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Extreme Leverage, Extreme Instability, Extreme Risk

Conventional economists are constantly cooing that oil accounts for a smaller percentage of the U.S. economy that it did in the 1970s; but does that mean that the economy is any less vulnerable to supply disruptions? The concept of leverage helps us understand how removing $650 billion in crude oil from the U.S. economy (18 million barrels a day X 365 days = 6.5 billion barrels X $100 per barrel = $650 billion) is not just a simple subtraction of 4.5% of total GDP ($14.7 trillion): it would trigger the implosion of the entire U.S. economy.

That’s leverage.

How many people truly understand the precise mechanics of last year’s “flash crash”? Does anyone really understand what interactions of high-frequency trading computers led to a stick-slip/criticality/crash? How dependent is the system on their expertise? How many people operate the Federal Reserve’s many opaque interventions in the market? What sort of daisy-chain ties the Fed’s moves to other central banks? What happens if that web of intervention breaks down or seizes up?

The conventional spectrum of punditry and economists dismissed the idea that U.S. housing was a highly leveraged sandpile waiting for a stick-slip event. But the leverage piled on leverage was self-evident: the consumer borrowing (home equity lines of credit, refinancing, etc.) that fueled much of the “growth” in spending was leveraged off the housing bubble, which also leveraged rising demand for lumber, granite countertops, high-end refrigerators, etc., and a stupendous mountain of derivatives, credit default swaps, mortgage-backed securities and other financial instruments which leveraged up Wall Street’s profits and valuations.

The entire sandpile collapsed once its riskiest grains–the designed-to-default subprime option-ARMs and no-document liar loans–succumbed to the inevitable.

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