Central Bank as Enablers of Global Instability

6 years ago I wrote an article for a major Swiss Newspaper looking at how the Fed was fostering longer-term instability by being obscessed by short-term stability. The analysis looked at the resulting uber-financialization of the society among other. We reached out to J. Taylor among other to discuss the subject but the accademic conclusion, I was told, was that it was hard to distinguish between credit linked to productive investment and credit linked to financial activity.

We recently stumbled upon an article from Ben Hunt from Epsilon Theory and saw that the subject was starting to finally get traction in some corners of the investment inteligentia (J.Hussman who to be fair started to talk about it a long time ago,R. Dalio,...) so we decided to translate our old article to English in the hope of starting up discussions on the subject (and expand it as it should to governement non-productive borrowing frenzy)

Le Temps December 2013 from Damien Cleusix Translation

Trying desperately to foster permanent stability, The Fed only increases the longer-term instability of the system

The decisions by the US Federal Reserve (Fed) have nowadays an influence they never had before. The Fed wants to achieve a laudable goal, stable and sustained economic growth in the long term. Unfortunately, it has yet to realized that its actions are the eneabling force of this bubble repetitae economy that has been raging for fifteen years. It is the enabler of the current environement when financial activity takes precedence over economic activity, when existing productive capital is exchanged rather than new capital created, when debts increase but not the ability to repay them. It worsens the outcome, slowly but surely, trying, after each failure, coming up with a more extreme strategy. A. Einstein said, "Insanity is about doing and redoing the same thing and expecting different otcomes.”

For some time now, the Fed has been controlled by an unelected fringe of the academic world, which believes that it has been given a quasi-divine mission to ensure financial stability in addition to price stability and full employment. The problem is that it continues to act without taking into account the structural changes that have disrupted the US and global economies (potential real growth of the US economy well below its estimates, deflationary effects of technological progress and misallocation of capital since the late 1990s...).

The result was an overly accommodating monetary policy. First, with key rates that are too low and, since they can no longer be lowered, monetary injections in the form of a "Quantitative Easing" (QE) program as well as verbal interventions at the slightest movement in the financial markets.

The Fed talks to us about "optimal control" policy, which is simply the use of macroeconomic models to derive future short-term interest rate developments that optimize the behaviour of inflation, the unemployment rate and financial stability in the coming years. Amen.

Decisions are therefore made on the basis of models that have been unable to predict macroeconomic developments in the past, not even a quarter in advance, using non-conventional monetary policies whose impact and consequences, as even those who use them admit, are unknown. And all this in interaction with an increasingly complex financial system where chaos (in the mathematical sense of the term) and reflexivity reign supreme.

Let us now return to the concept of a bubble economy by focusing on credit creation, without which a bubble dynamic cannot develop.

Two types of credits should be distinguished. The one that is used to invest in new productive capital and the one that is used only to exchange existing productive capital. The first increases the productive potential of an economy. The second, which we will call financial credit, brings nothing new except an increase in the level of aggregate debt.

The Fed, through its policy, wants to increase "productive" credit when in reality it promotes the creation of financial credit. Companies no longer borrow to invest but to buy back their own shares, for mergers and acquisitions, LBOs or refinance their bond debt. We will not enter the maze of financial credits granted to hedge funds and other financial entities.

Why? Why? The answer lies in the inter-temporal interactions between stability and uncertainty. Indeed, the Fed has managed to convince that it could ensure short-term financial stability by intervening at the slightest sign of stress (Greenspan Put, Bernanke Put and, more recently, governors intervening publicly to micro-manage market movements). Nevertheless, in doing so, and with the help of a government that is not very responsible (but the Fed allows it to be), it has increased the uncertainties about the more distant future. It is therefore entirely rational for economic actors to promote financial credit. Why in these circumstances take the risk of investing in the long term? To this must be added the prevalence of the use of risk management models based on recent market volatility (Value at Risk,...) by different financial institutions. Models that push to increase the risks taken as volatility decreases. Finally, let us not forget the "moral hazard" introduced by the bailouts of private financial institutions following the 2008 collapse.

All of this results in a massive increase in the stock of financial credit, inflating speculative bubbles reaching staggering proportions. And this without increasing the stock of productive capital in return. Productive capital without which there can be no increase in the potential for future growth necessary to repay this financial credit.

Let us also not forget that very large sums of money are needed to form a bubble, but the drop only requires the absence of a buyer. So even if we go from an initial situation to a bubble situation and back to the initial situation, huge amounts of money are lost. This is not a "zero-sum game". The debts contracted remain but the financial collateral disappears.

In conclusion, it is therefore high time that the Fed realized that its control is only illusory. Let Schumpeter's cherished creative destruction take back the place it should never have lost. The Fed must realize that the stability to which it aspires only increases the instability of the system (and says that H. Minsky was never awarded the Nobel Prize) by encouraging speculative behaviour and short-termism. Let us return to a system where risk has a price and where the various actors, whether economic or political, must face up to their responsibility. And, let's be crazy, let's leave it up to the market to determine short-term rates and limit the Fed's role as a "lender of last resort" to punitive rates in the event of a serious crisis.