Wednesday, April 18, 2012

No, the crisis is not over

The Economist has a good article this week about the euro crisis.  This retired guy (TRG) has a real soft spot for the cartoon too:

No more sugary euro's in the Sarkozy dispenser, better try the Merkel one.

The New York Times is also on it, and so is Reuters.  Although it's a mistake to think that this is just an exclusively European problem.  There is too much debt EVERYWHERE.  The US has it particularly bad, Japan too, and things are really unlikely to get better until we admit a few things about debt, and take appropriate action.

There are a few principles of debt that have existed since time eternal.  These principles of debt existed long before we even called it 'debt'.  Ever since it has been possible to owe something (anything) to someone (anyone) these principles have been true, so it's surprising that we are forgetting them now.

The FIRST Principle of Debt

The number one, critical, most important principle of debt, that every lender and borrower should understand intimately is this:

If you CAN'T pay a debt...  YOU DON'T.

It's that simple, really.  There are consequences to not paying, and they must be faced, but the simple fact is, if you can't pay, you don't.  You face the consequences.  You get on with it.  In fact, over time, as a society, we discovered that 'getting on with it' is the most important part.  The consequences themselves need to be focused on 'getting on with it', not on punishment, or retribution.  Think about it for a moment, take yourself back a few thousand years, it's not hard to imagine early societies where the consequence of default was DEATH.   In the more recent past, it was imprisonment (debtors prison).  However as a society, we moved away from these stern consequences, and not just because they were inhumane; we moved away from these consequences because they were unproductive.  If you kill or imprison some one for not paying debt then you have effectively GUARANTEED that you will recover exactly zero percent of the debt owed.  In our modern world, we have developed bankruptcy as an alternative.  Bankruptcy is a legal process whereby you pay what you can, and anything you can't pay, you don't.  You pay what you can, and then you get on with it.  How many successful entrepreneurs today were bankrupt at least once in the past?  Would be a shame if we had killed them for it!

The SECOND Principle of Debt

The second principal of debt (nearly as important as the first):

There are ALWAYS exactly TWO responsible parties for every default; the borrower AND the lender.

Whenever a loan goes bad, BOTH the lender and the borrower have failed.  It is easy to forget this, people who struggle to pay all their debts feel a natural resentment to those who don't pay, and the lenders (banks) feed this fire.  Banks want us to forget about the part they played, the lax loan standards, the unreasonable high interest rates, the complex structures, or the heavy handed marketing that entrapped people into more debt then they could reasonably pay.  Don't be fooled, when a loan fails, it's because the LENDER fucked up as much (sometimes more) then the borrower.  "But, what if the borrower never intended to pay?" you ask; that's not a loan, it's a fraud, and we DO have prison for that (China still has DEATH for fraud).

The second principle of debt explains why debts are erased in bankruptcy, it is not just because they CAN'T be paid, it's because the lender is partly responsible for them not being paid.  This is also why bankruptcy is final; even if the bankrupt party latter becomes rich, they don't have to pay debts that were erased in the bankruptcy process, those old debts go away, FOREVER.

Lawyers will go on at length about other principles of debt (pari passu for example) but these are legal principles that may or may not exist except in law.   The First and Second principle of debt ALWAYS exist, whenever there is a debt they exist, they have always have existed, and they always will.  The First principle cannot be ignored, the Second principle CAN be ignored (killing people for default is a good example), but it shouldn't.

The situation we find ourselves in today is not new or unique.  The world has too much debt, everywhere.  This has happened before, (see this book) in fact, you could argue that it happens every time we as a society forget the First and Second principle.  Unfortunately, history is littered with some very nasty consequences to times like these, for example, the great depression played a significant part in setting the stage for World War II.

Two years ago, it became clear to TRG that sooner or latter, Greece would default.  TRG was correct in guessing that that does not necessarily mean that Greece would leave the Euro, but it was clear that they would definitely default.  Greece has now defaulted on the private part of their debts, and they are not done, the public part (loans from the EFSF) will come latter.

Most governments have two ways of defaulting, they can stop paying (direct default) or they can create inflation (effective default).  Inflation (effective default) will likely be the path of the US, although some of the debts (Social Security for example) will likely get the direct kind of default.  There is no such thing as a bankruptcy process for governments, they have a really clean way of defaulting, they just change the law.  For example, when the US want's to default on it's Social Security payouts (probably sometime in the next 5 to 10 years) it will just change the law to reduce them.  Greece did a little fiddling with the law in their recent default too.

Inflation (effective default) has some real benefits over the direct kind.  The main one is the ALL debtors benefit  (and ALL lenders suffer).  When there's too much debt everywhere this is a GOOD thing.  It may be the best answer to our current dilemma.  One of the difficulties for Greece is that ONLY the government defaulted.  Greeks who had loaned the government money lost, but there own debts remain.  If Greece had been able to use inflation, the impact of losses on loans would have been slightly offset with gains on debts for everyone.

Countries in the Euro don't have inflation as an option (not individually at least).  But inflation is an attractive option, and that is why the Euro may be doomed.

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