"It's a Wonderful Life" - Why You Should Expect a Financial Panic

What needs to concern US lawmakers is an interesting report in Wired called "New Study Blames Greek Debt Crisis on Market's Invisible Herd."

Countries like Greece and the US issue bonds to finance projects or debt.

People, countries and financial institutions like banks buy these bonds. 

For example, suppose the US sells a $500 two year bonds at a 1% interest rate (real amounts are a million times larger but this will keep it simple).

So if I buy the bond for X dollars (whatever the price is but usually around $500) I will get my $500 back in two years plus my 1% interest.  The terms and details vary widely but the idea is you are loaning money to some entity that issues the bonds for a fixed period of time for a fixed amount of interest.

Now usually bonds are very solid investments - or at least they have been.  The idea that a city or state or the federal government would default was simply beyond imagination until recently.  Similarly other countries sell bonds, like Greece.

Now in the case of Greece some interesting things occurred prior to the Greek debt crisis.

First off, if your bonds are considered "risky" by the market typically they ask for a higher interest rate.  The more risk the more return.  Typically bonds are considered "low risk" because they are backed by sovereign national governments, state, etc. which are (or were) mostly immune from default - so they would be "safer" than a bank.  You accept a lower rate because you have a much higher chance of getting all you money back.

Now in the case of Greece the "risk" of a default got larger and larger over time pointing to a default sometime in 2013.  The study cited in the article (see it here) shows what should be obvious to everyone (but apparently not to academics and market-makers):  Instead of the risk simply rising in a linear fashion all of a sudden there was a panic which resulted in the "Greek Crisis" you saw on the news.

So instead of interest rates going nice and smoothly from 1% to 2% and so on up to 20% or more as the authors would have expected based on risk instead all of a sudden there was a panic well before the crisis.

The authors point out that without proper regulation this will happen again and again - perhaps here in the US as well.

So what am I saying here?

Perhaps the most well known example of something similar is the "bank run" in the Jimmy Stewart movie "Its' a Wonderful Life."  Jimmy Stewart's character owns a "Building and Loan" and when the evil "Potter" triggers a crisis those with money in the "Building and Loan" show up demanding the money in their savings accounts.

The only problem is that the money has been loaned out to build houses for others so there is no cash in the bank.

Normally the bank keeps some cash around with the expectation that not everyone at a given time will ask to withdraw their funds.

But in a "run" as shown in the movie things change - people "panic" because they are scared.  And the banks (or governments) don't have the cash available to repay.

Now a bond is not like a savings account because you get your money and interest back on a fixed schedule or at the end.

Instead, in the bond market, once people "panic" they simply stop buying your bonds.

Now if you are using bonds to fund things like roads then the road doesn't get built - which might be an inconvenience but is certainly not fatal to the country.

However, if you are financing debt with bonds - effectively paying Peter by borrowing from the bond holders (Paul) - you have a different problem.

If no one buys your bonds and your bonds are funding debt and you have to make payments, e.g., for Medicare, Social Security, etc. there is a serious problem.

And this is what happened in Greece.

All of a sudden people said "I want no part of these bonds!"  So the Greek government couldn't borrow to fund current obligations and rioting ensued.

Now the academics expected people to simply tolerate more and more risk by simply expecting a higher and higher interest rate.

The Greek problems had been going on for decades so its not like there was a sudden surprise in store... or was there.

Technically no - Greece was going down a linear road to disaster and at a nice predictable rate.

But investors didn't agree...  They saw that at some point soon there would be "too much" risk and decided to bail.

The US is headed down a similar road today.

We can keep borrowing money (we have borrowed about 100% of GDP - basically where Greece was).

Obviously we are a larger country with more resources - but also we have substantially more (and proportionally more debt).

The problem is that no one can predict what sort of information or event will trigger people to panic.

Hard assets like gold reflect this because they hold value independently of the US dollar.

There is no reasonable way to predict when and if panic will occur.  But if it does there will be a similar crisis here.

Printing money, on the other hand, doesn't solve the problem either because it devalues the investment.

The charts above show that several other European countries are on the same track.  The US is not shown but its in a similar state.

The US spends about $3.6 billion dollars a day - with about $1.6 billion borrowed via bonds (or manufactured via currency printing).
 And remember there are those smarter than you who will benefit from the demise of the US financial system.

We can only hope "Potter" doesn't trigger a run on US.