In 2008 the world was rocked by what is now called the Great Financial Crisis (GFC). The crisis brought down some banking institutions, prompted emergency action by the US government, and triggered an unprecedented reaction from central banks around the world led by the US Federal Reserve. New and never before tried monetary policies were implemented and literally trillons of units of various fiat currencies were created in a global effort to keep the system from imploding due to contagion.
Now, its 2018. So far a systemic collapse has been avoided and most people have slowly released concerns about the stability of the system from their minds. Despite this, there is a nagging problem that most everyone acknowledges; and yet nothing serious is done about it. We are talking the huge debt burden that overhangs both the US and the world. The National Debt clock is still documenting the ever expanding US debt burden (now over 21 Trillion and don't even ask about unfunded liabilities).
As noted above, virtually everyone describes this growing debt as a true systemic risk. Not only for the US, but for the world as well. Just this year both the IMF and the BIS repeated warnings on debt as a systemic risk for the world in general. A chart from the World Ecnomic Forum captures the total global debt picture as of early 2018.
For years and years now, these kinds of warnings have been issued not only by the IMF and the BIS, but also policy makers, politicians, think tanks, and various organizations concerned about the issue (here is one example and here is another). In the US, politicians from both major political parties speak in dire terms about how awful the debt problem is, especially when the other political party is in power. All this, and yet no serious efforts are undertaken to actually do anything about the problem.
It's not hard to understand why. The policy decisions required to contain debt (raising taxes or cutting spending or both) are essentially political suicide at this point. People have a sense of entitlement now that says no one will ever have to make any sacrifices. Central banks stepping in to create all the money needed to prevent widespread economic contraction after the last crisis has simply re enforced that sense of entitlement.
None of this is ground breaking news. Most people kind of know instinctively that the above is basically true and just don't think about it much since the system still rocks along and their daily lives are not disrupted.
This situation creates a couple of key questions in my mind:
1) Given the above situation - how has the US (and by extension the world) been able to avoid a systemic crisis resulting from the overhang of outstanding sovereign debt?
2) How long can the US (and by extension the world) avoid a debt related systemic crisis?
a) less than two more years?
b) two to ten years?
c) more than ten years?
d) a new international system (a reset if you will) will emerge on its own before we get a major systemic crisis (debt related or otherwise)
e) none of the above or a different answer
These are the key questions to consider in my view. If no new major systemic crisis is coming for years and years, not much is likely to change very quickly. If a new major systemic crisis arrives in the not too distant future, all kinds of potential for highly disruptive change (good and bad) will exist. The latter impacts everyone in their daily lives, the former probably goes mostly unnoticed.
I decided to put these two questions to some experts to see what their thoughts are on it. Below are the unedited comments they sent me.
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From a reader who works in this arena who prefers to be unattributed:
To respond to your question (#1) ...
"Over the past decade, many boundaries of sound monetary management have been crossed, with favourable marketing (of the lipstick-on-a-pig variety) working its charm to drown out the protests of those who would have respected the rules.
Many monetary system-level changes since 2007 have been clever 'back room' sophisticated survival methods that are typically rather difficult to describe.
An interesting paper by Philip Bougen and Joni Young called "Fair value accounting: Simulacra and simulation" explains: "Values are being assigned to financial instruments which do not reflect some external accounting reality that is ‘out there’ merely awaiting discovery. Rather this reality is being imagined and might be reimagined in a multiplicity of ways at the intersection of different calculations and different assumptions. ... ... it is precisely because of their application in an accounting context categorized as fair value accounting, one with a market focus, yet one with an absent market reality, that the use of simulacra need to be highlighted. Reference to an absent market as an authoritative basis for simulation, invests the market (albeit absent) and the associated simulacra with a reality they do not possess. Indeed, many of these instruments have never actually been traded on an organized secondary exchange. ... ... the construction of a reality of various clearly delineated levels of inputs and a stylized market focus for valuation purposes evaporated as quickly as it was formulated, as ‘anomalous’ circumstances and considerations intervened, requiring connections between the various levels of inputs. Given the brokered transaction basis of OTC derivatives we suggest that the anomalies associated with ‘market prices’ might in the future prove more common than previously considered." (pg 399)
Here also is a good explanation of one of the methods, called a "Currency Swap Line":
An interesting paper by Philip Bougen and Joni Young called "Fair value accounting: Simulacra and simulation" explains: "Values are being assigned to financial instruments which do not reflect some external accounting reality that is ‘out there’ merely awaiting discovery. Rather this reality is being imagined and might be reimagined in a multiplicity of ways at the intersection of different calculations and different assumptions. ... ... it is precisely because of their application in an accounting context categorized as fair value accounting, one with a market focus, yet one with an absent market reality, that the use of simulacra need to be highlighted. Reference to an absent market as an authoritative basis for simulation, invests the market (albeit absent) and the associated simulacra with a reality they do not possess. Indeed, many of these instruments have never actually been traded on an organized secondary exchange. ... ... the construction of a reality of various clearly delineated levels of inputs and a stylized market focus for valuation purposes evaporated as quickly as it was formulated, as ‘anomalous’ circumstances and considerations intervened, requiring connections between the various levels of inputs. Given the brokered transaction basis of OTC derivatives we suggest that the anomalies associated with ‘market prices’ might in the future prove more common than previously considered." (pg 399)
Here also is a good explanation of one of the methods, called a "Currency Swap Line":
Presenting this method in a formal respectable article from the ECB (etc) makes it seem entirely coherent. Well, it is. But one can also readily imagine a Monty Python skit called "Currency Swap Line" which would equally reveal it for what it is: a system-level hack. Perhaps one should rewrite the words of "I'm my own grandpa" into a song about this method of monetary system management. For some detail on how things have come about, see this paper from the Federal Reserve Bank of Cleveland -- and the references therein. Some choice phrases are...
- "Increasingly controversial, the Exchange Stabilization Fund is used to influence the international value of the U.S. dollar.
- "This impedes an informed public discussion of ESF operations.
- "...explicitly authorized it to operate without congressional oversight and accountability.
- "...the Fed warehousing arrangement allows the ESF to take a leveraged position in foreign assets that is not reflected on the ESF’s balance sheet.
Swaps are not new, nor are they 'bad'. Back in 1990 the World Bank funded development of methods for the valuation of "Debt-for-Nature Swaps". That was a clever (fully transparent and within-rules) bankruptcy-management arrangement for massively indebted governments, led by some bright people at the World Wildlife Fund and the Natural Resources Defence Council. They thought up a way to adapt the currency swap method. Bad debt title in USD was sold to environmental organizations at hugely discounted rates, and payment of the remainder was carried out in local currencies to fund large-scale ecological protection through counterpart organizations in those countries."
In response to Question #2
A little like (d) but rephrased as (e): a new international system is continually emerging by fits and starts through a combination of hasty patch-ups and thoughtful novel designs, as we lurch along from crisis to crisis, with a bright idea here and a bright idea there. Economies as a whole (like ecosystems as a whole) don't really die; they just rot. See Joseph Schumpter's work on creative destruction.
A little like (d) but rephrased as (e): a new international system is continually emerging by fits and starts through a combination of hasty patch-ups and thoughtful novel designs, as we lurch along from crisis to crisis, with a bright idea here and a bright idea there. Economies as a whole (like ecosystems as a whole) don't really die; they just rot. See Joseph Schumpter's work on creative destruction.
From Dr. Warren Coats (former IMF Assistant Director):
If the U.S. federal government ever defaults (not likely as I argued earlier), it will most likely take the form of inflation. While inflation is a tax, unlike other taxes it reduces the real value of existing debt public and private. Other forms of default and the resulting financial restructuring would reduce the real value of specific, targeted debt such as federal bonds etc."
From Robert Pringle (former Director - Group of 30)
"I just keep on thinking of what Adam Smith said when somebody came to tell him that the American colonists had defeated the British army and that this would be the ruin of our nation: “Young man,” said Adam Smith, “there is a great deal of ruin in a nation.” The US of A ain’t ruined yet. "
From Joseph Potvin (Executive Director - Xalgorithms Foundation)
"You never can tell what types of events might conspire to become the change, or when these might occur. System-level transformation can go unrecognized even by attentive participants within, until it's effectively the norm. The following is from a paper I did a quarter century ago on investment appraisal criteria (extending a list by systems design engineer Dr. James Kay, U Waterloo):
"Complex systems are:
- Unique - Each evolves through distinctive physical and historical circumstances;
- Nonlinear - Several controlling variables interact through multiple feedback loops;
- Discontinuous - Catastrophes and irreversible bifurcations can be internally generated;
- Not Predictable - Pivotal phenomena may not always be statistically significant;
- Pluralistic - At any moment several succesional configurations coexist;
- Fickle - From any state there are innumerable alternative developmental pathways; and,
- Self-Organizing - An open system enduring a persistent but moderate disturbance can, under some conditions, respond by establishing new stable structures to accommodate it."
From Dr. Leanne Ussher (Affiliate Scholar - Institute for Advanced Sustainability Studies)
"I actually don't agree with your premise.
I believe it is extremely important that there to be a clear distinction between US Federal government debt, and private debt (especially emerging market debt, which could be both private and sovereign). The fact that the federal government is NOT going to default on its debt (banning a political hijacking from the tea party) means that its debt excesses do not have the same impact as private debt. (Even US state debt and government sponsored enterprise debt could be easily taken over by the Federal Government in an emergency – e.g. the bailout of Fannie Mae). US Federal debt is quite different than private debt, since ultimately they can monetize their debt.
Federal government debt if used correctly can even save a financial crisis from escalating. It is true that this may cause moral hazard, or inflation, but this is something quite different from what you are inferring in your blog: excess US sovereign debt and a portending financial crises.
Conflating private debt with Federal Debt is a common mistake – and I believe it is common due primarily to ideological reasons. The famous ‘debt clock’ that you cite, only concerns itself with government debt, and was switched off when the national debt was decreasing in the Clinton years. Highlighting its ideological motivations.
The rising debt I’m concerned about is the rise in emerging market corporate debt, emerging market US dollar carry trades being reversed, and potentially private student debt, corporate debt, and financial corporation procyclical capital requirements.
The US is still currently the issuer of the world's reserve currency. What was of concern in the 2008/09 crisis was US private debt of financial firms, household mortgage owners, and a few non-financial firms. Too big to fail among private financial institutions (which to bail out -- not GSEs which were always going to be bailed out), and contagion across the national and international financial community.
The Federal Reserve was and will be rescuing private markets in the next crises (or overseas governments and their central banks extending USD swap lines). The Fed was not rescuing federal US debt markets, which is where everyone was running to, and they will run there again. Not until there is an alternative will the US suffer from its exhorbitant debt privilege, and even then it will be a slow burn (like Japan).
The US Federal government (like any federal government that issues debt in its own currency) can readily monetize and deflate its debt. This may cause inflation, and I’m not arguing for inflation. But inflation is a tax like any other. It is often levied on the poorest in a society, those holding assets or wages that are not indexed to inflation, and not debtors. But it is across the board.
I think, if you really want to blame Federal Debt for our next financial crisis, you would need to build a much more systemically related story of twin deficits, but even then I don't think I would be there.
US Federal debt and inflation is not going to be the next financial crisis. Rather, the debt deleveraging spiral that brings down private entities and their counter parties, across international borders, especially in the emerging markets, and here at home, will be a problem, but they will be running into US Treasuries when the crash occurs, not out of it."
"I actually don't agree with your premise.
I believe it is extremely important that there to be a clear distinction between US Federal government debt, and private debt (especially emerging market debt, which could be both private and sovereign). The fact that the federal government is NOT going to default on its debt (banning a political hijacking from the tea party) means that its debt excesses do not have the same impact as private debt. (Even US state debt and government sponsored enterprise debt could be easily taken over by the Federal Government in an emergency – e.g. the bailout of Fannie Mae). US Federal debt is quite different than private debt, since ultimately they can monetize their debt.
Federal government debt if used correctly can even save a financial crisis from escalating. It is true that this may cause moral hazard, or inflation, but this is something quite different from what you are inferring in your blog: excess US sovereign debt and a portending financial crises.
Conflating private debt with Federal Debt is a common mistake – and I believe it is common due primarily to ideological reasons. The famous ‘debt clock’ that you cite, only concerns itself with government debt, and was switched off when the national debt was decreasing in the Clinton years. Highlighting its ideological motivations.
The rising debt I’m concerned about is the rise in emerging market corporate debt, emerging market US dollar carry trades being reversed, and potentially private student debt, corporate debt, and financial corporation procyclical capital requirements.
The US is still currently the issuer of the world's reserve currency. What was of concern in the 2008/09 crisis was US private debt of financial firms, household mortgage owners, and a few non-financial firms. Too big to fail among private financial institutions (which to bail out -- not GSEs which were always going to be bailed out), and contagion across the national and international financial community.
The Federal Reserve was and will be rescuing private markets in the next crises (or overseas governments and their central banks extending USD swap lines). The Fed was not rescuing federal US debt markets, which is where everyone was running to, and they will run there again. Not until there is an alternative will the US suffer from its exhorbitant debt privilege, and even then it will be a slow burn (like Japan).
The US Federal government (like any federal government that issues debt in its own currency) can readily monetize and deflate its debt. This may cause inflation, and I’m not arguing for inflation. But inflation is a tax like any other. It is often levied on the poorest in a society, those holding assets or wages that are not indexed to inflation, and not debtors. But it is across the board.
I think, if you really want to blame Federal Debt for our next financial crisis, you would need to build a much more systemically related story of twin deficits, but even then I don't think I would be there.
US Federal debt and inflation is not going to be the next financial crisis. Rather, the debt deleveraging spiral that brings down private entities and their counter parties, across international borders, especially in the emerging markets, and here at home, will be a problem, but they will be running into US Treasuries when the crash occurs, not out of it."
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Added note: Recently, former Bear Stearns Director Nomi Prins wrote this article in which she attributes what she calls "dark money" from the Fed and other central banks as helping to prop up the system and avert collapse. Here is the concluding statement from her article:
It appears that our panel of experts mostly agree that central banks can and do use the tools available to them to keep the system afloat and can do this much longer than many people would expect. The first comment in the list above provides some specific examples of some of the tools available. Dr. Ussher makes a distinction between privately held debt and sovereign debt and feels the former is where the most risk lies in the financial system.
If the consensus of the views above is correct, it seems that what we should watch for is if the transition from the system we have today into whatever evolves in the future can be managed in an incremental way to avoid the sudden collapse so many watch for and expect at some point in the future (whether from sovereign debt or from private sector debt). Of course, only time will provide the answer as to what actually happens.
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