Major Regime Change – The Debt Crisis

A regime change is a corner that you cannot see around until you get to it.  It is when many of the old assumptions no longer hold.  It is the start of a new set of patterns.  Regime changes are not necessarily bad, but they are disruptive.  Many of the things that made people and companies successful under the old regime will no longer work.  But there will be completely new things that will now work.

The current regime has lasted for over 50 years.  Over that time, debt went all in one direction – UP.  Most other financial variables went up and down over that time, but their variability was in the context of a money supply that was generally growing somewhat faster than the economy.

Increasing debt funds some of the growth that has fueled the world economies over that time.

But that was a ride that could not go on forever.  At some point in time the debt servicing gets to be too high in comparison to the capacity of the economy.  The economy has gone through the stage of hedge lending (see Financial Instability) where activities are able to afford payments on their debt as well as repayment of principal long ago.  The economy is in the stage of Speculative Finance where activities are able to afford payments on the debt, but not the repayment of principal.  The efforts to pay down debt will tell us whether it is possible to reverse course on that.  If one looks ahead to the massive pensions crisis that looms in the moderate term, then you would likely judge that the economy is in Ponzi Financing land where the economy can neither afford the debt servicing or the payment of principal.

All this seems to be pointing towards a regime change regarding the level of debt and other forward obligations in society.  With that regime change, the world economy may shift to a regime of long term contraction in the amount of debt or else a sudden contraction (default) followed by a long period of massive caution and reduced lending.

Riskviews does not have a prediction for when this will happen or what other things will change when that regime change takes place.  But risk managers are urged to take into account that any models that are calibrated to historical experience may well mislead the users.  And market consistent models may also mislead for long term decision making (or is that will continue to mislead for long term decision making – how else to characterize a spot calculation) until the markets come to incorporate the impact of a regime change.

This may be felt in terms of further extension of the uncertainty that has dogged some markets since the financial crisis or in some other manner.

However it materializes, we will be living in interesting times.

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Explore posts in the same categories: Assumptions, Black Swan, Change Risk, Complexity, Enterprise Risk Management, Modeling, Uncertainty

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