In the current financial fantasyland, central banks are all seeing, all knowing seers who, even if they can’t get the economy going, can keep asset prices elevated. In real life, based on historical experience, central banks and the governments they are part of are usually the last to get the joke, and end up being the “greater fools/bag-holders” in the title. From Charles Hugh Smith at oftwominds.com:
Those who are confident the central banks can print unlimited money may find there are political and financial consequences to such extremes that cannot be foreseen.
The central problem with central banks is their mandate now includes propping up all asset markets globally. Back in the good old days before the Global Financial Meltdown of 2008-09, central bankers reckoned they could control the “animal spirits” released when the risk-on herd destabilized into a chaotic risk-off stampede.
As former Federal Reserve chairman Alan Greenspan noted in his 2014 Foreign Affairsarticle Why I Didn’t See the Crisis Coming, the models used by central banks and private economists alike presumed the demand for risk-on assets would remain robust even in a downturn:
Almost all market participants were aware of the growing risks, but they also knew that a bubble could keep expanding for years. Financial firms thus feared that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably. In July 2007, the chair and CEO of Citigroup, Charles Prince, expressed that fear in a now-famous remark: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Financial firms accepted the risk that they would be unable to anticipate the onset of a crisis in time to retrench. However, they thought the risk was limited, believing that even if a crisis developed, the seemingly insatiable demand for exotic financial products would dissipate only slowly, allowing them to sell almost all their portfolios without loss.
They were mistaken. They failed to recognize that market liquidity is largely a function of the degree of investors’ risk aversion, the most dominant animal spirit that drives financial markets. Leading up to the onset of the crisis, the decreased risk aversion among investors had produced increasingly narrow credit yield spreads and heavy trading volumes, creating the appearance of liquidity and the illusion that firms could sell almost anything.
But when fear-induced market retrenchment set in, that liquidity disappeared overnight, as buyers pulled back. In fact, in many markets, at the height of the crisis of 2008, bids virtually disappeared.
Translated into plain English, what Greenspan and other conventional economists expected was a deep pool of greater fools would gladly lose money by buying assets that were plunging in value. Greenspan et al. reckoned the seemingly insatiable demand for exotic financial products implied that greater fools would continue to “buy the dips,” enabling Wall Street financiers to unload the near-worthless exotic financial products to those willing to absorb rapidly increasing losses.
To continue reading: The Central Problem with Central Banks
