If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Friday, 5 August 2011

Irrational exuberance: two double whammies of the US debt limit increase

It is a rather unorthodox way of solving debt problems by taking on yet more debt. It is even more unorthodox if the servicing of the existing debts is impossible without taking such additional debt. This is a classic example of a downward debt spiral: sliding into bankruptcy. Yet this is exactly what the US, as well as Britain and many countries in the Eurozone are doing.

What the solution is for the US now, the debt limit increase of another $2.1 trillion on top of the existing $14.3 trillion, will come back later to haunt the world markets: the US will have to continue to borrow to meet their financial obligations. Unless and until the US produces a balanced budget, the problem will keep growing. And they better do it soon as such balance has to be sustained on average through ups and downs of the economic cycles in a long term. This, in fact, was a golden rule that Gordon Brown preached but was never able to put it in practice. US talk of a $2 trillion (or even $4 trillion) debt reduction over 10 years is farcical at best.

Rating agencies, by the nature of their business and, more importantly, their conduct create a lot of uncertainties in the markets. The credit rating is not just a figure that became popular recently. It is typically part of any creditor-debtor agreement on the financial markets. The lower the credit rating, the greater the interest rate that the debtor has to pay to cover the costs of the additional risk. Whilst it seems to make logical sense, such methodology is a source of instability.

If a debtor is less likely than before to satisfy the creditors then its credit rating has to be decreased. Consequently the interest payments on debt have to go up. But with the increased interest payments the debtor is even less likely to satisfy its obligations. Hence another rating downgrade is very likely. And so on.

The credit rating agencies would only have a stabilising effect on the markets if countries in debt had the scope to readjust their finances in order to prevent the downgrades. And they act as if they have such scope. The credit rating agencies methodology and practice is a typical recipe for a downward debt spiral.

Moreover the credit rating agencies credibility has not been enhanced by a rather inadequate (to put it mildly) assessment of many financial instruments in the run-up to the credit crunch of 2007 - 2008. The fact that the agencies did not come clean on what went wrong then should also be a point of reflection.

The US debt is a different kettle of fish to all other financial papers due to its value, and the fact that two-thirds of world reserves are held in US dollars. A downgrade of the US debt will have grave effects on the world markets. Moreover, as many American politicians ask "why we let these guys even be in business" the US may administratively deal with the credit rating agencies; effectively dismantling the financial markets as we know them.

Hence despite the US amassing a huge debt, the agencies seem to be determined to keep AAA rating. This, of course, makes a mockery of the rating system.

An AAA rating of the US debt allows the debt papers to be traded and considered by the financial markets as good as cash. But it is not cash. It is debt and it will have to be repaid at some point. As long as US debt papers function on the financial markets as cash they are effectively printed money that fuels high inflation. For that reason in the last couple of years, we observed high inflation in commodities and other durable assets, such as real estate.

Not unexpectedly the price of gold has been reaching record levels and Swiss Frank started behaving like a commodity rather than a currency. It is becoming clear that the investors use the time to convert as much as possible of the US debt to as much as possible "real wealth". It is clear that the AAA rating of the US debt does not reflect the confidence of sophisticated financial investors. And the world at large is artificially propped up on confidence. It is yet another bubble that is going to burst.

The real effect on consumer markets is that despite very low levels of lending to businesses, very low wage inflation, very low growth, the consumer inflation is accelerating. It is a state of stagflation.

The real effect on financial markets is that the financial bubble keeps on growing. The financial bubble is not an esoteric term describing imbalances. It is a simple formula, a ratio of the liabilities that the financial institutions have or may be demanded to settle, to the means of such settlements such as cash or financial instruments which are considered as good as cash. At present, with an artificial AAA rating, the US debt appears as a mean of settling financial obligations. This has the effect of making an already huge financial bubble look smaller. It is exactly as if an ordinary person mistook the figures on his credit cards statements for his savings.

However once the market returns to its senses, i.e. that the US debt is debt not cash and may not be repaid, its entire value will have to be subtracted from the means of debt settlement AND added to the liabilities of the bubble formula. The effect of subtracting the US debt from the bottom of the bubble ratio and adding it to the top will be the first part of the double whammy. The scale of the financial bubble will be seen instantly. This will have an immediate effect on any dollar denominated transactions and capital and is very likely to lead to a huge credit crunch.

But unlike the credit crunch that happened in 2008 which followed a period of very low inflation, the US debt induced credit crunch will have been preceded by a period of a very high inflation. This will leave the world, or at least a huge part of it, facing huge public debt, very high prices and very limited means to pay. This is the second part of the double whammy: a formula for sliding into poverty.

This article was first published in The Arab Financial Forum Newsletter August 2011, Issue 1

1 comment:

  1. This to me looks like what the Berlin wall coming down meant to the USSR.
    So the Hayek's will see the deleveraging they wanted.
    What will all that Yankee corn be priced in?
    Or will they start growing their own cocaine?