How Far Down The Rabbit Hole Must We Go?

How Far Down The Rabbit Hole Must We Go?

Posted by Karl Denninger

…. before our citizens – and government – wake up?

If you remember in October of 2008 I put forward the following:

The Truth is that we now require about $5 of debt to generate $1 of GDP.

The Truth is that the reason you were not asked to approve $700 billion to capitalize 10 new banks, thereby creating seven trillion in lending capacity is that the economy cannot soak up that new lending capacity; each dollar of new debt generates almost no aggregate GDP.  If this were not true then that would be the logical and effective cure for the ‘credit crunch” – if the borrowing capacity and impact on GDP necessary to help existed.  They do not. 

The Truth is that you were lied to about the purpose of the TARP/EESA, because what you were sold was mathematically impossible.  It is supposed to be unlawful to lie to Congress.

As I pointed out at the time, the reason they didn’t create that $7 trillion in new credit issuance is that there was no more capacity to take on new debt in the private sector.

They knew it.

They lied about what “had to happen” for stability to be restored.

They lied because the alternative was that their friends – powerful friends – would have to go bankrupt.

But it gets worse.  Some of the other points:

The Truth is that the absolute worst thing you can do when “in the hole” like this is to spend even more on a deficit basis, thereby driving the debt ratio higher and return-per-dollar-of-debt in GDP lower.  The last eight years have been disastrous in this regard.

Yet that is exactly what we have done – we have replaced fully 10% of private GDP with public spending, and while the claim was made that this is “temporary” the CBO says it is not, Obama’s budget says it is not, and the credit contraction that is continuing in the private economy says it is not.

Bernanke and Paulson, and now Geithner, know that this attempted “reflation” won’t – and can’t – work.  They have put forward this path not because it is the right thing to do, but because the alternative means a lot of people with power and money will go bankrupt and the Government of The United States will have to change how it finances itself, removing the corrupt influences that have been used to “cook” the books – and outcomes – for the last 30 years.

We have blown three trillion dollars since these intentionally-wrong decisions were made, and we will continue to blow more and more money until the entire banking and economic system collapse unless we change course.

Nate has updated the debt-GDP contribution chart that I posted back in 2008 (and which was originally generated by Legg-Mason – it’s not difficult to generate it from the Federal Reserve Z1) and it shows exactly what I was predicting – and why the policies of the government and Fed not only haven’t but can’t work:

Now let’s be clear: Essentially all money is debt in our current system.  As such attempting to “print” your way out, or attempting to “inflate” out, or attempting any act other than forcing the default of the bad debt in the system results in digging the hole deeper and deeper – that is, depressing private GDP further.

Government’s efforts have not helped, they have destroyed the four years we had before “zero hour” was reached.  Bernanke’s interference in the mortgage market didn’t “help” that market, he effectively entirely replaced the private market. The Government’s “interference” in the private markets by borrowing and spending $3 trillion over the last two years – more than 9% of GDP annualized – is an attempt to “paper over” the insolvency of private actors in the markets – both borrowers and creditors.

These acts of interference did lead to a huge stock market rally, but just as with all forms of cooking the books they are false dawns and false hopes.  They present a picture of “solvency” that does not actually exist.  They present a picture of private demand in the economy that does not actually exist. 

Since we are now below the “zero line” of GDP-contribution from further debt issuance we simply tighten the monetary flat spin by trying to further print or deficit spend.

The chart in the above link has been updated, of course.  It now looks like this:

Despite all the printing, despite all the borrow-and-spend politics each new dollar of currency is representing a decreasing monetary velocity multiplier – that is, we now get less than one dollar for each dollar – the real rate of return is now NEGATIVE.

As in a flat spin in an aircraft, you cannot pull up and live.  All pulling up does (printing or borrowing more money) is tighten the spiral.  I identified this crossover in December of 2008, and warned of it months earlier. 

We have tried it Bernanke, Paulson and Geithner’s way and it has failed.

We will strike the ground unless immediate corrective action – that is, pushing forward on the stick – occurs. 

Taking that corrective action will cause us to lose altitude faster for a while.  If we wait until the ground is “too close”, we will strike the ground and (economically) die.  The precise point where there is no longer enough time (altitude) is not known in advance, but that we have far less margin now, more than a year later, than we did in December of 2008 is a mathematical fact.

To halt this process we must take the following actions now:

  1. All direct taxes must be scrapped immediately.  This means implementation of something like The Fair Tax.  I fully understand the political ramifications of thousands of lobbying firms and individuals losing their ability to game tax code, and why this sort of reform is unpopular with the political class.  Politics must give way to mathematics; the government must align its revenue with the promulgation of actual business success as measured by actual consumer final demand.  In addition such a change, while radical, would cause an immediate rush into America for the world’s business headquarter locations, and with those businesses would come high-paying executive, administrative and manufacturing jobs.  This proposal is an actual bill (HR. 25 / S. 296) which means it can be moved and passed.  We just need the political will to do so.

  2. ALL government support for insoluble debt must be removed.  This means restoring mark-to-market, barring all off-balance-sheet activities and deeming that loans such as HELOCs behind underwater, non-performing firsts be written to recovery value (which in most cases is in fact zero.) I understand that this will expose the existing insolvency of some very large financial institutions.  I also understand this is very politically unpopular for obvious reasons.  It does not matter; this has to be done.

  3. Banks must be required to hold Capital Reserves equal to 10% of their outstanding assets that are secured and 100% against all unsecured loans.  This will cause even more insolvencies, but it will instantly clean up the banking system.  Provide a six month time period for all institutions to come into compliance with (2) and (3), with no extensions, and mandate that any firm that does business in the US must comply – no exceptions.  Going forward the 10% capitalization level (for secured assets) must be monitored and maintained as a “warning level” and firms must be liquidated at 6%.  This will guarantee in the future that the FDIC will never a take a loss on the deposit insurance fund.

  4. Treasury must then use the existing authority under The Constitution to issue non-debt-backed dollars.  This does not require new legislative authority – all existing coins are in fact not debt-backed!  Treasury can thus issue fiat, non-debt-backed currency under existing authority – it has simply refused to do so!  This use should be restricted to funding FDIC pay-out requirements for the firms that become insolvent under this reform process.  This issuance – if limited to FDIC payout coverage – will not be inflationary as it will exactly balance the deflationary force of default on the debt caused by those insolvencies.

  5. An expedited, one-time bankruptcy provision must be made available to consumers so they can enter and process against an expedited Chapter 7 liquidation.  It is essential that we permit consumers to de-leverage back to sustainable levels.  Points #2-4 will insure that banks that fail as a consequence will have their depositors covered.

  6. Credit-Default Swaps – or any other form of derivative – must be forbidden unless exchange-traded with a central clearing and margining counterparty that exposes all information to the market, including bid, offer, size and open interest.  That counterparty must be the buyer for all sellers and the seller for all buyers, as is done today by the CFTC and OCC.  Those firms that cannot post cash margin against their open, underwater positions must tear them up within 180 days.  Speculation is fine – provided you can prove you can clear the trade!  Again, any firm that wishes to do business in The United States must comply in all markets, or be barred from our markets.  Once again this may produce insolvencies but point #4 will (again) guarantee that all depositor guarantees are covered.

Government is enacting “health care reform” today not to reform health care, not to provide health care, but rather to impose an immediate tax on all Americans to attempt to pull up even harder on the monetary stick.

It won’t work folks.  It can’t work.  More than 18 months ago I identified the primary failure in the path that was being taken, and why.  We have tried it Bernanke, Paulson, Geithner, President Bush and President Obama’s way now for nearly three years, and yet there has been no resolution of the debt problem, no resolution of the housing market and no actual economic growth.  Instead we have papered over insolvency and lied about the health of both our banking and economic systems.

Meanwhile the cracks in the dam continue to grow.  Greece is not just “one little problem” over in Europe.  Behind Greece is Spain, Portugal, Italy, Ireland and even Great Britain.  None of these nations have yet taken the actions necessary to resolve the problem, for the same reason we have not – it is politically very difficult to tell the entrenched banking interests “you must eat your own cooking – even if you choke on it.”

We still have time to choose between bad and horrifically awful.  We can choose between recognizing the Depression we are already in (private GDP has contracted by more than 10% from the peak, which is the definition of economic Depression) or we can risk Zombieland or Mad Max becoming reality.

Since Europe and the rest of the world show no desire or expectation to do the right thing, we must either firewall ourselves off from their collapse or we will inevitably go down the bowl with them

We are risking severe civil unrest and the possible destruction of our republic by our continued refusal to face the mathematical facts, not just a “double dip” recession.  What Greece and other nations are seeing now is nothing compared to what is on the horizon and will reach us if we do not act.

Mathematics yield to no political desire or arrogance wielded by man or woman.  Those relationships described by mathematics inexorably come to pass, unless you change the equations.  In a debt-backed fiat currency world continuing to load debt into a system that has too much debt in it related to production is a futile and self-destructive act, just as is an alcoholic deciding to chug yet another bottle of whiskey.

Economically we are facing liver failure and brain cancer unless we stop gorging on our drug of choice – debt.  Whether the consequence of ceasing to do so is politically expedient or not is, at this point, immaterial.  We are literally gambling with the ability of this nation to continue forward as a going and peaceful, civil concern.

We still have time to act and do the right thing to halt what will befall us should we continue on our present path, but that time is running out.