So what is going on with financial markets? Extreme volatility, US dollar going up, asset values going down. Feds still manipulating the Bond Market, and EU Bankers about to try another dose of the same, by propping up a monetary system desperately in need of repair. Only God knows what is going on in China and the German wunderkind seems to be loosing its luster. Small wonder Christine Legarde of the IMF (International Monetary Fund) has toned down the rhetoric that all is well with the World Economy.
I believe that the confusion within the markets, maybe caused by a misunderstanding of the 2008 collapse, that was a credit crisis as opposed to a recession. Traditionally a recession has been described as a slowing of demand for goods and services, resulting in increased unemployment and all kinds of other misery. It has been the norm for this kind of correction to last no more than two years. With a credit crisis the whole monetary system is thrown into question bringing a new set of dynamics into play. Banks stop lending (even to each other) and spenders and savers lose confidence in the markets. This insecurity takes a long time (some say a generation) to correct, and in the meantime investors will be jumpy and nervous, a condition that fosters volatility. The experience of Japan in the early years of twenty-first century (a classic credit crunch) is a prime example, to the point where the subsequent sluggish growth and modest deflation of the past twelve years is now called the Japanese Disease.
To avoid a repeat of the dreaded decease Central Bankers in the rest of the world are apparently now willing to tolerate a 2.5% annual rate of inflation with a target of 4.5% unemployment. (even bankers now admit they are not perfect) To get to this nirvana the bankers are printing money at alarming rates, hence the race to the bottom that I have written about.
But where are the legislators and fiscal policy in all of this? Have they gone for good leaving it to the bankers to sort out? Well, it certainly seems like it.
When it comes to economics most politicians are Mugwumps those who sit on the fence with their mugs on one side and their wumps (sic) on the other. What they are really trying and do is to take the credit when things go well and avoid the blame when they do not. In their fantasy world stimulus is good, tax increases (heaven forbid) and bad. Only when faced with the harsh realities of the bond market will they act in a responsible manner, and then they blame the Central Bank.
There is one notable exception to this tendency is the righteous indignation shown by legislators after the fact. The Keystone Cops racing after the bad guys laying down arcane regulations that attempt to legislate function and morality. (Dodd Frank Banking legislation in the US being a good example)
The trouble with retro-legislation is that it seldom works, and more dangerous, it drives huge amounts of capital into shadow banking. This is the world of derivatives, hedges and other arcane financial tools invented by ‘quants’ (mathematicians) to mimic the ownership of all kinds of other assets. I call these things ‘funny money’
We have heard a lot about ‘Too big to fail’ AIG a good example. of a giant that had to be rescued with an infusion of $180 billion to honor Credit Default Swaps (Derivatives) for fear a partial settlement in bankruptcy would bring down the whole system.
But what about all the other financial hedges like the short straddle (whatever that means) that destroyed Barrings, the oldest merchant bank in the world. This is the case of Nick Leeson a rogue trader (another description of a crook) who hid his losses of 827 million pounds and broke the bank. Or the London Whale I wrote about last week who lost $6 billion before the keystone cops caught up with him.
Mega banks now make a great deal of money by trading in Funny Money, a process that few understand and even fewer can quantify. Even more scary most of the action takes place offshore in Hon Kong or Singapore where tax rates are benign. I have heard of one bank that is rumored to employ 5,000 traders in Hon Kong most of whom rely on quants for they’re highly leveraged pay packets.
So I suspect that these behemoths maybe causing many of the market gyrations that happen almost every trading day in European and North American markets. The markets for funny money are now so enormous they are driving, (rather than following) the values of other assets. In other words, the tail is now wagging the dog, and this tail is totally unregulated. If I am only half right we can expect more volatility and many more disasters.