Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.

OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.

Fed Funds Rate – St. Louis FRED database

One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation.  One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.

There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.

On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.

This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.

This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.

In Academically Adrift, Arum and Roksa paint a chilling portrait of what the university curriculum has become. The central evidence that the authors deploy comes from the performance of 2,322 students on the Collegiate Learning Assessment, a standardized test administered to students in their first semester at university and again at the end of their second year: not a multiple-choice exam, but an ingenious exercise that requires students to read a set of documents on a fictional problem in business or politics and write a memo advising an official on how to respond to it. Data from the National Survey of Student Engagement, a self-assessment of student learning filled out by millions each year, and recent ethnographies of student life provide a rich background.

Their results are sobering. The Collegiate Learning Assessment reveals that some 45 percent of students in the sample had made effectively no progress in critical thinking, complex reasoning, and writing in their first two years. And a look at their academic experience helps to explain why. Students reported spending twelve hours a week, on average, studying—down from twenty-five hours per week in 1961 and twenty in 1981. Half the students in the sample had not taken a course that required more than twenty pages of writing in the previous semester, while a third had not even taken a course that required as much as forty pages a week of reading.

One of the subtle cultural shifts arising from the education bubble has been how people are inclined to view college. It used to be that people went to college for an education. Now people go to college in order to ensure having a good job later on.* In essence, the role of college has shifted from education to credentials.

As such, it should not be surprising that colleges dumb down both their admission requirements and their curriculum, for the goal is not education. Rather, the goal is giving students customers a piece of paper that says they are smart. This claim doesn’t have to reflect reality in any meaningful way because most students don’t bear the direct costs of their “education.” Therefore, students are considerably more willing to spend their parents’ money and their future income on degrees that become less and less valuable.

Basically, then, the dumbing down of academic standards is proof of the education bubble because the free and cheap money subsidizes marginal students who would otherwise have no business being in college. This subsidy is then seen in the dumbed-down curriculum, for students expect to have something to show for the time and money they’ve put into college, and it’s easier to satisfy customers by giving them a degree regardless of their actual accomplishments.

*One thing that always puzzles me is how parents think that four to six years of extended adolescence is better for their children’s future than having an actual full time job is. But that’s for another post.

Researchers with the Federal Reserve Bank of New York found that investors who used low-down-payment, subprime credit to purchase multiple residential properties helped inflate home prices and are largely to blame for the recession. The researchers said their findings focused on an “undocumented” dimension of the housing market crisis that had been previously overlooked as officials focused on how to contain the financial crisis, not what caused it.

More than a third of all U.S. home mortgages granted in 2006 went to people who already owned at least one house, according to the report. In Arizona, California, Florida and Nevada, where average home prices more than doubled from 2000 to 2006, investors made up nearly half of all mortgage-backed purchases during the housing bubble. Buyers owning three or more properties represented the fastest-growing segment of homeowners during that time.

“This may have allowed the bubble to inflate further, which caused millions of owner-occupants to pay more if they wanted to buy a home for their family,” the researchers noted.

Investors defaulted in large numbers after home values began to drop in 2006. They accounted for more than 25 percent of seriously delinquent mortgage balances nationwide, and more than a third in Arizona, California, Florida, and Nevada from 2007 to 2009.

Sweet Keynes but the banksters just do not have a clue. Somehow, the FRB of New York has come to the hilarious conclusion that somehow, mysteriously, those who “flip” houses are the root cause of the recession. Talk about clueless.

The question that the NY FRB is apparently too stupid to ask is: Why would some people suddenly decide to “flip” houses? Answer: because it’s generally profitable due to the increased demand for houses as a result of a)artificially low interest rates from The Fed, b) massive fraud among the banks in regards to loan application, c) the Federal Government’s willingness to subsidize market risk, and thus eliminate moral hazard, through the agencies Freddie Mac and Fannie Mae, and d) the general tendency of the government to encourage and subsidize home ownership through, among other things, federal income tax breaks. Basically, the government as at the root of most of the problem here, and the Federal Reserve played a major role.

Of course, the FRB is not going to admit to wrongdoing, particularly since greedy businessmen make for a more compelling villain in this narrative. But blaming people for responding to incentives at the margin, as clearly happened in this case, is indicative of just how worthless mainstream macroeconomic analysis clearly is. Quite simply, it takes an astonishing amount of either dishonesty or short-sightedness to come to the conclusion that greedy businessmen are to blame for the current recession instead of the incentive system in which they operated.

The shallowness of this analysis, if honest, is simply evidence that those who are currently in charge are simply too stupid to merit the power with which they’ve been entrusted. If, on the other hand, they are liars, the case for their removal from power is not in any way diminished. In sum, there is no excuse for those presumed to be intelligent, and thus deserving of power, to be offering analysis this putridly vapid; they must be summarily dismissed and the system must be dispatched with.

* Cf. Dr. Sowell’s book Applied Economics.

Today, President Obama is effectively giving college students and their parents his middle finger. Whereas Jobs’ prank was harmless and symbolic, the President’s plan to bail out student loans will derail the  entrepreneurial dreams and financial security of countless young people. [Ed. - this claim is utter bulls**t.Bailing out student loans will increase their financial security because they will no longer be slaves to the banks. And, with less debt, they can actually become entrepreneurs.]

By executive order, the President’s unconstitutional “We Can’t Wait – Pay As You Earn” plan modifies the existing Income-Based Repayment Plan so that, effective in 2012, graduates may cap their loan payments at 10percent instead of 15 percent of their discretionary income. Anything remaining after 25 years (formerly 20 years) becomes fundamentally the taxpayers’ responsibility. And, if a student wants to become a public servant (i.e. work for George Soros) his loan will be forgiven after just 10 years.

Obviously, Obama is playing for political points with this plan, presumably to mollify the OWSers, so I understand outrage for that reason. But what I don’t understand is how anyone thinks that student loans weren’t already the taxpayers’ responsibility. The government guaranteed student loans a long time ago, which is one of the reasons there’s a college bubble—private lenders face virtually no risk on the loans. In fact, the government guarantee of repayment is why default was taken off the table as an option: the government didn’t want taxpayers to take it in the shorts.

Neo-con bomb-lobbing aside, Obama’s plan is pretty terrible. It shouldn’t wreck the economy(at least no more than seeding a college bubble would), and it’s better than a jubilee for the loans, but there is still a much better solution available: the federal government should stop guaranteeing student loans and allow them to be discharged in bankruptcy. This way, college student wannabes won’t be as inclined to pursue worthless degrees and banks won’t be as inclined to fund the pursuit of worthless degrees. You don’t need bailouts, you don’t need special debt laws, all you need is the ability to discharge student debt during bankruptcy. Problem solved.

The next 20 years are going to be completely unlike the last two decades. How the world works, how stocks grow, the very nature of investing and how our economy functions—all of these are due for fundamental, earth-shaking change. As investors, we have to adjust the way we look at the world.

We want growth. We need economic growth. It’s all you hear about when the treasury secretary talks about how we are going to get the economy growing again or when the president talks about jobs. When our money system is growing, things are reasonably happy. When it is not growing, things are very unhappy. As long as everything is growing, our economy functions reasonably well. And when it stops growing, it throws giant fits and gets into trouble. That is why we are always chasing growth. And there is a reason for that: Money. But what is money?

I don’t care what color it is or whose picture is on it or what counterfeiting measures you have in place. All money in the world today shares one characteristic: it is loaned into existence. It seems like a simple enough statement, but this has enormous implications. Because it is borrowed, we pay interest on it. That interest drives a peculiar feature in our money system (by “our” I’m referring to all fiat currencies in the world because all of them operate by this same loaning principle). When you loan money into existence, you have to pay both the principal and the interest back. That means there is always more debt than money in the system.

We are constantly growing our money supply because our population is growing. In the past, we had a seemingly endless supply of resources, energy and land to occupy—all of that has been OK. But we are coming to a point where it’s not OK anymore.

Consider a chart of total credit market debt. It tops out at about $52 trillion (T). Each of those big, blue, upside-down triangles mark a doubling of credit market debt. From 1970 to about 1977, total credit market debt doubled. It doubled again by 1983. Then it doubled again and again and again. Over four decades, we had five doublings of our credit market debt. In order for the next 20 years to look like the last 20 years, we would need two complete doublings of credit market debt. Let me put those numbers in: $52T to $104T to $208T. That is an absolutely obscene amount of credit growth. This is not how our economy is supposed to function. It was a result of the abandonment of the gold standard, and it is not sustainable.

The second thing I want to point out is the blue line. That is a curve fit. It is an attempt to mathematically model what is going on with that red credit market debt line. It shows that our money system, our credit system, has been growing nearly perfectly exponentially.

Debt:GDP Explosion

Another way to evaluate the economy is by looking at the debt:GDP ratio, because if you have a lot of income, it is OK to have a lot of debt: GDP is our income. Something really unusual is happening: The ratio is skyrocketing in an unprecedented range, with the exception of a blip during the Great Depression when manufacturing dived. We are in the middle of a very interesting experiment in this country. We can’t dig through the data series and say, “Oh, the last time we did that, this is how it turned out.” We don’t have any historical examples of any country in history getting out from under a debt:GDP load this high without going through some kind of a massive currency adjustment. There is one example from 1815 to 1900 where England got out from under 260% debt:GDP load, and it did that by cutting war spending after the Napoleonic Wars with help from the Industrial Revolution. Nothing on our horizon indicates that we are going to cut spending or increase our overall economic output by huge amounts. So we have to ask the question: How do we get out from under that? This debt:GDP imbalance is a global phenomenon. It is not just a U.S. problem.

That is why the economy must grow. In order to be happy, in order to service those debt loads, it must grow. Exponential growth, the kind that starts out nice and easy in a linear fashion and then shoots up suddenly, is what I am really worried about. It is everywhere. Human population grew rather sedately for a long period of time and, recently really accelerated. Oil consumption has increased on the same model. Starting in the early 1940s, it really turned up. The more we produce, the more we use. The same is true on the environmental side; water use, forest loss, species extinction, fisheries exploited—all of this turned up aggressively in in the 1940s and 1950s. We could look at miles of roads paved, numbers of McDonald’s hamburgers served; it doesn’t matter. We are surrounded by all of these nonlinear, very J-shaped curves. This is really critical if you believe in boundaries. There is only so much arable land. There is a limit to how much water is in an aquifer. There is a limit to how much oil is in the ground. We can argue about whether we are close to those limits, but we can’t argue about the fact that the limits exist. So we need to understand how we are using these things.

I like to use a thought exercise to explain exponential growth. I have this magic eyedropper. A drop of water from this thing is going to double every minute. So one drop will become two drops in one minute. In another minute it will be four drops. After about six minutes, it will be enough to fill a thimble. If we started this experiment at noon on the pitcher’s mound of Yankee Stadium and you are handcuffed to the highest row of the bleacher seats, how long would you have to escape from your handcuffs? By 12:50 that same day, the park would be completely overrun with water. In fact, at 12:45 this is still 97% empty space with a little water in the infield. You have 45 minutes to sort of fool around, but the next five minutes are critical. That is the power of exponential increases. If you have that sense that world events are speeding up, you are right. They absolutely are.

A Peak Problem

Dating back three million years from the australopithecine humanoid precursors to 1960, we put 3 billion people on the planet. It took 40 years for the next 3 billion to arrive. Someone who is 22 years old today has been alive when half of all the oil in the world that has ever been burned has been burned. We are burning oil at roughly 2–3% more per year than when we were in a healthy economy. This is a predicament.

Do you know the difference between a problem and a predicament? A problem has solutions. A predicament has inevitable outcomes that have to be managed. If you are in a predicament seeking solutions, you are wasting time. A lot of our efforts at the national level right now are centered around seeking solutions to predicaments. That concerns me greatly because it means we are actually wasting our time, wasting resources and not looking at things the right way.

Our predicament right now concerns energy. U.S. oil production peaked in 1970 and has never returned to its former days of glory—and it never will. As a result, we import two-thirds of our liquid petroleum needs to run our society. No matter how much we drill at this point, there is absolutely no chance that we are going to return to our former production highs. In fact, out of the 54 oil-producing countries, we have about 45 that have gone past peak. No country has ever managed to get back to a former peak and exceed it.

World Discovery by Decade

Source: Chris Martenson

The peak year for oil discover was 1964. The green in the chart represents history. The red is projections for what we think we might find going forward. There could be some wiggle room, but I think it would be a stretch to think that we are ever going to get back to that peak that we saw in the 1960s.

Here is the thing about oil: If you want to produce it, you have to find it. Our finds were 40 years ago. Interesting fact: The U.S. peaked in its domestic discoveries in 1930 and hit a production peak in 1970, a 40-year gap. World oil discovery peaked in 1964 and world oil production for conventional oil peaked in 2005, 41 years after its find peak. It has not yet been exceeded. It might, but it hasn’t, even though oil prices have tripled. If there is ever an incentive to get your oil out of the ground, it’s when prices triple. That’s what market theory tells us. Somehow, we haven’t done it.

The U.S. Energy Information Administration issued a shocking statement in its 2008 World Energy Outlook. It said that oil from currently producing fields peaked in 2006. It factored in natural gas, non-conventional oil and crude oil yet to be found and developed as possibilities for filling the country’s growing energy needs. The problem is that in order to get energy out of the ground, you have to put energy into the equation. If we take a barrel to find a barrel, then all we are doing is using energy to go explore and get energy out of the ground—there is none left over to go into our gas tanks. There is none left over to grow food, or for anything else. By the time you are using one barrel to find one barrel, you are spinning your wheels.

The same lopsided equation is operational in shale beds. If we decide to switch to natural gas, we will need to retrofit our cars, build filling stations and pipelines. This will take a lot of money and about 10 or 20 years to build out. There are going to be companies that make a lot of money aggressively attempting to expand into that, but we are already behind the eight ball.

When we first started drilling for oil in the 1930s, we were getting 100:1 returns from these little wooden drilling derricks going down maybe 1,000 ft, hitting spindletop. At that point we were putting in one barrel and getting 100 back. In the ’70s, we were getting maybe 25:1 back. In the 1990s, we were getting 18:1 or even 10:1. We were drilling deeper, more remotely. The substance was a little heavier, and more sour. We went after the good stuff first: light, sweet and near the surface. Now, we are drilling in a deep ocean environment. Some of our efforts are down to 3:1. Ethanol will make it even worse. As we fall down this energy cliff and get progressively less and less energy back for our efforts, the amount of energy available to us to run our economy drops rather precipitously.

Natural Erosion

This same dynamic impacts natural resources. Some 150 years ago, we found giant nuggets of copper the size of cars sitting in streambeds. Eventually we went after smaller nuggets. Then we went after copper ore grades of 10%. Now we have huge open-pit mines with ore grades of 0.2%. Regardless of whether copper is $4/lb or $3.50/lb or $35/lb, think about the energy required to take 500 lb of copper ore from the bottom of that pit, haul it up a quarter mile, run it through a crushing machine, smelt and refine it to get that 1 lb of copper out. Would we be doing that if we didn’t have liquid fuels, if we didn’t have diesel to run big trucks? I think the answer is no. And this is after just 150 years. What happens over the next 150 years? How about in 500 years? If we continue to deplete all of our mineral reserves at 2% growth in extraction per year, which has been our 40-year historical run, how long will they last? We might find more, but sources will be more remote, further away from infrastructure needed to extract them, refine them and move them to market. The end product will be more diluted and lower quality, with deeper costs attached.

We have a world where we will face exponentially rising costs if we continue to run our economy in the way it has been running. That is not a great strategy at this point. Our economy must grow by design because of how our money and debt systems operate, but it is connected to an energy system that can’t grow. This is the definition of a predicament. No matter what policies we pursue or how clever our technologies get, there are certain things that we just can’t undo. When you take oil out of the ground and you burn it, it is gone. And we are burning it up at a faster and faster pace.

Coming to terms with this reality has actually been a fairly liberating idea for me. It has allowed me to understand what is important in my life. And it has been very helpful in my overall investing philosophy. Even though it is not a terribly uplifting story for a lot of people at first, I do think that it helps to clarify where we are in the story and what is happening.

This was a summary of Chris Martenson’s presentation. For the complete audio collection of the Casey Research/Sprott Inc. Summit “When Money Dies,” click here.

Chris Martenson is a scientist, financial and economic analyst and writer at www.ChrisMartenson.com. He earned his MBA at Cornell University and a Ph.D. from Duke University. As one of the early econobloggers who forecast the housing market collapse and stock market correction years in advance, he launched a video seminar and later published a book entitled The Crash Course. To learn more about Chris and his work, including the Crash Course, go to chrismartenson.com.

1. Distribution: If we are going to give money away, why on earth would we give it to college grads? This is the one group who we know typically have high incomes, and who have enjoyed income growth over the past four decades. The group who has been hurt over the past few decades is high school dropouts.

2. Macroeconomics: This is the worst macro policy I’ve ever heard of. If you want stimulus, you get more bang-for-your-buck if you give extra dollars to folks who are most likely to spend each dollar. Imagine what would happen if you forgave $50,000 in debt. How much of that would get spent in the next month or year? Probably just a couple of grand (if that). Much of it would go into the bank. But give $1,000 to each of 50 poor people, and nearly all of it will get spent, yielding a larger stimulus. Moreover, it’s not likely that college grads are the ones who are liquidity-constrained. Most of ‘em could spend more if they wanted to; after all, they are the folks who could get a credit card or a car loan fairly easily. It’s the hand-to-mouth consumers—those who can’t get easy access to credit—who are most likely to raise their spending if they get the extra dollars.

3. Education Policy: Perhaps folks think that forgiving educational loans will lead more people to get an education. No, it won’t. This is a proposal to forgive the debt of folks who already have an education. Want to increase access to education? Make loans more widely available, or subsidize those who are yet to choose whether to go to school. But this proposal is just a lump-sum transfer that won’t increase education attainment. So why transfer to these folks?

4. Political Economy: This is a bunch of kids who don’t want to pay their loans back. And worse: Do this once, and what will happen in the next recession? More lobbying for free money, rather than doing something socially constructive. Moreover, if these guys succeed, others will try, too. And we’ll just get more spending in the least socially productive part of our economy—the lobbying industry.

5. Politics: Notice the political rhetoric? Give free money to us, rather than “corporations, millionaires and billionaires.” Opportunity cost is one of the key principles of economics. And that principle says to compare your choice with the next best alternative. Instead, they’re comparing it with the worst alternative. So my question for the proponents: Why give money to college grads rather than the 15% of the population in poverty?

Conclusion: Worst. Idea. Ever.

More like: Worst. Rebuttal. Ever.

However, I don’t find the idea of student loan forgiveness all that appealing, in part because students still deserve to face the consequences of their (admittedly stupid) decision to go to college instead of getting a real job. In order for a lie to work, one party must tell it and another party must believe it. If you believe a lie, you need to live with the consequences. But if you take advantage of those who have believed a lie, then you deserve the consequences thereof as well.

My proposal, then, is very simple: allow grads to default on their student loans. Grads’ credit scores will take a hit, which is a reasonable consequence t their decision to essentially waste four years of their life. And banks would be forced to write a bunch of bad loans, killing their profits, which is a reasonable consequence to their decision to loan money to people that didn’t deserve it.

The current system is broken and remarkably unfair to those it purports to help. Correcting this problem doesn’t require forgiving all students of their loans. Allowing grads who find that a college degree is worthless to default on their loans should be sufficient to clear the market.