It was the best of times. And it still is. Intrepid investors who never dreamed they’d put all of their eggs in one full-boar risk asset basket have never had it so good. Stocks are up, bonds are up, emerging markets are up, real estate is up. Heck, it’s all up. As it should well be. It’s different this time. No, really. It is.
Depositors pay banks interest to hold their hard-earned savings for the first time in written history. And, as far as investors are concerned, sustained bad news is the only true form of good news. For this warped reality, we owe a debt of gratitude to the world’s central bankers who have changed the rules of the game by dispensing with the conventional in favor of the arbitrary. There is a word for such extreme power, in both noun and verb forms: Overlord, as in a person who lords over lords.
Was happening upon and being stirred to employ this all-encompassing word pure coincidence? To boast such divine inspiration would be disingenuous at best. Rather, it’s another inspiration that begat today’s theme. Liaquat Ahamed, author of The Lords of Finance, is said to have been moved to write his seminal tome after reading a 1999 Time magazine cover story titled, “The Committee to Save the World,” which featured the then three superstars of the economy: Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin and Rubin’s right hand man, Larry Summers.
As droves of acrimonious Americans can attest, “Save” is not the word that comes to mind when they see those three men’s faces.
Some of the bitterest among the economic outcasts who were ruined by the ‘Committee’s’ manipulations will never have the wherewithal to pay off their dusty subprime mortgages with their still inadequate incomes. Others among the shell-shocked didn’t want to be told to stay in the stock market. They’d been burned twice and that was enough for one lifetime. For that, they are constantly chastened for missing the second greatest bull market of all time. But tragically, for some, they just wish they could exit this world with dignity; they fear they will outlive their savings in a world where savers are punished and cash itself is an endangered species.
The truth is Greenspan, Rubin and Summers were merely clones of the “Lords” to whom Ahamed refers to in his book. It is impossible to summarize Ahmed’s book, which still stands as yours truly’s greatest literary guidepost to where we find ourselves today. If you haven’t read it, please do.
To synthesize the thrust of the book, it is perhaps best to view it as a three-way study in the perils of devaluing stores of value by force, the dangers of runaway debts and the menace of monetary myopia.
How does one devalue by force? Illustrations from the period are numerous. Some suggest the best example comes from a decision made by President Franklin Roosevelt in 1933 as his country emerged from the most savage year of the Great Depression. To counter the scourge of the day, falling prices, one commodities economist hypothesized that prices merely need to be forced upwards. This simplistic rationale accepted, Roosevelt began to devalue the dollar by driving up the price of gold.
Moving on to the ticking debt bomb, the initial debt build sprang from the unpaid bills racked up both during and after World War I. History tells us these debts morphed into the very source of the hostilities that drove the world headlong into its second world war. Germany’s inability to pay its war reparations set off a daisy chain of defaults among U.S. allies. To finally tourniquet the wound, the U.S. effectively bailed out the bad German debts.
As for the hubris of those central bankers, a 2009 New York Times book review best summed it up as follows:
“The central bankers were prisoners of the economic orthodoxy of their time: the powerful belief that sound monetary policy had to revolve around the gold standard. That is, each country’s reserve bank had to have a certain amount of gold in its vaults to back up its currency – and indeed, ‘all paper money was legally obligated to be freely convertible into its gold equivalent,’ as Ahamed says.
Again and again, this straightjacket caused central bankers to make moves, like raising interest rates, that would allow their countries to hold onto their dwindling gold supplies even though the larger economy desperately needed help in the form of lower interest rates.”
If anything, the power of the kings and queens running the world’s central banks has become even more concentrated. In a reversal of economic fortunes, today’s economy is in desperate need of higher rather than lower interest rates, of a normalization of policy to put a floor under the bloodletting in pensions, insurance companies and among retirees worldwide.
And yet, the powers that be insist they know that better than the unwashed and uneducated masses that suffer at the hands of their misguided policies. Of course the benefits of negative interest rates outweigh the costs. And whose business is it anyway if central bankers impinge on the ability of capital to determine the value of a given entity?
If you think such encroachments into the Darwinian process of price discovery invite debt creation where it would not otherwise be possible, you are right. That brings us to the parallel between then and now, to the conflagrations smoldering under the surface of the world economy that have a similar source of kindling as the World War era. That is, debt, a huge overabundance of debt. The latest figures out there suggest that global debt now eclipses $200 trillion, or about three times the global economy.
What else do we know? The short answer is not near enough. The debt buildup is not contained to a handful of profligate sovereign borrowers as was the case in the late 1990s when Indonesia, Thailand and South Korea took on unsustainable debt loads. Russia’s default was all it took to ignite the mother of all contagions.
The debt problem, if you will, is also not contained to a single sector whose ‘AAA’-rated debt spread so far and so wide as to infect the entire global financial system. That was, of course, the case with U.S. subprime mortgage debt.
Rather, the debt is simply everywhere, at least to the extent we can see and measure it. Corporate and sovereign debt, of both the developed world and emerging market varieties, are at record levels. China’s debts certainly add to that record but who really knows to what extent? It’s the ultimate black box of leverage on Planet Earth. Even household debt is a problem in many countries including right here in the United States where it’s nearly hit its prior record high.
But it’s not just the debt. It’s the speculation that the debt has inadvertently unleashed that’s the other problem. Central bankers’ collective and growing fears of those debts, which could prove to be incapable of being serviced without interest rates at zero or in negative territory and quantitative easing (QE) running at full throttle, have given way to a perverted gentlemen’s agreement of sorts.
To tap the wisdom of Jim Bianco of Bianco Research, central bank bond buying has become fungible. As long as the buying continues, it really doesn’t matter who’s picking up the QE tab. To that end, over $2 trillion in global QE purchases have taken place in the past 12 months, the fastest pace since the onset of the financial crisis.
It is here that the regime shift kicks in, the one that made possible this new and improved gentlemen’s agreement between investors, politicians and central bankers. The operating assumption is not only that QE purchases continue to take place to keep the peace in the financial markets, but rather that the debt has literally disappeared, been retired, expired, matured, monetized, vanished into thin air. Governments have simply agreed to cancel the debts into the netherworld. The supply has been expunged forever.
“That $3.5 trillion on the Fed’s balance sheet is effectively canceled,” said Bianco. “Everything will be fine as long as the marketplace believes the bonds will never return. On a global level, we will have an ever smaller supply with the same level of demand.”
In other words, investors have seen no reason to be alarmed by the growth of debt because they are netting that growth out against central bank purchases. With an aggregate of $2 trillion of bonds wiped out on an annual basis, why worry?
Do you sense you are reading this in suspended animation? Good. Because you are.
There is another operating assumption that binds this illusion, namely that inflation is extinct. Prices will never rise again care of central banks continuing to look the other way. If headline inflation is too high, pronounce that food and energy are running too hot. Caveat that this heat is transitory. But emphasize that for the moment, ‘core’ inflation, which excludes them, is what matters.
And if food and energy prices are running too cold, as has been the case of late? Well that too should be treated as anomalous. Best to focus on the headline until that abnormality passes. And so it goes, round and round.
But wait! We’ve been told central banks are keen to create the inflation that in turn inflates debts away. Haven’t we?
“The minute there’s a whiff of inflation, even the slightest whiff, the implication will be that all those bonds are alive, that central banks could start to sell bonds to tighten monetary policy,” warns Bianco. “The illusion would be shattered overnight.”
Well ain’t that a thing! Now we know why the dialogue shifted just after former chair Ben Bernanke made his way out the door in January 2014. The exit from unconventional monetary policy, you may recall, was originally set to begin with the tapering of purchases, being followed by allowing the balance sheet to run off and then prompt the first rise in interest rates – in that order.
A funny thing happened on the way to the exit, though. Bill Dudley is not only the president of the Federal Reserve Bank of New York but also the vice chairman of the Federal Open Market Committee and coveted holder of a permanent vote. Back on May 14, 2014, in a question and answer session with reporters following a speech, he literally stood the preexisting exit principles on their head.
“Delaying the end of reinvestment puts the emphasis where it needs to be — getting off the zero lower bound for interest rates,” explained New York Fed president Bill Dudley. “In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.” Luckily for investors in any and every risky asset, his opinion holds a lot of sway. Dudley’s central banking peers in developed countries have followed his lead and peace on earth has held ever since.
As for those pesky financial stability concerns, we’ve been instructed to look the other way. Some have even gone so far as to suggest that the time has come to devise a new term to replace ‘bubble.’ No doubt, it’s an unseemly word given the nasty images it conjures. But what if the word ‘bubble’ is not substantial enough to capture what’s been created before our very eyes, across the full spectrum of asset classes?
“You cannot NOT worry about the Fed in this world,” warns Bianco. “The simple truth is ending reinvestment would bring the bond market to its knees.”
You connect the dots from there. Will the dollar buy more or less in the future given the path on which today’s modern day monetary myopia has placed us? Does a word even exist that’s capable of describing what the world economy would face if the orthodoxy of our Overlords of Finance collapses? That truly is the quadrillion dollar question.