Regular readers will recall that we’ve written a ton on the rolling boom-bust cycles that invariably accompany an untethered system (i.e. a system that is not based on or anchored to a universally accepted, finite store of value like precious metals).
Importantly, we separate this discussion from considerations about the actual value of gold or about the utility of holding it as a hedge against the apocalypse. On the latter point, it’s useless because you can’t eat it or burn it and on the former point, it has no actual value. As UBS bluntly reminds you, “currencies in themselves have no natural value – gold, for instance, is naturally as worthless as paper, sea shells, or wooden sticks.” But again, this is another discussion for another time.
Whatever you want to say about the inherent silliness in deciding that paper money has value because it is “backed” by a yellow metal which is itself naturally worthless, the simple fact of the matter is that at least gold is finite and whether a person who believes it to be valuable is a silly person is actually a silly question, because if enough people believe it has value, then the fact that it actually does not is to a large extent immaterial, and indeed, gold has survived the test of time as a store of value.
Ok, so what is the utility in an unanchored system – again, a system that is not tethered to a finite, universally accepted store of value? Well, the utility lies in an untethered system’s flexibility and the crisis-fighting tools that flexibility affords us. While an unanchored system allows us to combat downturns with unchecked credit creation/money printing, that policy response invariably sows the seeds for the next crisis which will almost always be larger than the last.
“Although 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,” Deutsche Bank’s Jim Reid wrote back in September, characterizing the current system as “a real double edged sword.”
Here is how we described this trade-off and the eventual end game back in September:
While we can observe an increased frequency of crises in a world that’s abandoned the gold standard and while we can draw common sense conclusions from that observation, there’s still the old “correlation doesn’t always equal causation” problem to contend with. That is, “yes” it is likely that the lack of discipline which invariably accompanies an unanchored system contributes directly to the incidence of busts. But it is certain that a constrained system lacks the flexibility to respond to busts when they occur. So if even one crisis out of a dozen isn’t attributable to the adoption of an unanchored system (i.e. a system not based on gold), then by tethering our fate to an archaic concept we may be unnecessarily ensuring a complete collapse from which there is no recovery. Hence Deutsche’s “double edged sword” metaphor.
The worry now however, is that in this latest iteration of responding to a crisis with intervention and money creation, we have exhausted our capacity to leverage (figuratively and literally) the flexibility afforded by an unanchored system to rescue us from the abyss. There’s a cruel irony inherent in that. Each time we respond to a panic with the tools afforded us by a system based not on some finite store of value, but rather based solely on the “full faith and credit” of governments and their printing presses, we almost always exacerbate (in one way or another) the imbalances that led to the very crisis to which we’re responding. The inevitable result: a rolling boom-bust cycle that snowballs with each turn, ensuring that each new crisis and each crisis response is even more spectacular than the last.
The only way this can go on in perpetuity is if we assume there is no limit on the extent to which we can leverage (again, both figuratively and literally) the flexibility inherent in an unanchored (i.e. a fiat-based) system. If the busts keep getting bigger, it will of course be painful and harrowing, but if the capacity of the fiat system to respond with ever larger money printing programs is limitless, then theoretically we will just boom-bust our way along forever until finally we’re all losing everything once every six months only to have central bankers make us all millionaires the very next day by topping up our bank accounts with newly-created money.
Ok, so that has a parallel to the following visual from Deutsche Bank’s Aleksandar Kocic. This is from a late October note in which Kocic illustrated the relationship between leverage and vol. that, in his words, “defines the dynamics of the economy.”
Now, think about that graph in the context of everything said above. The current system allows us to mitigate crises, but that flexibility has a significant amount of moral hazard built into it. It is doomed to be an exercise in can kicking and implicit in that characterization is the idea that the next crisis will everywhere and always be inextricably linked to its predecessor in the following two ways: 1) it will be larger than its predecessor, and 2) it will be a product of the policy response that accompanied its predecessor.
Can you visualize what those two enumerated points might mean for the chart? The implication is that the ellipse becomes a spiral. As Kocic writes in a characteristically brilliant new note out Friday evening, “every time history repeats itself, the price goes higher.” Here’s Kocic recapping the original note that accompanied the visual above:
To recap, we argued that there is a logical relationship between leverage and volatility. Low uncertainty engenders higher leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky’s take on financial markets.
Now, here’s where the spiral comes in. To Kocic again:
However, the most interesting thing for us at the moment, is the question of what comes after each crisis, namely how is the recovery engineered and economy brought back on track. To be specific, let’s choose as the starting point 1999, the beginning of the internet bubble and follow (in the clockwise direction) the subsequent economic trajectory in the vol-leverage plane in the Figure below.
As the economy is heating up, volatility declines and leverage increases until the bubble bursts sometime in the late 2000. There is a volatile deleveraging for the next 2-3 years when low rates and expansion of the real estate market created conditions for the turnaround and beginning of another cycle. The only difference is that, this time around, the bubble was bigger and the limits were more extreme. Instead of being a periodic object (e.g. ellipse), the trajectory now becomes an outward spiral – in the second sweep, the leverage is higher and risk premia compression more extreme leading, naturally, to a deeper crisis and a need for an even more extreme measures of recovery.
The vestiges of crises past always linger – creative destruction isn’t a viable option in the modern world. Again, that means that by definition, future crises will be i) inextricably linked to their predecessors, and ii) more spectacular than those that came before. That second point (i.e. the idea that a defining feature of a fiat regime is a rolling boom-bust cycle that snowballs with each turn) means that policy responses will need to grow in magnitude over time to keep pace with ever larger busts. Eventually, the busts become so large that the policy responses required to combat them become caricatures of themselves that border on absurdity.
That, according to Kocic, is the where we are now. To wit:
Spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes — and we believe that moment is now – the market is faces a dilemma.
We now have three choices.
The first is the permanent state of exception. This is a scenario Kocic outlined over the summer and it’s something we have repeatedly used in our own writing since, both as a tribute the brilliance inherent in the original note and also because the idea when applied to markets has quite a bit of explanatory power. Here’s Kocic explaining the first choice:
Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice.
As Kocic suggests, that is a decidedly unpalatable proposition – especially in the Trump era. “Settling for less” is not at all consistent with Trump’s amorphous #MAGA promise. In fact, inherent in #MAGA is a certain deliberate ambiguity that implies an infinitely high bar – as Trump himself put it on the campaign trail, “you’re going to say Mr. President stop! It’s too much winning. And I’m going to say ‘no, we have to win more!'”
If the abandonment of that is too hard to swallow (and if it would have been a bitter pill before, it’s been rendered even more so for large swaths of the American electorate now thanks to Trump) we risk making decisions that catapult us from the lower left quadrant in Figure 14 shown above into the upper right quadrant “where the wild things are.” Here’s Kocic on the second choice:
Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.
And there is a third scenario, which – depending on how you’re inclined to look at it – is either worse than the second or better:
Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.
Here’s Kocic summing up:
The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive.
So that is where things stand – we’re at a crossroads. There are no “good” or “easy” choices (depending, again, on your definition of “good”), only difficult ones.
And as Kocic notes, this debate is what lies at the intersection of current political and economic discussion. But bear in mind that not everyone comes at this from the same angle and it is by no means clear that everyone involved lists financial stability as the concern that overrides all others. Some of the political actors with a say in this would likely be willing to risk a period of even higher leverage and elevated volatility if it means not giving up on the idea that some bygone era of American “greatness” can be reclaimed.