Are You Exposed to the Risks of the Fiat Financial System? Part 2: Systemic Institutional Failure

The cornerstone of any sound way to grow money is diversification — not having all your eggs in one basket. Because most money is fiat (issued by governments) most investments carry the risks associated with the fiat financial system. In Part 1 I discussed the endemic need for inflation in the fiat system. Now lets move on and look at the risks inherent in how the system is built. Although not without risks themselves, crypto-currencies like Bitcoin and Bitcoin Enhanced avoid these fiat risks and therefore enable greater diversification in the way you grow your money.

A sweater unravels because each part of the system is dependent upon others.

Fiat finance is literally one system where every part is connected to every other. This interconnectedness means that should one institution fail this can have catastrophic implications for the system as a whole. Like the thread of a sweater, once it is pulled the entire sweater can come undone.

The problem of the interconnectedness of the fiat system is that it cannot be known in advance where failure is likely to occur. For example, at this time of writing Google has the following news headlines:

Thought the 2008 financial crash was bad? At this rate, there’s worse to come

Turkey’s lira turmoil could herald a global financial crisis

Vulnerabilities in emerging economies

The interconnected nature of institutions was clearly evident in the 2009 General Financial Crisis. The Wikipedia entry, not known for exaggeration, describes the event:

“It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008.[5] Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.[6] Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. “[1]

Steve Eisman, one of the people who saw the crisis coming, described the situation like this:

“’There’s no limit to the risk in the market,’ he said. ‘A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!’ The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup’s shareholders, bondholders, and employees — but the sums involved were known to all. Citigroup’s failure, however, would also trigger the payoff of a massive bet of unknown dimensions from people who had sold credit default swaps on Citigroup to those who had bought them.’”[2]

The “unknown dimensions” quoted be Eisman are the dependencies of other institutions on, in this case, Citigroup. That is to say, fiat institutions — banks, governments, insurers, investment firms, are all dependent upon each other to maintain themselves and the scale of this dependence cannot be known in advance of collapse. It is both this dependence and the inability to know its scale that represents the risk of systemic institutional failure.

By way of contrast, the Internet is also an interconnected system. But in this case, because one server, router or cable of the Internet is NOT dependent upon another, the interconnectedness of the system creates resilience. If one server or router or cable should go down, information is re-routed to its destination.


[2] Michael Lewis The Big Short, page 263.

Michael Lewis documents how the sweater unravelled in the 2008 General Financial Crisis.

In the last of this series we will look at regulatory risk. The fact that currency issuers and law makers are one and the same government adds to the challengers for the fiat investor.