The We-Fixed-Nothing Chickens Are Coming Home to Roost (June 4, 2012)
When the real problems are masked with fake "solutions," the chickens eventually come home to roost, and we wake up to the reality that the fake "solutions" have only made things much worse.
The reality that the global Status Quo has fixed absolutely nothing in four years is finally coming to roost in the global economy. Though there is an endless array of complexity to snare the unwary, the source of instability is both visible and easily understood: too much debt that will never be paid back. Making matters much worse, much of the money that was borrowed--by sovereign governments, local governments, households and private enterprises--was squandered on consumption or malinvestments, and so there are precious few assets or collateral underlying the debt.
Even when there is an asset--for example, a vacant house in a vacant development in Spain, or a Greek bond--the market value is considerably lower than the purchase price.
The reality is that trillions of dollars, euros, yen and renminbi in phantom wealth will disappear when the losses that have already taken place are finally recognized. Everyone in the world with exposure to the global economy will become poorer in terms of abundant money floating around buying goods and services as credit dries up and deleveraging wipes out trillions of dollars, euros, yen and renminbi of phantom wealth.
Deleveraging is the process of the market discovering the true value of the asset underlying the debt and the difference between the debt and the proceeds of the asset sale being absorbed as a loss. If an entity needs to liquidate liabilities and/or raise cash to pay bills and interest, then assets will have to be sold. If the market value is less than the debt, then a loss must be booked. If a house carrying a $200,000 mortgage is sold for $100,000, the lender has to absorb a $100,000 loss.
Credit will dry up for a number of reasons, but the basic dynamic is that lenders no longer have enough collateral to generate new loans (except for those guaranteed by Central States) and in a world where assets are being sold to raise cash to stay solvent (the mighty engines of deleveraging), then prudent lenders are wary of loaning money to purchase assets that are declining in market value.
The Status Quo has played a very risky game for four years: when private banks go belly-up from issuing risky loans on mal-investments, then the stupendous losses are transferred to taxpayers: the Sovereign State "nationalizes" the bank or "buys" the debt; whatever the mechanism used, the key point is the owners of the debt take no losses when the debt is transferred from private hands to the taxpayers.
The key dynamic is this: instead of the bad debt being written off so the owners of the debt must accept the losses that have already occurred, the owners of the debt (bondholders) suffer no reduction in capital as their losses are transferred to the Central State.
Bonds earn interest because there is a risk associated with any loan. When risk is disconnected from the return or gain, that is moral hazard: people who have no exposure to risk make much different choices than those who are exposed to risk and loss.
The transfer of private losses to the public "solves" the problem when the losses are modest; but the problem is the losses are not modest, they are so gargantuan that they are swamping the State's ability to pay interest (service the debt).
That triggers the "austerity" death spiral: as taxes must be raised to service the new debt, households have less money to spend in the economy or to invest. The State, meanwhile, must cut other expenditures to free up money to service debt, so the government spending that feeds the economy also shrinks. As credit and consumption both dry up, businesses must lay off employees to survive. That places more people on the State dole, which makes even less money available for productive investment.
Without productive investment, productivity declines and wealth generation ceases. As everyone becomes poorer, tax revenues decline and the economy contracts. The State, having promised to pay interest in perpetuity on the phantom assets, must raise taxes on the remaining productive taxpayers. These taxes eventually crush the life out of small enterprises, who lay off what's left of their staff, further shrinking the economy and the pool of taxpayers. The most mobile of the productive leave for less oppressive climes, and many others opt-out: either give up and go on the dole themselves, or shift their productivity to the black market.
Paying interest on debt that wasn't invested in productive assets and that has no collateral to back it is a fiscal black hole. Money that could have been invested in productive assets or at least in public-good consumption is now devoted to paying the bondholders who should have taken the losses but were protected by the Central State. That protection is the beating heart of crony-capitalism and the engine of eventual collapse: profits are private, losses are shifted to the taxpayers.
The zombie banks are now State property, but that doesn't mean credit is abundant: the zombie banks still don't have any collateral, as the assets on their books (the houses that underly all those defaulted mortgages, etc.) keep declining in value.
Who is dumb enough to lend money to uncreditworthy borrowers to buy declining-value assets? Only the Central State is that dumb. Here in the U.S., the Federal government continues to issue 3% down-payment FHA mortgages to risky borrowers, and as a result the default rate on FHA loans is rising so fast the agency will soon need a bailout.
And the losses, of course, are simply transferred to the taxpayers' account.
The machine is now freezing up. Since assets are declining in value, collateral (if there is any at all) is shrinking, and the risk of loaning money to buy assets rises even as the return (the interest rate) is kept below inflation by central banks. Those twin forces dry up prudent credit, leaving only "dumb credit" issued by the Central State.
"Dumb credit" issues loans to uncreditworthy borrowers in the hopes that these marginal buyers will re-inflate asset bubbles (such as housing), as a reinflated bubble will enable the lenders to sell the defaulted homes at full value and thereby avoid staggering losses.
But alas, the debt load already carried by households is so crushing that the number of marginal borrowers is too modest to reinflate the bubbles. The number of people who are anxious to unload their assets far exceeds the few marginal buyers of assets: the number of debt-encumbered households who want to sell their house because it's worth less than their mortgage and the number of "pre-foreclosure" homes rotting in the capacious inventories of lenders can be counted in the millions.
This is a game the lender will lose, even when the lender is the Federal government, the European Central Bank or the Bank of China. Loaning money on assets that are declining in value to marginally qualified lenders can only generate more losses, and when these losses are transferred to the taxpayers, the rising debt service triggers an "austerity" death-spiral.
There is only one real solution: reconnect risk and consequence, and make the owners of the impaired debt absorb the losses that have already occurred.
It would be nice if these monumental losses were limited to the global financial Elites, but the phantom wealth is widely distributed. Trillions of dollars, euros and yen of phantom assets are held by pension funds and insurance companies; the interest collected on phantom assets funds annuities, pensions and insurance claims. When these phantom assets vanish, the public-union pension funds will be unable to pay their beneficiaries, insurance companies will be unable to pay claims, and so on: the 99% will also become much poorer as all the income streams they thought were permanent dry up.
As noted above: Everyone in the world with exposure to the global economy will become poorer in terms of abundant money floating around buying goods and services as credit dries up and deleveraging wipes out trillions of dollars, euros, yen and renminbi of phantom wealth.
A sense of outraged betrayal will become widespread. That will generate volatility and launch dynamics that will distribute nations along a critical spectrum of impoverishment and instability: some will become poorer and unstable, others will be poorer but remain stable. Poorer and stable is one thing, poorer and unstable is another entirely different thing. Becoming poorer is bearable if you retain some measure of social cohesion, predictability and stability; becoming poorer in chaos and instability is a much riskier situation.
Social stability is a complex web of cultural conventions, work-arounds, interactions and ever-changing dynamics; I devoted my latest book Resistance, Revolution, Liberation: A Model for Positive Change to an exploration of social and economic stability. In a nutshell, society is an ecosystem: the more features the society shares with monoculture, the more prone it is to fatal destabilization.
Though we cannot avoid the melting away of phantom assets, we could avoid destabilization
by facing the real problem head-on and reconnecting risk to consequence.
Resistance, Revolution, Liberation: A Model for Positive Change (print $25)
(Kindle eBook $9.95)
We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.
If this recession strikes you as different from previous downturns, you might
be interested in my book
An Unconventional Guide to Investing in Troubled Times (print edition)
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