The further a society drifts from the truth, the more it will hate those who speak it. ... In a time of deceit, telling the truth is a revolutionary act. George Orwell

Thursday, September 8, 2011

Destruction of economy by parasitic governments and financial institutions


The destruction of our economy by parasitic governments and financial institutions


Most countries’ financial centers and governments are currently in the process of expanding the supply of world currencies and cheap credit, in order to boost their own budgets, salaries and political power and to avoid recessions.   One of the effects of this policy is the protection of their own personal wealth consisting of paper assets such as bond and stock funds that would otherwise have collapsed.


A similar expansion of the monetary supply has historically led to the de-industrialization of  entire regions or countries that followed such policies for a sustainable period of time, typically over several generations.   On the surface, the mechanism of such de-industrialization seems to work by inflating the costs of doing business faster than the price inflation of manufactured goods and services produced by affected companies, thus destroying profitability, especially when a vast supply of goods is available from peripheral provinces or from other countries.  One such example was the 5th century Roman Empire (see Fall Of Empire essay), the other one is 16th century Spain under Philip II.

“Nuts and bolts”

Industrial companies that may initially enjoy the cheap credit, use it to expand production facilities or other business assets, which then leads to excess production or excess supply of services and inevitably destroys profitability.   Decreasing profitability reduces investment yield, the Return On Investment (ROI) but it also serves to restrain the inflationary pressure fuelled by the financial expansion.   The reduced inflationary pressure due to collapsing profitability allows the central banks and governments to maintain the low inter-banking lending interest rate which in turn facilitates the issuance of even more credit, including borrowing by the governments for virtually limitless spending on themselves.

Risk management, CDS and leverage

The issuance of more and more credit to an expanding circle of corporate and other borrowers at a time of falling yields would have normally been stopped at some level by the rising risk premium preventing a further reduction of interest rates.  Rising loan risk would have acted as a negative feedback preventing the currently observed unprecedented drop in interest rates and related bond yields.  It would have ultimately prevented excessive credit generation.   The negative risk-mediated feedback has been sabotaged by the use of a special form of financial credit insurance called “Credit Default Swaps” (CDS).   CDS allowed the lending institutions to exceed the lending limits imposed by the normal risk avoidance standards (and by common sense) , by allowing them to profitably lend, giving very low and falling loan interest rates.   In this low interest rate environment, it was necessary to lower the required capital reserve for banks and financial institutions such as hedge funds in order to maintain the expected profitability.  Until recently, this required capital reserve was decreed to be 1:11 (capital-to-total loans), which was recently further reduced by the “Basel 3” agreement to 1:30 bringing the world banks to similar “standards” as hedge  funds which “enjoyed”  the 30:1 leverage even before the 2008 crash  (Leverage is the inverse of the capital requirement).

Positive feedback loop of destruction

Apart from destroying industrial profits, the excessive credit also creates bubbles in selected investment sectors such as stock, futures and bonds.  Rising bond prices are further depressing  the yields and interest rates which further accelerated the lending.  This situation is described in science and engineering by the term “positive feedback loop”. This means that even a small input stimulus is amplified by the system and fed back to an input, amplifying itself further until the system reaches some very large deviation from an equilibrium, and saturates or the system breaks down.

Eventually financial companies flee the market where interest rates and Return On Investment (ROI) has been depressed, moving most of their investment capital off-shore to countries where the ROI is still high.   The process is repeated until all manufacturing economies end up eventually running unprofitable industries, subsidized at first by the investment capital influx, later by government subsidies to maintain employment and to prevent the paper assets backed by industry from crashing.   Subsidized manufacturing in poorer countries floods the world market with underpriced industrial goods allowing prices of industrial goods to remain stagnant (deflation) in spite of the rapid expansion of the financial system and money.
I saw the future...
The last stage of this economic destruction is the breakdown of the unprofitable manufacturing, resources and agricultural sectors when the subsidies run out or when the employees refuse to work under the austere conditions imposed upon them by the profit squeeze. This process, like the credit growth itself, is also governed by the positive feedback law.   Once started, it will accelerate, fuelling itself like a cancer or fire.  This will happen specifically, when food prices and the cost of living overtake the wages paid by unprofitable manufacturing companies causing industrial disruption due to strikes and closures, leading to further increases in the cost of living and so on.   

The impact of this upon the developed countries that almost totally depend upon the subsidized under-priced production from the developing countries, will be equally severe.  A decline of the subsidized imports of industrial and consumer goods will cause the supply chain to break down in the developed economies, leading to explosive inflation of all prices for manufactured goods, commodities, food and services.  The ensuing inflation will put an upward pressure on interest rates which government will no longer be able to obfuscate or manipulate using financial techniques alone.


The  inflation-induced jump in interest rates and yields will crash the bond market (bond values are inverse to their yields).  Old bonds will drop in value destroying most of the pension funds and probably most of the financial institutions, given that it may trigger an avalanche of CDS claims (another positive feedback) which will accelerate the institutional and systemic collapse.  At the same time, the new bonds will become very expensive for borrowers to issue, thereby derailing the “gravy train” enjoyed by governments and large corporations the world over.  It may even make the refinancing or rollover of old debt impossible.

The break-down of the government bond market will cause currency exchange rates to vary wildly and may cause some currencies to crash and disappear, beginning with those countries that will default on their government bonds first and ending with probably all presently known paper currencies disappearing and being replaced by something else.  

Science, technology and ideas (including business ideas) are unlimited.   Completely new industrial companies, technologies and services will be created, filling in the present business vacuum, using new-old forms of self-financing and capital-rising that are more robust and do not depend on large financial institutions and governments.  This will happen in the countries that  provide a legal framework effective in protecting private ownership and civil order yet not stifled by any excessive legislation or taxation.

The good news is that that which worked in the past, will work in the future, and what didn’t work in the past will not work in the future either.


FredT said...

There is no doubt that we are in a decline. The time is unclear to me, and how it will go down. I think it will be plant closures, business failures, and government growth through medical industry growth and welfare that taxes the citizens to financial failure.

Stan (Heretic) said...

Hi Fred,

I doubt if medical "industry" will grow from the present level, it's probably poised to fall sharply (precisely because it is commonly believed that it will grow, "safe as houses" etc). It has all the characteristics of a bubble.

Besides, the country's economy cannot afford to pay their wages. A GP pulls 300k$ (per year), a registered nurses 80k$ while an average private sector salary is 35k$ (public sector 55k$).

Scott said...

Stan, which countries do think fit these criteria? "...provide a legal framework effective in protecting private ownership and civil order yet not stifled by any excessive legislation or taxation."

Stan (Heretic) said...

Switzerland, Singapore, Taiwan (probably), South Korea (probably). There may be more but I don't know much about (Costarica? Chile? not sure)

Mark said...

Heya Stan, I think we will have a deleveraging, comparing growth in credit supply today with growth in money supply going into 1929. Stimulus is off the table. Everyone is overleveraged everywhere, as individuals, corporations, and government. Some corporations and some savers do have cash.

China PMIs probably tell a more honest picture than the official GDP numbers and they're slowing. Eurozone PMIs are contracting. ECRI leading indicators are negative. Copper is depressed, so is iron ore. Business order to China are coming into Canada in very little time compared to a few months ago. Jim Chanos says the housing bubble there is already bursting. Their stock market is depreciating. I think there is not a slowdown in China but a crash. In Europe it's auterity. They are marking down the Greece debt and I think we will find that all the sovereign bullshit will be marked down similarly and we'll have losses.

In the US, home prices are still bottoming, high inventory, real confusin going forward over taxation, overindebtedness of the consumer. The US I'm least bearish on of all of htem, since some of the damage from the housing bubble (the high prices) have been addressed. They still have too much debt, but they would turn out best in a downturn. I actually own the USD. I think globally, the forces of deleveraging are strong. Canada and Australia, too. I don't see inflation in the future, there's no appetite for it and We don't even have QE3. There's social unrest and global recessions (Europe and China look to be in them). What happens going forward, due to the totality of the leverage, is a deleveraging. If they printed 10 trillion dollars, they couldn't outdo the deleveraging. And they will absolutely not print 10 trillion dollars.

Stan (Heretic) said...

Hi Mark, I agree with some points but not all.

I agree that China is crashing. I have lived through a very similar collapse of a socialist-communist totalitarian state in the 1980-ties that was Polish People's Republic. It was very similar to what communist China looks like now except it was 1/30-th of the size.

Deleveraging will not cause deflation in the fiat money system!

I also doubt that deleveraging is ever possible in the present circumstances! World GDP is not big enough and grows too slowly (if at all) to deleverage the present banking system.

This is not the same as in 1929 because the money supply was confined back then by the gold reserves of the USA and Canada. Now it is not. Therefore the present day economic collapse scenario will most likely follow the well beaten path of an inflationary scenario. Interestingly, back in the 30-ties, in spite of the deflationary constraints of the gold standard, the 1929 Depression era deflation was only a short lived phenomenon that stopped around 1933 as soon as Roosevelt revaluated the gold price. Since 1933, USA had experienced _inflation_ all the way through 1940-ties, 50,(except around 1956 for 1 year), 60,70,80,90 and today!

If you look at what is most likely to happen in the economy, it is that what will benefit the government and the ruling elite the most.

Will deflation benefit them? Absolutely not! They have too much debt spread all over their corporations and institutions. Deflation would wipe out all of their paper assets faster than a Greek would say hello! 8-:)

Will monetary inflation benefit them? Absolutely yes! Why? Regardless of the details, the answer is: it will benefit them the same way and for the same reason that it benefited them in the past! Inflation of the 1970-ties? The paper assets of the large corporations and especially the banks, grew and multiplied like rabbits while the smaller business grew smaller and everybody else was suffering. US appeared to have had more free capitalism less corporate fascism and less poverty in the past in the 50-ties and 60-ties than now!

History teaches us that the higher the inflation the more wealth has always concentrated in the hands of the megabanks and the financial & political elite, to the detriment of the real productive economic activity by everybody else.

The government and their banking oligarchs WILL create inflation because _they_ have no other choice! Fiat monetary systems always collapsed either through inflation (never by deflation), or through political annihilation. See the Fall of Empire article.


Mark said...

Hey Stan, just want to say thanks for the response. I need to reflect on what you wrote and do some further reading.

I have thought about the ruling elite favouring inflation since it absolutely benefits the rich the most. My concern is that the total extent of global bubbles and leverage is substantially greater than gov't will print, at least in an initial response. Once the pain of deleveraging hits and sinks in, I think then they would print astronomically. I say that based on my impression of the politics at the time, and not on a empirical and historical perspective (why I need to reflect on what you wrote and do some more reading).


Sam said...

I'm totally confused. My thoughts change from day to day on inflation vs. deflation. My general thought is inflation. I wonder what can smaller amounts of money be put in to keep their value and still be readily exchanged. Silver? Copper? The problem as I see it is if deflation comes all commodity metals will suffer.

Mark said,"...And they will absolutely not print 10 trillion dollars."

uuhhh... Didn't they already do that? 16 trillion. 8 to US banks and 9 to Europe?

It's terrifying.

Stan (Heretic) said...

Re: deflation vs inflation

It is confusing, and I am perhaps adding to it. I think we are experiencing both a deflationary trend and an inflationary policy at the same time, partially cancelling each other with a slight upper hand towards inflation (+2 to +3%). Both have balanced out in average, for the time being but I am not sure for how long.

I think governments are pushing on the inflation button (i.e "stimulus" and money M1 printing) out of desperation trying to balance out the deflationary consequences of (A) Western de-industralization and off-shoring, deflationary consequences of systemic-wide (B) paper assets' "value" destruction, (C) corporate and sovereign debt devaluation and (D) government policy of selling bonds to the financial institutions for cash, on the open market.

There is also another deflationary factor - social trend which was first proposed by Robert Prechter about 12 years ago. I under-appreciated his pro-deflationary thesis but I realize now that he has been largely correct with the exception of not appreciating the pro-inflationary counter-measures and policies of the Western governments (thus he was wrong about gold).

The main problem I can see is that both the deflationary trend and the government-adopted inflationary counter measures are shifting all wealth towards the government and public sector, and are extremely destructive to manufacturing businesses. It is killing the positive work ethics and the culture of American Dream.


PPLIC said...

Bril­liant! Great talk that was extremely insightful and very enter­taining. It’s given me loads to think about.