"The man who prefers his country before any other duty shows the same spirit as the man who surrenders every right to the state. They both deny that right is superior to authority."
Lord Acton

Monday, December 26, 2011

Lessons Learned: The financial collapse of a modern nation

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. - Ludwig Von Mises (Interest, Credit Expansion, and the Trade Cycle)
no more runway
I've been doing some deeper thinking on what may be in store for us in the West once the prevailing economic forces of gravity cannot be delayed, or further pushed any longer.  This led me to look back historically at other similar situations, beyond those I've analyzed to death (Weimar Germany, Ancient Rome, Argentina, and the US in the 1970s).  This led me to think on a conversation I had with a friend of mine from Poland about the Soviet collapse.  So I did some research and found an excellent paper on the topic which had elements eerily similar to present time.  

Lessons from the Russian Meltdown - The Economics of Soft Legal Constraints: by Enrico Perotti

Several themes of note that should be on the radar are cash stripping, and rational collective non-compliance of law.  I remember talking to my Polish friend about the hyperinflation in the 90s during which he described the asset stripping of everything of value from anything that wasn't nailed down (copper from houses, lead, aluminum, anything that could be turned into cash).  This cash stripping happened at the institutional level as well, executives stripped assets and cash from companies, dumped it in shell corporations, which vanished overnight.

This was able to happen because of the sheer volume of illegal activity that was going on:

Fiscal authorities are forced to tolerate arrears, thus validating non-payment. Similarly, regulatory and legal reform cannot be enforced and diffuse criminality cannot be policed. (Perotti 11)

  • Stabilization measures enacted which effectively delayed the problem served to increase the severity of the resulting crisis once it couldn't be delayed any further
  • The structure of incentives, crony capitalism, and regulatory capture were pervasive and fundamental to the buildup and crash
  • State and regulatory capture increased until the collapse
  • Many financial institutions were effectively insolvent before the crisis and increased their leverage until the final collapse to gain short term revenue while the management cash stripped the institutions
  • Cash-stripping took precedence over productive activity and was pervasive at the institutional down to individual levels
  • Individuals taking party to the cash stripping increasingly shipped cash offshore up-to and after the collapse
  • Many bankers and white collar thieves were allowed to escape with no legal consequence
  • Businesses increasingly switched en masse to barter between firms (demonetization) - as a protection to cash stripping and delayed payment in a high inflationary environment
  • The rule of law and tax compliance decreased geometrically as the crisis approached (especially at the institutional level.  The low level of enforcement caused more firms to ignore the law, which made it ever decreasingly the likely that the company would be held criminally or otherwise legally liable to enforcement. 
  • Bailouts increase the future expectation of more bailouts - moral hazard
A really good discussion of collective non-compliance to rule of law follows below:
The main conclusion of this simple model with a 'compliance externality' is that the
degree of compliance depends on the beliefs held by the population about other
agents' behaviour as well as on the credibility of enforcement authorities. If
individuals hold pessimistic beliefs about either, they will all choose to ignore rules
and financial obligations, however low is their individual cost of compliance. The
result is a lack of contractual reliability and the inability of the authorities to enforce
any legal and fiscal obligation.
If government credibility or the legal punishment are high, or the compliance cost is
low, other things being equal compliance will be higher. But note that a
deterioration in any of the parameters has a further effect, as it reduces compliance
indirectly through a reduced probability of punishment.
State capture, of course, reduces the credibility of authorities, as they are expected to
bend rules themselves to accommodate special interests. This may reinforce cynical
expectations of the behaviour of other agents. Coupled with high average
adjustment costs, this creates an expectation of a critical mass of non-compliance,
which will overwhelm the enforcement ability of policy-makers and justify noncompliance.
(Perotti 11)

His formal model of rational collective non-compliance is also very interesting reading.  I would be of interest if this qualitatively spilled over into other criminal activity (murder, theft, ets) as well.

Other countries of interest to me that are on my research list include the former Yugoslavia, which surpassed Wiemar Germany's inflation rate by a significant factor.

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