We have not yet launched ourselves off the edge, and while the mess and the pain will be immense, spilt soup is still preferable to a fatal crash…
Spilt Soup or Fatal Crash?
If while driving your car you suddenly noticed that you were heading straight for a cliff edge, of course the sensible thing to do would be to apply the brakes and sharply turn the wheel.
If, however, rather than travelling by yourself you were instead driving a carload of children holding bowls of hot soup, you might choose to maintain your speed and direction while opening a newspaper up in front of you. For the next few moments, by keeping the car stable and the children unaware of any pressing danger, you have made it unlikely that they will spill hot soup on themselves and suffer burns.
However, while by ignoring and obscuring the problem of the approaching cliff edge you have kept your passengers calm and their soup in their bowls, you have solved nothing. By failing to brake or turn, you have ensured that you will all plunge over the edge of the cliff in a fatal crash.
This analogy almost perfectly describes the current economic and political situation in the West.
Ever since Alan Greenspan was sworn in as Federal Reserve Chairman in 1987, central banks, and in particular the U.S. Federal Reserve System, have taken it upon themselves to smooth out any disturbances in asset markets through interest rate cuts and other forms of intervention.
They didn’t take on this ill-conceived responsibility entirely on their own. In response to the “Black Monday” crash of October 1987, which saw a one-day drop of over 22% in stock prices, the Reagan administration established “The Working Group on Financial Markets” (colloquially known as the “Plunge Protection Team” or P.P.T.), which brought together representatives from the U.S. Treasury, the Securities and Exchange Commission (S.E.C.) and the Commodities Futures Trading Commission (C.F.T.C.) as well as the Fed.
The P.P.T. is responsible for “enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets and maintaining investor confidence.” Referring to our analogy above, then, their job is to occasionally open a metaphorical newspaper across the windshield in order to prevent investors from seeing the inherent dangers of, and therefore demanding meaningful reform to, the current dollar-based international financial system.
And so, in crisis after crisis (the Mexican Peso Crisis of 1994, the Asian Financial Crisis of 1997, the related collapse of Long Term Capital Management in 1998, the Dot-com collapse of 2000, and finally the Global Financial Crisis of 2008) the P.P.T. has acted to, at all costs, maintain investor confidence through lowering interest rates (the trend is clear – from 1982 through to 2002, interest rates fell from over 18% to under 2%), printing money and, increasingly in recent years, directly purchasing financial assets to support prices.
The problem with such an approach, though, is that if financial markets are to work, both the positive AND negative price signals they generate and convey need to be seen and felt. Just as the driver needs to make his passengers spill their bowls of hot soup and suffer scalding pain in order to avoid driving over the cliff, so too do governments and central banks need to allow over-indebted financial institutions to feel the pain of periodic credit crises and falling asset prices. If this pain is not felt, and asset bubbles are allowed to inflate for too long, then either their eventual popping will lead to a deep depression or their continued inflation will result in a monetary crisis, with political and social disorder typically accompanying either outcome.
Looking at the 2008 crisis, the signal that ought to have been conveyed was that the natural consequence for issuing fraudulent housing loans to borrowers with no income, no job and no assets (“ninja loans”) and then securitizing such loans into bundles and selling them on to clueless investors after arranging for ratings agencies to misleadingly brand them as ‘AAA’ was bankruptcy and jail time for the institutions and individuals involved.
Instead, by the late fall of 2008 the Fed and other leading central banks, having already dropped interest rates to below 1% for the first time in history, introduced Quantitative Easing (Q.E.) to further support banks and the stock market. With interest rates at record lows and trillions of dollars of newly-created money flowing out of the Fed and into the banking system and the stock market, asset prices began an ascent which has continued for more than a decade. The ‘too big to fail’ institutions which took part in the swindle are more powerful than ever, and none of the individuals involved have gone to jail. Bailed out and protected, no pain was felt, no lessons were learnt and hence, no changes were made.
But at what cost? One consequence of throwing trillions of dollars of paper at the windshield has been the almost complete abandonment of prudence. For the past 12 (or perhaps even 20 or 30) years, the path to riches has been to borrow and speculate. Banks, hedge funds, corporations and even households are all committed to taking on as much debt as they can because they are confident that, in the face of any market turbulence, the P.P.T. and central banks will intervene to push up asset prices and save them from ruin.
Given this background, it should not surprise anyone that companies which earned billions of dollars of profits over the past decade, having spent it all on stock buybacks or acquisitions, have been pushed towards bankruptcy by the Coronavirus pandemic and consequent shutdown. Clearly, the lack of prudence encouraged by P.P.T./central bank intervention has made our economy a great deal more fragile and vulnerable to shocks.
The endgame of increasing fragility being papered over with ever-greater debt and money printing, though, is clear to see for anyone with an unobstructed view. As people (initially, probably foreigners) see more and more money being created from nothing, and as they begin to notice rising prices, they will lose confidence in paper currencies as a store of value. As the author Jim Rickards has put it, “Someday, sooner or later, … confidence will be lost very quickly. Then you will have your inflation all at once.” At that point we too shall become acquainted with the scourge of Weimar Germany, Yugoslavia, Zimbabwe and Venezuela – hyperinflation.
Another consequence has been rising inequality. People who had bought stocks, bonds or real estate before the mid-2000s have been made very wealthy by the interest rate suppression and Q.E. programs implemented to save the financial system after 2008. However, people who were either too poor or too young to have done so now find themselves both locked out of the middle class and, increasingly, pushed into poverty by rising prices for the essentials of life such as housing, education and health care.
Given this reality, is it any wonder that frustrated and angry people are engaged in civil unrest in places like the U.S., Hong Kong, Chile and France? All those paper trillions thrown against the windshield to maintain confidence and save the financial sector from suffering capital losses have acted like tinder, needing only a spark (such as the death of George Floyd) to be set alight.
And so, we now face two dangers. The crisis we faced in 2008 has not gone away, as we failed to heed its warning to change course and reduce debt levels. Instead, it has become bigger and more dangerous as, to obscure the risks we faced, we proceeded to pile up even more of the debt that had made the economy so susceptible to crisis in the first place. The soup bowls are now full to the brim.
Meanwhile, the wealth and income inequality exacerbated by those trillions of dollars of money and credit created from nothing to restore investor confidence post-2008 is now threatening to rip society apart. Possible hyperinflation will only further tear the economic, political and social fabric to shreds. The canyon beyond the precipice is unimaginably deep.
However, we have not yet launched ourselves off the edge. There is still time to slam on the brakes and turn the wheel. While the mess and the pain will be immense, spilt soup is still preferable to a fatal crash.
Workbook for the New I.B. Economics www.brycemcbride.com