The Emperor’s clothes

It has always seemed interesting to me that the world accepts paper money, even though it is no longer backed by anything of value. Once, of course, a paper bank note could be exchanged at any time for an equivalent value in silver or gold, so the paper money was really just a promissory note. But most nations have abandoned that practice by now, and so the whole system now runs on faith. That works as long as everyone agrees to pretend that the paper notes (or now, their electronic equivalents) really have value, and in fact the system has worked well for decades now in that manner – though it does encourage governments to “cheat” by just printing more banknotes to cover their debts (the euphemism for this is “quantitative easing”, and the US just did that).

This comes to mind this morning as I think about the world financial crisis – or more accurately, the debt crisis. Europe is teetering along, having bailed out Ireland, and Portugal, and now Greece (for the second time), but in fact the measures taken thus far are clearly too little. Even with a 50% “haircut” on Greek bonds, the Greek debt is still about 120% of GDP, far more than the nation can ever pay off with its current economy. And now Italy is looking shaky as well. Greece, Portugal and Ireland were relatively small nations, but the Italian economy is simply too large to bail out.

So in fact a large number of European banks (and probably a few big US banks as well) are actually insolvent, since they hold bonds from various EU nations that will never be paid back in full, if at all. No one wants to admit this out loud, because it would cause the banks to immediately fail, and precipitate a major banking crisis around the world. But it is true nonetheless.

And we are playing the same game here in the US. The Federal government currently has financial obligations that far exceed any revenue it could ever possibly collect. I’m not just talking about the $14 trillion in national debt – I’m also talking about the estimated $70-100 trillion in future obligations for federal pensions, Medicare and Medicaid, and Social Security. Not to mention the estimated $5 trillion that Fannie Mae and Freddie Mac are short from bad mortgages. Not to mention the estimated $3 trillion in unfunded pension liabilities at the state and local level. (Notice we are in trillions here -- billions are small change in this conversation!)

So far American politicians have been pretending that the Emperor still has clothes. They have been pretending that minor adjustment here and there (cut $1.5 trillion over 10 years from the federal budget, tax millionaires, etc) will solve the problem. And so far the financial world has agreed to this fiction, because to admit out loud how bad things really are would precipitate a crisis.

In fact, it is not unreasonable to pretend things are OK for a while to buy time to fix the real problem. That would be quite a reasonable strategy. Unfortunately that is not what is happening, either in Europe or in the US. Nothing effective at all is being done to address the underlying problem – all the effort is on “patching things up” month by month to maintain the fiction and avert the crisis.

At some point, no doubt, the world will realize that the Emperor has no clothes, and then things could get very bad indeed.