Contemplating Bernanke's '3% Solution'

by: Karl Denninger

As this is Buffoon's Day Weekend (otherwise known as "President's Day") and today the markets are closed, it is time for something that will require contemplation.

Pull up a chair or turn on the hottub and take this in; it may require more than one sitting.

We shall start with what I call the "3% Solution." This is the premise that Ben Bernanke loves to run. He of course argues that it's a 2% solution, but it rarely is. I am speaking of the intentional inflation that he fosters through the monetary system, an inflation that under the black-letter law of The Federal Reserve Act is a violation, albeit one without a penalty clause. As such he can do as he will, since this "law" has the same import as does a "law" against bank robbery with no penalty attached (the line for robbery stretches out the door and down the block in such an instance, of course.)

I'm going to pick on 110 years as my time frame. This is not an accident, of course; 100 years is approximately the age of the Federal Reserve, and the next 10 are the ones in which we will either stop this or perish as a nation.

We shall start with the following graph:

This is a two-axis graph showing the purchasing power of a dollar, starting at 100% in 1913 and declining to where it will be in 2023. The right axis is the price index. 100% is, of course, what you start with. By 2023 the price index will reach 2,500%, or 25 times what it was in 1913.

Of note is where we are now. At 100 years we have 5.4% of our original purchasing power per unit of currency left, and the price index is 1,870%, or 18.7 times the 1913 value. This means that over the next ten years we will suffer a combined inflation of 34%, which is of course reflected in the decline of the value of the currency.

It is rather instructive to look back just 10 years to see how badly you have been screwed. 10 years previous (2002) the price index stood at 13.9 times. Going to 25 times is nearly a clean double, while the currency value will go from 7.2% of it's 1913 valuation to 4.0%, nearly a clean halving.

If you wonder how 3% can "possibly hurt you", it should now be apparent.

But the real scam is not found here. It is found in the moneysmith game of lending against nothing. This is how bubbles occur -- every single bubble throughout history, in fact, has come about through this mechanism. The common screed, promulgated by politicians, is that this is an "accident" or "foolish gambling."

Nothing could be further from the truth. These are, and always have been, acts of intention and thus criminal fraud.

Let's do an exercise to help you understand how the game is played.

First, let's assume that an economy produces 10,000 units of output. We can denominate them in dollars, quatloos, zotlys, tally sticks, man-hours of labor or odd stones of yap. It doesn't matter what the denomination is, only that we have some means to measure it.

Now let's assume that you have a grand idea for a new business. But you were not frugal, and never laid back any sort of economic surplus (savings, that is) to fund this new venture. Instead, you wish to borrow someone else's capital.

They agree to lend it at a rate of interest.

But wait a second.... unless your new innovation causes the total economy to expand, such that there are more units of output than there were before sufficient to pay the interest, you must eventually go bankrupt! The reason should be obvious -- there is no output to cover your borrowing expense and you had no surplus to start with. In other words, unless your new innovation expands economic opportunity as a whole it cannot succeed.

The moneysmiths know this, of course, as do you if you think about it.

Now here's the problem in stark relief -- over the last 30 years we have never produced enough to pay down the debt in the system as a whole.

See that nice red line? It is always over the blue line since 1980, with one exception -- the crash we're in now. That's the annualized rate of change in both GDP and the outstanding total debt in the system. It is the cause of the bubbles. And it is a massive, pernicious and outrageous fraud.

Private banks do not have the right to lend United States dollars with the intent of creating debts they know will not be paid, but they have. For 30 years they have in fact done this on an unbroken basis. On balance, with the exception of a short period in the early 1970s when credit and GDP tracked almost-perfectly, they have done so continually since 1953, which is as far back as we have accurate information.

You can look at the imbalance a different way if you want, on a quarterly basis. I've presented this chart many times in the past.

This is the gross addition of both GDP and Debt in the economy on a per-quarter basis. You'll note that the alleged "recessions" from 1980 forward never actually happened -- that is, not once was there an actual drop below zero in net GDP change until 2008!

An updated copy including the last couple of quarters is here:

Notice that we are again putting on more debt than we are GDP.

In 2007 for every dollar of economic expansion we added six dollars of new debt. This debt -- credit to someone, who then went out and spent it -- was exactly fungible with actual money.

A "mistake" or "exuberance"? No. This is criminal fraud and counterfeiting. This "lending" was not taking place predicated on actual value of collateral (that is, against assets) it was predicated on literally nothing -- a promise to produce six times as much tomorrow as what was produced today!

If we assume that this was on ordinary commercial terms and over a 10 year span at a zero interest rate then the only way this bet could pay was if the actual GDP growth in the economy was 20% per year, compounded over the entire ten year period without any recessions.

The highest rate of GDP annualized growth ever posted since 1953 is approximately 12% in the early 1970s, when debt increases were running almost identical to that value. Inflation in 1974 was 11%, in 1975 9.1%, and then from 1979-1981 around 11-12% again, which incidentally was the other time we had similar "GDP Growth."

Why would any financial institution engage in a practice that they knew had to lead to ruinous losses?

They wouldn't, and they didn't.

Instead they put together these hinky "securities" so that all the banks would have to do is skim off a piece of the action and someone else would take the loss. But that doesn't work either if you're honest -- if you actually tell people that what they're buying is crap because it cannot possibly be paid as agreed predicated on 100 years of history then they won't buy at all!

There only way you can get people to buy into these schemes, whether they be the Internet Bubble or the Housing Bubble, is to lie.

When you lie about a financial matter for the express purpose of inducing someone to enter into a transaction they would not otherwise it is not a mistake, it is a criminal fraud.

It gets better, of course. All this credit didn't exist! That is, there simply wasn't enough money in the world to pledge against these loans. The banks literally created it out of thin air, a right that is supposed to be reserved to Congress under Article 1, Section 8. This creation of "credit money" out of nothing, backed by nothing, is the essence of counterfeiting exactly as it is if I put blank linen paper in my printer and run off a wad of Benjamins.

Do we need "100% Reserve" banking? Technically, no. But we do need one dollar of capital. That is, there's nothing particularly wrong with lending against an asset that is fairly value at the market price, even though it "creates credit", because if payment is not forthcoming there is no loss; the collateral is seized and sold, resulting in the borrower's bankruptcy (which is what should happen, since he borrowed imprudently.) Without this ability ordinary self-liquidating trade credit such as a letter of credit in international trade, a common commercial transaction that presents no counterfeiting risk, would be impossible.

But lending in the general sense on a fractional basis is an invitation to fraud and theft. Glass-Steagall attempted to prevent this by separating the securities function from depository institutions. The reason Glass-Steagall was undertaken was that in the 1920s the very same thing that happened this time -- fraudulent misrepresentation of credit quality and underwriting -- happened then. The consequence when the frauds were uncovered was mass bank failures and, since the government did not "bail out" the banks who committed these frauds and there was no FDIC depositors lost money they had not intended to put at risk, nor did they believe was at risk.

There is no way to "restore" the housing "values" that were present in the 2006 time frame as that "value" never actually existed. It was a lie and in fact the economic "progress" from 1980 forward never really happened -- it was all bought with credit money putting forward the illusion of demand that did not actually exist.

All of the politicians in the current election cycle at the Presidential level except one (Bill Still) are invested heavily in you not coming to realize this fact. If you do understand it, and a short period of time with the data and Excel will inevitably lead you to this conclusion unless you are either drunk or worse, you then will understand that none of their policy prescriptions can possibly work, as all of them are predicated on the continuation of a mathematical impossibility.

All -- literally all -- of the economic imbalances stem from this underlying and basic fraud. Trade imbalances. The Internet and Housing Bubbles. The offshoring of millions of American jobs and destruction of the middle class. Medical cost inflation. Higher education cost inflation. All of it is caused, at its root, by one thing -- deficit spending by governments and, via fraudulent credit creation, by people.

I wish there was a clean way out of this without acceptance of the very significant and immediate economic pain that our nation -- and indeed the world -- has to undergo.

There isn't.

And if you support a candidate for Federal Office who doesn't "get" this, and who refuses to deal with this singular issue, the rest of what you are basing your support upon simply does not matter, as our nation is fiscally doomed.