Four Votes from the End of the World

Coming to a street near you?

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.

If you step back from the chart, you can see this is a pentagram. I blame it on the Pope.

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.

(images courtesy of farmakidis, South Florida Hedge Fund Managers)

* 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.

  • Mr. God

    I love how that picture is a pentagram.

    Also, you need to add disqus as one of your comment widgets.

    • Ryan Michael Murphy (@NouveauSouth)

      God, I am flattered that you read my humble blog and appreciate you taking the time to comment. I will accept your infinite wisdom and try to put a disqus widget on here. However, I was under the impression that you were female. It is a rumor started by a 90s song. If you could clear that up for us, we would all be very grateful. Amen.

    • Ryan Michael Murphy (@NouveauSouth)

      There is a disqus widget for self-hosted WordPress. I’ve been meaning to rebuild my site that way, so I’ll be sure to add the widget once I get some time to re-do the site.

  • Sean Mullan

    I would not blame debt in and of itself. I would almost equally blame East Asian currency arrangements, i.e., “Bretton Woods II.”

    There are also the problems of financialization, which you lightly touch upon via derivatives, and the privatization of the provision of previously public goods, such as education.

    • Ryan Michael Murphy (@NouveauSouth)

      You’re right in that debt is a symptom of other structural economic problems. Its the way we’ve papered over declining prosperity. I just wanted to start from the point of liabilities in the system and play out the thought experiment.

      • Sean Mullan

        The East Asians also had to do something with the trillions of dollars they’ve accumulated to maintain their fixed exchange rates.

  • Bach

    Ryan, what do you think about taking debt sharing in Europe further and creating a single bond, of course, assuming there’s no political opposition. Doing so should create more confidence in the European economy and move the continent towards a greater union. I’m suggesting this move because I believe the majority of the developed world’s population simply cannot live without taking on debt due to incredibly high prices on all necessities. Hence, countries should think of ways to protect the debt bubble rather than eliminating it.

    • Ryan Michael Murphy (@NouveauSouth)

      I think there will be a fiscal union in Europe relatively shortly, but I don’t think this is the right response. It is treating the problems caused by integration with further integration. The current system doesn’t work for anyone. The PIIGS only have default risk because they lack control over their monetary policy. If they could devalue their currency, they could make their debts less onerous. Germany and Northern Europe, on the other hand, are doing relatively well, and they don’t want to lose purchasing power or transfer money to Southern Europe. The euro-zone is constantly trying to find a middle ground that doesn’t please anyone.

      How would that improve with a fiscal union? It would only be worse, because then they must put all the different economic conditions and cultures under one roof to determine how much to borrow and where the money should go. There is just too much difference to make it workable. Eurocrats keep doubling-down and forcing federalization down the peoples’ throats (remember the EU Constitution?). I don’t see how all of this can work. They’ll keep trying for a while, but ultimately, countries are going to start dumping the euro.

      Prices are getting higher, but the Western world has financed its lifestyle beyond just necessities with debt. Look at the debt map link. People can and do live without debt. Debt is just being used to paper over the fact that we are not actually as prosperous as we’d like to appear. Most people could get their necessities without debt, and in these countries, there are social safety nets in place to assure those who can’t pay for necessities get them. Standards of living are going to drop. Its just a question of how much pain there is in getting there.

      • James

        Well said, Ryan (both the post and this recent comment).

        Let’s not forget that the crucial obstacle to federalization in the EU is the people. No Greek person is going to allow the creditor nations of northern Europe to violate Greece’s sovereignty. End-of-story. The same goes for the other debtor nations. At some point, the only way for EU federalism to “succeed” is for its member nations to sign over control of their governments (or at least their economies) to some central EU body.

        And then, that governing body is going to impose incredibly strict controls on the people of the PIIGS in order to make them solvent. You think the riots last week were bad? Wait until the Germans and French are telling 46 million Spaniards (11 million of them unemployed) that they no longer have social welfare programs! And do you think the Italian police will stand in front of riotous protesters when the people they’re really protecting live in Brussels?

        You’ve called it right – eventually the debtor nations will have to leave the EU, recreate their currencies and then print money like mad. The creditors will take huge hits because they’re getting paid back in monopoly money. The major EU banks are toast. There’s no way they can withstand such large hits to their balance sheets.

        Of course we might also just skip straight to that step if Italy or Spain go under within the next few months. It all depends on how long we can keep papering over the losses.

        I’m currently trying to noodle out the game theory of the whole situation. Let’s take Greece as our example. They know that their debt is dangerous enough to substantially damage the creditor nations. So they come to the table with a strong negotiating position – the Germans will give them most of what they ask for because if not, they leave the EU and Germany faces bank failures. At some crucial point, the Greeks (or Italy, or Spain, or whoever) will realize that they can’t gain anything from remaining at the table and they’ll leave. So long as the EU keeps reducing and restructuring their debt, nobody will leave the union. Of course, the saying goes: The Markets can stay irrational longer than you can stay solvent. I guess that goes for sovereign debt too.

        I’m also guessing a little at the black swan in the scenario. We know the dangers in the EU. We know enough to worry that China’s economy is in bubble mode. We know the US in likely entering another recession. And in some sense, we’re prepared to deal with these things (even if it is ineffective and/or highly inflationary). What aren’t we prepared for? Where are our blind spots?

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