It’s 10 years this month since the Lehman Brothers supernova triggered the Global Financial Crisis (GFC). The big question is whether it’s over and not simply part of an interconnected pattern of events. Central bankers and national governments would have us believe that the GFC was an isolated, once in a lifetime event; that they’ve got this. But what if the cure – ever more debt – has simply created an even bigger bubble?
What makes this timely is that for the first time in 10 years, the medicine is being reversed. Beginning in the USA, the Fed is raising interest rates and reducing money supply, the feedstock that has ballooned asset values. Are we close to the next crisis?
False prophesy, flawed models
Prophesy is a human delusion. Time and again, models designed by the greatest mathematical minds harvested at great cost from Ivy League colleges, fail to detect incoming crashes. Everything is fine. Until it isn’t. The models are flawed, the wiring and feedback loops underneath the global economy are simply too complex for current science.
The models assume a world in equilibrium where extreme outcomes are about as likely as another Big Bang, so-called Sigma 25 events are so many standard deviations away from the consensus as to be unworthy of discussion. Around these models the groupthink converges, a groupthink that today believes that the Global Financial Crisis (GFC) is a past event and that the solution – ten years of Quantitative Easing (QE) – is a success.
Read September’s coverage of Irish national economic modelling by reporters writing fillers for broadsheets, and the same delusion repeats. It is grounded in the overwhelming human desire to believe that we can control events, yet the evidence is right before us, that we cannot.
First near miss: 1998
Within months of two of its board directors winning the Noble Prize for Economic Science, the Long Term Capital Management Fund (LTCM) spectacularly collapsed in a so-called Sigma 24 event in 1998. The destruction of its capital base of $4.5 billion threatened $160 billion of Wall Street bank loans upon which sat $1.5 trillion in derivatives. The US and global financial system were at stake if the LTCM imploded.
Twenty years ago, this month in 1998, the Federal Reserve System (Fed) stepped in. Interest rates were cut and capital created to bail out LTCM. That event marked the point when Wall Street crossed the Rubicon. Investment bankers concluded that if they make a truckload of cash by taking reckless risks, the Fed will bail them out, and if the gambles pay off, they pocket the loot to pay for private jets, houses in the Hamptons and political power.
It is not the only example. A Goldman Sachs global equity fund went spectacularly bust in 2009 in what its CFO described as a Sigma 24 event. It shouldn’t have happened, but it did. According to the models, Black Monday (October 1987) ought not to have happened, but it did. It is the models that are wrong, not the world or how it works.
Second near miss: 2002
The same banks went on to create the dot-com bubble, bringing unbaked companies to IPO on the NASDAQ where things like cash flow and profits were quaint ideas. It went spectacularly bust, causing a wealth loss of $5 trillion but not before enriching bankers who sold on the day of IPO. The reaction from the Bush administration was a tax back scheme, bypassing banks and putting cash into consumer accounts to spend. (Trump is doing the same thing today at a cost of $1.5 trillion. He is printing growth, or so he believes.) The Fed cut interest rates to nose bleeding lows and the result was the housing bubble, which went bust 10 years ago this month at a cost to the US alone of $20 trillion in wealth loss.
Third near miss: 2008
Lehman Brothers collapsed in September 2008. It marked the opening of a global financial crisis that threatened banks everywhere with ruin. The Central Bank’s response was the same as before, except global: cut interest rates and buy securities including government debt at prices no one else is prepared to pay. Print money.
Over the next 10 years, the US national debt doubled to $20 trillion under Obama while the Fed slashed rates for banks in supply-side measures that simply acted as a transmission vehicle to the balance sheets of the wealthy, the owners of capital. The Bank of England, Bank of Japan and the ECB followed the footsteps of the Fed.
This transfer of wealth, bypassing workers, is arguably the feedstock for Trump and the emergent right wing in Europe and it contributed to Brexit as populations attempt to reassert control, frustrated by high taxes on work and little sign of real gains on wages, despite raging stock markets.
For 10 years, capital was for nothing and so were risk assets. Property and shares were in distressed condition and bonds were great value as interest rates got crushed. It was a bonanza if you were in the club.
Who are the zombies?
It is over. But the delusion isn’t. Quantitative Tightening (QT) has begun. The biggest threat facing all economies including Ireland is that the greatest experiment in money expansion ever attempted is flawed, that much of the growth it has created can be traced directly to Central Banks and their collective attempts to fix the price of money and dictate business cycles.
What that means is that the values today for risk assets, property, equities, bonds, the stuff of pension funds, sovereign wealth, and savings which directly connected to the stability of the banking system, may be based on a trick. That much of it is fake.
We have entered the most dangerous phase of the rescue from the Lehman Brothers supernova, when the steroids are reversed, when the huge increase in money expansion starts to drain, exposing zombie economies, countries and banks who, at normal rates of interest, would have failed. The response to the GFC has created its own monsters and we will know them shortly by name. These are enterprises that are incapable of servicing their debt as interest rates rise. As debts come up for maturity, markets will price them off the board and this includes a host of countries facing a spike in loan maturities over the next few years.
The truth is that the global financial system that sits atop the global economy is inherently unstable. Global debt is up over 50% above its position 10 years ago but the underlying economy has grown by a third. Now that the tide is ebbing, the zombies are getting exposed. It is an everywhere bubble where countries like Italy, sectors like Australian property, and enterprises like Deutsche Bank that otherwise would have been forced into deep structural reform, didn’t do so. After all, why undertake radical surgery when you can kick the problem out to the next generation of management whether commercial or political?
The list of casualties is growing. Venezuela, the favoured child of President Michael D Higgins, experimented with Bolivarian Socialism and spectacularly collapsed leading to drastic food shortages and mass emigration. Venezuela, despite sitting on vast oil reserves, is experiencing inflation this year of one million per cent, its currency in ruins. Argentina, heralded in Ireland in 2011 as the example to follow in defaulting on debt, is in terrible condition, the peso has lost half its value against the dollar, interest rates are 60% and it is getting a $50 billion IMF bailout. Turkey, where Erdogan holds the Central Bank captive, is bordering insolvency and engaged in talks on a bailout with Germany and France. If the lira falls to more than $7 or €8 and stays there, it will not be able to service its foreign currency loans, the curse of emerging market national and corporate debt.
The decline of emerging market currencies against the US dollar as the Fed begins Quantitative Tightening (QT) will not be easily solved because global QE led to a decade of failure to address structural imbalances in economies. The curse for informed politicians is that they cannot do the right thing and get elected.
The result is that the destiny with excess debt and the delusion of Keynesian money expansion is arriving on our watch while the world fixates on Trump’s gamble in accelerating the pressure cooker US economy. Trump deploys a New York developer tactic in renegotiating trade agreements by going in boots flying, bypassing years of negotiations. It is working but Trump may be in a race with the next recession – which could be a structural one – and his second term election. That’s if he politically survives as POTUS.
Trump facing a Triffin dilemma
Longer term, what is at stake for the US is its competitive advantage as the supplier of global liquidity from its privileged position as the owner of the world’s top reserve currency. Belgian-American economist Robert Triffin (1911-1993) predicted that such currencies lead to dramatic tensions between national and global interests and that producing liquidity for the global economy eventually leads to currency collapse. The dilemma facing Trump, if he wishes to deploy the US dollar as a weapon to hurt economic opponents, is that such America First policies run contrary to managing a world reserve currency.
Trump is reshaping global power, driving erstwhile allies west in the direction of growing Chinese reach. Beijing, partnering with Moscow, has its sights set on breaking the hegemony of the US dollar which is perceived as being weaponised by the US administration. Across the emerging market landscape, national currencies used to finance US dollar debt and pay for imports in dollars are falling. Not all will degenerate into fresh casualties as creditors determine who has reformed and who hasn’t, but there is enough evidence to suggest that we are on the cusp of a fresh global debt crisis.
Closer to home, the Italian coalition government, about to set its first budget, appears to be on a collision course with EU fiscal rules. It will want to increase its elevated national debt even further and run bigger deficits longer if it is to deliver on the flat tax and pension enhancements that got it elected.
Behind the global debt surge and extreme QE, like in Japan where the Bank of Japan’s balance sheet now represents 100% of Japan’s GDP, is the simple arithmetic that the west is ageing. It is going broke, the welfare state built throughout the 20th century cannot stand, not without the state retreating from its growing share of economies.
Quite how that can be done without first reaching the next precipice is why I wrote The Pivot, (Imprisoned by Debt, How will the World Pivot and What can you do to Prepare?)
What can you do to protect your wealth?
Having a Plan B ready to roll makes sense for Corporate Reserves, Staff and Self-Administered Pensions, Bank Savings and Unit Funds, if the chickens are coming home to roost. Don’t expect this message to be supported from the consensus among asset gatherers, life offices, financial brokers and most wealth managers. It didn’t last time either. To discuss a review with us, get in touch today.