Rules Will Continue to Be Changed for Big Market Players
The well-connected get to play by one set of highly pliable rules, while everyone else must adhere to the much smaller footprint of hard-and-fast rules.
To anyone paying the slightest bit of attention, these remain very uncertain and trying times. On one side of the intellectual divide are the folks who are counting on deflationary forces overwhelming the normal credit-operated machinery of modern life, resulting in an implosion of economic activity. On the other side are those counting on hyperinflation as the most likely outcome of the grand printing experiment currently being conducted across the globe with its epicenter located within the United States.
In the middle of the intellectual divide are people like me, who are leaning slightly toward one view or the other. Not yet committed to any particular outcome, they're tensed and ready to spring in whichever direction necessary, like the last kids left standing in a game of dodge ball.
Some are expecting an imminent recovery (whatever that means), some a long, slow grind downward, and others a rapid, if not chaotic, plunge into new and unwelcome territory of one sort or another.
There are no right or wrong views here. All sides are on equally firm intellectual standing. However, I want to let you know why it is that I lean toward the inflationary line a bit (okay, a lot, by some people's standards) and why I think that a wide-scale, final fiscal collapse is in the cards.
More than a year ago I wrote an article entitled The Sound of One Hand Clapping -- What Deflationists May Be Missing, in which I framed the recovery in terms of bent rules, as opposed to what should be happening.
[Despite the bursting of a massive credit bubble,] everything just keeps perking along. What gives?
The answer, I believe, requires us to ask a Zen-like question along the lines of, "What is the sound of one hand clapping?" That question is, "If nobody recognizes a defaulted debt on their balance sheet, does it exist?"
Suppose, for the sake of argument, that there is a world in which banks are allowed by their regulators to pretend their default losses simply do not exist. And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.
What does "deflation" mean in such a world? Not much, as it turns out, at least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.
This is the world in which we currently live. Trillions in probable and provable losses quietly exist, out of sight, on the balance sheets of the Federal Reserve and other financial institutions. If they ever come out of hiding and onto the books, I think the deflationists will be proven correct beyond all doubt.
But let me ask this: What prevents the authorities from simply storing them out of sight forever? Or at least long enough to allow the wave of liquidity to work its inevitable magic? So far, much to my great surprise, they've managed to do exactly that, with hardly a squeak from the mainstream press (although the blogosphere is on the job, as usual). I am now wondering if they cannot keep this up indefinitely.
While I certainly took some heat from the deflation camp for these comments at the time, my words herald almost exactly what has happened since then. Losses have been ignored, the Fed has dedicated all of its efforts toward repairing bank balance sheets, and nothing really bad has happened to the financial system. Yet.
With the recent revelation that the Fed engaged with companies and banks headquartered here, there, and everywhere in more than 21,000 separate transactions totaling $1.5 trillion, in a successful effort to prevent bad investment decisions from turning into a series of cascading defaults, I think it's safe to say that what should have happened (i.e., deflationary defaults) didn't happen.
The New York Times published Fed Documents Breadth of Emergency Measures:
WASHINGTON - As financial markets shuddered and then nearly imploded in 2008, the Federal Reserve opened its vault to the world on a scope much wider and deeper than previously disclosed.
Under orders from Congress, the Fed on Wednesday released details of more than 21,000 transactions under the array of emergency lending programs and other arrangements it conjured up in response to the crisis.
At its peak at the end of 2008, the Fed had about $1.5 trillion in outstanding credit on its books. The central bank, in essence, pumped liquidity, the lifeblood of credit markets, into the circulatory system of an economy that was experiencing a potentially fatal heart attack.
At a recent event that I attended, which was heavily populated by political and monetary leadership, the view of most of the money types was that the "extend and pretend" strategy was a good and effective one. Others, like myself, argue that this "mission creep" by the Fed involves taking on too many roles, doing none of them especially well, and risking much, including the Fed's reputation and autonomy (such as they are).
Changing the Rules
The theme here is simple enough: If and whenever the circumstances justify a major response, existing rules will be changed, altered, bent, or broken.
Because of this, I routinely argue that what should happen won't happen, at least not right away, and that there's really no such thing as investing anymore, only speculating -- unless you're a big bank, favored by the Fed, with advance information.
To the first point, what should be happening right now, with consumer credit well below its 2007 peak and the housing market in disarray, is a massive deflationary spiral. Losses should be piling up and swamping bank balance sheets.
But they're not. Big banks are reporting record revenues and near-record profits, all thanks to Ben Bernanke's unshakable decision to prop them up and bail them out.
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