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Our Last President

Karl Denninger
Market Ticker
Mar 31, 2009

So here we have it, one quarter in the books (almost.)

2009 is shaping up to be an "interesting" year, in the form of the old Chinese curse - not the sort of "interesting" you want.

I am going to focus on a few things; let's start with this graph that got posted over on the forum and was apparently excerpted from a Morgan Stanley report; it depicts the debt load and breaks it out (I've run a previous copy of a similar chart, but without the breakdown - this is much prettier)

click image to enlarge

click image to enlarge

While GDP went from roughly $10 trillion to $14 trillion between 2000 and 2007 (I don't have a final 2008 number handy yet) debt grew much faster.

But from this graph it is clear that the problem didn't start in 2000. In fact we came out of the historical "safe range" after the early 1980s recession, as the decision was made by government to start playing games with regulation and soundness not only for private citizens and corporate America, but for themselves as well.

This sort of "fake prosperity" indeed looks real good and feels even better - for a while. I lived it, you lived it, we all lived it. I've spent a bit more than half my life living in this world, and indeed, life has been good. I have built businesses, sold one at a very nice profit, have been able to trade in the markets successfully and provide for my daughter, along with myself.

But let's not kid ourselves - this "growth" was not real, and the above graph only speaks to the "on balance sheet" debt, ignoring the over $53 trillion in other liabilities that the government is carrying "off balance sheet" via Social Security and Medicare - obligations that have grown dramatically (and unsustainably) in the last 20 years.

Anyone who has ever used a credit card (that would be most of us) knows how this works. If you walk into a store and buy a flatscreen TV for $1500, pulling out the plastic, you have taken an action that in fact has increased your cost of ownership of that television, not decreased it or kept it the same. Even if you pay it off at the end of the month, the store has paid a discount charge on your use of plastic (typically from 1-3%), and had you paid in cash you might have been able to negotiate for some or all of that as a lower price.

Further it is inevitable that you will be eventually forced to either pay for the TV or go bankrupt. Many people played the "roll it over" game with credit cards for years, taking the balance on one card and rolling it to some new card before they had to pay it off. That game can continue for quite some time but eventually you reach the end of the rope where lenders will no longer finance this charade, and you're once again forced to cough it up or go under.

Our government has become a machine to play "kick the can", but increasingly that can has been filling up with cement and it is moving a shorter and shorter distance with each kick. Eventually we will stub our toe.

In 2000 had we taken our medicine the total contraction in GDP necessary to restore balance was approximately 10%, or $1 trillion dollars in net output that was being "pulled forward" via debt service, plus the embedded cost of interest.

Today it has doubled as a direct consequence of our attempt to borrow and spend our way out of 2000-03 recession.

While it appeared good initially, we bought only a few short years of apparent and false prosperity, instead digging an even deeper hole into which the average American has now descended.

Government has learned exactly nothing from this; here are some excerpts from Tim Geithner this morning on "This Week". Note the contradiction:

GEITHNER: I think a lot -- people worry about this. You have a recession like this, which is born out of a period where people borrowed too much, and we let our financial system take on too much risk. The risk in that conduct is you have a longer, slower, more gradual process of adjustment and recovery.

The first part is right. But the second part isn't correct - it's a dodge for what was intentional misrepresentation of risk in instruments that the lenders knew were being mispriced.

GEITHNER: Well, we're going to emerge out of this stronger. And we're going to do that because the president and the Congress are going to make sure that we have the government doing a better job of things it needs to do.

Riiight. The very same Congress that passed Gramm-Leach-Bliley dismantling Depression-era regulations that would have prevented most of this silliness had they been in place? The very same Congress that has refused to rein in The Fed for effectively expropriating the power of appropriation that The Constitution gives exclusively to The House of Representatives? The very same Congress that not only allowed Henry Paulson to ramrod a bill through giving him plenary authority to spend $700 billion but when presented with hard proof that he knew full well prior to final passage that he did not intend to do with it what he had said with the first half, they let the other $350 billion out anyway?

GEITHNER: Well, you know, we want to have sustainable growth. We don't have -- we don't want to have a recovery which is going to be artificial and short-lived, just produce the seeds of the next crisis.

We want to have a durable recovery based on a stronger foundation that has a stronger, more productive economy emerging through it where the gains are more broadly shared across the economy as a whole.

You can't get there without reducing the debt back to sustainable levels. Levels that were sustainable and proved as such over the previous fifty years. Levels that are roughly half of where they are now. Levels that would require, with a constant GDP (ha!) the default or repayment of some twenty-five trillion dollars in debt!

GEITHNER: It should go down. Again, you know, if you look at the record of performance in the '90s, you know, we had very strong productivity growth during a period of fiscal discipline, fiscal responsibility, strong private investment, and the gains were shared much more broadly.

That's a lie. In the 90s the so-called "strong growth" was based on a broadly-repeated lie about growth in Internet use, which led to unreasonable expectations and thus asset price appreciation. It was no more true than "houses always go up in price by 10% a year" was.

And then we have this little ditty:

GEITHNER: That is a risk. And it's very important that people recognize that. To get out of this, we need banks to take a chance on businesses, to take risk again. We had a long period where banks were taking too much risk. The challenge for us is that they take too little now.

And for us to get through this, we need investors and banks to be willing to take a change again on providing credit to that business that has got a great idea and needs to grow, expand.

Cut the crap Tim. It's not credit, it's debt. See the above graph? Go back and look again. The total debt in the system must contract, not expand, before we can have a durable and sound economic recovery.

Yet everything this administration is doing is going to radically expand that debt - in fact, it will expand the total outstanding Federal debt by more than 10% this year alone, and 20% if you measure only against the public float (the correct measure.)

Accountability? Where?

GEITHNER: George, let's just step back for a sec. The problem we're facing on our financial system is that we -- banks made a bunch of loans, backed real estate that are now facing losses. And those loans are clogging up the financial system.

They're taking up room that could otherwise be used to provide new credits to a business or a family. Now we have two choices, we can let -- leave that as it is, hope that banks earn their way out of this over time. That would be a mistake. That would leave us with a strong -- with a deeper, longer recession.

OUR NATION pursued a policy at all levels, public and private, of pulling forward demand and when the bill came due, we pulled it forward again. This is unsustainable as eventually that debt must be paid down or defaulted.

We are here because of the policy that you are espousing here and now Mr. Geithner, along with your puppeteer President Obama. You, along with those who preceded you, believed that we could pull forward demand forever and never pay the check, continually rolling debt over and accruing the interest.

Anyone with more than two firing neurons and a basic understand of mathematics knows that eventually you must face the music with such a policy. We are simply arguing over when that music will be faced, not if.

In order to restore economic balance without massive defaults you would have to more than double GDP while not taking on one more dollar of new debt. That is obviously not going to happen, as put forward by President Obama's budget - in order to achieve that he would have to have promulgated a budget that was balanced, yet find a way while doing so to get GDP growth back on track and forsake private credit growth.

But that's not what he did or what you're promoting. You are attempting instead to kick the can down the road one more time, and it will not work.

GEITHNER: No, I think we're about where we were. You know, this is not easy for people. I mean, this is people -- there is a deep amount of public anger and frustration about the fact the American economy is suffering so much damage from the consequence of people who took too much risk.

And, you know, the tragedy of the financial crisis is they are -- the damage is brutal; it's indiscriminate. It affects not just the people who took too much risk but people who were careful and responsible in their decisions.

But the important thing is these things don't bring themselves out without catastrophic damage.

Why shouldn't those who "took on too much risk" suffer catastrophic damage?

Why shouldn't the homeowners who lied about their income go bankrupt?

Why shouldn't the bank who securitized debt with bought-and-paid-for ratings using fault models go bankrupt?

Why shouldn't the bank that funded too much commercial development at insane (and blatantly unsupportable) cap rates go bankrupt?

Why shouldn't those who refused to listen to people just like myself and a handful of others - who were warning years ago about the dangers of this sort of economic policy, both in writing and elsewhere, go bankrupt?

The fact is that they should and must go bankrupt, because it is only through bankruptcy that this sort of behavior is punished by the marketplace and people are dissuaded from doing it again!

Now, Goldman Sachs, for example. Their chief financial officer said he had no material economic exposure to AIG. So why weren't they forced to take a discount?

GEITHNER: George, we came into this crisis as a country without the tools necessary to contain the damage of a financial crisis like this. In a case of a large, complex institution like AIG, the government has no ability, had no meaningful ability to come in early to help contain the fire, contain the damage, prevent the spread of that fire. Restructure the firm, change contracts where necessary, and helped make sure that the financial system gets through this...

That's a flat lie.

AIG could have been told "no money unless these contracts are renegotiated with a haircut."

Indeed, GM and Chrysler were told this. "Here's some money, but if you don't get those haircuts negotiated in a reasonable amount of time, we're going to claw it back and you're going down the chute."

AIG could have had the same stricture imposed. It wasn't, and I believe the reason it wasn't was to allow what amounted to a $100 billion dollar heist to be perpetrated upon the American Taxpayer without the knowledge or consent of Congress.

STEPHANOPOULOS: So how about now, Goldman Sachs is taking other government money. They got this $13 billion whole from AIG. Congressman Brad Sherman and others have said, they should give that $13 billion back.

GEITHNER: George, the important thing is, we have no legal ability now. That's why I went to Congress last week, to propose a broad change in resolution authority so that we have the capacity to do what we do with banks now.

This is simply not true. Treasury could have conditioned the receipt of money by AIG originally on the haircutting of these contracts and could have conditioned the second "slug" of it as well. It also could, right here and now, today, use its 79.9% ownership stake in AIG to fire the entirety of the board and management in AIG, nationalize the firm entirely, and refuse to put one more dollar into the company until these contracts are renegotiated, forcing immediate defaults by putting the firm into receivership if the counterparties refuse.

All of this is within the government's power, but it is more important to provide a backdoor bailout to certain banks than to protect the taxpayer's interest.

STEPHANOPOULOS: And what's the most important single thing you've learned over the last three months?

GEITHNER: That to get through this, governments need to act. Great obligation responsibility for governments to act to solve these things. The market will not solve this, and the great risk for us is we do too little, not that we do too much.

Oh yes it will Mr. Secretary, and much sooner than you think.

Just not in a way you'll like.

President Obama hasn't got his arms around the truth yet - or is simply unwilling to speak it:

If people in other countries cannot spend, markets dry up -- already we've seen the biggest drop in American exports in nearly four decades, which has led directly to American job losses. And if we continue to let financial institutions around the world act recklessly and irresponsibly, we will remain trapped in a cycle of bubble and bust. That is why the upcoming London Summit is directly relevant to our recovery at home.


Second, we must restore the credit that businesses and consumers depend upon. At home, we are working aggressively to stabilize our financial system. This includes an honest assessment of the balance sheets of our major banks, and will lead directly to lending that can help Americans purchase goods, stay in their homes and grow their businesses.

Nope. That is exactly backward; the excessive debt must be paid down or defaulted and the economy must be re-based to a sustainable level of output predicated on actual production and ability to earn - that is, to spend what is earned, not what can be borrowed from someone who is a bigger sucker than you.

The Atlantic ran a powerful article by a former chief economist for the IMF; the short version is contained in this quote:

The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday's "public-private partnerships" are relabeled "crony capitalism." With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions - now hemorrhaging cash - and usually restructure a banking system that's gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or - here's a classic Kremlin bailout technique - the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk - at least until the riots grow too large.

Eventually, as the oligarchs in Putin's Russia now realize, some within the elite have to lose out before recovery can begin. It's a game of musical chairs: there just aren't enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely.

Gee, you think?

Then he comes out with what I have advocated all along:

To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards - contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.


And a warning. ...

The conventional wisdom among the elite is still that the current slump "cannot be as bad as the Great Depression." This view is wrong. What we face now could, in fact, be worse than the Great Depression - because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.

Does that make it clear where my "doom and gloom" comes from?

Do we have to wait for the full-on economic collapse before our government gets it? An increasing number of people who have seen this before, from bloggers like myself to economists at the IMF to people like Paul Krugman, have been and are sounding the alarm.

Many of them have come around slowly to the reality of what we face, but come around they have.

The math, my friends, is simply never wrong, no matter whether you would prefer to deny it or not.

Simply put, once again:

  • Debt-to-GDP must contract to a sustainable level, which is less than half of the present. This means that some $25 trillion in debt must either default (delivering someone a loss) or be paid down.
  • The economy must contract to a level that can be sustained through earnings (that is, output), not borrowings.

We can do this the hard way or we can do this the catastrophic way, but whether we like it or not it will happen, because the mathematics of the situation make it inevitable - whether the government and "elites" like it or not.

I will repeat what I said months ago - Barack Obama is our first Black President, and if he does not get his act together and stop this stupidity he is going to be our last President.

Mar 29, 2009
Karl Denninger

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