Total American consumer debt stands at $2.564 trillion. It had gone down three months in a row before expanding by $1.8 billion in January.

The consumer credit report comes out today and demand for credit is expected to resume its fall. Total debt is expected to decline by $1.5 billion in February.

Consumers are certainly feeling the pinch. Equifax reported last month that…

• Total personal bankruptcy filings rose 25 percent in January from a year ago
• Almost 40 percent of homeowners with subprime credit scores of 619 or lower were 30 days or more behind on their loans
• The number of credit cards fell by 30 million since the July 2008 peak to 408 million in January.
• 18.8 percent more auto loans were 60 days behind on their payments compared to the January before.

Despite all these headwinds, a small uptick in big ticket orders recently may indicate that lower interest rates on mortgage loans are loosening up consumers’ wallets.

I’m looking for the February consumer credit report to beat expectations. But consumers aren’t out of the woods. As long as home prices continue to decline and the economy continues to lose over 600,000 jobs a month, consumers will be reluctant to spend on credit.

Source: Consumers Are Still Playing Defense

1.87 billion shares of Citigroup exchanged hands on Friday. That’s easily a record, not just for Citi, but for any stock in the history of the New York Stock Exchange. Shares in the company dropped almost 40%, to $1.40.

The former record holder WorldCom traded 1.5 billion shares on July 1, 2002. The S&P 500 set a bottom three months later.

But on this snowy Monday, during the winter of our discontent, a bottom seems unlikely anytime soon. The Dow opened down 100 points today, breaching the 7,000 level for the first time since 1996. On this leg down, if the Dow goes back to Greenspan’s original proclamation of “irrational exuberance,” it will hit 6,500. He first said those words on Dec. 5, 1996.

If the Dow continues to follow the Japanese example, a 27-year low would bring it all the way back to 1,000 during the life of this bear market.

“I don’t think the market appreciates,” says Dan Amoss, “how much the TALF could help restart lending.

“Last fall’s screeching halt in bank lending was greatly exacerbated by the crisis of confidence in securitization. Prior to the crisis, many of the consumer, business and mortgage loans originated by banks were sold into asset-backed securities and mortgage-backed securities.

“Securitization was abused to the point that it exacerbated the lending bubble; banks quickly reopened the lending capacity of their balance sheets as soon as they securitized loans and sold them to investors.

“Securitization lies at the root of the collapse in lending standards, but that’s another story for another time. Longtime Strategic Investment readers will recall my view, starting over two years ago, that reckless securitization would lead to major problems once investors noticed the toxicity of the asset-backed securities they were buying. It was the primary reason I recommended the UltraShort Financials ETF in July 2007.

“The comparison is not perfect, but depending on its success, the TALF could provide stability to the securitization market, or “shadow banking system,” much in the way that the FDIC guarantees stabilized the banking system during the Great Depression. This could lead to a rally in economically sensitive stocks that have been sold down to distressed levels.”

Considering Friday’s debacle for Citigroup, we’re not surprised to hear Abu Dhabi is “carefully assessing” its $7.5 billion investment in the bank.

The wealthiest of the UAE’s emirates, Abu Dhabi’s got a bit of a dilemma on its hands: Its billions in convertible bonds will convert to shares this time next year. Once the date comes, the bonds will convert between $31-37 a share… just a bit higher than Citi’s current $1.50 bid. That’s assuming, of course, that the U.S. government won’t wipe out all the shares by then via sudden nationalization. Either way, should add an interesting twist for the world’s largest sovereign wealth fund… and fifth largest petroleum exporter.

The mood in the market is as grim as our most famous investor. When he participated in the panel following the premiere of I.O.U.S.A., Warren Buffett shocked many of the film’s makers by playing the token Pollyanna. He all but dismissed the possibility that the U.S. faces a crisis of any kind.

Today, a scant six months later, Mr. Pollyanna is singing a different tune:

“The economy will be in shambles throughout 2009,” Buffett wrote in his annual letter to shareholders over the weekend, “and, for that matter, probably well beyond.”

The above is certainly the most headline worthy quote of his latest missive, and the one that’s got most Buffett disciples running for cover. But of course, there were plenty of little nuggets of wisdom in his yearly letter. Here are a few:

– “In poker terms, the Treasury and the Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”

– “Our long-avowed goal is to be the ‘buyer of choice’ for businesses –  particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).”

– “Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.

“Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”

– “The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms.”

– “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

“Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.”

Yet the U.S. government pumped $30 billion more taxpayer dollars into AIG this morning. The injection came as the doomed insurer announced a $61.7 billion quarterly loss.

That’s a record for any publicly traded American company and even bigger than the group anticipated a few weeks ago.

Last year, AIG lost just under $100 billion. That’s around $3,200 for every second of the year. We’re impressed. Losing that much money that fast takes talent.

Today’s injection brings Uncle Sam’s AIG tab up to $180 billion. In exchange, you own almost 80% of the company… that you’ll never see.

Two more banks failed over the weekend. The 15th and 16th failure of 2009 will nick another $100 million notch in the FDIC’s belt.

Consumer spending in the U.S. registered a surprise gain in January, the Commerce Dept. said today. After falling a record six months in a row, spending popped up 0.6% during the month.

At the same time, personal savings in the U.S. has shot up to 5%. That’s the highest level since 1995.

Hmmn….

The climbing savings rate explains this phenomenon too. The dollar index, still the ultimate flight to “safety” (sic) is just below 89 — its highest level since April 2006.

Investors are showing commodities no mercy during today’s sell-off. Oil is down $4 a barrel, now just clinging to $40. Even gold can’t withstand the pressure… it’s down almost $30, to $933.

“The U.S. had better start looking for someplace else to store its high-level nuclear waste,” declares Byron King, with today’s energy opportunity. “Because they won’t be storing the waste at Yucca Mountain, Nev. This week, the Obama administration announced that it will not support the 20-year-long, $10 billion project to store waste at Yucca Mountain, located about 100 miles northwest of Las Vegas.

“The new administration had better start an alternative soon, and move fast. Almost every one of 104 operating U.S. nuclear power plants are either out of room for on-site storage or nearly so. And then we have to deal with the many forms of nuclear waste generated in government labs and everyday nongovernment industry.

“This ranges from the U.S. nuclear weapons complex to the medical arena and things like metallurgical testing and oil well logging. The nuclear waste that comes from these activities presents a serious problem, with no solution in sight. Lack of storage is a key roadblock to the expanded use of nuclear power in the U.S. Every nuclear-related project needs to show how it will handle nuclear waste from cradle to grave. So what happens when there’s no grave?

“Canceling the Yucca Mountain project may feel good to longtime critics. Indeed, canceling Yucca Mountain may even be the right thing to do. We’ll find out over the next century or so. But right now, we have a problem. Where else to store large volumes of high-level nuclear waste? Any volunteers? No, I didn’t think so. All the wise heads at DOE and in the U.S. nuclear industry had better get their thinking caps on. And whoever figures it out will probably make some serious money.”

For more from Byron, be sure to check out his latest special report: How to Buy Gold for a Penny per Ounce.

“Your reader complains ,” writes a reader, “that letting the big banks fail will be more than ugly, that it will be Armageddon. I have spent hours a day online reading about this crisis, and have found not a single article explaining in any significant detail how this conclusion is reached. The Fed and Treasury refuse to disclose the extent of the problem for two reasons: 1) fear of spreading panic, and 2) fear of disclosing the banks’ ‘trade secrets.’ We’re even denied the knowledge of how our money has already been spent. Bloomberg and Fox News have both filed FOIA lawsuits that the Fed is fighting.

“It’s not enough to describe the situation as a ‘house of cards.’ Let’s open the process to daylight, bring in outside persons who are likely to question our existing authorities (I’d nominate Buffett, Roubini, Taleb and Santelli to start). Have this group perform the ‘stress test,’ not the idiots who couldn’t and didn’t see this coming. An audit by the people who are to blame for the problem is NOT going to restore public confidence, any more than would a urine test by Barry Bonds’ trainer.

“Indeed, when I saw the stress test parameters issued yesterday by the Fed, I concluded that Geithner has already peed in Citigroup’s cup.”

The 5: Charming.

At least we’re not in Europe, eh? This miniature Hooverville is parked outside the capital in Kiev.

We saw what happened to the rest of Europe last month when Russia and Ukraine had their little pipeline tiff… hard to imagine the energy crisis that would result from total economic failure.

“Central Europe’s refinancing needs in 2009 could total 300 billion euro, 30% of the region’s GDP,” declared Hungarian Prime Minister Ferenc Gyurcsany. He said over the weekend that the richer EU members should set up a $200 billion fund to help keep union alive. Germany has already rejected the bailout… France and Italy will likely follow.

“A significant crisis in Eastern Europe would trigger political tensions and immigration pressures. With a Central and Eastern European population of 350 million, of which 100 million are in the EU, a 10% increase in unemployment would lead to at least 5 million unemployed people within the EU…

“We should not allow that a new Iron Curtain should be set up and divide Europe.”

Across the English Channel, Europe’s biggest bank is in dire straits too. HSBC was forced to raise over $17 billion today after announcing its 2008 income crashed 68%. The bank will issue over 5 billion new shares, Britain’s biggest ever rights issue. The mega bank also announced a 29% dividend cut.

Source: A Bottom in Sight? Buffett Wisdom, Energy Crisis, Eastern Europe and More!

In many ways, what’s happening now across Eastern Europe – including Russia – is reminiscent of the Asian economic depression that began in Thailand in July 1997.

Punch-drunk from easy credit in the 2002-2007 period, regional economies aggressively borrowed from abroad, mainly from Austria and other EU members that included leveraged mortgage loans tied to low interest rate currencies like the Swiss franc. That strategy has violently backfired since last summer as investors fled risky assets en masse.

In some East European countries, Swiss franc-denominated mortgages comprised more than 50% of all outstanding mortgage loans. Combined with plunging local currencies, the cost to service those loans has surged, causing foreclosures and defaults to skyrocket.

Auf Wiedersehen Bull Market

After a multi-year bull market against most major currencies since 2002, the euro is now hemorrhaging since last July as Europe’s economic miracle comes undone at lightning speed.

The euro’s decline pales compared to the outright plunge of numerous currencies in emerging Europe, especially since mid-January.

Eastern Europe’s largest economies – core manufacturing hubs for many Western European companies – have seen their currencies crash almost 20% versus the euro already this year, thanks to growing funding concerns amid a rapid acceleration of deflation across local economies. In December, Hungary received assistance from the International Monetary Fund (IMF). Now governments in the region, including the Austrians, are pressuring the European Union (EU), and specifically Germany, to open its vast purse strings to preserve the euro and save Eastern Europe.

Against the sagging euro, many of the regions’ once fast-growing economies in East and Central Europe are now in the midst of significant economic contraction and sharply declining currencies. Credit spreads have surged, credit default swaps are widening and rapidly dwindling foreign-exchange reserves in the region threaten market capitalism, which until recently served as a model for emerging economies in the post-1991 Communist era.

Austrians Plea for Euro-zone Bailout

A fresh full-scale banking crisis affecting Western European institutions is now accelerating this month, with Austrian banks on the hook for €278 billion ($354 billion) to Eastern Europe – the largest exposure among euro-zone members. Western banks are saddled with $1.6 trillion dollars’ worth of Eastern European loans, mostly tied to banks in Austria, Germany, Italy, France, Belgium and Sweden, according to the Bank of International Settlements.

Austrian bank losses are enormous and the cry for help couldn’t be louder.

Austria has been the most aggressive investor in Eastern Europe over the last decade. Local banks rank as the largest investors in the Czech Republic, Hungary and Romania (US$142 billion dollars) with several Austrian banks now attempting to secure government guarantees – including Raiffeisen Zentralbank, one of the largest lenders in the region along with Erste Bank.

Emerging European Collapse

Whereas the Austrians – harboring strong historical trading ties to the region – were heavily exposed to Eastern European banks, Swedish banks lent heavily to the Baltic Republics.

Lithuania, Latvia and Estonia are also fiercely contracting since October, with banks struggling to maintain solvency. Other countries in the region – including Ukraine – are barely solvent and require additional IMF funding while Kazakhstan’s largest bank saw a run on its deposits earlier this week. The list goes on and on, with several other markets in trouble as funding gaps widen in an environment of tight credit and shrinking bank capital.

Teutonic Shift as Euro Must Survive

Germany, the euro-zone’s largest economy measured by output, is now at the forefront of the crisis since earlier this month. Over 25% of Germany’s exports head to Eastern Europe – a vital market for her multinationals. As the region heads quickly into a full-blown fiscal and currency crisis, Germany, and possibly even France might have to bail-out the former Soviet satellite states that are part of the wider European Economic Area (EEA).

German finance minister Peer Steinbrueck breached the subject on February 18, stating, “some of the 16 euro nations are getting into difficulties and may need help.” He went further, adding, “Germany would act if fellow euro members got into financial trouble.”

The markets are screaming for an Eastern European rescue and fast. Thus far, European deficits have ballooned with more than US$1.5 trillion dollars committed to fiscal spending packages, including bank rescues and partial or full government bank nationalization.

Credit spreads for the most troubled economies in the region continue to rise vis-à-vis German bunds – the euro-zone’s largest and most liquid government bond market. And it’s not just Eastern Europe that’s feeling the pain; several high deficit countries in the euro-zone, including Greece, Ireland, Italy, Portugal and Spain have seen their financing costs rise on the heels of credit downgrades or failed bond auctions.

Inevitably, the Germans will finance most of a pan-European rescue for the weakest economies, especially those already part of the single currency euro-zone. That’s because the euro’s viability is at stake; the Germans would rather keep the most vulnerable euro-zone members a part of the single currency.

The consequences of losing one or more euro-zone members would imply higher funding costs for healthier members while probably devastating the economies of those members that abort the euro as financing costs skyrocket.

The endgame for the Europeans is inevitably higher long-term interest rates for all government bond markets. Like the United States, the Europeans will spend a record sum of capital in 2009 and 2010 to fund unprecedented fiscal spending plans and bank bailouts. This includes the Germans, who have now abandoned their mantra of fiscal responsibility to save the euro-zone from near financial ruin.

Germany might have been reluctant at first to participate in a broad-based European rescue effort. That tone has decidedly changed since January as the Merckel government unloads a tirade of spending ultimately leading to the first German budget deficit in decades.

Now Europe watches and waits for the Germans to come to the rescue. The future of the euro depends on Berlin’s quick response.

Source: Euro Bull Market Declared Over as Eastern Europe Crashes: Will They Be Saved?

In the first of four quarterly reports, Citigroup said the money it received from the U.S. Treasury’s Troubled Asset Relief Program (TARP) will not fund advertising, marketing, lobbying, compensation and bonuses. Nor will it used to pay the company’s dividend.

Citigroup also said it created a special committee that will approve and track how the company uses TARP money.

As of the fourth quarter of 2008, the $36.5 billion has been approved for these initiatives:

• $25.7 billion for U.S. residential mortgages
• $5.8 billion for credit card lending
• $2.5 for personal and business loans
• $1.5 billion for commercial loan securitization
• $1 billion in originating student loans through the Federal Family Education Loan Program

Citigroup has three goals with TARP capital: To help expand available credit for consumers and businesses; restore liquidity and stability to the capital markets; and support the recovery of the U.S. economy.

“Americans from all walks of life are facing real economic hardship, and Citi must do whatever we can to help them. Our responsibility is to put TARP capital to work quickly, prudently, and transparently to support U.S. consumers, businesses and our communities during these challenging times,” Citi Chief Executive Officer Vikram Pandit said in the report.

Since receiving TARP money, many U.S. banks have been mum on their plans to spend it, spurring heavy criticism from government officials, investors and the media, including Money Morning’s investigative series on TARP transparency.

Money Morning’s ongoing investigation demonstrated that billions in U.S. bank rescue funds are financing buyouts worldwide – instead of lending at home. Some of those buyouts deals are being done in markets as far away as China. Meanwhile, credit remains tight here in the U.S. market, a situation that could be alleviated only if the banks made the bailout money available to consumers in the form of loans.

Citigroup’s report – and promise of another for each quarter – takes a lot of pressure off Pandit and the rest of the company’s board. And hopefully, it will put pressure on other TARP benefactors to prove they are putting it to good use.

In its latest investigative offering, The Associated Press contacted 21 banks that received at least $1 billion in government money and asked four questions: How much has been spent? What was it spent on? How much is being held in savings? And what’s the plan for the rest?
According to The AP, none of the banks provided specific answers. Some banks actually admitted that they simply didn’t know where the money was going.

Source: Citigroup Lifts Curtain on $36.5 Billion in TARP Money; Will Other Banks Follow?

Like a parent dispelling a childhood nightmare, FDR soothed the masses with the assurance that they had nothing to fear but fear itself. To this day, he is revered for turning a depression into the Great Depression. In the aftermath of the dot-com bubble, Fed Chairman Alan Greenspan came to the rescue with a brand-new bubble in real estate.

Even if there was someone out there who could pull off one more illusionary rescue, it would only delay the inevitable and worsen the pain. Pain now or more pain later. The compassionate solution is to let Adam Smith’s invisible hand guide us, as should have been happening all along. Almost no public figures have the backbone to speak honestly about what’s wrong. There is no free lunch. Still, voters believe the promise that “I will give you what you want and make someone else pay for it.” Neither Congress nor either presidential candidate can take us back to the fairytale world of mortgaged opulence we blissfully enjoyed in the recent past.

It pained me to see former Fed Chairman Alan Greenspan struggle to salvage some remnant of his tattered legacy under the brutal and self-righteous questioning of Henry Waxman’s House Oversight and Government Reform Committee. Waxman chided Greenspan that “The Federal Reserve had the authority to stop the irresponsible lending practices that fueled the subprime mortgage market.” Talk about the pot calling the kettle black! Greenspan failed to come to the defense of the free market, even conceding that his faith in free markets was “flawed.” He declined to remind Waxman that congressional pressure to make mortgage loans available to those who had no business living in a house, not to mention owning one, rendered the markets less than free.

How could this one-time compatriot of Ayn Rand have strayed so far from his roots? Even today, Greenspan’s 1966 essay “Gold and Economic Freedom” provides a refreshingly simple and straightforward explanation for how we arrived at this sorry state of affairs. The Maestro’s essay appeared in the newsletter The Objectivist in 1966 and was later reprinted in Rand’s Capitalism: The Unknown Ideal. This is what Greenspan wrote:

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense – perhaps more clearly and subtly than many consistent defenders of laissez-faire – that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.

In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.

Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.

The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.

What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible. More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term “luxury good” implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.

In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value, will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.

Whether the single medium is gold, silver, seashells, cattle, or tobacco is optional, depending on the context and development of a given economy. In fact, all have been employed, at various times, as media of exchange. Even in the present century, two major commodities, gold and silver, have been used as international media of exchange, with gold becoming the predominant one. Gold, having both artistic and functional uses and being relatively scarce, has significant advantages over all other media of exchange. Since the beginning of World War I, it has been virtually the sole international standard of exchange. If all goods and services were to be paid for in gold, large payments would be difficult to execute and this would tend to limit the extent of a society’s divisions of labor and specialization. Thus a logical extension of the creation of a medium of exchange is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold.

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security of his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments.

When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion.

Thus, under the gold standard, a free banking system stands as the protector of an economy’s stability and balanced growth. When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one-so long as there are no restraints on trade or on the movement of capital. Credit, interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the “easy money” country, inducing tighter credit standards and a return to competitively higher interest rates again.

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World Was I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline – argued economic interventionists – why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely-it was claimed-there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks (”paper reserves”) could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain’s gold loss and avoid the political embarrassment of having to raise interest rates. The “Fed” succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930’s.

With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression. If the gold standard had not existed, they argued, Britain’s abandonment of gold payments in 1931 would not have caused the failure of banks all over the world. (The irony was that since 1913, we had been, not on a gold standard, but on what may be termed “a mixed gold standard”; yet it is gold that took the blame.) But the opposition to the gold standard in any form-from a growing number of welfare-state advocates-was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale.

Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government’s promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which-through a complex series of steps-the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy’s books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.

November 4 is right around the corner. Once again, the masses are clamoring for a savior. To rephrase Walt Kelly and the famous words of the possum Pogo, “We have met our savior and he is us.”

Donald Grove is a Washington D.C.-based lawyer and Washington correspondent for Casey Research, LLC., one of the nation’s oldest and most respected newsletter publishers, providing unbiased investment guidance for individual and institutional investors. You can now kick the tires on Casey Research’s flagship publication, The Casey Report, risk-free — learn more about our special $9.95 two-month trial offer. Click here.

By Donald Grove,
Washington Correspondent
Casey Research, LLC.- The Casey Report

Source: Why a Gold Standard

According to Reuters, the New York real-estate market is showing a significant reduction in new deals as Wall Street sheds staff to reduce costs.

“For the most part, the subprime crisis is past its inflection point,” says Eric Roseman in the Offshore A-Letter. “What matters now is how and when other credit indicators normalize.”

But Eric is highly dubious that credit markets have bottomed.

Sub-prime is now largely history. But other segments of the credit spectrum that have a far more profound impact on the American consumer are just beginning to unravel.

The consumer is now threatened by a liquidity crisis. Housing values continue to heavily contract and revolving credit installment debt is becoming harder to secure.

The culprit is less the write-downs themselves and more the virtual “shutdown” in the securitization market. At its height, the securitization market provided 66% of household borrowings in the first quarter of 2007. Without this market, consumer credit losses may be far worse than currently estimated.

Auto loans, personal loans, mortgage loans, and other segments of installment debt are still contracting. Auto loans are especially vulnerable with defaults recently hitting a 10-year high of 3.4% in March. And more Americans are dropping their house keys to their local lenders as housing values continue to plunge below the cost of their mortgages.

James Howard Kunstler in The Daily Reckoning considers the effects of oil scarcity and the housing bubble hitting at the same time: “The logical conclusion of all this is not what the American public wants to hear: we have become a much poorer society and are now faced with the unavoidable task of making major changes in how we live.”

All the three-card-monte moves at the highest level of finance lately amount to an effort to avoid the unavoidable, acknowledging our losses. Certainly the political fallout of all this will be awesome. But it’s not about politics, really. It’s about the entire society’s inability to form a workable new consensus of reality.

It’s hard to predict how long these institutions at the heart of our economic system can linger in the “far from normal” limbo of pretending that money has not been defaulted out of existence. Since the same process is underway in Great Britain and Spain, places beyond the control of Bernanke, Secretary Paulson, and the Boyz on Wall Street, and since actions and reactions there will affect the destiny of money here, its hard to escape the conclusion that we’re at most months away from the brutal recognition that Wall Street has managed to bankrupt itself (and, by extension, the United States).

This is dark heart of the matter of which no one dares speak.