"What's Next?": Simon Johnson Explains The Doomsday Cycle

Tyler Durden's picture

Via Simon Johnson and Peter Boone - Originally posted at VoxEU, (Via CentrePiece magazine)

There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque (Igan and Mishra 2011). Bailouts have encouraged reckless behaviour in the financial sector, which builds up further risks – and will lead to another round of shocks, collapses, and bailouts.

This is what we have called the ‘doomsday cycle’ (Boone and Johnson 2010). The cycle turned in 2007-8 and was most dramatically manifest in the weeks and months that followed the fall of Lehman Brothers, the collapse of Iceland’s banks and the botched ‘rescue’ of the big three Irish financial institutions.

 

The consequences have included sovereign debt restructuring by Greece, as well as continuing problems – and lending programmes by the IMF and the EU – for Greece, Ireland, and Portugal. Italy, Spain and other parts of the Eurozone remain under intense pressure.

Yet in some circles, there is a sense that the countries of the Eurozone have put the worst of their problems behind them. Following a string of summits, it is argued, Europe is now more decisively on the path to a unified financial system backed by what will become the substance of a fiscal union.

The doomsday cycle is indeed turning – and problems are undoubtedly heading towards Japan and the US: the current level of complacency among policymakers in those countries is alarming. But the next turn of the global cycle looks likely to hit Europe again and probably harder than before.
The continental European financial system is in big trouble: budgets are unsustainable and growth is nowhere on the horizon. The costs of bailouts are rising – and the coming scale of the problem is likely to undermine political support for the Eurozone itself.

The structure of the doomsday cycle

In the 1980s and 1990s, deep economic crises occurred primarily in middle- and low-income countries that were too small to have direct global effects. The crises we should fear today are in relatively rich countries that are big enough to reduce growth around the world.

The problem is that the modern financial infrastructure makes it possible to borrow a great deal relative to the size of an economy – and far more than is sustainable relative to growth prospects. The expectation of bailouts has become built into the system, in terms of government and central bank support. But this expectation is also faulty because, at times, the claims on the system are more than can ultimately be paid.

  • For politicians, this is a great opportunity.

It enables them to buy favour and win re-election. The problems will become apparent, they calculate, on someone else’s watch. So repeated bailouts have become the expectation not the exception.

  • For bankers and financiers of all kinds, this is easy money and great fortune – literally.

The complexity and scale of modern finance make it easy to hide what is going on. The regulated financial sector has little interest in speaking truth to authority; that would just undercut their business. Banks that are ‘too big to fail’ benefit from giant, hidden and very dangerous government subsidies. Yet despite repeated failures, many top officials pretend that ‘the market’ or ‘smart regulators’ can take care of this problem.

  • For the broader public, none of this is clear – until it is too late.

The issues are abstract and lack the personal drama that grabs headlines. The policy community does not understand the issues or becomes complicit in the schemes of politicians and big banks. The true costs of bailouts are disguised and not broadly understood. Millions of jobs are lost, lives ruined, fiscal balance sheets damaged – and for what, exactly?

Over the past four centuries, financial development has strongly supported economic development. The market-based creation of new institutions and products encouraged savings by a broad cross-section of society, allowing capital to flow into more productive uses. But in recent decades, parts of our financial development have gone badly off-track – becoming much more a ‘rent-seeking’ mechanism that draws support from politicians because it facilitates irresponsible public policy.

  • The question is: Who will be hurt next by this structure?

There are three prominent candidates: Japan, the US, and the Eurozone.

Japan’s long march to collapse

Figure 1 shows the path of Japan’s ratio of debt to GDP over the last 30 years, including IMF forecasts to 2016.

Figure 1

This is a worrying picture:

  • Japan has a rapidly ageing population.

The average Japanese woman today has 1.39 children, far fewer than is needed to replace the elderly. This means that the total population is set to decline by 26% by 2050. Having peaked in the mid-1990s, the country’s working age population will decline by a staggering 40% between 1995 and 2050. Naturally, many of the ageing Japanese have been saving for their retirement for decades. They deposit those funds in banks, buy government bonds, hold cash savings or buy Japanese equities.

  • Japan’s growth is slowing.

With an ageing population and slower growth, the broad outlines of responsible policy are straightforward. Japan should become a big investor in countries with younger populations, providing the capital investment needed to generate growth. Those countries can then return the savings to the Japanese as they retire. Singapore’s government does just that via one of the world’s largest investment funds.

Instead, for the last two decades, Japan’s government has been running large deficits, borrowing and then spending the savings of the young. When the elderly finally demand their savings back in the form of pensions, the government will need to reduce its budget deficit of 8% of GDP and start running a sizeable budget surplus. Unless there is a sudden burst of romance and fertility, there will be far fewer Japanese taxpayers in the future to pay this debt.

The government has not been willing to raise taxes in a timely manner to match its spending. The latest agreement is for a modest (5%) increase in the retail sales tax, which would only be fully implemented in 2015. Why would it do so in the future when the burden on the remaining workers will need to be ever larger?

Japan is saved from immediate pressure by the fact that about 95% of its government debt is held by domestic residents. As long as these investors are satisfied with very low – or perhaps negative – real rates, this situation can continue.

But sooner or later, Japan’s dreadful fiscal mathematics will catch up with the government. There is no sign yet of a broad loss of confidence, but major shifts in market sentiment are not typically signalled in advance.

America’s reckless private finance

In the US, the symptoms are different. Figure 2 illustrates the US version of the doomsday cycle: the rise of total credit as a fraction of national income. Major players in the financial system have become too big to be allowed to fail – and consequently receive large subsidies.

Figure 2

The latest crisis has led to the largest monetary and fiscal bailouts on record. The Congressional Budget Office estimates that the final fiscal impact of the crisis of 2007-8 will end up increasing debt relative to GDP by about 50 percentage points. This is the second largest debt shock in US history; measured in this way, only the Second World War cost more. (For more detail, see Johnson and Kwak 2012.)

The alliance that leads to unsustainable finance here is simple: the US financial system earns large ‘rents’ (excess returns to labour and capital) from the implicit subsidies offered by taxpayers. These rents finance a massive system of lobbyists and campaign donations that ensures ‘pro-bailout’ politicians win elections regularly.

Each time the US has a crisis, politicians and technocrats admit their errors and buttress regulators to ensure that ‘it never happens again’. Yet still it happens, again and again. We are now on our third round of the so-called Basel international rules for banks, with the architects of each new reform admonishing the previous architects for their mistakes. There’s no doubt that the US will someday soon be correcting Basel 3 and moving on to Basel 4, 5, 6 and more.

The problem that the country faces is that with each crisis, the financial risks are getting larger. If continued in this manner, bailing out the system will eventually be unaffordable. When the US finally runs out of enough savers to buy the bonds needed to bail out the system, it will suffer the ultimate collapse. (For more detail, see Schularick and Taylor 2012.)

Roughly half of all US federal debt is currently held by non-residents. So US fiscal policy remains viable only as long as the dollar is seen as the ultimate safe haven for investors. But what is the competition? Japan is not appealing today as a haven and it is unlikely to become more appealing in the near term. A great deal of the prospects for the US budget and growth therefore rest on what happens in the Eurozone.

The Eurozone: Flawed dreams

There is no sign that the Eurozone will emerge from crisis any time soon.

The incentive structure of the Eurozone ensured that each country’s financial sector clamoured to join it. The key feature that made it so attractive was the liquidity window at the ECB.

For smaller countries, the ECB is a modern day Rumpelstiltskin. Rather than spinning straw into gold, the ECB converts unattractive government and bank-issued securities into highly liquid ‘collateral’ that can be readily swapped for cash from the ECB. This feature instantly made sovereign and bank bonds very attractive debt instruments. Knowing that the borrowers had essentially unlimited access to liquidity from the ECB, investors became willing lenders at low interest rates to all banks in the Eurozone.

Given such attractive features, it is easy to understand why 17 countries mastered the political debate to join the Eurozone. It is also easy to understand how the system got abused and why it will be so difficult ever to make it ‘safe’. If the Japanese can’t control their public finances and if the US can’t control its too-big-to-fail banks, the added complexity of merging 17 regulators and 17 national governments into a system where someone else can be made responsible for bailing out the intransigents seems a financial and regulatory nightmare.

Such a system is sure to be crisis-prone. The Federal Reserve and the US federal government’s attempt to provide bailouts when there is trouble in the US. But in Europe, the bailouts are only partial. No country has a ‘lender of last resort’ like the Federal Reserve or the Bank of Japan – so markets are now learning that large risk premia are needed to reflect default risk in troubled countries.

Flexible exchange rates would undoubtedly make it easier to manage these crises. Devaluations instantly reduce wages and raise countries’ competitiveness. If Greece had managed a large devaluation, it could probably have avoided much of the unemployment and social turmoil we see today. Instead, each troubled country in Europe now suffers when having to force down wages and prices during adjustment.

This system poses great dangers to global financial stability. The Eurozone faces myriad problems, including insufficient bank capital, high levels of private and public debt, and the chronic inability of some member countries to grow.

It is now common to hear policymakers blackmailing populations: unless the Eurozone survives, tragedy will result. And it is true that tragedy will result; we only need to look at the rise of complex derivatives and the dangers they pose were the Eurozone to dismantle. (For a broader discussion of Europe’s problems, see Boone and Johnson 2011 and 2012.)

Figure 3 illustrates the growth of euro-denominated interest rate derivatives, the notional value of which now totals more than 10 times the GDP of the Eurozone. Regulators commonly use net figures when they consider ultimate risk for banks and this makes sense under the usual circumstances of bankruptcy. But when a currency area breaks up, the practice of netting off contracts needs to change dramatically and banks will be facing far more risks than regulators and risk officers currently report.

Figure 3

For example, if a German bank has a contract with a French bank and an opposite identical contract with a German pension fund, it can net those two contracts and report the ultimate risk as zero. (Of course there is counterparty risk, but under standard agreements, derivatives are cleared instantly at liquidation so the counterparty risks can be netted).

But if investors start to believe that there will be new currencies in each country, then the two contracts in this example are no longer offsetting so they must not be netted. It is reasonable to think that after any demise of the euro, the contracts between two German counterparties will be converted into deutsche marks, while contracts with international partners will be disputed or maintained in a euro proxy.

As a result, risk officers at banks should understand that if the Eurozone breaks up, all banks in Europe face enormous and unaccountable currency risk. Each of their ‘euro’ assets and liabilities needs to be examined to understand into which currency it would be converted. (For more discussion on redenomination issues, see Nordvig and Firoozye 2012.)

The threat of future crises

The tragedy of the Eurozone appears unavoidable, but it reflects far greater risks that will spread to Japan, the US, and other advanced economies.

Through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet are inherently difficult to regulate and control. We are at the behest of our politicians and financial sectors to prevent them from creating dangers. Yet around the world, our political and financial systems have aligned to build these dangers rather than suppress them.

The continuing crisis in the Eurozone merely buys time for Japan and the US. Investors are seeking refuge in these two countries only because the dangers are most imminent in the Eurozone. Will these countries take this time to fix their underlying fiscal and financial problems? That seems unlikely.

The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth.

The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and it is still growing. There are more crises to come and they are likely to be worse than the last one.

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buckethead's picture

You mis-named the first chart. It should be called the Virtuous Cycle.

~Regards, Mr Orwell.

 

tenpanhandle's picture

what a perfect picture to put on my dart board.

Colombian Gringo's picture

Or a list of criminals who should be grabbing their ankles for bubba in the iron bar hotel.  Given the inherent disgustingness of this cast of wall street felons, I would give the ass bandits free condoms to protect themselves.

economics9698's picture

What the fuck do you financial geeks call it?  Whip saw?  Some shit like that?

All I know is the bubble shit is about 99 years old and we need to hang a lot of bankers soon.

Snakeeyes's picture

Bankers are easy prey. But they couldn't have done anything without help/direction from government. Crooks like Clinton, Dodd, Frank, etc. all should be imprisoned.

4exNinja's picture

They ARE the government!! Just look at the CVs of those in power at the government...the bailouts for example were engineered by an ex-Goldman director. This wasn't directed by the government directly...they merely served as sock puppets of corporate America.

HD's picture

"I would give the ass bandits free condoms to protect themselves."

I'm more of a free market guy. I would charge them $200,000 for each condom - freedom from AIDS isn't free.

spentCartridge's picture

That's a fucking very good idea, tenpan, old bean.

 

I'm gonna print a few of those off and use 'em for target practice together with my hunting rifle.

Thank you for the inspiration.

economics9698's picture

I hope you are using a 30-06 or 30-30.  50 cal is good.

 

Freebird's picture

Yes, everyone of those motherfuckers makes my blood boil.
I guess the author knows his audience.

AldousHuxley's picture

circle jerk

 

but american consumers are stupid too.

buy your car with cash not lease

buy your house with cash not mortgage

buy stuff with credit card for rewards not for debt

 

only good debt is borrowing someone else's money to gamble. and you have to be inside wall st. to do that.

 

 

death_to_fed_tyranny's picture

"buy stuff with credit card for rewards not for debt"

NO! Buy gold and silver and lead with credit cards. Buy as much as your credit limit. Then default! When the dunning letter is received, send out a debt validation letter. If everyone did this, it would help speed up the impending collapse. And you will have real wealth. Remember that are you are all chattel to the criminal banking cabal. Use their game against them!

Urban Roman's picture

Regarding that first figure, with all the heads on it:

Is it really a cycle when we are doing all those things at the same time?

Peter Pan's picture

That first chart with the faces should have had a fan in the middle.

francis_sawyer's picture

Fuld is the only one who doesn't look too happy... He must have got the short order of matzohs...

Silver Bug's picture

History is simply repeating itself. Look out for the next big crash.

 

http://jimrickards.blogspot.ca/

max2205's picture

Add a crash in China and you really have problems.

At least China is smart; they are letting their stock market drop rather than crash later. Ben?, well he is dumber than a box of rocks

max2205's picture

Add a crash in China and you really have problems.

At least China is smart; they are letting their stock market drop rather than crash later. Ben?, well he is dumber than a box of rocks

TWSceptic's picture

You mis-named the first chart. It should be called the Virtuous Cycle.

 

Vicious cycle.

Radical Marijuana's picture

Yeah, a great graphic, which could be Orwellian on steriods. If it was animated, it would be spiral, picking up speed as it went down the drain ... After it goes down the drain far enough, it will transform into war and martial law.

The most important sentence was:

For the broader public,

none of this is clear –

until it is too late.

vast-dom's picture

looking at those charts is just pure fucking infuriating madness.

Colonel Klink's picture

Criminal circle jerk at it's worst.  Every person on there should be in a "bang me in the ass" prison.

dolph9's picture

There is a sort of insanity that exists in the developed world (N.A., Europe, and Japan) that doesn't exist elsewhere.  It is born out of sheer hubris.  Among the ideas are:

1)  It is possible to live forever.  Large amounts of money and spending are dedicated to "healthcare" which allows decaying organic beings to persist far beyond their natural expiration date.

2)  Fiat money is infinite, and valuable, and will make everybody a millionaire.  There are no limits to wealth.  Just work hard enough, and think happy enough thoughts, and you will have the perfect life, perfect home, perfect car, your children will be perfect and will go to perfect schools.  And then, their children will be even more "perfect"!  As if that's possible.

3)  Governments and laws are sound, and they are meant to protect the average citizenry.  Systems are robust, and one should feel privileged to live in a place where the "rule of law" is valued.

 

Talk to most people in the places that we disparage and they will laugh their heads off at the above conceits.

eatthebanksters's picture

We need a lot of rope and real big tree to solve this problem...

spentCartridge's picture

Trap door grease & a gallows is better, or a crane of course, Iranian style ...

Lin S's picture

I am feeling that way a lot more these days... ='(

geno-econ's picture

Add a fourth belief:

4)  All man made problems can be solved by the pursuit of technology whether it be medical ,envioronmental, physical,  economic or universal----we are after all doing God's work on earth, the moon and mars

Stuck on Zero's picture

Yes.  And add a 5th belief:

5) Greed is good.  Depravity is virtuous.  Sloth shall be rewarded.  Work shall be for the state.  Perversion is art.  And to deny this makes you a target.

 

Totentänzerlied's picture

#1 Applies to all peoples everywhere always. Immortality is a universal theme of the superstitions and religions of peoples in every corner of every continent. The difference is that some populations temporarily had the ability to spend massive amounts of credit-money in service of this ideal. It would happen anywhere given the appropriate precondition of too much easy credit. There are precious few groups which, once introduced to modern medicine, reject it altogether; now, would you argue that innoculations which save children from various crowd- diseases are artificially prolonging their lives "beyond their natural expiration date"? The view belies a presumption of a general baseline of health and longevity that in reality is very much the exception, historically and currently, than the rule. If you disagreed emphatically, you would simply kill yourself around age 35 - the "natural" lifespan of organisms of our species prior to the rise of allopathic medicine and nutrition standards possible only thanks to the second and third agricultural revolutions (i.e. nitrogen fixation, artificial fertilizers, mechanization, genetic modification, pest and weed control, etc.).

#2 Applies to every country that uses or ever used a fiat currency (all of them). Debasing the currency is a universal feature of fiat currency monetary regimes. The cultural beliefs attached to easy money are of minor importance and their expression is magnified greatly by the favorable climate easy money creates for capital malinvestment/misallocation and/or financial profligacy - the decoupling of actions from consequences. If some peoples don't hold this belief now, their ancestors likely did at some point; they are rationalizing away the fact that they share this desire with more privileged and thus hated (read: envied) groups but of course cannot admit to it.

#3 Is much more interesting, very well-phrased, and indeed likely true, though this is changing. However, it really is about social experience, the 'advanced' nations have been seduced and dumbfounded, the people know they can't challenge the system and so take it as a badge of honor vis a vis the backward third world and bury their heads in the sand like good slaves. The rest of the world once again merely has not had the "benefit" of this experience by which people come to believe the patent absurdities of political economy which our countrymen take as self-evident. The prevailing alternative in the 'rest of the world', though, is not much better - the honor-based society, the mafia/gang mentality of endless revenge and petty violence writ large.

Radical Marijuana's picture

While what you wrote is mostly true, it has changed over time, as the doomsday cycle accelerated. Not too long ago, in those places you name, the ratio of production to corruption was not so bad. The rule of law still meant something, or at least, it was not so blatantly obvious that it had broken down. (I.e., the rule of law was already broken, but the effects of that have been picking up speed at an exponential rate.) In the previous couple Centuries, the relative respect for the rule of law, and thus, the much better ratios of production to consumption, were one of the main reasons why the dominant world systems were able to become dominant. However, now that they have gone through so many doomsday cycles, they are destroying themselves, since the ratio of production to corruption appears to have gone past the point where it became a terminally fatal social sickness.

During the 21 Century, this doomsday cycle went past the event horizon into a social black hole.

Seasmoke's picture

looks like a circle jerk

krispkritter's picture

How about a 'circle of jerks'?

I think it's a fine illustration of who to hang first, second, and so on...

dog breath's picture

Yes, but no happy ending.

hedgehog9999's picture

This story below outlines the facts of the economic decay in the US. It is indeed a sad fact that Trillions are being spent to help the bankers with QE4EVER and nothing done to fix the the US infrastructure which would generate infinitely more jobs than Bernanke 's ill advised programs.

Sadly also is that this is the current state of affairs, and it is only going to get a lot worse as all governments are drowning in debt and the continuing debt pump liquidity cranked by Bernanke.

http://theeconomiccollapseblog.com/archives/21-facts-about-americas-failing-infrastructure-that-will-blow-your-mind

 

FutureShock's picture

Most people are tied up with the bankers in 401k's and pension plans and the stocks they are invested in.  The bankers deep behind the fed are another story. It is easy and simple minded (though not entirely untrue) to scream bad bankers and stupid Bernake. He knows it is disaster now or later and keeps looking for a softer spot to crash land the plane under others that control him. They are not trying to collapse the world and make sure bankers get bonuses.

max2205's picture

That's how bad it is. That's why they are scared to death. It must be WAY badder than we all can imagine.
Ben is beyond acting like a desperate man.

If things were a little bad, why, with interest rates so low and stocks so high, would Ben push the coke again. He sure as shit don't care about the unemployed or house prices. D E R I V A T E S!!!! Go boom!

ebworthen's picture

That circle contains the dynamic of bad children and their enabling Parents.

Economics, financial engineering, policy, bailouts, CONgressional hearings, and all the other gobbledegook are the whiskey, kitchen table confessions, promises to quit smoking meth, tearful confessions, and the continuation of the "lie-steal-drink/drug-confess-forgive" cycle of a liar-liar dysfunctional family.

AnAnonymous's picture

Investors need places to invest.

This destroys the analysis made in the article.

Europe is pushed under the train because you cant solve an overconsumption issue by getting rid of non consumers. You have to push over board some big guys.

But, contrary to the claims made by 'americans', economic laws'applications depend on the target.

It is like nuking the world. There is always a place to be nuked and nothing is less sure than the people who keeps nuking with no regards the rest of the world shows the same determination when it comes to nuking themselves.

The US is the safe haven in this 'american' world and will remain so.

magpie's picture

Whoa, graphic imagery there. Is that because China's new "Fallout" game will be released ?

Europe's center will undergo a slow self-peripheralization until the bond market for France and Germany has to be nuked to be saved.

PiratePawpaw's picture

"Investors need places to invest.

This destroys the analysis made in the article."

The 'Nuclear Rebuttal'.....It destroys any analysis. /sarc

And the USD will not be the safe haven forever, only as long as it's the best looking horse in the glue factory.

Poor Grogman's picture

An annoying mouse has been "over consuming" some very strange substances itself recently...

Lay off the imported rat bait old chap it's bad for you.

Freebird's picture

Stupid boy. Have another bottle of tequila.

gggunchi's picture

I vote nothing happens as politicans . . . the worthless scum bags they are will keep kicking the can until one of the 3 goes bust, and then the whole house of cards collapses in a few grand and explosive weeks. If history is to repeat herself . . . when the world's economies go to hell . . . expect a big war.  I would imagine this is no different. 

 

Winner of said can kicking gets a bailout . . . non-winners have to start the war.  

q99x2's picture

I like Simon Johnson. To coin a term he is the poor man's globalist.

orangegeek's picture

Read "the Road to Serfdom".  The socialists eventually canibalize themselves.

 

And the Nikkei did what the Dow is about to do - primary wave 3 down.

 

http://bullandbearmash.com/chart/dow-jones-industrial-average-weekly-sep...

Just Ice's picture

If going to link a chart, should link a chart, not a "subscribe" pop up (even if free subscription). . . jmo

Urban Redneck's picture

 Is my command of the English language failing or does this say what I think it says? (which was why I stopped reading the words and looked at the purdy pictures instead)

Roughly half of all US federal debt is currently held by non-residents. So US fiscal policy remains viable only as long as the dollar is seen as the ultimate safe haven for investors.

 

newworldorder's picture

The Doomsday Cycle is easy to explain.

Watch the movie Dune - sustitute "spice" for oil. Sustitute the "House Atriedies  " for the US military.

As long as the oil flows and the flow is guaranteed by the US Navy all is well with the world. Once the "spice/oil" stops flowing we all have a problem. The globalists through various WTO organizations have such a sweet deal.

Not convinced? Check out the US and "international naval armada" now gathering close to the Staits of Hormuz.