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Media and Politicians Ignore Oncoming Financial Crisis – Article by Ron Paul

Media and Politicians Ignore Oncoming Financial Crisis – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
July 7, 2019
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The mainstream media was too busy obsessing over Russiagate to notice that, according to an annual Social Security and Medicare Boards of Trustees report, the Social Security trust fund will run out of money by 2035. The trustees also reported that the Medicare Hospital Insurance trust fund will be empty by 2027.

The trustees’ report is actually optimistic. Social Security is completely funded, and Medicare is largely funded, by payroll taxes. Therefore, their revenue fluctuates depending on the employment rate. So, when unemployment inevitably increases, payroll tax revenue will decline, hastening Medicare and Social Security’s bankruptcy.

Another dark cloud on the government’s fiscal horizon involves the Pension Benefit Guaranty Corporation (PBGC), which provides federal bailouts to bankrupt pension plans. The PBGC currently has an over 50 billion dollars deficit. This deficit will almost certainly increase, as a number of large pension funds are likely to need a PBGC bailout in the next few years. Congress will likely bail out the PBGC to avoid facing the wrath of voters angry that Congress did not save their pensions.

Unfunded liabilities like Social Security and Medicare are not included in the official federal deficit. In fact, Congress raids the Social Security trust fund to increase spending and hide the deficit’s true size, while leaving the trust fund with worthless IOUs.

The media also ignored last week’s Congressional Budget Office (CBO) report predicting the federal debt will increase to an unsustainable 144 percent of the gross domestic product by 2049. The CBO’s report is optimistic as it assumes interest rates remain low, Congress refrains from creating new programs, and there are no major recessions.

Few in Congress or in the Trump administration are even talking about the coming fiscal tsunami, much less proposing the type of spending cuts necessary to pay down the debt and have the funds to unwind the entitlement programs without harming those currently reliant on them. Instead, both parties support increasing spending and debt.

Republican control of both houses of Congress and the While House led to increased federal spending of over $300 billion dollars. The House Democratic majority now wants even more spending increases. House Speaker Nancy Pelosi is threatening to not raise the debt ceiling unless President Trump and congressional Republicans agree to lift the spending caps put in place by the 2011 budget deal.

The Republican Congress routinely exceeded the caps’ minuscule spending limits. Therefore, Speaker Pelosi should have no problem getting President Trump and his Republic congressional allies to once again exceed the caps on welfare spending as long as Democrats agree, as they are likely to agree, to bust the caps on warfare spending.

America’s military budget already equals the combined budgets of the next seven highest-spending countries. Instead of allowing himself to be neoconned into wasting trillions on another Middle East quagmire, President Trump should bring home the nearly 170,000 troops stationed in almost 150 countries.

Unless Congress immediately begins making substantial spending cuts, America will soon face a major economic crisis. This crisis will likely involve the Federal Reserve’s debt monetization resulting in a rejection of the dollar’s world reserve currency status. Since the media and most politicians refuse to discuss this topic, it is up to those of us who understand the truth to spread the word, grow the liberty movement, and force politicians to make real cuts right now.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

Greece Today, America Tomorrow? – Article by Ron Paul

Greece Today, America Tomorrow? – Article by Ron Paul

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The New Renaissance HatRon Paul
July 14, 2015
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The drama over Greece’s financial crisis continues to dominate the headlines. As this column is being written, a deal may have been reached providing Greece with yet another bailout if the Greek government adopts new “austerity” measures. The deal will allow all sides to brag about how they came together to save the Greek economy and the European Monetary Union. However, this deal is merely a Band-Aid, not a permanent fix to Greece’s problems. So another crisis is inevitable.

The Greek crisis provides a look into what awaits us unless we stop overspending on warfare and welfare and restore a sound monetary system. While most commentators have focused on Greece’s welfare state, much of Greece’s deficit was caused by excessive military spending. Even as its economy collapses and the government makes (minor) cuts in welfare spending, Greece’s military budget remains among the largest in the European Union.

Despite all the handwringing over how the phony sequestration cuts have weakened America’s defenses, the United States military budget remains larger than the combined budgets of the world’s next 15 highest spending militaries. Little, if any, of the military budget is spent defending the American people from foreign threats. Instead, the American government wastes billions of dollars on an imperial foreign policy that makes Americans less safe. America will never get its fiscal house in order until we change our foreign policy and stop wasting trillions on unnecessary and unconstitutional wars.

Excessive military spending is not the sole cause of America’s problems. Like Greece, America suffers from excessive welfare and entitlement spending. Reducing military spending and corporate welfare will allow the government to transition away from the welfare state without hurting those dependent on government programs. Supporting an orderly transition away from the welfare state should not be confused with denying the need to reduce welfare and entitlement spending.

On reason Greece has been forced to seek bailouts from its EU partners is that Greece ceded control over its currency when it joined the European Union. In contrast, the dollar’s status as the world’s reserve currency is the main reason the US has been able to run up huge deficits without suffering a major economic crisis. The need for the Federal Reserve to monetize ever-increasing levels of government spending will eventually create hyperinflation, which will lead to increasing threats to the dollar’s status. China and Russia are already moving away from using the dollar in international transactions. It is only a matter of time before more countries challenge the dollar’s reserve currency status, and, when this happens, a Greece-style catastrophe may be unavoidable.

Despite the clear dangers of staying on our recent course, Congress continues to increase spending. The only real debate between the two parties is over whether we should spend more on welfare or warfare. It is easy to blame the politicians for our current dilemma. But the politicians are responding to demands from the people for greater spending. Too many Americans believe they have a moral right to government support. This entitlement mentally is just as common, if not more so, among the corporate welfare queens of the militarily-industrial complex, the big banks, and the crony capitalists as it is among lower-income Americans.

Congress will only reverse course when a critical mass of people reject the entitlement mentality and understand that the government is incapable of running the world, running our lives, and running the economy. Therefore, those of us who know the truth must spread the ideas of, and grow the movement for, limited government, free markets, sound money, and peace.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

Don’t Be Fooled by the Federal Reserve’s Anti-Audit Propaganda – Article by Ron Paul

Don’t Be Fooled by the Federal Reserve’s Anti-Audit Propaganda – Article by Ron Paul

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Ron Paul
March 9, 2015
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In recent weeks, the Federal Reserve and its apologists in Congress and the media have launched numerous attacks on the Audit the Fed legislation. These attacks amount to nothing more than distortions about the effects and intent of the audit bill.

Fed apologists continue to claim that the Audit the Fed bill will somehow limit the Federal Reserve’s independence. Yet neither Federal Reserve Chair Janet Yellen nor any other opponent of the audit bill has ever been able to identify any provision of the bill giving Congress power to dictate monetary policy. The only way this argument makes sense is if the simple act of increasing transparency somehow infringes on the Fed’s independence.

This argument is also flawed since the Federal Reserve has never been independent from political pressure. As economists Daniel Smith and Peter Boettke put it in their paper “An Episodic History of Modern Fed Independence,” the Federal Reserve “regularly accommodates debt, succumbs to political pressures, and follows bureaucratic tendencies, compromising the Fed’s operational independence.”

The most infamous example of a Federal Reserve chair bowing to political pressure is the way Federal Reserve Chairman Arthur Burns tailored monetary policy to accommodate President Richard Nixon’s demands for low interest rates. Nixon and Burns were even recorded mocking the idea of Federal Reserve independence.

Nixon is not the only president to pressure a Federal Reserve chair to tailor monetary policy to the president’s political needs. In the fifties, President Dwight Eisenhower pressured Fed Chairman William Martin to either resign or increase the money supply. Martin eventually gave in to Ike’s wishes for cheap money. During the nineties, Alan Greenspan was accused by many political and financial experts — including then-Federal Reserve Board Member Alan Blinder — of tailoring Federal Reserve policies to help President Bill Clinton.

Some Federal Reserve apologists make the contradictory claim that the audit bill is not only dangerous, but it is also unnecessary since the Fed is already audited. It is true that the Federal Reserve is subject to some limited financial audits, but these audits only reveal the amount of assets on the Fed’s balance sheets. The Audit the Fed bill will reveal what was purchased, when it was acquired, and why it was acquired.

Perhaps the real reason the Federal Reserve fears a full audit can be revealed by examining the one-time audit of the Federal Reserve’s response to the financial crisis authorized by the Dodd-Frank law. This audit found that between 2007 and 2010 the Federal Reserve committed over $16 trillion — more than four times the annual budget of the United States — to foreign central banks and politically influential private companies. Can anyone doubt a full audit would show similar instances of the Fed acting to benefit the political and economic elites?

Some fed apologists are claiming that the audit bill is part of a conspiracy to end the Fed. As the author of a book called End the Fed, I find it laughable to suggest that I, and other audit supporters, are hiding our true agenda. Besides, how could an audit advance efforts to end the Fed unless the audit would prove that the American people would be better off without the Fed? And don’t the people have a right to know if they are being harmed by the current monetary system?

For over a century, the Federal Reserve has operated in secrecy, to the benefit of the elites and the detriment of the people. It is time to finally bring transparency to monetary policy by auditing the Federal Reserve.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

Election Analysis: “Show Me Your Papers!” – Article by Charles N. Steele

Election Analysis: “Show Me Your Papers!” – Article by Charles N. Steele

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Charles N. Steele
November 11, 2012
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In my haste to let the religious right have it, I missed something important that suggests the GOP problem is deeper than just religious nuttery: the GOP has systematically refused to address immigration issues seriously.  Worse, they’ve adopted nativist hostility to immigrants and treat immigration as purely a law enforcement issue, one in which “suspicious-looking people” need to be ready to show their papers at any point.
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Hispanics voted almost 3 to 1 for Obama over Romney.  Anyone surprised by this wasn’t paying attention.  In a number of Republican forums this past year Hispanic politicians and party activists — all GOP members — voiced frustration that the primary campaigns were making it difficult for them to feel they had a place in the party.  Recall that the one and only intelligent thing Rick Perry said in his entire campaign was that children of illegal immigrants ought to be able to attend college at in-state tuition rates, since it was better that they be educated and productive rather than welfare cases.  It’s also the only thing for which conservatives raked him over the coals.
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Hispanics are about one sixth of the U.S. population and account for more than 50% of population growth.  Good luck selling them on the idea that Spanish accents and not-quite-white skin are cause for further police inquiries.

In fact, illegal immigration ought to be something conservatives support.  The primary reason people enter the country illegally is to work. Serious academic work dating at least to Julian Simon’s excellent book (available here for free!) have found that immigration, including illegal immigration, is on net beneficial for an economy.  Immigrants work harder and take less in government benefits.  Their work raises wages for non-immigrants.  They have higher rates of entrepreneurial activity.  In the recent financial crisis, illegal immigrants who were subprime borrowers had far lower rates of mortgage default than citizen subprime borrowers.  One would suppose that these would be the sort of people one would want to welcome, not drive away.  One would think these people would be prime constituents for a free-market message.

Certainly there are problems of crime, of crowding of public services, etc., associated with immigration, but many of these are at heart problems of the welfare state, rather than immigration.  Fixing these makes sense; fixating on immigration doesn’t.

If the nativists got everything they wanted on immigration — iron control over impervious borders, strict limits on who can enter, and deportation of 100% of all illegals — no important economic or social problem would be solved and the economic situation would be worse, not better.  But this wish list is impossible; economic forces cannot be legislated away, and neither can the human spirit.

The current Republican position on this issue is best described as stupidity, and one more reason they drove away potential voters.

Dr. Charles N. Steele is the Herman and Suzanne Dettwiler Chair in Economics and Associate Professor at Hillsdale College in Hillsdale, Michigan. His research interests include economics of transition and institutional change, economics of uncertainty, and health economics.  He received his Ph.D. from New York University in 1997, and has subsequently taught economics at the graduate and undergraduate levels in China, the Russian Federation, Ukraine, and the United States.  He has also worked as a private consultant in insurance design and review.

Dr. Steele also maintains a blog, Unforeseen Contingencies.

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

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Gerald P. O’Driscoll, Jr.
July 15, 2012
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JPMorgan Chase & Co., one of the nation’s leading banks, revealed in May that a London trader racked up losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank originally stated the trades were done to hedge possible losses on assets that might suffer due to Europe’s economic woes. There is now doubt whether it was a hedge or just a risky financial bet.

A hedge is a financial transaction designed to offset possible losses in an asset or good already owned. The classic hedge occurs when a farmer sells his crop in a futures market for delivery at a specified date after harvesting. He sells today what he will only produce tomorrow, and locks in the price. If the price at harvest time is lower than today’s price, he makes money on the forward contract, while losing a corresponding amount of money on the crops in the ground. In a perfect hedge the gains and losses should exactly offset each other.

How did JPMorgan suffer such large losses on its hedges, and what are the lessons?

It appears the London trader entered into financial transactions on the basis of observed relationships among various bond indices. The market relationships broke down. The indices moved differently from what historical patterns or financial models predicted. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management (LTCM) in 1998 and a number of others during the financial meltdown of 2007–08.

LTCM invested the money of rich clients in financial bets based on the expected relationships among the prices of various assets. According to Nicole Gelinas in After the Fall: Saving Capitalism from Wall Street—and Washington, at the time of its collapse LTCM had $2.3 billion of client money. By borrowing, it leveraged that investment 53 to 1. Further, it employed derivatives to further magnify its bets so that its total obligations were a fantastic $1.25 trillion.

A derivative is any security whose price movements depend on (are derived from) movements in an underlying asset. “Puts” and “calls” on equity shares are relatively simple derivatives familiar to many. Asset prices, like various bonds, move in predictable ways with respect to each other, and values of derivatives linked to the assets similarly move in a predictable fashion with respect to the prices of the underlying assets—in normal times.

But the summer of 1998 was not a normal time. There was turmoil in Asian financial markets, then Russia threatened to default on its domestic debt. Global credit and liquidity dried up, and LTCM could not fund itself. It collapsed spectacularly.

A decade later there was turmoil in housing finance. The housing bubble was bursting. Mortgage lenders were under pressure, and some were failing. Many mortgages had been packed together in mortgage-backed securities, which were sold to or guaranteed by Fannie Mae and Freddie Mac. Fannie and Freddie, allegedly private entities but in reality guaranteed by the government, were failing. Lehman Brothers, an investment bank, was heavily involved in housing finance; it borrowed short-term, even overnight, to finance long-term holdings; it employed heavy leverage; and it made liberal use of derivatives contracts. It declared bankruptcy on September 15, 2008.

The specifics varied between 1998 and 2008, and between LTCM and Lehman. But the reliance on certain asset prices moving in predictable fashion was one shared element. So, too, was the heavy use of borrowed money (leverage) and the reliance on derivatives contracts. The volatility of complex derivatives contracts led legendary investor Warren Buffett to characterize them as “financial weapons of mass destruction.”

The Usual Suspects

In short there is nothing new in what happened to JPMorgan. It claimed it was not trying to make risky financial bets, but hedge risks already booked on its balance sheet. While details of the trades that led to losses are sketchy at this writing, they apparently employed both leverage and derivatives. As documented here, these are elements present in major financial blowups and collapses going back decades (and further). LTCM, Lehman, and Fannie and Freddie all thought they had at least some of their risks hedged. But hedges have a tendency to unravel just when needed most: in times of financial turmoil. Even so, financial institutions permit their traders to make the same kinds of dangerous bets over and over again. We used to have financial crises every decade or so. Now the cycle seems to be halved.

In the past I have dubbed today’s banking practice of placing dangerous financial bets “casino banking.” It differs little from the activities conducted at gaming tables in Las Vegas and has little or no reference to the fundamentally healthy activity of matching viable businesses with capital and credit.

In a Cato Policy Analysis, “Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation,” Kevin Dowd and three coauthors examined some of the technical problems with standard risk models used by large banks. It is an exhaustive analysis, and I commend it to those interested. The authors delve into many issues, but concentrate on the many flaws of the complex mathematical models used by banks to control risks.

In August 2007 Goldman Sachs Chief Financial Officer David Viniar puzzled over a series of “25-standard deviation moves” in financial markets affecting Goldman. (Returns deviated from their expected values by 25 standard deviations, a measure of volatility.) Such moves should occur once every 10-to-the-137th-power years if the assumptions of the risk model were correct (a Gaussian, or “normal,” distribution of returns). As Dowd and his coauthors put it, “Such an event is about as likely as Hell freezing over. The occurrence of even a single such event is therefore conclusive proof that financial returns are not Gaussian—or even remotely so.” And yet there were several in a matter of days. In Dowd & Co.’s telling, the models lie, the banks swear to it, and the regulators pretend to believe them. All of this goes to answer how the losses at Morgan might have happened. Traders rely on flawed models to execute their trades.

Now to the Lessons

Major financial institutions continue to take on large risks. Why? Assume the trades made by Morgan really were to hedge the bank’s exposure to events in Europe. That implies, of course, that risky investments had already been put in place (since they then needed to be hedged). Additionally, the risks were so complex that even a highly skilled staff (which Morgan certainly employs) could not successfully execute hedges on them.

Reports indicate that senior management and the board of directors were aware of the trades and exercising oversight. The fact that the losses were incurred anyway confirms what many of us have been arguing. Major financial institutions are at once very large and very complex. They are too large and too complex to manage. That is in part what beset Citigroup in the 2000s and now Morgan, which has until now been recognized as a well-managed institution.

If ordinary market forces were at work, these institutions would shrink to manageable sizes and levels of complexity. Ordinary market forces are not at work, however. Public policy rewards size (and the complexity that accompanies it). Major financial institutions know from experience that they will be bailed out when they incur losses that threaten their survival. Morgan’s losses do not appear to fall into that category, but they illustrate how bad incentives lead to bad outcomes.

Minding Our Business

Some commentators have argued that politicians and the public have no business in Morgan’s losses. Only Morgan’s stockholders, who saw its share price drop over 9 percent in one day, and senior management and traders who lost their jobs should have an interest. But in fact losses incurred at major financial institutions are the business of taxpayers because government policy has made them their business.

Large financial institutions will continue taking on excessive risks so long as they know they can offload the losses onto taxpayers if needed. That is the policy summarized as “too big to fail.” Let us not forget the Troubled Asset Relief Program (TARP), signed into law by President George W. Bush in October 2008. It was a $700 billion boondoggle to transfer taxpayer money to stockholders and creditors of major banks—and to their senior management; don’t forget the bonuses paid out of the funds.

Banks may be too big and complex to close immediately, but no institution is too big to fail. Failure means the stockholders and possibly the bondholders are wiped out. Until that discipline is reintroduced (having once existed), there will be more big financial bets going bad at these banks.

Changing the bailout policy will not be easy because of what is known as the time-inconsistency problem. Having bailed out so many companies so many times, the federal government cannot credibly commit in advance not to do so in the future. It can say no to future bailouts today, but people know that when financial collapse hits tomorrow, government will say yes once again. The promises made today will not match the government’s future actions. There is inconsistency between words and deeds across time.

What to do in the meantime? The Volcker Rule was a modest attempt to rein in risk-taking. Former Fed Chairman Paul Volcker wanted to stop banks from making risky trades on their own books (as opposed to executing trades for customers). Industry lobbying has hopelessly complicated the rule and delayed its issuance.

Morgan’s chief executive officer, James Dimon, asserted the London trades would not have violated the rule. If true, it suggests that an even stronger rule needs to be in place. Various suggestions have been made to address excessive risk-taking by financial firms backed by the taxpayers. It is time to take them more seriously.

Gerald O’Driscoll is a senior fellow at the Cato Institute. With Mario J. Rizzo, he coauthored The Economics of Time and Ignorance.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Wall Street Math – Article by Douglas French

Wall Street Math – Article by Douglas French

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The New Renaissance Hat
Douglas French
April 11, 2012
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There’s plenty of blame for the financial crisis being spread around. Those on the left say Wall Street wasn’t regulated enough, while those on the right claim government mandates required lenders to make bad loans. The argument is made that the Federal Reserve was too loose, while the other side says Bernanke wasn’t loose enough. Some blame greed. Others blame Wall Street’s investment products. And then there’s mathematics.

Wall Street has become a numbers game played at high speed by powerful computers trading complex derivatives utilizing even more complex mathematical modeling. Writing for the Huffington Post, Théo Le Bret asks the reader to

Take the Black-Scholes equation, used to estimate the value of a derivative: it is actually no more than a partial differential equation of the financial derivative’s value, as a function of four variables, including time and “volatility” of the underlying asset (the derivative being a ‘bet’ on the future value of the asset). Differential equations are well-known to physicists, since such fundamental properties of nature as the wave equation or Schrodinger’s equation for quantum mechanics are given in the form of differential equations, and in physics their solutions seem to be very reliable: so why is this not always the case in finance?

Mr. Le Bret quotes Albert Einstein for his answer: “as far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”

Murray Rothbard put it another way:

In physics, the facts of nature are given to us. They may be broken down into their simple elements in the laboratory and their movements observed. On the other hand, we do not know the laws explaining the movements of physical particles; they are unmotivated.

Rothbard goes on to make the point that human action is motivated and thus economics is built on the basis of axioms. We can then deduce laws from these axioms, but, as Rothbard explains, “there are no simple elements of ‘facts’ in human action; the events of history are complex phenomena, which cannot ‘test’ anything.”

Using the models that work so well for physicists, mathematicians on Wall Street got it spectacularly wrong in the mortgage and derivatives markets, just as mathematical economists can never predict the future with any accuracy. Motivated human behavior cannot be modeled.

But the mathematicians or “quants” underscore all of Wall Street’s financial engineering, a process that takes a few pieces of paper and folds their attributes together to make new products, most times hoping to avoid taxes and regulation. Author Brendan Moynihan describes this engineering in his book Financial Origami: How the Wall Street Model Broke.

Origami is the traditional Japanese art of paper folding wherein amazing shapes and animals are created with just a few simple folds to a piece of paper. Moynihan cleverly extends the metaphor to the financial arena, pointing out that stocks, bonds, and insurance are pieces of paper simply folded by the Wall Street sales force into swaps, options, futures, derivatives of derivatives, and the like.

The author is adept at describing derivatives in terms a person can understand. Health-insurance premiums are a call option to have the insurance company pay for our medical care. Auto insurance premiums are like put options, allowing the insured to sell (put) his or her car, if it’s totaled, to the insurer at blue-book value.

Nobel Prize winners have played a big hand in the creation of derivatives. Milton Friedman’s paper on the need for futures markets in currencies paved the way for that market in 1971. But as Moynihan points out, it was Nixon’s shutting of the gold window that created the need to mitigate currency and inflation risk.

Nobel Laureate Myron Scholes was cocreator of the Black-Scholes-Merton option-pricing model. He and cowinner Robert Merton used their model to blow-up Long Term Capital Management.

But it was little-known economist David X. Li’s paper in the Journal of Fixed Income that would provide the intellectual foundation for Wall Street’s flurry into mortgages. “On Default Correlation: A Copula Function Approach” became “the academic study used to support Wall Street’s turning subprime mortgage pools into AAA-rated securities,” writes Moynihan. “By the time it was over, the Street would create 64,000 AAA-rated securities, even though only 12 companies in the world had that rating.”

Robert Stowe England, in his book Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, says Li’s model “relied on the price history of credit default swaps against a given asset to determine the degree of correlation rather than rely on historical loan performance data.”

“People got very excited about the Gaussian copula because of its mathematical elegance,” says Nassim Nicholas Taleb, “but the thing never worked.” Taleb, the author of The Black Swan, claims any attempt to measure correlation based on past history to be “charlatanism.”

Subprime mortgages were bundled to become collateralized mortgage obligations (CMOs), which are a form of collateralized debt obligation(CDO). CDOs weren’t new; the first rated CDO was assembled by Michael Milken in 1987. But instead of a mixture of investment-grade and junk corporate bonds, in the housing bubble, CDOs were rated AAA based upon Li’s work.

Mr. England wryly points out, “A cynic might say that the CDO was invented to create a place to dump lower credit quality or junk bonds and hide them among better credits.”

England quotes Michael Lewis, author of The Big Short: “The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America.” For Wall Street it was a machine that “turned lead into gold.”

Wall Street’s CDO mania served to pump up investment-bank leverage. England explains that if level-3 securities were included (level-3 assets, which include CDOs, cannot be valued by using observable measures, such as market prices and models) then Bear Stearns sported leverage of 262 to 1 just before the crash. Lehman was close behind at 225, Morgan Stanley at 222, Citigroup at 212, and Goldman Sachs was levered at 200 to 1.

Leverage like that requires either perfection or eventual government bailout for survival.

The CDO market created the need for a way to bet against the CDOs and the credit-default-swap (CDS) market was born. Bundling the CDS together created synthetic CDOs. “With synthetic CDOs, Wall Street crossed over to The Matrix,” writes England, “a world where reality is simulated by computers.”

It’s England’s view that the CDO market “was the casino where the bets were placed. Wall Street became bigger and chancier than Las Vegas and Atlantic City combined — and more.” According to Richard Zabel, the total notional value of the entire CDS market was $45 trillion by the end of 2007, at the same time the bond and structured vehicle markets totaled only $25 trillion.

So the speculative portion of the CDS market was at least $20 trillion with speculators betting on the possibility of a credit event for securities not owned by either party. England does not see this as a good thing. It’s Mr. England’s view that credit default swaps concentrated risk in certain financial institutions, instead of disbursing risk.

In “Credit Default Swaps from the Viewpoint of Libertarian Property Rights and Contract Credit Default Swaps Theory,” published in Libertarian Papers, authors Thorsten Polleit and Jonathan Mariano contend, “The truth is that CDS provide investors with an efficient and effective instrument for exposing economically unsound and unsustainable fiat money regimes and the economic production structure it creates.”

Polleit and Mariano explain that credit default swaps make a borrower’s credit risk tradable. CDS is like an insurance policy written against the potential of a negative credit event. These derivatives, while being demonized by many observers, serve to increase “the disciplinary pressure on borrowers who are about to build up unsustainable debt levels to consolidate; or it makes borrowers who have become financially overstretched go into default.”

Mr. England concludes his book saying, “We need a way forward to a safer, sounder financial system where the power of sunlight on financial institutions and markets helps enable free market discipline to work its invisible hand for the good of all.”

Polleit and Mariano explain that it is the CDS market that provides that sunlight.

The panic of 2008 was the inevitable collapse of an increasingly rickety fiat-money and banking system — a system where the central bank attempts to direct and manipulate the nation’s investment and production with an eye to maximize employment. In a speech delivered to the Federal Reserve Bank of New York, Jim Grant told the central bankers that interest rates should convey information. “But the only information conveyed in a manipulated yield curve is what the Fed wants.”

Wall Street’s math wizards convinced the Masters of the Universe that their numbers don’t lie, believing they could model the Federal Reserve’s house-of-mirrors market. Maybe the numbers don’t lie, but the assumptions do.

Advising about mathematical economics, Rothbard wrote, “ignore the fancy welter of equations and look for the assumptions underneath. Invariably they are few in number, simple, and wrong.” The same could be said for Dr. Li’s model and Scholes’s model before him.

Until the era of unstable fiat-money regimes ends, the search for scapegoats will continue — because the crashes will never end.

Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply and Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master’s degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee. French teaches in the Mises Academy. See his tribute to Murray Rothbard. Send him mail. See Doug French’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.