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.
The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by Alf Field in an article written back in November 2008 which warrants being revisited for its deep understanding of the dire economic conditions of our time and his insightful assessment of what can be done to alleviate the problem.
There is no doubt that the world is dealing with a credit/debt deflation of historic proportions [so let’s spend] a little time understanding how such events are precipitated.
- An economy…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…[it] delivers a boost to the nation’s GDP… [which, initially] 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.
Debt Must be Repaid Some Time, Some How
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.
Debt Deflation Then – and Now
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.
Stimulus packages and bailouts are helpful but…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.
How in the World Did the World Get 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 this article which 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 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…
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.
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…
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Other Articles by Alf Field:
I have come out of retirement for this one off, once only, speech to warn that the good ship “Life As We Know It” is sinking. You have the choice of getting into a life boat now or going down with the ship. The life boats consist of precious metals and other assets that will survive the coming currency destruction. [Let me explain.] Words: 1400
The Elliott Wave Theory (EW) gives superb results in predicting the gold price. [While] it is a complicated system with many difficult rules [which] I explain in simple terms in this article, [I have determined that] once this present correction in gold has been completed it should [undergo] the largest and strongest wave in the entire gold bull market. The target for this wave should be around $4,500 with only two 13% corrections on the way. [Let me explain how I came to that conclusion.] Words: 1924
When the supply of something is increased sharply relative to demand, the value of that commodity will decline. If the supply continues to increase rapidly and indefinitely, then that item will become worth less and less, with the potential to finally become nearly worthless. This is the Developing Disaster facing the US Dollar and the world. This is the factor that could become the single most important criterion in investment allocation decisions and possibly even for individual financial survival…[Let me explain this further by reviewing the 7 major problems facing the U.S. (and thus the world) and how they all will lead to problem #7 – devolution.] Words: 1520
The onset of the world’s worst financial crisis in many decades is one of the most important factors (if not the most important factor) currently influencing investment decisions. The crisis has created chaos and confusion. Not many people understand how the world has arrived at this unfortunate situation. This report endeavours to identify the underlying causes of the crisis and explains why the USA current account deficit has been the main destabilising force in world finance. Words: 3806