comments on: The Crisis of Credit Visualized (a video)

I watched an entertaining and fabulously animated video, derived from link to a Digg story via tweet from Kevin Rose.

The Kevin Rose/Twitter/Digg effect are, as of this writing, overloading the original site and the Vimeo mirror of the video, so you can catch it on YouTube:

Part1
Part2


While oversimplified, the video's explanation is better than your drive-by news has given, but not perfect. However, the graphics and presentation are sooo slick, I couldn't resist sharing!

The video either doesn't or under represents the role government played via promotion of loose-lending by various homeownership programs (Community Reinvestment Act), via applying funding to pressure groups like ACORN to agitate bank lending, and via the Federal Reserve (the base of the inverted monetary pyramid, and chief engine of magic money creation).

The video properly characterizes the idea of leverage used to magnify the returns of mortgage originators and investors in the securitized products.

(Incidently, MBS refers to pure mortgage backed securities, depicted in the video as CDOs. While MBS are a form of CDO, CDOs can and did include other types of debt, like consumer loans and automobile loans. The video mischaracterizes the risk of the CDOs issued to investors. While it's true that different risk pools existed, frequently, some prime mortgage debt would be mixed into a batch of CDOs containing mostly junk consumer debt or low-quality subprime mortgages, so as to garner a AAA rating from Moody's or S&P. This was an exploitation of lax standards of the ratings agencies, and their cloudy debt-type requirements. This is why these securities are now called toxic. It is now very difficult to separate the quality and worthy debt from the junk debt in any given traunch of CDOs, making them all the harder to value on the open market.)

The situation goes bust because it was credit expansion which supplied the $ to underwrite the mortgages. Up to $40 would be magically created from each $1 from an investor or investing institution. 39 of the $s were not real, they were bank magic. Even some of the $1 coming into the banks weren't real, they were Fed magic. Prices go up so long as the _rate_ of this magic money creation remains fixed.

The process of securitizing mortgage debt for resale to individual and institutional investors was a signal of the end-game.

See, the banks ran out of reserves, having levered 30:1 or 40:1 (the prev. limit of about 10:1 to 15:1 having been extended by Congress at the request of Hank Paulson, when he was Goldman Sachs' CEO, before he became Treasury Sec'y!), and needed more investment. Investors buy the CDOs, and the banks could take the proceeds and underwrite new mortgages up to 40x again.

Eventually the supply of dollars at the bottom of this inverted pyramid of inflation dries up and is fully invested. There are no new dollars to buy the next round of packaged mortgage CDOs. Thus the rate of money creation slows, bringing about the bust. Magical "paper" dollars evaporate and start to change back into the tiny pile of original real dollars, with the effect of falling home values (the inflated high values weren't real), bankruptcies, and investment portfolio loss.

That's fractional-reserve banking at work, and a boom-bust _always_ occurs with this system. Perversely, free-market forces act as a check on this leverage, keeping it small by magnifying the risks of bankruptcy by banks magically creating money. Banks don't want to be bankrupt (and it's this fear that helped _contract_ the magic money supply!).

Our gov't is embarked on its plan to try (in vain) to keep unsound banks solvent by puffing them with magic Fed $s (via Fed interest rate reductions and "quantitative easing"). The idea is to keep the highest levels of the inverted pyramid from contracting any more by injecting money into lower levels.

This money comes from TARP and other programs. And it came to those programs via our taxes or (more properly) via foreign investment and outright "printing" via Fed FOMC purchases.

You can think of that foreign investment as like a 2nd tier of CDO selling. Our gov't is absorbing the mortgage debt, and repacking it into gov't debt "CDOs" to sell to China.

As the 1st tier was an end-game signal for Wall St., unless we reverse course this 2nd tier signals the end-game for gov't!

The proper course is for government not to be involved, because this is the only way we will vanish away all the magic dollars on paper, and come back to actual dollars. The banks don't want to lend today because they understand this, that to do any more lending would cause them future bankruptcy, and that to secure solvency in the face of their existing bad debts means hoarding onto deposits and seizing any chance of selling the bad assets to someone else (though I disagree with any plan for the gov't to buy them, as this socializes the risk, and creates future moral hazard).

Allowing failures to occur will make for a very sharp, but also very short depression, like 6-18 months, as all depressions were prior to the Great one.

Our fear of the pain, and for purely political reasons, our government's fear of allowing us to feel that pain, is prompting the present bailout and stimulus effort.

The best-case outcome for our gov't intervention is a delaying action as the _rate_ of magic money creation is temporarily stabilized (or worse, reflated) and prevented from further contraction. This can be perpetuated only to the extent that we can continue to get ever more tax and foreign funding.

When we use up that credit, gov't will be forced to tax to crazy levels (unpopular, ultimately riotous), or monetize the debt ("print" the needed dollars to repay). Given the quantity of debt outstanding and forecast future debt, this monetizing would cause the money supply to become truly monstrous, meaning Zimbabwe-type inflation (an indirect sort of tax).

Bottom line as I've said in this blog elsewhere, is that we got here via a government-subsidy of business risk, leading to excessive risk taking which wouldn't have happened in a free and unfettered market. By a now decades long government culture of preventing failures, we've interrupted the free-market feedback mechanism that limits risk and contains leverage. The longer we continue this trajectory, the more we trade smaller amounts of present pain (peversely, even pleasure in the case of reflation), for greater amounts of future pain. By dialing back government involvement, we reconnect the risk-mechanism, experience more pain now, but are rewarded with a future of honest prosperity, rather than looming and protracted depression.

For more, read on:

• Jaguar Inflation - credit expansion illuminated entertainingly
• The Bailout Reader - for more on the mechanics of the crisis and our efforts to overcome it
  (also contains excellent gateway articles into the Austrian theory of business cycles)

A couple degrees of Twitter

Yep, so I was scrolling the Twitter feed overnight, seeing what had to be said by the folks there I'm following. I harkend upon an exchange between Leo Laporte and a dedicated follower of his media, who was shocked by a bit of liberalism Leo had espoused in a show. Leo had taken the interesting tack of kindly answering this man by citing Christian gospel.

But, Leo has missed a crucial element. Christian gospel socialism is voluntary. According to some Christians, you might be placing your soul in jeopardy if you don't play along. Nevertheless, it is still voluntary, just the same. Publicly eschewing the brand of socialism in Christianity is likely to get you prayers for your salvation.

Eschewing a government program of socialism...that's likely to get you fined or jailed, or perhaps worse. At least it will earn you additional deprivation of freedom.

The magic of Twitter, linked me back to the gentleman's own blog, where he commented eloquently on his experience.

I responded in the story's comments, in solidarity.

The kernel of the argument: liquidate the Federal Reserve

[...the supply of money is indifferent or "neutral" to the real processes of the economy. But, unfortunately, changes in the supply of money can have untoward and even devastating effects on the real processes of production.]

The Federal Reserve System is a central bank created to manage our currency. It's creation was supposed to be for our benefit, among its roles is one to ensure that cash can be obtained by banks to satisfy demands for cash from a bank's depositors. It was conceived as a way to "help" the free market operate.

Its very presence offered a new tool of influence by our government on the economy of the nation. It enables the government to change the supply of money within the economy. While this was possible even under a money made of and/or backed by gold (and silver) coin, the final disconnection of our US dollar from such intuitively limited and scarce commodities as precious metals finally allowed our government to control the supply of money with full, unrestrained freedom.

In a free and unfettered market (one in which regulation may either not exist, or exist only to facilitate exchange, enforce lawful agreements and protect property) grounded on hard money (such as gold coin), the money substitutes we enjoy for convenience (electronic bank card transactions, paper checking, paper banknotes) self-regulate and attain a stable equilibrium and purchasing power (or value) with respect to their backing.

Market forces beneficially conspire to keep participants and banks from magically creating too much credit. If people begin to feel that their checking deposits and private banknotes on a bank are going to be difficult to redeem for real, hard money, such individuals will act quickly to compel redemption. A bank run may ensue as rumor spreads, in the aftermath of which the bank will be found to be solvent and trustworthy, or it will be found a fraud and its assets seized upon by depositors and quickly liquidated, thus rapidly removing fraud.

In such an environment, it becomes very difficult to change the money supply. Only the convenient substitutes can be manipulated, and then only to the extent that a wary public is willing to trust their financial institutions to conduct business honestly.

With a stable money supply, the value of money is likewise stable. Inflation vanishes permanently (to be rigorous, inflation would only occur to the extent by which new supplies of the underlying hard money commodity, i.e. gold, could be mined, and even then, only a finite amount of the metal exists, whether in accessible bullion, coin, or inaccessible in minuscule ore deposits). To the extent by which technology and population available increase supplies of goods and services and productivity by which they're produced, a natural and gentle deflation persists!

We've been taught in the mainstream to believe that both inflation and deflation are bad things. What's bad is manipulation of the money supply! In the aggregate of the whole economy, with a fixed and unchanging money supply, modest deflation represents increases in efficiency and productivity with respect to production. The value of your dollar would be increasing. You savings, whether in a bank or under a matress, would still reflect the real value of our work when saved, and an appreciation of the increase in bounty that better productivity has afforded.

Rather than tales to your grandchildren of a can of Coca-Cola costing $0.75, and they being in awe of how cheap that price level seems to them in the present, they could instead be in awe of what it says about our economic fitness and vibrancy that Coca-Cola is now less expensive at, say, $0.40.

New young employees entering into the workforce to do your job would be hired at lower wage rate in dollar terms, but those dollars would be stronger and represent an increased purchasing power to what they had when you started.

Arguments for central-banking and its supposed necessary roles of fostering price-level stability and lender of last resort to banks are all nonsense. If a money supply is fixed and an economy growing, that growth will be manifest to the extent to which natural deflation is occurring. An economy that's stagnant will have a naturally stable price-level. And one which is shrinking will see inflation.

The Keynesian model views an economy and seeks to maintain an economy in a fixed state. Even if that could work, which it cannot and does not, a fixed economy would represent the end of human growth and achievement. We would have thus reached the limits of our abilities and from that point on, any improvement in any one area would have to be paid for by effacement in one or more other areas. Nobody could become rich without making others poor.

It's that last part to which Keynesians play for your political support. Every gain is another's loss.

But this isn't true. You participate and buy what you want to satify your own needs and desires. You're happy to make the trade because, to you in that moment, it represents a better alternative than remaining as you were. Maybe that was a new, more comfortable pair of shoes. Maybe that was at last a satiation of long endured hunger. Whatever the circumstance, you benefitted. In the end you may be compelled to work to earn money to facilitate similar exchanges. You want to work (even though there is a possibility you might not "like" your work), because the alternative is less appealing. Perhaps you striven and sacrificed and succeeded finally in finding work you absolutely love. Congratulations! And still this truth holds, you want to work because the alternative is less appealing. In so doing, whether you're enjoying your work or not, you're providing others with the things they want, and enabling yourself to acquire what you want in exchange.

Keynesianism, in the final analysis, is only a mechanism facilitating a race to live at the expense of, rather than in support of, others. You become dis-incentivized to support your fellow man because some or all of your wealth will now be given to you without any contribution on your part. Or, from the opposite end, some of the wealth derived from your work (which supports others) is now confiscated to support still others without your consent. You're deprived of the benefit your work earned. The harder you work the more you're deprived of those added benefits, so your incentive is suddenly to work less.

Both the wealthy and poor are similarly incentivized to work less. Now we all become poorer, because as a result of less work, there will be less stuff available. The best Keynesianism can hope for is stagnation, but more often you'll see recession and a growth industry in misery.