October 16, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“We have built an economy out of $50 trillion of credit over the past 50 years. When credit expands, it creates both an asset and a liability. The sustainability of the entire economic superstructure depends on how that credit is used going forward. If it is used for consumption, then it can generate no return and the superstructure will collapse. That is the mistake that led to this New Depression. If it is invested in projects that generate a high enough return to pay the interest on the debt, then it will not only support the economic structure now in place, it will support a larger and more prosperous economy.”
Richard Duncan, The New Depression (2012)1
In today’s world, every financial instrument represents some form of credit. Whether something is called a “stock” or a “bond” or a “commodity,” its value is ultimately determined by the ability of another party to fulfill its payment obligations. An obligation to pay is a debt. Unfortunately, there is not enough money in the world to repay all of the obligations that exist. As Richard Duncan writes, “We do not have capitalism now…Our economic system is not one in which the accumulation and investment of capital drives the production process. It is one in which the creation and expenditure of credit does.”2 In an era in which economies are driven by the creation of fiat money by central banks, and where the base of hard money is dwarfed by the volume of outstanding debt, every form of capital is tied to credit. In 1919, William Butler Yeats famously wrote that “the center cannot hold.” A century later, there is no center.
Instability and disequilibrium are the hallmarks of modern markets. As much as we would like to pretend that investors have improved their ability to deal with such conditions, nothing could be further from the truth. In fact, the very devices that human beings have developed to manage risk still fail to properly account for discontinuity and abrupt change. This is most apparent in derivatives, which not only fail to protect against such risks but tend to increase them because of their inherent leverage, opacity and counterparty risk component. Even the institutions most highly respected for their ability to manage risk still explain their attempts to do so in terms of a largely discredited tool such as VaR (Value at Risk). VaR theoretically measures the maximum amount of loss on a portfolio. Unfortunately, it is incapable of measuring changes in market conditions caused by irrationality or emotion. Phenomena such as feedback loops or discontinuity are far more influenced by factors that cannot be measured mathematically. For that reason, the utility of VaR as a risk management tool is undermined by the very language in which it speaks. As a mathematical expression of potential loss, it suffers from the limitations of mathematical language. It is very difficult for mathematics to distinguish different kinds of risks because it reduces everything to quantities of the same thing. History teaches us that it is extremely dangerous to rely on numerical tools to measure the non-quantifiable risks that move markets. The very commonality of mathematical expression renders it inadequate to measure the types of unquantifiable risks that exist in today’s world.
Moreover, markets are motored by technology. Money is moved around the world by massive computer power that reduces every form of capital to the same thing – bytes, or 1s and 0s. This leveling of differences is essential to facilitate the flow of money around the world, but it does not come without a cost. The treatment of everything as the same thing conceals the very real differences that lie behind the numbers. Technology creates the illusion that capital is stable and continuous when it is in fact highly unstable and susceptible to abrupt discontinuities. The failure to understand the dynamic nature of capital heightens the risks involved every time an investor takes cash and exchanges it for a stock or bond or tangible asset.
Its stewardship by human beings is what renders capital unstable. Even the most rational human being is highly irrational and driven by emotion. Human beings suffer from a fascinating dichotomy – they live their physical lives sequentially but are endowed with minds that are not bound by time. We live our lives in order but we can think them out-of-order. The ability of the human mind to remember and to imagine introduces an enormously influential element of unpredictability and emotion into human action. An investor’s greatest challenge is to reconcile this dichotomy, which is an ineluctable part of the human condition. And while an investor can try to rely on models that by their very nature simplify reality, he must acknowledge and include in his calculations the incalculable.
Credit is therefore the ultimate human construct. It relies on the past to predict the future. It enlists both memory and imagination. And it is subject to discontinuities that can lay ruin to the best laid plans. Central bank creation of limitless amounts of credit out of thin air is the ultimate human act. But it must be understood for what it is: not something that reduces risk, but an act that radically heightens systemic risk. The “consensus” appears to believe that recent actions by the European Central Bank (ECB) and the Federal Reserve to support their respective economies have removed “tail-risk” from the markets. That view is both dangerous and wrong. “Tail-risk” is how we describe the types of risks that result from discontinuity and instability. The term is generally used to describe outcomes that are thought to be unforeseen and unpredictable. By extending their liquidity operations into an open-ended phase, central banks have not reduced financial fragility and market instability: They have exacerbated it. Only the precise timing of the bad outcomes guaranteed by these policies is unknown.
1. Richard Duncan, The New Depression: The Breakdown of the Paper Money System (Singapore: John Wiley & Sons Singapore Pte. Ltd., 2012), p. 146. I highly recommend this book to everyone.
2. Ibid., p. 146.
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