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Government IOU For A Better LifeThat's right dear reader, we are finally here! Breakeven was achieved in the year of our lord the mighty fiat currency of two thousand and fourteen. A year that shall forever stand in financial history as the year of the folly.

Although since this was not how this article was supposed to be, instead of getting to the point we will drive you through our thinking process

To task.

AN OCEAN OF DEBT

It all started when we asked ourselves what do government world-wide finances look like. We know that debt is rampant, increasing and getting close to The Year The World Defaulted but what else is there?

Well, to begin with, a picture tells a better story than words, so, we fired up our trusty spreadsheet software, did some graphing and created the pretty picture you can see below:

World GDP and Debt

The green line is the World GDP in trillion USD. The Red line is the World debt in trillion USD. Both lines are sort of wiggly (an engineer would call this "noise") and so this "wiggliness" of said lines prevent us from seeing clearly what's going on. In order to remove this noise, we draw two trend lines. These lines follow the average values of each line and can were drawn in black.

There are three notable characteristics of these trend lines.

The first one is that they are exponential, not linear. This is really bad news in terms of debt because this means it is accelerating rapidly… acceleration as in dynamics in classic mechanical physics. This means that its velocity is increasing all the time; this means that the amount of the debt is growing faster every day that goes by.

The second characteristic is that both trend lines intersect each other at about 2014. This means that this year is the year that the debt of all governments on earth became the same as the world GDP; world's breakeven point. What this means is that if every person in the planet would work for free for one full year, this would equate to the same amount of debt the world owes.

The third characteristic is that this makes the entire world financially unstable. Think of this problem like this. If your salary is 1000 RUB per months but your mortgage payment is 950 RUB/month, not only are you left with only 50 RUB to buy everything you need, but if there are extra expenses, you are screwed! You won't be able to afford them.

In government terms, this means that they defer to the unholy trinity: tax, borrow and print. Either one of those options is bad for you not only because it means theft, but because it makes the entire financial system unpredictable and hence unstable. Crisis anyone?

COUNTRIES DEFAULT

Consequently, as the entire world financial system becomes more unstable and countries are able to afford less while politicians must spend more, the percentage of defaults must increase, right?

Therefore, if we plot the percentage of countries that default every year, we must see a line going up all the time towards 100%. As debt increases more countries must default, right? Confidently, we pulled the data, graphed it and got:

World GDP Debt and % Default

Disaster! Since about 1994 the percentage of countries that defaulted has gone systematically down!!! Chaos. Despair. Could our logic be so faulty?

We doubt ourselves for a second… and then we remember that we are dealing with politicians and their acolytes the Power Elite. There must be another explanation.

One of the possible reasons as to why fewer countries default may be because when they do so most of their debt is wiped out. This makes them stable for a longer time, the time required to accumulate sufficient debt to default again. If this is the case, if we graph the amount of defaulted debt we should see a correlation. We did just that:

World GDP Debt Default

Alas, there seem to be no mayor correlation. Sure, noise levels are more-or-less correlated with the amount of defaulted debt, but not to a level sufficient to alter a world-wide trend. This is not it.

However, this does explain (at least partially) the anomaly between 2011 and 2013. As you can see in the graph, between those years the world debt decreased a lot. This flies in the face of all the financial news we have whereby most governments capable of affecting world finances are taking debt like drunken sailors. This being the case, how is it possible for the world debt to decrease?

The answer comes in two parts.

The first part is that government are lying. What a surprise. Data is being massaged. But this cannot be all.

The second part is that the amount of defaulted debt skyrocketed and this changes the picture. You see dear reader, the source of our data does not consider defaulted debt the same as regular debt. Regular debt is debt whose interests are being paid regularly. Defaulted debt is debt whose interests are not being paid at all. Hence, they subtracted one from the other! The reality is much more complicated than that. At a country level, debts are almost never wiped out entirely; they are "restructured". Sometimes restructuring means simply swapping expired bonds with long date bonds hence kicking the debt forward into the future. Sometimes it means exchanging expired debt with new debt at a discount (i.e. bond holders lose money, but not all of it).

And so we are pretty much certain that over time this "anomaly" will correct itself. There is an old saying among traders: trends always regress to the mean. In layman's terms, world debt will eventually follow its trend line (in black).

THE MYSTERY OF THE UNSINKABLE COUNTRY

By now the graph was getting too cluttered and so we decided to clean it up. We left the percentage of defaulting countries in it and we added a trend line. Then, we went shopping for the culprit. We found it buried in the data from the BIS (Bank of International Settlements). The BIS is essentially a Bank's Bank.

Derivatives

What they have noticed few years back is that the amount of derivatives at the world-wide level has just exploded. Derivatives were not a problem up until a decade or so ago. However, recently they have become a real ticking bomb (we will develop this angle in a different article). What interests us is how these derivatives could possibly have any effect on countries not defaulting. Take a look at the picture below.

World Percentage Defaults and Derivatives

The word derivative simply means a contract of some sort that can be bought or sold, its price depending of something else. This "something else" is the underlying physical stuff that actually has value. Hence the name "derivative" since its value derives from something else. Absent this "something else" derivatives have no value whatsoever. They are just contracts about nothing.

For example, a gold option is a contract to buy or sell gold at a specific price and a specific date in the future. For this privilege a buyer is willing to purchase an option and pay its price to the seller. The buyer is speculating that the price of gold will change in a specific direction while the seller is speculating that the price of gold will move in the opposite direction.

For example, let's say we purchase a "call" option for one ounce of gold at a strike price of 1400 USD / ounce, which expires in three months. We pay let's say 10 USD for this option to Joe. This means that for the next three months Joe is obligated to sell us one ounce of gold at the price of 1400 USD.

If the price of gold goes up to let's say 1500 USD/ounce, we buy one ounce from Joe for 1400 USD and sell it for 1500 USD. Our profit equals 100 USD - 10 USD (the price of the option). John loses 100 USD.

If the price of gold goes down, below 1400 USD/ounce, we won't be buying gold from Joe because Joe will sell it to us at 1400 USD/ounce while we can purchase it from the market at less than that value. We lose 10 USD (the price of the option) which is Joe's profit.

In this sense, options can be seen insurance against the price of something going up or down. We pay the premium and if anything happens the insurance company pay us. The insurance company is betting nothing will happen and therefore they will be able to pocket the premiums.

Insurance scams

But what have derivatives to do with countries not defaulting? Excellent question! If you take a look at the plot, you will notice a brown dotted line. This line represents the trend up to roughly 1994 which indicated that by 2019 all countries in the world should be bankrupted and in default. As you can see, this actually makes sense since the world-wide debt was increasing exponentially. However, something happened around 1994 that changed everything; we call it the Key Turning Point. If you look at the derivatives line (dark blue) you will notice that it skyrocketed roughly around 1994. More specifically, the amount of derivatives in the world reached the same amount of the world-wide debt or about 1/2 of the world GDP. Is this significant? We suspect so although we don't have definitive proof (correlation does not mean causality).

But again, what have derivatives to do with countries not defaulting? Simple; there is one type of derivative called Credit Default Swap or CDS for short. CDS is essentially insurance against a country defaulting.

Consider this. Before the derivative deluge, banks had to loan countries based on their risk assessment that countries will actually repay the debt. The higher the risk the higher the interest rate demanded. This rise in interest rates actually placed a ceiling as to how much a country could borrow. Passed a certain interest rate, countries would not be able to repay not even the interest on the loans. Hence, if a country had a few bad financial years, they could not replay the interests of their existing debt and they could not borrow more because the interest rates would be too high. Ergo, the country would default.

Let's assume that the country of Drunkenland would like to borrow money. They approach the RiskAverse Bank Inc. and ask for a loan. The bank looks at Drunkenland's financial sheet and sees that Drunkenland is in bad shape with a huge debt and no means to repay it. The RiskAverse Banks makes and offer: 20% interest rate and a limited loan. Drunkenland knows they can't even repay the first installment and so they go broke.

Enter CDSs. Let's now add one extra element to the mix. The InsureAll Inc. insurance company. The company approaches the bank and makes an offer. If the bank loans Drunkenland money at an interest rate they can afford (let's say 5%), and a small percentage of those interests go to InsureAll as premiums, InsureAll will insure the bank against Drunkenland defaulting. If the country defaults, InsureAll will repay the entire debt to the bank.

Voila! Financial alchemy! Drunkenland went overnight from a country that any bank would not look at twice (and most would turn their heads away), to a new juicy "investment opportunity".

And why would InvestAll taking such a risk? Because InvestAll would in turn insure itself against having to pay to the bank if Drunkenland would default. As you can see, this is a classic Ponzi scheme. Somebody, somewhere won't be insured and the full force of the default would fall on them. But this is not InsureAll's problem!

And so, through the financial alchemy of the CDS's, countries that would normally be defaulting like dominoes can continue to borrow. Sure, every new loan increases their total debt, but who cares! The new loan can pay for the interest rates of the previous loans… and when this is not possible… some other politician will be in power!

The term "financial alchemy" is incredibly apt. Alchemists we people who believed that by endlessly repeating the same experiment in the exact same manner, they will eventually get a different result. Same as politicians and economists. If it didn't work today, try, try, try and try again until everything falls apart.

CONCLUSION

We began this article by attempting to show you how and why the entire world-wide economic system is in dire troubles and unstable. We ended up showing why this problem has been kicked forward but by doing so this process guarantees that when the explosion finally comes it will be spectacular indeed!

You may choose now to believe us or not. It actually matters not. The die has been cast and there is no escape from the future. The only question is, will you be prepared when it arrives?

Note: please see the Glossary if you are unfamiliar with certain words.

 

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