The Can Has Reached the End of the Road
Markets are like children. They can only learn the most important lessons the hard way, by making mistakes and suffering the consequences.
One of my earliest memories is of a visit to a local park with my father and my sister. This park had a big fountain full of fish and my sister climbed up to get a closer look while my dad repeatedly warned her to be careful. She didn’t listen and fell in, so dad had to pull her out. The water was cold and she was shivering.
Years later, my father told us that he intentionally fought the urge to grab her before she fell, even though he was certain that she would. He wanted her to learn an important lesson about listening to her parents, and being careful around water. He even let her stay in the cold water a beat longer to make sure the lesson stuck.
I share this story as an allegory of the right way to manage an economy and a financial system. Good policymakers know that economic agents (of any age) are like children. If you prevent them from suffering the consequences of their own decisions — however painful those consequences might be — then they will never learn. Investors, bankers, and borrowers are always probing the boundaries of what they can get away with. Bail them out from stupid risk taking and they will get stupider.
We’ve all met kids who are never punished by their parents or allowed to fail. They grow up to be miserable adults, stumbling from one fiasco to another and eventually spiraling out of control. That’s the state of the global financial system today.
For decades, central bankers and other government officials have been bailing out market participants from the consequences of their own folly. The 1987 crash, Long Term Capital, the 2008 financial crisis, the European debt crisis, and countless other macroeconomic events that should have resulted in major players being punished for making bad decisions did not. Instead, rates were cut, money was printed, stimulus was introduced, and the kids who ignored the warnings of their parents were not allowed to fall. They were given stern warnings after the fact, but kids who didn’t get wet don’t listen.
All of this was done under the guise of protecting ordinary people. Let Wall Street fail, government officials told us, and Main Street would suffer. This was always a dubious claim, but some version of it was embraced by both sides of the political spctrum in almost every country, and the financial system grew ever more fragile.
Then came COVID, and any pretense of discipline went out the window. Bailing out bad actors was now a virtue, no matter how little they deserved it. So the Federal Reserve backstopped the junk bond market then gave a speech about protecting healthcare workers. The most egregious interventions were eventually wound down, but the precedence had been set: the closer the kids got to the edge, the more the government would try to save them. An importat opportunity for a market reset was lost, and the can was kicked further down the road.
All that stimulus — the size and variety of which was unprecedented in modern history — resulted in record inflation. Unlike the prior interventions, whose negative consequences were felt in more implicit ways such as economic inequality, the negative consequences of this affair are front page news. People hate inflation so governments have no choice but to respond, undoing decades of easy money and raising interest rates. Markets are not taking it well. Currencies are plunging, borrowing costs are soaring and the global economy is starting to teeter.
Policy makers are now stuck in a bind. Do nothing and inflation will rage, or do something and important markets may break. The proverbial can has reached the end of the road.
What happened in the UK this week — a collapsing bond market that forced the Bank of England to reverse itself — is only the beginning. You can’t abruptly cut off a kid you’ve been spoiling for years without causing a tantrum. That’s not how people work, and it’s certainly not how markets work. A global economy built on cheap money is about to be tested in unprecedented fashion.
How many public companies who loaded up on cheap debt to finance share buybacks will now have to reverse the process? How many governments who run major deficits will be able to tighten their belts as borrowing costs rise? How many centrist governments will survive simultaneously surging food, fuel and borrowing costs? How many real estate deals will remain viable when mortgage rates approach 8%? Which hedge fund is about to blow up? Only time will tell, and you’ll have to protect yourself.
How? As it turns out, there’s one financial system that has never had a bailout, market intervention or outside stimulus. You’ll know it from its extreme volatility, and the fact that its biggest players can and do fail. In this system, the depositors who trust bad banks lose their savings and the traders who used too much leverage lose everything.
The stewards of the old system love to criticize this one, in part because lots of people can and do get wet on a regular basis, some of them undeservedly so. But in a year when the old system keeps teetering on the edge, this one has already had its baptism by fire, making it antifragile and far more trustworthy.