28 thoughts on “Effective treatment for this crisis will come with “The Master Settlement of 2009”

  1. I’ll float the naive question: what are the reasons that the several states are precluded from addressing the problems of their own citizens WRT the crisis? Or, why is DC the sole source of leadership?
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    Fabius Maximus replies: Many States will have severe problems, which they might not be able to cope with on their own. Many States and their municipal entities have expanded spending, relying on highly cylical sources of income. The recession will drastically reduce revenue and increase social service expenditures. States cannot print money, most are required to have a balanced budgets, and often have high debt loads. The results will not be pretty.

  2. “The solution must also not substantially raise US interest rates or destabilize the US dollar.” “We are likely to get the money we need.” “The US receives $1.5 trillion in new lending in 2009 and 2010, with smaller loans in the following five years.”

    Those are very large assumptions. China’s inflation rate is currently about 9%, a 12-year high. See “China’s inflation policy stirs the world“, Asia Times, 22 September 2007.

    Inflation in the Middle East is about 10%, per “Moody’s reports: Middle East inflation surge sharpens fiscal and political risks“, AME Info, 5 June 2008.

    My point is that our creditors may be forced to revalue their currencies and raise their domestic interest rates without any input from the U.S. This makes your Master Settlement an optimistic but unlikely scenario. Rising rates for government bonds in Asia will make foreign central banks and sovereign wealth funds look in their own backyards for new bond issues before they look to the U.S.

    “Like the post-WWII UK, foreign bases — and foreign wars — will become expensive luxuries.”

    Like post-WWI Germany, foreign military adventures are not necessarily ruled out for a debt-laden, destitute nation. Perhaps a study of the Weimar Republic would be instructive. Our creditors may have use for the U.S. as a mercenary proxy.
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    Fabius Maximus replies: A US devaluation vs. their (China, Arab oil exporters) currencies will slow their export growth and reduce their inflation — as their artificially depressed currencies and interest rates are the primary cause. So I see little conflict here. They have faster growth rates and should therefore have higher interest rates; this is part of the “global rebalancing” that has so long been discussed by economists.

    “Like post-WWI Germany, foreign military adventures are not necessarily ruled out for a debt-laden, destitute nation.”

    German military adventures of 1939 – 1945 were conducted by a nation far from “debt-laden, destitute.” The Weimer crisis was 1921-1923. This wiped away much of their debt (at the cost of destabilizing the political regime, eventually leading to Hitler). Hitler’s extreme Keynesian response to the Great Depression (taken before Keynes wrote his great work in 1936) meant that Germany did better in the 1930’s than the UK or US.

    This is easily seen by comparing pictures of German and British enlisted men in WWII. The Brits tended to be smaller than the Germans, and bowlegged (poor diet in childhood). Now if only Hitler had ambitions other than war…

    “Our creditors may have use for the U.S. as a mercenary proxy.”

    Let’s not exaggerate. The situation is not that bad. We are Asia’s best customer, and our continued economic health is in their interest as well.

  3. your lack of understanding of how the federal govenment funds itself is astonishing. your insitance on our need to arrange financing from other nations and the implications of such a need make the rest of your analysis laughable.
    why would we denomiate bonds in any currency other than dollars and put ourselves in the positions of the third would countries you allude to – those with dollar liabilities and no source of dollars.
    until you realize that we are no longer on the gold standard, that foreign central banks hold dollars as a result of their fx policy (obtained through fx intervention when their nationals sell dollars), that bonds issuance is a reserve drain, not a means for the federal government borrowing money your analysis will make no practical sense.
    eg. if the govt needs an 10 billion dollar aircraft carrier it doesnt go to china and borrow the money. the treasury’s account at the fed is debited and the payments are credited to the accounts of those building the carrier. bonds are issued that in effect drain the reserves that were added through governemt spending. this is not opinion or speculation, this is economic fact – its how the system works.
    the public sector deficit is equal exactly to the private sector surplus (private sector includes foreign private sector).
    the money to buy bonds must come first from public sector spending – there is no other source of dollars.
    btw, the current budget deficit of about 4% of gdp is far too small to support agregate demand expansion. we can increase this ratio substantailly without generating any significant inflationary pressures and we will.

  4. Seems like history repeating, the British Empire ended after being bankrupted by WW2 and its ‘closest’ ally had it repaying WW2 debts until just 2 or 3 years ago. America rose to the top lending money, launching economic plans with very specific requirements and shaped the world that followed.

    Now we have America, running short on money due to wars and questionable economic practices. You would be very lucky if the caveats you mention above are the only ones leveled by the few states capable of lending serious capital as they have their own specific ideas regarding economics and political/ideological views of the world. Indeed, this may well be an ‘inflection’ point if history.

  5. To sg:
    “why would we denomiate bonds in any currency other than dollars and put ourselves in the positions of the third would countries you allude to – those with dollar liabilities and no source of dollars.”
    “if the govt needs an 10 billion dollar aircraft carrier it doesnt go to china and borrow the money. the treasury’s account at the fed is debited and the payments are credited to the accounts of those building the carrier.”

    It is pretty amazing. It is just like alchemic transformation of copper to gold. You are real lucky to have such a finance perpetuum mobile.

  6. to VC-Beggars can’t set the terms of their debt. ‘Too big to fail’ in the interconnected world, and China’s fragile internal political predicament, may restrain creditors demands some. But the US will need so much borrowing that borrowing terms, especially rate & currency, will benefit creditor asian central banks and petro-state sovereign wealth funds.

    to FM-  Thanks for a great post and very timely. What do you see as the risk that foreign investors will also acquire broader US hard assets, especially substantial influencing (if not literally controlling) stakes in US technology companies?
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    Fabius Maximus replies: Forecasts on these things are just WAG’s. Much will depend on the objective and physchological situation of our external creditors. For example, are China’s internal dynamics — economical and political — fragile? So far as I can tell, we don’t know. Some experts tend to aggressive guessing, and their views seem to dominate over the cautious explanations of their peers.

    My guess is that there will be no extreme steps — like those you mention — at least for the next few years. These situations evolve slowly; there are many rounds of the game ahead. Our situation is not dire. If we handle ourselves well, we can come out of this even stronger — and much better founded — that we are today.

  7. The United States, in seeking to adjust to its post-settlement humbled status, should turn to Australia for guidance. Although culturally resembling the US in many respects, Australia has never had any pretensions for world dominance.

    In particular, the US should study the works of Henry Lawson, the Australian writer and poet whose theme was confronting the gritty challenges of the great, barren Australian outback.

    For a flavor of Lawson, read The Drover’s Wife. Her husband gone on a multi-year trek to the north, she, alone in the outback, cares for her children accompanied by her mangy dog. The plot directly involves her detecting and killing a snake in her cabin. ( Australia has snakes 100 times more venomous than the king cobra. )

  8. Most of your predictions about a master settlement sound credible. There will likely be waves of settlements — ongoing tranches of loans that will continue for years. You’re quoting the right people — Nouriel Roubini, Roger Ehrenberg, Warren Buffett, Bill Gross. I’d prefer that Gross or Buffett oversee this process rather than Paulson.

    It’s unclear what kind of political concessions China will demand. Personally, I suspect they’ll demand significant ownership positions in U.S. companies rather than concessions on Taiwan. The Chinese make much noise about Taiwan, but if they were to actually emake a mov to annex it, capital and engineering and tech talent would flee Taiwan en masse, leaving the Chinese with nothing. If, on the other hand, China extends a “sphere of influence” to cover Taiwan with guarantees against oppression of the kind China gave to Hong Kong after 1997, then it’s not a big issue. Taiwan would become a protectorate in name only.

    European bailout of Hypo Bank just failed. Settlement in 2009 is likely to go both ways. America needs loans from the Chinese and Europeans, while the Europeans need cash from us to shore up collapsing institutions like Hypo and the German central banks, which now threaten to default. Meanwhile, the Chinese central bank is in crisis, so they may need an infusion of cash from us as well.

    The essential issue? Restoring trust in the financial system so overnight loans unfreeze and LIBOR rates drop back to normal. Roger Ehrenberg keeps hammering on the need for more transparency, and that sounds especially important.

    One big problem: the current maladministration has lied so often that now, when it’s crucial to regain the trust of the markets, no one believes a thing the White House says. We’ve all been burned too often by their lies. Restoring trust in the markets may have to wait for a new president.

    This could pose a real problem, since the credit markets have to unfreeze within the next few days or everyone’s in real trouble.

    You’ve been getting extreme far-right crackpot suggestsion of “let it all collapse” and “do nothing” because Glenn Reynolds linked to your blog recently. Reynolds is a lunatic fringe crackpot who believes (just 2 examples among many) that this financial crisis was caused by too many poor black people taking out home loans they couldn’t afford, and that we can solve Peak Oil by invading the Saudis and forcing them to pump more oil. Clearly readers who believe that kind of kooky gibberish are not going to offer serious suggestions for solving this financial crisis.
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    Fabuis Maximus replies: The rebuttal to the “invade and take the Saudi oil” is in Gerald Posner’s book “Secrets of the Kingdom: The Inside Story of the Secret Saudi-U.S. Connection.” He says

    “based on National Security Agency electronic intercepts, the Saudi Arabian government has in place a nationwide, self-destruction explosive system composed of conventional explosives and dirty bombs strategically placed at the Kingdom’s key oil ports, pipelines, pumping stations, storage tanks, offshore platforms, and backup facilities. If activated, the bombs would destroy the infrastructure of the world’s largest oil supplier, and leave the country a contaminated nuclear wasteland ensuring that the Kingdom’s oil would be unusable to anyone. The NSA file is dubbed internally Petro SE, for petroleum scorched earth.”

    Also see the NY Times book review here.

  9. There won’t come so much foreign creditor’s money, at least not directly. The sum is too big.

    And most importantly, it’s impossible to get so much money without using a very large part of the PRC’s currency reserves. The Asian and European friends alone don’t have 1.5 trillion USD without the PRC. It’s unrealistic to expect such huge loans even if the PRC was included.

    The foreign state-controlled investment companies that hold dollars will buy some assets to proof the value against inflation, but they won’t simply transfer so much money to the U.S. federal state.

    The money would mostly come from the Fed, it would be newly created/printed money. THAT will cause the inflation/devaluation of the dollar – not some “fixed” “20%” action.

    To lend the money would not be superior than simply creating it anyway – there will be high inflation anyway when so much money enters the circulation. Why add high debt if you can create the money yourself?

    The weak dollar will gain value over years, and the competitiveness advantage will fade. The U.S. industry (all else is pretty much irrelevant in this regard) will have an easy time with a cheap dollar, and have a rude awakening once its value is high again.

    Any national strategy that doesn’t prepare for that moment by improving the competitiveness by other means will fail at that time.
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    Fabius Maximus replies: We will certainly borrow at least $1.5T (including the rollover of $500B old debt), and I have seen no experts concerned about this sum. I don’t have the numbers handy, but I suspect that our record borrowing (including rollovers) is roughly $1T.

    My forecast is that the key is not the dollar sum, but the nature of the borrowing. Before it was “vendor finance.” They loaned us the money to buy their goods. Now we want more than that, money to support our economy during the recession and restructure our finance sector. That’s a difference, any once we cross that line the current borrowing regime will be under intense stress — until it collapses and we need to negotiate a new deal.

  10. mclaren : “solve Peak Oil by invading the Saudis and forcing them to pump more oil.”

    Indeed, an adventurous notion. But where are they gonna get the MONEY from?

  11. question – where do these foreign nations get all these dollars to lend to us? according to you and your readers we keep asking for more and more and miracuouly they are able to come up with them – despite having economies that are much much smaller than ours and that operate under non dollar currencies?

    the dollar that buy bonds and pay taxes come from government spending.

    eg. the federal govt spends money to build a nucler power plant. the private sector is paid by the federal govt and that increases private sector savings by the exact amount as the federal deficit is increased. if everyone buys a toyota, toyota will acquire the dollars and sell them to pay their operating costs. the mof will instruct the boj to buy dollars and sell yen to prevent the yen from strengthening and killing their export lead economy (in china the same is true although the currency peg is less flexible). now, the mof is holding the dollars at the boj. they buy dollar assets instead of ho,ding non interest bearing reserves at the fed. if everyone bought a ford the dollars would stay with the domestic private sector. either way the dollars are generated by government spending and remain in dollar assets. even if foreign nations change their fx policy or dont want dollars the dollars remain in the system and end up being invested in dollar assets. this is how it works in a non gold standard world. it not alachamy – its fact.

    you say – They loaned us the money to buy their goods. Now we want more than that, money to support our economy during the recession and restructure our finance sector. That’s a difference, any once we cross that line the current borrowing regime will be under intense stress — until it collapses and we need to negotiate a new deal.

    thats crazy. how could an economy the size of china loan us the money to buy their goods and where do they get the dollars? you have the relationship completely backwards. please read some of the likes i sent you and understand how it works in the post gold standard real world. just think, how could japan with an economy half as big as the u.s. have a debt equal to that of the us and still have such huge dollar reserves. they would not have enough domestic savings to support both unless the savings was in part a result of their own domestic spending.

    thats why when they had the largest debt of any industrialized country in the history of the world the yield on tehir 10 yr bond traded to 0.5% (half a percent) and ther dollar reserves increased! their spending created the domestic reserves that bought the bonds they issued.

  12. FM, Was it here I read Buffet’s quote about the US economy being like a well-trained athlete who had just had a heart attack, and fell on his head?
    Let’s say he had both a heart attack AND huge cholesterol problems.
    1) Get the heart beating. This is different than cleaning up his coronary system.
    2) Examine (Treat?) for head concussion. Get him up and walking again.
    3) Change his diet to reduce cholesterol, and more healthy exercise.

    Up until his heart attack, being told “you’re sick, man”, didn’t seem relevant when his running times were still reasonable.

    I think your 3 steps are too simplistic in your #1 – stabilize the financial system; it won’t be stable until the economy is more stable, which can’t happen until house prices are stable.

    I like your analysis in the Master Settlement as something that would be ‘good’, but I find it highly implausible with either US Pres. candidate. If America is addicted to debt and spending, much of the rest of the world is addicted to working for and selling stuff to Americans — both sets of adjustments will be tough.

    In a contrarian way, US spending cuts under Obama seems more likely because if he tries that he can both lead his own party as well as count on support from many Reps. McCain would find that increasing spending is easier, for the same reason.

    In the immediate term, like a cardiac arrest patient needing the heart to work, the financial system has to work some; not fully stable, but lending money. That’s the bailout.

    In the short term, along with huge reduction in the finance & finance paper system, with reductions of wealth and thus strong deflation pressures, the real economy needs more expansive gov’t spending. Like this article says, America is likely to get the money from other Central Banks — but America would need less money if more lousy debt was converted to less-lousy equity.

    There is a Dexia bank (Belgium, France) nearby — France just had to help bail out a French bank, but is calling for a co-ordinated response to the crisis. I’d say this means your MS. #V foreign creditors will likely be complicated by being both co-debtors (like many Euro banks) and creditors. This also reduces the attraction of the Euro, without ending it.

    So while I wouldn’t be surprised to find more global finance done in Euros, I doubt that 2009 will see more than 1% of US gov’t debt in anything but US dollars; even if it would be a good idea.

    If I were Hu in China, I would be unilaterally declaring an end to “intellectual property (monopoly) enforcement”, especially if I could get India to agree. No penalty for copying 1s and 0s.
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    Fabius Maximus replies: By the numbers.

    (1) “I think your 3 steps are too simplistic”

    I look forward to your analysis of the situation written for a general audience in 1,000 words or less. Perhaps on your planet they communicate telepathically, perhaps using 12-dimensional gestalts. Here we use words, and aprox 1,000 or so is the max the traffic will bear.

    (2) “stabilize the financial system; it won’t be stable until the economy is more stable”

    I think you are misunderstanding my point. I am using stabilize in the clinical sense, like one does in the emergency room. As I have clearly indicated, we are heading into a recession — which will place even more stress on both the financial system and the wider economy.

    (3) “I like your analysis in the Master Settlement as something that would be ‘good’, but I find it highly implausible with either US Pres. candidate.”

    This will not be voluntary. You assume that at that point we will still be in control of events, rather than being swept along.

    (4) “I’d say this means your MS. #V foreign creditors will likely be complicated by being both co-debtors (like many Euro banks) and creditors”

    The only creditors that count in a situation like this are the foreign central banks. They are already almost our only source of credit.

  13. The U.S. will not “certainly borrow” USD 1.5 trillion. A loan needs two parties; a creditor and a debtor.
    The U.S. won’t get nearly as much credit as that, and even if it came close, it would have to pay outrageous interest rates, resembling Buffet’s recent deals.

    You didn’t really read or understand what I wrote anyway: There is no advantage of lending so much money over printing/creating so much money. The amount of money that gets injected into the economic cycle would force the price of printing/creating money (inflation) on the nation anyway.
    To print/create the money is for free in comparison to a debt which needs to be paid back.

    The inflation will come anyway. It’s even desirable because more inflation = weaker dollar = balancing of the trade balance.

    Look at the currency reserves (not all of them dollars, but converted to USD to make the table readable):
    http://www.imf.org/external/np/sta/ir/8802.pdf
    http://en.wikipedia.org/wiki/Currency_reserves

    There are barely enough USD in other countries’ currency reserves. Do you expect other countries to crash their currency reserves to about half? Only to save the American’s asses? Why should they do so? In exchange for paypack promises? At this time? Can you imagine the risk premium on such loans?
    To get so much money would require to accept that high interest rates that the USA should better declare bankruptcy immediately instead of inevitably 5-10 years later. Or simply print some paper.

    The idea that the rest of the world would still have enough faith into the USA to help on such a scale is VERY funny.

    It’s time to accept that the policies discussed in the presidential election campaign are only illusions. The ‘master settlement 2009’ will be an outrageous money printing.

    Let’s hope they manage to stop the high inflation in time and solve the underlying problem of economic output/consumption+investment mismatch in a sustainable way.
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    Fabius Maximus replies: Congratulations! You have proved that the past borrowing of the US was impossible.

    The US current account deficit was $790b in 2006 (source: BEA). Doing $1T in 2009 is only 8%/year growth over 3 years. As a fraction of total global currency reserves (which is not a useful comparison), it will be aprox the same due to the rapid growth in reserves 2006-2008. Comparing it to GDP is more appropriate, and gives a similar answer (GDP grew more slowly than reserves over that period, but still at a brisk 4% aprox).

    “The idea that the rest of the world would still have enough faith into the USA to help on such a scale is VERY funny.”

    I am impressed with your prophetic ability. I labeled my analysis a guess, while you speak with awesome certainty about the future. More seriously, they will probably help out of self-interest. It is not in their interest to see the world economy burn. Our creditors are highly reliant on experts (which is how they became our creditors), and a collapse in world trade will be painful for them.

    We went thru a review of the Econ 101 treatment of inflation/deflation in “The geopolitics of inflation, an introduction on 17 June.” I refuse to do it again. I will note that the comments of that post were filled with simple folks totally certain that inflation was the threat. I said then that deflation was an equally likely event; now 3 months later we are in the midst of a massive deflationary event (rising loan defaults, failure of financial institutions).

    Also, borrowing money from foreigners is not inherently or immediately inflationary for us. Domestically it usually is, as the Fed monetizes the debt by printing money. The monetary effect of loans from foreigners is far more complex. It might be inflationary for them (increasing the real value of their currencies vs. the dollar, a good thing). It might be inflationary for us in future years, depending on how events play out (after a deflationary collapse we might be praying for some inflation).

  14. “There are barely enough USD in other countries’ currency reserves”

    they obtained those reserves from our spending. the money for their reserves came from us. any additional reserves will come from our spending which will in large part come from govenment spending to support agregate demand as private sector balance sheets repair. that is, it is government spending that creates private sector surpluses. will it be inflationary – maybe but thats a seperate argument from the incorrect notion that we rely on foreigners to finance our debt at the federal level – we dont.

    we have seen the budget deficit increase from a surplus to about 4% of gdp and have not, outside of energy , had a meaningful increase in infaltion. 10 yr yields are lower than during the days of budget surpluses – and not just recently lower either. its demand growth and fed policy that drives rates higher. it will take a large deficit to support demand growth going forward – much larget than 5% to 6% of gdp.

  15. I doubt very much that the money can come from China as their coupled economy is already slowing down and they will need their reserves for their own fiscal stimulus. In addition, China is not immune from their own stealth banking crisis which may cause as many bank failures as in the West. Many of their loans are probably as fraudulently obtained as many of the subprime loans in the West.
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    Fabius Maximus replies: Their economy is slowing, but from probably unsustainable double-digit growth to high single-digit growth. Keeping the world economy from collapse is an important means to maintaining their exporting industries. But they will just be one of the nations at the table. Other Asian nations plus the major oil exports will also be there.

  16. OK; maybe you understand it like this:

    A) Do not insist on telling a macro-economist about economy 101. You sound stupid doing so because you don’t get the economy 101 right yourself.

    B) Times have changed, the past lending was done by exporting dollars and importing goods, now you want to import those dollars without exporting goods. To declare that the impossibility of the latter tells anything about the first only tells me that you didn’t understand.

    C) Borrowing USD U S D ! from foreigners to infuse that money into the domestic market has the very same effect as printing the money and infusing it into the domestic market. It drives inflation upwards.
    Past borrowing was a different borrowing; it was in exchange for imported goods, there was no additional M3 money infused into the domestic market by the past trade balance deficits themselves. Goods, not money, were infused into the domestic market by the trade balance deficits.

    D) I played along at first, but your whole idea sounds a lot as if the USA was a planning economy. Things will never ever work out like that simply because it’s no centrally-controlled economy. The market participants will decide, and I can tell you that the inclination to send any money to the USA is close to zero in Germany at least. There will be no agreement. The only way to get the necessary money is to print/create it.

    E) Rising loan defaults and failure of financial institutions do not describe anything “deflationary”.
    The inflation trend is showing upwards since early 2002, and presently U.S. inflation is in excess of 5% p.a.. It has moved from about 2% when the mortgage crisis began to about 5.5% last month. The Fed is pumping money into the markets and has its interest rates so low that it cannot really lower them anymore.

    Now consider that many people do not trust Fed statistics (remember the end of reporting M3 in 2006?) and believe that it gives too low inflation rates since several years. You’re seriously talking about deflation!?!

    F) An increase in net capital transfer is not feasible without excessive interest rates in times of collapsing foreign faith into the U.S. market and state. That would be possible for a small country, but the world market hasn’t got enough dumb people with money to make it possible for the USA.

    G) Professionals make forecasts that amateurs misunderstand as prophecies.
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    Fabius Maximus replies: By the numbers…

    (1) “You sound stupid”

    I am devastated, but will attempt to soldier on regardless of your low regard.

    (2) “because you don’t get the economy 101 right yourself.”

    My posts about economics are written after discussing them with some A-team economists. Also, from the 33 articles cross-posted at RGE Monitor, I have discussed these posts with several other economists. That does not mean that these are correct as forecasts or even analysis, just that they are within the range of conventional economic theory.

    (3) Recommendations 1 and 2 in this post are almost identical to those in Prof Roubini’s recent article “Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs“ (re-posted here on the FM site). The third has been discussed often by economists during the past few years; for example, several times by Brad Setser.

    You made similar claims in response to “The geopolitics of inflation, an introduction“. Despite your disappoval, my views were a commonplace — appearing in many economists’ analysis (I posted a few examples).

    (4) “the past lending was done by exporting dollars and importing goods, now you want to import those dollars without exporting goods. To declare that the impossibility of the latter tells anything about the first only tells me that you didn’t understand.’

    This bears no visible resemblance to anything I said. Could provide a quote?

    (5) “Borrowing USD U S D! from foreigners to infuse that money into the domestic market has the very same effect as printing the money and infusing it into the domestic market.”

    I don’t believe that is correct. It is too complex a point to debate here (far beyond Econ 101). We will see what happens during the next year.

    (6) “I played along at first,

    Are you doing me a favor? Please don’t.

    (7) “but your whole idea sounds a lot as if the USA was a planning economy.”

    We have a fiat currency, and with government its largest economic actor. The government controls the price of money. Now the government is nationalizing much of the finance sector, and increasing its already-tight regulation of the remaining private finance companies. We are not a “planning” economy, but are far from a “free market” economy — and are moving fast toward “planning.”

    (8) “the inclination to send any money to the USA is close to zero in Germany at least.”

    For several years the funding of the US current account deficit has been mostly by Asian and oil-exporting nations. In any case, we will see how “Germany” feels when the world is in major crisis mode. In the US we say that the sight of the gallows focuses the mind, so pulling together might seem reasonable even if requires (as it often does) bailing out imprudent debtors.

    (9) “Rising loan defaults and failure of financial institutions do not describe anything ‘deflationary’.”

    This is basic economics, though perhaps not 101 (too long ago for me to remember). For a nice outlike of the theory, see “Debt-deflation: concepts and a stylised model“, Goetz von Peter, IMF, April 2005 (56 pages). The intro is easy to understand for anyone who has taken first year economics.

    Here is a brief summary: For 30 years one (perhaps the standard) explanation of the US great depression has been that the Fed did not adequately respond to the deflationary effects of the 1929-1932 loan defaults and bank failures. Chairman Bernanke is an expert on the history of this period. Perhaps his best-known speech on the topic is “Money, Gold, and the Great Depression” (2 March 2004). Excerpt:

    “However, in 1963, Milton Friedman and Anna J. Schwartz transformed the debate about the Great Depression. That year saw the publication of their now-classic book, A Monetary History of the United States, 1867-1960. The Monetary History, the name by which the book is instantly recognized by any macroeconomist, examined in great detail the relationship between changes in the national money stock–whether determined by conscious policy or by more impersonal forces such as changes in the banking system–and changes in national income and prices.

    “… The banking crisis (of the 1930’s) had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures.” {end}

    Perhaps Bernanke’s best-known speech ever is “Deflation: Making Sure ‘It’ Doesn’t Happen Here“, in which he spoke of “Deflation: Its Causes and Effects” (21 November 2002), in which he discusses deflation– including his famous words “we have a printing press” to fight deflation by increasing the money supply.

    (10) “An increase in net capital transfer is not feasible without excessive interest rates in times of collapsing foreign faith into the U.S. market and state.”

    Our current account deficit has been fund for years by purely political calculations of foreign governments, as net private inflows trickled to a stop (see Brad Setser’s articles for more on this). I describe one scenario in which this flow increases, subsides, then reverses — and why. Your confident dismissal of the very possibility of such a scenario provides no supporting explanation.

    (11) “Professionals make forecasts that amateurs misunderstand as prophecies.”

    The experts I know tend to make their forecasts tentatively, quite unlike the bombastic tone of your pronouncements. Examples of this among economists are legion (to cite two: David Rosenberg and Brad Setser). Nuclear physicist and now energy expert Robert Hirsch is another example. This is purely a stylistic point, unrelated to the accuracy of their content (and yours).

  17. Ah, not quite a viable solution. Once this might have worked a couple of years ago, but it is too late now. We are into a situation where emergency resuscitation and ‘meatball surgery’ is required. This is not a heart attack now, it is a cardiac arrest, we are now in a credit freeze that has not been seen since 1929. Lending has stopped. No bank in the world will lend to another (look at the LIBOR rate), which says a lot about their confidence in each other! Without the huge amounts every central bank in the world is pumping into the interbank lending markets, virtually every bank in the world would collapse tommorrow.

    There are only a very few options left for each country and the World as a whole:

    (1) Choose a number of trading (ie not Wall St or ‘investment’) banks to save. Nationalise them and recapitalise, allow them to lend to real businesses only. Pick up all companies overdrafts, etc, and maintain. Let the rest go to the wall. Note this is a lot easier for creditor countries, countries already loaded by debt (e.g US, UK and Australia) have a much harder task.
    (2) Destroy debt (personal and corporate) as quickly as possible. There are only 2 ways, very high inflation or direct Govt decree.

    You engineer 10+% inflation (realistically need 20% or more) or you null and void by legislation certain debt contracts, e.g. all CDO contracts, and/or all Alt-A & A+ securitised mortgages, etc. The crediters go to the wall, but you save the debtors = Joe Soap and normal companies.

    You let every hedge fund, ‘investment’ bank, etc, go to the wall. As they die debt is destroyed. If an organisation is a mixture of ‘real’ economy and ponzi (e.g. AIG) you save only the real part and let the rest go. A train wreck, but a controlled one. Bit like switching a runaway train into a siding with a runoff and sand, instead of hitting the concrete at the end of the line.

    It is now too late for any moderate schemes to save anything. There can be no going back to Business As Usual (BAU) ever.

    It’s like a guy a few years ago, hiking on his own, fell, got caught up in a rockslide and got his arm trapped under a rock. He was faced with dying .. so he cut his own arm off with his knife … awful, but he saved his life (note that the Paulson scheme is more like cutting off the body to save the arm).

    Since I am a skeptical, cynical, pessimistic kind of a person … unfortunately FM, from the military point of view, I do not expect the US to do what the UK and the USSR did, cut military spending to the bone ..yet. I expect everywhere else in the World will do that (which is good), but the US? More likely what little social security, pension, health systems you have will be sacrificed on the alter of the JSF, F-22, etc … for a while. You are caught between 2 immense opposing forces, the FIRE economy and the military economy, both fighting for their lives and both of which will go down fighting to the very last dollar, sadly to the detriment of just about every US citizen and hence just about every person in the World.

    Proof? A week before the $700B Paulson bailout, $700B+ sailed through Congress for military spending. Debate, opposition? Nothing, except from Ron Paul and a very few others.
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    Fabius Maximus replies: The first of your recommendations is not only compatable with my recommendation #1, it is happening now. Roubini describes this in “Prof Roubini prescribes first aid for America’s economy.”

    As for the second, the “very few options” — there are four, as I describe in “A happy ending to the current economic recession“. They are growth, inflation, default, and nationalization. We are using options #3 and (even more) #4.

    I do not know what you mean by “World as a whole”. Recessions are not armeggedon, but part of the normal business cycle. The economy must both inhale and exhale. Let’s not be like the fictional savages, who each winter worry that the days will continue to shorten — and that Spring will never come.

  18. Just one question–what do you make of the recent bounce in the dollar and the falling yields on treasuries?

    As for China, I have a difficult time seeing a way that this doesn’t end somewhat painfully for them. Their economy remains tremendously reliant on export-led growth and I’ve yet to see a scenario in which that doesn’t take a hit. The early-90s recession hit when their economy was a lot smaller and the post-9/11 one was too mild to strike a real blow. As much as this represents New Times for us, it’s going to be quite a ride form them, as well.

  19. OK, FM, here’s the key thing in my speculations. The US has some $12 trillion in outstanding mortgages — on homes whose replacement cost is maybe only $6 trillion and whose current market price is sort of unknown.

    A huge part of the finance meltdown is the uncertainty of that housing stock market value. If it’s only $6 trillion, then there is $6 trillion of ‘paper value’ that will disappear. That’s the driving force of huge deflation you are correctly warning about, but which so far has been confined to houses (and finance companies).

    Who loses this $6 trillion, or however much it is? This disappearance of value, and from whose balance sheet it disappears, is what a lot of the clogged arteries of finance are about — most financial institutions don’t want to be the ones who disappear.

    Besides this vaporizing $6 (?) of $12 trillion house value financial meltdown, there is still a huge real economy doing otherwise OK, and there is still a lot of non-house based capital looking for good investments.

    Perhaps more than half of all US finance jobs should disappear — a depression in finance. But not in the real economy. Not yet.

    Despite the huge deflationary pressure, I don’t yet fear deflation so much because the Fed does know how to combat it — printing money. I do fear a credit squeeze that goes on ‘too long’ (weeks, not days), but there are a lot of stories about good companies getting some money, along with stories of difficulty. Watching the roll-over loan statistics seem wise right now.

    Who loses how many trillions?

  20. A very interesting series of posts by F.M. Some of the comments are also thought provoking. But I feel like there is one thing that is missing: consumption. If this is going to be a deep and long recession, then why aren’t people talking about the effect this will have on American consumption. I am not chiding FM here, it seems like this is something that is not addressed by any economist or journalist in the public sphere. The existing foreign debt and the additional debt required to finance the bailout and restructuring will have to be paid for. FM suggests that it can be paid for by exports, but I doubt exports will be sufficient to cover the payments. The only solution is to hold down domestic consumption in the US and to funnel that money into retiring debt.

    Lower consumption was a key part of economic restructuring in Poland, Hungary and many other E. European States during the ‘transition era.’ In Hungary, post WW2 consumption peaked in 1988 and it was largely financed by foreign debt contracted in the Kadar years. After the 1989 change in system, consumption plummited and stayed below 1988 levels until 2000. It was the price consumers had to pay so that the government could restructure and pay down foreign debt.
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    Fabius Maximus replies: That has been mentioned many times on this site, and discussed at length in “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008.

    Also, I have repeatedly said that one result of the probable devaluation of the US dollar is that imports will become more expensive — hence we will consume less of them. From another perspective, the problem is that the US consumes to much and saves too little. That imbalance is expressed via currency movements, both as the problem grows and fades.

  21. it should be so clear to those of us who have some education and some iq that this entire crisis has been in the planning stages for over 90 years…to control the people of the world all you have to do is control the printing of all money. except for the 5 countries that have not fallen to the federal reserve mob and they of course are on the black list ???all the countries in the world today are controlled by the rothschilds federal reserve masters. there is only– and i say that again- only one way to suvive a complete takeover by this gang and that is to eliminate them asap.— if we dont do it we are finished, any other way is like blowing smoke into a windstorm… so do it or become a slave.
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    Fabius Maximus replies: Quite a sweeping and confident statement!

    I wish it were so that our ruling elites could plan and execute anything over a 90 year (multi-generational) horizon! Unless they were Holywood evil bad guys (e.g., mad psychos), the world would probably be a far better place than it actually is.

  22. the us has massive unemployment and why not for the last 50 years we have sent our manufacturing over seas. while the international corps. have been making huge profits the over seas workers work for peanuts and in many cases they are just pure slaves. and the great polotitians stand up and say we have to compete. compete with who slaves,, you dont buy homes and cars with two dollars a day. get with the real world and admit that we have been taken for suckers for the last 95 years. it is time for ===fair trade– not open trade with others who work for a buck a day. if other countries want our stuff they are going to have to pay the cost of our labor and their stuff must be priced in line with our cost of living and not theirs. and as far as the federal reserve is concerned we shold pay them off as the deal made in 1913 was 450 million us puts them out of the printing job. — so stop crying and just—do–it– eugene
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    Fabius Maximus replies: The US does not have massive unemployment, as easily seen in the Bureau of Labor Statistics data (here). At least, not yet.

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