distribution of money wide enough to current bankrupts to float the system forward. Thus bank capital is in essense wiped out and banks are like Zombies in the "Night of the Walking Dead".

Where does money come from to recapitalize insolvent banks? It can only come from the deposits in the banks. It could come from the government, but if the government securities were matched with money in accounts, it would do nothing to increase bank net worth on a current basis. If it didn't come with deposit liabilities, it would merely widen the gulf between what is owed and what can be paid.

The TARP plan was at least a reasonable idea as to how to solve this problem. Short of closing the banks and making all the deposits good, this was really about all the government could do. How it was administered was a problem, in that Paulson forced all the big banks to take the money to hide which ones were really in trouble. Only a headless idiot couldn't figure out that BAC and Citi were in deep shit by mid 2007 if they only read the quarterly reports, so why the deception? Were they all broke and Paulson wanted to hide that? TARP didn't work because the banks wanted to get back to gambling and Tim "I have never been a regulator as head of the NY Fed" Geithner gave them back their I have money to spin the wheel card through allowing accounting fraud. Now banks are playing poker in an effort to strip as much of the deposit liabilities from their balance sheets as possible.

See, there are only 2 monies involved, bank capital and deposit liabilities and the 2 together cannot exceed the sum of bank assets. If the bank liabilities exceed the real value of bank assets, the bankers have no money and are in essense gambling with the money of their depositors, who are the real owners of all the assets of the bank, including the property that cannot be redeemed through payment. This is important because is really goes to who controls the country and to some extent commerce around the world. Is it going to be us prudent idiots who still have money left or the idiots that gambled and lost in an attempt to earn huge bonus checks and drive up stock prices?

My guess is that if they would close the banks that need to be closed, which is probably most of them, give the depositors a 50% haircut and a prorata ownership in the bank and all the assets, this would be a start to a solution. Most of the depositors wouldn't like it and I believe those that owed the bank money could be given a wash between their deposits and loans to start, but the current game is the bankers are looting the depositors and the game is getting worse, not better. Remember the guys that ran this system into the ground are still running it.

That would be the first step. The outside the banking game is going to take a haircut as well. The biggest danger is that the resulting drop in bank deposits would be a blow to the system, but then again, the banking system would have the room to take a haircut and those that needed money could sell their stock to those that don't. The people with no money and no credit are no longer part of the demand equation anyhow, other than their current earning capacity. Prices would surely drop, but as debt was liquidated, the price declines would eventually not affect debt.

The solutions I have presented are off the cuff. Remember that all the money is all the money and those that have the money are the only ones that can pay. Thus if the government incurs debts (giving government debt to bankers is unconscionable in that it is conversion of their depositors money to their money), those debts can only be paid at anything other than deceit by the money in the system. The question here is who owns the banks and I contend that in more cases than are being admitted, it is the depositors capital that is at risk. Remember what I just wrote that all the money is all the money and the depositors will be liable for the costs of their bailouts.

Bubble Blowing Started with Greenspan and the GSE's

I posted this in response to a very good article put on the market ticker website by Karl Denninger about Clinton trying to redefine his actions in regard to financial deregulation. My point was that even though the result was disaster, by November 1999, it was already clear that the system was going to need even more money creation and financial products to keep the game going and this was going to bring another bowl of punch to the party.


I hate to disagree with some of the points in what is a fastastic writing, but by November 1999, the bubble was hopelessly inflated. The backbone of the bubble wasn't the repeal, but the GSE's FNM, FRE and Sallie Mae. The repeal only brought the crooks into the same room.

There is one thing that creates a bubble, the creation of money. Doug Noland started his Credit Bubble Bulletin around 2000 and repeatedly he went through the 1990's history of FNM and FRE pumping huge amounts of credit into the system every time the economy sneezed. Greenie had his place, but the creation of credit off collateral goes back to John Law and the Mississippi bubble. Each cycle produced more of a bang and Rubin along with Greenspan did everything they could to keep the game going.

Debt in the US has been to the point it could cause a depression for a long time, probably since the early 1990's at the latest. Greenspan did what he had to do at the time, which was ease credit excessively and create the new collateral. Except for a few days in March 1987, mortgage rates had not been down to 9% since 1978 and had resided in the 10% or higher level for over a decade. I opened a 1 man mortgage shop in 1992 to do refinances and was at least a year late. The whole country refinanced and gained immediate access to more credit. Cap rates came down and it ignited a stock market boom which money started chasing. The most marketable paper in the world, save US treasuries was FNMA and FHLMC mortgage pools.

One thing about depressions is when one starts, it is like being seen coming out of a building where a crime has occurred. You become the immediate suspect and politicians get deserved and undeserved credit for booms and busts. By 1998, anyone with economic brains knew they would need more credit to stave off a collapse from the dotbomb bubble and the huge public participtation in the market. The market participation had reached all the way into the pension funds, private and public. The entire game became keeping the bubble inflated. The repeal was merely one more step to avoid being placed at the scene of the crime.

I really don't believe many people at that time realized how crooked Wall Street was. I used to joke in front of others that when Wall Street gave a strong buy on a stock, it meant they still had some left. I knew the whole game was nonsense, in part because I have a financial education. Being Wall Street controls so much of what is taught in college, almost no one had an education on why we had Glass-Stegal in the first place. I believe in part this was due to the fact that few alive had experienced a bank run because of the false security placed on deposit insurance. People thought all this bull market was based on reality and party on and let us all get rich.

The people that did know were Summers (nephew of Paul Samuelson and son of the head of the Princeton school of economics), Robert Rubin, Sandy Weill and his student, Jamie Dimon. Under the guise of deposit insurance (Securities insurance as well)and the lack of experience in runs on banks the public didn't have enough sense to know the difference. Efficient use of credit seemed to be the name of the game, but in reality, it was how to blow a bigger bubble to keep the fake prosperity going.

By early 2001, the system was pretty much insolvent. In comes Greenspan with the means to create another bubble and Bush with tax cuts to give the stimulus. What continued was the mortgage game, a new low rate mortgage interest to give the game another dose of debt relief. Again, it was the FNM/FRE brand name, along with another bubble blower, Franklin Raines. Along comes Armando Falcon of the OFHEO in an attempt to stuff the genie back in the bottle. You can go to youtube and see videos of the attacks the Democratic black caucus launched against this man, an appointee of Bill Clinton, I am sure at the urging of Mr. Raines himself. You would have thought this man was attacking someones mother, but he was really telling the truth. In any case, this was the primary attempt to stem the mortgage bubble. At the same time, it was probably this investigation that opened the door for Wall Street and their private label game.

Now what is the game? Recently some idiot Ivy League professor recommended young people buy stock on margin. Why? They need cash to pump the next bubble. The whole series of crap in this mess has to do with what is going to be the next collateral for the next credit expansion. If this rally goes on much longer, I can see a relaxation of margin requirements on call money. The government desperately needs another money machine outside of deficit spending to keep the game going. The pension systems are bankrupt and have no hope of being funded unless the game goes on. The biggest scandals center around the fictions about owning stocks, financial instruments that have actually not done much better than inflation when valued according to dividend payout. As I have seen Karl point out, risk has a way of catching up with excess return. As long as they can inflate, the truth can be hidden. Once deflation becomes the irresistable urge, there will be a lot of models swimming naked.

Class warfare

About a month ago I was almost kicked off a site because I recommended higher taxes on the rich in order to recycle the interest debt they were receiving through the economy in an effort to assist in paying down debt. I was cited as proposing class warfare as a solution. The warfare started long ago.

The idea that the general fund be used to bail out the bad collateral amassed by the NY banking group of millionaires and billionaires is class warfare in itself. The fact of the matter is that amassing more debt in any form in the current economic environment without a plan to reduce the massive pile that is strangling the economy into depression, therefore bailing out billionaires from their failed enterprise under the threat they are going to plunge us in depression is warfare. It is being waged and it isn't that all parties deserve a handout, because none do.

The US Constitution endowed Congress with the power to coin money and regulate the value thereof, but it has been ceeded to the Federal Reserve and its organized crime group of Wall Street enterprise. Organized crime always operates through the government and in this case we aren't talking about back ally thugs, but Ivy League, conected MBA's and other elite. Granting a private enterprise the privilege to create money is in itself illegal. To bail them out of their failed enterprise is also Anti American and likely Unconstitutional as well. A failed surety is a failed business and those running the game have failed. But, it appears that failure is only for small business and those who got themselves over their heads in debt. I propose that the very problem that was bailed out was those thought of as highly successful and clearly highly compensated commited themselves to debts they couldn't pay. They should have been bankrupted and investigated for criminal activity instead of being bailed out.

To have any understanding as to how this mess can be solved is to understand the nature of debt and credit to start. Michael Hudson of the University of Missouri, KC comes as close to describing what is going on as anyone I have read. His writings can be found at http://www.neweconomicperspectives.blogspot.com/ and http://michael-hudson.com/ . Mr. Hudson understands that non-self liquidating debt cannot be paid and that is has to be systematically eliminated, losses taken and the economy cleaned out. Savings and debt are mirrors of each other.

The equation most of us are familiar with is the compound interest formula. Hudson and Steve Keen both make note that the equation has historically collapsed, but our government and Wall Street is trying to reflate to continue their compound debt peonage on the American economy. Problem is the general population and the borrower on the fringe has broken down and demand for the general economy can only be financed by more debt or by bankruptcy. The losses should be taken, but instead they are bailed out, keeping the rich rich and the middle class in sinking poverty.

In banking, principal is created, put into an account and paid back with interest. The banker keeps this cycle in motion by reloaning his interest after extracting his income. Once a debt bubble has begun, it is dependent on enough rents being collected to pay the note and for the banker to continue to expand debt and inflate values. Once there is more interest and payment due than there is rent, the game begins to crumble. No equity, no loan, no security, bankruptcy.

Wall Street created this mess, paid themselves massive bonuses and went broke. Much of this money was earned financing and packaging fraudulent securities. It is almost assured that many involved knew they were packaging and peddling fraudulent paper, but they continued well after the gig was clearly up. Together with return seeking hedge funds and fraudulent ratings given by S&P, Moodys and others, the game went on beyond where it could have earlier. Wall street was broke and Wall Street was bailed out instead of being liquidated. Legitimate players on the street had plenty of money to recapitalize their own firms, but instead the firms were propped and bailed out by the government. Many of their borrowers are also being bailed out, not to their benefit, but to the benefit of the bankers in continued payment instead of bad debt allowances.

Better yet, the game continues. Wall Street and banks paid out well over $100 billion in bonuses this past year. The bill for the taxpayer will probably exceed the balances on all the mortgages that were in existance when this mess started. People are losing their homes, but Wall Street isn't writing down the loans or impairing their own capital. Instead they are looting the system as it is in slow collapse. The US is probably done as a major economic power now that the entire purpose of the system is to provide income for a few super wealthy families. In the end, the goose that laid the golden egg will have died and even the rich won't be so rich. But, the management of Goldman Sachs and others can't see past the tip of their nose. Most that need to will take flight to greener pastures, but modern economy will be in shambles.

To revive the goose, we are going to need to extinguish the goose poison, the excessive debt load on the working class. The only way I know to extinguish debt is to quit creating it to start, take much of the earnings from it away from those that have the bulk of ownership in it and pay it to the general population where they can then pay it to those that hold the debts and keep the system solvent. Otherwise, if we are going to end up with a poor middle class, then the rest is going with it and all will end up being much poorer.

Saving, Asset-Price Inflation, and Debt-Induced Deflation

I found this posted on a site from China. Dr. Hudson is a guy I am attempting to study closely, as it appears he has been onto many of the big time flaws in credit economies for decades. This is Michael Hudsons site. For those interested in learning more about what is happening and what we must do to save the US economy from ruin, it is well worth studying.

http://michael-hudson.com/

by Dr. Michael Hudson

Michael Hudson’s book Super Imperialism - New Edition: The Origin and Fundamentals of U.S. World Dominance is a critique of how the United States exploited foreign economies through IMF and World Bank. Other books by Dr. Hudson include The Myth of Aid (Orbis Books); Global Fracture: The New International Economic Order (Harper & Row)

As an advisor to the White House, State Dept. and Defense Department at the Hudson Institute, and subsequently to the United Nations Institute for Training and Research (UNITAR), he became one of the best known specialists in international finance. He also has consulted for the governments of Canada, Mexico and Russia. (Dr. Hudson's bio is continued at the end of this article.)

Summary

The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers.

Financial institutions re-lend their interest and other financial inflows as new loans to finance asset purchases. The result is that net savings do not increase for the economy as a whole. Meanwhile, lending out savings helps bid up asset prices, but does not necessarily promote new tangible investment and employment or increase real wages and commodity prices. In fact, new tangible investment and employment decline as investors find it easier to obtain price gains in stocks, bonds and real estate than to make profits by investing in factories and other tangible means of production. The effect is to divert savings and credit away from financing new direct investment, and hence from employing labor to produce more output.

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The growth of net worth through capital gains

The cumulative volume of savings also grows through a dynamic that Keynes had little reason to analyze in the 1930s: capital gains. Property and financial securities tend to appreciate in price over time. The main cause of this price appreciation is that the physical volume of assets grows slowly, while the financial volume of loanable funds grows exponentially.

Let us return for a moment to Richard Price’s example of a penny saved at the time of Jesus being worth a sphere of gold extending from the sun out to Jupiter. Few investors buy gold, as it does not yield an income. The largest investment – and the most heavily debt-financed asset these days – is land. More credit does not expand the volume of land, which is fixed, but it does raise its market price. A rising volume of savings is channeled to buy a fixed supply of land. The financial system thus creates capital gains as the finite volume of property and supply of buildings and financial securities expands more slowly than the potentially infinite volume of loanable funds.

Keynes did not anticipate that savings would be channeled in a way that bid up asset prices for securities and property without funding tangible capital formation. In the 1930s net worth was built up mainly by saving, not by asset-price inflation such as is occurring today. In traditional Keynesian terms, revenue or credit spent on buying property in place represented hoarding, not investment.

Homeowners and investors imagine themselves growing richer as prices rise for their assets. Their net worth rises without their having to save. However, this rise tends to require more income set aside to pay debt service on the loans taken out to buy their property. Credit lent out in this way does not increase consumption and direct investment. It creates debts whose carrying charges shrink markets. Savings and debts rise together, so that there is no increase in net saving.

New saving does occur as financial institutions recycle the receipts of debt service into new loans, whose carrying charges absorb yet more future income. The result is that gross savings (and hence, indebtedness) rise relative to national income. Stated another way, saving for many homeowners takes the form of paying off their mortgages. This is not the same thing as hoarding (in Keynes’s sense), but it plays much the same function, as it is not available for spending on current output.

As savings rise and are lent out, debt service absorbs more income. But the net economic surplus available to service these savings – by paying interest and dividends on the debts and securities in which they are invested – tends not to keep pace with their stipulated debt service. This debt problem therefore plays the deflationary economic role that Keynes attributed to savings.

How asset-price inflation aggravates economic polarization

Keynes favored inflation as eroding the burden of debt. Calling for “euthanasia of the rentier,” he saw inflation as the line of least political resistance to wiping out the economy’s debt burden. His idea was that inflation would leave more income available for consumption and for new direct investment. But asset-price inflation works in a different way. Instead of eroding the purchasing power of wealth relative to commodities and labor, it increases property prices without increasing consumer prices or wages. At least this has been the pattern since 1980. Wealth disparities have increased even more than have disparities among income brackets. The net worth for the wealthiest 10 or 20 percent of the population has soared, while the rest of the economy has fallen more deeply into debt and many of its gains have turned out to be short-term.

Keynes recognized that rich and poor income and wealth brackets had differing marginal propensities to save. But today’s financial polarization has gone beyond anything he anticipated, or what anyone else anticipated back in the 1930s, or for that matter even in the 1950s.

Long before the General Theory, economists recognized that wealthy people did not expand their consumption in keeping with their income growth. The image of widows and orphans living off their interest was relevant only for a small part of the economy. Rentiers always have tended to save their income and reinvest it in the financial and property markets. This occurs also with savings deposits, which banks lend out or invest directly in financial securities. Most of the interest and dividends credited to savers thus is left to grow by being lent out or plowed back into indirect securities and property investment, increasing asset prices.

The ability to get an easy ride from the resulting asset-price inflation – coupled with an easy access to credit and favorable tax treatment – prompts investors to take their returns in the form of capital gains rather than current income. In real estate, the economy’s largest sector, property owners use their rental income to pay interest on the credit borrowed to buy properties, leaving no taxable earnings at all. The same phenomenon characterizes the corporate sector, where equity has been retired for bonds and bank loans since 1980. Ambitious CEOs, managers of privatized public enterprises and corporate raiders have bought entire companies with debt-financed leveraged buyouts. Interest charges have absorbed corporate earnings, leaving little remaining for new capital investment. The name of the game has become capital gains, which have been spurred more by downsizing and outsourcing than by new corporate hiring.

Prices for property, stock, and bonds have soared relative to wages, forcing home buyers to spend a rising multiple of their annual incomes to buy housing. Also rising has been the cost of acquiring companies relative to corporate profits as price/earnings ratios increase.

Capital gains make the inequality of wealth and property more extreme than income inequality. The wealthiest layer of the population derives its power from capital gains, while using its income to pay interest – as long as interest rates are less than the rate of asset-price inflation. The ratio of wealth and property has risen relative to the value of goods and services, wages and profits, while the debt overhead has grown proportionally.

Does asset-price inflation “crowd out” new direct investment?

The FIRE sector has been expanding at the expense of the “real” economy. It drains revenue in the form of interest, rental income and monopoly profits, which are paid out increasingly as interest and financial fees. This triggers a fresh cycle of saving and re-lending by the FIRE sector itself, not so much by the rest of the economy. The more interest accrues in the hands of creditors, the faster their supply of loanable funds increases, thanks to the “magic of compound interest.” This revenue is lent out and accrues new interest (“interest on interest”), which is recycled into yet new loans.

This growth of savings and loanable funds in the hands of financial institutions is lent out mainly to buy property in place and financial securities, not to fund tangible capital formation. This financial dynamic spurs asset-price inflation, which in turn reduces the incentive to invest directly in capital goods, because it is easier to make capital gains than to earn profits.

These developments have prompted investors to seek “total returns” – capital gains plus profits or earnings – rather than earnings alone. Under Federal Reserve Board Chairman Alan Greenspan as “Bubble Maestro” in the 1990s, stock prices for dot.com and internet companies soared without a foundation in earnings or dividend-paying ability. Balance-sheet maneuvering was decoupled from tangible investment in the “real” economy. Companies such as Enron prided themselves in not having any tangible assets at all, just a balance sheet of speculative contracts. People began to ask whether wealth could go on increasing in this way ad infinitum.

Keynes’s analysis implied that the income “multiplier” (Y/S, or 1/mps) would increase as prosperity increased and people consumed a smaller portion of their income. What was being multiplied, however, was not national income – wages, profits and other earned income – but the volume of credit and hence the pace of capital gains in the asset markets.

Tax policy and financial bubbles

Unlike the industrial sector, real estate does not report a profit – and hence, pays no income taxes. Property owners do pay state and local real estate taxes, to be sure, but they have been joined by the financial and insurance lobbies to shift local government budgets away from the land and onto the shoulders of labor, through income taxes, sales taxes and various user fees for municipal services hitherto provided as part of the basic economic needs and infrastructure.

Although land does not depreciate – that is, wear out and become obsolete – by far the bulk of depreciation tax credits are taken by the real estate sector. This is because the economic theory underlying tax obligations has become essentially fictitious. Each time a property is sold, the building is assumed to increase in value, rather than the land’s site value generating the gain.

Nothing like this could happen in industry. Machinery wears out and becomes obsolete. (Think of computers and word processors bought a decade ago, or even three years ago.) Technological progress reduces the value of physical capital in place. But the prosperity that progress brings increases the market price of land.

In calling for “euthanasia of the rentier” Keynes pointed to the desirability of preventing the diversion of income into the purchase of securities and property already in place. He hoped to restructure the stock market and financial system so as to direct savings and credit into tangible capital formation rather than speculation. He deplored the waste of human intelligence devoted merely to transferring property ownership rather than creating new means of production.

Today’s financial markets have evolved in just the opposite direction from that advocated by Keynes. New savings and credit are channeled into loans to satisfy the rush to buy real estate, stocks and bonds for speculative purposes rather than into the funding of new direct investment and employment. Matters are aggravated by the fact that financial gains are taxed at a lower rate, thanks to the growing power of the financial sector’s political lobbies. This prompts companies to use their revenue and go into debt to buy other companies (mergers and acquisitions) or real estate rather than to expand their means of production.

Going into debt to buy assets with borrowed funds experienced a quantum leap in the 1980s with the practice of financing leveraged buyouts with high-interest “junk” bonds. The process got underway when interest rates were still hovering near their all-time high of 20 percent in late 1980 and early 1981. Corporate raiding was led by the investment banking house of Drexel Burnham and its law firm, Skadden Arps. Their predatory activities required a loosening of America’s racketeering (RICO) laws to make it legal to borrow funds to take over companies and repay creditors by emptying out their corporate treasuries and “overfunded” pension plans. New York’s laws of fraudulent conveyance also had to be modified.

Tax laws promoted this debt leveraging. Interest was allowed to be counted as a tax-deductible expense, encouraging leveraged buyouts rather than equity financing or funding out of retained earnings. Depreciation of buildings and other assets was permitted to occur repeatedly, whenever a property was sold. This favored the real estate sector by making absentee-owned buildings and other commercial properties virtually exempt from the income tax. To top matters off, capital gains tax rates were reduced below taxes on the profits earned by direct investment. This diverted savings to fuel asset-price inflation. By the 1990s the process had become a self-feeding dynamic. The more prices rose for stocks and real estate, the more mortgage borrowing rose for homes and other property, while corporate borrowing soared for mergers and acquisition.

Meanwhile, the more gains being made off the bubble, the more powerful its beneficiaries grew. They turned their economic power into political power to lower taxes and deregulate speculative finance – along with fraud, corrupt accounting practices and the use of offshore tax-avoidance enclaves – even further. This caused federal, state and local budget deficits while shifting the tax burden onto labor and industrial income. Markets shrank as a result of the fiscal drain as well as the financial debt overhead.

Abuses of arrogance and outright fraud occurred in what became a golden age for Enron, WorldCom and other “high flyers” akin to the S&L scandals of the mid-1980s. But free-market monetarism draws no distinction between tangible direct investment and purely financial gain-seeking. Opposing government regulation to favor any given way of recycling savings as compared to any other way, the value-free ethic of our times holds that making money is inherently productive regardless of how it is made. “Free-market fundamentalism” came to shape neoliberal tax policy in a way that favored finance, not industry or labor.

Can economies inflate their way out of debt?

Only a limited repertory of opportunities for profitable new direct investment exists at any given point in time. The exponential growth in savings tends to outstrip these opportunities, and hence is lent out. This lending – and its mirror image, borrowing – may become self-justifying at least for a time to the extent that it bids up asset prices. Homebuyers and investors feel that it pays them to go into debt to buy property, and this is viewed as “prosperity,” although it is primarily financial rather than industrial in character.

About 70 percent of bank loans in the United States and Britain take the form of real estate mortgages. Most new savings and credit creation thus enables borrowers to bid up the price of homes and office buildings. The effect is to increase the price that consumers must pay to obtain housing, as new construction loans account for only a small proportion of mortgage lending. Over-extended families become “house-poor” as rising financial charges for housing diverts income away from being spent on new goods and services, “crowding out” consumer spending and business investment.

Governments may try to mitigate the inflation of housing prices by raising interest rates. But this will increase the carrying charges for borrowers with floating-rate mortgages, as well as debtors throughout the economy. (Also, as Britain discovered in spring 2004, the increase in interest rates also raises the currency exchange rate, making its exporters less competitive in world markets.) For fixed-rate mortgages, higher interest rates may squeeze the banks, leading to losses in their portfolio values and prompting calls for the government to bail out losers (at least depositors, if not to rescue S&Ls and commercial banks).

Perception of this problem leads central bankers not to raise interest rates and take the blame for destroying financial prosperity by pricking the bubble. Instead, they try to keep it from bursting. This can be done only by inflating it all the more. So the process escalates.

Balance sheets improve as the pace of capital gains outstrips the rate of interest. Debt service can be paid out of rising asset values, either by selling off assets or by borrowing against the higher asset prices as collateral. The problem occurs when current income no longer can carry the interest charges. The financial sector absorbs more income as debt service than it supplies in the form of new credit. Asset prices turn down – but the debts remain on the books. This has been Japan’s condition since its bubble peaked in 1990. It may result in “negative equity” for the most highly leveraged mortgage borrowers in the real estate sector, followed by debt-ridden companies.

When interest charges exceed rental income, commercial borrowers hesitate to use their own money or other income to keep current on their debts. The limited liability laws let them walk away from their losses if markets are deflated, leaving banks, insurance companies, pension funds and other financial institutions to absorb the loss. Sell-offs of these properties to raise cash would accelerate the plunge in asset prices, leaving balance sheets “hollowed out.”

Savings do not appear as the villain in such periods. The zero net savings rate has concealed the fact that gross savings have been relent to create a corresponding growth in debt. America’s national debt quadrupled during the 12-year Reagan-Bush administration (1981-93). This increase in debt was facilitated by reducing interest rates by enough so that the unprecedented increase in credit rose without extracting more interest from many properties.

The natural limit to this process was reached in 2004 when the Federal Reserve reduced its discount rate to only 1 percent. Once rates hit this nadir, further growth in debt threatened to be reflected directly in draining amortization and interest payments away from spending on goods and services, slowing the economy accordingly. Further debt growth would require a rising proportion of disposable personal income to be spent on debt service.

How long can bubbles keep expanding?

The potential credit supply is limited only by the market price of all existing property and securities. The process is open-ended, as each new credit creation inflates the market value of assets that can be pledged as collateral for new loans.

Until bubbles burst, they benefit investors who borrow money to buy assets that are rising in price. Running into debt becomes the preferred way to make money, rather than the traditional first step toward losing the homestead. The motto of modern real estate investors is that “rent is for paying interest,” and this also applies to corporate raiders who use the earnings of companies bought on credit to repay their bankers and bondholders. What real estate investors and corporate financial officers are after is capital gains.

There is no inherent link with making new direct investment. Indeed, the after-tax return from asset-price inflation exceeds that which can be made by investing to create profits. Retirees, widows and orphans do best by living off capital gains, selling part of their growing portfolios rather than seeking a flow of interest, dividends and rental income. The idea begins to spread that people can live off capital gains in an economy whose incomes are not growing.

Asset-price inflation would be a rational long-term policy if economies could inflate their way out of debt via capital gains. The solution to debt would be to create yet more debt to finance yet more asset-price inflation. This dynamic is more likely to create debt deflation than commodity-price inflation, however. It is true that a consumer “wealth effect” occurs when homeowners refinance their mortgages by taking new “home equity” loans to spend on living, or at least to pay down their credit-card debt so as to lower the monthly diversion of income for debt service. If this were to lead to a general inflation, interest rates would rise, prompting investors to shift out of stocks into bonds. Foreign investors and speculators bail out, accelerating the price decline. This threatens retirement funds, insurance companies and banks with capital losses that erode their ability to meet their commitments.

The more likely constraint comes from asset-price inflation itself as price/earnings ratios rise. Interest rates and other returns slow, making it difficult for pension plans and insurance companies to earn the projected returns needed to pay retirees. In any event, asset sales exceed purchases as the proportion of retirees to employees grows, causing stock and bond prices to decline. Pension funds must sell more stocks and bonds – or employers must set aside more of their revenue for this purpose, in which case their ability to pay dividends is reduced.

Asset-price inflation reaches its limit when interest charges absorb the entire flow of earnings. Debt-financed bubbles remove more purchasing power from the “bottom 90 percent” of the population than they supply. Debt spurs rising housing prices but reduces consumer demand as a result of the need to service mortgages. Likewise, financing for leveraged buyouts, mergers and acquisitions may increase stock prices, but the interest charges absorb corporate earnings and “crowd out” new direct investment and employment.

The drive for capital gains thus complicates the traditional macroeconomic Keynesian categories. Although these gains are not included in the national income statistics, they have become the key to analyzing how asset-price inflation leads to debt deflation of the “real” economy. One thus may ask what sphere of the economy is more “real” and powerful: that of tangible production and consumption, or the financial sector which is wrapped around it.

Can the debt and savings overhead be supported indefinitely?

Richard Price’s illustration of the seemingly magical powers of compound interest is a reminder that many people saved pennies (and much more) at the time of Jesus, and long before that, but nobody yet has obtained an expanding globe of gold. The reason is that savings have been wiped out repeatedly in waves of bankruptcy.

The reason is clear enough. When savings, lending and “indirect” financial investment grow by compound interest in the absence of new tangible investment, something must give. The superstructure of debt must be brought back into a relationship with the ability to pay.

Financial crashes occur much more quickly than the long buildup. This is what produces a ratchet pattern for business cycles – a gradual upsweep and sudden collapse of financial and property prices, leaving economies debt-ridden. Many debts are wiped out, to be sure, along with the savings that have been invested in bad loans – unless the government bails out savers at taxpayer expense.

Financial crises are not resolved simply by price adjustments. Almost all crises involve government intervention, solving matters politically. As the financial and property sectors gain political power relative to the increasingly indebted production and consumption sectors, their lobbies succeed in lowering tax rates on rentier income relative to taxes on wages and profits. Tax rates on capital gains have been slashed below those on “earned” wages and profits, whereas the two rates were equal when America’s income-tax laws first were introduced.

Financial lobbies also have gotten law-makers to adopt the “moral hazard” policy of guaranteeing savings. Debtors still may go bankrupt, but savings are to be kept intact by making taxpayers liable to the economy’s savers. Ever since the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC) in the late 1980s a political fight has loomed over just whose savings are to be rescued. Unfortunately, the principle at work is that of “Big fish eat little fish.” Small savers are sacrificed to the wealthiest savers and institutional investors.

The mathematics of compound interest dictates that such public guarantees to preserve savings cannot succeed in the long run. Financial savings and debts tend to grow at exponential rates while economies grow only by S curves, causing strains that cannot be supported as credit is used to buy assets rather than to invest in capital goods or buildings.

Financial strains become further politicized as large institutions and the “upper 10 percent” of the population account for nearly all the net saving, which is lent out to the “bottom 90 percent” and to industry. The balance-sheet position of the wealthiest layer increases as long as capital gains exceed the buildup of debt. The bottom 90 percent also benefit for a while during the early and middle stages of the financial bubble. Workers are invited to think of themselves as finance-capitalists-in-miniature rather than as employees being downsized and outsourced. But much of what they may gain in the rising market value of their homes (for the two-thirds of the U.S. and British populations that are homeowners) is offset by the debt deflation that bleeds the production-and-consumption economy.

Throughout history societies that have polarized between creditors and debtors have not survived well. Rome ended in a convulsion of debt foreclosure, monopolization of the land and tax shifts that reduced most of the population to clientage. Third-world countries today are being stripped of their public domain and public enterprises by the international debt buildup, while industry and real estate in the creditor nations themselves are becoming debt-ridden.

Today’s bubble economy is seeing interest charges expand to absorb profits and rental income, leading to slower domestic direct investment and employment. Much as classical economists believed that rent would expand to absorb the entire economic surplus, it now appears that interest-bearing debt will play this role.