I am mildly annoyed every time I hear someone say "stimulus bill" with a straight face.

In order to get to the bottom of all of this, there are a few realities we need to consider:

There are a lot of charitable causes in the world. Heaps. Tons , even. The one that gets my support these days is the Electronic Frontier Foundation ("EFF"), "the leading civil liberties group defending your rights in the digital world." I know, there are a lot of causes out there that might feel more immediate - curing cancer, say, or providing service animals to the blind. That’s easy; everybody can get behind those causes. I can explain to my grandmother that blind people get along better with a dog, and she’ll pony up twenty bucks. On the other hand, if I tell grams that the EFF is behind the lawsuit to hold AT&T accountable for facilitating illegal NSA spying , or that they’re safe-guarding the future of cultural innovation , I’m going to be rewarded with a blank look. So here’s the thing - because I do understand what EFF does, and why it’s important, I’ve got a responsibility to support them on behalf of myself and those that are unwittingly protected by them .

And so do you. At least, I hope you think so, because EFF needs your help. To quote a recent email I received, "[d]ue to the tough economic times we are all experiencing (and maybe folks with spare cash to spend on activism feeling tapped out after the election), EFF is not getting the usual end-of-the-tax-year donation love." As a result, this non-profit organization that, to the best of my knowledge, never charges their clients for representation, is coming up short. Trust me on this, there are a lot of top-flight lawyers at EFF that are working waaaaaaaaaay below their market value because they believe in what they’re doing, but they (and EFF as an entity) still have bills to pay.

Please consider becoming a member of EFF. You can become a member here and get cool swag to boot, or just buy yourself some cool swag here . My personal favorites include the metal Bill of Rights card to set off airport security ("fun" fact: nobody will tell you under what law you’re being searched at the airport. It’s a secret. Now read the 4th Amendment .) and the mini LED flashlight specially designed to reveal the hidden tracking dots produced by laser printers . Whether you buy stuff or not, though, you really do owe it to yourself (as someone savvy enough to, at a minimum, read this blog) to help support this vital organization. Join EFF !

Bonus for reading this far: I’ll blog more about this later, but read Cory Doctorow’s latest collection of essays (c)ontent, about some of these very things, for free! Cory releases his books under a Creative Commons license, so this is a legal download of the entire book . Some % of you will buy it, of course, which is the point. I say "bonus," but it’s not like he’s doing this just for me - it’s just something I figure you don’t know about.

In other posts, I have written long expositions of why we are in a financial crisis. I have decided to write several short posts on the subject as well.

The root of the problem is counterfeit money. I’m sure that’s a statement worthy of a double take for most people, but it is true.

In today’s world, there is not very much difference between debt/credit and money. If you write a check to someone saying your bank owes them $100, that’s pretty similar to giving them a $100 bill. Businesses buy and sell debt like they buy or sell anything else.

Now, a relatively easy way to make money is to convince someone that some debt is good, and sell them the debt. If you know the debt is bad, this is really a form of counterfeiting. For those interested, here’s another take on the problem.

An everyday example of counterfeiting debt is writing a bad check.

Now there are three forms of debt we care about:

• Debt that will be paid back, or good debt.
• Debt that is good debt now, but will go bad later.
• Debt that is bad now.

And they directly correspond to:

• Money.
• Counterfeit money that will magically become worthless in the future.
• Counterfeit money that people realise is counterfeit, and won’t accept.

The housing boom, mortgage backed securities, credit default swaps, etc. was all about making counterfeit money, whether it be intentional or unintentional. Mostly, it was in some grey area really close to "intentional". Now, those same institutions dealing in this counterfeit money have been caught by their own creation.

That was the root of the problem.

The problem now is that lots of institutions are now holding counterfeit money that has turned bad, and they do not want to admit that they are bankrupt. Similarly, they are afraid to do business with other institutions, because they suspect those institutions have the same problem. They like to claim that they can’t sell their debt at the correct price, and that their "assets are illiquid". That is not true, if they were willing to sell those assets for what they were worth, they would sell like hotcakes.

Any bailout attempt that does not force businesses to come clean about how much counterfeit money they hold is doomed to failure. Markets will be frozen until trust is restored, and trust will be restored when institutions are forced to come clean, and not a second sooner.

Authorities are trying to paper over the problem by providing "liquidity"; that is, lending money for short periods to those in trouble. This is a fool’s errand, as I will cover in another post.

It seems that banks are now so afraid that their counterparts are insolvent, that they are not accepting letters of credit from other banks. This is a bit like a bank refusing to cash a check because the check draws on the account of another bank.

This is bad, because letters of credit are used as part of shipping goods around the world and within countries.

When letters of credit start failing, goods stop moving. Imagine not being able to buy food at your local store because it is empty, and not being able to drive to another because the gas station is also empty.

That is the logical end point for what is happening now.

Let us hope that the desire to make money keeps enough credit going that everyday life is not too badly impacted.

For more information, see:

http://www.nakedcapitalism.com/2008/10/international-trade-seizing-up-due-to.html

Where are we, why are we here, and what will happen? This post is my attempt to answers these questions as simply as I can. I have broken this post into three parts for ease of presentation.

This post will link to several other posts that will expand on a point. I will add links as time goes on, so please check back often.

Before I start, it’s important to point out that money and debt are almost the same thing in today’s world. If you have $1000 in the bank, your bank statement records that the bank owes you $1000. The bank is in debt to you for $1000. Companies buy and sell debt like they sell anything else. In today’s world, the easiest way to counterfeit money is to create bad debt and sell it to someone else before they realize that the debt is bad. If the debt changes hands many times before it goes bad, it may not even be possible to figure out who created the debt in the first place and if they knew the debt was bad. With that in mind, please read on.

Why are we in this economic crisis?

Because the shadow banking system (investment banks, banks and hedge funds) “counterfeited” a large amount of money over the last five years, by creating bad debt.

If someone was counterfeiting US Dollars, why didn’t the value of the dollar go down relative to other currencies?

It did. A lot of the counterfeiting went on in other currencies too, so it didn’t go down relative to other currencies as much as it could have.

If someone was counterfeiting US Dollars, why didn’t we see lots of inflation?

We did, but most of the inflation was hidden in house prices, and the US Government reports inflation in such a way that ignores this, which produced artificially low inflation numbers. The rest of the inflation was expressed in bank leverage ratios, but most people ignore this.

So why are we having problems now? Isn’t the actual problem some kind of credit crunch?

Aaah. Now we start getting down to the meat. In today’s world, money and credit are almost the same thing.

The shadow banking system managed to create lots of counterfeit money (credit) using various credit tricks. But, like some kind of fairy gold, the money eventually turns back into something worthless. The problem is that everyone had been using the fake money. It’s everywhere.  Now that that money is evaporating, everyone is afraid of three things:

1. That they are bankrupt, because all their money will evaporate.
2. That the people they do business with are bankrupt.
3. That any money they get from other people is actually fairy money.

So the fundamental reason for the credit crunch is a lack of solvency, and a lack of trust?

Yes! Large parts of the shadow banking system decided to use its own fake money, and it will probably kill those parts. They reasoned that if it ever looked like it would evaporate, they would get out before anyone noticed. Entities that are bankrupt are desperately trying to hide it, and all entities are refusing to do business, because they don’t know who is bankrupt.

So what’s all this about house prices then?

Mortgages were used as one of the primary ingredients in making the fairy money. Everybody was selling mortgage debt to everyone else, and using the debt as collateral to borrow more money. If bankers were turning lead into fairy gold, you could say the mortgages were the lead. This dramatically drove up the demand for lead, which increased its price and made it quite valuable. So, lenders did everything they could to make mortgages. ie. They lent to everyone they could at whatever rate they could, then sold those mortgages on to other entities to use in their counterfeiting operation. The next stage was to make “Mortgage Backed Securities” using the mortgage.

So what is this I hear about “Mortgage Backed Securities” being “illiquid”?

It’s a polite lie. The mortgage backed securities are part of the counterfeiting method, and they are now worth very little. They are fairy gold and everyone knows it. You cant sell the stuff more for than a few cents on the dollar. However, if you were willing to sell it for a few cents on the dollar, it would sell like hotcakes. It’s not “illiquid”; it’s just that the people who own it aren’t willing to sell it at the correct price.

So everything will be alright if we get the price of houses back up?

No. In the end, what matters is whether people can pay the mortgages off that they have bought. Any variation on them not being able to pay the mortgage in full means that the fairy gold turns back into lead.

Because it was so easy to “buy” a house, lots of people did it. Because it was so easy to get so much credit, they paid far more for the house than if reasonable amounts of credit were available. In the end, the houses are simply too expensive to be paid for. It is not possible for people to pay of those houses. It can’t happen. If house prices were magically restored to their peak values, nobody could buy them because there is no longer any way to make it possible to buy them. Meanwhile, those currently holding the houses would be in as much trouble as they were before prices started crashing.

So how do we make houses affordable?

Easy. We let the prices go down. Making it easier to borrow money just makes everything more expensive as people are willing to pay more for the same item. This just turns people into debt slaves.

So what does the future hold?

It depends on what the government does. There are three basic outcomes that could occur:

1. We have a deflationary crash.
2. We have an inflationary crash.
3. The US Government is forced into bankruptcy and defaults on all debt, making the US Dollar worthless.

Outcome (3) could actually happen in parallel with outcome (1) and (2).

I have presented the most extreme outcomes. In reality we’ll get something between 1 and 2, with potential for 3.

So which will happen?

It very much so depends on the US Treasury and the Fed (A private bank with a federal mandate). To date, they have been claiming (and may even believe) that this is a liquidity problem. That is, they claim that there is plenty of money, but it’s just not free right now to move around. If they pump more money into the system, then money will start moving around and all will be well. This is untrue unless they replace all fairy gold with real money.

So the current government solution is to replace all the fairy money with real money?

They would like to do that, but it’s probably not possible. There is too much fairy money out there. Also, real money has value because it’s hard to make. The US Government makes our money by selling treasuries (debt) to other countries. The other countries pay us for those treasuries, and we use the money they give us to make US Dollars. However, the US Government has to pay interest on those treasuries, and eventually the treasuries expire and the US Government has to take them back and give the foreign countries back their money.

So a “treasury” is a way to get money from someone else and then pay rent for the use of the money?

Exactly. If I sell you a treasury, you give me money for it, but for as long as you hold the treasury, I have to pay you rent. You can think of the treasury as a rental agreement, but you’re renting money, not a house.

But what does the US Government use to pay the rent?

Your taxes. The US Government can choose to not borrow money and just use your taxes directly. But, if they do borrow money, they pay rent on that money using your taxes. And, they have to give the borrowed money back eventually, too. If they borrow too much money, they have to increase taxes or not be able to pay the rent.

So the US Government would have to borrow money in order to replace the counterfeit money, and our taxes would pay the interest on the borrowed money?

Yes. However, there is a LOT of counterfeit money out there. It will be very hard for the US Government to borrow enough money. Eventually everyone else will be afraid that US tax income won’t be enough to cover the interest payments. So, they will demand higher rent on new money to cover the risk, which will make it even harder to borrow the money.

Continue to Part 2