Economists around the world are concerned about the economy.  Most of the news headlines relate to GDP and other lead indicators that suggest a real possibility that the economy is faltering, but what is concerning economists is money.  When the world economy was badly shaken by the GFC, money was central to the solution.  This time around, money is central to the problem.

The reason that money is central to the problem is that there is a very real risk that dominant currencies in global trade will no longer have the required attributes of money to support the global financial system. For money to work, it must have a consistent value, be able to be stored indefinitely, and be accepted by those an individual is trading with.

When the value of currencies was disconnected from the ‘gold standard’ it was because governments were seen to have assets well beyond gold in term of extensive funds, integrity and resources. Now, rather than being backed by these qualities, the US dollar and the Euro are backed by unpayable debts.  While this situation has been building for over a decade, there are a number of additional factors at play that could swing the balance against these currencies:

• The level of world debt of all types, (government, commercial and private), is at record levels;
• Brexit has highlighted to members of the European Union (EU) that they are part of something much bigger than a free trade zone, and many of them don’t like it;
• Economic difficulties in numerous EU countries, but particularly Greece and Spain, have highlighted how difficult it is to address an economic crisis when you do not have control of your own currency;
• In a world of floating exchange rates, the value of money is what people believe it to be;
• China is creating its own trade block with the Chinese Renminbi as the main currency;
• Key US Democrats have said that government deficits don’t matter because they can always print more money;

The reason that economists are so concerned is that there is no precedent for this being resolved painlessly, while there are lots of precedents for this situation going badly.  The most recent example being Zimbabwe, where the government tried to pay its way out of debt by printing more of its currency.  The predictable result being that the currency became worthless and the country descended further into debt and disarray.  The US and the EU are clearly very different to Zimbabwe, but the underlying principle remains.

Debt Default

The most common method of resolving an unpayable debt is to default on it.  The consequence of this is usually to hand over the security that was provided as part of the loan agreement.  This was commonplace with housing loans in the US during the GFC, where home-owners handed back the keys to the house rather than pay a mortgage that was worth more than the house.  The problem is that this time around the personal debt in the US is not for housing, it is for university degrees, medical expenses and motor vehicles.  In each of these cases the book value of the loan is irretrievable by the financial institution.

When a company defaults on loans, it usually results in the transfer of ownership of some of the company’s assets.  The issue is that in an increasingly integrated and specialised world, these loans may not be secured against tradable assets at the time of loan default.  So, the banks are likely to take a substantial hit.  Given that most banks also are financed by and lend to other banks, this web of debt default is likely to be contagious – just as it was during the GFC.

Governments can also defaulted on loans, again there are usually consequences, although for governments the consequences can be quite different depending on the nature of the debt arrangements.   What has become apparent since the GFC is that the debt arrangements between the EU and its member states are quite punitive on the member states.  Increasingly, the EU is looking like a rock band on the brink of breaking up – just swap policy differences for artistic differences and the story reads the same – at some point money just isn’t enough of a reason to stay together.

Similarly, smaller countries in the Chinese-lead trading block are also discovering that the loan arrangements favour China.  Potentially the unpayable debt could provide China with unprecedented access to natural resources in foreign countries.  So that mining rights in Africa, as well as fishing rights in places like the Maldives and Fiji, could soon be in Chinese hands.

Preventing the crisis

It is unlikely the world powers are prepared for the coming crisis, but it is even more unlikely that they are prepared to prevent it.  To prevent the crisis would require a level of cooperation that is the antithesis of the current tit-for-tat negotiations between the world’s largest economies.

The key to understanding the blowout in global debt is to understand its source.  The global response to the GFC was government bailout of the finance system, that is the injection of billions of dollars of money into the finance system to ensure it did not fail.  This money was created by a process call monetary easing (the creation of money from thin air) by the various Reserve Banks (see the footnote).  Because this money needs to be accounted for, as soon as it leaves the Reserve Bank, it enters the finance system as money owed to the Reserve Bank – i.e. debt.  So, it stands to reason that over a decade of record levels of monetary easing has resulted in record levels of debt.

What has unsettled economists is that the massive increase in the volume of money in the system did not result in a booming economy, complete with wage growth and inflationary pressure, to which they could respond with monetary tightening (the removal of money from the system) to bring the books back into balance.  Instead the economy has bumbled along with low levels of GDP, wage growth and inflation.  This divergence from the economic rule book indicates that if another global financial crisis were to occur, economists are unlikely to agree on how to respond to it.  A key barrier to this is that economists think too much like accountants.

In theory, the Democrats were correct when they said that government deficits can be funded by the Reserve Bank.  In the simplest sense, it is like saying you can pay for debts on your credit card by using the money in your savings account.  To extend this to say that government debt can be funded by monetary easing is also correct – but fails to recognise the systemic imbalance that is created; or that the inevitable outcome of continuous monetary easing is a worthless currency.  There are many examples of this throughout history.  One of the more famous was the hyper-inflation of the German currency in the early 1920’s, when Germany was attempting to pay the unpayable debt it was bestowed at the end of the First World War.

The answer to avoiding the pending financial crisis may be found in Germany’s economic management in the 1930’s.  During this time, Germany’s currency was not pegged to a gold standard, but to a standard unit of labour.  This gave it the essential properties of money: it had a consistent value, was able to be stored indefinitely, and was accepted by those an individual was trading with.  Given that this was an internally orientated currency, Germany resorted to a ‘barter’ like system for international trade: commodities were exchanged for other goods and services.  It was an arrangement that underpinned the transformation of Germany from an economy in crisis to a world power.  What kicked started this metamorphosis was the “reparations moratorium” – a moratorium on the repayment of the unpayable debt.

Debts Forgiven

Hyper-inflation is one way to forgive debt, by making yesterday’s money (the debt) worth nothing by today’s standards. The problem is that it simultaneously destroys savings.  In any debt arrangement, the party that is owed has it in their power to forgive the debt, and they can do this selectively.  So rather than print more money to fund a government debt, a Reserve Bank could simply forgive the debt.

Similarly, a government could choose to selectively repay certain loans on behalf of its citizens.  Rather than pouring the money in through the top of the financial system and hoping it makes it way to the right people to stimulate the economy, they can go directly to the people most in need.  At an international level, similar measures could be taken to unburden small countries from unpayable debts.

In an early post, Honest Economics discussed how monetary easing had failed to stimulate the economy. In the same way, having an excess of a catalyst fails to stimulate a chemical reaction.  The world is now awash with debt, across every level of government and society.  For many it is now an unpayable debt. From an accounting perspective there should be an equivalent level of credit somewhere.  But as much as the commentary on the debt treats it like an accounting issue, the laws of banking, and particularly reserve banking, mean that this does not have to be an accounting issue.  Perhaps it is time to look for a different solution.

Dealing with unpayable debts

Debt in society is not limited to finance. Small favours between friends are often acknowledged with ‘thanks – I owe you one’. Often these debts are summarily dismissed with ‘don’t worry about it’. Larger favours are given greater acknowledgement.  These are handled differently in different societies.  The famous book, (and movie) ‘The Godfather’ gave an insight into how significant favours were exchanged in a fictional American mafia community.  In one instant, some heavy handling of an abusive son-in-law was repaid sometime later with some discrete mortician work.  There was no financial transaction, no written contract.

The saving of a life is often acknowledged as an unpayable debt – ‘You saved my life! how can I ever repay you?’ This is sense of indebtedness is used as a plot devise in numerous books and films to inspire characters to take on tasks and challenges they would not otherwise have contemplated under a sense of obligation or duty owed because the other person saved their life. However, there are many circumstances in reality when a lifesaving act does not get this dramatic level of recognition, or dutiful response.  Often the distinguishing factor is the perceived cost to the saviour.

To illustrate this point, picture a scenario where, if there is no intervention, a person will walk off a train platform onto the tracks in front of a train and be killed. In scenario A, a bystander alerts the person to the proximity of the track, preventing them from walking onto the track.  In scenario B, a bystander jumps onto the track after them and hauls them both to safety just prior to the impact of the train.  In scenario C, a bystander jumps onto the track after them, and hauls the person to safety, but is injured in the process.  In all three scenarios the outcome is the same for the person destined to walk onto the track; their life has been saved.  However, the perceived value of each of the interventions is different, based on the cost to the bystander.  In scenario A, an embarrassed thankyou would probably be sufficient repayment. In scenario B, a much more generous acknowledgement and sense of debt would be considered appropriate, which would be further heightened in scenario C.

To relate this philosophical view on debt back to financial debt; consider the cost of the debt to the provider of the loan. This is where things become interesting.  The cost to the lender of a financial loan between two individuals would be the loan amount and the opportunity cost of not having the money.  The cost of a financial loan from a bank to an individual is dependent on the bank. Typically, a bank will lend a deposit multiple times, (refer to banking theory), making the cost of the loan to the bank a fraction of the loan. The cost of a loan from a Reserve Bank is theoretical, as Reserve Banks create money (quantitative easing), and destroy money, (quantitative tightening) as they see fit. This means the cost of the loan to the Reserve Bank is zero.

So philosophically, a government could pay off its debt to its Reserve Bank with an embarrassed thank you.  Indeed, in many countries the government is the nominal owner of the Reserve Bank, meaning that it owes the money to itself. So why is this option never discussed or considered?

There are two main reasons for this:  The first one is that considered good practice for governments to spend only as much as they earn.  One of the reasons the Reserve Banks were separated from the government structure was to encourage governments to be fiscally responsible and to treat the money as real.  Which brings us to the second philosophical reason: money is not real, but for it to fulfil its role in society, it is very important that people behave as if it is. In other words, the government debts to the Reserve Bank are treated as real because the bankers don’t trust the politicians to behave or the people to believe in money if they wrote off the debt.

There would be some sense to this if the debt was payable.  However, once a debt becomes unpayable, it polarises attitudes.  Some will treat it as irrelevant, why not add a bit more debt to the existing debt if we are never going to pay it off anyway?  Others will treat it as insurmountable, regarding all activity as necessary but pointless because the debt will be all consuming regardless. In either case, and in combination, the attitudes are unhealthy and damaging to individuals and society.

In the not too distant future, the Reserve Banks of the world will be faced with some stark choices, as the world looks to them to solve the next financial crisis. They could enforce the reality of the loans and initiate a tidal wave of bankruptcy across the world.  They could respond as they did last time and pump even more money (debt) into a complex system to keep it functioning. Alternatively, they could cancel their government debts, preventing a fire sale of government assets and equipping governments with the financial resources to address the issues that arise in their jurisdictions.

Footnote:

Money – the making of a super power

There is an old saying that in peace time generals prepare to win the last war, and the next war is never the same.  But this is often truer of the victor than the vanquished.  An example of this is at the end of the first world war, the victors claimed that it was a triumph of good over evil, spoke of it as the war to end all wars, and prepared for an enduring peace behind a heavily fortified wall.  The defeated Germans saw it as a victory of mechanical warfare (masterminded by Australian John Monash) over traditional warfare and prepared to master mechanical warfare to conquer Europe in the second world war.

The world then endured the cold war through the second half of 20^th Century as two military super powers sized each other up by backing different sides in a multitude of conflicts. The USA declared itself the victor of the cold war with the fall of the Berlin wall.  A victory that was seen by many as an economic victory more than a military triumph. Once again, the victor has prepared for an enduring peace, this time behind its financial powerbase.  But others appear to be plotting their downfall.

This time around it appears to be China that has learnt the most from the previous war and is challenging America’s preeminent position.  This time around finance is the strategic weapon of choice.

Having amassed perennial trade surpluses, China is using its financial muscle to penetrate deep into foreign territory and establish positions of dominance.  At the same time, the American people are pressuring their government to pull back from world affairs and focus on the country’s domestic issues.  To some extent this makes sense, America’s foreign debt and trade deficit are the biggest in the world and both are getting worse.  But these numbers are also irrelevant so long as the debt and trade continue to be in America’s own currency, (remember money is not real).  Surrender this position as the global currency and this un-payable debt will become very painful indeed.

China has already taken a dominant position in numerous countries in Asia, Africa and the Pacific. China has enticed numerous governments by offering investment loans and direct trade agreements to cash-strapped governments.  What has become increasingly apparent is that these arrangements are very one sided with the investments provided on condition that the projects are undertaken by Chinese firms (1). Countries are finding they are being left with a larger than expected bill for substandard, (often incomplete), infrastructure.  The debt owed on the investment loan is of course in Chinese Yuan. Being indebted to China is also proving to be problematic for these countries as China is a very demanding creditor, insisting things be on their terms.  Subsequently, some countries have established trade-free zones and residential enclaves that benefit the local Chinese population while being out of reach for locals.

By using its financial might in this way, China has legally taken control of major ports, trade routes, agricultural, fishing and mining resources that would have been strongly condemned if the same outcomes had been achieved via military pressure.  At this point it is worth noting that during the Irish potato famine, (which killed over 1 million people), in the mid 19^th century, Ireland was a net exporter of food.  The issue was not that it could not grow any food, it was that the farming land was owned by the British, who exported the food for profit, while the local Irish population starved.  A rapidly growing Chinese economy has a growing appetite for food and resources, and the same fate that the Irish experienced over 150 years ago could soon be shared by local populations in various countries across the world.

China is not the only player in the money wars.  Some say that the European Union created the Euro specifically to establish an alternative to the American dollar for international trade.  It has undoubtedly increased international trade within the EU.  However, the Euro has also demonstrated the perilous position that countries can find themselves in when they are in debt and do not govern their currency.   When these financial tensions are combined with the physical security issues highlighted by the immigration crisis, it forces the EU to focus on getting its own house in order before it takes on the world.

Russia is running its own race.  Although it appears to be seeking independence rather than dominance, it is avoiding trading in US Dollars, even if it means returning to an almost barter arrangement of exchanging gold, oil and other commodities for the things it needs. It is also content to niggle its old foe by taking the opposite side in complex conflicts.  Each aware that their military might is unable to solve the problem.  Each also knowing that military might is essential to protecting ones own rights.

Where China has brazenly dealt its way into strategic positions with over 70 countries, it has more subtly indebted the US.  Selling it cheap products and using the proceeds to buy government bonds it has simultaneous undermined its production capacity and its global financial position.  The relationship dubbed chimerica has become an important cog in global trade.  It is a relationship that President Trump is attempting to unwind by imposing tariffs on Chinese imports.  His attempts are making ‘Trade War‘ headlines across the world.  He is being condemned in the media for obstructing free trade.  What many in the west fail to understand is that many of the goods they purchase as cheap imports from Asia are actually more expensive if purchased in Asia – large flat screen televisions for example.  The change is US policy in this regard is policy recognition that the trade imbalance matters and that they are already in a power struggle – economically, politically, internationally, financially, with a country who’s government and military are not constrained by the will of its people.

Make no mistake the USA is under threat.  The US dollar has greased the wheels of international trade for over half a century, ably supported by the American military, and morally supported by its allies.  While its borders and security may be resistant to military and immigration incursions, they have been porous to financial and economic infiltration.  China now has the USA in a pincer movement, the way of life so treasured by the american people is now dependent on China continuing to sell it cheap goods on credit.  At any point China could decide to dump the US dollar, and/or change its trading policy with massive ramifications for the american economy and the status of the US dollar as the currency of choice.  The question is whether the threat is more powerful for the Chinese than actually pulling the trigger and having all hell break loose.

Keep a close eye on the global posturing.  In coming years many countries will be asked to make a choice between a trading partner and a military partner.  Not all will choose wisely, and the world could get a little messy before order is restored.

Recap

• Reward for effort – The effort and expense required to be the global currency is very well rewarded.
• Value is relative – The value of being able to trade in your own currency is very powerful relative to trading in someone else’s currency.
• Trade requires difference in value – China values power and influence over selected countries more than the value of the loan to them.
• Money is a catalyst – the US dollar is the catalyst for 80% of world trade.
• Trade creates economic ecosystems – The USA and China will remain a significant participant in the world economy, and as such will continue to be impacted by world events and world trade.
• Economic measurements are incomplete – Any sell-off of government assets is not appropriately reflected in economic measurements – giving a false positive increase

Trump and Economics

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There is general agreement that China is entering a new economic phase as its economic growth declines, its stock market plummets and its currency is devalued. Some economists are interpreting the change in the Chinese economy as an indication of its maturity. Other economists foresee that it is the bust that follows a boom as predictably as thunder follows lightning. Given the importance of China to the world economy, and particularly to the Asia Pacific region, it is worth digging a little deeper.

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The world is changing and so is the economy.  Throughout the world economic ecosystem there are many and varied local economic ecosystems.  Within each of these are households, families and individuals trying to create their own niche, existence and lifestyle.  We are each born into our own set of circumstances which impact on our opportunities.  Collectively the economy is what we make it, but some have more influence than others.

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