Saturday, May 9, 2015

Global Economic Collapse: Part 1 Can it Really Happen?



Of all of the doomsday scenarios that have been floating around I think the most feasible is a global economic collapse. Economic collapse is not a new idea, in fact there have been several collapses through out our history. We are going to cover a few of these crises and their causes as well as similarities to what we are seeing today. Some will think this post common knowledge, others may see this as a revelation, and yes I know there are some who will think all of this is nonsense, that is okay.

What is Money?

Money is really nothing more than a social contract, a means of exchange, and a store of value. Modern money gets its value from two sources: 1 we believe it has value. I am confident that if I wish to purchase something I can take the little pieces of linen with a number and some pictures and writing on it and get what I want. If everyone woke up tomorrow and decided that these little pieces of linen paper were in fact just that the financial system of the entire world would collapse instantly. Thankfully that is not going to occur because we are creatures of habit and we still believe. 2 our government says those pieces of linen hold value.

When a government wants to legitimize a currency all they have to do is make it acceptable to use it to pay taxes, but many governments go a step farther and enforce that it must be accepted for private debts as well. This forces you as the individual living in this country to accept the paper as having value. This does not mean that you have to accept that currency exclusively. If I want to I can build you a bookshelf and if we agree ahead of time you could pay me in tomatoes or really anything else that we agree upon as long as that item is not illegal. This is called a fiat currency. Fiat money has value just because the government says so, it is only based on the strength of the country that issues it. In a true fiat based system the government decides how much of the money is printed and released each year. This means that the government is in total control of inflation and deflation. This can be a very bad thing.

Germany broke the link between the mark and gold and funded their war effort almost exclusively by borrowing. After World War I Germany was required to pay retribution to several countries, these payments were to be paid in hard currencies.  With no link to gold existing these countries would not accept the mark as payment. What did Germany do? The turned up the printing presses and started printing marks like there was no tomorrow. They were taking these newly printed marks and were purchasing gold and gold backed currencies like the US dollar (no longer backed by anything), to pay the countries retribution. This caused hyperinflation. 
"Germany Hyperinflation" by Delphi234 - Own work. Licensed under CC0 via Wikimedia Commons - http://commons.wikimedia.org/wiki/File:Germany_Hyperinflation.svg#/media/File:Germany_Hyperinflation.svg


Hyperinflation is when prices are increasing at an alarming rate. As you can see from the graphic above the value of the paper mark was nothing. Those that still had jobs were having to be paid daily and run out to purchase what they could in order to survive. The next day they would go into work to find out that their wage had been doubled, that sounds great but when a loaf of bread costs 200,000,000 marks, well you get the picture.

We Are Not a True Fiat Based System

Like I said above in a true fiat based system the monetary supply is determined by the government, the value of that currency is determined by the government, the only thing outside of the government that has any bearing on that currencies value is the perception of the governments stability by the public and other world economies.

We are not a true fiat based system, we are a debt backed system. Allow me to explain monetary creation briefly. The US monetary system is what is called a fractional reserve system. What most people think is that if I suddenly find a million dollars buried in the woods. I am extremely happy and I run to put this money in the bank. The first thing that will happen is I will get a visit from either the IRS or the department of treasury to make sure how I got this money. After I have proven that I am just lucky and not some criminal mastermind that has lost track of his senses, they will allow this money to go into the system. Now you would think that if we were on a 10% fractional reserve that when I deposit this million dollars that would give the bank the ability to lend out 10% or $100,000 thus keeping $900,000 in reserves. That is simply not the case. If I were to deposit a million dollar the bank would be able to loan 10 million. The million I deposited becomes the reserve. This is also monetary creation. With one sign of a pen and a journal entry the monetary supply has increased by 10 million dollars. This money did not exist until the deposit was recorded and even then only exists electronically. Every time a loan is made the monetary system expands, this is why inflation is higher during times that seem good, people are borrowing and spending money so prices go up.

Commodity Based Currency

Believe it or not prior to 1971 the US dollar was partially based on the nations gold reserves. At one time if you had a dollar, you could go to any bank and exchange that paper dollar for a dollars worth of gold. 

A commodity based currency can be based on anything that has real tangible value. There have been currencies based on tobacco, gold, silver, and even wool. These products have real value no matter what. But there can be problems with commodity based systems as well. Here is a goofy explanation.

Lets say there is a country called Rural Econostan and its currency the farthing is based on brussel sprouts. One Rural Econostanian farthing is equal to one pound of brussel sprouts and it is a fixed ratio. This year there is a record harvest, this causes the number of farthing to go up. Everything except brussel sprouts will go up in price because people will have more money and be trying to buy the same things. Demand will be high and supply will be constant, this causes inflation.

Okay so next year there is some weird fungus that cuts the average harvest of brussel sprouts by half. That would mean that there would be half as many farthing so prices on everything except for the sprouts would go down because people wouldn't have farthings to spend and companies would continue to produce at their normal rate. This causes deflation.  This is very watered down, but you get the idea.

A gold based system is more stable than one that is agriculture based, but it can still have its ups and downs. The Spanish Price Revolution of the 16th century is a good example. The Spanish conquistadors were importing gold and silver at an unprecedented rate. This caused pretty much everyone in Spain to have more money. These people with all of this new revenue tried to buy more and higher quality things, the problem was everyone had more money so prices went up. Even though the inflation rates they saw would be a blessing today, they placed a major hardship on the average citizen. Oh the difficult inflation rates were 1 - 1 1/2 % per year. So you can see a commodity based system does have some benefits but there are also some challenges.

Challenges of a Commodity Based System

So we are back in good old Rural Econostan. The currency is based on gold, not sprouts. There is a robust internal economy and the country is rich in resources. As long as gold prices are stable there shouldn't be any problems, but in recent years gold prices have soared. In Rural Econostan all of the imported items have gotten cheaper, a lot cheaper. Everything Rural Econostan exports has gotten a lot more expensive. People in other countries have stopped buying things from Rural Econostan. This has created a massive trade deficit. Manufacturing companies are leaving Rural Econostan so their prices will be more competitive world wide and unemployment has risen. There is no sign of gold prices moderating anytime soon. The only thing Rural Econostan can do is hope the prices stabilize, they are not large enough to have a major impact on global gold prices. Tough times are on the horizon. 

What Could Cause an Economic Collapse?

Okay so now we are to the point where we are talking about the things that could cause major trouble. What are the things that trigger national or global hardships. Why does one countries problems affect more than just themselves? Are there signs to look for as warning of economic collapse?

 Stock Market Crash

I honestly don't know anyone who personally remembers October 29, 1929 or as it is commonly referred to as Black Tuesday. If you were to ask a room of 10 economic geeks what caused The Great Depression all of them would agree on a few things, after that depending on how passionate about it they are there could be a fist fight. We are going to focus on the things that most would agree on.

Mass exodus to cities.

The time immediately following World War I was a time of prosperity and optimism for most. People were leaving rural communities in the hopes of a better future in the cities. This placed a strain on the infrastructure of many of the larger cities and also reduced the number of agricultural workers available.

Speculation

Speculation is simply betting on the continued increase in price or value of something. The stock market does not sell cucumbers or anything tangible for that matter. They sell little pieces of companies. If you owned a stock in "Rural Industries", you would be providing them with capital to help with development or expansion. In exchange for your money you would be sold a share in the companies future profits. The accepted price a share should bring involves a very complicated equation that one of my economics professors called  "The Equation from Hell". There are times that a share sells for more than it is worth, this is speculation that the company will do better than projections or that the company has enough goodwill capital to fetch an even higher price later. At some point speculation always causes grief. There may be people that make a great deal of money along the way, but someone will get hurt. Now imagine if all of the stocks were overvalued simply because everything was going so great. That is a big portion of what caused the Stock market crash.

Loss of Confidence

As people began to realize that the stock market might be in trouble, people began selling their stocks as a way to protect their value. The more people that sold stock the lower the price went. This scared even more people and like water goes down a drain in a spiral so did the stock market. The erosion of value continued for 3 years. Every industrial sector saw a decrease in demand so they all had to layoff people. Unemployment reached 25% in the United States.

Protective Tariffs

As the global economy was falling countries thought they would protect their citizens by stopping goods from coming from other countries and by extension increasing the likelihood that their citizens would buy things purchased in their own country. This didn't help it actually caused the flow of money to all but stop.

Natural Disaster 

A natural disaster shouldn't cause a global economic collapse, but it certainly could cause a regional one. Haiti after the earthquake in 2010 could have been a scene from an apocalyptic movie. Over 11% of the nations population was killed in a single event. Billions of dollar in damage to infrastructure and property. Production in the entire nation came to a halt.



Debt

We have already talked about Germany after World War I, so we won't discuss that one again here. There are plenty of other examples of national debt causing major problems. When a nation runs into debt there is normally not a major problem, the country is able to service the debt aka make the payments. Maybe the nation will run budget surpluses and be able to cut down or possibly even eliminate the national debt. The US has been debt free one time in its history and that was all thanks to President Andrew Jackson. It didn't last long, but it does prove that it can be done.

When an entity loans money, they really do not care if the borrower will ever be able to pay off the debt. All they care about is that you are able to service the debt. Servicing the debt simply means make the payments. In fact most lenders really do not want you to ever pay them off. They want you to make payments for a while then go back and refinance the debt and hopefully take a little money home with you after the deal is done. By allowing and even encouraging refinancing many companies are making sure that you are in debt to them for longer than you had originally intended. By doing so they are basically making you an indentured servant by your own choosing. Not only that, we have been convinced that this is normal.

The United States and most other industrialized nations have decided they do not like this whole budget thing. Living within our means is so passe. Most countries so far have done pretty well even with massive debt, but can it go on forever? Some think it can, but history has another story to tell.


Argentina was in trouble in 1983 when its national debt reached  45 billion. The interest on the debt alone was greater than all of the trade profits for the entire country. What did the government do? They scrapped the old currency and introduced a new one with a whole new set of loans. This helped for a while until commodity prices dropped dramatically. When the commodity prices fell Argentina again lost its ability to service the debt. During all of this mess the inflation rate averaged 220% per year. Yup, you read that right something that costs $10.00 today would cost $32.00 in one year. This average lasted for 13 years. Something that started out costing $10.00 in 13 years would cost  $36,893,488.15. 

As if that wasn't bad enough in July of 1989 inflation reached 200% for the month. In one month the item that cost $10.00 would be $30.00. The highest annual inflation Argentina saw during this period was 5000%  that same item would cost $510.00 in a year. Needless to say riots broke out and the president resigned.

How did they stabilize their economy? First the scrapped the new money and reestablished the old money. Second they set a fixed exchange rate with the US dollar, this gave their money value because it could be exchanged for US dollars. The International Monetary Fund also provided loans, extensions of loans, and even reduced interest rates to Argentina. Slowly ever so slowly their economy improved. Not without a lot of bumps in the road I might add. These problems really started as early as 1973 and the effects are still felt in Argentina today.

The Economic Collapse of the USSR

This one I will add to what many of the textbooks say. The Soviet Union had a strictly "planned economy". Everything didn't go as planned. The Soviet Union went through a period of what is called stagflation.

Stagflation is a period of time where the economy doesn't grow or contract. It kinda just limps along at the same level. But during the same time there is a high level of inflation and unemployment. Stagflation is equally as bad as high inflation and deflation, but does not compare to hyperinflation.

If stagflation had been the only thing the Soviet Union would have had to deal with, they could have probably made it through, but it wasn't. The United States president Ronald Reagen decided that the past nuclear defense strategy wasn't really a strategy at all. It was called MAD Mutually Assured Destruction. Doesn't just the name make you feel safer. The rational was that if either country launched an attack they wanted to make sure that everyone on both sides died.

Reagan decided that defense needed to actually be defense. He pushed for what eventually was called the Star Wars Defense Initiative. This focus was on detection of nuclear launches and destruction of nuclear missiles before they reached American soil. There is still some debate as to whether this would even work at all, but that really isn't the point right now. The Soviet Union in an effort to keep us with US military spending, spent themselves into oblivion. When the Soviet Union fell apart it wasn't because of some massive civil war, it was because the centralized government couldn't afford to take care of or even attempt to control these breakaway republics. They really did just fall apart.

Greece 2009

Everyone who halfway pays attention should remember at least part of this one. Investors started getting nervous about the Greek ability to service their national debt. The reasons for this fear are deficit spending (spending more money than they make) and debt to GDP(gross domestic product or everything the nation produces in a year) ratio. These two factors spurred a fear sovereign default. Sovereign default is when a sovereign nation refuses to pay its debt obligations in full or fully servicing the debt.

The IMF and the Eurozone took action and provided a two bailouts to the Greek government totaling more than 240 billion euro. Part of the requirements to receive the bailout was the implementation of austerity measures (tax increases, spending cuts, or both), structural reforms, and the privatization of governmental assets. Things didn't happen as planned. The government that agreed to these terms was unseated in the last election and negotiations are ongoing as to how to handle the continued crisis.

There are more examples, but you get the picture.

This has turned into a multi post series just due to length. Please see Part 2. It will be live 5/16/2015


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