Difference between Wall Street and Madoff?

Q: So, what's the difference between Wall Street and Bernad Madoff?

A1: Madoff will spend time in prison.
A2: Madoff hadn't yet managed to involve the entire world in his Ponzi Scheme.

America is in for a rough ride, it seems. They are currently hit by a "triple whammy", consisting of some independent and interdependent situations.

[I can't seem to stop adding more links as the days go by - this is so interesting!]

The first problem, which everyone has understood, and often also have directly been touched by, is the housing price crash and credit crisis. Extremely simplified, the banks, insurance companies, rating agencies and large investors of wall street has by deep financial black magic "invented" money that by and large simply ceased to exist the second the housingmarket stopped going upwards. What they have done is to leverage their initial stash of money to an amazing degree, apparently up to 35 times. What you do is to take your dollar, get 34 more dollars from banks, and invest that. A 10% increase in the original investment now turns into a 350% increase on your dollar. The problem is that this also works the other way! So, ANY small decrease in the valuation of the underlying assets, which in this case to a large extent were people's houses, would amplify at least 35 times downward in the system. This in itself isn't all that bad - but since there is a huge feedback loop at play, it just continues downward by amplification of itself, in the same way it seemingly never stopped going upwards.

• A rather nice cartoon-style visualization of the credit crisis.
• January 22, 2009, From MIT's "View from the Top": The Future of the Economy.

The next problem, which one sometimes hear some mumblings about, but which largely has gone under the radar of most people, is America's federal deficit, which has become absurdly huge. USA have for several years been needing billions of dollars from external investors every month just to keep the wheels turning - this both because they import more than they export, and because it is expensive running such a big nation (and they even haven't got free healthcare nor education!). The net effect is that they spend more money than they earn - on a national scale. And the existing loans are of course already running an interest. As long as one aren't paying down on ones loan, the interest turn into compound interests - interest on the interests. This can actually lead to the situation where USA don't even have enough tax revenue to pay off the interest of what they have in debt. The root of this problem has nothing to do with the Crisis of Credit, and is of course extremely dangerous in itself.

(Note the dates of these next videos)

• August 28, 2007: A 60 minutes news story (only 8 minutes!) with David M. Walker, the Comptroller General of the Unites States's Government Accountability Office.
• February 08, 2007: YouTube video by the Comptroller General personally, about the deficit of USA, and part 2.

With the current mega crash of the financial institutions, USA feel that they have to bail out these banks, less their entire country would just stop working at all. This is because one needs the banking system for the wheels and gears of the country to turn around - all money are going through them, and if they just fully crashed, it would take months to get the wheels turning again, and in the meantime no-one could basically do any transactions, and nothing could thus be produced. This might have led to a complete breakdown of the society. It has been deemed that this cannot happen.

Since there was such a huge amount of "magicked" money in play, the government have to get hold of some actual money to inject into the supersized holes that opened up when the magic stopped working. This they were hoping to acquire by even more borrowing.

However, USA has, as described above, been living "above their means" for several years now, depending on this continuous supply of ever more new huge loans given largely by China. This is effectively like living on the credit card, and paying the interests by getting a new credit card and maxing out that too.

The recently released TIC data for January shows that there was a net outflow of money from USA. This number swings up and down, and have been negative before too - but the amount of money flow out during January is apparently worrisome compared to the trend. The Fed made a statement on March 18 that apparently can be read in a very dark way: What might have happened just days ago, possibly revealed by "private" TIC data (there is a lag of 1.5 months before this becomes public - while at least drafts of this data obviously is available to the governments before that), is that China has gotten cold feet, and basically feel that USA's credit rating has gone way down, worrying whether the stuff they've already bought might go massively down in value. Hence the money flow from China might already have all but stopped up.

The only way for a government to get hold of money when no one wants to borrow you cash, is to literally start the presses: Print those dollars! That should rationally lead to a marked decrease in the dollar's value, and hence inflation (The "insta-drop" in the exchange rate for the dollar-against-whatever-else a few days ago was most probably due to everybody's realization of this. It should fall further).

• March 16, 2009: Laura Mandaro @ Marketwatch: Foreign debt purchases fall sharply in January.
• March 17, 2009: Chris Martenson: A Funding Nightmare for the US.
• March 19, 2009: Karl Denninger: Bernanke Inserts Gun In Mouth.
• March 23, 2009: Steve Christ: The US Treasury Bubble: The worst kept secret on Wall Street.
• March 23, 2009: Rolfe Winkler @ Seeking Alpha: Added Debt Won't Rescue the Great American Ponzi Scheme.
• March 23, 2009: Jane Macartney @ Times Online: China proposes replacing the US dollar - they want a "world currency" instead.
• March 25, 2009: Karl Denninger: The End Game Approaches.

The third problem comes as a side effect of the credit crisis, and will compound the problems: Since the current crisis leads to people being fired because there aren't anyone buying the stuff they used to produce, the government gets another double-whammy: They have to pay benefits to these people, but even worse, they loose the tax income these people used to produce!

So, all in all: Three very bad effects at work: America is already living above their means, needing a continuous supply of fresh money in form of loans both to keep the system running, and to repay the existing loans. Then the economy suddenly starts crumbling due to a huge fault in the banking system, which means that America needs even more money to "fill in the holes" of the system. But to top this off, this same crisis leads to reduced production and consumption and rather massive job cuts (which also spirals), which lead both to a even bigger need for money for unemployement benefits AND to less income for the country in form of tax.

To round this off, read this Rolling Stone article. It is a lengthy 8 page feature, but I find it an extremely interesting read. It is maybe slightly conspiratorially inclined, but the research seems thorough.

• March 19, 2009: Matt Taibbi @ Rolling Stone: The Big Takeover. The article starts being very good at the chapter "I. PATIENT ZERO", page 2.

(Added 2010-03-01) Rolling Stone have several Matt Taibbi articles, all of them very interesting:

• July 2, 2009: Inside The Great American Bubble Machine
• December 2, 2009: Obama's Big Sellout
• February 17, 2010: Wall Street's Bailout Hustle

What really is amazing, is that the stock markets around the world is going fast upwards these days. If the above logic has any merit at all, the dollar, and most probably also USA's economy, should be in for quite a ride downwards within a rather short time. Intense. Wonder how this will pan out. PS: In the Wikipedia article on Ponzi Scheme, I came across the scholarly article "Optimal Design of Ponzi Schemes in Finite Economies" by Utpal Bhattacharya. It was published in the Journal of Financial Intermediation, Volume 12, Issue 1, January 2003. It was submitted two years before that. This is a pay-article, but there seems to be a possibly earlier version available here for free(Click the "Download" link). Here's a Google Scholar link, and a standard Google Search link. The abstract goes like this, highlights by me: "As no rational agent would be willing to take part in the last round in a finite economy, it is difficult to design Ponzi schemes that are certain to explode. This paper argues that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round. We model a political economy where an unscrupulous profit-maximizing promoter can design gigantic Ponzi schemes to cynically exploit this “too big to fail” doctrine. We point to the fact that some of the spectacular Ponzi schemes in history occurred at times where and when such political economies existed—France (1719), Britain (1720), Russia (1994), and Albania (1997).". The thought of what might have happened here is actually rather chilling, if you ask me. (Thanks to Øyvind Skårland for the "View from the top" and "gun in mouth" link, and Anders for the cartoon-style "CrisisOfCredit" link)