Sunday, 5 August 2012

Discussing Systemic Default

The Joy of National Default
Dmitry Orlov

31 July, 2012

At 78 pages of scholarly, somewhat jargon-laden prose, Trade-Off: Financial System Supply-Chain Cross-Contagion by David Korowicz is not quick reading, nor is it light reading, but it is important reading. It puts a lot of definition to the concept of cascaded failure, in which financial collapse inexorably leads to political and economic collapse with no possibilities for arresting this process or even altering its course. This may seem like a terribly pessimistic message, and, indeed, it is hard to imagine that it would provoke a cheerful reaction in any sane person. But for those who feel that it is important to understand what is unfolding, Korowicz offers a large dose of realism. Still, a fair warning is called for: “Abandon all optimism all ye who enter here!”

Most of us face a number of mental roadblocks when we think about such matters. First, our experience is one of gradualism: an action produces an equal and opposite reaction; after a disturbance, equilibrium is eventually restored; human institutions have permanence and evolve slowly. Second, our experience is compartmentalized. If the subject is sovereign defaults, then experts in finance are there for us to consult; if it is the failure of global trade, then we turn to experts in business. Sociologists will tell us about the negative effects all of this has on society, while psychologists will talk about individual patients but cannot address the societal causes of their problems. But systemic collapse is an interdisciplinary problem that defies all attempts at compartmentalization. It promises to sweep away such highly specialized domains of knowledge by driving down social complexity. Third, there is the question of motivation: what, beyond intellectual curiosity, would compel people to invest time and effort in a detailed study of a depressing subject which has no practical application? The topic tends to attract people who have plenty of free time and a morbid imagination. Still, I feel that there is great value in being able to foresee how events will unfold: a foreseen nasty development is still much better than a nasty surprise.

Our intuitive sense of gradualism is a product of our experience. Sudden transitions are often lethal, and this means that those who experience them are often not available for subsequent consultation. For example, we feel that cars are reasonably safe, and although great multitudes of people who died in auto accidents would disagree, they are in no position to make their opinions heard. Most of our remaining experts and pundits have led sheltered, boring lives with little experience of anything out of the ordinary. The few who survived one or two terrifying episodes of great discontinuity feel lucky to have survived and prefer not to recall them too often or in too much detail. The common understanding is that freak phenomena do occur, but an eventual return to some sort of equilibrium always occurs as well, eventually.

The opposite viewpoint can be, and is expounded by Korowicz and others, but has the drawback of being rather highly intellectual and abstract, offering little that is experiential or intuitive. This makes the exposition less than optimally effective for many people. Most people look out the window and see cars driving around and people going in and out of banks and shops and offices. But to really understand what underpins the stability of this scheme we have to be able to see, with our mind's eye, a dynamic system that can maintain homeostatic equilibrium and recover from shocks when all of its parameters remain within a certain range. Let's try a simple metaphor. Suppose you are sitting in the kitchen. On a saucer in the middle of the kitchen table is a pretty blue marble. You are in an earthquake zone. As tremors hit, the marble rolls around the saucer, but it never rolls out of the saucer. This is a dynamic system within its stability range. But then a bigger shock hits, a chunk falls out of the ceiling and smashes the saucer, the marble skitters off the table, rolls through the gap under the door, down the stairs, down the street, and falls into a storm drain. In other words, the system takes small shocks in stride, but big shocks destroy it completely. Where the dividing line between small and big shocks runs—nobody really knows, but that doesn't matter provided we know that the shocks are only going to get bigger. And we do know that.

Now let's tackle a bigger dynamic system: global finance. At this point in time, all of the highly developed economies are 1. very highly indebted and 2. are either shrinking or not growing. This is not a stable situation: “Because credit is charged at interest, credit expansion is required to service previously issued credit. In order for the issued credit-money to retain its value relative to goods and services in the economy, GDP must increase commensurate with credit-money expansion.” (p. 33) The end result of this process is national default. At this time, the fact that Greece is in some stage of national default is no longer controversial. Nor does it appear likely that the problems of Spain, Italy or Ireland can be sorted out.

Nor is it likely that growth will resume. First, there is the problem with natural resources, oil foremost among them. It is too expensive to allow growth, and it can't get any cheaper because the remaining marginal resources are, well, marginal—deep water, tar sands, shale oil and other dregs—and are expensive to produce. Second, there is a problem with levels of debt: too high a level of debt chokes off economic growth. Third, we are at a point now where it is not possible to stimulate growth: the latest figures are that it takes a 2.3-fold increase in debt to produce one unit of GDP growth. We have achieved diminishing returns with regard to growth: we need to dig a bigger hole in which to put all this debt, and are willing to go deeper into debt to do it, but no matter how fast we dig, the debt just keeps piling up next to the hole. The politicians still talk about growth, but it's a race to nowhere.

It may seem strange, but a national default can be seen as a positive development: bad debt is wiped out, new, sound money is printed and put into circulation, and the economy recovers. This has been observed in Argentina, Russia and Iceland. Could similarly positive things happen for larger pieces of the global economy? Perhaps it's a messaging issue; let's call it a “jubilee” instead. “We can imagine the spread of financial contagion expands, and is then arrested by some action of governments and central banks. Suddenly, all banks are solvent,... and trade and other credit is again available.” (p. 70) One key observation is that this would have to happen rather quickly, almost instantly, and require a level of international coordination that would be completely unprecedented. Korowicz is not confident that this is possible: “...we are locked into a vast and unimaginably complex fabric of conditions that we barely understand... we live in a culture that often assumes that being able to conceptualize major change, means such change is possible...” (p. 75)

Still, national defaults have happened before, and global finance recovered, so why wouldn't it now? Well, there is the little question of size. The significance of a national default varies in accordance with the size of the nation's economy relative to the size of the global economy. Argentina's default was a non-event at the global scale. Russia's default almost took the entire financial system with it when Long-Term Capital Management suddenly failed as a result. The Federal Reserve had to step in and bail it out. The subprime mortgage crisis in the US and the failure of Lehman Brothers brought global finance even closer to the brink, and required much bigger bailouts. And now, with Greece, Spain and Italy on the rocks, bailouts are coming fast and furious, but each one seems to restore confidence for a shorter and shorter period of time. All of these shocks add together, and at some point one of them will cause the global financial system “to cross a tipping point, causing cascading failure that would devastate the global financial system” (Korowicz, p. 11) The effect of each shock is to make the system as a whole less resilient. After each localized national default (Russia, Argentina, Iceland) recovery was critically dependent on access to a relatively healthy world economy and financial system. As we move from one financial crisis to the next, we continue to assume that each one will produce a proportional reaction. But any one of them can move the global system out of its linear range, and cause a flash crash from which there is no recovery because the process turns out to be irreversible: the complex global financial system cannot be recreated once the global economy that gave rise to it no longer exists.

There is an obvious reason why there have been so many bank failures and bailouts occurring in the countries affected by the crisis: these institutions are acting as canaries in a coal mine. Banks are designed to finance economic growth; they are not designed to finance economic contraction. In a deflationary slide caused by their loan portfolios going bad, they quickly go bankrupt. Their retained earnings and shareholder capital only amount to 2-9% of their loan portfolio, and so it doesn't take much of a loss to put them under. In a contracting economy all banks fail, but this process has been contained so far by governments and central banks that have been willing to bail them out. This process cannot go on forever: “In the end the only backstop a central bank has is the ability to print infinite money, and if it has to go that far, it has failed because it will have destroyed confidence in the money.” (p. 61)

One major complication is that the financial system does not exist in isolation from the rest of the economy: “The fabric underpinning the exchange of real goods and services is enabled by money, credit, and financial intermediation.” Korowicz carefully goes through the process by which financial failure causes an instant breakdown in commerce. Cargos have to be financed. This is done by banks on opposite sides of the planet that are willing to grant and to honor letters of credit, which are paid once the cargo is landed. If letters of credit cannot be obtained, cargo does not move. In a crisis, banks mistrust each other, and denying letters of credit is one of the easiest ways for them to decrease their exposure to counterparty risk (the chance that the buyer's bank, which drew up the letter of credit, won't be able to make the payment). In turn, missing shipments mean empty supermarket shelves within days, idled production at factories due to missing components, standstills at construction sites and maintenance operations, hospitals running out of drugs and supplies and so on. Within a week, local fuel inventories are depleted and transportation is disrupted. Modern manufacturing and distribution networks rely on a global supply chain and very thin, just-in-time inventories. High-tech manufacturing is most easily disrupted, because key components have just one or two suppliers, and little or no possibility for substitution. Experience of various disruptions (Japanese tsunami in 2011, Eyjafjallaj√∂kull volcano eruption in 2010) shows that the impact of a disruption does not scale linearly with its length but accelerates—and recovery takes disproportionately longer. Within a month or so the electric grid collapses due to lack of supplies and maintenance; it is probably at this point that recovery becomes impossible.

But even before that point the contagion will start to feed on itself. The region of negative feedback where homeostasis is maintained is surrounded by regions of positive feedback where the system is driven further and further from equilibrium. For example, “The financial system... would not just be collapsing because of unsustainable levels of debt-to-income, but because that income would be collapsing as production halted and its future prospects turned dire.” (p. 69) Nor would the economy of goods and services be spared similar degenerative processes: “One would expect a massive reorientation away from discretionary consumption towards primary needs—food, essential energy, medicine and communication.” (p. 62) As a result, many businesses would fail, further depressing demand, while maintenance would be deferred to the point where much of the infrastructure becomes non-functional. Much of that infrastructure is designed for a growing economy as well, and will become millstone around our necks: in a shrinking economy, the fixed costs of existing critical infrastructure give rise to negative economies of scale, making extensive infrastructure unaffordable at any level. The global aspect of the global economy would be perhaps the fastest to disappear: citing the evolutionary economist Paul Seabright, Korowicz writes: “Trust between unrelated strangers outside their own tribal grouping cannot be taken for granted.” (p. 23) Trust between strangers builds up slowly but is lost rapidly. In a shrinking economy, “taking care of one's own” becomes more important than maintaining a trust relationship with strangers across the world.

There is a cautionary tale to be extracted from all this, and it is the obvious one: that usury results in collapse. Usury—lending at interest—is only viable in an expanding economy; once economic growth stops, the burden of usurious debt causes it to implode. “The whole of the financial and economic system is dependent upon credit dynamics and leverage.” (p. 8) “Debt is now not just a feature of countries and banks—it is a system stress in the globalized economy as a whole.” (p. 9) It is no accident that Dante's Inferno consigned usurers to the lowest pit of the seventh circle of Hell. But beyond waiting for the usurers to die and get assigned to the appropriate pit for all eternity, what is there for us to do? Not lend or borrow at interest? Well, that's the one problem we certainly won't have to worry about!

Other than that, first and foremost, no matter who you are or where you are or how many wooden shekels you've squirreled away under your floorboards, don't expect a soft landing. After reading this treatise, I am now more than ever convinced that sovereign debt default is not some sort of spring shower that passes and then the sun comes out again. If Korowicz is right—and he appears to have done his homework—then at some point what is now still a gradual process will lead to a sudden, irreversible, catastrophic disruption of daily life. (And looking at the reports coming out of Greece and Spain, imagining such a scenario no longer requires much of an imagination.) Korowicz does not have a lot to offer when it comes to practical adaptations to survive such a systemic breakdown, beyond stating the obvious, which I will repeat: “Initially the most exposed would be those with little cash at hand, low home inventories, mobility restrictions and weak family and community ties.” In other words, be prepared, and do your best to give yourself a chance.

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