Liquidity Tug-o-War??

Many (myself included) have been worried about the excessive liquidity, both in dollar-land and worldwide. The causes have been clear: persistently loose USA fiscal policy whether through war, tax cuts, or just plain demagoguery, loose monetary policy (by any measure of Taylor-Rule or otherwise prudent exercise of monetary creation), a shadow banking system too-clever-by-half, a neutered US bond market prevented from expressing its displeasure in yield terms; pegs to the dollar by GCC and Asian mercantilists that has allowed US consumptive profligacy to exist upon the shelf long beyond its sell-by date; a complete unwillingness of America (and pointing a finger at the entire American polity) to countenance energy taxes sympathetic with other OECD nations. This is but a short-list and is by no means complete thought it is a fine place to start the search for culpability. The net result has been buoyant growth in and money and credit and hence oodles of liquidity contributing in a "virtuous" circle towards rising asset prices that emboldens both lenders and borrowers, the latter whether unsecured or against boated asset values.

This has been worrying to anyone concerned about the value of a paper chit from afar, or unluckily holding them in lieu of other assets pseudo-indexed to their rising quantities, forlornly watching their markers become more-diluted by the hour, day, year or other preferred descriptor of time. Some Moldbugs believe this dilution to be on the order of a reasonably consistent 10 to 20% per year - excluding the rare and more austere interludes characterized by tight money. Such figures, whether real or imagined - would be alarming for one need not be skilled in linear algebra or the finer points of calculus to understand that one will lose half the value of the paper every four to six years, despite the tamer prevailing rate of so-called inflation as measured by government officials and apologists for unfettered liquidity creation. Such a reality is sufficient for those with such paper to avoid its accumulation by (a) spending it immediately (b) converting it to other stores of value (c) borrowing it in order to do 'a' or 'b' or both above, the latter outcome a reflection perhaps that the archetypical cat, has escaped the proverbial bag.

Few would find significant fault with what I've recounted so far, even the most hardened of Moldbugs amongst us. But this might be the point where we diverge. And such departure is neither the result of excessive optimism or pessimism regarding human nature or a new-found desire of central bankers to be the bill amidst a rave, or The Dour Parents at a party of teenagers. Instead, the departure is driven by two theses I will posit: (1) the credit cycle resembles a lognormal distribution; (2) when we find ourselves collectively somewhere far from the normally [positive] mean [of monetary dilution], way out on the negative tail, such revulsion extinguishes existing money and credit quickly and prodigiously, and in the process creates a cascade that scars the collective human (and financial institution) pysche for what is perhaps a generation. These, together, I'll put to you, help tether an otherwise fallibly doomed system of human weakness in the hands of politicians and other parochially-selfish miscreants to something that might continue to be a useful servant of mankind, at least for the next unit of time or perhaps until the art of cold nuclear fusion is mastered.

Real monetary and credit growth significantly in excess of real GDP, resembles a growth stock that continues to increase in market capitalization above and beyond that commensurate with both the continuing fine expectation and undaunted realization of such expectations. Such robust nominal performance feels good, and doesn't hurt anyone...yet. It is a universal confidence booster, and, as a result of its price signals, draws further investment into itself in a virtuous circle, for with its heady rating, it can now easily make accretive acquisitions. But its very froth and beauty draws capital from everywhere towards everything similar. It is not an orgy - certainly not at first. It does so slowly and continuously, hence the daily and weekly return distribution has a definitively positive skew, though occasionally, when the market swoons, such small and continuous price appreciations are decimated in large and concentrated moves caused by panicked investors attempting to save profits or fearing the party is over, get out with their skin. Typically, real quality growth stocks shrug off such doubts, power ahead in their underlying business, soon reflected in share prices which eventually, at much higher levels than prevailed during the swoon, draw the moths back to the flame. This is the essence of the lognormal distribution: a mean of small positive returns, but with a fat negative tail far-departed from mean. Some have suggested that this is rooted human behaviour. reflecting the species preference for positive reinforcement before embarking upon a risky gambit. We see in it prehistory. Humans rarely hunted alone, emboldened by the safety in numbers, their success rates perhaps also lognormally distributed - the fat negative tail represented by an utter mauling of the hunting party with near catastrophic losses.

And so credit growth, fueled by rising asset prices and ever-more confident lenders, is likewise positively skewed. Like the first skaters testing the ice, they proceed slowly, whereupon confident of its integrity based solely upon the fact that they remain above the surface of the icy waters, signal to the others that all is fine in slippery Golconda. Of course this is overly simplistic. There are in reality many forces at work: agent vs. principal issues; keeping up with the jones'; and all manner of behavioural biases that serve to reinforce the alledged prudence of one's herd-like actions and penalize the questioning of the same, for no one benefits from caution, not least the individual. At least until the edifice is too large for its foundations. There are of course limits to how many can safely glide upon an ice-sheet of certain thickness. Exceeding such threshold limits results in rapid fat-tailed catastrophe with no recourse. Eschewing analogies, revulsion destroys credit and collateral values in vast quantities. It crushes the price of core asset values in real estate and equity, and cremates securities that use these assets as collateral. The size of core asset value destruction in our present case being measured perhaps, ultimately, in the double-digit trillions. This is not a matter of small-step back after a long promenade forward. It is monetarily, nearer to Jack&Jill falling off the hill back nearer to the intermediate-term bottom than the top.

But mega-revulsions do more. They scar the psyche, irrespective of whether by natural consequence of falling in under the weight of the edifice, or in response to man-made pressure such the Volcker's Saturday night massacre. Our current predicament is the former, the result of multiple attempts to prevent recession over the years, with diminishing marginal returns to the priming almost guaranteed that much of the investment would of marginal quality and ultimately wasted. Lenders, accustomed to lognormal distributions begin to rework risk under more symmetrical regimes. They reduce existing leverage to save powder and prepare for worse to come, much like the body will warm the trunk at the expense of the extremities. And like the body they do this not as opportunists but in self-preservation. Ray Dalio's Bridgewater in their latest research report makes the following points:

"The financial market unraveling is, as we've described, 'the Big One". What we have meant by this is that the implications of the last six months will impact how the financial system will work for years. Both directly and indirectly (through the literal profits and incomes associated with the financial sector) and indirectly (through the benefits of credit creation) the economy is more reliant upon the financial sector than ever. The virtuous circle of easy credit and rising asset prices leading to increased consumption and therefore increased incomes has been fueling the economy for so long that it has been taken for granted. The reverse of this cycle will have profound implications for the economy, and we have only just begun to see those implications upon the real economy."

It is a natural and logical reaction. This is what the beginning of a cascade feels like, and one that only will end with the eventual uprightness and sustainable leverage atop the system, corresponding levels of consumption related to output, and asset values that are either reasonably well-discounted or known, at the very least, to have stabilized in the longer-term. We are not there yet, and every bank - whatever their domicile - knows this, hence are reticent to lend except to all but the most creditworthy, and on terms that provide more than just compensation for there remains a reasonable probability that price discovery continues in a direction that erodes one's margin of safety. Falling asset prices, in turn, kills the speculative animal spirits. Why build a new shopping mall when the existing ones can be had for less than the cost of new construction? Time shares will trade at hilarious distances below where they were sold in the primary market. And banks, flush with assets recently foreclosed have no appetite to project-lend when they are recently - involuntarily - long the last cycles excesses. Again the chain of dependencies numerous and complex, but the end result is the same: more destruction in collateral values and hence both liquiidity and the supply of dollars.

The remedy for this is clear. Rapid Price discovery. Writedowns. Recapitalisation where required. This will return confidence, albeit upon a much diminished capital base, and much diminished risk-appetites on the part of financial lending institutions. A reordering of the deck occurs: leveraged asset holders - whoever and whatever they leveraged against lose, as do the previous financial sector shareholders. It is against this backdrop that I raise the ultimate question for Moldbugs and those in dread of helicopters and printing presses alike: Is it even remotely plausible that authorities can replenish anything remotely like what's been lost, or what will be lost? Is not "reflation", or Fed gestures to bridge recapitalizations for systemic lubrication anything more than a drop in the bucket to what has been destroyed, making inflationary fears resulting from Fed or Governmental actions a canard? The liquidity resulting from securitisation, wanton misuse of the shadow banking system and its conduits ARE ALREADY out there. Much of it having ALREADY circulated and coursed through sytsemic veins is in the hands of foreign Official entities. They can spend it, but they can multiply it, won't multiply. Moreover, the effects have already been seen in the BRICs in the form of raging economies, buoyant mercantilist exports, vaulting commodity prices, and the $1000+ Kruggerand. But that was then, and this is now. Replacing some of the destroyed credit and liquidity surely can be but a salve upon a lost limb. It will, in the end, simply be inconsequential in the grand scheme of what's gone before and what is to come.

Longer term, I will defer to Moldbugs of the world and not challenge their assertion that the probability that the current reign of fiat money will end. But here, and now, I am far less concerned with the inflationary effects of TAF, TSLF, fiscal packages or outright nationalisation of financial institutions when the need arises since I believe that the credit so destroyed by this revulsion, and the associated cascades and intermediate-term behaviour changes far outweighs the remedial impacts of authorities.