The Unlearned Lessons from 2008 Global Financial Crisis

Over a decade back, in 2008, the world was struck by a severe financial crisis. A great many people suffered and the world is still recuperating from its chaos. Against the convention belief, the situation is far from contained. To solve any problem and to ensure that the situation will never re-emerge, it is important we learn from such disasters. But have we learned from them? In this long but engaging essay, U. Mahesh Prabhu provides in-depth insights and credible perspectives for anyone to understand the 2008 Global Financial Crisis and realize why it is far from over. A must read.

Phil Angelides was appointed as the Chairman of Financial Crisis Inquiry Commission (or FCIC) to investigate the 2008 financial meltdown in the United States. His report confirms that the meltdown had occurred primarily due to easy (or reckless?) lending of home loans to anyone including those without any viable repayment capacities – whatsoever. These loans were termed as “Subprime Loans”.

It all began when mortgage companies, in a rush to book profits, overlooked every safeguard and made loans available to virtually anyone who applied without adequate scrutiny under the unwise assumption that “the property prices would go up anyways!” Not many knew that this was a perfect recipe for doom.

Bubble mortgages were created in which lenders would not have to pay their primary mortgages for several years. The idea was that by the time the bigger payment requirements arose a few years in the future, rising house values would allow a way out through selling the house at a profit if necessary. Unfortunately, the opposite occurred and house prices radically declined, making such bubble mortgages lead to default.

The only person who could have assessed the gravity of the situation and, therefore, should have stopped such malpractice was Alan Greenspan – America’s “most feared and revered banker” – even by Presidents – for over 40 years. But that he did nothing is the truth. When the FCIC Chairman asked Mr. Greenspan as to why he failed to intervene, then, his casual sounding response was “I was right 70% and wrong 30%…”

When the FCIC Chairman asked Mr. Greenspan as to why he failed to intervene, then, his casual sounding response was “I was right 70% and wrong 30%…”

The mortgages that were offered were complex and were sold to even the least educated and unsuspecting buyers. Even people less than twenty years old were given loans, assuming that their incomes would rise, which they did not.

This was the time when Angelo Mozilo, CEO of Countrywide Financials, was making billions of dollars by such subprime mortgage lending. Mr. Mozilo often introduced himself as the “friend of the poor” and that his “ambition was to help every American get his own home.” But after the real estate bubble had burst and the severe consequences were felt by many of his subprime mortgage customers, he, of course, did nothing when authorities were at their doorstep to enforce their eviction from their homes. Countrywide Financial was by large the largest lending company during the subprime lending boom and as a result, faced severe financial losses and was eventually sold for a pittance to Bank of America. When the Securities Exchange Commission (SEC) investigated Mr. Mozilo’s email communications they found many shocking facts. In one of such communications, he was found defining subprime mortgages that he was peddling were of “extreme toxic in nature.” Once the poster boy of mortgage industry Mr. Mozilo was eventually charged for trading and securities fraud by SEC. But that was after the damage was already done.

If the mortgages were simple ones and remained on books of the lending companies, the situation would have been simple and easy to contain. But unfortunately, these mortgages never stayed with their respective companies. With government establishments doing nothing to tame reckless financial malpractices, these questionable mortgages were bundled with other safer mortgages across the country and then sold to Wall Street companies as “positive investments.” At Wall Street, these mortgages were then packed into complex financial products into a market where there were no government regulations. Long term bank loans became on par with short term speculative loans and lost all protection.

When these markets crashed, people assumed it to be a case of good fruit gone stale.  What people who bought them never knew is that the fruit they had brought was toxic in nature from the very first day! It was not just a loss in short term investments but long term home loans. These toxic fruits meanwhile were already sold to markets not just in the United States but across the world where proper regulations weren’t in place, including Europe.

When these markets crashed, people assumed it to be a case of good fruit gone stale.  What people who bought them never knew is that the fruit they had brought was toxic in nature from the very first day!

As a matter of fact, these toxic products were traded first in “The City” of London. When such toxic financial products were being introduced in British markets, the country’s then Premier Mr. Gordon Brown was busy deregulating the financial markets through his “Light Touch” policy. The “Light Touch” was all about giving bankers and financiers a free run along with a host of other benefits including tax cuts. According to former Canadian Prime Minister Mr. Paul Martin, Britain was keen to make “The City” overtake New York as the international financial hub.

To lure clients into buying such toxic financial products several financial marketers were permitted to use various illegitimate and unethical methods including sometimes supplying drugs and prostitution to anyone who bought their products. Average salaries of these financial marketers were at $300,000 along with an outrageous annual bonuses nothing less than $700,000!

Be it Wall Street or The City the conventional idea became that “You don’t come here for charity but to make huge profits for yourself even if that required deception, misappropriation or false promises, in short cheating and stealing.”  Bankers and lenders gambled with the life savings of ordinary people, making large profits for themselves but having no liability when the market collapsed and people lost their homes, retirements or life-savings.

Be it Wall Street or The City the conventional idea became that “You don’t come here for charity but to make huge profits for yourself even if that required deception, misappropriation or false promises, in short cheating and stealing.”  Bankers and lenders gambled with the life savings of ordinary people, making large profits for themselves but having no liability when the market collapsed and people lost their homes, retirements or life-savings.

These toxic products had stuck not just Europe but many other countries throughout the world. The most important ones we find worthy of mention here are Iceland and Dubai.

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If one country could be the microcosm of everything that went wrong before the 2008 meltdown – It is Iceland!

Iceland is a place of staggering natural beauty. Before 2000 Iceland was never known for banking and finance. It was a prosperous nation by all standards. It was pushed into a financial abyss by its longtime premier Davíð Oddsson.

Oddsson decided to take his country out of the “old school” and into the free markets. His adversaries called him “Cunning as a fox and courageous as a lion.” He wanted to privatize everything touched by the government. He parcelled off the country’s shipping grounds, which was the traditional trade of the country, and sold it off to large ship owners.

He even auctioned off his country’s greatest financial banking establishments under “mysterious circumstances.” These banks then lowered the interest rates and encouraged Icelanders to buy one, or two, or more houses. These banks then sold these mortgages to each other in order to enhance value and get better credit ratings. This lead to reckless financial planning during the time which were called “boom years”.

The yet another country that resembled Iceland was Dubai. There was a mad rush among Sheikhs of middle-east and companies to see as to who would create the most ostentatious building. No idea here was considered too outlandish. When waterfront properties in Dubai skyrocketed in value, Dubai decided to create more such properties by getting ships to vacuum off the ocean floor to create the “Palm Island”. All the houses and exquisite palaces type condominiums were purchased by wealthy investors across the US, Europe and other parts of the middle-east.

People came to Dubai to buy houses, small or big, with no intention of staying in them. They were buying houses as if they were coupons with the sole intention of selling it to someone else in a few years for an expected large profit! Billions of dollar worth were sold to such buyers in a single day during the boom time as if the property would continue to rise in value, even if it was not being used or occupied.

People came to Dubai to buy houses, small or big, with no intention of staying in them. They were buying houses as if they were coupons with the sole intention of selling it to someone else in a few years for an expected large profit! Billions of dollar worth were sold to such buyers in a single day during the boom time as if the property would continue to rise in value, even if it was not being used or occupied.

Henry Paulson was a Wall Street veteran who during the delicate times was chosen by US President George W. Bush to head Secretary of Treasury. It was a controversial choice by any standards. Paulson wasn’t universally loved – even in Wall Street. According to Charles Gasperino, author of The Sellout, “He was nasty of all guys…” Soon after Paulson became the secretary of treasury situation began to worsen by leaps and bounds.

The alarm was sounded first in Paris during August 2007. BNP Paribas found that many of its funds were filled with “toxic US securities.” They stopped all withdrawals from those funds thereby creating an immediate response from the French Finance Minister Christine Lagarde, who summoned heads of all banks only to find that they had invested in something “insignificant”.

During the same time, BBC coverage of Northern Rock Bank’s liquidity issue sounded another alarm in the UK. Scores of people across the UK lined outside the bank’s ATMs to withdraw cash. The situation appeared disastrous. Northern Rock Bank’s crisis could have been taken as an early warning by the US Treasury, but that it was not is a reality. The sense of interconnection in the economy wasn’t felt by policymakers until the last moment.

It was only when Bear and Stearns and its CEO – James Cayne came under severe fire from all quarters that New York’s financial world felt serious jitters. Bear Stearns exploded in 2008. It is said that when Paulson heard the rumours he declared that “this will be over within days.” A few days before Bear Stearns’s share prices were traded at $170 and after its doom, JP Morgan took over the bank for a paltry sum of $2 a share!

Lehmann Brothers, no. 4 bank in the US was next. It was then headed by its CEO Richard Fuld, popularly known as Dick Fuld. It was the collapse of this bank that contributed significantly to prevailing chaos in the global economy. It ruined millions of Americans who had invested in Lehmann. Before the game was over Dick’s word was considered as law; his judgment was seldom questioned. Everything changed when Lehmann entered its death spiral on September 11, 2008.

After Lehmann’s collapse Paulson summoned a secret meeting of top bankers at New York’s SEC headquarters. It was attended by JP Morgan’s James Dimon, Goldman Sachs’s Llyod Blankfein, Merrill Lynch’s John Thain, and Morgan Stanley’s John Mack. Lehmann’s Dick Fuld wasn’t invited and needless to say, he was furious.

At the beginning of his tenure, Paulson had declared that “It wasn’t the government’s work to save private business…” yet at the meeting with the CEO’s he tried his level best to save Lehmann; he was failed by British who disagreed to approve his idea. The fate of Lehmann and scores of its clients were sealed.

Lehmann Brothers, founded in 1850, had survived great depression, 9/11 attacks – their offices were situated in WTC twin towers. None had even dreamt a few months before its collapse that the organization will be over such a way. A few days before the collapse everyone at Lehmann was confident that they’ll sail through this too.

During the real-estate bubble, AIG was running its business like a casino by insuring companies for bankruptcy. Paulson saved AIG hastily by infusing taxpayers’ $85 billion. Joseph Casano, President of AIG’s financial products, was “fired” not before paying $350 million dollars in “compensation”. Casano was working for AIG in the UK since his nasty business of insuring companies for bankruptcy was “banned” in the United States.

During the real-estate bubble, AIG was running its business like a casino by insuring companies for bankruptcy. Paulson saved AIG hastily by infusing taxpayers’ $85 billion. Joseph Casano, President of AIG’s financial products, was “fired” not before paying $350 million dollars in “compensation”. Casano was working for AIG in the UK since his nasty business of insuring companies for bankruptcy was “banned” in the United States.

Paulson along with Bernanke of Federal Reserve then went to Capitol Hill to seek more powers from US Congress. They were turned down. This aggravated the crisis further. Paulson wanted $700 billion and special powers from the Congress. In the end, they did get the power and money but signs of economic depression began showing off anyways.

Paulson then decided to make a direct takeover of all banks through direct investments. Bankers knew that if they took money from government they’ll also have to take a lot of interference from the government as well. They could even lose their personal payments and bonuses. Bankers desired to avoid. In the end CEOs of these banks signed a hastily drafted single sheet paper which approved $10 billion for Merrill Lynch, $10 billion for Goldman Sachs and $25 billion for JP Morgan. In simple terms, this was probably the biggest welfare check in the history which was paid to Wall Street banks. These banks’ CEOs were to then write generous checks for themselves. This is the reason why the Congressional Committee charged Paulson for making “favors to his former clients”.

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Meanwhile, Iceland defaulted British payments and in a fit of anger British premier then added the country to blacklisted organizations and nations including Al-Qaeda and other terror-sponsoring countries.

Chaos began to engross across Europe, where trade union leaders resorted to extreme measures including, but not limited to, kidnapping and riots.

Chaos began to engross across Europe, where trade union leaders resorted to extreme measures including, but not limited to, kidnapping and riots.

The European leaders met many times during these troubled times but left without any consensus. This was the time when French President Nicholas Sarkozy encouraged people and policymakers to “rethink capitalism.”

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Then came to Greece Financial crisis.

While this was the main financial news for Europe in 2015, it had its origins in the same policies and situation.

In June of 2015, the total value of Greece’s debt is $330 billion; that’s 15 times more than the cost of Apollo landing by NASA. 180% of Greece’s GDP is in debt; UK’s debt is 85% of its GDP by comparison. Greece’s IMF’s loan amount to $9.2 billion (as of 2015); this is the cost of buying 266 Challenger 2 tanks and maintain them for a lifetime. Greece monthly salary and pension bills amount to $1.4 – $1.7 billion; this is equal to the cost of buying 548 Bugatti Veyron every month. From what it appears as of now $50 billion of Greece govt. assets will be privatized by 2015; this is the equivalent of the UK government selling 435 Admiralty Arches in London.

In June of 2015, the total value of Greece’s debt is $330 billion; that’s 15 times more than the cost of Apollo landing by NASA. 180% of Greece’s GDP is in debt; UK’s debt is 85% of its GDP by comparison. Greece’s IMF’s loan amount to $9.2 billion (as of 2015); this is the cost of buying 266 Challenger 2 tanks and maintain them for a lifetime. Greece monthly salary and pension bills amount to $1.4 – $1.7 billion; this is equal to the cost of buying 548 Bugatti Veyron every month. From what it appears as of now $50 billion of Greece govt. assets will be privatized by 2015; this is the equivalent of the UK government selling 435 Admiralty Arches in London.

How Greece can pay for such debts and also develop a positive economy remains in doubt. Yet should the EU write off or downscale the Greek debt, the same would occur to the many other EU countries suffering from similar problems, leading to the possible financial collapse of the EU itself.

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Though subprime mortgage lending led to the financial chaos across Europe this wasn’t by any means the only reason. If you know history, the European economy itself appears to be flawed.

European history has been replete with feuds, rebellions and intranational rivalry for centuries. Doing business across borders was difficult and each time to do commerce there was a huge cost incurred on “exchange fees” alone. This, of course, was a great impediment to the continent’s economic growth. Post World War II the businesses and governments felt the desire for a unified Europe.

In 1993, a few years after the fall of the Berlin Wall which paved the way for the unification of Germany, 27 European nations signed the Maastricht Treaty and created the European Union. This made business across borders easier but there was one more major constraint – different currencies. The Euro was thus eventually launched on January 1, 1999, as the currency for the entire region.

Countries adopting Euro – called Euro Area – discontinued their own currencies, some of which had existed for centuries. They even discontinued their Monitory Policies giving more powers to ECB (European Central Bank). Yet they had many Fiscal Policies; a key reason for the current debt crisis.

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It’s important to know the difference between a Monitory Policy and a Fiscal Policy. Monitory Policy controls money supply in the economy. It also determines interest rates for borrowing money. Fiscal Policy controls how much money the government collects in taxes and how much it spends. The government can spend only as much as it can collect taxes. Anything above that amount has to be borrowed – this is called Deficit Spending.

It’s important to know the difference between a Monitory Policy and a Fiscal Policy. Monitory Policy controls money supply in the economy. It also determines interest rates for borrowing money. Fiscal Policy controls how much money the government collects in taxes and how much it spends. The government can spend only as much as it can collect taxes. Anything above that amount has to be borrowed – this is called Deficit Spending.

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Before the Euro in countries like Greece, people had to pay higher interest rates to borrow and they could borrow only certain amounts. But when they became part of Euro the money they could borrow skyrocketed. Interest rates dropped from 18% to paltry 3%.

There was a general and highly misplaced belief that if countries like Greece defaulted, the money could be recollected from Germany, which remained economically prosperous. This was because they were bound by a common currency.

Greece like countries incurred huge debts and for some time even promptly re-payed this money with more borrowed money. As far as borrowing continued so did the spending. Such countries also continued expensive welfare and social service payments to their citizens, but now paid for with borrowed money.

In Ireland and Spain cheap credit created huge housing bubbles, just like it did in the United States.

Credit flowed debt accumulated and economies in Europe became tightly intertwined, with borrowed money being confused with actual assets or real profit

Companies began opening new factories across Europe. German banks provided lending for French companies. French banks provided the lending the Spanish companies and so on and so forth. The debt was transferred as if it were an asset from one country to another.

This made doing business incredibly efficient and easy. Things continued the way as long as credit was available. Credit was available until 2008 when it became clear such credit had no real financial assets to support or sustain it

The collapse in the US housing markets created ripples across global markets bringing borrowing to a complete halt, as the supposed US house values were the ultimate basis of the supposed value of the credit that had spread to global markets. Suddenly the Greek economy couldn’t function, much like many others. They couldn’t pay for the new jobs and benefits they had artificially created. Greece couldn’t borrow the money it needed to pay the new debts. This was a problem for Greece since it was a part of the EU it became a problem for all of EU nations. Since most of the EU nations couldn’t repay they looked towards prosperous Germany.

The collapse in the US housing markets created ripples across global markets bringing borrowing to a complete halt, as the supposed US house values were the ultimate basis of the supposed value of the credit that had spread to global markets. Suddenly the Greek economy couldn’t function, much like many others. They couldn’t pay for the new jobs and benefits they had artificially created. Greece couldn’t borrow the money it needed to pay the new debts. This was a problem for Greece since it was a part of the EU it became a problem for all of EU nations. Since most of the EU nations couldn’t repay they looked towards prosperous Germany.

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As the biggest and strongest Economy in Europe, Germany reluctantly decided to bail out the debt-ridden EU countries. But Germany agreed to repay the bills only if other countries would agree to strict “Austerity Measures.” This was to make sure that the problem won’t ever happen again.

Austerity measures meant coming more under control of EU and German banks and never making any more debt-driven spending. Austerity measures meant cutting government spending, particularly on social benefits. And since by far the government is the largest spender in any economy when the government stops spending it can hurt many of its citizen’s income. People lose jobs, they get angry and they riot in the streets. Since the government collects taxes based on people’s earnings when earnings are reduced the government collects less in taxes. So they can only less repay their debts.

Austerity measures meant coming more under control of EU and German banks and never making any more debt-driven spending. Austerity measures meant cutting government spending, particularly on social benefits. And since by far the government is the largest spender in any economy when the government stops spending it can hurt many of its citizen’s income. People lose jobs, they get angry and they riot in the streets. Since the government collects taxes based on people’s earnings when earnings are reduced the government collects less in taxes. So they can only less repay their debts.

Yet there does not seem to be an easy alternative to austerity as continued spending based upon borrowing from other countries does not lead to a healthy economy either. In short, the financial quagmire created does not seem to have an easy or even perhaps a real solution, unless there is some radical change in how business is done.

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There are, of course, a lot of cultural differences between Germany and other debt-ridden EU nations. Germans are financially responsible as a nation. After terrible hyperinflation German experienced during World War I, the nation has been very inflation averse and careful about spending and borrowing. In simple terms: Germans work hard and expect little in retirement benefits and they meticulously pay their taxes.

Many Greeks, on the other hand, like other Europeans who live in countries with strong welfare states, expect generous state benefits and don’t pay taxes. Greece has never collected the majority of its taxes it has imposed on its citizens. Germany disagrees with Greece on this attitude. Germany’s argument is “If you want our money you’d need to follow our morals.” Unlike Norway, Greece does not have government oil revenues to share with the people and fund such social services.

As debt-ridden countries are headed towards default, the whole continent of Europe is in danger as all these economies are intertwined. Even though economies of these debt-driven countries are relatively small it is posing a great challenge since the European financial system is so interconnected – precisely because of the Euro.

As debt-ridden countries are headed towards default, the whole continent of Europe is in danger as all these economies are intertwined. Even though economies of these debt-driven countries are relatively small it is posing a great challenge since the European financial system is so interconnected – precisely because of the Euro.

A problem in one country can reverberate across the whole continent, triggering a chain reaction of default. If Greece defaults, then Spain will default, followed by Italy, Portugal, France, and Germany… pretty soon the situation will spread across the world.

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The problem is: even if debtor nations adopt austerity measures, and a bailout from Germany and other nations pay their debts and avert the crisis there is no system in place to prevent this from happening again.

This brings back to the fundamentals of Monetary Policy and Fiscal Policy.

Ultimately the Euro Area will require a fiscal union to match its monetary union or neither.

This means there needs to be in place a political authority to impose fiscal policy across the Euro area. It must have the power to cut spending, raise taxes and even set laws. A fiscal union may also prevent excessive borrowing and spending.

However, this is an enormously complicated as well as unpopular notion. This means surrendering sovereignty to higher powers. In essence the United States of Europe. Who or what country would be the prime power in such a situation. Likely Germany owing to its financial strength, but few European countries would like to come under German fiscal domination particularly given the two world wars of the last century. Yet even without such a union, Germany remains the dominant country in Europe.

Without a fiscal union, countries will continue to run deficits, accumulate debts, degrade the values of the Euro and even threaten the stability of Europe.

What is needed to be seen is as to whether Europe can take necessary steps to create a fiscal union alongside the monetary union or will the monetary union breakup thereby making Euro disappear?

A new idea of Europe may be required to bring this forward. But Europe has lost much of its older cultural unity and regional interests are still likely to be stronger.

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Currently, the American government has a lot of bills to pay. Almost $4 trillion in all. America’s income is a little over $2 trillion. To make up for the deficit America does what most Americans do – borrowing money.

When America picks up a loan – it’s called Bond. Bonds can be held by banks, investors or even foreign government. America has to pay interest on these bonds, just like interest on any loan. Do you consider paying your mortgage by credit card? That’s what the American government does! It takes out new bonds so as to make payments on the old ones. All those loans and especially that interest adds up over a period of time. Right now the American government owns over $14 trillion in debts. To put that in perspective $14 trillion is the same as national GDP in an entire year.

When America picks up a loan – it’s called Bond. Bonds can be held by banks, investors or even foreign government. America has to pay interest on these bonds, just like interest on any loan. Do you consider paying your mortgage by credit card? That’s what the American government does! It takes out new bonds so as to make payments on the old ones. All those loans and especially that interest adds up over a period of time. Right now the American government owns over $14 trillion in debts. To put that in perspective $14 trillion is the same as national GDP in an entire year.

$14 trillion is such a huge amount of money that America is running out of people, institutions, and countries from which it can borrow from. Right now America is having troubles paying its interest.

The obvious solution would be to either cut spending or increase taxes. But if it cuts spending, people upon whom America is spending money on will complain that they won’t have any money to spend and that America is hurting the economy.

If America tried to raise taxes people will not only have less money to spend, America will possibly have riots on its hand as it is in Greece currently.

So far America has been choosing an easy way to make money. It calls up the Federal Reserves and like magic dollars are created and deposited all around America. The problem with this is that more of something there is the less its worth; the same goes with US dollars. The more dollars there are the less of each one will buy. That’s why commodities like gasoline, food, and gold become more expensive when Federal Reserve prints money. It’s not that commodities are worth more but actually, it’s your money which is worthless. This is called inflation.

Remember the foreign governments that lent money to America? When they lend money to American government something interesting happens. It makes the US look richer, and their countries look poorer. When a country looks poorer compared to America one dollar buys a lot of their money. And these countries can pay their workers only a few pennies a day! With such low labor costs, they can sell their products in America for lower prices than any American manufacturers can. The easiest way for American companies to compete is then to move their facilities to these countries. This contributes to the recession in America. Americans lose their jobs, stop paying taxes, and start collecting government benefits, like Medicaid and unemployment benefits. This means America has less income and even more expenses. At the same time, the people who still have jobs are desperate to keep them so they will tend to do more work but not get paid more.

When the dollar is worth lesser and you are not earning more of them that’s called Stagflation. This is why America is currently in a Catch22. America can’t raise taxes or cut spending without making the recession worse. And it can’t get Federal Reserve to create more money without making inflation worse. For now, what America can do is keep borrowing money. But since it can’t repay interest on the loans it already has it just makes way for inevitable bankruptcy.

Whether in two years or two decades the day will likely arrive when America can no longer pay its bills. When that happens banks, investors and foreign governments counting on that money won’t be able to pay their bills. Like America, governments, banks, and investors don’t have much money, mostly what they have is a debt to each other. So if one link in a debt stops paying the whole thing falls apart.

Yet so far, American aggressive foreign policy continues to destabilize the world and make the dollar and American bonds appear safe. The American confrontation with Russia and China may be adding a new front to this policy. But how long it can go on remains questionable. The bigger the bubble, the bigger the problem when it finally collapses.

Yet so far, American aggressive foreign policy continues to destabilize the world and make the dollar and American bonds appear safe. The American confrontation with Russia and China may be adding a new front to this policy. But how long it can go on remains questionable. The bigger the bubble, the bigger the problem when it finally collapses.

If investors do not pay their bills, corporations cannot pay their employees. If banks cannot pay their bills individuals will not be able to take a loan, use a credit card or even withdraw their savings. If foreign governments can’t pay their bills their own banks and governments will have the same problems. That’s what is called the Global Economic Collapse.

It has never happened before so none really know how bad it might be or how long it might last, or how eventually will we get out of it. Unfortunately, the house of cards is already built. There’s no painless way to dismantle it now. All that we can do is anticipate and prepare for extraordinary circumstances. The more we do to change our values and develop a longer vision, the more we can compensate for the likely problem.

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The question many will have in their mind is how did this come to this? The reason is mostly simple. Not many of us understand the principles of economics. Those who do, too, don’t understand it well enough or are unable to explain it to others. It won’t be incorrect to suggest that our faith in our nation’s economy is by blind-faith. We expect it to be a little worse but mostly fine. We, therefore, believe that it would help our readers to explain in plain and simplest possible terms the functioning of any Economy.

The economy works like a simple machine. But many people don’t understand it or don’t agree on how it works. This is the core reason for a lot of needless suffering.

Though the economy may seem complex it works in a simple mechanical way. It is made up of a few simple parts and a lot of simple transactions that are repeated over and over again – over a zillion times. These transactions are by above all driven by human nature and they create three main forces that drive the economy, namely: Productivity Growth, Short Term Debt Cycles, and Long Term Debt Cycles.

Let’s start with the simplest part of economy Transactions. An economy is the sum of transactions that make it up. And the transaction is a very simple thing: You make transactions all the time. Every time you buy something you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services or financial assets. Credits spend just like money so adding together the money spent and amount of credit spent you can know the total spending. The total amount of spending drives the economy.

If you divide the amount spent by the quantity sold you get the price. And that’s a transaction. It’s the building block of the economic machine.

All cycles and all forces in an economy are driven by transactions. So if we can understand transactions we can understand the whole economy.

A market consists of all the buyers and all the sellers making the transaction for the same thing. For example, a wheat market, a car market, a stock market and markets for millions of things. An economy consists of all the transactions in all of its markets. If you add up the total spending and total quantity sold in all of the markets, you have everything you need to know about the economy. It’s just that simple.

People, business, banks, and governments all are engaged in transactions the way just described: exchanging money and credit for goods, services, and financial assets. The biggest buyer and seller is the government, which consists of two important parts: A Central Government that collects taxes and spends money and a Central Bank which is different than other buyer and seller because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money. For these reasons, the Central Bank is an important player in the flow of credit.

Credit is the most important part of the economy and probably the least understood. It is an important part because it’s the biggest and volatile part. Just like buyers and sellers who go to the market to make transactions, so do lenders and borrowers.

Lenders want to make their money into more money. And borrowers borrow money to buy things they can’t afford, like a house or a car, or they want to invest in something like starting a business. Credit can help both lenders and borrowers to get what they want.

Borrowers promise to repay the amount they borrow called principle, plus an additional amount called interest. When interest rates are high there’s less borrowing because it is expensive. When interest rates are low borrowing increases because it’s cheaper. When borrowers promise to repay and lenders believe them credit is created.

Any two people can agree to create credit out of thin air. That seems simple enough but credit is tricky because it has different names.

As soon as credit is created it immediately turns into debt. Debt is an asset to the lender and a liability to the borrower. In the future when a borrower repays the loan plus interest the asset and liability disappear and the transaction is settled.

As soon as credit is created it immediately turns into debt. Debt is an asset to the lender and a liability to the borrower. In the future when a borrower repays the loan plus interest the asset and liability disappear and the transaction is settled.

Why is credit so important? Because when a borrower creates credit he is able to increase his spending – the spending drives the economy. This is because one person’s spending is another person’s income.

Every dollar you spend someone else earns. And every dollar you earn someone else spends. So when you spend more someone else earns more.

When someone’s income rises it makes lenders more willing to lend him money because he’s more worthy or credit.

A creditworthy borrower has two things, namely: the ability to repay and collateral. Having a lot of income in relation to debt gives him the ability to repay. In an event that he can’t repay, he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him more money. So increased income allows increased borrowing, which allows increased spending. And since one person’s spending is another person’s income this leads to more increased borrowing and so on.

A creditworthy borrower has two things, namely: the ability to repay and collateral. Having a lot of income in relation to debt gives him the ability to repay. In an event that he can’t repay, he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him more money. So increased income allows increased borrowing, which allows increased spending. And since one person’s spending is another person’s income this leads to more increased borrowing and so on.

This self-reinforcing pattern leads to economic growth and is the reason we have cycles. In a transaction, you’ve to give something in order to get something and how much you get depends on how much you produce. Over time we’ve learned that accumulated knowledge raises living standards – we call this productivity growth.

Those who are hardworking increase their living standards and productivity faster than those who are complacent and lazy, but that isn’t necessarily true over the short run. Productivity matters the most in the long run, but credit matters the most in the short run. This is because productivity growth doesn’t fluctuate much so it’s not a big driver of economic swings – debt is! Because it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we pay it back.

Debt swings occur in 2 big cycles. One takes about 5-8 years and others take about 75-100 years. While most people see the swings, they typically don’t see them as cycles because they see them too up close – day by day, week by week. The reality what most people call money is actually credit. The total amount of credit in the United States is about $50 trillion and the total amount of money is only $3 trillion. In an economy, without credit, the only way to increase your spending is to produce more… but in an economy with credit, you can also increase your spending by borrowing. As a result economy with credit has more spending and allows incomes to rise faster than productivity over the short run, but not over the long run.

Credit isn’t necessarily something that’s bad that just causes cycles. It’s bad when it finances over consumption that can’t be paid back. However, it’s good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you borrow money to buy a big TV it doesn’t generate income for you to pay back your debt. But if you borrow a tractor and that tractor lets you harvest more crops and earn more money than you can pay back your debt and improve your living standards.

Credit isn’t necessarily something that’s bad that just causes cycles. It’s bad when it finances over consumption that can’t be paid back. However, it’s good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you borrow money to buy a big TV it doesn’t generate income for you to pay back your debt. But if you borrow a tractor and that tractor lets you harvest more crops and earn more money than you can pay back your debt and improve your living standards.

In an economy with credit, we can follow the transactions and see how credit creates growth. But remember borrowing creates a cycle, and if cycles go up it eventually needs to come down. This leads us into the Short Term Debt Cycles. As economic activity increases, we see an expansion – the first phase of a Short Term Debt Cycle.

Spending begins to increase and prices start to rise. This happens because an increase in spending is fuelled by credit – which can be created instantly out of thin air. When the amount of spending grows faster than the production of goods the prices rise when prices rise we call this inflation. The central bank doesn’t want too much inflation because it causes problems. Seeing prices rise, it increases interest rates. With higher interest rates fewer people can afford to borrow money and cost of existing debt rises. Less people borrow money.

Because people borrow less and have higher debt repayments they have less money left over to spend, so spending slows and since one person’s spending is another person’s income drop and so on and so forth. When people spend less prices goes down. We call this deflation. Economic activity decreases and we have a recession.

If the recession becomes too severe and inflation is no longer a problem the central bank will lower interest rates to cause everything to pick up again. With interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion. As you see economics works like a machine.

If the recession becomes too severe and inflation is no longer a problem the central bank will lower interest rates to cause everything to pick up again. With interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion. As you see economics works like a machine.

In the Short Term Debt Cycles, the spending is constrained by the willingness of the lenders and borrowers to provide and receive credit. When credit is easily available, there’s economic expansion. When credit isn’t easily available there’s a recession. And this cycle is primarily controlled by the central bank.

The short term Debt Cycle typically lasts 5-8 years and happens over and over again for decades. But notice that bottom and top of each cycle finishes with more growth than the previous cycle and more debt. Why? Because people push it – they have an inclination to borrow and spend more instead of paying back debt. Its human nature. Because over a long period of time debts rise faster than incomes creating the Long Term Debt Cycles.

Despite people becoming more indebted lenders even more freely extend credit. Why? Because everyone likes that when things are going great. People have been focusing on what’s been happening lately and what’s been happening lately? Incomes have been rising! Assets value have been growing up! The stock markets roar! It’s a boom! It pays to buy goods, services, and financial assets with borrowed money! When people do a lot of that, we call it a bubble.

So even while debts have been growing incomes have been growing nearly as fast to offset them. Let’s call the ratio of debt to income the debt burden. So long as income continues to rise, the debt burden stays manageable. At the same time asset value soar. People borrow a huge amount of money to buy assets as investments causing their prices to rise even higher! People feel wealthy! So even with the accumulation of lots of debts, rising income, and asset values, help borrowers remain creditworthy for a long time. But this obviously cannot continue forever. And it doesn’t. Over decades’ debt burden slowly increase creating larger and larger debt repayments.

At some point debt repayments starts growing faster than incomes forcing people to cut back on their spending. And since one person’s spending is another person’s income, income begins to go down which makes people less creditworthy causing borrowing to go down.

Debt repayment continues to rise which makes spending drop even further and the cycle reverses itself. This is a long term debt peak. Debts burdens have become simply too big. For the United States and Europe and much of the rest of the world, this happened in 2008. It happened for the same reason in Japan in 1989 and in the United States back in 1929.

Now the economy becomes deleveraging. In a Deleveraging people cut spending, incomes fall, credit disappears, asset prices drop, banks get squeezed, stock market crashes, social tension rises and the whole thing starts to feed on itself the other way. As income fall and debt repayment rise, borrowers get squeezed. No longer creditworthy, credit dries up and borrowers can no longer borrow enough money to make their debt repayments.

Scrambling to fill this hole, borrowers are forced to sell assets. The rush to sell assets floods the market at the same time spending falls this is when the stock market collapses, the real estate market tanks and banks get into trouble. As asset prices drop. This makes borrowers even less creditworthy. People feel poor. Credit rapidly disappears. Less spending, less income, less wealth, less credit, less borrowing and so on. It’s a vicious cycle. This appears similar to a recession but the difference here is that interest rates can’t be lowered to save the day.

In a recession lowering interest rates works to stimulate the borrowing. However, in deleveraging, this doesn’t work because interest rates are already low and soon hits 0%. So the stimulus ends. Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. They remain there in 2015, even though there has been some economic growth. The difference between recession and deleveraging is that in a deleveraging borrower’s debt burdens have simply grown too big and can’t be relieved by lowering interest rates.

In a recession lowering interest rates works to stimulate the borrowing. However, in deleveraging, this doesn’t work because interest rates are already low and soon hits 0%. So the stimulus ends. Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. They remain there in 2015, even though there has been some economic growth. The difference between recession and deleveraging is that in a deleveraging borrower’s debt burdens have simply grown too big and can’t be relieved by lowering interest rates.

Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt they don’t even want more. Lenders stop lending and borrowers stop borrowing. Think of the economy as not being creditworthy, just like an individual. So what do you do about deleveraging?

The problem is debt burdens are too high and they must come down. There are four ways this can happen, namely: Cut spending, Reduce Debt, Redistribute Wealth and Print Money. These 4 ways have happened in every deleveraging in modern history. England 1950, US 1930s, Japan 1990s, Spain & Italy in 2010s.

Usually, spending is cut first. This is referred to as Austerity. When borrowers stop taking on new debts and start paying old debts, you might expect a burden to decrease. But the opposite happens! Because spending is cut – and since one man’s spending is another man’s income – it causes income to fall. They fall faster than debts are repaid and the debt burden actually gets worse. As we’ve seen this cut in spending is deflationary and painful. Businesses are forced to cut costs which means fewer jobs and higher employment.

This leads to the next step: debts must be reduced. Many borrowers find themselves unable to repay their loans and borrowers debts are lenders’ assets. When a borrower doesn’t repay the bank, people get nervous that the bank won’t be able to repay them so they rush to withdraw their money from the bank. Banks get squeezed and businesses and bank default on their debts. This severe economic contraction is depression.

A big part of the depression is people discovering much of what they thought was their wealth isn’t there. Money lenders don’t want their assets to disappear and agree with debt restructuring. Debt restructuring means lenders get paid back less or get paid over a longer time frame or at a lower interest rate than that was first agreed. Somehow a contract is broken in a way that debt is reduced. Lenders would rather have little of something that all of nothing.

A big part of the depression is people discovering much of what they thought was their wealth isn’t there. Money lenders don’t want their assets to disappear and agree with debt restructuring. Debt restructuring means lenders get paid back less or get paid over a longer time frame or at a lower interest rate than that was first agreed. Somehow a contract is broken in a way that debt is reduced. Lenders would rather have little of something that all of nothing.

Even though debt disappears, debt restructuring causes income and assets to disappear faster, so the debt burden continues to get worse. Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower incomes and less employment mean government collects fewer taxes. At the same time, it needs to increase its spending because unemployment has risen. Many of the unemployed have inadequate savings and therefore need financial support from the government. Additionally, the government creates stimulus plans and increase their spending to make up for the decrease in the economy. Govt. budget deficit explodes in deleveraging because they spend more than they earn in taxes. This is what is happening when you hear about the budget deficit on the news.

To fund their deficits governments, need to either raise taxes or borrow money. But with incomes falling and so many unemployed where is the money going to come from? The rich! Since the government is going to need more money and since wealth is heavily concentrated in the hands of a small percentage of people government naturally raises taxes on the wealthy which facilitates a redistribution of wealth in the economy from the haves to have-nots. The have-nots who are suffering begin to resent the haves. The wealthy “haves” beings squeezed by the weak economy, falling asset prices and higher taxes begin to resent have-nots.

To fund their deficits governments, need to either raise taxes or borrow money. But with incomes falling and so many unemployed where is the money going to come from? The rich! Since the government is going to need more money and since wealth is heavily concentrated in the hands of a small percentage of people government naturally raises taxes on the wealthy which facilitates a redistribution of wealth in the economy from the haves to have-nots. The have-nots who are suffering begin to resent the haves. The wealthy “haves” beings squeezed by the weak economy, falling asset prices and higher taxes begin to resent have-nots.

If the depression continues along with such resentments social disorder can breakout. Not only does tension rise between countries, but they can also rise between countries – especially debtors and creditor countries. This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power, the war in Europe and depression in the United States. The pressure to do something to end the depression increases.

Remember, most of what people thought was money was actually credit. So, when credit disappears, people don’t have enough money. People are desperate for money and you remember who can print money? The central bank can.

Having already lowered its interest rates to nearly zero it’s forced to print money. Unlike cutting spending, debt reduction and wealth redistribution printing money is inflationary and simulative inevitably the central bank prints new money out of thin air and uses it to buy financial assets and government bonds.

It happened in the United States during the great depression and again in 2008, when the United States central bank printed over two trillion dollars. Other central banks around the world that could, printed a lot of money, too. By buying financial assets with this money, it helps drive up asset prices which makes people more creditworthy. However, this only helps those who own financial assets. The central government, on the other hand, can buy goods and services and put money in the hands of the people but it can’t print money so in order to stimulate the economy the two must cooperate.

By buying government bonds, the central government essentially lends money to the government allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increases people’s income as well as government debts. However, it will lower the economy’s total debt burden. This is a very risky time. Policy makers need to balance the four ways that debt burden comes down.

The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly there can be a Beautiful Deleveraging. Deleveraging can either be ugly or beautiful. How can a Deleveraging be beautiful?

Even though a deleveraging is a difficult situation, handling the situation in the best possible way is beautiful. A lot more beautiful than debt-fuelled, unbalanced excesses of the leveraging phase.

In a Beautiful Deleveraging debts decline relative to income, real economic growth is positive and inflation isn’t a problem. It’s achieved by having the right balance.

The right balance requires a certain mix of cutting spending, reducing debts and transferring wealth and printing money so that economic and social stability can be maintained.

Printing money won’t raise inflation if it offsets credit. Spending is what matters. A dollar of spending paid for with money has the same effect on the price as a dollar of spending paid for credit.

By printing money, the central bank can make up for the disappearance of credit with the increase in the amount of money. In order to turn things around, the central bank needs to not only pump up income growth but get the rate of income higher than the rate of interest on the accumulated debt. Which means income needs to grow faster than debt. For example, if a country going through deleveraging has a debt to income ratio of 1:1, it means that amount of debt it has is the same as the amount of income the entire country makes in a year. Now consider the interest rate on that debt let’s say its 2%. If the debt is growing at 2% because of that interest rate and income is only growing at 1% you’ll never reduce the debt burden. You need to print enough money to get the rate of income growth above the rate of interest.

However, printing money can easily be abused because it’s easy to do so and people prefer it to the other alternatives. The key is to avoid printing too much money and causing unacceptable high inflation, the way Germany did during its deleveraging in the 1920s. If policymakers achieve the right balance a deleveraging isn’t so dramatic. Growth is slow but debt burden goes down. That’s a beautiful deleveraging.

When income begins to rise, borrowers begin to appear more creditworthy and when borrowers appear to be more creditworthy lenders begin to lend money again. Debt burdens begin to fall. Able to borrow money people can spend more. Eventually, the economy begins to grow again leading to reflation phase of the long term debt cycle. Though the deleveraging process can be horrible if handled badly, if handled well, it’ll eventually fix the problem. It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal – hence the term “lost decade”.

When income begins to rise, borrowers begin to appear more creditworthy and when borrowers appear to be more creditworthy lenders begin to lend money again. Debt burdens begin to fall. Able to borrow money people can spend more. Eventually, the economy begins to grow again leading to reflation phase of the long term debt cycle. Though the deleveraging process can be horrible if handled badly, if handled well, it’ll eventually fix the problem. It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal – hence the term “lost decade”.

June 19, 2019

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