Of all the questions that need answers, I can think of none as universally pertinent as this:
Who is watching the watchers?
The question can be universally applied to just about every controversy and issue in the last several years.
The Patriot Act, rise of the police state, and big data retention with the subsequent rise of hacking certainly could use an answer to the question.
The NSA’s litany of issues need answering too, from wholesale mass surveillance, to lying to Congress while clandestinely monitoring congress members, to claiming that it cannot possibly provide court-mandated records because the systems are too complex to stop deleting evidence.
Here is one to add to the list — central banks and their new and increasingly dangerous addiction to the asset bubble and rising global systemic risk.
Positive Feedback Loop
Today, an organization called the Official Monetary and Financial Institutions Forum is releasing a report called Global Public Investor 2014.
This is the first comprehensive survey of investments held by 400 public sector institutions in 162 countries. These institutions now have $29.1 trillion in market investments, equivalent to about 40% of the global gross domestic product.
The dominant group in this report is made up of central banks, and they account for $13.2 trillion of the assets.
“A cluster of central banking investors has become major players on world equity markets,” says the report. In a diplomatically worded warning, it also stated that the trend “could potentially contribute to overheated asset prices.”
It appears that the unprecedented economic interventions and policies designed to force investors and businesses into swallowing risk to pursue any meaningful returns have created a positive feedback loop.
Here is how it works:
1. Central banks offer incredibly low interest rates to spur investment by investors and businesses.
2. Investors are forced to accept higher risk to see any gains. Companies with reasonable valuations become increasingly rare.
3. Thanks to incredibly cheap debt from the low interest rates, businesses take the easy path to entice these investors by using share buybacks. They use rotating debt to boost earnings per share, instead of capital expenditures to create meaningful long-term growth.
Corporations capitalized on these low interest rates by issuing $18.2 trillion worth of bonds worldwide since 2008. Currently outstanding corporate debt has risen over 50% to $9.6 trillion over the same period.
4. The policies enacted by the central banks reduce their own revenue. To make up for the shortfall, the central banks invest in the very equities that they are forcing everyone else to buy.
5. Valuations creep up more as fundamentals are abandoned. More businesses and investors chase artificially inflated stock market gains.
6. Central bank policies become increasingly hard to change because any correction would be more severe. Investors, businesses and the central banks themselves would take greater losses. Interest rates stay abnormally low, and the behavior reinforces itself and repeats.
The “Minsky Moment”
At a certain point, this runaway positive feedback loop makes a “Minsky Moment” inevitable.
Paul McCulley of PIMCO coined this term back in 1998, naming it after the late economist Hyman Minsky.
Minsky’s work focused on understanding and explaining the characteristics of financial crises. In particular, he looked at credit cycles.
He argued that during prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops. Debts eventually start to exceed what borrowers can pay off from their incoming revenue.
Banks and lenders are forced to tighten credit, even to companies that can afford loans. Unsustainable debt causes the forced sale of some assets.
This causes others to sell assets, which causes asset values to drop further and more forced sales to occur.
In the end, far more investors and businesses take greater losses than were actually required to correct the unstable bubble.
Interest rates will have to go up. There is no way around it in the long run. This could easily trigger the Minsky moment for us.
Since many corporations chose to forgo meaningful capital growth and focus on share buybacks, there is little room for revenue growth, making the increasingly expensive debt harder to maintain when rates rise.
If corporations start to fall, a shock would spread through the web of interconnected business to business spending and creditors.
The longer the positive feedback loop created by central banks persists without correction, the wider the gulf between reasonable equity prices and current prices becomes, the greater the damage.
Drinking the Kool-Aid
Perhaps a more reasonable scenario would be panning out right now if there wasn’t an unquestioned belief that central bankers know what they are doing and are in control.
Congress is technically in charge of central bank oversight, but is poorly equipped to question the Fed, let alone understand the implications of complex macroeconomic consequences.
As such, it is much like the NSA. Unless a question is perfectly worded, the same canned general responses are used.
For actual verification of what Congress is told, it takes specific legislation. Case in point: the amendment Sen. Bernie Sanders added to the Wall Street reform law in late 2011.
The amendment directed the GAO to do a comprehensive audit of the Fed. When the report was released, it detailed $16 trillion of transactions in bailouts to domestic and international corporations and banks, there was nothing that could be done about it.
Sen. Bernie Sanders stated, “No agency of the United States government should be allowed to bailout a foreign bank or corporation without the direct approval of Congress and the president.”
Yet there were no consequences for their actions and the implications were under-reported. The same will happen with the fallout from the feedback loop the Fed created. We’ll be reading about it in a postmortem report.
There is no oversight on how central banks are investing in equities. There are no 13F forms to publish holdings and keep tabs on the portfolio. The only option is to trust that they know what they’re doing.
Don’t question the Fed’s actions or the two starkly different classes it is creating in America. Keep buying overvalued equities. Keep making the inevitable “Minsky moment” worse and worse.
If this trend keeps up, central banks will implode with the blind faithful because they bought into their own manipulative scheme.
For your own sake, be very careful and have a contingency plan in place. Don’t drink the Kool-Aid with them.
