Cyprus is clearly in trouble but how did it exactly get where it is today?
Cyprus is a microcosm of the west. With just 1m people it makes for a simplified example of the basic problem that besets Europe, the US and Japan.
That problem is debt but there is more to it than simply going bust by spending too much. There is a process at work and it is the process that is impoverishing the first world.
This how the cycle runs.
Grow your state.
Why? The state grows because those in charge of the levers of government and the economy love the state and want more of it and they’d also like more compensation. Running a bigger state means more money all-round for those in charge.
Government people want to grow the state the same way as businessmen want to grow their businesses. Let us call those in charge of governments as “public sector entrepreneurs.”
The trouble is all this governing needs money to pay for it. You can only tax and borrow so much of today national income before you hit a wall. So to grow your national tax take, you have to lever the country up. You can tax tomorrow now if you can get your economy to borrow more.
So governments make credit more systemically available. They push credit by changing the rules. If you don’t get on the credit bandwagon you get left behind whether you are a bank of a family.
A credit bubble is created.
Grow the state some more.
To remain in power, send tax receipts to supporters and make more people dependant on you. People become quickly dependant on unearned income and will defend their cargo cult by keeping their benefactors in power.
Create an asset bubble through the credit bubble.
People love property. They will not see sense while buying it. They will take on all possible leverage to buy property. The state meanwhile taxes asset bubbles at every level, from new build (25%-50% of new build value), to capital gains, inheritance and stamp duty and license taxes. Re-mortgaging cash flows increase economic activity and are taxed. Pestilential property building kicks off. Asset bubbles create collateral bubbles which create more credit and more tax revenue.
Grow the state.
With more tax income, more people can be pulled into the public sector. Economic capacity shrinks as wealth creators sucked from wealth creation sectors into wealth redistribution sectors. Public sector generates economic activity but is the equivalent of “empty calories” as state sector payroll tax merely a book entry and resources misallocated by non-market driven processes. GDP rises even if that rise is purely based on spending by the state via non-wealth creation spending.
Debt bubble
Cheap credit is cheap debt. Economy loads up on debt. The cash is effectively created from by illiquid assets turned into cash through securitisation, a process enabled by the systemic encouragement of credit/debt by government and banking system mechanics. Invention of new financial instruments creates a runaway debt bubble powered by poorly understood mechanisms. Abuse, fraud and other malfeasance follows
Grow the state.
With asset and credit bubbles underway, state budgets look fine, even though the fiscal budgets are being financed by the hollowing out of the capital of the private sector through the taxation of asset and credit bubbles.
All parties are happy with their bubble valued assets and their easy credit lifestyles. Public sector largess further shifts economic balance towards to the public sector. Every new plaza gets a statue. The burden on the private sector increases as the balance of resources shifts further from market driven realities.
Increasing numbers of citizens become reliant and dependant on the state and reasons to be involved in the private sector diminish. Private sector especially manufacturing becomes emaciated.
Trade deficit bubbles.
New money flowing around the system drives consumption but a public sector heavy economy cannot supply enough private sector goods to fill demand. China etc. obliges and fills consumer demand and trade deficit explodes, sucking credit bubble cash out of the country to developing world.
Eg: Cyprus yearly government deficit is approximate to yearly trade deficit. Total bailout offered to bail out Cyprus is roughly equivalent to boom years trade deficits.
Trade balance is the hole in the bottom of the ship of state that ultimately sinks the economy. The trade deficit is the hidden menace that after years of running unchecked has eviscerated Europe and America.
Bubble cannot grow forever
At some point all bubble burst.
Credit bubble bursts, asset prices crash, government taxation take collapsed, budget deficit exploded, but with weak private sector, trade deficits remain high. Asset prices collapse, collateral values collapse, leveraged creditors collapse, leverage banks collapse.
Twin deficits bubble head past sustainable levels. (This used to be considered 60% of GDP, now suddenly 120%+)
Sovereign insolvency.
Here we are the end of the road for wests public sector bubble.
Call it Sequestration, Austerity or default, it’s the outcome of a process US, Europe and Japan have ridden.
What happens next?
Rebase your currency
Inflation is the crudest way of course, but there are others.
FDR did it in the great depression by confiscating Gold at $20 an ounce and then revaluing it to $32 an ounce a few months later.
QE will do the trick, haircuts can help and in the end default has always worked in the end.
In any event, the end of the wests government bubble is here.