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06/27/2006 Archived Entry: "Pyramids of Debt"


The Bank of International Settlements reports (PDF file) that notional value of derivatives exploded by 25% in the first 3 months of 2006 to $429 Trillion.

Gary North has pointed out in Bernankeís Bet on Derivatives, when the number was ďonlyĒ $285 Trillion, that the BIS estimate is low. The true scale of the derivative market is larger, possibly much larger than the reported figures.

Numbers like this are very difficult to grasp. I work with numbers every day, but I donít usually encounter man-made entities of this magnitude. When confronting very large numbers it can be useful to construct a model based on familiar objects to get some intuitive grasp of the scale.

Letís start with a pea whose volume is provided by Wikipedia. If each derivative dollar is represented by a pea, how big is a pile of 429 trillion peas?

I wonít bore you with the math. The volume of the pile of peas is about 116 million cubic meters.

Thatís clearly a lot of peas, but it still doesnít give much feel for just how big the pile is. So letís compare that pile with something really big that most people know about, the Great Pyramid of Giza. The stones in the Great Pyramid have a volume of about 2.6 million cubic meters. The Pyramid has a lot of chambers and tunnels; its total volume (calculated from the base and height of the present-day remains) is about 4.1 million cubic meters.

Dividing the 116 million cubic meters of peas by the volume of the Pyramid, I find that if every notional dollar in derivative contracts were represented by a peas, one could build 28 Great Pyramids of Peas, and make a good start on the 29th.

Imagine twenty-eight massive edifices of peas, stretching away to the horizon, while the financiers and fund managers of the world frantically create more peas from nothing, and shovel them into still more pyramids. If derivatives continue to expand at the 25% rate of January to March, by the end of June 1996 the line of pea pyramids will have grown to 44 or 45.

Itís too bad that derivatives arenít peas, one could feed a lot of people with them. But derivatives are nothing more than credit and debt. If you bet a billion dollars with your neighbor about who will win the World Cup, or what the spread will be, you have created obligations with a ďnotionalĒ value of $1 billion. But it was created from nothing, and when it comes time to pay, nothing will happen, at least with my neighbors. The problem is that the people making derivatives bets think they will actually be paid when the bills come due. When the payments don't happen, the world's financial system will lock up, and very possibly collapse outright. Your 401(k) and/or savings accounts? Forget them. They will vanish along with all that other notional wealth. Compared to $429 Trillion, your digitized savings aren't even a rounding error. Sure, the government may pay you in printed dollars, but you will surely find that no one wants them anymore.

I find it very hard to believe that these massive pyramids of debt will survive the ages as well as the stone monuments of the Egyptians. The image of great piles of peas may also provide an image of their ultimate fate. They will slump and disperse, blown by the winds and washed by the rain, until nothing remains but the memory of one of the greatest follies in the history of mankind.

Posted by Silver @ 08:55 PM CST

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