From Charles Hugh Smith's Of Two Minds Blog
We are being throttled by the Big Lie: we're told that if the predatory financial system implodes, we'll all be ruined. The opposite is true: the only way to save our economy is to let the corrupt, pathological and flawed financial system implode.I was recently challenged by a contributor to write something positive, and so I decided to write about the single most positive outcome of the current financial crisis in Europe: the complete collapse of the corrupt, predatory, pathological global banking sector and its dealers, the central banks. Exploring why this is so reveals the insurmountable internal conflicts in our current financial system, and also illuminates the systemic political propaganda which is deployed daily to prop up a parasitic, corrupting, pathologically destructive financial system.

Our first stop is modern finance itself. Modern financial "products" and "instruments" are often highly complex and abstract, but the entire edifice can be distilled down to this: the system is based on the assumption that all risk can be hedged, and the difference between the initial position's yield/gain (i..e. placement of capital at risk for a gain) and the cost of hedging the risk of the wager to zero can be skimmed from the system risk-free.

That is the entire system in a nutshell, and we can immediately see the advantages of this system over traditional Capitalism, where risk can be hedged but never to zero, and the return is correlated to the risk taken on.

In modern finance, high-risk "investments" (wagers) with high returns can be taken on without worry because any and all risk can be hedged to zero, even in super high-risk wagers.

And since even high-risk positions can be seamlessly hedged to zero, then there is no reason not to borrow money to increase the size of your wagers: since you can't lose, then why not? Wagering in risk-free skimming with borrowed or leveraged money is simply rational.

Put these together and we see how a system based on risk-free skimming eventually leverages itself to the point that the slightest disruption can bring down the entire over-leveraged, over-extended system.

Why is this so? Every hedge has a counterparty who is supposed to pay off if the initial wager blows up. A system based on risk-free hedging is ultimately a self-organizing system which maximizes return by increasing bet sizes, leveraging/borrowing to near infinity and hedging every hedge as well as every wager.

This creates long chains of hedges and counterparties. Here's an example based on an asset we all understand, a house. Let's say someone buys a house for $1,000 down, something that was common in the housing bubble. That $1,000 is leveraged up to buy a $200,000 house via a $200,000 mortgage.

The "owner" of the house then buys a hedge to protect himself from the house losing value, so the risk is reduced to zero: if the value rises, the owner reaps the gain and if it declines, then he collects the payoff of the hedge from the counterparty, for example, a Wall Street investment firm.

The counterparty calculated the risk of real estate declining and then priced the hedge accordingly. There is some small risk that the loss will exceed the cost of the hedge, so the issuer of that hedge bundles similar bets and then buys a hedge or "insurance" from another player, who makes the same calculations of risk and return.

Meanwhile, the mortgage has been tranched (sliced into principal and interest and into various pools of risk) and bundled with other "low-risk" mortgages and sold to investors, who also buy a hedge against any loss in the tranch, for example, a credit default swap (CDS) which pays out if a borrower defaults. Those hedges are sold or "insured" with another hedges.

All of this debt and all of these hedges are based on a mere $1,000 of actual capital. The players who originated each hedge are similarly leveraged, because since risk can be lowered to zero, who needs capital?

So what happens when one counterparty (issuer of a hedge) somewhere in the chain runs into trouble? The entire chain collapses. With razor-thin capital to cover any losses, then each link in the chain dissolves into insolvency if their counterparty fails to pay off.

This is how we get hundreds of trillions of dollars in "notational" derivatives: every hedged is hedged with another "instrument," "products" are bundled and insured, and so on. The system is based on the principle that risk can be reduced to zero, and so there is no need for capital.

Unfortunately, that premise is demonstrably false. Benoit Mandelbrot dismantled the notion that risk can be reduced to zero in his prescient masterpiece, The (Mis)behavior of Markets. The founder of fractal geometry showed that markets are fractal in nature, and are thus intrinsically prone to unpredictable disruptions. Simply put, risk cannot be massaged away.

Thus the fundamental premise of all modern finance is flat-out wrong, and this explains why systemic risk, rather than being eliminated, actually rises with every ratchet up in debt, leverage and counterparty hedging.

The entire global financial system is thus based on the equivalent of a perpetual motion machine: money can be borrowed or leveraged into existence in essentially unlimited quantities, and then deployed in risk-free skimming operations to harvest unlimited wealth.

What does this promise of using leveraged capital to skim risk-free fortunes do to the "real economy" of production and investment in plant and technology? It guts it. The risk of industrial Capitalism is real and cannot be hedged away; high-risk investments may blow up or they may return high yields. It literally makes no sense to risk real capital in productive Capitalism when a zero-risk skimming operation can be developed that essentially needs near-zero capital.

Thus financial capital has come to completely dominate industrial or productive capital. The pernicious consequences of this dominance have poisoned the economy and culture on multiple levels.

In the political sphere, the aggregation of hundreds of billions of dollars in skimmed profits gave Wall Street and the banking sector unlimited budgets to buy political influence. This created a monstrously pathological feedback loop: the more political influence Wall Street bought, the higher their returns on financialization skimming.

Consider housing as an example. Housing was once a simple, barely profitable long-term investment for both the buyer, who had to place substantial capital at risk (20% down payment) and the holders of mortgages, who took a modest yield for 30 years in trade for low risk.

Wall Street and the banks financialized housing via political influence. opening up a vast new territory to be exploited via skimming. Since capital wasn't necessary in no-risk skimming, then down payments were dispensed with to increase the pool of debtors, as they are the foundation of all skimming operations.

the cost of servicing that debt was manipulated via "teaser rates" and "interest only" loans, further leveraging up American home buyers' modest income streams. Mortgages were bundled, tranched and hedged, and the mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) were sold to trusting investors aroudn the world.

It was a bonanza of unprecedented wealth creation from financial skimming.$1,000 down and a few hundred dollars a month for a "teaser rate" interest-only loan was leveraged into a global chain of "products" and counterparties that could be skimmed all along the chain.

That deepened the political corruption that fed the skimming operation, and introduced the "no risk" pathology into Mainstream America. Since real estate never went down in value, then buying a second, third or fourth home on leverage was simply rational; in a Federal Reserve-controlled world of near-zero yields on cash, it was irrational not to.

But there were two intrinsic flaws in the skimming operation: while the Wall Street players were hedged (or so they reckoned), the average Americans buying homes with near-infinite leverage were not hedged. That meant that when their razor-thin capital went to zero, they were insolvent. Once they defaulted, then the income stream feeding the chain of skimming went away and the chain collapsed.

Once one counterparty failed in the chain, the entire chain collapsed as well. As Mandelbroit explained, such disruptions were an intrinsic feature of the system; though the timing of a systemic disruption could not be predicted, the fact that disruptions would occur on a regular basis could be predicted.

Some players knew this, of course, but that led to another pathology: those investment players who avoided the "no risk" skimming casino could not generate the yields being "earned" by the leveraged skimmers with legitimate investing, and so their investors abandoned them for the fully rational reason that "no risk" yields were higher elsewhere.

This too created a feedback loop, where the capital available to be leveraged grew rapidly, while the pool of capital available for "patient" risky investments in actual productive assets declined. Capital available for productive investment thus became costly and scarce, while capital available for leveraged skimming became cheap and abundant.

The Federal Reserve bankrolled the skimming to the hilt. Indeed, the entire pathology of low-interest, unlimited leverage skimming was based on the Federal Reserve's manipulation and intervention. That remains true today.

What happens when the whole chain blows up and the foundation of debt is impaired? Since the whole system is based on the debt and the income streams devoted to servicing it, the entire edifice collapses when the debt is impaired--debtors default and the system clogs with bad debt, i.e. uncollectable debt.

In a transparent Capitalist system, the debt would be written down and all the insolvent borrowers, lenders and counterparties would be wiped out. But the political corruption that enabled modern finance to poison the American economy and culture has stopped that cleansing from occurring.

Such a systemic writedown of bad debt in a system with only razor-thin capital to support a mighty edifice of leverage and debt would wipe out Wall Street and the banks and reveal the skimming operation of modern finance as an impossible perpetual motion machine rigged to enrich a thin crust of citizenry at the expense of the rest. And since they skim enough money to buy political protection, Capitalism has been strangled and tossed in a shallow grave lest it disupt the skimming and the political corruption that keeps the machine running.

What we end up with is artificial valuations, endless propaganda and a zombie economy. When borrowers are left dangling in default and the assets left on the books at full value, you end up with zombie debtors, zombie lenders, a zombie government that only has one lever to pull to keep the whole corrupt pathology going--borrow and squander more money-- and ultimately a zombie economy, drifting and decaying in a fetid pool of lies, shadow banking, ceaseless official propaganda, jury-rigged "fixes," manipulated statistics, corruption, predation, exploitation and pathology.

That's the U.S. economy, and indeed, the economies of the E.U., China and Japan in a nutshell.

The only way to clear a zombie economy is to write off uncollectable debt and liquidate all the assets, loans and hedges. That would collapse our financial system, but since it is the cause of our political and economic dysfunction, that would be the highest possible good and extremely positive.

There is a great final irony in the scare-mongering threats of the skimmers and their political toadies. If the taxpayers don't bail out the skimmers, then we'll have martial law by the weekend, the smouldering fires of Europe will rekindle into open warfare, and so on.

The irony is the propping up of a deeply, intrinsically pathological and destructive financial system is not saving the economy, it's the reason the economy is imploding. The Big Lie technique of propaganda is to reverse the polarity of reality: we are told up is down until we believe it.

We are told that liquidating the overhang of bad debt, leverage and hedges would "destroy the world as we know it." The truth is that keeping the zombie system from expiring and covering up the corruption with propaganda is what's actually destroying the world as we know it.

Thus the collapse of the current financial system of central banks, pathological Wall Street and insolvent banks would be the greatest possible good and the greatest possible positive for the global economy and its participants. 


"I voted for Obama, hoping that he would change things away from the Neocon fear-based politics to something better.

But as I warned right after the election in 2008:

"I - like most Americans - am relieved that the trickle-down emotion du jour has shifted from fear to hope. It feels nicer.

But it is no more real than switching from watching the tv from the horror channel to the feel-good-movie channel.

They are both fiction. Neither the Neocons or Neolibs deliver on their promises.

The Neocons drummed up fear of terrorists, but actually made America less secure, and stomped on our liberties in the process.

The Neolibs promised hope, but gave none ...

Hope is just an emotion. Admittedly, real hope for fundamental and lasting change is important.

But false hope ... is less than worthless . . . it is dangerous, for it lulls people to sleep so they won't demand real change.

After the Honeymoon is Over

When the honeymoon between the voters and Obama is over, people will judge him on who he picks to lead his cabinet and what he actually does.

After the honeymoon is over, the only questions will be whether Obama:

  1. Protected our liberty and restored the Constitution and the rule of law
  2. Restored the balance of power
  3. Ensured justice
  4. Kept us out of imperial wars
  5. Stopped the looting of our treasury and pockets ...
Whether or not Obama does these things - and not whether he administers the hope drug - is the question.

Unless the fundamental tyranny, injustice, imperialism and economic foolishness are addressed, then America will have one heck of a hangover when the drug wears off.
Well, it is now clear that Obama did none of those things, and our country does have a hangover. The bailouts and hand-holding of Wall Street has continued, without any help for Main Street. None of the biggest financial fatcats who committed criminal fraud have been brought to justice. We've gotten in yet another senseless war in Libya. The TSA, Homeland Security and other government agencies are becoming more repressive than ever.

As I noted last year:

Virtually all of our politicians are corrupt. See thisthis and this.

The giant banks are running the show.

The healthcare bill being rammed through Congress "is just another bailout of the financial system", and law school professors say that it is unconstitutional.

America is on a permanent war footing, when the people (and soldiers) are sick of war.

Our civil rights have been eroded, and yet we are not being made any safer.


Obama has sold us out.

Indeed, the American people understand that we're in trouble. As CNN Money pointed out last week:

Just 22% believe the country is on the right track, Rasmussen tells us. According to a new Gallup poll, more than half of us say the economy is in recession or depression, despite the fact that output has been expanding since the summer of 2009. In fact, more of us (29%) say the country is in a depression than say the economy is growing (27%).

From Hope to Fear

Many have accused Obama of being Bush's third term. Even McClatchy asks whether Obama is morphing into Bush.

Obama can't sell hope anymore. So he's switched to the Neocon fear card.

For those who think that the heightened fear of terror is solely due to Osama being taken out, remember, as I noted in February, long before the Osama raid story broke:

The Secretary of the Department of Homeland Security - Janet Napolitano - justtold congress that the U.S. might be facing the greatest threat of terrorist attacks since 9/11:

And in some ways, the threat today may be at its most heightened state since the attacks nearly 10 years ago.This is what the front page of the Drudge Report currently looks like:

click for larger image. Granted, Drudge calls himself a conservative, but all of the media is beating the terrorism drum).Do you remember when Japan's nuclear accident was in the news? How about the war in Libya, or the Federal Reserve document release showing that a lot of the money went to foreign banks (including Libya), the wives of Wall Street titans, and other elites? These stories have been pushed off the radar by the terrorism hype.

Remember, the father of the Neoconservative movement (Leo Strauss), who tutored many leaders of the current administration, believed that a stable political order required an external threat and that if an external threat did not exist, one should be manufactured. Specifically, Strauss thought that:
A political order can be stable only if it is united by an external threat . . . . Following Machiavelli, he maintained that if no external threat exists then one has to be manufactured"

And see this for background.

FBI agents and CIA intelligence officials, constitutional law expert professor Jonathan Turley, Time Magazine, Keith Olbermann and the Washington Post have all said that U.S. government officials "were trying to create an atmosphere of fear in which the American people would give them more power". Indeed, the former Secretary of Homeland Security - Tom Ridge - admits that he was pressured to raise terror alerts to help Bush win reelection.

Indeed, scientists have demonstrated that fear of terrorism makes people stupid and compliant. So if governments can scare people with exaggerated, shadowy threats, it can do whatever it wants.

Are we going switch from koolaid drinkers of false hope to mindless terrorized sheep? Or are we going to stand up as brave, independent, thinking people and demand realchange?

Postscript: If you believe that Obama is less brutal than Bush, read this