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Published by Kirke Sööt in category Financial news on 11.12.2008
Gold price (XAU-EUR)
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by Alar Tamming, Tavex and Dr. Krassimir Petrov, Prince Sultan University
December 8, 2008

Mark Twain once said that “if you don’t read the newspaper, you are uniformed. If you do read the newspaper, you are misinformed”. It is no surprise then, even to people who don’t follow the news, that a truly serious financial crisis is sweeping the world.

The headlines of newspapers and internet portals speak for themselves. Readers are inundated with facts about what is taking place. At one moment, bank write-offs to the extent of trillions are being discussed. The next moment, notice is given of guardian-angel intervention by governments and interest rate cuts by central banks. Aid packages in the trillions exceed the calculation skills and comprehension capabilities of ordinary people by a factor of several times. The main message conveyed by all of this “information” is mostly emotional. While write-offs may lead the reader to pessimism – what will become of my life, the government creates a feeling of security with the aura of a paternal figure, adding trillions of dollars to banks and “guaranteeing” that bank deposits and security holdings won’t simply vanish. Those geniuses are on the task and will never let the system collapse, the reader thinks, so he turns his attention to the next page of the paper.

What is missing is a deep analysis of the causes of the crisis, as well as possible future scenarios – papers look neither in the distant past, nor in the distant future. The cause of the financial crisis is claimed to be driven by two emotions – fear and greed; blame goes to poor regulations and greedy Wall Street investment bankers; rhetorically is added the fact that crises accompany capitalism, that they have regularly occurred in the past, and that they will continue to occur in the future. Some stock broker releases investment advice that from a long-run perspective, now is a good time to buy stocks.

Unfortunately, investing in stock markets is never as simple as it sounds. If every time we buy when stocks are down and afterwards stocks go up, then we would be all fabulously wealthy. Naturally, it is forgotten that this is accompanied by inflation and a drop in the purchasing power of money. Moreover, the fact that the world’s largest companies and banks can go bankrupt is never mentioned in financial publications; neither is the possibility that the assets of shareholders could be completely wiped out. Bankruptcies of large companies and banks are regarded only as a theoretical possibility and relegated to the pages of abstract economics textbooks.

Fundamental Causes of the Crisis

But let’s start at the beginning, with the question of why the current financial crisis has occurred. The reasons are quite fundamental, not fear and greed, nor a lack of faith in the markets. The problems are not caused by loose regulations either. The crisis also has nothing to do with herd instinct, which helps along, of course, in the deepening of the crisis. These are, after all, only symptoms of the underlying problems.

To gain a better understanding, one must first take a look at history. Unfortunately, from inside the system, it is difficult to view the system as a whole; all that is visible are individual problems and attempts to fix them, instead of understanding that perhaps the entire system is basically built on flawed and shaky basis, that the foundation of out global monetary system is built on sand and the current financial crisis and the resulting economic crisis are objectively inevitable.

The current attempts by the government are, above all, a desire to preserve the status quo, a desire to sustain the unsustainable, a desire to extend the life of a pathological system doomed to failure from the beginning. But governments have always set the goal for themselves of preserving the system. An exception would have been Gorbachev’s declaration, were he to have announced that the socialist system is destined for destruction and should be replaced by a capitalist system. Also excepted are central bank press releases, where it is announced that the current financial system is fundamentally wrong. As stated – inside the system it is impossible to see the system’s faults.

The main fault in the current system is that monetary historical experience is largely ignored. Throughout history, all successful monetary systems have, in one way or another, been tied either to gold, silver, or some other real asset of intrinsic value. If money has been only a piece of paper or a piece of copper, the system has always collapsed.

Beginning in 1971, for the first time in the history of global finance, no currency in the world has been backed by anything. This monetary experience should be properly called an experiment, which is now reaching its logical conclusion. This includes some curious facts, such as the Estonian kroon, which is backed by a reserve currency, primarily the Euro, while at the same time the Euro itself is backed by nothing. And the Estonian Kroon is not backed by euro banknotes, but instead, in all likelihood, is backed by a mixture of German, US, and Japanese treasury bills. These are only government promises to pay that will, at the end of the crisis, make Estonia’s entire foreign reserves, gathered for bad times, almost worthless.

If money is backed by nothing more than government seals, decorated paper, and strongly voiced promises, greed enters into play. No army in history has hindered central bankers and governments from creating money out of thin air and then spending it according to their own vision. The modern term for this is credit money, the loaning of credit by the central bank that becomes money itself. In normal and stable systems, bankers have only been able to loan out money that they have in their own vaults, and they were also always ready to exchange issued paper money and obligations for the gold bars stored in the vault of the bank. However, there has come a moment when bankers realised that people were not coming back to request gold, the result of which was that worthless pieces of paper (read: banknotes and electronic impulses) were placed into circulation and if they issued supplementary paper currency, which lacked any coverage, nothing happened, at least initially. In the old days, the mess would eventually surface and the matter ended with either the bankruptcy of the bank or the destruction of the state’s monetary system through hyperinflation.

Currently, the entire monetary system is global, and therefore has lasted longer than usual. The process, which took place in Germany in the 1920’s over a period of 3-4 years, will last for 3-4 decades on the global market. Throughout history there has been no monetary system that was not backed by a precious metal or some other equivalent accepted by all, ever, without exception, that has remained standing. The current experiment cannot remain standing either. We have created financial “capital” in a heretofore unseen extent. This “capital” is incorrectly believed to be wealth, because it could be exchanged for actual wealth during certain historical stages. Unfortunately, all this financial “capital” and all of this financial “wealth” have little backing in real goods or productive assets. This is an inherent property of our modern-day fractional-reserve banking system. Te result is that, whether we want it or not, the entire global financial system will fall into chaos and will destroyed, and hopefully a new and better system will be created.

What will happen is another important question, and impulse psychology comes into play here. People have a tendency to view things, above all, with a short-term time horizon. This “short-termism” can be seen on the stock markets and by the developments in the financial world. Even though the crisis had already been predicted at the end of the 1990’s, financial analysts were guided by “mystical” numbers and assessed the condition of the current situation as good. This type of analysis reminds of the anecdote where a man falls out of a skyscraper; when asked by someone from the fifth floor window how things are going, he answers “so far so good, I’m simply moving quickly”.

The Initial Phase – Financial Crisis

Unfortunately, the depth and length of the crisis are currently being discounted. At the moment, the crisis is in its initial phases. What is taking place only has affected mostly the financial sector; there has been only a minimal effect on the real economy. However, at the latest by next year, the second phase of the crisis will begin, with spillover effects into the economy. In 2009, the weakness of the global economy will become central.

The current economic system is built on providing loans in ever increasing amounts, not on saving and the repayment of debt over time. If a private person builds his life on a series of new loans, where he repays old debt with new debt, then he would be considered crazy and would inevitably end up either in debtor’s prison or bankruptcy. If the same thing were to take place at the corporate and state level, then nobody would dare say anything. It would be considered perfectly normal. Where is the child from the fairytale who wasn’t afraid to cry out that the king was naked!

Companies have become accustomed to taking new loans, although the financial system is attempting to correct. A contraction of bank credit to the private sector is in place, and inevitably the economy will not receive the money (read: credit) that it was planning on receiving. In addition, financial companies are unable to sell financial securities to finance themselves, since even the currently successful companies that kept free funds in shares and securities in order to earn a higher return, have lost over half of their value.

This first initial phase is well familiar to us. We have lived with it for almost two years. The media has called it by various names: “The Subprime Crisis”, “The Credit Crunch”, and “The Credit Crisis”.

The Second Phase – Economic Crisis

The lack of money becomes evident in the second phase of the crisis – the financial crisis is replaced by an economic crisis, triggering massive bankruptcies that would spread globally in a chain reaction. After the series of initial difficulties encountered by home borrowers and the construction companies, there have been no bankruptcies so far in manufacturing, shipping, media, food processing, not to mention luxury goods like luxury cars, yachts and watches, or exotic businesses like space tourism. But their time will come. During the second phase of the crisis, another large sum of capital will “evaporate” from the market, because a company which is going bankrupt will leave nothing for shareholders and very little for its bondholders. In the second stage of the crisis, unemployment will begin to grow along with the wave of bankruptcies. The final quarter of 2008 is only the beginning. Remember that in 1931-1932, the unemployment rate in the USA was 20%, with one in five people unemployed.

The Third Phase – Hyperinflation

Throughout the series of crises, politicians will attempt to interfere in the game, but the third stage of the crisis will nevertheless begin. Since banks were “saved” with large bailouts, politicians will also begin to lavish corporations with various aid packages. The recent charade of automakers begging for money is only the beginning. Thus, measures will be undertaken that, in the opinion of politicians, will help the economy and save jobs, something that will likely become known as Obama’s “New New Deal”. This will include a multitude of spending programs and, above all, the loaning of credit with astronomical increases in the money supply, together with the classifying of the corresponding numbers into the trillions. Just like now nobody talks any more in terms of millions, so in the not so distant future no one will be talking any more in terms of billions. Trillions will be the order of the day. Perhaps bank lending standards will be relaxed. Perhaps the government will lavish the banks with a lot more money than it does today, just to keep them lending. Perhaps the central bank will directly monetize private debt. Perhaps the government will guarantee many more corporate loans, just like it recently guaranteed the securities/loans of the GSEs. Perhaps GSEs will proliferate throughout the economy, transforming the U.S economy into the “GSE Economy”, transforming a former great capitalist economy into a modern-day nationalsozialistische economy. Perhaps the government will implement all of the above.

It will seem for awhile that peace has arrived, that the crisis has been overcome, as if the bankrupt companies have been “saved”, although this will only be the calm before the storm. If there is already more money in the financial system than actual goods, then after the subsequent injections of money, more like dropping money from helicopters or  showering corporations with money, the economic ship will begin to heel.

In this stage, the third stage, the hyperinflation scenario will begin when people realize that the money in banks will buy them next month half as much as it did this month. Then panic will ensue. People will begin to buy essential and non-essential items, just as long as there is something of value that can be obtained in exchange for their colourful pieces of worthless paper. Manufacturing enterprises would no longer want to sell goods, because the money received in exchange for the sale of their goods is not sufficient to purchase the new raw materials. Everyone who sells an actual object or good for paper money is a loser, since the same money is no longer enough to purchase again the same goods. Money created out of thin air electronically has brought tremendous benefits to the initial users and issuers, but at the expense of the wider masses through the collapse in their standards of living in this stage.

The third phase will be chaotic and difficult. The details are difficult to predict, but if history is any judge, the politicians won’t be asleep. They will likely pass a number of important laws, prices will be fixed, wages will be standardized, foreign currency accounts will be frozen; in general, everything that could be done, will be done, and this will only serve to extend the agony. Social upheaval and riots will be suppressed by brute force; many democratic freedoms and values will likely be lost. As of today, the hyperinflation spiral and Zimbabwe Syndrome have reached the point of no return.

Final Phase – Monetary Collapse

In the event that democracy survives, then the fourth and final phase will begin, a phase which can be called The Darkness before Dawn, the final agony before the rising of the sun. This is the ultimate destruction of the monetary and financial system, the loss of all electronic and financial values that is accompanied by monetary reform throughout most of the world.

In the worst case scenario, this will result in the creation of a Global Government; in the best case scenario, the process will take place separately in each country. For example, at the end of the Tulip Mania of the 17th century, all futures transactions with which tulips were bought and sold for millions of florins were declared void. Similarly, all electronic assets, contracts, securities, and futures contracts will be declared void, because the world doesn’t have a court or executive power which is capable of enforcing bankruptcies and debt collection resulting from millions of non-performing contracts. Only the actual collateral for loans will be demanded – land, houses, apartments. The losers will be private persons, while legal entities, along with their debts and non-existent collateral, will be lost in the virtual world, the place from whence they came.

Things will begin again with a clean slate. We will once again all be on an equal level. Railroads and planes, bridges and houses won’t disappear. All real wealth will remain, lost is only the paper wealth, those things that people believed they had and that they believed someone else (read: government, banks, pension funds, etc) will preserve for them. At that moment, faith will truly have been lost, as the fruits of a person’s life will have, through several metamorphoses, been transformed into banking sector profits and executive bonuses that had been spent by the suits long before the crisis even began.

The new economic system will be different than the current one. Its type, shape, or form is impossible to predict at the moment. Similarly to the end of the slave-holding system, it was not possible to see the creation of the feudal system. It was also impossible to foresee the blossoming of capitalism before the industrial revolution in England in 1785. So, it now is impossible to predict all the changes, although those changes are inevitable. Each process must go through its historical development and must reach its natural conclusion.

History shows that every changeover from one organisation of society to another has been very painful. Nevertheless, each following step, no matter how painful, has moved humanity forward and offered a better life to more people. Hopefully it will also go forward this time. All we have to do is hang on.

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