In the second part of their discussion Tim Price, Dan Denning and Nick OâConnor talk about what the government and central banks could have done differently in 2008, and how the next collapse might unfold.
You can read the first part of the conversation here.
Dan Denning: Two people were the âbuyers of last resortâ during the financial crisis of 2008. First, it was the mugs who didnât know what was going on, and then it was the Fed who did know what was going on, but stepped in with all of these other asset purchase programmes to provide liquidity in markets where it had disappeared.
My question is: if we get something like that again â whether itâs in corporate junk, high yield or even in sovereign bonds, which I think is possible â will we see the same response from central banks, and can you hypothesise about what the effect would be on interest rates and/or currencies?
Tim Price: Itâs an excellent question, but Iâm not sure that history can necessarily repeat. So in 2007/08, the corporate sector â specifically the banks â were bailed out and the bank debt problems effectively shunted onto the sovereign balance sheet. Now the problem is much more severe. This isnât just a suggestion, itâs fact. The McKinsey study earlier this year pointed out that global debt has actually risen since Lehmanâs failed. So the idea that mysteriously the world has de-levered is just a complete nonsense. Itâs a false narrative.
The world is more heavily indebted now than it was before, but the difference is governments are no longer in a position to sustain being buyers of last resort. Governments and central banks canât do it â even the Fed canât do it, because the Fedâs already teetering on the brink of insolvency by any banking standards. So the only answer would be that we find a planet in a solar system thatâs got inhabitants that are willing to take on this crap.
Dan: Why couldnât they do it, though? The Fed expanded its balance sheet to something over $4trn. The ECB (European Central Bank), the BOJ (Bank of Japan) and even maybe the Bank of International Settlements, and the IMF (International Monetary Fund) â isnât there some balance sheet flexibility left, not with sovereign governments anymore, but with central banks? Itâs not real money for them…
Tim: This is true, so they can expand the balance sheets further and buy equities even (which is already happening in Japan). Thatâs a fabulous game if you can do that. If you happen to be a central bank, youâre creating money out of nothing and then buying assets of real value â profitable, commercial enterprisesâ equity â with those assets. But at some point to me at least, the marginal investor is going to be watching this fun and games and thinking: âTheyâre creating money out of nowhere and then theyâve bought real assets with it. This is magic â but this is magic, this is not reality.â
Dan: Well, I think thatâs an important point, because it shows that thatâs whatâs different about now from 2008/09 â the credibility of central banks is whatâs on the line. Last time it was the private sector, and everybody had fun or relished the idea that it was the evil investment banks, and some of them got what was coming and some of them probably shouldnât have been bailed out. But the system itself wasnât jeopardised because central banks stepped in to provide liquidity.
But whatâs at stake now is that as people look at that, they start asking these questions, well, how does that work? How is it that the Fed can, expand its balance sheet to create $4trn where none existed before? How does that solve a debt problem? And I think the more people think about that, the more they say, well, that system doesnât work. That doesnât make sense to a lot of people.
Tim: James Grant of Grantâs Interest Rate Observer has described this very well. In his eyes we are seeing the failure of what he calls âthe PhD standardâ. So we previously had the gold standard â Bretton Woods ended in 1971 when Nixon tool the dollar off gold, and severed the last vestiges of backing for a paper currency. So since then, for the last 40-odd years, weâve had a pure experiment in paper money. That has never ever worked â in the fullness of time, these things have always failed. But nevertheless, the experiment goes on. And now, instead of having a gold standard, we have a PhD standard, whereby economists of a certain persuasion are calling all the shots.
And I think youâve hit the nail on the head â the key word here is confidence. For as long as people have confidence in the system, then the system lasts. But whether itâs confidence in the system, a central banking philosophy, or a currency, these things do not operate in a linear fashion. The confidence lasts until it breaks, but it doesnât break piece by piece. Suddenly the branch just snaps from the tree. So as and when this does become a bigger problem, it will happen very quickly.
Dan: Which is related to our whole focus in the last three months on cash â because that is an expression of peopleâs confidence either that things are going to be fine and you can go to the bank and get your money, or that things are not fine, and I want my money in my hand. That I think is why weâve seen â quite deliberately from official and unofficial idea leaders of the mainstream â an attack on the idea of cash, because cash is how you vote in the financial system. A vote of no confidence is to take your money out of the bank. If you canât take your money out of the bank because thereâs no cash, then you canât withdraw your confidence from the financial system â youâre locked into it.
Tim: I think thereâs a quote we used in the book, The War on Cash, the Hemingway quote, where someone says: âHow did you go bankrupt?â And he said: âtwo ways â slowly and then all at onceâ.
Nick OâConnor: When gold was roaring up to $1,900 an ounce, that was what people said â that it was a vote of no confidence. A vote of no confidence in the system was to buy gold. It was maybe not necessarily how people thought about it when they were investing in gold, but en masse thatâs what it was. Itâs kind of the same thing.
Tim: But weâre seeing that in reverse now because goldâs trading at around $1,000 an ounce which effectively implies there is more or less total confidence in the central bank PhD standard.
Nick: Or you could argue that gold being high was a signal of no confidence, and then it was people buying bitcoin, and now itâs cash. You could argue that the way that people show their dissatisfaction and lack of confidence in the system isnât always manifested in the price of one asset.
Dan: I think thatâs also a major difference between now and the last financial crisis. The move in gold had some retail element to it â people who had never bought gold before, and had never really thought about the value of money. For the first time they thought: âWell, maybe I should do this. It might be a reasonable position to hedge against the possibility that thereâs something seriously wrongâ. But I would say that most of the move came from people who were already in the investment markets. A lot of the liquidity came from exchange traded funds. So there was a lot of investment demand as part of the gold price. The difference now I think, and this is why cash is more interesting than gold as a reflection of what people are actually thinking is, everybody uses cash.
Tim: Yes, gold is a luxury and cash is a staple.
Dan: Right, to me it just shows that the stakes have been raised. In 2008, it was the viability of the financial sector and the credit that consumers and businesses could get. Itâs just ratcheted up to another level, and as you said, Tim, moved onto the sovereign balance sheet. And when itâs on the sovereign balance sheet and central banks have to step in and finance things, then a lot more is at stake. I think people sense that right now, but not as many people understand what that means, which is kind of why you wrote the book, The War on Cash, to show whatâs at stake in this conversation.
Nick: There are two key phrases that Iâve picked up from this discussion so far. You talked about it being âlike magicâ. You can âcreate money from nowhere and buy something realâ â that is like magic. And itâs the same with confidence, right. Itâs like a confidence trick. You have to keep people believing that itâs magic.
Tim: Itâs a faith-based system. I mean you could argue that any asset ultimately derives its value from faith in it â whether thatâs gold, the stockmarket, bonds and currencies, whatever.
Nick: But the thing that I think is interesting is â thereâs no such thing as magic, so really itâs an illusion that they can do this without consequences. Thatâs the trick. So theyâre really trying to pull the wool over our eyes. You can create lots of money from nowhere, buy stuff and there are no adverse consequences on the other side. Itâs the illusion that we live in a world without consequences now, and really the work that we do tends to try to unravel that myth and show that there are consequences for all of these actions. Theyâre just perhaps not the ones that you would expect.
Tim: The metaphor of the broken windows fallacy is possibly one of the best-known ideas in classical economics. The French economist Frederic Bastiat uses the example of a shopkeeper. A little boy throws a brick through the shopkeeperâs window â I think itâs a baker in the original French. So the shopkeeper now has to buy a new window and a crowd gathers and thereâs a bit of a commotion. The people in the crowd say, well, itâs a bit of a shame for the shopkeeper but look it on the other hand, the glazier is going to get some money now and the glazier can do stuff that he previously couldnât do. So maybe actually we should go and smash all the windows â I think thatâs an argument thatâs been taken ad absurdum by the likes of Paul Krugman.
The problem with that analysis is thereâs that which is seen â which is the broken window and the money that the glazier gets â and that which is unseen â the money that the shopkeeper had and that he can no longer spend, because heâs had to give it to glazier. Thatâs unforeseen consequences. Thatâs what would happen to all of the purchasing power that central banks are destroying by printing money, and giving it to the banking sector or whoever. Wherever itâs ending up, itâs not ending up with the man in the street, itâs ending up in a very privileged part of the financial elite and I would suggest that the greatest trick central banks ever pulled off was making people believe that central banks exist to serve the interests of the people. They exist to serve the interests of the banking sector.
Dan: I think thatâs an important point. Iâve had this argument with people who are economists and they say: âwell, it doesnât really matter whether the window is broken or not, because the important thing is to create more moneyâ. That once the money is created and someone spends it, it then has that multiplier effect throughout the economy. So what if the baker doesnât get to spend his $50 on a new window? The glazier has it and heâs going to spend it on something â and that money didnât exist before.
What they miss with that, and what is unseen, is not the choice that the baker no longer makes because he has to replace the window, itâs the fact that he loses his choice. His freedom, his financial freedom is what he loses, because he is no longer free to choose what to do with his money. That choice has been made for him by someoneâs act of destruction. And it is really absurd when you take Krugmanâs point to its logical limit â and actually he did this himself â kind of bemusedly saying that the best thing for a global recovery would be if aliens attacked the planet.
Tim: Or that we had another world war.
Dan: Yes, thatâs the logical conclusion, and no right-thinking, freedom-loving, liberal-order-appreciating person would say that the best way to promote prosperity is total war. Thatâs the absurdity at the kernel of their argument.
⢠If you want to listen to the whole podcast, it is available here.
Category: Market updates