"This is Ludwig Von Mises applied to the present
financial and economic situation".
Everyone must be
wondering where this “unprecedented global financial crisis”, (the World
Bank’s words), is heading. What follows, for what they are worth, are my
cogitations on this crisis.
There is no doubt that the world is dealing with a
credit/debt deflation of historic proportions.
It is worth spending a little time understanding how such events are
precipitated. An economy, as in personal households, corporations and
other entities, is financially sound when expenditures are less than
incomes. The difference can be saved and invested to produce additional
income and capital growth in the future.
When debt is introduced into the system, a different
dynamic emerges. We are not talking about self-cancelling debt but new
consumer debt which is spent in the economy. This results in expenditure
exceeding income and delivers a boost to the nation’s GDP. In the initial
stages the boost to GDP is quite large but as time goes by and the debt
total climbs higher, the cost of servicing that debt reduces the economic
benefit received from new increases in the debt mountain.
continuing supply of easily available and cheap debt leads to
speculative bubbles in one or more of the following areas:
real estate, financial assets, commodities and collectibles.
Once a bubble gathers momentum, a positive reinforcing
feedback loop develops. More debt pushes up asset prices and this higher
collateral value permits more borrowing which in turn pushes up asset
prices which provides collateral for further increases in borrowing, and
Eventually when debt becomes excessive, reaching extreme
and unsustainable levels, an extraneous event occurs that shatters
confidence and destroys the rationale that was underpinning the bubble.
This results in assets being sold to repay debt and a
downward reinforcing feedback loop develops. Asset sales reduce the prices
of those assets, which diminishes their collateral value, which causes
lenders to demand more security, which causes more asset sales, and so on.
Weaker lenders go bankrupt and the economy starts to collapse into
recession and possibly depression.
It is impossible to time the peaks of these debt bubbles
as they can develop a life of their own that continues for longer than any
rational person would think possible. In the recent debt binge we were
blessed (cursed?) with bubbles in all four categories, real estate,
financial assets, commodities and collectibles. Combined debt in the USA
has been estimated to have exceeded $50 trillion, which is 3.5 times the
estimated $14 trillion GDP level of that country. This is at least a 30%
greater ratio of debt to GDP than was achieved in 1929 just prior to the
last great debt deflation.
Once debt becomes excessive, and there is little doubt that this status
was achieved some time ago, debt cannot be repaid out of savings and
must be repaid in one of the following ways:
Via bankruptcies, which causes lenders to
wear the losses of debt failures, but eventually the broader community
also suffers from the economic depression that follows;
Via a rapid debasement of the currency which
allows debt to be repaid in currency with vastly reduced purchasing
power. Lenders are repaid but suffer a reduction in the purchasing
power of their capital. The broader community suffers from massive
price inflation and the economic dislocations that flow from this.
Via a combination of the above two methods
where there are initial bankruptcies followed later by a lesser degree
of currency debasement than that contemplated in 2 above. This
appears to be the course that the world leaders are headed towards by
their actions to date.
There are 3 major differences between the present debt
deflation and prior episodes. They are very important differences and will
probably impact on whatever new decisions our political leaders take to
ameliorate the crisis. These new factors are:
Modern economies are
linked by an electronic global interconnectivity which assists
modern commerce and trade to operate smoothly. This system relies on the
ability of banks around the world to readily respond to transactions
elsewhere. If you use your credit card to withdraw funds from a Moscow
ATM, the Russian bank must have instant certainty that the funds will be
delivered from your bank to settle the cost of the cash withdrawal. This
global electronic system has been developed over the past 30 years and
we now have electronic money. People are paid electronically and
make payments out of their bank accounts electronically. Modern commerce
and industry relies on this electronic system in order to function
did not exist 30 years ago but have become an important aspect of modern
commerce, investment and banking. These instruments are now massive in
quantity and have the potential to deliver staggering losses.
They have already become a destabilising influence in the world banking
and economic systems. A major problem is that these losses cannot be
quantified and nobody knows where they will settle, leading to distrust
For the first time in
history a world wide debt deflation is occurring in a situation where
virtually all countries have the ability to create unlimited quantities
of their own local currencies at will.
Baltic Dry Goods index, which measures the shipping costs for dry cargoes,
has declined incredibly by 90% in just a few months! And what follows also
is also the reason for the most recent sharp decline in commodity prices.
If the modern global banking electronic interconnectivity
system breaks down, world commerce will grind to a halt and the world will
almost certainly be pitched into an economic depression. The continued
operation of the system requires banks to have confidence in each other
and knowledge that the overall system works.
One area where the system is breaking down is in large
international trades for which special settlement systems called
Irrevocable Letters of Credit (ILC) are used. There are special
difficulties when the physical transactions are large in quantity and
value, when the buyer and seller are in different countries and when
lengthy sea voyages are required. The buyer does not want to pay for the
shipment until he is certain that he will receive it and that it meets
specifications. The seller, on the other hand, does not want to ship the
goods until he is certain that he will be paid.
The solution is for the buyer to go to his local bank and
open an ILC in favour of the seller’s bank, or possibly his bank’s agent
bank in the seller’s country. Irrevocable means just that, it cannot be
cancelled once it has been issued. It is effectively a guarantee by the
buyer’s bank to the seller’s bank that once the shipment arrives in the
buyer’s home port and is of correct specification, the seller’s bank can
pay the seller under the ILC and claim the money from the buyer’s bank.
What has happened in recent months is that these
international trades are grinding to a halt because sellers are saying to
buyers: “We don’t trust the ILC from your local bank. Go and get an ILC
from a bank that we trust”. This is why international trade has hit a
brick wall recently and why the Baltic Dry Goods index, which measures the
shipping costs for dry cargoes, has declined incredibly by 90% in just a
few months! It is also the reason for the most recent sharp decline in
Stimulus packages and bailouts are helpful but will
prove to be of no avail unless confidence in the banking systems of the
world is restored. It cannot be stressed strongly enough: it is
imperative to restore confidence in the banking systems around the world.
If this is not done quickly, world trade will grind to a halt and the
world economy will do likewise. How does one achieve this resurgence of
confidence in an environment of debt deflation with proliferating
There seems to be only one option. Governments will have
to take control of their national banking systems and be responsible for
all the bad debts, including the unquantifiable OTC derivative losses.
Nationalisation is anathema to those bred in a free
enterprise system. Economists of the Austrian
school argue that the deflation should be allowed to run its course. They
say that this would speed up the process of debt liquidation and reduce
the pain in the longer run. The immediate consequences of this would be
horrific and would certainly bring down the world’s banking systems in the
current environment. The issue at the moment is not whether the Austrian
school is correct or not, but rather what our leaders will do and what the
consequences of their actions will be.
Unfortunately, some form of nationalisation or Government
guaranteeing of banks around the world seems to be the logical
expectation. Short of this, we are headed for a depression of the 1930’s
variety, or something worse, and nobody wants to experience that.
Having nationalised (or guaranteed) the banks, the
problem of how to handle the debt will still remain. If we accept that
option 3 above – part deflation of debt and part inflation of the currency
– is the aim, one could postulate a situation where the US debt mountain
has deflated to say $35 trillion and that the massive new funding required
to instil confidence in the system produces a five-fold increase in money
and prices. In this situation, nominal GDP would have increased from $14
trillion to $70 trillion. Real GDP will remain unchanged, it is just the
purchasing power of the currency that will have been reduced by 80%.
A $35 trillion debt level is manageable with a GDP of $70
This seems to be the best “middle road” route that we can
hope for. Much will depend on how our politicians and central bankers
handle the situation. There is still plenty of scope for the situation to
get out of hand at either extreme, resulting in either a deflationary
depression or a hyperinflation.
In conclusion, I would like to discuss how the world got
into this situation. We have been bombarded by views that it was caused by
Greenspan’s excessive liquidity and low interest rates, combined with
weakness in regulation, rating agency mistakes and obfuscation from Wall
Street. Even the OTC derivatives have been blamed for part of the problem.
These issues are all valid but to use a medical analogy,
they are secondary cancers. They could not have existed without a primary
cancer being the underlying cause and stimulus. So what was the primary
cancer, the one which made it possible for all the other problems to
this we need to go back to basics: how the
fractional reserve banking
Briefly, the fractional reserve system requires
approximately 10% of new deposits to be lodged with the Federal Reserve or
Central Bank. Thus if a new deposit of say $1.0m of fresh money arrives in
the banking system, the bank receiving the deposit must put $100,000 with
the central bank and can loan the balance of $900,00. When that loan
arrives as a deposit with another bank, $90,000 must be placed with the
central bank and $810,000 can be loaned out. That in turn will arrive as a
deposit elsewhere and $81,000 must be placed with the central bank and
$729,000 can be loaned out, and so on. Finally when all these iterations
are complete, the central bank ends up with $1.0m as deposits from the
banks that have made loans of about $9.0m.
At this point new loans can only be made from profits
generated within the economy. This is important as the banking system will
have reached a period of stability which will remain until a fresh deposit
of newly created money appears in the system from somewhere. That new
money will allow the banking system to generate loans of approximately 9
times the amount of new money.
What happens if there is a money tap open somewhere in the
system and each day a large dollop of newly created money enters the
system? Very soon the banks will be awash with deposits and desperately
seeking new secure loans.
As lions kill instinctively in order to survive, bankers
make loans instinctively in order to survive. Eventually in these
circumstances of excess deposits, lending standards deteriorate and new
loans are made to less credit worthy borrowers. In time, anyone with a
good story gets a loan.
It is this desperate search for secure new loans by the
banking systems of the world that is the primary cancer referred to
earlier in the medical analogy. It allowed Wall Street to develop racy new
products which were gobbled up by banks around the world in the belief
that they were secure investments.
This is what actually happened in the real world. There was
an open tap pouring large dollops of newly created money into the world
banking systems over many years that created the insatiable appetite for
new banking loans and investments.
What is important to understand is that without this
insatiable demand for secure loans and investment by banks, it would not
have been possible for all the other irregularities to have taken place.
Credit standards would have remained robust and the banks would have
avoided the bulk of the toxic waste that they got involved with.
What was the money tap that was left running? It is a flaw
in the international monetary system which allows the USA to pay for its
trade deficit using newly created US Dollars. This has been going on for
two decades but has mushroomed in recent years. Ten years ago, the US
trade deficit was of the order of $100 billion per annum. This number grew
steadily until a couple of years ago it was running at $800 billion per
annum. An injection of $800 billion into the world’s banking system could
accommodate new loans of nine times that amount, or $7.2 trillion in a
Recently the US trade deficit has been averaging $700
billion per annum, allowing new loans of the order of $6.3 trillion per
annum to possibly be created. These numbers are in addition to other
sources of new money which individual countries injected into their local
monetary systems to stimulate their economies.
The simple fact is that the world’s banks were awash with
deposits looking for anything that resembled a reasonable loan or
investment. Wall Street created the products required to meet that demand,
resulting in the huge debt bubble that recently came to an end. In
addition, banks (prompted by the large availability of new deposits) made
many unwise loans across national borders which are now creating problems
in countries in Eastern Europe and South America.
The problems are manifold, but the most pressing one is to
restore confidence in the banking systems of the world. Failure to do so
will measurably increase the odds of a deflationary depression. The power
of the modern electronic money creating machine suggests that the odds
still favour an inflationary outcome, hopefully of the category 3 type
referred to earlier.