A lot of ink has been already spent explaining how bad US banks were in assessing their customers and how clever they were in discharging the undisclosed credit risk to others. And we will witness what this is going to mean for JP Morgan: if the 13 billions dollars fine is confirmed, it would be the largest fine ever faced to date by a private institution! Consistently with common practises in the banking world, the unspoken and implied message was that failure to repay debt (default) was only related to the debtor, not being able to ensure enough income to repay the debt. Systematic factors are indeed included in traditional credit analysis, but mainly to derive correlation between debtors, i.e. how likely the default if a debtor generates the default of another debtor.
Is it endemic?
We should consider another lens, genuinely systematic, which takes into consideration what money is. Because money is not linked to gold anymore and is fundamentally equivalent to debt, a credit crunch has to be fundamentally related to what money actually is! It is actually interesting to recall the simple example of the Fractional reserve. So: out of my $100 deposit, my bank will keep $10 as a fractional reserve and lend the other $90 to another customer: Peter. When Peter spends the $90, the recipient, John, will see his account augmented by $90. At this point in time, my bank statement will show a balance of $100 and John’s will show an increased balance by $90. This process can continue: out the exrra $90 John has in his account, $9 will be kept by the bank as a reserve and $81 will be lent again. Yes: in this example so far, $100 are the “real” money and $90+$81=$171 are the “virtual” money, generated through debt. Now it’s time to address another parameter: interest. In practice, John and Peter will have to give back $171 plus interest. If the bank has generated the $171 (that will be destroyed once the debt is repaid), how is the money to pay interests going to be generated and by whom?
Well, the short answer is that nobody has generated it! So there are two possibilities: either somebody generates this money – i.e. more debt – or these interests will have to be paid out the existing and circulating money. The first solution doesn’t really solve the problem because paying interests by generating more debt just procrastinates the situation for longer and makes it a bigger issue (it doesn’t stop countries to increase public debt in order to pay interest on older debt)! The second solution has a direct consequence though: if some of the circulating money – i.e. debt – is used to pay interest, some loans will not be repaid because the money has been destroyed while repaying interest on some other debt!
Default is a logical consequence of the fact that money is debt and that debt is repaid with interest. In other words, the system produces (undesired?) default by design: it should be expected that default occurs every time no further debt can be generated to pay for interests on older debt.
We should expect more
Following this approach, default is “part of the game” and needs to be expected, but with what amplitude? If its existence is linked to interest, it is reasonable for its amplitude to be linked to the interest rate levels: should high rates mean high interest amounts and higher number of defaults? Not necessarily: the dynamics is far more complicated and, anyway, not immediately: interests are usually post-paid and it require some time for the numbers to add up: i.e. years. This means that, in normal circumstances, every few years, a credit crisis needs to be expected. With all the relationships between economies that are currently observable – and all the ones that are not observable or we don’t know about yet – it is practically impossible to determine where the credit crunch is going to happen, but there should be no doubt it will.
So, it is acknowledged that the bad credit practices in place mainly in the US, together with a more-than-suspicious involvement of the rating agencies, triggered a series of consequences which the Global Financial Crisis has been the most serious consequence. But we should probably consider these as a contagion mechanism of a disease that actually has its root cause elsewhere: not matter how individual players organise themselves, the system will inevitably produce default. Misbehaviours will amplify or accelerate, as an electric sparkle, operating in a problematic debt-based monetary system, made of gun powder: the explosion shouldn’t be a surprise, should it?
There is no action from the Governments and/or the Monetary Authorities on this point. Strengthening risk processes is desirable but this system will create default anyway and would it really be such a surprise if another crisis happened again?
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