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The debt crisis we all saw coming


The collapse of Silicon Valley Bank (SVB), the regional US bank Signature Bank and the Swiss giant Credit Suisse, one of the oldest banks in the word, is again posing a question that has remained unanswered since at least the Global Financial Crisis of 2008. How can the financial system deal with debt when it gets out of control? The International Monetary Fund puts global debt at over 230 per cent of GDP, which is more than enough to set off alarm bells, (including in China, where debt is over 200 per cent of GDP).

Usually, two ways are proposed to get out of a debt hole. One is cancellation, which is the way that the problem has been dealt with for thousands of years. The difficulties with that are two-fold. In older societies, financial transactions did not dominate all parts of life as they do now, so the repercussions of debt cancellation could be managed. In the Middle Ages in Europe, for example, much of the population would never have used money at all, although they would have been aware of its existence. In twenty first century societies most activities are subject to the transactional system so a financial shock is far harder to contain.

The other problem is that most money creation comes from private banks which cannot forgive more than about 5 per cent of their debts and survive (China may be a little different because its banks are state owned). That is why, in 2008, the bigger American and European banks were deemed to be too big to fail. Their bad debts had to be paid by the government, from citizens’ tax dollars, because otherwise the whole system was at risk.

That these banks were allowed to remain private and the senior banking executives who caused the problem were rewarded rather than punished was a moral outrage. But it did have a certain cynical logic; it was about preserving the social system.

A second way out is to inflate away the real value of the debt. This is obviously far from ideal because it erodes monetary value across the whole economy. But it tends to happen incrementally and is perhaps less damaging to the social fabric than sudden debt cancellation or failure.

A third way out is to nationalise banks, which many think should have been the approach in 2008. The origins of this crisis, yet another one, do not date from when the American president Richard Nixon took the US off the gold standard in the 1970s. It was the deregulation of the financial system in the 1980s. The whole idea is logical nonsense – money is rules so it cannot be deregulated – but it was used as a pretext for private actors to take over the creation of money.  


'The growing signs of fragility in Western banking systems – it is rumoured Deutsche Bank is also in trouble, which would be devastating for Europe’s financial system – are probably a signal that we are finally reaching the end of the road.' 


As is cleverly depicted in the film The Big Short, this invention of new rules was motivated by greed. To see how it works, witness the scene with Jared Bennett, who was in real life an operative with Deutsche Bank (played by Ryan Gosling). The character explains how he has invented collateralised debt obligations, whereby mortgages of different quality are bundled together and called a AAA security. He says he smells money in the room – as he invents a new form of money.

The prevailing myth being pushed by financial analysts, private traders, Wall Street, gold bugs and cryptocurrency devotees is that the problems are caused by “fiat money”, edicts from governments. That is why there is the perpetual criticism of the US Federal Reserve and other central banks.

It is the exact opposite of the truth. The problems are mainly caused by characters, like Bennett, making up their own rules and devising mathematically complex magic tricks. Central banks have made the mistake of thinking they could manage the system solely with interest rates, the cost of capital, but they cannot because they have little or no control over the quantity of capital. It is like trying to fight a boxing match with one hand tied behind your back.

What central banks should have done, instead of dropping rates to almost zero, which only exacerbated the taking on of debt, is to set interest rates in a historically ‘normal’ range, say 4-6 per cent, and so create some stability in the system as the private players continue with their endless financial games.

The growing signs of fragility in Western banking systems – it is rumoured Deutsche Bank is also in trouble, which would be devastating for Europe’s financial system – are probably a signal that we are finally reaching the end of the road. Various types of nationalisation of banks – that is, banking controlled by government 'fiat' – may be in the offing.

The vulnerabilities are less likely to affect Australian banks unless there is a residential property price collapse. But there will be an effect, most likely tighter credit conditions. According to stockbroker UBS there has been a sharp decline in lending for housing in Australia when rates started rising. Since the record peak in January last year, home loans are down by 35 per cent, the weakest level on record since 1992. UBS is predicting that home loans will drop by about half in this interest rate cycle, reducing total credit growth by 3 per cent at the end of 2023. In the end, the debt merry-go-round has to end.




David James is the managing editor of personalsuperinvestor.com.au. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.

Main image:  Storm clouds (Getty images)

Topic tags: David James, Finance, Banks, Debt



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