Submitted by Charles Hugh Smith from Of Two Minds
Welcome to the Age of Instability
The phony fixes have failed, and the dam of toxic sludge and debt is leaking; instability will be the New Normal until the dam finally bursts and the financial Status Quo is swept away.
If you liked the past two weeks, you're going to love the next two years: welcome to the age of instability. As I explained yesterday, the quasi-religious belief in the stock market as a secure store of wealth has faded, and for good reason: The Junkie in the Pool and False Idols: Faith in Wall Street and The Fed Has Has Eroded (August 10, 2011).
In a nutshell, the Federal Reserve and Federal government's extend-and-pretend, mark-to-fantasy, paper over bad private debt with trillions in public bad debt "fixes" of the broken economy have failed, completely, utterly, miserably. Rather than drain the cesspool of impaired debt, risky bets gone bad and rampant abuse of the rule of law, the Fed and the Central State have poured trillions of dollars more bad debt into the fetid pool of sewage and sludge, which is now full to bursting.
For a deeper explanation of why instability is now the norm, and destabilization is now inevitable, I turn to my new book An Unconventional Guide to Investing in Troubled Times for this excerpt.
As Nassim Taleb of “black swan” fame has explained, it is misleading to say the last few grains of sand on the debt pile, for example, subprime mortgages in the housing bubble, are responsible for the entire sand pile collapsing: the masking of risk was systemic, and thus the sand pile was doomed to collapse regardless of the nature of the final few grains of sand.
Similarly, it won’t really matter what the final trillion dollars of Federal debt was borrowed for; the default/collapse of the government debt pile is inevitable.
In betting the farm to prop up a façade of financial stability, the Federal Reserve and the Federal government have doomed the entire system to collapse. Taleb explained why in the June 2011 issue of Foreign Affairs: “Complex systems that have artificially suppressed volatility become extremely fragile, while at the same time exhibiting no visible risks.” That describes the global economy in 2007, just before the financial meltdown of 2008 “surprised” conventional economists and Wall Street apologists.
As Taleb has explained, the very act of suppressing fluctuations renders systems extremely prone to large-scale disruptions that are viewed as low-probability events, the infamous “black swans.” The key to understanding this rising likelihood of supposedly improbable disruptions is to understand the difference between linear and complex systems. Linear systems lend themselves to causal chains (A causes B which causes C) or probability (the odds of drawing two aces in a game of Blackjack) that can be calibrated with a high degree of accuracy.
Complex systems such as financial markets exhibit fractal or chaotic characteristics that lead to an unpredictability that is prone to disruption by seemingly small events. When volatility and risk (in political terms, dissent) are suppressed by central authorities, the variations that inform an open market (“variation is information”) are lost.
The misrepresentation (and thus the mispricing) of risk and the suppression of everything which doesn't pander to the Status Quo is a defect not of individuals or specific institutions but of the entire system, including the Federal Reserve, the Treasury and the regulatory “alphabet soup” agencies (SEC, FDIC, etc.).
The misguided attempts to engineer a false stability by suppressing "undesirable" volatility have created an intrinsically fragile system that is doomed to crises of ever greater dimension even as the periods of calm between crises shrink from years to months. Recall that risk is like water in a closed system: it can never be squeezed into nothingness. The more pressure that builds up, the more inevitable it is that the risk will burst out in some part of the financial system that was viewed as “safe” and “stable,” for example, home mortgages.
This is how financial events that are widely viewed by conventional economists and government officials as “impossible” can occur with increasing frequency.
One model for this type of apparent stability that is disrupted by unpredictable spikes of volatility is stick/slip destabilization. In “sticky” systems—for example, those with major forces creating credit and regulations to maintain the Status Quo--pressure builds up within the system that is invisible to those looking at an apparently stable surface. But at some impossible-to-predict moment, the built-up pressure within completely disrupts the system, and it “slips” into a new and unpredictable configuration.
The rules of the investment/speculation “game” will be changed without warning as authorities attempt to stabilize an increasingly chaotic financial system. Their attempts to force a superficial stability will only make the next round of instability more severe and less controllable.
The Grand Partnership of the Central State and the Financial Plutocracy (parasitic globalized cartel crony-Capitalism writ large) has suppressed this natural implosion of speculative debt by printing and distributing trillions of dollars in "free" money so over-indebted borrowers and speculators can continue to “extend and pretend,” that is, continue the illusion that they are solvent.
As a special bonus to these financial Power Elites, this limitless pool of "free money" enabled them to ramp up their favorite pastime, leveraged financial speculations based on fraud, collusion and misrepresentation of risk. As any profits will be theirs to keep while any losses will be backstopped by the Central State and its taxpayers, it's a return to the risk-free days at the races for the financial Oligarchy.
But massive doses of free money unleash two destructive forces on the economy: as the free money flows into speculative bets on tangible resources, it reinflates asset bubbles and fuels rising costs.
As a result, the system is now facing the same old problems--asset bubbles held aloft by "free money," massive government intervention, systemic financial fraud--and a new problem: price inflation for the resources that sustain the real economy.
The Central State/Financial Elites are thus faced with an impossible choice: if they let the speculative free money flow, then their populations become impoverished as the prices of tangible goods such as food and energy skyrocket. Recall that the masses aren't provided with billions of dollars at zero interest; that privilege is reserved for the financial Elites who fund the campaigns of the Central State’s political class.
The Classical Capitalist answer to this vast financial overshoot is simple: once the unlimited free money and moral hazard guarantees stop, interest rates will rise as risk is repriced and the market “discovers” the cost of borrowing scarce capital (savings). Once interest rates rise, then the ballooning debt can no longer be serviced. Borrowers big and small go bankrupt, their assets are sold at auction on the open market, and their unpaid debts are absorbed as losses by their creditors.
This renunciation of debt triggers a domino effect as credit becomes increasingly expensive and other overleveraged borrowers and insolvent creditors are toppled into bankruptcy.
In other words, the Status Quo is now addicted to unlimited flows of free credit issued by central banks. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it. No matter what policy path is taken, the result is the same: instability and destabilization.
This is why a systemic financial meltdown is now inevitable.
Nobody knows how this devolution will play out, but we do know that those who are open to the possibility will do better than those who discount or dismiss the inevitable reckoning as “impossible.”