Can We Move Away from the Nuclear Options?

Accountability is lacking because somehow we found ourselves in a system where only the nuclear options have any deterrence effect. For instance, only wars can stop a dictator intent on invading others. No amount of diplomacy would work. The ‘good guys’ have to hit the ‘bad bullies’ where it hurts to stop them. This is something people understand. Yet, this was supposed to be a rare occasion where this rule applied. In other aspects of life, there was supposed to be room for compromise if not checks and balances. This is not how it is playing out. 

Police is only changing now because of their leadership and budgets are on the line. The complaints and pressures before did not work. 

Bigots are only trying to right their past wrongs now that they could lose their jobs. The HR complaint systems and social pressures before had no use.

Officials are only paying attention to the health risks and supply chain vulnerabilities due to covid. Past warnings and studies had no effect. 

Economic managers are only seeing the fragility of the ‘living pay check to pay check’ model due to covid. Previous statistics did not mean much because the pay checks did come in. 

As bad as these issues are, recent events have hit the powers where it hurts and accountability should improve going forward. However, there are two issues that still lack accountability. The nuclear option blowback for them could come one day, but that would not be a good outcome f. 

The first is the post Bretton Woods dollar system. The US dollar is the global reserve currency, which the world uses to trade, transact, save, and invest. (Long story short, this is the case because USD derives its value from US having the biggest economy and its security from US having the strongest military) Given only the US government can print USD or digitally create USD, it gives US a certain advantage. At this point, the world has grown used to this set up and accepts it for what it is. However, if the US does not use this power responsibly, then one day a big blow back would come. This is still a far-fetched scenario because there are no alternatives. It takes a lot to convince 6 bn people on earth to suddenly stop using USD and use EUR, RMB, or Bitcoin instead. As for what would happen, Lionel Shriver’s satire fiction called ‘The Mandibles: A Family, 2029-2047’ is recommended reading. It is a family story about what happens after the US government defaulted on its treasury. 

The second is China. It has done a good job in meeting the basics hierarchy of needs such as the physiological and safety needs, but it has shown much less interest in supporting the belonging, esteem, and self-actualization needs of people. This is becoming a problem because accountability is lacking. Since the calls for these greater needs are suppressed and even criminalized, it becomes next to impossible for the system to respond. Externally, China’s project of power has come fast and furious over the last few years. China argues everything it does is in its own right and others should mind their own business. This status quo could last. China gets to do what it wants, but the lack of accountability could lead to nuclear options one day. This could come in the form of unrests or an international conflict someday. The very probability of these events happening is a bad sign. These nuclear option outcomes are not in the interest of the people, the powers, and the world. 

A return to accountability and a move away from having to use the nuclear options are sorely needed. Here are some ways: 1) central authority to hold things accountable 2) create new ways for credible pushbacks 3) incentivize behavior so there is more accountability. 

These methods have been tried in various forms, whether they are the UN, CIA funded rebels/grassroot organizations, or backroom deals with promises of the bigger picture. I do not know which ways is the way out to tackle this accountability problem, but I do know we need one soon.

What Coronavirus? Says the Market - My take on why central banks can still dictate the market and for how? long

‘Cognitive dissonance’ is the word the Guggenheim Partners Global CIO Minerd used when he described the disconnect between the economics and financial markets right now.  

For a long time now, financial markets have been living on ‘QE’. The program to buy up government debt using created money 1) has lowered the cost of borrowing for the economy 2) pushed investors to buy other financial assets as they are crowded out from government securities. Whether one liked it or not, the result has been clear. Central bank balance sheet expansion drives up market prices. Many have made comments similar to Minerd over the past 12 years and they were shrugged off. However, the coronavirus is making comments like this relevant again.

China, the world’s second largest economy at around 15% of global, has been devastated by the coronavirus, but the market still marches on. Many believe the disruption is temporary and things will go back to normal (V-shape recovery) so there is nothing to see.

Yet, behind the sanguine outlook lies the more important assumption, which is that central banks are always here to save the day. Therefore, bad coronavirus news is actually good news because it makes supportive central bank policies more likely. For instance, if the gets worse in China, perhaps China’s People’s Bank of China will cut interest rates to zero and do QE for the first time. To take it a step further, if the virus spreads to the US and it becomes a pandemic, then perhaps the Federal Reserve Bank will cut rates to zero and do QE for the fourth time. We, as people who may contract the virus and die, know that these certainly are not good outcomes, but if China does QE and US does QE4, you can bet the market will just rip up mechanically.

Given this outlandish, but perhaps probable, scenario, it is a good time to ask the big questions: why does QE still work, when would it stop working, and how long can this ‘cognitive dissonance’ last?  (working as in it drives up real asset prices)

Why does it still work?

1)      Globalization, Moore’s Law, aging demographics in the developed markets have kept inflation low. This allows central banks to use their powers without limits and push back.

Globalization allows goods, services, labor, and capital to flow so that things can be done as efficiently, if not as cheaply, as possible. Moore’s Law predicts that chips’ processing power doubles about every two years, this makes technology cheaper and more widely adopted. Aging demographics in the developed markets are the richest group. If they aren’t spending on goods to drive up prices, then who can move prices? In the end, central bank can keep on creating money to buy government securities, but as long as these factors are at full force, the consumer price index will stay low. This allows central banks to use their powers without limits and push back.

2)      High quality asset needs

There is a lot of wealth in the world ($240 tn in 2014), but not enough high quality assets (something that generates a return). Don’t blame it on the rich either, this is an everyday person problem. The rich actually can afford to buy risky assets since they have more than enough already. It is the middle class who are saving for their retirement/children’s education or relying on their insurance to help them that need high quality assets the most. When central banks are making prices go up, the ETFs, money managers, and insurance firms will follow, often times no questions asked.

3)      Asset holders cooperating supports paper profits

Even though trading is a zero-sum game, global investors have cooperated with each other. Instead of rushing to sell the asset to realize the paper profit at once, they understand that they are in it together. By taking turns to sell, nearly all existing investors can realize their profits over time.

4)      Wealth effect

The paper profits are not real until realized, but the asset holders’ spending on goods and services are real. The wealth effect, the increased spending from the financial asset market wealth, does improve conditions. As the economy improves from the spending, the high assets prices become a bit more justifiable.

How long can it last?

The short answer is when capitalism gets diluted, too many people get in on the QE secret, and when there are better things to invest in.

Based on the four reasons mentioned above, central banks’ easing would stop working when inflation increases and middle class savers get scared. Yet, these scenarios may only be temporary. For instance, inflation will pass as supply or demand adjusts, the market fear behind any asset dump will fade, and consumer sentiment will bottom out at some point. For things to really change, we may need to see fundamental changes in capitalism, investor behaviors, and market structures. 

1)      A global shift away from capitalism may lead to more sustained inflation. In other words, if the profit incentive goes away, it will take longer for producers to find cheaper, faster, and better ways to produce whatever that is in short supply. This will make it permanently more difficult for the central bank to respond to support the market.

2)      A spike in investor interest given the central bank support would drive prices into a bubble. If too many people get in on the QE secret, major stock indices will be driven up like Bitcoin or TESLA. This will lead to a bubble burst, before investors come back betting on central banks’ support. In the end, successive rounds of bubble burst will either lead to central banks or investors walking away. At that point, the stock market will still exist, but at levels much lower than the bubble period. 

3)      The invention of a new market could drive interest and capital away from the major stock markets today. In a world where lifestyle, culture, and technology have changed so quickly over the past decades, who is to say the middle class savers and wealthy’ investment preference wouldn’t’ change.

As for these fundamental changes, things are already gradually happening. First, the world is moving away from the raw form of capitalism. There is now growing scrutiny over businesses’ environmental, social, governance, moral, and cultural standards. It is possible that all these forces contribute to future inflation from a supply standpoint. As for the second point, there may never be too many who get in on the QE secret. It has already been mainstream for 12 years and inequality makes it hard for everyone to participate in the market. Third, while a new market seems unlikely, weirder things have happened. Bitcoin's market cap is $130 bn because enough people said so. The difficulty is for a new market to get to a sufficient size. In 2014, there was about $240 tn of wealth in the world (Marginal Revolution). Today, global equity markets add up to $50 tn (BofA), global debt markets is about $135 tn (150% of global GDP), and US and China’s housing market is about $75 tn (Economist, Goldman Sachs). Unless there is a credible new market that rivals major equity market, middle class savers' money will still flow there. 

Ultimately, for those wondering whether the ‘cognitive dissonance’ of the market can last, watch how the market is treating the producers and whether a new asset market is on the horizon.

 

Disclaimer: risks such as political checks on central bank powers, financial stability concerns, and any end of the world scenarios are all possible, but are excluded for the sake of this thought exercise.