The Coming Economic Collapse
The Coming Economic Collapse
Part III: A systemic meltdown (Free)
Issues discussed:
Systemic collapse implies cessation of day-to-day financial transactions.
Effects of this would be felt in all levels of ordinary life.
Preparation for this concentrates on keeping sufficient cash balances.
Please note that GnS Economics has an updating blog describing and following the Stages of the Collapse, we first published in December 2019.
When I was finalizing the second entry to my series on the approaching economic collapse, I realized that the meltdown of the financial system is something people tend not to know very much about. Yet, it’s the most pervasive economic phenomenon existing, because it affects the foundations of everyday life: how you pay, with what you pay and what is generally available?
The complete collapse of the financial system, or a systemic meltdown, is likely to consist of two parts. The first one would be the collapse of the banking system, which I have detailed in several posts (see, e.g., this and this), and the second the collapse of the financial markets. Their harsh effects would be felt directly in the real economy and everyday life.
In this piece I detail what will happen, when the financial system fails to function, where it leads to and how would societies cope after. It’s paramount to acknowledge that human societies are highly resilient and innovative towards shocks, and that money is nothing more than an IOU. I will also discuss the likely response of financial authorities.
What happens when the financial system seizes to function?
Not many know that we came extremely close of a systemic meltdown in mid-October 2008. By the second week of October, financial markets were panicked. The DJIA had fallen by over 22 percent, the FTSE by over 21 percent and the Tokyo Nikkei Index by over 24 percent in one week. Trust in the banking system was collapsing, and there was genuine apprehension that global banks would not open their doors on Monday the 13th. However, between Sunday and Monday night the leaders of the G-7 industrialized nations hammered-out a comprehensive rescue package for banks, which included borrowing guarantees, the recapitalization of afflicted banks and liquidity support from major central banks. Banks kept their doors open and credit kept flowing, although in diminished quantities. A systemic meltdown was averted, but we are likely to approach another such event.
A systemic meltdown would mean a cessation of all banking services due to the collapse of several major banks. Thus, this is an extreme version of a banking crisis. Here I briefly detail the probable effects of a systemic meltdown on the capital markets and the real economy, which we dubbed in the September 2020 Q-Review as the Reset.
What a Reset effectively implies is a collapse and prolonged economic and financial calamity. A wide-spread banking crisis leading into a systemic meltdown will spread mistrust throughout the financial markets, as well as restricting liquidity, as banks pull credit lines from both corporations and market participants leading to widespread ‘margin calls’.1 When the flow of credit freezes, all levered positions must be liquidated en masse, predictably leading to chaotic fire-sales across capital markets and skyrocketing interest rates forced by the meltdown of the banking sector—and capital markets collapse.
Alas, a cessation of practically all financial market activity results. Trading simply stops in many parts of the capital markets. As assets will become illiquid, a tsunami of defaults by investors and borrowers is likely to overwhelm both commercial and shadow banking sectors. It’s actually rather difficult to imagine a situation where majority of financial assets will abruptly lose all value, but that is, in fact what the Reset implies. That is, a re-denomination—a reset of practically all financial assets.
As a result, credit issuance throughout the capital markets will seize-up, like an engine without oil. Since credit lines from the banking sector will also be unavailable, corporate bankruptcies will accelerate at a never-before-seen pace. This will create wide-spread unemployment engulfing all sectors of the economy. Global freight will grind to a halt, because banks stop providing insurance and loans for the cargo, creating wide-spread shortages of necessities and factory inputs.
Cessation of banking services combined with corporate bankruptcies and skyrocketing unemployment will wreak havoc in the real economy and of course, in society, where real people, not statistics, live and interact. Credit lines are withdrawn, credit availability vanishes, mass foreclosures hit banks, MBS investors, and families, and cash-shortages emerge as electronic and card payments freeze. An extremely rapid deflation, in the range of tens of percent, would develop. Makeshift and alternative means of transaction are needed to cope with the lack of sufficient cash in circulation. Widespread rioting and looting will be likely as shortages develop.
It’s also possible that many governments will fail through social unrest, sovereign defaults and currency crashes. In this case, the central bank would become the only source of funding, which like catastrophic consequences, like explained in my previous entry.
What happens after?
The collapse of the Soviet Union is the only “systemic meltdown” or “reset” of the modern era. The dissolution of the communist union led the mafia to takeover many parts of the society previously run the government, especially in Russia, and trade among the countries was thrown into a tailspin. The privatization of the Soviet economy, run the International Monetary Fund (IMF), did not go smoothly and opportunistic people were able to amass massive wealth basically ‘overnight’.2
In the wake of the collapse, the GDP of Russia plunged by 50 percent and a very high inflation developed due to extensive use of central bank credit. However, societies did not break down. Ravaging inflation did, however, cause a wide-spread social discontent and a barter-economy, which manifested in demands for a strong leader. Effectively, Russia and Former Soviet Union (FSU) countries first entered into a systemic collapse and then into a hyperinflation.3 They thus followed the path I envisaged in the previous entry to the Economic Collapse series. Yet, we can argue that Russia did experience only a partial systemic meltdown after the collapse of the Soviet Union, because her financial system continued to function at some level at least.
Even if there would a complete collapse of the financial system and the government leading to a financial anarchy, we have to remember that human societies are extremely resilient. For example, Ireland experienced a six month bank strike in 1970. It was the longest of three banking strikes that hit the country between 1966 and 1976. During that time the 23,000 pubs of Ireland became substitute for banks and also clearing houses. They held notable amounts of cash and were giving them out against credible claims, i.e., I-Owe-Yous (IOU), like salary payments in different forms than cash from trustworthy employers. While IOUs were first written to an legimitate check paper, at the end they were written to any paper available, including spent cigarette papers and napkins. Pub owners also knew all their customers really well, so they provided ‘credit clearing’ by giving statements whether the IOU’s issued by a person or a corporation were credible. That is, they provided information to the parties of financial transactions, what was their income level, net worth and reliability (of paying bar taps).
We are of course in a much more diverse society, financially, than Ireland in 1970. Yet, we have crypto currencies. As long as power stays on, they can be used as a mean of payment, and that is where we would transfer rapidly if the banking system would collapse. Crypto banks and payment systems would be setup with ‘lightning speed’. Many crypto-based payment systems already exist and they are in use, e.g., in El Salvador, where I visited in December. Major stores would rapidly develop their own tokens and credit system based on them. Although, I am no expert in crypto, I am certain that global freight companies and new crypto-banks would rapidly develop crypto-based Freight derivatives, or Forward Freight Agreements, which would reinvigorate global trade. And, even if we would lose power for a short-while, we would develop paper and pencil type IOUs, like in Ireland.
Thus, while a systemic collapse would lead to a deep economic and financial calamity, our societies would be likely to rise from it like the mythical Phoenix bird. In some cases, the new system could actually be better, more transparent and (much) less corrupted than the current one.
Conclusions
While writing these lines, I actually started to ponder, is a systemic collapse what would be needed to fix our societies? Let’s hope we can find a less destructive way, but I think it’s soothing to know that we would rise and likely even thrive from the worst economic scenario imaginable.
The most important mean for preparation for a systemic meltdown is to keep sufficient cash reservers, preferably at home (and not in, e.g., banks). Stocking food may also not be a bad idea, while I consider that actual food shortages would not develop even though certain more ‘exotic’ items would become in short supply due to global freight seizing. The collapse of (all) asset prices would create an enormous buying opportunity, but for conducting an actual buying transaction would become cumbersome. Physical gold would, most likely, be hoarded, which means that it would be good keep that in stock. Yet, like I explain above, it’s likely that crypto-based payment systems would be be setup rapidly. It may thus be a good idea to keep, e.g., some share of assets in Bitcoin. This is also, because that way you would be likely to be able to take advantage of the fire sale of assets.
In last entry to this series, I will deal with, at least, the timing issue. I am pondering, whether I should include war in the analysis somehow. I hope to find clarity to it during my summer break. In any case, the fourth instalment will accompany the July World Economic Outlook of GnS Economics.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. GnS Economics nor Tuomas Malinen cannot be held responsible for errors or omissions in the data presented. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk.
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In “margin calls” the value of the underlying asset held using borrowed money declines to a point where it no longer is a sufficient collateral.
How the privatization of the Russia’s economy after the centrally-controlled rule effectively went was that teams of IMF went over the country (Russia) establishing private ownerships to factories, etc. Some individuals understood that if they could provide some form of a document that they control that particular premises, it would be assigned to their ownership. This paved a way for ruthless opportunism where ordinary people, e.g., former workers became factory owners overnight. However, we have to remember that never before had we seen such a cataclysmic societal and economic change in such a large country. The operatives and the leadership of the IMF simple lacked analysis and tools, and mistakes were made in the chaos that followed the collapse.
Monthly consumer prices rose nearly 300 percent in some periods, but the mean monthly inflation rate in Russia was “only” around 21 percent from January 1992 till July 1995. This means that it did not break through the technical threshold of hyperinflation with 50 precent monthly inflation rate.