The Fiscal Cliff Reality

The “fiscal cliff” is another attempt to shift the attention of the public from huge problems to small ones.  The automatic spending cuts and tax increases were intended to reduce the deficit but instead it will be only by an insignificant amount over next ten years.

The problem is that you cannot legislate austerity to a faltering and recessionary economy.  This provides the setting to turn the Great Recession into the Great Depression of the Century.  The fiscal cliff is small compared to the Derivatives tsunami, Bond market bubble, or Dollar market bubble. (See previous blogs)

The fiscal cliff requires that the federal government cut spending by $1.3 trillion over ten years.  This means the federal deficit has to be reduced about $109 billion per year or 3 percent of the current budget.  The Derivatives tsunami and the other bubbles are of a different magnitude.  According to the Office of the Comptroller of the Currency’s fourth quarter report for 2011, about 95% of the $230 trillion in US derivative exposure was held by four US financial institutions: JP Morgan Chase Bank, Bank of America, Citibank, and Goldman Sachs.  The commercial banks became casinos, like the investment bank, Goldman Sachs, betting not only their own money but also depositors money on uncovered bets on interest rates, currency exchange rates, mortgages, and prices of commodities and equities.

The exposure of the 4 US banks accounts for almost of all of the exposure and is many multiples of their assets or of their risk capital.  Today these four US banks have derivative exposure equal to 3.3 times world Gross Domestic Product.

The entire economic policy of the United States is focused on saving four banks that are too large to fail.  The purpose of QE1,2,3… are to keep the prices of debt, which supports the banks’ bets, high. The Federal Reserve claims that the purpose of its massive monetization of debt is to help the economy with low interest rates and increased home sales.  But the Fed’s policy is hurting the economy by depriving savers, especially the retired, of interest income, forcing them to draw down their savings.  Real interest rates paid on CDs, money market funds, and bonds are lower than the rate of inflation.

Moreover, the money that the Fed is creating in order to bail out the four banks is making holders of dollars, both at home and abroad, nervous.  If investors desert the dollar and its exchange value falls, the price of the financial instruments that the Fed’s purchases are supporting will also fall, and interest rates will rise. The only way the Fed could support the dollar would be to raise interest rates. In that event, bond holders would be wiped out, and the interest charges on the government’s debt would explode.

With such a catastrophe following the previous stock and real estate collapses, the remains of people’s wealth would be wiped out. Investors have been deserting equities for “safe” US Treasuries.  This is why the Fed can keep bond prices so high that the real interest rate is negative.  If the “bond vigilantes” finally surface, it will be all over but the shouting.

In the meantime, under the disguise of the threat of the fiscal cliff, lawmakers will try to destroy the social security safety net.  There is no substantial job creation, real family incomes have been declining for decades, and wealth and income have been concentrated to a few.  Historically, this environment produces major changes in a society.  Change IS coming!

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