http://www.kitco.com/ind/Field/nov132008.html
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.
A
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 so on.
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 properly.
- OTC
derivatives 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 between banks.
- 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.
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 commodity prices.
It is like
trying to pay for your restaurant meal in a foreign country and the
restaurant refusing to take your credit card because their local bank
is not prepared to do business with the bank that issued your credit
card.
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 bankruptcies?
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 trillion.
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 exist?
We
need to go back to basics. This subject was dealt with in the article
“Chaos Chronicled” which can be found at:
(http://www.freebuck.com/articles/afield/080410afield.htm) This article
explains how the fractional reserve banking system works.
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 single year!
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.
Alf Field
13 November 2008
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