House of Debt - by Vasko Kohlmayer

What will keep the whole system up? What will bring it down?


The announcement by the Dubai State Corporation that it was unable to pay interest on its debt sent shock-waves through global markets. Stocks and weak currencies dropped as traders and investors feared that this could usher a new episode in the world's economic travailing.

One reaction in particular offered a revealing insight into just how uncertain things really are. Reported the UK Times:

Nervous traders transferred the focus of their anxieties from the risk of companies failing to the risk of nation states defaulting. Investors owed money by Mexico, Russia and Greece saw the price of insuring themselves against default rocket.

This should tell us much about the fragility of the world's financial system. The debt of the  Dubai's state-owned corporation is approximately $80 billion. Even though it is a substantial figure, it is not very large in the grand scheme of things. To give a sense of proportion, Dubai's debt comes roughly to one tenth of President Obama's stimulus package.

And yet the possibility of default by Dubai World immediately sent investors scrambling to insure themselves against default by whole countries. Their fears even extended to nations such as Russia, a country which in a comparatively good position thanks to its large energy revenues.

This shows how little confidence the international financial community has in the system. The world's money people fear that even a relatively small event can set off a chain reaction that would bring down nation states. Being part of the action, they are in the position to know what so many on the main street have suspected all along – things are not well. In the words of  noted financial commentator Bill Bonner, they fear that “the ripples stirred up in Dubai” could quickly “turn to Tsunami waves elsewhere.”

Despite what Barack Obama, Ben Bernanke and Timothy Geithner tell us, the problems that brought the global financial system to the brink in 2008 have not been fixed. They have only been papered over with massive amounts of freshly printed cash and cheap money in the form of near-zero interest rates. But too much money and easy credit were at the root of the problem in the first place. The measures that have been taken have only provided a temporary relief. Sooner or later the underlying problems will resurface again. The finance elites sense this, which is why even a relatively small failure makes them so nervous. They know that the seeming return to normalcy is only surface deep.

One can only wonder what governments will do when the crisis returns, since they have already fired the most potent weapons in their arsenal. It is not possible to lower interest rates below zero and given the current levels of government indebtedness, it will also be difficult to come up with more money for a new round of cash injections. A number of governments are on the brink of bankruptcy as it is. Another bout of massive borrowing is simply not a realistic possibility.

The next flare up could well bring on systemic failure. As it is, things do not look good. This year alone nearly 130 US banks have gone out business. This is four times more than the total for 2008. Recently it has been revealed by the Federal Deposit Insurance Corporation (FDIC) that more than 550 financial institutions are on the government's problem list. What this means is that roughly 7 percent of US banks face the possibility of failure in the short term. Their names have not been released in order to avoid bank runs. Should these troubled banks start falling in large numbers, the effect would quickly snowball and many other banks who still appear relatively sound would be pulled down as well.

Fearing this, banks are reluctant to lend and prefer to sit on their cash to play it safe. The government is unhappy with this situation, because it wants as many loans as possible in order to stimulate economic activity. The Wall Street Journal reports that “government officials have stepped up pressure on banks to make more loans in recent weeks.” FDIC Chairman Sheila Blair echoed this point when she said: "We need to see banks making more loans to their business customers."

Banks are, of course, correct in being careful. There is still too much debt in the system. What our economy needs at this point is further de-leveraging. Those businesses and enterprises that cannot make their payments need to go bankrupt so that the economy can be purged of the dross and then rise again on a healthier foundation. This, however, is precisely what the government is trying to prevent from taking place. It keeps propping up failed companies that should have been long out of business. Ensuring that they have access to cheap credit is part of that strategy. This approach averts some pain in the short term, but it ultimately only makes a sick system even sicker.

While the government is pressuring banks to make more loans, the FDIC – the very agency that insures depositors when a bank goes bankrupt due to bad loans – is itself in the red. What the FDIC's predicament shows is that banks should be issuing fewer loans than they are currently making. But this is not the lesson government officials draw from the situation. Instead, they counsel the banks to do the opposite. They apparently do not worry where the FDIC will get its money from should more banks fail. After all, the printing presses of the Federal Reserve can easily resupply the depleted fund. All this money creation, however, exerts immense inflationary pressures on the dollar. This in turn is destabilizing to the world's monetary regime which rests on the dollar as its foundation.

Rather than encouraging restraint, governments world over are making things worse by their irresponsible spendthrift policies. Those in the financial community know it, which is why they are so jittery these days. They know that even a Dubai size default could set off a chain of events that could eventually bring the whole system down like a house of debt that it is.