Despite the headlines trumpeting America’s death, quite the opposite is happening – we’re moving up.

In 1913 we hired an agent to oversee our economy, to maximize employment and moderate our animal spirits. When we created the Federal Reserve we opted out of truly “Free” Market Capitalism by making the pact that if they maximized employment, we’d accept the terms – inflation, and the risk - deflation. Inflation has worked like a charm, since the deflationary accident know as the Great Depression, because it compensated for interruptions to organic growth. Like an out of shape distance runner using cocaine to keep going, we deluded ourselves into thinking more credit would always work to mitigate a slow down; that a medicinal “line” of cocaine inflation could grant us perpetual prosperity. It can’t and, under this system, deflations aren’t accidents, they're axiomatic. The lure of cheap money is always too tempting in a tight spot. Ask any of the central banks throughout history, their track record has a perfect 100% failure rate.

It seems that buying into the banking system with preferred or common shares is perfectly fine to maintain our financial institutions but that a wholesale bail out of individual mortgages is not on the table. I propose a simple fix: Offer every conforming mortgage, regardless of lender, neighborhood or participant, the opportunity to receive up to a 20% buy-down of their mortgage balance directly by the government.

The bank would receive the funds from the Treasury and the mortgage payments would immediately be reduced by up to 20%. That part of the debt would be erased from the bank’s balance sheet – since the depreciation is what made the asset toxic – lots of breathing room. The amount would be no more than two trillion and represent a far better investment than buying the entire note. Before you choke, keep in mind that the average cost of a foreclosure is north of $75,000 and each one adds yet another house to the inventory.

Internet Time. Make no mistake, the credit collapse created a Modern Depression but it wasn’t allowed to metastasize. The fix, the only one known for depressions, is unimaginable deficit spending. That spending will only go up and is already baked into the recipe. It will work because the world is behind it. It will make more sense if you step back and take a macroscopic view of today’s events, because they are being compressed into “internet time”. The deflationary carnage of this Modern Depression has been not been mitigated; rather it has been accelerated - all the damage at a fraction of the time. Similarly, the reflation will occur much faster than anyone would guess.

In other words, 20th century capitalism has failed by creating more debt than it could write off and promising more benefits than it could deliver. Since we remain the leader of an ever-more-economically homogeneous globe, we will reform capitalism to reflect the values of a world swimming naked at low tide.

The Tales

A few short years ago, technology and the internet mesmerized the masses. The Marks were invited to the world of privilege, IPOs. The freshly minted stocks were rolling off the printing presses far too slowly to satisfy the Marks who had been whipped into a buying frenzy. The ink on most internet IPOs, like the ink on the subsequent subprime sequel, was worthless before it dried. Only when there were no new Marks to buy the worthless paper did they realize they’d been stung. 

Although they’re becoming ubiquitous, step back and notice the warning signs of a nation losing its way;

The first stimulus checks are being distributed with great fanfare; as if they had real substance.  At best the money, which took us further into debt, will offset a fraction of the damage to individuals from the Fiat Reserve Bank’s [FRB] massive sale of put options to secure their Wall Street patrons. 

Until lately, residential real estate steadily laid golden eggs for banks, insurers and municipalities alike. When the golden eggs started cracking, many thought munis were unfairly involved in the carnage rightly meted out to banks and insurers. Maybe rising municipal yields are accurately reflecting rising risk and not merely their insurer’s subprime dalliances. Although municipal insolvency has been rare, Vallejo’s bankruptcy is but a taste of things to come.

We have entered 2008 in much the same way the seemingly invincible Japanese entered 1990, teetering on bankruptcy. Japan’s banking system was an accident waiting to happen by allowing sub-prime, and even defunct business, loans to be held as good receivables. Their Central Bank oversaw such practices and no doubt assumed the bad debt would be consumed by future growth. Sound familiar? Our Federal Reserve presided over substantially the same delusion during our real estate bubble by allowing banks to sell loans at AAA rates to sub-prime borrowers. The good debt was then wrapped into tidy little institutional packages and sold as AAA paper, because it was mortgage backed. When the credit quality of all that “good debt” is finally market to market, money simply evaporates and the shock wave resonates far past ground zero. Bear Stearns’ (BSC) epitaph is being written with sub prime ink. If the #5 investment bank is on life support, how healthy are those beneath them?

I doubt that our Treasury or our Federal Reserve has any real money (other than hard foreign reserves, and a few billion in gold). They only have mountains of the highest rated debt. The evidence that they are indeed insolvent is growing: auctioning money, accepting anything as collateral and pretending foreign infusions are something more than our loaning them money, to loan back to us. It’s a sham, but as long as there’s no run on the bank, it works. Not unlike GM’s (GM) floating a massive loss while reporting quarterly profit, we have a history of pretending that our debts will be consumed by our growth; someday, somehow.

Foreign owners of trillions in US Treasury debt are not the happiest of financial campers these days. They’re relative investment has lost money each time we issued more credit and they now have to step in to shore up the private banks with hard capital just to keep the Federal bank in business? Eventually this deal’s not going to hold that much appeal compared to more fiscally responsible bonds issued in many other countries.

The recent Ben Bernanke bubble bail out is the equivalent of a monetary steroid injection, given to a global fiat monster growing out of control. The idea that recessions are an anachronism and that Central Banks can inflate their way to perpetual prosperity has driven our currency to 40-year lows. Our once-fiscally-responsible Central Bank is losing decades of organic growth with successive steroid (liquidity) binges.

Cutting interest rates reduces the denominator of a fraction that then presumes a higher intrinsic value of the numerator, equities. Money is cheapened and more credit is pushed into the bubble so that it doesn’t look like a bubble. As absurd as it might look in black and white, it sold and illusion has become reality. Al sold it with virtually no derivatives available and it’s even easier for Ben, with an estimated 500 trillion in global derivatives now trading.

Fed Chair (emeritus) Alan Greenspan sounded more like Bart Simpson in his recent” I didn’t do it” speech. Ben, as did his predecessor Al, hoped that publicly ignoring a bubble would help it deflate in an orderly manner.  After the nervous tap-dancing routine failed to convince the market that the housing bubble was only a flesh wound, Uncle Ben has been forced to admit evidence of gangrene. Like Napoleon in Animal Farm, now bellying up to the Discount Window is goooood, four legs baaaaad. If ever anyone wondered why confidence starts with “con” they need no longer. It begs the question of why anyone trusts the Federal Reserve to act as the adult on the economic playground.  

Only in this fairy tale, the three bears arriving back from their stroll are 1) Papa Bear – the implosion of the latest round of creative financing, 2) Mama Bear – the relentless march of energy costs and 3) Baby Bear – inflation.

It is often lamented that immigrants are doing work that American won’t do. Of course this is absurd but that illegals are doing it for less money is, however, quite true. This coefficient of labor has dramatically suppressed wage inflation while increasing productivity. The capitalist trend is for higher corporate profits, not keeping workers happy with high wages. This helps partially explain why inflation has been kept contained with employment so high. This isn't good for individuals vying for higher pay but it is good for business. Rhetorical question 1: What would happen if all that labor left?

Such an unprecedented number of foreclosures will not only disrupt the financial order but perhaps the social order too. In as much as all those new loans invited many of the "have-nots" to become part of the "haves" through home ownership. That is, after all, the definition of a sub prime mortgage. Just like Katrina's anti-government backlash, so too will these forlorn foreclosures find the Government ultimately to blame. The last time we've seen this degree of (potential) wholesale displacements was the Great D and we were, by and large, much more appreciative of just how wonderful life was in these great states. That's not quite the case today.