There was a popular economic theory last decade called “decoupling”. Decoupling was the idea that the stability and viability of the world’s economies were becoming independent of each other. It held that China’s success wasn’t subject to US success, the US wasn’t subject to Europe, Europe wasn’t subject to China, and so on.
Decoupling was rightly dumped from our vocabulary in 2008 when the financial crisis revealed a deeply integrated and co-dependent economic system. Nothing has changed in the three years since. The global economic system is like tectonic plates all pushing in different directions, kept from sliding by a tightly-strung piece of dental floss.
The source of these tensions is a deeply indebted world. Where ever there is debt, there is risk. Think of the risks of debt in personal terms. If you have a home mortgage, the risks are greater. If you lose a job, then you stand to lose everything you’ve invested into your house. The bank stands to lose, too. Now add in an auto loan, student loans, and credit card debt, and the risks compound. Now add an entire country of people with all these debts, and you can see how debt creates systemic risk.
Keeping with the analogy, there is little risk in living with your parents without student loans, car loans, and credit card debt. There is also little prospect for increased economic productivity without using debt to invest in job training, transportation to get to a job, and the next great idea that makes people’s lives better and creates jobs. As long as your expected return on a debt is greater than your interest rate, then taking on that debt is a good investment.
The worldwide debt picture is does not reflect a healthy use of debt. Much debt has been used for consumption instead of investment, and the quantity of debt is more troubling. Here is a nice interactive map from the Economist showing levels of debt around the world. I’ve seen higher numbers, but they still paint an equally disconcerting picture.
The floss is poised to snap at several points, and once it breaks, nothing will be holding back a series of earthquakes. The debt ceiling spectacle was the most recent reminder to the public of our precarious position. As we speak, no one will loan money to Spain and Italy, which are too big to save, and the European Central Bank is buying their bonds to support their credit markets. Chinese social stability continues to erode under the pressures of high inflation, bringing the world’s creditor greater and greater political and economic risks.
I’d like to turn our attention back to Greece. In May, Greece passed its austerity budget by four votes. Greece had passed an austerity budget in May of last year that was supposed to assure fiscal conditions where it could repay its debts. Obviously if they were passing another long-term austerity budget the next year, the first budget didn’t do the trick. Not passing the austerity budget the second time around would have been Greece’s way of telling its creditors that they weren’t even going to try to pay them back.
So what happens if Greece does not pass the austerity budget? The short answer is that Europe’s banking system collapses, but that’s just the beginning of the story. Banks all over Europe hold Greek debt, and they are already unstable. The value of that debt would continue to fall until the market could no longer risk holding equity in any bank that is almost certainly bankrupt. Other European nations also hold each other’s debts, and the nations themselves go bankrupt one by one. The US money-market funds that hold sovereign debts tank, and everyone pulls their money out of the funds. The credit markets immediately screech to a halt.
Then the $700,000,000,000,000 derivatives market kicks in (that is $700 trillion presented for effect). By way of comparison, Gross World Product is $74t, so the derivatives market is over nine times greater than annual world production*. The value of the euro collapses with its banks and countries, so someone is paying on a foreign exchange swap. Credit default swaps on the failed banks and nations are triggered. The five major US financial institutions that write 95% of all derivatives in the US fail as a result. Then credit default swaps on the failed US banks are triggered, this leads to other bank failures, and so on until the entire financial system collapses.
Who knows what happens from there? China keeps doing what it has been doing, buying up every kind of sovereign debt to try to keep its export markets afloat. Then, the facade on the Chinese economy begins to crack. After years of malinvestment in ghost cities, it turns out that China doesn’t have that much money after all. China and all the other manufacturing economies lose their big export markets, and so all the factories that make porcelain birds and America flag bandannas shut down. There is massive unemployment and social unrest. Tanks hit the streets in Beijing. The workshop of the world boards itself up.
Of course, the IMF and governments can try to intervene with more floss at any link in the causal chain. They can prop up banks, guarantee derivatives, bailout countries, and do it all by printing massive amounts of money and throwing it everywhere (everywhere but the people who are the most adversely affected by over a decade of financial shenanigans; they have to accept austerity). But you can see the numbers for yourself, and once the plates start shifting, there are not enough resources backed by anything of value to slow it down. The resources are taken from the average Joes and given to the financial oligarchy through a regressive inflation tax.
I don’t think policymakers are or were necessarily exaggerating when they talk about the implications of our financial condition. Nevertheless, I think that Greece should have rejected the austerity budget, the banks shouldn’t have been bailed out, and the debt system should be allowed to reset. I wanted to put together a plausible illustration of the worst-case scenario, and in subsequent post, I give an argument for why we should accept the reality of the untenable position we’ve created instead of, literally, borrowed time.
* You can thank former Treasury Secretary and Harvard President Larry Summers and your fine representatives that brought you the Commodity Futures Modernization Act for this monstrosity.