Monetary Madness

A Look Inside the World’s Biggest Pyramid Scheme

by Bullwinkle J. Moose; January 2016

Introduction

In late 2005, I bought gold for the first time in my life in the form of the SPDR Gold Shares ETF. I had previously never even considered buying gold. My motivation for doing so was that the U.S. economy seemed to have reached a fever pitch of activity fueled by ever increasing levels of debt. I was convinced that markets were in an unprecedented bubble that was going to end badly at some point. At the time I knew nothing about subprime mortgages, alt-A loans, synthetic CDOs or the shadow banking system. I had no idea that the investment banks had become leveraged at up to 40:1, or that Citibank maintained a shadow balance sheet with hundreds of billions of dollars of hidden assets and was on the hook for any losses on those assets through various derivatives contracts. Had somebody told me about any of this at the time I simply wouldn’t have believed anything so outlandish was possible. Nevertheless I had seen enough Wall Street schemes and asset bubbles over the years to know that there was a heightened level of economic activity fueled by excessive credit creation and speculative activity. It was clearly centered in housing but the debt fueled frenzy seemed to have impacted every asset category.

Ideally, I would have tried to take some short position on the market as a whole, but I had no idea when it might turn and had learned from past experience that shorting the market or specific securities has a lot in common with stepping in front of a freight train. Derailment may be certain, but you often face the choice of jumping off the track or agonizing pain and suffering well before the wreck occurs. For that reason I was searching for some form of protection against what appeared to be a looming catastrophe and going long gold at just over $400 per ounce seemed like a reasonably low risk and drama free way to profit from any turmoil that might develop. Gold was attractive because I assumed that any financial collapse would be serious enough to have a major adverse impact on the U.S. banking system and ultimately the U.S. dollar and government debt. Under such a scenario gold could be expected to move inversely to any move in those assets. As it turned out, the collapse began to manifest itself by the end of 2007 and the value of the dollar and U.S. government debt did in fact collapse relative to the value of gold but by almost any other measure they have showed resilience and strength that continues to this day. Most commentary on gold suggests that it went up in value due to the financial crisis, but I think it is better to look at it from the other side and say the value of the dollar collapsed relative to gold. This may be just semantics, but it’s important at some level because it’s the dollar and other fiat currencies that are in the midst of a monetary storm, not gold. This essay is a story of one person’s attempt to understand the dollar and the international monetary system, which are the ultimate keys to unlocking the true story of the financial crisis and its continuing aftermath. It is also an attempt to frame the 2008 crisis in a broader historical context.

Questions and Confusion

The financial debacle of 2008/2009 has generated countless discussions, analysis, articles and books in its aftermath. A general consensus has formed relating to the primary causes of the crisis. Loose monetary policy, greedy banks, dumb borrowers, financial innovation, failures by the rating agencies, lax regulation and flawed financial incentives are among the most common explanations for how such excessive debt levels built up in the U.S. financial system. All of these things contributed to the problem in one way or another and the primary debate has been about to what extent each is to blame. One issue that is rarely, if ever, discussed is the dollar’s role in the crisis. There have been some discussions suggesting that trade imbalances and capital flows also played a role in facilitating the conditions that gave rise to the crisis but these discussions are generally misguided and sidestep the real issue. This essay will attempt to explain that the 2008 debt crisis was the inevitable result of a structurally unsound, dollar-based, international monetary system. This a fairly unusual argument and one that is deeply unpopular in the U.S. for self-serving reasons. Quantitative easing (“QE”), zero interest rate policy (“ZIRP”) and negative interest rate policy (“NIRP”) are all signs that there is something seriously wrong with the monetary system. In order to understand this idea it is necessary to establish a few key points about money, banking and the international monetary system, which will be a primary focus throughout this essay.

Even though I was fortunate in anticipating the crisis and pleased to earn a 300% return on my gold investment, I nevertheless remained fairly confused about what had happened and even more confused about how monetary policy makers were dealing with the consequences. As I thought about the crisis and its aftermath three fundamental questions kept recurring in my mind and they had nothing to do with greedy bankers, dumb homeowners or the ratings agencies.

1. How was it that debt levels in the United States and the rest of world increased so dramatically in the period leading up to the collapse; or stated another way, what were the real causes of the massive credit bubble that ended so disastrously?
2. Why is the dollar strong and government debt costs so low in light of a massive banking failure and severe recession that implicates the country’s monetary system?
3. How can the U.S. central bank engage in a massive and unprecedented monetary stimulus campaign without causing all manner of negative consequences?

Given that the crisis involved the banking system, a dramatic increase in debt and a massive monetary stimulus program, led me to conclude that understanding money, banking and the international monetary system were the keys to understanding the crisis and its aftermath. Fundamentally, I kept wondering how did so much debt accumulate in the system and in order to understand debt one has to truly understand money first. Understanding money is not nearly as straightforward as it might sound. I was reasonably familiar with the standard definition of money: a unit of account, a medium of exchange and a store of value; as well as with the ideas behind fiat based money, central banks and fractional reserve banking. Still, I kept wondering: what is money, how much of it is there, what are the rules governing its creation and who is in charge? These are very straightforward questions with fairly esoteric and ambiguous answers that are poorly understood, even by many so called experts. We simply take the system for granted without much thought or understanding as to how it works.

Initially, I thought I could read one or two books and come to grips with money and how the monetary system operates, but I found that the more I read the more questions I had and the more confusing the subject became in many regards. I ended up reading a total of nine books on the subject of money and it was only towards the end that I finally started to become comfortable with the topic. This surprised me. I graduated from a highly regarded university with a degree in one of the real sciences and worked in banking and finance related jobs for almost 25 years so I assumed that I could come to an understanding of the topic fairly quickly. It ended up being more challenging and took longer than I expected.

All of the books I read were fairly similar in that they dealt with the history of money in one way or another and inevitably included some mention of the gold standard, the various physical forms money including the stone fei of Yap, Gresham’s law, John Law, greenbacks, the genesis of banking, the creation of central banks, the Bretton Woods conference, coin clipping and seigniorage to name just some of the topics. While each book approached the subject somewhat differently, one theme was consistent in all the books; the history of money is a history of crisis and failures. In short, the issuer, i.e. the sovereign, whether a kingdom or democracy, almost always reaches a point where they over spend and over borrow, often relating to war, and it invariably leads to some form of monetary cheating and eventual collapse/restructuring. What else would one expect after all? Who would not cheat if you had a monopoly on producing money?

As I made my way through the books I kept thinking there was something particularly strange about the current situation and that I must be missing something. After all, how did so much debt build up in the system and where did it come from? How could the dollar be strong and government bond rates low following a massive banking failure, an economic collapse, a decline in tax receipts, massive budget deficits, huge trade related imbalances and with the U.S. Federal Reserve fabricating trillions of dollars out of thin air. On top of all that, the U.S. is engaged in an endless, fruitless and misguided war that only serves to beget more war, and war has historically wreaked havoc on monetary regimes. If any other country in the world encountered such a perfect storm its currency would collapse, its bond yields would soar and no one would lend it a dime. The eureka moment came when I realized that I could not make sense of the current situation because it does not actually make much logical sense. Once I got through the cognitive dissonance and stopped suspending disbelief, the subject of money and the international monetary system became clearer. It is all a confidence game and it is not nearly as rational, controlled or stable as we would like to believe. Furthermore, there appears to be a good deal of cheating going on.

This is another historical period of monetary turmoil which is still in the process of working itself out and what looks stable is in reality stable in the same way a house of cards is stable. Much of the focus has been on Greece, the Euro-zone, Japan, and most recently China, which suits the United States just fine because it conveniently distracts from its fiscal and monetary issues. The secret to understanding the dollar and its strength in the face of significant fiscal and monetary problems is its status as the main reserve currency for the global monetary system. In short, the U.S. has been, and continues to be, the beneficiary of an extraordinary privilege as the issuer of the world’s reserve currency. A privilege, which upon close inspection and analysis, makes very little sense at this point in history. In fact, there is a fairly coherent argument that the U.S. dollar has taken on all the trappings of a pyramid scheme; a very, very large pyramid scheme. That probably sounds preposterous to most people but is not nearly as far-fetched as it might seem. It also does not mean it is going to collapse; to the contrary it could go on for a long time. As long as the world goes on believing, it works. In addition, there are a variety of reasons as to how it got this way and why the dollar may be able to maintain its privileged position. The Nobel laureate Paul Krugman frequently boasts and gloats about how right he has been and how wrong others have been to doubt the dollar and the Federal Reserve’s extreme monetary response to the crisis, but the ending to this chapter of monetary history has yet to be written. Keynesian stimulus policies make sense but there are limits to when they should be implemented, at what scale, and what they can accomplish in the face of other economic challenges.

To be fair to Keynes it is far from obvious whether he would have supported a continuation of the quantitative easing policies (“QE”) once a disastrous collapse had been averted. Keynes was no fool and believed in temporary stimulus, not endless money printing. In any case, the idea that you can print money and create more debt to solve a debt crisis is being put to the ultimate test and the results of this unprecedented monetary experiment are not yet known. Official monetary policy interest rates have been near zero for almost seven years now and have had little success generating nominal growth let alone any real growth. The central banks of the world have ginned up the largest monetary stimulus in history in a desperate bid to generate some inflation and all they have to show for it after seven years is a continuing threat of deflation that refuses to go away, which just shows how upside down and warped the system is at this point in time.

The Dollar as the World’s Reserve Currency

The dollar became the world’s official “reserve currency” following the Bretton Woods conference of 1944 for good reasons. The pound sterling, the only other competitor to the dollar on the world stage, was diminished by Britain’s war debts, weak economy, balance of payment problems and rapidly diminishing empire. The United States on the other hand had a strong and intact economy, positive payment balances and lots of that “barbaric relic” known as gold. This allowed the U.S. to largely dictate the terms and conditions governing the new monetary order that was being negotiated by representatives of the world’s major economies in a remote New Hampshire resort hotel. Gold was still seen as a critical component of the monetary system in 1944 and the cornerstone provision of the Bretton Woods agreements were that the U.S. dollar would be backed by gold and the world’s central banks could redeem dollars that were accumulated through trade for gold. Other nations could therefore safely accumulate dollars as reserves to back their own currencies and this arrangement was deemed sound since the dollar was linked and exchangeable for gold. The international monetary system was therefore still on a type of gold standard with the dollar serving as a global proxy for gold, thereby making the dollar the primary international reserve asset backing the entire monetary system. This privileged status created virtually unlimited demand for dollars throughout the world, which continues to this day. While that may have made reasonable sense at the time much has changed since then and the U.S. appears to have pulled off the world’s greatest sleight of hand whereby the fiat money of a massive debtor nation with large payment imbalances serves as the collateral for the entire monetary system. The more money the Fed prints, the more debt the government issues and the worse the U.S. balance of payments becomes; the more collateral that gets pumped into the international monetary system in terms of central bank reserve assets. This is nothing short of absurd! The multi-trillion dollar question is how did it happen and why does it persist?

The U.S. has had some third party assistance and good fortune in maintaining the dollar’s privileged position along with a certain amount of cunning. The dollar started its journey as the world’s reserve currency from a position of legitimate strength. Such real strength didn’t last for very long though and U.S. fiscal discipline started to seriously erode in the 1960s with the Vietnam War and great society programs such that by 1971 the U.S. had lost so much of its gold stock that President Nixon was forced to close the “gold window”, thereby severing the dollar’s final remaining ties to gold as it related to the world’s central banks. Breaking the final link to gold was a brazen betrayal of the rules of the game and one would think there should have been some re-ordering of the system following such a momentous change. The U.S. pulled a classic bait and switch at the time by declaring that the decision to close the gold window was only “temporary”, which probably prevented a more precipitous collapse of the dollar and forestalled any international pressure for an immediate review of the system. The decade of the 1970s was quite tumultuous for the dollar, marked by high inflation and a major devaluation, but by the early 1980s the situation had stabilized and the dollar emerged with its privileged position intact. Oddly, by this point in the story most of the fundamental economic advantages that allowed the dollar to become the so called reserve currency of the international monetary system had been long reversed. The entire system was now backed by the monetary equivalent of fool’s gold, although nobody seemed to care.

Once there is a reserve currency, there are tremendous advantages to incumbency and even if there are problems with that currency there has to be some alternative to knock it off its privileged perch. The U.S. was in a position to do that to Britain in the 1940s, but no one was in a position to do it to the U.S. in the 1970s. The secret to securing and perpetuating the dollar’s reserve currency status hinged on a clandestine agreement made in 1974, whereby Secretary of State and National Security Advisor, Henry Kissinger, and Treasury Secretary, Bill Simon, persuaded the Saudi royal family to support the dollar. The Saudis promised to continue pricing oil in dollars and further committed to invest their dollar trade surpluses in U.S. government bonds thereby providing critical support for the dollar at a very difficult time in its history. The Saudis demanded that the arrangement remain secret and the Treasury Department set up a special facility to accommodate Saudi purchases. To this day the U.S. has never officially disclosed this agreement or the secret Treasury procedure for Saudi purchases, nor has the Treasury Department disclosed Saudi holdings of U.S. treasury securities in any of its official reports. The fact that the word’s largest oil producer agreed to tie the world’s most important commodity to the dollar played a significant role in allowing the dollar to survive what was a very difficult period that threatened to end its dominant role at the center of the international monetary system. After all, even if dollars can no longer be swapped for gold, it’s at least as good, and arguably even better, to be able to swap them for oil, the lifeblood of the modern industrial economy. In terms of supporting the dollar, this agreement was the equivalent to the U.S. levying a tax on every oil importing nation in the world since it forced them to accumulate dollars which would be paid to the Saudis and then paid back to the U.S. in the form of Saudi investments in U.S. government bonds and American made military hardware. This was nothing short of a brilliant strategic move at the time, albeit one with profound long-term consequences. The ruling Arab monarchy got a security guarantee and the U.S. got critical support for the dollar; an important symbiotic arrangement that continues to this day. While not officially known, it is likely that similar agreements exist with Bahrain, home of the U.S. Navy’s 5th fleet, and the sheikdoms the UAE. It is also probably not a coincidence that the ruling Al-Thani family of Qatar, who happen to sit on the world’s largest reserves of natural gas, allowed the U.S. to build one of its largest and most advanced military airbases outside of Doha. The dollar is one of the U.S.’s most important strategic assets. It’s also why democracy will never see the light of day in any of those countries as long as there are bountiful quantities of hydrocarbons in the ground.

The final factors contributing to the dollar’s continuing role as the world’s reserve currency involve several things including its significant “legacy” advantages. From a simple practical standpoint the world is better off with a single unit of account and medium of exchange because of its practical utility, and the dollar has served that role for about 70 years. It is much easier to quote prices, trade and settle accounts in a single currency and for this reason alone the dollar has a significant advantage over every other currency in the world even if some of those currencies are superior as a store of value. The Swiss franc is a relatively well managed fiat currency but the Swiss economy is less than 1/30 the size of the U.S economy and as a result the franc is all but irrelevant in global monetary affairs. The fact is that the bulk of international economic transactions whether trade, foreign exchange or debt offerings involve the dollar, because it is easy, predictable and low cost. Additionally, the U.S. is the world’s largest economy, has a large and sophisticated banking system, albeit maybe a little too sophisticated, and the market for its government debt is large and liquid. The U.S. has also been very fortunate to find three massive “sinks” for the fiat dollar in the form of the Arab monarchies, Japan and most recently China. Finally, the U.S. possesses significant hegemonic power, which it aggressively exploits to gain advantage in all aspects of international affairs. Nevertheless, on a more fundamental level, there are serious reasons to question the dollar’s reserve currency status given all the cracks in its foundation. How long can the U.S. expect to go on living beyond its means and how long will foreigners continue to accept the monetary equivalent of fool’s gold to back their own monetary systems? So far the dollar has survived another major test to its international dominance but the monetary landscape is evolving and the dollar’s dominance in the system is not assured.

No More Gold, the Greenspan Put, Securitization and Greater Fools

By the early 1980s the dollar had stabilized and gained strength under Paul Volcker’s high interest policy. Once things were stable again and there was no longer any gold requirement to anchor the international monetary system, the banking system was free to pump out credit like never before, which it would begin to do when Alan Greenspan, a free market ideological nutter, took the helm of the U.S. Federal Reserve in 1987. The Great Greenfool’s appointment set the stage for an explosion of debt, lax regulation and financial hijinks that appeared to unleash an extended period of relatively high and stable economic activity. At a certain level this made sense and seemed reasonable at the time. After all, easy credit puts more dollars in the system, which acts as a catalyst for economic activity and economic activity acts as a stimulus for more lending in a self-reinforcing virtuous circle that eventually turns into a loop of doom. Inevitably, a lot of the economic activity that resulted was ultimately exposed to be unsound and the entire U.S. banking edifice finally collapsed under the weight of its own greed and idiocy in 2008. This of course came as a great surprise to almost all economists, bankers and investment professionals. Economists believed the U.S. economy had entered a new era and dubbed this period, corresponding to the largest increase in debt the world has ever known, “the great moderation”. A review of debt balances covering the period from the mid-1980s to 2007 shows a stunning increase in debt levels across all segments of the economy. This could have never happened if it were not for the breaking of the last vestiges of the gold standard in 1971. Gold acts as a very real physical constraint on the banking system’s ability to expand credit and the money supply. It’s also very effective at preventing trade flows from getting too far out of balance which also serves to constrain credit expansion.

Breaking the gold exchange standard wasn’t enough, in and of itself, to unleash the massive credit growth that led to the 2008 financial crisis. The October 1987 U.S. stock market crash and the central bank’s response to that event was a key development that ushered in the unprecedented 20 year expansion of money and credit. The 87 crash caused a panicked response by Greenspan who immediately pumped liquidity into the system in an effort to re-inflate the market. Flooding the system with liquidity appeared to work and Greenspan was so delighted with himself and his monetary magic trick that it became his modus operandi every-time the economy or financial markets showed any signs of weakness. Greenspan’s response to any sign of market turmoil became so predictable that it was even given a name: the “Greenspan put”. The media were so impressed by Greenspan’s monetary magic shows they nicknamed him the “Maestro” and breathlessly awaited his every word. The fact that he mumbled and spoke gibberish was taken as further evidence that he was some type of monetary genius. As for the financial markets, well, they loved him and thought everything he did was great! The way the Greenspan put works in official terms is that the Fed engages in open market operations to lower interest rates. It does this by buying government securities from the banks which puts more central bank “reserves” on the banking system’s aggregate balance sheet. This serves to lower key market interest rates and the added reserves allow the banks to create more loans and money. This is standard practice for the banking system and a legitimate, central bank tool for influencing the supply of credit and money, which in turn influences the overall level of economic activity.

Greenspan would use his monetary put on multiple occasions during his tenure which sent a signal to banks, businesses and the financial markets that the Fed would intervene whenever there were signs of market or economic weakness. Not surprisingly, banks, businesses and consumers then went on to indulge themselves in an orgy of lending, borrowing and spending that saw the total debt levels in the economy explode. Sadly, Greenspan’s actions were akin to those of the moron at a backyard barbecue who keeps squirting lighter fluid on the fire every time he sees the flames diminish not realizing that the coals would do just fine if left on their own. They may eventually burn out, but the best way to keep the fire burning is to add more coals, not more lighter fluid. In the case of the backyard chef they end up with no more coals nor any lighter fluid which is about where today’s monetary arsonists find themselves as they try to re-stimulate the economy with more debt. Since 2009 they have squirted a massive amount of metaphorical lighter fluid on the economy without generating the intended results.

The strange and inexplicable contradiction in Greenspan’s thinking was that he was a free market ideologue and lifelong proponent of sound money who didn’t believe in regulation, yet once he set up shop in the Eccles building he acted like a communist party central planner in his efforts to manage the economy via monetary policy. Under Greenspan’s laissez faire worldview, the bank’s “self-interest” would prevent them from ever doing anything so stupid as to threaten their own survival, hence no third party regulation was necessary since they would in effect regulate themselves. Accordingly, any bank or business that did do something so stupid as to harm itself would get its just reward; yet anytime the market itself showed any signs of self-regulating, Greenspan would rush in with his monetary fire-hose to stop any correction dead in its tracks. So instead of letting market forces run their course, he orchestrated multiple central bank interventions designed to disrupt and manipulate markets during his tenure. This allowed imbalances and distortions to compound themselves for nearly 20 years until they finally became unsustainable. Greenspan saw little or no need to regulate banks or other market participants yet he had no hesitation about trying to regulate the economy as a whole through central bank monetary policy. In any case, it’s probably futile to try and understand the mind of man that could read Ayn Rand and actually take her literally. To be fair to Greenspan, he may be the one person most closely associated with the crisis, and certainly culpable, yet he was hardly alone in creating the ethos that gave rise to the crisis, which implicates an entire generation of economists, financiers, investors, business school professors and policy makers. Greenspan at least had the humility and honesty to admit that he had been very wrong regarding certain of his core beliefs when pressed during testimony before a congressional committee. Most ideologues will never admit to being wrong and typically respond with an endless series of excuses and denials, even going so far as to double down on their fallacious reasoning.

Another major factor contributing to the dramatic increase in debt throughout the economic system was “financial innovation” in the form of securitization. Up until the early 1980s, when a bank made a loan, the loan would remain on the bank’s balance sheet until it was repaid. This had a couple of important impacts on the business of banking. For one, banks were very careful in evaluating the credit quality of all loans since they had to live with the consequences of making such loans. Secondly, since banks kept loans on their books they couldn’t continue to make new loans once they were “loaned-up” relative to their capital and administrative structures. Historically, banking existed in a relatively steady state where new loans were made as older loans rolled off the books via repayment. As a result, there was a sort of soft limit on how much credit and money the banking system could generate in support of the economy and credit therefore tended to expand in fairly close relation to the growth of the real economy.

Securitization radically changed the dynamics of commercial and consumer lending by effectively stripping away the limitations on how many loans could be originated. Contrary to conventional wisdom, banks do not act as “intermediaries” relying on savings to make loans, rather, as explained in more detail later, they simply create money from whole cloth in the form of deposits when they agree to make loans. Once the techniques for securitization were fully developed, banks were in a position to originate loans and sell them off in a “rinse and repeat” process of credit and money creation that had little nexus to the needs of the real economy. The fact that the banks did not have to live with the loans also had the effect of reducing the bank’s true interest in the credit quality of the loans they were originating. To make matters worse, banks were also forced to progressively seek out marginally weaker borrowers as the securitization frenzy ran its course since there is a limit to the number of high quality borrowers in any economy. Banks of course deny that there was any change in their rigorous credit standards, but one only has to look at how their incentives changed to conclude that they no longer have the same interests in the loans as they did when they had to live with them through maturity.

Securitization works by “pooling” individual loans into special purpose corporations or trusts and the resulting cashflows allow the special purpose entity to issue rated, asset-backed bonds that are sold to traditional fixed income investors such as pension funds and insurance companies. Securitization was hailed as a great innovation that broadened the investor base for mortgages, thereby lowering borrowing rates and facilitating home ownership. This argument may have an element to truth to it but it is also not quite that simple for a variety of reasons. Eventually, banks and their advisors at the investment banks figured out how to securitize all types of commercial and consumer loans and this business expanded dramatically over the span of 25 years. The important point is that securitization essentially stripped away the traditional constraints on credit and money creation, thereby turning the banking system into a giant debt pump that continuously pushed new debt into the economy in ways that were hitherto not possible. Within limits this may have provided some marginal economic benefits to the economy by broadening the investor pool for commercial and consumer credit. Unfortunately the banking system became addicted to the fees and bonuses such activities generated and the banks couldn’t leave well enough alone.

Once traditional American fixed income investors were stuffed full with securitized bonds, institutional fixed income salesman from the banks and investment banks cast their nets wider and further in search of new buyers. From outpost in London and other foreign capitals the banks succeeded in luring foreign institutions into buying American securitized debt. This was good business for many years, but the pressure to generate profits and the unmitigated greed engendered by huge bonuses continued unabated until eventually there weren’t enough real fixed income investors left on the planet to consume all the securitized dollar debt the banks were pumping out. The bankers then devised a plan to lure in a new set of investors for the securitized debt they continued to manufacture.

This scheme involved creating what amounted to a captive, synthetic investor base in the form of something called special investment vehicles, or “SIVs”. SIVs are just another type of special purpose entity designed to hold debt instruments of one type and issue debt securities of another type. Of course the SIVs weren’t like real investors because they were creations of the banks without any money to invest. The secret to the SIVs was that the banks could continue to originate and/or buy junk mortgages and their securitization departments could continue to produce asset-backed AAA bonds via the securitization process. There are lots of fees to made at every step of the process. These bonds, which traditional investor had their fill of, were then stuffed into a SIV, and the SIV would in turn use the cash flows from the asset-backed junk mortgage securities to issue asset-backed AAA commercial paper, which tapped into a new investor market. Through the magic of financial hocus-pocus the banks got money market funds, that preferred ultra-safe, short-term debt instruments, to fund long-term junk mortgages. This development allowed the securitization frenzy to continue on a while longer than it otherwise would have, adding yet more debt to the system. Technically, the asset-backed commercial paper SIV structure had been around for nearly two decades but had morphed into something that had little bearing to its predecessors.

Unfortunately for the bankers there was a “fly in the ointment” and the SIVs weren’t really independent of their creators. The banks didn’t want these leveraged debt time bombs sitting on their balance sheets so they needed some third party to own the SIVs. Very few real investors were willing to put up the money to own the SIVs outright, so the banks cut deals with third parties who would agree to put up the equity to fund the SIV, but only under the condition that the bank provide a “total return swap”, thereby providing the equity holder with a guarantee against any losses. This allowed the banks to treat the SIVs as off balance sheet entities under accounting rules even though they maintained all the risk associate with ownership. In the latter stages of the credit boom, many money market investors became leery about owning the asset-backed commercial paper issued by the SIV’s so the banks ended up issuing something called “liquidity puts” in order to induce money market funds and others to continue buying the commercial paper issued by the SIVs. The banks were therefore effectively still on the hook for the toxic loans they originated even though accounting rules allowed them to treat such obligations as non-balance sheet items. Making bad loans, booking fake profits and taking home huge bonuses was banking’s modus operandi for many years and good business while it lasted. The 2008 financial crisis involved massive turmoil in the SIV commercial paper market and this market was one of the primary targets of the Federal Reserve’s rescue efforts. The bankers’ bad loans polluted even the safest and most liquid sectors of the U.S. capital markets.

The story gets even more outrageous, complicated and convoluted including even more leverage based on overnight funding involving the repo-markets which grew to enormous size and importance over the last three decades. This so called “shadow banking” system includes a multitude of players including the banks themselves. Shadow banking involves even more credit creation whereby a single bank deposit, which already supports assets of equal value on a bank’s balance sheet, can miraculously be lent out multiple times in a series of overnight or short-term transactions. And, each time the deposit is lent and re-lent it finances someone’s ownership of some debt security. These overnight lending chains of hypothecated and re-hypothecated securities were the primary source of instability that led to the 2008 financial crash.

Financial innovation in the form of securitization radically altered the business of banking by fundamentally changing the limitations that were previously inherent to the credit and money creation process. Furthermore, the shadow banking system introduced a new form of credit and money creation into the economy that was not even recognized by the monetary geniuses running the system. When properly understood, this extreme financialization of the economy is a sort of economic cancer that constantly pumps debt into the economy, inflating asset prices and producing capital gains without causing a proportionate increase in the real output and income of the economy. The excessive credit creation does, however, conveniently result in an ever-increasing share of the income produced by the real economy being paid over to the financial sector. In addition to the financial sector itself, certain closely related industries that thrive on the use of high debt levels such as the real estate and leveraged buyout industries also derive immense benefits from an endless supply of cheap credit. Unfortunately, the vast bulk of the credit creation was not used for productive purposes, rather it was used to facilitate changes in ownership of real estate and corporate assets which inflates prices but does not lead to a commensurate increase in economic output. The true source of economic gains in any economy fundamentally comes from increased productivity, not an explosion of debt, and the U.S. economy has experienced very modest growth in productivity the last few decades. In certain regards the U.S. economy took on many of the trappings of a classic pyramid scheme wherein the payouts at the top of the pyramid in the form of asset appreciation and capital gains were fueled by endless money and credit creation, not real income. Under such a system, much of the apparent aggregate wealth creation in the form of asset price inflation is illusory and really just the mirror image of the increase in debt creation. The economy, has of course, produced some real gains in output and income over the last thirty years, but such gains have not been anywhere near proportionate to the increase in debt as seen in the following chart.

The severing of money’s only remaining link to gold in 1971, misguided central bank policy and financial innovation removed the only real constraints on credit creation; cumulatively it set the stage for the U.S. banking system to produce money and credit with abandon which it did between 1987 and 2007. Still, none of it would have been possible without some outside assistance which came, first from the Arab monarchies, followed by the Japanese, and later the Chinese. With the banks flooding the world with dollars and debt as fast as they could manufacture them, there had to be “takers” for all these new dollars. The Arabs, Japanese and the Chinese happily filled that role as providers of the world’s largest vendor financing programs whereby they sold the U.S. lots of stuff, effectively on credit, much the same way GE’s leasing operation might finance some locomotives for a railroad customer of theirs. China currently leads this role and is a big reason the U.S. can continue to run large payment imbalances without the dollar becoming weaker. As long as they are happy to recycle U.S. dollars for U.S. debt there is no downward pressure on the dollar’s foreign exchange value as there would be if country like Argentina tried to pull off the same stunt. In the fiat monetary system, money needs taking, not backing, and the dollar has had takers on a massive scale courtesy of the Saudis, Japanese, and Chinese.

In summary, U.S. and global debt balances were able to explode for the following four basic reasons: A) the dollar is the primary reserve asset that backs the entire international monetary system and once the dollar was no longer tied to a physical thing that was scarce, i.e. gold; credit and money creation technically became unlimited, B) the banking system created excessive credit and money because it could, which was further enabled by lax regulation, securitization and misguided central bank ideology and policies, C) certain major U.S. trading partners facilitated the credit and money expansion because to do so was mutually beneficial and D) the credit/money expansion was a self-reinforcing virtuous system and like all bull market phenomena it basically benefited everyone, as in the entire global economy, until it went KA-BOOM. Nobody had any interest in really questioning what was going on and anyone who did was viewed as a clueless contrarian. The story of the crisis is basically that simple and doesn’t really have much, if anything, to do with dumb homeowners. The U.S. mortgage/housing bubble was fundamentally just a symptom and result of a structurally flawed global monetary system. A system that is even more indebted and flawed than it was in 2008.

Understanding Money and Banking

There is no real money in the modern fiat monetary systems; there is only debt. A dollar, whether in the form of a paper currency, or a bank deposit, is not money. It is a form of credit, i.e. a debt. We may call bank deposits and physical currency money but upon close inspection both forms of “money” are credit instruments with two counter-parties; an obligor or maker, and obligee or payee/holder, which are key characteristics of all credit instruments. This simple fact is lost on most people including many economists and financial professionals. Sovereign money, the dollar in the case of the United States, is a debt instrument that happens to be in bearer form and is therefore freely transferable. It also happens to be a non-interest bearing, perpetual debt that is redeemable for nothing, but it is a debt nonetheless and is only as sound as the sovereign entity that issues it. The issuer in this case, the Federal Reserve, acknowledges as much by labeling all paper currency as a FEDERAL RESERVE NOTE, which appears in all caps along the top of every bill. The Fed accounts for all physical currency and electronic bank reserves backing the banking system as liabilities on its balance sheet even though it has not had an obligation to honor any of these so called liabilities for several decades now. The government mandates that all such notes are “legal tender for all debts public and private” and accepts them for payment of taxes, which allows these debt instruments to freely circulate as money.

Banks are special partners with the government who have been granted a concession to create money, or to be more precise debt, in the form of deposits denominated in the national currency. Therefore, bank deposits exhibit the exact same dynamics as paper currency. The balance in a checking account is nothing more than a debt of the bank and an asset to the account holder, in other words it is a credit arrangement. When an account holder writes a check to someone, the recipient then has a claim against the check writer’s bank. Once the check is deposited and cleared the recipient of the check now has a credit claim against his bank. No real money changed hands in this simple exchange, credit was transferred, not money. Modern banking systems are best described as public/private partnerships whereby the government and banks collaborate to manage the nation’s monetary system which exists in the form of central bank reserves including physical currency, and bank deposits. Bank money in the form of deposits and sovereign money are freely interchangeable, until suddenly they are not, as in the recent case of Greece. The public takes money for granted without any true understanding of what it is, where it comes from or the rules governing its creation. Fiat monetary systems are a very recent development in the history of money even though they are the only type of system most people have ever known.

So how much of this so called money is present? What are the rules governing its creation and who is in charge? The answers are: i) it varies and in any case is not precisely known, ii) there are in effect no real rules and iii) nobody is really in charge. How odd…….but true! And yet, we act surprised and are confused when something goes wrong. Without going into all the details discussing precisely how the system works, it is critically important to understand that the conventional explanation claiming that banks act as intermediaries by taking in deposits from savers and lending them out to borrowers, implying that there is only so much money in the system at any one time, is a grossly misleading and inaccurate explanation of how the system actually works. Remarkably, the Bank of England recently decided to acknowledge that the conventional wisdom of how modern banking systems work is not quite true. They even went so far as to acknowledge that most economics textbooks have it wrong. The Bank of England’s explanation/confessions can be found by searching for “Money in the Modern Economy: An Introduction “ and “Money Creation in the Modern Economy”. To make matters even worse, economists are not only confused about money’s origins, they also don’t really know what money is or how to measure it, as none other than the Maestro himself acknowledged back in 2000,

“The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.”

Actual scientists managed to send men to the moon and back nearly 5o years ago, yet early in the 21st century practitioners of the dismal science still aren’t sure what money is, where it comes from, or how to count it. Regardless of what some economists might claim, the truth is that banks simply create money, which is really just credit, out of thin air in the form of deposits, when they agree to make a loan.

A simple example using a credit card illustrates how this works and shows why so called money is really just credit. Assume that Citibank offers a customer a credit card with a limit of $1,000. For the sake of simplicity also assume that a merchant has its account with Citibank as well, although this makes no difference to the argument, it nevertheless makes it easier for most people to follow. When the credit card account is first established and no charges have yet been made there is no new credit or money added to the system. Now assume that the card holder uses the card for the purchase of a mink bikini from a merchant for $1,000. Remember, the U.S. economy has reached a point where it is highly dependent on consumers incurring debt to buy ridiculous things they don’t need and can barely afford; most of which are made in China. Citi now has a $1,000 asset in the form of a credit card loan to its customer and the seller of the mink bikini sees their bank account balance go up by a corresponding $1,000. No real money was involved anywhere in this transaction; rather, two credit arrangements were created as follows. The credit card loan of $1,000 is an asset of Citibank and a liability of the card holder; in other words credit was created. The merchant now has a $1,000 asset in the form of a deposit claim against Citibank and Citi has a liability to the merchant in an equal amount which is obviously nothing more than another credit arrangement even though it is called money. So this simple transaction between a buyer and seller created two credit arrangements, one of which is booked as an asset of the bank and the other of which is booked as a liability of the bank. In summary; loans payable to the bank are effectively funded by the bank’s own liabilities to its customers, i.e. deposits, and alternatively, the bank’s liabilities to its depositors are backed by borrowers’ liabilities to the bank. In very simple terms a bank issues I.O.U.’s to its customers that don’t pay interest, i.e. deposits, and in return customers issue I.O.U.’s to a bank that do pay interest, i.e. loans. One of the credits is called a loan and the other credit is called money. This description of loans and money will make many people’s head spin because it seems convoluted and odd but it is nevertheless accurate and the key to understanding money and banking. The truth is that the very act of lending creates money and so called money is in reality just a proxy instrument for the underlying debt.

People aren’t accustomed to thinking about money and banking very deeply and take the system of granted without any thought. Modern fiat money is an abstract concept and money is not at all what we think it is. Money and credit creation involves two transactions whereby the banks pump their own debts into the economy in the form of deposits, which pay little or no interest, in return for corresponding debt claims against their customers which do pay interest. The two credits clearly offset each other until one day when they don’t! The bank’s liability in this credit card example is an asset to the merchant and is commonly viewed as money but it’s not really money, it’s a credit arrangement which can become painfully clear in certain scenarios.

The primary point of this simple credit card example is that Citibank did NOT take the savings of some unknown depositor and lend the money to the credit card holder; it simply created the money, i.e. the deposit, for the transaction from nothing! The normal person might ask how they can do that and the answer is: they just can, it is how banking works! Now imagine millions upon millions of credit transactions: mortgages, car loans, business loans, margin loans and credit card loans and that is how credit/money expansion works and why it can create a lot of economic activity that would not otherwise exist. Next imagine that a large percentage of the things purchased in these transactions are made in China such that a significant amount of the deposits that are produced by the American banking system get paid over to China. The Chinese end up with lots of dollars that they are happy to accept because the dollar is viewed as the world’s major international reserve currency. Dollars don’t pay interest so they convert them into U.S. government securities which do pay interest and the dollars get recycled back to the U.S. The Chinese then get blamed for facilitating a “global saving glut” that contributed to the U.S. housing bubble! As for the U.S. government debt securities held by the Chinese; well, those make up a significant portion of the reserve assets held by the Chinese Central Bank to support its currency and banking system. In other words, China’s national currency, the yuan, is backed in large part by U.S. government debt securities, which get purchased by the Chinese with dollars manufactured from whole cloth by the American banking system. The problem, as those who are paying close attention will realize, is that the entire monetary system has all the characteristics of both a money laundering operation and an enormous Ponzi scheme! And no, this is not meant to be funny, it is actually how things work.

Is it really any wonder that the U.S. financial system imploded 7 years ago and remains in a suspended state of dysfunction, or that the Chinese are now facing their very own financial crisis? Ponzi schemes can work for extended periods of time because everyone is ignorantly unaware of reality and falsely believes they are doing well. Bernie Madoff’s Ponzi scam went on for nearly three decades and throughout that period people believed they were getting richer and richer. A typical Ponzi scheme continues until it runs out of fools to fleece, but this Ponzi scheme is unique because it has a backstop in the from of a central bank that can step in to fill the void once the Ponzi participants can no longer take on the ever increasing levels of debt needed to keep the payouts at the top going. To fill the void the central banks of the world have gone full Ponzi mode, ginning up hundreds of billions of currency units per month, which is the only thing keeping the whole system from imploding. Unfortunately, it is nearly impossible for anyone to opt out of this Ponzi scheme even if they realize what is happening and this largely explains why asset prices keep rising and the economy seems to be reasonably stable. Most people are incapable of even entertaining the idea that the entire system might be a classic pyramid scheme. It is so outrageous that people simply can not believe it even when confronted with the facts. A great lesson in the power of denial and delusions can be learned from Harry Markoplos’s efforts to call attention to Bernie Madoff’s Ponzi scheme. Markopolos attempted to alert people to Madoff’s fraud beginning in 1999 and in late 2005 he sent a 19 page letter to the SEC titled, The World’s Largest Hedge is a Fraud. Markoplos’s letter laid out in remarkable detail the reasons why Madoff investment fund was a Ponzi scheme. Even then nobody wanted to believe him and it was only when Madoff himself declared in 2008 that his returns were fraudulent that people decided to pay attention. A similar type of denial exists today with regard to the dollar and other fiat monetary systems.

The key point is that the extreme increases in debt and trade imbalances would have been all but impossible under the terms of the original Bretton Woods system because as the Chinese accumulated their credit clams in the form of dollars or U.S. government debt securities they would, at some point, ask the United States to settle it credit obligations by requiring the U.S. central bank to hand over some of the U.S. gold held in the vaults of its branch on Liberty Street in New York City. This would have served to curtail credit expansion and forced the parties to seek some semblance of balance in their trade relations. With gold at the fulcrum of the system, there was a mechanism that could be invoked to curtail or extinguish the credit exposure to a sovereign issuer of money. This is just how the system worked until 1971 and has been a common and fundamental characteristic of monetary systems throughout modern history precisely because it serves to keep monetary regimes somewhat honest. A good question in all this is why the Chinese, and the Japanese before them, are willing to sell the U.S. actual goods, consisting of real things made from raw materials and labor inputs, in return for modern day wampum! It probably has something to do with the same misguided trust that led German Landesbanks to buy American subprime mortgage securities. An interesting anecdote from the 1960s involves the French who were not willing to blindly accept and accumulate American paper claims. French President Charles DeGaulle eventually decided that France had enough American paper credits and took action to redeem them by sending a warship to New York Harbor to physically collect the gold backing French dollar claims. It was not long after that Nixon decided to close the gold window.

Many people will read this and say who cares, it all works fine, it is how trade works. Others will read it and find it so preposterous that they will not believe a word of it. Nevertheless, the truth is that there is only credit in a modern fiat based monetary system even though we define certain types of credit as money. This can best be seen by contrasting a fiat based system with a commodity based monetary system which has typically involved real gold and not fool’s gold in the form of someone else’s debts which is how the modern system is currently configured. Credit still exists in a commodity based monetary system in the same ways it exists in a fiat system, as there are still loans, bank deposits and currency but there is one key distinction. If the holder of credit so chooses, it can convert its credit claim to gold which is the real money backing the system because there is no counter-party involved once the gold is in hand. In other words, real money is an asset without a corresponding liability, or as J.P. Morgan said in 1906: “gold is money, everything else is credit.”

This may seem like much to do about nothing and an attempt to romanticize something from the past. It’s not. It is a critical feature that highlights different ways of organizing monetary regimes. Each has advantages and disadvantages vis-a-vis the other, and neither is necessarily superior, but they are quite different. Without going into a detailed discussion of the merits of each system it suffices to say that in a classic gold backed system people have the option of deciding to hold the actual money and not be subject to the counter-party credit risk of the sovereign or its banking partners. In a modified gold standard system like Bretton Woods central banks had the option to require gold when they became uncomfortable with their trading partner’s finances. Of course a gold standard system is not foolproof either since the sovereign can always alter the exchange value of the commodity by edict, thereby giving itself more money, or if it really wants to be aggressive it could confiscate the actual money at say $20 per ounce, and then once it has it all, turn around and declare that it is worth $35 per ounce, as the U.S. did in the early 1930s. The sovereign typically wins because it makes all the rules and has a legal monopoly on the use of violence. Nevertheless, the serfs, euphemistically called the public in a modern democratic society, are generally better off with a commodity based system because the rules are more clear and they at least have the option to hold the actual money if they begin to distrust how the system is being managed. The entire international system is also better off under a gold linked system like Bretton Woods because it is harder for one country to monetarily bugger another country, unless of course a country wants to get buggered like the Japanese and Chinese seem to want to do. Generally speaking, a commodity based system tends to limit credit expansion and keeps international financial flows in a relatively healthy balance, at least until a war comes along. Sovereigns and their monetary partners, the banks, on the other hand prefer fiat based systems because they are more opaque and the rules are ambiguous at best, which allows them much more leeway to create money. Fabricating fiat money is, after all, the world’s greatest business. This is of course a somewhat simplistic formulation of the pros and cons of the two types of monetary regimes but nevertheless highlights a key point. It is also why the last time the world sat down to discuss the design of the international monetary system they insisted that gold would remain integral to the functioning of the system. Harry Dexter White may have been successful at placing the dollar at the center of the system in 1944 but that could only be done by maintaining a link between the dollar and gold. Interestingly, no one ever actually agreed to remove gold as the keystone of the system; it just happened and the real gold was replaced with fool’s gold in the form of the purely fiat dollar.

The key characteristics of a true fiat monetary system, which is what the system became after 1971, are: i) there is really no limit to how much credit and money can exist at one time, ii) there are no formal rules governing the system, and iii) no one is truly in charge. Central banks do have some influence in terms of regulatory authority and can influence the credit creation process by manipulating interest rates through so called open market operations. In reality though the level of control that the Federal Reserve has over the economy is about equivalent to the control someone would have while trying to drive a car on a busy freeway from the backseat using a pair of ski poles. It can be done, but not very precisely and is partly why we have credit related booms and busts. Additionally, it’s doubly hard to do when the person driving from the backseat has a pair of ideological blinders on. Even under the best of circumstances nobody is in “control” within the normal meaning of the word control and the Bank of England had the candor to admit as much. The main thing that limits how much money the banks can create is their own self-restraint and as we have learned the hard way, on more than one occasion, they are sometimes not very good at that. It’s no wonder that Henry Ford reportedly remarked that it was a good thing that most Americans did not know how banking really works, because if they did, “there’d be a revolution before tomorrow morning”.

The fact that there is no real money in the modern system is not readily apparent yet obvious upon close inspection. It becomes perfectly clear in certain situations. Greece recently experienced a banking crisis where the Greeks came to learn that the so called money they held at their banks was not really money at all. It’s a credit claim against their bank which their bank couldn’t honor. The Greeks desperately tried to convert their credit claims against their banks into a type of quasi-sovereign credit claim in the form of the Euro which for the time being is viewed as money. On the other hand, in 2001, the Argentines learned that the money in their banks was not actually money, nor was the sovereign money in the form of the peso. Both turned out be credit claims against counter-parties that could not be honored at face value. In Greece they have a banking crisis and in Argentina they had banking and a currency crisis. Banking crises are manifested by bank runs and currency crises by devaluations and inflation.

Again, all of this seems pretty obvious when talking about Greece or Argentina but it is not nearly as obvious when talking about a country like the United States, even though there is no structural difference in how the respective systems operate. They are all fiat, fractional reserve, credit based systems that are only as good as the institutions that operate them. In summary, all dollars whether in the form of a bank deposit or currency are in reality just debts or credits that are readily transferable and universally accepted as so called money. The Federal Reserve is always described as being an independent institution, but that’s nonsense designed to fool people. The central bank was created by government, is part of the government and gets staffed in its most critical aspects by the government, or by the banks that it purportedly controls but that is another matter best left for another time. In short, there is nothing truly independent about the Federal Reserve; it’s just one of many public myths and delusions that are accepted as true.

It is worth noting that all U.S. notes and coins contain the phrase: IN GOD WE TRUST, which is kind of odd given all the talk one hears in the U.S. about the separation of church and state, but apropos since there is actually nothing tangible backing the system. Therefore, it is probably wise to invoke God’s blessing. Following the closing of the gold window in 1971, the authorities might as well have replaced George Washington’s picture on the dollar bill with Bugs Bunny’s and replaced “IN GOD WE TRUST” with “THAT’S ALL FOLKS”, although to do so might have aroused a bit of suspicion. The modern system is a confidence game at its core and there is nothing wrong with such a system, in theory, if it’s reasonably well managed by both the political and monetary authorities running it. In very simple terms, one system contains only credit which can be created on a whim by men and is therefore limitless and the other is tied to a physical thing that is not limitless. In a healthy and well run monetary system the vast bulk of credit and money creation should be closely tied to productive investments with much more modest lending for consumption and speculation. It is really that simple and the key to understanding money. In any case, the last forty odd years have shown what can happen when men are left in charge without any rules.

The Financial Crisis and the Response: More Debt!!!

The U.S. banking system was on the brink of a total collapse in 2008. This was the unforeseen but inevitable result of 20 years of cumulative credit and money creation by the banking system which reached its apotheosis with the exceedingly reckless lending and money creation during the first decade of the 21st century. The banking crisis was so severe that the sovereign issuer of money, the U.S. Federal Reserve, was forced to step in on an unprecedented scale in order to avert a banking debacle that might have caused a second great depression in the United States and brought the global economy to a near standstill. The paradox for those who haven’t picked up on it, is that the entity that allowed for the runaway creation of credit in the first place and is therefore a fundamental source of the problem, is the same entity that is now expected to somehow fix the problem, which is a leap of faith to put it mildly; particularly since their solution has been to engage in the exact same set of actions that created the original problem!

The basic issue for the banks is that when a loan goes bad they may end up recovering only a fraction of what they are owed, but all the money they created to fund the loan, in the form of deposits does not go bad and continues to exist as a claim against the banking system and ultimately the sovereign. This money, which is really debt, must be honored under the rules of the game and if the banking system is in deep enough trouble the sovereign is forced to step in to shore up the system. This promise to protect deposits is at the core of the system in that it provides the “confidence” that allows the monetary and banking system to function. It didn’t always work this way. For long periods of U.S. banking history when loans went bad, the money went bad as well because the money was just private bank money, a claim against the bank and nothing else. This was eventually deemed to be intolerable and led to the creation of the Federal Reserve System in 1914 and federal deposit insurance in 1934. The problem is that if the crisis is severe enough, the debts that appear to get written off by the financial system don’t really go away, rather they get dumped directly, or indirectly, on the public at large in their capacity as taxpayers. As show in the chart below, U.S. government debt has more than doubled since the onset of the financial crisis, increasing by more than nine trillion dollars, ($9,000,000,000,000.00) since 2007.

Once the Federal Reserve understood the gravity of the 2008 crisis they invoked all the resources at their disposal and even invented some new ones in a desperate attempt shore up the system. In short they created new money, a lot of new money. A central bank is the only institution in the world that can do this because they have what a child would view as “magical” powers. They can literally conjure money out of thin air; as much as they want, although there are probably practical limits to what they can get away with. And that is just what the U.S. Federal Reserve did; it went “all in” and fabricated trillions of dollars of new money and created other “facilities” that allowed it to buy up assets and flood the system with liquidity. The Fed was desperate to do several things when it ramped up its magical money machine. It wanted to: 1) stabilize the banking system, 2) provide support for asset prices, 3) stabilize the economy, 4) create inflation and 5) ensure adequate stimulus for the economy once the dust had settled. They also want to inflate away the sovereign’s debt but that is something they can’t willingly admit to. The Fed’s actions accomplished the first three goals rather effectively but the remaining two objectives have proven more difficult to achieve.

Most people understand why they did this and view it as an appropriate, but desperate response to an extraordinary crisis. What confused and still confuses many people though is the fact that it appears to have worked, at least in part, without causing any adverse consequences. The dollar has been strong and government bond yields are at an all-time low which is surprising in many regards. The Fed quite literally solved a debt crisis by creating more debt and that is a conundrum that remains unresolved to this day. How they did this without causing any apparent negative consequences in the form of a weaker currency, weaker government credit and substantially higher price levels is what many people have been struggling to understand. Under any other circumstances such actions would have caused interest rates to spike, inflation to soar and a major devaluation of the currency but none of those things transpired. Why?

There are several fairly clear cut reasons the Fed was able to do what it did without any adverse consequences. For one, most of the major world economies were experiencing similar type problems, albeit maybe not as severe. Second, most of the major monetary authorities around the world responded by implementing policies similar to those of the Fed; maybe not as radical, but similar nonetheless. Since everyone, or most everyone, was also in a leaky boat, there was no use in trying to jump in someone else’s leaky boat. There were of course a few relatively stable boats, such as the Swiss boat, but they were so small that there was no use trying to get to them as they were quickly swamped. So in short, a crazy solution to a crazy problem did not seem so crazy when investors looked around. There was effectively nowhere to go for safety so most investors decided it was best to get in the largest of the leaky boats, probably in the hope that as the largest it would be the last to sink. This has also been described with an alternative metaphor aptly named the cleanest dirty shirt explanation. It could also be described as the stick you head in the sand, cover your ass and hope for the best strategy or the Lemming strategy. So with all the authorities doing largely the same thing, what would normally have been a competitive “beggar-thy-neighbor” race to the bottom, effectively became a standstill on a relative basis, much to the surprise of many people.

The other cry of doom from the Fed naysayers, which included many seriously smart people like Stanley Druckenmiller, was that inflation would explode as a result of fabricating so much money. Superficially, this seems like a reasonable fear, but inflation has yet to materialize for two primary reasons. One, the economy was crushed and aggregate demand was so suppressed for a time that people didn’t want to spend even if they had money. The second and more accurate reason that inflation has been so subdued is that all the money the Fed printed didn’t really make its way into the real economy. Rather it went to prop up certain financial asset prices and the money ended up sitting on the banking system’s aggregate balance sheet in the form of excess reserves where it largely sits to this day. This money in the form of excess reserves could in fact lead to an explosion of new money since it is the fuel that would allow banks to aggressively ramp up their balance sheets again via new lending. The real money printing gets done by the Fed’s banking partners. In the meantime, the new reserves allowed the Fed to park $3 trillion worth of bonds on its balance sheet and translated to a nearly equivalent amount of new deposits in the banking system which serves as liquidity for the overnight funding markets. Unfortunately, or fortunately, depending on how you look at it, the banks are still chastised by their previous stupidity and the economy is still relatively weak so new net lending and money creation on the part of the banks has been modest the last few years. In any case the last thing the world needs is more debt!

For its part, the Fed is desperate to generate some inflation as well as some real economic growth because those are the two things it needs to bailout the sovereign, businesses and consumers out of their excessive debt. With a little bit of inflation and some real growth, the increased supply of money gets absorbed more normally and debts get marginally smaller over time. This is the $20 trillion dollar question! Is it going to work? The Fed is trying to engineer this outcome because it doesn’t know what else to do. The dirty secret that nobody is really talking about is that there hasn’t actually been any meaningful deleveraging following the 2008 crisis contrary to popular belief. The reality is that the debt crisis got covered up through financial engineering and the creation of more debt. The private sector may have deleveraged marginally, if at all, but the sovereign’s debts have grown enormously as a result of the crisis. Fortunately for the dollar, it is still Numero Uno in the world of Central Bank reserves and that goes a long ways towards explaining its strength in the face of what are truly fundamental weaknesses.

It is remiss to just blindly accept the Fed’s actions as the best policy choices to a bad and desperate situation. There were alternative options that should have been evaluated and possibly pursued. There is a reasonably strong argument that policy makers could have taken actions, similar to those used to resolve the savings and loan crisis. Such policy choices were never even considered. The S&L bankers were a bunch of petty crooks compared to the bankers who destroyed the banking system in 2008/2009. The financial industry has come to wield so much power and influence over the political system and government agencies that there was never any chance that market forces would be allowed to exact a proper toll on the banks or that anyone would be held responsible. Hence, the incoming Obama administration was stacked with Wall Street insiders who had been carefully placed there to do the industry’s bidding. It wasn’t by chance or merit that the likes of Larry Summers and Timmy Geithner, who were literally instrumental in creating the crisis, were placed in the administration while the likes of Paul Volcker and Shelia Bair were pushed to the sidelines. Summers, Geithner and Greenspan make anyone’s top ten list of fools most responsible for contributing to the crisis.

Credit Cycles and the Mother of All Credit Cycles

Last year Ray Dalio put out a strikingly simplistic 30 minute animated video entitled: “How the Economic Machine Works” which deals with ideas so basic and so obvious it’s a wonder he felt any need to make it. It may be simple but it is also quite good. He has also written a corresponding 300 page paper which lays out his views in much more detail. In summary, Dalio’s main argument is that the economy is driven by transactions, productivity and something called debt cycles. The debt cycle is based on the idea that credit expansion in the form of bank loans precipitates economic growth which precipitates more credit expansion in a virtuous self-reinforcing circle until the system overshoots by producing over consumption and superfluous economic activity. George Soros has long described this type of economic feedback loop as a reflexive process. Eventually the system gets far enough out of whack that it becomes a doom loop which leads to a correction; at least that is how it is supposed to work under normal circumstances, i.e. when Alan Greenspan is not around. Dalio suggests that cycles last from 5 to 8 years which seems to be supported by ample historical evidence.

The main point being that the system tends to produce excess credit which allows people and businesses to consume more than they produce which ultimately must lead to a period where they produce more than they consume in order to balance things out. This insight about the debt cycle isn’t really insightful other than in the context of the economics profession where the one-eyed man is king in the land of blind. In Dalio’s defense, his theory may be obvious to some people, but it’s also a view that is not widely held in mainstream neoliberal economic circles which hold a utopian and highly deluded view of how the economic system works. George Soros, for one, has espoused very clear theories on fertile fallacies, reflexive processes and market distortions for over thirty years but has been utterly ignored by the economics establishment. Interestingly, Dalio makes a distinction between money and credit in his presentation which is odd since there is no real distinction between them in the modern system. He may have done so in order to simplify the discussion but he also wouldn’t be the first person to overlook this key point. On the other hand if he or anybody else of his stature were to focus on this issue it would in all likelihood precipitate a call from the Federal Reserve Chairman and/or Treasury Secretary telling them to knock it off. And if that didn’t work they might be called before the National Security Council. The U.S. central bank is as much a part of the national security apparatus as the CIA and Pentagon even if it is not widely seen as such.

Dalio goes on to argue that there is another debt cycle that overlays the common 5 to 8 year credit cycle. This is a 70 to 80 year cycle where the economic system really over does it in terms of excess lending, consumption and speculation, leading to a depression as in the 1930s, or great recession as in 2008. In the short-run debt cycle a sizable portion of individuals and businesses over borrow and over consume to the point that they eventually blow themselves up but with relatively minor damage to the banking system. In the long-term debt cycle, individuals, businesses and the banking system as a whole overdo it and blow-up the entire economy resulting in crises like those of 1929 or 2008. Dalio is probably right about this long term debt cycle but the more interesting and relevant question in the context of Dalio’s thesis is whether there is a third cycle involving the sovereign debt cycle, i.e. The Mother of All Credit Cycles, and whether this debt cycle is nearing its endgame.

Any review of monetary history reveals that monetary systems, which are as old as human civilization, come and go with regularity. Inevitably, the issuer of money finds itself in a position where it has so overspent and over borrowed that it has to start cheating to keep it all going. The sovereign issuer is in a unique position to cheat because it sets the rules and controls the system. The United States has arguably entered such a stage in its monetary history. The dollar’s status as the world’s primary reserve asset along with the ability to create credit and money without any real rules or tangible physical constraints such as gold has enabled the U.S. as a whole, both the public and private sectors, to go on an extended credit binge that traces its origins all the way back to the 1960s although it didn’t kick into high gear until 1987. The 2008/2009 downturn marked the ending of the broad based 20-year long credit expansion which saw dramatic increases in debt levels across all sectors of the economy. Remarkably, policy makers have attempted to solve the problem of too much debt with more of the same medicine that caused the problem in the first place and beginning in 2009 the U.S. central bank put its fool’s gold machine in high gear in attempt to solve the debt problem with more debt and inflation. This is nothing short of insane and has only served to produce another financial bubble which may be even bigger than the last one.

The Fed Blows Another Bubble

The Fed’s actions appear to have been effective in terms of propping up asset prices and stabilizing the economy, but at what cost? The reality is that such actions have, in all likelihood, made the system even more unstable and have led to even more mal-investment, misallocation of resources, mis-pricing of assets and risk. Keynes, in his prophetic criticism of the Treaty of Versailles, The Economic Consequences of the Peace, called attention to Lenin, of all people, who is said to have claimed that the best way to destroy the capitalist system was to debauch the currency. As Keynes explained:

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls . . . become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished not less than the proletariat. As the inflation proceeds . . . all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless.”

“Lenin was certainly right. There is no subtler, nor surer means of overturning the existing basis of society that to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

While inflation has not manifested itself to the extent the Fed would like, extended zero bound interest rates have an equally perverse effect on the core principles of a capitalist economy. Seven years of zero interest rate policy (“ZIRP”) have sent the U.S. economy, and the global economy as a whole, into a proverbial rabbit hole where it remains trapped with no idea where it might lead or how to get out. Extended ZIRP has decimated savers and continues to enrich Wall Street gamblers who are adept at using the free money for their “carry trades” and leveraged asset speculation. $100 million paintings and $75 million apartments in New York and London are the rewards of a warped and rigged system where the funny money resulting from misguided credit expansion flows into the hands of those who best understand how to play the game. It is no coincidence that a Qatari oil sheik and leveraged buyout oligarch are currently involved in nasty legal dispute about who gets to unload some of their surplus dollars for a Picasso sculpture valued at around $140 million. Additionally, the corporate sector has gone on a borrowing spree to take advantage of the record low borrowing costs. Perversely they haven’t used the money to invest in their businesses; rather the bulk of the money has been used for stock buybacks which is just a form of financial engineering that conveniently rewards senior managers through their equity incentive plans.

It’s pretty clear to anyone who is paying attention that the U.S. economy and the dollar are in uncharted territory. The structural imbalances and problems are profound without any apparent solutions. The 2008/2009 banking collapse exposed the rot at the core of U.S. banking system and for seven years now the monetary authorities have been trying to repair the damage that resulted from too much monetary stimulus with yet more monetary stimulus. What is not widely known or discussed is that the rot at the core of the banking system has largely been paper over-ed with central bank financial engineering that has only inflated the rot and passed it on to the world’s central banking systems and their sovereign sponsors where it sits today. What is true for the U.S. is also true in general for the entire global system.

Japan, Euro-Zone and China

U.S. policy makers and financial pundits are always keen to point to the problems in Japan, Europe and most recently China. It is true there are major problems wherever one cares to look and the problems are largely similar which isn’t really surprising since it’s a highly interconnected global economy. Furthermore the international monetary system was designed in 1944 as an interconnected system that placed the U.S. at the center. While the problems of the U.S. and other developed economies may be similar, they are not identical. The situation in Japan gets a lot of attention because it is so extreme it borders on the surreal in terms of the debt figures and ratios. Japan’s government debt to GDP ratio is reportedly around 230% which is unheard of for a developed country and so high it doesn’t register in the realm of normal economic doctrines for advanced economies. In addition, Japan has basically had a zero interest rate policy for over 20 years which again is inexplicable in the context of standard economics. Japan nevertheless is a highly advanced and productive economy that continues to be instrumental to the world economy.

As strange as Japan’s situation may be it can probably go on indefinitely because its monetary system is largely closed. Japan is a net exporter of many value added products the world needs and it has no external debt. It takes in more than it needs in terms of foreign exchange reserves and does not rely on any foreign funding for its debt so it’s not subject to the same market forces that could instantly wipe out an emerging market economy with funding imbalances. In the case of Japan, the only people getting harassed by its loony central bank policies are the Japanese and anyone who knows anything about Japanese culture and society, knows the Japanese people are not disposed to questioning authority or rocking the boat. Japan’s cultural emphasis on social harmony makes lemmings look like a bunch of radical anarchists next to the typical Japanese. Hence, Japan may be a monetary mess but it’s hard to understand why it matters to the international monetary system unless of course they dumped their dollar foreign exchange reserves, which is not going to happen anytime soon. The fact is that they are net exporters and savers which has kept their system stable in-spite of the extraordinary levels of government debt. In addition, debt is not particularly burdensome if interest rates are zero. Zero rates do of course distort economic incentives but as anyone who knows anything about Japan also knows, it’s not a free market capitalist economy and never has been. The main reason Japan’s situation is so odd and long running is that they do not exercise debt write downs or austerity; they only do fiscal and monetary stimulus. They never really came to terms with their own massive credit bubble which blew up in 1991. At some point, something probably has to give, but it’s hard to see what that might be let alone when.

Europe faces serious issues as well which are also related to over indebtedness. U.S. financial commentators love to tee-off on Europe, but Europe is also unique in some ways. Europe’s monetary authorities and policy makers have attempted to address its crisis related debt burdens in ways that are slightly differently from the U.S strategy. From the perspective of policy makers there are five approaches they can take to address excessive system-wide over indebtedness. One approach is through a radical free market catharsis where the entire economic system is allowed to implode. The economy melts down, debts get wiped out and harsh austerity results with all the social and political turmoil that entails. That type of response is not really a policy choice at all because any policymaker who makes that choice will not be making policy for long. It simply is not feasible politically or morally, although it is close to what happened in the 1930s in the U.S. and is still the preferred remedy of some free market libertarians. Ideally, policy makers would use some combination of four things to achieve a deleveraging of an economy that has been crushed by excessive credit creation. Debt restructuring, austerity, government fiscal stimulus and central bank monetary stimulus are the main tools that can be used to try and revive an over indebted economy.

Compared to the U.S. and Japan, Europe has placed more relative emphasis on austerity than on fiscal and monetary stimulus. This approach has been highly controversial and unpopular because austerity is the hardest objective to achieve politically. Europe has been able to place more emphasis on austerity because they have been able to impose it somewhat selectively with Greece and Ireland being the most unfortunate targets of the EU’s austerity demands. U.S. financial pundits love to point out that monetary union without fiscal union cannot work and it is certainly a flawed foundation for a single currency that is being severely tested by the current crisis but the Euro does have some strengths that are not fully appreciated. For one thing, we are seeing their ability to strong arm some of their more problematic members which if successful will strengthen the common currency system in the long-term. More importantly, the design and leadership of the European Central Bank has been heavily influenced by the German Central Bank and the Germans, having learned an awful monetary lesson some time ago, are probably the world’s most competent central bankers which bodes well for the Euro. The ECB’s emphasis on monetary stimulus has been significant yet proportionally smaller when compared to the response of the U.S. Federal Reserve. Again, the Germans know something about unsound monetary policy and are only willing to go so far in terms of printing money. Unfortunately for the Germans, an Italian is now head of the ECB. Monetary stimulus is a valid response but it also one that poses the most insidious dangers if overused. The strength of any monetary regime is a function of both the strength of the economy it represents as well as a measurement of the how well the monetary system itself is managed. A good argument can be made that Europe’s approach to the crisis is the most balanced which may bode well for its currency longer term although the current immigration crisis is of such magnitude and severity it may fundamentally alter European unity at some point via the rise of heightened nationalism.

The Chinese economy has been making major headlines the last few months and the Western media is filled with reports of a looming crisis, one that might even be catastrophic. It’s difficult to understand the extent of the problems in China and even more difficult to predict how they may play out. China is an odd hybrid state managed economy that exhibits certain capitalist economy characteristics. The primary critique of China is that its economy is also laboring under an unsupportable debt burden that arose from years of excessive state led credit creation which led to unproductive investment, i.e. ghost cities and roads to nowhere. This is undoubtedly true but China’s problem of excessive credit creation resulted in over-investment and not over-consumption of fleece vests, Nike trainers and bombs as in the U.S. which is an important distinction. It is still a problem because debt created for unproductive capital investment is still debt that cannot be repaid in the ordinary course but it is an investment nonetheless. It is certainly a much better use of money than spending around $3.0 trillion blowing things up in Iraq and Afghanistan. The irony of course is that the Chinese are the ones who have lent the U.S. something around $3.0 trillion.

China may stall out or slowdown for a time but fundamentally it is still a rapidly developing economy that has a long way to go before it becomes like Japan. China has a nearly endless supply of peasants that can be productively integrated into its economic system in the years and decades to come so the cities and roads should eventually be utilized. Additionally, China, like Japan, is a net exporter so it has more foreign exchange that it needs and its debt is not externally funded so it doesn’t face any risk of foreign capital flight. Lastly, the Communist nation is a tightly managed state economy that lacks transparency so things can get “fixed and fudged” in ways that cannot happen quite so easily in the Western economies. The most troubling and odd thing about the Chinese economy is that a substantial portion of the reserve assets held by its central bank to back its banking system and national currency consist of U.S. government debt securities.

The one thing that is consistent in all the major economic/monetary systems of the world, i.e. the U.S., the Eurozone, the U.K., Japan and China, is over indebtedness. How is it that all the major monetary systems could become over indebted at the same time? What allowed each of these systems to produce credit and money at a rate which far outstripped the corresponding growth in GDP? The answer is quite simple; this should have never happened because prudent stewards of the monetary system should have never let credit expand at an excessive rate. It really is that simple. It was completely under their control whether they will admit it or not. The fundamental problem was economic ideology coupled with a system that had no rules or constraints. Unfortunately, the 2008/2009 crash isn’t the end of the story. Today all the major economies of the world are trapped in a bizarre and tangled Faustian bargain that has backfired big-time and nobody knows how to extricate themselves from the mess. The problems are actually worse today than they were in 2008. According to a report produced by the McKinsey Global Institute, aggregate global debt has increase by a staggering $57 TRILLION since the crisis.

Economists, Witch Doctors and Other Charlatans

Felix Martin, who earned a doctorate in economics from the University of Oxford, and the author of “Money, The Unauthorized Biography”, believes that many professional economists and investors do not truly understand money. This is a profound claim that sounds outlandish but may very well be true. Economists as a group know far less than they think they do as demonstrated by their repeated inability to predict almost anything about the economy including the biggest credit bubble in the history of the world. Not that any evidence is needed, but a review of Federal Open Market Committee transcripts from the 2005/2006 time frame is a stunning indictment of some of the “brightest” minds in the profession and makes for comical reading as they lay bare their ignorance and cluelessness.

Former Federal Reserve Chairman Ben Bernanke was out and about last year promoting his book with the self-serving title: “Courage to Act”. A much better and more honest title would have been “Dumbo”, “Eyes Wide Shut” or “Hear No Bubble, See No Bubble”. He also penned an op-ed piece in the Wall Street Journal which was titled: “How the Fed Saved the Economy. A more forthright title would have been “How the Fed Saved the Economy; After it Destroyed It”. The odd thing about Bernanke is that he is described as a student of economic history with an expertise on the 1930s depression yet somehow this student of economics evidently failed to learn anything about financial bubbles and crises which are a recurring and major theme of economic history. Bernanke’s understanding of economics, banking and markets is so poor that this student of economic history did not happen to notice, and evidently was not even remotely aware, that he was personally sitting on, as chairman of the Fed, the biggest credit bubble in the history of mankind. He literally had no idea! Worse than that, he and his fellow travelers on the U.S. Ship of Fools thought the system was healthy and sound right up until the moment it blew-up in their faces! Instead of writing a book examining and discussing the mind-blowing level of ignorance and stupidity that led up to the crash, Bernanke wants the reader to focus on his heroic efforts to save the economy from a second great depression.

It is hard to know what to make of Bernanke. He seems humble enough at times and he is reportedly quite intelligent yet his failures suggest otherwise. He has also proffered an explanation for the credit bubble and crash that is so outrageous it suggests he might be: A) a comedian masquerading as an economist, B) disturbingly disingenuous or C) an idiot savant who is a savant in something other than economics. Bernanke claims the financial bubble and excessive credit creation that created it were due in large part to a “global savings glut”. This idea has been widely repeated as one of the causes of the bubble and crash without any analysis or questioning. The problem according to Bernanke was caused in large part by the Chinese who saved too many dollars and unwisely invested them back in the U.S. thereby lowering U.S. interest rates and facilitating a massive U.S. housing boom. The problem with this story is that Bernanke has it completely and utterly backwards. The Chinese would not have all those dollars to lend if the banking system led by Bernanke, and his predecessor, had not ginned up an excessive amount of money and credit in the first place, thereby facilitating a reckless and unsustainable lending, spending and investment spree. It is the U.S. banking system that creates dollars out of thin air, not the Chinese! The Chinese ended up as the recipients of those dollars because American banks willed them into existence. Furthermore, it is the U.S. Federal Reserve that sets U.S. interests rates, not Beijing! The fact of the matter is that, there was, and is, a global dollar credit glut, not a global savings glut! To this day it has evidently never dawned on anyone in the financial media to ask Bernanke to explain where all these supposed savings actually came from, or why the major economies are swamped in debt if there is so much savings in the world. Robert Triffin pointed out the fallacy of allowing one country’s currency to serve as the international reserve asset in the early 1960s. It has taken a long time but the day of reckoning is finally drawing near.

Another “notable” economist, Paul Krugman, has repeatedly defended the profession by saying that anyone who foresaw the financial crisis was just lucky. Krugman has no time or respect for people like Michael Bury, the one-eyed California doctor, turned money manager, with no education in finance and economics who clearly foresaw the problems in the U.S. financial system well before it came crashing down. Krugman resorts to the broken clock analogy to dismiss people like Bury even though Bury was anything but lucky. With his one good eye and medical training, Bury, and a few others, were able to clearly see, and comprehensively explain, the imbalances and weakness in the U.S. financial system long before the system imploded. The likes of Krugman, Summers, Geithner, Bernanke and Greenspan were not only totally unaware of the problems in the system, they actually thought things were healthy and sound. Krugman is honest enough on one hand to acknowledge that he and his peers did not see it coming, yet he is so deluded and arrogant that he claims that if a Noble prize winner with a PHD in economics, i.e. him, did not notice that a gargantuan credit bubble had formed, nobody else could have possibly foreseen it either. This is a self-serving and demonstrably ridiculous claim. He and his fellow neoliberal economists have been indoctrinated with a dogmatic, unrealistic and deeply flawed intellectual framework. The fact that their theories cannot predict or explain anything is irrelevant because their intellectual framework is internally consistent and they are sticking to it. Unfortunately for the public, economists are in league of their own in terms of the frequency, severity, and consistency of their errors. No other professional or academic field has such a persistent and disastrous record of predictive failures in modern history. No other academic or intellectual discipline receives Nobel awards for promoting ideas and theories that have proven so wrong. George Soros famously said, during a talk on the financial crisis at the Central European University, that universities and business schools have been teaching financial and economic dogma for over thirty years, which if anything is an understatement. But then again what does a mere “currency speculator” like George Soros know.

An alternative and more sinister explanation is that they are not nearly as dumb as they seem. Federal Reserve officials like Bernanke and establishment economists are probably best viewed in the context of the national security establishment. The dollar’s position as the pretend gold at the center of the international monetary system confers immense and innumerable benefits on the United States. For over forty years now the U.S. has been stuffing the Arab monarchies, Japan and China full of paper credits, of dubious value, in return for things like: Arab oil which is pretty useful; Japanese cars, TVs and cameras which Americans really seem to like; and now the Chinese are sending over container ships filled with everything needed to stock a Walmart store. Lastly, and not to be overlooked, is the fact that certain financial elites know how to get their hands on the credit/money and have become obscenely rich over the last 25 years. In this context it is no wonder official economists say some really bizarre things since it is their job to keep the whole scheme intact without letting the cat out of the bag. Central bankers always discuss their actions in the context of economic growth, stable prices and low unemployment. Those things are, at best, secondary considerations. Their most important objective is maintaining confidence in the system plain and simple. At the end of the day it is hard to know what they really believe or what their motives truly are. It is entirely possible that it is a bit of everything. Their job is clearly to keep the whole thing intact even if it is not an orchestrated scam, and it is a reasonably complicated task to run a monetary system so maybe they are a bunch of smart guys doing the best they can and making mistakes as all humans do. Furthermore, they were dealt a really bad hand so to speak, partly of their own making of course, but the burden fell disproportionally on the central bank to deal with the crisis since austerity, fiscal stimulus and bank seizures weren’t politically feasible.

The good news is that the economics profession is slowly changing and beginning to come to grips with economic reality with the work of the behavioral economists like Dan Arley, Richard Thaler and Robert Shiller amongst others. Nevertheless, it is striking that it has taken this long for the profession to even begin to acknowledge that human rationality was a flawed foundation upon which to build an intellectual framework and academic discipline. George Akerlof and Robert Shiller released a book last year called: “Phishing for Phools” which may be the first book in the history of the dismal science that discusses how free market economies actually work and not how some academic eggheads imagine they work. Unfortunately, these long overdue epiphanies come too late to help with the present disaster.

For the time being we are stuck with the modern Federal Reserve, the one without any gold, which is a lot like the Wizard of OZ. We are supposed to be awestruck by its awesomeness and the brilliance of its wizards. Don’t ask any questions or look behind the curtain; just focus on the sounds, flashing lights and smoke billowing from the machine which is proof of its immense stature and power. Yet, just like the wizard in the Wizard of Oz, the modern day Fed wizards can only portray themselves as great and powerful. When it comes to performing actual magic and miracles they have turned out to be very ordinary and highly fallible men who have shown they have little or no idea what they are doing and are evidently no smarter than Joseph Cassano. They carry themselves with great importance and use esoteric jargon that bamboozles the jabber-mouths at CNBC who haven’t seemed to notice that the same ship of fools who sailed the economy into the abyss are back at the helm for another go and up to their same old tricks.

U.S. central bankers and economists were reportedly busy deliberating the Phillip’s curve during the latter half of 2015 as they considered whether to start normalizing interest rates. The problem is that the Phillip’s curve has not had any nexus to the American economy for over thirty years. The unemployment rate may have some relationship to inflation in theory, but not in an economy with tens of millions of illegal immigrants, or in an economy whose corporations are only too eager to outsource jobs. Additionally, the technology industry is hell-bent on eliminating as many jobs from the economy as possible. Technology has long had a role in labor markets, but for most of that history it made people more productive; it is now entering a phase where it wants to make people utterly irrelevant. In short, there has not been any wage generated inflation in the U.S. for decades and in all likelihood there is not going to be any for several more. The minimum wage may be increasing, but it is rising from a level that does not provide enough income to house and feed a cat. Paying people $15/hour certainly is not going to launch an inflationary firestorm regardless of what the U.S. Chamber of Commerce might claim. The fact that U.S. central bankers were focused on the Phillip’s curve as they weighed whether or not to raise interest rates proves how divorced from reality they have become. They would have been better off consulting a Ouija board.

Late last year, the Fed decided to raise its target interest rate to 50 basis points. Ignoring the fact that the Fed decided to raise rates in the face of persistent deflationary signals and growing evidence of global recession, the real issue with this announcement, and something that has not been widely discussed, is that the Fed cannot raise interest rates through normal monetary mechanisms. The reality is that there is no real Federal Funds market to target; not with over $3.0 trillion of excess reserves sloshing around the banking system. If the Fed had honesty tried to “tighten” monetary policy and utilized its traditional open market operations to normalize Fed Funds trading it would have had to shrink is bloated balance sheet by withdrawing a couple of trillion dollars of reserves from the banking system, which would have precipitated a financial crash of immense magnitude. So instead, the geniuses running the system came up with a way to fake an interest rate increase by declaring they would pay 50 basis points on excess reserves thereby gifting the banking system somewhere around $13 billion in free profits at taxpayer expense. They also announced that they would pay 25 to 50 basis points on their reverse repurchase program which is another way of faking a rate increase since it is not a rate that has anything to do with normal market pricing mechanisms. The fact that they had to fake their rate increase just proves that the U.S. system is still in state of serious dysfunction where all financial assets are mis-priced starting with the price of money. As it stands central banks no longer have any real control over interest rates; it is all an illusion and investors are just like the audience at a David Copperfield performance, dumbfounded and totally bamboozled by the sophisticated optics and slight of hand. The reality is the entire international monetary system is a total and utter mess with no solution in sight.

Conclusion

This essay is focused on the dollar but the points raised herein apply to most of the world’s major fiat money systems. Smaller, less important countries, such as Greece and Argentina routinely blow themselves up through unsound fiscal and monetary policies but the larger system has reached a point where it exhibits the worst of those unsound polices on a massive scale and has in effect become one giant Argentina.

It bears repeating to recall that there is no true money in the modern system. All so called money today is really debt and none of it is collectible. It can only be used to offset other debts. Bank deposits can be used to settle bank loans in which case both disappear from the system just as they appeared. Bank notes, and bank reserves, i.e. claims against the central bank can be used to offset debts to the sovereign in the form of taxes which is fundamentally where a currency’s value originates.

Some commentators get agitated and worked up about the expansion of the Fed’s balance sheet from $.9 trillion to $4.5 trillion and point out that the Fed is leveraged at something like 80:1 which is certainly a lot of leverage, but the real question is why they even have a balance sheet or any assets in the first place since they never have to pay any one. The Fed’s balance sheet could just as easily go to $6 trillion or $10 trillion if they wanted it to because it’s really just an illusion designed to make people believe there is something tangible backing the monetary system. The fact is that nobody can ever have any of those trillions of dollars worth of reserve assets the central bank maintains to back all the dollars, and even if someone could have them, those reserve assets are payable in the very thing someone would be trying to rid themselves of, i.e. dollars. In other words, modern money is really nothing more than the world’s largest and most elaborate daisy chain. The strange thing about this is that it has literally taken thousands of years for such a system to have come into being. For most of human history, up until about 40 years ago, if someone had suggested such a system they would have been branded a thief and thrown out on the street. Now we just unquestionably accept it.

The public is constantly told, and market participant seem to believe, that the Fed has immense powers, not realizing that such purported powers are a lot like the powers of the tooth fairy. They exist mainly in the eyes of the beholders, and children and investors are better off not knowing how they actually work if they want to avoid being disappointed. The illusion is much more powerful than the reality. If people want to believe that entering in a few commands on a computer monitor and thereby creating $3 trillion of new bank reserves involves some type extraordinary power they are sadly mistaken. Those people, no doubt, would be even more impressed if the Fed ginned up another $3 trillion of reserves because that would be even more powerful and that much more impressive! A modern central bank, running a purely fiat based monetary system, is an institution that relies more on myth and fiction than actual substance for its legitimacy. The real power of the Fed does not involve fabricating trillions of dollars from the ether, to the contrary, that is a sign of desperation and weakness. The proper power of a central bank is in carefully regulating the banking sector and monitoring the money/credit creation process in order to make sure it does not expand at a rate that is disproportionate to the growth of the real economy. The Fed has failed miserably in this role and has in effect abrogated its most important and real power. It is now desperately trying to debase the nation’s currency via inflation and has proven powerless to do even that successfully. For the time being, most investors still have confidence in the Fed, but that confidence is based on a delusion.

As cynical as this essay is about central banks, the dollar and other fiat based currencies it’s not an outright renunciation of such a system. Money does not necessarily have to be backed by anything tangible including gold. Money is best viewed as a credit, accounting and payment clearing system where some form of tokens are used to measure the value of real goods and services, i.e. the unit of account function. The tokens can then be used in exchange for those real goods and services as long as everyone in the economy is willing to accept the tokens, i.e. the medium of exchange function of money. Lastly, the tokens need to hold their value reasonably well which makes people willing to keep and store them; the store of value function. It’s really that simple and the tokens/money can take many forms including seashells, small pebbles of a certain color size or shape or bitcoins. They could even be engraved pieces of paper with pictures of dead people on them. In other words the existing system is perfectly fine because the tokens do not necessarily have to have any intrinsic value. What they do need though is some “scarcity” value; meaning someone cannot just conjure them up from nothing like the U.S. has been able to do under the current system. Gold has historically been used to address the store of value problem because it is proven in its ability to keep a monetary system reasonably honest. Control over the money supply is critical to maintaining its store of value function. Many people view gold’s role as a crude attempt to address this issue and an anachronism, but these people are naive to think that men alone can be trusted to run an honest monetary system based on a purely fiat standard. One only needs to look at what has happened to the value of the dollar since 1971 to prove this point. The dollar has lost approximately 98% of its value versus gold, about 85% of its value versus the Swiss franc, 75% of its value versus the yen and 95% of its value versus the Butterfinger. The “almighty dollar” is a vacuous slogan and effective bit of agitprop that rings true only when comparing the dollar to the currencies of third world banana republics.

The most fundamental questions relating to monetary systems are: who controls the system, and what are the rules. As we have learned over time, control of the system conveys immense power on those who run the system and those who know how to use it. We have also learned that such a system without any real rules or physical constraints on it is a recipe for mistakes, abuse, inequity and disaster. Commodity based systems are also prone to problems but are arguably much more stable because the commodity places some limits on the ability to create credit and money and also acts as a mechanism to stabilize inter-system trade balances.

Little known to the public at large is the fact that all of the world’s major central banks, and the Bank for International Settlements, the central bank for central banks, maintain massive gold holdings measuring in the hundreds to thousands of tons. The gold does not account for a major portion of their reserve assets at current values, but the fact that they all maintain substantial gold holdings speaks volumes about gold’s continuing importance in the system. No major central bank dares to go completely gold-less because gold is still the ultimate security in the system although no central banker in the world will publicly acknowledge this. Interestingly, the Germans recently decided to withdraw over 300 tons of their gold held in the vaults at the NY Fed and move it to Bundesbank vaults in Frankfurt. For decades the Germans preferred to keep their gold in vaults as far away as possible from the Russians, now they seem to want to get it as far away as possible from the Americans. To be fair, even after the withdrawal, the Germans will still maintain a sizable portion of their gold in the NY Fed’s vaults. The decision and timing of the move is nevertheless curious. Economists and central bankers always attempt to dismiss these gold holding as mere artifacts, which begs the question of why they need to hold so bloody much of it in heavily reinforced and well guarded vaults. A bar or two would be more than enough for a historical exhibit. As for gold and the international monetary system at large, the authorities do not want the public to understand the system; they just want the public to trust it.

Money is a cultural creation based on a foundation of mutual trust. Money’s most critical value is confidence. The money itself, even when comprised of gold, has limited intrinsic value. This can be a difficult concept to grasp but it is at the core of what money truly is and what makes the distinction between fiat systems and commodity systems hard for many people to understand. We have reached a point where many thoughtful people dismiss a gold backed system as something too primitive, inappropriate and unnecessary for modern civilization, and in theory they are absolutely right. What they do not grasp or understand though is that the current system is tethered to nothing, it does not even have a set of rules governing its operation and there is no central authority in charge of it, which is why we are in the midst of a monetary disaster. People have been duped and/or duped themselves, slowly and over an extended period of time, into trusting a system that is deeply flawed and fundamentally untrustworthy.

The imbalances and dysfunction in the global economy and international monetary system have reached such extremes that the current situation is clearly unsustainable. The difficult thing is to try and understand how it might play out. The history of money is one of crisis and restructuring of the prevailing order. This will be no different, the question is when and how severe will be the adjustment. One would expect something reasonably soon yet the example of Japan which has been muddling along just fine for 25 years suggests that strange and irrational economic situations can go on far longer than expected. The international monetary system is a logical subject that is presently riddled with illogical realities. Money is as fundamental to civilization as air is to life because it is what mediates almost all forms of social interaction and without money there is no economy and no civilization as we know it. There is no real choice to abandon the dollar because the alternate is global chaos. Yet, the current system is one enormous debt bomb that cannot last.

The question is how long can the current unstable situation continue and how abruptly does it end. History has shown that unstable and irrational situations can last much longer than people expect but eventually the reckoning comes along. The dollar has all the characteristics of a giant pyramid scheme although it is probably not on the verge of collapse. It is weak, unstable and vulnerable in spite of its apparent strength. This contradiction is hard to explain and reconcile yet we often see these things in economic affairs. A few years ago, the banks were viewed as highly profitable and well capitalized with sophisticated risk management systems that attested to the soundness of their assets and brilliance of their managers. Financial engineering, including the slicing and dicing of mortgages, was promoted as a testament to America’s standing as the most advanced and sophisticated civilization in the world, the economic equivalent of space travel. Derivatives such as credit default swaps were touted as innovative products that allowed risk to be hedged, dispersed and transferred to sophisticated players such that the overall stability of the system was increased. None of these things were true. In fact, the exact opposite was true, but for a long time it appeared to be true. Derivatives allowed risks to be increased, obscured and concentrated in ways that destabilized the entire system. The point being that delusions and idiocy can often masquerade as official wisdom until suddenly exposed to everyone’s great surprise. This time will be no different.

There is always a great deal of denial built into investor’s psyches and nobody has any interest in seeing the global monetary system abruptly upended. By comparison it is relatively easy to abandon the stock market and fairly easy to abandon a failing bank but it is very difficult to abandon the entire monetary system. A second coming of Bretton Woods is inevitable and we can only hope that the car full of clowns who created this mess can somehow diffuse the bomb without blowing up the world economy in the process. The new system may or may not incorporate gold again. In theory it does not need to. It can be rebuilt around the idea of something like the special drawing rights, or SDRs, which already exist but it will need to be a rule bound system subject to the consent and control of all the major countries and therefore not under the control of one country as the current system effectively is. In the meantime, it is probably prudent for any savvy investor to hold some real gold.

Serious doubts are beginning to slowly creep into the system and signs of economic weakness are spreading around the globe like wildfire. When the time comes all of the lemmings will simultaneously attempt to sell all risk related assets: stocks, bonds, real estate, money markets etc, and will in all likelihood stampede straight to the dollar which might ultimately prove to be the most dangerous place of all. Then again it is impossible to outwit stupidity and maybe the dollar will rise to unprecedented strength in some type of final, stupendous, self-fulfilling act of idiocy. It is sure to be interesting and it may happen sooner rather than later.

Many people may read this essay and think the observations and conclusions are farfetched, misguided and inaccurate. Anyone wanting to form their own opinions about money needs to first put the dollar and the 2008 crisis in a broad historical perspective. The time period from 1971 to the present is only the second major example in the entire history of money that there has been a purely fiat based monetary system. The other official fiat money regime existed in China several hundred years ago. Secondly, anyone who takes the time to read this essay should ask themselves the following five questions:

1. What is money?
2. How much of it is there?
3. Where does it come from?
4. What are the rules governing its creation?
5. Who gets to decide?

Very few people, including most economists, understand the answers to any of these questions, which is an indication of how esoteric and strange the modern system has become. We are in the midst of a great fiat monetary experiment which is in the process of playing itself out. The central banks of the world are engaged in an increasingly desperate attempt to maintain the fiat house of cards that they constructed over the last 40 years. There is no precedent in the history of money that provides any guidance on how to deal with the present situation. The central banks are flying by the seat of their pants and literally have no idea where this leads or how it ends. How long they can maintain the facade is unknown, and unknowable. The one thing that history has repeatedly shown is that whenever there has been monetary turmoil, when the sovereign’s clipping have been exposed, the natural reaction of people and subsequently the authorities, has been to hitch the monetary standard back to the “Golden Anchor“ albeit at much higher exchange ratio as a way of restoring confidence and stabilizing a chaotic monetary environment.

There are many rumors that central banks have been intervening in the gold market to keep the price of gold artificially low so as to downplay gold’s role in monetary systems. These rumors are impossible to verify but they are plausible at some level. The current system is the world’s largest and most sophisticated confidence game and if the public were ever to view gold as a monetary asset the entire fiat edifice will come tumbling down. This is not a conspiracy theory; it just a practical reality that has been forced on today’s central bankers. Their overriding objective is not unemployment, inflation or economic growth, it is first and foremost to maintain confidence in the system. It is interesting to note that a major Goldman Sachs partner left the firm a few years ago to found a company that allows wealthy individual investors to physically purchase precious metals and store them in vaults strategically located around the world. Again, there is no conspiracy implied in creating such a company but it does suggest that smart, sophisticated and well-connected people know what is at stake at the present time. There is basically a historical precedent over 3000 years of civilization to suggest that gold may “officially” re-enter the monetary system at some point. Is this period of monetary turmoil any different? Only time will tell.

Since the start of the year global markets have been in turmoil and leading business indicators are sinking fast. This is not an issue of commodity cycles or some kind of ordinary downturn in the business cycle, rather it is a sign of a badly broken monetary system. The monetary authorities have blown it and have lost control of the system although nobody in a position of authority dares to admit it. The grand fiat monetary experiment is approaching its denouement and the global economy is in for rough times for the foreseeable future. Central banks have been desperate to get the global economy going again by restarting the lend and spend model of the last several decades and it is not working for obvious reasons. Nevertheless they continue to consider more QE which won’t work and they can never raise rates in any meaningful amount with so much debt in the system. The latest policy of negative interests rates, or “NIRP”, hasn’t gone over well and only further distorts economic activity, although it does at least slow the exponential growth inherent in an over indebted system. Eventually, they will be forced to consider so called helicopter money, officially known as “money-financed-fiscal programs”, whereby they find a way to actually give money to the public without creating a corresponding debt claim. All of these so called “policy tools” are really just desperate “Hail Mary” efforts to keep the whole system from imploding. The end game may play out in a real disaster that will make 2008 look tame in comparison or it might muddle along for years in some type of dysfunctional state of affairs.

The fact remains that the entire global economic system is buried under a mountain of debt, much of which can not be repaid. There are two paths out of this morass, both of which are highly problematic. Each involves a type of monetary reset. The system is currently headed towards a deflationary collapse whereby asset prices collapse and debts get wiped out via defaults and restructurings. The authorities have succeeded in temporarily arresting the deflationary forces with their QE, ZIRP and NIRP policies, but they have done it by piling even more debt into the system which has only pushed the day of reckoning down the road. The other alternative, and the one that is favored, is to unleash an inflationary spiral that will raise the overall price level such that the debt burden becomes more manageable. The authorities, and those that hold the assets, prefer the inflationary solution because they will be better able to maintain their wealth and power under such a scenario. So far though, their efforts to create inflation in an over indebted system by ginning up even more debt is failing. It is simply not possible to create heightened economic growth and broad based price inflation under such circumstances.

The key insight is that there is no real money in the modern monetary system, there is only credit. Every dollar in the world, whether in the form of bank deposits or bank reserves, including the physical manifestation of those reserves, i.e. currency, began its existence simultaneously with the creation of some interest bearing debt claim and therefore, “money” is really just a proxy instrument for all the debts in the system. This is an esoteric point that very few people truly grasp. The problem for the central banks is that they are trying to create moderate inflation by creating more money, but money can not be created without creating debt and there is no way more debt is going to create inflation in an over indebted system. Japan has been proving this point for 25 years now. The only chance of inflation as things now stand is if monetary velocity takes off because people lose confidence in the system and reach a point where they want to hold anything other than money, a can of beans, some 2x4s, etc. Anything with real value. We haven’t reached that point yet but we may. In any case that isn’t the kind of inflation they are hoping for as both the debts and money become worthless under such circumstances.

One would think this would be obvious to the central bankers running the system, but it is worth remembering that these are the same clowns who didn’t happen to notice that their previous policies created the biggest credit bubble in the history of human civilization. Eventually they will decide to resort to helicopter money. Helicopter money is just more “quantitative easing” by another name and with a slight twist. The trick to helicopter money is to somehow create the money without creating an interest bearing debt claim against the sovereign, and to then give the new money to the public through some fiscal mechanism. Unfortunately for the public, helicopter money, when and if it should materialize in the United States, will probably only be given to the people who can already afford helicopters if past central bank policy and preferences are any indication.

The real problem with helicopter money is that in order to make all the balance sheet ledgers reconcile the Fed needs to put something on the asset side of its balance sheet and it can not be in the form of an interest bearing debt claim as would normally be the case with Q.E. In all likelihood this will involve some type of new “asset” claim against the government in the form of a “zero coupon perpetual note” which should be the final straw in the era of monetary lunacy. The problem for the Fed is that helicopter money involves a directly linked fiscal component, which involves congress, and when people actually stop to learn the details of what helicopter money really means they may finally wake up and realize that fiat money is really just fiat fraud! Desperate monetary policy only leads to even more desperate policy which is exactly what happens in the latter stages of any pyramid scheme as the orchestrators become ever more desperate to keep their schemes from imploding. When and how this ends nobody knows, but it will end at some point. The most intriguing questions are how much longer the world will go on pretending that central bankers are competent or that the dollar is as good as gold? The answer to those questions are anybody’s guess, but it’s unlikely to go on forever.