Saturday, November 05, 2011

Sweet, sweet default

I recently read This Time Is Different: Eight Centuries of Financial Folly as part of my attempt to gain a better understanding of the ongoing economic crisis. It's a very fine book, with an impressive amount of data relating to the many calamities which have wrecked economies throughout history. There are many takeaways, but the one on which I'd like to focus is the frequency of sovereign default. It would be very easy to extract a libertarian lesson in sound money from the propensity of nations to default on their debts, but I wish to focus on another, albeit related, lesson from the book.

Sovereign default is not the end of the world. No doubt it causes great harm for those who were dependent on the state fulfilling its obligations, i.e. creditors and beneficiaries of government largesse. For America today, the former are mostly foreign governments, though most banks throughout the world are invested in American treasuries. The latter is made up of the recipients of social security and medicare payments, as well as retirees with government pensions, along with any company with its hands in the pockets of Uncle Sam, from military contractors to the large banks. If the United States defaulted, there would be significant and far-reaching consequences for a large number of disparate parties.

But this does not mean it's a bad idea. The alternative is to double down on an over-leveraged banking system in the hopes of spurring economic growth to get us out of this mess. There are a variety of problems with this approach, not the least of which is that with out present ratio of debt to GDP, growth is exceedingly unlikely. The authors of the aforementioned book note that 90% is the key ratio, beyond which default becomes all but certain. We passed that Rubicon some time ago.

Incidentally, default makes growth more likely, albeit after a painful period in which debt deleveraging can occur. Karl Denninger does an excellent job of explaining the details in his book, Leverage, but I can offer a short explanation here.

Under our system of fractional reserve banking, banks are only required to keep some portion of deposits on hand. The rest can be lent out. Credit is created when banks lend out these "excess reserves." This credit creation facilitates a boom, during which everyone appears to be making money hand over fist and the economy seems to be doing well. Yet this growth is largely illusory. When deposits dry up--usually due to a tightening of the money supply of the central bank--asset prices begin to fall. The over-leveraged banks, i.e. almost all of them, are in trouble, for leverage is a cruel mistress: it multiplies profits on the way up, and multiplies losses on the way down.

The various government bailouts were intended to shore up the accounts of the banks and stave off the deleveraging process. This has only served to postpone the process. Fortunately, here in the United States, the Tea Party and Occupy Wall Street movements make future bailouts less likely, unless the Federal Reserve surreptitiously gives money to various banks. On a related note, this is precisely why Ron Paul has focused on auditing the Federal Reserve, and why anyone who fails to see the necessity of such an audit--such as Herman Cain--merits no consideration as a presidential candidate by anyone who understands economics.

Although no one can be certain of the day nor hour, default is in our future. The sooner we embrace this solution, the sooner the bad debt can be cleared from the books and the sooner we can return to real economic growth--as opposed to the increase in GDP which is a direct result of taking on more debt and, therefore, does nothing to employ more Americans.

While Greece is contemplating whether to accept another "solution" which purporting restores solvency to a bankrupt country, the example set by Iceland is illustrative of the benefits of default:

Iceland, whose banks defaulted on $85 billion in 2008, completed a 33-month International Monetary Fund program in August. The Washington-based fund expects Iceland’s economy to grow faster than the average for the euro area this year and next. It costs less to insure against an Icelandic sovereign default than it does, on average, to hedge against a credit event in Europe’s single currency bloc, debt derivatives show.

Since we have spent the last three years pretending to solve a problem by doubling down on our bad debt, 33 months is far too conservative for the deleveraging process. Yet this time period can only increase if we continue to delay the inevitable.

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