Too-big-to-fail Banks Will Kill the Global Economy

Editor’s Note: Anyone who is still wondering whether or not California’s trillion dollars of state and local government debt is a problem, or, by extension, whether or not the $15 trillion of federal government debt, or the $50+ trillion of total market debt in the U.S., is invited to read the following article. While reading, they are invited to reflect upon California’s version of financially too-big-to-fail; Wall Street enabled public sector pension funds and public sector bond debt. When public sector union spokespersons indignantly insist that concerns about government deficits or unfunded public sector pensions are merely shibboleths promulgated by “right-wing extremists,” they are ignoring this fact: The global economy is in the terminal phases of a long-term debt cycle that virtually guarantees, at the least, severe and ongoing financial challenges to the solvency of our public institutions. How these financial challenges might be overcome is not within the scope of this particular essay, but exploring solutions is the charter of the Prosperity Forum. To visualize solutions, you must appreciate the problem.

There are not many things on which Harvard professor-turned-Massachusetts Senator Elizabeth Warren (D-MA) and I agree. Yet, to her credit, she has been sounding the alarm about the threat that “Too Big To Fail” (TBTF) banks represent to our economy. However, that is where our agreement ends. Like most progressives, she vastly overestimates the efficacy and wisdom of regulatory bodies that invariably become captive to the corporations they are supposed to regulate as that great revolving door refreshes the influence of crony capitalists regardless of who is voted into office.

In fact, the regulatory policies she proposes would increase the TBTF behemoths’ threat to the economy by further entrenching the alliance of Wall Street bankers, the Fed, the Treasury Department, the White House, and congressional enablers from both parties that brought us to this point. Until we figure out how to unravel this single biggest threat to our prosperity, the best we can hope for the next time the TBTF house of cards comes tumbling down is for the ensuing violence and privation to be contained long enough to avoid the emergence of totalitarian regimes both here and around the world.

Sound apocalyptic? Think our problems can be solved with a regulatory nip here and a fiscal tuck there? Believe that our fiscal and monetary challenges can be overcome if we just get “the rich” to pay their “fair share?” If you answered “yes” to any of the above, then you are part of the problem, playing into the hands of the interests you believe you can control through the ballot box. Because the people who are driving this particular runway trainnever have to run for office.

Let’s take it from the top.

1) The global currency system is headed for collapse.

This will be unlike any currency collapse we have ever seen. It will not be geographically containable, and will leave no safe havens. For the first time in history, central banks around the world are debauching their currencies in unison. Even the normally prudent Swiss are so afraid of the threat currency appreciation poses to their export industries that they have joined the madness.

Stable exchange rates and the fact that Consumer Price Index (CPI)-based measures of inflation remain muted have calmed alarm bells. Meanwhile, the swelling asset bubble created by this unprecedented monetary expansion is being explained away — and in some quarters even welcomed — as some sort of stimulus-driven economic recovery.

Hurrah, look at the booming stock market! Look at rising housing prices! Look at the expansion of consumer credit! Keynesianism works! The so-called “wealth effect” will awaken animal spirits and kindle aggregate demand, which will revive the real economy, backfilling the value already priced into the stock market. Real economic growth will return, mass unemployment will abate, and all will be forgiven.

Unless it doesn’t. And to date, it hasn’t. The remedy for that? Print even more money!

2) The perceived elimination of counterparty risk is financial crack cocaine.

The subprime mortgage meltdown gave us fair warning of what happens when investors believe they will be protected by government intervention when parties with whom they do business fail. The most egregious case is the backdoor bailout of Goldman Sachs and others through AIG, whose debts from reckless derivatives trading were paid out to creditors by U.S. taxpayers at 100 cents on the dollar. By refusing to allow AIG, Fannie Mae, Freddie Mac, and other failed financial institutions on the losing side of subprime mortgage bets to go through normal bankruptcy (which would have paid off creditors at pennies on the dollar), Washington was essentially telling the financial institutions on the winning side of those bets that they never have to hedge or discount their positions for counterparty risk.

This has profound consequences on trading behavior, as it distorts the incentives that should inform institutional risk management. Individual traders’ winning positions can grow without bound, matched by losing positions held by counterparties. Meanwhile, no parties have to worry about which side they will end up on because Uncle Sam will be there with a bailout, either way. And the bonus band plays on.

3) There is no safe exit from ZIRP.

Future historians will puzzle in amazement about how otherwise sophisticated people allowed the entire global monetary system to come crashing down because some Princeton professor got his hands on a printing press. Fed Chairman Ben Bernanke’s unshakable commitment to a Zero Interest Rate Policy (ZIRP) has impoverished savers, driven investors dangerously out along the risk curve, and baked a ticking time bomb into the federal budget cake. The last feat is quite an accomplishment considering we haven’t evenhad a federal budget for almost four years. But when and if Congress finally does its constitutional duty, the Fed cannot even contemplate a return of real interest rates to historical norms because interest payments on the federal debt compounded at 4 or 5 percent will be fatal.

And so, our money printing policy is in a Red Queen’s race where, “It takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run at least twice as fast!” There is only one way for this race to end. We have seen it in the Weimar Republic and, more recently, Zimbabwe.

4) We only await our Archduke Ferdinand moment.

No one knows what will trigger the panic that wipes away the unfounded confidence upon which our entire fractional reserve banking system is perched. Will it be the inevitable exit of Greece from the euro? Sovereign debt repudiation by Prime Minister Beppe Grillo? An Iranian nuclear weapons test that draws a military response from Israel, followed by a seize-up of oil markets? There are so many potential triggers to choose from. We will know that the moment is near when the smart money starts heading for the sidelines, to be followed by everyone else.

Except that it is always too late for everyone else. By the time global equity markets finish imploding over a few days of carnage, the well-connected insiders that caused the mess will be licking their chops totaling up their short positions, safe in the belief that when their counterparties go down, governments will somehow make good with yet another round of freshly printed money. Whether this is provided through bailouts or nationalization is immaterial. The damage will have been done.

What happens next? That is impossible to call. No one can predict what the collapse of the TBTF banking system will lead to when impoverished people in country after country begin clamoring to be rescued by a man on a horse.

About the Author:  In the 35 years since Bill Frezza graduated from MIT with degrees in electrical engineering and biology he has been a scientist, an engineer, a product manager, a salesman, a consultant, an entrepreneur, an author, a technology evangelist, and a venture capitalist. His early career on high-tech’s bleeding edge included the development of first generation electronic newspapers, home banking, home shopping, cable modems, multi-user videogames, wireless LANs, and wireless email, all of which became a success – for someone else a decade later. His 15 years as a venture capital investor working with early stage telecom, semiconductor, and biotech startups taught him humbleness, risk aversion, and the ability to identify ten fatal flaws out of five in any startup business plan. Frezza is a frequent guest on CNBC, FOX, and CBN News where he is challenged to reduce complex economic and policy issues into thirty second sound bites. More writing by Frezza can be found at This article originally appeared in the Huffington Post and appears here with permission from the author.

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