Systemic Crisis: The Fish Always Rots From the Head

The economy, the financial markets, sovereign debts, and private debts, are all fundamental links that constitute a very complex system that can remain stable for a long time, then literally tip over in a very sudden and brutal way.

Mar 08, 2023 | By Michel Santi

The stars have aligned and the potential for severe turbulences that will affect both the global financial system and the budgetary stability of many states has never been so high. Various indicators have pointed to extreme fragility that has arisen from the continuous worsening of corporate, household and government debt. While all of these players accumulated a debt of 250 per cent of global GDP in 2008, the ratio has now reached 360 per cent as per the Institute of International Finance. Such levels have never been reached in times of peace.

While the quantity of debt has ballooned, the qualitative side is also a cause for concern as the unprecedented concentration of wealth greatly exceeds that of the national GDP. For a long time, various wealth measurement indices were used to track the progress of economic activities but today a fundamental divergence has occurred. While these tracking methods remain, production has remained stagnant and this goes in counter with economic growth as real wealth has not improved.

A study by McKinsey found that the deterioration in the quality of debtors is the main culprit in their inability to repay. This is probably the reason why central banks had many qualms about raising its interest rates when inflationary pressure started to grow; because these banks were informed by these “outdated” measures of wealth which were in fact only a gigantic smokescreen hiding an army of struggling debtors.

As inflationary pressures continue to mount, nominal rates will climb as well. Instability becomes more apparent with an unregulated, unsupervised, non-transparent shadow financial system. All this only exacerbates the burden of debt. Systemic risk is therefore fast approaching where in the near future, international actors will start to question the way in which certain countries — extraordinarily indebted — can continue their lifestyle.

Worried about Britain’s deficits, former Bank of England Governor Mark Carney had this significant repartee saying his country “lives on the generosity of foreigners”. He was thinking of the time when states were governed by the rule of trying to reduce public deficits during economic upturns. That era is well and truly over as we have become accustomed to spending lavishing, but also because we had very rare grace periods over the past 20 years.

The countercyclical doctrine of Keynes advocates that states pursue policies to drive demand, which often is through spending more and this is translated to actors opting to refinance their public debt eternally, maturity after maturity. But let’s face it: we have all known for a long time that some countries are technically bankrupt. In short, many nations of this world — powerful and respectable — live today on the generosity of others. The moment of truth is approaching for many of these sovereign debts which must also undergo an escalation of their financing costs. However, the fact is that real inflationary crises have always been caused by uncontrollable public deficits. The current inflation rates we have suffered so far may only be an appetiser if the markets decree that certain public debts are simply no longer sustainable for certain countries in virtual bankruptcy.

How then can central banks continue their rate hikes without harming the ability for repayment of public debts? How do they hope to fight inflation without aggressively raising their rates? In fact, the whole chain is contaminated, because the central banks themselves are under the mercy of the venerable Swiss National Bank, which has just announced a loss of more than 130 billion Swiss francs in 2022 (i.e. nearly 20 per cent of the confederation’s GDP!). No one is safe any longer, not even the central banks, whose salvation was expected during successive crises and who have actively participated in the rescue of the system — of which they are an integral part. The worm is really in the fruit, and the system begins to rot if central banks of such stature announce such massive underperformance.

The economy, the financial markets, sovereign debts, and private debts, are all fundamental links that constitute a very complex system that can remain stable for a long time, then literally tip over in a very sudden and brutal way. How can we still believe in such a system if a new major crisis were to arise?

Michel Santi

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