Why Can’t We All Just Net Along

Zero Hedge posted an article that asks an interesting question.  Every European country owes money to other European countries.  This creates a web of cross-linked debt.  Instead of each country laboring under the full nominal amount, why don’t they just cooperate and cancel out everything but the net debt?  This remainder would be very manageable for every country.

 Anyone with “common sense” should be able to grasp one thing about this supposition.  Each country borrowed, and hence got itself into debt, to run a budget deficit for many years.  This means each country consumed more goods and services than it could pay for by tax revenues.  Does it make any sense that this accumulated debt over many years or decades could be eliminated by a simple trick?

 As with many errors in politics and management, the fallacy becomes obvious if one eschews the “big picture view” (i.e. woozy floating abstractions) and dives in to the details.

 I read the paper on the site linked in the piece on Zero Hedge.  It was not clear to me if these numbers include only the sovereign debt of each country’s national treasury or if it includes banking system debt.  To make this simpler, let’s assume only sovereign debt.  This makes our case harder to prove, but stronger once proved.

 The paper discusses the problem of maturity and acknowledges that its simplistic method of putting all debt into three categories (short, medium, and long) was not realistic.  It notes that the fact that the true amount of debt at each maturity is withheld by the central banks is telling.

 What the paper neglects to address is that, in our worldwide regime of irredeemable debt-based money, debt is the basis for “money”!  Each central bank that buys this debt uses it on the asset side of the balance sheet against which it can issue money on the liabilities side.  Anyone who takes this asset away would be pulling the rug out from underneath the central bank!  The central bank would either keep the liability but witness the value of its currency crash as this would effectively be massive money printing in the true sense of the word: naked, unbacked paper created ex nihilo.  The affected currency would collapse, and prices of goods in terms of this currency would skyrocket (while they were quoted in this currency at all)!

 Or it would have to somehow call the liabilities, i.e. pull money and hence liquidity out of the markets.  How would this work?  Our system is based on (exponentially) growing amounts of credit and debt.  Every time the economy slows and begins to liquidate the malinvestments, the only antidote is to issue ever-greater amounts of fresh credit.

 So, how can this article blithely suggest that all of this credit could be pulled?  That would bring about a deflationary collapse, wherein every kind of debtor except the sovereign cannot get its hands on cash no way, no how.  The wave of defaults that cascaded through the economy would ensue until no debt, and no money, remained.

 One of the perversities of debt-based irredeemable paper is that it does not survive balance sheet consolidation.  The writers of this paper, and Zero Hedge failed to understand this simple (but unobvious) fact.

2 thoughts on “Why Can’t We All Just Net Along

  1. Gordon

    I understand your logic and you state that serious deflation would ensue if all the credit were pulled. But I ask the following: suppose that the various central banks stop printing money. Wouldn’t deflation also ensue (the thesis of Harry Dent). What is the difference. Also, what if we do not consider countries, but just banks? Bank A (non central bank) lends to Bank B, who lends to Bank C who lends to Bank A (at different times, different assets, etc.) Under these conditions, can the debt be netted out, in the sense that only differences are paid? Thanks. Gordon

  2. Keith Weiner

    Gordon: I agree, if they stop printing then massive deflation (i.e a forcible contraction of credit–see my paper here for more info: http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit) will ensue immediately.The problem when you add commercial banks is that it is not a closed loop only among banks. It also includes individual depositors, corporate payroll accounts, pensions, etc. Those would all have to be wiped out to net out the debt.


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