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A New Theory to Explain Our Current Derivatives Crisis

How Bernake’s Keynesian theories missed the primary causes of the great depression and this one, and how current economic bailouts favor the banking class but destroy the Mainstreet economy

America is facing a crisis, a complex crisis which is in fact a crisis of capital and credit. Historically such a crisis occurs in a collapsing money supply. Why has the central bank missed it?

In Keynesian analysis, a central principal is the IS/LM curve. In this curve the amount of Investment and Saving is plotted against the Liquidity and Money Supply.

“M / P = L(i,Y), where the supply of money is represented as the real amount M/P (as opposed to the nominal amount M), with P representing the price level, and L being the real demand for money, which is some function of the interest rate i and the level Y of real income. The LM curve shows the combinations of interest rates and levels of real income for which money supply equals money demand—that is, for which the money market is in equilibrium.” – Wikipedia

For Keynes, depressions ocurred for psychological reasons, Investors get cold feet and pull back. The typical solution of lowering the interest rate or cost of money is designed to rebalance the ISLM curve and stimulate the economy.

But America is facing a strange crisis that goes beyond this economic theory. By all acounts we are in an era of unbelievable money supply expansion. In the past four years the Federal Reserve corporation has released almost 20 Trillion dollars of credit around the world. With this much liquidity there should be plenty of money for capital expansion. So why are we facing a massive depression instead?

Money Supply * Velocity (or rate of circulation) = Price * Quantity (MV=PQ)

“With nearly constant velocity of money, and output growing slowly, the price level moves with the money supply” – Milton Friedman. Stated simply, an increase in the money supply leads to a increase in prices. Friedman argues that there is a several year lag before this hits the market. It HAS been several years since the 2008 crisis so why hasn’t run away price inflation hit yet?

I propose a new mathematical formulas –
(Money Supply – Derivitive Accounts – Offshore Spending) * Velocity = Price * Quantity


Let’s look more closely at the concept of Velocity. By way of example say a loaf of bread. The baker buys flour, The farmer buys seeds to make the wheat, The seed seller takes his profit and buys bread. In a robust economy V is high. V becomes like a river eddy spinning in circles with endless variations in currents populating and depopulating economic whirlpools. A recession or depression occurs when EITHER (M-D-O) declines OR EITHER V declines, resulting in a decrease in Q (an a resultant lowering in gross economic output). It is the difference between the seed seller coming in once a week to buy bread, and coming in every hour. Obviously the bread baker is going to make much more money selling bread 100 times a day.

Bankers Refuse to Loan to Small Business, Play their Trillion Dollar Bailout on the Derivatives Lottery

Now since the critical value which shows the health of an economy is actually the first derivite of velocity we have the Giavelli Equation:

The Giavelli Rule : “The Monetary Velocity of a System is related to the ratio of its Quantity of Production times cost versus its monetary supply correct for black hole financial instruments (derivities), the offshoring of capital, and debt service cost. ”

An era of expanding money supply and stable prices is a era of growth. An era of contracting money supply and stable prices is an era of decline. An era of contracting money supply and contracting prices may be steady state. Similarly an era of rising prices and rising money supply may be steady state.

Furthermore the first derivative of V is equal to the direction of the economic health. if V’ is negative, the economy is headed into a depression and that is exactly what occurred in 2008. Between 2001 and 2007 bankers aggressively increased M trying to maintain V’ and lost the battle to D and O.

So while we have a increasing money supply, America is suffering from something so gigantic that it is removing money which would normally be flowing into business creation. That is the massive derivatives market. Normally the financial markets would not be so large as to interfere with the general economy and as such they have not made it far into general economic theory. But we are in a aberrant state where the size of these markets and their capital requirements have overtaken the general market (mainstreet) and its capital requirements.

Take a look at what has happened with our money supply as reported by the broadest measure the M3 index.

Think of M3 GROWTH as wood for the economic fire. As an economy moves more and more into the financial sphere and more and more money gets taken by derivatives markets more M3 growth is required to keep up. What the charts show is that we entered an accelerated pace from 2006-2008 when finally the growth rate crashed. At this point we no longer have the fuel to offset the derivative weight on monetary acceleration and availability. Suddenly the D part of the equation becomes much more weighty. But there’s a problem here. While these changes are evident they are not of the level to throw the economy off course. In fact at some reading one might conclude we have been averaging a 15 trillion M3 more or less for some time now. So what is it that has actually happened. What is the real money story when you factor that 16 trillion was created by the Fed for Europe alone and another several trillion were created at home surely that pushes the M3 to well over 30 trillion. And yet by the results of things just the opposite is happening. Something is wrong with the equation.

The size of the US derivatives market is 600 to 1000 Trillion. The worldwide market is much bigger. Gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, have increased by 74% since 2004, to $11 trillion at the end of June 2007.

The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened.

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

But really what is ocurring is that banks have much of their money in derivatives market. The banks, in a market with a money supply of 14 trillion, have placed more and more assets into the derivatives market, removing them from the general productive economy.

So we have an economy where the small decline in M3 is actually a small symptom of the true financial velocity decline which is effectively a massive decline in M3 but hidden in the fact that it is in the derivatives market. And all of this became possible by the removal of the Glass-Stegall act. What has happened metaphorically is that half the river has been DIVERTED into a massive whirlpool caused by a hole. It is endlessly spinning and leaking. The government tries to stimulate the economy by pumping water into the river which only replaces the water spinning in the giant whirlpool. After the diversion the water is calm and not spinning at all it doesn’t have enough velocity and the supply is too low.

To correct this typically the Fed lowers interest rates. Think of interest rates as being the ANGLE of the river. When the rates are lowered the whole river becomes on a steeper bank so water should flow through it faster. But at near zero interest rates what has happened is the government has raised the bank of the river to near vertical still there is not enough velocity in the water that is not diverted to begin to eddy and swirl and create an energetic economy.

A second effect has been occurring with Offshoring or O. In this model offshoring is any off-country removal of capital. The offshore production model has resulted in capital which would have normally invested in American factory production which would have resulted in strong monetary circulation within the US (or increased V) has ended up in stagnated circulation. This capital now circulates in the host country which has received the investment, is sunk into non productive debt service instruments – federal bonds – which eat a greater and greater chunk of productive capital, or languish in billionaire accounts. Eventually this capital is repatriated via sovereign wealth funds and taken to its extreme the offshore recipient of capital may eventually end up with enough capital to purchase the host nation OUTRIGHT and convert both their economies to their own monetary system. This would be America run in China’s RMB currency, the ultimate financial warfare conquest of a once great nation.

Another influence of O is the massive amount that Empires spend overseas to support their troops and bases of influence. This is in effect capital ROBBED from the mainstreet economy and stimulatory to the offshore nations. In effect the economies of Pakistan, Iraq, Iran, and Afghanistan will strengthen from our involvements in the middle east as they become flush with capital and their own V velocity increases. At the same time our equation becomes unbalanced with the denominator O reducing our home velocity.

The only way to offset this is to attempt to massively increase the money supply. We are trying to fill a glass that has a hole in it so large its almost as if the glass has no bottom. Because with every rise of M, the derivatives markets rise. This is a direct side effect of central banking and banking as investment houses. As the banks receive the capital first not mainstreet, they are continually able to siphon it off into derivitive markets and debt service. Both at the bank and at the country level the cost of the debt service is a negative factor.

This is exactly why it is impossible to bail out a nation like Greece. With each addition of M to their economy, they increase D or Debt Service more. So they give Greece 20 billion but their debt service becomes 25 billion. It’s impossible for this to win.

So let’s summarize what our nation and central bank has been doing all wrong. We have relied on a central bank to stabilize our V’ or change in Velocity. We seek a increase in velocity. We hit an era where M dramatically declined in 2007 and 2008 and simultaneously D also dramatically rose and offshoring rose and debt service rose. To correct this the bank sought to increase M but sent 16 trillion to foreign banks. Of the 8-10 trillion that was injected locally much of it went into the derivatives market. So all the fed did was to make the value of the numerator even smaller decreasing V faster. Resulting in another depression.

There is a corollary rule – that V will strive for a value of 1 over time if nothing changes. So with a very lopsided low value numerator, eventually P AND Q BOTH will diminish. This means that GDP or economic output will diminish. And this is the situation we as a nation face.

If central bank monetary policy can’t save us NOR can any country be saved with endless bailouts what can correct this situation. There is one more factor which is critical to velocity and that is the Rate of Innovation. Innovation occurs in free societies. A critical blunder Obama is making in restricting our freedoms is that this is squelching our rate of innovation. Innovation also requires its own capital whirlpool. The dot com boom was not so much simply an era of capital frenzy as it was a whirlpool of financial velocity the flames stoked by radical innovation. It sent the velocity meter off the chart and broke the needle off. As a nation we need to embrace the policies that will encourage the rate of innovation. First and foremost a free society respectful of the bill of rights. Secondly tax breaks for investment in new small companies and for smaller investors. Easier application for patent rights and global enforcement ( no more giving china a break ).

We will re-examine the equation we have been working on one last time. Let’s add the Rate of Innovation.

Now this is an equation I can run my country by. It also shows how loss of freedom and loss of innovation leads to economic collapse and how a banker’s economy which encourages speculation and derivatives not innovation from investment in ideas ultimately dooms a countries economic output.

One thought on “A New Theory to Explain Our Current Derivatives Crisis

  1. The article was interesting in that it pinned on derivatives the mystery (to me) of the disappearing QEs. However, when it moves into the idea of innovation it steps way over the bound and lapses into being no more than a political diatribe at the end. The gratuitous equating of the Obama Administration with tyranny with absolutely no supporting data is inflammatory, not informative.

    [Let’s look at exactly what I said

    “If central bank monetary policy can’t save us NOR can any country be saved with endless bailouts what can correct this situation. There is one more factor which is critical to velocity and that is the Rate of Innovation. Innovation occurs in free societies. A critical blunder Obama is making in restricting our freedoms is that this is squelching our rate of innovation”

    Can you explain to me where in that sentence it equates Obama with Tyranny? I don’t see it. It says that he is reducing our freedom. Well this is true he has voted to remove our rights of Habeus Corpus and Posse Comitatus, he has voted against the first Amendment by enforcing free speech zones and also by sanctioning torture, he has stood against our fourth amendment by sanctioning unjustified spying on Americans and searches and seizures in about four hundred different ways if you’d like I can list them all out for you. He has come out against the second amendment and also appointed supreme court justices firmly against the second amendment, and he has forced Americans to purchase his Obamacare as a “tax” also very unconstitutional when the government forces you to do things. How can you possibly say that Obama is NOT limiting our freedoms?

    – ed]

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