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Dear Diary,

The Dow rose 288 points yesterday, or 1.7%. Gold was flat, despite further dithering from the Fed on when it will raise interest rates.

Last night, we dined with the head of the SEC. Actually, Ms. White dined at the table next to us. But it made us feel as though we were among the movers and shakers in the zombie capital.

The Occidental Grill & Seafood is a landmark restaurant in D.C. For about $120, you can eat reasonably well and spot the powers that be in the room.

Off the Record

The following morning, we joined a meeting of some of the city’s leading conservative activists.

“Everything is off the record,” warned an earnest young woman.

Among the things off the record was an insight into college campus rape.

“These are much less common than you think. I’m not saying it’s not a bad thing. It’s a terrible crime. It’s just not that common. The left is just using this as another way to push its agenda on college campuses.”

This was just one of many skirmishes the conservatives are fighting.

Another activist offered a comment on the “CRomnibus” bill – the pork-laden $1.1 trillion budget bill Congress approved at 1 a.m. on Saturday morning.

“We have to give our colleagues credit. There were about 50 different things in there that were good for our side.”

What they were, he didn’t say. And no one asked. But when you spend a trillion dollars in the dark of night there are bound to be a few presents under the tree.

At least one speaker was eager to “get the word out” about the CIA’s enhanced interrogation program:

“Torture is defined as inflicting pain. Waterboarding is not painful. So, it’s not torture. Our own soldiers undergo this as part of their training.”

Another speaker wanted to let us know that there would be a major gathering of “our side” coming up.

The conservative movement sponsors a large convention each year, he explained.

“This will give us a chance to tell people what we believe…”

What do you really believe? was the question we didn’t ask. Many at the meeting seemed ready to believe anything.

Were these men and women brave zombie fighters… or zombies in disguise?

We weren’t quite sure.

Capitalism Without Capital

But we need to move on – back to our crash course in money.

Today… the fourth installment on macroeconomics: the big picture in all its splendor.

When we left you on Monday we had just laid the keel. Today, we put on the sides and see if this baby will float.

In 1950, Diners Club introduced its first credit card (or “charge card,” as it was known then). Eight years later, American Express launched its own credit card network.

Aided and abetted by the new fiat money system that followed the “Nixon Shock” in 1971, other credit innovations followed: low-doc mortgages, mortgage-backed securities, subprime energy debt, “nothing down” auto finance… and so on.

This produced an entirely new monetary system: capitalism without capital!

You no longer needed real money. You could live… invest… do business… all on credit. And without any anchor to gold, the amount of credit banks could create was infinite (in theory at least).

There was about $1 trillion of credit outstanding in the US in the late 1960s. By 2010, the country had about $59 trillion in credit. Of this, about $33 trillion was “excess.”

Why excess? Because if the ratio of debt to GDP had remained at 1.4 – its average for the first seven decades of the last century – there would be only $26 trillion in debt.

Never before in the history of money had so much spending power come from nowhere.

Since the advent of a pure fiat money system in 1971, money no longer has to be earned… or saved.

Now, banks can create credit (money) at will. When your monetary system is backed by gold, the money supply is limited; there’s only so much gold. When you abandon gold backing, the sky is the limit.

The problem this presents is obvious: The more credit, the more debt.

And the more debt there is, the more claims you have on the output of the economy. This is as true for individuals as for economies. They both reach a point where they can’t afford any more debt. They just don’t have the earnings to support it.

Kick the Can

This point came for Americans in 2008.Households had too much debt – in particular, too much mortgage debt. When house prices fell, the value of borrowers’ collateral fell too. This put the entire mortgage finance industry in jeopardy.

This was a correction. The excesses of the housing bubble were being corrected in the classic way. Bubble gave way to bust.

But instead of allowing the correction to take its course, the U.S. government and its central bank, the Federal Reserve, stepped in. They were determined to stop the contraction in the only way they could: by sponsoring further credit expansion.

Readers may raise their eyebrows and clear their throats. Can you really fix a debt problem with more debt?

It won’t do you any good to wonder. Part of the mythomania of modern economists is that every slowdown reflects a lack of demand and that demand can be stimulated with more credit.

It’s a long, boring discussion. Let’s skip over it. The essential point is that the feds are hell-bent on keeping the supply of credit growing.

They believe – correctly – that a credit contraction would be devastating.

Whether or not they believe they can hold off a contraction forever, we don’t know. But we have no doubt they think they can kick the can far enough down the road that it will be someone else’s problem.

The open questions are: When will we come upon the can? And then what will happen?

We can reduce the macroeconomic situation to the following:

After 60 years of credit expansion, we now have too much debt (too many claims on output). The natural, market reaction is a credit contraction. But the feds resist. Like “rectal feeding” of a fat man, central bankers are making a grotesque situation worse.

This puts you as an investor in a difficult position. You face the irresistible force of a credit market deflation on one side… and the immovable object of central bank credit inflation on the other.

So what’s ahead? Inflation? Deflation? A catastrophic collision?

More to come…

Regards,

Bill