My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 issues by Peter J Underwood, author
Last week I explained my analogy of the ‘Jigsaw’ as representing the global financial system and how each element interacts with others to form a complex adaptive system which falls under the laws of chaos theory. In this regard, a tipping point is reached when all the interlocking pieces of the structure collapse before sprouting a new construction; much like a forest fire allows young shoots to grow into new trees and bushes: see here: https://www.theburningplatform.com/2018/06/16/the-financial-jigsaw-issue-no-5/#comment-1636504 Today, I promised an intriguing mind-game along the lines of Albert Einstein’s excellent examples; so let’s get on with it and see what I mean about chaos theory and its effects within the global financial system.
‘The Financial Jigsaw’ puzzle mind-game
I want you to imagine a box in which there are ten jigsaws of one thousand pieces each, all mixed up and no picture on a box to help you understand what any one complete jigsaw might look like. Your objective and task is to sort all the individual pieces so as to eventually knit together complete pictures of all ten jigsaws. How would you go about it? What would you do first? Perhaps you might make a plan, a road-map if you will, following a methodology and thus working gradually towards the objective.
I have been battling with this problem in the real world for over thirty years, and finally some of the jigsaw’s pieces are beginning to link together, in small sets of two or three items, offering clues to the overall emerging picture. One piece appears to represent the tiny island of Cyprus. There is also a special bit, a ‘corner’ piece upon which is written the word ‘Banks’. There are many other individual pieces of the jigsaw, displaying random, odd words which we all know, for example: ‘Money’, ‘Debts’, ‘Credit’, ‘Austerity’, ‘Wages’, ‘Jobs’, ‘Gold’, ‘Savings’, ‘Mortgages’, ‘Benefits’, ‘Inflation’, and ‘Markets’ et al.
We will come across all of these items and more as we continue our journey of discovery. At present the pieces lack any context within which to link them together, unlike a real jigsaw, where the picture on the box offers guidance. I have a picture in my mind that I want to paint, in words, for you to see and understand. However, each piece also provides a ‘negative’ clue to its partner in so far that some jigsaw pieces show how they don’t fit together, indicated by their very shape. Other pieces that do fit do not test for a colour or pattern match in my picture.
Do you think that this is an impossible task? Would you give up at this stage, throw all the pieces back in the box and do something more interesting? However, if you are as intrigued as me to know about this game of the economic jigsaw of life and curious about potential outcomes, that will surely affect you and your finances, then clearly you are ready to understand a little more about this complex world of ours and ways in which you might gain from this additional information and knowledge.
Knowledge empowers and releases positive energy
A mantra of the quality control professional claims: ‘If I don’t know, I can’t act.’ This implies that knowledge offers the power to get into action. We are so fortunate today to have the Internet, easily and freely available, offering an amazing amount of information, but without an understanding, we can’t claim it as knowledge:
- ‘Data’ are just jumbled up numbers, symbols and letters,
- ‘Information’ is organised data,
- ‘Knowledge’ is understanding information and
- ‘Wisdom’ is the prudent application of knowledge.
It takes a lot of personal energy and effort to gain enough information to claim an understanding of a subject. As an example, here is my understanding of the ‘Cyprus Effect’ in general. The impact of the crisis in Cyprus is an example of Chaos Theory. Dr Edward Lorenz, the father of Chaos Theory, wrote a paper in 1962 summarizing his findings. He later defined ‘chaos’ more concisely as: “When the present determines the future, but the approximate present does not approximately determine the future.”
In simple language, Chaos Theory says that if you want to forecast the future you need to know everything about the present state of the system. If only one small element is missing at the beginning or a tiny disturbance is left out, for example a spot on the surface of the global financial ocean, it ripples outward, influencing and magnifying effects on the worldwide sea area. This is often referred to as ‘the butterfly effect’, when a butterfly beats its wings on one side of the earth, a hurricane is created in another place on earth.
Chaotic systems become unstable
In 2008 a local banking crisis in the USA reverberated throughout the world, requiring eventually over 20 trillion dollars to be injected rapidly into global financial markets – many times greater than the cost of the local event. This demonstrates the inherent instability of our interconnected, global financial system. A small change in perception can lead to big price moves on financial markets; it happens all the time. It happened on 15 April 2013 when the price of gold fell $250 virtually overnight.
In order to clarify the massive numbers we will come across in this series, like ‘billions’ and ‘trillions’, here is what they mean in numbers:
- One Million (Mn): 1,000,000 –one thousand, thousand
- One Billion (Bn): 1,000,000,000 –one thousand, million
- One Trillion (Tn): 1,000,000,000,000 –one million, million
These are very large numbers and difficult for anyone to imagine, especially as they have entered common use in everyday language. We will be meeting these gigantic sums often as our journey proceeds and it is worth continually reminding ourselves what they really mean.
The ‘Troika’ solution to the Cyprus problem breaks two taboos regarding financial bail-outs of the past five years. It wipes out the rescued banks’ senior creditors and gives large, uninsured depositors a serious ‘haircut’ – up to 80%! If creditors and depositors lose faith in weak banks around the world they could go under, taking down the global economy with them.
The global financial system is holding major central banks and governments hostage. The Cyprus bail-out/bail-in exemplifies other serious flaws in today’s financial systems; an important one is ‘moral hazard’. Because of implicit government guarantees, the players in financial markets, banks and other financial institutions can take extreme risks with other people’s money, and profit thereby, without fear of loss which they know will be absorbed by governments through their taxpayers.
When a weak bank offers high interest rates to attract depositors, as the Icelandic banks did in 2007, investors are attracted to these banks because they assume government bail-outs will prevent them from suffering losses. Thus weak banks can survive by raising interest rates to depositors and use these accounts to gamble in high-risk, investment markets. If they are lucky, they survive; if not, they fail, as would have happened anyway. Such a vicious cycle deepens the cost of a final bail-out or bail-in. The Cyprus solution puts creditors and depositors on notice to pay for the banks’ inappropriate gambling debts.
The impact of the financial crisis on tiny Cyprus reminds us that governments and central banks are beholden to the global financial system. When they try to correct a flaw in the system the resultant market reaction can bring down the whole house of cards.
Imagine that Italians are withdrawing all their money from banks. Would the European Central Bank be forced into guaranteeing all their deposits? Based on the Cyprus event, we would expect this not to be the case as well as adding controls to prevent funds moving outside the country, known as ‘capital controls’.
This expectation encourages people to keep their money in the bank and therefore is a key to stability. The global financial system is now so flawed that its very stability depends on implicit government guarantees. Unfortunately, such apparent guarantees ensure that weaknesses will remain. And we already know, from last week, that these ‘guarantees’ are not going to be implemented anyway.
This vicious circle causes the global financial system to become unstable. Next week we will read how these fundamental flaws in the global financial systems reinforce each other and keep the system balancing on a knife-edge.
To be continued next Saturday
That box of pieces is what’s going to be left of the Federal Reserve Bankster’s customers, investors and the taxpayers.
So true Robert, I entirely agree. If you want to understand more about the Fed try reading: “Splitting Pennies” by Joseph Gelet. I am in the middle of reading it and it really does explain much about Forex and the Fed et el.