Many financial analysts agree that a financial meltdown is practically inevitable. Analyst Steve Denning writes in the prominent financial magazine Forbes in his article: “Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable” that while corruption and a number of financial scandals are certainly a grave danger to the stability of the world financial system, a far worse problem is something else:
… the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.
Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat. “The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.”
The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.
However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.
Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.
Eventually some bets will go bad, a global financial meltdown is only a matter of time. Knowing that the inevitable will come in the end, what is it that could be done to prevent large-scale suffering, when this 700 Trillion mega-bubble of derivatives finally will burst?
The answer is simple: just let it happen and let the banks go down with it, especially the big ones and together with the whole financial system!
Don’t be afraid. A total financial collapse does not inevitably lead to a total economic collapse.
How do I know that? Because I’ve seen it exactly here where I live, in Iceland.
When the three giant banks collapsed, (for Icelandic standards they were truly giants many times larger than the whole country’s economy) the Icelandic government and its economy had no capacity whatsoever to bail them out. So what the Icelandic government did was to let the banks go bankrupt together with their international business and all the speculative parts, and then take over the local branches, the ATMs and the ordinary personnel and create new banks out of them. And while share-holders’ equity was wiped out, all regular depositor accounts within the country were guaranteed by refinancing those new banks by basically “printing” (rather electronically creating) the money that had been destroyed.
This meant that in spite of a systemic crash ordinary banking business for most customers inside the country went on just as before.
Of course, this was the only possible course of action for the Icelandic government, but during the first weeks after the crash it led to a total boycott by the international banking establishment. The country was set on the list of terrorist supporting rogue states. Electronic money transfers to the outside world were no longer possible, not even in foreign currency.
In spite of the enormous short term damages for the Icelandic economy due to this boycott it still was not destroyed by it.
The fish were still in the sea and could be caught, the sheep were still eating grass and having lambs and the potatoes were still growing in the fields. The energy plants were still working (though deeply in debt to foreign banks), cold and hot water was still coming from the ground.
When the total boycott was over, the Icelandic fishing industry could sell their products again just as before and the tourism industry was booming, since with the dive of Icelandic krona it had become more affordable for foreigners to visit our beautiful country here.
In other words, while the financial system had crashed, the real economy was still alive and thriving and fully capable of production. And the government made sure that the necessary financial services to facilitate trade were performed by the now government owned banks.
Sure there were economic repercussions, even non-financial companies went bankrupt, since their owners had taken on too much debt, especially debt in foreign currencies. And some homeowners who had taken out foreign loans lost their homes. Unemployment rose from barely 2% to nearly 10%, but with the unemployment benefits people survived.
While those who were highly in debt sometimes had to make use of food-distribution centers and soup kitchens, still nobody starved or went hungry and nobody, except for long-term alcoholics and drug-abusers, had ever to sleep on the street.
In 2009 and 2010 the economy severely contracted. This was no surprise since a good part of it had been built on the financial sector in the previous five years. The construction industry also had a deep low, for ordinary people, companies and the government could not afford to build too many new houses. But since 2011 the economy has started growing again and the unemployment rate went sharply down. In April of this year (2013) the rate was only 4.9% and in July it had gone down to 3.9%. Only half of those people had been unemployed for longer than six months.
Let’s compare those numbers to those in any other European country, especially the southern European countries who all have tried to bail out their too big to fail banks:
The euro area seasonally-adjusted unemployment rate was 12.1 % in July 2013, stable compared with June; it was 11.5 % in July 2012. The EU-28 unemployment rate was 11.0 % in July 2013, stable compared with June; it was 10.5 % in July 2012.
Among the Member States, the lowest unemployment rates were recorded in Austria (4.8 %), Germany (5.3 %) and Luxembourg (5.7 %), and the highest rates in Greece (27.6 % in May 2013) and Spain (26.3 %).
Luxembourg, which has about a two-third higher population (about 522.000), never suffered a total financial meltdown, although at the moment doing rather well compared to other European countries, has still an unemployment rate 2% higher than Iceland’s today.
Cyprus with a population of about 1.1 million, an island state like Iceland, suffers today from 15,6% unemployment, a rate Iceland never reached after its own financial melt-down.
And here are the numbers for the United States, where enormous amounts of debt-money was used to bail out failed banks:
… as of July 2013, the unemployment rate in the United States was 7.4% or 12.0 million people, while the government’s broader U-6 unemployment rate, which includes the part-time underemployed, was 14.3% or 22.2 million people.
While part of its fast recovery might have something to do with Iceland being a small country, it still looks to me as if the Icelandic solution to the financial crisis might have been the better one.
The Icelandic way shows clear evidence that even a total financial collapse does not have to lead to an economic collapse, since the two of them are not the same thing.
If the basic financial services, which serve individual people and the real productive sector are taken over by the state, even if only temporarily (under international pressure 2 of the 3 major Icelandic banks have only months after their nationalization been privatized again) the economy will slump a little but will not be destroyed.
The near paranoid fear of a financial melt-down so many, especially American people, seem to have is not based on facts. America could survive and recover well without its speculative financial system.
Public banking and/or a monetary reform, like in the US a return to the government created green-back Dollar, would be a viable solution to counter the instability of today’s financial system as well as overcoming the enormous public debt problem.
The main obstacle for economic recovery America and most western countries have are governments beholden to the financial establishment.
And this is why financial collapses lead to economic collapses and the suffering of millions upon millions of people.
Once this has changed and western democracies have gotten themselves truly governments for and by the people, there are many feasible ideas out there of how to make countries like the United States economically independent from global markets, so that a default or a cut-down of unpayable public debt would not lead to resource shortages and economic suffering for the people.
I have collected a few of those ideas and will write about them next time.