The fragility of leverage

A conversation yesterday reminded me of how fragile our economic system really is.

Without disclosing too much personal information, let's just cherry pick out the most salient features.

As everyone knows, the economy tanked in 2008.  The story I heard pretty much shows the nature of the problem.  A small loss turned into a much bigger one.  That reminded me of leverage.  In fact, it was a real life example of how damaging leverage can be once its opposite -- de-leveraging --- gets going.

I wrote about economic leverage before with respect to my trading in currencies.  I was trading at 100 to 1 leverage.  That is, for every dollar I put in, the trading system allowed control over 100 dollars.

This story was a personal story like my own.

Leverage may sound wonderful, but it is very, very risky.  Even slight moves against your position can wipe you out.  But as long as everything goes according to plan, you can make plenty of money.  Unfortunately, things don't always go according to plan.  When that plan goes awry, bad things start to happen.

It is a like an avalanche.  An avalanche can start with just a few rocks, but once those rocks loosen up other rocks, there is a type of chain reaction that results.

Another example is dominoes.  If the dominoes are set up so that one falls, it causes others to fall, then a chain reaction occurs when all the dominoes will fall.

So, leveraging and  de-leveraging is like putting up all your dominoes, and an inadvertent mistake begins setting off the chain reaction that knocks them all down.

The thing that allows leveraging in the economy is debt.  The thing that knocks down the dominoes is when debts can't be paid.  That's what happened in 2008.

So, when I heard that small losses caused huge losses down the line, I understood completely what had happened in the story I heard.  De-leveraging in the broader economy caused a lot of ruin amongst individuals whose own dominoes got knocked down as the dominoes kept on falling along the line.

The economy is sitting on massive amounts of debt.  That debt supports our illusion of prosperity.  Once those debts start to fail, and that is inevitable, the dominoes will fall.  It will lead to the ruin of just about everyone.  The politicians in all their wisdom, have brought this to pass.  In order to shield us from our own mistakes, they have compounded the problem by making it much, much bigger.

It may take the wisdom of Solomon to avoid a catastrophe.  Better hope that there is one out there, because if there isn't, we are in heap big doo-doo, kemosabe.  This administration does not inspire confidence on that count.