In Part 19, I described the devastating impact of a societal default, and then I explained how the bankers averted it by creating a specie pool arrangement.
In this post, I’ll explain how societal leverage and societal diversification affect the risk of a societal default.
Societal Leverage
Remember the three kinds of societal leverage from Part 14? They are bank leverage, government leverage, and individual leverage. Let’s look at how each of these contributed to the near-societal default.
We haven’t added an Avarian government into the mix quite yet, so there was no government leverage at play here.
Next, take a look at individual leverage. If there hadn’t been so many individuals dependent on their expected income from that year to make good on their loans, the banks wouldn’t have dealt with such a high default percentage. But this is what happens when a society is suddenly flush with cash. People start making risky investments assuming money will continue flowing. There’s a generalized excitement that arises, neighbours seeing neighbours get rich quick and not wanting to be left behind, so they want to get in on the action to avoid being the ones who didn’t ride the wealth bubble up with everyone else.
Now, if people are making all sorts of investments with cash that they can stand to lose because they truly do have plenty of stored cash wealth to keep them going, then it’s not such a huge issue when some of that money is lost. But, as a rule, when society is suddenly flush with cash due to a dilution of the currency (through fractional reserve banking, in this case) and prices haven’t yet adjusted, this is not money people can stand to lose in most cases.
And, as for the banks, if they hadn’t been so highly leveraged, the high percentage of loans in default wouldn’t have triggered a bank run.
So high individual leverage and high bank leverage were the triggers of this near-catastrophe.
Those are my thoughts on how societal leverage contributed to this near-societal default, and, with that as context, it should be clear what the solution is. If you can avoid the sudden increase in bank leverage in the first place (optimally, by preventing the institution of fractional reserve banking), there wouldn’t have been the illusion of prosperity with a huge amount of surplus cash flooding the market, which means fewer high-risk loans and high-risk investments would have been made, individual leverage would not have ratcheted up so high, and society would have continued to generate wealth at a sustainable pace.
I think this is a good place to point out that booms and busts are not a “natural” part of an economic cycle. Sure, there are times when a natural disaster or a low crop yield can cause a loss of a lot of expected wealth from society, which will cause an economic downturn; and there are also times when a particularly high crop yield or something else can cause an unexpected influx of wealth to a society. But, as we just saw when I described Avaria’s societal default, these normal ups and downs are completely different from the economic torture incited by the booms and busts that come about from the wealth unit:money exchange rate rapidly changing as a result of human institutions (mostly banks and governments) tampering with the money supply. That tampering is what caused the initial boom through the illusion of wealth, and the aftermath of it is what caused the subsequent bust.
It’s like a spring that was pulled too far, and when the conditions that allowed it to be pulled so far like that went away, the spring contracted back suddenly. Normal economic growth and wealth generation build the spring to be longer, adding coils one by one. Sudden monetary expansion doesn’t add more coils; instead, it just stretches the spring. And the more strongly the spring is stretched, the more likely it is to suddenly recompress at the slightest provocation, the consequence of which is to rapidly destroy many of the coils that were slowly added one by one over many years of real economic growth.
Let me reiterate that point more concisely: Economic booms and busts are incredibly destructive of society’s wealth, and they are caused by human institutions tampering with the money supply.
Ok, now on to societal diversification . . .
Societal Diversification
If the society wouldn’t have been so dependent on a good crop every year to continue to make payments on their loans and keep up the house of cards, they could have weathered this much better. What if half of the new wealth coming into this society was from the farmer, but the other half was from exporting a product to other societies? Then a lower percentage of individuals in society would have lost all or part of their annual income when the crop was ruined, and that would have translated into a lower default rate, so the banks probably wouldn’t have been on the verge of collapse.
Income diversification is important for a society to help it weather unforeseeable drops in income streams.
These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If a society is highly diversified and not highly leveraged in any of the three ways, it will be an economically solid society, and investments in that society would have a particularly favorable risk-return profile.
Honestly, I wish someone would start calculating these things for the different countries in the world. It would establish an incentive for countries to be prudent with their leverage and become well diversified because doing so would bring more international investment money in. Of course, other factors would also need to be evaluated, such as corruption and the degree of economic decentralization/freedom allowed.
Speculation
One last thing for this week. I want to give my definition of the word “speculation.”
I believe a risky investment crosses over into speculation when the investment returns are predicated primarily upon the price continuing to go up.
If the investment is not actually generating any wealth through providing goods and/or services, or it’s only generating a little bit of wealth relative to its price (and without any solid prospects of it increasing that wealth generation significantly), then the only way to earn a good return on that investment is for its price to continue going up, which requires people to be willing to buy it for more than you did.
At some point, the hype over this continually rising price will die down as people realize that there’s no way this investment can actually bring in earnings commensurate with its price (ahem, tulips, beany babies, Tickle Me Elmo, . . .), and that’s when the buyers disappear and the last ones holding the investment take the huge loss.
The end result of speculation is not an increase in total wealth. The end result is just a transfer of wealth from the people who got stuck holding the investment at the end to the people who sold before the price started dropping. This is just like gambling. You’re making money off of others’ losses rather than from actual wealth generation, plus the deadweight loss of all the time and energy dedicated to the speculating.
Historically, the trigger for any speculative bubble is often a sudden influx of cash/perceived wealth just looking for a way to be invested, like what happened when the banks in Avaria instituted fractional reserve banking and rapidly lowered their reserve ratios. These days, there’s enough excess wealth around that speculative bubbles can happen even without a sudden influx of cash to an economy. All they need is a sufficient amount of hype to get the bubble started.
Let’s briefly apply this discussion to a modern topic: cryptocurrencies. Most cryptocurrency “investments” these days are nothing more than speculation, and I’ll explain more in future parts of this series why an intrinsically worthless currency (even one that cost a lot of electricity to mine, *ahem, sunk costs*) that doesn’t have a government requiring people to use it through legal tender laws is always going to be speculative in nature. Part 21 here.
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