Tuesday, June 23, 2009

“The spectre of default”

Sudden Debt offers a perspective consistent with mine (big picture here), but with a couple of charts I haven’t presented.  The classic deflationary “collapse of effective demand” occurs because the bottom 90 percent of the income distribution goes into debt trying to keep up with the top fraction (there are natural tendencies to compare one’s situation with that of others around one).  The debt load becomes excessive, as it has tended to do throughout history, as Michael Hudson points out here:

What to do?  Open debtors’ prisons and pack everyone in?  Have a war like World War II that somehow miraculously brings everyone together?  Not easy to pull off, that last one—the rich might just take the money from the war and retire to their gated communities (see On the coming neo-feudalism).  Sudden Debt argues for debt forgiveness—because default is already in the cards.  I agree.  What the imbecilic government of the United States of America has done is to guarantee that bad private debts mostly owed to the well-heeled investor class of American society will become United States Treasury obligations when they default.  This will cause the coming defaults, instead of being defaults on private debts, to become currency-destroying defaults on the world’s reserve currency.  Because outright default is unthinkable, the Fed will try the old “inflate our way out of this debt” trick. 

How many times does this story have to be told for the Senators and Congressmen to hear it?  I’m sorry, I forgot—”the banks own this place,” to paraphrase one senator.  Let me make clear though, that it is primarily high-flying New York banks, including the two former investment banks, that are at fault here.  The symbiotic relationship of Goldman Sachs and the Fed/Treasury is well-known.  For the record, there are thousands of honest bankers out in fly-over land whose balance sheets are pristine and who are mad as hell at the New York slicksters.

To be clear:  the problem is that our American social contract is broken (see this and this).  The income and wealth distributions have become unequal across industries; it’s not just banking.  We’re strangling the lower income classes.

There will be no significant recovery from the current severe recession without debt forgiveness.  The economy will stabilize for a few years as per our updates, and then effective demand will collapse again, for the same reasons it collapsed this time:  most households just won’t have enough money.  The obtuse macroeconomists will chorus in favor of “stimulus” that will run through the system (now “like a gasoline engine hitting on one cylinder”) and explode on the other end in some sort of price inflation.  And because all the currencies in the world are fiat currencies, and virtually everyone’s banks are messed up, we will see the Bretton Woods system finally go supernova, as all currencies inflate.  This will create a level of uncertainty about relative prices and the value of future cash flows that could depress aggregate demand on an international scale (even as nominal “aggregate demand” may be skyrocketing everywhere—happy, doctrinaire “Keynesians”?). 

Please also click through onto Simon Johnson’s set of charts on the global crisis (“Is it over yet?”  IMHO--no.) for a World Bank conference in Seoul. 

Here is Sudden Debt’s post:

Governments the world over are hoping to publicly borrow their way out of the stupendous mess created by the private financial sector. They are thus engaging in a monetary and fiscal experiment of Titanic proportions, steering a patchwork ship of State constructed from traditional Keynesianism and radical free-market ideology. Unfortunately, they are either blind to, or are nervously whistling past, the largest iceberg field in the history of economic navigation.
We are not going to escape unscathed.

Let's quickly set out what went wrong: oceans of debt blew asset bubbles for everything from clapboard houses and dinky mortgages to smelly shares, hedge funds, LBOs and 2/20 private equity funds. If an "asset" as much as fogged the mirror it was sliced, diced, indexed and leveraged to the hilt, transformed into a creative financial "product". A private banker friend told me two years ago that his nouveau riches customers from as far afield as Bangalore, Dubai, Sao Paolo and Moscow cared about one thing and one thing only: how many times can I leverage this baby up? At the top, if the answer was less than 40-fold they just sniffled and turned their noses away. (That's 97.5% margin, in case you were wondering..).

What happened next, predictably enough, was a debt crisis of historic proportions - and it's still going on. Amazing isn't it, how the newest generation of suckers always jump with glee into the oldest trap in the world* ?

Debt In The Yihaa !! Era

Governments, particularly in the U.S., are now desperately trying to avoid their biggest bugaboo: persistent asset deflation through debt destruction. Why? Because most assets are held by that tiny minority of the population for whom the golden rule applies (he who who owns the "gold" makes the rules). The vast majority of the rest have debts. To get a sense of the vast divide, in 2007 half of all American families had a net worth of $58,000 or less. By contrast, the top 10% had a net worth of $4,000,000 on average.

Chart: Federal Reserve

For a pluralistic republic like the U.S., does it make any sense to salvage the top 5-10% of the population's assets by placing more debt on the shoulders of everyone else - who already own next to nothing? Would it not be better to work out a debt default and reduction plan, instead of pumping the debt bubble even bigger?

But, mention debt default by (intelligent) design during a polite conversation and watch it grow hot and indignant - that's the moralistic Protestant Ethic weaving through most of us, I guess. Putting it another way, the Spectre of Default haunts, increasingly with as much fear as the other one did, back in 1848.
I am starting to believe that what America ultimately needs is a modern-day Solon and a healthy dose of seisachtheia.

1 comment:

  1. I largely agree with you but think you miss another large cause behind the diverging fortunes of the American public. The artificial management of interest rates to ensure a steep yield curve, and therefore a profitable banking sector, has penalized savors to the benefit banks for decades. This is another large, silent tax on the prudent that is never discussed.