The Greatest Risk
Evidence-based investing is so compelling numerically that it attracts vast amounts of capital to managers who have established track records of deploying it successfully.
But it has produced a market full of capital awarded to funds based upon historical trends, which are subject to dramatic realignment, particularly in light of what may be a generational economic episode that may result in the realignment of trade between nations, the bankruptcy of major global entities, or even entire countries and their currencies, Iceland being the first to fall.
Market participants can only seek to hedge against perceived risk, or known unknowns. When many stand on the same side of the boat in the belief that they are protected by the latest technology, the iceberg below the surface has a tendency to create a Titanic moment.
To combust, a fire requires three conditions: fuel, oxygen, and heat. Derivatives and evidence-based investing are not enough to cause a financial meltdown. What causes a generational event is the presence of a fiat based monetary system that encourages the printing of bank money.
The reason is that it beguiles the public to embrace leverage with gusto, at twice the magnitude seen just before the Great Depression. This bet was made based upon the assumption that real estate prices would continue to ascend, as they had historically, or at the very least not decline appreciably.
With the stock market downturn of late 2008, scales have fallen from the eyes of some observers such that leverage is now known to have built up excessively. The tremendous amount of debt that accumulated could only have occurred in a banking system that forced the creation of $1 trillion of new paper money annually from the peak of the Internet bubble in 2000 to the financial meltdown of 2008 through fractional reserve lending. And the creation of bank money was not much less prolific in the entire history of the Federal Reserve system.
The stability witnessed since World War II in the U.S. economy may ironically be a cause of economic instability, which could be deepened and extended in duration should cultural and political factors align in complete support of socialism.
Whenever there has been a recession, rates have been lowered and liquidity injected such that the impact of credit default was diluted. Although this avoided long, deep recessions, it has encouraged greater and greater waves of risk taking.
[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]