Crisis — The Inevitable Result of Modern Central Banking

The inevitable effect of contemporary central banking is serial financial booms and busts. With that comes increasing levels of systemic financial instability and a growing dissipation of real economic resources in misallocations and malinvestment. The world ultimately becomes poorer.


Because gains in real output and wealth depend upon efficient pricing of capital and savings. But the modus operandi of today’s central banking is to deliberately distort and relentlessly falsify financial prices.

After all, the essence of zero percent interest rates (ZIRP) and negative interest rates (NIRP) is to drive interest rates below their natural market clearing levels to induce more borrowing and spending by business and consumers.

It’s also the inherent result of massive quantitative buying (QE) bond-buying where central banks finance their purchases with credits conjured from thin air. The central banks’ big fat thumb on the bond market’s supply/demand scale results in far lower yields than real savers would accept in an honest free market. The middle class and retirees who rely on savings lose out.

The same is true of the old doctrine of “wealth effects” stimulus. After being initiated by Alan Greenspan 15 years ago, it has been embraced ever more eagerly by his successors at the Fed and elsewhere ever since.

Here, the monetary transmission channel is through the top 1% that own 40% of the financial assets and the top 10% that own upwards of 85%. Stock prices are intentionally driven to artificially high levels by means of “financial easing.” That’s a euphemism for cheap or even free finance for carry trade gamblers and fast money speculators.

As the stock averages rise and their Fed-subsidized portfolios attain ever higher “marks,” the wealth effects operators supposedly feel, well, wealthier. They are thereby motivated to spend and investment more than otherwise, and to actually double-down on these paper wealth gains by using them as collateral to obtain even more cheap funding for even more speculations.

The trouble is, financial prices cannot be falsified indefinitely. At length, they become the subject of a pure confidence game and the risk of shocks and black swans that even the central banks are unable to offset. Then the day of reckoning arrives.

Exactly that kind of Lehman-scale crisis is now descending on global markets. The end result of today’s massive central bank intrusion in financial markets is, everywhere and always, crisis.

Today central banks and their affiliates own about $21 trillion of government bonds and related securities. Most of that has been purchased in the last two decades and the preponderant share since the 2008 crisis.

The effect of that giant central bank thumb on the scales at the very interior of the fixed income markets — that is, the benchmark government securities sector — has been to radically inflate sovereign bond prices. In turn, that drastic mispricing has spread to the balance of the fixed income spectrum, and from there into equities and other markets.

Above all else, the QE driven falsification of bond prices means that central banks have displaced real money savers as the marginal source of demand in the government bond markets.

But when you replace savers with central bankers at the very heart of the price discovery process in financial markets, the system eventually goes tilt. You go upside down.

That condition was aptly described in a lengthy Wall Street Journal Wednesday about a recent development in sovereign debt markets which absolutely defies human nature and the fundamental dynamics of modern welfare state democracies.

That is, modern governments can never stop issuing more debt due to massive entitlement constituencies, special interest racketeers of every stripe and the prevalence of Keynesian-style rationalizations for not extracting from taxpayers the full measure of what politicians are inclined to spend.

Yet there is now a rapidly growing “scarcity” of government debt — the equivalent of a fiscal unicorn:

A buying spree by central banks is reducing the availability of government debt for other buyers and intensifying the bidding wars that break out when investors get jittery, driving prices higher and yields lower. The yield on the benchmark 10-year Treasury note hit a record low Wednesday. “The scarcity factor is there but it really becomes palpable during periods of stress when yields immediately collapse,’’ he said. ”You may be shut out of the bond market just when you need it the most.’’

On Wednesday, the yield on the 20-year Japanese government bond fell below zero for the first time, joining a pool of negative-yielding bonds around the world that has expanded rapidly over the past year. In Switzerland, government bonds through the longest maturity, a bond due in nearly half a century, are now yielding below zero. In Germany, government debt with maturities out as far as January 2031 is trading with negative yields.

Owing to this utterly insensible “scarcity” central banks and speculators together have driven the yield on nearly $12 trillion of government debt — or nearly 26% of total outstandings on the planet — into the subzero zone. This includes more than $1 trillion each of German and French government debt and nearly $8 trillion of Japanese government debt.

The systematic falsification of financial prices is the sum and substance of what contemporary central banking does. Forty years from now, for example, Japan’s retirement colony will be bigger than its labor force, and its fiscal and monetary system will have crashed long before.

But no matter. Before it self-destructs, the BOJ will buy all the Japanese government debt, anyway.

It already owns 426 trillion yen worth — an amount that equals fully 85% of GDP. When it comes to government debt, therefore, it can be well and truly said that “price discovery” is dead and gone.

Japan is only the leading edge, but the trend is absolutely clear. The price of sovereign debt is where central banks peg it, not where real money savers and investors will buy it.

Yet that’s only half the story, and not even the most destructive part. The truth of the matter is that the overwhelming share of government debt is no longer owned by real money savers at all. It is owned by central banks, sovereign wealth funds and leveraged speculators.

Regarding the latter, do not mistake the funding deployed by speculators with genuine savings. To the contrary, it’s pure credit extracted from the value of bond collateral being driven ever higher by central banks.

What this means is that real money savings — which must have a positive nominal yield — are being driven to riskier investments in search of returns, most especially into the corporate credit risk zone.

At the present moment, for example, there is nearly $3 trillion of junk bonds and loans outstanding in the U.S. alone. That’s double the level existing on the eve of the great financial crisis. But double the money embodies far more than double the risk.

That’s because a very substantial portion of current junk credit outstandings went into speculations that even leveraged buyout shops wouldn’t have entertained 15 years ago. That is, it was used to fund radical commodity price speculations in the shale patch, mining and other commodity plays, subprime auto lending schemes and financing for stock buybacks and dividend recaps by highly leveraged companies.

Indeed, the scramble for yield generated by central bank action has systematically impregnated the global markets with FEDs (financial explosive devices). Approximately 100 principal central bankers have spent the last seven years pushing interest rates toward the zero bound or below. It may have been a blessing for the 1% who’ve won big in the gambling casino.

But it’s crushed middle-class savers and retirees.


David Stockman
for The Daily Reckoning

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