The shaky edifice of global finance

Much of being made of the profligacy of southern European countries, their unsustainable levels of debt. It is worth asking how big this debt is in the overall scheme of things. You get some interesting answers. According to McKinsey & Company, global public debt last year was about $41 trillion. Private debt, consisting of financial institution bonds, non-financial corporate bonds, securitised loans and non-securitised loans is estimated at $117 trillion. So how big are these European debts in that context? Italian debt is $2.4 trillion, about 118% of GDP. It is 1.2% of global debt. Spain’s $900 billion, or 60% of GDP is 0.5% of the global total. Germany’s $2.6 trillion (78% of GDP) is 1.6% if the total. France’s $2 trillion (80% of GDP) is 1.8% of the total and the UK’s $1.8 trillion (80% of GDP) is 1.1% of the total. Add up them all and it is only 6.1% of the total global debt. The US has $15 trillion in debt, a touch over 100% of GDP and Japan as $12 trillion in debt or 225% of GDP.

And the profligacy is where, again?

The bigger point is that sovereign debt is only 25% of the total, most of it American and Japanese, both of which are special cases. The US has the world’s reserve currency, so can rack up debt with relatively little risk of being punished, until such time as there is a genuine alternative to the greenback as the reserve currency — for which read the floating of the yuan, assuming that the euro stays intact in some form. Japan is hermetically sealed off, owing the debt it itself.

So the picture that we are getting, that European debt is massive and unsustainable is plainly wrong. What is rather happening is that the real culprit, the explosion of private debt, much of it the fictions of what I call “meta-money” rests on a foundation of the “real” economy and when that “real” economy cracks from the strain then the whole edifice starts to sink.

Think of it like this. Imagine the global financial system as a block of flats. The first floor is conventional economics transactions plus the cash flow of those economies. The second floor is conventional forms of finance, such as government bonds, equity markets, corporate bonds, bank lending and confected forms of new finance: securitisation, new forms of new debt creation, debt/equity hybrids and so on. The third floor is extreme meta-money: $600 trillion of derivatives and who knows what else. None of it on balance sheet and much of it untraceable. Over $3 trillion of it spins around the world each day — Europe’s entire debt in about two days. That third floor has been the price of allowing financial “de-regulation” — that is, letting traders make up their own regulations.

Now, as we see, the second floor is getting pretty large. It is about 300% of the global annual GDP. Not cause for panic, but cause for concern. But the third floor …. Wow. At face value it is 12 times global GDP. Even if it “nets out” at at a quarter of that amount, it is still another 300% of global GDP. Because it is meta money, it does not use conventional debt with conventional interest rates, but it requires massive amounts of leverage to work because the trades are on such fine margins, as Long Term Capital Management (LTCM) displayed back in 1998 when the hedge fund’s debt threatened to undo the world’s financial system, requiring a bailout of the investment banks.

Now here is where I think much of the current analysis over the last few years of the series of crises has missed the point. It has focused on cracks in the first and second floors — the housing market (floor 1) in the US that “caused” the GFC; the bond market crisis in the EU that will “cause” a global slowdown now — when it is parts of the second floor and the third floor that are the real problem. If the upper floor of a building is too big relative to the ground floor, we all know what will happen. It is threaten to crack and at best be rickety. Yet rather than looking at that insanity, most of the attention goes on what is happening in the first floor — and especially what governments are “doing” about  the management of their economies. There is also some concentration on the need to deleverage on the second floor, but that, too, is conventional analysis. It is easy to concentrate on the familiar, but these circumstances are very far from familiar.

Many observers are looking in the wrong place; the symptom and not the cause. It is classic post hoc analysis — “what did happen must have happened” an inversion of cause and effect. The problem is the massive expansion of debt, which has resulted in the excessive financialisation of developed economies, and the absurd, Dr Strangelove activities in the meta markets: derivatives, high frequency trading, and other madnesses. Meta money has also created massive leverage, although whether one calls it debt is a moot point.

The lesson for governments is the lesson that the developing world brutally learned over the last decade. Don’t get exposed to the international capital markets (in the case of developing economies, the $US). It is no accident that Australia, which has very little government debt, is skating through all this. You can do what Japan has done, and owe all the debt to yourself, or just balance the public books. Either way, sovereign states need to stay away from the third floor.

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  1. OMG OMG a post of MB that make a bit of sense on the European “fake Crisis”, must be Christmas.

    most European countries own the debt themselves as well, especially Greece and Spain.

    • Now now Dam, I do not subscribe to the overly negative tendency of MB’s Europe coverage myself but you do have to admit there is some sound analysis in there and some valid points. I think they are spot on in their analysis of the flaws in the EMU (eurozone).

      I’m just a bit more optimistic about where it will lead.

    • LMAO Dam. When Lehmann bros went bankrupt on 15th Sep 2008, it had bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion.

      How much is that of the world economy? What did that even trigger?

      When a butterfly flaps its wings…

      • SkoptimistMEMBER

        I think when Lehmann bros went bankrupt the third floor knew they were in trouble as all of the insurance (CDS) they had been selling (with the assumption that it would never be required, or would only be required in isolation) was about to be be called upon. That is why AIG collapsed so quickly afterwards. The entire house of cards that the derivatives/swaps market was built upon was about to collapse.

          • SkoptimistMEMBER

            The preferred and only real path out of this for derivatives is wholesale printing. That way no one ever defaults, so the rubbish they have already sold won’t be called upon, and they can go on selling it.
            I suspect most of the pressure on individual European states to print/bailout (but not default) is just an attempt at divide and conquer by the derivatives market.
            Lets hope that the ECB doesn’t print and those that should lose do.

    • I thought De’s Europe coverage made it pretty clear that the European ‘fake crisis’ is a political crisis – due to conflicting interests of the ‘savers’ and ‘spenders’.

      There are a number of technically / financially possible ways through (partial default, eurobonds, inflate/print), but the governments of each country need not only agree to this, but stay in power in their own country to do it.

  2. What happens if the housing market crashes, banks go belly up, and the government has to take on the debt? What figure would we be looking at?

  3. Japan doesn’t owe the debt to itself. The Japanese STATE owes 225% of GDP to the Japanese PEOPLE. Different entities. The only way you can say there is no net debt is of you believe that the government OWNS the people and can simply treat them as serfs and appropriate all their assets or default on the debt at will, without consequences. In that case there is no net debt because you can treat the people as an asset.

    If the government defaults on its debt to the people, there will be severe economic and political consequences. If it expropriates property from the people sufficient to pay the debt, there will be severe economic and political consequences. The same goes for Italy or the USA.

    In times of crisis the gross debt matters, not just the net.

    Japan and the USA have the option of printing money to pay the debt to the people. In the long run this is just stealth default, but it is not as politically and economically painful as default or expropriation.

    Italy does not have this option (yet) which is why it is currently the focus of the crisis.

    Other people might have greater debts than the Italian goverment. That doesn’t mean they don’t have a problem. The focus is on Europe now because Italy et al have a problem NOW.

    Other people will get theirs later.

    • Grief, of course the government owns the people. That is the crucial difference between Asia and the Franco-German vision of Europe, they make no bones about it.

      We, the British diaspora, like to think that the individual should enjoy as much freedom as possible. It is part illusion, part reality.

      The Spanish know what it is to be a fascist state and the Italians and Greeks have found their own unique ways of upsetting the plans of those who would be their overlords.

      Curious that Italy and Britain have greater wealth per capita than Germany. Now where was that link…

  4. speaking of the third floor, i just saw a movie called ‘Margin Call’ quite good, good cast too. i recomend it.

  5. Right,exellent let me get this straight,Our,Sky Blue’s not falling..but
    Just could be,getting further away from our top..arr
    Cheers JR

  6. SoN, I assume pension liabilities aren’t included in the sovereign debt figures. I recall reading recently that if included UK’s debt would be closer to $5 trillion and over 300% of GDP! Again I would assume that once pension liabilities are included debt would be higher for all countries. When is it correct to included pension liabilities and the like in assessing debt obligations of sovereigns? Perhaps another reason focus is usually on levels 1 and 2 is they are the areas most of us can have some understanding of and potentially be affected by if governments squeeze generous welfare ‘entitlements’ – not so entitled after all…

    This BBC documentary ‘The Party is Over: How the West Went Bust’ certainly sets its sights on Levels 1 and 2, but may of some general interest. Much mention is made of the loss of manufacturing capability in the UK to cheaper offshore locations, very similar to what has occurred in Australia. Too little is discussed on prospects for the Chinese economy with a West in recession.

    • Doug Noland’s (Prudent Bear) weekly missive (focussed on the Eurozone this week, might interest DE). Noland has excellent understanding of the massive expansion of debt and corresponding financialisation of economies.

      ‘Counterparty and derivative issues now take center stage.’ ‘It’s ironic that the big European “banks” used the carnage of the 2008 fiasco to boost their presence in the global (hedge fund and securities financing) prime brokerage and derivatives businesses. It shouldn’t be too difficult to see the linkages from Europe and the euro to a very problematic global crisis.’

    • From Part 1:

      “I think we became convinced that markets would find a solution, and if we let markets operate they would be self-correcting and that turned out to be the wrong judgement.”
      Sir Philip Hampton, Chairman, RBS

      It seems to me that the markets are self-correcting, we just don’t like the method the markets choose to effect said correction. Much like population dynamics in nature, boom is followed by bust. We’re just unwilling to accept the bust.

  7. To personalise this: If you lend your neighbour $1,000, you expect it back, right? If a bunch of other neighbours say he only has to give $500 back you are going to be as mad as hell and maybe even suggest these nosy bastards come up with money. They say no, so you still want the neighbour to pay the thousand, right? You really don’t care what he has to sell to come up with the money. Expand this notion to the world’s economy. Insurance, interest rates, repo’s, CDSwaps, you name it, are just fancy crap on the initial problem.

  8. I guess it’s a second floor issue, but the money market mutual funds that basically failed in the last crisis before the fed stepped in has still not been addressed.

  9. Reading the above one could easily mistakenly believe that the $15t US debt is owed outside of the US and all the $12t of Japanese debt is internal.
    Only about $4.4t (about 30% of GDP) of US debt is owed outside of the US. About $5t is intragovernmental debt leaving the US public with about $5t.
    About 7% of Japanese debt is owed outside of Japan which is a still significant chunk of GDP, about 16%.

    • Dead right Russell. As has been noted with respect to house prices, that they are set (prices) at the margins.

      Interest rates would rocket in any currency / economy if 10% of capital took flight.

      So there is little comfort in these numbers.

      About the ‘third floor’ if it is unregulated, unmeasurable, non-jurisdictional who or what is going to sort it out?

  10. “It is no accident that Australia, which has very little government debt, is skating through all this.”

    No accident? Australia has plenty of debt, but it is owed by households rather than the Government. This in fact increases the potential vulnerability of our private banking sector to shocks emanating from global financial markets, because the household sector is intrinsically less able to support debt than the public sector.

    We have been able to return the public accounts to balance and see private domestic savings rise at the same time without also experiencing a recession. This has been possible because of the rise in foreign income attributable to resource exports. Is this an accident or was it always the plan?

    Not all the Europeans have been so fortunate, though, like Australia, Germany has benefited greatly from strong demand for its exports in developing economies.

    The problem for the deficit-struck Europeans is not so much the present level of their debts (other than Greece and Portugal), but the lack of the means to check their future increase. For all the reasons that have been canvassed at MB so often, these Euro-zone economies can neither shrink nor grow their way to durable fiscal balance.

    The arithmetic of this is irrefutable. The European states are slipping towards insolvency. This deterioration is generating insolvency in the European private banking system which in turn has caused debt markets to seize up. Were the ECB not supporting the European banks with unlimited loans, their banking system would probably already have collapsed.

    It is certainly true that the failure of any very sizable European bank could set off collateral calls in the derivative markets leading to a chain-reaction with unknowable further consequences. But these would be secondary effects and are not the locus of the current crisis.

    The basic problem is that the global monetary system and other features of the international industrial structure are propagating permanent imbalances between economies. These imbalances manifest as accumulating debts in either the public or the household sectors (or both) of deficit economies. This would not matter much if the debts grew less quickly than economic output. But we have passed that point, and economies are growing (if at all) far less quickly than total debt. This obviously leads to predictable insolvency in time.

    It is important to note that in the post WW2 period, global trade has increased very much more quickly than global output, which reflects the spread of industrial production from the Atlantic economies to the rest of the world. This expansion in trade has occurred with a monetary system in which the USD has been used as the reserve currency. This has required the creation of a continuously expanding supply of dollars to enable increased transactions between parties in the non-US economies. This increase in the supply of dollars to support non-US economic activity is axiomatically reflected in permanent current account deficits in the US accounts.

    This process can continue indefinitely as long as the US economy is able to grow its economy at least as fast as it is growing its debts. However, this condition no longer holds. US debts are growing at a faster rate than its economy. Unless growth in the US economy can be revived, the eventual need to achieve fiscal balance while households also de-lever will drive the US economy into depression or current account surplus or both.

    In such a context, it is doubtful the USD would be able to serve as a reserve currency, provoking a major re-construction of the global monetary. It will be necessary to create a new monetary order to allow the global system to achieve balance, stability and renewed growth.

    I don’t imagine much thought has been put into what such a non-USD-centric system would look like. But, for a start, there would probably be a statutory distinction between official reserves – able to be held by central banks – and other financial assets. The present system allows private banks to create new USD-denominated assets, and thus to generate new reserves held by private interests. This is a major source of imbalance in the current global monetary system. Reserve creation arises not merely from official policy, but from private asset inflation, and this generates debt expansion in the US economy.

    In a new system, private players would not have this privilege. Instead, non-reserve assets would have to be used to purchase reserves at prices determined in a floating market. This would prevent currency manipulation and over time inhibit balance of payments crises, such as we see in Europe at present. It would also enable the US economy to return to external income balance and a sustainable fiscal path without also precipitating a global depression.

    Combined with banking reforms to align global credit expansion with growth in both real output and productivity, the global economy should be able to placed on a path of stable economic growth – something that seems like a hollow fantasy at the moment.

    • Hi

      quick question:

      “It will be necessary to create a new monetary order to allow the global system to achieve balance, stability and renewed growth.”

      is renewed growth dependent on population growth? It seems to me that it may be.

      • Hi Pellicle. Well, I think the existing population carries a lot of unmet demand for all kinds of things, from the most basic goods and services to the most elaborate, so in principle economic growth does not depend on population growth. This potential demand is geographically as well as socially and demographically dispersed, but as the global economy develops, as the benefits of liberal trade and investment, improved education and labour-force development spread, more and more of the world’s population are experiencing increasing real incomes which is translating into expanded demand, production, investment and trade. This will accelerate in the coming decades, especially in the regions with the highest growth potential in Asia and around the Indian Ocean basin. This will be great for Australia, particularly for Western Australia.

        However, there are obstacles to growth in the Atlantic economies, not least being the recent accumulation of debts (to the point of saturation in many economies) and structural problems in the monetary and financial order. In the broad sweep, the institutional order reflects the past preeminence of European and US industrial and financial power. This era is ebbing irresistibly away and will be replaced eventually by a new, more highly differentiated and hopefully more resilient system.

        If the global monetary system were re-fashioned, we could achieve a far more balanced and less-convulsion-prone growth path. It may yet turn out that political and social stability in developed economies really depends on such reforms being conceived and realized.

        As usual with shifts in power, institutional change involves forcing adaptation onto the status quo. This is not a frictionless process, as we can see in the US, where the financially advantaged are resisting every step that might abridge their very considerable privileges, and where political stasis has almost completely frozen the legislative instruments. Equally, in Europe the financial hegemon, Germany – the main beneficiary of the status quo – has been able to impose a deeply conservative but unworkable monetary agenda on the weaker states. This will almost certainly lead to an eventual rupture of the post-WW2 European politico-economic consensus and is now the leading cause of instability in the global economy.

        • Hi Briefly

          thanks for the detailed and thoughtful response. I also would like to think that with as many poor as we have that creating wealth for them may in fact be quite enough potential for economic growth.

          But (as you touch on) its also about power and I see that there are those who direct ‘economy’ based on projecting their desired power outcomes, which of course results in different outcomes.

          I too have been of the opinion that the world has still not settled down to any sort of equilibrium after WW2, but then perhaps it really never had such a thing (equilibrium) in the last couple of hundred years anyway.

          Nice chatting 🙂

    • “This process can continue indefinitely as long as the US economy is able to grow its economy at least as fast as it is growing its debts. However, this condition no longer holds. US debts are growing at a faster rate than its economy.”

      This condition hasnt held for decades in the US. Hence why this is all coming to a head now; when the issue was manageable nobody took the initiative to deal with it. Too much can kicking.

  11. The euro nations are monetarily non-sovereign, meaning they do not have the ability to create their sovereign currency (not having a sovereign currency), so can be unable to pay their debts.

    The U.S. is Monetarily Sovereign, meaning it can service any debt of any size, instantly.

    Those who do not understand Monetary Sovereignty ( do not understand economics.

    Rodger Malcolm Mitchell

    • Hi

      from your page “the denominator is a one-year measure of productivity” (referring to GDP). While I agree it is a measure, it is not a particularly worthwhile or applicable measure. Just as volume is not an appropriate indicator for the mass of a balloon.

      Perhaps my error lies in misunderstanding, but it would seem to me that (by way of comparison) that GDP would be rather like me determining my household productivity as:

      I get paid working and bring money into the house, my wife gets paid working and brings money into the house. From this we determine how much we have left over from our external expenditure to save or to service a loan should we wish to.

      GDP would then be: my wife charges me for cooking meals, I charge her for cooking other meals, my kids pay me rent and I pay them to mow the lawn and do other chores. All these incomes would seem to add to GDP, but in effect make no difference to how much comes into the household and how much goes out.

      Looking at the GDP as the combined ‘noise’ in the system rather than the balance of in VS out is like inflating that balloon and saying “see, its twice the volume it was”.

      Of course this leaves out such things as we grow vegetables in the back yard and have some chickens to supplement our food supply as these are valid inputs to the system.

    • Monetary sovereignty is one thing. But fiscal discretion is another. If public sector debt really never mattered, if Governments could “print” anytime they wanted with no adverse consequences, then we would not need to tax ourselves at all. We could simply create public-sector services at will and pay for them by vaporizing the spending.

      While it is essential for stability that central banks be able to act as lender-of-last-resort to Governments, it is also essential that Governments be able to regulate their fiscal position – that is, that they be able to move from surplus to deficit or remain in balance according to the status of their real economies. This amounts to fiscal sovereignty and is the Siamese twin of monetary sovereignty.

      • Weimar – an example of what can happen when foreign creditors try to impose punitive demands on a stricken debtor in a fixed exchange rate world where economic growth has disappeared. That is, it is important to note the structural imperatives that drove Germans to adopt unconventional measures, such as attempting to finance a bankrupted state by printing money.

        This, however, does not excuse the creation of the Euro system, which is the Full Reverse Weimar, and will generate deflation as surely as Weimar generated inflation.

    • I don’t mean to be rude but I have no idea what you are exactly advocating. A flashing advertisment claiming that I am the one millionth visitor to your site does not give me any faith that you do either Rodger Malcolm Mitchell.

      • He is advocating Modern Monetary Theory, aka Chartalism. The economic school so bad they had to change its name when they decided to revive it.


        “Those who do not understand Monetary Sovereignty do not understand economics.”

        On the contrary, those who do not understand that the GDP equation is not the same as an economy do not understand economics.

        Step 1 of Chartalism is: “Assume the economy = GDP”. Then the erroneous conclusions follow.

        I’d suggest you think through what the consequences are for your theory but you dont need to, you just need to look up Weimar.

  12. Briefly-thanks for that note.My argument with your analysis is not with the maths of doing nothing-which is unsustainable-but with the range of policy options that now present themselves for turning the ship away away from the iceberg.A combination of careful fiscal consolidation and structural reform, plus a degree of transitional support from the ECB, will fix Italy and Spain provided Germany does its bit by reflating.All this-apart from the last point-is under way.(Forget Greece and Portugual as they are too small to worry about) The USA has plenty to do also but it will have to bite the bullet on entitlements and defence.These problems are all fixable and armageddon is not a given-provided the political machines can get their act together.Hand wringing doesnt help move things forward.

  13. Terry McF, the Governments in Europe are betting that they can achieve fiscal balance by cutting spending and increasing taxes before they reach the point of no return. Since it is absolutely essential that they do achieve fiscal balance, they have no other course open to them as things stand.

    However, this overlooks the fact that, in the absence of a rise in net foreign income, a fall over time in public sector borrowing will be matched by an equivalent rise in household borrowing – that is, the debts will just be transferred. In the absence of other factors, fiscal tightening will also drive economic contraction, while a rise in private sector debts may also undermine the growth in private consumption. That is, economies will contract and there will be fiscal deterioration in both absolute and relative terms. This is the blind alley of attempting to achieve adjustment by means of austerity.

    What has to happen in Europe is those economies that are in chronic external deficit have to regain competitiveness in relation to the surplus economies and at the same time move towards fiscal balance without shrinking their economies.

    This can only be done if the debtor economies re-base their output in domestic currencies. It cannot be achieved while all economies share the same currencies unless there is a full-scale federal system, allowing fiscal transfers to occur between regions.

    Since this is a constitutional and political impossibility, the only conceivable way out for the European economies is to adopt currency and (implicitly) monetary reform.

  14. “Many observers are looking in the wrong place; the symptom and not the cause.”

    With my naive knowledge of this stuff I did notice there seems to be so much discussion on how debt is going to be paid off, but no discussion on who issued so much debt in the first place. Is the flood of easy debt slowing? In my opinion failure to pay debt off is a symptom, and the cause – issuers of so much debt.

  15. Yes Briefly I agree that austerity is not-by itself-a solution. But combined with meaningful productivity reform in the South and reflation in the North it would be.And as a move to domestic currencies would be too traumatic the South and North will have to adjust their capital flows.What must happen will happen. The issue is when and how much pain between then and now.Wish I knew.

  16. SON,
    I 100% agree with your concern. I would suggest level 2 it is even bigger. Try inverted pyrmad. With the colapse of MF Global we start to see how big it realy is. The word everybody should be very afraid of is rehypothecation.

    • @Learner you mean an inverted CDO. In this case the mezzanine is sound and the top layer is junk.

      And yes we’ve all read ZH’s articles about rehypothecation. The CDS leverage is far far bigger – how many hundreds or trillions is it again?

      • Yes StanG,
        While CDS are larger I see rehypothecation as more dangerous as its base collateral can evaporate overnight. Also Politicans are aware of the CDS risk and have incorperated it in there response to “avoid” default in Europe as an example. Apart from rehypothecation, there is a lot more hidden stuff in the figures as SON mentioned, it is the result of the market making its own rules. Its also why I am continuing to keep a very defensive stance in my investments and checking the fine print.

        • Well everyone thinks the CDS ‘dilemma’ is OK because it’s a closed circle – everyone has bought insurance from each other from in a closed circle of banks – so if one has to pay out then that one claims from the other bank that IT bought insurance off, and in a giant puff of promisory notes all the debt cancels itself out.

          All fine, as long as one of the banks doesn’t fall over before it can pay out.

          But yes I think that rehypothecation and god-only-knows what else is going on in the incredibly opaque shadow-banking world is the *really* interesting unknown factor.

  17. out of interest, this level 3 meta money liabilities which could be anything in the trillions, I assume its essentially banks betting amongst themselves?

    therefore are the too big to fails the too big to bail?

    and thus is large bank failures inevitable as any unseen volatility or ‘squeeze’ will essentially make them unable to cover bets?

  18. SkoptimistMEMBER

    Thanks SoN, I always really enjoy your weekend pieces. A great article that puts things into perspective and highlights the often under reported issues surrounding the derivatives market on the third floor. Personally given the amount of damaged they have caused, I think the third floor should either be re-regulated or taxed into oblivion.