By far the biggest question facing the global economy is where the money supply will come from going forward.  Money is debt, and money is really only created when consumer debt is created.  Government debt simply shuffles existing debt around.  Since the 1944 Bretton Woods agreement the U.S. consumer has been the global source of new debt, but we are tapped out.  Consumer debt is plummeting at an unheard of rate and this is causing deflation around the world.

The average U.S. consumer is now indebted for the rest of his life and current generations cannot be counted on as a reliable source of debt creation. We've had an incredible stint as the primary money creation engine of the world, what with our consumerist culture and our willingness to take on new debt to buy a Big Mac and all, but we're tapped out, and a new source of money must be found.  Our current system of compounding interest and debt-based money has been around for some 600 years and the people who own the most debt would certainly like to see it stay intact if possible.  It's a wonderful system if you own the debt, not so much if you create it like most of us do.

Over the past six or seven years, when credit was plentiful and the money supply was exploding, people were spending money like crazy, even to the point financing much of their consumption.  Giant flat screen TV's with low low monthly payments and so on.

This resulted in a flood of customers to most businesses, which steadily increased as our consumption society really started roaring.  A big problem for many businesses was that their infrastructure was not built to handle such a large volume of customers.

This created a bubble in the technology industry--products that were built to help businesses accommodate perpetual growth.  That growth has now slammed into reverse.

When people first take an interest in finance (beyond balancing a checking account and buying a few stocks here or there) the first big revelation they have is that paper money is, in and of itself, worthless.  Really it's just a piece of paper, not even blank so you can write on it, not even big enough to wrap a fish in.

This quickly leads to the fact that "the governent" (not really but that's the thought) can print up money on a whim, at any given time.  This leads to gold fever and the urge to exchange as many pieces of paper for yellow metal as possible.  You turn into a hyperinflationista.

I went through this phase, I remember it well.

If you stop your education there, as many people do, the fact that the dollar has been on a tear increasing in value since last fall is perplexing, to put it mildly.  The government is spending money like it's going out of style, how's this possible, etc.

I've seen goldbugs go through all types of contortions to try to explain how this is possible while clinging to their um, novel--ah hell, who am I kidding, flat out WRONG--view of the world.

Here's what's really happening:

Ready for a blast from the past?

You're about to become very familiar with an artifact from the 1930's--a byproduct of the Great Depression come to life again--scrip.

A month or two back I was watching some interviews from the Great Depression and people were talking about buying things with "scrip".  I thought maybe it was slang for money, but it's not.  Scrip is an I.O.U. 

In a deflationary depression such as the Great Depression, or the one we're in now, there simply isn't enough money in existence to pay everyone who needs to be paid.  This leaves cities, states and companies with a decision between not paying their vendors and employees at all, or giving them I.O.U.'s promising to pay at some point in the future when they do have money.

This was a common practice during the Great Depression.  Cities, states, and companies would print up their own I.O.U.'s--scrip--and pay their vendors and employees using that.

Since there wasn't enough money to run the economy, people started using scrip as a medium of exchange.  Companies would sell products in scrip at their own general stores--at huge markups to what they'd cost in dollars--and banks started accepting scrip deposits.  It was of course much less valuable than REAL cash, but banks were simply not manufacturing enough cash to run the economy.

As it always is, history is in the process of repeating itself, and scrip is making a comeback.

In what is sure to be the first of many of these events, California has run out of money and is going to issue its tax refunds in--you guessed it--scrip.  They're calling the I.O.U.'s registered warrants, presumably only because they don't want to mentally invoke the Great Depression.  It's scrip.  If you live in California you are going to start seeing I.O.U.'s in commerce.

States and municipalities are flat broke.  Tax receipt projections were based on a debt bubble that popped over a year ago.  The debt bubble has burst and the amount of money in the world is declining so rapidly that most 2009 budgets are pure fiction at this point.

Politicians just can't wrap their heads around the fact that they have to be frugal--that word is not in their vocabulary.  Instead of cutting back they're increasing taxes and fees on small businesses which is only going to shutter more businesses, lose more jobs, and further decrease tax revenues.  Hi ho.

Once the bottom line goes negative, the only alternative besides outright bankruptcy is to start paying in I.O.U.'s where possible.  Meaning, where people are forced to accept it because they have no recourse.

It'll be interesting to see what happens when people start sending in state taxes paid in scrip, I wasn't able to find any examples of that from the Depression.

I have an obsession with economics.  My wife says I need a new hobby.

I look at it like a puzzle.  Hidden under all the opinions and theories are facts, the things which REALLY dictate where the economy is headed. I've had an obsession with figuring out this puzzle. 

I think I can trace this obsession to my background as a programmer.  That's because 99% of economics can be boiled down to a few mathematical functions, which are a lot like code.

Money, you see, is a recursive function, and I believe programmers who are familiar with this concept are uniquely equipped to understand money.  The ability to understand recursive functions and a willingness to throw everything you think you know about money into the garbage are all that's required.

Whenever I think about the nature of money I'm reminded of this anecdote:

Recursive functions, if you're not a programmer, are routines which call themselves.  Turtles standing on other turtles.  They're one of the hardest concepts for people to comprehend when you're first learning how to program, but they're also extremely elegant and powerful when used properly.

Recursive functions are the basis for much of physics and nature, such as the fractal patterns which can be found everywhere.  They're also the basis for our entire economy.

Money, you see, is a recursive function.

In our system, as weird as it sounds, money is debt, and debt is money.  Every cent of it is created by a bank in response to somebody taking on debt.  Banks are little money factories, quite literally.

I'm going to get into a little bit of economic geekery here, because I forgot how many people don't realize this fundamental fact.  I hear it from people all the time.  And it's important to understand if you want to have any hope at all of grokking the economy.

The Federal Reserve absolutely, positively, does not set interest rates.

The credit markets do.

In a nutshell, rates go up when perceived risk in the economy is low, and rates go down when the perceived risk in the economy is high.  Guess where rates are now. 

The Federal Reserve is just a noisy spoiled toddler screaming at the top of its lungs that it's running the show.  Like parents that don't realize that they're actually in control, we all stupidly listen to the spoiled brat and do what it wants.  Not because we have to, but because we don't know any better.

Want proof?  Grab a cup of coffee or two and read on.

I want to quickly point out one very important thing that most people don't realize:

The Federal Reserve Manages Your Expectations.

They don't set interest rates, the market does that.  The only useful tool they have is psychological.  They manage expectations.  And they are not shy about this fact, if you care to look.

What in the world do they want to manage expectations for?  For the simple fact that if people believe in Deflation, they will hang on to their money because it will be worth far more down the road.  This act of hoarding causes Deflation to kick the market's butt even more quickly.

A perfect example of this True Purpose of the Federal Reserve appeared recently in a statement by the president of the Federal Reserve Bank of St. Louis, James Bullard.  A couple of snippets for you to digest:

Yep.  Sure would.  Anything they can do to take the focus off of Deflation and make people focus on inflation is just peachy.

Do you see that?  Normally they manage expectations by announcing changes to the federal funds target rate, but with rates already at zero they are out of ammo (ammo being ANNOUNCEMENTS about rate cuts, not actual rate cuts).  They have to come up with new ways to get people to focus on inflation.  Anything to take your eye off the ball.

Heaven forbid people expect what they're actually going to get.

The reason I bring this up is because I see an awful lot of people under the impression that the government and/or the Federal Reserve Bank are all-powerful and have the ability to steer markets and the economy.  They're most certainly not.  They are not all-powerful, nor can they change the direction of the markets.  All they can do is attempt to freak you out so that you part with your money.

Just keep this in mind next time you hear Bernanke or anyone else in charge of monetary policy talk.  It's all theater designed to keep you spending.

The sad part is, people and companies who buy into this propaganda are going to get their heads cut off by deflation.  Unfortunately the Fed has no reservation at all about throwing you under the bus to slow the decline a little.

One of the major themes for the new year will be risk aversion.  Not just your plain vanilla variety risk aversion but quaking-in-your-boots-run-for-the-hills style outright fear of risk.

Over recent years risk appetite has gone parabolic, people being willing to take on more and more risk and throwing caution to the wind.  Unfortunately, they haven't been adequately compensated for the risk they've taken on, and now they're being forced to eat the costs.  Instead of being wary of risk, investors simply assumed that they could repackage it, put lipstick on it, and pass it on to the next sucker.  This mindset was epidemic and permeated every level of our society.

Charles Ponzi, eat your heart out.

The mania of eternal growth and expansion made any talk of risk management sound old-fashioned, fuddy-duddy, and outdated--and now we're paying the price.  Billions of dollars were thrown at investments which, in retrospect, will look like absurd wastes of time.

The pendulum will, of course, now swing too far in the opposite direction before risk appetite re-appears.  People and businesses are going to hunker down and go into hiding this year.  Risk aversion is going to be evident in every facet of our lives: 

• Banks will be very risk averse, which will contract our ability to obtain credit and the ability of small businesses to obtain business loans.
• Investors will be very risk averse, which will stifle the ability of large businesses, states, and cities to obtain credit by selling bonds.
• Startups will have an incredibly hard time finding funding, and when they do find money available the cost will be guido-like.
• Expect to see a sharp uptick in try-before-you-buy and product trials, especially for expensive products.  Show me the money!
• Unproven companies will find it very difficult to get in the door at new customers, who will recently have been burned by long-time vendors going out of business.
• Risky projects with iffy ROI's will be canned left and right.  I'll call this the trail of bodies left behind after the Web 2.0 tsunami recedes back into the ocean.
• People who still have jobs will stay in them, reluctant to give up a steady paycheck to start a business or take a gig with a risky startup.
• Expensive projects will be put under the microscope and their ROI's gone over with a fine-toothed comb.  "Soft" benefits don't count now.
• I will even go so far as to say that risk aversion will become "cool".  It will be "cool" to be safe and conservative.  Conservative cars, conservative clothes, safe movies and music.  Pimp your safety.  Say good-bye to bling and flash, risk aversion is going to permeate our culture.  Nun habits are in this year (kidding ;)

This risk-averse mindset really didn't start taking hold until October of this year, and everybody is still relaxed from their forced Christmas vacation.  I wouldn't be suprised to see a brief honeymoon while Obama takes office (the "Hope Halo"), but earnings season in the March timeframe is going to throw gallons of freezing cold water on everybody and force them to wake up.

Happy New Year!

A post by Erick Schonfeld at TechCrunch today really got me riled up:  The SEC has shut down Prosper, a peer-to-peer lending site.  This was up in the air until yesterday:

Yesterday, the SEC issued its formal cease-and-desist letter (embedded below or download PDF), outlining its reasoning for characterizing Prosper as a seller of investment, something prosper had vigorously resisted in the past by arguing that it was merely a marketplace matching lenders and borrowers. But the SEC is having none of that.

If this sounds familiar, it's because this is an exact rerun of what happened with the original Napster and the music industry, only worse in my opinion.

The key here is that Prosper itself was not lending or borrowing, it was simply matching up willing borrowers and willing borrowers.  It also provided additional services such as collection and tracking.  The HORROR.

The real fact is, if private citizens were allowed to freely lend to one another, the private banking cartel that is our central banking system would lose the little control they have over the economy.  The free  market would freely set interest rates and people and businesses would be free to do an end-run around our corrupt and bloated financial system.  The financial engineering that has allowed Wall Street to siphon off trillions of dollars in profit at our expense would be crippled.  The SEC is simply acting as the enforcement arm of our private national banking cartel.

Don't fall under the protection of the cartel?  Goodnight, chump.

Ever since I wrote a few posts about deflation, I've had a lot of traffic coming in via Google from people looking for ways to protect their money during deflationary credit collapses.

Since there's a lot of what I consider to be garbage advice out there right now (such as throwing your money away into the stock market because it's a great time to buy!), I thought I'd put something out there to counteract the tsunami of stupidity. Just doing my part.  So I'll go over my short-term investment strategy, for what it's worth.