Richard Karn: Nobody's Right When Everybody's Wrong (Chapter 2)

On Tuesday of this week we featured chapter 1 of Richard Karn's fascinating e-book, Credit and Credibility, about the future of  markets, the global economy, global credit markets, and the 5 most pressing issues in the midst at this ‘hinge of history’ we have arrived at.

Karn has been described as one of the finest analysts and writers in the financial industry. Karn happens to be the featured guest speaker in an upcoming webinar (1 CE credit), on December 2, on the subject of currency debasement, sponsored by BMG Inc.

Chapter Summary: Credit and Credibility

Chapter 1: Pay no attention to the man behind the curtain! discusses fiat currency, the financial excesses and abuse it engenders, interventionist policy response to perpetuate it, and the role of the US dollar going forward;

Chapter 2: Nobody’s right when everybody’s wrong develops our contention that all fiat currencies today have become derivatives of the US dollar;

Chapter 3: May you live in interesting times explores the extent to which emerging markets can decouple from “consumer” economies and the role of China as the litmus test for the thesis;

Chapter 4: The report of my death was an exaggeration details our contention the world has had its fill of “financial innovation”, and the only way the US economy will recover will be through its traditional strengths in agriculture, manufacturing, invention, and hard work; and

Chapter 5: Passing laws, just because offers our assessment of the anthropogenic global warming debate and pending legislation.

Below we are very pleased to feature once again, for its relevance, the full Second chapter. Karn offers us a hype-less, lucid, insightful, look at the “macro” picture and begins to answer leading questions, proffered from his profound research. Yesterday, we featured some of Richard Karn’s latest thoughts. Very interesting reading. Enjoy!

Credit and Credibility

Chapter 2: Nobody’s right when everybody’s wrong

Arguably more effective than the military adventurism that dominates the headlines, what amounts to American cultural imperialism has subtly seduced large swathes of the world, and it has not been limited simply to a taste for fast food, film, and fashion.  The far more addictive aspect has been the successful overseas marketing of the "debt culture" via the financial innovation associated with the securitization (derivative) markets, which at $27 trillion has constituted the US' largest export of the 21st century.[1] This is the realm of the money center banks.

Enticed by various forms of off-balance sheet 'accounting' skullduggery, very few large banks globally managed to resist the siren song of easy profits and big bonuses offered by these financial innovations simply because it appears the only restriction on 'profits' was how far a bank dared to push its exposure.  That these vehicles were purposefully unregulated only increased their allure: calls for regulation as far back as 1998,[2] and again in the aftermath of the Enron scandal when these vehicles' deceptive capabilities were fully exposed, were shouted down at every turn by none other than Alan Greenspan, Larry Summers and Robert Rubin and their cohorts in the SEC,[3] ostensibly not to stifle innovation or to drive markets offshore. But the behavior at Enron, far from being viewed as a cautionary tale prompting stricter agency enforcement, was adopted as the exemplar by money center banks-the very same banks, incidentally, that had made the ongoing fraud at Enron possible through a host of derivatives and special investment vehicles[4] the likes of JPMorgan, Citibank et al[5] actively marketed to Enron; instead, derivatives were the mechanism use to transmit the cancer globally.

This tacit government sanction suggests to us then that in effect the whole financial crisis only came to light because of what amounts to a falling out amongst thieves. No investigative reporter or oversight committee or regulatory watchdog safeguarding the interests of the public discovered and exposed any wrong-doing: major international banks' books just became so overloaded with god-awful paper they knew may well be worthless that they grew terrified of loaning money to each other even over night for fear of not being repaid.[6] Once inter-bank lending stopped, credit creation froze, and the Ponzi-scheme parallel in the fiat currency mechanism began to breakdown.

The securitization and derivatives markets were so thoroughly corrupted by 'innovation' that if a bank shuffled paper, adjusted notional values and tweaked their infallible computer models furiously enough, they could arrive at the happy position of not requiring any capital reserves whatsoever to make loans. In other words, major banks worldwide indulged in what amounts to rampant uncollateralized lending-literally creating and distributing unfathomable amounts of money in the form of debt issuance from nothing, secured by nothing.  And quite possibly worth nothing.  It is widely assumed the still undisclosed expenditure of $2 trillion of taxpayer money referred to in the previous chapter was used to purchase boatloads of this stuff in order to stave off the recognition by the public that this behavior had rendered many of these 'too big to fail' money center banks literally insolvent; similar bailouts have been undertaken by governments worldwide.

Concurrent with the runaway lending, central banks throughout the world were channeling trade surpluses with the US as well as with each other into US Treasury bonds while simultaneously creating equal amounts of domestic currency to weaken it in order to maintain export competitiveness. This got so out of hand that today two-thirds of the world's assets are denominated in US dollars.[7] The most controversial of these arrangements has been the de facto vendor financing agreement China has extended to the US: China suppressed the yuan, exports exploded, and it accumulated surpluses; the US let the dollar fall, consumption exploded, and it accumulated debts.[8] Both actions were irresponsible and highly inflationary.  Combined with similar behavior from much of the world, it produced a flood of liquidity that was if not misinterpreted as emerging market prosperity, certainly overstated it.  At the time it was noted primarily for contributing to the low interest rate environment enjoyed in the US that enabled the American consumption binge accompanying the housing bubble.  Few realized housing bubbles were pandemic.[9]

Our analysis concludes it was never a case of a "global savings glut" as proclaimed by Mr. Bernanke and the Fed in 2005[10] and reiterated by ex-Treasury Secretary Paulson[11]earlier this year  to deflect blame for the global financial crisis but a global fiat currency glut-a case of rampant global monetary inflation. Too much money could be leveraged too many times and transferred between too many international markets too quickly.  In addition to masking the extent of fiat currency creation, it produced, by historic standards, rapid-fire sequential bubbles in a range of real assets and commodities supported by credible explanations like 'the emerging market infrastructure build-out,' or 'they're not making any more real estate' or 'emerging middle classes will want to improve their diets' or 'Peak Oil,' and was reinforced by price action.  These bubbles, as they must be, were largely based on the sound reasoning, analysis and extrapolations of economic data, as was the price action that supported it on charts; however, positive technical chart patterns cannot readily distinguish between breakouts driven by a glut of fiat currency looking for a speculative return and the supply and demand imbalances in this instance attributed to emerging market growth. Momentum produced the self-reinforcing hype of being right-something the ETR fell victim to itself-and as markets have discovered, it works in both directions. 

Download a PDF of the complete chapter here.

[1] Pittman, Mark: "Evil Wall Street Exports Boomed With 'Fools" Born to Buy Debt"; Bloomberg:   27.10.2008.

[2] O'Brien, Timothy L.: "A Federal Turf War Over Derivative Control"; The New York Times: 08.05.1998.

[3] Whalen, Christopher:  "Statement to the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, Insurance, and Investment": June 22, 2009,

[4] McLean, B., Elkind, P. & Gibney, A.: Enron: The Smartest Guys in the Room; Magnolia Pictures: 2005.

[5] Thornton, Emily & France, Mike: "For Enron's Bankers, a 'Get out of Jail Free' card"; BusinessWeek: 11.08.2008.

[6] Carney, Brian M.: "Bernanke is Fighting the Last War"; Wall Street Journal: 18.10.2008.

[7] Tett, Gillian: "In uncertain times, all that glitters is the gold standard"; The Financial Times: 09.04.2009.

[8] Grant, James: "For a better fuse box"; Grant's Interest Rate Observer: Vol. 27, No. 6, 20.03.2009.

[9] Tomlinson, Richard & Doyle, Dara: "Ireland Loses Iceland Stigma as Euro Ensures No Return to Past"; Bloomberg: 04.06.2009.

[10] Cassidy, John: "Anatomy Of A Meltdown"; the New Yorker: 01.12.2008.

[11] Yanping, Li: "China Central Bank Attacks Paulson's 'Gangster Logic'"; Bloomberg: 16.01.2009.

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