When the Weakest Critical Part Fails, the Machine Breaks Down

The assets are still phantom, the collateral nonexistent, the guarantees empty and the power illusory

Consumer spending is the bedrock of the global economy, and consumer spending depends on expanding debt and leverage. Once that subsystem fails, consumerism and the global economy grind to a halt.

by Charles Hugh Smith

The failure of any critical subsystem in an organism triggers a catastrophic, fatal decline. It doesn't matter if the rest of the critical subsystems are functioning at optimum levels; the failure of even one essential "part" leads to death.

The metaphor is easily extended to machines, where a perfectly sound engine will fail once the oil pump ceases functioning.

The cliche is that a chain is only as strong as its weakest link. The conventional wisdom is that the U.S. economy is so large and diverse that the failure of any one part will have only limited consequences on the economy as a whole.

But this belief was undermined by the financial crisis of 2008, in which the apparently "limited" implosion of subprime mortgage debt dominoed into a full-blown global financial crisis.

Conventional wisdom confuses redundancy and complexity. The implicit foundation of the conventional view (that the U.S. economy is so large and diverse that the failure of any one subsystem will have limited negative effects) is a belief that the system's complexity offers intrinsic redundancy: that is, if one part of the economy underperforms or even vanishes, it will quickly be replaced by the expansion or emergence of some other part.

This view can be distilled down to a belief in a sort of "automated redundancy," that capital and labor that is displaced by failure in one sector will naturally flow to a replacement sector.

This belief system fails to grasp the critical roles of financialization and consumerism in the economy. The two are of course intrinsically bound together, two sides of a single coin: consumption depends on expanding credit, leverage and assets, and financialization depends on consumers' expanding debt service and collateral.

When financialization fails, the consumerist economy dies. This is what is happening in Greece, and is starting to happen in Spain and Italy.

The central banks and Central States are attempting resuscitation by issuing credit that is freed from the constraints of collateral. The basic idea here is that if credit based on collateral has failed, then let's replace it with credit backed by phantom assets, i.e. illusory collateral.

In essence, the financialization system has shifted to the realm of fantasy, where we (taxpayers, people who took out student loans, homeowners continuing to make payments on underwater mortgages, etc.) are paying very real interest on illusory debt backed by nothing.

Once this flimsy con unravels, the credibility of all institutions that participated in the con will be irrevocably destroyed. This includes the European Central Bank (ECB), the Federal Reserve, the E.U., "too big to fail" banks, and so on down the financialization line of dominoes.

Once credit ceases to expand, asset bubbles pop and consumerism grinds to a halt. And since ever-expanding consumption is the bedrock of the global economy, the global economy will also grind to a halt.

There is no magic redundancy in a complex economy that ultimately depends on the functioning of a single subsystem, financialization, i.e. the permanent (and thus eventually exponential) expansion of leverage and credit based on phantom assets and illusory limits on risk.

As noted in Financialization's Self-Destruct Sequence, the one critical subsystem of the economy (along with liquid petroleum fuels) is self-destructing before our eyes if we look beneath the surface chatter of propaganda, bogus official statistics and officially sanctioned manipulation of stock, bond and currency markets.

As I observed in We Are All Muppets Now, everyone with a stake in the Status Quo wants the resuscitation/reflation to succeed, by whatever means are necessary, lest their piece of the pie vanish along with the phantom assets and illusory guarantees.

These expectations of security and wealth have been slowly raised to lofty, impossible-to-meet heights, and the inability to meet those expectations will inevitably lead to the wholesale destruction of institutional credibility: Heightened Expectations and the Collapse of Credibility.

Everyone who benefits from the continuation of financialization hopes it will continue expanding and thus save their piece of the Status Quo. But systems that self-destruct by their very nature cannot be fixed by waving dead chickens around and declaring "we will do whatever it takes to save the Status Quo."

This magical-thinking Cargo Cult mentality is the result of expectations exceeding the resources and surpluses of the real world: rather than accept losses, we prefer to place our faith in "leaders" who have painted radio dials on rocks and are busy declaring that they are now in contact with the gods of permanent prosperity, and that the gods will magically restore the broken machine.

Alas, it's all artifice, theater and stage tricks: the assets are still phantom, the collateral nonexistent, the guarantees empty and the power illusory.