An Untenable Equlibrium

I recently concluded Crisis Economics and found one of Mr. Roubini and Mr. Mihm's ideas incredibly interesting. They build upon Lawrence Summer's idea that China and the United States are locked in a 'balance of financial terror'. In essence, they argue that the world is in a state of equilibrium that can not last. The Chinese are dependent on the US to purchase their goods and to make good on its debt obligation. The Americans are dependent on the Chinese to continue producing cheap goods and finance their purchase. Such a state is ultimately untenable.

While this is one example of an international equilibrium that will eventually fail, there are countless examples of others. Simply put, the world is teetering on a dangerous precipice. This type of situation was shown during the bursting of the housing bubble in the US. Americans financed the purchase of new homes by borrowing from lenders who created bonds which were then sold to a vast number of investors. A large percentage of this debt ultimately ended up in foreign hands in Europe and Asia. The world was in equilibrium as long as lenders continued to loan money, consumers continued borrowing and home prices continued rising. As soon as any of these conditions failed (home prices stopped rising), the house of cards collapsed.

The United States and China find themselves in a similar situation today. Once either stops fulfilling its end of the bargain the entire system will collapse. The Chinese could stop purchasing American debt which would cause Americans to stop purchasing Chinese goods. Any action by one party would likely harm the other.

However, the Sino-American relation is not the sole unstable equilibrium in the world today. Major oil producers find themselves in a similar suicide pact with the industrialized world. Should they stop selling oil, their economies (in addition to their trading partners') would likely collapse. Similarly; many nations, such as the Greeks, Portuguese and Spanish, are locked in pacts with their creditors. These nations have based their economies on debt-driven social spending and must roll their debt quite often. Should their creditors stop allowing them to do this, their national economies would collapse and those who financed their spending would probably take major losses in any default. Such are the problems faced by many European banks in the current crisis. Likewise, the entire Euro-zone finds itself in an untenable situation as it must help its over-indebted members refinance their debts. A shift could easily cause the currency to fail or break up.

Fortunately (or unfortunately), this world is not one of only a simply equilibrium. There are many possible equilibrium and the current one we are at is likely non-optimal. Many of the situations described above are untenable and likely can not last in the long term. Once those regimes collapse, the world will shift to another point of equilibrium. Such a series of events can occur countless numbers of times. In fact, each recession is just a movement from one point to another. Creative destruction will occur and move the world economy to a more advanced state. The recent recession did not totally reset the world economy. Yet, if there is a double dip the world will likely move away from its previous unstable state into a new, more optimal equilibrium.