Inevitable Catastrophe: The Fruits of Moral Hazard on a Global Scale (June 24, 2011)
Insulate participants from risk with policies like the Bernanke Put and you guarantee destruction of both the market and institutional legitimacy.
Identify the common characteristic of these three statements:
1. The Federal Reserve will never let the stock market decline, i.e. the "Bernanke put"
2. The Chinese government will never let property prices decline
3. The European Central Bank will never let Greece default
The answer of course is moral hazard: a person who is insulated from risk will have an insatiable appetite for risky bets because any gains will be theirs to keep but any losses will be covered by the central bank or government. The global financial authorities’ success in propping up assets (stocks in the U.S., real estate in China, banks in Europe, etc.) over the past three years has strengthened this asymmetric disregard for systemic risk into a dangerously quasi-religious faith that central banks and governments have essentially unlimited power to keep asset prices aloft via printing money, manipulation of markets and financialization of their economies.
What happens if markets crumble despite massive, sustained central bank and government intervention? The institutions that created moral hazard will be revealed as false gods, and that faith will be destroyed.
This loss of faith in the transparent functioning of markets will trigger what I call the delegitimization of both the markets and the institutions which have essentially promised a permanent upward bias in assets.
We can see the global scale of this central bank-cnetral State induced moral hazard in the tight correlation of all markets: the stock exchanges rise and fall in near-perfect unison, oil and gold rise and fall in parallel with equities, and so on.
As I have noted before, beneath the surface there is really only one trade in the entire global marketplace: all assets on one side and the U.S. dollar on the other. Correlation is not causation, of course, but it is more than peculiar that every decline in global equities is matched by a concurrent rise in the dollar.
Transparent, independent markets do not move in lockstep. The campaign to prop up all asset classes with implicit guarantees of intervention has completely insulated institutions and punters who believe that the Bernanke Put and the Chinese government's equivalent prop under real estate is not just policy but a guarantee of god-like power.
Thus the gains from gargantuan speculative bets are yours to keep, and any losses will be made good by the central bank or government. This is the ideal recipe for misallocation of capital and speculative derangement on an unprecedented scale.
Moral hazard is the ultimate perverse incentive: it rewards all that is unproductive and risky and punishes long-term investment and prudent risk assessment.
A second feature of the global central bank's moral hazard is the necessity to punish any punters who dare to bet against the banks' manipulations. Thus Fed Chairman Bernanke could opine that oil would decline and presto-magico, a "surprise" release of oil by central authorities occurs the next day.
This second feature of central bank manipulation leaves a market devoid of short sellers and thus of any buyers as markets crumble.
Once trust is lost, it cannot be won back. Once participants' faith in the markets and in the god-like power of central bank intervention is crushed, the markets will lose participation on a grand scale. The authorities' favorite game, goosing asset prices to create an illusion of recovery and rising wealth, will be revealed as a global fraud.
Announcements of future interventions will be scornfully dismissed and thus they will have lost their power to prop up the markets.
All of this flows from the very nature of moral hazard: insulate participants from risk
and give them unlimited leverage and "free money" to play with, and what you eventually
end up with is catastrophe. There is no other possible end state.
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