Macroeconomic Analysis of The Hyperinflation Second Great Depression

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Tobin Maginnis, Last update: 5-Jun-14

At first it may seem unusual for a computer science professor to give a talk on macroeconomics in a computer science seminar. However it is perfectly natural for any educator to want to point out issues that, if left untouched, will change our computing lives as we know it. The macroeconomic issues that we face as a society need to be more widely discussed. At present, only a college junior economics major studies these issues in a required course. I suggest that we should include an introductory macroeconomics course into the basic 60 hour core curriculum for all majors and an introductory macroeconomics course could also be offered an advanced placement (AP) high school course. Let's see if you agree with me at the end of this talk.

Of course, no one can predict the future, but one can see trends than point to future events. In this case it looks like an economic near-earth asteroid heading right for us. One may not be able to predict which city it will hit, if it will even hit land or water, or exactly when it will hit, but one will be able to say with some confidence that it will hit earth.


Our economic difficulties result from a perfect storm of five factors coming together. They are: 1) excess debt; 2) continued unregulated credit creation where world-wide investment banks have bet up a $quadtrillion dollars that the US collateral market would never decrease in value; 3) well laid out public plans of the Federal Reserve to protect the financial industry regardless of how much new money must be created; 4) a lack of savings and structural inability to grow out of our bad debt; and 5) an unprecedented foreign ownership of US treasury securities.

As bad debt feeds the the ongoing depression and the depression leads to more bad debt that spreads to near-prime (Alt-A) and prime mortgages, auto loan debt, student loan debt, and credit card debt, it forces losses in the lending institutions. These losses ripple through the financial industry and up through the world-wide structured credit-derivative markets which require that these investments continue to receive monthly payments plus the requirement that short-term interest rates remain lower than long-term interest rates.

Therefore, to protect the structured credit-derivative investment market from collapsing, the Federal Reserve reduces interest rates and, outside of its charter, exchanges treasury securities for mortgage debt thereby increasing the money supply to banks. (At the current annualized rate, there is about 17% more money in circulation this year than last year.) As the increased money supply (plus the current speculation in commodities) adds to inflation, the US dollar is devalued.

Thus, our options are to stop protecting the financial industry and let it fail (which includes losses in bonds and pension funds) and proceed immediately into a deep depression. Or continue to have the Federal Reserve fund the financial industry (paid by future tax payers) and risk runaway inflation, foreign investor flight-to-safety, hyperinflation, and a subsequent Great Depression. My bet is on the latter outcome.


Deflation is an overall drop in the cost of property, commodities, or services. Other factors being equal, a reduction in the money supply, such as bad, unpaid, debt, leads to deflation. The Great Depression was an example of a deflationary depression driven by a contraction in the money supply making things less expensive. However, since there was less money in circulation, pre-deflation debt became relatively more expensive and a positive feedback cycle, or deflationary spiral, of bad debt begetting more deflation begetting more bad debt and so on. This process continued for years.

The 2008 housing market is in the beginning of a deflationary spiral. As homes are abandoned and foreclosed, neighborhood home prices are affected and values are reduced with each foreclosure. As the home prices drop, the mortgage on the full price becomes a burden to the remaining homeowners. Eventually another homeowner defaults and the process continues. Nouriel Roubini has been tacking this for a year and predicts home prices will continue to decline from the current 10-12% loss to an average 30% loss in the foreseeable future which represents a $6 trillion loss in home equity and would put 21 million households, or 40% of all mortgage-holders, would owe more to their mortgage than the home is worth. But others see no reason the deflationary spiral would not continue beyond 30% maybe even down 50% from high home values.

Inflation is the opposite of deflation, but with a similar outcome. Inflation is an overall increase in the cost of property, commodities, or services. Other factors being equal, an increase in the money supply leads to inflation. This can only occur with a centralized banking system and with a currency based upon the value of debt rather than a fixed asset such as gold. Debt-based currencies are considered "paper money" and allow governments to adjust the money supply up, to encourage growth, or down to slow growth in the economy. Fixed-asset currencies are considered "hard currencies," since the government is limited by the amount of asset reserves in adjusting the supply of money. All things being equal, too much money supply allows more dollars to be used to purchase a stable supply of items and, as a result, costs rise. Over time, increased costs ripple through the economy raising the cost of all goods & services.

Deflation of a single item or class of items, like cell phones, or the cost of sequencing a whole genome is considered an increase in productivity, while inflation of a single item or class of items, like home prices, is considered an asset bubble.

Gross Domestic Product (GDP) is the total market value of all final goods and services produced in a year and considered to be a measure of the size of an economy. All final goods and services means that GDP includes the sum of value added at every intermediate stage of production.

There are no uniform definitions for Recession, Depression, and Great Depression, but John Williams offers a definition of these terms.

Recession consists of two or more consecutive quarters of contracting real GDP. The NBER is the official arbiter for labeling when the United States economy is in a recession, but it uses a more elaborate method than Williams' method.

Depression is a strong recession where there is a minimum loss of 10% or more of GDP in non-inflation dollars.

Great Depression is a strong economic depression where there is a minimum loss of 25% or more of GDP in non-inflation dollars.

Using these definitions, and an approximate loss of 5% GDP, we are already half way from a recession to a depression while the government does not claim officially that a recession has begun.

Sample Diary Entries from a Lawyer Before and During The Great Depression
Everyone was on the highroad not only to comfort, but to wealth and luxury. Second, third, and fourth mortgages were considered just as good as government bonds. Money was easy, and every bank was ready and anxious to loan money to any Tom, Dick, or Harry on the possibility that he would make enough in these trades to repay the loans almost before the day was over. Every country bank and every county-seat town was a replica in miniature of brisk day on the board of trade.

I have represented bankrupt farmers and holders of claims for rent, notes, and mortgages against such farmers in dozens of bankruptcy hearings and court actions, and the most discouraging, disheartening experiences of my legal life have occurred when men of middle age, with families, go out of the bankruptcy court with furniture, team of horses and wagon, and a little stock as all that is left from twenty-five years of work, to try once more, not to build an estate -- for that is usually impossible, but to provide clothing and food and shelter for the wife and children. And the powers that be seem to demand that these not only accept this situation but shall like it.

The Great Depression was the result of credit losses or debt implosion where wealth, primarily on paper, was lost through unpaid debt. However, there is a second path to economic depression resulting from the rapid rise in inflation and subsequent loss of paper wealth. A hyperinflationary depression happened in our country after the Civil War and in Germany after World War I.

Hyperinflation is inflation on steroids. Rather than have prices jump 10-50% annually, hyperinflation changes are 50-100% per month or week (52,000% annually). In other words, the value of money is increasing so fast that it become meaningless in determining the value of goods and services. Hyperinflation is the result of a government's massive and rapid increase in the amount of available money, which competes for a fixed amount of goods and services. International Accounting Standard 29 lists four criteria that indicate hyperinflation:

  1. The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power.
  2. The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that foreign currency.
  3. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short.
  4. Interest rates, wages and prices are linked to a price index and the cumulative inflation rate over three years approaches, or exceeds, 100%.

Finally, hyperinflation has been historically associated with war (or its aftermath), economic depression, and political, or social upheaval.

A quote from a 1993 interview of Friedrich Kessler, a law professor at Harvard and University of California Berkeley, who experienced the Weimar Republic Hyperinflation:

It was horrible. Horrible! Like lightning it struck. No one was prepared. You cannot imagine the rapidity with which the whole thing happened. The shelves in the grocery stores were empty. You could buy nothing with your paper money.
(From: Fiat Paper Money, The History and Evolution of Our Currency by Ralph T. Foster, 2189 Bancroft Way, Berkeley, CA 94704)

Measurement of Inflation

When the average person thinks of inflation, they usually think of an unscrupulous merchant jacking up prices to make more profit. But it is a well established principle of economics that the primary driver of inflation is a result of the amount of money people have to spend (the money supply). If more money is added to a fixed system of goods and services, then there are more dollars to purchase the same fixed number of goods and services.

So inflation is an odd concept. It seems like more money (or credit) would allow the economy grow rather than hurt the economy. And yes, more credit does help the economy grow, and as long as the economy grows at fast clip (3-10%) no one cares about a small amount of inflation (1-2%). The problem arises when there is a quick jump in the money supply, so quick that it floods the economy and, in severe cases, leads to run-away inflation.

Everyone seems to have their own way to measure inflation, probably because the concept seems complex. But inflation can be simply stated as: "How much more does it cost to buy the same goods and services you purchased last year?" (See United States Consumer Price Index)

Uncomplicated as that is, the government tries to make inflation complex and opaque as possible. Why? Because they have a conflict of interest between the amount of inflation stated versus the amount of inflation-adjusted growth there is in the economy, as well as the amount of benefits provided, be it interest on Treasury notes that must keep pace with the inflation rate, or a Medicare payment indexed to the cost of living.

To understand how to measure inflation let's see what is in the Bureau of Labor Statistics (BLS) market basket:

  • FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
  • HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
  • APPAREL (men's shirts and sweaters, women's dresses, jewelry)
  • TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
  • MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
  • RECREATION (televisions, pets and pet products, sports equipment, admissions);
  • EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
  • OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).
But what about the headlines such as Medical Care Running 3.5 Times the Rate of Inflation? and College Tuition Leaps Above Inflation Third Year in a Row? If medical and education costs are part of the CPI, the government, through the media, is using a divide and conquer strategy to extract items from the CPI basket and label them as "non-conforming." But non-conforming to what? These items cost more and they are all part of the same inflationary process.

Before 1980 inflation was measured as simple inflation or the year-to-year change in the cost of the BLS basket. But in the late 1980's and early 1990's during the Bush I administration, Boskin and Greenspan began revising the definition of inflation. Their position was that people adapt to higher prices by switching to less expensive items, so the CPI should follow the consumer to the less expensive items to calculate inflation. This "hedonic" calculus is another way of saying that as the general population lowers its standard of living, we should also lower the CPI. Hedonic calculations are also used to exclude high-end items which appear to be luxuries to the average person. All of this, of course, avoids the question how much has the price of a basket of reference items changed from year to year.

As Dmitry Orlov puts it: inflation is "controlled" by substituting hamburger for steak, in order to minimize increases to Social Security payments.

During the early Clinton years (1993-1994) the CPI was further obfuscated by assigning linear weighting factors to individual items in the basket. In this way items that increased in cost faster than others would be assigned a lower weight. Later in the Clinton administration, the CPI basket items were assigned a geometric weighting promoted by the Boskin and Greenspan committee. Geometric weighting even further obfuscated the CPI by automatically assigning a lower weighting to basket items that were rising in price, and a higher weighting to those items dropping in price.

According to John Williams, geometric weighting reduce reported CPI on an annual basis by 2.7%. Geometric weighting has been used since the mid-1990s, and it reduced annual cost-of-living increases in social security over a 12 year period by more than a third (33.3%) of what would have been paid using the the 1980s method.

But there was even more obfuscation to come. The CPI was split into an urban (CPI-U), urban wage earners and clerical workers (CPI-W), chained CPI-U (C-CPI-U), as well as a measure reported in the press and used by the administration referred to as "core" CPI. CPI-U is the popularly used inflation measure reported in the financial media and the CPI-W is used in calculating Social Security benefits. The C-CPI-U measures substitution of one item in the BLS basket with another item. Finally, core CPI is the CPI basket without food or fuel.

If one calculates the CPI based upon the BLS 1980 method (simple inflation) versus the above methods, a consistent relationship is noted. John Williams has done this and observed that the CPI-U underestimates simple inflation by a constant year-to-year rate of 7%, the C-CPI-U underestimates simple inflation by 7.4%. The core CPI, which does not include food or fuel as a measure of inflation, is a simple fraud on the American Public. Core CPI, by the way, is not a term used by the Bureau of Labor Statistics.

Thus, to measure inflation, simply use the CPI (CPI-U) noted in the press and increase it by seven (7) to it to see the rate of simple inflation. For example, if the CPI is 4.6% then the BLS 1980 simple (real) inflation rate is 11.6%.

Gold as an Inflation Measure

The Real Price of Gold

From an economic perspective, gold is unique in that it's the only form of currency that cannot be "multiplied" by a central bank simply because it's difficult to dig out of the Earth. And from a historical perspective, gold is far from the purchasing power it achieved in January 1980. By tracking the price of gold using the BLS 1980 method and the current CPI-U method, the right side graph shows that the dollar is losing more of its purchasing power every month (i.e, the Fed is putting more dollars into circulation every month).

Gold Anti-Trust Action (GATA) Committee has documented no less than 11 public statements by the Federal Reserve and International Monetary Fund that they actively "lease" or sell gold reserves to intervene with (suppress) the price of gold on the open market. GATA has filed a freedom-of-information request with the Federal Reserve and the Treasury in December of 2007. The Fed has reported it is reviewing approximately 400 pages of "gold swap" related documentation for release to GATA. World-wide consumption of gold exceeds production by 1,000 tones per year (2,400 versus 3,400) and the Western central banks must sell off their stockpile to suppress prices. Since bank activities are secret, central banks have never been audited to confirm that they hold the amount of claimed gold reserves. GATA estimates that Western central banks have sold off approximately half the 32,000 tonnes of gold claimed to have in their vaults, so price intervention can not be continued indefinitely.

Oil price in gold versus dollars

Regardless of government intervention, the price of gold continues to rise indicating that crude oil is not becoming more expensive; rather, the purchasing power of national currencies continues to diminish. In fact, the price of crude oil has remained relatively unchanged for decades, when measured in terms of the price of gold in grams.

Using today's figures, oil is ~$145/barrel and gold is ~$930. $930/31 grams/troy ounce = ~$30/goldgram. $14,500/$30 = ~483 goldgrams/100 barrels. However, if the Fed and IMF were to cease intervening and the price of gold were allowed to rise to a predicted $6,000 dollars/Troy ounce, then oil would be just ~74 goldgrams/100 barrels ($14,500/($6,000/31)).

The table below shows the year, the BLS 1982-1984 derived index, todays' BLS CPI-U inflation estimate, the same BLS index and CPI, but using the BLS 1980's non-gimmicked method, cost of a gallon of gas, inflation adjusted gallon of gas, and finally, the cost of a gallon of gas in gold grams (1/30th of a Troy ounce) using the average price/oz for that year.

Year    Index   CPI-U   Index   1980-CPI $/gal  Adj/gal Gg/gal
1999    166.6   2.19%   263.8   8.47%   1.36    1.24    0.14
2000    172.2   3.38%   289.5   9.74%   1.69    1.53    0.18
2001    177.1   2.83%   315.9   9.12%   1.66    1.51    0.18
2002    179.9   1.59%   340.7   7.85%   1.56    1.44    0.16
2003    184     2.27%   369.8   8.55%   1.78    1.63    0.15
2004    188.9   2.68%   403.4   9.09%   2.07    1.88    0.16
2005    195.3   3.39%   443.9   10.05%  2.49    2.24    0.18
2006    201.6   3.23%   489.1   10.18%  2.81    2.52    0.14
2007    207.3   2.85%   540.5   10.51%  3.03    2.71    0.14
2008    est     ~4.3%           12.00%  3.55    3.12    0.12
Is this not a surprise? The cost of gasoline, in gold, is less expensive today than it was in 1999! In fact, assuming and average gold price of $900/oz, gas would have to be $5.5/gal to equal the past cost of 0.18 gold grams/gallon! What does this mean? It means inflation, world-wide inflation like we have never seen before.


Ninety Five Years of Mostly Inflation

Williams presented these two graphs to show how throughout the history of our country, since 1665, there have been inflation and deflation cycles with an approximate 30 year harmonic. However, it was not until 248 years later, in 1913 when the Federal Reserve is formed, that inflation continues to slowly creep up without a corresponding deflation periods of the same magnitude as the inflation periods. Furthermore, when FDR abandons the gold standard in 1933, inflation rises to higher levels than it has in the previous 268 years. And since 1971, when Nixon closed the gold window to let the dollar float free of any fixed asset, inflation subsequently climbed to such heights that the previous 306 years of inflation appear as constant line in comparison.

The point is that the ~25% GDP contraction of the economy during the Great Depression was so traumatic, that the subsequent 11 administrations have systematically used the "debt standard" to slowly eat away the dollar's purchasing power to insure there would not be another Great Depression.

Loss of U.S. Dollar Purchasing Power through March 2008
                                   ----Since January of ----
            Versus:                1914      1933      1970
             Swiss franc           -80.4%    -80.4%    -76.5%
             CPI-U                 -95.1%    -94.0%    -82.3%
             Gold                  -97.9%    -97.9%    -93.4%
             SGS-Alternate CPI     -98.2%    -97.8%    -93.6%
            Note: Gold and Swiss franc values were held constant
            by the gold standard versus coins in 1914 and 1933.
            Sources: Shadow Government Statistics, Federal Reserve,
This currency debasement is quantified with above table from Williams showing the dollar's 80 to 98% loss in purchasing power since 1913 based on four separate parameter measurements. And he shows how 76 to 94% of this loss occurred since 1970.

Federal Reserve - A Private Bank Controlling the Nation's Money Supply

In a well known speech, Ben S. Bernanke, chairman of the Federal Reserve, described how to control deflation. In his 2002 speech: Deflation: Making Sure "It" Doesn't Happen Here he said:

But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Why would the chairman of the Federal Reserve Bank use the oxymoron positive inflation? Why have the 11 administrations since the Great Depression worked so closely with the Federal Reserve to systematically devalue (debase) the dollar over the last 95 years and into the future? It is because the government and the Federal Reserve lose control of the monetary system in a depression. As the currency devalues in a depression, old debt becomes relatively more expensive and cannot be controlled by interest rate adjustments. But the Federal Reserve can regain control of the economy by adding to the supply of money.

With our debt-based monetary system the Federal Reserve has to balance increases in credit (debt) for growth, but also be careful deflation does not take hold. However, if credit (debt) expansion runs wild, as described in the next section, excess credit will overflow and be used to buy assets that are not calculated in the government inflation numbers such as stocks, bonds, and other investments vehicles. As loose credit expansion continues, interest rates will be come so low that, in essence, debtors are paid to take money. However, they are also indebted, they can't take on any more debt since they have no way to pay it off (economists call this a liquidity trap). We are very near a liquidity trap. Can the Fed raise rates to encourage savings? Not with existing massive debt levels since it will bankrupt the debtor and lead to deflation.

Notwithstanding the Federal Reserve printing more money, there is another way to create money and that is to obtain a bank loan. Banks do not actually have cash to loan out, rather a bank debts your account with the loan principle. You, in turn, purchase goods by writing a check which is deposited into another bank account and so on. This process is known as fractional reserve banking which is highly regulated. In this way banks can lend out up to ten times their cash reserve and inflate the money supply though the creation of debt.

Of course, cooperation among the Federal Reserve, its regional banks, primary dealer banks, and smaller banks have a multiplicative effect on the money supply as newly created money is exchanged for hard-to-sell-assets which allows the retail banks to multiply new money by a factor of ten as new loans (debt).

Unregulated Massive Debt Creation for Profit

(This section is based on a National Public Radio (NPR) Terry Gross interview of Michael Greenberger, the former Dir. of the Commodity Futures Trading Commission (1997-99) and currently Professor of Law at U of MD to explain the current economy issues. Our Confusing Economy, Explained.)

It begins on On November 12, 1999 when Phil Gramm sponsored the Gramm-Leach-Bliley Financial Services Modernization Act which, in turn, repealed the Glass-Steagall Act and allowed traditional depository institutions (banks) to speculate in financial markets just as they used to do before the Great Depression.

The Gramm-Leach-Bliley Act now allowed banks to sell their mortgages and thereby disassociate themselves from the consequences of non-payment. They did it by creating complex structured investment vehicle (SIVs) which are $1 to $30 billion funds that issue short-term securities at low interest to borrow (raise) money and then lend the money out again by buying long-term securities at higher interest, making a profit for investors from the difference (spread) between short and long term rates. One type of SIV is the Collateralized Debt Obligation (CDO) made up from residential mortgage backed securities. These CDOs were traded as cash among investment banks which were essentially placing bets that certain events would or would not occur, such as interest rate changes. Again the Gramm-Leach-Bliley Act allowed these CDO transactions to be private (i.e., opaque to the public) transactions, where banks make huge fees on CDO transactions.

But the finance industry wanted more, so lobbyists drafted another 285 page bill for Phil Gramm called the Commodity Futures Modernization Act which he introduced on December 21, 2000. (This act also included the infamous "Enron On-line" loophole that allowed Enron traders avoid regulation by using telephone-based transactions.) The Act also allowed banks to trade in another class of securities called credit derivatives. They used the credit derivative to "insure" their CDOs in the event of non-payment. The insurance policy was called Credit Default Swap (CDS) which was carefully crafted to disguised the insurance aspect and thus avoid any local state insurance industry regulation. Home values had never declined in the history of the country and many banks thought their CDO and CDS bets were so safe that they included them as assets on their balance sheets, but now we know they bet wrong, the CDOs and CDS have become liabilities that are "written down" as losses. Moreover, the Commodity Futures Modernization Act allowed off-book betting, so no one really knows how many of these bets the banks have off of their public balance sheets.

Banks would originated mortgages and wrap them as Mortgage Backed Securities (MBS) in CDOs packages and then buy and sell CDOs as well as CDS. But banks did not keep records as to the number or nature of the CDO & CDS bets. In other words, unlike a Las Vegas bookie, the banks did not hedge their bets on both sides of an event so that if one bet went bad, the other bet would cover the loss and they would still make money on transaction commissions.

Meanwhile, the banks convinced the municipal bond insurance companies (e.g., MBIA Inc. and Ambac Financial Group Inc.) that CDS were risk free, so they over insured (did not have enough capital). And when they failed, the municipal bond issuers must pay outrageously high premiums for new insurance.

CDOs are not just made up from bank mortgages, there are also other asset-backed securities including credit card, student loan, and private equity CDO Structured Investment Vehicles (SIVs) that make up a vast 500-600 trillion dollar world-wide debt ball of inter-related finances. So, is the failure of Bear Stearns the end of the financial nightmare or the beginning of a true financial collapse?

In the center of this incalculable mess sits former senator Phil Gramm, former chair of the senate finance committee, sponsor of the enabling legislation, chair of John McCain campaign finance committee, and board member of the Swiss bank UBS which has loss around $40 billion in SIVs to date. (See 2007 subprime mortgage financial crisis.)

So rather than FDR type fireside chats where the government explains what is happening to the economy, we have the various governmental agencies and the Federal Reserve deliberately obfuscating the market with arrogant hand waving saying "it's too complicated for you to understand." The Federal Reserve has been repeatedly warned as far back as 2001 about the house of CDO and CDS cards being built but did nothing. Thus, reinforcing the idea that the Federal Reserve's policy is one of private profits, but socialized losses!

The problem begins at loan origination where the banks have no consequence if the loan is not paid. This led to corruption in loan origination. To solve this problem, we must go back to 2000 where mortgage loan originations are regulated.

The current Paulson Treasury Secretary proposals actually call for more deregulation by taking power away from states and putting after-the-fact control in the Federal Reserve. Washington politics has become a revolving door between the government and the finance industry with the regulatory agencies politicized to support the republican party. For example, before 2000 the Commodity Futures Trading Commission (CFTC) would be responsible for regulation. An affable Mississippi cattle rancher was appointed by Bush to the CFTC. He admitted in casual conversation that he did not know much about commodities trading and said little his first year of service. However, as time went on he agreed with the deregulation position of the republicans and rose to chair the CFTC. He was subsequently appointed to NYMEX and made three million dollars in bonuses. So, the clear message is that if you help Wall Street, Wall Street will take care of you.

Where has all the lost money gone? Besides the non-payment evaporating debt, money went to the lucky few who bet right. Three gentlemen named John Paulson (not the Treasury Secretary), George Soros, and James Simons made a total of 9.4 billion in 2007 betting the sub-prime CDOs would not pay. Goldman Sachs also bet correctly in 2007 and made 11.6 billion in profits. But an economy based on betting is really wasting its resources since it is not performing real value by creating products or services. Today's economy is really people sitting at their computers making bets and gambling!

Berkshire Hathaway, Warren E. Buffett's investment company and the most trusted company in America, said on Friday, May 2nd, 2008, that first-quarter 2008 profit tumbled 64 percent, hurt by $1.6 billion of pretax losses tied to credit derivative contracts.

Structural Inability to Grow

If we use a David Walker (former Comptroller General) type analysis of the Federal Government using Generally Accepted Accounting Principles (GAAP) we can show that the US government is bankrupt. This key graph shows rather dramatically that the US government financial obligations are three times the rest of the world's combined debt ($62 versus $18 trillion); and it shows the US GDP is three time smaller that the rest of the world economies ($14 versus $40 trillion). In other words, how is it possible for the USA to pay this debt? Who else will pay this debt? Our children? Our children's children?


The classic answer to this question is that we live in a wealthy and powerful country that will use our economic engine to grow out of debt, like we did in the 1990's, but has that been true growth or just inflation masquerading as growth? This graph, also from Williams, shows the demise of the middle class. Elizabeth Warren has also shown how dual-income families have failed kept pace with inflation. And even though the middle class have been a significant part (70%) of the GDP in the past they no longer have wealth. Our country still has great wealth; however it is held in so few hands that it ends up locked away in investments that cannot drive (churn) the economy as the middle class would by purchasing appliances, automobiles, homes, etc. In fact, wealth is more concentrated today that it was in 1929 and nearly double that of any other advanced economy.


We are systematically dumbing-down and reducing value-add jobs. In 1950 manufacturing jobs accounted for 36% and leisure for 6%. Today, 12% of all private sector jobs are now classified as leisure and hospitality - the same percentage as manufacturing. Within a short time, as history goes, the US gutted its industrial labor force by two thirds while doubling its life-style jobs. Between 2001 and today the US shed 4 million manufacturing jobs and added 2 million leisure jobs, plus 3 million health care and social assistance jobs.


On the other side of the national debt, who is holding the IOUs? The answer is approximately 70% foreign investors. As of May 15th, 2008, the Federal Reserve has exchanged more than 20% of its Treasury Notes for bank CDOs and these foreign investors are seeing that the dollar is getting to the point where it is not backed by Treasury securities, but rather bad mortgage debt. As a result, these foreign investors are seeing significant devaluation of the dollar or even the possibility of a loan default from the USA. Therefore, these investors have to be seriously planning for a "flight to safety" to protect their remaining wealth.

Will the Next Cycle be Inflation, Deflation, or the Second Great Depression?

The answer lies in how our economy has shifted over the last two decades. Corporations have sought higher profits by pushing high paying manufacturing jobs offshore and, as a result, we purchase much more from offshore than we sell. Our trade deficit is the highest of any country in the history of the world and real earnings, adjusted for inflation, have declined by a factor of 300% since 1972. Thus, this structural inability to grow has made the Federal Reserve's interest rate adjustments, or government tax cuts, or increased federal spending ineffective in stimulating growth. Plus, the Congress continues to accumulate increased budget deficits at $4 or more billion per year.

We are at the proverbial fork-in-the-road. Will our government call an end to this madness, stop spending money it does not have, cut back programs that promise more spending, cut back existing programs to reduce spending, cease offering money to "stabilize" the financial industry, and if necessary raise taxes to meet current spending? (I guess no, what do you think?) Or rather, will our government choose to increase the money supply by continuing to sell Treasury bills to foreign countries who are stuck with excess dollars in their sovereign wealth funds as a result of the ever expanding trade deficit? (I guess yes). The government will use the increased money supply to pay for the Iraq war, the Wall Street bailout, defense spending and so on, while inflation continues to increase. (In a perverse way, not only is inflation a hidden tax on the American public, but the government is silently extracting wealth from its foreign customers in the form of a "doing business" tax.)

Our immediate economic concerns are the mortgage crisis and subsequent bad debt write-offs that put pressure on the Federal Reserve. One reason for the high home foreclosure rate is a new attitude among home owners who say: Foreclose me... I'll save money. For example a Los Angeles-based writer bought two properties in Hancock Park, west of downtown, using no-down, interest-only mortgages in 2006. He paid just over $1 million for both and planned to sell them quickly but got caught in the slump. Soon his interest rate will jump by a few points, and his payments will go up by several hundred dollars a month for each place. He figures his properties have fallen in value by at least $60,000 each. According to Nouriel Roubini and 2008 Global Financial Stability Report, bank mortgage losses were approximately $1 trillion as of March 2008. A trillion dollars would wipe out most of the capital of most of the US banking system and lead most of US banks and mortgage lenders, exposed to real estate, into bankruptcy. However, mortgage foreclosure will not be in full swing until mid-to-late 2008 when it is expected that 10 to 15 Million Households Likely to Walk Away from their Homes/Mortgages. Thus, $1 trillion in mortgage related losses is a low estimate. Higher estimates put mortgage losses closer to $3 trillion. So this monetary contraction, combined with declining home values, suggests a classic economy-wide deflationary spiral.

But the policies of the last two Federal Reserve chairs and, of course, references made in Bernanke's infamous 2002 helicopter speech where he confidently proclaims the ability to regain control of an economy through "positive inflation" tell a different story.

Historically, a reliance upon foreign investment combined with an inability to grow and high government spending have lead to hyperinflationary periods such as after the US Civil War and after World War I in Germany. So we have the stage set for hyperinflation and the Federal Reserve is determined, at all costs, to support (monetize) the deflating financial industry with fresh money. The money supply has already increased by an annualized 17% in the first quarter of 2008, an estimated $2.5 trillion, and if multi-trillion increments continue, it will initiate a inflationary spiral of currency debasement, flight to safety, and hyperinflation. The only remaining question is will the financial industry deflate enough to tip the scales into hyperinflation? We will try to answer this question in the next section.

Besides the mortgage-based collaterlized debt obligation (CDO) problem are other asset backed securities (ABSs) such as credit cards, student loans, automobile loans, commercial leases, and so on that have also begun to fail. If that were not enough, there is another extended aspect of the financial industry, the un-regulated shadow banking system, that is free to create unlimited debt through its disguised insurance polices called credit default swaps (CDS) and other credit derivative instruments. Since these contracts are private, it is difficult to gauge the exact amount of debt created, but best estimates place the figure around $550 trillion of world-wide debt! And it is this very debt that collapsed Bear Stearns over the weekend of March 17th 2008 and has everyone concerned about the viability of Lehman Brothers, Citi Group, and JP Morgan Chase.

Beginning on December 17, 2007, the Federal Reserve began offering Term Auction Facility (TAF) loans where it exchanges un-sellable ($0.05-$0.10 on the dollar) CDOs for sellable Treasury notes. The weekly average of Fed loans outstanding has climbed steadily, from some $83 billion in December, to $99 billion in January, $111 billion in February, $191 billion in March, and $413 billion in April, for a total of $814 Billion. This money will be subsequently used in the fractional loan banking system to create $814B X 10 or $8 Trillion in new debt after a 12-18 month delay. Meanwhile, the Federal Reserve has promised to continue these money actions into the foreseeable future.

If that is not enough to worry about, unregulated bankers appear to be going back to the betting tables with the fresh Federal Reserve funds as Swaps Tied to Losses Transformed Into `Frankenstein's Monster'. Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the [Term Auction Facility] contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.

To answer the previous question, yes, there appears to be more than enough possible debt collapse to cause the Federal Reserve to increase the money supply to the point that it will tip the scales into hyperinflation.

How Do We Stop It?

The basic problem is that a ~500 trillion, world-wide, debt bubble has been created on behalf of the American consumer who is now broke and cannot pay the accumulated debt.

But wait a second, the American consumer did not create the CDOs and the CDSs, so why do they have to pay for them? Because that debt is based (structured) with home mortgages, automobile loans, student loans, etc. Even though banks have made billions re-packaging those loans, they have to receive monthly payments to keep the CDO and CDS deals working.

I thought the vast majority of loans are being repaid, so why is there a problem? The problem is that the banking system works on small margins over long time intervals. When a homeowner walks away from a non-recourse mortgage, that represents a loss of the total face value of the loan (until the house can be resold). So even though a small percentage are walking away now, they generate huge waves in the CDS markets. To minimize the fallout of this bad debt we must:

  • Have a honest government that informs the public as to the true condition of our national economy.
  • End bank accounting secrecy and enforce an "open book" policy with all banks.
  • Identify insolvent banks and declare bankruptcy.
  • Let investors take the losses. This means that our money market, savings, and pension funds will, to one degree or another, evaporate since our money managers purchased these CDOs & CDSs for high returns.
  • Educate ourselves in basic macroeconomic issues and demand leadership that will not defer to a private bank (the Federal Reserve) but rather be accountable for money creation and the regulation of credit creation at all banking levels.
  • Come to terms with our situation and admit that as a country we are broke. Enforce immediate and severe reduction of government spending. Collectively tighten our belts and move on with life.
Do you think this will happen? Then we must prepare for one of two alternatives:
  1. Stop paying interest and default on our debt. Tell the rest of the world that we are sorry and that we will try to be better borrowers in future generations. This alternative, of course would reduce the USA's economic status to that of our neighbors while other countries that export manufactured goods or export raw materials, (e.g., China, Russia, and Saudi Arabia) would rise in economic status.
  2. Or, we could add the the world's reserve currency thereby inflating the dollar and decreasing our debt to manageable levels.
So the bottom line is really about you! Do you have the courage to face the fact that we are broke and the courage to ask tell demand better economic leadership from our government?

Failure of the Financial Industry versus Failure of the Economy

Wall Street firms like to represent themselves as the economy, but nothing is farther from the truth. Wall Street represents the financial industry while the economy is a separate and independent concept. The economy is the generation of wealth through the provision of goods and services, while Wall Street manipulates the wealth of the economy for profit. Given the position we find ourselves today, it may be possible to save one or the other, but there are not enough resources to save both. The clear an obvious choice is to save the economy since it "hosts" the financial industry, Therefore, to attempt a rescue of the economy, the commensal financial industry must be allowed wither and die. This means:
  • Debt and credit will no longer matter. Yes, your home mortgage, credit card balance, business loans, etc. will no longer matter. That debt just went "poof" to money heaven.
  • But your bank account balance, CDs, and money market account also just went to money heaven as well. All of the credit saved in retirement accounts will disappear.
  • The economy, on the other hand, is the future. It is where services and goods are exchanged for currency and it will lead to a rebuilding a better financial industry.
  • Thus, if there is a rescue plan, it must protect and nurture the economy (future production of goods and services) and not the financial industry.
The recession of 1929-1939 was initiated by financial collapse. However, a Great Depression was created by those who fought to save the financial industry and, in the process, destroyed the economy. The same is happening today. Hank Paulson and Ben Bernanke are engineering a second Great Depression.

Economic Triggers for a Great Depression

To grasp how significant the shadow banking debt is, let's describe the $550 trillion in the context of some other domestic and international monetary data:
  • U.S. annual gross domestic product (GDP) is about $15 trillion.
  • U.S. money supply is also approximately $15 trillion.
  • Current proposed U.S. Federal budget is $3 trillion.
  • U.S. government's maximum legal debt is $9 trillion.
  • U.S. mutual fund companies manage about $12 trillion.
  • World's GDPs for all nations is approximately $50 trillion.
  • Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion.
  • Total value of the world's real estate is estimated at about $75 trillion.
  • Total value of world's stock and bond markets is more than $100 trillion.
  • BIS 2007 valuation of the world's credit derivatives is now ~$550 trillion.
So the trigger set ups are:
  1. Ninety five years of relentless inflation, especially in the last 35 years.
  2. A political system frozen in fear of the last Great Depression.
  3. A political system in partnership with, and directed by, big business (Fascism).
  4. A political system that would rather deceive than inform.
  5. A political system that is preparing to control its population with martial law, detention centers, informants, and satellites tracking all in the name of Homeland Security.
  6. Massive trade deficits sending the country's wealth offshore.
  7. Seventy percent of the country's debt held in foreign hands that can perform flight-to-safety operations at any moment.
  8. A banking system that gambled all of its assets on a bet that the price of residential housing would not decline.
  9. An un-regulated shadow banking system that has created 36 times our GDP in world wide debt.
  10. Naive end-users playing with very fragile CDS instruments (i.e., Jefferson County, Alabama, ($3.2 Billion default).
  11. Undercapitalized CDO monoline insurers such as MBIA Inc. and Ambac Financial Group Inc. and hedge funds betting that home prices will not fall.
  12. The same investment banks holding CDOs, CDSs, and hedge fund loans. In other words, the bank looses if house prices fall or interest rates go up.
  13. The Federal Reserve that will have issued $411 Billion to banks since December 2007.
  14. The Federal Reserve that is accepting RMBS CDOs as collateral for additional $100's of Billions.
  15. The Federal Reserve that is accepting non-recourse loans for bankrupt investor banks (i.e., Bear Stearns).
  16. The Federal Reserve committed to keeping the banking system solvent at all costs.
Thus, trigger sequence appears to be:
  1. Recession Begins (4th quarter 2007) - Housing market stalls and poor holiday retail sales suggest consumers are broke and cannot carry any more debt.
  2. Monetize the Debt, Phase I (1st quarter 2008) - 2005-2006 vintage sub-prime residential mortgage defaults began -> CDO losses -> CDS called in as backup -> under-funded insurance and hedge funds cannot pay -> Bear Stearns investment bank goes bankrupt -> Federal Reserve issues ~500 Billion in loans to banks, primary dealers, and investment banks (Fed pays JP Morgan Chase $30 Billion to take on Bear Stearns credit derivative debt). DataQuick Information Systems had counted 47,171 California foreclosures in the first quarter, a rate of more than 500 per day from January to March.
  3. Investment and Depository Banks are Broke (2nd quarter 2008) - Citigroup, Merrill Lynch, JPMorgan, Morgan Stanley, Bank of America, National City, Washington Mutual, and Wachovia are issuing new stocks (diluting existing shares) to raise cash. May 9, 2008 NB Financial N.A., a Bentonville, Ark. based bank, was the third bank closed by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. in 2008.
    • Commercial losses mount. Bankruptcies include: Linens 'n Things, ($650m), Kimball Hill ($703m), Home Interiors ($310m), French Lick Resorts ($142m), Recycled Paper Greetings ($187m), KB Toys Inc. (500m), and Tropicana Entertainment ($2.49bn). America's most trusted investment company, Berkshire Hathaway Inc., first-quarter 2008 profit fell 64 percent mainly because it recorded an unrealized $1.6 billion pretax loss on its credit derivative contracts.
    • California has 44,101 new "Notices of Default" filings in April, a new record, according to ForeclosureRadar. On average, one out of every 519 homes will received foreclosure notices in the month of April.
    • Municipalities file for bankruptcy because of lost tax revenue: May 2008, the California city of Vallejo (117,000 inhabitants) declares Chapter 9 bankruptcy.
    • Paul A. Volcker, former chairman of the Federal Reserve warned on May 14th, 2008 the United States could face a 1970s-style period of sky-rocketing inflation if investors lost confidence in the buying power of the dollar.
  4. Stock Market Crashes (3rd quarter 2008) - Stocks no longer based upon value. Market mechanisms draw assets from investment mode to a "mania" trading mode. The current period parallels the prior manias of both 1929 and 2000. Financial sector problems are now pushing recessionary forces onto the real economy which, in turn, fuel another wave of loan defaults that will force mid-size and smaller banks into failure. The credit squeeze has moved far beyond the subprime segment to affect nearly every borrower. Tighter credit slows economic growth, especially consumer spending. A second major investment bank like Citi Group or Lehman goes bankrupt.
  5. Monetize the Debt, Phase II (Late 2008) - Recession continues to spiral with many more job losses. Eighteen months have now passed since the bulk of the 2006-2007 vintage 10-13 million sub-prime residential mortgages were issued and now defaults multiply -> more CDO losses -> more CDS called in as backup -> more under-funded insurance and hedge funds cannot pay and go bankrupt -> investment banks go bankrupt -> recession deepens. Process repeats with other ABSs in early 2009 including credit card debt, automobile loan debt, student loan debt, etc. Process repeats a third time in 2009 for commercial mortgage debt, commercial leases, and so on.
  6. Monetize the Debt, Phase III (2009) - Deep recession or "stagflation" leads to Alt-A and prime mortgage defaults. The Federal National Mortgage Association and Federal Home Loan Mortgage Corporation are nationalized. Federal Reserve continues to hold/purchase bad ABS debt which causes massive cash infusions into the banking system at the expense of the future taxpayer. As the dollar continues to depreciate inflation continues at 15-20% per year or per month?
  7. Hyperinflation Tripwire Crossed (2010) - Systemic inflation becomes built into pricing and grows out-of-control. Or foreign investors fly-to-safety. 70% of Treasury notes are sold and investments move to other currencies and precious metals to preserve remaining wealth. A commodities asset bubble, ripple price shocks through the economy.
  8. World-Wide Second Great Depression (2011) - Lack of money stops inflation. All debts ($550 Trillion of paper wealth) evaporate. Official economy ceases to exist.

What Does A Hyperinflationary Great Depression Looks Like?

The first thing Williams points out is a lack of physical cash. The Federal Reserve only holds about 1.5% of the total money supply in cash or about $200 billion plus another $50 billion in commercial bank vaults. Another $780 billion is held outside the USA in foreign bank vaults. So as the demand for more cash skyrockets, the limited cash supply will be quickly exhausted. Subsequently the government would release its so called red-colored high denomination paper money. Next, our debit and credit card based society would also cease to function in hyperinflation and, in turn, worsen the existing economic crisis.

Aside from government action, debt will quickly fade away in pre-inflation dollars. Home mortgages will become insignificant to pay, but also savings will melt away including baby boomer pension funds.

Small barter-based black markets will eventually evolve, but maybe not for 1 to 6 months. What little gold and silver there is would be used as a back-up reserve currency. Other valuable barter currency include high quality liquor (scotch & wine), as well as canned goods and personal services. But if you do barter with these physical goods, be sure to check the weight of gold & silver, check expiration dates and taste the liquor before completing the transaction. So, to be prepared for an economic collapse one needs a six-month store of essentials such as canned goods, toilet paper, booze, guns, and gold.

As noted earlier, hyperinflation is associated with social upheaval. Probably a quarter of the population will not be able to find jobs. Hunger will be rampant and people will be eating out of garbage dumpsters. A third political party, probably Libertarian, will replace the Republican party. And in case you have forgotten what a hobo looks like, here are pictures of modern young hobos.

It will take years, maybe 10 or more years to work out of a depression and some believe that the depression will be localized to America, but more likely, given the world-wide nature of modern debt (CDOs and CDSs), other nations will experience a depression in one form or another.

Dmitry Orlov witnessed the economic collapse of Russia and offers insights into day-to-day life in a Great Depression.

Expect shortages of fuel, food, medicine, and countless consumer items, outages of electricity, gas, and water, breakdowns in transportation systems and other infrastructure, hyperinflation, widespread shutdowns and mass layoffs, along with a lot of despair, confusion, violence, and lawlessness. We definitely should not expect any grand rescue plans, innovative technology programs, or miracles of social cohesion.

When faced with such developments, some people are quick to realize what it is they have to do to survive, and start doing these things, generally without anyone's permission. A sort of economy emerges, completely informal, and often semi-criminal. It revolves around liquidating, and recycling, the remains of the old economy. It is based on direct access to resources, and the threat of force, rather than ownership or legal authority. People who have a problem with this way of doing things, quickly find themselves out of the game.

Expect the transition to permanent unemployment to be quite abrupt for most people. Very little will be obtained for money which will be treated as tokens rather than as wealth and shared among friends. Many things, such as housing will be either free or almost free. Economic collapse tends to shut down both local production and imports, and so it is vitally important that anything you own wears out slowly, and that you can fix it yourself if it breaks. Old debts will never be repaid.

Economic collapse is about the worst possible time for someone to suffer a nervous breakdown, yet this is what often happens. The people who are most at risk psychologically are successful middle-aged men. When their career is suddenly over, their paper savings are gone, and their property worthless, much of their sense of self-worth is gone as well. They tend to drink themselves to death and commit suicide in disproportionate numbers. Since they tend to be the most experienced and capable people, this is a staggering loss to society.


How to Prosper During the Coming Bad Years in the 21st Century
by Howard J. Ruff

The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity
by Robert Kuttner 
Knopf, 2007

Bad Blood: Reckless Finance, Failed Politics & the Crisis of American Capitalism
by Kevin Phillips
Viking Adult, 2008

Fiat Paper Money, The History and Evolution of Our Currency
by Ralph T. Foster
2189 Bancroft Way, Berkeley, CA 94704
Telephone: (510) 845-3015, E-mail:

Manias, Panics, and Crashes: A History of Financial Crises, 3rd Ed.
By Charles P. Kindleberger & Robert Aliber
John Wiley & Sons, 2005

The Case for Gold
By Ron Paul & Lewis Lehrman
Mises Institute, 2007

The Creature from Jekyll Island: A Second Look at the Federal Reserve, 3rd edition
by G. Edward Griffin
American Media (CA), 1998

Worse Than The Great Depression by Krassimir Petrov, PhD - Prince Sultan University, Saudi Arabia - November 2, 2008
So, why Worse Than The Great Depression? What makes me believe that the current depression will be worse than the Great Depression? I present six of the most important fundamentals "baked-in-the-cake" that suggest a "Greater Depression."

Web sites that discuss macroeconomic issues