Tuesday, May 12, 2015

The Central Problem with Central Banks: They Become the Greater Fools/Bag-Holders

Those who are confident the central banks can print unlimited money may find there are political and financial consequences to such extremes that cannot be foreseen.

The central problem with central banks is their mandate now includes propping up all asset markets globally. Back in the good old days before the Global Financial Meltdown of 2008-09, central bankers reckoned they could control the "animal spirits" released when the risk-on herd destabilized into a chaotic risk-off stampede.

As former Federal Reserve chairman Alan Greenspan noted in his 2014 Foreign Affairsarticle Why I Didn't See the Crisis Coming, the models used by central banks and private economists alike presumed the demand for risk-on assets would remain robust even in a downturn:

Almost all market participants were aware of the growing risks, but they also knew that a bubble could keep expanding for years. Financial firms thus feared that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably. In July 2007, the chair and CEO of Citigroup, Charles Prince, expressed that fear in a now-famous remark: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Financial firms accepted the risk that they would be unable to anticipate the onset of a crisis in time to retrench. However, they thought the risk was limited, believing that even if a crisis developed, the seemingly insatiable demand for exotic financial products would dissipate only slowly, allowing them to sell almost all their portfolios without loss.

They were mistaken. They failed to recognize that market liquidity is largely a function of the degree of investors’ risk aversion, the most dominant animal spirit that drives financial markets. Leading up to the onset of the crisis, the decreased risk aversion among investors had produced increasingly narrow credit yield spreads and heavy trading volumes, creating the appearance of liquidity and the illusion that firms could sell almost anything.

But when fear-induced market retrenchment set in, that liquidity disappeared overnight, as buyers pulled back. In fact, in many markets, at the height of the crisis of 2008, bids virtually disappeared.

Translated into plain English, what Greenspan and other conventional economists expected was a deep pool of greater fools would gladly lose money by buying assets that were plunging in value. Greenspan et al. reckoned the seemingly insatiable demand for exotic financial products implied that greater fools would continue to "buy the dips," enabling Wall Street financiers to unload the near-worthless exotic financial products to those willing to absorb rapidly increasing losses.

The problem with this model is the pool of greater fools drains almost instantly, leaving Wall Street holding the bag of collapsing-in-value risk-on assets. As the exotic financial products crashed to Earth, the highly leveraged banks were quickly rendered insolvent.

The world's central banks have attempted to keep the asset bubbles inflated by lowering interest rates and manipulating markets with secret purchases of assets, either directly or through proxies.
Whenever markets threatened to collapse, central banks stepped in and "bought the dip," reinforcing the faith that central banks will never let markets fall.
The problem for central banks is the pool of greater fools is increasingly skittish.Once the herd is no longer willing to "buy the dip," central banks will have no other choice other than to increase their buying--in effect, replacing private demand with their own purchases of assets.

That works when a few billion dollars spent "buying the dips" reinvigorates private "animal spirit" buying. But when the risk-on herd stampedes into risk-off selling, markets go bidless: there are no more greater fools left except the central banks.

Central banks have inflated the markets to such high valuations that no central bank can possibly buy enough to keep the bubble intact. Here is Doug Noland's summary:

Total Debt Securities grew to $36.152 trillion, or 208% of U.S. GDP. Total Equities inflated to $36.457 trillion, or 209% of GDP. Having inflated almost 2,000% since 1981, Total Securities ended 2014 at $72.608 trillion, or an unprecedented 417% of GDP.

The Federal Reserve expanded its balance sheet of assets owned from $800 billion in 2008 to $4.5 trillion at the end of its quantitative easing programs in 2014. This massive expansion was enough to calm the stampede and reinforce another six years of risk-on herd buying.

But having succeeded in blowing another unprecedented global bubble in assets, central banks have backed themselves into a corner of direct asset purchases to prop up markets. In the U.S. alone, a risk-off selling spree that liquidated 10% of the $72 trillion in financial assets would require the Fed to print $7 trillion and use every dollar to buy the assets being dumped wholesale by the stampeding herd.

Can central banks double, triple and quadruple their balance sheets almost overnight to absorb the mass dumping of risk-on assets? Will there be no consequences, political and financial, to central banks becoming the greater fools who will buy even as asset values are crashing?

The conventional view is that the Fed will never need to print-and-buy more than a few hundred billion dollars to stem the tide of selling. But the conventional view has a fatal flaw that Greenspan outlined in his Foreign Affairs article: when markets go bidless, "animal spirits" may be beyond calming. Once central bank buying fails to stem the tide, markets will truly panic.

At that point, central banks will have to decide to buy trillions of dollars of rapidly depreciating assets or finally let the market find its own level. Those who are confident the central banks can print unlimited money may find there are political and financial consequences to such extremes that cannot be foreseen. 

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