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THE
ROCKET SCHOOL OF ECONOMICS


The Financial Equivalent of Faulty Towers.
by Professor von Braun

February 6th, 2008

I am sure that most readers are familiar with John Cleese's performance in the English television comedy, Faulty Towers. He plays the bumbling manager of a small hotel that never quite gets it right and in most episodes what can go wrong does go awfully wrong.

Given the decline to date of the stock market since January 1, 2008 and the unfolding of the now apparent subprime debacle I would say that the question on the lips of most economic commentators should be: "what hits the fan next?"

Will the subprime bailout work? The odds are not good and evidence of that is beginning to appear. Some State housing agencies, such as New York, Ohio and Massachusetts, that have been offering mortgage refinance options are not able to make loans to people simply because its not an economic proposition, based upon three main reasons: 1) the value of the property has fallen too far, 2) the mortgagee does not have the income to cover the loan, and 3) their additional (credit card and auto, mainly) debt levels are too high.

In addition, the fall out from the debacle is hitting the corporates as they, too, now have to write off the value of their 'temporary' investments in the subprime area. Banks won't lend to each other because they don't know what the other may hold by way of subprime liabilities and other exotic instruments.

In addition there is the bond insurer debacle that potentially will see the Triple AAA investment rating ability moved down a notch or two or three. Add further to that the commercial real estate market and its now apparent slowdown (read falling prices) and what do you get?

Throw into the mix the fact that US government T-bills are yielding less than the 'official' inflation rate -- which means they too are losing value.

Now what does all this mean? What have we got unfolding here? What are the overall implications when it comes to where to be invested? What happens when the commercial paper market dries up to the degree that no one can roll over, as in not replacing due debt when it's due? What is there to lend on that is not headed down hill? To put it another way, where is the floor?

At what stage do we see the beginnings of a complete reversal of the familiar, ever-expanding monetary lending system that now becomes a contracting monetary system? We have never seen an example of something this widespread that appears to be ready to unfold on a global basis. Again, what happens to a fiat system when the ability to expand the monetary supply by adding further debt, which is what is required for its very survival, comes to an end?

The questions go on. What happens when the debt issuance game stops and asset prices begin to recede?

What happens when the price of the underlying asset falls below the value of the debt attached to it?

The answers are not simple. Providing liquidity is not the answer and I doubt that the powers that be know what the answer is because they don't know what the problem is. As an integral segment of the problem, they have ignored all the warnings given by the free market and hard money advocates -- warnings that are now becoming at the very least self evident. How do you rectify a system where nobody gets paid with anything other than that which is an irredeemable IOU, actually an IOU nothing?

It's a monetary system gone berserk, with the creation of debt being taken over by those who had no business taking it over in the first place. Now we have a global monetary system with US dollar denominated debts as reserves, reserves which cannot, en masse, be redeemed for anything of a tangible nature. Other Central banks are completely dependant upon the Federal Reserve's monetary policy which is controlled by those who are the culprits in the subprime debacle -- the very investment banks who should have stayed out of the mortgage business in the first place. The monetization of non-producing 'assets' will turn out to be the straw that breaks the camel's back.

How does this system, which is inherently flawed, fix itself? This is not a sound money system. On the contrary, there is nothing sound about it. Since its inception there has been a decrease in the purchasing power of the dollar, which is the principal unit of account and a corresponding issuance of debt. In other words, as more debt was issued an equal reaction took place in the purchasing power of this principle unit of account.

In addition, the original item used for settlement in transactions, gold and silver, have demonstrated their remarkable ability to maintain their value as expressed in the 'price' in which they are quoted, an indirect reflection of the increased debt levels. The price of gold has risen from $20.67 in 1913 to over $900 in early 2008, a 44-fold increase. The loss of purchasing power of the principal unit of account is best demonstrated by the simple fact that at today's gold price $20.67 will buy you 0.0224 ounces of gold.

The national debt in 1913 was said to be $1.028 billion and today it stands at $9 trillion+. That is a 9000-fold increase. Then, that debt was $10.67 per person; today, that debt is some $30,000. That's a 2800-fold increase. US gold reserves in 1913 were at 2293 ton which equated to a dollar value of $1.42 billion, considerably more than the national debt.

The increase in house prices over the last 40 years is not a result of the actual value of the house going up, rather it is an aspect of the debasement of the unit they are priced in. The idea of rising prices is a direct result of the debt game which is what a fiat currency is. It needs to rollover the same debt at a higher level, thereby allowing a book entry to be made that appears to be a profit. In actual fact, it indicates more debasement of the principal unit of account.

At what point does the debt swamp those whose role it is to provide the income to service it, in this case the US taxpayer? The US taxpayer has been relied upon by the issuers of debt one time too many. The introduction of income tax coincided with the setting up of the Federal Reserve and was a necessary element as that was the mechanism with which the debt issued by the Fed to the government would be serviced.

Now all the sheep were in one corral but the banking community was not satisfied with that arrangement. They needed to add more debt to keep the game going, to increase "profits" and to latch on to as much of everybody's pay checks as they could, while maintaining the illusion of wealth in the face of a loss of purchasing power of the dollar.

In 1933 the national debt had increased to $23.1billion, a 23-fold increase since 1913. Roosevelt confiscated the citizens gold in 1933 and added to the US official gold reserves a further 2640 ton. After raising the official gold price to $35 the 1935 total reported of gold holdings, 8998 tons had an implied value of $9.44 billion, slightly more than 40% of the national debt.

Today with the national debt at $9.3 trillion, reported US gold holdings represent 8137 tons, and with gold at $920 per ounce gives an implied value of $224 billion, which represents about 2.5% of the debt. For gold to represent 40% of the current debt would require a gold price of at least $12000.00.

So what happens when, as predicted over the years, the fiat monetary game comes to an end?

What happens when asset prices fall below the levels of debt these 'assets' are carrying by way of regular and exotic securitization's? Who picks up the pieces? What happens when you have a compounding to the downside, as opposed to the upside?

What happens to those who are holding trillions of dollars worth of instruments that can't be redeemed for anything? Does anybody know?

Should these debts be written off, as was done in the 1930's when the Federal Reserve effectively stood aside and let banks collapse, more importantly how can they not be written off if they become worthless? What happens to the entity that is holding them, whether it be a corporate, a pension fund, or a bank? How do they recapitalize and with what do the recapitalize?

The main difference between now and the 1930's is that central banks had gold reserves to fall back on, where as now they are all holding mostly US dollars as reserves, reserves that are not reserves at all. Chairman Bernanke's problem, the banker's problem, is not going to be resolved by the addition of liquidity, regardless of how much spin is put on their actions. The crisis unfolding is about the creation of too much debt, debt that has been issued predominately upon non-productive assets which are liabilities that need to be maintained on an ongoing basis. Where is the store of value in a house?

To some degree it's a case of killing the goose, in this case the American wage earner, that laid the golden egg. Essentially it is savings deprivation, a malady that has to be changed if indeed the present system can be corrected. Where is John Cleese when you need him?


The Prof can be contacted by email at profvonb2@aol.com

Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.

Return to the The Gilded Opinion Index Page

The Rocket School of Economics -- The Lecture Series Index

  • 22 May 2009 -- An Often Overlooked Issue!
  • 28 Mar 2009 -- Problematic Banking Systems!
  • 14 Nov 2008 -- What Exactly is an Asset?
  • 23 Aug 2008 -- Through the Looking Glass?
  • 02 Aug 2008 -- Compounding to the Downside!
  • 26 May 2008 -- Back to Basics Again!
  • 31 Mar 2008 -- The Broken Watch -- Part 2.
  • 27 Mar 2008 -- The Broken Watch -- Part 1.
  • 06 Feb 2008 -- The Financial Equivalent of Faulty Towers.
  • 10 Dec 2007 -- Monetary Systems & Productive Assets.
  • 14 Feb 2007 -- Divorced from Reality
  • 06 Sep 2006 -- Gold, Bankers, the Trade Deficit and Unsettled Transactions
  • 19 Jun 2006 -- When is a Reserve Not a Reserve?
  • 31 May 2006 -- The significance of August 15, 1971.
  • 08 Apr 2006 -- Keep Your Eye on the Ball!
  • 30 Mar 2006 -- What came first?
  • 11 Mar 2006 -- An Unanswered Question.
  • 08 Jan 2006 -- Where have all the projects gone!
  • 11 Dec 2005 -- Gorillas, Rising Gold Prices and Depreciating Paper Currencies!
  • 23 Oct 2005 -- Custodial Risk.
  • 16 Sep 2005 -- An Inherent Flaw.
  • 08 Aug 2005 -- Central Banks and 'Reserves'.
  • 31 Jul 2005 -- Central Bankers, Actors and 'We'.
  • 17 Jul 2005 -- Unintended Consequences! -- Part 3.
  • 07 Jul 2005 -- Unintended Consequences! -- Part 2.
  • 25 Jun 2005 -- Unintended Consequences! -- Part 1.
  • 14 Jun 2005 -- The Two Greater Fools Theory.
  • 03 Jun 2005 -- Real Money, Funny Money and YOU -- Part 4.
  • 30 May 2005 -- Real Money, Funny Money and YOU -- Part 3.
  • 26 May 2005 -- Real Money, Funny Money and YOU -- Part 2.
  • 21 May 2005 -- Real Money, Funny Money and YOU -- Part 1.
  • 09 Nov 2002 -- Carrying a Big Stick.
  • 17 Sep 2002 -- Wishful Thinking!
  • 27 Jul 2002 -- Gold Bugs Beware -- part 2.
  • 10 Jun 2002 -- Gold Bugs Beware!
  • 06 Apr 2002 -- Currencies versus Gold.
  • 26 Jan 2002 -- Bear Market Strategies.
  • 01 Jan 2002 -- 2002 -- A Perspective.
  • 20 Oct 2001 -- The Storm Clouds are Gathering.
  • 30 Sep 2001 -- What to Say?
  • 01 Jul 2001 -- ...Said the Fly to the Spider.
  • 14 Jun 2001 -- Upward and Downward!
  • 28 May 2001 -- Volatility Time, Again!
  • 14 May 2001 -- The Coming Bull Market in Gold Stocks?
  • 24 Feb 2001 -- High Hopes, Wishful Thinking & The Absurd
  • 20 Feb 2001 -- Who Put the Holes in the Swiss Cheese?
  • 22 Jan 2001 -- US Dollar Admits Identity Crisis!
  • 16 Jan 2001 -- Dear George W.
  • 24 Nov 2000 -- The Bubble Has Burst
  • 11 Nov 2000 -- The Media, Bull Markets & the Gold Price
  • 02 Nov 2000 -- Gold Stocks
  • 29 Oct 2000 -- Oh The Tangled Web We Weave ...When We Set Out to Deceive
  • 24 Oct 2000 -- A Mystery!
  • 16 Oct 2000 -- A Peso Here ...and a Few Thousand Pesos There
  • 10 Oct 2000 -- The Unfolding
  • 30 Sep 2000 -- What's Wrong with THIS Picture?
  • 25 Sep 2000 -- Buy Gold Now!!
  • 23 Sep 2000 -- The Times, They Are a' Changing
  • 15 Sep 2000 -- Time WILL Tell!
  • 27 Aug 2000 -- SS "Paper Assets" Begins to Take on Water
  • 06 Aug 2000 -- The Indian Summer
  • 26 Jun 2000 -- A Yellow Brick Wall
  • 22 May 2000 -- The King IS Naked
  • 30 Apr 2000 -- Goodbye Yellow Brick Road
  • 18 Apr 2000 -- Beware the Ides of March, April and May
  • 08 Apr 2000 -- Really, Sir Aldot!
  • 25 Mar 2000 -- Where To From Here?
  • 18 Mar 2000 -- The Gnomes of Zurich
  • 12 Mar 2000 -- The "New" Economy??
  • 06 Mar 2000 -- Two Questions
  • 04 Mar 2000 -- Iceberg Dead Ahead!
  • 28 Feb 2000 -- The Wizard of Oz
  • 06 Feb 2000 -- Here We Go Again!!
  • 15 Jan 2000 -- Comments on the Gold Market
  • 29 Dec 1999 -- No Raw Ingredients Required
  • 28 Dec 1999 -- No Way Out
  • 14 Dec 1999 -- Ho, Ho, Ho!
  • 07 Dec 1999 -- Greenspan's Bubble
  • 03 Dec 1999 -- Early Warning Signs


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