Financialization's Self-Destruct Sequence (August 16, 2012)
We are in the latter stages of financialization's self-destruct sequence.
Like all systems that follow an S-curve of growth and decay, financialization cannot return to its growth phase. I addressed the impossibility of reflating asset and credit bubbles in Let's Pretend Financialization Hasn't Killed the Economy (March 8, 2012).
But there is another dynamic at play: a self-destruct sequence triggered by central bank and Central State efforts to reflate asset and credit/leverage bubbles. All central bank and State policies aimed at driving capital into risk assets boil down to reflating phantom assets purchased with debt by issuing more debt that is based on newly issued phantom assets.
Phantom assets purchased with debt cannot be reflated by issuing more debt that is based on newly issued phantom assets. Piling more debt/leverage on a sandpile of phantom assets (CDS, bonds that cannot possibly be paid back, empty condos in the middle of nowhere, etc.) only heightens the probability that the unstable pile will collapse.
The implicit Central Planning campaign to trigger "mild" inflation is part of the self-destruct sequence. Central planners metaphorically fight the last war, or at best the last two wars, and so they remain blind to any dynamics that did not exist in their case studies.
In the 1970s, central bank easing and Central State stimulus sparked a nasty bout of accelerating inflation. This reduced the weight of debt because wages inflated along with goods and services.
Now that labor is in surplus globally, wages are not keeping pace with inflation. This completely changes the dynamic of "mild" (3%) inflation: as the purchasing power of earned income declines, servicing debt becomes more burdensome. Inflation only renders debt less burdensome if wages rise at the same rate as the cost of goods and services.
In a decade of "mild" inflation and stagnant wages, households will experience a very real-world 30+% decline in their income. Meanwhile, their debt payments remain unchanged.
"Mild" inflation in an era of stagnant earned income will crush households, forcing liquidation or renunciation of debt. What happens as debt service costs rise as a percentage of real net income? There is less cash for consumption, and so the consumer-dependent economy spirals down. Credit is poured into the banking sector, but little trickles down to high-debt, stagnant-income households. This is deleveraging writ large.
What happens when central bank financial repression--lowering the yield on cash to near-zero--causes pension plans to fail and savings to earn negative real returns? Households must save more income to compensate for the destruction of yield by Central Planners.
These mutually reinforcing dynamics feed the self-destruct sequence's inevitability. Add up the self-destructive forces: declining purchasing power, negative real returns on savings, rising debt based on newly issued phantom assets, and promises unbacked by real assets or based on declining national surpluses.
As Central Planning reflation of phantom assets fails, the credibility of the Status Quo institutions that promised success will crumble. I have described the dynamics of Heightened Expectations and the Collapse of Credibility and discussed The Keys To Understanding the Collapse of the Status Quo: Credibility and Expectations.
In the euphoric blow-off top phase of financialization, expectations of security and wealth were raised by political Elites anxious to mask the systemic looting of national wealth by financial/political Elites. Promises were even easier to issue than paper money.
But issuing promises, credit and leverage did nothing to expand the national surplus or the resources that ultimately back the promises and credit.
We can characterize the sudden, explosive convergence of fantasy (phantom assets and promises) and reality as Snapback! (October 9, 2008). The entire project of Central Planning (central banks and States) is to "extend and pretend" the Status Quo in the hopes that the gargantuan divergence between fantasy and reality will magically close as the result of "aggregate demand" or a new business cycle, or some other version of renewed "animal spirits."
But "animal spirits" require trust in the transparency and fairness of markets and Status Quo institutions. As markets are rigged and manipulated to manage perceptions and enable vast skimming operations to continue, the credibility of the markets, politicos, State oversight agencies and the financial sector is eroded.
As central bank/State reflation of phantom assets fail, the credibility of the entire political/financial Elite and the institutions they control will be irrevocably lost.
Financialization's self-destruct sequence has been triggered, and there is nothing anyone can do to stop it. The workings of the machine are opaque, and the interactions complex. We cannot know when the sandpile will collapse, or what the proximate cause of the collapse will be, but we can know that the unstable pile will collapse under the weight of the system's illusory assets, fraud, collusion, embezzlement, corruption and corrosive dependence on artifice and lies.
We also know that self-serving vested interests will continue their pillaging until the destruct sequence's final implosion brings the entire rotten edifice down in heap of empty promises.
In a word: Snapback!
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We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.
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