Debt Dynamics

Debt, in itself, generates more debt by attracting interest. At present it appears that the current level of debt, in Eurozone - and in almost all western economies including the US' - attracts more interest than the repayments generated through economic growth (collected as taxes). There is no doubt that recovering from the current crisis will require debt write offs. But how much would it be on a global scale? It makes a significant difference if, for example, 20% of debt on the banks' books (globally) has to be written off for the economy to recover, or 99%. And it is actually likely to be far closer to 99% than 20%. And then there is a question who will be on a receiving end of such write offs: basically who is going to lose loads of money. As the history shows the answer to this question may make the difference between peace and war.

But debt write off is not such a simple process. If it happens it will be a default. Even if voluntary the courts are likely to rule that it is a credit event. This, in turn, will trigger CDS' payouts (sometimes referred to wrongly as insurance against a default; in fact these are the bets put that default would happen). Due to the nature of CDS' these payouts may actually be greater than the underlying debt, value of default (since it is possible to buy CDS' on a particular default event exceeding the value of the debt). So from financial system perspective, debt write offs may trigger liabilities much greater than debt itself: i.e. the cumulative value of CDS' payouts may exceed, by far, the value of written off debt (some estimates go into hundreds of trillions or even quadrillions of dollars). And who is going to pay it? The guarantee will come back again on the taxpayers doorstep.

The current credit creation mechanism in the banking system (lending with loan to deposit ratio greater than 100%) is also unsustainable. Such mechanism needs financial innovations, like collateralising and rolling over of debt, to be operated. The unsustainability of this mechanism is such - it is basically a pyramid scheme mechanism - that even if a sufficient global debt reduction is done (even a total 100% write off), and somehow CDS' liabilities are written off too, the debt write off strategy will not work anyway: the world will be back in debt and soon.

The new debt generated by credit creation with loan to deposit ratio greater than 100% will very quickly (at exponential, intractable, pace to be mathematically precise) return to pre write-off level. But a credit creation process cannot be stopped totally without killing the economy altogether. This is actually what is happening to a large extent now: banks lend very little to genuine businesses. The solution to such quagmire is given by basic mathematics (this is what the work on this blog has been all about): after making sufficient write-offs, lending with loan to deposit ratio (system-wise) greater than 100% should be banned explicitly. Thus far it is banned implicitly as pyramid schemes are banned, but financial institutions ignore it. In practice ledning with loan to deposit ratio greater than 86.5% (or even less) should be banned. This is not a guarantee of a solution to all economic and financial system problems giving a speedy recovery, but without it no solution is possible. The world will keep getting into debt deeper and deeper.

The quagmire of the current situation is that, from technical and legal perspective, for some years (at least a decade but most likely much longer) the financial institutions have been running a massive global pyramid scheme. What we have been observing for the last 3 years is a typical ongoing collapse of the pyramid. It looks exactly the same as Albanian pyramids of 1996 - 1997. The fact is that the financial system - with the support of politicians - is determined to maintain such a massive pyramid scheme. In practice it means more collapses and bailouts and never ending debt for the taxpayers to keep such a loan shark business going.