You may have heard that the government proposes to create a “bad bank.” Duh! I think they have already created dozens if not hundreds or maybe thousands of bad banks!  Hello!

The U.S. banking system is insolvent, period. It is just a matter of time before it is recognized and dealt with.  If you would like to read the analysis, click here and read the second feature written by Roubini and Parisi-Capone.

The government proposes to use your money to re-capitalize the banks. This is great for the banks and terrible for you.  Why will the government re-capitalize the banks with your money?  Because bankers are influential, they run the Fed, they contribute millions to politicians in both parties,  they are all part of the same fraternity, and because they can.

Should we let all of the banks fail?, you may ask. Yes. We have deposit insurance to take care of small depositors and new banks will spring up in a hurry to fill the void of failed banks. The difference would be that all of the foolish bankers who got us into this mess would either have to find new jobs doing something else or they would have to re-capitalize the new banks with their own money.  The new banks would be much smaller, far more humble, and not inclined to take foolish risks.

Re-capitalizing the banks with taxpayer money is crazy. You cannot have capitalism without failure. Failure and bankruptcy are the price of bad decisions. When taxpayers cover the cost of bad decisions, there are more bad decisions to come. For example, the 1998 bailout of Long Term Capital Management by the Fed averted a financial mess. But the Fed may as well have sent a postcard to every banker on Wall Street and others around the world saying, “If you bet right, you will get millions in bonuses and if you are wrong, we’ll cover the losses.” Guess what happened: Bankers took risks in sub-prime and elsewhere that they did not comprehend!

Debt Deflation

America has been through three periods of debt deflation such as we are now experiencing, although each was somewhat different from the others. The first was in 1837, the second in 1873, and the last from 1929-1933.  A number of noted economists have analyzed and written about these periods. Each began with a period of extreme over indebtedness and neither money supply growth nor any measure of government spending was able prevent the ensuing economic decline because in each case, what economists call the “velocity” of money, fell.  That is to say, the turnover of dollars declined because people and businesses began to favor saving over spending due to the difficulty of repaying their debts.

In each case, the propensity of people to save and save rather than to borrow and spend and borrow and spend some more lasted for something like twenty years.  This resulted in each case in falling prices,  pressure on employment, and declining wages, in short, a debt deflation.  (It also planted the seeds of subsequent prosperity.)

The past periods of debt deflation also resulted in lower interest rates as people favored saving over spending. Whether it works that way this time remains to be seen.  The Fed is committed to buying Treasury debt in amounts large enough to keep interest rates low. The theory apparently is that low interest rates will discourage savings and will instead encourage spending  so that the debt deflation will be averted. This has been described as an experiment of uncertain outcome. If you care, you can read about this in detail here.


The question has been asked, will all of the Trillion dollar bailouts lead to hyperinflation?  I wish I knew for sure!  Here is my best guess today subject to change as conditions develop:  In the near-term we are likely to continue to see deflationary pressure.  While it seems probable that we will have high inflation at some point because of the excessive creation of money, the destruction of wealth from deflation is presently a much greater force.  If no one will pay more than $150,000 for what was once a $500,000 house, what difference does money supply make? That relates to people’s tendency to save rather than to spend and to the possible difficulty in borrowing, that is, slow money velocity.

I think inflation may be more likely at some point because it will be the only way the government can pay off the absolutely unsustainable federal debt. The problem for the government is that when people get a whiff of inflation, then they demand higher rates to compensate for the loss of purchasing power. This becomes a vicious cycle as even more money is needed to re-finance the debt.

If you are really interested in a good discussion of the cause of deflation, click here. I know that still does not answer the question about inflation but it will provide some food for thought.  Who knows? Maybe next week I’ll have the answer!

Times like these are challenging but they also present opportunities for building wealth.  The best first step in that direction is to get out of debt if you are not there already.                                                      <*))) ><


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