A whole “New Economics.” With new rules.  Why? Classical economics is fatally flawed. So investors better learn the new rules that’ll win in the “New Economy” dead ahead. Delay, deny, you’ll lose. After the coming global collapse—the big wake-up call—classical economics will be exposed as a fraud sabotaging investors, killing capitalism, destroying America … and the world.

Yes, 20 new rules. Why? Because everything you know about economics is wrong. Everything. Wrong. The old economics is a rigged game in Wall Street’s casino. The cards are stacked in favor of the banks and their co-conspirators, political lobbyists, corporate CEOs and the Super-Rich. The house always wins. You always lose. Worse, America is losing.

Here’s why: All classical economic ideas derive from one central idea. Not even a scientific theory, merely an unproven hypothesis. Worse, all economic conclusions are based on this illusion, a fantasy, myth, wishful thinking. Consequently, all economic conclusions are speculations favoring Wall Street, corporate CEOs and the Super-Rich.

“Eternal Growth:” Bad economics, unscientific, old myths

Here’s the one central (and fatally flawed) hypothesis of all traditional economists today—from Bernanke’s Fed staff, economists in the World Bank, IMF, CBO and White House economic advisors, to economists at Wall Street banks, think tank and academic economists—is their unquestioned acceptance of the dogma of “Eternal Growth.”

All economic thought evolves from one unproven and fatally flawed hypothesis: The unscientific assumption that the global economy will continue growing indefinitely … that the world’s economies will be able to support global population growth indefinitely … and that all necessary commodities and essential natural resources will be available indefinitely to sustain the world’s relentless economic and demographic growth.

Unfortunately, that’s impossible. Absurd. Irrational. Unscientific. Just plain wrong. That’s right, the core assumption of classical economics and American capitalism is an illusion. So are all their economic conclusions. Get it? America’s entire economic system is based on one crucial yet unproven premise that taints the work of all economists. Worse, most are blind, still refuse to see that their own system is not only fatally flaw, it proves the need for a “New (No-Growth) Economics.”

Here’s the 20 Rules Manifesto for the “New (No-Growth) Economics:” Twenty rules, trends, principles emerging after Wall Street and the American economy get hit by another bigger meltdown, totally predictable in today’s self-destructive political arena. Warning: Even with another market meltdown, taxpayers may still get duped into bailing out the banks again. Eventually, however, they will wise up and revolt against this corrupt system.

20 “New Rules” emerging through crashes and wake-up calls

Why shouldn’t you trust economists anymore? Since the 2008 meltdown it became painfully obvious that America’s 15,000 traditional economists were clueless (as were more than 50,000 portfolio managers and all government leaders in both parties). Not just because they’re paid mercenaries. The real problem is their brains are short-term thinkers. They really cannot see the future. So they simply project old data. They’re not future-thinkers. They missed the last crash. They will also miss the next one. …. read the “20 Rules” and full column in MarketWatch.com

Bernanke’s ruling ideology is the culmination of a 30-year economic war that since 1981 has forged together Reaganomics for the super-rich, Greenspan’s toxic allegiance to Wall Street, the extremes Ayn Rand’s capitalist dogma, culminating in the toxic bailouts of Treasury Secretaries Hank Paulson and Tim Geithner, two Wall Street Trojan Horses corrupting government from within. For three decades this “monetary dictatorship” has caused enormous collateral damage, systematically sabotaging democracy, capitalism and the American Dream, while fueling the rise of our most dangerous new enemy, China.

When Obama reappointed Bernanke a couple years ago, Black Swan’s Nicholas Taleb was “stunned.” Bernanke “doesn’t even know that he doesn’t understand how things work,” that Bernanke’s economic methods are so inadequate they make “homeopath and alternative healers look empirical and scientific.” We called Bernanke, the “Captain of the Titanic” last year, warning that he was setting up the “third meltdown” of the twentieth century, predicted by Irrational Exuberance’s Robert Shiller, a coming crash worse than the 2000 dotcom crash and the subprime credit meltdown of 2008 combined.

Inside the Fed: Cassandras, Chicken Littles & a Governor Crying Wolf
Unfortunately, Bernanke (& the ghosts of Greenspan & Reaganomics) are Tone Deaf

The 30-year dictatorship now headed by Bernanke must end soon: And when it does, the class wars will not be pretty. But it is no “black swan,” no one can claim they did not see this new crash coming. For several years before the 2008 meltdown we reported on money managers, economists and financial gurus warning of a coming meltdown, they included two other Fed governors who warned Greenspan in the early Bush years. And yet, as late as summer 2008 Bernanke, Paulson and Greenspan were systematically dismissing mounting evidence of a mega-crash dead ahead.

That’s why Time magazine’s cover story about Thomas Hoenig, president of the Federal Reserve Bank of Kansas City grabbed me. David Von Drehle’s “The Man Who Said No to Easy Money” is a warning to all America. Like Ed Gramlich and William Poole, the two Fed Governors who warned Greenspan during the Bush years, Hoenig regularly dissented from the Bernanke’s “easy money” policies that have been favored by Wall Street throughout this 30-year dictatorship. We’re paraphrasing Drehle’s interview with Hoenig as “10 warnings” because it brilliantly reveals the broader historical tragedy of the Fed’s 30-year “monetary dictatorship” driving America to the edge of another 1930s economic revolution, one that will be triggered by a repeat of the 1929 wake-up call.

Now please read Hoening’s ”10 Warnings” about Bernanke in my earlier 2.15.11 version on MarketWatch

Worse, Obama’s giving ol’ Capt Ben a second chance to pilot into new icebergs dead ahead. The Economist calls them “Asset Bubbles.” Problem? Capt Ben can’t see through his ideological Greenspan/Reaganomics goggles, clouded by his obsessive allegiance to Wall Street’s “Fat Cat Bankers.” Nothing new: He failed to see warnings of “icebergs” back in 2007. Yes, and he’ll miss any new icebergs, sink the global economy, and plunge the world into the eerie depths of the “Great Depression 2.”

When the Senate reconfirmed Capt Ben, it became Obama’s “biggest domestic policy blunder.” And he made matters worse when he failed to push the “Volcker Rule,” a defacto revival of Glass-Steagall separating commercial banking from the “Fat Cats” high-risk gambling with derivatives trading and investment banking.

Greed & “fat-cat” bonuses

Wall Street lawyers, lobbyists and traders love their mega-bonuses. So they’d get around any new “rules” fast. “Fat Cats” really don’t need any new Supreme Court cases (like that one allowing disasterous unrestricted political donations) to “buy” votes in the Senate. Glass-Steagall or not, the “Fat Cats” will just double up on their tools for lying, cheating, stealing and manipulating Main Street’s 95 million investors. So assuming we’re stuck with this weird new version of “Captain Queeg.” And it’s only a matter of time before Capt Ben runs “Titanic-2” into a battleship, a new iceberg, or another unseen black swan.

Hollywood remake of Titanic? Yes, a great idea. Got it from Jeremy Grantham, founder of the $100 billion GMO money managers. He’s got a track record: In 2007 he saw the icebergs in “The First Truly Global Bubble: From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it’s bubble time. … The bursting of the bubble will be across all countries and all assets … no similar global event has occurred before.” He sees again.

Unpredictable? No, Capt Ben’s “Titanic” is a very predictable “black swan”
This Titanic sequel was exactly what Grantham had in mind a couple months ago in his letter to investors: “Lessons Not Learned: On Redesigning Our Current Financial System.” Listen to his thriller plot: “Imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship’s construction, of the company’s policy, or of the captain’s competence. ‘No one could have seen this coming,’ would have been their constant refrain’.”

Sound familiar? You bet. Capt Ben’s “Titanic II design committee” would also include his ol’ buddies, Greenspan, Paulson, Summers and Geithner. “Their response would have been to spend their time pushing for more and improved lifeboats,” says Grantham. However, “by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one.”

Grantham’s not hopeful, but his dialogue rivals the best of James Cameron’s Avatar and Paul Volcker’s Glass-Steagall speeches: “After a crisis … begin with an open and frank admission of failure. The Titanic, for example, was just too big and therefore too complicated for the affordable technology of its day. Given White Star Line’s unwillingness to spend, she was under-designed” so “the passengers bore the risk of unnecessary speed and overconfidence in ‘too big to sink,’ while the captain stood to be rewarded for breaking the speed record.” And thanks to Capt Ben, that describes why “Fat Cat Bankers” like Lloyd Blankfein made $410 million the past three years during the meltdown, why his Goldman Sachs staff got average $500,000 bonuses last year, and why one of six Americans are unemployed. Why? ‘Cause ol’ Capt Ben’s a lousy pilot, guided by a suicidal ideological compass.

So, we already see four huge plot points dead ahead for this new “Titanic II,” at least four huge “icebergs” still out there lingering from the last disaster he created to protect the “Fat Cat Bankers” using the discredited Greenspan “cheap money” ideology that piled $23.7 trillion debt on taxpayers. This is all so familiar. Reminds me of my old days at Morgan Stanley’s Real Estate Investment Banking Group working with big banks in trouble during the seventies recession. Just keeps repeating. Here, look at the four mega-icebergs flashing: “Crash! Dead ahead!”

First iceberg: “Global Assets Bubble Warning”
From The Economist: “Bubble Warning: Why Assets are Overvalued … Markets are too dependent on unsustainable government stimulus. Something’s got to give … The effect of free money is remarkable. A year ago investors were panicking and there was talk of another Depression. Now the MSCI world index of global share prices is more than 70% higher than its low in March 2009. That’s largely thanks to interest rates of 1% or less in America, Japan, Britain and the euro zone, which have persuaded investors to take their money out of cash and to buy risky assets … cheap money is driving up asset prices.”

Sounds as ominous as The Economist’s warning back in June 2005, two years before the last meltdown: “The worldwide rise in house prices is the biggest bubble in history. … Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000.” Values increased 75% worldwide in five short years. “Never before have real house prices risen so fast, for so long, in so many countries … This is the biggest bubble in history.” And Capt Ben is just using Greenspan’s discredited strategy.

Worse yet, at a recent conference in Shanghai, St. Louis Fed President James Bullard said America’s interest rates will likely remain low for “quite some time.” Yes, he loves blowing and busting bubbles. Unfortunately, with that outdated ideological mindset protecting the Fed’s “Fat Cat” members, we’ll see a rapid buildup of “Asset Bubbles” across the globe, just as The Economist is warning. We can even predict that Capt Ben will again ignore warning signs and push us blindly ahead into his fog.

Second iceberg: “Gulf Oil Real Estate Bubble Collapse”
In “Burj Dubai: A Temple to Hubris,” an LA Times critic wrote a brilliant critique of the total bankruptcy of the newest tallest building in the world, sitting in a desert metropolis: ”Burj Dubai’s real symbolic importance: It is mostly empty, and is likely to stay that way for the foreseeable future. Though most of its 900 apartments have been sold, nearly all were bought three years ago—near the top of the market—and primarily as investments, not as places to live. … And there’s virtually no demand in Dubai at the moment for office space, of which the Burj Dubai has 37 floors.”

The Dubai Tower “is a powerful, iconic presence in ways … the latest, and biggest, in this string of monuments to … easy credit, during the boom years and the sudden paralysis of the financial markets in the fall of 2008 have created an unprecedented supply of unwanted or under-occupied real estate around the world,” dead monuments to “the broader notion … that growth can operate as its own economic engine, feeding endlessly and ravenously on itself … the tombstone—for some ruined ideas.”

Third iceberg: “China’s Overheated Real Estate Bubble”
Worse, read “Mania on the Mainland: Think the U.S. real estate bubble was bad? China’s could be worse” in Bloomberg/BusinessWeek. China’s “real estate rush is fueling fears of a bubble that could burst later in 2010, devastating homeowners, banks, developers, stock markets, and local governments.” Then China’s “economic growth will stop, warns Yi Xianrong, a researcher at the Chinese Academy of Social Sciences’ Finance Research Center.” Premier Jiabao even told the Xinhua news agency that “property prices have risen too quickly,” pledging “a crackdown on speculators.”

Fourth iceberg: Commercial Real Estate, a Ticking Time-Bomb
But worst of all, here at home we read in yet another Bloomberg/BusinessWeek article, “Why This Real Estate Bust Is Different,” that “unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate.” Yes, there’s another homegrown mess far bigger than America’s residential real estate. Imagine, a $1.7 trillion ticking time-bomb sitting on our bankers’ books, equal to “roughly 25% of the assets of the average institution.” A very big iceberg.

What happened? “Overbuilding isn’t the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge. It turns out the same excesses that drove the housing market’s crazy rise and fall were present in commercial real estate, too—but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers’ wildest growth assumptions and readily overlooked other shortcomings on loan applications” to “easily sell their dubious loans to investors in the form of commercial mortgage-backed securities”

Bottom line: How to avoid sinking the USS Titanic-2? A Capt Ben mutiny!
Ben can’t be trusted. What’ll Capt Ben do if he’s still around piloting the good ship “Titanic-2?” He’ll hit more icebergs, or battleships, or black swans. Can’t help himself, it’s in his ideological DNA. Then he’ll blame others, while secretly bailing out his Wall Street banker buddies, piling on trillions more debt, doing it with his usual arrogance, no transparancy and no accountability. Yes folks, as long as Capt Ben remains at the helm, you can bet our unaudited Fed will secretly ease the banks pain (again) shifting trillions more to taxpayers, the “suckers-of-last-resort.” Yes, it’s time for a “Capt Ben Mutiny!”

original post MarketWatch: 1.26.10

High-octane trading may be counterproductive to taxpayers, for sure. But not to the speculators who win big when such transactions pay off. And in the case of A.I.G., the speculators got their winnings from the taxpayers … Derivatives are responsible for much of the interconnectedness between banks and other institutions that made the financial collapse accelerate in the way that it did, costing taxpayers hundreds of billions in bailouts. Yet credit default swaps have been largely untouched by financial reform efforts.

This is not surprising. Given how much money is generated by the big institutions trading these instruments, these entities are showering money on Washington to protect their profits. The Office of the Comptroller of the Currency reported that revenue generated by United States banks in their credit derivatives trading totaled $1.2 billion in the third quarter of 2009. Congressionl “reform” plans for credit default swaps are full of loopholes, guaranteeing that another derivatives-fueled financial crisis awaits us.

Get it? Wall Street’s lobbyists are winning, reform is virtually dead, another derivatives crash is guaranteed! Then, echoing Warren Buffett’s concern that derivatives are “weapons of financial mass destruction, Morgenson adds:

Credit default swaps are “a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent,” said Martin Mayer, a guest scholar at the Brookings Institution and author of 37 books, many of them on banking. “They were not well-motivated.” Mr. Mayer has been critical of credit default swaps almost since they arrived on the scene. In 1999, for example, he wrote an opinion piece for The Wall Street Journal entitled “The Dangers of Derivatives.”

“These ‘over the counter’ derivatives — created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing — are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall,” he wrote, referring to the market turmoil of 1998. “The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions.”

Calling credit derivatives “the most dangerous instrument yet,” Mr. Mayer concluded in his article that neither banks nor bank examiners have any idea how to handle them. “The system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries — their knowledge of their borrowers, and their incentive to police the status of the loan,” he wrote.

Pointing to a study by the Federal Reserve Bank of New York, he said: “In the presence of moral hazard — the likelihood that sloughing the bad loans into a swap will be profitable — the growth of a market for default risks could lead to bank insolvencies.” But, “if companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”

Taxpayers remain decidedly on the hook for future bailouts because Congress has done nothing to eliminate the once-implied but now explicit government guarantees backing large and interconnected companies. And on derivatives trading, lawmakers’ moves have been depressingly incremental. Couldn’t agree more. Too bad Washington doesn’t see it that way.

What is dead ahead is another bigger meltdown, followed by the “Great Depression II.” As former IMF economist, Simon Johnson and his co-author James Kwak, recently said in 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown:  ”No one can predict what market will produce the next financial crisis, or when it will occur, but … when it comes, the government will face the same choice it faced in 2008: to bail out a banking system that has grown larger and more concentrated or let it collapse and risk an economic disaster. … There is another choice: The choice to finish the job that Roosevelt began a century ago, and to take a stand against concentrated industrial power. That is a choice Barack Obama could make. It is a choice that the American people need to make—and sooner rather than later. The Panic of 1907 only led to the reforms of the 1930’s by way of the 1929 Crash. We hope that a similar calamity will not be a prerequisite to action again.” But it will be!

Europeans are blaming financial transactions arranged by Wall Street for bringing Greece to the brink of needing a bailout. But a close look at the country’s finances over the nearly 10 years since it adopted the euro shows not only that Greece was the principal author of its debt problems, but also that fellow European governments repeatedly turned a blind eye to its flouting of rules. Though the European Commission and the U.S. Federal Reserve are examining a controversial 2001 swap arranged with Goldman Sachs, Greece’s own budget moves, in clear breach of European Union rules, dwarfed the effect of such deals. … years of overspending, leaving bond investors worried the country can’t pay back its debts—weren’t supposed to happen in the euro zone. 

Well, it did happen, as if willed by Greek Gods on Mt. Olympus. So America and Goldman are off the hook: The “controversial derivative transactions Greece used to help mask the size of its debt and deficit numbers” were small compared to Greece’s failure, for example, “to book €1.6 billion ($2.2 billion) of military expenses in 2001—10 times what was saved with the swap.” 

Not so fast, says Niall Ferguson, a leading financial historian whose works include the recent “Ascent of Money: A Financial History of the World,” “The Cash Nexus: Money and Power in the Modern World,” “Colossus: The Rise and Fall of The American Empire.” Writing in the Financial Times, Ferguson warns that a “Greek crisis is coming to America,” like America started the trend of going deep into debt to finance domestic economic expansion, then the idea gets picked up all over European nations, and now it’s going to backfire on America:

It began in Athens. It is spreading to Lisbon and Madrid. But it would be a grave mistake to assume that the sovereign debt crisis that is unfolding will remain confined to the weaker eurozone economies. For this is more than just a Mediterranean problem with a farmyard acronym ["PIIGS," an for Portugal, Italy, Ireland, Greece, Spain]. It is a fiscal crisis of the western world. Its ramifications are far more profound than most investors currently appreciate. … The idiosyncrasies of the eurozone should not distract us from the general nature of the fiscal crisis that is now afflicting most western economies. 

What we in the western world are about to learn is that there is no such thing as a Keynesian free lunch. … For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008. …

The Obama administration’s new budget blithely assumes real GDP growth of 3.6 per cent over the next five years, with inflation averaging 1.4 per cent. But with rising real rates, growth might well be lower. Under those circumstances, interest payments could soar as a share of federal revenue – from a tenth to a fifth to a quarter. Last week Moody’s Investors Service warned that the triple A credit rating of the US should not be taken for granted. That warning recalls Larry Summers’ killer question (posed before he returned to government): “How long can the world’s biggest borrower remain the world’s biggest power?”  

As in all Greek dramas, from Sophocles to the Goldman derivatives, the audience sees self-defeating chararacter flaws and psychological traits revealed. National heroes and leaders act like the Gods, then fall from the heavens. But they can’t see what we see. Call it original sin, fate, destiny or just plain arrogance, Greece, Europe and America all share this same trait, and the endgame is closer than you think: As Ferguson summarized it in an LATimes column, “America, a Fragile Empire: Here Today, Gone Tomorrow, Could the United States Fall That Fast?” His answer is clear and emphatic:

“For centuries, historians, political theorists, anthropologists and the public have tended to think about the political process in seasonal, cyclical terms … we discern a rhythm to history. Great powers, like great men, are born, rise, reign and then gradually wane. No matter whether civilizations decline culturally, economically or ecologically, their downfalls are protracted.” We are deceiving ourselves, convinced “the challenges that face the United States are often represented as slow-burning … threats seem very remote.”

No, the threats are not remote: “One of the disturbing facts of history is that so many civilizations collapse,” warns anthropologist Jared Diamond in Collapse: How Societies Choose to Fail or Succeed. Many “civilizations share a sharp curve of decline. Indeed, a society’s demise may begin only a decade or two after it reaches its peak population, wealth and power.” Maybe Ferguson does see the future … the “Greek crisis is coming to America.”

“All around the world, you still have a lot of undisclosed losses” …

“You never recover until the cleansing of the banks’ balance sheet has been done, and now we’re not at the point where this has been totally done.”

“I’m rather pessimistic … politicians seem to have drawn the lesson that they need to change the way they’re working if they want to manage the global economy” but “the banking sector — very little lessons have been drawn in terms of behavior.”

Ouch! And that’s direct from the International Monetary Fund’s boss. You really have to wonder if we’re headed for another meltdown soon. And since the US doesn’t have another $23.7 trillion (nor the political will) to bailout Wall Street’s “too-greedy-to-fail” banks again, investors better wake up fast and prepare for that dreaded “Great Depression 2″ we barely dodged in last year’s financial “near-death” experience.

n our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” That warning was in Buffett’s 2002 letter to Berkshire shareholders. He saw the future meltdown years before Greenspan, Bernanke, Paulson and many other political ideologues. They were in denial, ignoring the “mega-catastrophe” triggered by derivatives, the world’s new “financial weapon of mass destruction:” The Iraq war build-up was at a fever-pitch back then. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared to the $100’s of billions of subprime-credit write-offs now making Wall Street’s bigshots look like amateurs. Buffett tried to sell off Gen Re’s derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a “financial weapon of mass destruction.” That was 2002.

Derivatives bubble explodes five times bigger in just five years

Wall Street didn’t listen to Buffett, and any of the other leaders’ warnings, as derivatives grew into a massive bubble, from about $100 trillion in 2002 to $516 trillion by 2007. The new derivatives bubble was fueled by several economic and political trends that were driving Wall Street into what Bill Gross calls the “shadow banking system:” Derivatives, private equity, hedge funds and a world with little regulation nor taxation. The five key trends are:

1. Sarbane-Oxley increased corporate disclosures and government oversight.
2. Federal Reserve’s cheap money policies creating the subprime-housing boom.
3. War budgets burdening the U.S. Treasury and future entitlements programs.
4. Trade deficits with China and others destroying the value of the US dollar.
5. Oil and commodity rich nations demanding equity payments rather than debt.

In short, despite Buffett’s clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession. Data on the five-fold growth of derivatives to $516 trillion in five short years comes from the most recent survey by the Bank of International Settlements, the world’s clearinghouse-for-central-banks, in Basel, Switzerland. The BIS as like the cashier’s window at a racetrack or casino, where you’d place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is to $516 trillion, let’s put it in the context of some other domestic and international monetary data, so you can better appreciate the potential this huge derivatives stockpile of “financial weapons of mass destruction” has to trigger another even bigger “mega-catastrophe” in the near future:

• US gross GDP is about $15 trillion
• US money supply is also about $15 trillion
• Current proposed US federal budget is $3 trillion
• US government’s maximum legal debt is $11 trillion
• US mutual fund companies manage about $12 trillion.
• World’s GDPs for all nations is approximately $50 trillion
• Unfunded Social Security and Medicare benefits $50-65 trillion
• Total value of the world’s real estate is estimated at about $75 trillion
• Total value of world’s stock and bond markets is more than $100 trillion
• BIS valuation of world’s derivatives back in 2002 was about $100 trillion
• BIS 2007 valuation of the world’s derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes “transactions in which a major private dealer (bank) is involved on at least one side of the transaction,” but doesn’t include private deals between two “non-reporting entities.” They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion “notional” value (maximum in case of a meltdown) of the deals is a good measure of the market’s size, the 2007 BIS study notes that the $11 trillion “gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.”

Bubbles, domino effects and the very “bad 2%”

However, while that may be true as between a contract’s two parties in an individual deal, the broader risks to the world’s economies are minimized. Remember back in 1998 when LTCM’s little $5 billion loss nearly brought down the world’s banking system. That “domino effect” is now repeating many times over, straining the world’s monetary, economic and political system as the subprime housing mess metastasises, taking the US stock market and the world economy down with it.

This cascading “domino effect” was brilliantly described in “The $300 Trillion Time Bomb: If Buffett can’t figure out derivatives, can anybody?” published early last year in the Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger’s $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded: “There’s nothing intrinsically scary about derivatives, except when the bad 2 percent blow up.” Unfortunately, that “bad 2%” did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was “contained.”

Bottom line: Little things leverage a helluva big wallop. It only takes a little spark from a “bad 2% deal” somewhere in the “shadow banking system” to ignite this $516 trillion weapon of mass destruction. And ironically, in spite of the recession, by the end of 2008 the derivatives market had grown to $670 trillion. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile … it’s only a matter of time.

World’s newest and baddest “black market”

The fact is, derivatives have become the world’s biggest “black market,” exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today’s slowdown plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco’s bond fund king Bill Gross said “What we are witnessing, is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.” In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman, the Treasury Secretary and the rest of America’s leaders can’t “figure out” the world’s $516 trillion derivatives.

Why? Gross says we are creating a new “shadow banking system.” Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way creating money outside the normal central bank liquidity rules. How? Because they’re private contracts between two companies or institutions. BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic “shadow banking system” that has become the world’s biggest “black market.”

That’s crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don’t. They’re not “real money.” They’re paper promises closer to “Monopoly” money than real US dollars. And it takes place outside normal business channels, out there in the “free market.” That’s the wonderful world of derivatives, and it’s creating a massive bubble that could soon implode.

So what do you think about derivatives: as “financial weapons of mass destruction;” as a “shadow banking system;” as a “black market;” as the next big bubble exposing us dangerously close to that unpredictable “bad 2%?” They’re dead ahead, again!