Having made no small issue of how I had been predicting the current economic crisis for the past nearly four years here at online properties of Dark Wraith Publishing, on a comment thread to a recent article here at The Dark Wraith Forums, the following question was posed to me:

[S]eeing how your crystal ball wasn't in need of cleaning... are you surprised at anything that has occurred in the past coupla weeks?

Let me mince no words before I use my admission as an opportunity to expand the explanation from basic macroeconomics principles of what is happening and why.

Yes, one thing has surprised me, and I am glad it is affording me yet another opportunity to pay attention to everything in the data. I am seeing a wild, ebb and flow, inflation/deflation whipsaw occurring.

Normally, a massive, inappropriate, continual infusion of money into an economic system will cause an inflation; and, given that the United States central bank has been letting the total money supply grow way above the real growth rate of the economy, that is most certainly happening and will continue. However, on the other hand, I looked right at the monetary aggregates data (which can be seen graphically in my March 2008 article "The Gospel of Impending Doom") and saw that the Fed was holding the growth rate of M1, the money aggregate that comprises cash and demand deposits (checking accounts), well below the real growth rate of the economy. In and of itself, that would most decidedly lead to a deflation, as well as to a more general economic disaster were it not corrected.

My thought, however, was this: the Fed was allowing M2 and M3, the kinds of money that only huge financial institutions and others of powerful resources can use for liquidity, to grow out of control at rates way in excess of the real growth rate of the economy. It seemed that this would be the overwhelmingly dominant effect. We have had a situation where the economy had a real growth rate of maybe three percent or so, with M1 growing at around zero percent or so and M3 growing an accelerating rate approaching maybe 20 percent: that should mean M3 wins, and we get an eventual inflation rate at something approaching twenty percent minus three percent (or worse, as the real growth rate of the economy slows down below three percent and thereby cannot use even a fraction of the escalating overhang).

Okay, so where's the deflation coming from, then?

In retrospect, I understand it, although even now I'm trying to get my mind around what happened: this was the "credit crunch"! It was, at least in part, a disintermediation between all that liquidity the Fed was pouring in at the top to keep the Wall Street investment firms afloat and the money the base economy of ordinary people and businesses needed.

That M3 money (the part that isn't M1, which is actually included in the M3 aggregate count) really isn't "money" in any ordinary sense. Huge institutional financial services companies can use it like money because they can make it the collateral backing for access to the liquidity needed for transactions; but, in the end, it isn't liquid money.

When I was a consultant years ago, I knew some players out of Vancouver who had managed to find a trick way to do exactly what these large Wall Street firms have been doing. Those Vancouver boys were getting people with so-called "restricted stock" (insider stock that hasn't been held long enough to be freely tradable) to pledge their "Rule 144" stock for what were called "program trading" campaigns — short-term investments in incredibly high-yield global currency investments. In other words, those guys from what used to be the Wild West of small-time financial roulette had figured out a way to turn highly illiquid "money" (restricted stock) for a brief period of time into pure cash-money to throw into high-stakes global currency markets, adding into the mix their own staggering margins for gains to leverage. That was essentially the very same game the Wall Street boys have been playing, except the players in Manhattan (and other points around the globe) have been doing it with billions of dollars of book-value "money" backing hundreds of billions of dollars of book value transactions. Every time the game came out a winner, the M3 monetary aggregate shot up even more, and that was how the Fed was allowing the M3 monetary aggregate to grow at such an accelerating, alarming rate, while M1, which is a subset of M3, just sat there flopping around the zero-growth line!

But, again, that M3 money is money only to a tier of the "economy" just loosely connected to the rest of the economy where normal people and businesses operate and use money for real transactions. Hence, the M3 growth rate would not rapidly articulate into inflation for two reasons: expectations of inflation would remain sluggishly behind for a substantial period of time since inflation has not been a problem for years, which means wages and prices would remain fairly insensitive to the emergent inflation signs (I explain this so-called 'sticky wages' phenomenon in Part Three of my series, "The Economics of Wreckage"); and, more importantly, the money aggregate that was growing so blisteringly fast simply could not rapidly become money usable to the real economy of tens of millions of people and millions of companies.

The upshot was this: the fast-growing pool of M3 money eventually and ultimately could not be used at a rate nearly sufficient to finance projects down the productive system, where people borrow for homes and durable goods, companies borrow money for floor-planning and buildings, and both households and firms need money every day for all the trillions of typical transactions in which they engage that keep an economy humming along.

This is a cautionary tale of why it is never a good idea for the Federal Reserve to get itself involved in "helping" the economy. Money should be "neutral": there should be exactly enough of it to ensure that real transactions for real things go smoothly. Too much money in the system, and it causes real values of transactions to become non-transparent as the watered-down money interferes with buyers' and sellers' assessments of how the money they are paying and asking for relates to the real, intrinsic values being exchanged; too little money in the system, and real transactions become more difficult to execute because the money is not there that everyone expects as the anticipated medium of exchange.

Going back to the later years of Alan Greenspan as head of the Federal Reserve, the growing federal budget surpluses had the desirable effect of actually stripping the Fed of its ability to engage in activist monetary policy, since the Federal Reserve uses so-called "open market operations" to add money to and drain money from the banking system (as I explain in Part Two of my series, "The Federal Reserve under Fire"). These open market operations are carried out with—are you ready for this?—United States Treasury debt instruments, specifically, the short-term, liquid species called "Treasury bills" (or "T-bills," for short)! If the United States is no longer running budget deficits, it is no longer issuing Treasury bills, the short-term debt instruments the Fed likes to buy to carry out its open market operations within the banking system.

Imagine what it would be like for Alan Greenspan to see his unelected seat of power being taken away. First, he trotted up to Congress to bawl that the stock markets were exhibiting "irrational exuberance," which gave him an excuse in the 1990s to execute a pattern of discount rate increases to try to kill the bull market because he thought (as has often been repeated since then) that the closing federal budget deficits were the result of rising federal tax revenues from capital gains.

When that didn't work, and the federal budget deficits kept closing and finally ended up in federal budget surplus territory with no end in sight, he signed on to newly elected President George W. Bush's massive, decade-long tax cuts to deal with a "recession" in 2001 that turned out not to be a recession by technical definitions of that term (which can be seen in this table of U.S. recessions since 1920).

Sure enough, that did the trick: massive federal budget deficits started coming in year after year, and the Federal Reserve was back in business as the unelected body controlling major parts of the economy through daily open market operations fueled by an unrelenting, rising tide of Treasury bills the U.S. government had to issue to pay for its expenses that its diminished tax revenues could not cover.

Now, here we are: an economy that is such a mess that reverberations are being felt around the world, although some of those global "victims" deserve every last ounce of suffering that will be visited upon them, most notable among the scoundrels being the faux free market-loving Communist rulers in Beijing, who manipulated the yuan-dollar exchange rate for years to make their imports to the United States artificially cheap and our exports to China artificially and symmetrically expensive: the Chinese central bank accumulated a monster pool of greenbacks in foreign reserves from this multi-year gambit, investing the dollars in American assets like U.S. Treasury debt and (dear Lord, let me keep from smiling as I write this) mortgage-backed securities.

Our illustrious Federal Reserve—first under the increasingly addled, self-serving chairmanship of Alan Greenspan and then under the obsequious, incompetent stewardship of Ben Bernanke and his fellow Governors of the Federal Reserve Board (one of whom is a former dinner theatre actress)—were part and parcel of a disaster that has hit this country like a falling brick building, all because an old Keynesian trick of using short-term punches of money to wake up an ailing economy was turned into an everyday, 365-days-a-year alternative to sound fiscal management by the United States Congress and President.

And how did our government first address the crisis when it was too big to ignore? Why, it bullied into law a $700 billion-plus-no-end-in-sight bailout for the welfare queens of Wall Street, with both the respectable Republicans and Democrats muscling it through over the objections of those who, first, didn't like the whole idea and, second, didn't like Nancy Pelosi putting the House of Representatives under martial law and apparently threatening some congressmen with the same for everyone if the legislation did not pass.

But I'll be darned if that massive collapse of real asset values reflected in stock prices didn't happen anyway, despite the $700 billion dollar rescue package that was supposed to avert a global financial meltdown. Talk about throwing money down the drain. We have a former bigwig, Henry Paulson, from the failed investment house Goldman Sachs as the head of the United States Treasury, and he has just appointed his fellow former crony from Goldman Sachs, Neel Kashkari, to oversee the use of that $700 billion to buy up the bad investments of the reckless financial services industry giants.

So, returning to the question that began this article, what did I get wrong? That's easy: I did not see the deflation component of the current economic crisis.

In my own defense (aside from the fact that I'm calling the deflation aspect before virtually anyone is mentioning that it is happening), I shall state that my error is minor compared to those of President George W. Bush, the Congresses of the past seven-and-a-half years, the Federal Reserve, the U.S. Treasury, the mainstream news media pundits, the Republican Party, the Democratic Party, the financial services industry, the two major party candidates, and even most Right-wing and Leftist bloggers. While the important people and institutions flail around with worthless excuses, vapid theories, and useless remedies, be assured that here at The Dark Wraith Forums, readers will get the benefit of my best judgment, which is based upon years of training, observations, and teaching combined with a gut-level knowledge born of those hard-earned credentials.

Unlike pretty much everyone out there in official circles talking about this catastrophic economic downturn, I do not get paid for what I think and write. I shall leave it to readers to assess what that indicates about my reliability relative to that of all the men and women who live at the hog trough of approved opinions, excuses, and solutions.


The Dark Wraith could, however, use an occasional donation from George Soros (although Mr. Soros would probably get the donation back with a friendly note telling him to go to Hell).