A confidence crisis in the bar, left, caused the 2008 meltdown. What about the bar at right? What’s that? (Graphic DanielAmerman.com)
By David Tulis
If you are like me, you value small steps toward greater financial independence. You are progressing in plans to start a small home-based business. You are less intimidated by shaky prospects at your job. Time you once gave to your employer you are giving to family members. You feel closer to them, more committed.
You have a greater sense of private organization, and if you’re like me you are heartened by the ideas of local economy, a largely overlooked conceptual gem. You see in it potential not just for yourself as a tiny-scale entrepreneur; you percieve value for your neighbor, your friend and the people at your church.
The free market we hope to restore locally is free because it is not organized and controlled by people and institutions not qualified to run it. It is, shall we say, unorganized. It is not managed. It’s not part of somebody’s else’s hierarchy or plan.
I call this disorganization the beautiful weakness of local economy. No one is in charge. No one superintends. No one controls it. Rather, local economy and the free market are comprised of thousands of people in my hometown and yours seeking the prosperity of others, and in that service seeking their own livelihoods and self-interest.
In contrast to this weakness is the gigantic might of national economy, particularly in the financial sector. The powerful centralization in national economy is necessary to stall a collapse engendered by centralization of credit and what some analysts call the financialization of the economy (paper shuffling vs. production and invention). In other words, a fiat paper money economy that cannot stop inflating, else it will crash in ruin.
Why national economy is unsafe
The Fed is in its fifth year of pumping the banking sector and the economy with new dollars, created from nothing. Inflation is the act of adding dollars to the monetary base, the effect being to cheapen the dollars in your billfold. Quantitative easing, in a third round, artificially elevates stock and bond market valuations, giving an illusion of prosperity. QE1 began as an emergency measure in October 2008 to prevent systemic collapse of the rickety global banking system. Without inflation (more paper money), the system faces cataclysmic “existential threats,” says analyst Daniel R. Amerman.
National economy faces three interconnected risks that threaten every local economy in the U.S. when they finally force the managed marketplace into a reckoning. They are:
➤ Liquidity risk — loss of confidence pushes investors to demand cash and immediate payment)
➤ Contagion — A rush to safety or cash by even a mid-level player in the financial sector could prompt others to rush to the exits, too, to make sure they can get through. A panic.
➤ Counterparty risk — The spreading of risk among myriad financial actors, whose fates become inextricably bound. Mr. Amerman explains: “Now most of the dollar volume of derivatives outstanding are not actually independent risks, but instead represent the same risk being resold time and again in different forms, which in theory reduces the risks for each firm on a micro basis. However, we also know that in practice this creates an elaborate chain of promises (a.k.a. systemic “counterparty risk”) that links together the solvency of all of the financial firms. And it’s the estimation of the profitability of each one of these levels of interconnected promises which has allowed for the payment of so much bonus income.”
A risk pool escapes notice
If I could take a single page from his 10-page analysis to give you for its power of suggestion, it would be the one bearing bearing a graphic comparing the value of derivatives contracts. In 2008 the subprime mortgage derivatives market was valued at F$1.2 trillion. Today’s market is valued at F$561 trillion.
The bets on interest rates are 450 times that of the subprime derivatives market in 2008. Wall street, Uncle Sam and risk rating agencies are ignoring this risk, Mr. Amerman asserts.
Brittle system
Because the system is highly centralized and its players interconnected, the risk of contagion are great. The system works when everyone trusts everyone else. What damage might a stray doubt have in this finely tuned system in which risk insurance assumes only the occasional house fire, and is incapable of reimbursing a neighborhood going up in flames? Here’s how bank runs work, whether at your FDIC insured lender, or the financial sector.
Everybody wants out — simultaneously. Nobody wants to buy in. Buyers disappear, just like they did in 2008, and just like they did in 1998. The market drops straight from 96 to 65 without ever trading at 94 or 92 or 85 — and there might not even be any buyers at 65. Or at 45. Or at 25.
Because of the gap, there is no dynamic exit strategy, there is no way to exit the claims before they destroy the solvency of the firm. No firms are able to exit before 80 — meaning all the big players simultaneously become insolvent. Within a vast interlocking web of counterparty risk, to the extent that the actual failure of even one “Too-Big-To-Fail” bank or Systemically Important Financial Institution (SIFI) could pull down the global financial world — and the deeply indebted sovereign governments along with them.
The governments of the world have been building derivatives “clearinghouses” into the system which are intended to knock out the counterparty risk – but the ultimate guarantor of the clearinghouses are the deeply indebted sovereign governments. This mutual exposure of the major financial firms and sovereign governments to each other creates a potentially fatal toxic feedback loop. (Daniel Amerman, “Taper & Quantitative Easing Reality Check”)
Do you think I have an overly rosy idea of local economy peopled by folks such as you? National economy’s great enemy is truth. “Free market forces have created more real wealth for the world than any other economic system,” Amerman says, “but we have to remember that these forces do so by forcing honesty. Individuals acting in their own self-interest make the informed decisions about prices and returns, that in turn determine the best allocation of resources for economic growth. Honesty would necessarily force the collapse of a dysfunctional and unstable system in which resources are redistributed primarily by political and monetary decisions in a manner that is not understood by the general public or average voter.”
Preppers, regular investors both wrong
Notes Franklin Sanders, the Moneychanger of Westoint, Tenn.: “Amerman’s argument is that the folks who believe that the Fed can taper then the world will go back to normal, status quo before the last bubble burst AND the folks who believe a collapse is imminent are both short-sighted. They don’t understand that the whole game has changed, that the Fed literally must continue controlling interest rates or risk a global financial panic. Nor do they understand that the era of central bank/government control has arrived, and the Fed has shown by the gigantic money creation of the last five years that it will keep on manipulating interest rates as long as it can.”
Local economy has much to be desired. We lack a convenient way to invest locally. I propose a lococentric investment hub along the lines of a co-op to help local small investors like me find worthy companies and individuals in which to invest patient capital. The risks of investing locally seem much less the more I consider the disaster waiting quietly in the shadows of national economy.
Sources: Daniel Amerman, “Taper & Quantitative Easing Reality Check”. Please email me and I’d be happy to send you a PDF of Mr. Amerman’s text with my recommendation of its felicitous analysis. Please subscribe to Nooganomics.com. Like me on Facebook. Send your request through my contact window above.
VERY TRUE AND AWESOME ARTICLE…