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At the establishment of our constitutions, the judiciary bodies were supposed to be the most helpless and harmless members of the government. Experience, however, soon showed in what way they were to become the most dangerous; that the insufficiency of the means provided for their removal gave them a freehold and irresponsibility in office; that their decisions, seeming to concern individual suitors only, pass silent and unheeded by the public at large; that the decisions, nevertheless, become law by precedent, sapping, by little and little the foundations of the constitution, and working its change by construction, before any one has perceived that that invisible and helpless worm has been busily employed in consuming its substance. In truth, man is not made to be trusted for life, if secured against all liability to account.

ideas > The breakdown of the world money machine (www.dailyreckoning.com)

The breakdown of the world money machine (www.dailyreckoning.com)
The Breakdown of the World Money Machine
Ouzilly, France
Tuesday, December 30, 2008
FROM www.dailyreckoning.com

"What an awful year. And 2009 doesn't look like it's going to be any better."

Our neighbor, Pierre, was describing the state of the agricultural industry in Europe…and, indirectly, why he couldn't pay the rent. He leases some land from us at a price of about $150 per acre. He's now far behind on his rent payments. Elizabeth had asked for a meeting to try to collect. Your editor sat off to the side, listening.

"Of course, I'd like to pay," Pierre explained. "And I'm sorry I'm so far behind. But this is just a terrible time for us. I have to feed the cows. That's the first priority. I have to feed them…and buy medicines and fertilizers…even though nobody is buying them. The meter turns over pretty fast - even though I'm not going anywhere. I'm not a meat producer. I'm a breeder. We've been breeding Limousine cattle here for more than a hundred years. These cows can trace their ancestry better than most people. But when farm prices fall, people stop investing in the quality of their herds.

"Normally, I sell about 20 top breeding bulls per year. This year, I've sold 5. There are many people who want to buy, but they don't have any money. They don't have any money because they can't get good prices for their cows…and can't get credit from the bank. So they don't buy my bulls…so I can't pay you."

"Well, the publishing business is no picnic either," Elizabeth replied. "Your customers don't have any money…you don't have any money…and now I don't have any money either," she added with a laugh.

We wondered how many conversations like this were taking place all over the world. The world's money machine has broken down.

Yesterday, the Dow fell 31 points. Oil rose to $40. The dollar held steady at $1.40 to the euro. Gold rose $4 - giving it a nice gain of about 6% for the year.

Everything else is losing money. This will go down in history as the worst year for investors of all time. Oil, copper, and most financial stocks are down 2/3 from their highs. Stock markets generally are down 40% to 60% all over the world. Housing markets are down in most places too - with prices in Britain and America off about 20%.

Bloomberg reports that holiday sales were so bad it will "force store closings, bankruptcies."

And USA Today reports that global trade is expected to shrink by 2% in '09, after rising at nearly 10% per year for the last decade. Smoot? Hawley? Who needs those knuckleheads? Global trade is collapsing without trade barriers. Because Americans aren't buying.

And here, we can trace the breakdown in the entire world money machine…from the pistons that don't fire to the crankshaft that doesn't turn. Like the farming business in France, one man doesn't have any money…so the next man is a little short…and so on all up and down the line.

And here, for the benefit of new readers, we offer a simple schema of the machinery of the Bubble Epoch: Americans bought stuff from the Chinese. The Chinese printed up yuan to buy dollars from Chinese merchants. Then, the nice Chinese financial authorities lent the money back to America. What else could they do with it?

So, you see, everyone had plenty of money. And the more Americans bought…the more money they had to spend. And the more they spent, the more the Chinese had to lend!

Of course, it didn't take a genius to see that a system that depended on people buying things they didn't need with money they didn't really have couldn't last long. In the event, it lasted longer than we expected. But still, not forever.

It broke down under the strain of its own absurdity.

But wait a minute. How come all of a sudden Americans don't have any money? Won't anyone lend any money to them? And why not?

Oh dear reader, throw us a bone!

The financial authorities are clumsily turning screws and tightening valves. They think they can fix the machine by simply getting more credit into consumers' hands. But this machine is not that simple. In fact, it's not a machine at all…but a living, organic thing. It has emotions as well as a brain. It is capable of self-delusion, deceit, corruption, wishful thinking, and extravagance.

Investors, businessmen, householders and consumers are all now reacting to the madness of the Bubble Epoch. They lent, spent, speculated and borrowed wildly - as if there were no tomorrow. Now, every day is tomorrow. And they're afraid. After the sub-prime bubble popped, all the bubble delusions began to fall from their eyes. While once they looked through the glass rosily, not they look darkly:

Wall Street was not making them rich, after all - it was ripping them off! Houses didn't go up forever - sometimes they went down! Things didn't get better and better all the time; often, they got worse! Prominent analysts and economists often have no idea what they're talking about! Alan Greenspan wasn't such a genius after all!

Suddenly, they looked at their balance sheets and realized that they were in danger. Investors have lost half their money in 2008. Homeowners have lost about $4 trillion in America alone. They read the news. They talk. They know the whole thing is imploding. How are they going to pay their bills? How are they going to keep up their standards of living? How are they going to be able to retire?

Instinctively, reflexively, they cut back their spending. And when the pistons stop pumping, the drive shaft stops spinning, and the wheels stop turning. Americans don't go to the stores, the stores don't order more stuff, the ships don't bring more stuff, the Chinese merchants don't make money, the Chinese central bank doesn't have to buy it from them, and then the Chinese have less money to lend back to Americans - who aren't borrowing in any case.

The machine is busted. It can't be fixed.

*** "The Undeniable Shift to Keynes," begins a piece in the Financial Times.

Why the shift? Because Friedman has let us down. The Fed kept the supply of money and credit fairly constant, just as it was supposed to. Then, when credit got tight, it cut rates…all the way down to zero, just as it was supposed to.

Did that solve the problem? Nope. Because the economy is not a simple machine. It's a complex, organic system. It cannot be controlled. It can only be survived. Tolerated. Enjoyed.

Let's imagine that the Fed's key lending rate was zero all year long. Even so, if you'd borrowed money directly from the Fed and used it to buy stocks, your rate of return would be about MINUS 50%. Or suppose you bought a house with a zero-interest mortgage? Your rate of return would be about MINUS 20%. Or, it could have been worse. You might have invested your money with Bernie Madoff, in which case your rate of return would be MINUS 100%.

What business…what investment…what durable consumer item is worth borrowing for under those conditions? Not many.

Besides, once the Fed gives away money at zero interest, what more can it do? Well, it still has some tricks up its sleeve, but its main monetary tool is worthless. It can't cut rates further.

So, it turns to another great economist - Keynes. Instead of colluding to fix the price of money, Keynes said governments should make up for the lack of private spending with public spending. That is, instead of allowing consumers to use their resources as they wished, politicians should divert resources to their own pet projects. In its idealized form, if the private sector found no use for a working man, for example, the feds should put him to work on some socially-useful project - such as building a bridge or picking up trash.

Of course, if there are idle hands in an economy it's because the feds have already distorted it. Typically, various government rules and safety nets make it difficult to adjust the price of labor downwards. So, when prices fall, labor rates become disproportionately high. Who's going to pay a man $25 to make a gadget that sells for $15? No one. That is what causes unemployment. But rather than allow labor prices to fall, Keynes came up with a trick. Government should spend money, thus causing inflation. The rising prices will make labor seem relatively affordable again.

But like all the tricks and quick-fixes in economics, Keynesianism causes more problems than it solves. Governments rarely have any genuine savings. So, in order to spend, they either have to take money away from other spenders …or print it up. If they take it from other uses, the net gain, in theory, is zero. In practice, it is much less than zero, since most government spending is wasted. If it prints up the money, on the other hand, the inflationary effect is much greater…and ultimately ruinous. As we shall see…as the reckoning continues.
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