Debt Expansion Leave Markets In Jeopardy
The Fed has overseen a massive expansion of debt flowing through the economy since the last debt bubble burst in 2008. Today the economy is deeply relying on cheap debt and the $4.5 TRILLION dollar capital injection into the debt market, as a means to artificially hold rates at extremely low levels. The Fed views monetary policy that inspires a massive expansion of debt as a solution to a struggling economy. It believes if you can pump record amounts of debt into the economy the economy will perform in an effective manner. This has been their grand solution since the financial crisis of 08/09. The other major central banks followed suit. This grand solution has failed.
Before we ponder the future of this debt fueled environment we need to review the crisis from a decade ago. Back then we faced a similar problem of far too much debt circulating in the economy. Conditions were ripe for a collapse, which resulted in the great recession. The housing bubble was fueled by excessive debt, that was enabled by a very low Fed funds rate. The availability to cheap credit encouraged leveraged risk taking. Money was practically free, which made for some very exciting times.
Leading up to the crash, it was a speculators paradise. Builders were building homes as fast as they could. Developers were selling them as fast as they could. Mortgage companies were issuing debt to anyone with a pulse. Banks and mortgage companies were generating huge numbers. People were buying housing they couldn't afford. Everything was great. Some people saw themselves as real estate tycoons. Buying and flipping homes became popular across the nation. Making money with ease seemed to be the name of the game. This debt fueled economy felt really good to many people and heaven forbid you try to tell anyone that it was a debt bubble. No way, it was the real thing, just ask the Fed. They insisted that there was no frothiness in the economy and everything was just fine. No signs of bubbles, they told us. It was full steam ahead.
The debt expansion was coupled with a complete indifference to risk by everyone including government agencies, consumers, speculators, rating agencies, and the financial community. The thought was just pump more debt into the system, stamp it "investment grade" and move on. Money flowed like a massive river and resulted in debt fueled income for the speculators, financial institutions, mortgage companies and many big fat bonuses to go around. Housing was going up at a record pace, as housing prices kept surging higher and higher. Money was sloshing through the economy as debt levels climbed to the stratosphere. Massive bubbles were forming throughout the economy, while the risk levels continued to be ignored by everyone including the agencies paid to warn of such risks.
Then one fine day the magic seemed to run out. The debt bubble popped and the world was in panic mode. The Federal Reserve scrambled reassure the markets before all the air from their bubble escaped . They decided the best path was not to let the markets work its way through the mess they created, by allowing failed financial products to default. Instead the Federal Reserve choose to remove the invisible hand of the free market and replaced true price discovery with giant doses of quantitative easing as a means of keeping the debt market juiced up.
Governments backstopped the largest of the failed businesses who were utilizing the least prudence in managing their books. They also backstopped the largest speculators who took extreme levels of risk by leveraging their positions to ridiculous levels. Instead of allowing the markets to correct itself from the massive debt bubble created by the Federal Reserve, it poured trillions of dollars into the markets to keep the least worthy from failure.
This is not free market capitalism. These types of actions prevent the balance between risk and reward. What we got was crony capitalism, where the government picked and choose who it favored and poured taxpayers dollars behind those entities. Tipping the balance of the free markets from equilibrium in favor of a rigged centrally planned economic system. All centrally planned economies eventually fail because bureaucrats can not replace the efficiency of the free markets with some form of ham handed favoritism, but that is a thought for another day.
Moving forward, the Fed proceeded to monetize trillions of dollars of debt by printing more and more money, through multiple levels of quantitative easing. They lowered rates to near zero percent to drive air into a new debt bubble. Other major central banks followed suit by doing their best to flood there own economies with more debt while monetizing trillions more in their own quantitative easing (see: market manipulation).
The Federal Reserve went out and bought all kinds of toxic debt it could get its hands on in the debt market, in efforts to hold up the failing bond market. It did everything it could do to prevent the markets from correcting and as a result it opened up a whole new can of worms. Who needs free markets when you have good old Uncle Sam to buy all the pieces of excrement that are floating out in the markets. A true incentive to ignore moral hazard if there ever was one. The message was sent and the markets received it loud and clear. The Fed Put is in place. Take as much risk as you want, because Fed won't let you go down.
Under normal conditions when there are bad investments that fails, the free market is allowed to do its thing. For instance when a bond fails, it forces those who took on the risk to absorb the loss. After the crash of 08 the Fed poured trillions of dollars to protect those holding excessive levels of risk and kept the markets from correcting the debt bubble they created The market can not correct if the Fed is allowed to manipulate the the whole system. By removing price discovery they have eliminated market efficiency. The balance between risk and reward is gone. Interesting to note the Fed was far less willing to socialize the debt of the millions of people who bought homes without proper income qualifications.
The Fed did allow Lehman Brothers to fail, as a false warning to the markets they were not going to continuously bail out every big player in the markets. This turned out to be a lie, as they ended up bailing out the market players over and over again. The failure of Lehman nearly took down the whole debt economy, as lending froze in response to the crashing debt market. The market was beginning to believe that excessive risk taking was not in their best interest. In retrospect this is the primary reason why having an economy based on a massive debt bubble is not the best foundation. Its like building your house on a pile of TNT. As long as it doesn't ignite all seems fine, until one thing goes wrong and there is a massive problem.
The best time to prevent a car crash is not after you decide to drive recklessly down the street and inevitably have an accident. Prevention needs to occur before the the decision is made to ramp up risk. Sadly the Fed does not subscribe to this point of view. They prefer to keep risk conditions at high levels and worry about the consequences after the fact. If the economy crashes, just bondo over the damage with some QE and get back to reckless behavior.
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| Source: Thomson Reuters Datastream |
Today the debt bubble is bigger than ever and and risk has returned to critical levels. The major central banks have pumped over 13 trillions of dollars of capital injections, since the last fed induced crisis, onto the global markets in an effort to inflate this new epic debt bubble. Now we have a debt bubble that is multiple times larger than the one in 2008 and even today there is over a trillion dollars of new money being funneled into markets by the world's largest central banks annually.
This is not just an American problem. The European Central Bank and the Bank of Japan have been pumping huge sums of money in to the not-so-free-markets to keep a new landslide of economic collapse from hitting. They believe that keeping interest rates negative has no impact on risks in market. They think as long as you socialize the markets with massive injections all should be fine. Once again this is not how capitalism works. There needs to be a free flow of money to allow the markets to find true price discovery. Without true price discovery you get very warped markets and in this case the balance of risk and reward is completely ignored. As long as the central banks manipulate interest rates so money is free for the big players and prove they are willing to absorb all the risk, excessive risk will be taken and it just takes one event to set off a chain reaction.
On the other side of this course of manipulation is the fact that the global economy is being monetized. Each capital injection by the major central banks of newly minted currency out of thin air is only further devaluing fiat currency and hurting the global economy in the long long. Yes the central banks can continue to buy the markets higher and the people can continue to celebrate these actions, but there is a severe price to be paid as the risk-o-meter continues to climb.
There once was a ship that people said was unsinkable. On its maiden voyage its captain wanted to cross the Atlantic in record time. So he ignored the risks and steamed ahead, while the passengers felt very privileged to be on this luxury engineering marvel. The balance of risk and reward was off and it is at these times danger is at its highest. In essence fear is something that our mind feels as a means to keep us safe. Remove fear from our minds and bad things are sure to follow. In the case of the ship, ignoring known risks resulted in disaster as the mighty Titanic struck an iceberg. Initially the captain did not want to alarm the passengers so he had the band continue to play their music, until it was very obvious to all that something was very wrong. Then panic struck.
