THE DEVIL IN THE DETAILS IS GOLDMAN SACHS, PART II

Like I said in Part I, all analogies will collapse if pushed far enough. That still goes, so give me a break.

Say you are Goldman, and I am Sachs (or vice-versa). We own a bank. We have a rep for being able to solve anyone's financial problems. It is also well known that we are extremely risk averse, so our fees are high, and our profits must be assured.

Mr. Zorba comes to us having a real bad problem. He wants to join a very exclusive club whose members are all snobs of European descent. The people in the club don't think you're rich unless you hold Euros. The club has high admission standards, and requires potential members to prove that they have short-term debts of no more than 3% of their annual incomes, and long-term debt of no more than 60%. Zorba explains that he can't meet either standard, and he needs to put some cash on the books, because he wants to join the club real bad.

Zorba says he's heard that we helped his acquaintance, Salvatore, get into the club in the past. We can neither confirm or deny this, but we say that if Zorba gives us the ugly truth about his finances, we'll see what we can do.
Zorba's financial statement shows that he holds a lot of real estate, and recently bought a parking garage in Little Tokyo. To buy the business, he borrowed Yen. To buy real estate, he borrowed Dollars. Interest costs are eating him up.
We explain to Zorba that his interest expenses on his debt could be reduced if it were expressed in Euros, but while this would be good, he couldn't really put any cash on the books by a break-even transaction in the present spot currency market.

And so...

We suggest that we could pick out an historical exchange rate that would be quite favorable for him, and we could acquire his debt at that rate, paying him in Euros. But he couldn't tell anyone. This would give him the equivalent of $1 billion right away, and maybe $9 billion more in the long term. Of course, he'd have to pay us back with a balloon payment in 15 or 20 years. This sounds good to Zorba.
Then we go see an insurance agent named Otto. He charges us $200 million for a policy insuring us against Zorba's default on the $1 billion. Of course, Zorba has to pay for our credit risk. That would only be fair.

With Zorba's balance sheet now looking pretty good, he applies for admission into the club. He gets in, and is very happy.

Now all we have to do is sell Zorba's debt to somebody else, and, you know, "buyer beware". This won't be too tough, because, after all, he just got into a very exclusive club, and everyone in the world knows that to get in, your financial statement has to be in great shape. Besides, the "currency swap/loan" was off the books. He'll have to deal with all the deferred interest payments the best way he can, if he can. Not our problem. We got him in the club, and we're off the hook. Plus we made money.

This is basically how Goldman Sachs helped Greece get into the European Union by falsifying its balance sheet and concealing its true debt levels. Then they underwrote Greek debt and sold it, knowing it was shaky.

THE DEVIL IN THE DETAILS IS GOLDMAN SACHS, PART I

All analogies break down when pushed far enough. I know this. But bear with me.

Say my name is Goldman, and you are Sachs (or vice-versa). We recently bought a house for $165,000 cash. The fair market value is $200,000. Our friend, Lehman, wants to buy it, but he's making $400/month payments to his brother for a car loan that he got on a handshake deal, and he can't make a 20% down payment. We tell him we'll take 5% down, and we'll finance the balance with interest payments he can afford. We require a financial statement from him which leaves out the part about the car loan. We close the deal.
Then we take all the mortgage papers and Lehman's financial statement to another friend, Mr. AIGner, who is an insurance agent/bookie who thinks he knows something about real estate finance. We tell AIGner (with tongue in cheek) that although we know we have made a very solid loan, we'd like for him to sell us a kind of insurance policy against Lehman's possible default. AIGner examines the documents,and goes for it. We agree to pay premiums of $100/month for a $200,000 "policy'.
Then we put the word out that we have a golden mortgage loan for sale. Lots of people who trust us want to buy it. The more we talk it up, the greater the demand to buy it increases. We decide to sell the loan at auction. The bidding is frenzied, and our other friend, Stearns, pays us $210,000 for the note. We transfer it to him. We no longer on the hook as a lender.

But we still own the "insurance policy".

So when Lehman defaults two months later, we have $419,800 in bank (which we also own), and everyone else is screwed and tattooed.

This is how credit default swaps work. This is how Goldman Sachs hyped crummy mortgage paper (that they knew was crummy), sold it to people who should have known better, and put AIG on the hook for all of it.

PAUL KRUGMAN DISTORTS HISTORY

Liberal economists like Paul Krugman have always tried to sell the story that conservative politicians have a very sinister agenda: to intentionally erode the government's fiscal position to such an extent that social welfare/entitlement programs would have to be eliminated in order to reconcile the national budget. Most recently, Krugman claims that President Reagan's tax-cutting program was the mechanism through which which he attempted to accomplish this evil goal. That's not how Krugman and others portrayed Reagan's reputed "strategy" at the time. Back then, liberal economists insisted that Reagan's spending on military and national security initiatives (remember the Star Wars debate?) was secretly designed to take so much money out of the budget that there would be no choice but to eliminate welfare and other entitlements.
A couple funny things happened, though. Instead of the arms race bankrupting the U.S. economy, it bankrupted the Soviet economy. It was their government that was "fundamentally transformed" by Reagan's military spending, not ours. Also, if it had been Reagan's intention to ruin the nation's balance sheet by cutting taxes, he failed miserably. Revenues went up. Does anyone, even Krugman, really believe that President Reagan was disappointed in that result?

PAUL KRUGMAN SHADES THE TRUTH

Paul Krugman's most recent column ("Now, Finally It's Time For GOP To Put Up Or Shut Up") is a perfect example of how he often distorts the truth. He notes that "conservatives have backed away from spending cuts they themselves proposed in the past". He is referring to the fact that Republicans, about twenty years ago wanted to cut Medicare spending, and that they now oppose the Democrats' plan to move about $500 billion out of Medicare in order to help fund their Health Care/Health Insurance Reform bill(s). Sounds like a purely political flip-flop made by the "Party of No". But it isn't, and Krugman knows this very well.
The Republicans oppose stripping the Medicare budget for two reasons. The first is that Medicare is on a course to insolvency. Taking money away from the program will only accelerate its demise. Secondly, the Republicans doubt that Democrats will, when push comes to shove, actually take money away from Medicare. Cutting entitlement programs is not their M.O. The Republicans expect that the Dems would contoct a way to take $500 billion out of Medicare, spend it on their Health Care program, then restore the Medicare budget with tax increases.

HAVE CHINA AND JAPAN OVER-EATEN?

There is some tension building between China and the U.S. A lot of it has to do with our plans to sell Taiwan a bunch of sophisticated military equipment. Some of it has to do with the Chinese government's disregard for the human rights of its citizens, as displayed in its dispute with Google. Some of it has to do with our concern for China's occupation and suppression of Tibet. Part of the tension is due to China's holding so much U.S. debt, and their worry that the debt will be repaid with inflated dollars. Part of it is due to China's indifference to the intellectual property rights of American companies. Some of the tension is due to all the cyber-attacks that originate in China, government-sponsored or not. Then there's China's reluctance to participate in sanctions against Iran.
Some have been concerned that China might someday, in anger, or out of spite, or just to flex its economic muscles, flood the market with U.S. government paper. I don't think there are any circumstances under which this would happen due to the negative impact it would have on China's balance sheet.
What has happened, though, is that in December, China sold off 34.2 Billion dollars worth. Interestingly, Japan sold off $11.4 Billion.
The next U.S. debt auction will be very interesting.

OBAMA'S ADMINISTRATIVE FIAT

Several days ago, a bill was defeated in Congress by a bi-partisan majority which would have allowed President Obama to appoint a commission that would recommend specific spending cuts and tax measures that bring the budget down, and help control long-term government debt. The bill was offered as a solution to these problems because of Congress' demonstrated unwillingness to confront them.
But the bill was defeated. There were a couple reasons. First, the Congress was unwilling to convey their constitutional responsibilities to a presidential commission, although some Republicans, in the past had favored the idea. Secondly, legislators were unsure if the the commission would truly be a bi-partisan group. In the end, the bill was defeated, and even co-sponsors of the bill (Democrats and Republicans) voted against it, even though congress would have had to approve its recommendations in an all-or-nothing, up-or-down vote.
What was President Obama's response to the congressional rejection of the commission? He said that he would appoint one anyway by executive order.
When it became clear that Obama's Cap-and-Trade legislation was dead in the water, how did the president respond? He said that he would just have the EPA regulate CO2 emissions and achieve his energy policy in this way.
President Bush was widely (and rightly) criticized after 9-11 for trying to unconstitutionally consolidate governmental power within the executive branch. Now where are the critics when President Obama does the same thing?

SKEPTICS AND DENIERS

I'm not big on conspiracy theories. I believe, for example, that the U.S. really landed a man on the moon. I don't think that the film of the landing was shot in the Arizona desert. I think that Lee Harvey Oswald acted alone. I don't think that FDR allowed Pearl Harbor to be attacked, just to get into WWII. I don't think that Bush stole the election from Gore. (However, everyone knows that Mayor Daley stole the election for JFK in 1960.) I don't believe that the U.S. government was complicit in the 9-11 attacks, or that the Jews were behind it. I believe that the Rosenbergs were guilty as sin. The Holocast is not a hoax. There was no UFO at Roswell.
There is only one thing in history I'm not sure about. "Shoeless" Joe Jackson might have actively tried to throw the 1919 World Series. I hope it ain't so, but I don't know.
Conspiracy theories abound. For every true believer you can name, there is a skeptic or denier. I am always among them. This goes for global warming being a "man-caused" phenomenon. It also goes for the claim that President Obama's stimulus package created a single, solitary job. Or "saved" one. Nor do I believe for a second that the stimulus package prevented a national economic melt-down or prevented a second Great Depression as the president asserted yesterday.
I'm skeptical about any numbers released by the Bureau of Labor Statistics. I have no faith in the numbers released by the Obama administration regarding the U.S. GDP. I find it odd that our economy can be growing while energy consumption and gasoline prices are not increasing. Shell and Chevron have both reduced personnel, citing low demand as the reason. That make any sense to you?
What really bothers me, as a denier and a skeptic, is that the true believers think that I am stupid or crazy. President Obama has no patience for those that think the stimulus package has been an overall bust, or that Cash For Clunkers was idiotic. Now we go on to his "Jobs" bill, which is nothing more than another stimulus bill we can't afford. Does anyone think an employer will be motivated to hire an employee for $40,000 a year just to get a $5000 tax credit? Not lately.
I just don't believe a word of it.

"PAY-AS-YOU-GO" BROKE

The Democrats are all giddy about their new dedication to a "pay-as-you-go" strategy to control the deficit. Basically, this means that for every dollar of new government spending, there has to be an equal reduction somewhere else in the budget. Alternatively, a new source of revenue may be found to fund the new expenditure. Either way, the new spending is off-set, and the deficit is not increased. Good idea. It worked before when Clinton was president, and Congress was led by Republicans.
Now the picture is a little different. President Obama, as a candidate, assured us that taxes on persons making less than $250,000 per year would not see their taxes increased. Now he is an "agnostic" about tax increases on the middle class. It's not hard to foresee that any new expenditures will result in higher taxes, and that they will be rationalized as deficit-neutral under the "pay-as-you-go" program.

GREECE, THE SQUEAKY WHEEL

The problems in the Greek economy have not yet been addressed. The Greek government keeps insisting that they do not want or need a bail-out from the other nations in the Euro Zone. Germany and France keep implying that they may help, but they have not done so yet. The IMF is still on the sidelines. It would be best for all if Greece could solve its own problems. They are talking about a major bond issue. Good luck with that.
A number of other countries in better economic shape have tried recently to raise some money in the bond market (e.g. Panama and Great Britain), but have not had very good results. It's hard to think that anyone will have any enthusiasm for a Greek issue. Greece has to reduce its spending, particularly in government payroll. Watch the union members hit the streets when that happens. The only other way out is for the Greek government to PRIVATIZE their way out. The government owns banks, hotels, resorts, and other hard assets that they can sell off. The Greek government needs to get "out of business" before they are really "out of business".

PREVENTING INFLATION

If an inflationary period can be foreseen, how can it be prevented? It can only be prevented (or ended once it has begun) by sucking out of the economy all the excess money that is causing the problem. This can be difficult at any time, but especially difficult in the circumstances the U.S. finds itself in now with the extremely rapid expansion of the money supply, and the rates of government spending and borrowing.
There are only a few ways to get money out of the economy once it has been issued. They all involve monetary and fiscal policies. On the monetary side, the Fed has to stop digging the hole. The printing presses have to stop excessive printing. Obviously, this tightens the money supply. Secondly, the Fed can use the banking system to take money out of circulation by increasing their reserve requirements. (It is the opinion of some that this is nearly all the "banking reform" that is currently needed. If you don't want banks to take big risks with their money, make them hold more of it in reserve.) To make it easier for banks to do this, the Fed will pay a higher rate of interest on money that the banks park with the Fed.
Higher interest rates will be a broad-based feature of inflation control. Higher rates take money out of the economy, and also serve to reduce demand for goods and services. Higher rates discourage individual and corporate borrowing. They result in higher rates of savings.
On the fiscal side, government spending has to decrease. Also, government borrowing has to decline. Finally, higher taxes will take money out of the economy. And with less disposable income, demand for goods and services declines.

So, what do you think the prospects are that the U.S. can avoid a period of inflation? As for monetary policy, these things can be done. As for the fiscal side of the coin, I think we can be sure that taxes will go up, but will government spending and borrowing be curtailed? Unless that happens, the likelihood of inflation is increased.

IS INFLATION ON THE WAY?

Yes. It is. There is no question about that. The only question is whether hyperinflation is on the way.
First of all, hyperinflation is only possible if paper money is in use. Back in the gold rush days, new discoveries put more gold in circulation and reduced its value temporarily. This was a kind of inflation, but it was limited in its effects because soon the amount of goods available for purchase caught up with the money supply as the gold came into wider circulation. And the supply of gold was soon stabilized as were prices of goods.
With paper money, the currency isn't tied to availability of precious metal. Its supply can be expanded for almost nothing at any time. It's just as east to print a $10 bill as it is to print a single. As many times as you want. And this is why inflation exists: The amount of money in circulation out-paces the amount of goods produced, and the availability of services for purchase. The thumbnail definition of inflation is "too much money chasing too few goods".
So understand this: the only cause of modern inflation is a government that prints too much money.
Why would a government deliberately debase its own currency by over-printing? The government needs money to operate, and politicians need it to support the programs they want. The money can only be raised in limited ways. These include taxation, borrowing,and imposition of fees, tariffs and duties. Citizens don't mind any of these things as long as somebody else pays the freight. But it becomes very unpopular if it affects you personally. But who knows, and who cares, if the government just prints a little more money here and there? So it's easy for the U.S. Treasury to sell bonds to the Federal Reserve who pays for them with notes fresh off the presses. Politically, this is a simple solution.
It looks like nobody really pays. Of course, everyone who holds the currency pays, because prices inevitably go up as the value of the money declines. The more there is of anything, the less value it has.
Another reason the government may be willing to promote inflation by over-issuing money is that it can pay back its debts with dollars cheaper than the ones it borrowed.
So these are the reasons the U.S. money supply has nearly doubled in recent times. The government needs to spend money, and it has to come from somewhere. So we're printing and borrowing as fast as we can. The more debt we accumulate, the greater the incentive to print more money.
Inflation is on the way. But will it go hyper?

HERE COME THE P.I.G.S.!

About a month ago, I discussed the P.I.G.S. (Portugal, Ireland, Greece, and Spain) of the European Union, and the financial risk they posed for the E.U. At that time, it looked like Greece would be the first P.I.G.S. economy to tank, and it has. The E.U. "requires" that its members hold no more than 3% of its GDP in debt. Greece now acknowledges debt of nearly 13%, which means that it probably is more like 17%.
The dilemma for the rest of the E.U. is what to do about it. Officially, the E.U. charter doesn't permit a bail-out. And officially, Greece isn't asking for one. . That doesn't mean there won't be one, but it is no sure thing. Yesterday, the US stock market was buoyed by the prospect, and today, as the bail-out became less certain, the market was down, but only slightly as of this writing.
The Euro has been sliding against the dollar for about 7 months. It remains to be seen what effect this will have in the currency market, whether or not there is a bail-out. Generally, the Euro is seen as the "anti-dollar". If the Euro weakens further, this will continue to strengthen the dollar and bring money into the U.S. bond market as investors seek refuge.
All this will be up to France and Germany to decide. The U.K. has never adopted the Euro, in part because of the viral nature of currency problems. Another reason is that when countries like the U.S. get in debt trouble, they can print more money and inflate their way out. This is not an option for any country using the Euro. And they can't print gold.
Of course the rest of the P.I.G.S. are still in trouble.

WHERE ARE THE SANCTIONS ON IRAN?

Almost a month ago, I commented on President Obama's delinquency in imposing sanctions on Iran for its refusal to negotiate an end to its nuclear program. The deadline was supposed to be January 1, 2010. There still have been no sanctions imposed. While the U.S. has done nothing, Iran has:
1. Said that it has no intention of allowing Russia or France to receive its nuclear material, and return it to them in a form that can be used for medical or other non-military purposes.
2. Has launched a missile in as part of its emerging "space program" that can be tipped with a nuclear payload.
3. Has assured the world that it has begun to enrich uranium to beyond 20%, a level that is obviously consistent with a nuclear weapons program.

Meanwhile, President Obama announces that it remains his policy to pursue a dual-track policy toward Iran, which includes seeking international sanctions while being open to negotiations. Hillary Clinton has, of course said that the purpose of sanctions would be to force Iran into negotiations. Very simply, this means that there is only a single track being pursued, and that is negotiation.

Where will the sanctions, if any (if ever), come from? Not the U.N. Security Council. China will veto it. From NATO? Only France, the U.K., and Germany would be interested, and without Russia signing on to a serious set of sanctions (which is unlikely), any sanctions President Obama achieves may be puny.
Of course, the government of Israel is watching closely. They have said that their expectation is that any sanctions imposed would be "crippling" to Iran.
We continue to watch and wait .

MODERN MONEY MELTDOWNS

The collapse of currencies is not a phenomenon which occurred only in ancient history. There are plenty of modern examples. I'll note a few.
We all remember seeing in our history books pictures of Germans taking wheelbarrows full of Weimar marks to the grocery store to buy a loaf of bread. The Weimar government owed so much in war reparations that they had to run their printing presses full-time to print enough money to pay it off. Germans saved "money" by burning marks in their stoves instead of coal.
Here's how the mark was valued in relation to one USD:
April, 1919: 12 marks
Nov, 1921 263 marks
Jan, 1923 17,000
Aug, 1923 4.621 Million
Oct, 1923 25.26 Billion

In 1932, Argentina had the world's 8th largest economy when its currency collapsed.

In 1994, Mexico's peso crashed.

In 1998, the Russian ruble was severely devalued.

Right now, the currency of Zimbabwe has no value due to hyperinflation (among other things).

Note to Obama, Geithner, and Bernanke: This is Peoria, not Port au Prince!