So why is this a problem?
The government's somewhat rosy forecasts of its budget deficits are based on the aforementioned assumption that an economic recovery is underway. But if in fact there is no recovery, and the economy is about to worsen, then the trillion-dollar-plus deficits, which the government forecasts for as far as the eye can see, will be even larger than they otherwise would be. And since more debt creation will eventually require more in the way of inflationary money creation by the Federal Reserve (which creates all the money the economy needs . . out of thin air), the future purchasing power of the US dollar will eventually be quite dismal, as all that money creation accumulates into an amount that cannot help but be inflationary. (Ever more dollars chasing a fixed amount of goods and services equals inflation.)
The federal government's reckless issuance of debt in order to finance its hegemonic wars, and the Federal Reserve's misuse of its authority to create $16.1 trillion in secret loans to US and European banks (as revealed by the recent GAO audit of the Fed) have created (out of thin air) an enormous number of new dollars. In addition, financial deregulation (the elimination of Glass Steagall) has resulted in banks creating paper claims (derivatives), on real assets, that far exceed the value of the underlying real assets. Obviously this is an untenable situation. See the explanatin that follows.
How is this to be resolved?
Derivatives like Mortgage-Backed Securities greatly exceed the value of the homes they are based upon (and from which they derive). Similarly, credit Default Swaps and other financial innovations (also being derivatives) have resulted in paper claims on assets that once again exceed the value of the underlying real assets from which they derive.
Consider Credit Default Swaps, a form of insurance that will supposedly compensate bond buyers in the event that a borrower (the country that issues or sells the bond) does not pay back this money that it has borrowed by way of selling the bond. Investors -- speculators, really -- do not have to own a Greek government bond or a mortgage-backed security (derivative) in order to purchase a "swap" (a kind of insurance policy) that insures its value. Therefore they are purchased freely in a kind of speculative marketplace or casino. Therefore, the total value of the associated "swaps' (insurance policies) issued on Greek bonds, for example, can far exceed the total value of the bonds themselves. Similarly, the value of swap/insurance issued on mortgage-backed securities can far exceed the total value of the underlying mortgaged real estate! Hence the total value of all derivatives in the world is in the hundreds of trillions of dollars.
Financial institutions such as US banks, which sold 'swap/insurance' on Greek bonds, are gambling that Greece is going to be bailed out and will not default. These financial institutions regard as gravy the super-abundant insurance fees or premiums paid to them for these "guarantees" (insurance policies) -- on which they now cannot possibly make good in the event that Greece does default on the bonds they've sold. (Like AIG during our last financial meltdown, they simply don't have the assets with which to cover all these guarantees, in the event that the underlying bonds (which people and banks bought and therefore invested in) go bad.
Furthermore, no one knows the total extent of the swaps insurance that has been issued on the sovereign debt of countries like Greece, Spain and Italy. However, we do know that the Bank of America alone has sold $2.1 trillion in swaps insurance on this kind of sovereign debt. Once again, keep in mind that these are insurance policies sold to those who purchased the bonds of countries like Greece, Spain, and Italy. So imagine the crisis that would be released upon us if the Bank of America had to try and pay off on all these swaps insurance policies in the event that Greece, Spain and Italy default on the bonds they have sold to investors! BofA and a number of other US banks would have to be bailed out by the Fed, just like AIG was, last time around. Only this time we're talking about a much, much larger bailout. And they know they would be bailed out, so they have no fear as to how many such derivatives they sell.
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