Uncle Sol Starting a thought farm

Prescription For a New Economy

Karl Denninger rants this morning quite vociferously on what needs to be done to clear up the mess we are in. It wouldn't be popular. In fact, I would expect mass protests if this sort of thing were done. Yet, that doesn't make it any less true. The only thing I can think of that I would do differently is I would abolish the Federal Reserve outright. Here is an excerpt:

(It)...will happen - an "unexpected" recognition of the reality that what is being done today both is unsustainable and won't work, but we will do nothing appropriate about any of it until we find ourselves well-off the cliff and furiously pedaling in the air like Wile-E-Coyote - and at that point it will be to late to avoid the ugly consequences.

Read the whole article here. It's well worth the time.

UPDATE:

It's been pointed out to me that while Denninger's post is very well to the point, the actual consequences of these things are not specifically articulated. If you read the Market Ticker, you'll note that he has gone into more detail in other articles, but still, it's worth pointing out here to save you the trouble of reading through hours of archives.

Water always finds its level. This works in the physical world as well as within economics. If there is a supply of a scarce resource, and a demand for it, some system must be used to distribute it. For most goods and services in the U.S. we use the price system. We use it because it works. It isn't always fair, but saying so is like me saying that my ruler isn't fair because it never tells me that I'm over 6 feet tall. Price is simply a measure of the supply of a scarce resource and the demand there is for it in the market place. The millions of people making transactions over that resource are what set the price. Charge too much for it and you'll have a surplus (note the empty seats at Ford Field circa 2008). Charge too little for it and you'll quickly run out. Try to sell your mint collection of bootleg Beatle's LP's for a buck a piece on Ebay and see what happens.

This all makes sense to most people. But then, we don't think of things like interest rates as being prices. The interest rate I pay on my mortgage is the price of borrowing the money I used to purchase my home. But we don't use a normal price system for setting interest rates. We use a bunch of powerful people in Washington who have set up a very complicated system to set interest rates where they want them. One key to how this system works is the continued expansion of bank credit. By this I mean that over time banks have to lend more and more money to keep this system working.

However, some very thoughtful people like Ludwig von Mises and F.A. von Hayek, quite a long time ago pointed out that if you use the expansion of bank credit to expand an economy you will create inflationary bubbles in that economy, which will, by definition, at some point burst. Over the past couple of years we have seen some very big bubbles burst. First with the housing market, and then within the banking system itself. Water is finding its level. These things we are borrowing money for are going back to their true value, and we are helpless to stop it.

If you look at the statistics lately, the one statistic that really stands out is what the Federal Reserve calls Z1. It is the total amount of money being lent in the economy. In a debt based system such as we have, Z1 is the real money supply. This has contracted by more than 10% over the past two years. A 10% contraction of money supply is the textbook definition of a depression. What is happening is banks are scaling back the amount of money they are lending.

Why?

Why are banks scaling this back? This is a point that seems lost on many economists, but seems fairly obvious to me. Banks are keeping large amounts of cash reserves on hand instead of lending the money out. I've heard the President and Treasury Secretary complain about this on the news. The reason is that the banks know they are in trouble. These banks own the paper on the loans that have been drawn to purchase many things (mostly houses) that are now worth much less than the loans given. Every time one of those loans goes bad, the bank is unable to recoup the difference and that money simply disappears as tribute to the economy gods. It goes "poof". So, in order to keep from going under, the banks are not lending money, lest their asset bases evaporate. Though, it's recently been pointed out that if these banks had to mark their assets at the true value of the properties they have mortgaged, there isn't one bank in the U.S. that would currently be solvent. This is a problem.

So, in a debt based economy with lending contracting, less "stuff" is being purchased. The government is trying to counterbalance this effect by borrowing a bunch of more money itself and pumping it in to the economy. The trouble is that this never works. Government doesn't spend money the way that you and I spend money. So when government pumps money into the economy it makes it look like demand for certain goods and services is higher than it actually is, and when the water finds its level again, the producers of those goods and services find that they have over-invested in production and the bubble bursts again.

Yet Washington continues to try. Now, finally, they are running into the final problem. They can put as much money out there that they want banks to lend and they want people to borrow, but people just don't want to borrow it. People are at their limits with debt. They are concerned about their jobs. They just don't want to borrow anymore.

The real trouble is just beginning. As the government borrows more and more money to fund its stimuli and the economy refuses to recover, the ability to pay it back will come severely into question. When investors in that debt (people that hold treasury securities) begin to doubt it will be paid back, they will begin to rush to cash those securities in. And then the government will be forced to inflate more to pay it back (see Weimar Republic, circa 1930) or they will default. If the government defaults on its loans, the currency will tank. The best case scenario is that this will cause imported goods (including oil) to shoot sky high. The worst case scenario is that no one will be willing to take dollars in payments, as it has become virtually worthless. In any of these cases what will result is catastrophic. It doesn't make sense to go to work if they can't pay you in anything of any value. If you can't get paid you can't eat. Then you have to find a way to survive.

What we have at risk here is a systemic crash. The falling of an empire. The end of the U.S.A. So, when you read Denninger's piece, you can see why he's so upset. You can see why he calls for jail sentences for the offending parties. This isn't just a slump we're talking about here. It's survival.

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