What we are reckoning with is the breakdown so big hardly anyone notices it. The model of a political economy set up in response to the industrial revolution is now worn out. Exhausted. Headed for the trash heap of history. We're not in the habit of giving advice here in The Daily Reckoning. Sure, we warned readers about the biggest threats to their finances in 30 years - the bubbles in tech stocks and then in housing. And sure, we urged them to buy what turned out to be the best investment they could have made - gold. And yes, we criticized governments for doing all the wrong things. But urging them to do the right things would be both futile and earnest. Futility doesn't bother us. But we can't stand earnestness. Left unchecked it leads right to world improvement...and thence to Hell.Still, in the spirit of civic betterment, today exceptionally, we offer a bit of advice to financial authorities all over the world. In a word:Default! When you have more debt than you can pay, it is always best to own up...default...hang your head...say you're sorry...promise not to do it again.....and go about your business. And do it as soon as possible.Whence cometh this august advice? From the pages of history - recent...and not so recent.In the second half of the 19th century, the Arab states borrowed heavily from Europeans. The Ottoman Empire was an anachronism. The modern state had already been developed by Napoleon and Bismarck. Meanwhile, in America, the War Between the States sealed the fate of the founding fathers' republic. The limited government of Jefferson became the runaway military government of Lincoln...and later the all- powerful social welfare state of Franklin Roosevelt. Back in the Old World, in the 19th century, modern technology gave Europeans a huge advantage over their neighbors. The Ottomans - who governed from the Balkans to Morocco - were being left behind. Their economies were less productive, so they lacked the tax base needed to sustain modern armies. So, they brought in European entrepreneurs and European capital to build railroads, canals and other improvements. Then, as now, declining economies were supported by more dynamic ones. "China's lending hits new heights," says a headline at The Financial Times today.China has the most dynamic economy in the world...with $2.8 trillion in reserves, most of it in dollars. It is lending money all over the world. It is America's biggest creditor. And now it is helping wobbly European nations go deeper into debt too.Foreign money comes at a cost. When the Ottomans couldn't pay, they tried austerity...and then borrowed more. The natives grew restless under the austerity measures. The debt grew larger too...as more and more money was needed to support previous borrowing. Soon, there was no way out. Backed by better armies, the Europeans foreclosed. France's general Bugeaud laid waste to Algeria's fertile plains. Later, France found a pretext to invade Tunisia. Italy took Libya. Britain invaded Egypt. Soon, Europeans were in control of all of North Africa...and much of the Levant.
Lesson # 1 - don't borrow from foreigners.
Lesson #2 - if you get into trouble, don't borrow more from the foreigners. Default.
And we return to our theme...Next, it was the Europeans' turn to be the borrowers. They got into a nasty, pointless war in 1914. The French borrowed from the English. The English borrowed from the Americans. The Germans couldn't borrow, so they printed money. Then, when the war was over...everybody waited to get paid. The Americans waited for the English to pay. The English waited for the French. And the French waited for the Germans. The Huns were supposed to pay reparations, but they were broke...so they printed more money. In the end, after many disasters, no one got paid...neither the Americans, nor the English, nor the French. Instead, they all suffered a worldwide depression and then another worldwide war.Same lessons: if you can't pay; don't try; don't pretend. Default. And now the European states are in debt again. Not because of war, because of the social welfare system...aging populations...and bank debt. They cannot pay. So they try austerity measures and borrow more. The Chinese and Japanese are the latest benefactors.In the US...the problem is similar. The government runs at a loss. Debt mounts up. The states implement austerity efforts; they have no choice. The central government, like Germany, prints money. Now, both America and Europe are the Old World. Their social welfare model is failing. It was developed as a response to the needs of the nation state in the early days of the industrial revolution. It was suited to an era with expanding populations, fast-growing wealth, large pools of factory labor and almost unlimited resources. Governments needed to keep the urban masses under control. It was no good to provide them with security, insist that they obey the laws, and let it go at that. The politician that promised only a dollar's worth of benefit for a dollar's worth of taxes was soon replaced by one who promised to give back $1.20...or $1.50. In theory, this made perfect sense. Once government became recognized as the servant of the people, rather than their master, the people had a right to get their moneys' worth. And then, why would anyone willingly submit to the authority of a government if it delivered no more than the citizen could get on his own? Why allow yourself to be forced to pay into the government's social security program, for example, if it paid out no better than a private plan? Or, if the government's health care system delivers no more or better service than you can get from private plans, what's the point?The promise of government's social welfare projects was that they would take money from the few rich and the many as yet unborn in order to give it to poor and middle class voters. That is, voters thought they could get something for nothing. And, for a very long time, governments could deliver. They simply relied on the next wealthier, larger generation to make good on promises made to the previous one. It worked for 150 years. But now the next generations are often smaller. And maybe poorer. The old live longer. And there are more of them. The rich are too few to pay the bills. The rate of growth has slowed down. The return on additional inputs of debt have turned negative, while trillions in unpaid debt and commitments comes due. Again, governments in the Old World have borrowed and promised too much. But rather than default honestly and openly, (forcing the people who lent imprudently to take the losses) they try to put the burden of the losses onto the innocent citizen...and the unenlightened investor.He will pay higher taxes. He will get less in services. His money...his savings...his pension - all will be devalued by inflation. If he has stocks...they too will likely be sold off in the financial crises to come.But let's look at another, more recent example. Iceland.You may remember, two years ago Iceland was a mess. Its banks had borrowed, lent, and speculated recklessly. Iceland's feds squirmed and winced. At first, the government decided it would do what Ireland was doing. It would rescue the banks...that is, it would bail out the banks' lenders with public funds.But when the public caught on to what was going on, a referendum was held. Voters rejected the bailout as if they were voting against sin itself. More than 90% of voters cast ballots against a taxpayer bailout. We were impressed. We wrote about it. The "Patsy Revolt of 2009" we called it.Unable to stick the voters with the losses, the government left the banks to default. Was this the end of the world? Did Iceland slip below the North Atlantic waves...joining the Titanic on the chilly, dark bottom of the sea? Did commerce break down? Did the Icelandic money become worthless? Was this the "end of time"...the apocalypse forecast in the Bible?Nope."Iceland is doing better than anyone could have hoped," reports Bloomberg.Inflation fell from 18% down to 5% last year. The cost of insuring Icelandic debt fell to less than a third of the price in early 2009. Unemployment is barely 6%."Thanks to its rescue plan," says the IMF, "the recession in Iceland has been less deep than expected and not worse than in the other countries deeply affected."How did they achieve this? Are the Icelanders smarter than the Europeans?Not exactly. They tried the typical dead-end solution. The trouble was, no one would lend Iceland more money. And once the public revolted, after realizing that it would be left holding the bag, the Icelandic feds had no choice. They had exhausted all the bad ideas. They were forced to go with a good one.The foreign debt was consolidated into a few banks...which then went broke. The remaining banks were left intact, ready to keep the country's financial machinery in business.Lesson learned: got too much debt? Default quickly. Make it clean. Make it fast. Make it work.There. That's all the advice we're going to give today. Any European or American government that would like more details could contact us on our mobile phone...if we had one.
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