Thursday, March 12, 2020

Call For "Liquidity" Sign That Government Debt Load is Cracking Economy

I keep hearing complaints from Wall Street media outlets that there is "no liquidity". It's usually phrased in such a way that the average person thinks it should be some kind of problem for them and coupled with demands that the government "do something". Government has been doing something, for a long time, and that's only feeding an unsustainable addiction to credit and leverage.

When hedge fund dealers complain "there is no liquidity" what they mean is that banks won't loan them the amount of money they want at a price they like on the collateral that they have. Say they borrow a Government bond overnight, and then use that bond as collateral for a loan, then use that loan to buy something for one day that pays slightly more interest than the bond. Each transaction makes only a tiny profit from all that moving of paper and digits around, but when you move a billion dollars a day around, even a tiny net can get you very rich. At least on net. You may need to borrow a billion a day to make a billion and ten thousand a day.

This doesn't really add much to the real economy. It doesn't produce a product people use. It doesn't provide a service people want. It just gets in the middle of other transactions and reaps a tiny profit each time. But financialization has grown to become such an enormous part of the economy that if it goes down, it will be disruptive.

Look, when people buy a U.S. Treasury, it should be good collateral for a loan. So someone should be willing to pay to borrow them to use as loan collateral. This may be in the form of an agreement where "I will buy at price X for three days and you will buy it back from me at price Y at that point in time." A lender should be willing to loan some amount for some price against that collateral. But the bond in this case is a hot potato. They don't really want the bond for itself, just as something that can be used as collateral over and over again. The dealers just buy the bonds because the government allows them to buy it, then create credit from thin air based on the bond as collateral to buy something else, then rent the bond out on a short-term basis for others to use as collateral.

If this system breaks down at any point- including any player in the chain deciding they want more compensation for the transaction - then not only can those who spend all day doing this not skim, but the demand for bonds as collateral would collapse.  These bonds pay interest below even the official rate of inflation. They are not a  good investment in themselves, but government has managed to juice demand for them by allowing them to be used as top-notch collateral in all sorts of complicated schemes. Basically the financial industry can buy bonds that pay almost no interest but then borrow money against it for the full amount and rent it out to others for them to do the same and also use that money to buy something else. If you can do that, why not buy the bonds? Why not leverage to the moon and buy up the whole earth with it? That's what certain connected players have been doing for years now.

But highly-levered players are players that will go broke if their investments ever lose even a tiny percentage. If I borrow a billion to make a billion plus a million, then I am a millionaire even though I gained only one-tenth of one percent on the money. But if I lose one-tenth of one percent, I am insolvent and can't even pay back all of the billion that I owe. What if I owe that to someone who is also highly levered and they need my money to stay solvent? Then the people they owe money to are in trouble. It is a house of cards built on leverage, which as I explain in my book, should be strictly regulated.

When people along this chain can't be sure the other players can make good, they either don't loan them as much, or raise the price, or don't loan them anything at all. Why should the government care if rent-seekers and gamblers go broke? Because government bonds have become the chips. Their value has been grossly inflated by their use as "collateral". If that system breaks down and people only want the bonds for their value as final investments instead of collateral for other speculation, then the price, or interest rate the bonds pay, would have to reflect true market value. And that would be the end-of-the-world-as-we-know-it. The US government is teetering on the edge of insolvency now, and only gets away with it because of the ridiculously low payments it makes on bonds.


If the demand for these bonds is cut in half because the other half of the players are suspected of not being able to pay back their debt, then who will buy government bonds? Increasingly, governments themselves are doing that. That is the expressway to currency collapse but it may be the only off-ramp on the super-highway to deflationary collapse. When leverage is this high in the system, an economy has to ride a razor's edge to keep from veering off to one side or the other. The only way to build resiliency in the system is to restrict leverage, but then the moguls on Wall Street would really have to work for a living instead of getting rich gaming the system. Politicians couldn't just borrow and spend with impunity. Unsafe levels of leverage has allowed both. Localism has the solutions.







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