So an urgent question screams out. Didn’t the obstinate zealots at the Fed realize that zero cost overnight money has only one use, and that is to fund the speculative trades of Wall Street gamblers?
The reason that ZIRP is of exclusive benefit to financial gamblers is straightforward. No businessman in his right mind would fund equipment, inventories or even receivables with borrowings under a one-day or even one-week tenor. The risk of fatal business disruption resulting from the need to precipitously liquidate working assets if funding cannot be rolled-over at or near the existing interest rates is self-evident.
Likewise, no sane householder would buy a home, automobile or even toaster on overnight borrowings, either.
And, yes, financial institutions experiencing the daily ebb and flow of cash excesses and deficiencies do use the money market. That’s what the “Fed funds” market used to be until Bernanke and his band of money printers effectively abolished it in the fall of 2008.
But managing fluctuating cash balances does not require ZIRP—especially when most banks historically alternated between being suppliers and users of funds on practically an odd/even day basis. Cash balances in the financial system can be cleared at 0.2%, 2%, 5% or even 10% with equal aplomb.
So ZIRP is nothing more than free COGS (cost of goods sold) for Wall Street gamblers. It is they who harvest the “arb.”
That is, the spread between the free overnight funding dispensed by the Fed and any financial asset with a yield or prospect of short-term gain. And, yes, if push comes to shove, these same fast money gamblers can ordinarily liquidate their assets, repay their overnight borrowings and start with a clean book the next morning—unlike business and household borrowers in the Main Street economy.
Stated differently, the Fed’s ZIRP policy is a giant subsidy to speculators—and one that is made all the more egregious by an utterly foolish communications policy. In the name of “transparency” the Fed actually telegraphs, via such code words as “patient”—that there will be no rate increases without ample warning. In this case, at least for the following two meetings.
Accordingly, speculators don’t have to worry about even one single dime of unexpected change in their carry cost. Nor are they ever inconvenienced by the losses that can result from needing to suddenly dump less than fully liquid assets (or liquidate options and other similar “structured finance” positions) in order to repay their overnight borrowings in the event of a sudden rise in the money-market rate.
The truth is that in an honest free market traders cannot earn windfall returns arbing the yield curve. The vigorish gets competed away. Likewise, asset prices and funding costs move independently, thereby causing return compression toward the time value of money and the risks embedded in each trader’s specific book of assets and liabilities.
By contrast, the ZIRP market is completely dishonest and therefore deeply subsidized. And every Econ 101 student knows that when you deeply subsidize something, you get more and more of it.
In essence, by clinging obstinately and mindlessly to ZIRP, the Fed is just systematically juicing the gamblers, and thereby fueling ever greater mispricing of financial assets and ever more dangerous and explosive financial bubbles.
In fact, after 90 months of ZIRP, it must be truly wondered how supposedly rational adults can obsess over whether the another tiny smidgeon of a rate increase should be permitted this year or next, and whether the economy can tolerate a rise in the funds rate from 38 bps today to 63 bps when it finally does move.
The difference is utterly irrelevant noise to the Main Street economy. It can’t possibly impact the economic calculus of a single household or business!
But then, again, the Fed doesn’t serve the Main Street economy: it lives to pleasure Wall Street.
Having pinned the money market rate at the zero bound for so long and with such an unending stream of ever-changing and fatuous excuses, the occupants of the Eccles Building are truly lost. They do not even fathom that they are engaging in a word splitting exercise that is no more meaningful to Main Street borrowing, spending, investing and growth than counting angels on the head of a pin.
CAUGHT IN A TIME WARP—WHY THE FED KEEPS FEEDING THE GAMBLERS
So why does the Fed persist in this farcical minuet around ZIRP?
The principal reasons are not at all hard to discern. In essence, the Fed is caught in a time warp and fails to comprehend that the game of bicycling interest rates to heat and cool the macro-economy is over and done.
As further documented below, the credit channel of monetary transmission has fallen victim to “Peak Debt.” This means that the Main Street economy no longer gets a temporary pick-me-up from cheap interest rates because with tapped out balance sheets most households have no further ability to borrow.
The only actual increases in household debt since the financial crisis has been for student loans, which are guaranteed by Uncle Sam’s balance sheet, and auto loans, which are collateralized by over-valued vehicles.
Stated differently, home equity was tapped out last time and wage and salary incomes have been fully leveraged for years. So households have nothing else left to hock.
Accordingly, they now only spend what they earn, meaning that the Fed’s interest rate manipulations—which had potency 40 years ago—have no impact at all today. In fact, it cannot be repeated enough: Keynesian monetary policy through the crude tool of money market rate pegging was always a one-time parlor trick.
Likewise, as documented in Chapter 2, the Fed’s interest rate machinations have not, as per the traditional Keynesian model, induced the business sector to acquire incremental productive assets financed with borrowed capital. Instead, virtually the entire increase in business debt outstanding—and it is considerable, having rising from $10 trillion on the eve of the financial crisis to nearly $12.5 trillion today—has gone into financial engineering.
But stock buybacks, LBOs and cash M&A deals do not cause output to expand or productivity to increase whatsoever. They just bid up the price of existing financial assets, thereby further rewarding the ZIRP-enabled gamblers who inhabit the casino.
Still, notwithstanding the utter blockage of the credit channel of monetary transmission to households and businesses, our monetary central planners cling desperately to ZIRP. This obstinacy arises from the theory, apparently, that it might still do a smidgeon of good. Besides, ZIRP hasn’t caused any consumer price inflation, or at least that’s what they contend—so where is the harm?
Well, yes. Doing a rain dance neither causes harm nor rain. Yet there is a huge difference. Zero interest rates are not even remotely harmless. They amount to a colossal economic battering ram because they transform capital markets into gambling casinos.
So doing, they cause risk and long-term capital to be mispriced, generating an accumulating level of malinvestments and excess production capacity. And this is a worldwide condition because all central banks are engaging in the same game of financial repression.
As is now evident in the case of oil, iron ore, copper, consumer electronics, shipping and much more, vast excess capacity ultimately results in the collapse of boom time prices and profit margins. At length, a withering cycle of deflationary adjustment, profit collapse and plunges in new capital spending is set in motion.
So the traditional Keynesian model of Main Street “stimulus” is just not working, but beyond that our monetary central planners are trapped in a dangerous feedback loop. Having fueled the boom with cheap money, they now justify the prolongation of ZIRP on the grounds that they must use the same tool to ward off the deflation they caused in the first place.
At the end of the day, there is nothing behind the curtain at the Eccles Building. The spurious words clouds in the Fed’s 500-word meeting statements, and hints about the next meeting’s potential for hairline changes in the money market interest rate, or not, are of relevance only to the day traders and robo-machines in the casino.
Fed policy is designed to keep the
m rolling the dice. It rests on the delusional hope that the drug of ZIRP or near-ZIRP can keep the stock market averages rising and a trickle down of extra spending by the wealthy flowing into the reported GDP and job numbers.
FINANCIALIZATION AND THE BUBBLE AT THE TOP
These considerations make clear that it was neither a slightly lower trend rate of CPI inflation over the past 29 years nor an improvement in the art of central banking which has driven the core reference rate in the world financial markets—the 10-year U.S. Treasury note—down by 85%.
Greenspan, Bernanke and the rest of their central banker posse have been quick to take credit, of course, but never for what they have actually done. The stunning decline in the world benchmark cap rate is owing to the fact that central bankers flat-out falsified it.
They accomplished this by pegging the money market rate closer and closer to the zero bound, meaning that the cost of carry on repo was reduced to virtually nothing. This, in turn, enabled speculators to buy increasing amounts of government debt with tiny slivers of true capital, thereby turning the U.S. treasury bond market into a daisy-chain of collateral.
And a daisy chain it was. As a result of massive QE purchases, bond prices have had a huge artificial bid from the central bank printing presses as opposed to real money savers. These steadily rising bond prices meant that carry trade punters could capture both the current interest spread between the coupon yield and zero-cost repo, and also the holding period capital gain on the bonds.
In a word, the profit opportunity was so fabulous that speculative capital flowed into the staid sovereign bond markets like never before. Owing to this speculative capital inflow, traders were able to generate massive amounts of collateral-based repo credit, which funded even more demand for bonds and even higher prices.
In short, the sovereign-debt markets essentially became a giant confidence game. Government debt nearly financed itself by generating its own carry.
Once upon a time, of course, this wondrous bubble of ever rising bond prices couldn’t have happened because the catalyst—massive QE—was correctly understood to be an outright monetary fraud. Yet during the last two decades monetary rectitude has vanished. The combined balance sheets of the world’s central banks, in fact, have expanded from $2 trillion to $21 trillion.
All the while and without question, however, the central bankers had not repealed the law of supply and demand.
To the contrary, they had their big fat thumbs on the scale to the tune of nearly $20 trillion of “demand” for securities that was funded with fiat credits conjured from thin air, not from honest savings out of current production and income.
Needless to say, the resulting plunge in the yield of the 10-year treasury note shown above to what are completely false and unsustainably low levels caused two powerful distortions.
In the DM economies like the United States, it generated an enormous expansion of unproductive debt that funded excessive fiscal expansion, household consumption and business financial engineering. In the EM economies, it resulted in the systematic underpricing of long-term capital, thereby generating a tidal wave of malinvestments and excess capacity.
On the home front, two decades of price falsification resulted in a monumental financialization of the U.S. economy. The sum of business debt and nonfinancial market equity rose from about $12 trillion at the time of Greenspan’s arrival at the Eccles Building to $93 trillion today. Accordingly, the value of debt and equity securities mushroomed from about 2.4X GDP to 5.4X.
HOW BUBBLE FINANCE WAS EXPORTED TO THE REST OF THE WORLD
At the same time, the Fed’s financial repression campaign was exported to the rest of the world. The mercantilist export-based economies of east Asia and the petro-states, in effect, mopped up the Fed’s excess emission of dollar liabilities through massive currency pegging operations and the accumulation of U.S. Treasury and GSE paper.
The staggering extent of the Fed’s export of monetary inflation is shown in the chart below. In round terms, the collective balance sheets of the world’s central banks have grown by 10X during the last two decades. There is nothing even remotely resembling this in all of recorded financial history—nor was it even imagined by the most rapid inflationists and monetary cranks of yesteryear.
Self-evidently, this monetary eruption did not happen in a vacuum. When central banks expand their balance sheets in today’s fiat money world it has a double whammy impact. It can led to the expansion of both conventional bank credit and also to capital market based credit in the form of repo and other loans based on financial collateral as described above.
As a result, the world economy was inundated by a veritable credit tsunami. During the last two decades total public and private debt outstanding on the planet has soared from $40 trillion to $225 trillion or by nearly 5.6X.
The compound growth rate of 9.0% annually was nearly double the growth rate of global GDP during this period, implying that global leverage rose in nearly parabolic fashion. In fact, the gain in total debt was nearly 4X greater than the gain in GDP.
Yet even that understates the level of risk and deformation embedded in these worldwide trends. That’s because a goodly share of the GDP gains—especially in the vast Ponzi scheme of China and its supply base (as addressed in later chapters)—represented one-time fixed asset investment spending. But much of that will turn out to have been both unsustainable and economic waste which will have to be written-down or liquidated entirely.
Stated differently, the global credit tsunami funded massive over-investment in fixed public and private assets, but especially in China and the EM. The impact was a one-time acceleration of global economic activity that temporarily inflated current income and profits—phantom growth that goosed the value of financial assets even more.
But this central bank fueled boom will ultimately be paid for in the form of a prolonged deflationary contraction. Then, trillions of uneconomic assets will be written off, industrial sector profits will collapse and the great inflation of financial assets over the last 29 years will meet its day of reckoning.
UNSUSTAINABILITY OF FINANCIALIZATION
There is no reason whatsoever to believe that the financial carrying capacity of the U.S. economy—or any other DM economy—has improved since the 1980s. And that means that soaring cap rates on financial assets are way overdone and unsustainable. At current nosebleed levels, neither stocks nor bonds are earning their valuations.
In fact, DM cap rates should have gone in the opposite direction in recent years. That is due to aging demographics, declining competitiveness versus the surging EM economies, dwindling rates of productivity growth and a dramatic increase in the leverage ratio against both public and private incomes.
All of these adverse macro-trends mean that the U.S. economy’s ability to generate growth, incomes and profits has been significantly lessened. Accordingly, since the U.S. economy’s ability to service debt and equity capital at an honest market rate of return has diminished, the logical expectation would be that the finance ratio to national income would fall.
In fact, once Greenspan took the helm and his apparently atavistic embrace of gold standard money melted-down under the Wall Street furies of October 1987, the finance ratio erupted. As shown below, it has never looked back and at 5.5X national income has reached a point that would have been unimaginable on the morning of Black Monday.
Stated differently, under a regime of honest money and market determined financial prices, the combined value of corporate equities and credit market debt would not have mushroomed by 8X—from $11 trillion to $93 trillion—during the past 29 years. For crying out loud, the nominal GDP grew by only 3.6X during the same span.
In effect, the U.S. GDP has been capitalized at a higher and higher aggregate financial valuation for no ascertainable reason of fundamental economics. And the standard mainstream argument that today’s extremely elevated cap rates are warranted because interest rates are so unusually low is an especially meri
tless rationalization.
Those are not genuine economic rates. They are the artificial product of central bank financial repression and falsification. The cost of debt and money must inevitably revert to honest market levels or the central banks will simply destroy the monetary system.
Indeed, there is no reason why the 260% ratio of equity and credit market debt to GDP that was recorded in 1986 should have risen at all. At that point, in fact, Paul Volcker had completed his historic task of extinguishing runaway commodity and CPI inflation and had superintended a solid recovery of real economic growth.
Arguably, therefore, the U.S. economy was carrying about the right amount of finance. At that healthy ratio, in fact, today’s $18 trillion economy would be carrying about $48 trillion of combined market equity and credit market debt, not $93 trillion.
In a word, the Greenspan era of central bank driven price falsification and monetization of trillions of existing assets has generated a $45 trillion overhang of excess financialization.
HOW ST. WARREN BUFFETT RODE THE FED’S $45 TRILLION BUBBLE
Even when you purge the cumulative price inflation out of these gargantuan figures, the story does not remotely add-up. The above outlandish graph—which implies that real finance grew at 10X real median incomes—does not capture capitalism at work. Nor did the speculators who surfed upon this $45 trillion bubble harvest their monumental windfalls owing to investment genius.
Instead, it is the perverted fruit of Bubble Finance, and there is no better illustration of this bubble surfer syndrome than the sainted Warren Buffett.
The Oracle of Omaha is no genius and he did not invent anything, even a unique method of investing and allocating capital. He may have read Graham and Dodd as a youthful punter, but his nominal net worth did not grow from $2.1 billion in 1987 to $73 billion at present by following the old fashioned precepts of value investing.
Trumped! A Nation on the Brink of Ruin... And How to Bring It Back Page 6