The ideological assault of the market worshipers on government is starting to have its inevitable result — extreme market uncertainty. In a system of rules, which is what a financial system is, endless denigration of the rule setters (governors and regulators) because of alleged incompetence or wicked constraint on basic liberties will always result in the weakening of the very rules on which the libertarians rely. For their liberty. That is the lesson of the current extreme volatility. In practical terms, as a Credit Suisse report details, it is making it very hard for investors to work out where to turn.
Equities and bonds are simultaneously cheap. Investors do not want to buy equities because of prevailing growth risks. But they are also reluctant to buy bonds, because of sovereign debt concerns. In this context, the recent S&P downgrade of the US government seems to have had a significant psychological impact on investors. Seemingly, investors are massively overweight cash. But it is now costly for investors to hold cash. Recently, the custodian Bank of New York Mellon started charging a 13bps fee for large deposits. This effectively creates a negative interest rate. It is symptomatic of a liquidity trap – an environment where there is an abundance of money supply – but no-one willing to put cash to good use.
Yep, the usual rules don’t apply. Which is what you would expect when privateers and banksters have for decades attacked those who set the rules. You can always go to gold, but that is not even valued on supply and demand, just the ancient belief that it is worth something:
Understandably, investors have been desperately seeking out alternatives to cash and bonds. They have been buying gold and CHF. But these alternative safehaven trades are now very crowded. Gold prices are exceptionally high in real terms, whereas the CHF is massively overvalued relative to longer-term fundamentals.
Therefore, investors have been forced to move even further out the risk (or yield) spectrum in search of safety. Currencies like the AUD have been viewed more favourably. After all, the AUD is backed by hard commodities, and is therefore a beneficiary of money printing globally. Also, the Australian government has very low debt levels compared with its foreign counterparts. To be sure, the AUD is not a safehaven currency in the strictest sense, because Australia is a net borrower of funds from abroad, and is therefore vulnerable to capital outflows during episodes of global risk aversion. Also, if world growth is weak or negative, commodity prices tend to fall, causing a deterioration in the trade balance. But notwithstanding these considerations, investors have been willing to buy the AUD as a quasi-reserve currency, because there has been precious little else to buy. Clearly, investors still have a preference for safety.
There is the usual advice about how Europe should manage its problems.
(Investors) are demanding a quick resolution of European and US debt issues. But a quick resolution is not possible or palatable. Germany may need to transfer saving to peripheral Europe. Peripheral European debt must be restructured. China may need to allow its export sector to be downsized to create room for the US to kick-start its manufacturing. These ideas are not very popular – and even if policy makers could agree to implement them, the adjustment process would take many years. In the short-term, the best thing that policy makers can do is to buy time for longer term adjustment processes to take effect. But so far, policy makers and investors alike seem very uncomfortable with this state of affairs. Nobody likes the idea of “kicking the can down the road”.
What is notable in the recent ructions is the lack of sense of responsibility in the market worshipers and their smug preaching at governments as if they had nothing to do with what went wrong. Somehow government is always other, and a pernicious other at that. It is not important that the self interest of this view is odious. What matters is that it is flat wrong. We are all in it together, and the refusal to acknowledge that is at the heart of the current near panic: The Credit Suisse report gives a glimpse of recognition, though:
Ironically, their discomfort could be self-fulfilling and making matters worse. They are depriving (desperate) borrowers of cash. They are creating a fundamental dislocation of fund flows. We can see this, because there are pockets of credit market stress in the world despite an abundance of cash in the global financial system. It is like having starvation in one part of the world, and obesity in the other – possible, but not sensible.
This looks a lot like a co-ordination failure. It is possible that investors could help themselves by helping policy makers. They could continue to fight the Fed, ECB, and fiscal policy makers – but perhaps they should simply choose not to. After all, valuations on safehaven assets are now so stretched that even risk assets are starting to look attractive. And if nominal interest rates really are turning negative, investors could be forced back into the market for risk assets again. At this juncture, it could be mutually beneficial to endorse the credibility of policy makers and indeed, the path of least resistance.
Support government in the collective interest? What about enlightened self interest, and the limitless benefits of self interest, fear and greed? Adam Smith’s invisible hand would be turning in its grave, to use an entirely unconvincing metaphor.