Human Nature Isn't Part Of the Monetary Handbook
As the chronic malady that passes for the global banking system continues to exhibit new symptoms of dysfunction, the response of authorities and policymakers is near universal in their championing methods of willful destruction (the latest being the Swiss National Bank). I suppose this makes sense in this current age where, for much of the last few decades since the uneven adoption of Basel rules in the late 1980's and early 1990's, safety has been thought of as the imprimatur from one or more ratings agencies.
In other words, in an era where risk is a variable in an equation and investors and people respond by the numbers, this all makes perfect sense. The shifting of risk management within the banking system to this kind of approach is an excellent representation of how the entire financial system reworked the very idea of risk into mathematics and models away from the humanity of basic economics.
The basic idea of this modern transformation is actually sound on its face. The old measures of banking health that were based on the actual quantity of cash in a vault or on reserve with a central bank said absolutely nothing about the probability that the bank might actually fail. The old depository notions of reserve requirements merely set minimum standards of survivability for depositors should the bank get into trouble. So the move to define and quantify the probabilities of a bank to experience trouble before imperiling the liability structure was a leap forward in theoretical thinking.
Unfortunately, as is the case with nearly every major regulatory change, the weaknesses were exploited in the never-ending attempts of banks to simply grow as large as permissible under whatever rules were adopted. As we know now, the banks and ratings agencies essentially modeled a pathway to obscene levels of leverage. And further, their hubristic assumptions of being able to precisely model and predict risk were fatally flawed, especially as they were blind to the fact that banks really don't want to be inhibited.
At the same time this transformation of the basic perceptions of risk was reworked, these ideas of credit "safety" became ingrained into the very foundations of finance. So much so that as the age of mortgage bond collateral ended in the Panic of 2008, no one really thought to challenge the basic assumptions about not just what risk bucket mortgage bonds really belonged to, but whether any mathematical construct can ever satisfactorily describe any risk bucket for any security.
Very few seem to have asked whether it is appropriate to begin with to discriminate against individual securities by grouping them into quantifiable risk classes. Instead, the banking system in particular, and finance in general, simply substituted one "riskless" product for another: mortgage bonds were easily replaced by sovereign debt, including Portugal, Ireland, Italy, Greece and Spain.
Once again, however, the shift in asset composition of the aggregate banking system globally represented not an attempt to return to safer assets, rather banks were simply and desperately clinging to the status quo of leveraged bank books. They moved to questionable sovereign debt not out of safety considerations, but because they wanted to maintain their size per given quantity of equity capital. It was a calculated gamble on the part of banks that they could use this regulatory loophole pertaining to sovereign debt to appear solvent, while implicitly counting on unleashed moral hazard should the sovereign situations deteriorate further (which banks knew was a sizable probability).
So, while the regulatory framework under the Basel rules described the banking system as shifting toward safer assets, in reality banks had done nothing of the sort - but they were priced as if they had. The packaging of risk buckets held no real value in the schematic of actually defining riskiness. In truth, the overall pricing of riskiness has been askew for decades. In fact, risk is intentionally being mispriced still today under the cover of a hodgepodge of global, ad hoc central bank interventions.
In economic terms, a cyclical recovery is one defined by engaged risk takers. The downslope of recession produces extreme values denoted by unfettered price discovery. While that process is messy, complicated and in many cases unfortunate, it forms the essential conditions for that recovery. That is the essence of creative destruction and market discipline, and the necessary roles they play in pruning the inefficient from the economic tree.
But our current economic case is not a cyclical event. Any "normal" cyclical business cycle exhibits a much tighter grasp and understanding of real risk.
As I wrote last week the current, building banking crisis has developed as a result of paper refutation on several derivative levels. The central problem is that no one rightly knows what all this paper is worth, or, in the case of rehypothecation, to whom it even belongs. This disconnect between price and value is not just a symptom of the intentional interruption of price discovery by central bankers. There is a much deeper disconnect that is at the heart of our current struggle against unending uncertainty. It is the structural problem that must be squared before any meaningful progress can be made.
So much paper exists without any fundamental link to real wealth or value, and the public's collective perceptions of this disconnect kickstarts a kind of financial survival instinct. Real risk, not risk buckets, applies here.
We can examine this idea of price and risk through the lens of government debt, where its true value lies in the authority of governments to levy and collect taxes. At least that was how it was perceived historically. Yet, as we see in current example after example, that is not what really supports the system of debt-based paper (fiat) employed currently.
Even under the "modern" assumptions of risk buckets, sovereign debt was afforded lower risk weightings because it was assumed they could simply tax themselves to solvency. Again, as a practical matter, it is never so simple.
The ability of any nationalistic economy to absorb taxation is, and has always been, a function of its productive capacity. Since taxation reduces productive activity and capacity, there is a finite limit to that ability to tax, or even the potential to tax. That boundary is being enforced and explored by the PIIGS, and even the U.S. What market prices, propped by central bank transactions, are saying is that all this paper is riskless, money good debt, while individual perceptions of the effects of increased taxation on productive abilities say otherwise.
What was seen as rising prices in the last decade was nothing more than a pyramid of credit and paper circulating around and about a stagnating ability to produce real goods and services (mostly the former). To put it simply, the additions of "riskless" debt grew exponentially simply because mathematical assumptions were so badly calibrated to economic realities - the entire period of monetarism was an episode of simple price inflation. Leverage was easily applied because the regulatory framework abided it in the face of quantifying risk as a financial concept. If risk was better understood as a function of the productive economy, perhaps the pyramid of paper and the productive economy would never have moved so far asunder.
Now that this flaw of modern finance has been exposed, the pricing of risk and the attempt to reconcile that pricing to fundamental values has led to refutation and devaluation everywhere, across national boundaries and asset classes. Not only are financial assets being rethought, productive assets also undergo this revaluation now that the entire systemic framework is rethought in terms of true value as represented by something other than paper price.
So in basic terms, what the global financial system is experiencing is an esoteric episode of conceptual deflation. There is a growing disconnect between the financial world and the real economy. Unfortunately, closing that gap requires a radical reconciliation. Either a significant amount of paper has to be destroyed, or all that paper has to force productive assets into existence to rebalance these proportions more favorably.
The latter has been the goal of government and central bank intervention from the start - this belief that the quantity of debt or money can create sustainable activity. Unfortunately, in the real economy, this is a backwards product of tortured logic. If it really were that simple, all any central bank would have to do is print money to pay off government debt (circumventing the link to the productive economy), or allow the banking system to redefine risk in even more narrow buckets in order to further leverage out credit creation. All that needs to be accomplished, if we believe this line of thinking, is a tight control on the price of risk. Unfortunately, every time this has been tried it has ended in collapse. A true recovery is not a monetary event.
Yet central banks persist in their belief that they can create economic activity through monetary or paper means. In a 2002 speech, Ben Bernanke, current Federal Reserve Chairman, summed up this belief:
"But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation." [emphasis added]
The central bank commits itself to destroying the currency to get people to stop holding on to what is being devalued by diktat. Yet, ordinary, self-interested people don't necessarily respond to this destruction consistently in the manner Mr. Bernanke spoke of then, and has put into practice now. Bernanke, the Federal Reserve policymakers and the economics profession collectively believe that humans, in this instance of intentional currency destruction, will make the rational decision to trade declining dollars for real goods and services. The central bank can force people, it is believed, to do what they otherwise do not want to do by changing the perceptions of relative value through price.
Again, this mistaken monetary proposition (the "always" in the last sentence spoken by Mr. Bernanke has proven to be incorrect by our current circumstances) presupposes money first, activity following. Money, expressed through price, is the cause and economic flow is the result. What actually happens, however, is that while economic activity can result from money creation, it is neither a uniform consequence, nor is it of a clearly desirable breed (the housing bubble came from money creation; it is easy to classify activity that flowed from the bubble as undesirable).
Economic flow, or what we call an economic system, is really predicated on something far less rational and far more human: faith. Humans will not let go of devaluing dollars if they do not perceive stability in their belief of acquiring that spent dollar's replacement. The Fed can destroy the public's holdings of financial assets all it wants, but if the same public is consistently worried about their ability to survive past today, meaning humans actually care about how they will acquire goods tomorrow, the public will consistently and knowingly act against what might be considered financial self-interest.
This is where risk and stability intersect. Stability loosens that fear of the longer-term, allowing individuals to more faithfully part with current means of exchange simply because future means are perceived to be far more assured. Under conditions where the pricing of risks are not well understood, not completely transparent, or universally accepted as easily falsifiable hogwash, the public will rationally accept a diminishing store of value simply because it represents the assured ability for at least a minimum of future exchange (a bird in the hand, etc.). The calculus of risk in this vital case is really about the utility of self-denial today in exchange for survival tomorrow (or to put it less dramatically, an instinct to preserve and maintain a minimum lifestyle for the future).
The destruction of purchasing power, then, cuts both ways. It may make current asset holdings deflationary and less desirable to hold, but it also diminishes future purchasing power and imperils the productive economy's ability to expand or even maintain future prospects for all participants. In times where risks are so fundamentally mispriced, future purchasing power, the ability to replace current money if spent, tips the aggregate scales of economic flow against what the central bank subjectively views as "logical" self-interest. Flow cannot result from debasement because of the basic survival instincts of humans - it is feckless to destroy the bird in hand to get people to chase the two in the bush, especially if they believe the birds out in the bush are particularly and unusually elusive.
Since central banks have opted for the wrong monetary direction, their efforts at stimulation are counterproductive - the vast chasm between prices and the perceived values that flow from the productive economy fosters this dynamic of the utility of self-denial. This line of thinking is essentially a parallel proposition to Milton Friedman's permanent income hypothesis.
Where Friedman asserted primacy of how a person acquires money, I believe it is equally important to consider how people view the value and probability of maintaining access to future money flows. Uncertainty, defined here as both economic disruption and financial fears through the elevated risk/price disconnect, interferes with the more basic notions of maintaining steady income, so the natural response in these more extreme imbalances is rightfully to save, not spend. Centrally planned interventions are a feedback loop of destruction, then, as their policies serve to ingrain this impulse ever more forcefully.
To far too many experts and economists, this seems like a "chicken and egg" problem. It's not. They fear the unknowns of actually allowing the system to naturally reprice risk since that will certainly bring about losses, disruptions and general financial pain. So we sit in the Purgatory of uncertainty where the official global policy is to make the illogical and surreal real. Central banks and governments feign that the bounds of self-constraints don't apply in the face of a true assessment of productive capabilities.
Official policy continues to pretend that all sovereign debt is riskless and actively works to make sure it is priced as such. Above all, everyone with a lever of authority or power intentionally embraces wanton destruction, all in the name of aiding a recovery that, for some unknowable reason or circumstance, just does not want to ignite or appear. I suppose in a similarly tortured way, that makes uncertainty a universal property of this paper age, equally applicable to the public's intuitive sense of productive value as it continually diverges from the enforced pricing regime as to policymakers' mathematical grasp of human nature.
