Keywords

Human life; globalization; web of debt; slavery of debt; leveraging; assets bubble; government bailouts

1.1 “My Lord,” Answered Solon to King Croesus, “You Are Asking Me What I Think of Human Life”

“My Lord,” answered Solon (640–599 BC), the Athenian lawmaker, to a question by King Croesus of Lydia, “You are asking me what I think of human life. How can I answer you otherwise than by judging people only after their life is over, when I know that divinity is jealous of the happiness of human beings and it makes it pleasure to upset it. Man is subject to a thousand accidents.”¹ How true.

Established by Solon, the laws of the Republic of Athens formed the basis of what we are used to call Western civilization. Solon did much more than setting the code of social morality and of social order. Through laws which were tough but more liberal when compared to the laws of Dracon, who preceded him as lawmaker of ancient Athens, Solon aimed to assure social and financial stability. He also initiated important monetary reforms, including:

To a large measure, Dracon had adopted Hebraic laws, adapting them to the early society of Athens.³ The concepts on which he based himself followed the legal policies of Hammurabi of Babylon (1792–1750 BC), particularly in establishing severe sanctions for violation of the laws. This is a practice our society has more or less abandoned (presumably for “humanitarian reasons”) replacing it with nearly total impunity. In restructuring Dracon’s laws, Solon took a broader and somewhat more liberal approach and also set the basis for evolution of economic thought.⁴

Contrasted to the ancient times when law setters were philosophers, today’s law setter, and not only in monetary policies and finance, is the financial elite: City of London and Wall Street. (The latter is also known as Eastern Liberal Establishment.⁵) According to Anthony C. Sutton, this is populated by American corporate socialists.⁶ The Eastern Establishment has also been:

As in ancient Carthage, the Eastern Establishment’s criterion of excellence is wealth and competitiveness—the latter being based on financial systems, private institutions, infrastructures, skills, educational performance, flexible labor markets, and (until recently) monetary stability. Together, these make the “free economy,” though rules, beliefs, and criteria vary widely by country and so does the per capita gross domestic product (GDP).

If at the time of King Croesus a huge amount of wealth was rare exception, today from America to India and China there is no lack of billionaires.⁷ In 2010 (latest available statistics), global GDP amounted to over 60 trillion dollars, an income divided up in the most unequal way between 7 billion souls on planet Earth—to each, according to his or her effort and (sometimes) to his or her connections.

Using per capita gross domestic product⁸ per year as basic criterion, a study by UBS divided the world population into three layers: The top 1 billion people are largely living in Western countries, including Japan. The next billion people is a class on its own interfacing between the top and bottom layers. The lower layer is populated by 5 billion people, those of low income and the really poor.⁹ This stratification makes it easier to compare not only annual earnings but also:

On an average, the wealthier people in the first billion enjoy a per capita GDP of close 40,000 US dollars per year. People living in the richest countries of this first billion, such as Luxembourg, Norway, or Qatar, enjoy an average per capita GDP close to 100,000 dollars per year.¹¹ South Korea, the bottom country in this first billion has a per capita GDP of 17,000 dollars. Always talking of averages, the per capita GDP in the United States is 45,000 dollars and that of Europe and Japan is 40,000 dollars.¹²

As these statistics document, per capita GDPs vary from country to country and, as well, within each of the three layers, for instance, within the top billion of the Earth’s citizen. Always in average income terms, the population of this first billion people is homogeneous enough when compared to the (country-by-country) income averages of the second billion and, most evidently, to those of the third layer of 5 billion people.

In this lower stratum of 5 billion in terms of average per capita GDP, people live under conditions of poverty to extreme poverty compared to western standards. Within each country, however, the range between higher and lower income is wide. This happens even if in the course of the last three decades large stretches of population have benefited handsomely in terms of per capita GDP—particularly in countries which are energy and mineral producers.

At the top of the 5 billion people bottom layer is Iran, with average per capita GDP 4500 dollars; China, 3700 dollars; India, 1200 dollars. At the bottom’s bottom lies Niger with 300 dollars average per capita GDP per year and Congo with 170 dollars. Yet, the Congo is a relatively rich country in minerals, but its wealth distribution is awfully skew.

The reader will be right if he or she thinks that a global comparison of per capita GDP averages resembles Fata Morgana. Average dollar values are illusory; they tell nothing of the cost of living and other conditions. At the same time, however, in an age of globalization, the magnitude of aforementioned “average” differences has to be kept in perspective because it leads to an interesting pattern permitting comparisons.¹³

Plotting the scores against average per capita GDP in each of the aforementioned three layers reveals some interesting facts which override what is usually looked at as “common economic wisdom”¹⁴: competitiveness brings wealth, and the richer countries can best afford to be competitive as long as they remain “the richer.”

The model of per capita GDP per year distributions one derives from differences between 100,000 dollars and 170 dollars—or over 58.800 percent in average—is that inequality is at an all-time high and even greed has gone global. While a major reason for this discrepancy is explosive birth rates in poorer countries and ill-focused daily human effort, the reader should not forget Solon’s dictum that divinity is jealous of well-being in human life, and it makes itself pleasure to upset it. Chapters 4–6 explain what has happened in Greece while subsequent chapters focus on Spain, Italy, France, and the United States. The common thread behind these studies consists of:

This common thread also explains how the casino society marches on and looks as being unstoppable. “The list of measures to curb the gambling is already long,” one could read in The Economist.¹⁵ Yes, but under the lobbyists’ massive impact, the trumpet heralding government action gives an uncertain sound, and no one prepares him or her for the battle.

Beyond the sovereign and household debt, there is a swarm of companies with fragile balance sheets who have been able to bide their time and avoid potential bankruptcy in 2012–13, thanks in part to the voracious investor appetite for high-yielding debt. That helped keep default rates low, as managements pushed out toward 2014 and 2015 a debilitating wall of debt maturities. We are just entering that time frame.

Divinity has its own, largely secret, criteria for judging people and nations while the wheel of fortune continues turning. Those best known are hard work, thrift, and discipline. King Croesus might have been the richest man of the then known world when Solon visited him, but years later destiny changed. Fortune which had lifted him to the crest washed him away as hostage in the hands of King Cyrus.

1.2 Globalization Worked As Long As It Worked¹⁶

As contrasted to the internationalization of trade which dates back to the second millennium BC, as the twentieth century neared its end, three decades of economic and financial globalization sailed seamlessly through the world’s economic fabric. Then, things began to change. Something like a U-turn is now championed—at least in the West—by a crisis which has been moving from US mortgages to the slow-motion breakup of the euro.

“Globalization worked as long as it worked, now it does not work anymore,” said George Soros in an interview he gave to Bloomberg News on July 27, 2012. Then he added, “We have global markets, but we don’t have global governance of markets. The markets are unstable as global regulation conflicts with national sovereignty. Hence, deregulation is the dominant force.”

As time goes on, the lack of global financial regulation, and therefore of discipline, creates an environment of growing uncertainty where everyone does whatever he or she likes. This leads to anarchy and eventually to chaos. The wave of novel financial instruments, many of which are beyond the regulators’ ability to compete in terms of establishing checks and balances, has aggravated an already bad situation created by wide swings in cross-border capital transfers. The silver lining of the crisis we are in is that it made many people aware of the severe consequences associated to unregulated globalization.

International trade itself is falling. An obvious cause is the global economic slowdown. Trade often tracks quite closely worldwide GDP. Exports are sales to other countries, and they tend to weaken when buying power is low or (even worse) in reverse gear. Patterns of trade match the fortunes of economic prosperity or lack of it. At least in recent years, trade has typically grown faster than GDP; then, the curve ebbed.

In 2011 and 2012, imports into the European Union have fallen by 4.5 percent, but in oil-rich Middle East, imports increased by 7.4 percent. The International Monetary Fund (IMF) thinks that trade will grow by 5.1 percent in 2013 because of a strengthening economy; this, however, is still to be seen. Shipping data are an early indicator and statistics hold out little hope for rapid rebound. On September 5, 2012 a survey by Lloyd’s indicated that container volumes from Asia to Europe plunged by 13.2 percent year-on-year to July 2012.¹⁷

A growing number of economists now think that the ongoing economic reversal may have deeper roots than simple malaise. For several decades, following World War II, worldwide business transactions increased and globalization created a new phenomenon of tighter integration of markets. This has been further promoted by global companies with research centers, production facilities, sales, and service networks. Such an expansion, however, has not been followed by sophisticated:

The Group of Twenty (G20) chiefs of state has not delivered the expected benefit in global business guidance; neither did it bring forward an effective structure of management planning and control. Some efforts aimed to make sense out of globalization, and the leveraging it brings along (Section 1.5) turned into a sea of paper. Take the capital adequacy rules of the banking industry as an example:

The tendency to beef up the size of volumes on rules and regulations prevails in practically all domains. In the United States, the Glass–Steagall Act of 1933, which separated commercial and investment banking, required 37 pages; the Dodd–Frank Act of 2010 ran up to 848 pages, and experts say that it may go to 30,000 pages of detailed rule making when various agencies provide their input. If so, this will become a bureaucratic mega book sinking under its own weight.¹⁸

A few but clearly stated and cutting rules of behavior—like the Ten Commandments—are urgently needed in global finance, and in other industries. They should provide a stable global business framework, like the laws of Hammurabi and Dracon did at their time (Section 1.1). In their absence prevailed negative paradigms of business, social behavior and wealth distribution.

The way Zanny Minton Beddos had it in a recent essay: “A majority of the world’s citizens now live in countries where the gap between the rich and the rest is a lot bigger than it was a generation ago…¹⁹ (in the US) the portion of national income going to the richest 1 percent tripled from 8 percent in the 1970s to 24 percent in 2007.”²⁰

The economic crisis we are going through, and most particularly the high unemployment, saw to it that times have changed. The era when the swallowing sea lifted all boats is now a memory. As Gideon Rachman reminds his readers James Callaghan, the Labor Prime Minister of the late 1970s, had said: “There are times, perhaps once every 30 years, when there is a sea change in politics.”²¹ Not only in politics, of course, but also:

The free reign (therefore also lust and greed) lasted too long. Now has come the time for discipline in order to get out of the tunnel. An old proverb says that to move “the human donkey must see a carrot in the front and feel a stick in the back.” The carrot in the front is standard of living. The stick in the back are the laws Dracon and Solon set in ancient Athens, and before them Hammurabi in Babylonia. Let’s face it: society has turned against itself. To be lasting, the change must be both:

Successful regulatory frameworks always have a cultural quotient which holds together complex and highly fragile standards of interdependence. The right financial legislation and regulation can have a profound impact on the way commercial systems, investment plans, and capital markets work. Only a cultural change can assure that political, economic, and social thinking follow a line which defines the limits within which stakeholders should behave.

Culture is promoted through education, and education Socrates said is more than teaching. Its aim is not to feed his students with information but to make them think and, therefore, make them better persons. In a frequently quoted passage Cicero, the Roman senator, orator, and author, says that Socrates was the first to bring philosophy down from heaven. To Cicero’s mind, Socrates:

Globalization has never been up to Socratic standards of enquiry, a reason why over several decades, a long roster of scandals have made matters worse than they were earlier on. An example is the so-called Geithner doctrine²² which professes that the preservation (with total impunity) of self-wounded big banks is an obligation of the state—and therefore, of the taxpayer—no matter which might be the consequences. In full moral hazard, this constitutes the globalization of:

This double-whammy perverted the justice system. Critics say that Geithner’s doctrine also demolished the American criminal justice system turning it into a two-tier framework which assures “more excessive risk, more crime and more crises.” That’s what writes Neil Barofsky, former inspector general of the Troubled Asset Relief Program (TARP), in an article in the Financial Times²³ (see also the discussion on Barofsky’s book Bailout in Chapter 2).

Rather than providing service to their community, global banks have been pursuing their self-interests offering a poor, indeed very poor, public service. This created public anger. The bank, particularly the big bank, became the global casino losing a torrent of money from its gambles, while its executives and traders are awarded fat bonuses.

In a speech he gave in 2010, Hector Sants, of the British Financial Services Authority (FSA), said that trust has been lost between the financial community and the rest of society. This is compounded by different around the world scandals which followed the financial debacles from 2007 to 2014 and beyond.

The LIBOR scandal, which surfaced in 2012 (for greater detail see Chapter 3), revealed a culture in which bankers knew they were doing something wrong but did not fear being caught—or, if caught, punished. It is not that regulatory rules have been missing, but they have not been applied. No wonder, therefore, that the aftermath of this attitude is the global casino society and continued erosion of public confidence.

In conclusion, the culture of too big to fail and too big to jail creates a global climate of uncertainty which destabilizes persons, companies, and nations—at least those who would rather like to live in an environment they can understand and trust. We are at an inflexion point. “Man is subject to a thousand accidents,” as Solon aptly remarked more than 2500 years ago. In the following sections, we will look at the most immodest.

1.3 The Web of Debt Has Led to Slavery

A popular French proverb says: “Un banquier bon est un banquier con.” This roughly translates into: “A banker with a good heart is nuts.” Nuts, however, are not only the good-hearted bankers but also those who become loan addicts and continue sinking into debt. They have no idea of what they are getting into—from taking loans to accepting economic assistance programs with strings attached to them.

Economic assistance which followed WWII, says John Perkins, did not target swift economic recovery. It aimed to assure, or at least encourage, that countries become part of a network promoting the commercial interests of industrial nations.²⁴ And because debt is addictive, in the end the highly indebted sovereign becomes paignion—a plaything.

To Perkins’ opinion, after WWII ended, country after country became ensnarled in a web of debt. This has been built over decades by international banks recycling money, big corporations colonizing a market, as well as sovereigns eager to have a say on the way other countries manage their procurement and how they vote in the United Nations. According to this opinion, the foreign aid program set for itself two objectives:

This strategy works in a way fairly similar to that of the late nineteenth century European nations which used sovereign default of their borrowers as an excuse to invade foreign countries. It is as well the strategy employed by rogue creditors, known as debt vultures, who actively prey upon people, companies, and countries likely to default, buying up significant portions of their debt and then storming in to demand that they repay their debts at 100 cents on the dollar.

If they are successful, debt vultures make impressive gains because they have bought the debt in the secondary market at huge discount, a price arrived under the assumption that the debt would never be redeemed at face value. Not only countries but also their currencies may be repeatedly attacked, in full knowledge that, more often than not, defenses are ill-thought-out, poorly planned, and weak.

Pure debt is not the only game in town. A more polished debt-upon-debt trick, at sovereign level, takes the form of loans to develop power plants, industrial factories, universities, highways, ports, airports, and other infrastructural projects. Repayment conditions aside, the loans carry the requirement that contracts will be given to engineering, construction, and consulting companies from the country providing the aid.

Interestingly enough, disbursements are limited because money is simply transferred from the banks to the engineering and other firms, and then back to the banks as the recipient country is required to pay the loan with interest. To a large extent, this is a con game based on the assumption that:

John Perkins introduces an interesting hypothesis on how the world’s economy is being run nowadays. It starts with the assumption that no major power looks at nuclear warfare as the way to gain or sustain global dominance. Instead, it prefers debt-based covert operations with global banks acting as interfaces.

Punishment for trying to get out of the con game can be severe. Strategies modeled along the line of a palace coup, or an organized but unexpected uprising from within, have been used throughout history. This time around, however, they have been restructured to take advantage of globalization which:

An early example dates back to the late 1950s with the overthrow of the Mossadegh regime in Iran, which opened the way for another two decades of the Shah’s reign. The uprising in Teheran was organized by Kermit Roosevelt who was in CIA’s payroll. The way Perkins has it: “Had he been caught, the consequences would have been dire. He had orchestrated the first US operation to overthrow a foreign government, and it was likely that many more would follow, but it was important to find an approach that would not directly implicate Washington.”²⁶

That’s where the international web of debt came in, incarnated by global banks, mammoth manufacturing companies, marketing corporations as well as supranational organizations such as the World Bank and IMF. A whole constellation of consultancies and other service industries revolved around them. They were not directly paid by the government but drew their financing from firms in the private sector. If they did dirty work and this was exposed, it could be nicely attributed to corporate greed rather than the policy of a sovereign.

The role played by money without frontiers was further promoted by the freedom to print currency which is internationally accepted as legal tender. This gives to sovereigns, and central banks in their jurisdiction, immense power because the webs of debt are multiplied as commercial banks and governments continue to make loans that know they will never be repaid. (See in Chapter 2 the discussion on European Central Bank’s (ECB’s) Outright Monetary Transactions, OMT.)

Banks can make loans to countries with full knowledge that the chance of seeing their money back is slim or nonexistent. They do so because they appreciate that the sovereign, and its central bank, stand behind them. In fact, the sovereign does not really want that the borrowing countries honor their debts. Nonpayment gives him an inordinate amount of leverage.

Simon Bolivar, the liberator of the Andean Spanish Colonies (roughly Venezuela, Colombia, and Ecuador) had stated in his time: “I despise debt more than I do the Spanish.” Mao, too, knew enough of the racket associated to the web of debt to be eager to repay China’s loans from Moscow. Mao understood that loans from other governments come at huge political cost:

Therefore, China’s leader had insisted on repaying the Soviet loans quickly. He saw that the cost of debt cannot only be measured in financial terms, and he did not want to risk being so dependent on the Soviet Union that he lost political maneuverability, while at the same time he endangered his own sovereignty.

If China could lose its freedom of action because of debt to its Soviet neighbor, then imagine what happens with small countries which fall into the “easy money” trap and, from there, become victims of long-term financial woes leading them into subservience and/or virtual bankruptcy. The billions advanced by their “aid” benefactor and the banks’ sovereign loans have been used to import consumption goods, buy oil, hire more bureaucrats, and sign contracts with engineering and construction firms for consumption purposes. Either way, it is no more available to repay the loans.

The more dramatic part of all this is that the misguided, highly indebted country continues to contract more loans and spend more money on entitlements which are unaffordable. The net result is falling even deeper into debt. Politicians are not known of being able to calculate the consequences of their decisions, and therefore, they are ever prone to look at the public debt racket as an “opportunity.”

In an article he published in The Four Pillars, of the Geneva Association, Milton Nektarios presented an excellent example of how political leaders fail to protect their country’s interests and longer term well-being. “The politics of irresponsibility practiced by successive Greek governments since 1975,” Nektarios writes, “have resulted in the effective bankruptcy of the country and the request for international financial assistance in the form of a joint European Commission/International Monetary Fund/European Central Bank”:²⁷

To the opinion of Nektarios, without any serious preparation, the Greek Ministry of Labor and Social Insurance started producing successive drafts of legislation trying to meet two contradictory objectives: appease the citizens and labor unions and, at the same time, satisfy the demands of the European Commission (EC)/IMF/ECB (the Troika) on pension reform.

That has been misguided. Pensions, salaries, and public health care costs had to be downsized because they were unaffordable. A weak Greek economy could not really honor them, as its virtual bankruptcy documents. But this had to be done by an overall economic plan, not by following orders. This case of accumulated bad government decisions underlines the fact that countries strangle themselves by:

The reader should appreciate that this situation is by no means a “Greek exception.” As far as the global economy is concerned, it’s the rule. It is a process that has occurred in history as a matter of course bringing countries to an unsustainable condition because of living under the steady stress of debts. The most tragic part of living literally on debt is that it becomes a habit which is difficult to eradicate. Ironically, there is more resentment against those who advise to kick the debt habit, than against those who created it and sustained it.

1.4 Policies That Brought Us to a Mess

One of the principles of Taoism is that in order to follow in one direction you have to start from the opposite. This finds an excellent field of application with globalization, as countries have to examine their strengths and weaknesses by first studying those of their competitors, then compare themselves to their competitors, some of which may be at the other side of the globe. Having sized up themselves at world scale, they have to carefully:

Both require a thorough internal restructuring which may be painful, but the alternative is decay. Sovereigns who fell on hard times should be keen to enact reforms, from structural changes of the labor market to cutting the tentacles of the nanny state. Both are doable, but attempts fail when they are half-baked and/or give rise to fierce opposition by an ill-informed public and by special interests.²⁸

In times of crisis, relatively generous and constructive impulses which come with a rising standard of living give way to increasing enmity between “haves” and “have-nots,” and not just in terms of money or employment. Measures which might soften the edges of a society of rising differences are being put in the time closet, while the gaps between people benefiting from the economy and those suffering from it increase. Experts say that the years ahead will be rocky, marked by:

To a substantial (and unexpected) degree, globalization of the economy and worldwide communications led to a widening economic rift both internationally and within the same jurisdiction. As the “highs” and “lows” of living standards (particularly the latter) became more visible than they used to be, differences in income as well as in wealth have been shown to be extensive with wide parts of the population confronted by:

Political instability is believed to be the reason behind the paradox that even when world trade prospered some countries fell into deeper rooted economic troubles. At his time, Adam Smith had made reference to “the principal architects” of global policy, “our merchants and manufacturers” who sought to assure that their own interests have “been most peculiarly attended to.” Nothing really changed over the centuries, except that nowadays the East is master of income and wealth while the West finds it difficult to recover its past position.

Even some of the formerly upcoming countries in the BRIC (Brazil, Russia, India, and China, see also Chapter 12) have fallen way behind, because their leaders have been singularly incapable to keep them in a course of global competitiveness. A case in point is India, which during the last few years seems to turn into a violent do-as-you please social environment with gang rape of young women becoming a sort of sport.²⁹ This would have never happened under Indira Gandhi. Personal security aside, like India the West confronts itself with a double deficit:

When the system of competitiveness crashes, the person responsible is not just the latest chief of state but a tandem of them who have been unable to see that when quality takes a dive, mistrust increases almost exponentially. Under these conditions, hopes that problems can take care of themselves are awfully misplaced, because bad news continues coming from declining fortunes while prudence and personal responsibility take a leave.

For a consumer/producer society which most unwisely confined itself to consuming alone, the price paid by the West has been steep. Starting in the late 1980s and continuing into the 1990s and the twenty-first century all the way to the present day, the Western standard of living stagnated then fell, particularly for middle class households. Income redistribution which benefited high income earners lifted the averages, and this gave a misleading picture of greater wealth. The true condition is an increase in relative poverty.

The boom of the 1990s and of the first years of this century has bypassed most common people in western countries, who were kept quiet by a rapid but unaffordable increase in obligations toward them through entitlements, assumed by the sovereigns. These increased the public debt by leaps and bounds.³⁰ Past a point, it led to the economic and social crisis in which we landed.

The taxes the state collects are no more sufficient to pay salaries and pensions for its swallowed mass of bureaucrats,³¹ over and beyond the endowments and other free lunches it offers. To make ends meet, even formerly serious sovereigns have joined the speculators in high gearing while the common citizens are crashed. Euroland’s member states are now planning to leverage to euro 2 trillion, the euro 500 billion of European Stability Mechanism (ESM), the fund set up to help those over-leveraged sovereigns to come up from under. (The ESM funds are insufficient, but throwing them to profligate governments is simply silly.)

As for the shrinking standard of living, a study by the Federal Reserve released in June 2012 shows that between 2007 and 2010 the median net worth of American families fell to level last seen in 1992—except for the top 10 percent of earners, whose wealth rose.³² While most of the decline was attributed to the collapse in the housing market, it is no less true that the gap between the better off and those worse off has increased to levels which are difficult to justify.

The reader should also know that even within the top 1 percent of US citizens exist enormous differences in income. In 2011, Ray Dalio, head of Bridgewater, a large hedge fund, made 3.9 billion dollars—or 480 times the 8.1 million dollars received by Brian Moynihan, CEO of Bank of America. Compare either and both of these to the income of 8.3 million people unemployed in the United States, and you see what’s the size at the gap’s edges.

This gap pattern characterizes as well other Western countries (even if it is less dramatic). Leveraged sovereigns have become accustomed to live with a poorly planned and ill-thought-out system of income and expense, which will unavoidably crumble with the cost paid by the worst off common citizens. Take Italy and its public debt at 127 percent of GDP as an example. In early September 2012, Professor Johnson of MIT said that Italy’s debt is the most unsustainable of Euroland³³ —in spite of the other basket cases at both shores of the North Atlantic.

On August 20, 2012 Le Figaro, a Paris daily, published an interview by Nouriel Roubini, the economist, who stated that the only effect of delaying the breaking-up of Euroland is the continuation of the crisis. To Roubini’s opinion, the bailout strategy adopted for sovereigns, like the financing of Greece and Portugal, and (eventually) through OMT for Spain and Italy, will (in the near future) lead to the destruction of the ECB’s balance sheets.³⁴

In addition, highly indebted sovereigns who are being offered manna from heaven are not likely to take the necessary but painful steps of pruning the economy and putting it back on its feet. Their demand that the taxpayers of other Euroland nations pay for their debts lacks ethics, makes no economic sense, and is as well politically unrealistic. It is unthinkable that the Germans would pay part of the French debt when the French have cut their retirement age to 60 while Germans retire at 67.

“German voters have every reason to feel misled about the euro,” writes Gideon Rachman in the Financial Times. “They were once promised that the single currency involved a no-bailout clause that would prevent German taxpayers from having to support other eurozone countries. But Germany has already had to accept potential liabilities of euro 280 billion to fund Europe’s various bailouts – and there will be further demands to come.”³⁵

Not only highly leveraged nations should look at public debt as their citizen’s and their own enemy No. 1, but also tough measures are needed reversing “liberalizations” of the last three decades which promoted high gearing at global scale. In Bretton Woods, John Maynard Keynes considers as the most important achievement of the conference the establishment of the right of governments to restrict capital movements.

Keynes has said that cross-border finance should be regulated at both ends. In the case of the American economy: margin requirements, the Volcker rule and the Dodd–Frank Act have the potential to stem outflows. However, since Dodd–Frank implementation has exempted foreign exchange derivatives and bank branches from the Volcker rule, the gates are wide open for gambling in the global financial market, including wide capital movements.

In sharp contrast to a policy of restraint, globalization looks at free capital mobility as its “important entitlements,” if not “fundamental right.” It is indeed curious that the self-proclaimed Neo-Keynesians make no reference to this and other important policies of Keynes. They only spouse deficit spending, which Keynes had advised as an exceptional measure—not as permanent policy. Guess why.

Bretton Woods also restricted financial speculation as well as attacks on currencies, which today have become a second religion. Let me be clear on this issue. The more free reign is given to speculation, the more skewed becomes income and wealth distribution to the disadvantage of common citizen. This has serious consequences, particularly as lobbyists are busy protecting the interests of high earners and of the different excesses which characterize the 1 percent of society at the expense of the other 99 percent.

1.5 Leveraging and Getting Deeper into Debt

Leverage is debt. As the level of gearing grows that of assumed, risk increases exponentially. Leverage exists everywhere in the economy, but at very different degrees and for different reasons. Sometimes debt is used to start a new firm or to better the productive capacity of a company or of an industry. The practice of leverage is not always negative but it:

Leveraging is done by means of loans and trading. Derivative financial instruments³⁶ are, in principle, geared. To explain the sense of leverage, Wall Street analysts use the paradigm of cracking a whip. A force applied in the snap of the wrist results in multiples of that initial effort discharged at whip’s end. In a similar manner, as derivative financial instruments exploded all over the globe, two things have happened:

A leveraged nation, a leveraged company, or a leveraged family can survive as long as the environment continues to grow in the virtual world. A geared entity’s biggest fear would be a long period of calm and stability in the markets and in society at large, lulling companies and investors into slowing their trading activities.

The worst of all worlds for those who are geared is a marketplace where nothing happens. The most important risk, in this case, is not that a high volatility will hit the market, but that in a market which is calm and stable customers are less susceptible to continue entering into risky contracts. Then something big happens to the economy followed by sharp rise in volatility leading to destruction.

At the G20 Washington economic conference of November 15, 2008, after the collapse of Lehman Brothers, leverage was blamed for having wrecked the American and the global economy. The third paragraph of the communiqué which has been issued after that conference states: “[W]eak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.”

In his book Secrets of the Temple,³⁷ William Greider gives an example on an alternative to leverage: “As a banker who understood leverage, (Marriner) Eccles³⁸ argued that the government could have more impact on housing through direct spending.” The funding for public housing, he said, “was just a drop in the bucket so far as need went.” Washington, Eccles suggested, could stimulate millions of housing starts by:

Buying one’s own house is an investment, provided that he or she is not doing it for speculation. Investments have a return. For the typical household, leveraged investments are risky; when leverage filters largely into consumption, with too much money chasing a finite amount of goods, it pushes up inflation. In principle,

Leveraging makes a mockery of financial staying power, and it obliges the speculator: person, company, or sovereign to shorten his or her horizon. Money is always invested. Somebody is financing somebody else’s leveraging by extending credit and assuming counterparty risk. The more leveraged an entity is, the less the likelihood that it can face up to its financial obligations, particularly in times of crisis.

When adversity hits, a leveraged entity enters a phase of reverse leverage, a vicious cycle of disposing assets at fire-sale prices to confront margin calls or the demand to repay loans that have become due. Reverse leverage is particularly dangerous because speculators have assumed an inordinate amount of debt to capitalize on a projected upside in securities and commodities prices. But the doors of risk and return are adjacent and identical. Paraphrasing Mao: “The market is the sea. We are only the fish in it.”

In the banking industry, leverage is often associated with large off-balance sheet liabilities as well as questionable corporate governance. Mid-May 2012, an article in the Financial Times put it this way: “Chesapeake Energy ticks all of the boxes for a company that investors should beware of.” The article stated that according to analysts Chesapeake will have to go further to bring its debts under control. “Chesapeake is fixable,” said Jon Wolff of ISI Group, (but) management needs to make clear that reducing leverage is a much bigger concern than funding growth.”⁴⁰

A record with leveraging was set in 1998: 5000 percent, when Long-Term Capital Management (LTCM) crashed. That crisis was averted at the twelfth hour through the intervention of the New York Federal Reserve, which brought LTCM investors into the rescue plan. This 5000 percent leverage was a high water mark in the 1990s, but today, it is in its way to become rather common.

The LTCM experience says Henry Kaufman, the economist, has shown that international diversification worked in bull markets but failed in bear markets.⁴¹ More recently, alert analysts have detected broad structural changes in the financial marketplace due to the wide use of derivatives and the increasingly global nature of investments. Both have made small game of diversification—which is a sound principle, but it has been turned on its head.

In theory, the highly leveraged LTCM reduced its risks by scattering its investments among many markets and types of instruments. But in practice as anxiety began to spread through the global landscape (after Thailand’s currency collapse in the summer of 1997) these instruments and markets correlated with one another. Prices fell and businesses failed all along the Pacific Rim. In response, by early 1998, investors worldwide began seeking a haven in US Treasuries.

The gamblers had leveraged themselves expecting a windfall of profits, but what they got was a torrent of red ink. This has plenty of similitude to governments loading themselves with debt and granting unsustainable entitlements to please the voters, then penalizing these same voters through austerity measures. Sovereigns gear themselves up to pay the bills of the nanny state, and by so doing, they hurt the common citizen.

One of the risks with leverage, particularly with high gearing, is that it becomes addictive leading to the pyramiding of debt. Sovereigns, companies, and households get deeper into debt to live beyond their means. That’s the mentality of the State Supermarket⁴² into which has drifted western democracy toward economic and social chaos. Shakespeare had given the right answer when in one of his plays Polonius advised his son: “Neither a borrower nor a lender be” (let alone a leveraged borrower).

Bringing leverage under lock and key is good advice for people, companies, and sovereigns particularly in times of “risk-on.” Organizations, and society at large, are misguided by the existence of several fallacies about the practice of gearing. Here are three examples:

Leverage suggests that one is clever enough to use a tool that multiplies his or her financial power.

Such frequently heard bad advice does not even mention the fact that leverage weakens one’s financial staying power, and this is true in practically any case. Debt has to be repaid. The alternative is bankruptcy.

Using leverage is something to boast about, not to conceal.

This type of argument conveniently forgets that who steadily uses leverage, particularly high leverage, becomes credit-impaired, and the day comes when the mountain of debt drives a country, company, or family against the wall.

After you file for bankruptcy protection you are viewed as good credit risk, because you become debt-free.

Bankruptcies, including filings for bankruptcy protection, reduce an entity’s creditworthiness. Its credit rating plummets. Serious banks don’t court borrowers who have caused them (or their competitors) to lose money in the past, though derelict banks may.

High leverage has disastrous effects on financial stability. The longer term value of a dominant currency should be questioned when the central bank of their jurisdiction keeps its printing presses busy to pay for huge sovereign deficits. Still, several central banks in the so-called advanced economies have violated their charter by pursuing unconventional policies: quantitative easing (QE), pseudo-assets purchases, and large liquidity provisions to self-wounded big banks, without accounting for the fact that “more of the same” implies:

Like any other leverage, the rapid printing of paper money becomes addictive—and it debases the currency. It is wrong to believe that the only challenge is technical: to provide hundreds of millions of perfect copies of a product that is difficult to fake but cheap to make. The real challenge is financial stability, which has taken a leave. Since the gold standard has been repealed, there is no strict formula on how to taper this massive money printing process which has become one of the casino society’s better known follies.⁴³

1.6 Tic, Tac, Tic, Tac … The New Bubble Builds Up

“Money exists not by nature but by law,” said Aristotle. Well before Aristotle, the Laws of Solon (Section 1.1) have been the first on record to target monetary stability. The lawmaker of ancient Athens was thinking for the long term. By contrast, sovereigns who have been leveraging themselves are short-termists. They are thinking too much of their present problems and too little or not at all of the future.

The public debt of Japan currently stands at 240 percent its gross domestic product, largely due to over 20 years of continuing but unsuccessful efforts to jump start the economy. Italy’s public debt is 127 percent of GDP, that of the United States 110 percent of GDP with the raising of the nation’s debt ceiling having become an almost annual business.

Spending is running ahead of income. Even if taxes rise and rise what enters into government coffers is not enough to cover bloated budgets. Both sprawling bureaucracies and entitlements are fed through tax money. In the United States, aside federal taxes there are state and city taxes. A major part of city taxes is earmarked for financing the school system. But as education has become an increasingly costly chapter, in some states, the citizens have voted to put a ceiling on local taxes.

Politicians are lying when they say that the government provides “free” education and “free” health service. The public is not dupe; it knows that there is no “free” lunch. As Thomas Jefferson (1743–1826) had it: “He who permits himself to tell a lie often finds it much easier to do it a second and third time, till at length it becomes habitual. He tells lies without attending to it, and truths without the world’s believing him.”⁴⁴

Free education is a lie even when taxes are not rising because, helped by banks, school districts now use derivatives to leverage themselves and mortgage their future. In the process, they are feeding the next bubble. Few school districts have an idea of how to control their expenses, let alone how to be in charge of risk. If they had, they would not embrace derivative financial instruments as a way to ease their budgetary constraints.

Let me offer some hindsight prior to going on with this case study. Since 1990, the use of derivatives increased the complexity of the financial system, and nowadays, risk controllers who know what they are doing are very few. The crisis of 2007 which is still around has been promoted by instruments like collateralized debt obligations (CDOs) and credit default swaps (CDSs) which (during the 2007–2014 crisis) held many surprises for their issuers and users because of:

Instead of being financed through taxes and keeping their expenses at or below their income, American school authorities started to issue a swelling volume of leveraged bonds to supplement tax money. School administrations don’t know, and therefore cannot appreciate, the intricacies of derivatives. If they could understand the risks being involved, they would not even touch the new generation of derivatives designed by investment banks for the US school system (of all places).

Experts say that in the background of this silly policy of leveraging then crashing the educational system lies the fact that following the 2007 bust of the real estate market, property tax revenues (largely used to fund schools) have declined. As fiscal controls have been imposed by voters on educational boards, schools searched for and found some “innovative” but highly risky solution to financing. California led the pack.

In 2011 Poway Unified, a San Diego educational district, issued over $100 million worth of capital appreciation bonds to finance previously planned projects. These are similar to zero-coupon bonds; hence, the district does not need to start repaying interest (or reimbursing capital) until 2033. But the risk is enormous. To attract investors and compensate for payment deferral, such bonds are paying double-digit interest rates with the result that:

At present time, it is not possible to know how widely such a crazy 20-year school bond has spread. The Securities and Exchange Commission (SEC) stated, in early August 2012, that the $2.7 trillion municipal bond market is extremely opaque. The Poway case, however, is far from being unique. Others (albeit less extreme leveraging schemes) exist at several San Diego school authorities, and they are also based on derivatives:

An important question is how fast this sort of dynamite bond will establish a national pattern in the United States and then spread over the global economy. In some states, like Michigan, public entities are banned from capital appreciation bonds, but not every state takes that attitude. Lack of firm rules to stop high stakes gearing leaves residents, investors, and school districts exposed to a nasty future shock of a bubble whose bust may be the most destructive ever.

What can be stated with certainty is that the culture of spending more than one has and going beyond the limits of rational behavior has taken roots because there is money to be made in decadence (Chapter 2). As new huge debt is created, the crisis moved seamlessly from US mortgages to other domains. Today the most important is the high indebtedness of sovereigns. But school districts and companies, too, compete in bubble making.

A recent case is the Facebook Bubble. The price/earnings (P/E) multiple is a good indicator of two things in one shot: how much a given equity is sought after, and what’s the state of the economy. By contrast, a way to look at a growing bubble is how a company’s workers are valued in terms of annual income.

This is a bubble, given that what bubbles have in common is the drive to extremes. No wonder that Facebook’s capitalization fell by half a couple of months after the initial public offer (though it subsequently recovered part of the loss). One does not need to be a Taoist to appreciate the dictum: “Don’t go to the extreme; if you do so you will fall.”

There is a risk of contagion with to bursting bubbles. Researchers at the University of California, Berkeley, and Geneva’s Graduate Institute who looked at 20 currency crises in industrial economies (between 1959 and 1993), found that a crisis in one country increases the probability of crises in others. When an economy sours, its trading partners pay a price, as demand for their exports falls. Contagion also spreads through financial channels transmitting severe losses in income and unpaid bank loans across borders.

In the globalized economy, indirect links via common creditors play a crucial role. In the late 1990s, Japanese banks had lent to companies in booming Thailand and Indonesia. When Thailand went bust, Japanese banks found out the hard way that their Thai customers would never repay their loans. To compensate, they cut credit to Indonesia and other economies. As contagion spread engulfing the “Asian tigers,” economists said that abruptly retracting credit was reckless.

Bubbles follow a similar pattern with more pronounced financial and trading characteristics than other types of contagion. Subprimes sold by American banks to European banks brought a massive amount of unstable debt across the Atlantic; the European banks’ fuses blew shortly after the subprimes bubble burst in the United States. As these examples show, speculation, leveraging, and greed are the viruses infecting financial systems and feeding bubbles. Weak regulation in one country promotes contagion between countries, and it fails in its duty of punching the bubble when it is still small.

End Notes