In Times Of Crisis…

Ok, so one of the things that most market participants fail to grasp is the extent to which interdependence increases the odds of crises.

I may be constructing a bit of straw man there. I don’t have any data to back up the “most market participants” bit. But if you count retail investors in “all market participants” I think it’s entirely fair to say that the degree to which interconnectedness amplifies the risk that local shocks become global (“when a butterfly flaps its wings“) is underappreciated by the majority of investors and traders.

It’s not so much that investors don’t grasp the idea that interconnectedness increases the risk of spillovers – that’s intuitive. Rather, as we alluded to above, it’s that most investors don’t appreciate how interconnected markets have become and thus don’t fully understand the potential for amplification. The presence of algos makes the situation more precarious still. Because while we can argue the fine points of liquidity provision, efficient execution, etc., what’s not up for debate is that when robots all get to chasing down the same rabbit hole, the potential exists for bad situations to become worse.

If you want to look at how quickly things can spiral out of control, look no further than the morning of August 24, 2015 when it suddenly dawned on everyone that China’s move to transition to a new FX regime had far-reaching and profound implications the magnitude of which could not immediately be discerned. Once things started moving in the wrong direction, the technical land mines embedded in markets courtesy of HFTs and ETFs became apparent as giant NAV disconnects contributed to the already palpable sense of panic at the open on Wall Street.

The point here is there’s a certain self-awareness that takes hold as markets become more interconnected. That is, markets evolve in ways that allow participants (carbon-based or otherwise) to take advantage of increasing interdependence. The rapidity of that evolution makes it impossible to know, ahead of time, just how connected things are. In most cases, that is only knowable after something goes wrong.

At a conceptual level (and probably at a technical level too), the unanchoring of currencies from an accepted and finite store of value (precious metals) serves to exacerbate the situation, as it becomes impossible to determine the extent to which assets priced in fiat scrip are “real.”

All of that perhaps helps to explain why, as Deutsche Bank’s Jim Reid writes in an expansive new note, “since the Bretton Woods system collapsed in the early 1970s and we moved into an era of fiat currencies where we broke all ties to gold, financial crises have been more regular.” Here’s Jim with a point-counterpoint on this:

Although our analysis so far shows that the post Bretton Woods financial order has been more crisis and shock prone than the prior 25+ years, and also that seen through most of observable financial history, the reality is that the current period of fiat currencies also arguably allows a buffer against an even greater number of them. So a real double edged sword. Since 1971, the global financial system has completely broken its ties with precious metal currencies systems. Prior to this period the vast majority of countries were tied to precious metal currencies for all but rare and short periods away from them.

Such forced discipline massively constrained the financial system and in particular made it very difficult to create credit in the same way we do in today’s economy. It also made it very difficult for governments to run large budget or current account deficits. Any economic system tied to Gold left countries unable to expand the amount of money/debt in the economy without fears that it would lead investors to rush to convert the currency into gold as concerns over inflation mounted.

The difference between any global currency system based on gold and the current world financial order is like chalk and cheese. The current environment allows (and maybe encourages) great imbalances and huge credit and debt creation but also allows for huge operations to overcome such crises even if they perhaps make a subsequent crisis more likely by passing the crisis along to some other part of the global financial system and usually in bigger size.

In a fiat currency world, intervention and money creation is the path of least resistance. In a Gold standard world, mining new gold is the only stable way of increasing the money supply. We think this leaves the current global economy particularly prone to a cycle of booms, busts and then heavy intervention, recovery and the cycle starting again.

That’s a great assessment of the prevailing dynamic. Of course it assumes that gold actually has value, and as usual, we contend that is merely a matter of convention that is subject to change should the world suddenly decide that something else for which there is a finite supply is preferable.

In any event, consider the following chart and color from DB:

A simple internet search of financial crises through history confirms that the frequency has increased over this period. Examples include the UK secondary banking crisis (1975), the two Oil shocks (1970s), numerous EM defaults (mid-1980s), US Savings and Loans mass failures (late 80s/early 90s), various Nordic financial crises (late 80s), Japanese stock bubble bursting (1990-), various ERM shocks/devaluations (1992), the Mexican Tequila crisis (1994), the Asian crisis (1997), the Russian & LTCM crisis (1998), the Dot.com crash (2000), the various accounting scandals (02/03), the GFC (08/09) and the Euro Sovereign crisis (10-12).

Recognizing that that isn’t a very scientific way to go about things (because you know, an internet search is likely to turn up more results for things that have happened recently than for things that happened 500 years ago), the bank took things a step further. To wit:

A more quantitative search backs this up. We show the number of DM countries (%) in our sample back to 1800 experiencing one of the following on a YoY basis; -15% Equities, -10% FX, -10% Bond move, a sovereign default, or +10% inflation. This is our crisis/shock indicator. 0% equals no country with one of these conditions met, 100% equals all in our sample with one being met.

Obviously, busts are happening more frequently.

As noted above, this is a long study that really needs to be broken up into parts and dissected. But the implication from what you’ve just read it clear. Here’s Reid again:

It would take a huge leap of faith to say that crises won’t continue to be a regular feature of the current financial system that has been in place since the early 1970s. The near exponential growth of finance and its liberalisation since this point has encouraged this trend.

As it relates to a world operating under a fiat regime, the question thus becomes one of perpetual can kicking. An unanchored currency gives you the flexibility to paper over (figuratively and literally) crises, but it simultaneously ensures that future crises will be even more acute.

So you know, do you care about your great grandchildren, or not so much?…