Monday, March 31, 2008

Hades Confirms: Hank Paulson Works for the Devil

I was preparing to write a nuanced, subtle analysis of the U.S. financial system's regulatory failures and the inadequacy of Treasury Secretary Henry Paulson's proposals to "fix" the system (double entendre intended) when I came across a document which proves beyond a shadow of doubt that Hank Paulson is working directly for the Devil.

I know this is a shocking revelation, and unfortunately I can't scan the incriminating document, as it was written in goat's blood and only becomes visible for extremely short periods when sluiced with a secret Dark Arts formula (eye of a newt, etc.)

Despite the difficulties, I was able to transcribe the text, which is reprinted below just as it was written.

To provide the proper context for understanding the fiendish cleverness of Paulson's "reform" proposals, let's turn to a cogent quote from Gullivers Travels by that incomparable satirist Jonathan Swift, courtesy of frequent contributor U. Doran:

"They look upon fraud as a greater crime than theft, and therefore seldom fail to punish it with death; for they allege, that care and vigilance, with a very common understanding, may preserve a mans goods from thieves, but honesty has no defence against superior cunning; and, since it is necessary that there should be a perpetual intercourse of buying and selling, and dealing upon credit, where fraud is permitted and connived at, or has no law to punish it, the honest dealer is always undone, and the knave gets the advantage."

Here's the letter from the Devil to Paulson:

"Prince of Lies and proud of it"

Dear Hank:
You have outdone yourself once again, my loyal servant, with these fraudulent, deliciously deceptive proposals to reform the utterly corrupt financial system you exploited so profitably as head of Goldman Sachs.

My plans for the destruction of the United States of America have been going along rather swimmingly until we rushed things a bit with Bear Stearns--ah, the wondrous power of pure, unmitigated greed! It remains my favorite tool--and calls for reform were suddenly everywhere.
The rules which would have undone us were simple indeed, as you know all too well:

1. complete transparency of risk and leverage in all financial documents and financial instruments
2. the marking to market of all financial instruments and assets at the close of the trading day, as is currently done with commodities futures and stock options
3. the banning of "off balance sheet" accounting
4. the banning of offshore accounts and holding companies
5. the uniform enforcement of these regulations across all financial classes, assets, firms, brokers and banks

As you know, Hank, transparency, mark-to-market and strictly enforced regulations of all banks, broker-dealers and financial institutions would deal a death blow to my plans to destroy the U.S. via destruction of its financial system. Having sold your soul to me for the glory and riches you received at Goldman Sachs, you had to comply with my orders to destroy any such useful regulations with cunning "fixes" of your own.

Though I counted on your native feral survival instincts, I did not expect a plan of such evil genius. Imagine how foolish and naive humans must be to accept your "fix"! My mind boggles at the ease with which you have conned the gullible gallery of idiots in Congress and the mainstream media:

1. you diminish the powers of the Federal agencies and favor the "shadow government" Federal Reserve, which is not even a government agency but a private institution
2. Instead of proposing transparency, you are adding another layer of secrecy in what the Fed can investigate and do to "fix" future problems
3. Enable more "self-regulation" (hahahaha, I can't stop laughing at this one! You really are a comedian!)

I am still amused that the American populace hasn't noticed that you, Master of the Dark Arts at Goldman Sachs, have been duly appointed as the wolf assigned to guard the sheep. Now you have suggested opening the rusty wire fencing and lighting the opening so your brethren can more easily slip in and slaughter as many sheep as they wish--and the American sheep sit there mesmerized by my other crowning achievement, the TV, blithely accepted that the most voracious, cleverest wolf is now their "guardian." Never in my wildest imaginations did I hope for such gross stupidity, ignorance and naivite.

Keep up the fine work--
Your Lord and Master,

Lest you think I exaggerate: please read the following excerpts and commentaries:

Bleakonomics (New York Times, by Roger Lowenstein, courtesy of frequent contributor Harun I.)

Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Capitalism isn't supposed to work like this, and before the advent of modern finance, it usually didn't. Market values fluctuate, but --n in the absence of fraud -- billion-dollar companies do not evaporate. Yet it's worth noting that Lehman Brothers' stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion -- no typo -- of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits -- and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth -- sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, "it would have been the end: pandemonium and global meltdown."

Harun also sent along this story,
Plan would expand Fed's power to intervene in financial crisis (CNN)
and made these comments:

The Fed doesn't want another BSC because there is probably no entity with the capital to buy another failed institution. How many bullets does the Fed have left?

I find it somewhat ironic that Paulson, fresh from years of financial alchemy, wants to expand the powers of the banking cartel. It is as if no one remembers that by default he played a part and therefore is partly responsible for what is happening today.

But it seems (as much as I don't like the banking cartel having more power) that Paulson and the Fed realized that WS firms do create credit money (fiduciary media) and left unchecked as it has been leaves the system vulnerable to serious dislocations.

However, if the Fed can't or won't recognize "bubbles" and act, all of this will be academic.
We should be wary of the Fed having sprawling powers. It potentially means that no big institution will be allowed to fail, meaning this could easily segue into normalizing the socialization of losses. We must remember that this is a private organization, its officials are not publicly elected. It is not transparent or accountable like the SEC or CFTC. And without sweeping reforms in regards to transparency and accountability I would vigorously resist the expansion of the Feds powers. "

Knowledgeable correspondent Jon H. recommended this thought-provoking story: Revolution Monday: The Bankster's Coup

Back in earlier times in America, before the Central Bankers took over, there were lots of financial institutions in the country. Most were fiercely independent and they played a key role in the development of the nation. That was a time when the White House was able to dictate to the banks and financial interests rather than today's mirror/reversed situation where bankers largely tell the government what to do.

So the Banker's Revolution begins Monday and the choice is simple:
We can take the easy way which means more government and a furtherance of the recent price fixing in markets...I'm sorry; maintenance of market stability. Come to the great casino, no losers here. Good times, but more regulations, less freedom of choice and a bigger and meaner Big Brother. Did someone over there lose? Well, you just chip in and pay for their losses. The house will keep a share for its hard work, of course.

Or, we can take the hard path and limit bankers, contain government, hold greedy speculators accountable, and let the markets clean themselves. And if we make bad choices, we will live with those. Hard times for a while, but 30% interest rates can be beaten back to 8%, states can legislate usury, and the wealthy elite 'ruling class' can be sent packing: Those who would export our jobs, leave our borders unfenced, and abdicate their responsibilities to preserve sound money, are welcome to leave.

So give it some thought this weekend. Which side will you choose? Soft and Easy but totally Ruled, or Hard and Thrifty - yet FREE?

U. Doran recommended this from Peter Schiff: Bail me out Bennie (Financial Sense)
and this history of The Federal Reserve System

Erudite reader Michael S. recommended this article Taleb Outsells Greenspan as Black Swan Gives Worst Turbulence ( and submitted this haiku:

the black swan dives deep
but becomes white from a cloud
caught in a rainbow

Thank you, readers, for the recommendations and thank you Harun for the comments and Michael for the haiku. I for one feel better knowing about Hank and Lucifer. Now who appointed Hank? Hmm....

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Thank you, William M. ($50), for your extremely generous contribution to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.


Sunday, March 30, 2008

Saturday Quiz: Truffaut's Last Film

What was French director Francois Truffaut's last film?

Confidentially Yours (French title: Vivement Dimanche!) 1983.

This film is considered an homage to Truffaut's favorite director, Alfred Hitchcock. I recommend it as pure entertainment. In black and white, with subtitles.
Truffaut died in 1984 at 52 of a brain tumor.

At knowledgeable film buff/contributor Don E.'s suggestion, I am adding Truffaut's Shoot the Piano Player to my French Tough Guys list which I reprint below for your viewing pleasure.
A Man Escaped (1956) Robert Bresson
Pickpocket (1963) Robert Bresson
Touchez Pas au Grisbi (Hands Off the Loot)(1953) Jacques Becker
Le Trou (1960) Jacques Becker
The Wages of Fear (1952) Henri-Georges Clouzot
Rififi (1954) Jules Dassin
The Crime of Monsieur Lange (1935) Jean Renoir
Le Samourai (1967) Jean-Pierre Melville

Astute reader Michael S. offered this excellent comment on yesterday's entry Interest Rates and Supply and Demand:

You recent article on “Interest Rates and Supply and Demand” made a lot of sense, talking about how there has been a contraction in credit and a drop in credit spreads. However, near the end of the piece you then claim that demand for US treasury debt is dropping, but this claim doesn’t make sense. You had already pointed out how the intense demand for US t-bills has driven yields to unprecedented lows. If anything, the evidence seems to show that demand for US treasuries is increasing.

Basically, I am just saying that your claim that demand is falling for US sovereign debt seems to come out of the blue, and I would like to know if there is some data you are using to help come to this conclusion. If there is some information that shows people are dumping T-bills at faster rates, that would be very interesting to see (although it would seem to contradict the falling yields).

I responded thusly:

There seems to be high demand for 90-day T-bills because people can't even trust money market funds anymore, but I'm not so sure about the 10-year and up maturities. I have read references to central banks cutting their exposure to dollars (South Korea, etc.) but I didn't note the sources--I'll keep an eye out for that.

I should have distinguished between short and long-term T-bills.

And Michael added these thoughtful points:

Yes, the demand for short-term t-bills is extraordinary, but even the demand for 10 year notes seems to be robust, since yields really haven’t gone up there.

We seem to have some contradictory actions occurring in the market. The US dollar is dropping in value, yet demand for treasuries is robust. Is the dollar decline telling us that interest rates are going to rise, and investors are going to shun US debt? Or is the debt market currently telling us that a flight to safety is going to result in very low interest rates and a rising US dollar?
I would argue that this dichotomy won’t last long (i.e. falling dollar and rising t-bills). At this point, however, I don’t think we have enough evidence to know which way things will go. The unfolding credit crunch tips me a little more to the dollar appreciation camp since a contraction in the money supply (i.e. credit) should lead to a crash in asset prices and a rise in the value of currency. However, I don’t have evidence for this view, and will just have to wait and see how this bifurcated market works itself out.

Either way, I don’t think the outcome will be good for the over-all economy. A rise in the value of the dollar, and t-bills, would be disastrous for debtors, and utterly destroy the financial and housing industry. A collapsing dollar will destroy savers, and the purchasing power of the consumer.

Readers, I apologize for not updating Readers Journal the past few weeks. I have been dragging through my second chest cold of the year--what some call "the 100-day cold" or "100-day flu" and am slowly recovering my usual energy. I will post three new essays and recent comments next week. Thank you for your patience.


Friday, March 28, 2008

Interest Rates and Supply and Demand

Astute reader Than H. recently posed this question:

"I know you have done a number of pieces on interest rate cuts, but it's sort of overwhelming to understand the complexities, so is there a quick correlation you can tell me about or would you just recommend I read your posts on the subject? I understand that in a sense, cuts are good for Wall Street short-term, but bad for the U.S. (and Dollar strength) long-term, and I don't quite grasp why."

Despite the many complexities Than alludes to--for instance, currency carry trades-- I think we can achieve some basic clarity by looking at credit as a commodity, i.e. in terms of supply and demand.

So first, let's understand that the Fed Funds Rate which the Fed had dropped 3% in the past few months is the rate charged to banks, not consumers. While there is a correlation between the Fed lowering rates and the cost of credit to various financial players, it is virtually nonexistent in terms of consumer credit.

The reason is that in a credit crunch, lenders are (suddenly) wary of risk, and their ability to insure themselves against loss either disappears or rapidly increases in cost. As a result, auto loan and mortgage rates have not dropped 3% in the past few months; they have actually increased. (Needless to say, credit card interest rates haven't dropped 3% either.)

Until recently, lenders could bundle their consumer and commercial loans and mortgages and sell them to institutions around the world. This increased the velocity and volume of credit. If you wrote $100 million in new home mortgages, you could quickly offload those loans to an investment bank who would bundle and sell them as mortgage-backed securities. This cleared your loan book and you could then sell another $100 million in new mortgages.

The demand for debt was thus high, and so the supply could increase by leaps and bounds. Credit was easy, and debt was easily sold.

Now that risk is being recognized and re-priced, institutions are wary about buying new debt whose risk is essentially opaque. That is, recently they trusted AAA rated debt and they lost huge sums of money as that debt lost value. So now they are restrained from buying more potentially risky debt.

The demand for new debt has dried up, and so the supply of credit is drying up, too. If there are no buyers for new debt, then the lenders have to keep whatever loans they write on their own books. That reduces how much credit they can extend, regardless of the qualifications of the borrower.

Put another way: as risk is recognized as opaque/unknown and trust vanishes, de
mand for new debt drops. The supply of credit is thus restricted, and an imbalance is created between supply of credit (tight) and demand for credit (high). As with any commodity, tight supply and high demand leads to higher prices.

Consider the point of view of the lender: I can borrow from the Fed at low rates, which is nice, but where can I extend new credit without risking losses? Housing? You've got to be kidding. Consumer credit and auto loans as the country slides into recession? Forget it. Now that pension funds, insurance companies and non-U.S. institutions are suffering stupendous losses on the U.S. debt they purchased in the past, then I can't sell new debt. That tunnel is now a pinhole.

In other words, the supply of actual available credit has shrunk, regardless of what the Fed does with its Fed Funds Rate and Discount Window. That means the cost of credit is rising.

Let's look at some charts. The first chart (above) shows that on the Federal level, the demand for credit/borrowing via selling Treasury bills is set to skyrocket as the cost of entitlements (Social Security and Medicare) are poised to ramp up dramatically for decades to come. With the U.S. government already in deficit, this massive demand will drive up the cost of money: it's simple supply and demand. As credit supply tightens and demand soars, prices rise--perhaps by a lot.

From the technical point of view, we see in the next chart courtesy of frequent contributor Harun I.) that the interest rates on U.S. bonds appears poised to increase. (Recall that bond yields and face value are inversely correlated; as interest rates rise, the face value of existing bonds drops; as interest rates drop, the face value of existing bonds rises.)

Here we see how bond yields (interest paid) runs in cycles of about 20+ years. We also see how interest rates could stay low even as the U.S. borrows ever more prodigious sums: China and other nations have, via their central banks, bought astounding quantities of U.S. bonds. The high demand (deficit spending) has been met with equally high supply (of buyers willing to snap up U.S. bonds for a pathetically low rate of interest/yield).

But now this virtuous cycle has reversed. As the dollar plummets (again, for reasons of supply and demand), central banks are unloading their U.S. debt and cutting back their new purchases. The demand for new U.S. debt is dropping--precipitiously for mortgages and commercial debt, and more slowly for long-term Federal debt.

As demand for credit increases (due to deficit spending and a consumer economy), and supply decreases (nobody is dumb enough to keep buying U.S. mortgages), then the price of credit rises.
If you look at these charts, it seems highly likely that the cost of credit (the interest rate needed to pursuade someone to buy the debt) will rise for the next 15-20 years.

What are the consequences of such a cycle? No mystery there: a staggering rise in the cost of servicing the Federal debt and the consequent restraining of Federal spending, and the constriction of consumer debt and thus spending.

Some smart analysts are calling for an 18-month recession. Based on the charts and the simple laws of supply and demand, I suggest looking for an 18-year recession.

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Thursday, March 27, 2008

That Letter From the IRS--Please Read It Carefully

You received a letter from the IRS recently, describing the "Economic Stimulus Payment" you will be getting from the IRS in May or June. You probably tossed it without even reading it--but really, you should read it carefully. It is an amazing document.

I reprint it here below for you to read and ponder.

Economic Stimulus Payment Notice

Dear Taxpayer:

We are pleased to inform you that the United States Congress passed and President George W. Bush signed into law the Economic Stimulus Act of 2008, which provides for economic stimulus payments to be made to over 130 million American households. Under the new law, you may be entitled to a payment of up to $600 ($1,200 if filing a joint return), plus additional amounts for each qualifying child.

We are less pleased to inform you that the $160 billion cost of this giveaway is being borrowed in its entirety from Gulf oil exporting nations, Asian banks and African oil kleptocracies. We are even less pleased to inform you that once interest on this stupendous new debt is included, this giveaway will cost your children $320 billion.

We are downright pissed to inform you that this $320 billion roughly equals the tax receipts that should have been collected this year from fellow Americans, the vast majority of whom are extremely wealthy, who made use of questionable tax shelters and outright lies to avoid paying their share of Federal taxes.

You do realize, dear Taxpayer, that we get that $320 billion anyway from wage earners and legitimate small business owners like you. So every American tax cheat is taking money directly from your pocket.

As you know, the IRS has been demonized for decades, and we are ecstatic to inform you that we don't spend all your tax money--Congress does that--nor do we make the arcane, idiotic, loophole-ridden tax codes. Congress does that, not the IRS. We're not rewarding our fat-cat donors and special interest buddies with special tax breaks--Congress does that.

So when you pay your taxes this year, or look at your paystub, think about all those millionaires sipping drinks on their yachts who cheated you by not paying their share of taxes, and be sure to thank Congress for protecting and enabling their tax-cheat pals.

We are deeply annoyed to inform you that though the Mainstream Media constantly reports that high-income Americans pay most of the Federal taxes, they fail to mention that these are wage-earners and legitimate entrepreneurs much like you. The real tax cheats operate at a much higher level--the level of Enron, offshore holding companies, and Bear Stearns/investment bankers tax breaks and loopholes.

We are equally furious to inform you that other American millionaires are cheating you daily by hiring illegal employees and paying them cash, and then pocketing the profits without paying taxes. Meanwhile, their legitimate competitors are paying legal workers' taxes and income taxes. So next time you support a black-market business whose employees are all cash-paid illegals, think about all those "savings" you're getting while the business owner reaches into your pocket and makes you pay his share of taxes. Maybe you'll wise up and stop hiring tax cheats to mow your lawn and re-roof your house.

And when the Hollywood types hire an entire house of illegal aliens to serve them, they're stealing from you, too, because they don't pay any Social Security taxes on those illegals, and the illegals don't pay any taxes, either--though you're paying for their medical care and their kids' education, etc.

Thanks to Congress and the President, our investigative branch--yes, the guys and gals who are tasked with saving you money by locating and nailing the hundreds of thousands of tax cheats and liars who are robbing you of $320 billion a year, you who have no way to really cheat on your taxes--anyway, Congress and the President have gutted our ability to find and collect from tax cheats.

Their propaganda machine has convinced you that we, public servants who merely do their bidding, are the enemy, when in fact it is Congress and the Executive branch who are robbing you, enriching their wealthy buddies and allowing tax cheats to prosper by stripping our investigative budgets.

You see, dear Taxpayer, the Hollywood types and Enron/Bear Stearns types are their close pals, the ones who feed them millions in donations. You are merely fodder, cleverly herded peasants who can't worm your way out of paying taxes. So Congress and the President make you pay the taxes their pals should pay, and then blame the IRS as if we wrote the laws and mis-spent all your hard-earned money.

So when you get your miserable $600 check, and wonder which credit card to pay down, think about the Hollywood mansions with their illegals and the Wall Street and big-bucks types hiding their immense wealth behind tax shelters specifically written to protect them, and think about all the tax cheats who are laughing at you while their factory and slaughterhouse is filled with illegals they pay nothing to hire, while you pay for the illegals' medical care and education.

And remember that all the investigative branches of government except the Intelligence agencies have been gutted. When that millionaire's employees are discovered to be illegals paying no taxes, and that he's paid zero taxes on them, too, then he gets a wrist slap. He just got unlucky. Think about it, dear Taxpayer--why is there no real effort to nail the employers who are actually to blame for the illegal worker's presence in the U.S.? Because Congresspeople who like to pontificate about illegals have insured that the investigative agencies tasked with rooting and and nailing the employers have been gutted, and the fines reduced to pinpricks.

We are very miffed to inform you that you have bought the propaganda hook, line and sinker. You foolishly blame the illegals rather than those who hire them illegally, and profit immensely from doing so, and you blame us rather than the kleptocracy in Congress and the White House.

So go ahead and blame us, the IRS, even though Congress has tied our hands behind our bags and sucker-punched us, so we can't possibly catch their tax cheat buddies and pals. Think about the $320 billion your kids will be paying in interest to African dictators and Communist-owned banks for decades to come. And then think about how effectively you've absorbed the propaganda that we're your enemy, when your real enemies are sitting in Congress and the White House, collecting millions from their grateful tax-cheat buddies.

For additional information on this sickening travesty of a mockery of a sham of a borrowed giveaway to the dumb peasantry who pay the taxes so wealthy tax-cheats don't have to, please visit the IRS website as

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Thank you, Karl A. ($15) , for your generous contribution to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.


Wednesday, March 26, 2008

Why We're in this Handbasket--and It's Getting Hotter (Part 2) Perverse Incentives

As our handbasket hurtles ever faster down a tunnel toward a glowing red opening surrounded by grinning red creatures with pitchforks in hand, it's a good moment to consider the set of incentives --mostly perverse, but all politically selected--which contributed to our destruction.

All the happy paens to Capitalism neglect to mention its most fundamental characteristic: laziness is the highest virtue. Wait a minute, that's not what we were taught in school!

Uh, I know. But think about it. if you can maximize your profit without actually producing value, then there's a huge incentive to do so. If you can make a stupendous profit by signing a few papers, as opposed to sweating and toiling and risking a bunch of capital, then you'll gladly choose the lazy way to wealth.

If you can grind up free rats (or melamine) into your sausage rather than have to pay good money for pork or beef, then the incentive--maximum profit--says "go for it." This is how business operated at the turn of the century in the (unregulated) U.S. and how it operates in (mostly unregulated) China today.

If you can drive your competitors out of business, by whatever means are necessary, then you will be maximizing profits the lazy way, by charging more for the same product. Hey, it worked for Rockefeller in the oil business, and many others since.

If you can "option" three houses which aren't even built yet for a few thousand dollars, and then flip those options-to-buy for $20,000 profit each, then the incentive is to do so. Why risk capital or bother actually building the darn thing yourself? Just take the laziest profit possible--that's the systemic incentive.

Now we come to the sleaziest--oops, I meant easiest--and laziest--way to generate vast profits: take some debt, chop it up, add a couple hundred pages of boilerplate, and then sell the new pieces of paper for billions in pure profit. Talk about lazy: nothing of value has been produced, and no service rendered except to yourself.

Wait, you protest: you're combining speculation with monopoly and unfair trade practices and with cheating the customer--you can't do that. I repeat: the fundamental characteristic of Capitalism is laziness. If you don't have to risk your own capital, then you don't-- you risk someone elses. If you don't have to risk any capital at all, then you don't. If you can double the price of your good or service overnight, then you will, and you're not worried about efficiency or fair trade or any of that crap: to get rich is glorious, especially if it's easy.

You see where this is going, right? This is why we have regulations: about making sausage, about mortgages, and about financial instruments.

We have been in a cultural and psychological climate since 1981 in which government regulation has been decried, even derided, as stifling, bureaucratic, etc. And indeed it can be. In fact, over-regulation and outrageous regulatory fees are perverse incentives themselves.

If obtaining a sewer connection permit in the city costs $20,000 per unit, then what's the incentive? It's to go out to the boondocks and build the houses in a county where the permits for everything cost $1,000, not $40,000 or more.

Then there's the issue of having regulations which are rendered toothless by gutting the investigative staff or refusing to enforce the regulations. For instance, someone bought 200,000 puts on Bear Stearns stock (controlling 20 million shares) just days before it dropped from $30 to under $5. That someone (or group) made stupendous profits by trading what was obviously insider information that BSC was about to go bankrupt or be acquired for much less than $30/share.

Will anyone be brought to justice for this insider trading? Not in today's climate. Sure, the rules are on the books, but if they're ignored or enforced sporadically, then what value do they have?
Regulations are a key part of what is known as "good governance." It's what kleptocracies, dictatorships and "basketcase" countries lack.

Regulatory systems are not random events. They are political assemblies of choices made by leaders of our government. Now we come to the issue of what has been regulated and what has not, and what has been so laxly regulated that is has in effect operated in near-complete laissez faire fashion.

Want to buy and trade stock options? They're regulated.
Want to buy and trade commodities futures? They're regulated.
Want to start a depositor banK? They're regulated.
Want to create a complex derivative combining currency, interest rates and asset-backed securities? You're home free, baby--there's no regulations to limit how many sheep you can round up and slaughter.

If you think such a derivative is farfetched, please read Fiasco: The Inside Story of a Wall Street Trader (recommended by longtime correspondent Cheryl A.)

For more on what is not regulated, we turn to frequent contributor Harun I. for an explanation:

"What most people don't seem to understand that most of what happened has involved securities not regulated by the SEC or the CFTC. The argument that these mysterious instruments were indeed futures contracts and therefore should be regulated by the CFTC was finally defeated (more by brute force than by logic) -- and the feeding frenzy began.
Furthermore if you deal with exclusively "sophisticated" investors (QEPs) and (in the futures markets) claim a 4.7 exemption, then you are released from disclosure and the requirement to provide investors with an annual certified audit. More simply, once a 4.7 exemption is granted the risks don't have to be disclosed. (emphasis added, CHS) The catch is that disclosure document must be made available at the investors request. Therefore due diligence is entirely up to the investor.

The above is lengthy but very informative. While it deals with CPO's, hedge funds in the equity markets are similar.

for those who don't wish to read the link in its entirety, although I highly recommend it, here are the paragraphs that cut to the chase:

"(1) Disclosure relief. (i) Exemption from the specific requirements of §§4.21, 4.24, 4.25 and 4.26 with respect to each exempt pool; Provided, That if an offering memorandum is distributed in connection with soliciting prospective participants in the exempt pool, such offering memorandum must include all disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading; and that the following statement is prominently disclosed on the cover page of the offering memorandum, or, if none is provided, immediately above the signature line on the subscription agreement or other document that the prospective participant must execute to become a participant in the pool:


(3) Annual report relief . (i) Exemption from the specific requirements of §§4.22(c) and (d); Provided, That within 90 calendar days after the end of the exempt pool's fiscal year, the commodity pool operator electronically files with the National Futures Association and distributes to each participant in lieu of the financial information and statements specified by those sections, an annual report for the exempt pool, affirmed in accordance with §4.22(h) which contains, at a minimum:

(A) A Statement of Financial Condition as of the close of the exempt pool's fiscal year (elected in accordance with §4.22(g));

(B) A Statement of Income (Loss) for that year; and

(C) Appropriate footnote disclosure and any other material information.

(ii) Such annual report must be presented and computed in accordance with generally accepted accounting principles consistently applied and, if certified by an independent public accountant, so certified in accordance with §1.16 as applicable.

(iii) Legend. (A) If a claim for exemption has been made pursuant to this section, the commodity pool operator must make a statement to that effect on the cover page of each annual report.
(B) If the annual report is not certified in accordance with §1.16, the pool operator must make a statement to that effect on the cover page of each annual report and state that a certified audit will be provided upon the request of the holders of a majority of the units of participation in the pool who are unaffiliated with the commodity pool operator.

Being somewhat dim and overwhelmed with the above, I then asked Harun specifically: does this mean derivatives are unregulated? Here is his reply:

The Commodity Futures Modernization Act, as adopted, is a significant step forward for U.S. financial markets. This important new law creates a flexible structure for regulation of futures trading, codifies an agreement between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission to repeal the 18-year old ban on trading single stock futures and provides legal certainty for the over-the-counter derivatives markets.

Yes. Since as far back as 1982 there had been an argument as to whether OTC derivatives were in fact futures contracts and therefore, in order to be legal, should be regulated by the CFTC. In the meantime these derivatives, whose very legality was in question, were created anyway and grew to such and extent that through brute force alone (with the help of the PPT) rather than logic was it decided that these derivative were legal and exempt as long as they are entered into be eligible contract participants.

CDOs are indeed securities but as long as the purchasers meet certain requirements there is relief from disclosure and reporting."

Thank you, Harun, for explaining a complex topic.

Let's go back to kleptocracies, dictatorships and "basketcase" countries run by oligarchies. These nations often have sham regulations which are constructed to offer the appearance of good governance without actually providing good governance.

In international negotiations such as the World Trade Organization, the U.S. stands on the high moral ground and wags its finger in stern admonishment of nations who come hat in hand to join the ranks of those paragons of good governance such as the U.S.

When you let a bank hold a miniscule 1% of its loan book as reserves against loss, how can that be considered good goverance or prudent regulation? And when investment banks are allowed to sell trillions in derivatives specifically constructed to mask risk and maximise profits to the banks, is that good goverance or prudent regulation?

Exactly what is the difference between a hopelessly corrupt regime with sham (unenforced) regulations on its books and the U.S.?

Here is the difference: if you're going to actually produce a good or service, then you will be burdened with an immense load of regulations, and of course fat regulatory fees and heavy taxes at every step.

But if you're adding no value whatsoever, creating no good or service, printing up and trading paper, then you have virtually no regulations. And if you hire the same outfits Enron did, then you can hide much of your profit overseas--just like those tin-hat dictators and kleptocracies do.
These perverse incentives have put us in the handbasket and aimed us straight down the tunnel to a very hot Heck. (Hey, this is a family blog.) It will take a severe societal adjustment (otherwise known as a revolution) to transform the U.S. from a well-cloaked oligarchy/kleptocracy serving an elite to a nation of good governance.

NOTE: contributions are humbly acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.

Thank you, G.F.B., for your generous gift to this humble site, and for your encouragement. I am greatly honored by your contribution and readership. All contributors are listed below in acknowledgement of my gratitude.


Tuesday, March 25, 2008

Why We're in this Handbasket--and It's Getting Hotter (Part 1)

Not to put too fine a point on it--but why are we in this handbasket, sliding ever faster down a tunnel toward a glowing red opening surrounded by grinning red creatures with pitchforks in hand?

There are many reasons, but let's tackle two of the biggies: the surfeit of dollars and the Pyrrhic triumph of U.S.-created leverage/exotic financial instruments.

The first thing to note about the dollar is that people overseas have been accumulating stupendous mountains of them for some time. As we all know, the U.S. has been importing far more goods and commodities than it has been exporting; this is the current account deficit or trade deficit. Here is a snapshot 2001-2005 courtesy of U.S. Department of Energy.

According to the Commerce Department, here's the trade deficit 1999-2008:
1999: $270 B 2000: $370 B 2001-2005: see above2006: $763 B 2007: $711 B 2008: 750 B (est.)
That adds up to $5.76 trillion. A trillion here, a trillion there, and pretty soon we're talking real money.
By broader measures, the U.S. imbalance is more on the order of $1 trillion a year-- that is, the U.S. requires inflows of $1 trillion a year:

The global current account deficit of the United States is now larger than it has ever been— nearing $800 billion, almost 7 percent of US GDP. To finance both the current account deficit and its own sizable foreign investments, the United States must import about $1 trillion of foreign capital every year or more than $4 billion every working day. The situation is unsustainable in both international financial and domestic political (i.e., trade policy) terms. Correcting it must be the highest priority for US foreign economic policy. The most constructive remedy in the short term is a three-part package that includes credible, sizable reductions in the US budget deficit, expansion of domestic demand in major economies outside the United States, and a gradual but substantial realignment of exchange rates.

(source: Peterson Institute)
For an in-depth look at the damage done, take a look at this National Bureau of Economic Research paper: The Unsustainable US Current Account Position Revisited.(Cost is $5)

Here are some of the mechanisms which have been at work:

1. U.S. consumers spend $3 trillion more in 2000-2007 than they would have in previous decades, mostly by extracting housing-bubble "wealth" from their homes and adding to consumer credit cards and other debt.
2. U.S. businesses prospered not by increasing capital investments in the U.S. but by shipping manufacturing overseas and importing trillions in overseas goods. This enabled corporate profits to zoom even as U.S. wages were stagnant and sales were so-so.
3. Financial gaming grew to dominate U.S. corporate profits: companies which made things to sell domestically and abroad were outstripped by corporations which manufactured nothing but exotic financial instruments like CDOs, CLOs, credit swaps, mortgage-backed securities, asset-backed securities, etc. As The Economist explains:

The financial system--What went wrong:

The American financial-services industry's share of total corporate profits rose from 10% in the early 1980s to 40% at its peak last year. Its share of stock market value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services account for only 15% of corporate America's gross value added and a mere 5% of private-sector jobs. So 5% of the U.S. workforce made 40% of the total corporate profits from playing around with risky, hard-to-understand paper.

Meanwhile, from the non-U.S. point of view, the question was pressing: what the heck do we do with all these bloody dollars we're accumulating? Having sold the U.S. $6 trillion dollars worth of oil, car parts, Wal-Mart goods, etc. in excess of what they purchased from the U.S., these non-U.S. governments and companies were stuck with a stupendous and ever-growing mountain of greenbacks.

That led to a shotgun marriage which was made in Heaven for Wall Street and straight from Hell for the hapless foreign buyers. Wall Street sharpies conjured up a whole universe of debt instruments to sell to foreign banks, pension funds, companies, etc. who were seeking somewhere to put their bucks in a world awash with dollars, credit and cash.

Here's a chart to depict what happened:

The global boom--largely a product of the global housing bubble and the global credit bubble--created trillions in profits for every player: Japan, China, the EU, USA, etc. The players were all chasing returns, and all were looking for some place to dump their depreciating dollars.
And why were they depreciating? Simple supply and demand: there were too many dollars being "printed" via bank leverage (take $1 cash, use it to create $100 loan on a rapidly appreciating house somewhere like Florida, Arizona or California) and then shipped overseas to pay for the outrageous, stunning amount of goods and commodities the U.S. was consuming--i.e., the trade deficit.

Apparently fear is so rampant in the global financial markets nowadays that despite losing value virtually every day, foreign entities are still buying short-term U.S. Treasuries. This has enabled the U.S. to keep borrowing hundreds of billions to lavish on giveaways to poor U.S. consumers, (the $160 billion giveaway), the $500 billion war in Iraq, etc.

What drives this desperate buying of U.S. debt even as the dollar sinks? There is no place else to put the trillions of dollars piling up overseas. Some dollars are flowing back to buy U.S. real estate or U.S. companies, but investors who stepped up and bought a chunk of Bear Stearns or Citicorp have been burned--so U.S. assets might actually be riskier and more dangerous than T-bills which earn less than the dollar depreciates. In other words, buy a T-Bill for $1 and get back 95 cents--such a deal! At least you got back something!

In a saner world, non-U.S. players would stop exporting so much to the U.S. and save themselves the trouble of losing money in the dollar and U.S. debt. But then who else will step up and buy 25% of the global GDP?

It's a conundrum, to be sure, but one with an eventual end. As explained in the book The Dollar Crisis: Causes, Consequences, Cures the eventual cure is the rebalancing of trade via recalibrations of currencies. In effect, the author builds a strong case that all massive, structural trade imbalances like the one the U.S. has enjoyed/engineered for the past 10 years come to an end when the currency (in this case, the dollar) drops so low that imports and exports reach rough parity.

Take another look at that U.S. Dept. of Energy chart. A sharp recession and a stiff contraction of credit might well cut demand for foreign autos and for oil, too-- which make up half of the trade deficit. It would be a start toward righting the trade imbalance, and toward shipping fewer dollars overseas to be gambled/mis-invested/dumped.

NOTE: contributions are humbly acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.

Thank you, Eric A. ($20), for your generous financial support of this humble site, and most especially for your wise words of encouragement. I am greatly honored by your contributions and readership. All contributors are listed below in acknowledgement of my gratitude.


Monday, March 24, 2008

The Financial Centipede: Waiting for the Next 99 Shoes to Drop

After last week's dramatic bailout of Bear Stearns, the world is waiting for the proverbial "next shoe to drop" in the global financial crisis. Too bad the crisis isn't a two-legged creature: it's a centipede.

With a respectful tip of the hat to Tony Ross's wonderful children's tale, Centipede's One Hundred Shoes let's start a list of some of the next 99 shoes to drop. In no particular order:

1. Recent new home buyers sue builders and lenders over bogus inflated appraisals. KB Home sued over appraisals. It seems KB Homes used a house in the same subdivision which it claimed was sold for $475K when the county records indicate it was sold to the new home buyer for $407K. Oops! Our bad. Now go away. Not so fast, KB Homes and Countrywide.

2. Existing home buyers suing appraisers for inflated appraisals.

3. Home buyers suing lenders for predatory/illegal/fraudulent lending practises.

4. Buyers of mortgage-backed securities suing investment banks for misrepresenting of the assets' risks.

5. Buyers of mortgage-backed securities suing the rating agencies for misrepresenting assets' risks.

6. Plaintiffs' lawyers seeking whatever deep pockets remain amidst the carnage (i.e. "grab-bag of lawsuits against everyone involved")

7. Non-U.S. banks getting judgments against U.S. investment banks and ratings agencies in overseas courts which then put the entire U.S. judicial system in an awkward light. Everyone knows the mortgage-backed securities were fraudulent; so a British or German judgment will be rejected despite the fact the U.S. entity has branches in the EU?

8. Food riots increase in the Mideast, Egypt, China, the Philipines, etc. as food prices continue to skyrocket. Rice up 60%. Hmm. How many people depend on rice for their survival?

9. Oil falls $15/barrel in a day or two, wiping out another "sure thing," i.e. "oil will stay above $100 for the indefinite future."

10. Job losses start mounting so fast the government can't create enough phantom jobs to mask the precipitous decline.

11. People begin waking up to the consequences of the global era of "easy borrowing" ending. According to BusinessWeek, Countrywide alone wrote $2 trillion in mortgage debt from 2000-2006. Who bought all that debt? Who is dumb enough to buy the next $2 trillion in mortgages? No one.

12. As oil plummets, Venezuela, Iran, Nigeria, et. al. suffer financial and social turmoil as their budgets are slashed. Oil-export states which spend much of their petroleum revenues on social welfare programs to placate their populace will be in big trouble.

13. As the recession goes global, oil demand shrivels, further reducing the speculative fever which drove oil above $100.

14. Oil exporting states' own consumption, being heavily subsidized, doesn't drop as global demand drops. This further squeezes the exporters: as more of their oil is consumed by their citizenry for peanuts/barrel, there is even less to sell overseas.

15. Consumer spending will slow further and faster than analysts expect. Consumers borrowed $3 trillion above long-term trendline spending 2000-2007. (source: this week's BusinessWeek.) "Tapped out" doesn't quite do justice to what lies ahead.

16. Smaller regional banks start folding/becoming insolvent as commercial loans go bad; these roll up and threaten a money-center bank.

17. Lenders who financed unsold/empty condominium highrises will start going bust.

18. The world realizes the Fed just burned its last belt of heavy ammo, and the hordes of financial banshees keep coming. Sure, the Fed can lower interest rates again but the mortgage rates don't drop. It can 'save" another tottering financial institution but trust has been destroyed between financial institutions.

19. The home ATM machine is not only broken, it's hauled to the dump. Let's lower the Fed rate to 1%--will that magically increase the value of homes in an environment of tight lending standards, risk aversion and massive inventories of unsold houses and condos? No. So take the home ATM (mortgage equity extraction) machine to the dump, or sell it for scrap.

20. A counterparty to a bunch of toxic derivatives goes under, lighting a chain of derivative failures which launches the "liquidity crisis" to a new level. Fed's rescue halted a derivatives Chernobyl (for now) (link courtesy of U. Doran)

21. Massive reductions in real estate valuations gut local government property tax revenues. With less money to spend, local governments have no choice but to lay off hundreds, then thousands, of employees.

22. Non-U.S. investors give up on the dollar and long-term Treasuries, buy only 90-day T-Bills. The entire "bailout" exercise and "tax rebate" is essentially funded by non-U.S. capital; as that capital dries up/goes away in disgust, America's borrowing binge dries up too--even at the Federal level.

23. Non-U.S. investors who came to U.S. financial institutions' rescue with fresh capital suffer staggering losses in a few months. Twice burned--by the dropping dollar and now by the institutions such as Citi and Bear which misrepresented their risks--the non-U.S. Posse stops coming to the rescue of defaulting U.S. institutions.

24. Global shipping shrinks unexpectedly, reflecting global glut of comsumer goods and the sharp dropoff in consumer demand. Empty containers stack up and "shocked" analysts admit the slowdown is global in reach.

25. A major U.S. company reports a dramatic quarterly reduction in profits. With U.S. stock markets barely off their all-time highs, this "surprise" sends the markets reeling.

26. Subprime crisis spreads to all mortgage classes. As this chart shows, there are plenty of other mortage classes ripe for defaults/late payments/foreclosures: not just ARMs but balloon payment loans, FHA, VA, properties with second and third mortgages, etc.:

27. Wal-Mart and the Chinese government join in a class-action lawsuit against American consumers, demanding they increase their spending despite the recession. Just joking; as the saying goes, "you can't get blood out of a turnip."

These are just a few of the "other shoes waiting to drop"--I'm sure you can add a dozen or two off the top of your head.

NOTE: contributions are humbly acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.

Thank you, Eric A. ($20), for your generous financial support of this humble site, and most especially for your wise words of encouragement. I am greatly honored by your contributions and readership. All contributors are listed below in acknowledgement of my gratitude.


Sunday, March 23, 2008

Saturday Quiz: How much oil does Iraq have?

How much oil does Iraq have?

Answer: It depends on who's doing the estimating. According to the Brookings Institute:

Over the past several months, news organizations and experts have regularly cited Department of Energy (DOE) Energy Information Administration (EIA) figures claiming that the territory of Iraq contains over 112 billion barrels (bbl) of proven reserves—oil that has been definitively discovered and is expected to be economically producible.

In addition, since Iraq is the least explored of the oil-rich countries, there have been numerous claims of huge undiscovered reserves there as well—oil thought to exist, and expected to become economically recoverable—to the tune of hundreds of billions of barrels. The respected Petroleum Economist Magazine estimates that there may be as many as 200 bbl of oil in Iraq; the Federation of American Scientists estimates 215 bbl; a study by the Council on Foreign Relations and the James A. Baker III Institute at Rice University claimed that Iraq has 220 bbl of undiscovered oil; and another study by the Center for Global Energy Studies and Petrolog & Associates offered an even more optimistic estimate of 300 bbl—a number that would give Iraq reserves greater even than those of Saudi Arabia.

It is particularly important to verify the estimates of Iraqi reserves since the DOE figures stand in contrast to those of an equally reputable U.S. government organization. In its 2000 World Petroleum Assessment, the Department of the Interior's U.S. Geological Survey (USGS) presented figures based on extensive geologic studies by a team of more than 40 geoscientists claiming that, as of the end of 1995, Iraq had 100 bbl of proven reserves, of which 22 bbl had already been recovered. Hence, according to the USGS, Iraq's current proven reserves amount to only 78 bbl—only two-thirds of the DOE's more commonly accepted 112 bbl estimate.

When it comes to assessing Iraq's undiscovered reserves, the differences between the DOE and the USGS becomes even starker. According to the USGS—which is hardly a Chicken Little when it comes to reserve predictions—there is a 95 percent probability that Iraq has at least 14 bbl, a 50 percent probability that it has at least 45 bbl, but only a 5 percent probability that it has 84 bbl of undiscovered reserves. This means that the probability that Iraq has 200 bbl or 300 bbl, as so many of the reports have suggested, is, according to USGS calculations, close to nil.

We will be exploring some larger issues of oil supply and demand next week, so stay tuned.


Saturday, March 22, 2008

How We Select Topics

I want to pull away the curtain a bit today and discuss the process of topic selection here at

At any given moment we have 30 or so topics under consideration, with long lists of subjects of interest on file. On any given day, our multitude of well-informed correspondents send in story links and commentaries which add to the list.

Then we gather round the editorial desk and ask: is there a topic we really add something new to, something that hasn't been covered elsewhere? Is there a topic we can add some humor to, or one where we can offer some unique insight?

The answer soon becomes clear: no, there isn't. Despite this, we pick a topic anyway, usually based on pure whim and who on staff has the strength to attempt semi-coherence.

And that's a tough call, as the other office projects--scraping up a miserable meager sum of cash to survive, losing money in the stock market, writing books no one wants to read, opening rejection letters from literary agents and publishers, helping friends and family because, well, that's what friends and family are for, doing stuff for nothing, answering voluminous email and pondering our hate mail, wondering why we don't hide behind a nice I.D. like Cantankerous-Old-Crazy-Hippie--require quite a bit of time.

We then set aside a few moments for navel-gazing, during which we ask ourselves why we're so stupid and idiotic that we persist in posting drivel for free, when others are posting drivel about their cute kids and dogs and raking in vast sums of advertising money.

We conclude, sadly, for the zillionth time, that nobody is dumb enough to advertise on this site, and our readers are too astute to click on ads anyway, so it was a hopeless line of thinking.
Another moment is spent agonizing over why we're so stupid that we can't think of a brilliant concept like our friend Aaron Krowne, creator of the wonderfully viral Implode-o-Meter sites. (See right sidebar for links.) But alas, we remain poor and dumb and without inspiration.

Then we wonder why we have this foolish urge to be contrarian, and why we don't post platitudes and pablum about Mom's apple pie and the wonderfulness of things, topics which would inspire warm fuzzy feelings in grateful readers tired of all those doom-and-gloom blogs. After all, to get rich is glorious, and the easy thing to do. But our timing is always off, and we're always opposite where we should be.

Despite innumerable reasons to give up and pull the plug, some idiot volunteers to write an entry, and staff gathers round to post an erudite quote from a reader which says whatever we hoped to say much better than we could.

Wondering once more why we bother, we post the entry and then turn off the computer, recalling Sartre's dictim than "man is a useless passion" (he meant humankind, Ladies, not just males, though you can certainly argue for the stricter interpretation).

So that's how it works here behind the computer screen, folks; kind of like making sausage only cleaner and much less profitable--and it's trans-fat free.

Meanwhile, other bloggers are raising millions in venture capital (Thanks to correspondent Michael S. for the story): More Bloggers Raising Money. Here Come The Politics. And Here Comes My Rant.

Good Golly, Molly, why can't I find someone to give a couple of mil? I know the answer: they get nothing in return except smart-aleck commentaries. It's just an idiotically poor investment--almost as dumb as owning stock in Bear Stearns.


Thursday, March 20, 2008

Generational War and Our Future Prosperity

During my recent visit to Honolulu, I was fortunate enough to meet esteemed historian Gavan Daws for coffee. I have been in email correspondence with Gavan for some years and have recommended three of his classics to you:
Prisoners of the Japanese : Pows of World War II in the Pacific
Shoal of Time: a History of the Hawaiian Islands and
Follow the Music: The Life and High Times of Elektra Records in the Great Years of American Pop Culture (co-authored with Jac Holzman). He has written a diverse array of books, many others of which you may find interesting as well.

Our free-ranging multi-hour discussion covered an astounding number of topics, but the one which struck me as the most profound was Gavan's insight into the source of national wealth. He referred to the 2006 World Bank report Where Is The Wealth Of Nations? as a key source document. In a recent email, he summarized the report thusly:

The hard evidence, worldwide, from Third to First World, is that the societies that do best by their people are those that invest in human capital, as opposed to having their people work in resource capital (digging coal) or produced capital (oil).

The 21st century is the century of human capital, worldwide.

And the hard evidence is that the best return on investment in human capital comes through education.

Gavan has put this idea into practice by launching an innovative professional music program at Honolulu Community College called MELE (the Hawaiian word for song). here is an editorial he wrote for the Honolulu Star-Bulletin: 'MELE' Hits A High Note Honolulu Community College expands skills and opportunities for the Hawaii music scene.

Hawaii's first music business courses offered at Honolulu Community College MELE program presented in partnership with Nashville's Mike Curb College of Entertainment & Music Business at Belmont University.

In a nutshell: Gavan's insight is that as the global digital revolution continues apace, music--a form of human capital in its creation, recording, distribution and marketing-- will only become easier to distribute digitally, and that Hawaii, with its rich history of musical innovation and musical talent, should be well-placed to reap the benefits of this digital development. But the key is providing young people with a solid education in the business of creating, distributing and marketing music. Hence the MELE program's connection to the music business's "ivy League" music program in Nashville.

Hawaii's political leaders have attempted over the past three decades to create centers of human capital by launching a law school, a medical school, and most recently, a medical research facility. While the efforts have certainly created new concentrations of human capital, they are competing with other similar centers for funding and talent. Their "edge" in a global sense largely flows from the attractiveness of Hawaii's climate and culture.

It is actually extremely difficult to create a self-sustaining concentration of human, financial and entrepreneural capital: Recreating Silicon Valley Not an Easy Task (Johns Hopkins University)
The two historians, who specialize in science and technology, have investigated why it is so difficult to recreate California's vital high-tech center. Silicon Valley owes its unparalleled success to an unusual interplay between corporate and university researchers and a truly unique set of circumstances, they concluded in a paper to be published next month.

"No one actually has been able to successfully replicate Silicon Valley, including the original father of Silicon Valley," said Kargon, a professor in the History of Science, Medicine and Technology Department.

Other regional high-tech centers, such as Research Triangle Park in North Carolina, attract established firms by offering low taxes and other incentives. That strategy has been successful, creating many jobs and bolstering the regional economy. But the companies are based somewhere else.

"They are not self-generated," Leslie said. "That means that it's always going to be a satellite to someplace else, where the ideas are created."

One of Silicon Valley's key ingredients of success has been a rare symbiosis between industry and university researchers, two cultures that often clash.

Even the man whose vision spawned Silicon Valley, Stanford University electrical engineer Frederick Terman, was unable to successfully copy his creation anywhere else in the United States. When he tried to duplicate Silicon Valley, Terman tended to overestimate the importance of having a particular kind of educational institution as the catalyst, while underestimating how hard it is to convince competing firms to cooperate, Leslie and Kargon said."

In other words, education is only one building block in a complex relationship with entrepreneurs, sources of venture capital, government research funding, intellectual property rights, and so on. Nonetheless, it remains a key factor.

The ills of the American educational system are well-known. Low test scores compared to other nations, half the PhDs in hard sciences are awarded to non-U.S. graduate students who we then kick out of the country in the name of "Homeland Security"--great idea, let's make it nearly impossible for the smartest, brightest people we educate to work here! That is a recipe for Homeland Insecurity, at least financially.

Various ideas are being tried to improve American education: longer school years, enrichment programs, private schools receiving public funding, No Child Left Behind which effectively closes down incompetent schools or causes new management to be hired, and so on.

I don't claim to be an expert in education, nor can I claim to know which of these ideas and innovations is actually bearing fruit. As always, the evidence in social sciences is all too easily swayed to fit the ideological biases of the researcher. If you're looking selectively for data to support your presupposition, you will find it.

Many of the causes of American youth's poor education stem from American culture: horribly unhealthy fat and sugar-heavy diets, an obsession with television and other electronic distractions, widespread drug use (prescription and illegal), two-working-parent families, one-parent families, long commutes, the generalized "dumbing down" of America, the insane disparities in school funding created by America's obsession with local school boards, the idiocies and gross financial incompetence of many of those school boards, a cultural disdain for education (at least compared to Asian nations), and so on. (This is only a partial list but you can fill in the rest.)

But we must also look at what our Federal government spends the vast majority of its revenues on--and it sure isn't education or human capital.
Let's start with The $3 trillion Dollar War (book by Joseph Stiglitz and Linda Bilmes) Linda Bilmes on Our 'Three Trillion Dollar War' (article and book excerpt)

According to Wikipedia's breakdown of the 2008 Federal budget (well-sourced), our government spent:
$1 trillion on the elderly (Social Security and Medicare)
$210 billion medical care for low-income children and families$
481 billion for National Defense (not counting Iraq and Afgan wars--they have cost $526 billion for combat operations to date) Source: Only World War II was costlier than Iraq war
$145 billion: Global War on Terror (GWOT)
$34 billion: Homeland Security (sic)
$217 billion: interest on National Debt (this is external debt; total interest paid in 2007, according to the U.S. Treasury was $430 billion; please see The Debt to the Penny and Who Holds It
$66 billion on education

Now this total for education is clearly incomplete. That's because billions in other funding end up in universities: DARPA (The Defense Advanced Research Projects Agency) research, National Science Foundation grants, etc. And most education funding is local: state, school board, etc. Add all this up and it is tens of billions beyond $66 billion.

Nonetheless, it is obvious that at the Federal level caring for the elderly and war/defense are much higher priorities than educating the young.

Before you accuse me of wanting to abandon the elderly to the wolves, please read my extensive critique of Medicare waste: Medicare Waste--50%? (January 24, 2007) and then do the math on that handy Social Security Summary you receive every year which lists exactly how much you paid into the system during your working life.

First, adjust each years' contribution for inflation with the CPI calculator, a very easy to use tool courtesy of the U.S. Labor Dept.

Now add interest you could have earned had you saved that money yourself. Be generous and give yourself 8% a year, the long-term average return of the stock market.

Total your contributions and interest in 2008 dollars, and then deduct all the money (also calculated in current dollars) you're scheduled to receive (assuming an average lifespan) in Social Security benefits.

If you are typical, you pulled out all of your inflation-adjusted contributions and all the interest you would have earned on that money in the first few years of (full benefits) retirement. Throw in your employers' contributions and all the money paid into the system by you and your employer(s) is good for around five or six years' benefits. (Results will depend on wages earned, length of working life, etc. Though many workers pass away before they get a dollar of Social Security, their survivors qualify for benefits.)

Everything beyond the paid-in money and accrued interest is "welfare," i.e. a generational transfer of wealth from current taxpayers to the elderly.

I say this as someone who is 12 years away from retiring, and who hopes to get something. But if it was means tested and I got nothing, then I'd reckon I was doing well enough not to need it.
There is no getting around this generational transfer, which was designed when the worker-to-retiree ratio was 15 to 1, not 3 to 1 as is it now.

And that raises the question: should we be subsidizing the elderly, regardless of their accumulated wealth, assets and investment earnings, or should we be devoting more of our resources to building human capital, i.e. educating our young?

As for the war: what could $3 trillion buy us in the way of advanced education to prepare our young to compete in the global marketplace? Or how about $1 trillion on education and $2 trillion on solar panels?

Generational war in the U.S. is as verboten a topic as racism. Nobody wants to question the enormous subsidies being spent on the elderly, or question if these funds should be means-tested or shared with the project of building the nation's human capital via education. But even a cursory review of the sources listed above should make us wonder if we are squandering our national treasure not just on a "war without end for oil we don't need," but on a hopelessly wasteful Medicare system and "welfare for the elderly regardless of their wealth."

The reason it matters is this: if we fail to "build" human capital, then our future prosperity is at grave risk.

As a nation, we would be well-served by assessing these Federal priorities in light of the nation's dependence on human capital for its future wealth.

NOTE: contributions are humbly acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.

Thank you, Charles U. ($10), for your much-appreciated support of this humble site. I am greatly honored by your contributions and readership. All contributors are listed below in acknowledgement of my gratitude.


Wednesday, March 19, 2008

A Generational War We All Lose

As a very astute reader pointed out last year, what we call "healthcare insurance" is not actually insurance. Insurance means pooled risk, as in, three out of every 100 cars will be involved in an accident this year, and we spread the risk out by all having auto insurance. Many of us will go decades without making a claim against our auto policy. The same is true of home insurance and even life insurance: an actuary table enables the company to estimate how many of its insured will die before the policy matures.

But we all get old, ill, and die. That means all of us will pull money out of the Medicare system. That is not insurance; that is a generational transfer of wealth.

Those of you in the medical and healthcare insurance/services worlds know what care costs in the U.S.; those of you with good coverage might not know that a few days in the hospital can cost $20-50,000 or more, and any major procedure can run over $100,000. Toss in some long-term care, years of multiple expensive medications, horrendously expensive tests and the final weeks of life when the medical community is more or less forced to pull out all the stops to keep the patient alive, and you easily get to $1 million dollars per Baby Boomer in the waning years of their lives.

There are about 76 million Baby Boomers--roughly speaking, the generation born between 1946 and 1964. Even assuming a total cost per Boomer of less than $1 million, that adds up to $60 trillion in medical costs. Gee, that's kind of a big number. OK, let's grant that some Boomers will die prematurely or suddenly, and many others will require less than $1 million in government-paid care. But others will cost more than $1 million. Any way you cut it, Boomers did not pay $60 trillion into some magical "fund" which awaits their insanely expensive decline; current taxpayers will have to foot the bill.

How many taxpayers does it take to pay $1 million over 30 years of work? Some high-income taxpayers (less than 10% of the U.S. workforce) might pay $30,000 a year in Federal tax, and therefore pay about $1 million over their careers, but many lower income U.S. workers with mortgage deductions and children pay little or no taxes. These workers might pony up $20-$40,000 a year in lifetime Federal taxes, meaning that 40 -50 taxpayers are needed to pay the $1 million needed for Medicare benefits for one chronically ill Boomer.
Shall we guess that 10 workers on average will need to pay taxes their entire lives just to fund the Medicare bills? Or do you think it might be only five? Well, the worker-to- retiree ratio is falling to 3-to-1 or less, so any way you cut it, there isn't enough taxes being paid to fund Medicare--not to mention the rest of the Federal government.

As the chart above indicates, Medicare alone will suck up the same GDP as the entire non-Social Security/Medicare Federal government. Will your children and grandchildren gladly pay 40-50% tax rates in order to fund your third MRI and your useless stent procedure and your $20K per year in meds?

The bigger question is: should they? My answer: no. As I wrote almost three years ago in Boomers, Prepare to Fall on Your Swords (June 2005):

Now it falls to us to fix the finances of our foolishly bankrupted nation. Either we sacrifice our freebies (every recipient of these programs has extracted far more than they paid in, even including accrued interest) or we leave our children and their children burdened by an impossible debt.

I say we go out with idealistic panache, and fall on our swords with grace and dignity. Instead of sucking off future generations like our parents have, let's pay our own way, tighten our belts, stay healthy without absurdly expensive operations and medications (which don't work that well anyway, in case you've ever read the fine print) and leave the next generations a financially stable nation rather than a bankrupt, self-absorbed "pass the buck to your kids" mess--which is the current state of affairs.

So how do we start? First, admit our entire "healthcare" a.k.a. "sickcare" system is irredeemably broken. I mean the whole thing: the legal part, the care part, the pharmaceutical part, the FDA part, the multiple-forms-paperwork-insurance part, all of it.

You think this is some wild opinion from left field? Apparently the providers have reached the same conclusion, because they're shipping patients to Thailand for affordable procedures:
Outsourcing the Patients More U.S. health insurers are slashing costs by sending policyholders overseas for pricey procedures (BusinessWeek):

"For years, Americans have been traveling abroad to save money on elective procedures or dental work. David Boucher, 49, doesn't fit the usual profile for such medical tourists. An assistant vice-president of health-care services at Blue Cross & Blue Shield of South Carolina, he has ample health benefits.

But Boucher recently chose to have a colonoscopy at Bumrungrad International Hospital in Bangkok, mainly to make a point about the expanding options available to Blue Cross customers. And his company happily picked up the $640 tab—a bargain by U.S. standards.

Blue Cross and other insurers would like to see more policyholders traveling abroad for medical care. Since the start of the year, Boucher has signed alliances with seven overseas hospitals and hopes to add five more by yearend, including them all in coverage for his company's 1.5 million members. As health-care costs continue to rise in the U.S., "medical travel is going to be part of the solution," he says."

In other words: affordable care is simply not available here yet--that will take turning off the endless spigots of money (i.e. Medicare and other "insurance"). When bills are paid in cash and "insurance" is a dead/abandoned system, then affordable care will magically appear--if not in the U.S. (which will then lose all those millions of jobs) then in Mexico, Thailand and India.

This is capitalism at work, folks. When a bloated, inefficient bureaucracy finally grows to unaffordable heights, it is toppled and replaced by a much leaner system. As Fernand Braudel and other historians have shown, this process of obtaining cheaper goods and services from overseas has been underway for hundreds if not thousands of years. Those who do the replacing reap immense profits. Here is BusinessWeek again:

"After all, a heart procedure that costs $100,000 in the U.S. runs only $10,000 to $20,000 at some of the best private hospitals in Asia. And the quality of care? Foreign hospitals in such arrangements are typically approved by Joint Commission International, part of the same nonprofit organization that accredits American hospitals."

Two factors which don't make it onto charts of future Medicare costs are: the costs of borrowing trillions from oil exporters, China and Japan will be rising for decades to come, and the U.S. economy will be shrinking for years. The interest on the national debt is already an immense burden, and it will be increasing just as tax revenues are shrinking. As for Federal deficits: you ain't seen nuthin' yet.

So far, we've been cruising down East Street via borrowing trillions from our friendly allies the Gulf Oil States, China's central bank, Japan, et. al. As their economies slip into recession and their big surpluses vanish like summer rain in Death Valley, they will be unable/unwilling to pony up the $50 trillion we need over the next 20 years.

Here is my affordable solution to Medicare's obviously unaffordable future: Every taxpayer (and no, that doesn't mean recent citizen's parents--it means people who have paid taxes for 30+ years and their spouses) gets a lifetime account of $50,000. That is still a lot of tax money but it's certainly more affordable than $1 million.

If you want a heart procedure done in the U.S., then Medicare pays $50,000 and you pay the $50,000 balance in cash. That's it; the government's done with its obligations to your care after the age of 65. From now on, it's on you and your family.

Alternatively, you fly to India or Thailand and get the deal done for $10K plus $2K for airfare, and you have $38,000 remaining in your Medicare account. (Of course this number must be adjusted for inflation.)

Or, you may want to try to solve your heart condition with the Dean Ornish diet and some exercise, and save the $12,000 for later.

As millions of Americans flock overseas for procedures, new kidneys, MRIs (same machines, same tests, at 5% of the cost in the U.S.--I know this for fact in China), than suddenly competition sprouts up around the world. Look, if you can't afford the procedure here, or you can't wait for an organ here, then would you go elsewhere for the organ? Yes, there are risks--when did Americans get the idea that risks could be evaporated, or that we can sue somebody if it doesn't work out?

If you want all those legal protections, then by all means, have the operation done here and pay the fees in cash. That's always an option.

I predict that a global free-for-all for U.S. healthcare dollars will encourage price cuts in U.S. care which would be considered impossible. Longtime correspondent Jum Twamley is on record here supporting the idea of "cash and carry" medical care at drive-in clinics provided by Wal-Mart and other consumer-oriented corporations: A Partial Answer to National Health Care (November 11, 2006)

Is this "the answer" a near-sighted populace wants to hear? Of course not. But as $7 trillion in real estate wealth vanishes into thin air, and trillions in stocks, bonds and other "financial insruments" slip from our fingers, what is "affordable" is about to undergo a radical re-assessment. And once we face there is no more free money from overseas lenders, then we will have to finally face the truth of our national bankruptcy, and deal from that reality instead of wishful thinking.

You might be interested in these entries in the archives:
Medicare Waste--50%? (January 24, 2007)
Financial Worry, Health, and the Reverse Wealth Effect As Housing Pops (December 12, 2007)

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Tuesday, March 18, 2008

The Housing Bubble - Infrastructure Connection

Longtime correspondent UKC recently offered some disturbing speculations about the consequences of the housing bubble bursting and the decline of the U.S. infrastructure:

Just some thoughts on how the decline in the municipal tax base due to the housing crisis might play out. My feeling is that the general consensus (amongst those who think about such things at all) is that the various governmental organizations will cut back but most of the really essential stuff will be maintained. What if political considerations cause the municipalities to make unwise decisions which have serious long term consequences?

Governmental organizations are not known for their long sightedness, and may well choose to cut based along fault lines in their own internal power structures rather than providing essential services. For example, they may decide to decimate the road repair budget in order to avoid an expensive battle with the unions in other areas. What effect could this have? Well, it might balance the books in the short term - but it might have serious knock on effects. I would submit the article below (from the kunstler site) in which the corresponent from South Africa blames poor upkeep on the roads for the power companies recent inability to keep the lights on.


If this sort of infrastructure degradation appears, it could be very hard (for free enterprise or public) to provide many of the fundamental services we expect (water, electricity, gas, sewage, fuel and food distribution etc). Personally I have do not have too much faith in the governments ability to do the necessary but unpopular things. It's something to think about.

On a related topic, the recent failures in the Municpal Auction bond market are very serious stuff. Seems the munis are finding it very hard to sell new paper or roll over the old debt. This does not bode well for the future - I suspect very, very soon municipalities will only able to spend what they can raise from taxes because nobody will lend them any money. This will be true for corporations and people as well. Credit will dry up and the velocity of money in the system will decline dramatically.

Remember our many conversations about exurbs falling apart? Here's an interesting article regarding the decline of an exurb and also the popularity of walkable urban centers. Who'da thunk it.

The Next Slum? (

As always, I do enjoy your writing - read the site every day."

Thank you, UKC, for yet another thought-provoking set of ideas.

Thanks to longtime correspondent J.F.B., we have an up-to-date story on the muni meltdown:

Auction-Bond Failures Deplete New Hampshire Fund

The $330 billion market for auction-rate securities imploded in February after dealers who supported it for more than two decades stopped bidding for bonds investors didn't want, pushing interest costs to as high as 20 percent. Since then, almost 70 percent of the auctions for debt sold by cities, colleges, student lenders and closed-end funds have failed each week, according to data compiled by Bloomberg."

If Municipal bonds become difficult to sell, or require hefty premiums, that will have an enormous impact on local governments' ability to pay for infrastructure repairs. Here in California, most of the infrastructure work is paid for by bonds: school repair, park expansions, etc. Road upkeep is supposed to be paid out of gasoline tax revenue but these funds have (until new laws were passed) been diverted to other "needs."

UKC aludes to a battle I have long predicted: the one between stretched/angry taxpayers and the public unions whose generous pension and benefits are already breaking municipal budgets:
Boomers, Prepare to Fall on Your Swords (June 2005)
"Retirement": The New American Elite? (June 2005)
The Chickens Are Coming Home to Roost (February 6, 2006)

In a nutshell: Federal entitlements (Medicare and Social Security) are set to balloon to 22% of GDP as Baby Boomers retire en masse. This is roughly the same share as the entire current Federal budget consumes. That implies the Federal Government will need to suck out 40% of the GDP if these benefits are to be paid.

Given that state and local taxes eat up another 10-15%, then that would mean Americans would have to accept Swedish-style tax rates of 50% or more. That seems unlikely. And at least the Swedes have universal healthcare and free higher education--two huge benefits which aren't even in the U.S. entitlement picture.

I then posited a "class war" between the approximately 30 million government and related agencies (school districts, municipal water districts, transit agencies, etc.) retirees/employees and the 100 million taxpayers who are largely dependent on private retirement funds (401K and IRAs). The taxpayers are facing huge tax increases to fund extremely rich (compared to a meagre IRA-and-Social Security retirement) pensions and healthcare benefits for public employees.

Public pensions often outstrip the wages paid to the employees; in many cases, military and other government pensioners have worked a second career and are now "double-dippers" at the public trough--there are even "triple-dippers" pulling in three pensions.

As the financial meltdown destroys stocks and bonds, the pension funds which are supposed to fund these rich retirements will be decimated. This is how the war will begin: the public employees will demand the taxpayers foot the bill, as "we were promised these benefits."
Well, guess what--employees of Enron were "promised" this and that, too--but when your employer goes belly up, all the promises go by the wayside.

The political battles UKC alludes to are entirely predictable: as public unions hold huge sway over politicians, the politicians will naturally strip their budgets to placate the unions. As I have covered here before, the rising costs of municipal healthcare and pension benefits are already pushing municipal and agency budgets into the red:

What's Different Now (July 12, 2007)

In 2005, $15 million of Berkeley’s $115 million general fund will pay for contributions to the California Public Employees System (PERS). Last year, the city spent $8 million on retirement benefits. The year before, when the state Legislature passed the bill that allowed Berkeley to improve the pension benefits, the city spent only $2.8 million."

City employees retire with 84% of their highest salary--about $85,000 (plus generous benefits) for higher ranks of police and fire department employees.
How many private-sector retirees are pulling down over $100,000 a year in pension and healthcare benefits? Very very few. Yet it is the private-sector taxpayers whose "benefits"--in the form of serviceable streets, open libraries, etc., which will be stripped in order to fund the promised pensions.

It doesn't take much of a crystal ball to see the budget crisis facing suburban cities which depend on a growing housing market for revenues.

According to the The Atlantic article cited above:
Nelson forecasts a likely surplus of 22 million large-lot homes (houses built on a sixth of an acre or more) by 2025—that’s roughly 40 percent of the large-lot homes in existence today. 22 million empty McMansions aren't going to generate much tax revenue."

The near-bankruptcy of Vallejo, Calif. offers a snapshot of the future: California Suburb Vallejo Faces Bankruptcy.

The play will unfold in predictable fashion: the municipal unions and city leaders will hash out some modest cuts and announce "problem solved," and then a few months later the city will announce--surprise--revenues have declined even more than expected. Another round of negotiations begins, only this time the unions are not so generous: they demand cuts in basic services and current staffing to pay for pensions and retiree benefits.

The city either caves in and closes fire stations and libraries and cuts staff in every department, eliciting howls of protest from disgruntled citizens, or it declares bankruptcy. The union lawyers jump into the bankruptcy fray, claiming the city is going BK just to evade its "responsibilities." (Never mind the taxpayers--they are mere sheep being led to the slaughter.)

Beneath all the political wrangling the fact remains that the city cannot afford the pensions which were promised at the height of the dot-com boom.

As wage earners become unemployed, tax revenues will continue to decline, and the vise will only tighten around city, county and agency budgets. Any politician who publicly demands the pension and benefit packages be re-neotiated in light of reality will face unions willing to spend their last dime to defeat such backsliding. The distracted, harried taxpayer/citizen will not contribute to the candidate who might actually seek a truly affordable budget, and so the "compromisers" will win--those with union backing who will hope to trim here and there but retain the pensions and benefits promises which are crushing the city budget in a vice of rising retirement costs and shrinking revenues.

This will go on until someone forces the city into bankruptcy. Then the issues will be hashed out in court, and the citizenry can only hope the judge will show more long-term wisdom than the leaders they elected.

And if the municipal bond market dries up, then cities will not be able to fund infrastruture repairs by selling bonds--which by the way, costs the taxpayers double or triple when interest and other costs are included.

Will the bankruptcy judge look at the potholed streets and decrepit public works before deciding how to handle the pension and benefits of city retirees? Will the judge be aware the municipal bond spigot has been turned off? The citizenry might well prepare themselves to let him/her know, because in the fight over the remaining public revenue stream, no one else will be interested in anything but their share of the crumbling, shrinking pie.

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Thank you, John R.B. ($20), for your unexpectedly generous support of this humble site. I am greatly honored by your contributions and readership. All contributors are listed below in acknowledgement of my gratitude.


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