Planet Ponzi

by Mitch Feierstein

  Japan

  So far in this chapter we haven’t mentioned Japan. The bond markets still regard its government debt as super-safe. I don’t regard it in that way at all‌—‌I think an Italian-sized mountain of debt piled on to a stagnant economy and managed by temporary prime ministers and secretive, obstructive bureaucrats is a recipe for disaster.

  The same goes for Japanese banking. A recent note by Fitch commented:

  Unless major Japanese banks are successful in bolstering their core capital, their ratings will likely remain constrained by their weak capitalisation … The agency remains concerned over the weakening asset quality at major Japanese banks and the impact it may have on the banks’ modest profitability and weak core capitalisation … Furthermore, the Japanese government’s strong encouragement for banks to increase lending and/or to restructure loans to SMEs [small and medium-sized enterprises] could also put pressure on their loan quality … Fitch notes that their large stock investments remain a significant risk on the banks’ balance sheets and that the risk is currently understated in terms of the capital charge these investments attract.13

  This short note refers to many of the themes we’ve already discussed. The dead hand of the Japanese government interfering in a negative (and behind-the-scenes) way with ordinary commercial operations. Poor asset quality, arising in part from past government interference and in part from a stagnating economy. Shoddy and even deceitful accounting techniques, which mean that large risks (banks holding equity stakes) are poorly handled in terms of disclosure and risk management. Everywhere you look in Japan, you sense that whiff of historical and traditional relationships overriding commercial good sense‌—‌which means, of course, that bad commercial decisions are made, leading to poor credit quality, weak and unambitious banks, and finally to an economy stifled by lack of credit where credit is most needed.

  Nevertheless, creditors can be reassured by one thing: namely that everything Japanese happens in slow motion. I think a credit crisis is brewing in Japan, and one on a potentially horrendous scale. (Recall that Japan has gross debts outstanding of $13.3 trillion, and net debts of $7.4 trillion.) But the crisis isn’t imminent. When debt yields start to nudge upwards, and when domestic savers start slimming down their holdings of government bonds, that’s the time to run for the hills. I personally wouldn’t hold Japanese bonds because I don’t like playing a timing game‌—‌holding something I know to be toxic in the expectation that I’ll be able to get out in time. But that’s me. I’m cautious that way. This chapter’s mission, however, is to examine the scale of losses likely to hit the world’s banking system over the next few years and, for once, I’m optimistic. A credit crisis in the West combined with serious recession in the world economy will cause some injury in Japan, of course. But the damage will be limited. A hundred billion dollars. Maybe two. But that won’t be the real issue. The real issue is a few years away, but is at least an order of magnitude larger.

  US federal and state debt

  Similarly, I haven’t made any allowance for any US default. Again, that’s not because I think everything’s fine. As a matter of fact, I consider the US 100% certain to default on its obligations, but it’s important to be careful about precisely what we mean by that.

  As we saw earlier in the book, the US government has obligations equal to somewhere between $80 trillion and $200 trillion. Of those, some obligations‌—‌such as its Treasury bonds or pension commitments to its employees‌—‌are set in stone: court-enforceable obligations which must be paid, no matter what. Other obligations, however, are less binding. At the moment, the government makes certain moral commitments on social security, Medicare, and Medicaid, but those things are subject to reversal. Pension entitlements can be slashed, the provision of health care withdrawn. Such actions would constitute an ethical default. They would mean that the government is betraying all those countless Americans who have trusted its promises, but you can’t take the government to court for such breaches of trust.

  Inevitably, therefore, that’s how the government will choose to default. It will, at some stage, be forced into a massacre of entitlements, simply because those entitlements were unaffordable when they were promised and are ever less affordable now. Even if tax rises are forced through or exemptions slashed, the massacre will happen because the funding gap is so enormous. As a matter of fact, what we’ll see is the precise reverse of the past thirty years. For three decades, our politicians have cut taxes and expanded entitlements. The tax cuts weren’t real (because they were made at a time of national debt). The entitlements weren’t real either (because they were never achievable). Nevertheless, for three decades, voters have lapped up the sweet delusion that these impossible things could all happen together, like the Oscars and the Superbowl and Christmas Day all arriving on the one same miraculous morning. In the default phase of Planet Ponzi, we’ll experience the opposite. Years will go by with no Oscars, no Superbowl, no Christmas. Tax increases and entitlement cuts. Our poor and elderly citizens will feel cheated and lied to, and they’ll feel that way because they have been. That’s the first type of default that’s going to happen, and it’ll start happening very soon.

  The second type of default has to do with the dollar. If the government can’t pay its debts in good old-fashioned dollars, it can always seek to trash the currency instead. It’s a sweet little trick, when you think about it. You borrow money that has some value, repay it with money that doesn’t. You’ve cheated your lender, obviously enough, but nobody can touch you for it, because you’re paying the money back, dollar for dollar.

  If you wanted to achieve such a default, you wouldn’t want to just go ahead and blurt it out. You’d be a little subtle about it. The first thing you’d want to do is tweak those inflation figures, so that inflation looked stable whereas in fact is was galloping away at 10% or more a year. You’d want to cover your manipulation in plenty of complicated talk about statistics, but the talk wouldn’t signify a string bean.

  The second thing you’d want to do is to start churning out new dollar bills. You’d print like crazy. You wouldn’t talk about trashing the currency, of course; you’d talk about price stability, about quantitative easing, about Operation Twist and bringing down the long end of the yield curve. Ideally, too, you’d have someone in charge who really believed in the value of what he was doing, someone who didn’t really live in the real world. Maybe a professor of something. A guy who had studied a period of history from eighty years ago and who’s been yearning all his life to save the world using techniques which might or might not have worked back then, but which certainly don’t make sense in the present day.

  Needless to say, these things are going on right now. Ben Bernanke, chairman of the Fed and student of the monetary history of the Great Depression, is in charge of our money supply. He truly believes that rolling the printing presses will make a difference‌—‌and he’s right, of course, it will: just not in the way he thinks. For each new dollar that the Fed creates, the dollar in your pocket will lose a little value. Creditors will lose out. Worse still, ordinary Americans will lose out. If median household incomes are now back where they were in 1996, a good part of that awful record lies with the destruction of the dollar.

  That’s the second type of default the government can pull, and it’s already happening.

  The third type of default involves a failure to make scheduled payments on court-enforceable obligations. As we’ve just noted, that term includes financial debts, such as Treasury bonds, but it also includes pension liabilities. Because these things can be enforced in a court of law, any failure to pay would be unambiguously serious. That point of ultimate seriousness was almost reached in early August 2011, when a bunch of congressional lunatics decided to play a game of chicken with national prosperity. Since the debt ceiling increase was passed and since no default did take place, most commentators assumed that no damage had been done. In practice, of course, it had: huge damage. Starting up new bu
sinesses, hiring new staff, and investing in new projects requires a degree of confidence in the future: ‘animal spirits,’ in Keynes’s evocative phrase. The sight of elected American lawmakers happily tossing around high explosive right by the beating heart of American prosperity would not make me, as a business owner, more likely to invest in the US. I suspect most business owners feel likewise. So damage‌—‌real, job-killing damage‌—‌has already been done.

  Nevertheless, actual default on financial obligations did not happen and I continue to think it is probably unlikely to happen, at any rate in the near term. I don’t, however, think that this third and most serious type of default can be ruled out in the longer term. Our politics has become so dysfunctional, our leadership so obsessed with re-election and party dominance, our legislators so bitterly divided, that all bets are off. Financial default is unlikely to happen soon. It probably won’t happen later. But that’s the most you can say. (And these remarks apply only to the federal government. At a state level, I’d say that default is almost certain to happen.)

  Since our objective in this chapter is to count up the scale of financial losses likely to hit banks and other investors in the next few years, and since we’re trying to be as cautious as we can in our predictions, I’m going to assume that state and federal governments will pay their bills for the next few years. Default on health and pension commitments will certainly happen. The destruction of the currency has already started. The mountain of financial debt will be a horrendous problem for the future. But for the purposes of the present chapter, I’m going to estimate financial losses on US government debt at $0. Optimistic to the last.

  Summary

  In April 2009, the IMF started to sweep up following the first phase of the credit crisis. It published a note summarizing the estimated scale of financial sector writedowns over the period 2007–10. Its figures were as shown in table 22.4.

  Table 22.4: The end of civilization, Part I

  Note: The figure of $490 billion for ‘commercial mortgages etc.’ in the US includes losses of $80 billion for municipal debt.

  Source: IMF, Global Financial Stability Report, April 2009.

  Bluntly summarized, the first phase of the credit crisis caused losses of $4.4 trillion. A large chunk of that devastation was borne by insurance companies, pension funds, and the like, but banks alone suffered losses of $2.8 trillion. Given that the banking sector as a whole has capital of just $3.3 trillion (and had less in 2008), you could pretty much say that the first credit crisis destroyed the solvency of nearly all American, European, and Japanese banks.

  Total catastrophe was averted by government action on an extraordinary scale, but since few of the fundamental problems were addressed, the problems are still there. Only this time governments have no room for further action. I’ve summarized the problems we might be facing today in table 22.5.

  Table 22.5: The end of civilization, Part II

  Source: See discussion in text.

  In our cautious best-guess scenario, the banks are kaput. In our (not very severe) ‘worst case’ scenario, the banks are so kaput that they couldn’t be much kaputter. These figures make no allowance for potential problems in Japan or in the US. They make no allowance for any emerging market losses triggered by problems in the West. Some people will feel I’m being overoptimistic here‌—‌but, what the heck, let’s enjoy a little sunshine.

  The problems in the banking sector are so serious that the only plausible rescue could come from government action; but, as we’ve seen throughout this book, Western governments no longer have the resources to find a few trillion dollars from anywhere.

  And that’s that: the end of Planet Ponzi. We turn now to what comes after.

  Part Four

  Solutions

  23

  The end of days

  I am frequently asked when I talk about the themes of this book: What happens now? How does it end?

  Those are fair questions and I wish I knew the answers, but I don’t. So much depends on chance and circumstance, all one can really address is the probabilities. The coming crisis is almost certain to play out first in two areas: American mortgages and European debt.

  Take the mortgages first. Because the economic news is so relentlessly bad, because there is no room for fiscal or monetary stimulus, and because of the plague of uncertainty which weak leadership and political bickering has spread across our usually confident nation, the US housing market is going to weaken further. Like unstable mountain ice slowly thawing in the sunshine, that creeping weakness will at some point cause an avalanche. Bear in mind that the wreckage from the last slump hasn’t yet cleared from the system. There are still almost 2 million foreclosed or delinquent homes not yet released to the market. Some commentators reckon that although Bank of America has already taken losses of some $30 billion on its US mortgage book, the total damage could run into the hundreds of billions.1 Damage on that scale could yet capsize a major lender even without further housing weakness; any further house price dips will make that outcome more probable and more rapid. As the roughest of rough guides, each 10% dip in house prices is inflicting $1 trillion in losses. Not all of those losses will be borne by the banking sector. Homeowners will take their share. Investors dumb enough to have bought bubble-era mortgage debt at bubble-era prices will take their share. But such comforting thoughts run only so far. You can share the pain of a $1 trillion loss all you like: the losses that remain may still be enough to blow some weak banks sky high. And when they go, others will go too. That’s how the avalanche will start.

  Same thing in Europe. We’ve already heard the head of Deutsche Bank expressing his opinion that numerous eurozone banks are already insolvent. That terrifying comment means that the system is already dead; all that remains is for the corpse to recognize the fact. That act of recognition could be prompted in any number of ways. A sovereign default could trigger the formal bankruptcy of some local banks, which in turn would propel losses through the financial system, swelling as they go. Or some crooked trader working in a bank with hopelessly inadequate risk management systems could cause a collapse in confidence, a run on deposits‌—‌and bankruptcy. Or it could emerge that a big French lender has become entirely reliant on funding from the European Central Bank, causing another huge loss of confidence and the kind of panic we saw in fall 2008.

  Or something else. You can’t predict which melting snowflake causes the whole snowfield to disintegrate. All you can do is watch the snowfield and try to avoid the collapse.

  It’s also worth repeating that nothing will be left untouched by anything else. The financial system is global. Americans can’t watch catastrophe in Europe and feel unharmed. Quite the opposite. Small things matter today as they’ve never mattered before. Take Greece, for example. Even in European terms, the economy of Greece is small enough to figure as little more than a rounding error, yet the fate of that small country is currently terrorizing the continent‌—‌and Europe’s terror is America’s fear. The same is true the other way round. The collapse of Lehman brought devastation to Europe. If a big American lender goes, the consequences for Europe will be immediate and violent. The truth is that the financial system is barely surviving as it is. It only needs one significant lender to declare bankruptcy for there to be a repeat of 2008–9 on a worldwide scale. The only difference this time is: there isn’t any safety net.

  People tend to listen to me politely as I say all these things, then interrupt before I’m quite done, saying, Yes, but what will actually happen?

  Well, bankruptcies. To some extent, policymakers will try to magic up capital from nowhere by getting their central banks to roll the printing presses and conjure up money from the void. Some of that money will be used to nationalize banks and set them back on their feet‌—‌a task which, as we saw in 2008, often enough means that you start with a corpse and end with a zombie.

  But it seems unlikely that, in the current climate, voters will have patience for more
such nonsense. Without fiscal or monetary resources, policymakers will probably just have to let companies fail. Those failures will cause other failures‌—‌and those failures will just have to be tolerated too. The economic downturn will get worse. More companies will fail, house prices will sink. For a few years, we’ll live in genuinely uncomfortable times. But bankruptcies are cleansing. GM’s bankruptcy saw it bounce back with a clean balance sheet and renewed management vigor. It could start investing, start hiring, start growing.

  Indeed, the reason why people press that question at me‌—‌What will actually happen?‌—‌is because they are still prey to a little Ponzi-ish thinking. That thinking says that bad things never really have to happen, because the government will always step in to fix things. It’s the kind of thinking which says that house prices have to go up, that banks can’t fail, that government promises can be relied upon, that there will always be enough money to put things right. That thinking is nuts. It comes straight from Planet Ponzi.

  The simple truth is that I don’t know precisely what’s going to happen, or when, or how. No one knows that. All we can say is that bad things can happen, and they will, and that events in Europe and the housing market in America are equally likely to provide the initial trigger. What matters much more, of course, is what we‌—‌politically and personally‌—‌should do about all this. The question is not: When will the end days come and how will they unfold? Rather, it’s the question the millenarians want to put to us: Are you Rapture-ready?

  That’s the issue we turn to next: first at a policy level, next at a personal one.

  24

  What is to be done?

  In 1902, a young Russian revolutionary‌—‌Vladimir Ilyich Ulyanov, better known to history as Vladimir Lenin‌—‌wrote a pamphlet entitled What Is To Be Done? In that work, Lenin argued that it was no longer enough for workers to struggle against the owners of capital. The struggle had to become politicized, made conscious. From that pamphlet, the Bolshevik movement‌—‌and later the Communist Party proper‌—‌was born.1