The Upside of Default

Writing The Archdruid Report has its pleasures, and one of them is the wry amusement to be had when some caustic jab of mine turns into an accurate prediction of the future.  Longtime readers may recall a comment of mine late last year to the effect that ordinary investors would surely find some way to pile into the shale gas bubble before the next year was out. Thanks to an anonymous reader and the August 2012 edition of SmartMoney Magazine, which arrived from said reader in yesterday’s mail, that comment can now be moved over into the "confirmed" category.

The prediction, to be sure, didn’t require any particular clairvoyance on my part.  Its sources are, first, a decent grasp of the history of economic stupidity, and second, a keen sense of the levels of desperation in what we might as well call the investmentariat, the people who have a little money and are looking for a safe place to put it.  The investmentariat has been told for decades that their money ought to make them money, but nobody told them that this only works in an economy that experiences sustained real growth over the long term, and nobody would dream of mentioning in their hearing that we don’t have an economy like that any more.

All the investmentariat knows for sure is that the kind of safe investment that used to bring in five per cent a year is now yielding a small fraction of one per cent, and the risks you need to take to get five per cent a year are those once associated with the the kind of "securities" that make a mockery of that title. The resulting panic is SmartMoney’s bread and butter. Smart money in the old sense—that is to say, the people who know what’s going on in the sordid and scam-ridden world of investment—wouldn’t waste five seconds on such a magazine; they know you can’t get any kind of advantage from something that a couple of million people are also reading.  No, this is strictly for the investmentariat:  as glossy, glib, and superficial as a teen fashion magazine, and just as unerringly aimed at the lowest common denominator of contemporary thought.

It will thus come as no surprise that the cover story on the August 2012 issue of SmartMoney is "The Return of Fossil Fuels," and that it rehashes the latest clich├ęs about vast new gas and oil reserves without raising any of the the inconvenient questions that a competent practitioner of the lost art of journalism, should one be wakened from enchanted sleep by the touch of a 1940s radio microphone, would ask as a matter of course. The article trumpets the fact that America is importing less oil than last year, for example, without mentioning that this is because Americans are using less oil—unemployed people who’ve exhausted their 99 weeks of benefits don’t take many Sunday drives—and it babbles about natural gas for two largely fact-free pages without mentioning that claims about vast supplies far into the future rely on assumptions about the production decline rate from fracked shale gas wells that make professionals in the gas drilling industry snort beer out their noses. 

All this, inevitably, is window dressing for suggestions about which stocks you should buy so you can cash in on the fracking boom. Last I heard, it was still illegal for journalists to take payola for pimping individual companies, or to speculate in the stocks they promote; still, I trust my readers will already have realized that one set of professional market players will get copies of the magazine the moment it hits the newsstand, snap up shares in the companies promoted in each issue, and dole them out at inflated prices to SmartMoney readers who get their magazines later, while another set of professional market players will take out short contracts on those same stocks as they peak, wait for the rush of buyers to crest and recede, and cash in on the inevitable losses. Those are among the ways the game is played—and if this suggests to you, dear reader, that the readers of SmartMoney are not going to get rich from shale gas by following this month’s tips, well, yes, that’s what it means.

This is business as usual in the financial industry, which has made a lucrative business out of extracting wealth from the investmentariat in various ways.  This is part and parcel of the broader and even more lucrative business of extracting wealth from everywhere by every available means.  The question that might be worth asking here, and is rarely asked anywhere, is whether the financial industry provides anything to the rest of the economy commensurate with its immense income and profits. Any economics textbook will tell you that companies raise capital by issuing stock, selling bonds, and engaging in a few other kinds of transactions in the financial markets, and that this plays a crucial role in enabling economic growth. Well and good; there are many other ways to do the same thing, but we’ll accept that this is the way modern industrial societies allot capital to new and expanding businesses. How much of the financial industry’s total paper value has anything to do with this service?

Let’s do some back of the envelope calculations. In 2010, the latest year for which I could find figures, the total value of bonds issued by nonfinancial businesses was $1.3 trillion, and the total net issuance of stock by all companies was $387 billion—that includes stock issued by financial businesses, but since this is a rough estimate we’ll let that pass. Total stock and bond issuance in 2010 to support the production of real goods and services was thus something less than $1.7 trillion; let’s double that figure, just to leave adequate room for other ways of raising capital that might otherwise slip through the cracks, for a very rough order-of-magnitude figure around $3.4 trillion.

In 2010, the total stock of debt and equity potentially available for trading in financial markets was $212 trillion, and the total notional value of derivatives that same year was estimated at $707 trillion. Exactly how much of this was traded in the course of the year on all markets is anybody’s guess—some stocks heavily traded by computer programs may change hands dozens of times in a day, while other assets spent the whole year sitting in a safe deposit box; still, this is back-of-the-envelope stuff, so we’ll use the total value just listed as a very rough measure of the size of the financial economy. We can round up a little here, too, to make room for forms of wealth not included in the two categories just named, and estimate the total paper value of the world’s financial wealth at $1 quadrillion, of which the fraction directed into the productive economy in one year amounts to around a third of one per cent.

Now of course providing capital to the productive economy is only one of the things the financial industry does that’s arguably useful to someone other than financiers. Local and national governments use the financial industry to raise funds for public works, individuals borrow money for the occasional useful purpose, and so on.  Let’s be generous, and assume that the amount of money that flows from the world of finance for these purposes is double the total input of capital into nonfinancial businesses via stocks and bonds. That means that in any given year, maybe one per cent of the financial economy has anything to do with the production of real, nonfinancial goods and services.

The rest?  It consists of ways to make money from money.  That seems innocuous enough, until you remember what money actually is. Money is not wealth; it’s a system of abstract, culturally contrived tokens that we use to manage the distribution of real goods and services.  A money system can simplify the process of putting energy, raw materials, labor, and other goods and services to work in productive ways; that’s the reason we have money, or rather the reason most of us are prepared to discuss in public. That’s not what the other 99% of the world’s financial assets are doing, though. They are there to ensure that the people who own them have disproportionate, unearned access to real, nonfinancial goods and services. That’s the other reason, the one nobody wants to mention.

Not that many centuries ago, across much of the world, usury—lending money at interest—was considered a serious crime, more serious than robbery, and was also classed as a mortal sin by Christian and Muslim religious authorities; it’s no accident that Dante consigned usurers to the lowest pit of the seventh circle of Hell. That’s been dismissed as a bit of primitive moralizing by modern writers, but that dismissal is yet another example of the way that contemporary industrial culture has ignored the painfully learned lessons of the past.  In a steady-state or contracting economy, usury is a parasite that kills its host; since the total stock of real wealth does not expand from one year to the next, each interest payment enriches the lender but leaves the borrower permanently poorer. 

Only in an expanding economy can usury be tolerated, since interest can be paid out of the proceeds of economic growth.  Periods of sustained economic expansion are rare in human history, since most societies live close to the edge of the limits to growth in their bioregions; the exceptions, such as the late Roman Republic and early Empire, usually involve the expansion of one society at the expense of others.  The late Roman Republic and early Empire, it may be worth noting, had a large and very successful moneylending industry, which fed on the expanding Roman state in much the same way that the Roman state fed on the accumulated wealth of the Mediterranean world. Only after Roman expansion stopped did attitudes shift, in favor of a religion that was violently opposed to usury.

During the three centuries of their power, the world’s industrial nations looted their nonindustrial neighbors with as much enthusiasm as the ancient Romans looted theirs, but they had another source of plunder—half a billion years of fossil sunlight, stored up in the form of coal, oil, and natural gas. In effect, we stripped prehistory to the bare walls so that we could enjoy an age of gargantuan excess unlike any other.  One consequence was that our moneylending industry was able to metastasize to a scale no previous gang of usurers has ever been able to attain. The basic arithmetic remains unchanged, though: usury is only viable in an expanding economy, and as the global economy enters its post-peak oil decline, the entire structure of money that makes money is going to come apart at the seams.

I’d like to suggest, in fact, that the unspoken subtext behind the financial crises of recent years is precisely that the real economy of goods and services is no longer growing enough to support the immense financial economy that parasitizes it. The current crisis in Europe is a case in point. Since the crisis dawned in 2008, EU policy has demanded that every other sector of the economy be thrown under the bus in order to prop up the tottering mass of unpayable debt that Europe’s financial economy has become.  As banks fail, governments have been strongarmed into guaranteeing the value of the banks’ worthless financial paper; as governments fail in their turn, other governments that are still solvent are being pressured to fill the gap with bailouts that, again, amount to little more than a guarantee that even the most harebrained investment will not be allowed to lose money.

The problem, as the back of the envelope calculations above might suggest, is that you can cash in the whole planet’s gross domestic product—that was a little under $62 trillion in 2010—and not come anywhere close to the value of the mountain of increasingly fictive paper wealth that’s been piled up by the financial industry in the last few decades.  Thus the EU’s strategy is guaranteed to fail. EU officials are already talking about "haircuts" for bondholders—that’s financial jargon for investors not getting paid as much as their holdings are theoretically worth. Not so long ago, that possibility was unmentionable; now it’s being embraced frantically as the only alternative to what’s actually going to happen, which is default.

There’s been a lot of talk about that in the blogosphere of late, and for good reason. No matter how you twist and turn the matter, Greece is never going to be able to pay its national debt. Neither are Spain, Italy, or half a dozen other nations that ran up big debts when it was cheap and convenient to do so, and are now being strangled by a panicking bond market and a collapsing economy. This isn’t new; most of the countries on Earth have either defaulted outright on their debts or forced renegotiations on their creditors that left the latter with some equivalent of pennies on the dollar. The US last did that in a big way in 1934, when the Roosevelt administration unilaterally changed the terms on billions of dollars in Liberty Bonds from "payable in gold" to "payable in devalued dollars," and proceeded to print the latter as needed.  That or considerably worse will be happening in Europe in the near future, too.

A good deal of the discussion of these upcoming defaults in the blogosphere, though, has insisted that these defaults will lead to a complete collapse of the world’s financial economy, and from there to an equally complete collapse of the world’s productive economy, leaving all seven billion of us to starve in the gutter. It’s an odd belief, since sovereign debt defaults have happened many times in the recent past, currency collapses are far from rare in economic history, and nation-states can do—and have done—plenty of drastic things to keep goods and services flowing in an economic emergency.  Partly, I suspect, it’s our old friend the apocalypse meme—the notion, pervasive in modern culture, that the only alternative to the indefinite continuation of business as usual is some unparallelled cataclysm or other.

Still, there’s another dimension to these fantasies, which is simply that the financial industry has done a superb job of convincing people that what they do is important to the rest of us. It’s true, to be sure, that having currency in circulation makes economic exchanges easier, and the kind of banking services that people and ordinary businesses use are also very helpful, but governments used to produce and circulate currency without benefit of banks until fairly recently, and banking services of the kind I’ve just mentioned can be provided quickly and easily by a government that means business; in 1933 it took the US government just over a week, at a time when information technology was incomparably slower than it is today, to nationalize every bank in the country and open their doors under Federal management. The other services the financial industry provides to the real economy can equally well be replaced by hastily kluged substitutes, or simply put on hold for the duration of the crisis.

So the downside of any financial crisis, however grandiose, can be stopped promptly by proven methods. Then there’s the upside. Yes, there’s an upside.  That’s the ultimate secret of the financial crisis, the thing that nobody anywhere wants to talk about: if a country gets into a credit crisis, defaulting on its debts is the one option that consistently leads to recovery.

That statement ought to be old hat by now. Russia defaulted on its debts in 1998, and that default marked the end of its post-Soviet economic crisis and the beginning of its current period of relative prosperity. Argentina defaulted on its debts in 2002, and the default put an end to its deep recession and set it on the road to recovery. Even more to the point, Iceland was the one European country that refused the EU demand that the debts of failed banks must be passed on to governments; instead, in 2008, the Icelandic government allowed the country’s three biggest banks to fold, paid off Icelandic depositors by way of the existing deposit insurance scheme, and left foreign investors twisting in the wind. Since that time, Iceland has been the only European country to see a sustained recovery.

When Greece defaults on its debts and leaves the Euro, in turn, there will be a bit of scrambling, and then the Greek recovery will begin. That’s the reason the EU has been trying so frantically to keep Greece from defaulting, no matter how many Euros have to be shoveled down how many ratholes to prevent it. Once the Greek default happens, and it will—the number of ratholes is multiplying much faster than Euros can be shoveled into them—the other southern European nations that are crushed by excessive debt will line up to do the same.  There will be a massive stock market crash, a great many banks will go broke, a lot of rich people and an even larger number of middle class people will lose a great deal of money, politicians will make an assortment of stern and defiant speeches, and then the great European financial crisis will be over and people can get on with their lives.

That’s what will happen, too, another five or ten or fifteen years down the road, when the United States either defaults on its national debt or hyperinflates the debt out of existence.  It’s going to do one or the other, since its debts are already unpayable except by way of the printing press, and its gridlocked political system is unable either to rationalize its tax system or cut its expenditures.  The question is simply what crisis will finally break the confidence of foreign investors in the dollar as a safe haven currency, and start the panic selling of dollar-denominated assets that will tip the US into its next really spectacular financial crisis. That’s going to be a messy one, since the financial economy is so deeply woven into the fantasy life of the average American; there will be a lot of poverty and suffering, as there always is during serious financial crises, but as John Kenneth Galbraith pointed out about an earlier crisis of the same kind, "while it is a time of great tragedy, nothing is being lost but money."

It will be after that, in turn, that the next round of temporary recovery can begin. We’ll talk more about that in the weeks to come.

End of the World of the Week #32

"If at first you don’t succeed, try, try again," is a common proverb in many fields, but it’s particularly appropriate for prophets of apocalypse. Some make one prediction and vanish from history when it fails, to be sure, but a good many of them are made of sterner stuff, and respond to the failure of one prediction by making another a little further into the future.  Bravest of all are those whose prophecies emerge one after another, each one just as inaccurate as the ones before it, each one uttered with  serene conviction, as though none of the others had ever appeared—or flopped.

Among this aristocracy of apocalypse, evangelical Christian author Hal Lindsey ranks high. He first burst onto the end of the world scene in 1970 with The Late Great Planet Earth, which blended standard Protestant fundamentalist apocalyptic rhetoric with a flurry of topical references to the Soviet Union and other headline-making themes, to claim that the Rapture, the Tribulation, and the Second Coming were going to arrive any minute now.

The Late Great Planet Earth was followed by more than a dozen books, each mapping the same theological claims onto a different set of current affairs  The only thing that was lacking was the Rapture, the Tribulation, and the Second Coming, or for that matter any reason even for believers to think these events would happen when Lindsey said they would.

—for more failed end time prophecies, see my book Apocalypse Not