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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://news.goldseek.com/AlfField/1207839600.php
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
Disclosure and
Disclaimer Statement: The author is not a disinterested party in that he has
personal investments gold and silver bullion, gold and silver mining shares
as well as in base metal and uranium mining companies. The author’s
objective in writing this article is to interest potential investors in this
subject to the point where they are encouraged to conduct their own further
diligent research. Neither the information nor the opinions expressed should
be construed as a solicitation to buy or sell any stock, currency or
commodity. Investors are recommended to obtain the advice of a qualified
investment advisor before entering into any transactions. The author has
neither been paid nor received any other inducement to write this article
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