It Ain't Gonna Work

Allow me to put away my tinfoil hat and replace it with one I'm more comfortable with: Railing against idiotic economic central planning. And there's been plenty of news on that front over the last week. Please consider:

US Delays Finance Plan as Officials Debate Debt

Treasury Secretary Timothy Geithner delayed the announcement of the Obama administration’s financial-recovery plan as officials debated proposals aimed at addressing the toxic debt clogging banks’ balance sheets.

Some aspects of the plan, to be announced by Geithner tomorrow in Washington, have been settled. They include a new round of injections of taxpayer funds into banks, targeted at firms identified by regulators as most in need of new capital, people briefed on the matter said. A Federal Reserve program designed to spur consumer and small-business loans will be expanded, possibly to include real-estate assets, they said.

This is so far removed from the actual problem at hand that I'm almost left speechless. Almost. Months of preparations, meetings with bank officials, lawyers, and accountants have not proved to be enough for this band of geniuses to come up with a solution. But just one more day will be enough to come to some hard and fast conclusions? No. I'm sorry. No sane person could believe that. These people have absolutely no clue what is going on or how to fix it. It's like a veterinarian being asked to do heart surgery on a human. Their models are so distanced from reality that they provide no use whatsoever. An extra day?

Still outstanding is the issue Geithner’s predecessor failed to address: the illiquid assets that have caused the credit freeze. Officials continue to consider a so-called bad bank to buy them, perhaps in cooperation with private investors, such as hedge funds and private equity. It’s unclear how big a role there’ll be for federal guarantees of securities that remain on banks’ balance sheets.

Banks are “looking for clarity, we’re looking for this to be the complete package,” said Wayne Abernathy, an executive vice president at the American Bankers Association in Washington. “If they don’t have the details spelled out they will just freeze the market.”

"The complete package." It sounds like they're hocking entertainment systems. They have completely given up trying to say anything meaningful and all efforts are now focused on providing an image of being "in control." This idea of a bad bank doesn't make any sense. And attempts to get private capital to buy the assets should not have to be "attempted" if the securities were being offered at market prices. Why would private capital buy something for more than it is worth?

Anyone can see that such an idea does not make sense in theory or in practice. It is complete lunacy. They floated the same idea last year under a different name. Remember the "Super SIV?" The idea failed then for the same reasons it will fail now: It doesn't make any sense.

Over the last year I've seen numerous attempts by sane economists (stop laughing, there are a few) to try and explain how the current approach to fixing this crisis will not work. Every time such a plan has been put forward, it has been correctly predicted that it would fail by these same people. And the reason is simple: those trying to do the fixing are operating with a set of assumptions about the economy that are false. You cannot fix a solvency problem with liquidity. And that is what all of these solutions amount to.

People scream about a coming hyperinflation due to all of these bailouts and liquidity injections, yet they are operating from a false understanding of our economy.

Last week, Steve Keen, an Australian economist had a fantastic (and long winded) discussion about why all of this "stimulus" essentially amounts to a potato gun in a bazooka fight. I don't agree with everything Keen proposes, but his analysis of "what's wrong" is spot on. I highly recommend my readers take a look at this paper in entirety. The article is called, "The Roving Cavaliers of Credit," which is, yes, a reference to Marx. But don't let that dissuade you from reading it.

In the article, Keen attacks the popular belief of what money is and how it is created. We would like to think that the people making these trillion dollar bailouts and stimulus packages would at least have a decent handle on a subject so basic. But they don't. Bernanke, Geithner, Krugman and the rest of them cling to the fallacy that we live in a fiat money world. This is not true. Fiat money only makes up for about 2% of the entire supply of money, being printed and supplied by the Federal Reserve and by other central banks. The other 98% percent is lent into existence by private banks - not as a multiple of their reserves, but at a whim, knowing that they can create deposits for nearly every dollar lent out and search for reserves to back them up later.

Bernanke and the other neoclassical economists believe that the Fed controls the supply of money (via interest rates and other measures - now predominantly by "talking"). Yet Keen outlines quite clearly that is is blatantly false. That private banks create credit and the Fed follows with a lag by providing reserves. As such, the Fed creating reserves will not have the desired effect of expanding the money supply because it essentially puts the cart before the horse. From the article:

...from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

1. Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;

2. Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;

3. Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and

4. The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted: “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”.

A prerequisite for a credit based monetary system is that the total credit supply needs to continually expand. Any contraction in credit (or even a slow-down in the rate of acceleration) would self-perpetuate itself through falling asset prices that further lower the demand for credit. This is happening now and has been for some time. Although Bernanke and other government officials talk of it as some future event that must be prevented. They don't want the psychology to ingrain itself in the minds of consumers. But it has already happened.

I've been talking about this for quite a while and wrote that "deflation is on the way" as long ago as late 2006. This was very easy to see by treating credit as an equal to money in our credit-based monetary system. People would simply send me charts of John Williams M3 charts like the one below along with a note saying something like, "M3 is expanding at 15%. You're wrong, hyperinflation is coming...buy gold."



Unfortunately, charts like the one above are not as all encompassing as they purport. When home prices began to fall in 2006, and subprime mortgage lending began to be cut off, that was all the information required to know that the jig was up for the credit binge of the previous 10-25 years (depending on where you define your starting point '82 or '95). Certain credit instruments continued to expand (derivatives) but none of this had nearly the effect on the economy as did the falling asset prices around the world.

For example, we know that as of May 2008, total world equity markets were valued at approximately 60 Trillion dollars. They're now worth closer to 30 Trillion. According to Zillow.com, US real estate owners have lost 6.1 Trillion since the peak in mid 2006. I would assume a similar amount or more has been lost elsewhere in the world. And now commercial real estate values are plunging worldwide also.

These many trillions in wealth being destroyed have a far greater impact on the average person than does unused bank reserves piling up at the Fed or its member banks. And the numbers are orders of magnitude greater than the figures being thrown around by Obama and his new buddies Geithner and Bernanke.

Now I know the solution most will come up with in order to get banks lending again will be to nationalize them and have the government do the lending. Unfortunately, this won't work either because consumers and businesses no longer have the same motivations to borrow - asset prices are falling, so they would rather wait to expand business or buy a new home. Inventories of nearly everything are enormous and growing and the generation of people (mine) are buying from a more numerous pool of sellers, thus adding even more natural supply as the years go on.

The reasons are many and those understanding them are few, but it is apparent that none of the solutions being put forth will have anything close to the advertised effect. And by extension, there is no conceivable chance that the actions could have more than the desired effect and thereby send us on a Zimbabwe/Weimar style hyperinflation that would destroy the value of the dollar.

Quite simply, it ain't gonna work. Deflation. Full steam ahead.