Saturday, July 23, 2022

When You Put Too Many Eggs in One Basket...

Greed is good until all the vulnerabilities and fragilities of systemic risk asymmetries manifest.

When you put too many eggs in one basket, you create systemic fragility: if anything knocks that basket over, the loss is so overweighted that the entire system unravels.

Why do we put too many eggs in one basket? because it's easy and profitable. We do more of what's easy and profitable and don't consider the systemic vulnerabilities created by relying on one asset class or sector.

This is the foundation of the resource curse: nations with abundant reserves of highly valued resources (oil, copper, cobalt, guano, etc.) have a ready source of income that doesn't require much beyond controlling the resource so outsiders don't steal it. This source of income is so much easier than competing with the rest of world in other sectors that resource extraction ends up being the majority of the economy.

This asymmetric economy is highly profitable until the resources are depleted or the market demand tumbles. The downturn unravels the entire economy, which became overly dependent on the one sector.

The same dynamic is evident in nations that have become dependent on exports--the mercantilist economies such as Germany, Japan, China and many east Asian economies. Having put too many of the nation's eggs in exports, when exports sag, the entire economy stagnates due to the dependence on exports for profits and growth.

Whatever is optimized ends up dominating the economy. Whatever fits the national character and resources in terms of being profitable ends up being favored, as the expense of a more balanced but less profitable mix of sectors and assets.

Nations can put too many eggs in one basket due to government policies. Consider China's dependence on real estate development for domestic growth and household wealth, a dependence that is now unraveling.

As a result of central government policies, the primary source of local government revenues is real estate development leases and fees. This created irresistible incentives to keep pushing real estate developments regardless of market demand or overinvestment.

Culturally, gold and real estate have long been considered safe stores of value, so families put (in many cases) all their eggs in one basket: empty flats in new developments.

Since real estate development generates employment, profitable loans, local government revenues and until recently, capital appreciation, this overweighting of real estate development was a win-win-win for all participants.

The problem with overweighting one sector or asset class is that the money pouring in soon sloshes into projects that don't make financial sense: in effect, private-sector bridges to nowhere, funded by high-risk credit which is effectively optimized to default.

In the U.S., the stock market has become overweighted due to central bank and government policies that have encouraged speculative bubbles as a means of supporting consumption via the vaunted wealth effect: when our stock portfolios rise in value, we feel richer and therefore spend more freely--even if the "wealth" is only the short-lived phantom-wealth of a speculative bubble.

It's ironic, isn't it? Doing more of what's easy and profitable ends up distorting the economy by putting too many assets and too much risk in one basket, which inevitably takes a tumble as the wise investments spur optimized to default malinvestment.

Those nations reaping windfall profits from hydrocarbons are riding high at the moment, but should demand fall faster than supply, the speculative frenzy propping up oil prices globally will collapse, impacting price in ways many now view as "impossible."

Any economy that's counting on people paying for abandoned, half-finished flats for "growth" is exceedingly vulnerable to the dominoes of default and the collapse of confidence that buying half-finished flats is guaranteed to be profitable.

Any economy that's dependent on speculative bubbles for "growth" is putting far too many eggs in a basket that is sure to topple.

Any economy that's counting on exports as the global economy deglobalizes and definancializes has put far too many eggs in a basket that's already tumbling down the hill.

Greed is good until all the vulnerabilities and fragilities of systemic risk asymmetries manifest. As I often note, risk cannot be extinguished, it can only be hidden or transferred to others.




Recent podcasts/videos:

Tectonic Shift of Mercantilism Revalued (Gordon Long, Macro-Analytics, 42 min)

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