If optimists are right, restructuring is better done sooner and in an orderly way; if they are wrong, the outlook is bleak
WHEN ONE surveys the broad sweep of human history it is hard not to be an optimist. From the time our species evolved the capacity to manipulate its environment the pace of material progress has been accelerating.
The industrial revolution turbocharged progress. Angus Maddison, a historian who specialised in attempting to measure economic output over millennia, calculated that 20th-century worldwide output – of food, widgets and services – was greater than that of the previous 19 centuries combined.*
Whatever quibbles one might have with the precise figures, few would deny that the transformation of the western world in recent centuries (and of Asia in recent decades) has been little short of miraculous. Its effects have been overwhelmingly, if not unambiguously, positive: almost everyone on the planet today lives longer, healthier and more comfortable lives than their forebears. The hundreds of millions of people fortunate enough to be part of the world’s rapidly expanding middle class live better lives in most respects than even the richest and most powerful a mere 100 years ago.
This big picture point is made in order to emphasise that I am not a pessimist by nature or by analysis. I am certainly not a catastrophist. But broad optimism about the direction of human affairs does not lead one to believe that catastrophe can be ruled out. Over time, as humanity has proceeded onwards and upwards, there have been catastrophic reversals. One such was the protracted population collapse on this island triggered in the 1840s.
While most reversals have been caused by natural phenomena, such as newly arising or newly arriving germs and changing climate, some have been man-made, including wars and environmental degradation. Entirely new man-made threats have emerged in the form of the fragility of highly complex critical systems, such as finance and IT.
In recent decades we may have been lulled into a false sense of security because many of the most talked about big risk threats to humanity did not, or haven’t yet, come to pass.
Nuclear annihilation during the cold war was avoided. Oil and food have not run out, as some have been predicting for decades. January 1st, 2000, came and went without the Y2K computer virus bringing down critical cyber infrastructure. In almost a decade, jihadists have not succeeded in carrying out even one more attack on the scale of 9/11. The extraordinarily virulent avian flu pathogen has not species-hopped from bird to man. The human impact of global warming has been small.
But the relatively good fortune of most of the planet’s populace in recent decades does not mean that big and bad things will not or cannot happen.
Last week the Organisation for Economic Co-operation and Development published an assessment of major global risks.** The need to conduct such an exercise, it said, was triggered in part by the greater realisation of the fragility of man-made complex systems following the (largely unpredicted) global financial crisis ongoing since 2008.
The OECD identifies five major risks to human society: pandemic; cybersystemic failure, geomagnetic storms, social unrest and financial crisis. The latter risk will be focused upon here.
Here is a worst case scenario (mine, not the OECD’s).
Country “A” defaults. Half of the wealth tied up in its sovereign bonds disappears. Its already teetering banking system, which is the largest holder of these bonds, quickly becomes insolvent. The banks fail. More wealth is destroyed as their shares become worthless. They default on their own bonds, resulting in more wealth evaporation. Meltdown occurs.
Internationally, as the repercussions of this country’s collapse reverberate, extreme risk aversion grips financial markets. A liquidity crisis of the kind that took hold after the collapse of Lehman Brothers sets in. This time, though, fiscally enfeebled states cannot offer credible backstops to their financial systems. Nor can they continue to borrow to fund their deficits, never mind provide offsetting fiscal stimulus. The weakest states are locked out of a seized-up bond market. They default. The fate of country “A” befalls them too.
More dominoes start to fall. The solvency of stronger but still high-debt countries – such as France, Britain and the US – is undermined owing to their banking systems’ losses on sovereign, bank, corporate and household debt in the defaulting countries. Banking and sovereign crises merge. Some timely downgrades by ratings agencies push them into default too.
A downward spiral of wealth destruction takes places. More and more financial assets become worthless, as the institutions behind them fail. No country that is integrated into the international financial system escapes. The system comes down like a house of cards.
The impact on the real economy of not having even a payments system is huge and much greater than in the 1930s – economies are much more financialised now than then. Households, having seen the asset side of their balance sheets decimated, slash spending (this is known as a negative wealth effect). Consumers hoard what they can and cease discretionary spending.
Non-financial companies fold in growing numbers as demand dries up, credit is unavailable at any price and there is no means to send or receive payments.
The end result is a global depression even greater in its severity than the 1930s.
Will this happen? Most probably not. Could it happen? Yes.
Those who advocate Greek default – a large and growing proportion of the economics profession – believe restructuring is inevitable. Best get it over with, they say. If it is done sooner rather than later it can be “orderly”.
They may be right. But if they are wrong, that country’s default could trigger the chain of events that lead to the nightmare scenario outlined above.
*http://www.economist.com/blogs/dailychart/2011/06/quantifying-history?page=3
**http://www.oecd.org/dataoecd/7/55/ 48329024.pdf
