This article is going to be a little bit different. Today we are going to analyze the net effect of Central Bank action at a global level with respect to economic information contained in markets. We know that when markets are truly free, prices (and other data such as liquidity) paint a very clear picture of prevalent economic conditions. We know that this concept may be a little bit difficult to grasp but believe us, it is real. Take the simple concept of price. If the one item you are interested in buying is going up in price, it could be because of lower supply or higher demand. This price tells you very little about economic conditions in general. However, if most of the items you are interested in purchasing go up in price at the same time, then there is clearly something going on here. It is not probable that the supply of every single item decreased or that the demand for those items increased simultaneously within normal market conditions. You would expect that some prices would remain the same, some would go up and some would go down. However, when we observe massive changes in the same direction, we must conclude that something big is affecting all prices at the same time. This “something big” are market conditions.
In our current managed economy, if prices go up and up and up, we know that we are in an inflationary situation (i.e. Central Banks are printing worthless paper). In these conditions we know that economic activity will slow down, most likely leading to a “contraction” (i.e. bad economic times). Thus, armed with this information we act accordingly. We buy stuff that will retain its value. We save. We ensure we have a job, and so on. On the other hand, if we see that prices remain more or less stable, we know that we are not in an overly high inflationary scenario and thus we spend, we enjoy ourselves, we may even start a business.
The point here is the idea that the information provided by markets matter far beyond the purpose for which traders use it. Information contained in markets allows us to perform economic calculations and with such calculations we can make estimates of the future and act accordingly because in the absence of other external factors perturbing the economy, it will follow a more or less pre-determined course. In totally free markets, this course is fairly clear and simple; yesterday’s conditions are the most likely conditions to be found tomorrow. In mildly managed markets (such as when Central Banks interfere lightly) we know what Central Banks are attempting to do; when they lower interest rates, they are “stimulating” market activity and when they raise interest rates, they are a “fighting” against inflation. This “managing” process is ugly, does not work and creates booms and busts; however, we can at least forecast it to a degree. The information contained in the market does provide some idea of the near future.
However, what happens when Central Banks “manage” markets in major crises? The main purpose of those “management” techniques is to “diminish the pain” in “financial markets”. The what? Right! That’s the spirit. The concept of “diminishing the pain” simply means preventing certain people and organizations from going broke and there is a major problem with this kind of action. Going broke is part of normal market operations; it is what makes markets so efficient in satisfying people’s needs. Going broke is a cleansing process whereby entrepreneurs offering products that people do not want are stopped from continuing wasting capital so that it can be re-deployed for better use. In financial areas we find banks, financial institutions, trading companies, insurance companies and so on in this category. In a truly free market, nobody escapes from market action. In managed markets however, that is not the case. When Central Banks intervene to prevent bankruptcies, they are acting against the market. This concept is important because it implies that they are modifying the normal operation of markets, which means that they are modifying the informational content of such markets.
As we explained above, in normal conditions the modification of market information is not drastic. However, in crisis situation the information is massively affected. As a consequence of this massive modification, all market information is destroyed. Yes, we still have numbers but those numbers reflect nothing more than Central Bank action. We cannot interpolate or extrapolate what markets will do. As such we should not be making any economic calculation based on those numbers because those numbers do not reflect what markets will do. Yet, we do.
Even though we know that the information contained in those economic statistics is meaningless, we simply cannot stop making economic calculations. If we would stop so doing, we would die. All entrepreneurial activity would stop. Manufacturers would stop manufacturing. Retailers would stop selling and people would stop buying. Life as we know it would come to a sudden stop. Basically, we are trapped. In order to survive we must continue to perform economic calculations based on meaningless numbers… and how meaningless they are!
Consider the following:
Quantitative Easing has destroyed any meaning of the pricing in bond markets. It is now impossible to forecast what will happen in the future (long term) and it is now impossible to make any meaningful investment based on the issuance of debt in the form of bonds.
ZIRP (Zero Interest Rate Policy) has destroyed short term interest rates. They are now meaningless. The average person has no idea what will happen tomorrow, not even in within the Keynesian (or Monetarist) recipe to “stimulate” the economy followed by a “fight against inflation”.
Negative interest rates have imposed yet another tax on people and are threatening with unleashing massive inflation world-wide. Should negative interest rate have their desired effect, i.e. to get people spending their savings, printed money will pour out from banks at an astonishing rate. Presto! Massive inflation.
Other Central Bank operations (such are forced re-capitalizations and bail outs) in conjunction with those above mentioned, have prompted people to “follow the Central Bank” when it comes to trading. As markets no longer carry any meaningful information and the only force to be reckoned with are Central Bank actions, traders do just that. Is this a problem? Yes. There have been mini-flash crashes in several markets since few months back. This is strange because by any standard measure of trading activity, there are sufficient traders for this not to happen. When prices drop sufficiently, typically traders jump in to buy bargains. This has not been happening. How is this possible? Simple. Everybody is following what Central Banks are doing. No trader is stupid enough to go against the force controlling the markets. As a consequence, there are no multiple points of view and no contrary behavior which is what keeps markets going. In market terms, there is no liquidity.
The derivatives market is completely out of control. As derivatives depend of the “underlying” i.e. the actual, physical stuff we are betting about, if the prices of the underlying make no sense, then prices for derivatives will make no sense… at a leverage of anywhere between 1:2 to 1:100.000!!!
Country debt is now mostly meaningless. If banana republics such as Mexico can issue bonds denominated in EUR to 100 years and if Switzerland can sell bonds at negative interest rates, there clearly is more than enough fiat money going around to paper over any debt. These concepts have lead to the humorous (not to say incredibly stupid) idea that debts are assets. That’s right! If you are a country and you owe a lot of money, that’s an asset!
Do you get the idea? The more money Central Banks pump into markets using one mechanism or another, the worse the distortion of information and therefore the worse the economic decisions made by people. And what happens with bad (or stupid) economic decisions? That’s right! The market forces them into bankruptcy. And what happens then? More Central Bank action to prevent said bankruptcy. And the cycle re-enforces itself. Until when? Until it can no longer function. And then what? Global bankruptcy. Cascading cross-defaults.
Why is this important to you? The bottom line is that Central Bank action always distorts the information available in markets. It is for this reason that we have booms and busts. However, when this “action” is extreme, then we have extreme distortions leading to extreme screw-ups. This is a basic concept that it is not difficult to grasp but in general terms it is not in peoples’ minds. This is so because governments and Central Bankers are very clever in disguising what they do in techno-babble and economic-gobbledygook. But it is all a smoke screen. Eventually markets reassert themselves and when that happens, nobody is safe. And so when the next financial/economic tsunami inevitably hits, don’t be surprised at all. You will know its origins. If only forecasting earthquakes would be so easy!
The massive destruction of market information has the highest price of all when it comes to government action because what must be accounted for is not only Central Bank and government losses, but entrepreneurial losses which are several orders of magnitude higher.
But then again, perhaps you are a betting person and enjoy betting your future on the decisions of a few people hidden in posh boardrooms. If this is the case, you are in luck. You are having and will continue to have plenty of it. Enjoy!
Oh… just one thing, when you are broke, hungry, dispossessed, unclothed and alone, don’t bother knocking on those peoples’ doors. They will be very busy in their private clubs and mega-mansions enjoying their “well deserved” government retirement income.
Note: please see the Glossary if you are unfamiliar with certain words.