Hera : OTC derivatives

Financial Crime Is A Systemic Risk

Ron Hera — Tue, 23 Oct 2012 11:38:00 GMT

Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur.

While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate result. There are three general ways in which the U.S. dollar system could break down: (1) rejection of the U.S. dollar as the world reserve currency, or (2) as an eventual consequence of U.S. federal government insolvency and (3) a domestic failure of confidence. Of the three, U.S. federal government insolvency is the most serious because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a new threat to the U.S. dollar has emerged which could trigger a hyperinflationary collapse before the U.S. federal government’s finances become unworkable, e.g., when debt service begins to crowd out military and Social Security spending. Specifically, the perceived legitimacy of the U.S. financial system has not merely been tarnished by recent scandals but is in danger of collapsing. The consequences of a domestic breakdown of confidence and trust in the U.S. financial system cannot be overstated.

World Reserve Currency Status

The most commonly cited challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.

At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower.

At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term.

Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss.

In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities

Setting aside the world reserve currency status of the U.S. dollar, the largest threat lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it.

Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’

Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

Domestic Confidence in the U.S. Dollar

Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people.

A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy.

An outlying but growing problem is the risk of a breakdown of confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to the U.S. dollar system.

Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending.

In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorist organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud.

Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial system.

A Black Swan?

Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement could trigger a hyperinflationary collapse. The result of a domestic breakdown of confidence and trust in the U.S. financial system would not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a rush out of dollars into hard goods due to runaway inflation but rather a run on financial markets. If investors, pensioners, private institutions and fund managers withdraw from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial markets. The failure of financial firms, the accelerated disintegration of the U.S. dollar’s world reserve currency status and the final bust of the U.S. government’s finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate the problems of the U.S. dollar. History may record yet again that “there is no means of avoiding the final collapse of a boom brought about by credit expansion” because the escalating moral hazard engendered by limitless bailouts is itself a cause of collapse.

The Unholy Alliance of John Maynard Keynes

Ron Hera — Sun, 01 Jul 2012 20:03:00 GMT

Perhaps the greatest modern champion of central economic planning was the 20th century English economist John Maynard Keynes. Keynes, who was a political socialist and for a time a central banker, advocated the idea that the government should play a large, active role in the economy. Among the consequences of Keynes' economic theories, whether intended or unintended, is the fact that Western economies today are characterized by large, central governments, central banks and massive debts.

According to Dr. Andrew Gelman, Professor of Statistics and Political Science at Columbia University, "the law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple. It operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives. Society, in contrast, is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences." Professor Gelman's statement seems equally apropos to central banking.

Government policies based on Keynesian theories and the institution of central banking form a nexus of central economic planning. Control of the central planning process is a winner-take-all proposition for businesses. In the U.S., the result is an unholy alliance of the U.S. federal government, the Federal Reserve (along with the largest U.S. banks) and the largest U.S. corporations. The logical chain beginning with Keynes' fundamental idea that government, supported by a central bank, should play a large and active role in the economy sets the stage for a centrally planned economy and ultimately produces a corporate state.

The U.S. economy is locked in a downward spiral of economic decline. By growing in size, and by engaging in ever larger economic interventions, the U.S. federal government became itself a material cause of the recession that began in 2007. By attempting to grow the economy through monetary expansion, i.e., consumer spending fueled by debt, the Federal Reserve destroyed savings and fueled a series of disastrous economic bubbles, culminating in the housing bubble. At the same time, the largest U.S. banks engaged in reckless lending and high-stakes gambling on hundreds of trillions in over the counter (OTC) derivatives. OTC derivatives, which amount to risky, largely un-backed wagers, were the root cause of the "too big to fail" doctrine that has virtually bankrupted Western governments since 2008. By seeking ever greater influence over Washington D.C. and by seeking to generate higher profits by cutting production in the U.S., the largest U.S. corporations undermined the U.S. market and economy. The U.S. federal government did virtually nothing to prevent the destructive developments because of the influence of the largest U.S. corporations.

Following Keynesian economic theories, the policy response of the U.S. federal government to the recession that began in 2007 and of the financial crisis that began in 2008 was to expand the government further and at a more rapid pace. In other words, some of the root causes of the economic imbalances that lead to the recession and financial crisis (the relative size of the government and the resulting economic distortions) were compounded. As a consequence, the so-called "double dip recession" in the U.S. that began in the second half of 2011 will be longer and ultimately more severe than the economic downturn of 2007-2009.

The Baltic Dry Index (BDI) indicates international shipping returning to crisis levels. Since the U.S. is the world's largest economy and has a large trade deficit, the BDI suggests that the U.S. is in a recession.

Leviathan: The Size of the State

Originally a sea monster referred to in the Bible and, in demonology, one of the seven princes of Hell, as well as its gatekeeper, the name Leviathan was adopted by the English philosopher Thomas Hobbes to refer to an artificial political order, i.e., to the institution of the state. Hobbes was concerned with the distinction between individual rights and the powers of sovereign governments and he elaborated the idea of the social contract. When a government taxes its citizens, it implicitly asserts the right of the government over the property rights of individuals and presupposes that the government can make better use of economic resources than households, individual entrepreneurs, businesses and private investors.

In theory, the government's use of economic resources accomplishes goals that privately owned businesses cannot, such as national defense or emergency response services, i.e., things that, by their nature, are not economically productive or profitable but still necessary for society. In contrast, embarking upon idealistic projects such as "creating jobs" or "expanding home ownership" encroaches on the productive elements of the economy. However, governments are inefficient compared to privately owned businesses due to the absence of competition. Further, the record of history suggests an inability on the part of central planners to make superior economic decisions.

Government encroachment on the private sector, like a self fulfilling prophecy, often magnifies the reasons why government intervention was originally believed to be necessary. For example, when the U.S. federal government became involved in education through federally guaranteed student loans, the result was that the cost of a college education rose towards the limit of what students could borrow and repay during their careers simply because the loans were guaranteed by the government. The guarantees produced more and riskier loans, larger loans and higher education costs.

When the U.S. federal government promoted home ownership for minorities and the poor, mortgage loan guarantees resulted in higher home prices and contributed to the sub-prime lending debacle where banks originated loans to unqualified borrowers in order to sell them to government sponsored entities (GSEs), i.e., to Fannie Mae and Freddie Mac, and to investors as collateralized debt obligations (CDOs) and other mortgage backed securities (MBS).

Banks were certainly to blame for knowingly making bad loans, which is fraud, but the conditions that made the problem possible existed substantially because of government intervention in the housing market, i.e., opening the door to fraud was an unintended consequence of policies intended to increase lending to unqualified, low income borrowers. Of course, the U.S. federal government did not compel lenders to commit fraud, thus accountability for the U.S. mortgage disaster is shared by the federal government, which interfered with the free market, pursued misguided policies and failed in terms of regulatory oversight and law enforcement, and by banks, which engaged in widespread mortgage related fraud.

Governments redistribute wealth and manipulate economic activity through taxes, subsidies, guarantees, regulations and so forth, but they do not produce new wealth. Government spending may be for good purposes, or at least stem from good intentions, but it unavoidably favors businesses with close ties to the government over those that are taxed but that do not benefit. Despite the theoretically higher moral purposes of lofty government undertakings, government programs that overlap the private sector divert economic resources to businesses that have the favor of politicians minus the cost of government, thus producing economic distortions and a net loss of wealth for society.

The Rahn curve is an economic theory proposing that there is an optimal level of government spending, 15% to 25% of gross domestic product (GDP), to maximize economic growth. As the government grows larger, economic growth is curtailed and, eventually, the economy contracts, crushed under the burden of government. As the government grows in size relative to the economy, not only is economic growth compromised, but the potential for, and the cost of, government waste, fraud and abuse increases.

How the Government Destroys Jobs

While politicians extol the theoretical benefits of ever more government control of the economy, e.g., through increased regulation, from the standpoint of individual entrepreneurs, businesses and private investors, the government is a nuisance, an impediment to wealth creation, and the source of countless costs and risks. The larger the government becomes relative to the size of the economy, the more it tends to discourage economic activity. Although roughly 70% of U.S. jobs are created by small businesses, ranging from family owned businesses to high technology startups, the burden of government falls disproportionately on them because they have fewer resources with which to administer and to demonstrate compliance with government regulations.

When large companies are audited or investigated by any of several government agencies, their accounting, legal and compliance departments are well equipped to deal with such matters. However, when a small company faces the same hurdles or seeks government permits, licenses or certifications, its operations are directly impacted and the associated accounting, legal and regulatory compliance costs can cause the business to lose money or to fail. In the event of an audit or investigation, small business owners in the U.S. generally seek to comply immediately and often pay fines or penalties without contest in order to end the government's interference. While large companies can afford to dispute the government, small businesses face the equivalent of extortion.

As a practical matter, small businesses in the U.S. are permitted to operate at the sole discretion of government bureaucrats that can effectively shut down small businesses without any evidence of wrongdoing. Setting aside the fact that small business owners live in constant and well justified fear of their own government, the result is a stifling of economic activity and a net loss of jobs. For example, traditional small businesses in the U.S., i.e., sole proprietorships, increasingly avoid hiring employees.

Free market competition and the inherent uncertainty of economic conditions provide ample risk for startup businesses. A disproportionately large government relative to the size of the economy damages economic activity and discourages investment in new businesses. The aggregate overhead of government regulations and regulatory compliance, along with taxes and potential penalties, e.g., the 2010 Patient Protection and Affordable Care Act ("Obamacare"), increases business costs, amplifies business risks and further increases the burden of regulatory compliance. The result of systematically increasing the costs and risks of doing business-in lock step with the size of government-is to reduce the rate of business formation and to encourage investors to look elsewhere to find returns.

If the U.S. government, currently almost 45% of GDP, desired to create jobs, the correct policy would be to greatly reduce the countless regulations, taxes and fees that encumber small businesses. The path to job creation is for the government to reduce job destruction. Since no political will to reduce the size of the government exists, however, continued shrinking real GDP and permanent workforce reduction can be expected.

Money Out of Thin Air

Central banks, such as the Federal Reserve, are examples of central economic planning, i.e., they control the money supply and exercise centralized control over the value and cost of money through interest rates, bank reserve ratios, monetary inflation and by other means. In contrast to the government's central planning for the putative public good, the Federal Reserve engages in central planning for the benefit of banks. Like the U.S. federal government, the Federal Reserve, through monetary mechanisms, distorts spending and investment patterns, redistributes wealth and preempts the financial and economic decisions of households, individual entrepreneurs, businesses and private investors.

When a central bank increases the money supply beyond the level necessary to support a sustainable economy or population growth, it destroys the value of savings and wages by diluting the value of money and causing prices to rise. Wall Street embraces the Federal Reserve because easy monetary policies provide an inexpensive way to finance operations and to expand, but there is a cost. Inflationary monetary policies favor speculators over savers and debt over genuine capital formation.

Banks do not create wealth. The structure of the financial system, where debt-based money is created ex nihilo, virtually guarantees banks a piece of the action whenever wealth is created. When debt service (principal and interest payments) is attached to the income streams of consumers and businesses, excess production is diverted from capital formation into the coffers of banks. The Federal Reserve, therefore, is at the core of a system where, over time, wealth accrues to banks while capital formation is reduced, ironically increasing the need to borrow. The majority of entrepreneurs and businesses have little choice but to borrow and, even if they are successful, the economy as a whole may still suffer due to increased debt levels relative to GDP.

Keynesians embrace the Federal Reserve's un-backed, fiat money because it permits the government to borrow and spend freely based on the theory that stimulating the economy through deficit spending produces economic growth at a faster pace than debt accumulates. However, as a function of debt service, the number of dollars that must be borrowed and spent to generate each new dollar of GDP becomes larger as the total amount of debt grows.

The result is debt saturation where further debt funded increases in GDP are impossible and where, therefore, existing government debt cannot be retired, i.e., the result of Keynes' theory, taken to an extreme, is government insolvency and sovereign default. Default, of course, can take the form of monetary inflation in order to debase the currency and reduce the real value of debt, e.g., the Federal Reserve's monetary easing and continued accommodative monetary policy.

Keynes and The Corporate State

The U.S. economy is anything but a free market today. In fact, the U.S. government increasingly resembles an oligarchy in which the oligarchs are large corporations, i.e., a "corporatocracy". Thus, the illegitimate offspring of the grand government envisaged by Keynes and the institution of central banking is a corporate state.

Without a large government, businesses have little incentive to influence it, but with the government (local, state and federal) representing nearly half of the U.S. economy, influencing the government is a mission-critical objective for every company. The size of government implied by Keynesian economics provides motive and opportunity but only the largest corporations have the means to succeed.

The goals of businesses seeking to influence the government include winning government business, mandating consumption of products and services (from child car seats to health insurance), avoiding taxes, guaranteeing profits, creating regulatory loopholes, protecting markets, eliminating competition, socializing losses and so forth.

Obama		Romney
Citigroup Inc	$736,771	Citigroup Inc	$57,050
Columbia University	$547,852	Bain & Co	$52,500
General Electric	$529,855	Bain Capital	$74,500
Goldman Sachs	$1,013,091	Goldman Sachs	$367,200
Google Inc	$814,540	Bank of America	$126,500
Harvard University	$878,164	Barclays	$157,750
IBM Corp	$532,372	Blackstone Group	$59,800
JPMorgan Chase & Co	$808,799	JPMorgan Chase & Co	$112,250
Latham & Watkins	$503,295	Credit Suisse Group	$203,750
Microsoft Corp	$852,167	EMC Corp	$117,300
Morgan Stanley	$512,232	Morgan Stanley	$199,800
National Amusements Inc	$563,798	HIG Capital	$186,500
Sidley Austin LLP	$600,298	Kirkland & Ellis	$132,100
Skadden, Arps et al	$543,539	Marriott International	$79,837
Stanford University	$595,716	PriceWaterhouseCoopers	$118,250
Time Warner	$624,618	Sullivan & Cromwell	$79,250
UBS AG	$532,674	UBS AG	$73,750
University of California	$1,648,685	The Villages	$97,500
US Government	$513,308	Vivint Inc	$80,750
WilmerHale LLP	$550,668	Wells Fargo	$61,500
Total Primary Dealers:	$3,603,567	Total Primary Dealers:	$810,050
Political campaign contributions indicating U.S. Federal Reserve Primary Dealers (Source: opensecrets.org)

The influence of Wall Street over Washington D.C. through political campaign contributions, corporate lobbyists and revolving doors (where the same individuals alternate between closely linked private sector jobs and government posts) is almost absolute. Lobbyists are intimately involved in writing legislation that is often rubberstamped by the U.S. Congress, i.e., passed without reading or meaningful debate. The largest corporations support political candidates through campaign contributions and by funding political action committees that, among other things, use corporate public relations tools for political purposes, i.e., propaganda. Key government posts are consistently held by individuals with clear conflicts of interest and the existence of such conflicts is routinely ignored.

The current reality of the United States is that the largest corporations have hijacked the Keynesian central planning powers of the federal government and have used these powers to encourage ever larger and more direct interventions in the economy for their own benefit, as well as laws and regulations that serve as a barrier to free market competition. U.S. regulators, such as the Securities and Exchange Commission (SEC), Commodities and Futures Trading Commission (CFTC) and the Food and Drug Administration (FDA) appear to have been captured by the industries they are intended to regulate. Government regulators selectively enforce regulations, often against small businesses and growing companies, such as organic dairy farmers, protecting the interests of the largest corporations from small businesses, free market competition and consumer choice.

The largest U.S. corporations (including oil companies like ExxonMobil and Chevron; drug companies like Johnson & Johnson, Pfizer and GlaxoSmithKline; agribusiness companies like Archer Daniels Midland, which are heavily subsidized by the U.S. federal government; agricultural biotechnology companies like Monsanto; military contractors like Lockheed Martin, Northrop Grumman, Boeing, Raytheon and General Dynamics; and banks like Bank of America, J. P. Morgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) have not only been the beneficiaries of government expansion, deficit spending and central economic planning, but, considering political campaign funding practices, have become the de facto oligarchs of America.

Sliding Into the Keynesian Abyss

The decline of the U.S. economy is the logical outcome of Keynesian economics, which enshrines central economic planning and embraces central banking. The unholy alliance of the federal government, the Federal Reserve and Wall Street has all but eliminated capitalism and has transformed the United States from a burgeoning free market economy into a failing corporate state.

The U.S. federal government, the Federal Reserve and Wall Street each played a role in the progression from central economic planning and central banking to a corporate state. Politicians used Keynesian economics to justify big government, a welfare state and budget deficits. The Federal Reserve sought to grow the economy through monetary expansion, focusing on consumption but ignoring debt levels and inadvertently encouraging financial speculation. At the same time, Wall Street sought higher profits both by eliminating production (and jobs) in the U.S. and by sparing no expense to influence the government. The resulting corporate state undermined capitalism and the free market in the United States and produced a downward spiral of economic decline from which there is no escape without fundamental reforms.

How the U.S. Will Become a 3rd World Country (Part 2)

Ron Hera — Sun, 01 Jul 2012 19:50:00 GMT

The United States is quickly coming to resemble a post industrial neo-3rd-world country. Unemployment, lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth are major trends in the U.S. today. Behind these growing problems are monetary inflation created by the Federal Reserve's monetary policies, federal government deficit spending and the dominant influence of "too big to fail" banks and large corporations in Washington D.C., which has altered the direction of law in the United States. To make matters worse, the U.S. government faces a historic fiscal crisis.

High unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive policies are defining characteristics of 3rd world countries. Other factors include poor public health, nutrition and education, as well as lack of infrastructure-factors that deteriorate rapidly in a failing economy.

Apparently ineffective regulation and relatively little law enforcement action by the federal government in the wake of the sub-prime mortgage meltdown resulted in widespread speculation that special interests had taken priority over the rule of law. Critics have also charged that the federal government's policies threaten to eliminate what remains of the American middle class.

Accelerating Concentration of Wealth

In response to the economic downturn that began in 2007 and the start of the financial crisis in 2008, the U.S. federal government and the Federal Reserve resorted to a radically inflationary policy intended to save banks and to shepherd the U.S. economy through a recession. Instead, radically inflationary policies greatly increased the concentration of wealth.

Under ordinary circumstances, monetary inflation has the effect of redistributing wealth in favor of those who receive newly created money first. The value of money is reduced as a function of the number of currency units in the economy but recipients of newly created money can spend it before it loses value. In a declining economy, however, the wealth redistribution effects of inflation are magnified.

When the Federal Reserve or the federal government supports banks and financial markets through liquidity injections, bailouts, asset purchases, quantitative easing, etc., the lion's share of financial support, i.e., newly created money, is captured by the largest financial institutions and by the wealthiest 1% of Americans. Money printing skews the distribution of money over the economy while the value of money, i.e., the purchasing power of wages and savings, is reduced. The overall effect is a wealth transfer from proverbial Main Street to literal Wall Street.

Looming Fiscal Crisis

U.S. government debt and deficit spending have markedly accelerated over the past decade. For example, The U.S. Department of Homeland Security (DHS) was created and the U.S. military grew to 3 million active duty and reserve personnel, not including contractors. Since 2001, the U.S. spent approximately $1 trillion on military expansion while the total cost of the U.S. wars in Afghanistan and Iraq has been estimated to exceed $3.7 trillion.

Although the U.S. federal government remains in denial, the Congressional debt ceiling debate and subsequent U.S. credit rating downgrade on August 5, 2011 were only the tip of the iceberg. In fact, the United States faces a historic fiscal crisis.

As of 2012, the majority of new federal government debt will stem from interest on existing debt. Treasury bond issues totaled $2.55 trillion in 2010, roughly 2x the federal budget deficit of $1.3 trillion. Artificially low U.S. Treasury bond yields, created by the Federal Reserve's quantitative easing (QE1 and QE2) programs and by its current "Operation Twist," only slow the rate at which the federal debt balloons.

The U.S. federal government's fast growing debt is $14.94 trillion, approximately 100% of GDP. Additionally, future liabilities total $66.6 trillion based on generally accepted accounting principles (GAAP accounting) and using official data from the Medicare and Social Security annual reports and from the audited financial report of the federal government.

Medicare: $24.8 trillion
Social Security: $21.4 trillion
Federal debt: $10.2 trillion* (not including intra-governmental obligations)
State, local government obligations: $5.2 trillion
Military retirement/disability benefits: $3.6 trillion
Federal employee retirement benefits: $2 trillion

The eventual insolvency of the U.S. federal government cannot be averted through any combination of taxes, budget cuts or realistic GDP growth. Inflationary policies, i.e., increasing deficit spending by the federal government and debt monetization by the Federal Reserve, would devalue the U.S. dollar and potentially trigger a hyperinflationary collapse of the currency. To stave off the inevitable, interim measures might include tax increases, exchange controls, nationalization of pension funds or other measures similar to those taken in 3rd world countries.

Dominant Corporate Influence

In a 2009 radio interview on Elmhurst, Illinois' WJJG 1530 AM, Senator Dick Durbin (D-Ill.) explained that "...the banks-hard to believe in a time when we're facing a banking crisis that many of the banks created-are still the most powerful lobby on Capitol Hill. And they frankly own the place." Senator Durbin was unequivocal in saying that the federal government of the United States is controlled by banks. Simon Johnson, former chief economist of the International Monetary Fund (IMF), had reached the same conclusion one month earlier in his widely read article The Quiet Coup. Johnson explained that the finance industry had effectively captured the U.S. government, a state of affairs typical of 3rd world countries.

Corporate influence over the political process, as well as over the tax and regulatory policies of the United States, is at an all time high. The federal government is the largest single customer in the U.S. economy and, through taxation or regulation, the government can grant or deny market access to private companies and can either prevent or mandate the consumption of their products and services. As a result, virtually every large corporation in the United States seeks to win the government's business and to steer government tax policies and regulations in their favor. Naturally, politicians who accede to the wishes of particular corporations are given campaign funds to ensure their reelection. In the past decade, the amount of money spent on lobbying has more than doubled and there are currently 24 lobbyists for every 1 member of Congress.

The interdependence of elected officials and the largest U.S. corporations reached a new high with the 2008 bank bailouts. The influence of private corporations and de facto industrial cartels (comprising the largest corporations in each major industry) over tax and regulatory policies creates significant economic distortions that ultimately compromise the sustainability and the stability of the economy. Ideally, the government would be an impartial referee, rather than an active business partner that overwhelmingly favors large businesses over small businesses, despite the fact that small businesses account for the vast majority of American jobs.

Impact on the Rule of Law

Corruption, cronyism and weak rule of law are typical of 3rd world countries. The United States exhibits a clear corporate influence over elections and legislation and, arguably, relatively little law enforcement action where large, legally well-equipped corporations are concerned. Reports of so-called crony capitalism have appeared in the U.S. news media, but the term "corruption" has been avoided, along with discussion of fundamental reforms.

A cursory examination of legal developments over roughly the past decade evidences a pattern in which U.S. federal law systematically favors the largest financial institutions, as well as a paradigm in which financial institutions heavily influence both the regulations that putatively govern their activities and the laws that apply to consumers of their products and services. The financial crisis that began in 2008 and the subsequent response of the federal government appear to follow logically from prior legislative events:

1999 Gramm-Leach-Bliley Act (GLB). The Act repealed key provisions of the Banking Act of 1933, commonly known as the Glass-Steagall Act. In the aftermath of the Great Depression, the Glass-Steagall Act prevented depository institutions from engaging in high risk financial speculation.
2000 The Commodity Futures Modernization Act (CFMA). The Act deregulated over-the-counter (OTC) derivatives, such as credit default swaps, referred to by Warren Buffett as "financial weapons of mass destruction." OTC derivatives were at the heart of the financial crisis that began in 2008 and are the root cause of the "too big to fail" doctrine. The Act preempted state gaming laws that had prevented banks from speculating in OTC derivatives with no connection to underlying assets.
2001 USA PATRIOT Act. The financial provisions of the Act allow banks to collect additional financial information about account holders, for example, linking business accounts to the personal financial records of business owners, thus weakening both financial privacy and the corporate veil. The Act enhances the ability of creditors to collect and allows federal authorities to monitor financial transactions and to obtain financial records without a subpoena.
2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The Act, which was sponsored by banks and credit card companies, effectively eliminated the concept of a "fresh start" by allowing banks and credit card companies to engage in collections activities, in effect, forever. As a result, small business owners who end in bankruptcy are less likely to ever start another business. The Act places banks in front of bankruptcy courts, creates liabilities for bankruptcy attorneys and contains many widely criticized, anti-consumer provisions.
2008 Emergency Economic Stabilization Act. The Act, commonly referred to as a "bank bailout," authorized the United States Secretary of the Treasury to spend $700 billion to purchase distressed assets, especially mortgage-backed securities (MBS). Instead, the funds were given to foreign and domestic banks to offset their risky MBS, OTC derivatives and other losses. The bank bailout set a precedent of socializing losses but keeping gains private. The Act effectively bound the fate of the U.S. Treasury to that of the largest U.S. financial institutions.
2010 Citizens United v. Federal Election Commission. The Supreme Court of the United States held that corporate funding of independent political broadcasts in candidate elections cannot be limited under the First Amendment, overruling prior case law and guaranteeing the ability of corporations to influence elections without meaningful restrictions. The Court's decision gave carte blanche to corporations to influence elections, legitimized the interdependence of elected officials and large corporations and created a precedent under which the rights of corporations supersede those of citizens.
2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act failed to restore critical provisions of the Glass-Steagall Act, significantly regulate OTC derivatives, break up "too big to fail" banks, prevent another financial crisis and prevent further bailouts. The Act created a Consumer Financial Protection Bureau, but did not repeal any provision of BAPCPA or restore the financial privacy of U.S. citizens removed by the USA PATRIOT Act. The Act failed to provide adequate funding to the government's watchdogs, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Federal Bureau of Investigation (FBI), potentially hobbling enforcement. The Act has also been criticized for the burden it places on smaller competitors in the financial sector, which could ultimately result in an increased concentration of financial power in "too big to fail" banks.

Critics have alleged that, underlying the sub-prime mortgage meltdown that triggered the financial crisis in 2008 was rampant fraud. Fraud has been alleged at virtually every level from the assessment of property values and credit risk; to the loans themselves and to their securitization as MBS assets; to the ratings of MBS assets as AAA; to hedging or betting against MBS assets in the OTC derivatives market (perhaps including financial firms allegedly betting against MBS assets that they themselves created and sold to clients as AAA assets). After the crisis, a seeming pattern of fraud continued apparently unabated in the robo-signing foreclosure scandal where documents submitted to courts were falsified. Despite an avalanche of alleged crimes under existing federal law, no firm or individual of any significance in the financial crisis has yet been prosecuted.

President Barack Obama said in October 2011 that the mortgage finance practices leading to the economic meltdown were "immoral, inappropriate and reckless ... but not necessarily illegal." Since fraud is, in fact, illegal, critics claim that the U.S. federal government has simply failed to enforce the law. Adding fuel to the fire, the Solyndra loan scandal could be construed to suggest corruption at high levels and the MF Global debacle could be construed as indicative of weak regulation and law enforcement and even of questionable market integrity.

In theory, selective enforcement of the law risks the creation of two sets of laws: one for big banks and corporations, and for their executives, i.e., those with connections in Washington D.C. or on Wall Street, and one for everyone else. Among other things, failure to enforce the law could create an environment in which crime pays, but, for ordinary citizens, hard work, prudent financial decision making, saving and investing for the long term do not.

More than any other aspect of America's progression towards 3rd world status, the federal government's low level of law enforcement action where "too big to fail" banks are concerned is perhaps the most insidious because it raises questions of legitimacy and of the social contract. A financial and legal system of moral hazard implies that victims face double jeopardy while they are deprived of legal recourse, i.e., those allegedly defrauded might face inflation and tax burdens stemming from preferential treatment of favored corporations or from further bailouts.

Destructive Tax Policies

In the face of rising government debt, the rapidly shrinking American middle class is the primary target of the U.S. federal government's tax policies. The eventual extinction of the American middle class would be a key milestone along the road to 3rd world status. Current U.S. tax policies favor the largest corporations and this is unlikely to change in the foreseeable future. Although tax increases exacerbate economic downturns, several tax options have been or are being discussed. However, none of them are likely to be put in place.

Increasing taxes on corporate profits would result in job losses in the short term and would affect dividends and share prices in the stock market. Lower dividends or share prices would affect pension funds, including government pension funds.
Increasing taxes on capital gains would impact the non-tax-exempt investments of the now retiring "baby boomer" generation and would reduce capital formation thus reducing investment in new businesses or business expansion and hampering job growth.
Increasing payroll taxes would cause companies to downsize resulting in job losses and would have a chilling effect on hiring.
A Value Added Tax (VAT) is impractical in the United States because countless special taxes already exist at all levels of the supply chain. To prevent unpredictable, disruptive consequences, implementing a VAT would require years of study and comprehensive tax reform.
A national sales tax is undesirable because it would overlap and interfere with already existing state sales taxes, which are highly inconsistent across states.
Carbon taxes remain possible but they would encumber businesses and result in job losses or reduce hiring.

Chief among the remaining possibilities is the income tax but, according to the Tax Policy center at the Urban Institute, Brookings Institution, 46% of American households will pay no federal income tax in 2011. The reasons include income tax exemptions for subsistence level income, dependents and nontaxable tax expenditures for senior citizens and low-income working families with children.

Assuming that big banks, multinational corporations and the wealthiest 1% of Americans remain off limits in terms of tax policy, the range of income taxed is likely to widen from the current tax on households earning more than $250,000 per year to progressively lower income levels. In fact, the government's intended revenue source is precisely what remains of the once much larger middle class: professionals, small business owners and dual income families in urban areas, etc. These are the households that have managed to stay ahead of inflation, declining real wages and falling household incomes.

Among other things, U.S. tax policies will erode capital formation within the remnants of the middle class, which is the engine of small business creation and the source of most American jobs. The eventual result will be a three-tier socioeconomic structure consisting of a super rich wealthy class, a much poorer working class and a massive, politically and financially disenfranchised underclass, similar to that of a 3rd world country.

Via Dolorosa

The United States increasingly resembles a 3rd world country in terms of unemployment, lack of economic opportunity, falling wages, growing poverty and concentration of wealth, government debt, corporate influence over government and weakening rule of law. Federal Reserve monetary policies and federal government economic, regulatory and tax policies seem to favor the largest banks and corporations over the interests of small businesses or of the general population. The potential elimination of the middle class could reshape the socioeconomic strata of American society in the image of a 3rd world country. It seems only a matter of time before the devolution of the United States becomes more visible. As the U.S. economy continues to decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate. There is little evidence of political will or leadership for fundamental reforms. All other things being equal, the U.S. will become a post industrial neo-3rd-world country by 2032.

How the U.S. Will Become a 3rd World Country (Part 1)

Ron Hera — Sun, 01 Jul 2012 19:44:00 GMT

The United States is increasingly similar to a 3rd world county in several ways and is accelerating towards 3rd world status. Economic data indicate a harsh reality that obviates mainstream political debate. The evidence suggests that, without fundamental reforms, the U.S. will become a post industrial neo-3rd-world country by 2032.

Fundamental characteristics that define a 3rd world country include high unemployment, lack of economic opportunity, low wages, widespread poverty, extreme concentration of wealth, unsustainable government debt, control of the government by international banks and multinational corporations, weak rule of law and counterproductive government policies. All of these characteristics are evident in the U.S. today.

Other factors include poor public health, nutrition and education, as well as lack of infrastructure. Public health and nutrition in the U.S., while below European standards, stand well above those of 3rd world countries. American public education now ranks behind poorer countries, like Estonia, but remains superior to that of 3rd world countries. While crumbling infrastructure can be seen in cities across America, the vast infrastructure of the United States cannot be compared to a 3rd world country. However, all of these factors will rapidly deteriorate in a declining economy.

Unemployment and Lack of Economic Opportunity

Unemployment, which is a deep, structural problem in the U.S., is a fundamental challenge to economic opportunity. The U.S. labor market is in a long-term downward trend linked to globalization, i.e., offshoring of manufacturing, outsourcing of jobs and deindustrialization.

The U.S. workforce has declined by approximately 6.5% since its year 2000 peak to roughly 58.2% of working age adults and the U.S. now suffers chronic unemployment of 9.1%. Although the workforce grew in the 1980s and 1990s, as dual income families became the norm, the size of the workforce is shrinking due to a lack of economic opportunity.

Officially, long-term unemployment is 16.5% and the ranks of the long-term unemployed (those jobless for 27 weeks and over) include 5.9 million, 42.4% of those unemployed. However, prior to the Clinton administration, unemployment measures included workers who are now no longer counted as part of the workforce. Using the more accurate pre-Clinton criteria, unemployment exceeds 22%, only 3% below the worst point (24.9%) of the Great Depression. For countries with populations greater than 2 million, Macedonia leads the world with 33.8% unemployment, followed by Armenia at 28.6%, Algeria at 27.3% and the West Bank and the Gaza Strip both at 25.7%.

Compounding the unemployment problem is the fact that an entire generation of young Americans is being left behind in terms of economic opportunity. Student loans exceed $1 trillion while the labor force participation rate for those aged 16 to 29 who are working or looking for work fell to 48.8% in 2011, the lowest level ever recorded. Lack of economic opportunity among the youth, including millions of unemployed college graduates, is a political wildcard reminiscent of countries like Tunisia.

The structural decline of the U.S. labor market will continue as American workers are merged into a global labor pool in which they cannot yet directly compete for jobs with workers in countries like China and India. In China, for example, gross pay, in terms of purchasing power parity, is equivalent to approximately $514 per month, 57% below the U.S. poverty line. According to the Economic Policy Institute, the U.S. trade deficit with China alone caused a loss of 2.8 million U.S. jobs since 2001.

Falling Real Wages and Household Incomes

Workers earning more dollars are actually poorer in terms of purchasing power when the cost of living rises faster than wages,. In fact, if household income is adjusted for inflation, most American families have grown significantly poorer over the past ten years. In 2010, for example, real median household income fell 2.3%. Although the average wage has risen steadily in nominal terms, dwindling purchasing power is a reality for most Americans. When adjusted for inflation, the wages of most Americans have not kept up with the Consumer Price Index (CPI).

According to famed economist Milton Friedman, "inflation is always and everywhere a monetary phenomenon." In other words, prices rise when the money supply is increased faster than population or sustainable economic activity. Apparent economic growth created through credit expansion, i.e., by increasing the money supply, has a temporary stimulative effect but also causes prices to rise. True Money Supply is an accurate measure of inflation.

Although CPI is sufficient to illustrate declining real wages, CPI does not measure the cost of living in a realistic way. According to economist John Williams of Shadow Government Statistics, CPI systematically understates inflation.

The decline in real household income has set Americans back to 1996 levels, despite many households now having two incomes rather than one. Dual income families accounted for much of the increase in real median household income during the 1980s and 1990s, but, today, two incomes are barely better than one income was three decades ago. The decline in real wages was obfuscated in the 1980s and 1990s by growth in the workforce, e.g., by women entering the workforce. Real median household income rose while real wages declined because more households had two incomes. As U.S. wages and household income continue to fall in real terms, both poverty and reliance on government assistance programs will continue to rise.

Growing Poverty

According to the U.S. Census Bureau, the poverty rate in the United States rose to 15.7% in 2011, with 47.8 million Americans living in poverty (1 in 6). The official poverty line, determined by the U.S. Department of Health and Human Services, is $22,314 for a family of four. The number of families living in poverty has risen sharply since 2006 and continues to climb. The U.S. Department of Agriculture's Supplemental Nutrition Assistance Program (SNAP), commonly known as "food stamps," serves 45.8 million households as of May 2011. The program now feeds 1 in 8 Americans and nearly 1 in 4 children.

Based on the outlook for employment and wages, both poverty and reliance on government assistance programs will continue to grow. However, the negative trends in employment, wages and poverty have not affected all Americans equally. In fact, the household income and wealth of the wealthiest Americans has increased sharply, despite the overall deterioration of the U.S. economy.

Increasing Concentration of Wealth

Alan Greenspan, former Chairman of the Federal Reserve, warned that, "Ultimately, we are interested in the question of relative standards of living and ... trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume." In other words, concentration of wealth undermines the consumer base of the economy, causing GDP to decline and resulting in unemployment, which reduces living standards. Obviously, the total wealth of society is reduced when wealth is highly concentrated because there is a lower overall level of economic activity.

Economic data from several sources, including the Congressional Budget Office (CBO), show that wealth and income in the United States have become increasingly concentrated with the wealthiest 1% of Americans owning 38.2% of stock market assets, e.g., shares of businesses. For the wealthiest 1% of Americans, household income tripled between 1979 and 2007 and has continued to increase while household wealth in the United States has fallen by $7.7 trillion. The Gini Coefficient illustrates the growing disparity in income distribution. In terms of the Gini Coefficient, the United States is now at parity with China and will soon overtake Mexico, a still developing country. It should be noted, of course, that the U.S. remains a far wealthier country overall. If the current trend continues, however, the U.S. will resemble a 3rd world country, in terms of the disparity in income distribution, in approximately two decades, i.e., by 2032.

Welcome to the 3rd World

The United States is quickly becoming a post industrial neo-3rd-world country. Partly as a consequence of worsening unemployment and lack of economic opportunity, falling real wages and household incomes, growing poverty and increasing concentration of wealth, the U.S. government faces a historic fiscal crisis. Dominant corporate influence over the U.S. government, particularly by large banks, weakening rule of law at the federal level and destructive tax policies are compounding the economic problems facing the United States. Barring fundamental reforms or a hyperinflationary collapse of the U.S. dollar (due to the fiscal problems of the U.S. government), the deterioration of the U.S. economy will continue and accelerate. As the U.S. economy continues its decline, public health, nutrition and education, as well as the country's infrastructure, will visibly deteriorate and the 3rd world status of the United States will become apparent.

Jim Sinclair: The Financial System Is Less Stable Today Than It Was in 2008

Ron Hera — Sat, 07 May 2011 11:35:00 GMT

The Hera Research Newsletter is pleased to present an in-depth interview with Jim Sinclair, Chairman and CEO of Tanzanian Royalty Exploration and founder of Jim Sinclair's MineSet, which hosts his gold commentary as a free service to the gold investment community.

Jim Sinclair is primarily a precious metals specialist and a commodities and foreign currency trader. He founded the Sinclair Group of Companies in 1977, which offered full brokerage services in stocks, bonds, and other investment vehicles. The companies, which operated branches in New York, Kansas City, Toronto, Chicago, London and Geneva, were sold in 1983.

From 1981 to 1984, Mr. Sinclair served as a Precious Metals Advisor to Hunt Oil and the Hunt family for the liquidation of their silver position as a prerequisite for the $1 billion loan arranged by the Chairman of the Federal Reserve, Paul Volcker.

He was also a General Partner and Member of the Executive Committee of two New York Stock Exchange firms and President of Sinclair Global Clearing Corporation (a commodity clearing firm) and Global Arbitrage (a derivative dealer in metals and currencies).

In April 2002, shareholders of Tanzanian Royalty Exploration (formerly Tan Range Exploration) approved the acquisition of a Sinclair managed private company, Tanzania American International, and its exploration assets in Tanzania. Subsequently, Mr. Sinclair became Chairman of Tanzanian Royalty and now leads its efforts to become a gold royalty and development company.

He has authored three books and numerous magazine articles dealing with a variety of investment subjects, including precious metals, trading strategies and geopolitical events and their relationship to world economics and the markets. He is a frequent and popular commentator on financial and market related issues in various news publications, and has been profiled in the New York Times.

In January 2003 Mr. Sinclair launched, Jim Sinclair's MineSet, which now hosts his gold commentary and is intended as a free service to the gold community.

Hera Research Newsletter (HRN): Thank you for speaking with us today. You are one of very few people who have tried to warn investors about OTC derivatives. Why are OTC derivatives a problem in your opinion?

Jim Sinclair: Over the counter (OTC) derivatives are the reason we are going through what we are going through now. An OTC derivative is a kind of wager on what something will do. Up until 2009, most of these wagers had very little, if any, money behind them and, if the direction you bet on didn't come to fruition, the amount of leverage resulted in extraordinary losses. There was a major rollover in derivatives tied to real estate in 2008, as well as in other types, such as those tied to sub-prime auto loans.

HRN: Did OTC derivatives destabilize the financial system in 2008?

Jim Sinclair: Absolutely.

HRN: Don't financial institutions use risk cancellation models to hedge risks using OTC derivatives?

Jim Sinclair: Before the failure of Lehman Brothers, OTC derivatives losses would have almost netted out to zero. You can consider derivatives like a string in a circle with various knots representing all the derivatives transactions. When Lehman went broke, the string broke. When Lehman couldn't meet its obligations on derivatives, they could no longer be netted out to zero. That's why the banks went down, and that's why you had the government bailouts and quantitative easing (QE).

HRN: OTC derivatives are the real reason for the bank bailouts?

Jim Sinclair: That is a fact which can in no way be argued away.

HRN: Hasn't the problem been cleaned up by the Dodd-Frank Wall Street Reform and Consumer Protection Act?

Jim Sinclair: The pile of OTC derivatives is over $1 quadrillion. After 2008, the International Monetary Fund (IMF) adopted a new method of valuing them called value to maturity. Value to maturity assumes all of them will function, which is a cartoon. The derivatives pile hasn't contracted. Basically, it has expanded, but value to maturity reduced the notional value from over $1 quadrillion to under $700 trillion. The amount outstanding is the same as it was in the first place.

The flavor of the present moment is credit default swaps against the solvency, or lack thereof, of sovereign nations. New derivatives have some margin behind them, but they only work if they are not called upon. If a nation's debt was in fact to default, it would happen very quickly without a great deal of run up before. Most people would expect a rescue to be coming. Let's say a rescue didn't come, those credit default swaps would simply not be able to function and down again would come the banking system.

HRN: Are you saying that the financial system is less stable today than it was in 2008?

Jim Sinclair: It appears more stable but that's only an appearance. The entire equity rally took place almost to the day from when the Financial Accounting Standards Board (FASB) relaxed the mark-to-market rule. It allowed financial institutions to make up whatever value they wanted for their worthless pieces of paper. If they used the real values, the banks would have come down.

HRN: Wasn't the FASB change a temporary measure to halt the decline in mortgage-backed securities?

Jim Sinclair: It wasn't just mortgage-backed securities. It was all the paper on bank balance sheets. The balance sheets of banks appear to be in good shape but they're not. In fact, they will need a lot more funds.

HRN: Then the financial system is still vulnerable?

Jim Sinclair: They've kicked the can down the road. The purpose of QE, in other words the printing of money, is to maintain some degree of integrity in the financial system. Bear in mind that the grease for the wheels of equity markets is liquidity, meaning that if you create a lot of money, it goes into the hands of banking institutions and international investment houses. So, the equity out of thin air market has been sustained by QE.

HRN: What can the government do to prevent another crisis?

Jim Sinclair: You can assume that what's been done already will be done again. There are no other tools in a practical sense. The idea that there won't be a continuation of QE is nonsense.

HRN: Can the government bail out the banks again?

Jim Sinclair: The central banks will buy the government debt. That's called quantitative easing.

HRN: Doesn't QE undermine the dollar?

Jim Sinclair: The dollar is an exercise in psychology. It's a piece of paper with a promise to pay but there's nothing in which it can be paid. It's legal settlement for debt but there's nothing that it's convertible into. To maintain confidence, it's necessary to maintain the stature of a currency. In an arithmetic sense, if you go into a market to sell a supply of apples, and if you're the only seller, you can get a nice price. If more sellers, meaning more apples, come into the market, there goes the price of apples. QE creates more dollars, which increases the supply.

HRN: If the dollar is losing value because of QE, what about the euro?

Jim Sinclair: If you look at the dollar or the euro or the yen, or even the Swiss franc, it's a race to the bottom amongst all currencies. All countries everywhere are creating more paper every day. It's a relative valuation, rather than a valuation based on an objective reference. What happens in the European Union immediately affects the dollar.

HRN: You mean the sovereign debt crisis?

Jim Sinclair: There's too much focus on the euro countries. There's no difference between the economic union of Europe and the union of the states in the United States. The states of europe have been revealed to be insolvent. How about the states of the United States? Out of New York, Illinois, California, etc., how many are solvent? The focus of the media has been on the euro. The U.S. should stand in front of a mirror. The states of the economic union of America are in no better shape.

HRN: The news media is ignoring the U.S. sovereign debt crisis?

Jim Sinclair: In George Orwell's Nineteen Eighty-Four, there were loud speakers constantly teaching the people what Big Brother wanted. The loudspeakers today are financial television. How much attention has financial TV put on the insolvency of U.S. states? It's been mentioned, but not like the solvency problems of Portugal, Greece, Spain and Ireland, which have gotten hours, days, weeks and months of constant coverage. The solvency of New York, Illinois and California has been brought up but fleetingly at best.

HRN: So, the solvency problems of U.S. states are like an elephant in the room that no one is talking about?

Jim Sinclair: How can you say that the euro is a disaster based on the financial condition of the states of the economic union of Europe, when the states of the economic union of the United States are in equally bad shape and in some cases worse? There's no difference. If you want to analyze the euro based on the weakness of its member states, how can the dollar be strong when the states of the United States are as weak or weaker?

HRN: So, the euro could rise against the U.S. dollar, despite the European sovereign debt crisis?

Jim Sinclair: Sure it can. The question is, can the dollar go lower? The euro could go to $1.50 or higher.

HRN: But the U.S. dollar is the world reserve currency. Doesn't that guarantee its value?

Jim Sinclair: Only by default. It remains so because central banks own dollars. If central banks could exchange them for gold or other currencies without a major dislocation, they would.

HRN: Then, as a practical matter, central banks can't get out of the dollar?

Jim Sinclair: The only one that's gotten out of it is China. They've made deals all around the world for metals, materials, energy and manufacturing. If you add it all up, China is no more stuck in the dollar than the man in the moon.

HRN: Doesn't the U.S. maintain a strong dollar policy?

Jim Sinclair: The strong dollar policy has only been a moderate, long-term downtrend that continues lower.

HRN: Don't central banks manage currency exchange rates to prevent disruptive changes, like the recent Japanese yen intervention?

Jim Sinclair: In the Japanese yen intervention, the central banks intervened but how long can they intervene? They have to create money to intervene, which comes back to QE.

HRN: Do you mean the overall affect of currency interventions is to create new money?

Jim Sinclair: Anything that happens around the world, for instance, the Bank of Japan's response to the horrible disaster in Japan, was to go straight to QE. Money is being created everywhere without any discipline but the problems of financial institutions remain because they have make-believe balance sheets with improper values for their OTC derivatives.

HRN: Doesn't the suspension of the FASB mark to market rule buy time for banks to repair their balance sheets?

Jim Sinclair: There are five million homes for sale in the United States if you include the off-market shadow inventory, which is a real inventory. There's no repair coming in the real estate market, therefore, there's no repair coming in the OTC derivatives based on that. That means there's no repair coming in the underlying paper that the banks now value at much higher levels than they could possibly sell them for, if they could sell them at all.

HRN: Will bank balance sheets eventually get better?

Jim Sinclair: As long as confidence remains in place, which depends on the equity market and that comes back to QE.

HRN: Are you saying that the U.S. stock market rally is driven by QE?

Jim Sinclair: There's an inability to stop QE without the whole house of cards coming down on itself. There's no other choice. It's the only tool left. The Federal Reserve can't take a hawkish position on monetary policy and interest rates without this whole thing rolling over. They can talk about it constantly and might have more back-door QE than front-door QE.

HRN: If QE doesn't stop soon, what will happen?

Jim Sinclair: The end game is a virtual reserve currency linked to gold. It will be based on an average of major currencies, which will slow down the movement in the index. The IMF is moving in that direction with Special Drawing Rights (SDRs). The dollar will be just another currency. The dollar's not going to zero. It could loose a significant part of its buying power, which it already has and could again.

HRN: How would a virtual currency work?

Jim Sinclair: There would have to be a broad measure of the money supply, such as M3 used to be for the U.S. dollar, but on an international basis. The price of gold would be related to that measure. Central banks would have to value their gold according to their contribution to or extraction of international liquidity, so the price of gold would rise or fall on its own.

HRN: Wouldn't that be a gold standard?

Jim Sinclair: There'll never be a return to a gold standard in my opinion. The end of all hyperinflations has been a commodity currency. That's exactly what happened in Germany, for example. Gold has the capacity to give confidence to people if there's some relationship between the currency and gold. The virtual currency will be linked to gold but not convertible into gold.

HRN: So, a gold component will restore confidence?

Jim Sinclair: The answer is a commodity currency. That's what happened every time there was this type of situation in monetary history. The rentenmark, which ended the German hyperinflation in 1923, was supposedly backed by all the real estate in Germany, but the government didn't own that real estate. The point is that it wasn't true. There was no great commodity backing for the rentenmark, but it was enough. It was a period when people were searching for anything to restore confidence in the currency.

HRN: Do you expect high inflation in U.S. dollar terms?

Jim Sinclair: The deed is done. Inflation is a pregnancy. The conception has already taken place. There's a delayed effect but if you do the crime, you do the time. The Federal Reserve could stop QE tomorrow and it wouldn't stop what's going to happen because of what they've already done.

HRN: Won't inflation reduce the real value of debt and help to repair bank balance sheets?

Jim Sinclair: Inflation is the way debt will be taken care of. The value of the currency will be so reduced as to reduce the debt load. It will also change the political scene. Whoever has power going into this will not have power coming out of it.

HRN: In other words, inflation is politically destabilizing?

Jim Sinclair: People really haven't seen the big picture. Currency induced cost push inflation is already here. Look at what's going on right now in the Middle East. We are moving from order to lack of order.

HRN: Would you say that inflation in food prices is indirectly driving oil prices higher?

Jim Sinclair: Oil goes right through from fertilizers to farm equipment to transportation and to food prices. The price of food is going to go even higher than we are seeing this year. The price of oil is headed decidedly higher. Peak Oil was a concept of the future. Now it's a concept of now. A car getting 25 miles per gallon will probably be too expensive for the average person to drive.

HRN: How will high oil prices affect the prices of other things?

Jim Sinclair: There will be dislocation in the means of delivery of products. There may be shortages of goods, not because there are no available goods but because the means of distribution breaks down. It's not that there won't be corn or wheat, but the fuel needed to deliver it will be too expensive and people who work in transportation will demand higher pay so they can live. That's where hyperinflation comes in.

HRN: And money to maintain the distribution of goods will be printed out of thin air?

Jim Sinclair: Every nation that has ever done this has turned into a banana republic. People can live in banana republics but there will be few wealthy people. There will be a few super wealthy people and an enormous amount of poverty. You can see it across the border in Nogales, Mexico, where people continue to live in extreme poverty.

HRN: America is becoming like Mexico?

Jim Sinclair: The standard of living is going much lower. People have to realize that the damage is already done. It's not a question of whether the U.S. can be pushed over the edge. We are over the edge. We are watching the consequences play out now.

HRN: What can people do to protect their wealth from inflation?

Jim Sinclair: People have to try to maintain their buying power. Each person can become their own central bank and, to the best of their abilities, focus on the assets that benefit from the disorder that's taking place and that will continue to take place.

HRN: Do you mean buying precious metals or commodities?

Jim Sinclair: I've spoken to people who, over the last ten years, have had this perspective. They have done very well. Even doing it now could protect your wealth.

HRN: What about gold? Do you see gold as a currency that can't be debased?

Jim Sinclair: What is real money? Gold is a currency that has no liability attached to it. It's a measure of value and a store of wealth that's universally acceptable.

HRN: So, gold is an alternative to dollars or euros?

Jim Sinclair: Physical gold is the answer. An individual who holds gold will have more time and ability to function.

HRN: How much higher do you think the price of gold could go?

Jim Sinclair: What's the exchange rate of a currency with no liability attached to it? Gold is going much higher. We could see shocking gold prices, maybe Alf Fields' target of $10,000 per ounce or Martin Armstrong's target of $12,000 per ounce. I think that my price target of $1,650 per ounce gold is going to be so low it will be considered silly.

HRN: Thank you for your time today.

Jim Sinclair: It was my pleasure.

Nicknamed "Mr. Gold" for his incredible timing of the gold market in the 1970's, when he called the top of the market in 1980 to the day, Jim Sinclair, is a legendary precious metals, commodities and currency trader. Mr. Sinclair was influenced by his father, Bert Seligman, who was the business partner of Jesse Livermore, "The Great Bear of Wall Street" famous for short selling in the stock market crashes of 1907 and 1929. Currently Chairman, President and CEO of Tanzanian Royalty Exploration Corporation, part of Mr. Sinclair's strategy to protect his interests from the effects of currency debasement, is to acquire as much gold in the ground as possible without rushing to production because, he believes, the price of gold will go much higher. Mr. Sinclair's famous 2001 gold price target of $1,650 per ounce in 2011-a prediction ten years into the future-fell within 22% of the gold price in January 2011 after a phenomenal 511% increase over a ten year period, from an average price of $265.49 in January 2001 to an average price of $1,356.40 in January 2011 (London p.m. Fix)-one of the most astonishing calls in the history of precious metals trading. As a commentator on precious metals, commodities and currencies, investors ignore Jim Sinclair at their peril.

QE2 and its Consequences (Part I)

Ron Hera — Tue, 18 Jan 2011 01:35:00 GMT

The Federal Open Market Committee (FOMC) announced on November 3, 2010 that it would purchase longer-term Treasury securities at a pace of $75 billion dollars per month through the Federal Reserve’s Permanent Open Market Operations (POMO) facility by the end of the second quarter 2011 and potentially beyond. The Quantitative Easing Two (“QE2”) program, championed by Ben Shalom Bernanke, Ph.D., Chairman of the US Federal Reserve, is expected to total at least $600 billion and the program may total more $600 billion, if Dr. Bernanke and the FOMC deem it to be necessary. Currently, QE2 is expected to continue until the end of 2011, i.e. up to $1.2 trillion, although there is ongoing policy debate within the Federal Reserve amidst growing fears that the policy may backfire.

Chart courtesy of Shadow Government Statistics

Monetary inflation is one result of QE2 because when the Federal Reserve buys US Treasuries it injects newly created money into the financial system, which, in turn, reduces the value of the US dollar (due to the increase in the quantity of dollars). A lower US dollar could stimulate US exports but could have unintended consequences, such as creating excess liquidity that could lead to asset price bubbles in the US. Low interest rates are already fueling a US dollar carry trade that seems likely to create asset price bubbles abroad. In 2010, borrowing in the US and investing abroad yielded significant returns, thus, there is a profitable carry trade in the world’s reserve currency, which has been called the mother of all carry trades by New York University economist Nouriel Roubini because of the US dollar’s increasingly tenuous status as the world reserve currency.

Global Outcry against QE2

The announcement of QE2 touched off an international firestorm of controversy. QE2 has been widely criticized by financial and political leaders representing US creditors, exporters and emerging economies. Nobel laureate Joseph Stiglitz has become an outspoken critic of QE2, warning that it poses a risk to emerging economies where asset price bubbles are already apparent. European Central Bank (ECB) President Jean-Claude Trichet expressed the same concern. The growing consensus on the part of emerging economies, such as Brazil, India, China, Argentina, Taiwan, Thailand, South Korea, Peru and Indonesia, is that capital controls are necessary to prevent excessive capital inflows, which can be highly inflationary. The International Monetary Fund (IMF), which bailed out a number of smaller countries in 2008, has supported capital controls since February 2010. The dilemma for exporters is that they must seek to control inflation, e.g., by raising interest rates, but must also debase their currencies to maintain their exports. The only other option is to institute capital controls. One of many critics, Brazil’s Finance Minister, Guido Mantega, warned that the US-led currency war “…is turning into a trade war.”

The growing consensus is that inflation in Asia will damage Asian economies before Western countries, which are debasing their currencies, fully recover from the recession that began in 2007. The trade relationship of the US and China is in the eye of the storm and fears of a trade war are growing. Debasing the US dollar reduces the value of China’s US Treasury holdings while China relies on exports to the US, totaling between $200 and $300 billion annually. For exporters, QE2 is a doubly destructive policy since capital inflows are inflationary while exports are reduced due to currency appreciation. The potential effects of a downturn in manufacturing resulting from falling exports, coincident with the bursting of an asset price bubble, is a formula for disaster. As more countries begin to conduct international trade without using US dollars, the world could be split into two camps. For example, talks are taking place between the US and Japan regarding the establishment of trans-Pacific free trade.

Interestingly, QE2 has the potential to “cash out” favored holders of US Treasuries in exchange for US dollars at their current value, i.e., before the US dollar declines further. China, Russia and Brazil are already reducing their US Treasury holdings and could be favored sellers of US Treasuries to the Federal Reserve (through its intermediaries). However, given the size of the US federal deficit, the simplest explanation is that the Federal Reserve is simply funding the US government.

Keeping the Wolfpack at Bay

While it may stimulate US exports and help to create conditions for renewed economic growth in the US (rather than relying mainly on the stimulation of consumer spending), QE2 represents a debasement of the US dollar and suggests that demand for US debt may be weakening. The current facts regarding the US economy do not justify the AAA rating of US sovereign debt. In February 2010, Moody’s publicly warned that it might have to cut the rating on US government debt. The warning was reiterated in December, while American politicians debated tax policy, and surfaced again in January. Until the US economy shows stronger growth, and until the US federal government gets its budget deficit under control, confidence in US sovereign debt and in the US dollar will continue to deteriorate.

US Treasury yields began to rise after the announcement of QE2 and, in December, US Treasuries experienced an unprecedented sell-off causing speculation that the US may become the next target of the so-called wolfpack, comprising short sellers of sovereign debt that are also OTC derivatives (credit default and interest rate swaps) traders. Artificial demand for US Treasuries created by QE2 could potentially head off the shorting of US Treasury bonds to generate credit default and interest rate swap related profits. Short sellers seeking to drive up yields run the risk that the Federal Reserve will step in and buy aggressively to drive yields back down, thus QE2 may preempt the wolfpack. The United States is not immune to such predatory practices might because the notional value of OTC derivatives is currently more than $605 trillion (approximately 10 times world GDP).

Chart courtesy of StockCharts.com

Artificial demand for US Treasuries could hold down bond yields thus supporting an inflationary monetary policy but the Federal Reserve’s own Primary Dealers forecast higher bond yields for 2011. The Federal Reserve’s control over US Treasury bond yields appears to be limited, ironically, as a consequence of currency debasement. Even if US Treasury bond yields rise, however, QE2 might still provide a means of keeping the wolfpack at bay.

Let them Eat Dollars

While QE2 has been generally positive for equities in the short term, the FOMC announcement in November 2010 triggered a sharp rise in commodity prices with gold closing over $1400 and silver closing over $30 at the end of 2010 and with the Commodity Channel Index (CCI) and global food prices at new highs. Rapidly rising global food prices pose an escalating risk of food shortages or worse, particularly in poorer countries, leading analysts to conclude that the world is one poor harvest away from chaos. President of the World Bank, Robert Zoellick, warned that rising food prices are “a threat to global growth and social stability.” Food riots, for example, have already begun to break out in Africa. In the US, consumers and businesses paid an additional $25 billion for gasoline between September 2010 and January 2011 and gasoline prices have continued higher.

Chart courtesy of StockCharts.com

Since the corrosive effects of expanding the money supply in excess of the rate of increase in sustainable economic activity, i.e., inflation, could not so quickly have resulted from QE2, QE2 seems to have damaged global confidence in the US dollar and in US Treasury debt. The January pullback in gold and silver showed that the sharp rise in prices after the announcement of QE2, in November 2010, was in part reactionary. Nonetheless, the strengthening of the US dollar can be largely attributed to the ongoing debt crisis in Europe and the ongoing bull market in commodities and precious metals points to a continuing influx of capital and to a reduced preference for the US dollar and US Treasuries. Had it not been for the revelation of Ireland’s economic troubles along with those of other European countries, the US dollar would certainly have fallen further compared to the Euro towards the end of 2010. What is more important is that the Euro, the US dollar and the Japanese yen have the same fundamental problem in common, which is a combination of high debt levels and economic fundamentals that, in the best case, do not inspire confidence.

Chart courtesy of StockCharts.com

All other things being equal, if the QE2 program were terminated, the US dollar would certainly rally and demand for US debt would certainly strengthen, lowering demand for commodities and precious metals. The termination of QE2 or an announcement of its impending termination is a potential short term risk for investors. Conversely, as QE2 continues indefinitely, the current commodities bull market, which has been amplified by the weakening US dollar, will continue And precious metals prices, which are currently consolidating, will move higher.

The emerging pattern since the announcement of QE2 is bullish for commodities and precious metals. Episodic flights to safety have tended to cause the US dollar to rally, despite poor economic conditions in the US, i.e., in response to economic instability in countries such as Dubai, Greece, Ireland or Spain. The pattern of US dollar-centric flights to safety has begun to break down, suggesting that investors may increasingly favor commodities and precious metals over US dollars and US Treasuries as hedges against inflation and sovereign debt risk.

Diminishing US Credibility

The credibility of the US government and the Federal Reserve is gradually deteriorating. In the worst case, a total collapse of confidence could trigger a race to divest of US Treasuries and to shed US dollars, i.e., a hyperinflationary currency event. The declining US dollar and the diminishing desirability of US debt and of the Federal Reserve bode well for commodities and precious metals while warning away any sane investor from US Treasuries.

In the face of indefinite QE2, it remains unclear (1) when the disintegration of the US dollar’s status as the world reserve currency might accelerate and a new reserve currency will be established, (2) if and when holders of US Treasuries seeking a way out might reach critical mass potentially triggering a proverbial rush to the exits (i.e., a collapse of US Treasuries despite the Federal Reserve’s artificial demand), or (3) if and when a race, whether global or domestic, to shed US dollars in favor of equities, hard assets, alternative currencies, precious metals or other real goods might begin. The first and second processes (removal of the US dollar’s world reserve status and the divestment of US Treasuries) are already under way and the Federal Reserve’s current policies are on track to eventually trigger the third.

Fundamentally, the Federal Reserve cannot prevent rising prices while the US dollar moves lower due to QE2 and due to the US’ deteriorating creditworthiness and credibility, nor can it control the flow of liquidity resulting from its actions or, therefore, resulting asset price bubbles, whether in the US or abroad. In light of the Federal Reserve’s current policies, it seems likely that, in the next 12 months, global economic volatility related to inflation, currency debasement and, potentially, developing currency and trade wars will increase while the financial stability of the US and of the Eurozone countries continues to decline and while commodity and precious metals prices continue to move higher.

OTC Derivatives: Failed Banks or Failed Nations?

Ron Hera — Tue, 11 May 2010 12:20:00 GMT

Economic bubbles are not recognized by those inside of them, and the entire Western world has become quietly trapped inside the largest economic bubble in history. The global financial crisis that began in 2008 has been attributed to sub-prime mortgage lending and mortgage backed securities (MBSs), such as collateralized debt obligations (CDOs), which were revealed as toxic assets. While the root cause of the financial crisis is assumed to have been the residential real estate asset price bubble, the underlying systemic risk, and the primary reason for the "too big to fail" doctrine whereby governments were compelled to save financial institutions at any cost, lies in over the counter (OTC) derivatives. The suspension of the US Financial Accounting Standards Board (FASB) mark-to-market rule in 2009 preserved the value of bank balance sheets, i.e., of their mortgage portfolios, but what was of far greater importance was that it prevented triggering the conditions of thousands of OTC derivatives contracts, such as credit default swaps (CDS), that would have wiped out virtually all of the largest banking institutions in the world.

OTC derivatives can serve a straightforward role as financial insurance policies covering real business risks. In a hedging scenario, an investor that has exposure to a variable interest rate can transfer the risk to a second investor (the counterparty) by entering into an interest rate swap. A swap is simply an agreement to exchange cash flows. If the interest rate goes up, the second investor pays the difference while the first investor pays the original rate (to the second investor) along with the cost of the swap. Of course, if the second investor becomes insolvent, the original investor is still liable to the lender and will have lost the insurance from risk provided by the second investor as well as any net amount paid to the second investor. Taken in isolation the risks to both investors are limited, but the second investor can offset their risk through a third investor, and so forth, giving rise to a web of interconnected risks. Other types of OTC derivatives include currency exchange rate swaps and forwards, which are essentially non-standard futures contracts, as well as credit default swaps (CDS). OTC derivatives can be used for speculation, as well as hedging. In a speculative scenario, OTC derivatives are analogous to wagers, e.g., a bet that a certain company will default on its bond obligations. Speculation in OTC derivatives involves no connection to an underlying asset or to a real business risk, but the liabilities and risks they create are real. Under state gaming laws the speculative use of OTC derivatives, such as naked CDS (similar to naked shorts) and synthetic CDOs, was illegal in the US until state gaming laws were preempted by the federal government's Commodity Futures Modernization Act of 2000 (CFMA).

Derivatives on different underlying assets are traded in the absence of clearing houses, i.e., in unregulated markets. Since they are not exchange traded, derivatives, such as CDS, are not widely understood. In OTC markets, counterparty default risk generates a network of interdependencies among market actors and promotes risk volatility. The resulting emergent property of the financial system is systemic risk, which became apparent in 2008 when Lehman Brothers Holdings, Inc. failed.

Officially, roughly $604.6 trillion in OTC derivative contracts, more than ten times world GDP ($57.53 trillion), hang over the financial world like the sword of Damocles, but to the average investor the derivatives bubble is invisible. From the perspective of those outside the bubble, the explosion of OTC derivatives is a mania.

The inherent lack of transparency in OTC markets impairs price discovery and obviates the efficient markets hypothesis, i.e., that financial instruments are almost always priced correctly, thus OTC derivatives and the risks associated with them may be priced incorrectly, as in the case of American International Group's CDS contract premiums.

Chart courtesy of Bank for International Settlements

Although media attention continues to focus on the political theme of economic recovery and residential real estate, the true cause of what came to be known as the credit crisis continues unabated, outside the purview of the central banks and governments.

Regulation and Ideology

An attempt by the CFTC to regulate OTC derivatives in 1998 was rejected by Alan Greenspan, then Chairman of the Federal Reserve, Robert E. Rubin, then Secretary of the Treasury, and Lawrence ("Larry") H. Summers, then Assistant Secretary of the Treasury. At the time, regulation ran counter to the dominant ideology in Washington D.C., which reflected the views and interests of the banking and financial services industry.

Despite early warnings such as the bankruptcy of Orange County, California, the Proctor & Gamble lawsuit against Bankers Trust and the failure of Long Term Capital Management (LTCM), the President's Working Group on Financial Markets described OTC derivatives in November 1999 as an important innovation that had "transformed the world of finance, increasing the range of financial products available to corporations and investors and fostering more precise ways of understanding, quantifying, and managing risk." In 2000 Greenspan, Rubin and Summers backed deregulation of OTC derivatives.

The regulatory rationale for OTC derivatives stems from the use of derivatives to circumvent existing regulations and tax laws. Investors prohibited from investing in certain financial instruments can assume virtually identical positions in unregulated OTC derivative markets. By changing the type, source or timing of income, OTC derivatives can have different tax results compared to investments in underlying commodities or financial instruments. OTC derivatives can also create moral hazard and perverse incentives. Moral hazard may exist when an entity assumes more risk than it would have otherwise without regard for the effects on counterparties because executives know they will be bailed out should the firm become insolvent. An example of a perverse incentive would be where an entity stands to gain, e.g., in the CDS market, if a certain company defaults on its bond obligations but concurrently has other relationships with the company that influence the outcome, e.g., as a creditor. Widespread speculation puts financial firms and the financial system itself in jeopardy while forcing governments to choose between bailing out irresponsible investors and allowing the economic disruption that would result from the failure of the financial system. Regulation of OTC derivatives, i.e., placing them on regulated exchanges, would increase transparency, force standardization of contracts and provide legal certainty. Since derivatives can be a source of off balance sheet financing, regulation would also make the true leverage of financial firms visible to investors. Regulation can also ensure that counterparties can cover losses and would therefore help to contain speculation and greatly reduce systemic risk.

Exponential Risk

If every market actor seeks to hedge their risks in a like manner, the total notional value of all OTC derivatives can grow exponentially. Considering the notional values of existing contracts, speculation clearly represents a substantial portion of all OTC derivatives. As the number and total notional value of OTC derivatives grows, systemic risk increases because more interdependencies, complexity and credit exposure are created, i.e., the systemic impact of a particular party's failure grows, simultaneously becoming less predictable.

Chart courtesy of Bank for International Settlements

Rather than distributing risk, it became clear in 2008 that OTC derivatives increased the magnitude of financial system instability and the probability of systemic failure due to the complexity and lack of transparency of the contracts, disproportionate leverage exposure and dependencies on other markets vulnerable to disruptive forces. It also became clear in 2008 that the reasons OTC derivatives promote systemic instability are fundamental.

The Underlying World

Since the terms of derivatives contracts involve market factors that can change independent of the actions of the counterparties, OTC derivatives create contingent credit exposure and therefore involve an intrinsic element of uncertainty in addition to counterparty risk. What is more important, however, is that because counterparties tend to participate in the same markets, an implicit correlation inevitably exists. This deeper level of risk, endogenous risk, occurs when funds or institutions with similar positions also have similar risk tolerances and preferences, thus create unexpected correlations between economically diverse and otherwise uncorrelated positions.

At the same time, risks transferred between parties remain present in the financial system but exist in different, and perhaps less well-understood forms. Regardless of the techniques used to model risk, and despite the theory of risk cancellation, i.e., two risky positions, taken together, can effectively eliminate risk, market actors naturally seek to transfer higher risks to counterparties while paying less than fair value, if possible, and accepting only lower risks in exchange for premiums when taking on liabilities. Used irresponsibly, OTC derivatives expose counterparties to risks they would never accept if they had all of the relevant information. Maximizing profits in an unregulated environment means exploiting misalignments of risk that correlate positively with system instability. Since it is impossible in principle for all market actors to win the competition to shed risk while maximizing profits, some portion of market actors will always misprice risk and be rendered insolvent. The failure of a market actor, however, can trigger a domino effect through their network of counterparties, potentially taking down winners and losers alike. Both risk obfuscation and competitive dynamics thrive on a lack of transparency and ultimately destabilize the system.

Since Gaussian distributions do not reflect the real world, large changes up or down are more likely in the stock market than a normal distribution and standard deviation (sigma) would suggest. However, it is possible to model risk using statistical techniques such as the Monte Carlo method.

Diagram courtesy of Wittwer, J.W. (Monte Carlo Simulation Basics)

The Monte Carlo method, named for the casinos in Monte Carlo, is a stochastic method, meaning the state of a model is determined by both predictable and random elements. The Monte Carlo method provides a way of analyzing uncertainty, e.g., in the craps dice game. For example, the Monte Carlo method can be used to analyze the effects of random variation or errors on the sensitivity, performance or reliability of a system. Monte Carlo simulations can be used to simulate real problems, e.g., using historical data, and to predict future outcomes. Probability distributions, used as inputs to the simulation, are generated randomly or derived from historical data. The results can, in turn, be represented as probability distributions and used, for example, to estimate value at risk (VaR) in an investment portfolio, i.e., a prediction of the worst likely loss under a given confidence interval over a specified time horizon. Of course, Monte Carlo simulations and VaR estimates depend on historical price trends and volatility.

At a particular point in time, the global financial system is most like a closed system; essentially an idealized representation of wealth and economic activity that, in reality, exists largely outside the financial system. In other words, the financial system is itself abstract and therefore has properties like those of a model. As a result, patterns that occur in financial markets never perfectly represent the world and every pattern that exists in the financial system is potentially vulnerable to inconsistencies with the underlying world, which is not only non deterministic but subject to change without notice. The problem is not variation within a domain but variation of the domain itself, i.e., structural rather than cyclical change.

British journalist Dr. Gillian Tett, in her Financial Times article Mathematicians Must Get out of Their Ivory Towers, observed that "...when finance has borrowed ideas from physics, it has been an old-fashioned Newtonian branch of physics, not the Theory of Relativity. So, just as the Theory of Relativity has forced scientists to recognise that space and time can expand or shrink, [...] calculations of probability can shift according to context." The implication is that virtually any statistical model of financial risk can be invalidated. In contrast, investors who apply fundamental analysis, such as Warren Buffett, rely primarily on data from the underlying world rather than on trading patterns that reflect only the financial system, which is an abstraction.

A model that is correct n -1 times out of n is insufficient to allay risk if case n is a catastrophic failure. According to Warren Buffett, "If you hand me a gun with a thousand chambers or a million chambers in it and there's a bullet in one chamber and you said put it up to your temple, how much do you want to be paid to pull [the trigger] once; I'm not going to pull it. You can name any sum you want. It doesn't do anything for me on the upside and I think the downside is fairly clear. So, I'm not interested in that kind of a game, and yet people do it financially without thinking about it very much. ... I think it's madness."

The failure of LTCM in 1998 demonstrated that risk modeling need only be incorrect to a degree, in a single respect or over a limited time horizon to invalidate a model, i.e., models are as fragile as the underlying world is complex. As Eric Rosenfeld, former LTCM principal, explained "The risk management was wrong. The risk management managed to the sunny days. You have to manage to the bad days." Referring to LTCM's partners Warren Buffett said:

Those guys would tell me ... a six sigma event wouldn't touch us, or a seven sigma event, but they were wrong. History does not tell you the probabilities of future financial things happening. They had a great reliance on mathematics and they felt that the beta of the stock told you something about the risk of the stock. It doesn't tell you a damned thing about the risk of the stock in my view; and sigmas do not tell you about the risk of going broke in my view and maybe in their view now too. ... The same thing in a different way could happen to any of us probably, where we really have a blind spot about something that's crucial because we know a whole lot about something else. It's like Henry Kauffman said the other day. He said "the people that are going broke in this situation are of two types, the ones that knew nothing and the ones that knew everything." It's sad in a way.

The risks of OTC derivatives, according to George Soros, "...are not always fully understood, even by sophisticated investors", which Mr. Soros most certainly is. In the 2002 annual report of Berkshire Hathaway, Inc., Warren Buffett famously wrote:

The derivatives genie [having been deregulated two years prior] is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. ... Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts [emphasis added]. We [are] apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Ground Zero

In August 2007, central banks took emergency action to head off a global credit crisis, but their efforts were in vein. By June 2008, the notional value of OTC derivatives was more than $683 trillion, after more than doubling in the preceding two years. The event that Warren Buffett anticipated in 2002 occurred on Sunday, September 14th, 2008, when Lehman Brothers filed for bankruptcy, the largest corporate bankruptcy in US history. The failure of Lehman Brothers set off a derivatives chain reaction affecting Lehman's counterparties and directly caused the credit crisis. Since it is impossible for market actors to know what risks or how much leverage their counterparties have, OTC derivatives render credit ratings meaningless. The flow of credit and lending activity halted on a worldwide basis, causing sharp contractions in economic activity and deflation.

Until Western governments took action, it remained possible that virtually every major financial institution in the Western world would go bankrupt simultaneously. The imminent collapse of the global financial system threatened to destroy wealth and damage economic activity more severely than the Great Depression. Members of the US Congress reported having discussed financial and economic Armageddon and martial law with former Secretary of the Treasury, Henry Paulson, and Federal Reserve Chairman, Ben Bernanke. In later testimony before the Congress, Mr. Paulson explained that "...when a financial system fails, a whole country's economic system can fail" thus the interconnecting web of OTC derivative contracts can "...lead to chaos or people even questioning the basic system."

Mr. Paulson was widely criticized for his alleged hyperbole but the blame has been at least partially misplaced. For example, despite historic efforts to support the financial system, the credit crisis virtually halted international shipping almost overnight. The breakdown in letters of credit, used by importers to pay suppliers, was reflected in the Baltic Dry Index, which tracks international shipping prices of various dry bulk cargoes on a worldwide basis.

Chart courtesy of InvestmentTools.com

While it is not possible to know precisely what would have happened had governments and central banks not bailed out the global financial system, real economic activity would certainly have contracted more quickly and more severely, and financial markets would have behaved accordingly, declining more sharply and destroying more wealth. Since the failure of the global financial system was narrowly averted, commentators have often underestimated the seriousness of the problem and its potential consequences.

The argument that bankrupt institutions should have been allowed to fail, while true to the tenets of capitalism and to free market principles, is often made without appreciating the fact that virtually all of the largest banks in the Western world might have been wiped out leaving governments to deal with the depositors and investors. Further, history shows that serious economic disruptions have tragic human consequences, such as widespread starvation.

In the final analysis, Western governments were effectively held hostage by large banks. The resulting, bitterly disputed bank bailouts (which are still ongoing) came at a staggering cost of roughly $5.3 trillion in the EU and as much as $23.7 trillion in the US (officially $4 trillion).

Speaking at a meeting organized by The Economist at the City of London's modern and impressive Haberdashers' Hall, George Soros said that "The success in bailing out the system on the previous occasion led to a superbubble, except that in 2008 we used the same methods. Unless we learn the lessons, that markets are inherently unstable and that stability needs to be the objective of public policy, we are facing a yet larger [sovereign debt] bubble. We have added to the leverage by replacing private credit with sovereign credit and increasing national debt by a significant amount."

The Aftermath

For taxpayers in Western countries, the multi-generational debts incurred have come in addition to loss of wealth in stock portfolios and asset values, along with other losses resulting from severe economic recession, such as loss of business revenues or insolvency, personal unemployment or bankruptcy, etc. The political consequences have yet to play out. The citizens of affected countries can find little comfort in the knowledge that the situation could have been worse when the root cause of the problem was and remains a massive economic bubble fueled by what has been revealed as reckless speculation, grossly out of proportion to real economic activity.

The colossal debts incurred by Western governments are only a fraction of a percent of the potential liabilities stemming from OTC derivatives that still exist in the global financial system. Warren Buffett recently said that "when the financial history of this decade is written, it will surely speak of the internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost as extraordinary." US Treasury debt continues to grow as emergency measures continue well beyond their expected durations. Federal Reserve Chairman, Ben Bernanke, said in a recent address that "It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation."

Sadly, Mr. Bernanke's point is moot. Two and a half years on, virtually nothing has been done in the aftermath of the global financial crisis to regulate OTC derivatives or to control the extreme risk they pose. With several US states and European countries now virtually bankrupt, the capacity of Western governments to bail out financial institutions has been exhausted. The risk of systemic failure is higher at present than before the crisis began in 2008, as there is now no backstop for the global financial system other than debt monetization, which would result in high inflation or hyperinflation. History may yet remember the global financial crisis that began in 2008 as a fateful choice between failed banks and failed nations.

In an effort led by Representative Barney Frank in the House and Senator Chris Dodd in the Senate, a vast array of financial system reforms have been compiled into a single bill that is more than 1400 pages long. The massive bill subsumes numerous common-sense provisions, such as restoring the prohibition on bank holding companies that prevented them from owning other kinds of financial businesses (enacted in 1934 as a part of the Glass-Steagall Act and repealed on November 12, 1999 by the Gramm-Leach-Bliley Act) and Representative Ron Paul's widely supported bill to audit the Federal Reserve (formerly HR 1207 and S 604). However, the bill stops short of rolling back changes to the Commodity Exchange Act (CEA) made by the Commodity Futures Modernization Act of 2000. Backed by Greenspan, Rubin and Summers, the Commodity Futures Modernization Act of 2000 is what let the OTC derivatives genie out of the bottle and resulted in the global proliferation of financial weapons of mass destruction.

The 1,410 page bill (S 3217), entitled "Restoring American Financial Stability Act of 2010," contains roughly 150 pages related to financial derivatives, but numerous counterproposals to specific provisions are being discussed. Not surprisingly, measures to control OTC derivatives and to prevent depository institutions from engaging in OTC derivatives trading are opposed by banks, which are actively lobbying against reform.

The failed financial ideology of Greenspan, Ruben and Summers, which led to the financial crisis that began in 2008, remains deeply entrenched in Washington D.C. While election year political rhetoric focuses on "consumer protection," reforms vital to the stability of the basic system are being quietly lobbied away. A proposed ban on swaps, for example, was dropped early on. Current economic advisor to President Barack Obama, head of the President's Economic Recovery Advisory Board, and former Federal Reserve Chairman, Paul Volker, recently said that "the provision of derivatives by commercial banks to their customers in the usual course of a banking relationship should not be prohibited." Similarly, plans to establish a bailout fund to prevent US taxpayers from again being held hostage by "too big to fail" banks have been scrapped, along with plans to break up "too big to fail" banks; and the effort to audit the Federal Reserve is being watered down to a one-time disclosure.

Trading derivatives on regulated exchanges would be a major step forward, but it may no longer be enough. Economic bubbles are not recognized by those inside of them, the Congress of the United States being no exception. The $604.6 trillion derivatives bubble, which is equal to more than ten times world GDP, is a global issue. If existing OTC derivatives remain in place and there are no restrictions on what banks can trade derivatives, there is no actual or immediate reduction of systemic risk. Thus, the risks that led to the financial crisis in 2008 are likely to remain present in the global financial system for years to come. In fact, many banks have more CDS risk now than in 2008. Passing a bank-approved version of the financial reform bill, while it may be portrayed as a political victory or serve to calm financial markets temporarily, is unlikely to prevent another global financial crisis.