Central Banks vs. Wave Theory

The short version of the Long Wave story is that human beings are emotional creatures with limited memories. For as long as there have been markets we have been traversing the same sequence of emotional states, beginning with anxious conservatism in the aftermath of hard times, followed by cautious optimism and finally –as the original “depression-era” generation is replaced by their clueless grandkids — let-it-all-hang-out financial excess. A horrendous debt-driven crash then resets the cycle.

There are several variations of Long Wave theory, but the most famous is based on the work of Nicolai Kondratieff, a Russian economist who gave the various stages seasonal names, with summer and autumn denoting the peak of financial speculation and winter the aftermath of the resulting crash.

The most recent cycle began after World War II and lasted until the tech stock crash of 2000, which means according to this theory we’ve already spent a decade in Kondratieff Winter. But the headline statistics published by the US and other major governments tell a different story, in which we have an anemic economy but not a depression.

What happened?

This time around the world’s central banks have a new set of tools. In past cycles money was mostly gold and silver, it was real and in limited supply. Credit might have been flexible because of fractional reserve banking, but the money at the base of the financial system couldn’t be created out of thin air. Today, in contrast, it can. Since the US broke the final link between national currencies and gold in 1971, everyone has been running fiat currencies that can be created in infinite quantities and depend for their value on the trust we place in the competence and honesty of our leaders.

The fact that trust dies only slowly (at first) has given the world’s governments an effectively unlimited credit card that they can max out to keep the debt implosion at bay. And that’s what they’ve done since 2000, with ever-lower interest rates and ever more creative asset purchase plans. The result is a global economy that continues to grow — when measured by the same governments that are printing the money — and an electorate that still hopes for a solution in the run-up to each election.

But the debt is still out there, and is in fact growing as unfunded liabilities and derivatives and other exotica continue to pile up. So the Long Wave’s pressure on the global financial system is getting stronger. The past year has shown that if taken off of central bank life support, the European, American and Japanese economies will implode.

Over the past couple of weeks the European and US central banks have accepted this reality and announced open-ended asset purchase plans, implying that zero interest rates and unrestrained money printing will go on for as long as the markets keep accepting fiat currency.

Does this mean the contest is over and the printing press has won? No, but it means that the analytical framework has to shift from linear to non-linear systems. Jim Rickards devotes a chapter in his book Currency Wars to the idea that a financial market is more like a weather front than a car engine, in that the various parts of the former communicate with each other and change in response to that communication. This gives a complex system some unique characteristics, the most notable of which is that as its size and complexity increases, its propensity for catastrophic failure grows exponentially. Double the size of a financial system and its chance of coming undone rises by ten times or more.

By going all-in, the major central banks are committing to a progressive increase in the complexity of global financial markets. As more individuals and pension funds abandon cash and safe-but-low-yielding paper for higher-yielding but more-volatile stocks and junk bonds, the system grows ever-more fragile, making a crash both likely and more destructive.

Another trait of complex systems is that the timing of their catastrophic failure is unpredictable. Once the conditions are in place the system can collapse immediately or continue on for a long time. Rickards’ analogy is a mountainside where snow accumulates until a single snowflake sets off an avalanche. But there’s no way to know which snowflake will be the one, or when it will fall.

So here we are. The conditions for a global catastrophic failure are in place. Snow (in the form of trillions of new dollars and euros) is falling. There’s no way to know which dollar (or which external event) will start the avalanche, but without doubt something will.

The nature of the avalanche is still to be determined, though. Will it be a wholesale loss of confidence in the dollar, euro and yen which manifests as hyperinflation, followed by a crash? Or will the bond markets at long last figure out they’re being conned and push interest rates up in a spasm that’s too fast and wide-spread for central banks to counter, sending us back to the 1930s in matter of weeks? We can’t know the answer, any more than we can know whether the next tropical depression will turn into a Cat 5 hurricane. We can only watch it happen and prepare for the most obvious risks.


America’s economic myths exposed

The Olympian GodsMainstream economists have filled the minds of most Americans with economic myths that are constantly reinforced by the media and repeated on the streets.

These myths are erroneous at best, sometimes based on half truths. Many of them are just false. We hear and read them every day:

    • “inflation” is caused by rising oil prices;
    • consumption is the most important element for economic growth;
    • low interest rates are helpful to the economy;
    • government expenditures help “stimulate” the economy;
    • there is an energy “crisis,” and many others.

In this article we will examine some of the most common ones and explain the reality behind these myths.

Inflation and Energy Myths

Inflation — or, rather, the general rise in prices – and the increase in energy prices are issues that have always created numerous economic myths. The following are some of the most common ones.

Myth 1: “Dependence on Foreign Oil”

This myth suggests that the problem with oil prices is due to America’s “dependence” on foreign oil.

The high price of oil has nothing to do with its origin; the price of oil is determined in international markets. Even if the United States were to produce 100 percent of the oil it consumes, the price would be the same if the worldwide supply and demand of oil were to remain the same. Oil is a commodity, so the price of a barrel produced in the United States is basically the same as the price of a barrel of oil produced in any other country, but the costs of labor, land, and regulatory compliance are usually higher in the United States than in third-world countries. Lowering these costs would help increase supply. Increasing supply, whether in the United States or elsewhere, will push prices lower.

Importing a product does not mean you “depend” on it. This is like saying that when we “import” food from our local supermarket we “depend” on that supermarket. The opposite is usually true; exporters depend on us, since we are the customers. Also, importing a product usually means buying at lower prices, whereas producing in the United States often means consuming at higher prices. This point is proven when we see the cheap imports we can purchase from China and the higher prices of many of these same products manufactured in the United States. The amazing thing is that the protectionists claim, on the one hand, that America should be “protected” from cheap imports, but when it comes to oil, they say we should be “protected” from “expensive imported” oil.

Most, if not all, of the higher price of oil can be explained by the expansion of the money supply or the debasement of the dollar. The foreign producers are not at fault; our national central bank is the culprit.

Myth 2: “Inflation is caused by rising oil prices.”

False. If the money supply were to remain constant, then an increase in the price of one good, such as oil, would cause a decrease in the price of other goods. If more money is spent on oil, then less money will be available to spend on other goods. This will in turn cause a drop in the demand for other goods, which will subsequently cause a drop in the prices of these goods. The reality is that inflation is always a monetary matter, caused by the increase in the money supply due to the interest-rate-easing policies of central banks.

Myth 3: “Current inflation is being caused by the increased demand of millions of new consumers in China and India.”

At first glance this myth might seem true. Millions of new Asian consumers have entered the market, thus, there is higher demand for most goods, which would apparently cause higher prices. What is being overlooked is that these new consumers are also new producers. In general, most people produce far more than they consume, because most workers have to produce more than what they earn in wages (if not, they lose their jobs). While it is true that demand has risen due to these new consumers, supply has increased even more, due to their increased production. This can clearly be seen by the frequent drop in prices of most goods being manufactured in China. On the other hand, the only way these new workers can increase their consumption beyond what they produce is through credit. Thus we return to the real culprit behind inflation: credit expansion due to central banks’ intervention in the financial markets.

Consumption Myths

These myths were injected into the mainstream mainly by Keynesian economists who were trying to influence public policy.

Myth 4: “Consumption is the most important element of the economy.”

Consumption is indeed important in a free economy: particularly the freedom of consumers to buy their goods in unhampered markets. However, key to long-term economic growth is investment (savings), which is the opposite of consumption. Public policies that promote consumption — such as low interest rates — do so at the expense of savings. Less savings means less investment; an economy that does not save or invest will consume all of its resources and eventually end up bankrupt.

Myth 5: “Excess consumption is a feature of the free-market capitalist system.”

False. Excess consumption is mostly caused by central bank’s artificially low interest rates, which promote lower savings and higher consumption than would naturally occur. Currently, the real interest rates of savings accounts are negative. Thus it makes no economic sense to save. Since these same policies cause price increases, it makes sense to consume as much as you can immediately, before prices rise. Therefore we see that excess consumption is being caused by government policies and not by the capitalist free-market system.

Myth 6: “Federal Reserve interest-rate policy can help the economy.”

It is baffling how most Americans — including many of those who fought so hard against central planning in the 20th century — believe that the financial markets and the economy benefit from the central manipulation and influence conducted by the Federal Reserve.

To maintain a target of low interest rates, the Fed must add liquidity to the money supply by creating money without obtaining additional reserves. This is the infamous creation of money “out of thin air,” which so many have criticized. Many believe that this artificial injection of liquidity creates economic stimuli and promotes growth. However, even though it creates an apparent bonanza, these monetary injections must eventually be “paid back.” This payback happens by means of higher prices, the so-called inflation.

Low interest rates also create a dislocation between the market’s natural interest rate and the interest rate that the Federal Reserve sets. Supply and demand of money — mainly supply of savings and other deposits and demand for credit — is what should set interest rates in a normal unhampered market. Risk, too, should play a role in setting market interest rates.

When the Fed artificially lowers interest rates, it does so below the market rate. A rate below the market rate creates a higher demand for credit; thus people and companies get into debt beyond normal levels. On the other hand, low savings-account rates push people to withdraw money, lowering the market supply of funds. These dislocations are at the root of the eventual credit crisis, which follows the boom period that was caused by artificially low interest rates.

With today’s risky financial crisis, most people would demand a premium to deposit their money in a bank. Further, the current liquidity crunch should mean a lower market supply of money. Both forces should be pushing interest rates up. If the market were unimpeded (that is, if there were no intervention from the Fed), interest rates would be higher, not lower.

These economic myths have plagued the minds of mainstream Americans. Despite an alleged return of pro-free-market forces to the main political parties in the 1980s and ’90s, new myths seem to surface almost every day.

This article originally appeared on the Ludwig von Mises Institute.


How To Hide a Depression

I’ve suggested for some time that the U.S. is in a depression. The primary reason we do not have visible evidence of widespread poverty and suffering is massive government intervention in the economy. Despite the multi-trillion dollar “extend and pretend” game being played today, I suspect that with a little historical perspective the past 12 years and the coming five (or more) will replace the 1930s Great Depression as the most significant downturn in modern U.S. history.

Following are a series of charts which highlight just how far the federal government has gone to hide the depression.


The above chart shows those receiving benefits. Those who are not in the labor force claiming a disability is much higher.

Not in Labor Force – With a Disability, 16 Years and Older


Those not in the labor force and receiving disability benefits are not considered unemployed and do not affect unemployment statistics. This is one means the federal government uses to understate unemployment.

Beneficiary Data

The following charts are from Social Security Online.

Social Security Beneficiaries By Type


Number of Beneficiaries as of December 2011


A few more charts will put this in perspective.

Civilian Labor Force


Private Employment


Quick Stats

  • As of June 2012 – the civilian labor force was 155,163,000
  • As of June 2012 – there were 111,145,000 in the private workforce
  • As of June 2012 – there were 56,174,538 collecting some form of SS or disability benefit
  • The ratio of SS beneficiaries to private employment just passed the 50 percent mark (50.54%)

Following is one final chart to consider.

Social Security Benefits in Dollars


As of May 2012, social security outlays are $756.9 billion annually. Fewer and fewer workers support more and more recipients. Social Security benefit payments are now growing exponentially. This is how you hide a depression.

Source: Global Economic Analysis

Does Anyone Do Math Anymore?

While the European crisis continues to take center stage, nobody seems to remember the mess that the US is in.

The federal government spends about $ 3.8 Trillion in a year and takes in approx. $2.15 trillion in various shapes and forms. That leaves a gaping hole of $1.65 trillion a year.

The official national debt is about $16 trillion. In that official debt, we have not included any unfunded liability for pensions to government employees, Medicaid, Medicare and Social Security. Estimates of those unfunded liabilities vary from $66 trillion to $140 trillion. For example, Uncle Sam has promised about $700,000 in pension and health benefits to its retired civil servants and so far the only source of that money is an IOU. Add another $17 trillion to that coming from Obamacare.

It astounds me how, as a nation, we talk about borrowing and spending trillions of dollars as if it was chump change. It is chump change for the federal government. But it is worthwhile to remind ourselves how absurd government spending has become. Following is a visual representation of the millions, billions and trillions:

This is one million in $100 bills.

And this is 100 million, $100 notes, stacked on a standard pallet.

This is 1 billion, about 10 tons of paper.

And here is the US deficit, $16 trillion — not including unfunded liabilities.

Remember we were talking about that $140 trillion deficit. Here is a visual.

How much is a trillion dollars anyway?  If Jesus Christ spent $1 million every day since his birth until today, he would still not have spent $1 trillion.

Understanding Derivatives and Their Risks

Global financial markets are awash in hundreds of trillions of dollars worth of derivatives. By some estimates, the total amount exceeds one quadrillion dollars.

Derivatives played a central role in the 2008 credit crisis, as they had a brutal multiplying effect on the magnitude of the carnage. As a bad asset was written down, oftentimes there were derivative contracts written against it that resulted in total losses 10 times greater than the initial write-down.

What exactly are derivatives? And how do they work?

Have we learned to treat these “weapons of mass financial destruction” (as Warren Buffet colorfully coined them) any more carefully in the aftermath of the global financial crisis?

Not really, claims Janet Tavakoli, derivatives expert and president of Tavakoli Structured Finance.

But the danger behind derivatives doesn’t lie in their existence, Tavakoli stresses. They play an important and constructive role in a healthy financial system when used responsibly.

But when abused, derivatives can create massive damages. So at the root of the “derivatives problem”, Tavakoli stresses, is control fraud – the rampant unchecked criminal action by influential players on Wall Street. Derivatives contracts are too often constructed in favor of these parties, who if they end up on the losing side of the trade, are able to socialize their losses. Until we address this root problem of corruption, says Tavakoli, derivatives (as well as other securities: stocks, bonds, etc.) will continue to subject investors and our markets, overall, to unacceptable risk.

On The Nature of Derivatives

Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.

Let’s take an example. Goldman-Sachs used derivatives they used to help supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide. Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.

So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.

Now how did they do that? They did that with the magic of derivatives.

Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.

Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.                

On Control Fraud

The root cause of it is control fraud – people in the financial system being able to do whatever they want and remain unchecked.. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system,

On Derivative Risk in a Market Downturn

When you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.

Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?

On Gold and Counter Party Risk

Counterparty risk is the biggest risk.

And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.

We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold. You don’t want euros, you don’t want any other currency; you want gold. The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.