Central banks are in deep – like "$250 trillion dollars and 50x leveraged" deep. What do central banks do when basically the LAST THING ANYONE EVER EXPECTS happens? What do central banks do when a global pandemic threatens to disrupt the house of cards they’ve spent 20 years so carefully constructing?
They do whatever it f**king takes, that’s what.
What does that mean? It means unprecedented money printing. It means stimulus measures. It means that central banks are adopting “Whatever It Takes” economic policies
What does that mean for us all? Read on.
It’s pretty wild to imagine that in between the first two parts of my economic series and this article, a global pandemic hit (Part 1: Our Financial System 101 & Part 2: Understanding Modern Monetary Theory). OK, I might have taken my sweet time writing these, but still….
It’s fascinating looking back at the earlier pieces, because, in many ways, I was speculating on how unprepared our financial and economic system was for a disaster. What that disaster might be was impossible to predict. Then it struck. That’s the thing about disasters. They’re by definition unexpected.
This unexpected disaster seemed to hit us at the most inopportune moment. It was a perfect storm you might say.
This storm hit as global central banks poured obscene amounts of money into perpetuating a 10-year bull run. On February 6th, 2010, the S&P 500 was $886 per share. 10 years later it was $3345 with barely a blip in between.
This storm hit as global debt hit record levels – $250 trillion – which represents approximately 50x the $5 trillion of circulating global money. On a side, even if we accept the far more lenient definition of “broad money” which includes money held in checking accounts, savings accounts, and money-market accounts (basically all the places people just “hold” their cash), the total amount of global money is $80 trillion and our system is still 3x leveraged. However, the definition of “broad money” is far too inclusive considering that much of the money in these accounts has already been loaned multiple times by the banks as "debt."
It’s hard to fight an economy-ravaging global pandemic when you’re 50x leveraged. Fortunately for the Fed, there’s no credit score check needed to print money – and print money they have, with almost $3 trillion having been printed in new stimulus money to prop up the economy so far. The Fed also announced unlimited QE measures and slashed interest rates to zero.
Yet, after crashing, the markets are almost to an all-time high, leaving investors scratching their heads. Everything seems to be pointing towards more bleeding markets – a 10% unemployment level, massive layoffs, an uptick in cases – yet they stay green.
We’re looking for answers and I hope my thoughts help provide some clarity. First, I’m going to look at why the system is overleveraged and how bad it actually is. We have to assume that with the virus’ resurgence, hard times are still ahead. So then if our system is overleveraged and central banks have trapped themselves with their ‘anything goes’ policy, what’s going to happen to our world? To our markets? To our money? That’s what we want to understand: how we should hunker down when the world’s gone crazy.
Ok, it’s pretty bad.
Overleveraging is fine as long as you keep making nice, fat returns. Just ask all the cryptocurrency gamblers who bought crypto on credit. It worked out nicely until the crash. Then it just amplified their losses.
Governments have made debt cheap as they tried to funnel their beloved countries towards eternal growth. Most everyone has bought into Keynesian economic principles that cheap money makes the economy go up.
Why have they done this? Short term thinking? Greed? Over-idealistic belief in a utopian economic ideology where the government can fix everything? Yes. Yes. Yes.
I’m not here to disparage debt. It’s absolutely correct that debt is the best way of stimulating economic growth. Growth essentially depends on debt since debt makes the pie grow bigger instead of just cutting it into differently-shaped pieces. Naturally, this has lead to the conclusion that more debt means more growth. Thus, economic policy, with the goal of generating growth, has sought ways to stimulate debt – i.e. lower interest rates and engage in generous Open Market Operations.
However, more debt only means more (sustainable) growth if the debt is taken on responsibly. See, debt ALWAYS needs to be paid back. Even governments have to pay it back. As I’ve pointed out in my past articles, they don’t really pay off the debt. Rather, they have to pay off the borrowed trust. For example, when the Fed prints money, it's essentially leveraging global trust that, even with $3 trillion in new spending, people will maintain their faith that a dollar is worth a dollar. The U.S. pays back its debt by reducing spending and increasing economic growth later on to raise the corresponding value (the economy) on which the dollar is based. If they print for too long without repaying the borrowed trust, the trust framework breaks down. When people stop believing that the Fed can responsibly maintain the stability of the dollar, we can kiss the stability of the dollar goodbye.
Traditionally, debt is expensive. It’s risky. Borrow money today and pay back more tomorrow. Individuals (and governments) incur that risk because they believe tomorrow will be better than today. But what happens when money is free? Just like with investors, people take on more risk then they should.
People borrow. They borrow for good reasons. They borrow for bad reasons. People equate cost with value. They want value and they actually want to pay for that value. If they’re not paying for it, they stop valuing it. The problem with 0% rates and infinite QE Measures is that people stop valuing money.
Borrowing stops being risky. It changes the paradigm and not borrowing actually becomes risky. Companies have lost any risk adversity to borrowing because all the risk is several layers removed from where it once was.
I'm going to quote the Epsilon Theory here:
“This is a huge question for the Fed, maybe the biggest question they have. How is it possible - with the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever experienced, with all the amazing technological advancements that we read about day in and day out - that companies have not invested more in plant and equipment and technology to improve their labor productivity, to make more with the people they've got?
The reason companies aren't investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history….Why in the world would management take the risk - and it's definitely a risk - of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? It's like going to a college where grade inflation makes an A- the average grade. Sure, I could bust a gut to get that A, but why would I do that?”
And borrow they have. Global corporate debt in USD has increased from $34 trillion in 2009 to $51 trillion to $72 trillion in 2020. $72 trillion!
Quoting one more writer I admire, Lyall Taylor, when he wrote this in his blog LT3000:
“This is how you end up with the environment we have seen: relatively weak growth in investment and consumptive demand; falling consumer debt; rising fiscal deficits and government debt burdens; falling interest rates; and rising asset prices. It's also how you end up with a breakdown in the historical inverse correlation in the performance between bonds and stocks - they are both going up as capital has ceased to be scarce and a precipitously falling cost of capital is driving up the price of everything.”
Well put. That’s how we get almost all-time highs in the stock market in the middle of a global pandemic that seems to be wrecking economic demand.
Democracies are very bad at promoting sustainable growth. They’re good at promoting short-term growth and the narrative of sustainable growth.
Look at how we measure growth today: the stock market, low unemployment levels, GDP growth. It’s not that these indicators aren’t effective or honest. It’s just that they only tell us what is happening today, not what will happen tomorrow. Every professional investor learns this on day one. You make decisions based on risk management strategies and not according to past or present success. This is because past and present success tends to cloud judgment and encourage us to take on more risk then we should. This happens to investors. It happens to lawmakers. It happens to economists. And the U.S. economy has thrown risk management outside the window and appealed to the gods of ever-lasting success. Just like with investing, there’s also a cyclical nature to national economies. Money makes it easier to make money. A strong economy makes it easier to have a really strong economy. Until something unexpected happens. And as everyone bleeds, those who were overextended get demolished.
So as long as the market is going up, we’re all fine with the Fed spending as much as it wants. It’s working, we say to ourselves. Just look at those green arrows. Unemployment is low! Who is going to be the one to point out that the country is taking on too much risk? That too much money spending with not enough real value creation results in inflation. Because, contrary to popular opinion, higher markets have more risk, not less.
Who is going to be the one to call out that America has too much risk right at the time that the stock market is at an all-time high, the unemployment rate is at an all-time low, and everyone is making money hand over fist?
Certainly not the President. He wants to get reelected and is all too happy to keep the money wheel spinning. Certainly not the lawmakers for the same reason.
Certainly not the companies. They’ve increased their stock price. They’re succeeding. Why would they be skeptical? And besides, if they’re wrong and get caught with their hand in the cookie jar, they can always look forward to governmental bailouts.
Certainly not the American people. They have jobs. Their investments and 401ks are skyrocketing. They’re making money. Now is definitely not the time to point out the discrepancy.
That’s the problem. There is no one interested in the truth when the truth means less money.
It’s no secret that the global economy is struggling. Global economic shutdowns aren’t good for bottom lines.
Overleveraging is fine as long as we make more money tomorrow than we owe today on our debt payments. When we can’t make enough money to pay off debt, we default. In a perfect world – even in a greatly leveraged economy – it’s easy to expect that we can avoid defaulting. We invest and spend and spend and invest and continue on into eternity. But what happens when disaster strikes and we can’t depend on the economy expanding tomorrow; when it begins contracting? Then what?
Imagine that as unemployment continues to rise, more people won’t be able to pay their rent. That means many property owners won’t be able to pay their mortgages. Stores without customers will fire employees, further contributing to the defaults. Eventually, we could hit a critical tipping point where defaults happen at a fast-enough rate that the entire system simply collapses. The precipitous cliff towards which we are rolling is the point of time when a cascade of defaults becomes so powerful that the entire domino tower collapses and we enter a global debt crisis.
But good ole Uncle Sam won’t let that happen. Right? Central banks won’t let that happen. Right? So what do they do when a reckoning comes after 12 years of artificial economic manipulation and enormous liquidity policies?
They do whatever it takes.
Here’s the one lesson I hope you take away from this series on economics. Economies and currencies are built on trust narratives. The strength of the dollar depends on people’s belief in the dollar. Inflation only happens because people begin to worry that it will happen. Bank runs happen because people lose trust in banks.
The Fed and other central banks will do whatever they can to promote the narrative of economic safety. They will keep rates at 0%. They will give banks all the money they want with QE. They will send out economic stimulus checks. They’ll bail out companies.
If they do this effectively, their hope is that they’ll create a little self-sustaining economic circle. They print money and give it to Bob. Bob goes and spends that money at Jane’s store. And so on. If Bob runs out of money because he gets fired, we give Bob money to go spend at Jane’s. If Bob still won’t spend that money and Jane gets into trouble, we’ll just give Jane more money too. Then she can rehire Bob. And then maybe that stingy bastard Bob will finally start spending again.
And then hopefully, if they do this just long enough, we’ll have a vaccine and we can go back to normal and we can return money printing levels to normal. Everything will be nice and pretty again and our economy can go back to pumping-up stock tickers. Maybe.
Let’s also assume that as things get worse, they’ll do this more. If there’s one thing Republican and Democrats can agree upon it’s that crashing the global economy is bad for reelection campaigns.
The problem with predictions, especially doomsday ones, is that they highlight the negatives, while largely ignoring the equally powerful positives and positive actors attempting to prevent the doomsday from happening. Even if time moves us towards the doomsday outcome, it will do so awkwardly and unpredictably, as the momentum is intercepted by other forces – governments, central banks, you and me. Predicting markets is almost impossible, especially since, as I discussed before, markets are a poor reflection of economic reality.
Rather, I'd like to lay out some of the realities that I think this situation will create. I think two definites are that the economic situation creates more dependency on the Fed and furthers economic inequality.
Once the government does something, it’s hard for them to stop. Even though QE came as a result of the ‘08 crash, that didn't mean that the Fed was going to stop QE after the crash. They still held QE in their back pocket for whenever the economy seemed to be faltering. Spending has continued to skyrocket.
When the economy grows dependent on federal stimulus, it changes the fundamental economic framework for long enough, that reducing the spending can fracture the system.
In many ways, corporate bailouts upset the true risk-reward nature of a free-market. Adam Smith said, “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Well, companies’ interest is to make money. Usually, the constraint on that behavior is: one, law, and two, risk. Bailouts take the risk away, and there’s a lot of irresponsible money-grubbing behavior that can happen inside the law once risk is removed.
Just look at the effect of Federal responses to the 1929 market crash and subsequent Great Depression. The National Industrial Recovery Act demanded corporate wage increases in exchange for the softening of anti-trust and anti-monopoly laws. The Wagner Act (the National Labor Relations Act) strengthened unions which further strengthened work salaries. In the short term, this helped. But in the long term, it may have even hindered growth. I quote the Hoover Institute here: “in the absence of these policies, we estimate that labor input would have been about 20 percent higher than it was at the end of the 1930s and would have returned the economy to trend by that time.”
In light of that, the government did manage to roll back a number of those measures. Roosevelt declared sit-downs illegal, limited the power of unions, and increased competition with his economic policies in the late 1930s. But with such a divided Washington and fractured country, who sees that happening today? Especially when reducing spending would dampen immediate market growth.
We’re creating an ultra-centralized economy that can’t breathe without the Fed providing the oxygen. And if the Fed is giving us our fix, they’re certainly going to implement more controls on how we can use it. Centralized economies lead to political centralization. Milton Friedman would agree when I say that economic freedom is social and political freedom.
The problem is that federal spending goes disproportionately to capital creators over non-capital creators. A capital creator is someone who keeps capital moving – keeps the markets up. They’re the investors, the businesses, the banks. They’re critical for sure. They represent the infrastructure; but there’s a whole host of people who provide non-capital value – e.g. teachers. Struggling teachers don’t collapse the economic narrative. Teachers have always struggled; the incentive to help them is lower.
Thus, we will continue to perpetuate the growing economic inequality. I’m not even trying to make an ethical or political statement here. You can believe that these capital creators are more worthy of governmental relief, but the truth is that federal spending targeting big business will create disparity. And income and social inequality lead to political and economic instability.
As LT3000 said:
“When wealth inequality reaches extreme levels, there are only three ways the imbalance can be resolved. The first is a 1929–32 type depression (wealth inequality last peaked in 1929) which wipes out all the banks and most companies and hits a giant reset button. The second is a swing to left wing economic policies (as opposed to centre left) that leads to a combination of income/wealth redistribution, improved bargaining power for labour, and eventually inflation; and the third — somewhat counter intuitively for many I’m sure — is a long period of negative interest rates. Any of these outcomes are theoretically possible. Without regulatory intervention, 2008 could easily have morphed into a #1 reset, but the actions of the authorities decisively ruled that option out. Instead, we have so far gone down the road of #3.
COVID-19 + Central Bank interference will likely make sure that #1 doesn’t happy. Bailouts and debt forgiveness will assist that. But unless there is money pumped towards lower income families, I expect the inequality to grow dramatically. This will lead to either dramatic redistribution policies, is widespread anger."
I worry about what the COVID-inspired economic recession will do to an already fracturing country. I’ve always been on the fence regarding universal basic income. But I think there’s an argument for it here.
We've already seen inflation. Don't let low annual inflation rates fool you. Healthcare costs, education, the stock market, and luxury items have inflated greatly. The real question is whether we'll see base good inflation or USD inflation in relation to other global fiats.
Ultimately, the question is whether we see an inflationary or deflationary recession. So far, it’s been deflationary. If it’s deflationary, everyone sells everything in a run for the dollar. If it’s inflationary, the dollar stops being a safe-haven and people run for everything that has scarcity.
It all depends on how resilient the Fed’s economic narrative proves. The question is: what will it take for a critical mass of people (both domestic and international) to look at the books of the United States and most “financially stable” countries and start worrying because: tanking markets + economic fissures + social instability + irresponsible fiscal policy = a questionable fiat currency. At that point, they might stop seeing the dollar as a safe haven from inflation.
Even just a small jump in inflation could facilitate a bit of a run on the dollar. It could also push the Fed towards wildly desperate moves to curb inflation which could deepen a U.S. recession. In the ‘80s, the Fed pushed interest rates to 20% in an ambitious (and desperate) effort to curb inflation. It largely succeeded in its intended goal but it had brutal consequences for the economy.
I do think we could begin seeing the first signs of the dollar inflating above 10% a year since the 1980s. We saw it briefly break the 5% mark in 2008. Without many other trustworthy fiat currencies available, I think there could be a move towards assets with inflation protection – i.e. assets with fundamental scarcity: gold and precious metals, bitcoin, certain cryptos, and collectibles.
I think that’s what it all depends on – finding a vaccine. I don’t think governments will fully embrace a no-quarantine philosophy without a vaccine. Even if governments go the route of Sweden and try to weather the storm towards herd immunity, I think we’ve seen that there’s an element of chance. Some countries seem to get hit by particularly virulent strains and can do little to avoid it. If enough countries get unlucky and suffer, others will think twice before risking the wrath of their population. And if we keep countries locked down, economies will suffer, and the population will suffer in turn. Even if some countries stay open and follow Sweden's example, there’s still the brutal economic blow of minimal trade and tourism. Sweden’s unemployment rate is still the highest among Nordic countries and up from 7.1% pre-Corona to 9% today. So there we are, back to the vaccine. No economic recovery until the vaccine.
I think the markets are holding until news of a vaccine. They'll weather more economic bad news until then, because, that’s what they’re expecting. We have three vaccines that are in or moving towards phase 3 trials. The Fed has committed to buoying the markets and the economy until then. Likely, at the first news that a vaccine has passed through phase 3, the markets will jump. There’s a lot of hope and a lot of patience for this vaccine. The expectation is that the economy will explode when it happens.
However, I think it's also unlikely that we go from vaccine trials to rollout to success without any hiccups. Perhaps the vaccine only creates antibodies that don’t last long. Preliminary research (albeit in a small sample size of 34 individuals) into the antibody levels of those who recovered from mild cases of COVID-19 shows that antibodies wear off within months. Perhaps the vaccines prove less effective or research drags on with little success. These vaccines use novel mRNA vaccine techniques. It’s not clear how successful they'll be. It’s difficult to say how long it will take until they create one that is good enough to “return things to normal,” even if initial reports are positive. I don’t think between now and August 2020 we see the announcement of a successful vaccine, its successful rollout, and successful herd immunity without some hurdles. Such hurdles could quickly crash initial optimism.
Of course not. The global economy still remains strong. Technological progress has created unprecedented value in recent years and it's unlikely to stop. America’s tech center and economic might will ensure people don’t give up entirely on the dollar. There's also not a lot of other trustworthy fiat currencies out there since everyone is spending like the U.S.
Even when the market next crashes, it will eventually bottom, and it will eventually recover. Remember that in the next buying opportunity when everyone is calling doomsday.
Things will play out differently than expected. Humans are resilient. They will adapt. They'll find ways of morphing and filling in the cracks with new, innovative economic value. I'm concerned. But that doesn't mean I don't think we might be able to weather this storm.
I don't know exactly what is going to happen. However, I’ve learned from past losses not to make too many excuses to cover up poor fundamentals. Sometimes markets simply don't reflect the underlying reality and try as we might, no logical fit can be found for why it’s so. They usually eventually correct. I’ve learned to trust this. If there’s one thing I learned from watching the cryptocurrency crash, it’s that people always have a million reasons for why we’re not actually in a bubble. But when almost no actual businesses emerged to support a total asset market cap that stood at almost a trillion dollars, crypto corrected. Just because markets are moving in one certain direction doesn’t mean they’re logical or sustainable. Patience is key.
Companies will need bailouts. The unemployment rate will stay high. The poor will get hit harder and America’s inequality gap will grow. I'll stay wary of equities while I wait for a correction. It’s certainly possible everything works out and the markets stay up indefinitely because people are simply sheep. They’ll spend when they’re told to spend and invest when they’re told to invest and the Fed will just keep on sputtering forever. But I’ve never thought investing in other people’s stupidity was a very good idea.
What am I going to do? I’ll buy what’s not insanely overvalued given the risks (or at least attempt to). I refuse to FOMO. You’ll find me buying things that I think have real fundamental value instead of buying heavily inflated equity prices boosted by stimulus checks. History has value. Sentimentality has value. Scarcity has value. Real estate has value. I'll hold Bitcoin and crypto in case the dollar inflates and I'll hold cash in case it doesn't. I’d rather play it safe during a time like this.
I’ll also continue to read. Lyall Taylor just put out an exceptional post called Market inefficiency, liquidity flywheels, asset class arbitrage, and Hong Kong Land. It’s all about finding value in an overvalued world.
Please join the discussion in the comments section. What do you think will happen? There's only so much one lonely, coffee-addicted writer can cover on his own.
You can FOLLOW me on Twitter: @noamlevenson. I received no compensation for this article.
Create your free account to unlock your custom reading experience.