QE: Solution or Roadblock?
05/23/2013 9:15 am EST
Despite effectively infinite levels of government stimulus, debt is still the specter keeping the brakes on the economy, says John Mauldin of Thoughts from the Frontline.
In theory, returns on investment should look like a smooth bell curve, with the ends tapering off into nothing.
According to the theoretical distribution, events that deviate from the mean by five or more standard deviations ("five-sigma events") are extremely rare, with ten or more sigma being practically impossible—at least in theory.
However, under certain circumstances, such events are more common than expected; 15-sigma or even rarer events have happened in the world of investments. Examples of such unlikely events include Long Term Capital in the late 1990s, and any of a dozen bubbles in history.
Because the real-world commonality of high-sigma events is much greater than in theory, the distribution is "fatter" at the extremes ("tails") than a truly normal one. Thus, the build-up of critical states, those fingers of instability, is perpetuated even as, and precisely because, we hedge risks.
We try to "stabilize" the risks we see, shoring them up with derivatives, emergency plans, insurance, and all manner of risk-control procedures. And by doing so, the economic system can absorb body blows that would have been severe only a few decades ago. We distribute the risks and the effects of the risk throughout the system.
Yet as we reduce the known risks, we sow the seeds for the next ten-sigma event. It is the improbable risks that we do not yet see that will create the next real crisis. It is not that the fingers of instability have been removed from the equation; it is that they are in different places, and are not yet visible.
So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."
But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more thoroughly that state of stable disequilibrium can go critical on us.
If it were not for the fact that we are coming to the closing innings of the Debt Supercycle, we would already be in a robust recovery. But we are not.
And sadly, we have a long way to go with this deleveraging process. It will take years as banks write off home loans and commercial real estate and more, and we get down to a more reasonable level of debt as a country and as a world. You can't borrow your way out of a debt crisis, whether you are a family or a nation.
Bringing this tale of instability up to date, we find that Ben Bernanke and his central bank colleagues worldwide have taken much of the burden of sovereign debt upon their mighty shoulders. But as they push their quantitative easing boulders up the ever-steepening sandpile of the global economy, which side of the pile will collapse first?
Will it be the European side, already dangerously unstable? Or the Japanese side, where the QE boulder is about to grow into a real whopper? Or could it happen over on the China slope, which is riddled with fiscal and financial crevasses?
And lest we be complacent here in the US, we only need Niall Ferguson to remind us that the US may be in the grip of a profound structural malaise that neither easing nor austerity can relieve.