How an Attack on Iran Could Lead to WW III

The war machine propaganda is now in high gear to mobilize what public opinion remains to be swayed into supporting a war against Iran.  The WMD threat against Iraq was demonstrably false to begin with, and Scott Ritter pretty much shredded it.  He was in turn shredded by a system that had already made up its mind to go to war on any pretense.  So this effort may also be in vain, if the decision has already been made to fight Iran.  But I won’t be accused of not trying.  In my book “The Land of the Free” I outlined a scenario where American debt to China could precipitate an international crisis.  Here I want to outline one that could emerge from an attack on Iran.

In the first place, let’s discuss the concept of WW III.  Broadly speaking, it would involve a direct conflict between the world’s superpowers, the USA, Russia, China, where the confrontation gets out of control and a massive nuclear attack is launched, followed by a counter-attack that leaves a large part of the developed world utterly desolate and over a billion people dead.  This is something that was avoided during the cold war, as both the USA and USSR were acutely aware of each others’ every move.  They walked on tiptoes to try to prevent the nightmare scenario, both aware of the others’ devastating nuclear arsenal.  Even during the Cuban missile crisis, cooler heads prevailed, though not by any reassuring margin.   This has led the world into complacently thinking that reason will always prevail in a potentially nuclear confrontation.  Yet we don’t have to search history too far to find a scenario where reason did not prevail, even though the outcome was the suicide of the previous societal order.

World War I had no villain nation and no hero nation, only victim nations, some worse than others.  In the century before the Great War, there had been general peace in Europe since the time of Napoleon.  The Crimean War was the exception that foreshadowed modern warfare and cautioned against its power to inflict mass casualties.  In the USA, the War Between the States served the same cautionary role.  In 1913, the thought of a total war involving most of Europe was out of the question.  The aristocratic societies of Europe had nothing to gain and everything to lose.  Most of the monarchs were related to each other, so nobody thought a war could put their collective reigns to an end.  Alliances emerged that were supposed to guarantee the peace by making the stakes of war too steep to contemplate.  So it can’t be denied that all parties understood that if war broke out, it would engulf all of Europe.  The stalemate produced an uneasy peace that appeared it would last.  So what happened?  It comes down to contingency planning.

The Germans had calculated that in any war, they would have to carry the bulk of load for the triple alliance of Germany, Austria-Hungary, and Italy.   Italy was in no shape to fight, and Austria-Hungary could not count on its disparate ethnicities to fight under its flag.  So the German tactical plan had to make quick work of its enemies in the west in order to conserve its fighting strength to face the danger of Russia, which would be slow to mobilize but formidable in its strength thereafter.  The Schlieffen Plan was developed to address this situation, and the structure of the alliances was such that Germany felt it was the only way to fight a war with a chance of victory.  Remember, they did not expect a war.  They thought the alliances themselves would ensure peace.  Then came Sarajevo.

What happened in July of 1914 was that war started on auto-pilot.  The responses were pre-programmed, and once in motion, it was impossible to stop.  Commitments, threats, all previous statements had to be backed up with action or exposed as worthless.  Nobody was willing to say “I was just kidding”.  So when Gavril Princip shot Franz Ferdinand, Austria-Hungary declared war on Serbia, which was an ally of Russia.  Automatically, the Schlieffen plan kicked in, because Germany’s ally was now at war with Russia’s ally.  Germany would have to fight Russia eventually, so she had to assume that Russia’s allies France and England would fight also.  Germany’s first move therefore was to start fighting against France.  Think about that for a second.  A Serb shot the Austrian heir, so Germany invades France.  Absurd, isn’t it?  But it was perfectly logical at the time, when understood in terms of the alliances and the Schlieffen plan.

One last point about WW I.  The alliances were known, but the Schlieffen plan was secret.  It’s only with 100 years of history that it is crystal clear how everything developed.  At the time, it would have happened in a fog to anyone but the German top brass.

Iran today is facing encirclement by the United States that named it 10 years ago as a country comprising the “axis of evil”, and that has in the past overthrown its democratic government to install the Shah.  It is justifiably afraid, and it observed that North Korea, also on the “axis” has at least pretended to have nuclear weapons, and it was not invaded.  By contrast, Saddam Hussein did not have nuclear weapons, and he was invaded.  So Iran has a rational reason to pursue nuclear weapons, whether or not it is true that it is in that pursuit.  It is enriching Uranium to 20%, which is more than they need for a simple reactor, but far less than the 96% needed for a bomb.  So in principle, whether or not they produce a bomb, it is in their interests to make it seem as though they were, to deter attack.  Until they achieve demonstrable breakthroughs in that endeavor, their only other means of deterring attack is to use their strategic location at the Strait of Hormuz.

20% of all the oil traded in the world passes through the narrow strait at Hormuz, and if it were cut off, the price of oil would surely top $200 per barrel, and probably higher.  Further, much of that oil is bound for China, whose supply would be seriously disrupted even if they bid more for oil than the market price.  It would be fair to say that such a disruption in oil flow would constitute a mortal wound for China’s manufacturing economy, high on materials costs relative to labor costs.

Israel is the sole nuclear power in the Middle East, and whether or not they are America’s vassal or America’s master (arguments exist for both, and I’m neutral on the issue), their supremacy in the Middle East would be compromised by a nuclear Iran, and not because of any direct threat.  If Iran were to produce a modest sized nuclear arsenal (they could not produce a large one.  Israel only did so by access to American isotopes), they could threaten a retaliatory strike against Israel, but not a credible first strike.  Israel could “wipe Iran off the map” a lot more than vice-versa.  Tehran is in a valley, and it contains nearly the totality of the non-oil economy of Iran.  Destroying that city would leave little but desert.  And with the overwhelming size of Israel’s arsenal, it would be easy to do so.  So attacking Israel first would be utter suicide for Iran.  Ironically, the threat to Israel is not Iran, but Saudi Arabia.

Iran and Saudi Arabia are bitter enemies of long duration.  There is the Sunni-Shia split, and the Saudis are constantly threatened by the Shia majority in their eastern, oil-rich provinces.  If Iran acquired nuclear weapons, their warheads would probably not be aimed at Israel, but at Saudi Arabia.   It might even be said, with some credibility, that American opposition to Iranian nuclear ambitions is driven more by the Saudis than the Israelis.

The Saudis would have no alternative but to acquire nuclear weapons of their own, to balance the Iranian threat.  But once they did, they would no longer be so dependent on the American military umbrella, and could act independently.  Israel would be more insecure, but more significantly, America would lose control of the world’s oil distribution.  That is worth more than money, because the threat of turning off the spigot represents real power.

Now that we’ve laid out some of the regional interests, let’s intertwine them some.  China can’t allow the Straits of Hormuz to be closed.  It means death of the current system and probably the regime.  No doubt China has spoken to Iran and asked politely if they would not mind disregarding their threat to close the strait.  “Would you mind saying ‘I was only kidding'” is the way the request would come across.  Iran would of course say “talk to the Americans.  If they don’t attack us, we won’t close the strait, but we need that credible threat to protect ourselves.”  The Chinese won’t get anywhere with this tactic, and will conclude that indeed they have to speak to the Americans.  Failing there, they will make a credible threat against America.  I don’t know what that would be, but I can be sure it would be something drastic.  Something to make America think twice about attacking Iran.  The USA may convince themselves the threat is a bluff, since it would be met with nuclear retaliation from America, and “nobody would risk that”.  But like with WW I, even though the act may be suicidal, once the process starts, it becomes impossible for a nation to say “I was only kidding”.  The credibility of threats has to bee substantiated.  So you could have a situation where a terror attack against Israel causes the US and China to exchange nuclear salvos, if Israel goes after Iran in the process.  Saudi Arabia could also be a trigger for events in the region, and its society is rife with problems, the Wahhabi sect utterly disgusted with the ruling class and its corruption, waiting for its chance to seize power.  Meanwhile the disposessed Shiites in the eastern provinces are waiting for a chance to get their due.

There are multiple ways that things could tangle themselves and involve the US and China, and I have not even discussed Russia.  It is increasingly encircled by the US and is bristling over this.  Witness the way they reacted when Georgia moved against South Ossetia during the 2008 Olympics.  Having an American client state on their southern frontier might be a step too far for them.  But the point is that when something happens, these considerations and countless unknown others will quickly result in an auto-pilot conflict that happens quicker than anyone can really think it through.  In a hundred years, working by candle-light, maybe historians will piece together all the interlocked pieces that worked to produce the catastrophe, but we can’t see it all.  I’ve outline some possible pieces that appear obvious to me, but rest assured there are many others.  The region is too important for there not to be.


Update Jan 15:  China is threatening WW III if Iran is attacked.  So it evolves as is now inevitable.

You’d think this would stop matters, wouldn’t you?  But the blood lust from the neocons and associates is now so high I can’t see how they can stop things.  It’s on auto-pilot…

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Chapter 61 from “The Land of the Free”, posted for preview purposes

Hanna Morgensen brought CIA Director Bill Connolly with her on her morning visit to [President Jackson] Torres. “I thought I would have Bill brief you in person on some unfortunate developments.”
“Sir, we targeted a list of engineers working on the Chinese missile defense system. We carried out a hit in Hong Kong on one of the people on the list, but it turned out to be a high ranking Chinese politician by the same name. Go figure, Chinese names being so similar and all.” Connolly finished with a morbid chuckle.
“You assassinated a Chinese politician?” asked Torres, aghast.
“That’s not all” said Morgensen. “The idiot he sent to do the job got caught. He wasn’t counting on the kind of security that attends politicians. As soon as they find out who he is, there’s going to be hell to pay with the Chinese government.”
“There should be plausible deniability” said Connolly. “We won’t back our operatives when they screw up this badly.”
“Why are your operatives even doing this?” asked Torres, veins bulging in his forehead.
“Since you banned us from dealing with the professionals at Morningstar, we’ve had to take on their roles ourselves” said Connolly. “These are the results.”
Morgensen waited a moment for that news item to be fully digested before continuing. “That’s not all. They’ve mistakenly killed Chinese agents in Pakistan.”
Torres was numb by now, and simply shook his head.
“It was a drone strike, and our intelligence indicated they were militants opposed to US activities in Afghanistan” said Connolly. “The intelligence was mistaken, and they were Pakistani regulars with Chinese attachés.”
“And who authorized you to carry out any of these attacks?” asked Torres.
It was my understanding from Secretary Morgensen that you did” said Connolly.
“Hanna, would you please leave us?” asked Torres. She stood up and left without a word.
“Mr. Connolly, can you show me a memo with my signature on it which specifically authorizes any of this?”
“No sir, it was all verbal.”
“Then I could have you charged with murder or treason.”
“Don’t be ridiculous, sir. I was acting in the national interest and you know it.”
“And who in your opinion defines the national interest, Mr. Connolly? The CIA Director or the President?”
“Presidents come and go” said Connolly. “If it was the President, we’d have chaos. The bureaucracy, working together with the corporate entities, has always defined our national interest. With all due respect sir, your skill set is suited only to sell the decisions to the public.”
“I also have to answer to foreign governments when you murder their citizens. I demand you clear every decision with me first.”
“That’s simply not practical. We would never be able to act quickly enough, and your political cronies would leak information all over the place. If this is not okay, I can resign. But then you’d have two high profile resignations at once and the rumors would start flying.”
“I will confer with my Attorney General and we’ll decide together whether you will be charged, Mr. Connolly. If you are, you will resign in disgrace.”
Bill Connolly shrugged his shoulders as if he could not care one way or the other what Torres had to say. He stood up and left without a word.
Several minutes passed, during which Torres could hear that there was a conversation outside his office. Hanna Morgensen then walked into the Oval Office and went right on the offense. “If you had not been such an obstructionist at the beginning and approved the covert operation, they would have kept you in the loop at least as a formality. Instead they had to keep it from you, and now you’re going to lose face when you have to back down on your threats to Bill Connolly.”
“Suppose I don’t back down, Hanna. Suppose I go on the air and tell them the truth about who runs the government. Suppose people knew they were electing a figurehead who executes the will of the elite with no regard for the people?”
“If you forced us to drop the pretense, we would reluctantly do so Mr. President. Do you really want a United States with a formal oligarchy, out in the open? Because that’s where this is heading if you follow through.”
Torres stewed for a few moments, looking at the Cobra with such hatred in his eyes that even she appeared to show some fear. “That’s not what I want, Hanna” he finally said. “But I do want to be kept in the loop for anything we do as a government, where I will be held to account by those who believe the pretense.”
“That can be arranged” said the Cobra, visibly relieved that she had won that standoff. She then stood up and left in a bit more of a hurry than was customary for her.

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“The Land of the Free” is now available on Kindle

The Land of the Free” is a work of fiction that explores one possible answer to the question:  “What might those who’ve lost value lending money to governments do to recover what they see as their rightful property?”


The Description is here:

Cam Burrows of the Border Patrol discovers a massive military complex and air base in northern Mexico, staffed by Chinese nationals. He is captured and may not be able to get word back unless he can escape and find a way back to the United States.

Meanwhile Robbie Linssman uncovers a conspiracy involving his employer, a large shipping company. When he tries to notify the FBI, he turns up dead. His best friend and long-retired SEAL John Corson has soured on life. He wants nothing to do with any investigation but is reluctantly pulled into it. Joining Corson are Robbie’s daughter Jess and two others, Frank and Lyle, who have their own reasons for helping out. Jess and Lyle visit an island off Panama that holds the key to the conspiracy. Will they find what they’re looking for and live to tell about it? Will John and Frank, pursued by a paramilitary group trying to kill them, stay alive long enough to learn the truth and find a way into the White House to warn the President?

But President Jackson Torres has problems of his own. Drowning in debt and facing a financial crisis, he struggles with his unpopularity and is surrounded by cabinet members intent on their own agenda. President Torres finds his foreign policy is spinning out of his control and tensions with China are escalating in spite of his best efforts. As he is manipulated into a confrontation he can’t win and is in fact meant to lose, the very existence of the United States is in jeopardy.

In today’s world of budget and trade deficits, not much consideration is given to the motives of those who hold all that debt. When the inevitable happens and the bonds are devalued by inflation or default, what acts might the losers contemplate? “The Land of the Free” explores one frightening possibility as only a work of fiction can.

Here is a review from someone I gave early access to:

It’s not often you get to read fiction that makes you think “wow, I’ll bet it really does happen like that.” The Land of the Free does exactly that. Krakondack (a pseudonym) has a rare gift of painting a high-level confrontation in very convincing language, making you feel like you were in the room when it happened. For instance, the chapter where the President threatens to drop the pretense and tell the public how they are governed, and the Cobra’s response, had me highly agitated and really believing her threats. The masterful dialog is interspersed with crisp action that keeps you turning the pages to see the next plot twist. Yes, there are twists, particularly near the end as what you thought was happening turns out not to be exactly the case. Is it conspiracy stuff? Yes, and it’s written for those willing to take the red pill and open their eyes to the reality that things are not as they seem. But if that’s you, then this is the book for you. Why would the wealthiest entities in the world continue to lend money to a nation that can’t pay it back, value for value? Simple, because they expect something else in return, something of higher value. That premise forms the basis for the plot, and it is slowly revealed as something truly frightening. I truly appreciated that the author brought Mises into the discussion, even if it was just a passing mention. The teachings of that great economist are proving themselves more every day, and scenarios like the one painted here arise repeatedly in history when a nation is overcome by debt. The ending is unexpected, but it is on a note of hope for the future, something we need urgently. I unequivocally recommend this book.

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Supplement to Chapter 4 of “Land of the Free” by Krakondack

Here follows the entirety of Chapter 4 of “Land of the Free” by Krakondack (to be e-published imminently), before edits for easy readability.  The Chapter consists of an exchange between President Torres and the Chinese envoy Mr. Zheng.  This is reproduced for those interested in the economic factors influencing the relationship between America and China…..

Chapter 4:  Visit from an Envoy

Torres spent a half hour reading the news on various web sites on his computer.  He enjoyed the coverage given him by the mainstream media but was far too intelligent to treat those obsequious reports as indicative of how the people saw him.  He knew too well that there would be suspicious and critical coverage linked from aggregator web sites, so he checked every day to see what his political adversaries were saying.  Sometimes the attacks were simply laughable, like when they accused him of actively trying to de-industrialize America.  But he had a problem with those who called him a socialist and could not bring himself to understand what their problem was.  The word socialist was a pejorative in America but he was sure that deep down most Americans were socialist in a limited sense, regardless their discomfort with the label.  Nearly every Representative and Senator from both parties voted for progressive social programs to varying degrees, so what did they consider themselves? 

Torres’ private time was interrupted when the intercom buzzed.  “Mr. Zheng has arrived at the White House.” 

“Have him escorted to the Map Room in the Executive Residence” said Torres to the receptionist.  He felt this would be more personal than the Oval Office or the Diplomatic Reception room.  They would serve Zheng some tea and let him make himself comfortable for a few minutes.  Torres finished his last cup of coffee, shut down his computer and paced around the office anxiously, trying to gather his thoughts and his wits.  He did not want to appear agitated at the meeting, but as usual he had too much coffee this morning.  It was easy to do when they kept offering him more.  He imagined the nerves that Mr. Zheng must be feeling, and reminded himself that he always projected authority well.  At last he took a deep breath, checked himself in the mirror, and said “It’s show time.” 

Suddenly cheerful and imperious, Torres opened his door and walked the colonnade to the Map Room.  “Welcome to the White House Mr. Zheng” he radiated, giving the visitor a firm handshake. 

Zheng had been chosen as much for his comfort with the English language and American customs as for his negotiating skills, which were considerable.  His family was originally from Shanghai, but Yu-Xin Zheng had grown up in Beijing with stints in Australia and Canada where his father was assigned as a diplomat.  His English was consequently very strong, with only the softest Mandarin accent.  “Thank you for receiving me at this time Mr. President.”  Zheng smiled at the President and sat down in the chair that had been prepared for him across a small table from Torres.

“Your people said it was urgent” replied Torres, looking Zheng in the eye.  “I can’t stress enough how we value our relationship with the Chinese people.”  Torres consciously used the word “people” rather than “government” when speaking of China, a detail that was not unnoticed by Zheng. 

Zheng appeared to relax back in his chair still holding his teacup in one hand, the saucer in the other, then began.  “I was asked to come here on behalf of the representatives of the Chinese people Mr. President, which have for some time been America’s largest foreign creditors.”

“As America is China’s biggest customer” retorted Torres, hoping Zheng remembered that the customer is always right.

“Mr. President, a conservative estimate of America’s total debt and social obligations is in excess of 50 trillion dollars.  The Chinese are concerned about America’s continued solvency.”

Torres frowned and objected.  “Just a second, our debt to China is less than a trillion, and our total debt is only around 10 trillion.” 

Zheng avoided eye contact but continued.  “Mr. President your total debt is not just 10 trillion, and I’d be happy to explain that to you.  You are correct about the amount of debt owed to China, but our concern is with the total debt.  Let’s face it sir.  When America starts defaulting, your own retirees will not be the first to have their claims defaulted.  It’s clear to us that the first losers will be foreign creditors, of which we are the largest.”

Torres held his pen in his right hand and waved it at Zheng in lieu of his finger.  “What accusations are you making here?  That we’re going to default?  We’ve never done anything remotely like that.  Furthermore, our seniors are funded from a different pool of funds than the general funds of the Federal government.”

Zheng appeared to tighten his shoulders at the realization that an unavoidable dispute had to be resolved.  “Very well Mr. President, we’ll discuss the entitlements.  Can you tell me where the money is for your Social Security and Medicare programs?”

“It’s in the trust funds designated for those programs” replied Torres.

“And do they hold cash and bank reserves?”

“Of course not.  That would sideline too much cash from the economy.  They hold US government securities.”

“Correct” said Zheng, who then looked up straight at the President.  “Those securities were issued in exchange for cash, which was then spent.  All that’s left is the promise to pay it to the beneficiaries, and you first have to acquire the cash from someone else before you can pay them.  By any standard of accounting, that is considered a debt.  And when those debts are added to those you acknowledge, it amounts to more than 50 trillion.  Our concern stems from our analysis of your ability to raise the money you need to cover your debt obligations, government operations, and programs for your retirees.  It is simply an implausible assertion that you can keep all your promises moving forward.  And that brings us back to China’s special concern.  In a default, we expect to be the first to lose.”

Torres leaned forward across his desk and saw Zheng recoil slightly in his chair.  “I’ll say it again Mr. Zheng.  The US government will never default on its obligations.  We are the most reliable financial entity in the world.”

Zheng was intimidated, but undaunted.  He stayed in his seat, motionless.  “You’ve defaulted before Mr. President, though not by honestly declaring your inability to pay.  Anybody who bought long-dated government bonds in the 1960s suffered a partial default by inflation.  This concerns us much more than an overt default.”

Torres was ready to snap.  He threw his head back and visibly rolled his eyes.  “Inflation is the lowest it’s been in years.  You’re losing nothing on the value of your bonds.”

“Forgive me Mr. President, but I must speak the case I was sent to make” replied Zheng, now conscious of Torres’ irritation.  He wiped the palm of his hand on his pant leg then continued.  “Inflation is at all-time highs when it is correctly defined as an increase in the base money supply.  You speak of inflation in terms of prices, which are volatile and are measured subjectively in any event.  We don’t focus on prices because they can change dramatically.”

“Then focus on loan defaults, which are deflationary!” said Torres, barely concealing his anger.  “Every time a loan defaults and a bank has to write it off, money vanishes into thin air.  We’re barely keeping up with that.”

Zheng was not swayed.  “Mr. President, that refers to credit and is irrelevant over the course of 10 years because it too is volatile.  And that is just the problem.  When an economy starts to rely on credit expansion for growth, only two ultimate outcomes are possible.  Either there is a voluntary abandonment of that credit expansion which brings on a deep recession, or a crackup boom ensues resulting in the complete destruction of the currency system in place.  There can be endless rationalization, hedging and trying to walk the fine line between the two, but in the end one or the other will occur.”

Torres remained silent for some time then stood, walked to the window, looked outside and ignored his guest for the better part of a minute. “We’ll just have to disagree on economics.  My advisors are unanimous in their advice, which differs markedly from your argument.  But the reason you came here was to make a case for your government.  If it is as you say, a question of inflation or default – which I do not concede at this time – which would be less objectionable to the Chinese government?”

Zheng tensed up, gripping his tea cup so tightly it rattled against the saucer in his other hand.  He quickly put both down on the desk but he had betrayed his tension and to Torres indicated that this was the moment when Zheng would deliver the crux of his message.  Zheng stood up and walked to the far end of the room, glanced at the art on the walls, then continued:  “The representatives of the Chinese people want neither option, as either one would destroy the United States as customer and world power.  We would like to pursue an alternative form of compensation that does not damage theUnited States.”

“I don’t follow.”

Zheng took a slow step forward, now sensing that he had an opening in the conversation.  “China has strategic objectives in the international arena and the United States is often a major obstacle to their achievement.  We wish to expand our sphere of influence with your acquiescence.  In exchange we will forgive your debt.  I’ve been asked to invite you to negotiate these items with representatives of the Chinese people.  Upon your agreement to negotiate these items, we will appoint a team to come to Washington to work out the specific details to be in play.  We ask that you consult with whomever you need to consult and let representatives of the Chinese people know your willingness to negotiate in one week’s time.”

“So you’re giving me an ultimatum” said Torres in a subdued voice, still standing at the window.  “We turn our backs on our allies for money.  And if we refuse?  Are you going to make the threats, or will those follow at a later date?”

Zheng moved slightly closer to Torres but stopped at about the middle of the room.  “Mr. President, I am but an envoy, and in any event it is the fervent hope of Chinathat it never comes to that.  The Chinese people are faced with the loss of the value of their hard-earned assets.  The money that has gone toChinahas been accumulated by many formerly poor families, at rates of pay Americans would find unlivable.  If this value were lost, it would cause such a loss of social stability in Chinathat my government is frightened at the possibilities.  So we are looking for an alternative arrangement that would avoid the financial ruin of America while giving China something tangible.  Something of value that could create the right circumstances for us to stabilize our society in the difficult years to come.”

“In that case Mr. Zheng, I thank you for your visit.  We will be in touch through the Chinese embassy” said a highly irritated Torres.  “Now if you’ll excuse me” he said as he quickly shook Zheng’s hand, feeling the sweat on the envoy’s palm, then walked out of the room and down the colonnade back to the oval office. 

Back to his office, Torres sat down and started to review the implications of what had just transpired. “China wants us to sell out allies, possibly Taiwan, in exchange for wiping out our debt.  No threats have been expressed yet but they have something up their sleeves, that much is certain.  He typed an email to Mansour Kurdistani instructing him to convene his advisory council for 2 pm that afternoon.  Attendance would be mandatory and any conflicting appointments were immediately to be cancelled.  Kurdi was also told to arrange a working meal at around 6 pm with everyone notified that it could be a late evening of work.  He signed off and added “count me among your attendees.”

Torres then called an all-cabinet meeting for the following morning at 10 am.  Attendance was again mandatory and all conflicting appointments had to be cancelled.  He did not want to face the Cobra right now so he would ensure his unavailability until the cabinet meeting where she had to respect her place.  He then called his chief of cyber security, requesting that the audio recording of his meeting with Zheng be placed in his secure folder on the White House server.  He then walked back to the Treaty Room that he used as his study, ordering his lunch in there.  This would give him some quiet time to collect his thoughts and review the recording of his meeting with Zheng, to make sure he had correctly understood everything the man had said.

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The truth about money, inflation and deflation, part III

Having given the historical context, let’s now to put these factors together to examine today’s dynamic.  The Fed’s balance sheet in 2007 was in the neighborhood of 800 billion dollars, of which perhaps 500 billion was held in foreign banks, and not contributing to the reserves in America’s banks.  That left an effective 300 billion dollars of monetary base available in US banks, against which all leveraged money was created.  M1 at that time was in the neighborhood of 1.5 trillion, about 5-fold above the effective monetary base, which is more than one would conclude if just using the figure of 800 billion as the monetary base without correcting for the amount held abroad.  When the current deleveraging cycle started, the Fed, not willing to let big financial institutions go bankrupt, bought mortgage securities directly, swapped them for T-bills at face value, and bought new T-bills, engaged in “quantitative easing”, whereby they bought longer-dated Federal debt, all combining to swell the balance sheet to today’s 2.4 trillion.  I don’t have access to what component is overseas, but for now will assume it is still about 500 billion.  So the effective monetary base has gone from 300 billion to 1.9 trillion, more or less.  Yet M1 is stagnant, and even shows occasional signs of shrinkage.  This has many stymied, and our friend Ambrose Evans Pritchard again calling for deflation.  Do note however, that this time he shows some interest – hence the title “The Death of Paper Money” – in the possibility of hyperinflation, and the article recalls the dynamic at work during Weimar Germany’s episode of hyperinflation.  Even the estimable Bill Bonner is now predicting that “The de-leveraging period will be longer and harder than people expect…leading to spells of deflation…”.  So how do we explain what is happening?

The first item to explore is the increase in monetary base.  It has indeed increased from an effective 300 billion to 1.9 trillion, an increase of 1.6 trillion.  But of that 1.6 trillion, about 1.1 trillion has never left the Fed.  See this graph from the St. Louis Fed.  What it shows is the reserves held by banks that are retained at the Fed, to secure the capital structure of the bank, and never loaned into the economy.  The Fed does not own the money, the banks do.  They could withdraw it at any time but they have chosen not to.  The Fed pays interest on the money, about 0.25%, that it did not historically pay, which is apparently enough incentive to keep the money out of the economy.  Also notice that the graph, going back to 1950, was at close to zero for the whole period up until the current financial crisis, when it rocketed over 1.1 trillion.  This is so highly unusual that it may be right to read into it.  Bernanke’s first responsibility is to keep the big banks solvent, and his second is to keep the depreciation of the dollar slow enough not to cause economic disruptions.  He did this in the first instance by swapping the Fed’s T-bills for worthless mortgage securities at face value.  He is now in a quandary.  He can’t return those mortgage securities, because the banks won’t take them.  Even if he could force the issue, that would again undermine the banks’ capital.  So the money belongs to the banks, and he can’t get it back.  So what is keeping the banks from taking that money and lending it into the economy?  We can’t know if he has any other threats up his sleeve, and I’m open to there being something along those lines because of the absolute avoidance of any withdrawals of that money.  But for the most part, it is fear that keeps the banks from lending.  They fear deflation.  They see that M1 is less than the monetary base, a highly-negative money-multiplier.  Like Penguins on an ice-floe, nobody wants to be the first to jump off, lest there be a shark waiting. 

Of the additional 500 billion in new monetary base (the difference between the 1.1 trillion excess reserves and 1.6 trillion in new monetary base) that does not correspond to excess reserves, about 300 billion was used to buy longer-dated government debt (Quantitative Easing, it was called), putting it in the hands of government to spend directly, and about 200 billion more is not clearly accounted-for.  It is fair to assume that the amount of the QE made its way into the economy, but it’s not clear at least to me, about the 200 billion left over.  If the pre-crisis effective monetary base was about 300 billion, then it has likely doubled now, but M1 is still flat, and bankers fear deflation.  It appears that the goal at the Fed all along was to maintain M1, which they don’t directly control, by making up for the loss of M1 by loan defaults with new money in the monetary base, which they do control.  I think they would never let true deflation happen, and I think they are holding back most of the money they have created, in case it is needed.  Even the official reports of occasional minor deflation should be taken with a grain of salt, since the measures of inflation have changed radically over the years, effectively understating true inflation numbers. carries the numbers measured by previous methodologies, and they constantly show positive inflation in the 5-10% range, something that agrees with everyday people’s experiences.  But assets are deflating, and that is what worries banks, for the danger that creditors will default on mortgages en masse.  Everything possible will be done by the Fed to prevent this, even if it means taking things too far, and even if it means the real estate market stays highly illiquid because prices are not allowed to equilibrate to where they are affordable. 

So will they succeed?  The market does not give you what you want, but what you deserve.  With Bernanke waffling about all that extra money waiting at the Fed, and the continuing correction in the economy, it is likely that assets will continue to deflate for some time, as Bill Bonner predicts.  But the situation is highly unstable:  Too much deflation and defaults will pick up, right when commercial real estate is going through a difficult time.  The reaction to this could be as simple as discontinuing the paying of interest to banks for their excess reserves, or it could be further quantitative easing.  The point is that pressure will mount on the Fed to ramp up their inflating of the monetary base.  At some point, they will overcome the reticence of the market, and that is when the money multiplier will turn positive.  Pritchard noted that in the Weimar hyperinflation, money printing for the first several years had no effect on prices, since the money sat unused as people were fearful.  When it finally hit, the inflation caught them by surprise because it had not come earlier.  Likewise today, the justification for further inflation is that “price inflation expectations are low, so it is safe to inflate the money”.

When the first incipient inflation hits, itwill also likely be a surprise to the Fed, who will note that unemployment is too high for inflation to really take hold (ignoring or excusing the lesson of the 1970s).  They will not react before events spiral out of control.  They will not be able to take away the 1.1 trillion in excess reserves, because they don’t have quality assets to sell in order to repatriate them.  They could sell them at a severe loss to limit the damage, but that would require an admission of a terribly embarrassing fact – that they took junk as collateral – and they are unlikely to do this.  The Fed is hampered in many other ways, that Alan Greenspan likely foresaw, as outlined in part II.  It now holds debt of longer maturity and lower quality, and lacks the credibility that they could effectively and quickly shrink it.  The 1.1 trillion in excess reserves will be loaned into the economy, as will all the other money that has sat on the sidelines.  It is possible to get to mass inflation with these factors alone.  If the US dollar then collapses, it could cause a secondary effect, that of the whole world synchronously dumping all the dollars they have accumulated over 60 years.  The world’s accumulation of these dollars blunted the price effects of past inflation, again with the people responsible no doubt assuring themselves that they had “gotten away” with that past inflation.  But if it all reversed, it would only add gasoline to the fire of price inflation.  If all the current 2.4 trillion in monetary base makes it into the economy at a multiplier of 5, it would balloon M1 to 9-fold greater than it was pre-crisis.  Even at much lower rates of money entering the economy, it is easy to see price inflation hitting the neighborhood of 100%.  At that point, what happens is a political decision.  The time it takes to collect taxes allows the depreciation of the dollars used to pay those taxes, and costs of programs and wars the government chooses to wage will escalate substantially.  The deficits in the federal budget would explode to 70-80% of the budget.  If the US government decides that its spending is too important to sideline, and borrows the deficits, the Fed would be forced to buy most of the debt, which will lose its natural market in such a crisis.  This will be the last tipping point into hyperinflation.  But it is avoidable.  It would require retrenchment, severe budget cutting, and a deep depression, but the crisis would be over in a matter of 2 years or so, if past history is a guide. 

In conclusion, deflation is a myth.  It is not upon us, other than the correction of seriously overvalued assets which were not in any case considered inflationary when they were appreciating.  Even with assets, the Fed will not let the deflation run its natural course, and will continue to inflate money in order to prevent this.  At some point, M1 will turn positive, very likely quickly, and the Fed will be first surprised, then powerless, to stop it.  Mass inflation will ensue, which will require a deep depression to correct, though that will be preferable to the alternative.

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The truth about money, inflation and deflation, part II

The scenario described in part I was not altogether attractive to the banks, who although they could loan out receipts for gold coins they did not have, thus creating money and charging interest on that money, they still faced the downside when deleveraging hit, and their prosperity could turn to ruin.  This led first to the creation of the Federal Reserve and other central banks, then to the elimination of the right of the depositor to withdraw the gold coins backing the money.  Gold still played a role in international exchange for a while, but that too was eliminated by Nixon, and there has been no link between money and gold since.  Now the money was issued by the central bank, and that was the backing for all loans.  Most people lose the ability to follow at this point, but just substitute the gold coins in the earlier scenario with Federal Reserve Notes (FRN), or their electronic equivalents, excess reserves held by banks at the Fed.  What used to be receipts for gold was now just receipts from central banks.  The same principles still hold, but there are a few points unique to Fiat money that could not hold when a scarce commodity was the backing for money. 

Banks today make loans from their reserves of FRN or excess reserves, and still create money in making loans, inflating the effective money supply.  Because banks are required to keep minimum reserves, the amount of money they can create is limited as a multiple of the amount of FRNs they have.  There are two relevant measures that track these amounts:  The Fed Balance sheet, or adjusted monetary base, measuring the total FRNs and excess reserves in existence, and M1, which is a measure of credit in the economy as created by banks.  The correspondence between M1 and total credit is not perfect, and additional measures to track effective money supply have been devised, including M2, M3, and MZM.  But M1 is the best measure for price inflation, and behaves as a good proxy for credit (again, acknowledging that it is not strictly a measure of credit).

The Fed’s balance sheet represents the number of FRNs or excess reserves the central bank has created in order to pay for assets the bank has acquired.  In principle, the two halves of the balance sheet should be equal, and at least in theory, the Fed could shrink the balance sheet at will by selling the assets it has acquired, and in the process reclaiming the FRNs it had previously issued.  When this has credibility, then it gives the market confidence in the currency, since shrinking of the balance sheet would severely curtail M1, and deflation would ensue.  In practice, the Fed used to buy Treasury bills in exchange for FRNs, and constantly roll over the short-term bills for new ones, maintaining its balance sheet on short-term US government debt, which again added to the credibility of the central bank, since in theory, it could in short order bring the balance sheet down over one maturity cycle of US government debt, only a matter of months.  It should not be overlooked here that the amount of money in the economy was therefore limited by the amount of US government debt.  This is the biggest difference to take place over the past 100 years:  Money used to be backed by precious metals, where it is now backed by debt.  In 2001, Alan Greenspan gave a speech warning of the surpluses being run at that time reducing Federal debt to “an irreducible minimum”, and how it would have negative impacts.  He couched his words as he always did, but that was giving him reasons for panic:  He would have lost control of the money supply without Federal debt, and in fact the FRNs that had purchased that debt would be returned to the Fed, shrinking the monetary base or forcing it to purchase private assets to keep FRNs in circulation.  Greenspan no doubt saw the troubles it would cause if the Fed held corporate bonds or even stocks, distorting markets and inviting corruption into the decisions of which bonds and stocks would be held.  Further, it would pose problems if the Fed had to sell stocks, depressing their prices, and with corporate bonds, terms of maturity would be greatly longer, and there were risks of default, impairing their ability if called-upon to re-absorb the FRNs, to uphold the credibility of the Fed.   If the markets could doubt the ability of the Fed to stop monetary inflation, it was thought that the risk of inflation would cause what was then coined as an increase in “inflation expectations”.  It was about the power of the Fed to shrink the monetary base, something they rarely if ever actually did, but the threat of which was their major weapon.  Greenspan was heard, and government quickly put an end to those surpluses, one might say with ever-greater efficiency.

But the Fed’s balance sheet is not the principal regulator of prices; that role belongs to M1.  Yet the Fed only controls the balance sheet, or the monetary base.  M1 is a good measure of the amount of money effectively at work in the economy.  I’ll stay away from the formal definition for now, but for monetary base to become M1, banks need to make loans, and in the process create money.  The relationship between monetary base and M1 is called the money multiplier, which is a measure of the amount of leverage at work in the effective money supply.  The money multiplier is highly negative right now (more in part III). 

When the Fed tightens monetary policy, which usually manifests in slowing the rate at which the Fed acquires new T-bills rather than actually selling them, this makes FRNs scarce, causing increased competition between banks to acquire them, and hence higher prices for them in the form of interest rates.  But interest rates are just the measure, the real quantity is the supply of FRNs.  With those limiting, banks are not able to make new loans and still maintain their minimum reserves, which shrinks the number of loans outstanding, and M1 shrinks as a result.  The monetary base usually does not shrink much.  Paul Volcker shrank the monetary base very slightly over 3 months, and interest rates rocketed.  It has not been done since then.  When the Fed loosens, it increases the availability of money by buying more T-bills, which increases the supply of FRNs, and therefore the reserves against which banks can make loans.  But it does not force the banks to make loans, still a voluntary activity, which is why loosening is often referred to as “pushing on a string”. 

In part III, today’s picture.

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The truth about money, inflation and deflation, part I

Everywhere you look, you see arguments about whether the bigger risk is inflation or deflation.  Amrose Evans-Pritchard never goes more than a story or two without warning of the perils of a deflationary spiral.  We hear constant stories about deflation hitting the markets, with even Roubini Global Economics joining the fray.  But by far the most predictable reaction you will get will be from bankers, who fear deflation more than anyone, which at first seems implausible since loans owed to them become more valuable if deflation hits.  But is there really any deflation?  And if there is, should we be worried?  The true answer to both questions is NO. 

Inflation or deflation as their true definitions go, refer to an increase or decrease in the money supply.  For the first 4,000 years or so of civilization, money was simply the most marketable commodity; something that just about anybody would take in return for his goods or services, because he knew it would be useful in getting what he needed later.  The money supply was easy to measure:  It was the sum of all the circulating gold or silver coins that were used in exchange.  If nobody kept track of that number, it did not matter, since they were always scarce and valuable.  There were times when rulers debased their coins, or clipped portions of each coin to make more, and that usually led to a financial crisis that brought down the ruler.  Of course, the fact that he had to resort to debasement in the first place probably meant that he was in trouble to begin with.  The one big disruption in money supply came in the 16th Century when Spain stole all the gold from Central and South American Indians, brought it back to Spain, and spent it into the economy.  What happened was obvious from the vantage point of history, yet the same principles apply today.  The “wealth” of Spain, measured as all the goods and services that were available for purchase, did not change much when all that extra gold came to the country.  Yet the medium of exchange, gold, was inflated substantially.  Where before there was 1 dubloon bidding for that keg of wine, now 2 dubloons could bid for the keg, since there was more gold.  Naturally, the one bidding 2 won over the one bidding 1.  Thus the price for wine doubled, and the same happened for every other good and service that was in demand.  In not too much time, the wealth had trickled down to the citizens from the royals, and they all had more money, but were no richer because there was no more stuff available than before.  But the rest of Europe did not have access to all this gold, yet they understandably wanted a chance to get their hands on some.  So they sold stuff to Spain at pre-inflationary prices, which still prevailed throughout Europe.  It did not take long before most goods were imported, since Spain could not produce at the low prices the rest of Europe could produce at.  Productivity in Spain fell dramatically, and increasingly more brazen imperial adventures were required, bringing back more Central American gold, to continue to fund a country that now operated on a strong trade deficit with the rest of Europe.  And so it went, that Spain stopped producing, instead importing their goods, paid for by the flood of extra gold that was coming in.  Sounds like a good deal, if you can sustain it, which of course was the problem – they could not sustain it.  The gold ran out, the bills could not be paid, and Europe kept the gold and its goods, while Spain went into a deep depression for an extended time.  What happened to Spain is that in the beginning, the money supply was inflated, creating imbalances between those who had the new money and those who did not, leading to increases in prices locally where the money was, then the loss of competitiveness to those who had no money.  This could be sustained so long as ever-increasing amounts of gold made their way into Spain to fuel ever-increasing monetary inflation, to keep the rest of Europe producing so Spain could consume.  Being that Spain was using gold, which is scarce and readily depleted, they ran out of gold.  At that point, the unsustainable nature of Spain’s economy became obvious, and the depression hit.  One could say the “bubble popped”, because the dynamic was very much that of an economic bubble, though the focus of the bubble was Spain’s empire.  From this we learn that the bubble that starts when currency is inflated always ends badly, because of the imbalances it creates, and the unsustainable nature of the flow of money from the source.  Had Spain been using paper currency, they could have kept it going a lot longer, to the point where the currency itself would become without any value.  Gold however, was favored as money because it is limited, and even with this once-in-history surge in supply, it still could not be sustained indefinitely.  Spain’s bubble burst when they ran out of currency, but in other circumstances, the bubble bursts when the currency itself loses all value.  This is in essence the insight that Ludwig von Mises brought to economics some 300 years later, and which mainstream economics has somehow lost.

Over time, with the development of banking, receipts for gold issued by banks or governments became the most marketable commodity, with advantages over using gold coins.  They were called Francs and Dollars, or other names, but they represented gold (or silver) coins that could be redeemed at will, at a fixed exchange rate.  You could not have significant inflation or deflation so long as gold coins were the basis for exchange.  If I deposit 100 gold coins in my bank, which lends those coins to a creditor, who defaults on the loan, then the bank, or I, have lost 100 gold coins, but those coins still exist, and someone else has them, so the supply of money has not changed.  But banking like this is not conducive to making a lot of loans, which is not good for bank profits.  So the bankers made use of the fact that most people trusted them to have on hand the gold coins they deposited with them, and rarely withdrew them.  The bankers loaned out receipts for a  portion of those coins, which meant that they no longer had title to all the coins they promised their depositors they had.  The one who borrowed the receipts for gold coins may have transferred them to another bank, and that bank may or may not have called in the actual coins from the first bank.  The coins only existed once, but receipts existed twice.  This increased the effective money supply.  If the bank of the borrower also made loans with the coins they had called in, then a third set of receipts were created for the same coins.  When everyone is dealing only with receipts for the coins, nobody can know from personal experience the degree by which the money supply has been expanded, but entrepreneurs who had developed a business plan and acquired money to make it come to fruition would find that it was insufficient, as capital goods and labor that they had planned for would be costlier than expected, the result of more money in the economy competing for a relatively stable supply of goods and services.  They had now experienced price inflation.  The bankruptcies that result from business plans becoming unrealistic would mean loan defaults.  When a bank has issued receipts for gold as a loan, and that loan defaults, the bank has to write off the value of the loan from its list of assets.  But it still retains the liabilities represented by the receipts for gold they had issued.  So long as everyone pretends this is not a problem and everyone accepts receipts for gold at face value, the system can work a little longer.  But with the defaults brought about by the inflation, one bank or another is going to call in the receipts of other banks, to bolster their reserves, or to redeem receipts for gold to their depositors.  The situation becomes very unstable, and one trigger event will cause a wave of redemption.  At that point, it becomes clear that the vast majority of gold receipts are not backed by coins, and the wave turns into a panic.  The first to come to the bank to redeem their receipts get their gold coins, but after about 10% of depositors, there are no more gold coins.  The receipts are now worthless, and only the coins themselves are of value.  This has resulted in a rapid reversal of the initial inflation, and deflation of the money supply.  The economy will likely seize up for a period of time, until new banks are opened, or surviving ones with credibility draw the holders of gold coins to deposit them and again making loans with a portion of the deposit.  But note that the actual monetary base, being the number of gold coins in existence, has not changed.  Only the receipts for gold, which were never fully backed by gold, became worthless to the extent that they could not be redeemed.  So while there was deflation, and we can assume a total withdrawal of all gold and redemption or default of all gold receipts, there was a floor to this deflation, and it could never become a spiral, dropping below the level of existing gold coins, or of the pre-inflation money level.  Any milder panic would have less deflation.  This is the business cycle as it came into being with fractional-reserve banking, where money creation unbacked by precious metal would alternatively inflate and deflate the money supply.  Prices generally followed, offset by other factors in the economy such as productivity increases. 

In part II, I’ll discuss the role of fiat money, and how the situation works in today’s financial structure.

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