Every Folly Has Its Consequences


Emile Woolf, Going Postal
Lehman Brothers Building, New York, NY, 2007, Ernie McClellanLicence CC BY 2.0

The great Spanish master, Francisco Goya, expressed it concisely: “The sleep of reason produces monsters”.

Today, wherever you look, insanity masquerades as rational thought. Lunatics flout their blatantly potty views as if they carried the imprimatur of a sound mind.

As you know, in these essays I generally avoid controversy tainted with political issues, and prefer to stick to economic principle as a life raft in a sea of confused currents. But when a Lib-Dem activist comes to my door to tout for my support, given that his party’s over-arching mission is to strike out and reverse what the majority voted for in the nation’s largest referendum ever, I can think of nothing to say other than “I think you are mad – completely mad. Please just go away!”

This cameo of aberrant mental inconsistency is reflected throughout the economic sphere. Finance ministers, treasury officials and central bankers prevaricate like proverbial yo-yos and plainly haven’t the remotest clue what to do next. It’s a paralysis of will, born of a paralysis of mind.

Lehman was beyond rescue

In September 2008 Lehman Brothers bank collapsed into bankruptcy with sub-prime mortgage debts of over $600 billion. Having got itself into this pickle, even in the face of a highly regulated banking sector, it was plainly beyond the rescue-reach of even the mighty Federal Reserve, America’s central bank.

But what happened then? The now-familiar pattern of liquidity-ballooning, or quantitative easing (QE), followed and, much to the relief of global central banks, appeared to stave off the crisis – for a time. These economic geniuses didn’t (and don’t) know that short-term expedients have a vicious longer-term tail. And that’s where we are.

For the very reason that QE seemed to work they simply kept on doing it, and a decade of ultra-loose fiat money creation followed, coupled with ever-diminishing interest rates that enabled governments and their closely-allied institutions to generate mountains of debt without having to pay for it. But what it also did was encourage businesses to embark on a binge of uncosted malinvestment.

The ECB: manifest madness

But of course it couldn’t work, and it didn’t. The European Central Bank provides us with a neat case-study. Unlike the USA Fed, the ECB is additionally tasked with keeping Eurozone countries solvent and fiscally compliant. Most of the ECB’s newly printed money (50 billion euros per month for four years) disappeared into the gaping hole of Club-Med and Irish budget deficits and bailouts.

When Mario Draghi, the ECB’s chief, was forced to confront the impossibility of continuing with this level of blatant debasement, he followed the lead of Janet Yellen at the US Fed and eased up on the money-printing, while signalling a gradual rise in interest rates. So far, so good, and the markets saw it as an attempted recall to monetary stability at last.

…. the cry for more and more liquidity

But that didn’t work either. Too much of a good thing breeds dependency, coupled with its concomitant fear of deflation and falling price levels. So, guess what? The name of the new game is, once more, injecting liquidity to replace last year’s modest shrinkage. Prevarication yet again – as if it is a product of sane reasoning.

These irrational policy swings are put into effect at the Fed by its “repos” and “reverse repos” manipulations that, alternately, withdraw and inject liquidity in an unpredictable dance, leaving money markets bewildered. They demonstrate only that there are no underlying rational threads to support this knee-jerking charade. The emperor, really, has no clothes.

At the core of the 2008-9 crisis was the huge edifice of leveraged debt collateralised on largely fictional values of sub-prime property that didn’t stack up when the time came to realise them. Banks, including Bear Stearns and Lehman, that had succumbed to the temptation of trading in the packages of highly-rated “liar-loans” were caught with their pants down when the music stopped. The squeals were awesome: after all, those tranches of collateralised debt obligations (CDOs) carried a respectable S&P credit rating!

An enactment of the same syndrome

Although taking on a different guise, an enactment of the same syndrome had swept through credulous markets only four or five years earlier when shares in dot-com businesses were hyped-up to display billion-dollar potential – but without one important ingredient: cash flow. They flopped, of course, amid oceans of tears.

Do you really believe that a lesson has been learnt? Oh yes, banks’ balance sheets are now subject to stress testing by central banks and their reserve cushions are larger – but when an ignoramus is given an “all-clear” pass, all that happens is that he will commit the same follies but on a greater scale.

I remember an episode in one of Alastair Cooke’s brilliant “Letter from America” series in which he recounted the story of an Italian immigrant shining shoes at Grand Central Station. When asked what 30 years in the USA had taught him, he thought for a moment before replying: “There ain’t no free lunch”. He knew what traders in Wall Street, Geneva, Frankfurt, City of London, Milan, Tokyo, Beijing – everywhere  – have never learnt.

Slicing and dicing – again

The Bank of International Settlements (BIS) sounds a new warning of an old dodge. The name on the poison pills’ label has barely changed. Instead of CDOs, they are now called CLOs (collateralised loan obligations) – personally, I would simply call them DDs (duff debts)! The really frightening aspect is the high proportion of high-risk loans – and the form they take has more than a passing resemblance to the pre-2007 packages of sliced-and-diced sub-prime mortgage debt. The detritus inside these packages comprises highly leveraged bank loans to heavily indebted companies with junk ratings, 60 per cent of which are carrying debt of over 5 times earnings – and all of them are vulnerable to the slightest interest rate shock.

Despite being labelled “collateralised”, almost 80 per cent of these debts have no covenant protection; such is investors’ desperation for a modicum of yield in this barren zone. If the additional risks lead to a wave of defaults the overall loss ratio is scarcely quantifiable.

Negative rates – the ultimate perversity

The BIS’s research chief highlights the sheer perversity of a situation in which investors willingly hold $17 trillion of debt, including private bonds, trading at negative rates. Why are they paying for the privilege of parting with their money? His rhetoric borders on the poetic: “There is something vaguely troubling when the unthinkable becomes routine.”

The Fitch ratings agency clearly concurs, pointing to the structural mismatch between maturities and redemptions-on-demand, spelling a huge liquidity risk for open-ended funds. While uncannily redolent of what happened in the last crisis, the real lesson for today lies in what followed. Instead of allowing the avalanche of DDs to unwind, a decade of desperate monetary distortion was inflicted, leaving us with a financial system so deformed that it craves liquidity like a drug, heedless of natural time preferences.

In last week’s Goldmoney Insight, Alasdair Macleod aptly quoted a verse from Edward FitzGerald’s rendering of Rubaiyat of Omar Khayyam that pointed up the futility of argument that, no matter how learned, is devoid of reason. In the context of today’s essay, I’ll conclude with my own favourite, on facing up to consequences, from that rich tome:

“The Moving Finger writes; and, having writ,

Moves on: nor all thy Piety nor Wit

Shall lure it back to cancel half a Line,

Nor all thy Tears wash out a Word of it.”


© Emile Woolf October 2019 (website)

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