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In February 2009, as the Obama administration pushed a $787 billion deficit-spending economic stimulus plan through Congress, the American public was largely unaware that the true deficit of the federal government was already measured in trillions of dollars.
Moreover, total U.S. obligations, including Social Security and Medicare benefits to be paid in the future, have effectively placed the U.S. government in bankruptcy, even before we take into consideration the future and continuing social-welfare obligations embedded within the Obama administration's massive new spending plan. According to the U.S. Treasury, the total obligations of the United States in 2007 exceeded a negative $59 trillion, a sum that was more than the 2007 gross domestic product, or GDP, of the world, which the World Bank estimated to be $54 trillion. By 2008, the total obligations of the U.S. had grown to over $65 trillion, with no end in sight.
There is no way the federal government could ever meet the future obligations of the massive social-welfare state we have created since Franklin Roosevelt signed the Social Security Act, even if we confiscated all salaries and corporate earnings of individuals and corporations in the United States as an emergency form of taxation. The United States today is bankrupt, whether or not the government wants to admit it, and whether or not the public is aware of how extreme the situation has become.
Understanding that the United States is bankrupt is fundamental to understanding the true dimensions of the Economic Panic of 2009. Had the United States been running federal budget surpluses on a cash basis, the nation would still be bankrupt. Why? The answer is that future liabilities in federal social-welfare-entitlement programs have grown beyond the ability of the federal government to raise by taxes enough money to pay what is already due to the baby boomers as they retire.
This reality severely limits the ability of the federal government to manage a financial crisis like what we have faced since the mortgage bubble burst. It is necessary to appreciate fully just how bankrupt the federal government truly is: Mortgage losses as well as losses in a variety of consumer credits plus losses in commercial loans and commercial real estate already total trillions of dollars. We are certain to have more losses in complicated investments including hedge funds and derivatives, regardless of how smart the federal government officials at the U.S. Treasury and the Federal Reserve appear to be or how clever Wall Street experts seem. Ultimately, financial bubbles have no alternative but to burst.
The real 2008 federal budget deficit was $5.1 trillion, not the $455 billion previously reported by the Congressional Budget Office, according to the 2008 Financial Report of the United States Government released by the U.S. Department of the Treasury.
The difference between the $455 billion "official" budget deficit number and the $5.1 trillion deficit based on data reported in the 2008 report is due to the fact that the official budget deficit is calculated on a cash basis, where all tax receipts, including Social Security tax receipts, are used to pay government liabilities as they occur. The calculations in the 2008 report are calculated on a GAAP basis ("Generally Accepted Accounting Principles"), which includes year-for-year changes in the net present value of unfunded liabilities in social-insurance programs such as Social Security and Medicare. Under cash accounting, money is spent as it comes in, while the government makes no provision for future Social Security and Medicare benefits in the year in which those benefits accrue.
"As bad as 2008 was, the $455 billion budget deficit on a cash basis and the $5.1 trillion federal budget deficit on a GAAP accounting basis does not reflect any significant money from the financial bailout or Troubled Asset Relief Program, or TARP, which was approved after the close of the fiscal year," John Williams, an economist who publishes the website Shadow Government Statistics, told World Net Daily.
"For 2009, the Congressional Budget Office estimated the fiscal year 2009 budget deficit as being $1.2 trillion on a cash basis and that was before taking into consideration the full costs of the war in Iraq and Afghanistan, before the cost of the Obama $787 billion economic stimulus plan, or the cost of the second $350 billion tranche in TARP funds, as well as all current bailouts being contemplated by the U.S. Treasury and Federal Reserve," he stressed.
"The federal government's deficit is hemorrhaging at a pace which threatens the viability of the financial system," Williams added. "The popularly reported 2009 budget deficit will clearly exceed $2 trillion on a cash basis and that full amount has to be funded by Treasury borrowing. It's not likely this will happen without the Federal Reserve acting as lender of last resort for the Treasury by buying Treasury debt and monetizing the debt."
"Monetizing the debt" is a term used to signify that the U.S. Treasury will ultimately be required simply to issue huge amounts of new debt to meet current Treasury debt obligations. We have monetized the debt when we are forced to issue debt both to cover current budget deficits and to pay interest on outstanding federal debt. So far, the Treasury has been largely dependent upon foreign buyers, principally China and Japan and other major holders of U.S.-dollar foreign-exchange reserves, including Middle Eastern oil-producing nations purchasing U.S. debt through their financial agents in London. "The appetite of foreign buyers to purchase continued trillions of U.S. debt has become more questionable as the world has witnessed the rapid deterioration of the U.S. fiscal condition in the current financial crisis," Williams noted.
The sad reality is that the U.S. Treasury has not reserved any funds to cover the future Social Security and Medicare obligations we are incurring today. "Truthfully," Williams pointed out, "there is no Social Security 'lock-box.' There are no funds held in reserve today for Social Security and Medicare obligations that are earned each year. It's only a matter of time until the public realizes that the government is truly bankrupt. No taxes are being held in reserve to pay in the future the Social Security and Medicare benefits taxpayers are earning today."
If President Obama manages to add universal health care to the list of entitlement payments the federal government is obligated to pay, the negative net worth of the United States government can only get worse.
Calculations from the 2008 Financial Report of the United States Government, as displayed in the chart below, show that the GAAP negative net worth of the federal government has increased to $59.3 trillion while the total federal obligations under GAAP accounting now total $65.5 trillion.
"Put simply, there is no way the government can possibly pay for the level of social welfare benefits the federal government has promised unless the government simply prints cash and debases the currency, which the government will increasingly be doing this year," Williams said, explaining in more detail why he feels the government is now in the process of monetizing the federal debt.
"Social Security and Medicare must be shown as liabilities on the federal balance sheet in the year they accrue according to GAAP accounting," he argued. "To do otherwise is irresponsible, nothing more than an attempt to hide the painful truth from the American public. The public has a right to know just how bad off the federal government budget deficit situation really is, especially since the situation is rapidly spinning out of control."
Williams makes a compelling case that in a post-Enron world, if the federal government were a private corporation, "the president and senior Treasury officers would be at risk of being thrown into a federal penitentiary."
On March 12, 2008, David M. Walker resigned as comptroller general of the United States and head of the Government Accountability Office, or GAO, out of concern that as head of the GAO, he could no longer certify the financial soundness of the U.S. government under the GAAP accounting analysis of the federal budget conducted annually by the U.S. Treasury. As the CBS television show 60 Minutes noted, even before he resigned Walker had begun "traveling the country like an Old Testament prophet, urging people to wake up before it is too late." Walker was highly regarded as a respected public official while head of the GAO, charged with managing its more than three thousand employees. The GAO serves as auditor of the government's books, as an investigative office of the U.S. Congress.
"I would argue that the most serious threat to the United States is not someone hiding in a cave in Afghanistan or Pakistan, but our own fiscal irresponsibility," Walker, once the nation's top accountant, told 60 Minutes, in an obvious reference to Al Qaeda terrorist leader Osama bin Laden.
"We are spending more money than we make," Walker told a group on his "Wake-Up Tour" throughout America. "We are charging it to a credit card," he said, warning that by 2040, U.S. tax dollars would not be able to keep up even with just the interest payments on our national debt. No federal funds would be left for any other programs, including national defense or homeland security. "We suffer from a fiscal cancer that is growing within us and if we do not treat it, the cancer will have massive consequences for our country," he said.
Walker's concern is that the massive entitlement programs the federal government has created over the past few decades will go bankrupt as the baby boom generation retires. "The first baby boomer will reach 62 and be eligible for benefits under Social Security on January 1, 2008," Walker pointed out. "They will be eligible for Medicare just three years later. When those boomers start retiring en masse, we will face a tsunami of spending that could swamp our ship of state if we don't get serious." Walker warned that the real coming problem was the health-care problem, which he viewed as five times more serious than the problem with Social Security, largely because modern medicine allows people to live longer and the cost of medical treatments continues to escalate.
In testimony before Congress in 2007, Federal Reserve Chairman Ben Bernanke specifically endorsed the warnings that Walker was then issuing from the GAO. "Unfortunately, economic growth alone is unlikely to solve the nation's impending fiscal problems," Bernanke testified, rejecting the proposition that future rates of U.S. economic growth would be sufficient to provide adequate tax revenue to handle federal debt comfortably. Bernanke envisioned a scenario where U.S. debt could approach 100 percent of gross domestic product, the ratio the United States experienced in World War II. Alan Greenspan dismissed the World War II comparison, noting that people "at that time understood the situation to be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact they did." Today is different, Greenspan argued. In 2007, before the economic downturn and the new trillions in then-unanticipated deficit spending caused by the TARP and Obama economic stimulus programs, Bernanke projected the debt-to-GDP ratio could reach 100 percent by 2030. "Ultimately, this expansion of debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts or tax increases, or both," Bernanke warned Congress.
Bernanke saw the crisis as one that would continue beyond the retirement of the baby boomers. "Rather, if the U.S. fertility rate remains close to current levels and life expectancies continue to rise, as demographers generally expect, the U.S. population will continue to grow older, even after the baby-boom generation has passed from the scene," he told Congress in 2007. "If current law is maintained, that aging of the U.S. population will lead to sustained increases in federal entitlement spending on programs that benefit older Americans, such as Social Security and Medicare." Bernanke agreed with Walker. Both saw the United States headed toward a crisis of irreversible budget deficits and future obligations under federal entitlement programs that would create a level of federal debt that anticipated U.S. economic growth would not be able to sustain.
Almost certainly, 2009 will be the largest cash-basis federal deficit ever reported in the history of the United States. According to the minutes of the U.S. Treasury's Borrowing Advisory Committee, or TBAC, a key advisory committee to the Treasury Department, Acting Assistant Secretary of the Treasury for Financial Markets Karthik Ramanathan affirmed estimates for Treasury borrowing needs range as high as $2.5 trillion for fiscal year 2009. The TBAC's formal report warned that federal borrowing in fiscal year 2010 could reach levels as high as $4 trillion.
While conservatives faulted the Bush administration for running large deficits and increasing the national debt, the magnitude of the national deficit problems under the Bush administration was small compared to the Obama administration. The Bush administration added more than $4 trillion to the national debt, increasing the national debt more than 70 percent from the time George W. Bush took office on January 20, 2001. With federal budget deficits projected to run into the trillions of dollars, the Obama administration appears willing to increase the current $10 trillion U.S. national debt by 65 percent in just two years. If the Obama administration increases the national debt by 65 percent every two years, our national debt will be $16.5 trillion in 2010 and $27.225 trillion by 2012, the year of the next presidential election.
The U.S. national debt, which was at approximately 40 percent of U.S. gross domestic product at the end of 2008, is now expected to be at 60 percent by 2010 as a result of the economic slowdown, the TARP, other bailout programs, the $787 billion deficit-funded Obama administration economic stimulus program, and the proposed Obama administration $3.6 trillion federal budget for 2009. If the national debt does grow this fast, the national debt could exceed 100 percent of U.S. gross domestic product sometime before 2012, an uncomfortable phenomenon that has not happened since the World War II era, when the national debt reached 122 percent of GDP in 1946.
To answer the question of how big a problem borrowing $6.5 trillion will be over the next two years, we need to examine just how large a trillion actually is.
One trillion is the number 1 followed by twelve zeroes, as in: 1,000,000,000,000.
- If you had gone into business on the day Jesus was born, and your business lost a million dollars a day, day in and day out, 365 days a year, it would take you until October 2737 to lose $1 trillion.
- If you spent $1 million a day, every day since Jesus was born, you would still be only slightly more than three-quarters of the way to spending $1 trillion.
- One trillion dollars divided by 300 million Americans comes out to $3,333 per person.
- One trillion one-dollar bills stacked one on top of the other would reach nearly 68,000 miles into the sky, about a third of the way from the earth to the moon.
- Earth's home galaxy, the Milky Way, is estimated to contain about 200 billion stars; so, if each star cost one dollar, $1 trillion would buy five Milky Way galaxies full of stars.
- One trillion seconds of ordinary clock time equals 31,546 years. So, spending money at the rate of one dollar every second, or $86,400 every day, a spending spree would still take nearly 32,000 years to reach $1 trillion.
- If someone were to build city blocks that contained ten homes valued at $100,000 per home, you would end up with ten houses to a block, ten blocks to a mile, and a hundred blocks per square mile. It would take 10,000 square miles to reach $1 trillion in value. This would be more than six of our states: Vermont, 9,615 square miles; New Hampshire, 9,351 square miles; New Jersey, 8,722 square miles; Connecticut, 5,544 square miles; Delaware, 1,954 square miles; and Rhode Island, 1,545 square miles.
With the estimated 2009 population of the United States at 305,556,415 people, each citizen's share of the national debt is $34,769.40. Craig Smith, founder and CEO of Swiss America Trading Corporation, has estimated it would take approximately four generations of Americans to pay off the interest of the U.S. Treasury bonds sold as debt to create $1 trillion, factoring in a 3 percent growth rate in the economy.
As noted above, the U.S. national debt now exceeds $10 trillion and was estimated at $10,624,012,813,982.43, on January 30, 2009, at 6:44:38 p.m., according to the U.S. National Debt Clock, at Times Square in New York City. In September 2008, the digital display on the Times Square debt clock was modified to eliminate the dollar sign, so the national debt in tens of trillions of dollars could be displayed. The clock, which was created in 1989 by Manhattan real estate developer Seymour Durst, is now being redesigned so the new clock can display the national debt in numbers measured in the hundreds of trillions, with a dollar sign that could be eliminated should the national debt ever reach $1 quadrillion.
As pointed out previously, a difference of scale is a difference of phenomenon. The U.S. Treasury has never had to finance a U.S. debt that exceeded $1 trillion on a cash basis. Treasury debts measured in the hundreds of billions have proved manageable up until now. Will financing trillions of dollars in debt be the same phenomenon? Most likely, the answer is no.
In the Economic Panic of 2009, we have raced past the point where U.S. Treasury debt financing can be considered "business as usual." If the Treasury is projecting a need to raise $4 trillion in debt financing to sustain the federal deficit on a cash basis in 2010, will a debt of that magnitude be sustainable, or will the dollar simply collapse? If the federal deficit on a cash basis in 2010 is $4 trillion, the GAAP-accounted federal deficit will jump even more tens of trillions of dollars. Deficits of this magnitude have never been managed by any government on earth in human history.
Selling a trillion dollars in debt is not like selling hundreds of billions of dollars in debt, just more. Psychologically, a threshold is crossed when the Treasury goes into the world market to sell $1 trillion in debt. Foreign governments suddenly begin to ask if the United States is bankrupt. This translates into a concern that the unthinkable might become thinkable, possibly even today. If U.S. federal budget deficits continue to spiral out of control, is it possible the U.S. government might default not only on future Medicare, Medicaid, and Social Security obligations, but also on trillions of dollars of debt sold by the U.S. Treasury? Or, will the U.S. government continue to meet debt obligations but only with seriously devalued dollars?
Yu Yongding, a former adviser to the Chinese central bank, the People's Bank of China, expressed concerns to journalists in September 2008 that China was growing increasingly cautious about purchasing more U.S. Treasury debt.16 In March 2009, Chinese premier Wen Jiabao lent his voice to warning the United States that China's appetite to buy Treasury debt was not unlimited. "We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets," Wen Jiabao said at a press conference in Beijing. "Frankly speaking, I do have some worries."17 The Chinese premier called on the United States to honor its words, remain a credible nation, and ensure the safety of Chinese assets.
By the end of 2008, China had amassed nearly $2 trillion in foreign-exchange reserves, the largest amount held by any nation, largely because of its strong exports to the United States and the resulting negative balance of trade, which the United States has allowed to grow to unprecedented levels with China. Approximately 80 percent of Chinese foreign-exchange reserves have been held in U.S. assets, including Treasury bills and other U.S. debt obligations, such as bonds issued by U.S. mortgage giants Freddie Mac and Fannie Mae. At the end of 2008, China held $696 billion of U.S. government securities, having surpassed Japan as the largest purchaser of U.S. Treasury debt.
In 2009 and 2010, the Obama administration will need to almost double the amount of Treasury bills held in Asia. Should concerns about the solvency of the United States continue to mount, will holders of U.S. Treasury bills begin dumping them on the open market? "We are in the same boat, we must cooperate," Yu told Bloomberg. "If there's no selling in a panicked way, then China willingly can continue to provide our financial support by continuing to hold U.S. assets." Clearly, China was giving warning signs, suggesting a likelihood China would begin diversifying its foreign-exchange reserve assets away from U.S. government debt.
U.S. bondholders face the risk that the value of their bonds on the current market could easily deteriorate, causing the foreign holders of U.S. debt to lose money on their U.S. debt portfolio. For example, the Telegraph in London pointed out that if China's holdings match the U.S. Treasury's average forty-eight-month duration, then a 5 percent rise in yields, from 1.72 percent on the five-year note to 6.72 percent, would cost China 17.5 percent of its holdings' value, or $119 billion. Foreign buyers have typically absorbed only about $200 billion of Treasury debt annually, little help when the Treasury is planning to issue as much as $2.5 trillion of new debt in 2009 and $4 trillion in 2010.
In February 2009, Yu Yongding demanded U.S. government guarantees on various U.S. Treasury debt securities, including Treasury bills. On its face, Yu's request appears to ask for a redundant guarantee, since U.S. Treasury bills are by design backed by the full weight and force of the U.S. government. The request for an additional specific U.S. government guarantee only underscored China's increasing uneasiness with continuing to buy burgeoning levels of U.S. federal debt. China's concerns came as China was struggling to finance its own $600 billion bailout for Chinese financial institutions and corporations fighting for survival in the global economic downturn. In January 2009, China's exports dropped 17.5 percent, while imports collapsed 43.1 percent. China's economy, heavily dependent on making cheap goods for the U.S. market, was cast into its own deep recession by the U.S. economic downturn.
In February 2009, Luo Ping, a director-general at the China Banking Regulatory Commission, told reporters after a speech in New York that China would continue to buy U.S. Treasuries in spite of its concerns about U.S. finances. Speaking at the Global Association of Risk Professionals 10th Annual Risk Management Convention, he asked, "Except for U.S. Treasuries, what can you hold?" He answered his own question, suggesting gold may be the only alternative. "Gold?" he asked rhetorically. "You don't hold Japanese government bonds or U.K. bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option." Still, Luo was not enthusiastic. "We hate you guys," he added. "Once you start issuing $1 trillion $2 trillion...we know the dollar is going to depreciate, so we hate you guys. But there is nothing much we can do."
If the dollar depreciates in value as a consequence of massive borrowing in 2009 and 2010, all holders of U.S. Treasury securities, including China, will take a loss in the value of their asset holdings. Dollar devaluation, whether officially declared or not, affects the buying power not only of U.S. citizens but of all foreign nations that hold U.S. debt securities. China has been steadily reducing the percentage of its foreign-exchange currency assets held in dollars, down from a 2003 high, when it was 83 percent. Should China decide to reduce those holdings to 65 percent or lower, the U.S. Treasury would have a much more difficult time subsidizing massive U.S. budget deficits.
Unwittingly, we have empowered China to inflict massive damage on the United States without firing a shot. All China would have to do is sell U.S. Treasury bonds on foreign exchanges at a deep discount. While China might lose billions of dollars in the process, the cost could be seen as cheap, especially if the result were to inflict permanent economic damage on an archrival that was once the world's sole superpower. Truly, China would be making wiser investments to stop buying U.S. Treasuries altogether, resolving instead to use its $2 trillion in foreignexchange reserves to buy gold, land in the United States, and oil and natural gas reserves around the world.
Early in 2008, Bernard Connolly, a global strategist at Banque AIG in London, became concerned that the failures in the U.S. banking sector could set off another great depression. As a step to prevent this from happening, he recommended the U.S. government and Federal Reserve take the unprecedented step of buying a wide range of assets, including stocks and Treasury securities. Changes in federal law would be required to allow the Federal Reserve to purchase stocks, say on the New York Stock Exchange or NASDAQ, but currently the Fed is authorized to purchase Treasury securities and debt issued by U.S. agencies, including the Government-Sponsored Enterprises, or GSEs, Freddie Mac and Fannie Mae. By purchasing U.S. debt securities, the Fed would be hoping to create enough U.S. government demand for U.S. government debt that the yield, the price the government has to pay to get purchasers to buy the bonds, would actually go down, making the debt cheaper for the U.S. Treasury to finance.
By the end of 2008, Federal Reserve Chairman Bernanke and the Federal Reserve were taking the idea seriously. In a speech to the Chamber of Commerce in Austin, Texas, on December 1, 2008, Bernanke noted the Fed could purchase longer-term Treasury or U.S. agency securities on the open market in substantial quantities. "This approach might influence the yields on these securities, thus helping to spur aggregate demand," Bernanke said. "Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates."
Yet the idea that the U.S. government would become a major buyer of U.S. debt was risky, especially at a time when the federal debt was increasing so dramatically. After all, if yields on Treasuries go up because the U.S. Treasury is entering the market to borrow trillions of dollars of debt, the Fed could take substantial losses on Treasury securities previously purchased. Also, if the Fed bought mortgage-backed securities (MBSs) at or near the original offering price, the Fed could take substantial losses when the MBSs which contained losses were marked to market. The resale value of Fed-purchased MBSs would likely reflect a lower current market value, especially if the Fed were motivated to buy the MBSs from the balance sheets of financial institutions to relieve them of their toxic assets. Marked to market, most MBS securities today would have to have prices lower than their initial-issue prices, reflecting the subprime or other mortgage losses experienced since the mortgages were bundled together to create the MBS issues in the first place.
Federal budget deficits counted in trillions of dollars are staggering, until we realize that a nearly $1 quadrillion bubble is still building in derivatives.
The Bank of International Settlements (BIS), in Basel, Switzerland, now estimates that derivatives, the complex bets financial institutions and sophisticated institutional investors make with one another on everything from commodities options to credit swaps, now top $680 trillion worldwide that's $0.68 quadrillion.
- A quadrillion is the number 1 followed by 15 zeroes, as in: 1,000,000,000,000,000.
- To visualize a quadrillion, you need to multiply one trillion by one thousand.
The hedge-fund and derivatives markets are so highly complex and technical that they are little understood, even by many top economists and investment-banking professionals. Moreover, both markets are almost totally unregulated, either by the U.S. government or by any other government worldwide.
While the hedge-fund market is small in comparison to derivatives, hedge funds in the United States are still a $1.5 trillion industry. Hedge funds and derivatives share a common characteristic in that both were initially set up by professional investment advisers to assist them in managing the risk contained in institutional investment portfolios, including mutual-fund assets or pension funds that typically involved hundreds of millions of dollars.
Hedge funds were set up originally to assist professional money managers of corporate portfolios, including bank and investment-company assets, and mutual funds in increasing their yield, by making esoteric investments in various interest-rate or other instruments that would theoretically increase in value even when stock prices went down. A popular hedge-fund concept is the "fund of funds," in which an investor's cash is used to buy fractional shares in a pool that owns many mutual funds. The original idea of a hedge fund was to diversify a large, typically institutional investment to reduce risk. The concept of diversifying an investment generally works, unless, as today, the entire market is down. In down markets there are too few upvalue stocks or funds in any "fund of funds" to balance out the losses that must inevitably be taken.
One of the original ideas behind derivatives was the realization that professional money managers, including those in banks, investment companies, and hedge funds, needed to make bets to offset the possibility of taking losses. To make this clearer, let's consider an investment manager of a multimillion-dollar bond fund who is worried about how interest-rate changes will affect the value of the bonds in the portfolio. A popular form of derivative contract was developed to permit one money manager to "swap" a stream of variable-interest payments with another money manager for a stream of fixed-interest payments. The idea was to use derivative bets on interest rates to "hedge" or balance off the risks taken on interest-rate investments owned in the underlying portfolio. In other words, let's say an institutional investment manager held $100 million in fixed-rate bonds. To hedge the risk, should interest rates rise or fall in a manner different than the institutional investment manager had projected, a purchase of a $100 million variable-interest-rate derivative could be constructed to cover the risk. Whichever way interest rates went, one side to the swap might win and the other might lose. The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.
Another dangerous form of derivatives involved credit-default swaps, or CDSs. Here Bank A, the swap seller, purchased protection on a portfolio of loans or bonds, insuring the loans or bonds in case of default. The swap seller, Bank B, acted much like an insurance company selling protection, in effect agreeing to take a premium amount for promising to make good the loan or bond principal should the loans or bonds default. Bank A had limited risk, in that the premium paid to Bank B would be lost if the loans or bonds did not default. Bank B, however, had a much higher potential for loss, should the loans or bonds default and Bank B were required to make good the principal amount of loans or bonds that defaulted.
That Bank A could buy a CDS derivative encouraged Bank A to be more aggressive in making loans or buying bond portfolios. Bank B had a good business, collecting premiums to insure against loss, as long as the loans or bonds that were being insured continued to perform as expected. In a down economy, Bank B might be wiped out, should the derivative losses exceed Bank B's capital. Billions of dollars in credit-default-swap losses were a major factor in the losses that caused insurance giant AIG to fail, as loans and bond portfolios that AIG ended up insuring went into default as the mortgage bubble burst and the credit crisis deepened in late 2008. As the mortgage bubble burst, trillions of dollars in mortgage-related CDS derivatives also defaulted.
In the strong stock and mortgage markets we experienced beginning in the historically low 1 percent interest-rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the nearly $700 trillion of derivatives floating around the world today. Bloomberg reported that the number of hedge funds tripled in the last decade to a record of 10,233 at the end of June 2008, according to the Chicago-based Hedge Fund Research, Inc. Even more frightening, Bloomberg reported that up to one-third of these hedge funds could be "wiped out" in the economic downturn that began in December 2008. The BIS makes no estimate how much of the $684 trillion in outstanding derivative contracts are today vulnerable to collapse.
Deepcaster.com, a financial newsletter that tracks derivatives, explains there are many types of derivatives, but the most common involve stock options, commodities, and financial futures options. In a commodity option, for instance, the value of the future contract is dependent on, or derived from, the underlying price of the commodity in question. The value of a corn-futures contract depends on the current price of corn, just as the value of a silver-futures contract depends on the current price of silver. The problem internationally derives from the more complex kinds of derivatives we have just examined.
Most derivatives are traded over the counter in largely unregulated markets outside the stock exchanges and clearinghouses. Financial professionals consider derivatives to be "dark liquidity," with billions of dollars changing hands privately, largely between financial institutions, without any public record in regulated entities such as stock exchanges, where transactions are subject to public and regulatory scrutiny.
If you still don't fully understand derivatives, you're not alone. As noted at the start of this discussion, very few financial professionals have a clear understanding of how derivatives work or the trillions of dollars in risk the contracts contain. The problem is that as the mortgage bubble grew in the United States, the derivatives bubble has grown dramatically worldwide.
Most banks and brokerage firms in the United States and abroad have invested heavily in derivatives. With the current turmoil in global financial markets, trillions in derivative losses are being realized by financial institutions that are doing everything possible to keep the losses hidden from the public. A good example is Merrill Lynch, a major U.S. investment and brokerage firm that has had to admit massive losses in both derivatives and collateralized mortgage securities, even though it has done everything possible to avoid specifying the quantity and nature of the losses. According to Forbes magazine, in July 2008, Merrill Lynch realized $9.4 billion in losses, largely from write-downs in mortgage-backed securities and derivatives.
In September 2008, the U.S. Treasury and Federal Reserve talked Bank of America, or BofA, into absorbing Merrill Lynch in a $50 billion transaction that was engineered by the government to keep Merrill Lynch from collapsing. Mortgage-backed securities and credit-swap derivative losses measured in the billions were the reason Merrill Lynch technically went bankrupt. Even after Bank of America absorbed Merrill, additional losses at Merrill from mortgage-backed securities and credit-swap derivatives losses forced BofA to return to the government in January 2009 for another $20 billion in bailout funds, with an additional federal guarantee of $118 billion to cover yet more anticipated losses from mortgage-backed securities and credit-swap derivatives that still remained on Merrill Lynch's balance sheet.
The lesson here is that Merrill Lynch, even with a $1 trillion balance sheet, was unable to absorb these huge losses without triggering insolvency. Yet even as Merrill collapsed, Merrill and the Bank of America remained unwilling to report exactly the amount of losses attributed to derivatives, choosing instead to lump derivative losses into "other revenue" categories on financial reporting forms required by regulators.
Many hedge-fund and derivative-contract bets that were good when the Dow topped 14,000, as it did in July 2007, no longer worked when the Dow started trading under 7,000, as it did in March 2009. Should the bubble in hedge funds and derivatives burst, financial institutions around the world could be faced with having to absorb hundreds of billions of dollars and possibly even trillions of dollars in losses, an amount of money almost inconceivable in any other era of global financial history. If those bubbles burst, the world financial system will melt down quickly, with no government in the world able to provide a solution, except to print the hundreds of billions or trillions of dollars in near-worthless fiat currency needed to nationalize the bankrupt banks and investment companies involved in the collapse.
As the administration pushed the $787 billion economic stimulus package through Congress in February 2009, President Obama warned that the financial crisis could turn into a "catastrophe" if the measure was not passed by Congress immediately. "No plan is perfect," Obama told conservative critics who charged that the bill was the largest welfare bill ever passed in the United States and that it depended entirely upon deficit spending.
Since the Great Depression of the 1930s, the economics of John Maynard Keynes has influenced Republican as well as Democratic presidential administrations. The key Keynesian theory that has become dogma is that government fiscal policy can and should sustain federal budget deficits to stimulate economic growth.
Whether a 2009 federal deficit in the range of $2 trillion would solve the problem of reduced U.S. consumer demand or deepen the economic recession that began in December 2008 remained to be seen. What was clear was that President Obama and the Democrats in Congress had decided to roll the dice, betting that massive government spending would stimulate the economy and create more jobs than widespread tax cuts would. Republicans countered that the Democrats were trying to outdo Franklin D. Roosevelt in using deficit spending to create a new generation of Democratic voters dependent upon government-entitlement programs.
Either way, with the passage of the $787 billion economic stimulus plan in February 2009, Obama and the Democrats were beginning to own the economic problem the administration inherited from President Bush. The Obama administration was prepared to argue that the bill would be successful if it prevented job losses that would have occurred had the bill not been passed. Yet that argument appeared a hedge, designed principally to lower expectations. After all, the bill had been sold as an economic stimulus plan, not as an economic stabilization plan.
Was deficit spending and an expansion of government-funded programs the way to end the Economic Panic of 2009? Or would they end up pushing the U.S. national debt to the breaking point? Once the bill was signed into law, President Obama owned the results. The success of the plan would ultimately depend on whether the massive deficit-spending proposed in the bill did what it was supposed to do namely, stimulate the economy and create the millions of jobs needed to end the recession. Saving jobs would not only be hard to prove, it would be hard to sell, unless enough new jobs were created to reverse growing unemployment and get the nation back to work.
An Obama plan to redistribute wealth through massive social-welfare programs with the result of dramatically increasing the federal debt could never be sold directly. Yet utilizing the economic crisis as an excuse and selling an income-redistribution agenda as an economic stimulus plan are risky: if more financial institutions continue to fail and more Americans continue to be unemployed, the Obama administration will be vulnerable to a charge that the stimulus package only made the economic problem worse. Moreover, since the nation never committed directly to a massive expansion of the government and the welfare state as such, a backlash against the welfare state will be inevitable if the Obama plan fails to stimulate the economy.
The modern social-welfare state, despite all the humanitarian arguments that can be made to support it, may in the final analysis end up being too expensive for either Europe or the United States to afford, especially during periods of economic downturn. That massive government deficit spending is the solution to stimulating the economy enough to create the jobs needed to make the modern welfare state affordable may well turn out to be an exercise in wishful thinking.
A "highly optimistic" President Obama, speaking to top executives of the Business Roundtable in Washington, D.C., on March 12, 2009, gave an upbeat view of the economic downturn, saying that the national crisis is "not as bad as we think" and trying to reassure the audience that his economic stimulus plans would speed recovery.
Yet some bad news may be too big to ignore. Estimates of the losses experienced in the global economic recession are staggering.
Stephen Schwarzman, chief executive officer of private-equity company Blackstone Group, told Reuters that between 40 and 45 percent of the world's wealth had been destroyed in the past year and a half. "This is absolutely unprecedented in our lifetimes," he said.
In 2008, U.S. households suffered a record 18 percent drop in wealth, or $11.2 trillion, to end the year at total U.S. household net worth of $51 trillion. Since a second-quarter 2007 peak of $64.4 trillion, U.S. household wealth has dropped by more than 20 percent. The Wall Street Journal noted that the single-year decline of $11.2 trillion equaled the combined annual output of Germany, Japan, and the United Kingdom. The Journal commented that the data signaled the "end of an epoch defined by first and second homes, rising retirement funds and ever-fatter portfolios." The decline was especially disturbing given that household wealth had increased by nearly 50 percent in 2006, reflecting the bubble-like increase in housing prices at the peak of the housing boom.
Also, consider the following, reported by Reuters:
-The Asian Development bank estimated that financial assets lost around the world may exceed $50 trillion, a collapse of wealth equivalent to a year's worth of world economic output.
- The World Bank concluded that the volume of world trade in 2009 will fall for the first time since 1982, suffering the biggest decline in eighty years.
- The World Bank also predicted that world gross domestic product, or GDP, will decline in 2009 for the first time since World War II.
- China, the largest exporter among emerging economies, has seen 20 million jobs disappear, while India reports 3 million jobs were lost because of shrinking exports.
- The Institute of International Finance, a Washington, D.C., think tank, reported that net private flows to emerging markets declined 50 percent in 2008, to less than $500 billion; net private-capital flows to emerging markets in 2009 are expected to decline even further, to $165 billion.
- The World Bank anticipates that ninety-eight developing countries will face a cumulative financing gap of between $270 billion and $700 billion in 2009.
On September 29, 2008, when the market dropped 778 points for its biggest single-day point loss ever, approximately $1.2 trillion was wiped out in market capitalization. It was the first $1 trillion daily loss in Wall Street history. The MSCI World Index, a Morgan Stanley-maintained index of world stocks, calculated world stock losses at $21 trillion from a market peak in October 2007 to the trough of November 2008. That is $21,000 for every individual in the developed world.
So, regardless of President Obama's optimism, the recession that officially began in the United States in December 2008 quickly became the worst economic decline the world has seen since the end of the Great Depression of the 1930s.
Should the Obama administration manage to double the national debt within its four years in office and should the Federal Reserve begin buying the debt issued by the Treasury, the risk of "hyperinflation" could become very real. Even the mention of hyperinflation immediately brings to mind the frightening images of the Weimar Republic in Germany at the end of World War I, when hundreds or thousands of German marks were required simply to buy a loaf of bread or mail a letter through the government post office. The unfortunate reality is that during the Obama administration, the U.S. economy could experience a severe recession and hyperinflation at the same time. The last incident of U.S. stagflation occurred in President Jimmy Carter's term of office in the 1970s; we suffered both a slowdown in economic growth and double-digit interest rates, a situation made even more unbearable by unemployment, then as high as 7 percent, and a spike in oil prices after the Arab oil embargo in 1973.
In the final analysis, the idea that the U.S. government would be reduced to being the final buyer of U.S. debt is bizarre. Has money become so meaningless that we are free to print whatever we need? If so, why stop at a federal deficit of $2.5 trillion in 2009 or $4 trillion in 2010? As we will see in the next chapter, the mortgage bubble's bursting may have left financial institutions around the world holding $10 trillion or more in unmarketable mortgage-backed securities. Why shouldn't the federal government simply print enough money to buy all those troubled assets off the balance sheets of the troubled financial institutions, so banks and brokerage firms might lend again freely, without the burden? Why not simply print enough money to buy every mortgage in America? Why not simply buy unoccupied homes and give them to the poor?
Unfortunately, even for the federal government, at some point deficits have a limit, even if the nation went along step-by-step to accept what only a few years ago would have been federal budget deficits of unimaginable magnitudes. This is the impact of the Little Green Frog analogy. The U.S. taxpayer is in the pot on the stove and the heat is turned on.
When no other foreign government will purchase U.S. debt, the U.S. government may have no choice but to consider seriously declaring bankruptcy and reorganizing. Incrementally, the United States has allowed a negative net worth to grow to a magnitude where the phenomenon has changed, such that the very economic viability of the U.S. government itself is now in question.
That the government could default on the "full faith and credit" obligations of the U.S. Treasury is now imaginable, for the first time in U.S. history. And if the government is incapable of managing its finances responsibly, then the larger setting of a regional economy and a regional government may be offered as the only solution.
We must realize that the U.S. government is bankrupt if we are to understand why a one-world government and a one-world currency may end up being the only solution the globalists offer to the problem.
Copyright © 2009 by Jerome Corsi