byKarl Denninger

� Question everything – including me.

� The foundation of “economic theory” is wrong.

� From an incorrect thesis flow bad decisions and even worse outcomes.and even worse outcomes.

� If it doesn’t make sense when you hear it, you’re probably being bamboozled.

MV = PQ

(Money supply * Velocity = Price * Quantity)(Money supply * Velocity = Price * Quantity)

“M” is incorrect – oops.

� Money and credit are “fungible”

� Your VISA card spends exactly as does the Benjamin in your wallet.

� Therefore, “M” cannot be the money supply.

IT REALLY IS THAT SIMPLE!

� All “money” in modern monetary systems is debt.

� Therefore, credit = money.

� That is, base money followsfollowsfollowsfollows, not leads, credit.

� The price of borrowing someone else’s capital

� That price is set by expected inflation, the risk of default, and a margin to provide a profit.

NOBODY IN THE PRIVATE SECTOR WILLINGLY AND INTENTIONALLY LENDS AT A NEGATIVE

REAL RATE OF RETURN.

� The more debt to have for a given income level, the higher the risk you will not be able to pay.

� The more uncertain your income is, the higher the risk you will not be able to pay.higher the risk you will not be able to pay.

� Unsecured lending (that is, where the amount you borrowed is more than whatever can be seized is worth) is dangerous, as the lender has no recourse if you cannot pay.

It is not what you hear on “Tout TV”

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shallshallshallshall maintain long run growth of the monetary and credit aggregates Committee shallshallshallshall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. (12 USC 225a)

� It’s missing, because that’s not what The Fed actually does – or is charged with under the law.

� The Market leadsleadsleadsleads, and The Fed followsfollowsfollowsfollows.

� The Fed influencesinfluencesinfluencesinfluences the market through � The Fed influencesinfluencesinfluencesinfluences the market through control of credit (that is, liquidity) management, but it cannot control rates but it cannot control rates but it cannot control rates but it cannot control rates should the market vehemently disagreeshould the market vehemently disagreeshould the market vehemently disagreeshould the market vehemently disagree.

� How well has The Fed discharged its responsibility over the last 20 years?

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Absolute Debt To GDPAbsolute Debt To GDPAbsolute Debt To GDPAbsolute Debt To GDP

Copyright 2009 The Market TickerSource: Federal Reserve Z1, BEA GDP Table 1.1.5Redistribution permitted with attributionRev: 09/17/09

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Debt GDP Debt-To-GDP (Right Scale)

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$60,000,000How Much Debt Is In The United States (Cumulative)?How Much Debt Is In The United States (Cumulative)?How Much Debt Is In The United States (Cumulative)?How Much Debt Is In The United States (Cumulative)?MillionsMillions

Copyright 2009 The Market TickerSource: Federal Reserve Z.1, Data Series D.3 (Quarterly)Reproduction permitted with attribution

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Household/NP Credit NonFin Business Credit State/Local Gov

Federal Government Financial Instruments "Rest Of World"

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Absolute Debt to GDP, 1980 Absolute Debt to GDP, 1980 Absolute Debt to GDP, 1980 Absolute Debt to GDP, 1980 ---- PresentPresentPresentPresent

Copyright 2009 The Market TickerSource: Federal Reserve Z1, BEA GDP Table 1.1.5Redistribution permitted with attributionRev: 09/17/09

Millions

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Debt GDP Debt-To-GDP (Right Scale)

� Approximately $228 trillion in GDP (total) since 1980 in the United States.

� $53 trillion in debt, about twice what can be sustained = $20 trillion of “pulled forward demand.”demand.”

� Net impact: ~10% of GDP since 1980 has been false.

� For a 10% increase in reported GDP we have sacrificed long-term economic stability.

� Two exponential (compound) functions will will will will alwaysalwaysalwaysalways run away from each other 10000

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GDP .vs. Debt Spread Over 20 GDP .vs. Debt Spread Over 20 GDP .vs. Debt Spread Over 20 GDP .vs. Debt Spread Over 20

YearsYearsYearsYears

from each other over time.

� We argue WHENWHENWHENWHENdebt will become unsustainable, but not IFIFIFIF it will be.

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GDP, 5% Debt, +2% Spread

Debt, +4% Spread Debt, +6% Spread

Debt, +8% Spread Debt, +10% Spread

� 20+ years of decreasing debt coverage .vs. GDP growth, and the government overstates GDP by double-counting. It’s worse than it It’s worse than it It’s worse than it It’s worse than it appears.appears.appears.appears.

� Increasing debt-to-GDP demands ever-� Increasing debt-to-GDP demands ever-decreasing interest rates (or massive defaults occur), but higher debt to income always presents higher risk.

� The immovable object meets the irresistible force with disastrous consequences.

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The Market Ticker "Ponzi Finance Indicator"The Market Ticker "Ponzi Finance Indicator"The Market Ticker "Ponzi Finance Indicator"The Market Ticker "Ponzi Finance Indicator"

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Copyright 2009 The Market TickerReproduction permitted with attributionData Sources: Fed Z1, BEA GDP SeriesRev: 09/17/09

� Repeal of Glass-Steagall made sovereign credit available for financial speculation.

� The banks benefit from this speculation –when times are good.

� Effective bribery of government officials � Effective bribery of government officials (lobbying .et.al.) is as old as government.

� The misallocation of credit due to financial speculation is exactly the same disease we were infected with in the 1920s.

� Positive Positive Positive Positive ---- Productive Lending: Borrowing to purchase “PPE” – a CNC machine that produces auto parts, for example.

� Neutral Neutral Neutral Neutral ---- Consumptive Lending: Borrowing to purchase a home, vehicle, or other asset with purchase a home, vehicle, or other asset with utility value but no direct productive use.

� Negative Negative Negative Negative –––– Ponzi Lending: Borrowing to purchase financial instruments containing an element of speculation (e.g. stocks, bonds, credit default swaps, etc.)

� Financial institutions allegedly “transferred risk” through securitization.

� Credit-default swaps allegedly allowed institutions to “insure” against default, thereby claiming dodgy assets were “money thereby claiming dodgy assets were “money good.”

� But “securitized” debt has huge mark-to-market losses hidden until maturity – or sale.

� And credit-default swap writers (e.g. AIG) had no money to pay.

� Credit-default swaps are similar to my buying fire insurance on youryouryouryour house. My buddies all bought those “insurance” policies too.

� Why are we all running around with a gasoline can and a pack of matches?can and a pack of matches?

� Writing insurance (whether called insurance or not) when you have no capital to cover it is a pure scam, and selling “insurance” to people who have no insurable interest encourages financial arson.

� Leverage is great – when times are good. But it hurts just as much as it helps when times turn bad.

� The presumptionpresumptionpresumptionpresumption since 1987 has been that if you’re a big bank and make a bad loan, The The The The you’re a big bank and make a bad loan, The The The The Taxpayer will be forced to bail you out.Taxpayer will be forced to bail you out.Taxpayer will be forced to bail you out.Taxpayer will be forced to bail you out.

� Therefore, making bad loans became policy.policy.policy.policy.

� Unfortunately, even taxpayer bailouts run into the mathematical limits of Ponzi Finance.

� Big banks can borrow at zero, but your rate reflects risk of default – and is 29.9%.

� Mortgage market interference by The Fed is unlawful unlawful unlawful unlawful (no FF&C) but nobody seems to care.

� The bad debt in the system has not been � The bad debt in the system has not been flushed out – it has been transferred and hidden via phony accounting tricks.

� Government borrow & spend replaced private borrow & spend - $1.4 trillion worth last year, $300 billion more the last two months!

� We mustmustmustmust stop trying to prop up housing prices so the market will clear.

� We mustmustmustmust stop coddling major financial institutions with below-market-risk interest rates subsidized by sovereign (Federal) credit.rates subsidized by sovereign (Federal) credit.

� We mustmustmustmust withdraw liquidity to force contraction of both consumer and financial credit – a withdrawal on balance of $10+ trillion in outstanding credit aggregates between these two areas to start.start.start.start.

� We’re already in one (credit is contracting)

� We can (and should) redirect some (20% or so) of the withdrawn credit into Main StreetMain StreetMain StreetMain Street –Main Street creates jobs, not Wall Street.

� Long-term financial balance must be restored � Long-term financial balance must be restored by changes in the law.

� Congress must enforce existing laws (“Prompt Corrective Action”, The Fed’s charter, etc.)

� We cannot avoid the math, and the longer we We cannot avoid the math, and the longer we We cannot avoid the math, and the longer we We cannot avoid the math, and the longer we wait to acknowledge it the worse the pain.wait to acknowledge it the worse the pain.wait to acknowledge it the worse the pain.wait to acknowledge it the worse the pain.

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PerPerPerPer----Capita Income, Assets & Debt 1970 Capita Income, Assets & Debt 1970 Capita Income, Assets & Debt 1970 Capita Income, Assets & Debt 1970 ---- PresentPresentPresentPresent

Mortgage

Copyright 2009 The Market TickerData sources: US Treasury, US Census, Fed G.19 (9/8/09)Shaded areas indicate recessionsReproduction permitted with attribution

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Consumer

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Sweep accts

"Free Money"

Rev: 9/17/09

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Debt In The United States, 1980 Debt In The United States, 1980 Debt In The United States, 1980 Debt In The United States, 1980 ---- Present (Cumulative)Present (Cumulative)Present (Cumulative)Present (Cumulative)Millions

Copyright 2009 The Market TickerSource: Federal Reserve Z.1, Data Series D.3 (Quarterly)Reproduction permitted with attributionRev: 09/17/09

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Household/NP Credit NonFin Business Credit State/Local Gov

Financial Instruments Rest Of World Federal Government

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Consumer Credit Rate Of ChangeConsumer Credit Rate Of ChangeConsumer Credit Rate Of ChangeConsumer Credit Rate Of Change

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Revolving Non-Revolving

Copyright 2009 The Market TickerSource: FRB G.19, 12/7/09

� “A house” is a place to hang your hat – not a speculative financial instrument.

� There must be nononono off-balance sheet games or other financial “cookery” – anywhere.

� “Or Else” must be written into all financial � “Or Else” must be written into all financial laws – including those binding the government.

� Those who speculate must be exposed at all times to the risks they take on.

� The Government had it right in 1933.

� Separation shifts the balance toward Productive Lending and away from PonziLending.

� Tinkering will not do it – financial institutions � Tinkering will not do it – financial institutions will use any opportunity to circumvent the law, as has been shown over the last 20+ years.

� Those who wish to speculate must be allowed to do so only with their own capital.only with their own capital.only with their own capital.only with their own capital.

� Each dollar of unsecured lending must be backed by one dollar of excess capital.

� All assets marked to market nightly.� “Tier 1” reserve ratios provide sufficient time

to close a bank before the “uncovered” loans outstanding exceed excess capital.to close a bank before the “uncovered” loans outstanding exceed excess capital.

If Banks operate in this fashion there is If Banks operate in this fashion there is If Banks operate in this fashion there is If Banks operate in this fashion there is never a risk of depositor or FDIC loss never a risk of depositor or FDIC loss never a risk of depositor or FDIC loss never a risk of depositor or FDIC loss ––––

it is mathematically impossible.it is mathematically impossible.it is mathematically impossible.it is mathematically impossible.

� You cannot spend more than you make forever – you will eventually hit the wall.

� We cannot live on serial asset bubbles. Each one removes margin between income and debt. When the limit of debt coverage is debt. When the limit of debt coverage is reached disaster occurs.

� We learned this in the 1930s, but everyone who lived it as an adult is now dead.

� Glass-Steagall was the answer: discourage Ponzi Investment by barring credit expansion.

� “The Monetary Base” is not M1, M’ or anything of the sort. It is all unencumbered assets against which market actors both can and are willing to borrow against.

� Credit growth beyond GDP growth is is is is � Credit growth beyond GDP growth is is is is mathematically impossible to be sustained in mathematically impossible to be sustained in mathematically impossible to be sustained in mathematically impossible to be sustained in the long run.the long run.the long run.the long run.

� When you try to cheat math through fraud you suffer dramatic consequences, just as Madoff’s “investors” did.

� “Hard Money” solves nothing. The problem is and always has been in credit expansion, not base money.

� Tulip Mania and fivefivefivefive Depressions in The United States (the last of which being the United States (the last of which being the 1930s) all occurred on “Hard Money” standards.

� With “Hard Money” it is actually easiereasiereasiereasier for “the powers that be” to causecausecausecause Depressions. History says they will do exactly that.

� “The Fed and Treasury saved us from Depression.” No - the bad debt was not flushed from the system.

� “The economy is improving.” No, credit continues to contract, rail shipments are continues to contract, rail shipments are down and all GDP “improvement” so far was in fact government borrowing.

� “Government’s borrowing saved the day!” Can you drink yourself sober?Can you drink yourself sober?Can you drink yourself sober?Can you drink yourself sober?

� We can fix what’s broken, but we must return to production to generate wealth: “Mine, Mine, Mine, Mine, manufacture or growmanufacture or growmanufacture or growmanufacture or grow”

� Papering over losses just results in bigger losses: The first loss is the best (and The first loss is the best (and The first loss is the best (and The first loss is the best (and losses: The first loss is the best (and The first loss is the best (and The first loss is the best (and The first loss is the best (and smallest) loss.smallest) loss.smallest) loss.smallest) loss.

� Both major political parties have it wrong, and both are in the pocket of those who have – and will continue to, if we let them – fleece the nation.