Eight Mistakes That Caused The Financial Crisis

Former Federal Reserve Vice Chairman Alan Blinder notes that six major human errors, all of which were highlighted and criticized at the time, caused the financial crisis.  Blinder makes an important point and one that I hope the new administration takes to heart.  The problems the US is experiencing right now didn't come about because capitalism isn't a good system.  They came about because of misjudgment, stupidity, greed and a lack of studying financial history.  You will never be able to legislate these basic human traits, but you can certainly develop a better framework and better enforce existing regulations to make sure you avoid the current disaster. 

The following are Blinder's six mistakes that could have been avoided as published in the International Herald Tribune:

WILD DERIVATIVESIn 1998, when Brooksley Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top U.S. officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the SEC let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn't have grown as big or been as fragile.

Today in Business with Reuters ING Group to cut 7,000 jobs Philips to shed 6,000 jobs after quarterly lossAt Davos, crisis culls the guest listA SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn't this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURESThe government's continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear's rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP'S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry Paulson Jr., the former Treasury secretary, about using the TARP's first $350 billion were an inconsistent mess. Instead of pursuing the TARP's intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures. 

I would add to Blinder's list 1) Alan Greenspan's desire to manage the economy to maintain his political popularity and 2) the mismanagement at the SEC in terms of eliminating the uptick rule. 

Greenspan and BushAlan Greenspan needs to take blame for lowering interest rates to irrationally low levels during the 2002 and 2003 recession.  The artificially low interest rates allowed homeowners to flood into Adjustable Rate Mortgages that were signifcintaly cheaper than long term mortgages.  It also allowed housing speculators to leverage up on cheap money.  This spurred on an already strong housing market into bubble status.  The fact that Greenspan was blind to the consequences despite repeated warnings that a housing bubble was forming, is inexcusable.  Greenspand blatently ignored the central banker's job to "take away the punch bowl just when the party starts getting interesting." Instead, he added fuel to the fire by keeping rates low even as an economic recovery was taking hold in order to appease politicians and the President.  Greenpan will go down in history as the worst and most politically influenced Fed Chairman in history.          

In addition to allowing bank leverage to go unchecked, the SEC also added to the crisis by repealing the uptick rule and allowing markets to operate unchecked.  The uptick rule was enacted in 1933, after regulators witnessed the destruction that short raids could have on investor confidence.  The regulators seemed to think these rules, enacted during the most horrific economic collapse in our history, were "quaint" and difficult to enforce.  However, they served a very important purpose – to slow down the market so investors and regulators could adjust to rapidly changing conditions.  

So with that, I propose eight human errors led to the current crisis.  All of them could have been avoided had the powers in charge understood economic history and followed the strong precedents set before them.  Theses errors can be fixed without enacting major socialist legislation, imposing trade barriers or placing undue burden on a very fragile economy.     

Digging Into The Layers Of Domestic Debt

Most economists and stock market analysts are finally coming to the conclusion that the United States is in too much debt to jump start a quick economic recovery.   Yet most of the analysis of the US debt levels is still simplistic and misleading.  Digging into the layers of debt within various sectors of the economy is very similar to excavating archaeological layers of the earth.  While some sector debt levels will have to be reduced drastically, others can still be expanded. 

The following chart has been widely distributed now thanks to Henry Blodget at Yahoo Finance, nakedcapitalism and Nouriel Roubini, among many others. It shows the ratio of domestic debt to total US Gross Domestic Product – comparing the total amount of debt outstanding to the gross economic output.  Right now, the amount of debt outstanding is staggering relative to our nation’s economic output.


Source: Ned Davis Research

Click To Enlarge Chart

But the chart is a bit misleading and simplistic.  First, the government didn’t keep official debt figures until the mid 1950s.  You’ll see at the bottom of the chart that data prior to 1946 was “interpolated”.   While I’m sure Ned Davis did their best to make sure the data was accurate, it’s far from clean data.  Second, a large part of the increase in the Credit Market Debt ratio in the early 1930s was caused by the implosion of the numerator – i.e. Gross Domestic Product (GDP) growth fell off a cliff by 40% in the early 1930s.  That accounts for much of the spike in the ratio.  So while the overall idea of the chart is correct – there’s a lot of debt outstanding – the numbers are a bit questionable.

The other problem with simply looking at the total debt is that it doesn’t take into account the other side of the balance sheet – the assets.  Over the past two decades, the level of assets for US Households has increased significantly as a percent of total GDP.  So while Household debt has grown rapidly, so have household assets.  However, that trend is now reversing and if it continues as is likely, it will become an issue.   The absolute level of assets still far outweighs the level of debt as is shown in the chart below. 

Household Net Worth Relative To Household Debt 012109  

Source: Bloomberg

Click To Enlarge Chart

Debt is definitely a problem.  The overall level of debt has increased dramatically in all economic sectors which is now weighing on the potential for an economic recovery.  Let’s take a look at the official government data since the 1950s and the various components of that debt to get a better understanding of what we’re up against.  The following chart comes from Bloomberg and shows the total debt levels by sector of the economy as measured by the Federal Reserve.   Remember, the debt levels are shown as a ratio – Debt/GDP.  Therefore, an increasing line means that debt is rising faster than GDP growth and a declining line means debt is declining versus GDP growth.  This data is compiled quarterly and published in the Federal Reserve’s Flow of Funds Report.

  Debt as a percent of GDP By Sector   

Source: Bloomberg

Click To Enlarge Chart

The Federal Reserve breaks down debt levels into two broad categories – 1) Domestic Non-Financial sectors and 2) Domestic Financial sectors.  The Domestic Non-Financial sector is further broken down into the following economic sectors – 1) Household 2) Business 3) State and Local Governments, and 4) Federal Government.   The Household debt includes both secured Mortgage Debt and unsecured Consumer Credit, neither of which I have shown on the chart. 

Domestic Financial Debt

Let’s examine the debt levels by category.  First, the largest and most rapidly growing sector has been Domestic Financial sector debt.  As we now know, the absurd increase in leverage by Investment and Money Center banks caused the huge increase in the Domestic Financial sector.    The deleveraging of this sector is currently weighing on the overall market.  As you can see, there’s a long way to go before the debt levels in this sector return to more normalized levels.  

The total amount of Domestic Financial sector debt currently stands at $16.9 trillion.   As of the fourth quarter of 2008, US financial companies have written off approximately $729 billion in debt, according to Bloomberg.   I would estimate that the Domestic Financial sector would have to continue to deleverage either through write-downs, write-offs, asset sales or simply paying down until debt returns to $10 to $12 trillion or 70% to 80% of GDP.   That implies another $3 to $4 trillion in debt deleveraging.  Mind you, I’m not predicting $3 – $4 trillion in write-offs – much of the debt will be eliminated through asset sales, paying down debt and portfolio run-offs.

Debt Outstanding Financial Institutions 012109  

Source: Bloomberg

Click To Enlarge Chart

Household Debt

The second largest sector is Household debt which consists of Mortgage Debt and Consumer Credit.   Household debt currently stands at $13.9 billion or 97% of GDP.  Debt growth in this sector began increasing at an accelerating rate in 1999 and 2000 as the housing bubble began to inflate and as households turned to credit to maintain their lifestyle during the 2001 – 2002 recession.  It’s interesting to note this is the only sector which has begun turning down.  Obviously, the housing bust is largely responsible for the reduction in mortgage debt.   However, after the horrendous holiday retail sales season, I believe even consumer credit has turned down as well.  This is perfectly rational behavior on the part of the consumer.  The economy has slowed, the housing market has turned down and consumers are retrenching.  I venture that until Household debt declines to the mid 1990s level of 70% of GDP, the consumer will continue to pull back.  That implies consumer debt will have to decline $3.9 trillion from current levels.

Debt Outstanding Household 012109

Source: Bloomberg

Click To Enlarge Chart

Business Debt

The remaining sectors of business and government debt are actually in relatively good shape.   Business debt stands at approximately $11 trillion or 75% of GDP.   While this is high, it’s not much higher than debt levels in the mid 1980s or early 2000s when Business debt averaged around 70% of GDP.    I estimate that over the next several years, Business sector debt will decrease by $1 trillion as companies go bankrupt or decide to pay down debt with cash flows rather than increase dividends. 

Debt Outstanding Business 012109  

Source: Bloomberg

Click To Enlarge Chart

Federal Debt

The deleveraging from the private sector is being offset by the leveraging up of public debt.   Luckily for President Obama, Fed Chairman Bernanke and Treasury Head Timothy Geithner, Federal government debt as a percent of GDP is actually relatively low.   Current Federal Government debt as a percent of GDP stands at 40% or $5.8 trillion.  Be aware that this figure is not the $9.4 trillion figure widely quoted as “public debt.”  The $5.8 trillion number does not include State and Local Debt, not does it include debt owed to the government itself, such as in the Social Security Trust Fund.  The amount of Federal Debt actually compares favorably to other developed countries.  For instance, Germany’s debt relative to GDP stands at 60% and other European countries stand at over 100%.  Most amazingly, Japan’s two decade long fight against deflation has increased its level of Federal Debt to GDP to over 160%. 

Debt as a percent of GDP Japan

Source: Bloomberg

Click To Enlarge Chart

The fact that Federal Debt is actually a relatively low percent of GDP partially explains why the US government debt is still considered a “safe haven.”   The US government actually has the ability to continue leveraging up.   If it were to expand its balance sheet to the level of Japan’s, it could borrow over $17 trillion more.    This level of borrowing seems unrealistic but it does go to show that the Federal government does have room to maneuver.   It also explains why, despite the huge deficits projected by the Obama administration, the dollar has remained relatively strong. 

State and Local Debt

The final layer of debt measured by the Federal Reserve is State and Local Debt.  At $16.9 billion, this also seems well under control relative to GDP.  Most states are not allowed to run budget deficits and many governments were aided by the housing boom in expanding revenues.  That spending will have to contract to keep the ratio in line relative to GDP. 

Based on my back of the envelope calculations, I believe Financial, Household and Business debt will be reduced by $8 – $9 trillion over the next decade.   This level of deleveraging would bring debt to GDP levels back in line with the early 1990s.  However, the deleveraging of the private sector will be met by the leveraging up of the public sector.  Lawrence Summers, director of the White House’s National Economic Council, confirmed this week that the government will run deficits as far as the eye can see in order to combat the deleveraging going on in the real economy.  

The implications for stock market investors are rather obvious.  While the consumer retrenches, retail spending will remain weak.  The domestic financial sector will also remain weak as those companies continue to deleverage, impairing profitability and reducing growth.  And while businesses will also see some retrenchment, the balance sheets of many US corporations remain strong.   Companies with strong balance sheets should come out on the other side of this downturn in better shape than ever.  Finally, while unchecked government spending is abhorrent to most every taxpayer, the Federal Government actually has the balance sheet to leverage up.  That should avoid a major crisis of confidence in the solvency of the United States, at least in the upcoming four years.

Stick That In Your Pipe and Smoke It

In an obvious reference to Alan Greenspan's loose monetary policy in 2002 and the mis-management of the money center banks and brokers, TCF Financial's (Symbol – TCB – "Takin' Care of Business") Chairman writes this pointed paragraph in his earnings release today:

 “TCF did not engage in the activities that have created so many problems in the financial industry,” said William A. Cooper, Chairman and CEO. “TCF has not made subprime, broker purchased, Option ARM, teaser rate, out of market, low doc or other risky mortgage loans. TCF kept on its balance  sheet all the loans it originated. TCF has no auto or credit card portfolios or asset backed commercial paper. We have never owned Fannie Mae or Freddie Mac preferreds, trust preferred securities or bank owned  life insurance (BOLI). TCF does not have any derivative contracts. Higher charge-offs at TCF have been primarily due to the imprudent behavior of our competitors and an ill-advised monetary policy that created the unprecedented rise and fall of the housing markets. TCF remains profitable, solidly capitalized and ready to take advantage of prudent growth opportunities. TCF declared a $0.25 quarterly dividend payable to stockholders on February 27, 2009. We expect to continue our dividend in future periods subject to maintaining solid profits and strong capital.

In accordance with our compensation programs, TCF Executive Management  received no bonuses for 2008. As Chairman and Chief Executive Officer, I receive neither a salary nor a bonus.”

I don't own TCF, nor have I ever done research on the stock.  However, based on that one paragraph, I'm going to dig in a bit further.  A 10% dividend, if it can be maintained, makes me very interested.  Oh, and I nominate TCF Chairman William Cooper for Treasury Secretary. 

Don’t Let The Door Hit You

Tim Knight over at the Slope of Hope posted this last night but it was so good, I had to post it, too. This was written eight years ago by the Onion, America's Finest News Source.  If it weren't so sad, it would be funny.  It just goes to show how weird the last eight years have been and how far the Republicans strayed when a satirical news site basically predicted the future.

Bush: 'Our Long National Nightmare Of Peace And Prosperity Is Finally Over'
January 17, 2001 | Issue 37•01

WASHINGTON, DC–Mere days from assuming the presidency and closing the door on eight years of Bill Clinton, president-elect George W. Bush assured the nation in a televised address Tuesday that "our long national nightmare of peace and prosperity is finally over."

"My fellow Americans," Bush said, "at long last, we have reached the end of the dark period in American history that will come to be known as the Clinton Era, eight long years characterized by unprecedented economic expansion, a sharp decrease in crime, and sustained peace overseas. The time has come to put all of that behind us."

Bush swore to do "everything in [his] power" to undo the damage wrought by Clinton's two terms in office, including selling off the national parks to developers, going into massive debt to develop expensive and impractical weapons technologies, and passing sweeping budget cuts that drive the mentally ill out of hospitals and onto the street.

During the 40-minute speech, Bush also promised to bring an end to the severe war drought that plagued the nation under Clinton, assuring citizens that the U.S. will engage in at least one Gulf War-level armed conflict in the next four years.

"You better believe we're going to mix it up with somebody at some point during my administration," said Bush, who plans a 250 percent boost in military spending. "Unlike my predecessor, I am fully committed to putting soldiers in battle situations. Otherwise, what is the point of even having a military?"

On the economic side, Bush vowed to bring back economic stagnation by implementing substantial tax cuts, which would lead to a recession, which would necessitate a tax hike, which would lead to a drop in consumer spending, which would lead to layoffs, which would deepen the recession even further.

Wall Street responded strongly to the Bush speech, with the Dow Jones industrial fluctuating wildly before closing at an 18-month low. The NASDAQ composite index, rattled by a gloomy outlook for tech stocks in 2001, also fell sharply, losing 4.4 percent of its total value between 3 p.m. and the closing bell.

Asked for comment about the cooling technology sector, Bush said: "That's hardly my area of expertise."

Turning to the subject of the environment, Bush said he will do whatever it takes to undo the tremendous damage not done by the Clinton Administration to the Arctic National Wildlife Refuge. He assured citizens that he will follow through on his campaign promise to open the 1.5 million acre refuge's coastal plain to oil drilling. As a sign of his commitment to bringing about a change in the environment, he pointed to his choice of Gale Norton for Secretary of the Interior. Norton, Bush noted, has "extensive experience" fighting environmental causes, working as a lobbyist for lead-paint manufacturers and as an attorney for loggers and miners, in addition to suing the EPA to overturn clean-air standards.

Bush had equally high praise for Attorney General nominee John Ashcroft, whom he praised as "a tireless champion in the battle to protect a woman's right to give birth."

"Soon, with John Ashcroft's help, we will move out of the Dark Ages and into a more enlightened time when a woman will be free to think long and hard before trying to fight her way past throngs of protesters blocking her entrance to an abortion clinic," Bush said. "We as a nation can look forward to lots and lots of babies."

Continued Bush: "John Ashcroft will be invaluable in healing the terrible wedge President Clinton drove between church and state."

The speech was met with overwhelming approval from Republican leaders.

"Finally, the horrific misrule of the Democrats has been brought to a close," House Majority Leader Dennis Hastert (R-IL) told reporters. "Under Bush, we can all look forward to military aggression, deregulation of dangerous, greedy industries, and the defunding of vital domestic social-service programs upon which millions depend. Mercifully, we can now say goodbye to the awful nightmare that was Clinton's America."

"For years, I tirelessly preached the message that Clinton must be stopped," conservative talk-radio host Rush Limbaugh said. "And yet, in 1996, the American public failed to heed my urgent warnings, re-electing Clinton despite the fact that the nation was prosperous and at peace under his regime. But now, thank God, that's all done with. Once again, we will enjoy mounting debt, jingoism, nuclear paranoia, mass deficit, and a massive military build-up."

An overwhelming 49.9 percent of Americans responded enthusiastically to the Bush speech.

"After eight years of relatively sane fiscal policy under the Democrats, we have reached a point where, just a few weeks ago, President Clinton said that the national debt could be paid off by as early as 2012," Rahway, NJ, machinist and father of three Bud Crandall said. "That's not the kind of world I want my children to grow up in."

"You have no idea what it's like to be black and enfranchised," said Marlon Hastings, one of thousands of Miami-Dade County residents whose votes were not counted in the 2000 presidential election. "George W. Bush understands the pain of enfranchisement, and ever since Election Day, he has fought tirelessly to make sure it never happens to my people again."

Bush concluded his speech on a note of healing and redemption.

"We as a people must stand united, banding together to tear this nation in two," Bush said. "Much work lies ahead of us: The gap between the rich and the poor may be wide, be there's much more widening left to do. We must squander our nation's hard-won budget surplus on tax breaks for the wealthiest 15 percent. And, on the foreign front, we must find an enemy and defeat it."

"The insanity is over," Bush said. "After a long, dark night of peace and stability, the sun is finally rising again over America. We look forward to a bright new dawn not seen since the glory days of my dad."

Premium Multiple Being Drained Out Of Wells Fargo

The premium earnings and book value multiples that Wells Fargo (WFC) has enjoyed for the past decade are being drained from Wells Fargo. Wells Fargo's stock has always traded at approximately a 20% premium to the banking group because of its higher than average earnings growth, higher returns on equity, and low level of non-performing assets. However, that premium multiple relative to the group is beginning to erode in a phenomenon known as "multiple compression."  Wells Fargo has underperformed the other bank stocks since the beginning of the year. Wells is down 37% vs 23% for the group since December 31st.

WFC Comparable Returns Since Jan 1st  

Source: Bloomberg

Click Image To Enlarge

Several events in the past two weeks account for investors deciding that the premium multiple was no longer worth paying for Wells Fargo.   First, the company has a very low tangible common equity-to-assets ratio after the Wachovia deal.  My estimate is about 2.6% – 2.7% vs the average bank of around 5.0% – 6.0%. This raises the probability that Wells will be tapping the TARP II for a second time to consummate the Wachovia deal.  Even though most refer to this as a bailout (i.e. free money) tapping the TARP is anything but free because the government's preferred shares sit higher in the capital structure than the common shareholders.   In addition, the TARP II money seems to be coming with many more onerous terms from Hank Paulson and company including reducing or limiting dividend growth. This makes the common stock much less attractive.

Second, Bank of America increased the loss ratio of the Merrill subprime CDOs to over 30%. This is higher than the "worst-case" 20% loss ratio Wachovia had assumed in some of its subprime mortgage portfolio.  Most likely, loss estimates will be going up significantly for the bad loans at Wachovia.  Increasing loss estimates will require additional capital.  It's hard to see how the combined Wells Fargo/Wachovia can be considered a premiere institutions given the rising level of losses and need for additional capital.  

Third, the sentiment toward bank managements has soured significantly since Ken Lewis was exposed as a liarregarding the Merrill Lynch merger. Wells' CEO John Stumpf and CFO Harold Atkins have, on numerous occasions, touted Wells' strong capital ratios and outperforming mortgage portfolio. However, after the Bank of America announcement, investor skepticism is high.  Wells Fargo has been magically impervious to the California real estate collapse despite it being their home market. Many short sellers believe that Wells is simply taking their time recognizing losses in their mortgage portfolio rather than taking their medicine as the the losses occur. Management is delaying taking the losses under their accrual accounting basis rather than taking mark-to-market losses like the investment banks. And who knows how many troubled loans Wells Fargo will "discover" now that it has consummated the merger with Wachovia? John Stumpf might yet turn out to be the next Ken Lewis.

The premium multiple is being drained out of Wells Fargo as investors anticipate increased government investment because of these issues. Yet some of the premium still exists. The following charts show that even relative to other high quality banking companies, Wells still trades at a high multiple. As late as December, Wells traded over 4.0x tangible book value and over 2.0x stated book value. This was a significant premium to the other national banks, which traded around 1.5x tangible book value and 0.9x stated book value. Impaired companies such as Citigroup and Bank of America currently trade around 0.3x stated book value.

WFC Book Relative To Industry


Source: Baseline

Click Image To Enlarge

If the consensus view becomes that Wells Fargo is no longer a premiere institution, then the premium multiple could disappear all together. This indicates to me that Wells could see further downside from these levels. At 0.9x book value, which is the current median multiple of the banking group, Wells Fargo stock would be trading at approximately $12 – $13.

The rapid decline in Wells Fargo shares will also have a negative effect on the broader market. Wells Fargo is one of the most widely held financial stocks by insitutional investors. Every fund looking to maintain some financial exposure has been hiding in Wells Fargo. The 37% decline in this "safe" stock will weigh on the performance of most every large cap mutual fund. Even Warren Buffett has taken a $4 billion hit on the stock in the past two weeks.

A list of the top 25 fund holders is a who's who of large cap stock managers who are now underperforming their indexes.

WFC Institutional Holders

Click on Image To Enlarge

The decline in Wells Fargo stock is certainly weighing on its holders but could also have negative implications for the future performance of the market as a whole.  If the once impervious Wells Fargo turns out to be worse than expected, the confidence in the overall securities markets will erode further.  And that could lead to further multiple compression for the entire market.

Absurd Bailouts

"Anyone else have their hand out?

– Lewis Black 

With the announcement this morning that Bank of America is getting an additional $138 billion, the bailouts have reached a level beyond absurdity. Has anyone at the Treasury noticed that the market value of Bank of America is only $41 billion right now? With $138 billion you could essentially let BAC go under and start three new BAC's.

I've stopped crying. All you can do now is laugh. The only person you can turn to in a case like this Lewis Black

Martin Armstrong: The Collapse of Socialism

Martin Armstrong takes the kids to school in this wide ranging essay that provides historical background for the situation we are facing today. The historical comparisons he draws are profound and frightening.

I have taken the liberty to edit the essay to streamline its core points because I believe the topic is that important and the arguments are very persuasive. Martin Armstrong is a incredibly learned man and sometimes his writings drift from the main point. I want to make sure the majority of readers can get through this essay without too much trouble. I have made the best efforts not to distort any of Martin’s ideas or alter his basic writing style. However, I have re-arranged part of the essay to make its points clearer. If you would like to read the full, un-edited version of the essay, I have provided a link here to the PDF file

Armstrong Economics

The Collapse of Capitalism or is it Socialism?

What does this mean for Government?

There have been plenty of articles asking whether Capitalism is now dead. The problem is the question already presumes an outcome and fails to realize that we are still in the middle of the greatest Economic Transformation in the history of mankind. We are in fact not seeing the collapse of capitalism, but are in the final stage of the death of Socialism.

Governments will rail against the collapse of Socialism because it has been the source of their power – “vote for me and you get something for nothing.”  We are in the final phase – a transition which is taking the form of a “tsunami of spending” to try to make it all better. What we must be concerned about will be who gets blamed when it fails?

Lifting this rock allows the scorpions to surface. It is more akin to opening Pandora’s Box and allowing a swarm of evils to escape and torment mankind. We have no choice but to speak very frankly, for unless we truly understand the nature of events, there is no way to close the box and make it all better. As Saint Jerome said of Rare: “When Rome fell, the Romans were still laughing.” They had no idea of what was taking place and just assumed Rome was impregnable. We can only stop an event if we recognize it is happening.

If we are afraid to ask the correct question, then perhaps we are too biased to comprehend what we have done and take responsibility for our own actions? To paraphrase Edward Gibbon in his memorable epitaph on Rome: We were the capitol of democracy, the citadel of the earth, the terror of tyrants, illustrated by the footsteps of so many triumphs, enriched by the leadership in economic freedom that was the beacon to so many nations. This spectacle, how is it fallen?

The Greatest Economic Transformation

It may seem strange, but we have been undergoing a battle of economic philosophy that transcends so many concepts that unless we step back, we will have difficulty understanding the trend. This battle has often been laced with efforts to control mankind. For within this battle, we will fight religion, politics, scientific innovation and progress spanning technology in all areas, but also issues that include both slavery and labor that all create what has become known as our economy.

Sometimes we are too close to a problem that it is just impossible to see. When man landed on the moon and sent the first pictures of Earth rising, only then could we see what our world truly looked like. We are facing the very same problem. The change that we now see and are debating, is still from the view of a fly on an elephant’s back. We do not know we are even on an elephant or what is an elephant.

Our society is still growing and changing. We are going through puberty where the youth rebels against the parent. The profound change, the Great Economic Transformation, became bluntly visible back in 1989 where the world economy began to change with the fall of Communism. That fundamental change was truly an Economic Transformation wave which is now causing the collapse of socialism in the Western nations. What we are facing is confusing. Nevertheless, if we want to see the elephant, it is time to take flight.

There is a very core structure to the economic society of man. The Industrial Revolution was not just a slogan. It is hard for modern man to look back from where he now stands and comprehend the meaning of “revolution” as it was truly expressed. The way of life prior to the Industrial Revolution remained essentially the same from Greek times, Rome, middle-ages, and the birth of the United States. The word “Economics” was an English translation of a book written by a great mind and a diversified man of tremendous experience – Xenophon (ea 431-350 BC). Xenophon was a brilliant, practical man. He began life early on as the commander of the elite Greek force known as the “Ten Thousand.” Xenophon admired Socrates profoundly, and developed a dislike for extreme democracy for the very crime it had committed by ordering Socrates to be executed for his ideas. Xenophon wrote three works on the subject casting Socrates in a different light than that of Plato – the “Apology” – “Symposium” – “Memorabilia.” Yet in the field of finance and economics, his political work is what the powerful committee on Capital Hill is named after – “Ways and Means” written around 351 BC advocating peace rather than war between the Greek states. But we owe the very word “Economics” to the title of his truly master work – “Oeconanicus” that simply meant in ancient Greek – how to regulate the household. It was a How-To Book for Gentlemen Dummies that explained how to manage your estate from growing crops, managing slaves, and your wife.

What does this have to do with the Industrial Revolution? Everything! Life as society knew it was completely different before the 19th century. The same economic model had existed for thousands of years around a self contained farm-like enclave. The Romans called them “villa” and we call them “plantations.” This is how society operated. Villa were independent estates that were virtually self-sufficient. The work force was composed of slaves purchased after battle in ancient times, or serfs in the middle-ages, or imported African slaves. The King of England had even used the criminal laws to create labor. Any misdemeanor allowed the King to sell someone as a laborer for a certain period. Instead of prison, you were sent, at first, to America. When the American Revolution began, the destination changed to Australia.

During the 3rd century AD, money became rare following a hyper-inflation. This caused tremendous hoarding and an economic contraction strengthening the villa model. The Roman Emperor Diocletion (284-305 AD) tried, to revive the empire like Ronald Reagan & Margaret Thatcher, and created many of the practices still employed today. To be able to collect taxes, passports were created and people could not move without permission. To tackle inflation, he substituted wage and price controls as did Richard Nixon. He redesigned the entire monetary system, i.e. Bretton Woods 1944.

When Rome fell after 476 AD, the concept of the villa prevailed. Life survived because of this self-contained economic model. This evolved into feudalism during the 9th and 15th centuries due to the increase in population and the inability to acquire wealth to establish a villa. Towns would form and the landlord became the nobility. Castles were constructed because of the lack of security. Charlemagne (742-814) began to reconstruct the old Roman Empire. This economic model received its first major shock that not even the fall of Rome had inflicted. The Black Plague in the 13th-14th Centuries killed about 1/3rd of the population making labor scarce and causing landlords to start to pay wages in addition to a percentage of the crop and free housing. Yet, predominantly, the economy was still agrarian and the model was still the villa.

In Russia, the seeds of the 1917 Revolution were sowed during the reign of Ivan IV (the Terrible)(1530-84), when he confiscated lands of his enemies to give to his supporters. Ivan found the lands worthless once the serfs fled. He then decreed that the serfs would be bound to the land for life in order to maintain its value. He essentially made all Russians living on farms slaves of the state. This eventually created the pool of discontent that fueled into the bonfire of Revolution years later.

Of course in the United States, the slavery issue was recognized as wrong and a real problem, especially after the language written by Thomas Jefferson in the Declaration of Independence. This issue dominated early politics, and perhaps came to a head when the Supreme Court showed it was indeed, as Judge Posner refers to it, the “Political Court.” In 1857, the Supreme Court held that blacks were just property in the case of Dread Scott, who sued for his freedom when his master traveled to a state that did not allow slavery. The Civil War was not fought over racism. It was fought over the collapse of the economic system of labor. Racism emerged more so as a bitter response by the South attaching blame for their demise to the freedom of the slaves.

We can see that slavery was a very ancient practice as outlined by Xenophon in “Oeconanicus.” It was how the villa model maintained its economic viability for thousands of years. In Roman & Greek times, the economy was 90% agrarian. However, that declined to 70% in the 1870s, 40% in 1929, and finally 3% by 1980. It has been this villa model that was undergoing the Great Economic Transformation to the Industrial Revolution.

The Great Economic Transformation has been the growth of society through progress and technologies. We have been evolving even in our understanding of economics, since the nature of the economy is in fact changing with each passing year. We must look at this transformation and understand that as the changes in labor have taken place, everything else in our world also changes. Had it not been for the Black Death, there would never have been a shortage in labor giving birth to wages that led to payroll taxes.

The Battle Lines

Before we wage further, we have to explore what caused the battle between communism and capitalism. We can attribute this to Karl Marx (1818-1883) but this does not explain why Marx came to the conclusions that he did and set in motion decades of geopolitical conflicts that has cost the lives of countless millions! 

We must understand that from the school of Physiocrats, who believed that all wealth was created only by nature, we end up with the runaway idea that man can create utopia – the imaginary world where man could live indefinitely under the perfect plan. This idea was sparked by Sir Thomas More in 1516 that created a whole class of thinkers who believed in this Utopian world was possible. Sir Thomas More (1478-1535) was a major influence and contributed to what we now face today under Socialism.

Marx railed against the change from the agrarian society to the industrial revolution. He did not see the State as the issue. What he saw was that this new economic model would lead to paid workers in factories who would be exploited to make a profit for the employer. Marx saw this “new” economic model as changing the world taking people from the traditional farm and turning them into consumers of products manufactured. However, he believed that their employers would be so greedy, they would decline to pay the worker. Eventually this new system would collapse because the greed of the employer would suppress the income of the laborer, and that would result in the collapse of this new evil experiment – industrial capitalism.

The battle begun by Marx between his Utopian ideal of communism vs. capitalism is not over. The Communistic system transfers power to the state, as does Socialism. This has sanctioned the power of a central government at the expense of the economic freedom of Capitalism. What we are really saying when we ask whether Capitalism is dead, is should we abandon freedom and run behind the walls of the castle since the state is the modern day landlord? Do we reverse this Great Economic Transformation, or understand what is going on for just once?

American Labor

Marx began a class-warfare that could yet tare the very fabric of our society to shreds. The beginning of the end of the labor union movement was marked seventy two years after the first real labor riot that took place on May 4th, 1886 known as the Haymarket Riot. The Taft-Hartley Labor Act of 1947 was designed to take away the power of the unions. By the 1960s, the unions were cast in the light as being evil and controlled by organized crime after the Jimmy Hoffa incident. This critical shift in perception curtailed the union movement after just one 72 year political cycle.

The collapse of General Motors is the collapse of the last vestige of Marxism – the labor unions. The foreign auto-manufacturers have set up shop in the South where the labor laws were far more favorable to create non-union work forces that have been quite successful. The foreign car manufacturers have demonstrated that unions are a bad idea. The union movements had their points from the outset. But working conditions should have been attacked in a political context (democracy). Unions assumed the mantle of communism creating confrontation and transferred the power from management to labor. It did not solve the problems and only became like a drunk who then had the keys to the liquor store – self-destructive.

The reason why unions were a bad experiment was because they merely turned the employer into a slave and altered the free markets that was contrary to the nature of mankind. Historically, when the crops failed in an agrarian model, people simply migrated. The Philistines of the Bible were most likely Greeks who migrated due to crop failures at the First Heroic Age. Invasions of the Goths, Germans, and even Attila the Hun were all caused by the “grass is greener” on the other-side belief. Unions just promoted increased wages rather than increased skills, diminishing the individual motivation to learn new skills and migrate between jobs. This is the same reason why communism died. Creating a system where one-size-fits-all, promotes a decline in human growth that is then manifest within the economic decline.

We have to understand, that the fatal flaw in Communism was to diminish the essence of mankind. They say necessity is the mother of all invention. That is so true. If we try to create utopia, we destroy the very engine that creates progress.  Do not for one minute think that a labor union is any different that the communistic model. It is not. Where in a normal economic model, to earn more one improves his skills, the Communistic model promotes advances income without improvement in skills.

This union labor system stymied natural economic progress and created much damage to the benefits of the Industrial Revolution. This is the fatal flaw that had led to the destruction of American jobs. It froze the natural economic evolution and began a trend toward transferring jobs overseas. The trend was only accelerated by the imposition of the payroll tax that essentially increased the cost of labor. Historically, mankind migrated in an agrarian society. This very same trend still takes place today. However, instead of the work force migrating to better lands, the communistic model reversed the roles and caused the employer to migrate. What government did not notice, was this trend was not caused by the “greed” of the employer, but by the Invisible Hand of Adam Smith. Labor demanded the highest wages with the lowest productivity, and consumers demanded the lowest price with the highest reliability. The employer migrated to survive. Throughout history, human nature has never migrated for no reason. Migrations take place when prodded by the fickle finger of necessity.

Communism, when implemented as a government policy, lasted only one 72 year political cycle. In 1917, we find the Russian Revolution and Sun Yat-sen set up the rival government in China at Guangzhou as the Nationalists. Seventy-two years later, Tinennamins Square in 1989 was followed about five months later by the fall of the Berlin Wall. These changes were economically driven. The stagnation of the human spirit led to the steady decline in productivity. This is the same trend we have seen in the American labor unions.

What we must understand is that only when people lose their security, then and only then do we see political unrest. Just as humans did not migrate without reason, all political unrest is unleashed following economic implosions. As we shall see, the collapse of the Mississippi Bubble set in motion a irresponsible government policy regarding the money supply – the invention of paper money. This collapse of a European-wide speculative boom in 1720, set the stage for the great wave of revolutions that toppled the last vestige of Feudalism – Monarchy. It was not just the American Revolution, with its slogan, “No Taxation Without Representation,” but also 72 years later we come to 1792 and the overthrow of the French monarchy.

Understanding the Mississippi Bubble and the French Bailout that set in motion the Age of Revolution

At first, you might ask: Why look at something from 1720? Well, the answer is simple. The French Government was in part responsible for the Mississippi Bubble and contributed to its exponential rise at the end. The Government had to then bailout the mess and, to pay for it, implemented higher taxes. This is not so different from current events.

The Mississippi Bubble was a financial scheme not so different from the wild un-backed derivatives created by AIG and others. The scheme was at first engineered by John Law, an early economic theorist, who was friend with the Duke d’Orleans. In 1716, John Law founded Banque Generale, with the authority to issue notes that were the earliest form of paper currency. The following year, he founded Compagnie d’Occident (“Company of the West”) with the exclusive deal to develop the new French territories in the Mississippi River valley. This enterprise began to monopolize the tobacco and African slave trade as well. By 1719, he then formed the “Compagnie des Indes” that was essentially just renaming the “Company of the West” with a complete monopoly over all French trade. This new entity also assumed the powers as if it were a Roman governorship, with the power to both collect taxes and to coin money. This operation in essence assumed control of both the trade and finances of the French government.

It was this link and exclusive power with the French government and the vast expansion of unlimited profits in the New world, that created the image of the best possible investment. The public was naive. But they were also exploring how capital could be used to actually work and make more money. This was a novel idea for since the fall of Rome, during the Middle-Ages, there was no national organized state that promoted international investment. It was akin to the fall of Communism and the interest in investing in a new world of private investment in China and Russia.

It was this expectation of potential profits that created perhaps what may still remain as the wildest speculative boom in history. Between the discovery of America in 1492 and 1700, the majority of investment was professional or solely by the state. There was no opportunity for the public to get involved on a speculative nature. So this was the first true experience of allowing the public to participate is the new frontier. As this cycle unfolded, its duration would be 224 years from the discovery to the bust that set in motion Revolution. The shares of the lead enterprise, Companie de Indes, rose from 500 livres to 18,000. By 1719, 625,000 shares had been issued. This boom gave rise to the term “millionaire.” The boom was so profound, Compagnie de Indes was merged thereafter with Banque GeIlerale and the scheme was expanded to retire the national debt of France by exchanging shares for the bonds.

This led to a monumental speculative bubble that spread throughout Europe. A similar theme played out in England with the South Sea Company. The The South Sea Bubble transformed into a scheme to retire the national debt of England in return for shares. That entire incident occurred between late 1711 and late August 1720.  The last stages of the speculative boom saw the shares rise from 128 1/2 pence to 1,000 between January and August 1720.

Back in France, the “Compagnie de Indes” was so successful without really producing profits that the French government began to get involved. The French government began to issue paper money itself. This was a form of derivative for the money was widely accepted only because it was convertible into shares of this new company. The vast economic expansion was fueled by the unlimited issue of paper currency between late 1719 and the fateful time of the year – September/October 1720.

The linkage between the speculative shares and the government finances created a bust that became the closest thing to a financial mushroom cloud. The bear market collapse was so significant, that by December 1720, John Law had to flee France. The collapse was fierce because there were no market-makers, middle-men, or a mature two-sided market. The concept of puts and calls had developed in the earlier speculative bubble known as the Tulipmania (1634-1637) in Netherlands. But that panic did not involve a debt crisis or the government issuing derivative forms of money convertible into stock shares. The lack of sophisticated market functions led to a one-sided collapse in both the South Sea Bubble and the Mississippi Bubble within three months. The English shares collapsed from 1,000 to 124 by December 1720 though the company did survive until 1853.

It was the collapse in debt that devastated the economy. The French government was forced into a bailout assuming all the debts of the company, and then, to pay for their own folly, began to raise taxes. That set in motion the resentment that led to the French Revolution.

The French Bailout The Revolution (The Bonfire of Discontent)

The involvement of the French government in the speculative boom, also placed the focus of responsibility for it upon the King. The raising of taxes to pay for the bailout set in motion the French Revolution fueling the bonfire of discontent. The Revolution began with the storming of the jail, Bastille Day (7/14/1789) as it is remembered today. This led the king to flee to his palace at Versailles in October 1789, which the people later stormed on June 20th, 1792. At trial, they referred to the King now as “Citizen Capet” and tried him for treason on December 1792. He was executed on January 21, 1793 followed later that year by his wife, Marie-Antoinette. The First Republic was declared on September 21, 1792. This citizen government simply failed until Napoleon took power in 1799 and eventually crowned himself emperor in 1804.

Consequently, it was the direct involvement of the French Crown and its very costly bailout that resulted in raising taxes and oppressing the people that led to the collapse of the French economy and ended with a Revolution.  Looking at government to bailout the follies of the Investment Banks is a dangerous course of action. It shifts the burden to the Government and raises the risk of political instability in the long-run should the Government fail to reverse the trend.  What if we end in hyper-inflation? The massive monetary printing and funding of debts could drive interest rates higher, which will compete with the common man and destroy his ability to survive economically. If we then turn to higher taxes to make those who did not cause the crisis pay for it (letting the investment bankers off the hook once again), how can we justify this vast transfer of wealth?

It Is Always Debt That Destroys The Best Plans and Foundations of Mankind!

The debt crisis is always distinguished from the mere speculative bubble. The Tulipmania did not change the course of history as did the Bubble of 1720. Likewise, the excessive borrowing by Spain and the desperate attempt to invade England to payoff those debts with its Armada in 1588, resulted in the collapse of Spain taking with it Italy, who was its banker. In the end, Spain and Italy lost their ability to be any sort of a world power. It is always debt that destroys a nation. It destroyed even Rome.

What we must understand is that we have been evolving as an economy for a very long time. Communism and Socialism are a mere blip on a screen. Governments’ stepping up to bailout the crisis raises concern.  For had we just let the Investment Bankers fail and stood behind the public deposits 100% in Commercial Banks, we would have been better-off. Sometimes, it is honestly best to let the free markets sort out the weak from the strong, because it is quite frankly, far too complicated to anticipate correctly – this is why Communism also failed.

Marx railed against the coming of the Industrial Revolution. He saw evil and was blind to the evolution of the economy as a whole. We are still caught-up in the philosophy of Marx. Phase One was the collapse of Communism. Phase Two, will be the collapse of socialism – state promises that are unfunded yet seek to still create the world of Marxism to a lesser degree. There is not much difference between the state taking title to the land, or allowing you to keep the title but dictate how it is to be used. Labor can no longer migrate, only capital.

The Communistic/Socialistic theory of Marx is collapsing. Our socialistic life may be coming to an end because our promises exceed our resources. This bailout is likely to push the government over the edge. If we cannot see how we make the same mistakes over and over again, what hope do we have? We can survive as a society only when we open our eyes. If we cannot do that, then we may be headed into a new dark age of feudalism with the break-up of organized states. We have to stop the debt and insane taxes before it is too late once again. We are in the last death throes of Marx’s ideas of Communism/Socialism. He railed against the Great Economic Transformation, because he remained just a fly on an elephant’s back. We can survive if we are rational and objective. We need to restructure or we will lose it all.

Martin A. Armstrong December 11th 2008

You may send comments directly to Martin Armstrong at ArmstrongEconomics@GMail.com

Martin Armstrong: The Coming Great Depression


Armstrong Economics
The Coming Great Depression
Why Government Is Powerless

1929_panic_on_wall_street It is frustrating to read so many comparisons of our current situation with 1929 while watching policy be set-in-motion to create spending on infrastructure. Everyone has their hand out looking for a bailout like a bunch of street burns pleading for money so they can get drunk or stay drunk. Almost nothing of what I have read is close to being accurate.  The scary part is depressions are inevitably caused by politicians who may be paving the road with good intentions, but are relying upon analysis so biased, we do not stand a chance.

The stock market by no means predicts the economy. A stock market crash does not cause a Depression. The Crash of 1903 was properly titled – “The Rich Man's Panic." What has always distinguished a recession from a Depression is the stock market drop may signal a recession, but the collapse in debt signals a Depression. This Depression was set in motion by (1) excessive leverage by the banks once more, but (2) the lifting of usury laws back in 1980 to fight inflation that opened the door to the highest consumer interest rates in thousands of years and shifted spending that created jobs into the banks as interest on things like credit cards.  As a percent of GDP, household debt doubled since 1980 making the banks rich and now the clear and present danger to our economic survival. A greater proportion of spending by the consumer that use to go to savings and creating jobs, goes to interest and that has undermined the ability to avoid a major economic melt-down.

The crisis in banking has distinguished depression from recession. The very term "Black Friday" comes from the Panic of 1869 when the mob was dragging bankers out of their offices and hanging them in New York. They had to send in troops to stop the riot. A banking collapse destroys the capital formation of a nation and that is what creates the Depression. The stock market is not the problem despite the fact it is visible and measurable and may decline 40%, 60% or even 89% like in 1929-32. But the stock market decline is normally measured in months (30-37) whereas the economic decline is measured in years (23-26). Beware of schizophrenic analysis that is often mutually contradictory or often antagonistic in part or in quality for far too often people think they have to offer a reason for every daily movement.

Our fate will not be determined by the stock market performance. Neither can we stimulate the economy by increasing spending on infrastructure any more than buying your wife a mink coat, will improve the grades of your child in school. We are facing a Depression that will last 23-26 years. The response of government is going to seal our fate because they cannot learn from the past and will make the same mistakes that every politician has made before them. Even if the Dow Industrials make new highs next week (impossible), the Depression is unstoppable with current models and tools.

Stocks & Consumers vs. Investment Banks

Let us set the record straight. The Stock Market is a mere reflection of the economy like looking at yourself in a mirror. It is not the economy and does not even provide a reliable forecasting tool of what is to come economically. We are headed into the debt tsunami that is of historical proportions unheard-of in history. There have been the big debt crisis incidents that have hobbled nations, toppled kings, and set in motion economic dark ages. It is so critical to understand the difference between the economy and the stock market, for unless you comprehend this basic and root distinction between the two, survival may be impossible.

Economic Confidence Model Close UP 010909 To the left I have provided the Economic Confidence Model for the immediate decline. You will notice I did not call this the "stock market model" nor a model for gold, oil, or commodities. I used the word "economic" with distinct and clear purpose. I have stressed it does not forecast the fate, of a particular market or even a particular economy. It is the global economic cycle some may call even a business cycle. Please note that what does line-up and peaks precisely with this model often even to the specific day that was calculated decades advance is the area of primary focus. Yet the US stock market reached a high precisely with this model and then rallied to a new high price 8.6 months later. In Japan, the NIKKEI 225 peaked precisely on February 26th, 2007. This is not a very good omen. But there was something profound that turned down with the February 27th, 2007 target – the S&P Case-Shiller index of housing prices in 20 cities. February 2007 was the peak for this cycle in the debt markets – not the US stock market. 

The stock market always bottoms in advance of the economic low. In fact, we will see new highs in the now even in the middle of a Great Depression. At least the 1929 cycle was more of a bubble top in stocks than what we have in place currently in the US stock market.  We still had the bubble top in the NASDAQ back in 2000, but this illustrates the point. There was a major explosive speculative boom. The bubble burst in 2000 and there was a moderate investment recession into 2002, but there was no appreciable economic decline that was set in motion because of that crash. Currently, we have a major high in 2007, but it was not a bubble top because it was not the focus of speculation. The real concentration of capital that created the bubble top, took place in the debt markets. This is the origin of the economic depression – not stocks and not the displacement of farmers because of a 7 year drought created by the Dust Bowl that invoked the response of the Works Progress Administration (WPA) in 1935. Keep in mind the stock market bottomed in the mid summer of 1932 when unemployment was not excessive from a historical perspective.
The 25% level of unemployment came after the major 1932 stock market low that was followed by both the banking crisis after the election of FDR and before his fateful inauguration. The Banking Crisis came about because of rumors that Roosevelt was going to confiscate gold. Herbert Hoover published his memoirs showing letters written to Roosevelt pleading with him to make a statement that the rumors were false. He did not.

It’s the Debt Level Stupid

In 1907, the excessive debt was in the stock market. Call Money Rates (the level of interest paid to support broker loans) reached 125%. Even 1929 never came close to such levels. This also illustrates that the capital markets do not have enough money to invest equally on all levels in all segments of a domestic economy or in particular nations. To create the boom-bust, it requires the concentration of capital. A bubble top is formed when the majority of those seeking to employ money to make money are focused in a particular market or even country. The 1907 Crash was a bubble top because capital invested on a highly concentrated basis in railroad stocks. The bubble top in Japan back in 1989 was caused by a concentration of both domestic and international capital that had made Japan the number one market in the World. It is this concentration of capital that creates the boom and bust cycle. If money was evenly disbursed like the socialistic & communistic philosophies argue, we would be back to the dark ages where there was no concentration of capital and no economy beyond the walls of the castle so to speak. That is why communism failed.

It is the overall level of debt that has reached a bubble top in almost every possible area. For example, in 1980, household debt was about 50% of GDP. Going into the February 2007 high, it reached about 100% of GDP. We must also realize that something profound took place back in 1980. Americans would on the first blush seem to be living it up, buying everything they can on credit and have piles of tangible assets to show for it. That is like looking at the statistics for carrots and arguing that they are lethal because every person who has ever eaten a carrot is dead or in the process of a gradual slow death. This absurd example illustrates the bias that can produce the schizophrenic analysis.

There were, once upon a time, usury laws that generally held any interest rate greater than 10% was illegal. The Federal Reserve under Paul Volker believed that interest rates needed to be raised to insane levels to stop the runaway inflation, which  was the first stone that hit the water sending the shock waves that we are having to pay for today. Once the usury laws were altered so the Fed could fight inflation, it set in motion the doubling of household debt, not to mention the national debt. At 8%, the principle is doubled through interest in less than 10 years. The national debt exploded from $1 to about $10 trillion in 25 years and household debt has doubled.  Some states now consider usury to be 26%. Historically, these are the interest rates paid by the very worst of all debtors – the bankrupts. In fact, in China, the worst creditors historically paid at best 10%. What we have done is the lifting of usury to fight inflation back in 1980, has resulted in usury now being so high, a larger portion of income of the common worker is spent on interest, not buying goods & services that even create jobs. This is one primary reason why jobs have been leaving as well. The consumer needs the lowest possible price and labor wants the highest wages, and to stay competitive, producers leave taking manufacturing jobs as well as service jobs. The extraordinary rise in interest rates that are historical highs since at least pre-Roman times, could not have been possible but for the lifting of usury laws back in 1980 to fight inflation. This amounted to setting a fire to try to stop a brush fire that failed. Consumers pay the highest rates in thousands of years that feed the banks at the expense of economic growth. Even the National Debt rose from $2. 1 to $8.5 trillion between 1 986 and 2006 with $6. 1 trillion being interest. We are funding the nation on a credit card and destroying the economy simultaneously.

This has been enhanced by the tremendous leverage and false position that were created in the derivative markets causing the banks to just implode.  Indeed, this is the origin of the economic Depression we are facing. The $700 billion bailout might have worked if Paulson did what he said he would – buy the debt and take it out of the banks. Had the debt been segregated into a pool and managed independently by a hedge fund manager not an investment banker, we could have mitigated the problem. But that is now too late. The credit implosion is taking place on a wholesale basis around the world. The more the economy declines in housing prices, the greater the defaults, the greater the foreclosures, and the lower the economy will move. We are now in a downward spiral that cannot be fixed by indirect schemes. As I said, you cannot get your kid's test scores up by purchasing a mink coat for your wife. Everyone will have their hand out begging for infrastructure money. But the theory of just spending money that will somehow make things better, it is like handing Mexico a trillion dollars and arguing that they will buy US goods that will somehow reverse the economy.

The leveraging of debt by the Investment Banks in particular has undermined the global economy. Where household debt has doubled since 1980, the professional financial service sector has seen a rise from 21% of GDP in 1980 to 116% by February 2007. Now consider the debt that they created with the mortgages is already down by 50% and falling, the bailouts will keep coming. To help correct the problem, the commercial banks will tighten credit to make their exposure less, and in fact, their solvency ratios will require it anyway. This we can expect to see not just in business, but housing and car loans that will contract the economy as well.

The Great Depression is not the perfect model for today. It was a complete capital contraction. The stock market basis the now Dow Jones Industrials fell 89% between September 3rd, 1929 and July 1932. The contraction in debt was quite massive. Then too, the leverage in banks collapsed that reduces the velocity of money and therefore the money supply. The banks were the first real widespread failures with 608 in 1930. Between February and August 1931, the commercial banks began to bleed profusely as bank deposits fell almost $3 billion or about 9% of all deposits. As 1932 began, the number of bank failures reached 1,860. The massive amount of bank failures in the thousands took place with the rumor of Roosevelt's intention to confiscate gold. Although he denied that was his policy the night of the elections, he remained silent refusing to discuss the issue until he was sworn in. on March 6, 1933 just 2 days after taking office, Roosevelt called a bank "holiday" closing the banks from which at least another 2,500 never reopened.

All of these events are contrasted by the collapse in national debts in Europe. Other than Herbert Hoover’s memoirs, I have yet to read any analysis of the Great Depression attribute anything internationally other than the infamous US Smoot-Hawley Act setting in motion the age of protectionism in June 1930. It was the financial war between European nations attacking each other's bond markets openly shorting them that led to all of Europe defaulting on their debt. Even Britain went into a moratorium suspending debt payments. This is what put the pressure on capital flows sending waves of capital to the United States that to sane degree was kind of like the capital flow to Japan into 1989. This put tremendous pressure upon the dollar driving it to new record highs that were misread by the politicians who did not understand capital flow. They responded with Smoot-Hawley misreading the entire set of facts. (see Greatest Bull Market In History) (Herbert Hoover's memoirs).

It is true that today we have Keynesian and Monetarist theories to manage the crisis. Sad to say, neither one will now work. Bernanke has responded in force dropping the federal funds rate from 5.25% to .25%. He has also opened the Fed Window and thrown out more than $1 trillion in 13 months. However, as admirable as this may be, he has no tool that will do the job. Milton Friedman was correct! The Great Depression was not caused by the decline in the stock market. The event was set in motion by the credit and banking crisis that resulted in a one-third contraction in the money supply.

Interest rates will do nothing. The flight to quality always takes place so what happens is a two-fold punch. (1) Interest rates collapse because capital seeks preservation not yield and will accept during such times virtually a zero rate of return, and (2) the flight to quality takes more available cash from the private sector because government debt truly does compete with the private sector. We are seeing this even now. Federal debt becomes the place to go so we see higher yields in both state am municipal bonds because they are not quality and could default like any bank. This contracts the money supply.  Opening the window and just throwing buckets of money into the system will never have any impact to reverse the trend.

Furthermore, we are now in a Floating-Exchange Rate system that has made the global economy far more complex than it was in 1929. We all know that China is one of the biggest holders of US government debt. With the contagion spreading to Russia, South America, and China aside from Europe, we see a steeper decline in the China stock market than we do in the United States because that is where capital had concentrated domestically. If China needs money to stimulate its own economy when exports appear to be collapsing by about 50%, then we can see that the Keynesian model is worthless. If the Fed tries to pump money into the system through buying bonds from the private sector, those bonds may be held by aliens who take the money back to their own economies. The Fed cannot be sure it is even capable of stimulating the purely domestic economy. Lower interest rates to virtually zero like Japan did during the 19905, then if capital finds a better place to invest, it can leave for a higher rate of interest as capital did from Japan to the United states, which is why their domestic economy was never stimulated by the' lower interest rates.
Leverage during the Great Depression was not even remotely close to what we have to face today. The credit-default swaps are alone worth about $60 trillion. This was a stupid product for it has so tangled the world there may be no way out. This product created the false illusion that you did not have to worry about the quality of the loan because it was insured. We have no way of covering this level of implosion. Add the unfunded entitlements and then the state and local debts who cannot print money to cover their shortfall s, and we are looking at a contraction of debt that is simply beyond all contemplation.

So What Now?

So now that we see it is not Wall Street, again, but the banks, perhaps we can separate the facts from the fantasy. We can now see that there are two separate and distinct forecasts to be made – (1) economy and (2) stock market. Economic Depressions have a duration unfortunately of generally 23 years with an outside potential of 26 years. The 1873 Panic led to a economic depression of really 23 years into 1896. There were bouts with high volatility and injection of major waves of inflation following the major silver discoveries. It was the age of the Silver Democrats who tried to create inflation by over-valuing silver relative to gold. This created a wave of European-American arbitrage where silver flowed into the US exchanging it for gold, which then flowed back to Europe. By 1896, the US Treasury was broke.

The Panic of 1873 marked the collapse of J. Cook & Co, the huge investment bank that was the 19th Century version of Goldman Sachs. They went bust because of excessive leverage in railroad stocks. It matters not what the instrument may be, it is always the leverage, which set the tone for a economic depression that lasted into 1896 where JP Morgan became famous for leading a bailout of the us Treasury organizing a loan of gold bullion. The stock market rallied and made new highs with plenty of panics between 1873 and 1896. The point is, The Panic of 1893 was quite a horrible one. The point is, the stock market is not a reflection of the economy. It often trades up in anticipation of better times, and trades down on those same perceptions of bad times. In both cases, new highs or lows unfold even contrary to economic trends.

We will see new highs in the now long before we see the final low in the economy. The ideal lows on a timing basis for the stock market will be as soon as April 2009 or by June of 2009. The more pronounced lows would be due on a timing basis between December 2009 and April 2010. The most extreme target would seem to be August 2010. The shorter the resolution to the stock market low, the sooner we will start to see much higher volatility.

The low for the Dow would be indicated by reaching the 3,500-4,000 area. A 2008 closing below 12,000 in the cash now Jones Industrials will signal that the bear market is underway into at least 2009 if not 2010. A year-end closing for 2008 below the 9,700-9,800 level, will signal higher volatility as well. The real critical level for the closing of 2008 will be the 7,200 area generally. A year-end closing beneath this general level will signal that we could see the sharp decline to test the extremes support at 3,600-4,000 by as early as April 19th, 2009 going into May /June 2009. If we were to drop so quickly into those targets, this would be most likely the major low with a significant rally into at least April 16th, 2010.

The less volatile outcome would be a prolonged decline into the December 2009 target to about April 16th, 2010. A low at that late date would tend to project out for a high as early as June 2011 or into late 2012.  Nevertheless, volatility appears to be very high. Those who were at the 1985 Economic conference in Princeton, may want to review those video tapes. The volatility we were looking at 20-30 years into the future is now. As 3 of the 5 major investment bankers failed, Merrill, Lehman and Bear, the liquidity has evaporated so the swings are going to be much more dramatic.

The major support is 3,600 on the now Industrials. During '09, the support area appears to be 6,600, 5,000, and 4,000-3,600. Clearly, resistance is shaping up at 9,700-9,800. It would take a monthly close back above the 12,400 level to signal new highs are likely. If we saw a complete collapse into a low by April 2009 or June 2009 reaching the 4,000 general area, this would be the major low with most likely a hyper-inflationary spiral developing thereafter. In that case, the now Jones Industrials could be back at even new highs as early as mid 2011 or going into late 2012.

Gold has decoupled from oil as it should and has been rising on an ounce-to-barrel ratio. Here, the pivot area for 2009 seems to be the $730-$760 area with the key support being still at the $525-$540 zone. The major high intraday was on March 17th, 2008. A weekly closing below $800 warns of consolidation. Only a monthly closing below the $535 area would signal a major high is in place. The more critical support appears to be at about $680 – $705. A weekly closing beneath this area will also warn of a potential consolidation. A major high is possible as early as 2010-2011 with the potential for an exponential rally into 2015 if there is any kind of a low going into 2011.45. The key to watch will be crude Oil. The collapse of Investment Banks has removed the speculation that exaggerated the trend. A year-end close below $40 for 2008 would signal a major high and serious economic decline ahead.

There Are No Tools Left!  The Emperor Has No Clothes

It is hard to explain to someone who believe he has power, that he really has nothing of any significance. This becomes the story of the Emperor Has No Clothes. No one will tell him, and if you do, it may be off-with-your-head. This is akin to the man behind the curtain in the Wizard of OZ trying to keep up the whole illusion. After all, why do we vote for people unless we believe that will somehow change our lives?

Interest Rates

When an economy is rising and the stock market is exploding, interest rates always rise because the demand for money is rising because people believe that they can make a profit. Government pretend to be raising interest rates to stop inflation, but they do not create a trend contrary to the free markets. What happened in 1980 was merely that the government over-shoots the differential between expectations and the rate of interest. If you believe the stock market will double, you will pay 20% interest. A rising interest rate does not create a bear market. Only when the rate of interest exceeds expectations of potential profit offering almost a fixed secured return, will capital leave the speculative market and run to the bond market.
In a bear market, interest rates always decline because of the flight to quality. When there is a risk of a .banking crisis as well, then the flight to quality shows that capital is willing to accept virtually zero in return for the privilege to park itself is a secure manner to preserve the future.

In both cases, the government may accelerate the trend, but by no means can they create the trend or alter the trend. Lowering interest rates to zero right now will not reverse the economic decline. People will look out the window and until they feel confident again, they will not come out from behind the castle walls. Japan lowered interest rates to virtually zero for nearly a decade. All it did was fuel the carry trade whereby yen was borrowed at 0.1 % and invested in dollars at 5-8%. There was little opportunity to invest domestically in Japan and the stock market languished in a broad consolidation with flurries the upside every-now-and-again.

Monetary Theory

The Fed has already put into the system about $1 trillion in 13 months. The real problem is they are buying back US government debt injecting cash into the system. But if those bonds are sold to the Fed by foreign holders, there can be no injection of cash into the domestic economy. This amounts to the monetization of our debt in any event. Clearly, buying bonds from the market is not a guaranteed increase in domestic money supply especially when the velocity of money is itself collapsing. Borrowing heavily all these years and depending on foreign investors to buy that debt, altered the course of economics.  Of course there has always been the foreign investor, but there has not been the floating exchange rate system. The rise and fall of the dollar itself can now either attract foreign capital with an advance or repel capital with its decline. Like we needed another new variable.

Infrastructure Spending

There really is nothing left in the tool bag that can help even to mitigate the coming Economic Depression. The unemployment rate at the end of 1930 was only about 8.9% – similar to the 1975 recession. Things were very slow back then. Even housing was not moving and people took whatever offers came their way. It was the Dust Bowl that began in 1934 that sent the unemployment rising after the 1932 low in the stock market. About 40% of the work force was agrarian. Hence, Congress could not pass a law to make it rain. The real devastation was that this presented a huge portion of the work force that had to be retrained into skilled labor. It was the Great Depression that finally by force of necessity, created an industrial work force that may have taken another 200 years to unfold by gradual transformation.

The WPA was formed in 1935, 3 years after the low in the stock market (1932). It had a slow and marginal success. At best, if we attribute all improvement to this one program, very unlikely, unemployment was only reduced by about 20%. 

1935 20.3% 

1936 16.9%

1937 14.3%

1938 19.0%

1939 17.2% 

1940 14.6%

Even if we attribute everything to the WPA, all the way into 1940, the most the unemployment declines was by 30%. However, at the end of World War II, we see an Unemployment rate of 1.9% by 1945. Any ideas that we can spend trillions on infrastructure and make it all better, forget it.

Turning to infrastructure in the middle of a debt crisis makes no sense. The idea of just spending money will somehow stimulate the economy, will not work. This is like trying to fight in the desert of Iraq using the same tactics as in Vietnam. There has to be sane connection to what we are doing. Just because FDR instituted the WPA when we had a huge displacement issue in the work force, almost 6 years after the crash began, makes no sense at all for our current problems. As I said, this is like buying your wife a mink coat to somehow influence your kid to get their grades up. The connection is tenuous at best and nonexistent in all reality.


Unless we attack the debt structure directly, there is no point in counting upon any government to help mitigate the problem and more-likely-than-not, our very future may be recast in so many ways, the level of frustration will rise, and that leads to war because war distracts the people from hanging their own politicians. The oldest trick in the book is to blame the guy next-door down.  Unless we are honestly prepared to truly 1) reorganize the structure of government, 2) reorganize the entire debt structure both private and public, 3) regulate leverage,  4) restore usury laws that will free up personal income, and 5) look at just eliminating the federal income tax in combination with 6) establishing a new national heathcare system that will restructure all pension plans public and private, there is not much hope for the future from government. Our definition of money (M1) does not include bonds so we can fool ourselves by issuing $10 trillion in bonds is different than printing the cash. It is still money. Taxes are needed in a gold standard where money cannot be created. Stop competing with the states, control the budget as a percent of GDP, increase the money supply to that degree, and stop the taxing when money is created by leverage and velocity anyway. This will restore jobs and inject huge confidence as in 1964 when the payroll tax was cut permanently. One-offs never work. People save the rebates for a rainy day. We need real honest reform since the states will go broke and seek handouts as well. So, it is time to get real. It is time we restructure the entire system including the banks which always cause the problem. We don't need excessive regulation of things that did not create the problem when the real culprits always escape.

You may send comments directly to Martin Armstrong at ArmstrongEconomics@GMail.com.