A subtle understanding of economic change comes from a knowledge of history and large affairs, not from statistics or their processing alone…Arthur Burns
While the the ultimate resolution of the current economic imbalances will have very significant long-term consequences, it also has important shorter-term implications for investors. Namely, the fear of banking collapse has driven many investors to accept negative interest rates since they prefer to lose a little bit over time by holding title to redeemable securities than to hold cash in the bank and risk losing most of it. If the Global Systemically Important Banks (GSIBs) will be perpetually bailed out, then this logic no longer holds and investors will reject interest rates lower than inflation. That could ultimately lead to a collapse of the bonds bubble, which in turn would burst the equities bubble. Either way, the future promises to be interesting.
What with the failing banks?
Those of us who spend time analysing financial markets have been anticipating an impending banking crisis for years now. A number of GSIBs as well as many lesser banks have been struggling under an increasing burden of bad debts and deteriorating credit quality in their balance sheets. Deutsche Bank, probably the worst offender, has been on death watch since 2016. But as years went by and doubts about the bank’s solvency multiplied and compounded, no banking crisis materialized.
Then, in September 2019 the REPO crisis burst on the scene, a sure sign that one or several large banks were insolvent. However, the Fed stepped in and provided the liquidity to plug up the holes. Meanwhile, the crisis never went away and the Fed’s REPO facilities metastasized, from the initial $100 billion/day to reaching ultimately $5 trillion in varying maturities (if fully allocated). Nonetheless, virtually all of the analysts I read still expect an imminent collapse of a GSIB (chief contenders are Deutsche Bank and HSBC). But as months go by the imminent collapse still hasn’t happened. And then it hit me: it might not happen at all!
Everyone who understood that many of the GSIBs are walking corpses and that their failure is inevitable and imminent assume that the banks are subject to normal market economy where business failure leads to – well, business failure. For an institution like Deutsche Bank, with $49 trillion in derivatives exposure and only just over $70 billion in loss absorbing equity (implying a 680x leverage), even slight adversity could spell game over. But with the insane global pandemic policy response we got a bit more than slight adversity: we got a severe global recession. But for now, the GSIBs are still happily coasting along… and they may continue like that for a long time.
I grew up in a socialist regime in former Yugoslavia. For as far as I can remember, during the 1970s and 1980s the economy was in a crisis – yet we never had bank failures. What we had was a system where the government and our central bank issued all the credit needed to cover bad debts and keep zombie companies and their creditor banks operating. I think by now this should sound familiar to everyone in the West.
The silent coup
I confess, I was slow to wake up to all this. The signs of the creeping coup that fundamentally transformed the financial/economic order in the developed world have been out in plain sight for quite a while. The changes may have seemed incremental since the “socialist,” planned economy already operated alongside free market economy for decades. I’m talking about the military industrial complex, big oil, big agriculture and the big banks who could always count on government subsidies and periodic bailouts to exempt them from the exigencies of free market competition. All that had already become accepted as normal in our supposedly capitalist free market system.
But under this year’s New Normal, the free market segment of the economy is being systematically destroyed and the society’s capital is being channelled to the largest of large multinational corporations and the Global Systemically Important Banks. The coup was actually declared by the former ECB chief Mario Draghi, who’s already built a reputation for staging silent coups and who has proven his disregard for market rules and equal contempt for the rule of law.
One thing Mario Draghi is not known for is his passion for public welfare and health, so he may have surprised many with his 25 March Financial Times column titled, “We face a war against coronavirus and must mobilise accordingly.” In that article, Draghi unveiled what the central planning mandarins had in store for us:
- The only way to overcome the pandemic crisis will be to fully mobilise the financial systems of all Eurozone nations. This has to be done immediately, avoiding bureaucratic delays. Translation: laws and regulations will be disregarded and the central banks will take over and rule by decree.
- Much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation. Translation: we’ll pick the winners of the game and their debts will be paid by the taxpayers.
- Loss of income incurred by the private sector – and the debt raised to fill the gap – must eventually be absorbed on government balance sheets. Translation: also a wealth transfer from the public to the mandarins’ handpicked champion zombies.
- [Commercial] banks should become a vehicle for public policy and create money instantly by allowing overdrafts or opening new credit facilities. The capital they need to perform this task must be provided by the government in the form of state guarantees on all additional overdrafts or loans.
- Neither regulation nor collateral rules should stand in the way of creating all the space needed in bank balance sheets for this purpose. The cost of these guarantees should not be based on the credit risk of the company that receives them, but should be zero regardless of the cost of funding of the government that issues them. Translation: the cost of funding shall be borne by the public and given freely to our handpicked corporate champions.
- Speed is absolutely essential for the effectiveness of these measures – the cost of hesitation may be irreversible. Translation: do not think, analyse, debate… do as we say right now – or else…
It would be a mistake to take Draghi’s prose as idle musings of a retired banking mandarin. What his economic therapy prescription sets out is the roadmap to the central planners’ dictatorship, effecting a massive transfer of wealth and economic power to a small number of large, zombified multinational corporations and banking institutions. The measures he’d prescribed are already being implemented in many nations including the US, Europe. We know where that experiment leads because it has been done before.Banking coup’s socio-economic consequences
In our small socialist petri dish of the former Yugoslavia, the central planners created all the money needed to fund the publicly owned enterprises. In this way they could maintain full employment and pre-empt any bank runs. But the cost of the experiment was borne by the public through inflation, which accelerated during the 1980s into a hyperinflation. The much larger petri dish that was the Soviet Union achieved the same result, as I elaborated in my article, “Inflation: lessons from the last empire’s collapse.”
The takeaway here is that with central planning, the walking corpses will continue to walk for a time, propped up by the captive public who will pay the bill through inflation that will eat up their savings and the purchasing power of their pay checks. To keep the public’s discontent from boiling over, the central planners will have to eviscerate what little is left of democratic process and implement a harsh, rigid totalitarian system of control. While their rhetoric is wrapped in nice, progressive ideas like green economy, sustainable development, fourth industrial revolution, and economic inclusiveness, these top-down socio-political arrangements tend to end badly. In our little petri dish of the socialist Yugoslavia it ended in a war. In the Soviet Union it ended in the longest economic depression ever recorded and an estimated 5 to 6 million excess deaths during the 1990s.
If we passively acquiesce to this slithering totalitarian coup we should expect to experience a drastic loss of freedoms and decades of perpetual war, terrorism and severe deprivations. We will also discover that in totalitarian regimes, the ruling bureaucracies tend to turn very sinister and malicious. If their coup goes unchecked, we will bestow an ugly, dystopian future on our children. I do not intend to close this article on a dark note, however. There are many reasons to believe that the banking cartel’s coup will inevitably fail and that the changes afoot will create room for us to build a future that’s better than anything we could even imagine thus far. But that’s the subject for a different write-up…
In the mean time, the purpose of my endeavors is not only to correctly diagnose the risks and opportunities in the global marketplace but to also propose high quality, dependable solutions to the coming challenges. From today’s perspective, the greatest macroeconomic risk to investors in inflation. Experience and empirical evidence all suggest that the most effective means of hedging against inflation is through judicious exposure to commodity futures. Managing diversified commodity futures portfolios is precisely what I’d been doing since 2007. For more information, please have a look at our Inflation hedging portfolios page.
 Arthur Burns was Milton Friedman’s economics professor and Chairman of the Federal Reserve.