Must Read Article on the Big Financial Picture

Zerohedge has Simon Johnson explaining the panoramic view of the world’s financial risk:

On Japan:

Instead, for the last two decades, Japan’s government has been running large deficits, borrowing and then spending the savings of the young. When the elderly finally demand their savings back in the form of pensions, the government will need to reduce its budget deficit of 8% of GDP and start running a sizeable budget surplus. Unless there is a sudden burst of romance and fertility, there will be far fewer Japanese taxpayers in the future to pay this debt.

Collapse! But a slow, inexorable one.  Not one you’d want to make a movie about.

On the U.S.:

The blue line is the Fed’s interest rate, which of course is zero today.  Look how with each economic crisis, the target rate is lowered, and, subsequently, the amount of debt held by consumers rises.  The chart would be far more alarming if they used a percentage on the right side for publicly held debt.  Instead, so the line wouldn’t scream up past the top of the chart, they made is a ratio of publicly held debt over the Gross Domestic Product.  So, when it goes up one full unit, that means a 100 percent increase!  And it has gone up about 200 percent!  That last decrease is probably a factor of credit opportunities drying up due to failing banks and skittish lenders.

The alliance that leads to unsustainable finance here is simple: the US financial system earns large ‘rents’ (excess returns to labour and capital) from the implicit subsidies offered by taxpayers. These rents finance a massive system of lobbyists and campaign donations that ensures ‘pro-bailout’ politicians win elections regularly.

Each time the US has a crisis, politicians and technocrats admit their errors and buttress regulators to ensure that ‘it never happens again’. Yet still it happens, again and again. We are now on our third round of the so-called Basel international rules for banks, with the architects of each new reform admonishing the previous architects for their mistakes. There’s no doubt that the US will someday soon be correcting Basel 3 and moving on to Basel 4, 5, 6 and more.

The problem that the country faces is that with each crisis, the financial risks are getting larger. If continued in this manner, bailing out the system will eventually be unaffordable. When the US finally runs out of enough savers to buy the bonds needed to bail out the system, it will suffer the ultimate collapse. (For more detail, see Schularick and Taylor 2012.)

so, like Margaret Thatcher said, the problem arises when you run out of other people’s money.

On Europe:

So the total value of the derivatives is 19 times the GDP of the Eurozone.  Derivatives are complex and can be less risky due to having a concurrent opposite derivative to cancel out the balance sheet, but the huge risk is if one country (or two!) decide to withdraw from the union, it all goes haywire as the national currency makes all the fancy accounting worthless.

For example, if a German bank has a contract with a French bank and an opposite identical contract with a German pension fund, it can net those two contracts and report the ultimate risk as zero. (Of course there is counterparty risk, but under standard agreements, derivatives are cleared instantly at liquidation so the counterparty risks can be netted).

But if investors start to believe that there will be new currencies in each country, then the two contracts in this example are no longer offsetting so they must not be netted. It is reasonable to think that after any demise of the euro, the contracts between two German counterparties will be converted into deutsche marks, while contracts with international partners will be disputed or maintained in a euro proxy.

As a result, risk officers at banks should understand that if the Eurozone breaks up, all banks in Europe face enormous and unaccountable currency risk. Each of their ‘euro’ assets and liabilities needs to be examined to understand into which currency it would be converted. (For more discussion on redenomination issues, see Nordvig and Firoozye 2012.)


The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth.

The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and it is still growing. There are more crises to come and they are likely to be worse than the last one.

Yeah, what he said.


2 Responses to “Must Read Article on the Big Financial Picture”

  1. Joan Landes Says:

    This is more than troubling, it is ghastly. Does anyone really know how bad this could be? Wow. Buy gold. . .

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