Beyond The Tipping Point: Setting the Stage for Weimar?
Metamorphosis in 2009/2010

London, UK - 23rd December 2008, 02:19 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

Will the "zero interest rate policy" help the US economy recover? Or will it make matters worse? In recent weeks the US Federal Reserve has dramatically enlarged its role in the functioning of the financial markets. It has even taken over the role that was the original purpose of the Treasury's USD 700 billion Troubled Asset Relief Program (TARP). The difference between a Fed bailout of troubled financial institutions and a Treasury bailout is that central bank loans do not have the oversight safeguards that US Congress imposed upon the TARP. The total of such emergency Fed lending exceeded USD 2 trillion on November 6th. It had risen by an astonishing 138 percent, or USD 1.23 trillion, in the 12 weeks since September 14th, when the central bank governors relaxed collateral standards to accept securities that were not rated AAA. They did so knowing that on the following day a dramatic shock to the financial system would occur.

On September 15th, Federal Reserve Chairman, Ben Bernanke, New York Federal Reserve President, Tim Geithner -- the new Obama Treasury Secretary-designate -- along with the Bush Administration led by Treasury Secretary, Henry Paulson, agreed to let the fourth largest investment bank, Lehman Brothers, go bankrupt, defaulting on billions of dollars worth of derivatives and other obligations held by investors around the world. That event, as is now widely accepted, triggered a global systemic financial panic as it was no longer clear to anyone what standards the US Government was using to decide which institutions were 'too big to fail' and which were not. Since that fateful decision, the US Treasury Secretary has reversed his policies on bank bailouts repeatedly, leaving markets confused as to whether he and the Bush Administration had any coherent strategy for management of the continuing crises in credit markets, or whether their actions simply represented improvisation in fighting fires one at a time.

On November 7th, Bloomberg filed a law suit under the US Freedom of Information Act (FOIA) requesting details about the terms of eleven new Federal Reserve lending programmes created during the deepening financial crisis.

On December 8th, the Fed denied this request on the grounds that details of its actions would reveal 'trade secrets' and 'commercial information' about the recipients of its actions. Thus, the Fed has bluntly refused to disclose the recipients of more than USD 2 trillion of emergency loans from US taxpayers, and refused to reveal the assets the central bank is now accepting as collateral. This has left markets uncertain as to what the Fed's ultimate objective might be, or even whether there was any consistent strategy underlying the Fed's continuous stream of innovative lending facilities and purchases of asset backed securities. Questions are now being raised as to whether the Fed's unprecedented expansion of the monetary base in recent weeks might set the stage for a future Weimar-style hyperinflation in 2009/2010.

In response to the widening credit market crises and signs of deepening recession, the US Fed is expanding what is technically called the Monetary Base, defined as total bank reserves plus cash in circulation, the basis for potential further high-powered bank lending into the economy. Since the Lehman Brothers default, this money expansion rose dramatically by end October at a year-on-year rate of growth of 38%. This has been without precedent in the 95 year history of the Federal Reserve since its creation in 1913. The previous high growth rate, according to Fed data, was 28% in September 1939, as the US was building up industry for the evolving war in Europe. This leaves market analysts worried about whether the American economy is confronted with deflation or inflation, or even worse, a period of deflation soon followed by hyperinflation generated by the hyperactive expansion of the monetary base and the Fed's balance sheet. In parallel, US government borrowing has spiked -- up from an annualised rate of USD 310bn in the second quarter of this year to an astonishing USD 2+ trillion at present and rising.

Both US fiscal and monetary policy now seem wildly expansionary, to an extent never seen before. The present course of Fed policy seems likely to continue at least until a new Administration takes office. At that time, President Obama will have the opportunity to shape his own fiscal stimulus package but also to appoint a number of new Governors of the Federal Reserve, whose opinions could prove crucial in shaping the Fed's actions early next year. Up until now, President-elect Obama has declared that he wants the US Congress to enact a major fiscal stimulus package of a little less than USD 1 trillion. He has not explained what he would hope the Fed might do in parallel with his fiscal plans.

Whether the threat of deflation is converted into hyperinflation may thus depend upon decisions taken in Washington, DC, in coming weeks. We already have some insight into the potential dangers when we consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honour cheques, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the Reichmark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%. Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history in 1923/1924. As a result, with no countries to competitively devalue against, even the Weimar hyperinflation failed to achieve its goal, resulting only in the worldwide slide into recession that culminated in competitive devaluations in all countries to achieve the inflation against gold that was necessary to start the recovery. [Reference ATCA: Bretton Woods II]

If we examine the US monetary base -- all paper dollars and coinage in existence -- it took two centuries for the monetary base to go from USD 0+ to USD 800 billion, but in just the past 3-months it has nearly doubled -- growing from around USD 800 billion to USD 1.5 trillion -- and by the time we look closely again in 2009 it will probably have surpassed USD 2 trillion. That is double the number of paper dollars in existence since last summer! Moreover, until September 2008, the month of the Lehman Brothers collapse, the Federal Reserve had held the expansion of the Monetary Base virtually flat. The 76% expansion has almost entirely taken place within the past three months, which implies an annualised expansion rate of more than 300%.

Despite this, banks continue to be unwilling to lend further. As pointed out by the some of the top economists at the Federal Reserve Bank of Minneapolis [Working Paper Number 666], it is not at all clear that bank lending is the problem, as even the Federal Reserve Board's indicators of bank lending show little or no significant decline. Hence, the US economy is in a depression free-fall of a scale not seen since the 1930s. Banks do not lend in part because under Basel-II -- Bank for International Settlements (BIS) -- lending rules, they must set aside 8% of their capital against the value of any new commercial loans. Yet the banks have no idea how much of the mortgage and other troubled securities they own are likely to default in the coming months, forcing them to raise huge new sums of capital to remain solvent. It is far 'safer', they reason, to pass on their toxic waste assets to the Fed in return for earning interest on the acquired Treasury paper they now hold. Bank lending is risky in a depression. Banks are also well aware that their off balance sheet exposure is far larger than their on balance sheet positions. As Prof Joseph Mason pointed out in his recent ATCA submission, the off balance sheet exposure of FDIC insured banks is now an extraordinary multiple of 16 times their on balance sheet positions. There can be little doubt that the off balance sheet positions are primarily constituted of troubled assets, since if there were any high quality assets in those structured vehicles they would have long since been brought back onto the balance sheets of troubled banks.

American banks have exchanged USD 2 trillion of presumed toxic waste securities consisting of Asset-Backed Securities in sub-prime mortgages, stocks and other high-risk credits in exchange for Federal Reserve cash and US Treasury bonds or other Government securities still rated AAA, ie, risk-free. The result is that the Federal Reserve is holding some USD 2 trillion in largely junk paper from the financial system. The banks benefiting from the Fed's actions naturally oppose any release of information because that might signal 'weakness' and spur short-selling, selling or a run by depositors - whether or not they are appropriate in doing so.

To replace wholesale deposits with retail deposits is a process that in the best of times will take years, not weeks. Understandably, the Federal Reserve does not want to discuss this. That is clearly also behind their blunt refusal to reveal the nature of their USD 2 trillion assets acquired from member banks and other financial institutions. Simply put, were the Fed to reveal to the public precisely what 'collateral' they held from the banks, the public would know the potential losses that the government may take. Even though the Fed does not reveal the details, the very act of omission is an implicit confession that there are more toxic assets hidden than they would care to have revealed at this stage.

Making the situation even more drastic is the banking model used first by US banks beginning in the late 1970s for raising deposits, namely the acquiring of 'wholesale deposits' by borrowing from other banks on the overnight interbank market. The collapse in confidence since the Lehman Brothers default is so extreme that no bank dares trust any other bank enough to borrow. The US Federal Deposit Insurance Corporation is currently considering an additional regulatory tax on Brokered Deposits, placed in sound banks by knowledgeable brokers, confusing liability risk with asset risk. That leaves only traditional retail deposits from private and corporate savings or checking accounts.

On December 10th, in Congressional hearings by the House Financial Services Committee, Representative David Scott, a Georgia Democrat, said Americans had 'been bamboozled,' slang for defrauded. Several members of the US Congress are now demanding more transparency from the Federal Reserve and US Treasury on bailout lending. US Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson said in September they would meet Congressional demands for transparency in a USD 700 billion bailout of the banking system.

In early December the US Congress oversight agency, GAO, issued its first mandated review of the lending of the US Treasury's USD 700 billion TARP program (Troubled Asset Relief Program). The review noted that in 30 days since the programme began, Henry Paulson's office had handed out USD 150 billion of taxpayer money to financial institutions with no effective accountability of how the money is being used. It seems Henry Paulson's Treasury has indeed thrown a giant 'tarp' over the entire taxpayer bailout.

The next chart is "Cash in Circulation". So far only a small amount of all that extra currency has leaked out of the banking system and into circulation. But one can assume that at some stage it will begin to do that more excessively. When it does, it means that prices must rise to soak up all that extra currency, like a sponge which soaks up liquidity. This could be bad news for someone holding cash US dollars, but cause for celebration for those holding physical assets such as houses, land or precious metal. The two spikes are illustrative of the massive infusions of cash the Fed has relied upon in righting recent recessions of 2001 and 2007/2008 (thus far).

Here is a chart of how many dollars the banks have borrowed from the US Federal Reserve through the end of last year (2007). Please note the spike that indicates the banks had to borrow USD 8 billion from the Federal Reserve during the Savings and Loan (S&L) Crisis of the late 1980s.

Here is the same chart, but ATCA RAW has now taken it out to the beginning of November 2008. One cannot even see the USD 8 billion S&L crisis peak anymore! In fact, the banks are approaching USD 800 billion in borrowings. This means that the central banking system already perceives this crisis as being 100 times larger than the S&L crisis. In terms of policy response, this is already about on par with that in the Great Depression. For example, the Reconstruction Finance Corporation's USD 50 billion (1937 dollars) in real dollar terms today, amounts to between USD 600b and USD 7.5 trillion depending on inflator.

This next chart is Reserve Bank Credit. It is the total amount the Federal Reserve has loaned out of its theoretically infinite check book, ie, bank borrowing. This chart includes all the rest of the bailouts (at least to the beginning of November 2008). This chart also rises to roughly USD 800 billion by the end of 2007, but by the start of November 2008, it has risen to USD 2.2 trillion.

Finally, ATCA has a chart of "Excess Bank Reserves". These are reserves in excess of the amount that the Federal Reserve requires the banks to have. It looks almost identical to the chart of Bank Borrowings, except for two small features; there is a tiny blip in 2001 and a small bump around 1941. It would imply that the banks perceive this crisis to be 50 times larger than 9/11 or even World War II.

All graphs in this article have been sourced from the US Federal Reserve Bank (of St Louis). These charts raise the question of whether in a few years a chart of the price of physical assets like land and precious metals including gold might look similar to these charts. In such a case, would the chart of the purchasing power of the US dollar look like one of these charts flipped upside-down?

Under the euphemism of "quantitative easing", the Fed appears to be printing trillions of dollars, using them to buy up mortgage debt, credit card debt and other junk securities the private sector does not want. The Fed's actions are evidently designed to avert deflation. The question must, however, be asked whether the Fed's current actions will inevitably bring about a surge of Weimar Republic-style inflation. Is the Fed "lubricating" the system, or is it flooding the engine of the US economy with so much cash that the ultimate outcome will be a hyper-inflated recovery, characterised by hyperinflation and anaemic economic growth?

The Fed's actions have driven the yield on the 30-year US bond down to 2.6 percent -- the lowest for 50 years. This Fed may be determined to maintain such a low yield for a prolonged period, but in the event that the markets ultimately become overwhelmed with the Fed's printing presses, the yield could take off in the midst of an economic blood-bath. It may be asked whether such low yields suggest the US Treasuries market could perhaps be moving into bubble territory. The Fed has committed itself to buying long-term US government debt in huge quantities. But, as America's liabilities rise and the printing presses keep rolling, there will increasingly be risk that the dollar will fall. If that were to happen, the argument for holding US Treasuries would collapse! The danger is now rising that, in the near future, the only net buyer of US Treasuries could be the Fed itself. Very serious questions would then be asked about America's ability to service its debt. Would foreign creditors remain passive in such a challenging situation?.

This scenario is alarming, but far from impossible. It is apparent that the Fed believes it is fighting deflation. But its argument and modus operandi raises questions. As measured by the pre-Clinton methodology, before the politicians started messing with the numbers -- inflation stands at +4.5 percent. Is that inflation or deflation at present? Deflation is clearly being used as a basis to print money in an effort to bury mistakes -- past policy errors -- and bail out Wall Street. US regulators have undertaken a massive policy of forbearance in recent years, and many banks need to be closed. The inflationary stance is therefore currently being used to patch over those shortcomings without really closing insolvent banks and recapitalising others.

The Federal Reserve's actions since September suggest signs of panic. The new money is not being 'sterilised' by offsetting actions by the Fed, a highly unusual move suggesting a degree of desperation. Prior to September, the Fed's infusions of money were sterilised, making the potential inflation effect 'neutral.' This means once banks begin finally to lend again, perhaps in a year or so, the lack of sterilisation will flood the US economy with liquidity in the midst of a deflationary depression. At that point or perhaps well before, depending upon the economic and monetary policies of other governments around the world, the dollar could collapse as foreign holders of US Treasury bonds and other assets run. Such a scenario would result in a sharp appreciation in the euro and a crippling effect on exports in Germany and elsewhere should the nations of the EU and other non-dollar countries such as Russia, OPEC members and, above all, China not have arranged a new zone of stabilisation apart from the dollar.

On December 15th, Bloomberg reported -- Dollar Staggers as US Unleashes Cash Flood: "US policy makers are flooding the world with an extra USD 8.5 trillion through 23 different plans designed to bail out the financial system and pump up the economy."

In the present circumstances, with the government and the central bank taking a growing role in the functioning of credit markets -- and even in the functioning of industry -- it is not surprising that people in the Western world are finding it difficult to trust their banks. Is money safe in a bank? If gut feeling suggests "No", one might be right. Remember, we don't have physical asset backed money in the bank, we only have a number on a computer screen. This time around, there is no commitment to re-establish the "Gold Standard" and no intent to even try to return to pre-crisis parity, even if that could be judged as theoretically correct.

Right now, the US Federal Reserve, and the Western banking system in general seem to be gearing up for an event the type of which we have never before seen. ATCA RAW and the mi2g Intelligence Unit are of the view that the crisis that will unfold over the next few years could potentially add up to the biggest economic event in history. The scale of what has happened and will happen may dwarf all other economic events combined. The Tulip mania of 1637, John Law's "Mississippi Scheme" of 1720, and the dotcom bubble of 1999/2000 are all set to pale in comparison. Even the hyperinflation in Weimar Germany in 1923/24 and the 1930s Great Depression which followed the stock market crash in 1929 may be inappropriate comparisons.

The world faces the greatest financial and economic challenge in history in coming months. The incoming Obama Administration may find itself with a choice of literally nationalising the credit system to insure a flow of credit to the real economy over the next 5 to 10 years, or to face an economic Armageddon that will make the 1930s appear to be a milder event by comparison.

For the week ended December 6th, initial jobless claims in the US rose to the highest level since November 1982. More than four million workers remained on unemployment, also the most since 1982 and in November US companies cut jobs at the fastest rate in 34 years. Some 1,900,000 US jobs have vanished so far in 2008.

As a matter of relevance, 1982, for those with long memories, was the depth of what was then called the Volcker Recession. Paul Volcker, a Chase Manhattan alumnus of the Rockefeller family institution, had been brought down from New York to apply his interest rate 'shock therapy' to the US economy in order as he put it, 'to squeeze inflation out of the economy.' He squeezed far more as the economy went into severe recession, and his high interest rate policy detonated what came to be called the Third World Debt Crisis. The same Paul Volcker has just been named by Barack Obama as Chairman-designate of the newly formed President's Economic Recovery Advisory Board.

Virtually every time governments, and/or the banking system, abuse a fiat paper currency enough to push it to a tipping point (such as in these charts), the free market and the will of the public revalue gold and silver as well as land to account for the excess currency that was created since the last time they were revalued. But this time, for history to repeat, and for gold to do what it did in 1980, 1934, and hundreds of times throughout history going all the way back to ancient India, Greece and Rome, it will require a gold price of over USD 10,000 per ounce from today's USD 800+. That is if they stop printing US dollars today!

The present economic collapse across the United States is driven by the collapse of the several trillion dollars market for high-risk sub-prime and Alt-A home mortgages and other forms of securitised debt, superseded by the eight bubbles outlined within ATCA. Fed Chairman Bernanke is on record stating that the worst should be over by end of December, but there seems little reason to make such a judgement. The same Bernanke stated in October 2005 that there was "no housing bubble to go bust." Moreover, once the residential mortgage market blew up, he assured that the problem would be "contained." So much for his predictive acuity. The widely-used S&P Schiller-Case US National Home Price Index showed a 17% year-on-year drop in the third quarter with a rising trend. On present estimates it could take as long as another five to seven years to see US home prices reach bottom. However, if hyperinflation should manifest, house prices will start rising dramatically. In 2009 as interest rate resets on some USD 1 trillion worth of Alt-A US home mortgages begin to kick in, the rate of home abandonments and foreclosures could potentially explode. Little in any of the so-called mortgage amelioration programmes offered to date reaches the vast majority affected.

The definition of Depression was recently published, a term that was deliberately dropped after World War II from the economic lexicon as an event not repeatable. Since then all downturns have been termed 'recessions.' Per the US economic authorities at the Commerce Department's Bureau of Economic Analysis and at the National Bureau of Economic Research (NBER), as well as numerous private sector economists, the more precise definitions of 'recession,' 'depression' and 'great depression' follow. The official NBER definition of recession is, "Two or more consecutive quarters of contracting real GDP, or measures of payroll employment and industrial production." "A depression," is defined, "as a recession in which the peak-to-bottom growth contraction is greater than 10% of the GDP." "A Great Depression," is defined as, "one in which the peak-to-bottom contraction exceeds 25% of GDP."

In the period from August 1929 until he left office in January 1934 President Herbert Hoover oversaw a 43-month long contraction of the US economy of 33%. Is it conceivable that Barack Obama might break that record, and preside over what historians might end up calling the Very Great Depression of 2008-2014?

What is needed is a radically new strategy to put virtually the entire United States economy into some form of an emergency 'Chapter 11' bankruptcy reorganisation where banks take write-offs of up to 90% on their toxic assets, that, in order to save the real economy for the American population and the rest of the world. Paper money can be shredded easily. Not human lives. In the process it might be time for the US Congress to consider retaking the Federal Reserve into the Federal Government as the Constitution originally specified, and make the entire process easier for all.

The Risk of Sudden Collapse of All Capital-Based Pension Systems

The Fed's relentless effort to suppress long-term yields could generate yet another crisis affecting the future years of the majority of the working population. By April 2009, the general public will become aware of three major destabilising processes beyond the scale, speed, severity and synchronicity of the present global downturn, which are linked to the next leg of The Great Unwind:

. Time Horizon: The full length and end-point of the crisis will become more (and not less) elusive to determine;
. Unemployment: Major increase of unemployment in millions per month per major G7 country and worldwide with attendant social unrest; and
. Sudden Collapse: The risk of sudden collapse of all capital-based pension systems as the value of annuities and paper assets erodes.

Among the various consequences of the crisis for tens of millions of people in the G7 -- US, Japan, EU-4, and Canada -- from the end of this year and starting early in 2009, news about major losses on the part of the organisations in charge of managing the financial assets that finance pension annuities could multiply.

The OECD anticipates that pension funds have lost USD 4 trillion in 2008 already. In the Netherlands as well as in the United Kingdom, monitoring organisations recently blew the whistle asking for an emergency contribution reappraisal and a state intervention. In the United States, growing numbers of announcements call for contribution increases and benefit reductions, knowing that it is only in a few weeks time that most of these pension funds will start calculating their total losses.

Most of the pension systems are still deluding themselves about their capacity to build up their capital base again after the markets turn around. In March 2009, when pension fund managers, pensioners and governments will become simultaneously aware of the fact that the crisis is there to last, that it coincides with the baby-boomer generation's age of retirement and that the markets will not resume their 2007 levels until many long years to come, chaos will flood this sector and governments will reach the moment when they may be compelled to nationalise all these funds. Surprisingly, Argentina, which took this decision a few months ago already, may appear to have been a pioneer!

Metamorphosis

Numerous Western government have been preparing their domestic security systems precisely for the unfolding consequences of The Great Unwind projected by April 2009, as the establishment expects backlash, ie, domestic violent unrest when people become frustrated with the economic crisis and cross the tipping point, much like what has happened in Greece. A whole range of psychological factors are contributing to this tipping point: people are starting to become aware in Iceland, the Euroland (especially Greece, Ireland, Portugal and Spain), UK, America and Asia that this trans-national crisis has escaped from the control of every public authority, whether national or international; that it is severely affecting all regions of the world, even if some are affected more than others; that it is directly hitting hundreds of millions of people in the "developed" and "emerging" world; and that it is only worsening as its consequences reveal themselves throughout the real economy.

National governments and international institutions may have only a few months left to prepare themselves for the next blow, post the reconciliation of books and numbers in Q1 2009, one that could go along severe risks of social chaos. The countries which are not properly equipped to cope with a surge in unemployment and major risks on pensions' capitalisation will be seriously destabilised by this new public awareness. Especially countries which are running digital exchange economies, based on a lot of numbers that could end up meaning nothing in the event of black holes like Madoff and collapses in the market value of major assets held across the eight bubbles.

All the trends tracked are already at work. Their combination, together with growing public awareness of their potential consequences, will likely result in the great collective psychological trauma of 2009/2010, when everyone will realise that we are all trapped into a crisis worse than in the 1930s. That there is no possible way out in the short-term. The impact on the world's collective mentalities of people and policy-makers will be decisive and modify significantly the course of the crisis in its next stage. Based on greater disillusionment and fewer beliefs in the trust-me system, social and geo-political instability may unleash a number of black swan events that could compound the challenges for governments and social organisations as we know them.

It is worth remembering that asset-backed real wealth is never destroyed -- it is merely transferred into another form. What form will wealth take in its new manifestation?

[ENDS]

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