“The world at large is drawing lessons from this economic crisis that will influence the political destiny of mankind. Mr. Sarkozy is trying to harness the collective dissatisfaction into a bold call for global reform. He is calling on world leaders to hold a summit before the end of this year to lay out proposals for a new approach to international financial and monetary relations. It could be the world’s biggest boondoggle — or the dawn of a new beginning for capitalism.”—Judy Shelton, “A Capitalist Manifesto,” Wall Street Journal, October 13th, 2008.
As the world attempts to get a handle on the global financial crisis, there is some question as to whether the current crop of world leaders have learned anything from the current pain being felt by markets. After all, of the ideas that have been implemented thus far, not a one has attempted to address the root cause of the pain: unstable money.
It was loose monetary policy that allowed the credit bubble to form in the first place, and it is loose monetary policy that now attempts to “solve” a global debt crisis with yet more debt. If leaders are unable to break this tautology, and choose only to treat the symptoms of this disease, the patient will move from severe to critical over the coming months and years.
A look backward over the past 7 months is instructive, to see, if nothing else, how the goals of government interventions have shifted as new symptoms have emerged. Those have ranged from preventing a recession, to stabilizing the mortgage markets, to unfreezing credit markets, to now rescuing/guaranteeing banks. All moves made have had but two instruments: for central banks to pump more liquidity into banks, investment firms, and other companies, and for governments as a whole to guarantee that if debts are not repaid by borrowers, then the taxpayers will be the ones to pay.
The liquidity game has been played for decades, and in the process, definite bubbles have emerged. These have recently severely destabilized the global economy, with the U.S. housing market bubble and then the commodities bubble being the two most recent examples. In what has been called by some a crisis of confidence, what has not been said is that this economic system hardly inspired confidence in the first place.
Some may argue that it is too simplistic to say that “too much credit” caused this problem. But it just may be that simple. The fact is that the markets were trading far more capital than actually existed. It’s been called a house of cards for good reason, and there is no question that the cause of these troubles is overleveraging. From an article published in March from seekingalpha.com predicting the market crash:
“What has gone wrong in the current market environment, however, is that we are still excessively leveraged. The problem is that the bond and derivatives markets dwarf the stock market in size. The Financial Times has published estimates that the size of the derivatives markets is currently estimated to be 450 trillion dollars and the notional value of credit default swaps is 45 trillion. And these staggering sums do not even include the gargantuan government and corporate bond markets or the commercial paper markets.
“And these enormous markets are unfortunately traded typically on 3-5% margin. Recall that Carlyle Capital only put up 3% margin and then folded when the market turned against them. Bear Stearns (BSC) leveraged its 11.8 billion of capital from its shareholders to control a balance sheet of 395 billion. There is simply not enough room for error when trading at such gearing ratios.”
In the run-up to the crash experienced last week, investors were told not to panic. At that stage, the apparent “solution” to a run on the markets was “don’t sell.” It’s similar to the problem that banks face worldwide, where depositors are told: “don’t withdraw.” At least, not all at once—because the money isn’t all there. It’s a classic swindle.
This is why 401(k)’s were decimated last week. The money was never actually deposited, and thus safe. They were merely valued. And when the market fell, they were devalued. Is there such a thing as a safe-deposit anymore? Apparently not.
It’s also why declining home values are of such concern. The real reason why. Not keeping folks in homes, rather, keeping an overleveraged system afloat and from falling into a vortex. These firms are so overleveraged that they cannot even withstand homes returning to normal values because of the cost involved.
And the “solution” offered by Europe to save this failed financial system? Put their taxpayers on the hook for the entire kitten-caboodle. European governments are guaranteeing the entire worth of their banking system, and analysts are declaring success based on a mere day’s gains in world markets. Here’s the gag: guaranteeing all of the loans by governments does not mean those governments can actually afford to do so—let alone the taxpayers who fund those governments.
If the U.S. follows suit to permanently nationalize the entire banking system, it will be the greatest bet made in the history of the world. The bet? That nobody will look behind the curtain. At least, not all at once.
If that thought is unsettling, it should be. In their efforts to prevent a global bank run, central banks may have only forestalled one. And in the process enslaved taxpayers worldwide to the task of “guaranteeing” loans, deposits, and investments. Do you like your shackles in iron? Or steel?
A total run on such a system would make the wealth destruction of last week look like the tip of the iceberg. Next time it would be a run on government itself. The only outcome then would be that government socialized the greatest risk in economic history, and failed because it finally told a lie far too big.
Here’s the real question: if markets cannot guarantee the debts currently made, what makes anyone think that governments can?
It doesn’t have to be this way. Not if, instead, world leaders learn from the mistakes of the past and determine to make the harder decision to solve the global debt crisis by reducing debt and engaging in monetary stabilization. There also needs to be a way of deleveraging these portfolios without putting taxpayers on the hook for perpetuity. It will be a painful process to be sure, but a necessary process for future prosperity. The alternative may be the riskiest scheme in human history.
