Here in Oregon, certain factions of state government recently managed to whip up a public scare about the projected future indebtedness of the Public Employees’ Retirement System, then persuade the legislature to abrogate legal contracts with public employees. The state supreme court upheld. From this I induce that legal contracts with governments are binding only insofar as governments choose to honor them.

The government may bend for peasants at the castle gates, but before it does, it’s a lot more likely to call in police and tear gas, or machine guns. However, we have seen repeatedly that the government readily bends for money interests, especially those who have tended to provide campaign funds. The Golden Rule applies.

http://www.ft.com/cms/s/0/90126fca-a810-11dc-9485-0000779fd2ac.html?nclick_check=1

Also, do you read Dani Rodrik at all?

The problem was that the US remained the ‘reserve’ currency (in which much of, particularly raw materials including oil, international trade is denominated in US$). This created an irresistible opportunity for the US (people, companies, Gov’t, etc) to live above their means by utilising almost free debt simply by increasing the supply of US$.

The dangers of this were warned about at the time. To be fair, as a short term ‘fix’, to buy time for the US to clean up its house, it was acceptable. Trouble was that there was no ‘clean up’, instead the trade deficit steadily increased as its own resources became depleted and its manufacturing base started declining in absolute terms.

Gov’t (State and Federal) and corporations jumped on the bandwagon as well. As the volumes of US$ steadily increased the financial industry adapted and changed. Deregulation increased the capacity of the industry to issue debt.

Eventually, by the early-mid 90’s the entire financial system had become a mechanism to recycle US$.

Here’s a very simple example of how it works:

A US company buys (say) oil. Oil is paid for in US$. The company goes to its bank, which has sufficient $ available (thanks to the Federal Reserve creating, them through the wonderful multiplier of the financial system). The US$ are transferred to the (say) Saudi organisation. This will use some of them to buy other things it needs from other countries, but is still left with a surplus of US$. What can it do with them?

Multiply this up by US imports from all over the world (EU, Japan, China, etc) and it doesn’t take too long for mere billions to become trillions.

For along time this was reinvested in US Treasury bonds, the US stock market, corporate debt, property, etc. This demand also allowed the US Govt to issue more bonds, to cover its deficit. Banks could take these deposits and re-lend them (multiplied up of course, in some cases by as much as a 10:1 multiplier), much of that domestically. This was made worse by deregulation of the finance sector, which allowed banks to set up subsidiaries that could issue more debt than the actual bank would be allowed to do (due to reserve and liquidity requirements), then 10:1 multipliers became 100:1 or more.

So the US financial system was sitting on the capacity to issue tremendous levels of debt on very small reserves. However lenders need borrowers. Fortunately for them cheap money always finds a home.

This funded the various stock market ‘booms’ over the years, as well as corporate takeovers, private debt explosion, et al. It also funded the US Govt’s deficits, since there was always demand for Govt bonds.

But as each ‘bust’ happened’ the investors of US$ became more reluctant to invest in ‘risky’ investments. More ever, the US consumer started to become tapped out, overloaded by debt with negative net savings.

This is where the current mess started. The US financial system was awash with money thanks to the Federal reserve pumping even more money into the system after the dot com collapse and 9/.11. Thanks to the trade deficit this was exported throughout the world.

Trouble was all those organisations with large amounts of money had fewer, high earning investments available. Putting their money into safe bonds, with their low earning rates would simple depress earnings and get the CEO fired.

Then came the ‘bright idea’. Securitise debt, lump them into packages and sell them off, with higher earning potential. Good debt got mixed in with bad debt, risk and values were ‘invented’ by complex equations. Soon everyone got in the act.

Back to the US consumer, always ready to borrow to consume and ever optimistic about the future. Banks (and huge numbers of other organisations) got into the last bastion of consumers assets, housing. Cheap loans, allowing people to ‘draw down’ on their existing mortgages (ie turn their house into an ATM), investment loans, etc, etc. As competition increased (and the flow of funds needing a home) lending standards went down, way down.

This debt was then packaged, given a ‘rating” of how good it was and then sold off. Many holders of US$, looking for a high earning safe home flocked to them all over the world, as well as those people and organisations in the US that actually had some money.

This made things worse, as many financial companies then realised that they could buy this stuff, and then borrow against these ‘assets’ and issue more debt in other packages. Then debt multiplier ratios started moving to 1000:1 or more (oh those miraculous hedge funds). At this point it had taken on a life of its own, but the Federal Reserve still kept pumping money into the system (pouring more petrol on the fire).

And so it went on, not only in the US. The UK for example has total debt (private and Govt) now greater than its GDP (if it was a company it would be put into receivership).

Politicians loved it, war with Iraq, issue more debt, boondangle to a favoured group, issue more debt. At a stroke of a pen the US Govt could add 100, 200 …. billion $. $700 billion for the Iraq war , stroke of a pen. Hit the Govt debt limit, change it. Cut taxes to the rich, stroke of a pen. A new corporate tax dodge lobbied for? Give it and add more debt.

Consumers loved it. You could borrow more on your house. But because there was so much money around housing prices exploded (this is called hyper inflation). So the value of your house kept growing as fast, or even faster, than you could borrow on it. Flat screen TV, buy it, new car, buy it, etc.

Business loved it. Consumers spent and spent. Money for takeovers abounded. Share prices went up. More importantly senior executive pay and bonuses went up even more.

Of course there is always an ending and all Ponzi schemes always collapse in the end. What is called the ‘sub-prime’ crisis was just the match that lit the fuse. What is actually happening now is that all packaged debt is looking toxic

The problems right now are the incredible volumes of debt and the packaging and re-packaging means that no one now knows what they are worth. So there is now a de-facto credit freeze going on as people who have money are scared to lend it out and those who need it are getting desperate.

The multiplier effect both multiplies gains and losses. If you are an organisation that has a trillion $ in debt issued and it loses 10% of its value then you lose $100 billion. Some organisations have already gone under and even some of the big banks are looking very shaky. Citibank and some others could conceivably lose all their capital reserves, at which point it shuts down. Have a look at the Hedge Fund Implode-meter and The Mortgage Fund Implode-meter (http://hf-implode.com/?source=cmailer and http://ml-implode.com/?source=cmailer) for a day by day list of who’s going under.

There are simply too many US$ around in the world, this means they are losing value. Other creditor countries are now facing the horrible situation of either dropping off the $ as a reserve currency, letting it going into free fall and lose a lot of money, or ruining their own economies by the inflationary effects of too much money. China and Saudi Arabia are caught right in this cleft stick at the moment. Eventually they will have to drop it.

Could this have been avoided, sure. If the US had voluntarily stopped being the reserve currency in (say) 1980, after managing to put together a reasonable basket of currencies replacement. The subsequent financial discipline required (such as actually having to earn foreign currency to buy something) would have concentrated minds acutely. If debt had been sucked up into real, wealth generating investments (infrastructure, industrial investment, etc) instead of consumption. Et al.

But greed, stupidity and short term thinking won out as they unfortunately often do,

The 2 trillion $ question is, can it be unravelled without the worlds’ financial systems collapsing and a world wide depression? Maybe. But we can say with certainty:

• The US $ will no longer be the reserve currency.
• It will be stuck in a long recessionary period, possibly with stagflation.
• Large amounts of US assets will pass into foreign hands.
• There will be collapses of major corporations (think GM, Ford or Citibank, etc)
• Taxes will have to rise and spending dropped (note raising taxes to discourage private consumption as well as stabilise Govt debt is actually a good thing in this situation).
• The US standard of living will drop markedly, how this pain is spread (equitably or concentrated in just the middle and lower classes) will be critical for the US’s future.
• Military spending will decline unless the US turns into a dictatorship (even then actually).
• Forget the F-23, new destroyers, 1,000 foreign bases, etc, etc. There will be no money to pay for them. Hard decisions will have to be made (and soon).
• The US will leave Iraq, sooner than most people think, with Afghanistan not much later, due to the financial strain.

From a longer term perspective this is not all bad. With deft and clever handling the pain can be turned into an opportunity for re-building and revitalisation, with the US coming back in (say) 20 years a lot wiser and in many ways a lot stronger. Taking just one simple example, if the US has to actually earn foreign currency to pay for oil, energy efficiency will improve. New domestic energy alternatives will become attractive, whole new industries could come into being.

Then again if it is stuffed up …..

This plan will benefit homeowners who meet ALL of the following requirements {should say “conditions”, not “requirement”}.

The homeowner has at most 3% equity
The homeowner is not hugely underwater on current loan to value.
The home is in an area where home prices are not apt to plunge over the next few years.
The freeze will permanently prevent foreclosure.

It takes all four conditions before homeowners will benefit. The plan has negative benefit for nearly everyone in the small select group of people that meet the carefully crafted eligibility requirements.