In May 2010, I wrote an extended blog-post entitled, “A Troubling Dawn in the Distance,” which assessed the European debt crisis through the lens of historical Western development.

With the Euro-zone in crisis after the surprise Greek decision to hold a referendum on the EU bailout package – or not –  this piece from eighteen months ago is timely and prescient.

Please read on and enjoy…..

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Monday, May 10, 2010

Confidence and Credit.

Clear away the underbrush and these are the fundamental organizing principles of Western civilization.

As we search for an explanation for the “great unraveling” that we see around us in continued financial instability, a view from history would identify “confidence” and “credit” at the core Western success, and the subsequent problem children of today.

Think about it.

Western civilization is essentially premised on a simple, deterministic view that we can control events based on our perceived knowledge of the rules that create the behavior of objects.1 If we are certain that we know the underlying principles of how something works, we can then collectively set up laws, regulations, rules, systems and processes that maximize the results we seek.

In a simple example, we know we can plan for tomorrow because of our certainty that the sun will rise tomorrow, creating a new day.

It is this abstract but powerful certainty of “confidence” which forms the basis of our society. The necessity of that sense of control is all the more important given the heterogeneous nature of Western civilization, where a common intellectual framework serves to organize diverse societies.

“Credit” is the natural outgrowth of “confidence,” which enabled the mechanisms of commerce by transforming assets and collateral into abstract expectations, subject to mutually agreeable and enforceable terms and conditions.

In the roughly 500 years since the discovery of America, this deterministic view – and the tools of “confidence” and “credit” – created the greatest leap in human development and well being in recorded history.

Consider this tangible economic analysis conducted in 1998 at the University of California, Berkeley.

 * In the year 1500, global Gross Domestic Product (GDP) – all goods and services produced in the world – was $58 billion.2

* It took 300 years for that value to triple to $175 billion, in 1800.

* The march to modernity, with its ever more complex social and economic institutions, hit its apex in the 100 years of the 20th century.

* Between 1900 and 2000, global GDP has grown from $1 trillion to $41 trillion; an astonishing increase in global wealth that enabled dramatic scientific, social, political, and economic development, and created a living standard unseen in human history.3

It bears mentioning, of course, that this march forward did not come without its own excesses, injustices and plain brutality. But it is the West’s deterministic path, never perfect but always perfecting, which bore witness from slavery, war, colonialism and monarchy to the rights of individuals, limited and accountable government, free markets and rule of law.

And from the ashes of global calamity in the aftermath of the Great Depression and WWII, came perfecting, integrated economic, financial and social systems and processes designed to prevent global war and promote economic integration and prosperity.

Those efforts were largely successful.

Despite a variety of military activity after 1945, the great powers never again went to war. And the economic and financial agreements set up in Bretton Woods in 1944, which were the genesis for global rules and regulations that set international economic policy, saw startling success.

Between 1900 and 1950, global GDP increased four-fold.  From 1950-2000, it increased ten-fold. Technological innovation, new markets and goods, efficiencies in production and shipping measured by orders of magnitude, and ever tighter economic integration all contributed to the vast, new wealth creation.

And it was all based in confidence; that we could understand the forces around us and create rules to control those forces to our collective benefit, using tools such as credit.

 As we consider our global conditions today, however, what if the domestic policies that we have set in motion, almost entirely with the best of intentions and consistent with our deterministic outlook, have, in fact, created forces that are beyond our control, and undermine the very institutions, policies and processes that are suppose to guarantee our economic and political security?

Said a different way, what if the natural evolution of advanced Western societies – their continued steps toward perfection – in fact are shaping forces that will overturn the very order that is the cornerstone of our prosperity?

What if the presence of credit without confidence has morphed into something fundamentally counter-productive, particularly in light of domestic spending priorities that are at variance with our ability to pay for them?

The future is in front of us, friends, and a great crisis in Western civilization is in progress.

We ignore it at our own peril.

It is not without a little irony that today’s crisis finds us in Athens, the cradle of Western political thought, and the straight-line source of our success and prosperity.

Today Greece is in turmoil.

Successive Greek governments have expanded the public sector to shower an ever increasing number of Greek citizens with generous benefits; either through public employee unions, or through programs for education, health care and pensions for the elderly.

These robust increases were not rooted in a model of economic viability – what Greece could afford – but on what was considered socially just; the right thing to do regardless of the cost.

And each new program created a new constituency in the public for that particular program, fostering a personal selfishness amid collective and expanding government largess.

The iron law of economics is that there is no such thing as a free lunch.

But in a democratic system that un-tethers expansion of social programs of the public sector designed for select constituencies – unions, students, the elderly – from how they will be financed, political and economic realities necessarily collide. The public good is suddenly undermined by the well being of the government-dependent individual.

That, in turn, paralyzes the political system, which can only reconcile economic reality and social expectations either by ignoring them, or taking steps that will all but assure that political leaders are voted out from power.

In Greece, elected officials chose a mix of denial and hope, essentially cooking the books to avoid having to face the painful fact that the government was providing a level of public benefits completely at odds with Greece’s ability to pay for them.

So they borrowed.

A lot.

As a new member of the European Union (EU), Greek leaders found that money was cheap, debt was easily off-loaded to hungry bond holders in other EU countries, and rosy estimates of future economic growth would take care of the rest. Similar to justifying a fancy new car on the high wage job you know you will get in a few years time.

But that’s not the way it worked out.

The spending spree instead, has left the Greeks with a sovereign debt that is equal to 124% of Greece’s GDP. So if you took everything Greece produces in one year and dedicated it to debt reduction; every salary, every manufactured good and service, the Greeks would still not be able to retire their outstanding debt.

The current Greek Prime Minister, determined to get to the bottom of Greece’s exploding debt, uncovered activities by previous governments which borrowed money to pay the interest on their debt. This is akin to taking out a new credit card to pay the minimum balance on your AMEX.

Anyone who has been in that situation knows where that ends.

And now that the full proportions of Greece’s crisis are known, there is a crisis of confidence.

Suddenly, Greek debt does not look like a good risk, so fresh loans – credit – to carry over existing, annual budget deficits, have become vastly more expensive. Greek debt is now untouchable for less than 18% interest, compounding the government’s debt woes.

And the only way out for the Greeks is nothing short of draconian cuts in spending and tax increases, designed to bring the budget into something approaching balance, and give investors’ confidence that Greece will not default on its debt and continue to pay its bills.

Of course, the draconian spending cuts and tax increases are borne by the very people who were so recently recipients of Greek government largess.

You can imagine that there is not a lot of appetite to accept cuts in services, pay and benefits, as well as an additional tax burden on less income, simply to pay foreign creditors. All this in an economy already suffering from high unemployment and anemic economic growth.

So the Greeks have taken to the streets in demonstrations that have become full scale riots, many organized by labor unions, protesting their unwillingness to accept the new reality.

This has set economic reality on a collision course with democratic politics, where political leaders are at grave risk of being voted out of office for taking steps that are essential for national economic salvation.

That collision, fuels an ongoing crisis of confidence and credit, which continues  in an unnerving downward cycle.

And the contagion is spreading.

Once the Greek model was exposed with all its flaws, other, over leveraged economies in the EU have now come under scrutiny, particularly Portugal, Ireland and Spain. These three countries have public debt that is respectively, 90%, 80% and 60% of GDP.

And all three are running annual budget deficits that call into question each country’s ability to control and service its debt.

Ireland is running a deficit at nearly 12% of its GDP, Spain at 8.9% and Portugal at 7.3%.  Thisconfidence crisis is causing the credit price of borrowing to increase for these countries, which like Greece, compounds the original problem and creates an unvirtuous cycle of decline.

Germany and France, as the anchors of the EU, are stepping in with a bailout plan to save Greece, while pressuring other, vulnerable governments in the EU to take aggressive action to curb their borrowing.

The EU bailout is no more popular with Germans than service cuts and tax hikes are with Greeks. German taxpayers are incensed that their frugality and relative cost consciousness is now being used to subsidize the reckless borrowing by the Greeks; essentially rewarding bad behavior.

But the sad truth is that at the end of the day, the Germans have very little choice but to be the guarantor of last resort if there is to be a united Europe under the Euro. The alternative is a cascade of sovereign debt failure that not only threatens to trigger sustained recession across the continent, undermines the European Monetary Union (EMU) and the Euro, but will ultimately undermine the stronger EU countries in the longer run as well.

Who do you think is holding all that bad debt anyway?

It’s German, French and other international banks.

This leaves the Germans with the unappetizing choice to either stem the hemorrhaging now by extending emergency credit – and hope that a sense of stability in Greece will buy time for other, troubled European economies while the nascent economic recovery takes hold – or watch as sovereign debt failure cascades from nation to nation and ultimately impacts the heart of Germany’s financial system, plunging the Germans and other economies into crisis and renewed, deeper recession.

But at just the moment Germany needs to marshal its political will to forestall an epic crisis, elections threaten to undermine the government’s ability to react, now and in the future.

If Angela Merkel’s Christian Democrats lose in a regional vote on Sunday, how likely is it that the ruling Christian Democrats will go out on a limb for the sake European unity or concerted European economic policy when such action will be at a premium? And what will that do to confidence in the European economic system?

Across the countries of the West, instead of a national unity to protect our capacity to create individual prosperity, we are now divided into groups, protecting our capacity to access national government spending programs; using the political process as a shield for personal selfishness in over-promised, financially destructive and targeted wealth transfers.

It has turned the most successful system designed by man to create wealth and prosperity on its head.

“Confidence” and “credit.”

They under-gird 500 years of unsurpassed progress and achievement in Western civilization. But that society and its core foundation are under fantastic pressure as economic reality catches up with decades of exponentially increasing and un-moored government largess.

Can our democratic political institutions adapt to make the fundamental changes essential to our continued prosperity? As Moody’s said, changes that will test the “social cohesion”’ of our society?

Ultimately, can a nation substitute shared sacrifice for personal gain, not to the detriment of their individual economic freedom, but in their expectation of what government can and will do for the individual; effectively rescuing us from our own public-sector avarice?

Can we take responsibility for ourselves once again?

The jury is out, but the wave is still coming.

That is chilling.