The global economy is sitting on a volcano. What happens next?

Summary:  Previous posts have discussed our perilous situation and how we got into this predicament.  Let’s take a step back and ask why we are here.  The says much about where we’re going.

From National Geographic Jan 2008


  1. We’re living on a volcano
  2. Let’s look at the volcano
  3. How big an eruption might we get?
  4. What can we do to prepare?
  5. For More Information

(1)  We’re living on a volcano

Why do people choose to live on a dangerous explosive volcano?  People are too comfortable to move, and it pays to live there. The soil is often rich.  Some volcanoes have rich mineral deposits or tourism. And they probably will get lucky, as large eruptions occur decades or even generations apart.

Why do we choose to live on in a grossly unstable economic structure?

  • I believe my government can prevent or mitigate a crash.
  • I do not understand the risk, the odds of a crash and its potential magnitude.
  • We believe this system is the morally best choice or the economically optimal choice.
  • I believe that I can withstand a crash, or even profit from it (The rich often do, like Mr. Potter in It’s a Wonderful Life).

The Great Depression shattered most people’s faith in the West’s forms of free-market systems.  But not the faith of those rich folks who benefited, like the Kennedy’s.  Many of them found the New Deal’s efforts to mitigate the Depression’s effects more objectionable than the depression itself.

Now three score and ten years later we face a similar crisis.  Fortunately the world’s leaders learned the danger of allowing a deflationary collapse to take hold.  Facing an event roughly the same magnitude as 1929 (see here), they acted boldly and stabilized the global economy.  That restored confidence in our systems — but that complacency prevented reforms (like those during the New Deal).  Only the horror of the depression provided the impetus to overcome entrenched powerful interest groups.

The first aid was successful, but the underlying illnesses were not treated.  So in the fourth year since the crash we see the pox reappearing.  Cracks in the structure showing through the hastily applied paint. For example see About the May jobs report – a few new jobs, bought at great cost.

Perhaps we’re in the eye of a hurricane


(2)  Let’s look at the volcano

We face a different Act Two than experienced in the 1930s.  We avoided the long depression that led to WWII (which ended it, although not a “cure” in any usual sense).  The same arguments emerge, about the same economic theories. We’ve learned so little.

Last week we described The unseen but perhaps decisive grand alignment of the nations — how the EU, Japan, China, and USA all face major (but different) developmental challenges simultaneously.  If we all make good decisions, our successes will re-enforce one another.  Positive synergy.

And vice-versa.  That’s the volcano.

(3)  How big an eruption might we get?

In a May 2012 presentation Raoul Pal, publisher of Global Macro Investor, describes aspects of the volcano.

  1. The world has no engine of growth, with most of the G20 countries approaching stall speed at the same time.
  2. For the first time since the 1930’s we are entering a recession before Industrial Production, Durable Goods Orders, Employment and Private Sector Employment and Private Sector GDP have made back their Previous highs.
  3. These are the weakest ever-foundations on which to enter a recession.
  4. There are almost no brakes in the system to stop this, and almost no one realises the seriousness of the situation.

The first three points have been frequently noted on the FM website and elsewhere. After a crash and four years of slow and uneven recovery, a large fraction of the world’s people, governments, and businesses are weak — with exhausted reserves, of both money and will.  Another downturn will hit us hard.  Key institutions might break, as in 2008-09, sparking a spiral decline.

(4)  What can we do to prepare?

The last point, #4, is ludicrously wrong.  Many experts, such as Paul Krugman, have warned of our peril — and the misguided policies that have brought us to the brink of ruin.  Also, we have the tools to deal with these problems, using economic theory developed and tested during the past century.

For largely political reasons vast effort has been made to erase this history from our minds, erase the theory from our minds — and replace them with a form of learned helplessness.  Just like during the 1930s, when men like Robert Taft and Andrew Mellon advocated letting nature take its course.  The painful path that supposedly led to long-term prosperity (see Schumpeter here).  Unlike the actual policies followed in the US and UK, which they forecast would lead to serfdom (see Hayek here).

President Hoover wrote in chapter 4 of Volume 3 of his Memoirs (1951) that his Secretary of the Treasury Andrew Mellon (a 2nd generation banker) had …

… only one formula:  “liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate …. It will purge the rottenness out of the system.  High costs of living and high living will come down.  People will work harder, live a more moral life.  Values will be adjusted, and enterprising people will pick up from less competent people.”

The side-effects of this course — destruction of the middle class, further concentration of wealth and political power — were pleasing to the people that mattered, the stake-holders in America.

But we need not surrender to fear.  This is just an economic event, probably not as bad as 1928-1939 or 1883-1896.  It’s not a physical event, like a volcano, plague, or war — something that devastates our homes and factories.  Even in the worst possible economic crash nothing important changes.  It’s just a social event, the result of poor organization.  Wisdom and social cohesion can easily and rapidly repair the damage.  It’s a matter of choosing the right leaders and being good citizens.  Solidarity, common sense, and hard work are effective medicines.

In this way events during the next few years might determine the shape of the 21st century world.  For details see:

(5)  For More Information

For more about living with a volcano see:

For more about these matters see the posts listed at these FM Reference Pages:

23 thoughts on “The global economy is sitting on a volcano. What happens next?

  1. R Pal: “The problem is not Government debt per se. The real problem is that the $70 trillion in G10 debt is the collateral for $700 trillion in derivatives…”
    Yes, that equates to 1200% of Global GDP and it rests on very weak foundations. That is the end of the fractional reserve banking system and of fiat money.

    R Pal: “It is the big RESET”

    He calls it ‘the big reset’. That’s kind of catchy, actually. Banks with derivative losses that are so great, that they bankrupt the countries they are based in, cascading into bankruptcies of all large banks and nations. As far as the end of fractional reserve banking, well, that’s an extreme prediction. Even when there was a gold standard, they still had fractional reserve banking. It’s a mind-blowing possibility, though I’m kind of skeptical about this one.

    FM: “Also, we have the tools to deal with these problems, using economic theory developed and tested during the past century.”

    The tool is the legislature — and they should simply ban gambling in derivatives by the TBTF banks. Any institution that ‘cannot be allowed to fail’ should not be allowed to place bets which might end up being payed by taxpayers after a major failure. As has been said many times, we’ve socialized the risk, but privatized the gains.

    1. (1) I very much doubt this is the end of “fiat money”. That’s like saying a large black-out is the end of using electricity.

      (2) Derivatives. Widely misunderstood. Everything in the global economy is big, which let’s people cite scary numbers that are not so scary.

      1. Derivatives are normal financial instruments, used for centuries (eg, wheat futures).
      2. Most of that pile of derivatives is relatively harmless interest-rate swaps.
      3. The massive figure is a gross number. The net exposure — the important number — is quite small.

      Derivatives are poorly regulated, and hence a problem today. But letting banks gamble under government guarantees is insane, no matter what instrument they use. As we saw, they can go broke using plain vanilla loans and mortgages. Remember the early 1980s and 1990s banking crisises?

    2. “As we saw, they can go broke using plain vanilla loans and mortgages. ”

      Derivatives and bad loans go hand in hand — they had amplifier effect in the 2008 bubble because these subprime loans were insured by derivatives sold from AIG’s London office. The bubble could keep growing as long as there was just one TBTF stupid enough to keep writing insurance policies on crap. Right now, we still don’t really know the whole story with ‘Voldemort’ over at JP Morgan Chase, but it has weird echos of the AIG disaster. Some wonder-kid, over in the UK, making all kinds of money with opaque derivative deals in a branch that is connected directly to a large US financial institution? They’ve announced a $2B loss, so far. Maybe this is nothing, but, you know, I’m just getting curious and suspicious. That’s all.

    3. While the economically-ignorant news media has gone hysterical about derivatives, it’s just another financial machinery — with none of the magical effects you attribute to them. They were almost unregulated, and are now lightly regulated, and hence were abused by bankers playing heads we win-tales the government loses. But bankers have gambled in similar ways for centuries, long before modern finance.

      As for the JP Morgan, that’s just more hysteria. It was a small glitch, not even offsetting a quarter’s earnings. Misjudgements by industrial companies result in larger losses as routine. It’s a distraction from the far more serious macroeconomic exposures of banks, and their capture of the bank regulatory apparatus.

    4. It’s not magic, it’s just common sense. If you have a safety net, you take more chances on the wire. If the banks believes derivatives can make their dangerous bets more safe, they can take more chances and make more risky loans and bets. What it doesn’t take into account is that all these risky bets by the likes Mr. Whale over there in the UK, increase the fragility of the entire system. That’s what the ‘big reset’ idea is all about. When the defaults start, everyone ends up bankrupt at the same time, due to cascading failures.

    5. It’s not magic, but nor is it true. Individual bets like Mr. Whale’s affect bank profitability, but not solvency of individual banks — let alone the entire banking system. It’s a fake issue, run in the news media to excite and amuse the plebes without posing any threat to the banks.

      Banks are poorly regulated on several levels, and far too subject to failure. But the discussion in the news media is largely bogus; I’ve attempted to explain why in these comments.

  2. For a starting point as to why it happened read the great Australian economist Steve Keen, one of the only 12 that predicted what was going to happen.

    He also comes out with ideas of how to dig ourselves out of this mess, Michael Hudson being another. Steve Keen {website}. Must read list along with M.Hudson and Yves Smith, etc.

    1. “one of the only 12 that predicted what was going to happen.”

      Can you document that? I personally know more than 12 economists who expected a major deflationary event. If you include financial experts (most of whom have some economic training), then you’d need auditorium-seating to get them together.

      “For a starting point as to why it happened”

      That’s a good point. Although we know what happened, the “why” remains somewhat mysterious. Much of this was avoidable, and our failure to take the necessary measures is largely a political failure — with the usual complex causes. Why China waited so long to rebalance its economy? The US bank regulators failed to address the violations that created the massive mortgage bust. The EU leaders who failed to even see the widening competitiveness gap in Europe, and the resulting trade imbalances AND debt accumulation. And Japan…

      It’s as if someone was using goof gas on the world’s leaders.

  3. The prospect which concerns me is what would happen if the FDIC were to become insolvent, since it is as far as I know still operating in the red (and has been doing so since late 2009) as a result of the multiple bank failures stemming from the Great Recession. When you consider the fact that the overwhelming majority of Americans have most if not all of their money in the kind of deposit accounts protected by the FDIC — checking, savings, money-market, and/or certificate of deposit accounts — this is no small matter.

    People may recall that the FSLIC (Federal Savings & Loan Insurance Corporation), an equivalent to the FDIC for the savings-and-loan industry, became insolvent as a result of the crisis in that industry resulting from multiple failures and had to be merged into the FDIC. Granted, from what I understand, the FDIC could potentially borrow up to $500 billion from the United States Treasury if they fell into dire straits…but at the same time, forcing the American people to either risk losing most of their individual assets or go to such extreme lengths to save the FDIC would probably be more than they would be prepared to countenance and completely destroy whatever shreds of faith they still have in our government (which, as Fabius Maximus pointed out in a recent post, aren’t anything to crow about right now anyway).

    1. The financial sector acts as a shock absorber to cushion the real economy. Any large-scale economic disturbance will bankrupt much of the banking system. But that’s a minor effect of the shock, and among the most easily fixed through government nationalization or recapitalization (which has been done many times since 1929). Keep the loans alive and the depositors whole; let the bank bondholders and shareholders take their losses.

      Much economic reporting comes through the affected guilds, and so shares their obessions. The real estate industry lives on turnover, therefore they measure the health of that asset class by the commissions it generates each month (home sales). The banks dominate Wall Street, so the health of banks is the most important thing to its employees. Both nonsense.

      Worrying about the banks in a depression is like worrying about the post office in a nuclear war. How will they process all those change of address cards?

  4. ” It’s just a social event, the result of poor organization.”

    In other words, a symptom of entropy.

  5. How we got in this mess and how we get out are two very separate issues. Those who understand/understood how we got in, with all the social and financial machinery running forward during a credit expansion may or may not be the ones who offer good advise on getting out. The social and financial machine that brought us here running forward is ill equipped to carry us out running backward. That is the crux of the problem IMO.

    De-leveraging uses processes and institutions (bankruptcy, fairness considerations, changes in political leadership, structural changes, among others) that did not bring us here. Moreover, these same are by in large creaky, under manned and under funded, and subject to abuse by the powerful. Most complex machines don’t run backward as well as they run forward.
    I once toured a paper mill that made trees into toilet paper. The hundred yard long process train was called “Wilbert”. At the packaging end of the plant they had a sign that said,”If you run Wilbert backwards, he makes trees.”.

    1. That’s an important point, one on which I’m not clear. In medicine a cure (ie, more than first aid) often requires correct diagnosis. But who well does that metaphor apply to geopolitics.

  6. FM: “It’s as if someone was using goof gas on the world’d leaders.”

    That’s exactly what it seems like to me. You can research and study everything on this great crisis and you are always left with the question: how could this have happened!?

    I mean, you have to assume that those that lead us know a whole lot more than we do and the checks and balances that the government has in place would have been smart enough to prevent this all from happening.

    It completely boggles my mind and keeps me searching for why!

  7. I think it is more to Duncan Kinder’s point about entropy. The reason you can’t run Wilbert backward and make trees is entropy, and the second law writ large. For the same reason we can’t turn our economic crank backwards and get out of this mess. Complex systems don’t work that way. I have no idea how to turn toilet paper back into trees, but I guarantee it can’t happen by running a paper machine backwards. Those who suggest the path forward somehow involves doing the opposite of what got us here are dangerously naive.

    1. I’m skeptical that these analogies (eg, entropy) are of much use for economics, except as illustrations. Nothing in economics is really like entropy. The real question is the necessity of diagnosis in order to accurately prescribe a cure. My guess is “yes”, but not with conviction.

  8. The banks do not determine the health of the nation. As long as there is a functioning clearing system for transactions the marketplace will get along just fine.

    The concentrated banks are viewed as too-big-to-fail. That is only because they have been bribing politicians to socialize their trading losses. If we were to separate commercial banking from speculation, the fees from providing the transaction clearing function and inventory loans would serve commerce nicely without the big risks taken by the likes of JPM, BAC, GS etc. in speculating for their own account.

    There is a misalignment of interests at the heart of todays crises. The executives get bonus pay for taking risks, while the bondholders just want a steady return on their investment.and abhor the speculative risks taken by the current banking system. We should re-institute Glass-Stegall and get the job of a banker back to fee-for-service. If someone wants to speculate, fine, but there is no reason they have to have their speculation backed up by the taxpayer.

    Sovereign debt used to be viewed as risky debt. A Russian bond crash caused the demise of Long Term Capital Managment. Countries mandating low reserve requirements (or NO reserve requirements) for banks when holding sovereign debt is imprudent. This is the fault that is a the heart of the current Euro-zone debt crisis. This practice of no reserves for sovereign debit will be punished by the marketplace.

    It wont be pretty.

    1. “Everyone is asking the wrong questions about derivatives.”

      That’s quite a statement. Especially about one of the more closely studied aspects of global financial system.

    1. Most experts agree with you. Perhaps that’s even understated! Profits in financial firms are results of accounting calculations even more than in other kinds of businesses. Incentives — both reputational and compensation — that do not accurately adjust for the risk taken can seriously damage the firm. And that’s almost always the case in the US.

  9. I’d like to offer my perspective. I’m not an economist. I’m an engineer. I’d like to split my perspective of the financial system into two parts.

    One serves the real economy. That’s the one the finances real investment, profits, payroll, taxes real mortgages etc… I see nothing wrong with this side of the financial system. In this case money is borrowed into existance and repayed out of existance as needed.

    The other side of the financial invents ways to make money out of money,( capital gains). it is the source of all our problems. Rising asset prices introduce a positive feedback loop in the financial system. It draws interest and creates hype. People are willing to borrow money to take part in the boom and when the population of investors has been exhausted, the bubble bursts / the volcano errupts. The root cause is the positive feedback loop. Positive feedback loops cause systems to race uncontrolled to their limits and self destruct.

    The solution: increase taxes on capitol gains. Do everything possible to attenuate the hype. High taxes on capitol gains could stop this endless train of ponzy schemes and force the financial industry to refocus on true investments and producing products and services and profits.

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