Russian roulette in an unstable world

Obviously, now that the backlog is into many, many hours, lots of the crew who could work are prevented from doing so as they would be over the acceptable working hours per week or month. Here in the business lounge after 12 hours, it’s like a refugee camp for people with lots of air miles, and the levels of middle-aged male indignation is rising ever higher. The Filipino stewards are doing their best, but they have about as much idea about what is going on as the rest of us. However, their Etihad uniforms makes them legitimate targets for customer ire.

This collapse this morning got me thinking about systems’ failures in general.

Running an airline and an airport that prides itself on being a transit hub is an extremely tricky business and – as everything is profoundly interconnected – when something small goes wrong, like fog in the early morning, everything can collapse. You’d hope that this would not be the case, indeed you convince yourself that this can’t be the case, but it is.

Systems can be very fragile and the difference between smooth organisation and total chaos is, in reality, very small. The possibility of contagion – in this case with flights, connections and crews – is everywhere. Like the ecosystem of a rain forest, each small change can have an amplified effect on activity somewhere further down the food chain.

Deeply unstable set-up

These changes, which on their own don’t seem to add up to much, can profoundly affect the health of some creature or plant. Similarly, the airline network with its web of connecting flights, each one depending on each other, is a deeply unstable set-up.

Financial markets are similarly integrated ecosystems and the question is whether they are becoming more – or less – stable.

It seems fair to suggest that they are becoming much less stable and much more fragile. Each year there are more and more financial crises which have enormous impacts on people’s lives, can overwhelm economies and reduce many millions of people’s ability to make a living. These are real costs, real human costs, and yet the trigger for these crises can be remote and appear inconsequential at first.

In financial markets, confidence can evaporate almost as quickly as it arrived. The reason is leverage. If the entire system is a series of bank-financed IOUs, where borrowed money is speculated on an asset which may yield a bit more cash, then the fortunes of everyone are linked. If a trader in a hedge fund in one part of the world is losing money on his Russian portfolio, and the positions in that portfolio are financed by debt, then he will have to sell something else to pay down that debt.

The difference between the value of a stock and the debt you took out to buy that stock is called the margin. If the value of the stock falls, then the trader is forced to come up with cash to plug the difference between the value of the stock today and the original value of the stock on the day he bought it.

How does he get this cash? Well he has to sell something doesn’t he?

This need for cash is very dangerous because the trader has to sell good assets (which are worth something) to pay for bad assets (which are falling in value). You can see very easily how when there is too much borrowing around, good assets can turn bad very quickly. And more significantly, good assets in one country which may be doing ok, have to be sold to finance bad assets in another country which may be doing badly. There doesn’t need to be any real connection in terms of investment or trade between these countries. The only common denominator needs to be that the same sort of people own the assets in each country. Indeed, it is often the same person.

Debt dynamics

So, for example, as The Sunday Business Post reported, the guy who owns the most Irish government debt, Michael Hasenstab, also owns a big position in Ukrainian government debt.

He is betting that Ukraine – like AIG in 2008- will be deemed ”too big to fail and that ultimately, Russia will extract money from the West to prop up a weakened Ukraine achieving its two geopolitical aims of (1) having a Ukraine firmly in the Russian orbit and (2) getting the West to pay for the pleasure. This is the bond guy’s bet. He bets that the West – the IMF – will use Western taxpayers’ money to pay him what the Ukrainian government owes him. Yet again, we see more and more of other people’s money being passed on to people who had nothing to do with the debts in the first place. What if that doesn’t happen? Then this investor has to sell some of his good stuff to pay for his losses in the Ukraine.

This means he would have to sell some of his peripheral European or other emerging markets debt to pay for his Ukrainian gamble. This means that the debts of emerging markets would fall in value. Where are a significant amount of emerging markets debt held? Why it’s on the balance sheets of European banks, which filled up with this stuff from 2010 to 2012. But this fall in emerging markets debt prices would put a hole in their balance sheets. And what happens then when the ECB stress tests come? The banks with exposure to emerging markets need more capital than previously thought. And thus we can see how bank leverage can lead us into a fresh European banking crisis sparked by an incident over Crimea?

This is how systems break down. As I look out at the rows and rows of grounded Boeings and Airbuses rendered useless because of one small glitch earlier this morning, the nature of system failure comes home to roost.

David McWilliams writes daily on international economics and finance at www.globalmacro360.com

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