Industrialised countries today face serious risks – for their financial sectors, for their public finances, and for their growth prospects. This column explains how, through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet are inherently difficult to regulate and control. It explains how this has happened and why there are more and worse crises to come. Words: 2434
Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and www.munKNEE.com (Your Key to Making Money!), has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.
Johnson and Boone go on to say:
There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque. Bailouts have encouraged reckless behaviour in the financial sector, which builds up further risks – and will lead to another round of shocks, collapses, and bailouts.
This is what we have called the ‘doomsday cycle’. The cycle turned in 2007-8 and was most dramatically manifest in the weeks and months that followed the fall of Lehman Brothers, the collapse of Iceland’s banks and the botched ‘rescue’ of the big three Irish financial institutions.
The consequences have included sovereign debt restructuring by Greece, as well as continuing problems – and lending programmes by the IMF and the EU – for Greece, Ireland, and Portugal. Italy, Spain and other parts of the Eurozone remain under intense pressure. Be that as it may, in some circles, there is a sense that the countries of the Eurozone have put the worst of their problems behind them. Following a string of summits, it is argued, Europe is now more decisively on the path to a unified financial system backed by what will become the substance of a fiscal union.
The doomsday cycle is indeed turning – and problems are undoubtedly heading towards Japan and the U.S.: the current level of complacency among policymakers in those countries is alarming but the next turn of the global cycle looks likely to hit Europe again and probably harder than before. The continental European financial system is in big trouble: budgets are unsustainable and growth is nowhere on the horizon. The costs of bailouts are rising – and the coming scale of the problem is likely to undermine political support for the Eurozone itself.
The structure of the doomsday cycle
In the 1980s and 1990s, deep economic crises occurred primarily in middle- and low-income countries that were too small to have direct global effects. The crises we should fear today are in relatively rich countries that are big enough to reduce growth around the world.
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The problem is that the modern financial infrastructure makes it possible to borrow a great deal relative to the size of an economy – and far more than is sustainable relative to growth prospects. The expectation of bailouts has become built into the system, in terms of government and central bank support. This expectation is also faulty, however, because, at times, the claims on the system are more than can ultimately be paid.
- For politicians, this is a great opportunity. It enables them to buy favour and win re-election. The problems will become apparent, they calculate, on someone else’s watch so repeated bailouts have become the expectation not the exception.
- For bankers and financiers of all kinds, this is easy money and great fortune – literally. The complexity and scale of modern finance make it easy to hide what is going on. The regulated financial sector has little interest in speaking truth to authority; that would just undercut their business. Banks that are ‘too big to fail’ benefit from giant, hidden and very dangerous government subsidies. Yet despite repeated failures, many top officials pretend that ‘the market’ or ‘smart regulators’ can take care of this problem.
- For the broader public, none of this is clear – until it is too late.
The issues are abstract and lack the personal drama that grabs headlines. The policy community does not understand the issues or becomes complicit in the schemes of politicians and big banks. The true costs of bailouts are disguised and not broadly understood. Millions of jobs are lost, lives ruined, fiscal balance sheets damaged – and for what, exactly?
Over the past four centuries, financial development has strongly supported economic development. The market-based creation of new institutions and products encouraged savings by a broad cross-section of society, allowing capital to flow into more productive uses but in recent decades, parts of our financial development have gone badly off-track – becoming much more a ‘rent-seeking’ mechanism that draws support from politicians because it facilitates irresponsible public policy. The question is: Who will be hurt next by this structure?
There are three prominent candidates: Japan, the U.S., and the Eurozone.
Japan’s long march to collapse
Figure 1 shows the path of Japan’s ratio of debt to GDP over the last 30 years, including IMF forecasts to 2016.
The above is a worrying picture:
- Japan has a rapidly ageing population.
The average Japanese woman today has 1.39 children, far fewer than is needed to replace the elderly. This means that the total population is set to decline by 26% by 2050. Having peaked in the mid-1990s, the country’s working age population will decline by a staggering 40% between 1995 and 2050. Naturally, many of the ageing Japanese have been saving for their retirement for decades. They deposit those funds in banks, buy government bonds, hold cash savings or buy Japanese equities.
- Japan’s growth is slowing.
With an ageing population and slower growth, the broad outlines of responsible policy are straightforward. Japan should become a big investor in countries with younger populations, providing the capital investment needed to generate growth. Those countries can then return the savings to the Japanese as they retire….Instead, for the last two decades, Japan’s government has been running large deficits, borrowing and then spending the savings of the young. When the elderly finally demand their savings back in the form of pensions, the government will need to reduce its budget deficit of 8% of GDP and start running a sizeable budget surplus. Unless there is a sudden burst of romance and fertility, there will be far fewer Japanese taxpayers in the future to pay this debt.
The government has not been willing to raise taxes in a timely manner to match its spending. The latest agreement is for a modest (5%) increase in the retail sales tax, which would only be fully implemented in 2015. Why would it do so in the future when the burden on the remaining workers will need to be ever larger?
Japan is saved from immediate pressure by the fact that about 95% of its government debt is held by domestic residents. As long as these investors are satisfied with very low – or perhaps negative – real rates, this situation can continue but sooner or later, Japan’s dreadful fiscal mathematics will catch up with the government. There is no sign yet of a broad loss of confidence, but major shifts in market sentiment are not typically signalled in advance.
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America’s reckless private finance
In the U.S., the symptoms are different. Figure 2 illustrates the U.S. version of the doomsday cycle: the rise of total credit as a fraction of national income. Major players in the financial system have become too big to be allowed to fail – and consequently receive large subsidies.
The latest crisis has led to the largest monetary and fiscal bailouts on record. The Congressional Budget Office estimates that the final fiscal impact of the crisis of 2007-8 will end up increasing debt relative to GDP by about 50 percentage points. This is the second largest debt shock in US history; measured in this way, only the Second World War cost more.
The alliance that leads to unsustainable finance here is simple: the U.S. financial system earns large ‘rents’ (excess returns to labour and capital) from the implicit subsidies offered by taxpayers. These rents finance a massive system of lobbyists and campaign donations that ensures ‘pro-bailout’ politicians win elections regularly.
Each time the U.S. has a crisis, politicians and technocrats admit their errors and buttress regulators to ensure that ‘it never happens again’, yet still it happens, again and again. We are now on our third round of the so-called Basel international rules for banks, with the architects of each new reform admonishing the previous architects for their mistakes. There’s no doubt that the U.S. will someday soon be correcting Basel 3 and moving on to Basel 4, 5, 6 and more.
The problem that the country faces is that with each crisis, the financial risks are getting larger. If continued in this manner, bailing out the system will eventually be unaffordable. When the U.S. finally runs out of enough savers to buy the bonds needed to bail out the system, it will suffer the ultimate collapse.
Roughly half of all US federal debt is currently held by non-residents so US fiscal policy remains viable only as long as the dollar is seen as the ultimate safe haven for investors…
The Eurozone: Flawed dreams
There is no sign that the Eurozone will emerge from crisis any time soon.
The incentive structure of the Eurozone ensured that each country’s financial sector clamoured to join it. The key feature that made it so attractive was the liquidity window at the ECB.
For smaller countries, the ECB is a modern day Rumpelstiltskin. Rather than spinning straw into gold, the ECB converts unattractive government and bank-issued securities into highly liquid ‘collateral’ that can be readily swapped for cash from the ECB. This feature instantly made sovereign and bank bonds very attractive debt instruments. Knowing that the borrowers had essentially unlimited access to liquidity from the ECB, investors became willing lenders at low interest rates to all banks in the Eurozone.
Given such attractive features, it is easy to understand why 17 countries mastered the political debate to join the Eurozone. It is also easy to understand how the system got abused and why it will be so difficult ever to make it ‘safe’. If the Japanese can’t control their public finances and if the U.S. can’t control its too-big-to-fail banks, the added complexity of merging 17 regulators and 17 national governments into a system where someone else can be made responsible for bailing out the intransigents seems a financial and regulatory nightmare. Such a system is sure to be crisis-prone.
The Federal Reserve and the U.S. federal government’s attempt to provide bailouts when there is trouble in the U.S. but in Europe, the bailouts are only partial. No country has a ‘lender of last resort’ like the Federal Reserve or the Bank of Japan – so markets are now learning that large risk premia are needed to reflect default risk in troubled countries.
Flexible exchange rates would undoubtedly make it easier to manage these crises. Devaluations instantly reduce wages and raise countries’ competitiveness. If Greece had managed a large devaluation, it could probably have avoided much of the unemployment and social turmoil we see today. Instead, each troubled country in Europe now suffers when having to force down wages and prices during adjustment.
This system poses great dangers to global financial stability. The Eurozone faces myriad problems, including insufficient bank capital, high levels of private and public debt, and the chronic inability of some member countries to grow.
It is now common to hear policymakers blackmailing populations: unless the Eurozone survives, tragedy will result – and it is true that tragedy will result; we only need to look at the rise of complex derivatives and the dangers they pose were the Eurozone to dismantle.
Figure 3 illustrates the growth of euro-denominated interest rate derivatives, the notional value of which now totals more than 10 times the GDP of the Eurozone. Regulators commonly use net figures when they consider ultimate risk for banks and this makes sense under the usual circumstances of bankruptcy but when a currency area breaks up, the practice of netting off contracts needs to change dramatically and banks will be facing far more risks than regulators and risk officers currently report.
For example, if a German bank has a contract with a French bank and an opposite identical contract with a German pension fund, it can net those two contracts and report the ultimate risk as zero. (Of course there is counterparty risk, but under standard agreements, derivatives are cleared instantly at liquidation so the counterparty risks can be netted) but if investors start to believe that there will be new currencies in each country, then the two contracts in this example are no longer offsetting so they must not be netted.
It is reasonable to think that after any demise of the euro, the contracts between two German counterparties will be converted into deutsche marks, while contracts with international partners will be disputed or maintained in a euro proxy. As a result, risk officers at banks should understand that if the Eurozone breaks up, all banks in Europe face enormous and unaccountable currency risk. Each of their ‘euro’ assets and liabilities needs to be examined to understand into which currency it would be converted.
The threat of future crises
The tragedy of the Eurozone appears unavoidable, but it reflects far greater risks that will spread to Japan, the U.S., and other advanced economies. Through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet are inherently difficult to regulate and control. We are at the behest of our politicians and financial sectors to prevent them from creating dangers yet around the world, our political and financial systems have aligned to build these dangers rather than suppress them.
The continuing crisis in the Eurozone merely buys times for Japan and the U.S.. Investors are seeking refuge in these two countries only because the dangers are most imminent in the Eurozone. Will these countries take this time to fix their underlying fiscal and financial problems? That seems unlikely.
The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth.
The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and it is still growing. There are more crises to come and they are likely to be worse than the last one.
*http://www.voxeu.org/article/doomsday-cycle-turns-who-s-next (Editor’s note: this piece first appeared in CentrePiece magazine (Centre for Economic Performance, LSE).
Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
With the pop from the USFed’s latest attempt at financial shock and awe already seeping from lackluster markets, and the teleprompter news networks losing steam over their promotion of the same, it is time to take a look back at the decisions made on 9/13/2012 and set the record straight on some things.
The Fed professes that QE 3 or as I call it, QE Infinity (QEI), will create jobs but I am not sure how they can expect anybody to buy their rationale. As we know, QE 1 and QE 2 did very little in the way of creating jobs. Might the Fed realize that QE Infinity could actually be counter-productive to economic growth?
The latest round of quantitative easing (an additional $40 billion a month until conditions improve) has been dubbed as “QEternity” or “QE-Infinity” by its critics but it will end much before that. We are witnessing a massive bubble in US government debt, and we’ve reached the point where no one in charge believes it will ever end – an excellent contra-indicator. [Let me explain.] Words: 720
The choice facing the leaders of the world’s largest economies is a simple one: Either they engage in massive money printing, or they let the world slip into another great depression. This article examines why they have no choice but to print money, something which will have significant consequences for everyone. Words: 560
I keep wondering to myself, do our money-printing central banks and their cheerleaders understand the full consequences of the monetary debasement they continue to engineer? [Below is what I think awaits us.] Words: 1013
There is a clear link between our system of fiat (paper) money, the supply of money and credit in an economy, and the 30-year boom that came to a dramatic end in 2008. It’s only by understanding this link that investors (and anyone with wealth) can appreciate just how fragile our financial system is, and what to do to protect themselves from its inevitable collapse. [Let me explain.] Words: 961
The outcome of the election of 2012 will [only] determine the rate of speed at which we approach the [financial] cliff [because] neither political alternative is willing to change course, to steer away from the cliff. The cliff is so high that whether we go over it at 200 mph (Obama) or whether we merely slip over the edge (Romney), the end result is the same — fatal for the economy and perhaps our entire political system. It is the fall that will kill us. [This article explains why that is going to be the case.] Words: 1135
The deficits aren’t going to stop anytime soon. The debt mountain will keep growing…Obviously, the debt can’t keep growing faster than the economy forever, but the people in charge do seem determined to find out just how far they can push things….The only way for the politicians to buy time will be through price inflation, to reduce the real burden of the debt, and whether they admit it or not, inflation is what they will be praying for….[and] the Federal Reserve will hear their prayer. When will the economy reach the wall toward which it is headed? Not soon, I believe, but in the meantime there will be plenty of excitement. [Let me explain what I expect to unfold.] Words: 1833
…The US Government and its catastrophic fiscal morass are now viewed by the world as a ‘safe haven’. This would easily qualify for a comedy shtick if it weren’t so serious….[but] the establishment is thrilled with these developments because it helps maintain the status quo of the dollar standard era. However, there are some serious ramifications that few are paying attention to and are getting almost zero coverage from traditional media. [Let me explain what they are.] Words: 1150
With the U.S. election just months off, political pressures will mount to favor fiscal stimulus measures instead of restraint. Such action can only accelerate higher domestic inflation and intensified dollar debasement culminating in a Great Collapse – a hyperinflationary great depression – by 2014. [Let me explain why that is the inevitable outcome.] Words: 2766
Whether our current economic crisis will end with massive inflation or in a deflationary spiral (ultimately, either one results in a Depression) is more than an academic one. It is the single most important variable for near and intermediate term investing success. It is also important in regard to taking actions which can prepare and protect you and your family. [Here is my assessment of what the future outcome will likely be and why.] Words: 1441
Daniel Thornton, an economist at the Federal Reserve Bank of St. Louis, argues that the Fed’s policy of providing liquidity has “enormous potential to increase the money supply,” resulting in what The Wall Street Journal’s Real Time Economics blog calls “an inflation inferno.” [Personally,] I think it’s too soon to make significant changes to a portfolio based on inflation fears. Here’s why. Words: 550
The developed economies of the world have opened the money spigots…[and this] massive money and credit creation is sitting in the banking system like dry tinder just waiting for a spark to set it ablaze. How quickly it happens is anyone’s guess, but once it does we are likely to be enveloped in a worldwide inflation unlike anything before ever witnessed. [Let me explain further.] Words: 625
Evidence shows that the U.S. money supply trend is in the early stages of hyperbolic growth coupled with a similar move in the price of gold. All sign point to a further escalation of money-printing in 2012…followed by unexpected and accelerating price inflation, followed by a rise in nominal interest rates that will bring a sovereign debt crisis for the U. S. dollar with it as the cost of borrowing for the government escalates…[Let me show you the evidence.] Words: 660
Interest rates have been manipulated to keep them extremely low in an attempt to stimulate the economy but…unless deficits are dramatically reduced…. interest rates will eventually rise and government interest expense will double or triple from the amounts being paid today. That potentially triggers a debt death spiral, where government has to borrow more than otherwise expected. It also raises the credit risk and could ratchet interest rates up again. It has happened to Greece, Portugal, Spain and other European countries already this year and could well happen in the U.S. too. Words: 595
Everyone who purchases a Treasury bond is purchasing a depreciating asset. Moreover, the capital risk of investing in Treasuries is very high. The low interest rate means that the price paid for the bond is very high. A rise in interest rates, which must come sooner or later, will collapse the price of the bonds and inflict capital losses on bond holders, both domestic and foreign. The question is: when is sooner or later? The purpose of this article is to examine that question. Words: 2600
LOOK! Everyone needs to see this. United States owes a lot of money. As of 2012, US debt is larger than the size of the economy. The debt ceiling is currently set at $16.394 Trillion, estimated to be hit around Sep 14, 2012. In the infographic below that enormous amount is illustrated in $100 bills. It’s frightening! Words: 605
The U.S. already has more government debt per capita than the PIIGS (Portugal, Italy, Ireland, Greece and Spain) do and it just keeps getting worse and worse thanks to both political parties. We are on the road to national financial oblivion yet most Americans don’t seem to care. They don’t realize that we have enjoyed the greatest prosperity we will ever see…and that when the debt bubble bursts there is going to be an immense amount of pain. That is a very painful truth, but it is better to come to grips with it now than be blindsided by it later. [Let me explain.] Words: 1140
Even as I write these words, the world’s largest economy — the E.U. — is coming unglued at the seams, the world’s second largest — the U.S. — is careening headlong toward a fiscal cliff that promises to gut its GDP, nearly all of Asia — including Japan, China and India — is slowing…and yet most investors still don’t get the message. [Let me go on to explain just what that message is.] Words: 1357
The U.S. is one of the worst debt ‘offenders’ in the world [and, as such, unless] dramatic spending cuts and tax increases [are undertaken within the next 5 years,] America’s debt/GDP ratio will continue to rise, the Fed will print money to pay for the deficiency, inflation will follow, the dollar will inevitably decline, bonds will be burned to a crisp, and only gold and real assets will thrive. [Here’s why.] Words: 674