Financial System - just another industry
People take for granted institutions formed generations ago as something we can rely on well past our generation. The world constantly evolves, and technology has been accelerating this change. We have seen entire industries rise and fall purely on innovating new approaches to old paradigms in the last 20 years at an ever accelerating range of impact. People forget, the financial system is simply another industry, like music.They are selling a service, using FIAT currency as a facilitator of business and investment, to make the world a better place. The center of the financial world like it or not is the USA, with the dollar being the world's reserve currency. The short take on what this means is everyone tries to 'peg' their currencies using the value of the USD as the gauge. For example, if China allowed their currency to rise to parity with the USD, their cost and goods to USA would be come MORE expensive than if we made it locally. This is due to shipping, taxes, and other costs with remote delivery of products.
You could theorize 'so what, China hates the USA, they could just sell to the rest of the world'. But the rest of the world would NOT all allow the USD to devalue relative to their currencies for the same challenges. It becomes a game of chicken, who will allow the dollar to devalue and brace for potential economic disaster for that country in the transition? Is it reasonable to expect the free world to peg their currencies to a dictatorships like China, Russia, or a basket of currencies rules by non-democracies? The wealth of those countries would become at the whim of dictators.
The Federal Reserve Bank
So here we are, everyone clinging onto a system that was birthed in 1913 created on Jekyll island. There it was decided that all US banks would be subject to an entity called the Federal Reserve Bank, and the US Government cannot issue new currency, but instead must issue a request for debt bonds and the Federal Reserve Bank creates these debt instruments. The US government gets the proceeds from these debt bond sales. Therefore we live in a democracy, that cannot create new money, but instead must subjugate to the US banking system for the mechanism to get debt based funding.
I have zero problem with the system historically, well at least through 1987, then Allan Greenspan took office. A model of appeasement took shape and here we are, the natural evolution of appeasement. The issue at the heart of the system is the Federal Reserve Bank with 7 voting members that decides the Federal Reserves policies and actions. None of these people have lived through a currency failure or are experts in every aspect of the global economy effects of Federal Reserve actions. Further the measurements of the economy are using large grain indicators such as "money velocity, money support, debt to income ratio, inflation (take your pick on the definition), deflation, employment, interest rates, and other measurements.
Federal Reserve intervention
Simply put the world is much more complex of the effects of US fiscal policy with the world attached through global reserve status, than any 7 people can truly understand.
The result is, seven people trying to do their best to set a tone, to stabilize the system when something looks out of whack, and to innovate on what else they can do with their limited toolset. I say limited toolset for they can't tell the government what to spend money on, or influence changing world culture, or to understand how dissolving the fed and 'hoping' a decentralized model will work out well. All of these items are out of their control or responsibility. So they push it along.
Each bubble, and pop has been a result of the Federal Reserve policies that I assume are with best intentions that eventually yield unintended consequences.
Looking ahead the numbers, the magnitude the Fed must take, and the reduced effect each action has on the system is accelerating. Back in 2008, the Fed created 700 Billion for the financial system to loan out to save it, and the Fed assets on the balance sheet was ~800 billion, (before the 700B created), now the total is 8 trillion dollars! Please keep in mind the story is in January 2020 the US economy was strongest ever at a debt rate of 1 trillion a year and a Federal Reserve assets at 4 trillion!
Using the past experience to gauge the future can improve accuracy, but new events can change the outlook. Historically when economic measurements hit extreme levels, such extreme levels will force a reaction back to the 'mean'. This will happen to the consequence of the extreme values, for example the US stock market valuation. Think of it this way, if the US stock market appreciated each year, every year at 10-30% per year for the next decade, would there be any negative consequences? If so could the negative consequences be the catalyst for stopping the market advance?
Whatever the next catalyst, the Federal Reserve will react, and try to stabilize. They may succeed until a new challenge emerges in a 'whack a mole' game of stop the system from popping. Then, once there is a pop, the Fed switches mode from stopping the pop to minimizing the damage.
The Problem
The question is, why didn't the federal reserve takes these types of extreme actions before 2007, what changed? On August 5th, 1971 the US government switched from a gold backed currency to a Fiat currency. Before that day, you could exchange USD for gold backed by the US Government. I actually support this move, for gold is not money, but it has proven an effective way to be the 'reserve' across all countries for 1,000's of years. When a fiat currency fails, it historically provided a vehicle of retaining wealth and kept countries from abusing printing too much fiat currency.
But I DON'T view this event as THE problem. In 1971 US GDP 1.1 Trillion, this was more then the Eurozone, China, and India combined. As a percent of world GDP, the US was a little under 35%, in 2018 it was 24%. I do think there is distortions here as the US get a bit of a boost as a world reserve currency in its valuation in the world GDP, compared to 1971 when there was a 'neutral' value of gold underpinning these valuations across countries.
So as the world becomes a greater contributor to GDP, and America GDP is reduced compared to the world, this is the reasons why we see the issues being magnified. The creation of new wealth right now is tied to the USD as the world currency, FORCING the US government and the Federal reserve to issue more and more debt to keep the world financial system growing.
When the US had a solid 35% (no valuation games) of world GDP, the US creating more currency in the world system was not a distortion, but a reflection of reality. So if the US decided to become rigidly fiscally responsible, the world financial system dance would stop. It maybe a better world on the other side, but the transition would be very, very painful.
End Game
As I see it, we have 3 options in our future, or some combination of them.
The Good
One end game is the system keeps evolving and the distortions are reduced, and we gain back equilibrium. The USD may be allowed to float around more than it does today, and the US can become one of the countries in the world rather than a peg everyone else jockeys to measure their currency against the USD.
The Bad
The US currency system is forced into a new 'innovation war' pitting the US against challengers like China for the future of the financial system. China may promote their currency using their ever increasing gold holdings to show how you can trust a dictatorship that has gold backing their currency. The US will be forced into greater risk taking in a model that has stood for 100+ years, my expectation is they will issue Federal Reserve Crypto and transition to using a more centrally controlled crypto currency. The idea will be to nudge towards decentralization of wealth movement (transactions) while keeping a central control for new crypto coin creation. I believe this model will in essence model the Eurozone, when no one country is free to issue new currency.
The crypto part will enable the system to reduce financial system operating costs and to allow new ways of injecting currency into the system. One possible outcome is the Federal Reserve issuing new dollars to individuals, with restrictions on how quickly it can be (or must be) spent and on what.
To get here however, we need another disaster, so the Federal Reserve can use the crisis to advance new innovation into the system.
The Ugly
Buy your gold bars, bitcoin, buy some guns, and buy property outside the US! For the system can't adapt, public trust evaporates, and we go into a chaos mode. The government, not the fed, will mandate innovation upon it's citizens. These maybe good, or a series of failed attempts. Having wealth invested in other countries, gold, or things like bitcoin will be a cushion for those holding wealth outside the US ecosystem.
Synopsis
My bet is on option "The Bad" above. I believe in more extremes in our future, with a more chaotic route to get back to stability. If you think "The good" is in our future, simply continue to invest into the system and you will be rewarded just as everyone has since 2008. If you think "The Bad" is viable, you can invest in the system but be nimble. Invest in some alternatives such as bitcoin/gold. I think the crisis is needed for real change, hence why I am in bonds. Bonds have potential to rise 30% or more in a crisis, and then convert the cash there to investments.
There is quite a bit to digest. I will do a post on the current crack being shown in reverse repos spiking very quickly this past week to all time highs! Throw on many assets bubbling to extremes, I continue to believe another crisis is brewing, the key is to maintain wealth and deploy in the next bottom.
