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Article from Stuart Lawson.

How did we get here?

Enough, enough! One headline follows the next proclaiming the imminent end of the economic world as we know it. Sages are dragged from their caves and asked ‘what next?’ and they proclaim doom, gloom and more gloom. A few months ago, the world seemed a lot brighter and the prospects good that having recovered from the last crisis, we were set fair for a recovery, powered by a resurgent East and enabled by the well thought through actions of the political class.

The new reality appears simply dreadful. The recovery in the USA stalled and the committee that was appointed to bring together the deadlocked Democrats and Republicans, is itself deadlocked and unable to offer any realistic solution to the public debt crisis. The news from the Eurozone is even more alarming as sovereignty has to take a back seat to the requirements of the technocrats to address the need for unpopular austerity measures. Unelected leaders have taken power in Greece and Italy and the market waits in judgement to see whether cuts are deep enough, actions determined enough.

But what about the electorate? What will they say to these new leaders in the coming months when there is the need to actually vote for the measures imposing pain on their countries to rewind the past? A schism potentially opens between the actions required of the politicians by the market and the aspirations of their electorates.

So, how did we get here? Not technically how did create these fiscal imbalances? Not, what were the interest rate policies, exchange rate agreements and trade balances that created this, but what was the fundamental reason that collectively the major economies have drifted so close to the edge? This is an extremely complex situation but one element relates to the debt taken on to deliver a better quality of life.

Perhaps it is just the result of evolution. When populations exist in subsistence mode, whether that is from poverty or as a result of a post war need to rebuild society, expectations are limited. It is a case of getting through the next day with enough food, water and shelter to provide for those in their immediate circle, normally the family and perhaps close friends. There is an expectation that the society will enable this to occur in an environment that is essentially safe and that doesn’t threaten the individual’s ability to attain these goals.

As the society achieves these goals and moves to the next stage in which the population has access to education and can start to plan for its future, new dynamics appear. A middle class emerges that wishes to consolidate the progress it has made from generation to generation. Alongside this, aspirations grow and a widespread desire to improve its environment takes hold.

Against a backdrop of global growth, it is natural that these expectations will gradually build on one another and the concept of relative deprivations will appear. People will no longer view themselves in a vacuum but will compare their progress with that of others that they define as being within their same socio economic class.

Enter the concept of leverage. By using debt, consumers can accelerate tomorrow to today and provided social norms exist for this to occur and there is a functioning banking system that provides the mechanism to achieve this, society will gradual take on more debt to facilitate this enhanced lifestyle (of course this is simplistic and takes no account for borrowings acquired out of necessity). There is nothing untoward in this, provided the leverage is not excessive and provided there is sufficient economic growth to sustain the increase in demands on the consumer’s income made by the debt burden.

The model does not work when the chemistry between the banks and their customers enables an environment of excessive risk taking by both sides. If this does occur and then there are subsequent shocks to economic growth (as occurred in 08), the fragility of the system is exposed.

Unwinding these expectations is a painful process and starts with a realisation by the individual of the need to accept a period in which, not only will their future expectations of enhanced lifestyle not be met, but they may need to accept a reduce quality of lifestyle as their reduce their leverage.

Unfortunately, it is not only those that are directly responsible for increased leverage that will need to reduce their expectations. Because of the interconnected global market, whole nations may need to endure low growth and lowered expectations until the excessive leverage is removed from the system.

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