I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.

I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.

It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.

So what is the problem that governments fear so hugely?

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. The $18 billion that Greece owes to the banks are in turn owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more. The great cyclical wheel of international debt is only as strong as its weakest link. This kind of breakdown is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

Now, I believe that the most significant factors in robustifying society are economic, as opposed to financial. The West’s greatest fragilities stem not from its weak financial system, but from its energy dependency and susceptibility to energy costs (for example, the financial crisis in 2008 might never have been so severe had there been such a huge spike in energy costs), its deteriorating infrastructure, and its imperial largesse (the cost, the blowback, the shortage of manpower). Simply, if America and the West were fuelled by decentralised domestic energy production (e.g. solar), and decentralised local production and resource extraction, the ululations of the global financial system would be irrelevant to the common people.

But, in reality, we live in a globalised and interdependent system. So anything that might robustify the financial system would be welcome.

Here’s what Taleb and Spitznagel originally wrote:

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers. 

The strongest advantage, though, goes unmentioned. Systematically transforming debt into equity would end the problem of financial entities being too big to fail, as failure would no longer lead to a breakdown in the debt cycle. This is because insolvent positions would simply default to a majority-minority equity position, and — if the debtor’s equity position were high enough, say about 33% — liquidation could be avoided.

A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract seen fit.

But the larger picture is rather intriguing — in a world where all debt has become equity, there is no such thing as a default, because an equity position is one of ownership, and thus a claim on future earnings.

Simply, lending would be done through lenders buying a share in a person or company’s or government’s future earnings, rather than through creating debt. Loan contracts could still be structured precisely the way they are today. But, as Taleb and Spitznagel insinuate in saying that “banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity”, lenders would have much more of an incentive to assist in the development of their equity position, as this would surely be the best way to get back their initial investment. And — as an equity position, rather than a cast-in-stone lending contract — terms could be far more easily renegotiated.

Of course, this new system would surely pose a whole new universe of challenges and moral and regulatory quandaries, not least the moral and philosophical problems of government effectively banning debt-based lending.

But, if we are looking to avoid the moral hazard of bailouts, and the dangers of default cascades, the architects of the global financial system — including banks themselves, who could of their own volition choose to cease debt-based lending, and adopt equity-based lending — could do much worse. While systematically transforming debt to equity is too difficult and controversial (not least for contractual reasons), we must remember that in a purely free-market, all of those debt-based lenders would have gone bust a long time ago.