By Sarah Mills, ninemsn Money
The October global financial crisis struck fear and loathing into western consumer hearts around the world.
Cheap, easy debt, consumed by the swollen ranks of addicted baby boomers, has fired Western growth for the past three decades. But, with the world's banks wobbling, the debt-tap was about to be cut off. The fear was palpable.
Trillions of dollars were wiped off the value of global sharemarkets and the world's governments were forced to bail out floundering financial institutions. The markets have since regained some degree of normality but the world is far from stable.
The days of securitisation, which fired the mortgage boom, are gone and banks are looking elsewhere for capital to lend to consumers. The question hanging in the minds of many is: is this the end of credit?
The short answer is no. Financial Armageddon has been postponed. For how long is another story.
Government bail-outs and guarantees for deposits and interbank borrowing have ensured the debt life-support system remains hooked up. The banks meanwhile are using those guarantees to pump as much debt as possible into the economy to keep consumption afloat and stave off recession.
The bail-outs and rate cuts mean people are essentially borrowing from themselves — this state of affairs is not sustainable. It also substantially increases the cost of debt to the consumer. It means you are using your own tax money to repay your debts. Suddenly your mortgages, credit cards, plasma TVs and cheap furniture become very expensive.
Interestingly, the US bail-out legislation remains into perpetuity and is not renewable by any court. This turn of events has interesting repercussions.
The power to bail out the financial system at will basically removes the risk-reward equation from debt markets. By moving from a market system to a centralised system, an unsustainable situation can be maintained for longer than the markets would normally allow. It promotes profligate, unsustainable behaviour by both rich and poor because it removes consequences from the borrowing equation. It also makes it more difficult to predict the timing of market trends.
So while it is not the end of credit, it is the end of credit as we know it.
The world has entered new and dangerous territory
The only question now is how long can the world's governments hold up economies built on smoke and mirrors.
The chronic imbalances caused by a debt-driven economy will not go away. While leverage exacerbates rises, it also exacerbates falls. Examples of this include:
- Current estimates suggest that if lending were to fall 5 percent it would be enough to tip the economy into recession and trigger a 50 percent fall in house prices.
- The world's banks have only raised enough capital to pay for about 70 percent of their write-downs. That gap could widen substantially given asset values are inflated by debt. If debt levels fall then asset values fall (as the above point illustrates) and then the amount of capital one can raise falls — and the cycle continues: the snowball becomes an avalanche.
- University of Sydney associate professor of economics, Steve Keen, stated on ABC's Lateline that about 20 percent of spending in Australia last year was financed by extra debt. He points out that household budgets are strained and incapable of taking on much more debt. Therefore that 20 percent of spending can disappear as fast as it appeared and will comprise a big hit to the economy.
So why don't we all pay down debt?
There are four problems with paying down debt:
- Most people can't afford to.
- We are at the wrong stage of the generational cycle. Debt can only be repaid out of reduced future consumption. Given the baby boomers are ageing, that will induce the very recession and asset-price collapse that most are desperate to avoid. This is the old "swallow the spider to catch the fly" syndrome.
- The scale of the problem. On top of physical debt there are leveraged debt instruments. The notional value of all outstanding derivatives totals roughly US$1 quadrillion (US$1000 trillion). To put this into perspective, the US subprime loan problem is estimated at US$1 trillion and the number of credit default swaps (one of the culprits behind the world financial crisis) was roughly US$60 trillion.
- Nearly everyone has a stake in the system — borrowers and depositors. China, for example, has lent the US$1 trillion, yet the US Government is running a huge deficit. Bank depositors have lent mortgagers the money for their houses.
Both big and small are trapped in an intricate web of debt that spans the globe. Yet very few are comfortable with so many intimate bedfellows. It calls to mind another nursery rhyme: there were 10 in the bed and the little one said roll over.
Credit will keep flowing until the game is over for the simple reason that everything will collapse if it doesn't.
The safest place to be in such times is in charge of the military. Which takes me to another interesting snippet. US congressmen Brad Sherman and Michael Burgess have stated that, in private conversations, members of Congress were told there was a risk of martial law being imposed within one week if Congress refused to pass the bail-out Bill. On October 1, almost 4000 US army soldiers were deployed onto the streets. Australian Prime Minister Kevin Rudd's threat of a rolling national security crisis now becomes clearer.
Apparently, the fine print in the US bail-out Bill (which cannot be repealed by any court) gave the US President access to $100 billion in discretionary (which amounts to his own army). Scary stuff — even scarier than a mortgage default.
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