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    The Shell Game – How the Federal Reserve is Monetizing Debt

    by Chris Martenson

    Monday, August 3, 2009, 2:02 AM

    Sunday, August 2, 2009

    Executive Summary

    • The Federal Reserve and the federal government are attempting to “plug the gap” caused by a slowdown of private credit/debt creation.
    • Non-US demand for the dollar must remain high, or the dollar will fall.
    • Demand for US assets is in negative territory for 2009
    • The TIC report and Federal Reserve Custody Account are reviewed and compared
    • The Federal Reserve has effectively been monetizing US government debt by cleverly enabling foreign central banks to swap their Agency debt for Treasury debt.
    • The shell game that the Fed is currently playing obscures the fact that money is being printed out of thin air and used to buy US government debt.

    The Federal Reserve is monetizing US Treasury debt and is doing so openly, both through its $300 billion commitment to buy Treasuries and by engaging in a sleight of hand maneuver that would make a street hustler from Brooklyn blush. 

    This report will wade through some technical details in order to illuminate a complicated issue, but you should take the time to learn about this because it is essential to understanding what the future may hold. 

    One of the most important questions of the day concerns how the dollar will fare in the coming months and years. If you are working for a wage, it is essential to know whether you should save or spend that money.  If you have assets to protect, where you place those monies is vitally important and could make the difference between a relatively pleasant future and a difficult one.  If you have any interest at all in where interest rates are headed, you’ll want to understand this story.

    There are three major tripwires strung across our landscape, any of which could rather suddenly change the game, if triggered.  One is a sudden rush into material goods and commodities, that might occur if (or when) the truly wealthy ever catch on that paper wealth is a doomed concept.  A second would occur if (or when) the largest and most dangerous bubble of them all, government debt, finally bursts.  And the third concerns the dollar itself.

    In this report, we will explore the relationship between those last two tripwires, government debt and the dollar.


    Replacing private credit with public credit

    Our entire monetary system, and by extension our economy, is a Ponzi economy in the sense that it really only operates well when in expansion mode.  Even a slight regression triggers massive panics and disruptions that seem wholly inconsistent with the relative change, unless one understands that expansion is more or less a requirement of our type of monetary and economic system.  Without expansion, the system first labors and then destroys wealth far our of proportion to the decline itself.

    What fuels expansion in a debt-based money system?  Why, new debt (or credit), of course!   So one of the things we keep a very close eye on over here at Martenson Central, as they do at the Federal Reserve, is the rate of debt creation.

    One of the big themes in the current credit bubble collapse is the extent to which private credit has been collapsing and the corresponding degree to which the Federal Reserve has been purchasing debt and the federal government has stepped up its borrowing.  In essence, public debt purchases and new borrowing has attempted to plug the gap left by a shortfall in private debt purchases and borrowing. 

    That’s the scheme right now – the Federal Reserve is creating new money out of thin air to buy debt, while the US government is creating new debt at the most fantastic pace ever seen.  The attempt here is to keep aggregate debt growing fast enough to prevent the system from completely seizing up.

    How are they doing?

    The debt gap

    One of the great perks of living in a relatively open society is that we generally get access to pretty good information. The Federal Reserve routinely publishes a document called “Monetary Trends,” where they collapse all their points of interest into a nice, tidy collection, and then make it available for all to see.

    Here’s what caught my eye in the most recent one:

    What we see here is federal debt (bottom chart) exploding at a nearly 30% yr/yr rate of change in response to a collapse in corporate and consumer borrowing (top charts).

    This raises a most interesting question:  “Who is lending the money to accommodate all that federal borrowing?”

    Here’s where the story gets interesting.

    Treasury International Capital (TIC) flows

    Lately, a number of observers have made note of a troubling decline in foreign demand for US paper assets, notably bonds.  Worse, it’s even turned into outright selling which will ultimately translate into dollar weakness.

    The relative demand for the dollar “out there” in the international Foreign Exchange (or “Forex”) market directly impacts the dollar’s strength.  If there are more sellers then its value will fall; if there are more buyers, then its value will rise.  One way to assess this delicate balance is to ask, “In total, are foreigners buying or selling US assets and what are they doing with those proceeds?”

    Luckily for us, the exact answer to this very question is released in a monthly report put out by the Treasury Department, called the Treasury International Capital Flows report, or TIC report for short.

    The recent TIC reports have been quite alarming, because they not only reveal the most sudden deceleration in flows in history, but also that they have been negative for some time now. This chart is from the Federal Reserve:

    What we see here is that from the early 1990’s onward until 2007, foreigners bought progressively more and more US assets and did so by bringing their money to the US and leaving it there.  It is only over the past seven months, out of decades, where that process has reversed and become negative.  This is a significant event, to say the least.

    On the surface, the above chart hints at a potential disaster for a country that is embarking on the largest-ever federal debt binge in history. 

    After all, if US assets are being shunned by foreigners, how will we find enough buyers? And what will happen to the dollar?

    The answers are:  “We won’t” and “Nothing good.”

    Digging in

    If we dig into deeper into the detail of the report, we find something even more interesting. While the overall flows have been negative, there is an enormous difference between the behaviors of foreign central banks and private investors.  Fortunately the TIC report distinguishes between these two broad classes of buyers.

    Since the start of 2009 and continuing through the month of May, private investors sold $364 billion dollars worth of US assets, while central banks purchased  $50 billion dollars worth (source is a .csv file available here from the Treasury).  Added up, some $314 billion dollars of foreign money has left the country since the start of the year.

    What this demonstrates is the utter reliance of the entire house of cards upon the continued purchase of US financial assets by foreign central banks. Without the continued cooperation of the foreign central banks in accumulating US assets, suffice it to say that the dollar will fall a lot lower than it already has.

    The dollar

    Not surprisingly, the dollar recently put in a new closing low for the year (YTD 2009) and is approaching a major area of support and resistance. If it breaks through, we could be looking at a rapid game-changer here.

    Of course, I’ve said all this before, and every time we seem to get close, there’s been an upside surprise in store.  The forces aligned to prevent a dollar collapse are numerous.

    But the same risk remains, and the fundamental picture concerning the dollar has not changed since I first became wary of its fortunes in 2002.  In fact, it’s grown worse.  Federal deficits are higher than I ever imagined possible (13% of GDP!), and now the TIC flows are negative.  The only somewhat bright(er) spot is that the trade deficit has shrunk quite a bit.  However, it, too, remains solidly in negative territory, meaning it continues to apply pressure to the value of the dollar by increasing the total number of dollars that need to find a quiet resting place outside of the country.

    Treasury auctions

    During this past business week (July 27th – 31st, 2009), the US Treasury auctioned off more than $243 billion worth of various Treasury bills and bonds. “Indirect bidders,” assumed to be mainly central banks, took an astonishing 39% of the total, or nearly $95 billion worth.

    With the exception of the 5-year auction, which mysteriously stank up the joint with a worrisome bid-to-cover ratio well below 2.0 (the bond market behaved poorly upon the release of that news item), the story here is that foreign central banks are buying up vast quantities of Treasury offerings.

    Wait a minute, hold on there…I thought we just talked about how the TIC report said that foreign central banks have only bought $50 billion in total US paper assets through May – and now they are said to be buying $95 billion during a single week in July alone?

    Something is not adding up here.

    To understand what, and to get to the essence of the shell game, we need to visit one more source of information – something called the Federal Reserve Custody Account.

    The Federal Reserve Custody Account

    It turns out that when China’s central bank (or any other foreign central bank) decides to buy either US agency or Treasury bonds, they do not walk up to some window somewhere, hand over a pile of cash, and then take some nice looking bonds home with them in a suitcase.

    Instead, what happens is that the Federal Reserve actually holds the bonds (or rather an electronic entry representing the bonds) in a special account for these various central banks.  This is called the “Custody Account” and it holds US debt ‘in custody’ for various central banks. Think of it as a magnificently vast brokerage/checking account, run by the Federal Reserve for central banks, and you’ll have the right image.

    Although the TIC report shows flows of capital into and out of the country, it does not show you what is going on with those funds that are already in the country.  If you look again at the first chart in this report, and behold the vast flows of money that came into the US between 1995 and 2008, you can get a sense of how much money got sent to the US and mostly remains parked there.

    The custody account currently stands at $2.787 trillion (with a “t”) dollars.  It has increased by over $430 billion the past 12 months and by more than $275 billion in 2009 alone (through July 29).  These are truly shocking numbers, and they tell us that foreign central banks have been accumulating US debt instruments throughout the crisis.

    As we can see in the chart below, there has been absolutely no deflection in the growth of the custody account as a consequence of the financial crisis, bottoming trade, or the local needs of the countries involved.  It’s almost as if the custody account is completely disconnected from the world around it.  If you can spot the credit bubble crisis on this chart, you have sharper eyes than me.

    What does such a chart imply?  We might wonder what sorts of distortions are created by having such a massive monetary spigot aimed from several central banks towards a single country.  We also might question just how sustainable such an arrangement really is.  It is a complete mystery how such a chart can display nary a wiggle, despite all that has recently transpired.

    This next table showing the yearly changes in the custody account actually surprises me quite a bit.

    Despite everything that’s been going on, the custody account is on track to grow by the largest dollar amount on record this year, nearly $500 billion dollars (if the current pace continues).  Where is all this money coming from and for how much longer?

    Understanding the gap between the TIC and the Custody numbers

    One thing you might have noticed is that the TIC report only shows $50 billion in foreign bank inflows for 2009, while the custody account grew by $277 billion.

    How is it possible for the TIC report to show smaller inflows than growth in the custody account?  We can see that clearly in this table, which compares the two.  (Note: These are 12 monthly yr/yr changes, so the numbers will be different than the YTD numbers I just cited):

    One explanation is that the custody account, at some $2.7 trillion dollars, is accumulating a lot of interest. If those interest payments are not “sent home” and remain in the account, then the account will grow by enough to more or less explain the difference. For example, the $135 billion difference shown above could be generated by a 5% return to the custody account, which is not an unthinkable rate of interest for that account.

    International check kiting

    Some people view the custody account as nothing more than an elaborate version of check kiting, played at the central banking level.

    Check kiting

    An illegal scheme whereby a false line of credit is established by the exchanging of worthless checks between two banks. For instance, a “check kiter” might have empty checking accounts at two different banks, A and B. The kiter writes a check for $50,000 on the Bank A account and deposits it in the Bank B account. If the kiter has good credit at Bank B, he will be able to draw funds against the deposited check before it clears, i.e., is forwarded to Bank A for payment and paid by Bank A. Since the clearing process usually takes a few days, the kiter can use the $50,000 for a few days, and then deposit it in the Bank A account before the $50,000 check drawn on that account clears.


    In this game, Central Bank A prints up a bunch of money and buys the debt of Country B. Then the central bank of Country B prints up a bunch of money and buys the debt of Country A. 

    Both enjoy the appearance of strong demand for their debt, both governments get money to use, and nobody is the wiser.  Except that the world’s total stock of central bank reserves keep on growing and growing and growing, as reflected in the custody account, which will someday result in thoroughly unserviceable amounts of debt, an unmanageable flood of money, or both.

    If this strikes you as a scam, congratulations; you get it.

    If that was all there was to the story, then it would be far less interesting than it actually is. When we dig into the custody account data, we find that the total picture is hiding something quite extraordinary. Even as the total custody account has been growing steadily and faithfully, the composition of that account has been changing dramatically. 

    Here we note that agency bonds peaked in October of 2008 at nearly a trillion dollars but have declined by $178 billion since then.  Treasuries, on the other hand, have increased by over $500 billion over that same span of time.  A half a trillion dollars!  If you were wondering how the US bond auctions have managed to go so smoothly, here’s part of your answer.

    What is going on here?  How is it possible that central banks are buying so many Treasury bonds, at the fastest rate of accumulation on record?   

    It would appear that foreign central banks have been swapping agency bonds for Treasury bonds, but that’s not how the markets work.  First, they would have to sell those bonds, before they could use the proceeds to buy government debt. So to whom did they sell those Agency bonds in order to afford the Treasury bonds?

    Here we might recall that the Federal Reserve has been buying agency bonds by the hundreds of billions. 

    The shell game

    Have you ever seen a sidewalk magician run the shell game, where a pea under a shell is magically shuffled around – now you see it under this shell, now you see it under that shell, now it disappears completely – or does it?  The more it moves around, the more confused you get.  If you can only figure out which shell the pea is hidden under, you win!   But where is the pea?  The point of the game, from the perspective of the street hustler, is to use complexity of motion to confuse the mark.

    These are the three critical points to remember as you read further:

    1. The US government has record amounts of Treasuries to sell.
    2. Foreign central banks, which have a big pile of agency bonds in their custody account, would like to help but want to keep things somewhat under the radar to avoid scaring the debt markets.
    3. The Federal Reserve does not want to be seen directly buying US government debt at auctions (and in fact is not permitted to, but many rules have been ‘bent’ worse during this crisis), because that could upset the whole illusion that there is unlimited demand for US government paper, but it also desperately wants to avoid a failed auction.

    For various reasons, the Federal Reserve cannot just up and start buying all the Treasury paper that becomes available in record amounts, week after week, month after month. 

    Instead, it uses this three-step shell game to hide what it is doing under a layer of complexity:

    Shell #1:  Foreign central banks sell agency debt out of the custody account.

    Shell #2:  The Federal Reserve buys those agency bonds with money created out of thin air.

    Shell #3:  Foreign central banks use that very same money to buy Treasuries at the next government auction.


    Shuffle, shuffle, shuffle, shuffle, shuffle, SHUFFLE, shuffle! Confused yet?

    Don’t be.  If we remove the extraneous motion from this strange act, we find that the Federal Reserve is effectively buying government debt at auction.  This is exactly, precisely what Zimbabwe did, but with one more step involved, introducing just enough complexity to keep the entire game mostly, but not completely, hidden from sight.  They can scramble the shells all they want, but the pea is still there somewhere – the pea being the fact that the Fed is creating money to fund the purchase of US debt.

    At the time, the Federal Reserve program to purchase agency bonds was described like this:

    Fed to Pump $1.2 Trillion Into Markets

    Greatly Expanded Purchases Are Designed to Lower Interest Rates, Stimulate Borrowing

    The Federal Reserve yesterday escalated its massive campaign to stabilize the economy, saying it would flood the financial system with an additional $1.2 trillion.

    In its statement yesterday, the Fed said it will increase its purchases of mortgage-backed securities by $750 billion, on top of $500 billion previously announced, and double, to $200 billion, its purchases of [Agency] debt in housing-finance firms such as Fannie Mae and Freddie Mac.

    While “stimulating borrowing,” “stabilizing the economy,” and “lowering interest rates” are laudable goals, the primary goal of the program seems to have been something else entirely – to assure plentiful funds for the massive US Treasury auctions coming due.  I saw nothing in any article I read about this program that even suggested that one of the goals was to allow foreign central banks to effectively swap their agency debt for US government debt using money printed from thin air.  But that’s clearly one of the outcomes.

    The Federal Reserve, for its part, has been quite open about these purchases of Agency debt. It even provides an excellent website with nice graphics, allowing us to track the purchase program.


    However, this openness only extends to the amounts themselves, not the source(s) of those Agency bonds.  This is, in my mind, yet another reason the Fed desperately wishes to avoid an audit. The results would expose the game for what it is.

    As we can see in the above chart, the Fed has purchased more than $640 billion of Agency bonds, and has promised to buy more in the near future. 

    As we now know, at least some of that money has been recycled into US government debt, where “indirect bidders” have been snapping up an unusually high proportion of the recent offerings.  (Note: The way Indirect bidders  are calculated has recently changed, and I am not entirely clear on how much this influences the numbers we now see….I’m working on it).

    A fair question to ask here is, “If there are green shoots everywhere and the stock market is racing off to new yearly highs, why is the Fed continuing to pump money into the system at these mind-boggling rates?”  One answer could be, “Because things might not be as rosy as they seem.”


    The Federal Reserve has effectively been monetizing far more US government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt.  This is not a sign of strength and reveals a pattern of trading temporary relief for future difficulties.

    This is very nearly the same path that Zimbabwe took, resulting in the complete abandonment of the Zimbabwe dollar as a unit of currency.  The difference is in the complexity of the game being played, not the substance of the actions themselves.

    When the full scope of this program is more widely recognized, ever more pressure will fall upon the dollar, as more and more private investors shun the dollar and all dollar-denominated instruments as stores of value and wealth. This will further burden the efforts of the various central banks around the world, as they endeavor to meet the vast borrowing desires of the US government.

    One possible result of the abandonment of these efforts is a wholesale flight out of the dollar and into other assets.  To US residents, this will be experienced as rapidly-rising import costs and increasing prices for all internationally-traded basic commodities, especially food items.  For the rest of the world, the results will range from discomforting to disastrous, depending on their degree of dollar linkage. 

    Under these circumstances, “inflation vs. deflation” is not the right frame of reference for understanding the potential impacts.  For example, it would be possible for most of the world to experience falling prices, even as the US experiences rapidly rising prices (and hikes in interest rates) as a consequence of a falling dollar.  Is this inflation or deflation?  Both, or neither?  Instead, we might properly view it as a currency crisis, with prices along for the ride.

    Further, all efforts to supplant private debt creation with public debts should be met with skepticism, because gigantic programs are no substitute for the collective decisions of tens of millions of individuals and cannot realistically meet millions of individual needs in a timely or appropriate manner.

    The shell game that the Fed is currently playing does not change the basic equation: Money is being printed out of thin air so that it can be used to buy US government debt.

    My advice is to keep these potential issues and insights in sharp focus, make what moves you can to diversify out of dollars, and be ready to move rapidly with the rest.  This game is far from over.

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    Three Reasons This Stock Market Rally Is False

    by Chris Martenson

    Sunday, July 26, 2009, 7:59 PM

    Sunday, July 26, 2009

    Executive Summary

    • Data is either good, murky, or unreliable.  The good data says we are not yet at the bottom.
    • Stock trading volumes are way, way down.
    • High frequency trading (HFT) harmfully obscures true market activity.
    • S&P 500 earnings indicate that stocks are still expensive.
    • The recent stock market advance is lacking a solid fundamental story to base itself on, it is running on hopes and fumes.

    On a recent leg of a flight heading between Denver and Detroit, a kindly, middle-aged woman took the seat next to me and made small talk. As she hailed from Detroit, I had all sorts of questions for her. Did she know anybody who is out of work? How did the city ‘feel’ these days?  What had she noticed lately?

    When she inquired as to my interest and I told her a little bit about my work, she asked for my prognosis. I said, "Not good, not yet; the base data is very weak." She immediately replied, "But the stock market has been going up. How do you explain that?"

    She said this as if she had just played an undetected trump card; as though I was missing out some incredible secret. Given the power of the stock market to communicate to the masses (as exemplified by this exchange on the plane), and given how easily large, self-interested parties are able to manipulate and influence people, I consider the stock market to be among the least reliable of indicators.

    So, understanding that all bull markets climb a wall of worry and that I could well be wrong, here are my three main reasons for discounting the messages implied by the recently rising stock market:

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    The Coming Collapse

    by Chris Martenson

    Sunday, July 12, 2009, 7:43 PM

    Sunday, July 12, 2009

    Executive Summary

    • Underlying beliefs can get in the way of action.
    • The status quo is unsustainable.
    • We face a future filled with "less" on many levels.
    • Surplus energy determines social complexity.
    • Peak Oil has passed and there is no return to the old economy.
    • We still have some choice in how this change plays out.
    • We must continue reformulating our beliefs and moving towards action.

    The topic of this Martenson Report is one of the most important we will ever cover. My mission is to help you see that change is coming – potentially highly disruptive change – far enough in advance so that the opportunity exists to make gradual changes on your own terms.

    Standing in the way of our taking actions are our beliefs, which we have formed over a lifetime of observation. For example, if I show someone forty-two very compelling graphs of Peak Oil, but the person remains unconvinced (as evidenced by their lack of action), I invariably find that they hold an underlying belief which is in conflict with the data.  Most often, that belief turns out to be "technology will save us."  This is a powerful belief, because it has been reinforced by a lifetime filled with the most exceptional technological progress ever seen in human history.  So it won’t matter if I show that person one graph, or ten, or forty-two, or a hundred.  That stuff is just data.  We take actions based on our beliefs.  But if a belief is in conflict with data, the belief wins every time.

    Every day I try to convince people that one era is drawing to a close and a new era is beginning.  The lure of the old way is very strong.  It is constantly reinforced by a media machine and an interlocking institutional framework that are fully dedicated to preserving the status quo.

    From my point of view, the status quo does not have a future.  It was unsustainable from the start, and even if we manage to resuscitate it for a few more years, nothing will change that fact.  Worse, every attempt to sustain the unsustainable results in squandering our precious remaining time and resources, which means that with these attempts, we relegate ourselves and our children to a future of decreased prosperity.

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    Inflation vs. Deflation – What You Need to Know (Part II)

    by Chris Martenson

    Monday, July 6, 2009, 1:50 AM

    Sunday, July 5, 2009

    Executive Summary

    • Inflation or deflation? – the most important question of our day
    • Vast disagreements exist
    • Timing
    • Inflation = persistent increase in money and credit
    • Inflation Myths
    • What you can do

    There is simply no more contentious or important issue sitting before everyone these days than resolving the question of whether deflation or inflation lies before us. Sides have been drawn, opinions hardened, and camps formed.

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    Inflation vs. Deflation – What Comes Next? (Part I)

    by Chris Martenson

    Sunday, June 14, 2009, 7:23 PM

    Sunday, June 14, 2009

    I want to cover quite a bit of background here to properly set up today’s topic of Inflation vs. Deflation. But because of my schedule, this would require stringing out three reports over five weeks, and given where we stand in the markets today, that isn’t ideal. There is much afoot, and I want you to be armed with as much timely information as I can provide.

    So we are going to jump to the end and discuss the conclusions before the background. I will fill in the background in a later Martenson Report. If you find this report difficult to follow for this reason, I invite you to re-read it again after the background information comes out in a few weeks. I appreciate your understanding.

    Executive Summary

    • Inflation correlates best with government spending.
    • Inflation/deflation is a dance that exists between the supply/demand for money and the supply/demand for goods and services.
    • Most government spending growth is in mandatory categories – not simple to reduce.
    • Inflation will bail out debtors?  Don’t count on it.
    • Future generations have been consigned to a tremendous economic challenge.
    • Prepare now for upcoming destructive inflation.
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    Green Shoots? Not Yet.

    by Chris Martenson

    Monday, June 8, 2009, 9:24 AM

    Monday, June 8, 2009

    Executive Summary

    • No green shoots in the consumer data
    • Mortgage Equity Withdrawal (MEW) is negative
    • Consumer credit is negative
    • Retail sales are negative
    • Rail and port traffic is deeply negative
    • Unemployment not as positive as presented
    • State tax revenues are negative
    • Federal tax receipts? Don’t ask.

    I want to counter the recent incantations by the media, fiscal, and monetary authorities that "things are on the mend" and that there are green shoots sprouting all over the place. There are indeed some encouraging signs, but there are an equal number of discouraging signs. This is a time for caution, not complacency.

    Let’s break down the economy into its biggest pieces and see what we can find in each of them.

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    The Five Horsemen

    by Chris Martenson

    Sunday, May 31, 2009, 9:12 PM

    Sunday, May 31, 2009

    Executive Summary

    • What can we expect next, and how will we recognize it?
    • A series of sharp, interrupted shocks is more likely than a major sudden collapse.
    • Five game-changing events, what I call The Five Horsemen, will indicate that the rules have changed and a new reality is about to take over:
      • The First Horseman: New credit growth falls below interest payments
      • The Second Horseman: The Fed monetizes debt
      • The Third Horseman: Government deficit spending exceeds 10% of GDP
      • The Fourth Horseman: The dollar goes down, while interest rates go up
      • The Fifth (and final) Horseman: US debt becomes denominated in foreign currencies

    Severe structural damage has already been inflicted on our economy. As I wrote two weeks ago in It Has Hit the Fan:

    If you have been waiting for further confirmation about the direction of the economy, or waiting for a sign that it’s now time to get serious about preparing for a future filled with less, this report is written for you.

    You are living in the midst of the collapse of western economies, which are moving from a more complicated state to a less complicated one. This is it.  Keep a journal, because it’s happening right now.

    After the Great Depression, many people remarked that it was only obvious in retrospect. While it was unfolding, things steadily eroded. But 75% of the workforce remained employed, while hopeful signs of progress were constantly trotted out by various politicians, private economists, and official-sounding government agencies. It is often quite difficult to appreciate the true magnitude of sweeping change while it is occurring.

    The most pressing question now is this:  What can we expect next, and when? 

    In this report, I give you the precise combination of macro-events that will cause me to issue an alert and kick my thinking and actions into new orbits.

    The Path

    I do not expect a major sudden collapse to be the most likely path, although it is a possibility. Instead, I anticipate a series of sharp shocks, followed by periods of relative tranquility. 

    Here’s how I described the various paths in May of 2008, in a report entitled Charting a Course Through the Recession:

    While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future. The three scenarios around which I tend to form my thinking (and actions) are:

    • No change. The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen. The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments. This is not a very likely outcome.  Probability: 1%.
    • A series of short, sharp shocks. Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective. Think of the food scarcity and riots, and you know what this looks like. One day there was low awareness about food scarcity and the next day shortages and prices spikes were making the news. Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process. I see this as the most likely path forward.  Probability: 80%.
    • A sudden major collapse. Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows. Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society. Food and fuel distribution would be the most immediate concerns. There’s enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourselves and your loved ones.  Probability: ~20%.

    Based on the odds, the most likely outcome that I see is a series of short, sharp shocks (#2, above) as being the most likely to define the path forward. So far this has been our exact pattern with the first shock occurring in 2007, the second between October 2008 to March 2009 and now a period of stability between March and June of 2009. I invite you to re-read the piece linked above as a means of assessing my information,gathering abilities, and my ability to connect the dots, and shine a light on the future.

    In the grand sweep of the trajectory that will deliver the United States, and many other western countries, to a lower standard of living (although not necessarily a lower quality of life, but that’s another story), there are several discrete elements that I think of as The Five Horsemen.

    The Five Horsemen

    I believe that a diminished standard of living is in the future for each of the major economies across the world especially those where the inhabitants have been living beyond their means.

    Another belief I hold is that any period of living beyond one’s means must certainly be followed by an equivalent trough of living below one’s means. For example, if you produce 100 but consume 110, then at some point you will need to produce 100 but only consume 90. 

    There are two ways that we might expect this period of adjustment to unfold economically. I laid out the basic elements in Crash Course: Chapter 12 – Debt. When too many claims (debts) are laid upon the future the only question is whether those debts will be defaulted upon or paid back (with “inflated away” being a form of default). If all those claims are destroyed by default, then the reduction in future living standard falls to the holder of the debt(s). If the debts are paid back, then the debtor must accept that they will have less money to spend on consumption.  Either way, somebody has less coming to them in the future than they either expect or currently enjoy.

    Stretched across an entire nation, too much debt becomes an unsolvable problem, a predicament, due to the fact that no benefit accrues from shifting the burden of bearing the impact of default from one sector to another.  Shifting a promisory note from one pocket to the other does not change the net worth of the individual and this tactic is equally ineffective for an entire country.

    Thus the fact that the US government is assuming massive piles of bad debt from stricken financial corporations does nothing to solve the underlying problem, which sprouts from a nation that has overconsumed for decades. But this is exactly what the government is doing, and the goal seems to be to preserve the status quo at all costs. 

    Assuming this view is correct, there are signs we can read along the way to confirm if our fiscal and monetary authoritites have selected the right path or the wrong path.  This report details the signposts that will tell us when certain thresholds have been crossed that will mark that the current strategy is failing and that a new leg of the journey has begun.

    The problem and the mindset of the economic elites are neatly revealed in this quote:

    May 30 (Bloomberg) — World Bank President Robert Zoellick warned policy makers that fiscal-stimulus plans are insufficient to turn around the “real economy” and rising joblessness threatens to set off political unrest across the globe.

    “While the stimulus has given an impulse, it’s like a sugar high unless you eventually get the credit system working,” Zoellick said in an interview yesterday

    I like this quote because it distinguishes between the “real economy” and the economy resulting from excessive government borrowing and spending. Stimulus money is almost by definition wasted money because the probability of it resulting in proper investment is so low. The gains from stimulus money run out the very second the juice is turned off. 

    But it is the second part of the quote that is revealing – “…unless you eventually get the credit system working…” – apparently those in charge find it unthinkable that an economy could be built on anything other than credit.

    An alternative quote expressing a more fundamental view would read, “While the stimulus has given an impulse, it’s like a sugar high, unless it is followed by growth in wage-based income“.

    The difference between the real quote and the one I provided is like night and day. The Zoellick quote assumes that our past period of living beyond our means is recoverable and extendible, and mine does not. Mine assumes a long-term relationship exists between what people earn and what they can spend. In order for us to service our past debts, we need to grow our incomes, not our access to easy credit.

    There is a mathematical limit to this “game,” at which point it cannot be carried on any longer. I think we have reached the outer limits of our debt-fueled fantasy, although I recognize that the extreme efforts to carry it on a bit longer may well produce short-term results.

    The most obvious and mathematically-defendable end of a credit economy comes when interest payments exceed all income. However, things rarely progress that far, as the trouble becomes painfully obvious far earlier and creditors withdraw their continued support.

    How will I know that the participants in this game have finally caught on to the fact that it’s over? Here are the five game-changing events that will indicate that the rules have changed and a new reality is about to take over.  As I mentioned, I have been tracking these for years and, unfortunately, been watching them unfold one by one.

    The First Horseman: New credit growth falls below interest payments

    Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.

    ~Kenneth Boulding, economist

    In our debt-based monetary and economic system, it is imperative that new credit growth at least equal the interest payments on past debt. If this does not happen, then the entire financial edifice, levered up as it is, immediately begins to wobble and crumble. Of course this imposes an exponential growth “requirement” on our entire debt/money system rendering it a long-term impossibility.

    Total credit market debt (chart below) stood at over $52 trillion at the end of 2008 and has fit an exponential curve nearly perfectly over the past 5 decades.

    The “getting the credit system working again” quote by Mr. Zoellick refers to keeping the curve of this chart sweeping upwards in an uninterrupted fashion, as nothing less will get us back to “how things were.”

    Where this chart required ~$1 trillion of new yearly credit growth in 1995, the remorseless math of the exponential function turned that into $2 trillion per year by 2000, $3 trillion by 2005, and more than $4 trillion by 2008.

    While the government’s $1.8 trillion of deficit spending for 2009 is certainly heroic, it needs to be complemented by more than twice that amount from the private sectors in order to keep this chart on a smooth path. That, I am confident to say, will not be happening this year.

    Status of the first horseman: Arrived.


    The Second Horseman: The Fed monetizes debt

    “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

    ~Ludwig Von Mises

    My second sign occurs when the Federal Reserve directly “monetizes debt,” which is a fancy way of saying “prints money out of thin air and exchanges it for private and/or government debt.”  This started in 2007 with the first set of rescues, although at the time the Fed took great pains to stress that it wasn’t really monetization because they planned to reverse their actions soon.  Of course, that has not happened yet.  Some of their activity was cleverly concealed with complexity, such as when the Federal Home Loan Board (FHLB) bought up $160 billion in mortgages from failing originators such as Countrywide and then quietly passed them to the Federal Reserve for cash.  Minus the FHLB complexity, this represented nothing less than the Fed printing up some fresh electronic cash and handing it over to Countrywide for some failing mortgage products.

    The beginning of the end for nearly every debt-ridden country has always been the attempt to pay for past expenditures with newly-minted money. It always starts innocently enough and seems like the right thing to do, but soon the programs grow and grow, and eventually the currency of the country is destroyed.

    Now the Fed is openly and actively buying dodgy debt from the government as well as from the private sector. I covered this in a recent “In Session” posting, where I charted the amount of US Treasury debt that was being purchased by the Federal Reserve on a daily basis. 

    Fed POMO activity daily rate v2.jpg

    This chart reflects only the Treasury purchases. When we add in agency debt, mortgage-backed securities, and various other corporate debt programs, we find that the Federal Reserve is printing up roughly $15 to $30 billion dollars a day just to keep things limping along.

    As for the opening quote by Mises, which I think most accurately reflects how things will turn out, I think it is safe to say this: Any country that is printing up to $30 billion a day just to keep things moving along is not voluntarily abandoning credit expansion.  

    This means that we are risking a final catastrophe of the currency system involved. Unfortunately, the currency in question also happens to be the world’s reserve currency, so this has enormous, far-reaching implications. 

    Status of the second horseman: Arrived.


    The Third Horseman: Government deficit spending exceeds 10% of GDP

    I did not expect to see this one arrive for the US this early in the game and I am quite stumped by the apparent acquiescence by the rest of the world’s financial authorities to the US running a fiscal deficit of over more than 13% of GDP.  I would have expected some resistance on their part, such as a refusal to continue buying US Treasury debt, more than a third of which (this year) has been bought by foreign central banks.

    I am convinced that this stimulus money, as historical and enormous as it is, will fail to provide any lasting benefit, in part because so little of it is being spent on investments in the future. Promising to cover the losses for bad debts only protects those who financed past malinvestments.  At most, a few measly percent of the total cost of this bailout and stimulus is going towards investments such as beefing up our energy independence or modernizing our transportation infrastructure.  If, instead, 95% was going towards investments, and Wall Street had to fight over the remaining scraps, I would be singing a different tune. 

    The inertia of government spending programs assures that these record deficits will recede slowly only under the best of circumstances and will actually grow larger under normal or worsening conditions.  I also want you to recall here that government deficit spending has the strongest correllation with future inflation handily beating out the impact of bank monetary reserves, a common red herring argument trotted out most recently by Paul Krugman who wrote in the NYT:

    Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

    Again, inflation correlates most highly with government deficit spending and I remain at a loss as to why this clean, clear fact eludes so many who should, truth be told, know better. 

    Status of the third horseman: Arrived.


    The Fourth Horseman: The dollar goes down, while interest rates go up

    As long-time readers know, it is this fourth horseman that I watch on a daily basis. The combination of a failing dollar and a rapidly rising interest rate on US Treasury obligations will signal to me that the “limitless borrowing spree” of the US government is over.

    Currently, more than $7 trillion in US Treasury debt is “held by the public.” (The other $4 trillion is owed by the government to the government, so it is not on the open market.)  Treasury debt is bought and sold in vast quantities on a daily basis. More than half of it is held by foreigners.  If foreigners sold this debt, rates would rise. If they then took the dollar proceeds from these sales and exchanged them in preference for some other currency, the dollar would fall.

    The combination of rising interest rates and a falling dollar will signal (to me) that a final loss of confidence in the US dollar as an international store of value has occurred.  When (not if) this happens, all manner of financial ills will stalk the globe.  Everything priced in dollars will go up in price – in dollars.  That includes basically all commodities.  All holders of US dollars and US debts will be desperate to get out of their holdings, and you can expect wild plunges and gyrations in most markets.  Interest-rate derivatives, which are mainly denominated in dollars and linked to US interest rates, will become toxic destroyers. 

    So much hinges on the US dollar retaining its role as the reserve currency of the world that thinking through this scenario would require a report all its own. Suffice it to say, that you cannot overestimate the impact of a rapid decline in the value of the dollar coupled to rising US Treasury interest rates.

    Because of this, I am quite perplexed that the other central banks continue to play along and buy US debt, while the Fed monetizes like crazy and the US government sports a 13% of GDP fiscal deficit. 

    Here’s the latest data. We certainly are seeing a bit of a decline in the dollar and a bit of a rise in interest rates espoecially since mid-March when the Fed announced its intention to buy massive quantities of US Treasury debt. 

    USD down.jpg

    TNX up.jpg

    However, these moves are not not yet strong enough to cause me to issue an alert or take personal actions.  They definitely have a big portion of my attention, but are not yet at the top of my list of immediate concerns.

    What would make me sit up and take notice?  Right now that would involve the dollar slipping into the low 70’s, while the $TNX (ten year bond yield) vaulted up by some massive amount which, for me, would be 50 basis points in a day (which is one half of a percent).

    At that point, I would be putting out an alert that it’s time for any fence-sitters to hurry up and grab some dollar-decline protection. 

    Status of the fourth horseman: Maybe it’s here. Maybe. But not yet in full swing.


    The Fifth (and Final) Horseman: US debt becomes denominated in foreign currencies

    For whatever reason, some people still trust the debt-rating agencies, and one of the more farcical practices is that these agencies routinely “rate” the US for credit-worthiness. The good news is that Moody’s recently reaffirmed that the US still has a “AAA” rating, which is the highest possible rating. Or is this good news?

    The reason this is a farce is captured in a post that I wrote in an “In Session” forum thread on this matter:

    This is a bit of a non-issue.  For a country that has 100% of its debt denominated in its own currency there can be no other rating besides AAA.

    The idea behind the rating is to answer the question, “What is the probability that this entity can pay off this debt?”

    Well, that probability is 100%, when the entity has a printing press.

    The only thing that would change this would be if/when that entity has debt denominated in something other than its own currency.

    So while we can all be relieved that Moody’s has such a high opinion of the US, this is useless information for the purpose of deciding if one wants to hold the debt of that country.  An alternative measure would be, “What’s the chance that this country will resort to printing to relieve itself of its debt burden, thereby eroding the claims of the current bondholders?”

    Let’s call this new rating the “M system.”  One M means, “Sort of likely,” two Ms means, “Probably will do it,” and three Ms means, “No doubt, they will print.”  By this system, I rate US government debt as quadruple M, or MMMM.

    Off the charts, in other words.

    However, the absolute game-changer would be if the US had to pay off borrowed money in a currency other than its own.  Yen, for example. In order to pay off that loan, we’d have to get Yen from somewhere, with the usual source being a positive trade balance. 

    If the US could not get the Yen through legitimate trade, then it could always print up dollars and buy Yen off the open market.  But this would serve to drive up the value of Yen and drive down the value of the dollar, so this scheme would rapidly unravel in a currency crisis.  If this sounds familiar, it should.  This is how most developing nations get in trouble and experience severe currency and debt crises.

    Having your debt denominated in your own currency is an enormous privilege.  Should that luxury go away, it would become immediately apparent how much the US depends on the kindness of strangers to continue living beyond its means.

    So far, only Japan has made some low-level noises about denominating their loans to the US in Yen instead of dollars, but you can be sure other countries are quietly considering it as well.

    Status of the fifth horseman: Not here yet.



    Three out of the five “horsemen,” which indicate where we are in the trajectory of our downfall, have already arrived.   A fourth is possibly here; perhaps not quite yet. And the final one will mark an inevitable date with a vastly lower standard of living for US citizens and all countries that are the accidental holders of too many US dollars and debts.

    I urge you to begin keeping a close eye on these five horsemen:

    1. New credit growth falls below interest payments
    2. The Fed monetizes debt
    3. Government deficit spending exceeds 10% of GDP
    4. The dollar goes down while interest rates go up
    5. US debt becomes denominated in foreign currencies

    The current presence of three, or possibly four, of these signs has me thinking very carefully about my assets, my family’s needs, and how we will manage the changes ahead.  When the fifth horseman arrives, it will bring a new reality for all of us, and I intend to be as ready as possible.

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    Food Outlook 2009 – Understanding the Risks

    by Chris Martenson

    Monday, May 25, 2009, 1:36 AM

    Sunday, May 24, 2009

    Executive Summary

    • Global grain stocks at lowest levels in over four decades
    • Shockingly low fertilizer sales suggest possibility of a disappointing yield
    • Food supply and demand are tightly balanced
    • Food distribution networks are cost-efficient but not terribly robust
    • Ways you can increase your food security


    Food is something that many of us take for granted, but it is important to recognize that this luxury is a recent development in human history. It is time to give more thought to this critical staple in our lives.

    In March of 2008, food commodity prices hit an all-time high. This coincided with a world-wide food crisis, food riots, and even a few instances of national rice hoarding. Many believe that this was triggered by economic conditions (e.g. a flood of cheap money), not a fundamental or structural shortfall in food production. But I hold the view that both were at fault.

    Food demand has grown steadily over the years, as has food supply. However, in recent years the excess margin of supply over demand has tightened and even gone negative several times. Reserve stocks are incredibly tight, resting at levels not seen since the early 1970’s. 

    It is easily conceivable that food deliveries could be disrupted within any country, leading to rapid onset of local food shortages. This report will apprise you of several of the challenges that currently exist regarding world food supplies and the possibility that these challenges could lead to a structural shortfall in global food supplies in 2009 or 2010. It also contains specific actions that could greatly enhance your own food security.

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    It Has Hit The Fan!

    by Chris Martenson

    Sunday, May 17, 2009, 6:04 PM

    Sunday, May 17, 2009

    Executive Summary

    • Stop waiting for "it" to happen; it already has.
    • Keep the big picture in mind.
    • This is a crisis of too much debt, not too little spending.
    • This is a global crisis.
    • The energy situation is getting worse, not better.
    • It’s not possible for an insolvent nation to borrow money from an insolvent financial system to bail out insolvent financial, real estate, and insurance companies.
    • Change is necessary, and we must embrace it.

    If you have been waiting for further confirmation about the direction of the economy, or waiting for a sign that it’s now time to get serious about preparing for a future filled with less, this report is written for you.

    My job is to provide you with a big-picture view of where we are and where we are headed, with an emphasis on clarifying the ways in which the dominant spin-cycle news machinery attempts to lure us back into the false comfort of borrowing and spending more.

    At, people often wonder about what they’ll do "when things fall apart."  A frequently-used acronym-containing alternative to this phrase is "when TSHTF," where the "F" refers to a fan and the other letters to something else hitting the fan that I will be coy about, so as not to offend anybody’s sensibilities or trigger any spam filters.

    I have news for everybody:  It has hit the fan.

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    Bank Stress Tests Have Already Failed

    by Chris Martenson

    Sunday, May 3, 2009, 8:39 PM

    Sunday, May 3, 2009

    Executive Summary

    • The bank stress tests are a sham.
    • Reality is already worse than the worst case stress test scenario.
    • The stress test results will be used as a “positive indicator” anyway.
    • Don’t fall for it.

    The bank stress tests, the results of which are to be announced later this week, have already failed. Why? Because the stress test is supposed to assess how a bank’s loan portfolio would fare under a variety of scenarios, but reality is already far worse than the worst-case scenario. The FDIC, Treasury, and Federal Reserve went ahead with their weak input assumptions to conduct the stress test, even though they knew that reality was outpacing their most dire scenario.

    In other words, the stress test is a sham.

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