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Stranded in the maze of the last crisis

Published at: 06-12-2019

Posted on: December 6th, 2019 by RaduC No Comments

It was a bullet whizzing past us, investors, bankers, employees, employers, consumers, deposit holders and the list could go on. The 2008 crisis, by its complexity, has had a serious and profound impact on financial and economic systems, in the developed economies, in particular but also on the rest of the world by a spillover effect. The interconnection of economies and globalization compounded the situation by a domino effect which could have thrown the entire global economy into a deep crisis.

Ben Bernanke, the Chairman of the Federal Reserve at the time the crisis broke out, stated in one of his hearings that „September and October of 2008 was the worst financial crisis in global history, including the Great Depression”. And it was he again who said that „12 [of the 13 most important US financial institutions] were at risk of failure within a period of a week or two”.

The wave of contagion which would have ensued would have wiped out the financial systems in most countries given that the interbank lending market extends to the entire globe. And that is because absolutely all transactions of this type are underpinned by one key ingredient: confidence.

Once confidence is gone, however, everything freezes. That actually happened at one point. Nobody would lend to anyone, whether to a bank or a retail costumer. A perfect gridlock which could have led to economic and social mayhem. The stakes were so high at that point that the main central banks decided to cross the red line.

A red line that had remained for decades the law of every central bank mandate.

A red line for which any teacher of economics  would have immediately failed their students and any economist would have lost its hard-earned credibility.

A red line which directed central banks not to finance the debt of their own governments under any circumstances. For decades it had been considered that the approach guaranteed an inflationary process which might spiral out of control.

And yet, that was exactly what the main central banks decided to do. They started to finance their own governments and thus create money to inject liquidity into the system, unlock lending and prevent national budgets from running out.

The quantitative easing program of the Fed, the US central bank, pushed its balance sheet to over $3,500 bn from bond purchases. It peaked at 25% of GDP, against 6% before the crisis.

Of course there are always economists and politicians who claim, after the facts, that the approach by the Fed and other central banks was excessive and that taxpayer`s money should have never been used to bail out privately-owned institutions. Fair enough, in principle, but in practice things are more complicated.

The truth is that we do not know for sure what might have happened. Central banks thought that the stakes were too high, the perils too grave not to take any chances. At the end of the day, the responsibility never lay with today`s or yesterday`s kibitzers, but with the central banks which had to make a swift decision.

It did manage to bring financial systems back to life. Money started to flow through the veins of the global economy, everybody felt a sense of relief and slowly went back to business as usual. Without realizing that central banks` decisions back then propelled us into a new paradigm which we know absolutely nothing about so we are clueless as to where it may lead.  And despite central banks constantly issuing confident messages that things are under control and that they know exactly what they are doing, as per their job description, in actuality there are very few instruments left to navigate through an upcoming crisis. What better evidence than the fact that in the midst of economic slowdown and with a recession looming, they are getting ready to…..create more money.

Let`s not hide behind words here. Such a measure would be the result of a lack of ammunition which forces them to keep up an abnormality started ten years ago. What spurs them on is that for now inflation continues to remain very low. Or not… Indeed, the consumer price index is low across most developed economies which ironically suggests that quantitative easing has partially failed. At the end of the day, money had been printed to drive economic flows and consumption.

The missing inflation suggests that the money so generously injected into the system actually took a different direction. If we look closely we will see that it mostly went into finacial assets, real estate and luxury goods. These are items accessible to a minority rather than the large public.

The US stock market which is already at a record high is considered by virtually everyone to be overvalued, a consequence of investors making „leveraged” investments, meaning a mixture of own capital and cheap money. When central banks crashed interest rates we ended up in an unprecedented situation where time is no longer money.

The opportunity costs, the discount rates are so low that one dollar received one or two years from now will have the same value as today. That is the new “normal”. Hence the feeling that the American stock market is starting to look more and more like a Ponzi scheme in which investors follow the crowd and pump money, hoping that they will be the last to sell before the tide turns.

Abnormalities made investors blind to the compass which a decade ago used to show the right direction. So the only possible direction left if you don`t want to miss out on opportunities is follow the herd. Indeed, all financial assets ended up correlated, breaking the historically inverse relationship between the stock market and bond market which now move with each other. At the same time the measures taken by the Fed in anticipation of a recession are being met with enthusiasm by investors, who push the stock markets to new record highs. With a recession at the doorstep …

We are virtually, at a time when investment risk assessment is completely distorted and is no longer connected with the cost of money. Because money is free. And the despair to invest it at a positive yield somehow, anyhow is so pressing that they are hunting high-risk assets regardless of credit risks. Which suggests something else…

The quantitative easing run by central banks has been discriminatory and led to suboptimal allocation of liquidity which has widened the winner/loser gap. Central banks abandoned their neutral umpire status and aimed their money at governments and certain companies, with no restraint. On the other hand, the profits coming from lower financing costs only marginally translated into pay rises, which turned the public into the collateral damage of quantitative easing. In a world where nominal or real interest rates are negative only people with access to sophisticated investment know-how will manage to hold onto their wealth, and not those keeping their money in the bank.

The problem is that central banks now have their backs against the wall. They dread a recession so much that it suggests that even though it won`t be publicly admitted, they realize that something in the economic mechanism has broken.

Ultimately, economic cycles are part of the game and should not scare anyone. However, pumped with the quantitative easing steroids, the US economy is seeing the longest period of continuous growth in history, breaking the record by 120 months. So the threat of recession is so big that we meet it with the money printer ready? For how long? How will the gap between total goods and services out there and money supply be fixed? How long will financial and real estate assets cover this difference before the bubble bursts?

These are questions with currently no answers. Both simple citizens and savvy investors, however, are beginning to be increasingly wary when it comes to investment decisions. We may suspect that the change in public behavior occurred ten years ago as a symptom of the trauma triggered by the crisis. The prospect of losing one`s job, the inability to repay the bank, friends and neighbors without a job, aging put a damper on Americans and Europeans` appetite for consumption and increased their willingness to save. This may actually be one of the explanations for this decade`s lack of consumption and inflation. And I don`t see why things will be different any time soon.

At the same time, professional investors although encouraged to stay on the market first by companies` fundamentals and later by herding, have started to accommodate portfolios with lower profit margins.

Slowly people are bracing up. They just don`t know for what.

Is there a way out or the convenient answer is to knock off the “ab” in abnormal and pretend that everything is under control?

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