Author : John E. Charalambakis
Date : August 10, 2013
The developed world’s crisis of 2008 was the result of credit over-extension fed by international imbalances and a finance sector that was issuing instruments whose collateral base was questionable. Developing economies such as the Chinese resorted in avoiding severe recessions by financing projects whose real cash-flow value nowadays proves to be pretty shaky. “Money-for-nothing” tales since then bring back to memory Bernard Mandeville’s prose titled Fable of the Bees: Or Private Vices, Public Benefits. Mandeville’s piece is an illustration of efforts to sustain what is thought to be a stable disequilibrium where the private lifestyles of few – despite being universally recognized as vices – sustain the jobs and incomes of the many.
Three hundred years later after Mandeville’s work the fable continues. We (the developed world) may no longer finance excessive spending through the savings of developing nations (at least not as much as prior to 2008), but our innovations now build modern Trojan horses and through swap lines among the central banks we can sustain what is perceived as a stable disequilibrium. Debt-fueled spending (accommodating also political vested interests) and the over-development of sophisticated markets for those IOUs, have entrapped us into a skyscraper/tower whose foundation can barely hold a building of ten floors.
We cannot deny the fact that the modern Trojan horses invented have made it possible to avoid a depression for the time being. In that sense they represent a Pyrrhic victory, but have inflicted significant damage in the form of nonlinearities where non-teleological open-endedness (in the sense of what to expect) has become the norm in the markets. The fear of this development is that we have moved from a reversible process into a stochastic nonreversible one. Therefore, we can no longer talk about market equilibrium but only about the possibility of sustaining a stable disequilibrium.
Such a system with its nonlinearities is able to amplify small causes into large effects where due to bifurcations (inflection points) small events result into major macro effects. The consequence of that is the exacerbated probability that what could have been a non-event, now can decide the path that the system will take, which could be disastrous. This stochastic element introduced by the modern Trojan horses, renders a potentially self-organizing process into an inherently undetermined one, with the possibility of destroying the capital base of institutions such as banks and corporations.
As an example let’s review what has happened to the Fed’s portfolio since the beginning of the year. The yield on 10-year Treasuries has increased from about 1.6% to around 2.6% (an increase of about 62%). Such an increase has inflicted a mark-to-market loss of about $192 billion on the Fed’s portfolio of bond- assets (a.k.a. someone else’s liabilities). If this trend continues or if another small event forces a different path on interest rates, then the Fed’s capital cushion could be wiped out. Same – if not worst – outcomes are happening on the ECB’s balance sheet. Both institutions sit on very thin ice (capital base) where a non-event may incapacitate them from selling their assets (in order to recover), since more sales will drive interest rates even higher, backfiring and creating at that point an unstable scenario that will feed uncertainty and not only freeze credit but also has the possibility of destroying currencies. (The latter happens because according to the Fed’s accounting changes implemented in 2011, the Fed transfers all its losses to the Treasury exacerbating the deficit and thus undermining the currency).
The chosen path of the central banks is to keep interest rates at almost zero levels and hold on to their bond-assets until maturity, hoping that the system will recover by then (the Fed’s portfolio duration has increased from 2.6 years to almost 7.3 years). However, the new evolutionary, nonlinear, and non-teleological monetary scheme developed has gravitational effects that distort and amplify non-events. The measures applied with abundance, overwhelmed the system’s ability to absorb and emit the equivalent of light (real growth that dissolves labor, capital, and other surpluses) in the cosmological universe; hence they have been converted into dark matter demonstrating its presence only through gravitational forces.
Unless such gravitational forces are counterbalanced by internal pressures, the system (like any star in the universe) is destined for collapse since anything that enters the event horizon crashes and a singularity is being formed. The current evolutionary phase has followed the stages of originally being flattened and then contracting (2007-2009), to the current phase where the gravitational forces are so intense that trap growth prospects (event horizon). In that sense the pronouncements about the new normal where growth is anemic and unemployment stays high make good sense. The new normal is the period where the entrapment of growth prospects forms the event horizon that crashes material entering into its zone.
The inflection point for the current phase has been the significant increase in the 10-year yield. If an estimate could be made (let’s not forget that the only certainty about a forecast is that it will be wrong) at this stage is that the old duration of the Fed’s bond portfolio is the time interval before a singularity (collapse) takes place.
Ode to counterbalancing forces that may cancel the gravitational pressures of those Trojan horses a.k.a. dark matter.