Central banks must carry the box for the state we’re in


Supply shocks, rising prices and labor shortages are in the news. Analysts blame specific factors, ranging from the strength of the economic recovery to Brexit. The likely reality, however, is that the phenomena we see are connected and interconnected with social and political developments. The interaction of the financial system with the economy forms a complex and evolving system, which consists of a multifaceted network of relationships and forces with “emergent properties”, which means that the result of these interactions may be greater than the sum of their parts. It is very difficult, if not impossible, to understand all of these interactions and predict their consequences.

This is especially true when the system has been the subject of massive interventions, such as those seen over the past two years: lockdowns, supported businesses and governments paying people not to work, huge public deficits and unprecedented interference from the government. central bank in the markets. The economy and financial markets are in an extreme imbalance.

One of the simplest and most striking measures of this imbalance is the relationship between the value of assets and income. A key indicator of this relationship is the ratio of total personal wealth to GDP, which has grown tremendously. For the United States, the ratio of wealth to GDP is 6.23, having increased almost vertically since the onset of the coronavirus crisis. Until 1995, the relatively stable long-term average of this ratio was 3.6. The increase in wealth has exceeded the increase in GDP to an unprecedented degree. The UK is similar.

A blip in a steep upward trajectory

Yet, on a graph of this ratio, the Covid-19 panic appears as barely a jolt in its remarkable rise. In his 1988 book, The alchemy of finance, George Soros explained his theory of “reflexivity”. He postulates that market prices are determined by investor beliefs and expectations, and that these prices in turn impact “fundamentals” – which then affect investor perceptions in what can be a self-perpetuating cycle. reinforced. This prospect has come under criticism that central banks could be a countervailing force; they control short-term interest rates and have a strong influence on market liquidity. But central banks themselves have now become captives of the markets.

In the book The rise of babywearing, Jamie Lee, Kevin Coldiron and I present the case that the driving force of markets today is “carry”, the suppression of financial volatility. Central banks have acted to guarantee market prices, giving the impression that risky assets, such as stocks, are much less risky. This has particularly benefited wealthy asset holders. The S&P 500 is at the center of this suppression of volatility. This is due to the dominant role of the US Federal Reserve and the dollar as the funding currency for global leverage.

More broadly, this idea of ​​porterage can be linked to power. If there are large imbalances of wealth and power in society, then the political forces leading to the suppression of volatility will be stronger. The suppression of volatility can be directly equated with the concentration of power and, by extension, less freedom in society. In totalitarian states there is less natural volatility than in a free society. By implication, the artificial suppression of volatility will gradually lead to an increasingly less free society – again, often through processes that are difficult to understand.

This may raise questions about actions taken by governments in response to the coronavirus. Is it possible, for example, that extreme measures such as lockdowns were in part due to the need to prevent the implosion of financial markets (by directing all liquidity created by central banks to asset markets? rather than towards the real economy)? This could be true, even if no one involved in these decisions really clearly understood it.

What does all of this have to do with the stock market today? Ideas in The rise of babywearing suggest that because the S&P 500 and the Fed are at the center of the suppressing volatility regime, and suppressing volatility is a manifestation of the concentration of wealth and power, then the S&P 500 continuing to rise is a restriction freedoms. It’s easy to see how this could relate to the growth of Big Tech (which dominates the S&P 500) and the state of surveillance.

Another conclusion is that accidents must happen. There must be occasional spikes in volatility as the leverage gets too high and there are episodes of forced unwinding of the leverage. Each crash leads to an increasingly important intervention by the authorities.

“The system” will find ways to justify these increasing interventions. Besides health crises, in the future other candidates could include climate change, a global cyberattack or food shortages. Various types of rationing are likely. The end result will inevitably be a new alignment of the interests of the very rich, big business and governments.

Only inflation can end this cycle because it constrains the actions of governments and central banks. But inflation is bad for financial markets. Therefore, being bullish on the S&P 500 for the long term means believing that individual freedoms will be further curtailed. But it also means accepting that crashes do happen occasionally – crashes that will require increasingly huge central bank and government action to reverse.

Tim Lee is co-author of The Rise of Carry: The Dangerous Consequences of the Suppression of Volatility and the New Financial Order of Declining Growth and the Recurring Crisis (McGraw Hill 2020, £ 24.99)

About Alma Ackerman

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