Let's start with the basics. The most commonly accepted "pedestrian shed", or distance that people are willing to walk is 1/4 mi, or 400m. This distance comes from academic work studying the distance people are willing to walk to transit stops, which is actually a very different question. Transit expert Jarrett Walker does a great job explaining where this metric comes from, and how useful it is in the real world on his blog [1].

That said, this first blog post is primarily not about transit, but walking in general. I want to look at the idea of walking by itself, and question whether or not 1/4 mi. makes very much sense.

The inspiration for this post started with a recent trip my wife and I made to Baltimore, MD [2]. We stayed in a hotel in Mount Vernon, and one evening we decided we wanted to do dinner and a movie.

Here's a map of our route:

1. We left our hotel heading south towards the waterfront.
2. There was a convenient circulator bus running the same route we were walking, so we hopped on when one passed and used that to shorten one leg of our trip.
3. From there we walked across the waterfront and into Little Italy (4), where we had dinner.
4. From Little Italy we walked to a Wells-Fargo branch to visit the ATM (5).
5. From the ATM we walked to the movie theater (6).
6. After the movie we walked the whole way home, taking Charles St. most of the way.

Our travel distance? 2.27mi to the movie theater (0.68 mi on bus), 1.76 mi on the way home. 3.35mi total. That sounds like a lot, but at the time we didn't even notice.

Worth noting, the most direct route home would have been 1.4 mi, but that was using some oversized stroads. So, we added .36 mi to our route to walk on streets that felt safer.

The reason this inspired the blog post, is when we got home I realized we had probably walked more than a mile from the theater, and I was curious how far we had actually walked on our route. When I realized the round trip was more than 3 miles, I was surprised. It didn't feel like we went all that far. But, Baltimore is interesting, mostly pedestrian friendly, and we didn't have a car with us on this visit, so it was just the natural thing to do.

After sketching out some notes for this blog post I went to CNU 21 in Salt Lake City. As part of my interest in how far people really walk, I recently got a pedometer, and I brought this with me. The giant block pattern in Salt Lake City causes trips to be a little longer than you would expect in an urbanized area, but I was surprised to see my totals.

On Saturday of the CNU trip I walked 8.2 mi all together (18,127 steps). The above map includes a rough depiction of where I walked that day.

Now, I knew I had walked a lot that day, but it was spread throughout the whole day so I wasn't especially tired or sore at the day's end. I've been on trips (to Europe, Asia, and places like Disney World) where I'm sure I walked more than this in a day and was very tired at day's end.

These trips are good little snapshots of ordinary experiences for me, and the sum of these experiences has led me to conclude the following:

1. The 1/4mi walking distance may be relevant to how far people routinely travel to get to transit stops, but it has no relevance to how far people will walk when taking trips entirely on foot.

2. In my own life, and in comparing stories with many others, I find 1-2 mi. is much closer to the range that people will go on-foot without worrying about it, under the right circumstances.

3. People choose to walk or not to walk based on many factors. Among these factors, I believe distance much less important than people usually think.

How could distance not be so important, and what are the right circumstances for walking?

I'll come back with thoughts on that question in Part 2, Thursday, and Nate Hood will have a new blog post for us tomorrow.

Footnotes:

[1]: Jarrett Walker's website, Human Transit, is really a fantastic resource. Bookmark now, read regularly.

[2]: If you haven't been, Baltimore is worth a visit. It's a really wonderful city.

To summarize where we've been, I spent the first two days last week (Day 1 and Day 2) explaining some fairly straight forward, but not widely known or understood, ways in which the financial system operates. On Day 3 I shared startling concerns that were raised by the Federal Advisory Council -- a group of advisors to the Federal Reserve -- in their most recent meeting minutes. Finally, in Day 4 I tied it together to make three main contentions: (1) stock markets gains are not real but simple a byproduct of cheap credit, (2) rising housing prices reflect this same bubble and likewise are not real and (3) we can't make up for a lack of savings by simply printing money.

So let's assume, in a very optimistic sense, that Fed interventions have the desired effect, the economy begins to grow on its own and the Fed is then able to reduce QE and allow interest rates to return to market prices. 

The housing market is then going to have some huge downward pressure. First, the main buyer of Mortgage Backed Securities (MBS) is now the Fed, which purchases 70% of all new mortgages that wind up on the secondary market (nearly all). Without that buyer, rates will rise. Optimistically, this will present a buying opportunity for those that have kept cash under the mattress (granted -- not sure who those people would be as QE and the other Fed interventions have been designed to get all that cash into the market) and others who are looking for higher yields, perhaps from overseas investors looking for a place to put their dollars (and not worried about recent history in the housing market).

As rates go up, those investors that own low rate MBS sell them to avoid getting burned in the carry trade (see Day 1). While this wave of selling makes rates spike, once the shock passes and banks (and pension funds) have taken their losses, the market stabilizes at a new normal of moderate interest.

So interest rates will rise, by definition, as the Fed stops artificially suppressing them. As rates rise, purchasing power declines as the same payment now buys less house. While this has traditionally exerted downward pressure on home prices, the vigor of the recovery and the pent up demand (?) for housing convinces those (few) people who qualify yet don't own a home overlook the fact that they didn't buy at historically low interest rates. This, along with immigration, allows the housing market to remain healthy.

As part of this, homebuilders -- used to the mode and method of housing construction developed over the past sixty years -- begin modifying their approach en masse to correct the imbalance between single family homes and and households of single individuals. As such, the number of one and two bedroom units being constructed begins to climb as the number of new 4+ bedroom units declines rapidly. This is a different approach for home builders, appraisers, lenders, brokers, realtors and insurers -- not to mention inconsistent with our tax and regulatory structure -- yet there are market incentives to make the shift and so it occurs in relative order. 

As Baby Boomers seek to sell their suburban homes and relocate to other areas, there are enough Millennials -- as well as recent immigrants -- with sufficient affluence to purchase all of these homes at higher rates. Some places of the country fare better than others, but the worst performers are not sufficiently bad as to drag down the national economy.

As this is going on, the stock market continues to climb steadily. Stock prices are a reflection of earnings and earnings a reflection of sales and margins. A climbing stock market indicates that companies are still expected to make increasing earnings, improve sales and increase their profit margins while interest rates rise. 

Rising interest rates will certainly dispatch some high growth companies whose business models rely on low borrowing costs to build new stores and expand their market position. Rising rates will also force the liquidation of a number of companies that are highly indebted when those companies now have to take their narrow profits and pay competitive rates of interest. These bankruptcies will only make room for other competitors to gain in the market.

As interest rates rise, consumers -- particularly the prolific spenders that are carrying high debt levels -- will be squeezed by higher debt payments. Home equity loans will not longer be as readily available or as lucrative. Despite this, the growing economy increases optimism about the future.  People feel they will have increased capacity in the future so they begin to take on (even) more debt for consumption purposes, despite the higher rates. This allows businesses to continue to grow and expand justifying elevated stock prices.

Despite higher interest rates, commercial construction continues as national chains, and local enterprises, expand to more and more locations. In contrast to the established approach for national retailers, their protocols for store siting, their chains of suppliers and the entire regulatory and tax structure, business models begin to shift to respond to a new geography. Fewer strip malls are being built and business expansion is now taking place within traditional neighborhoods. This transition represents something of a new market niche and profits continue to soar, justifying broadly higher stock prices.

Finally, as interest rates climb and the Federal Reserve backs out of being the primary buyer of US Treasury bills, Congress is forced to deal with the rising deficit problem. A national debt of $17 trillion financed at less than half a percent interest suddenly becomes unwieldy when rates rise to 5%. The "devastating" sequester of $83 billion looks paltry in the face of what is now an additional $800 billion annually just in interest.

So Congress is forced to act decisively. A 2 to 4 percentage point increase in tax rates relative to GDP along with steep declines in military spending (and military commitments) and means testing of Social Security, Medicare and whatever emerges once Obamacare is implemented. These policy changes are made without any defaults and without any downgrading of the US credit rating. Foreign governments remaining willing (and able) to pick up the gap now that the Fed has exited the market, with Europe, China and Japan now buying trillions of dollars of US debt each year.

All of this allows the US economy to sail on, the Great Recession a nasty episode that we resolved by learning the lessons of the Great Depression and acting aggressively in times of crisis.

Later this week -- or early next week -- I'll give you a more pessimistic version of how this will all go down. In the meantime, I welcome your comments and critiques, particularly if you think I've not been fair in describing the optimistic outcome we culturally seem to want to believe in.

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A couple of late evening additions....a friend of mine (a banker) emailed me this article from the NY Times. The article elegantly made some of the points I tried to make earlier in this series. Second, Neil21 and I are having an enjoyable discussion over on the Strong Towns Network. We might be solving this whole thing. :)

I've also experienced a lot of enthusiasm for municipal investments to induce growth, borrow more money to get things going and essentially get back to the economy of 2005, which is going to happen really soon for those that get in the game. I also wanted to shatter this delusion.

And finally, I'm just so frustrated with the narrative from the Krugman Keynesians. As they hold out the king-sized candy bar and tell everyone that, if we just ate another, the sugar rush would get us up off the floor and we'd then have the strength in our economy to prosper. It's true, we can get up off the floor with another candy bar, but a lot of good, prudent and innocent people are going to get slammed hard when the sugar rush goes away. Statements to the contrary are comforting and convenient, but ultimately are reckless and harmful.

Neil21 is a long time reader and someone I've become a friend with here. I'm looking forward to heading out to BC later this year and meeting him in person. We do, disagree, however, on this topic. Here's a statement he made yesterday to summarize his contention:

Abundant capital is a great thing.

On it's face, that is clearly true. For an economy, abundant capital will provide for investment and growth. Continuing with the human body analogy (another complex system), it is a little like saying "energy" is a great thing. When we have a lot of energy, we can accomplish a lot of things.

(I'll also note here that too much capital causes inflation while too much energy causes hyperactivity and insomnia -- abundant capital/energy has limits, for certain, but what we're talking about here is a lack of sluggishness.)

We all understand that a body can get energy in productive ways and unproductive ways. Good sleep habits, a healthy diet and plenty of exercise is the healthy way for a body to have energy. This requires discipline and balance and, even when it is not pleasant, it requires one to listen to their body. That sore muscle is telling you something; maybe you need to stretch it more, or make sure it isn't neglected in your routine. That headache is a good thing if it is warning you that you are dehydrated.

So the human body, a complex machine, experiences volatility and gives off warning signs when things are not optimal. Sometimes we can respond to those signs in a way that is clearly productive -- we can drink more water or alter our exercise to be more balanced -- but sometimes we have to resort to other means. We can't solve a torn ACL with diet and exercise; for that we need some surgery followed by some antibiotics and pain killers. 

He's the fine line; we all understand that we ultimately need to shed the pain killers. Even Ben Bernanke and Paul Krugman will say, we ultimately need to shed the pain killers -- the low interest rates and quantitative easing --  and let this patient (a sick economy) learn to walk again. The trillion dollar question is: when?

This gets me back to the statement I made on Tuesday.

So, in normal times, we must save to invest.

Savings is the diet and exercise of a healthy economy. We save money -- delay the immediate reward of consumption -- for the promise of a greater future reward. These savings, in turn, can be productively invested by others today, resulting in growth. The natural regulator between savings and investment is the interest rate.

What economic stimulus does -- whether it is manipulation of the interest rate, printing of money or deficit spending -- is to give us investment without the need for savings. So we get energy without the need for a healthy diet and exercise.

We can see how, in an emergency situation or on a really bad day, it might be convenient to drink a Red Bull or eat a candy bar to give ourselves an energy boost. A steady diet of Red Bull and candy bars, however, can only lead to disaster.

I'm going to finish Day 4 with three graphs that show how the steady, sixty year diet of Red Bull and candy bars every time our economy has felt a little sluggish has deformed our economy. I particularly want to give some context to the recent stock market highs and housing data.

Here's our overall economic growth as compared to debt. As we proceeded through the second life cycle of the Suburban Experiment, the lack of real productivity in the economy was replaced with Red Bull (debt). This kept the economy going, allowed us to continue to grow our GDP, but allowed us to also become increasingly unproductive. By 2005, the height of the housing boom, our ability to sustain growth was almost entirely based on Red Bull (debt) and even then, we needed to grow debt at a faster rate than the economy just to manage meager growth. 

The gains we are seeing now in the stock market -- paper gains -- are not based on real productive growth. They are largely the result of cheap credit, something only sustainable so long as the Red Bull continues to flow at accelerating amounts. The crowding out of real savings by the Federal Reserve also means that people are being enticed into stock markets as a way to have any earnings at all. Although people have been shown to be unwilling to gamble where they can lose, when the momentum shifts and perceptions change, people are more than willing to gamble when they believe they will win.

In terms of housing, this was the chart that brought together everything that I'm seeing. We've been treated to the media reports that median homes prices are rising. This graph shows how this relates to median incomes. 

In short, home prices might be rising, but it is not a product of us having an economy where people are making more, earning more and having more money to invest in housing. It is an artificial creation of cheap credit. If we were transitioning to a real economy -- something stable -- that graph should be trending down, not up. 

And finally, we must save to invest. As we got into the second life cycle of the Suburban Experiment and the growth from horizontal expansion slowed, we replaced savings with Red Bull, putting off a difficult conversation about the wisdom of our approach and, in the process, creating an even larger deformation that we will ultimately have to deal with.

This is an incredibly fragile economy. That fragility is not the construct of recent bailouts, natural economic cycles, greedy politicians, a prolific consumer, lazy freeloaders, the 99%, the 1% or any of the other groups we like to pin the blame on. It is the result of sixty years of deformation, of responding to the aches and pains with Red Bull and pain killers.

Yes, that approach - what has evolved into a supply side, Keynesian amalgamation -- allowed us to grow faster, much faster, than we otherwise would have. It allowed us to live large, have an enormous standard of living, and accomplish many, many things that we would not have been able to do were we not taking economic steroids. 

Smoothing of the business cycle and decades of this faux-prosperity has all come at a price, however. That price is a great unwinding. On Day 5, I'm going to provide an optimistic roadmap for how a great unwind could happen. On Day 6, I'll give a less generous version.

(Note: I'm taking next week off to work on a private writing project, attend some girls softball games with a 8 year old and a 6 year old and get caught up. We'll have content here on the blog, but continuation of this series might be on hold until I get back.)

On Monday, we showed how banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt. We also explained one form of the carry trade that takes advantage of the interest rate difference between short term and long term securities, a trade that has much less risk when interest rates are kept artificially low and stable.

On Tuesday, we pointed out that a normal economy requires savings in order to have money that can be loaned out by banks and that interest rates are the market's mechanism for balancing savings and investment. This equilibrium is manipulated by the Federal Reserve to discourage or encourage savings in an effort to optimize market outcomes. Finally, Mortgage Backed Securities -- a financial product consisting of home mortgages -- provide a higher yielding, shorter term investment than long term treasury notes.

So let's move on to the red flags, as indicated by the Federal Advisory Council, a group that regularly advises the Federal Reserve. Here is how the FAC is described on the Fed's website:

The Federal Advisory Council (FAC), which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board's jurisdiction.

The most recent FAC meeting was May 17, the minutes of which can be found here. While the fifteen pages are generally full of statements that support current Fed policies and give endorsement to the notion of a gradual recovery in the economy, the last page has some very revealing insights. The FAC was asked to comment on current Fed policy, which is essentially manipulating the overnight borrowing rate to zero and using quantitative easing to further manipulate downward short term and long term treasuries. Here are some of their statements, which I'll provide some comments on.

The Fed’s securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns.

The first sentence is essentially what we've been discussing here -- yield is the interest rate and the Fed has been driving down rates. The second and third sentences can be read like this: because your savings account is not paying any interest (or your pension fund, 401(k), etc...), in order to have some earnings, you need to put your money elsewhere. Somewhere more risky.

That's the "undue risk" part, AKA: dumb money.

When your pension fund, for example, is underfunded by 25%, an amount that also assumes an 8% annual return from this point forward, very low interest rates on risk-free securities means that, to avoid falling further behind, the fund needs to invest more and more into higher risk areas. While we may think of the unsophisticated investor as the kid betting on dot.com stocks (been there, done that, circa 1998), we can just as easily think of them as the pension fund manager being sold the comparatively high-yielding Mortgage Backed Security that is very risky yet rated AAA by Moodys.

If you want to remove for yourself the veneer of sophistication surrounding Wall Street and investment in general, read Liar's Poker or The Big Short, two essential Micheal Lewis novels. 

Unsophisticated is essentially a euphemism for "dumb money," which includes everyone not part of the inside operation (and even some of those that are.) This is not a commentary on intelligence, but access to information and, increasingly, access to bandwidth.

The FAC is indicating that, with interest rates directed by the Fed to remain low for a long time, capital is moving from safe to risky investments. To preview what we're going to talk about tomorrow, junk bonds are now paying around 5%. Understand that junk bonds are the packaged debt of high risk corporate borrowers. Just a few years ago, these funds, which are very risky, paid over 20% interest. So much money is flowing out of zero-interest, safe havens and into high risk places that there is huge competition for even junk.

MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply.

As we discussed Tuesday, mortgage backed securities (MBS) are going to pay a higher rate of interest than a treasury note. With the rates on treasury notes being artificially depressed, investors (think your pension fund) are looking to mortgage backed securities to increase their returns.

Here's the problem: the Fed is actually buying 70% of all mortgage backed securities. Read that again. Seven out of ten home loans being sold onto the secondary market today are being purchased by the Federal Reserve. The remaining -- which are in high, high demand because they have a slightly higher rate of return -- are fought over by investors (fixed income, again think pension fund). 

This all drives mortgage rates down, down, down to historic lows. Any mortgage that can make it through the origination process can be purchased, securitized and sold in short order.

Many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favor of corporate, municipal, and emerging-market bonds.

The term "underweight" here is meant to denote that investors (keep thinking pension funds) are not holding a normal share of MBS and instead are buying other, more risky, bonds. In other words, the Fed is essentially forcing investors not inclined to risk into risky investments. This is why junk bond yields, for example, are so low. If these fixed-income investors could get their yield in a normal mortgage market, they wouldn't be buying junk bonds and the interest rate on junk bonds would rise.

There's also another risk here with the Fed dominating the mortgage market, that being the issue we discussed Monday in the carry trade. If the Fed starts to exit the MBS market, rates will go up. That makes the low rate securities actually drop in value (remember: I'm not going to pay you full face value if I can get a higher rate somewhere else). Since few people are going to refinance when rates rise -- we're essentially mining the refi market right now with these low rates -- MBS holders could be stuck with low yielding, long term notes. Corporate bonds, emerging market bonds and other instruments have a quicker turnover and give a little bit more flexibility in a market where rates are rising, but they are quite a bit riskier.

There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices.

Let's skip the whole conversation of inflation -- a black hole we could get lost in (as one example, note how the size of a basic candy bar has shrunk over the past couple of years -- no price inflation when you shrink the size) -- and focus on the unsustainable bubble in equity and fixed-income markets.

The equities market is the stock market. The FAC is saying that all of this money printing and frantic search for yield could encourage a lot of people to invest in stocks, something that would drive up prices to unjustified -- and thus "unsustainable" -- levels. On the way up, this is actually a self-reinforcing effect; the more stocks rise and the more yields on safe investments are depressed, the more the "dumb money" is lured into the rally. That the "smart money" counts on this reaction from "dumb money" is a tragic reality.

Further, current policy has created systemic financial risks and potential structural problems for banks. Net interest margins are very compressed, making favorable earnings trends difficult and encouraging banks to take on more risk.

Banks can't pay much interest in this environment, just look at your bank statement. With banks competing against the Federal Reserve for places to put money, they are left with the same choices everyone else has: make no money or take uncomfortably high risks. Banks that takes risks face huge problems when the market changes. Banks that don't might not make it that far.

The Fed’s aggressive purchases of 15-year and 30-year MBS have depressed yields for the “bread and butter” investment in most bank portfolios; banks seeking additional yield have had to turn to investment options with longer durations, lower liquidity, and/or higher credit risk.

With the Federal Reserve crowding everyone else out of the mortgage backed securities market -- and thus sucking all the mortgages out of banks (the originators) and into the secondary market -- what's a bank to do? Two things. More transactions, meaning originate more loans and essentially make your money on fees (a dwindling market as the number of homes that could refinance but haven't is shrinking rapidly) and take on more risk.

For at least a portion, that means that carry trade we explained Monday, taking short term money (deposits that can be redeemed at any time) and buying long term notes that fewer people want (which is what is meant by "lower liquidity"). This makes the bank very fragile.

Finally, the regressive nature of the artificially compressed savings yields creates pent-up demand within bank deposit portfolios; these deposits may be at risk once yields begin to rise and competitive pressures increase.

Here's the million dollar statement. Or perhaps the trillion dollar statement. Let's break it down slowly.

Regressive nature: this means the Federal reserve policy of low rates and money printing is hitting ma and pa investor really hard.

Artificially compressed savings yield: this means banks are not paying any interest because the Fed is manipulating the rate downward. This is a distortion of the market price.

Pent-up demand within bank deposit portfolios: Without good options, people are sitting on cash. They wish they could be putting that money someplace productive, yet not overly risky.

Let's put that together: Federal reserve policy is hitting the average saver really hard. Those savers are going to bolt to something that pays a market rate of interest when they get a chance.

So when you read the rest of that statement -- deposits may be at risk once yields begin to rise and competitive pressures increase -- it could be taken one of two ways (or both).

As the Fed stops intervening in the market and things go back to normal, depositors bolt to higher yielding securities, say a normal 90-day Treasury paying 5%. For the bank -- which has been forced to invest in longer term, less liquid instruments (see above) -- they risk losing their depositors very quickly if they don't raise rates to match their competition. No depositors, no money, fire sale, out of business. However, if they do raise rates, now they are struck with the downside of the carry trade (see Monday -- owning a long term note that pays less than the short term debt that finances it) and quickly burn through their equity. That is the same result: no equity, fire sale, out of business.

There's another way to read the FAC statement that builds on this insight on deposit flight, however. I'm not sure if the FAC is going Cyprus on us here, but they could be saying that deposits are at risk, meaning the insolvency of the banks and the sheer scale of the problem could be so great that it would exceed what a depleted FDIC could bail out. If that were the case, then your actual deposit -- the money you have put in the bank -- could be at risk for a partial or complete loss.

Imagine the US government saying, sorry, the FDIC is insolvent and so we're going to take twenty cents of every dollar you have in the bank and put it into the bank itself. We'll give you (non-redeemable) shares in the bank in compensation, so if the bank someday earns a profit you can share in that. That's Cyprus, and probably not what the FAC meant (although some members may have).

Either way, this is not a fun time for the dumb money that is left holding the bag.

Uncertainty exists about how markets will reestablish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses.

So the Fed may have things under control today, but it is not clear how they are going to remove the fingers from the dike without the whole thing collapsing. And, by the way, the water is building behind the dike and so this can't go on forever, there needs to eventually be a change in policy back to normal markets.

But look; the entire economy is shifted to either (a) those in cash and desperate for a return to market rates so they can bolt or (b) those who have positioned themselves at great risk with assurances that the Fed will continue to keep rates low. The more people that shift from (a) to (b), theoretically the better the economy will get since there will be less hoarding (saving) and more investing and spending. The problem is, the more people following strategy (b), the more critical it is to suppress rates as rising rates will sink their investment.

And there's the problem. The Fed is stuck in a trap of its own making. If it stops intervening, bank positions go bad, the stock market retreats and mortgage rates climb depressing housing prices, all at once. If it continues to intervene, it is only making these distortions worse, setting itself up for an even more painful unraveling, a reality summed up in the final sentence from the FAC.

Given the Fed’s balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system.

What is your house worth? What is a company's stock worth? What is your dollar worth? Nobody really knows because there isn't actually a market for any of those things. Now there's a "market" where things are bought and sold, but not a market where price discovery plays a role in determining what something costs. The very value of the currency is being manipulated, forced into risky and speculative places where it would not naturally go. We're living through the greatest, high stakes, financial experiment in human history.

If it is not already clear, tomorrow I'm going to show how these distortions are manifesting in the housing market and in the stock market. Then Monday (sorry for taking Wednesday off, but something came up) I'm going to lay out two scenarios: the optimistic where the Fed gradually unwinds its positions and the other where things don't quite work out as hoped. You can compare the likelihood of one extreme over the other -- I'll do my best to make them each as realistic as possible.

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Footnote: Woke up this morning to do another edit of this post and read this article on global markets. Here's the money quote:

"If you look at it historically, there has never been a period when the Fed has started to take back stimulus that has left the markets untouched," said Hans Peterson, global head of investment strategy at Swedish bank SEB.

"And this time it is a bigger exercise. We have moved markets from 2009 to 2013 on stimulus and now we are trying to take a step into a world which is more driven by natural growth. That transition will not be easy."

We all understand how savings is supposed to work. We put our money in a bank and the bank pays us a rate of interest for our capital. The bank then turns around and loans that money out at a higher interest rate, a mechanism by which they (a) make money and (b) pay depositors interest. If you had a lot of money, you could make your own loans, but for most of us (and even for the wealthy) it makes more sense to diversify over many projects and have the bank, made up of financial experts, evaluate projects on your behalf. 

So, in normal times, we must save to invest. The bank is not going to have any money to loan out unless people deposit money into it. (If you want a 200-level explanation, note that banks are part of the process in which money is created, a process described eloquently by Chris Martenson in this Crash Course video.)

Here's the next critical insight: In a normal market system, interest rates represent the supply and demand for capital. If there is a lot of demand for money from businesses and individuals that want to borrow, then a bank will raise interest rates to encourage people to save more. If the bank has too much money and not enough people asking for loans, then interest rates will drop. Now banks borrow money back and forth among each other which tends to even things out across institutions, but every now and then you'll see one pop up with a rate quite a bit on one side of the curve. Something's going on -- they either have a big deal and they need some capital or they have too much money and are having a tough time putting it to productive use. 

Now enter the Federal Reserve system and national, centralized monetary policy. I'm not going to go Ron Paul on you here and get into talk of the Fed being a construct of Wall Street, etc... I simply want to point out that, when the Federal Reserve intervenes to manipulate interest rates, it is distorting the relationship between supply and demand of capital. That is by definition. If the Fed raises rates, it will encourage people to save and if the Fed lowers rates, it will encourage people to do something else with their money. This is irrespective of what would naturally be happening in the market.

I'm not suggesting anything sinister there. This is, after all, an accepted practice among nearly all economists. According to their theories, when the economy needs a kick in boot, the Federal Reserve should lower interest rates to make capital easier for people to borrow. When the economy is overheated, manipulating interest rates higher is a way to dampen it down.

It is important to understand the mechanism the Federal Reserve uses to raise and lower interest rates. Remember yesterday we talked about the 90-day and 30-year treasuries? To lower rates, the Fed simply buys treasury notes. When they buy the notes from Wall Street banks, those banks then have a lot of cash and so they need more borrowers, fewer savers. Thus interest rates go down. To raise rates, the Fed does the opposite and sells notes. When it does that, it is putting these US treasury certificates -- instruments of savings -- out there and taking the cash back in return (which they put under their digital mattress). This reduces the amount of cash the banks have and, in order to attract money to lend, banks then need to raise interest rates.

So let's put these two things together; When the Federal Reserve determines that the market is not working correctly -- generally that growth, unemployment and inflation are not being optimized -- they will intervene to manipulate the market interest rate.

I feel like that's a lot, but there is one more concept we need to get through so we can spend the rest of the week talking about implications and that is the Mortgage Backed Security (MBS). As an analogy, if you created a company, had that company buy a thousand mortgages, then you sold a thousand shares in that company, each of those shares would be a MBS. With that MBS, instead of owning the debt of one mortgage, you would own 1/1000 of each. You are essentially spreading out your risk over a wider pool, just like a bank does when they do multiple loans. 

Mortgage Backed Securities become important to this story for one reason: yield. Yield is the interest rate at which the MBS pays. Due to the fact that there is more risk in an MBS than in a federal treasury note (which is falsely believed to have no risk) -- even when that MBS is rated AAA -- the MBS is going to pay a higher interest rate.

Now go back to yesterday where I described the carry trade. An MBS with a higher yield and a generally shorter maturing period (few mortgages make it the full 30 years w/o a refi) is a much more attractive buy when compared to a 30-year Treasury note. The MBS has a higher return with a much shorter maturity.

See where this is going?

Actually, I'll throw in one last thing here. You may remember the Federal Reserve's Operation Twist. This was a shift by the Federal Reserve from buying short term Treasury notes to long term notes, driving down the interest rates on those longer notes even further. The effect of this is to make those MBS investments with their higher yield even more attractive by comparison.

So let's summarize:

• In a normal economy, we must save to invest.

• In a normal economy, interest rates represent the supply and demand of capital.

• When the Federal Reserve determines that the market is not working correctly, it will intervene to manipulate the market interest rate.

• Mortgage Backed Securities provide a higher yielding, shorter term investment than long term treasury notes.

Tomorrow we start talking about the implications of these interest rate manipulations, as pointed out by the Fed's own advisors. Then on Thursday I'm going to bring it all together and show how the current growth in stock prices and housing is a debt-fueled illusion, one begging for dumb money to rescue the smart money. Finally, on Friday I plan to lay out two scenarios -- one optimistic and the other pessimistic -- for how this could all play out.

This week I'm writing for the choir, for those of you that generally buy into the Strong Towns approach. I want to bolster those of you that inherently believe that there is something rotten at the core of the economy. I want to give you context for all the propaganda being thrown at you about how our economy is getting back on track (record stock prices and accelerating housing market being two oft-repeated benchmarks). I especially want to support those of you that are actively working to realign your communities around resilient, Strong Towns principles. I don't want you to slide back into the Ponzi Scheme, especially since the market's need for dumb money is so intense right now. This week is about giving you confidence to stay the course.

First we are going to start with a lesson on debt and something called the "carry trade." Let's start with a very simplified explanation of how debt is used to magnify returns.

Let's say I have $1,000. I use it all to go out and buy a 30-year treasury note paying 3.5% (which is roughly the current rate). I now own a $1,000 note that will pay 3.5% ($35) annually for each of the next 30 years, after which my original $1,000 will be returned to me.

With that $1,000 note as collateral, I now go and borrow $900. I have 10% equity here -- some skin in the game -- but I'm still pledging the entire $1,000 so I can borrow another $900. I get the additional $900 and use that to buy 30-year treasury notes at 3.5%. Understand what I've done: I started with $1,000 and now, after one iteration of leverage, I have $1,900 in treasury notes along with a $900 debt. It's the same amount of money -- $1,000 -- but deployed differently in the market.

Now I take my $1,900 in treasury notes and I go through this leverage process again, essentially pledging that collateral for a loan of 90%, or $1,710. I promptly buy another $1,710 in AAA rated 30-year US treasuries. Good as gold. My $1,000 has now gotten me $3,610 in treasury notes along with $2,610 worth of debt. I still have more assets than liabilities, meaning I still have equity and everything I owe is fully collateralized with AAA securities.

This cycle continues again and again and again until my $1,000 yields $47,046 in 30-year treasuries along with $46,046 in debt. This is roughly the ratios of leverage that firms like Goldman and Bear Stearns were at when they went under and, reportedly, the levels that many of the remaining Wall Street banks are at today.

Why would a bank take on so much debt? The answer is something called the carry trade. While I said that our $1,000 is being used to buy 30-year notes at 3.5%, I didn't say what rate we were borrowing at. Obviously, if we had to borrow at a rate higher than 3.5% -- which you and I would have to for something like this -- we'd lose money in this trade. That's not how things work for banks, however.

A bank can borrow overnight today at essentially no cost. The bank borrows $46,046 this morning and promises to repay you at the end of the day. There is a tiny charge, but not much. Even if they were borrowing for a term -- say 90 days -- the rate is going to be really low (say, 0.1%) thanks to the Federal Reserve artificially supressing interest rates. At the end of 90 days, you just roll that debt over into a new 90-day loan.

So the carry trade is simple. You borrow at a low rate and lend back at a high rate. In this case you borrow for 90-days at 0.1% and then lend out at 3.5% for a 30-year note. In the first year, you have to pay 0.1% on your $46,046 debt (that's $46), but you make 3.5% on your $47,046 in 30-year treasuries (that's $1,647). 

I know this is a lot of numbers, but pause there for a second and understand what you just read. You started this exercise with $1,000. Due to your ability to leverage and the artificially low rates you pay on that debt, you pay $46 in interest expense and have $1,647 in interest earnings. In other words, your $1,000 earned you $1,601 in pure profit. You can sell all your securities, pay off all of your debts and walk away at the end of one year with a profit of 260%. (Now just imagine that, instead of $1,000, you were talking about $100 billion.)

Whoa Chuck, it can't be that easy.

Generally, it's not. The carry trade has some obvious risk involved. By financing short term to purchase a long term security, you are taking a very real risk that short term rates could rise and invert the trade. Let's say short term rates rose to 5%, the historical average over the past thirty years. Now you have a 30-year security paying just 3.5% but you are paying 5% on your financing. You are going to burn through your $1,000 in equity very quickly and then you're insolvent. Nobody is going to lend to you short term (or any term) and it's all over.

But what if you just sold your long term notes to pay off the debt? Well, when short term rates rise, long term will rise as well. If I am going to take a long term risk, I'm going to demand a higher interest rate than I could get for a short term risk. So if short term rates go from zero to 5%, long term rates would make at least that bump, from 3.5% to 8.5% (the rate of my first 30-year mortgage back in 1996 - how quaint).

Why is that important? Well, if I'm in the market trying to buy a 30-year note and I can get one paying 8.5%, how much am I going to be willing to pay you for your $1,000 note that is paying just 3.5%? The answer: a lot less than $1,000. In other words, as those long term interest rates rise, your long term securities are now worth less. This trade is now blowing up on both sides; your financing costs are rising while your asset value is falling. That's a deadly combination.

So the carry trade has a lot of risk.....that is, unless the Federal Reserve signals very clearly that they are going to keep interest rates low and stable for an extended period of time. When that happens, the carry trade is on and becomes a relatively low risk way to make a lot of money very quickly.

Let's end there for today, but first let me summarize.

• Big banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt.

• One form of the carry trade takes advantage of the interest rate difference between short term and long term securities.

• Interest rates kept artificially low and stable reduce the risk associated with that form of a domestic carry trade.

Tomorrow we're going to talk about the theoretical relationship between savings and investment as well as mortgages and the mortgage-backed securities market. Wednesday I'm going to explain how the Federal Reserve is now held hostage by their own zero-interest rate policy, to the point where their own policy advisors are pointing out the obvious. Thursday I'm going to bring it all together and show how the current growth in stock prices and housing is a debt-fueled illusion, one begging for dumb money. Finally, on Friday I plan to lay out two scenarios -- one optimistic and the other pessimistic -- for how this could all play out.

I'm going to pound this one out in 140 character bites -- nice and tweetable -- in deference to time constraints. Two girls have indicated they would like lunch.

Enjoyed the news.

• How did Minnesota get so lucky? Open Streets national training here in August -- save the date. openstreetsproject.org/blog/2013/05/3…

• Nate Hood, my Strong Towns colleague with the pink shorts, justifies his fashion faux pas by citing @andres_duany. nathanielhood.com/2013/06/03/pin…

• Norman Wright with a thoughtful dissection of Carl Schramm's critique of the planning profession. Worth reading. planetizen.com/node/63284

• The site plan for this "pedestrian friendly" "entertainment district" proves that English is a malleable language. m.bizjournals.com/cincinnati/new…

• People seem to like red light cameras. I guess I prefer a new scratch off game if we need another revenue gimmick. washingtonpost.com/local/traffica…

• Overlooking the disastrous safety implications, somehow it's not entrapment to design for high speeds & mark for low. stroadtoboulevard.tumblr.com/post/517524586…

• Illegal assessment we wrote about last year (strongtowns.org/journal/2012/1…) was settled before a judgement. $17k - too bad. startribune.com/local/south/19…

• If you cheer for the market downgrading toll road company for lack of drivers, consider the implications for cities. kvue.com/news/local/Cre…

•  Star Trib in classic Infrastructure Cult mistake not realizing that equations have two sides. startribune.com/opinion/editor… "Data Driven" Really?

• Hey Memphis. You know I love you, but Bass Pro? This dude needs none of your limited $. bloomberg.com/news/2013-06-0…

• A new dog park in my hometown -- awesome! I can't wait to walk my dog there...oh wait, I have to drive to get there? brainerddogpark.com 

• America's reserve currency status in fatal decline as we transition to entire new world economic order. Yawn... cnbc.com/id/100461159

and finally....

• Someone special in my life is always excited when I branch out into new music (she is constantly trying). OK Go. npr.org/event/music/18… 

Enjoy your weekend, everyone. Next week I have a four or five day series planned on a topic I've been dancing around (Supply side Keynes, economics, the American economy and how it all relates to housing and cities). See you then.

You can get more of Chuck Marohn's insights by reading his book, Thoughts on Building Strong Towns (Volume 1). It is a primer on the Strong Towns movement and an essential read for those wanting to get up to speed quickly.

You can also chat with Chuck, Nate Hood, Andrew Burleson, Justin Burslie and many others over at the Strong Towns Network. Join the ongoing conversation on how to make yours a strong town.

Click on the audio link below to listen or rightlclick to download.

The scene with Scott Doyon on stage.Russ Preston on the big stage.

Thanks to everyone who participated in this great event.

So, you the actively engaged reader/listener, help us decide where to prioritize. I hope to have these all our in the next couple of weeks, but if I can only get one done this week, which one is it?