To switch metaphors, let’s say that we are witnessing the two stages of a tsunami. The current disappearance of wealth in the form of debts repudiated, bets welshed on, contracts cancelled, and Lehman Brothers-style sob stories played out is like the withdrawal of the sea. The poor curious little monkey-humans stand on the beach transfixed by the strangeness of the event as the water recedes and the sea floor is exposed and all kinds of exotic creatures are seen thrashing in the mud, while the skeletons of historic wrecks are exposed to view, and a great stench of organic decay wafts toward the strand. Then comes the second stage, the tidal wave itself — which in this case will be horrific monetary inflation — roaring back over the mud flats toward the land mass, crashing over the beach, and ripping apart all the hotels and houses and infrastructure there while it drowns the poor curious monkey-humans who were too enthralled by the weird spectacle to make for higher ground. The killer tidal wave washes away all the things they have labored to build for decades, all their poignant little effects and chattels, and the survivors are left keening amidst the wreckage as the sea once again returns to normal in its eternal cradle.

So, that’s what I think we will get: an interval of deflationary depression followed by a destructive wave of inflation that will wipe out both constructed debt and constructed savings, scraping the financial landscape clean. There’s no question that stage one is underway. But we can be sure the giant wave of money recklessly loaned into existence in just a few weeks time will wash back through the global economy leaving a swath of destruction.

And then what? The societies of the world will be faced with the task of rebuilding systems of fruitful activity, i.e., real economies based on productive behavior rather than the smoke-and-mirrors of Frankenstein-finance con games. In fact, excuse me while I switch metaphors again, because the Frankenstein story — the New Prometheus — is yet another apt narrative to inform us what we have done. We have “played” with financial fire and brought to life a monster now bent on killing us. One question that this metaphor-narrative raises is: when will the angry peasant mob storm the castle with their flaming brands and cries for blood from the makers of this monster? Rather soon, I think. Perhaps, in some countries (maybe the USA, if we’re lucky), this will take the more orderly form of systematic prosecutions, bringing to justice persons who perpetrated swindles involving the alphabet soup of investment “products” that have gone bad in so many accounts (and ruined so many individuals, institutions, and governments). I think it has already begun with the inquisitors summoning the shifty Dick Fuld of Lehman Brothers — but there are hundreds of other characters like him out there, who scored untold millions of dollars in activities that were simply grand swindles. I wouldn’t be surprised if, eventually, Treasury Secretary Hank Paulson found himself in the dock to answer how come, when he ran Goldman Sachs, there was a special unit in the company dedicated to short-selling the very mortgage-backed securities that another unit in the company was so busy pawning off to every pension fund on God’s green earth.

Apart from orderly prosecutions (which can certainly turn harsh and cruel), there is the possibility of sociopolitical upheaval — revolution, violence, civil war, war between nations, the whole menu of monkey-human mischief that afflicts mankind. We are not necessarily immune to it here in the USA, despite our cherished notion of exceptionalism, which would have us inoculated against all the common vicissitudes of history.

Anyway, prosecution through the courts, while perhaps satisfying the hunger for justice (or, more particularly, revenge), is not a productive economic activity. So, the question begs itself again: what will we do? Under the best circumstances we will reorganize our society and economy at a lower level of energy use (and probably a lower scale of governance, too). The catch is, it will have to be a whole lot lower. I think we’ll be very lucky fifty years from now to have a few hours a day of electricity to do things with.

The energy story and its handmaiden, the climate change situation, are both lurking out there beyond the immediate spectacle of the financial fiasco. Both these things imply pretty strongly that the economic relations currently unraveling will not be rebuilt — not the way they were before, or even close to it. The best outcome will be societies that can practice small-scale “process-intensive” organic agriculture and equally small-scale process-intensive modes of manufacture in the context of very local sociopolitical networks. An accompanying hope is that we can remain civilized in the process. Personally, while I recognize the appeal (to others, not me) of the “singularity” narrative, which has the human race making a sudden evolutionary leap into some kind of cyborg-nirvana, I regard it as an utter bullshit fantasy that has zero chance of occurring, given our stark predicament.

But returning to the short term, or “the present,” shall we say, there is the matter of how the U.S. gets through the election and then the first months of a new government, even while the larger fiasco continues. I feel sorry for anyone who is placed nominally “in charge” of things this coming year. The best the President can do is offer some reassurance to a public that is totally unprepared for the convulsion now upon us. He will certainly not have “money” to “spend” on any of the promised social support programs that have been endlessly debated. But he could clearly articulate the reality we’re facing, and ask not necessarily for “sacrifice,” as the common plea goes, but for something more and better: For bravery and resolute spirit, for intelligence and resilience, for kindness and generosity — among a people long unused to consorting with the better angels of their nature. The change that has been in the air all year — that Mr. Obama has talked so much about — is coming in a bigger dose than anyone expected. I hope we’re ready to get with the program.

Regards,
James Howard Kunstler

October 24, 2008

What Now? was originally featured on Whiskey and Gunpowder

Yes, there are a few other asset and income plays as well in the market. After all, there’s still an economy to run out there. There are 303 million Americans, and 6.2 billion other people in this world, who want to eat every day. But much of the stock market is a crapshoot. If you love pain, then the broad stock market is the place for you. While gold and silver represent the flight to safety and quality.

The U.K. Telegraph put it nicely: “As investors scrambled to make sense of last week’s events, already one conclusion was all but irrefutable — the U.S. dollar will have to take another major fall. The dollar rally that began in July and pushed the pound’s value against the greenback significantly lower has come to an abrupt end as markets face up to the fact that the currency will have to absorb the effects of a sudden shocking increase in America’s budget deficit.”

So we see lots of bad news for the dollar. But when you own gold, it’s your asset. With a specific gravity of 19.3, gold is dense, non-reactive and otherwise immutable. Gold is nobody’s liability. As one of my old professors at Harvard used to say, “That’s physics.”

Gloomy News from Wall Street

Speaking of physics, I’ve looked east of the sun and west of the moon. I can’t see much good news for the U.S. dollar on any horizon. Really, what’s gloomier than the news from Wall Street? The investment model of the modern era (borrow short, lend long, pay big bonuses) is dying before our eyes. “And it’s about time,” some might say. But it’s happening on our watch. So we had better suit up in battle-rattle.

Wall Street’s losses are in the range of hundreds of billions, maybe trillions. Which prompts me to inquire, where are Bonnie and Clyde when you need them? At least the Barrow couple knew who they were and what they did for a living. To their credit, on their last foray the dynamic duet had the guts to shoot it out with the cops and go out in tragic style.

But now the modern bank robbers are talking about how they should get big bonuses for all the good work they put in right until things blew up. Really, I’m serious. Lehman Brothers wants to pay $2.5 billion in bonuses to 10,000 employees. That’s an average of $250,000 per person. (Except I think the office runners and secretaries will get less than $250K and a select few will rake in a lot more.) What has anyone there done to deserve $250,000? Did I miss the news about somebody at Lehman discovering a cure for cancer? It’s all just so… Baby Boomer.

At the end of the day — and the clock is ticking fast — it’s too bad that the wrong people are going to get paid. And bonuses? Oh, if only I could be a bankruptcy judge for just one hour.

The War on Risk

Do you recall the $700 billion of borrowed money that the U.S. paid over the past seven years to fight the War on Terror? Well now, with the stroke of a pen the U.S. taxpayers will pay another $700 billion (and probably more) for the “War on Risk” in the next year or so.

War on risk? It seems that way to me. Let’s back up. In the past few years — seven or so, coincidentally — a lot of people gambled and lost. People bought houses they couldn’t afford. Brokers arranged the loans. Bankers lent the money. Other bankers bundled-up the mortgages and sold them as “asset-backed securities.” Rating agencies sprinkled their holy water on the transaction. Insurance companies insured everything against default and loss.

A lot of people were making a darn good living for a while. But it was all a farce based on cheap credit and an abiding faith in a “something-for-nothing” way of life. And it’s too bad that a lot of people bought — as the saying goes — “as much house as they could afford.” Except they couldn’t afford it.

So now the whole mess is falling apart. And in true Baby Boomer fashion, the key perps on Wall Street want to change the rules and stick the house with the bill. That is, the White House and the House of Representatives, and your household as well.

The advertised number of $700 billion for the Wall Street bailout is just the posted price — the “loss leader” to get the American people into the store, so to speak. But get set for a bad case of sticker shock as events unfold. A group of business reporters at Bloomberg tallied up the raw numbers and came up with their own number of $1.8 trillion.

$700 billion? $1.8 trillion? When the numbers are that big, does it even matter? It’s the inflation-adjusted equivalent of fighting World War II again. Except who is the enemy?

Whatever the final tally may be, it cannot be good for the U.S. dollar. So buy gold and silver. If you can’t acquire the metal in the form of coins or bars, then buy precious metal stocks of companies with ore in the ground.

Until we meet again…
Byron W. King
September 26, 2008

The Dollar and Precious Metals was originally featured on Whiskey and Gunpowder

The reader’s letter comes from a Mr. D.P. Marchessini. I suspect that Mr. Marchessini is correct and the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives. The letter traces the sequences of events:

“In 1933, the United States passed the Glass-Steagall Act, which prohibited commercial banks from dealing in investments, and prohibited investment banks from doing commercial banking activities. This was a very sensible measure, and kept the banks in reasonable order until 1990.

“Unfortunately, in 1990, this Act was repealed — for reasons best known to the psychiatrists of the legislators. The result was that all the big Wall Street brokers became banks, as well as brokers, and the big banks started trading and speculating. This was combined with an enormous increase in “leverage” — borrowed money — by all the banks. Leverage is the ratio of a bank’s capital to its total assets.

“This used to be between five and seven times, pre-1990. But post-1990, it immediately started ballooning and, although the banks tried to keep it quiet, it was known that Merrill Lynch was more than 40 times. Goldman Sachs was 28 times, and Lehman Brothers was 30 times when it failed. Regardless what one thinks of such hair-raising tactics, the one thing that is clear is that they only work when the market is going up. Apart from their Balance Sheet, all the banks also had an enormous amount of ‘derivatives,’ which were kept off the Balance Sheet. Derivatives are an enormous cocktail of very exotic Options, on almost anything. In 1995, I was talking to someone at a dinner party, who was rich and supposedly very well connected in the financial world. I asked him what he thought the total amount of nominal value in derivatives were at that time. He said he thought perhaps $100 billion. In fact, at that time, they were $1 trillion. Today, they are $1.3 quadrillion — all off the Balance Sheet. They are also not included in any bankruptcy. Of course, this is the nominal value, and the actual amount at risk is much less. But five percent of $1.3 quadrillion is $65 trillion — still a tidy sum.”

I do not understand derivatives, certainly not at a level of $1.3 quadrillion. I am not even sure what a quadrillion is, though I assume it is 1,000 trillion. I do not feel ashamed of my inability to understand the global derivatives market, since the Sage of Omaha, Warren Buffett, himself has said that he does not understand them. What is clear is that they have been created in very large numbers. If Mr. Marchessini’s figures are correct, the gross value of derivatives is far in excess of the capacity of all the world’s governments to bail them out. Even a net value of $65 trillion is beyond the bailout potential of the major powers.

The Secretary for the Treasury, Hank Paulson, has asked Congress to authorise $700 billion as a bailout for those banks that have invested in sub-prime mortgages and other toxic assets. This is a sum one can reasonably understand. In London there are a large number of houses worth £1,000,000 or more. A thousand such houses are worth £1 billion. That is a solid reality. The $700 billion, which Secretary Paulson is asking for, is worth about £400 billion. It is therefore equivalent to about 400,000 good town houses in London.

Plainly that would be a valuable estate, but it is conceivable. I can imagine the suburbs of London rolling out to Heathrow and the West. If one started at Canary Wharf and went on to Heathrow one could easily identify 400,000 houses worth £1 million each. If the U.S. Government chose to pledge itself for 400,000 such houses that seems reasonable. This may involve very large figures, but so does the Federal Budget.

It is the trillions that cease to be meaningful. I know several billionaires; I have certainly never met a trillionaire, let alone a quadrillionaire. If these derivatives hang over the whole banking system, then they should presumably be wound down and, over time paid off. They represent potential liabilities of the banking system, even if they are off the banks’ balance sheets. They cannot simply be consigned to a bad bank or simply be allowed to go into default. Even if Mr. Paulson gets his $700 billion, what will that do to settle the problems of quadrillions of derivatives?

Regards,
Lord William Rees-Mogg
September 25, 2008

The Limitations of a Bailout was originally featured on Whiskey and Gunpowder