The world we live in today is incredibly interconnected. In some ways this is good because we can easily share ideas, goods and services among each other. In other ways, however, it can be very dangerous because problems in one place quickly spill over to other places. In fact, the global economy has often been likened to a set of dominoes which, if the first one is toppled will create a domino effect and bring the entire system crashing down.
Probably the most publicized of the possible domino chains is the ballooning sovereign debt of developed nations. The reason why this situation got so grossly out of control is because politicians win elections by making expensive promises – promises that can only be fulfilled by taking on tremendous amounts of debt. The naive electorate then obviously elects the politician promising the most outrageous welfare benefits and other government spending and expects to see these benefits immediately.
As an example, social security, Medicare and debt interest currently eat up close to 80% of US state revenue, leaving almost nothing for the remainder of government functions. As a result, the US government spent 156% of their tax revenues in 2011 (obviously requiring a huge amount of borrowing). Governments in many other western countries are in a similar position.
In day-to-day life, such a situation can continue only for as long as these insolvent governments are able to borrow money at reasonable interest rates. The interest rate that a government has to pay on the debt it takes out is a reflection of the confidence that investors have in that country to pay up at a later stage. A fiscally responsible country will be able to borrow at low rates because investors see borrowing to this country as a risk-free investment. Fiscally irresponsible countries, on the other hand, are seen as very risky investments and investors demand very high interest rates to compensate for this risk. Loan interest adds directly to a country’s expenses and very high interest rates can very quickly drive a country to bankruptcy.
In essence, this is what is happening in Europe at the moment. Investors are losing confidence in the ability of a number of Southern European states to pay back their debt and demanding very high interest rates on the loans they offer. These high interest rates add significantly to the expenses and the budget deficits of these countries, forcing them to either borrow even more or impose painful austerity measures. Both of these alternatives can quickly spiral out of control and lead to bankruptcy or, in the case of the EU, bailouts.
The reason why rich fiscally responsible EU nations choose to shoulder the massive expense of bailing out fiscally irresponsible EU nations is simply because they want to avoid the domino effect. Banks all over the EU hold the debt of these struggling Southern European states and heavily rely on the regular repayment of this debt as a source of income. If one of these countries defaults on their debt by declaring bankruptcy, this flow of income is cut off and many banks become insolvent as well. This will lead to massive financial turmoil and, above all, much fewer banks who can now buy the bonds (debt) of other struggling EU nations. As banks then become more and more risk averse, they will demand higher and higher interest rates on the loans they make to governments and thereby push more and more countries over the brink. If this process gains momentum, it can very quickly derail the entire global economy.
These problems are exacerbated by some other smaller scale domino effects within the economies of rich nations. The most prominent of these is the unemployment spiral. This spiral originates from the fact that the economies of western nations have become totally lopsided away from production and towards consumption. Developed nations have become expert consumers of the goods produced by developing nations by creating millions of jobs especially focused on bringing imported goods to local consumers in the most efficient way possible. In addition, millions of totally unnecessary luxury service-providing jobs have been created and the public sector has grown sufficiently large to become a massive burden of bureaucracy on productive enterprise.
This badly unbalanced system of people living way beyond their means is just another nicely stacked row of dominoes. When economic times turn downwards, people are forced to rein in their totally unnecessary consumption (which has been proven to bring no happiness in any case) and millions of pointless consumer and public sector jobs are lost. And since the majority of people working in this consumer economy are living from paycheck to paycheck and have virtually zero financial resilience, such a job loss immediately forces them on to government welfare and often gets them rioting in the streets as well. The increasing welfare withdrawals, loss of productivity and expense of containing riots are a further financial burden on the government, forcing it to borrow even more money which worsens the sovereign debt crisis, further destabilizes the global economy and only leads to further job losses.
It is therefore clear that we have created for ourselves an economic system that runs fairly well when times are good, but has the potential to totally implode during bad times. Interestingly, this is exactly the same for the individuals living in this system. We’ll take a look at them on the next page.