Back in August of 2007, Moldbug explained that the business cycle is really a central banking cycle.

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There is no conceivable way for “the system to collapse.” Much as the Fed would like us to think, the Ring has not been cast into Mount Doom. The lender of first and last resort has a printing press and shows no signs of smashing it.

For this reason, leverage is certainly not “a thing of the past.” Some of the hedgies who have been picking up nickels may need to be peeled off the steamroller wheel. Others will take their place.

The acute crisis of the financial system is a complexity breakdown in the regulatory system. The proximate cause is the existence of a large set of securities whose current market price appears to be much lower than their current regulatory-accounting value.

Investors did not buy subprimes and CDOs because they were stupid. They bought these instruments for a variety of quasiregulatory reasons which seemed politically sound at the time, but since have become invalid.

This is what happens when you speculate on political decisions, a task which by now consumes most of the combined brain and computer power of the financial world - certainly more than it spends on analyzing the productive economy.

For example, pension funds were required to buy AAA-rated bonds, and the ratings were obligingly issued by ratings agencies which had in effect become parts of the federal government, meaning they could face no market consequences for a failure of common sense, such as that implied by models which assumed the future would mirror the past. For example, banks could buy credit protection from hedge funds that were sure to vanish in a stiff breeze, without alarming the creditors of those banks, because the Fed would not let J.P. Morgan fail.

And, most of all, the global central banking system, considered as a unit, was dependent on the incredibly pathological practice of printing money to buy bonds. The “savings glut!” Of course, to the bond market, it makes no difference that the cycle of dilution crossed borders. The Fed printed a dollar, then the PBOC printed eight yuan to buy it, then bought an US mortgage security with the dollar. So? As far as it affected financial markets, Prof. Bernanke could simply have been buying American securities with fresh green Benjamins. The whole Voldemort game is smoke and mirrors.

The result of these abuses was to completely obliterate any semblance of a natural price signal in the money market. All interest rates at all maturities in all currencies were the consequence of official decisions. Price signals were only visible in risk spreads. And even there - as many found to their discomfiture - official action, such as the ratings mess, induced many to buy instruments whose risk was assigned administratively, not inferred by markets.

I state all of these propositions in the past tense. But if they were really past, leverage would indeed be a “thing of the past.” They are not and it is not.

The chronic problem is that “the economy” - in other words, the set of statistics that influence political events - is dependent on these abuses. If they were to be genuinely terminated or even scaled back, a massive “recession” would be inevitable. Some kind of “slowdown” is probably inevitable even now.

If central banks were genuinely independent, they would love a “recession,” because a genuinely independent currency issuer always wants to maximize the price of its currency relative to other goods. This can be done easily - stop creating money. I’ll bet the Fed could drive the dollar up to fifty pounds if it really wanted, assuming of course the Brits didn’t fight back.

Obviously this is ridiculous. So the “Greenspan put” or the “Bernanke airforce” have nothing to do with personalities. Central banks do not have the political power to orchestrate sustained “recessions.” At most they can do what they are doing now - creating shocks that destabilize overextended speculators, and may result in “accidental recessions” that are in fact quite predictable.

The problem is that long-term markets are learning to look past these shocks and see the big picture. And the big picture is that avoiding a “recession” in the present monetary configuration requires long-term interest rates at 5%, and (it seems) short-term rates even lower - combined with asset-price appreciation and money-supply growth above 10% per year.

The difference between these numbers is a hemorrhage of money. It is a river of cash flowing from Printing Press to Bond Market. And indirectly, thus, to voters - who have no knowledge of what it means to be cut off from this river, and no intention of finding out.

The long-term financial effect of this distortion is that any durable goodwhose price is reasonably sure to ascend linearly with the amount of money available to buy it will beat a T-bill. Over 10 years, the difference between 5% and 10% is pretty big. Especially if you add a little leverage.

And the effect, of course, is even larger if all the speculators pile into the same asset. Such as mold. Essentially, the market is responding rationally to a leaky monetary system by trying to create a new one.

This is Mises’ “flight to real value.” Since the CBs have shown great discipline in obeying their CPI indicator, which obviously has no direct influence on any financial market, the hyperinflationary spiral Mises’ phrase implies has not occurred and can’t. A hyperinflationary spiral (in which everyone flees to assets whose price will increase proportionally to monetary dilution) cannot avoid a CPI effect, so this brake is effective.

However, the CBs have yet to face a difficult choice: the stagflationary problem of whether to relax CPI targets, or visibly impose austerity. If the CPI targets are relaxed, the hard-asset speculators will become incredibly jazzed, and it will be very difficult to regain the credibility needed to stop the slide. But it is not clear to me that the CBs have much tolerance for austerity to begin with.

But the guys at the Fed are incredibly smart, and no doubt they will solve the problem as they have in the past. This is the art of central banking - creating temporary crises in which the price of your currency increases relative to other assets, to break the speculators who would otherwise drive it to zero in five seconds with the use of infinite leverage. It’s a stupid and pointless game, but it won’t stop any time soon.

Ultimately, the entire practice of printing money to purchase or guarantee financial instruments - public or private, foreign or domestic, short-term or long-term, is an appalling abuse of power. It is a leftover from the century of socialist mercantilism. And if the citizens of the world ever figure out that the authorities who pretend to be curing the business cycle are in fact in the business of causing it, I wouldn’t want to be anywhere near Washington DC.

Back in February 2007, Mencius Moldbug predicted that dollar hegenomy will end, not when the Chinese government calls in U.S. treasury debt, but when Chinese savers lose faith in the Yuan and head for gold.  Are we closer to that happening today?

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A tremendous post. Perhaps the best elegy for BWII I have read yet.

One point that this otherwise magisterial discussion does not cover, though, is that Chinese savers are not sheep. Their actions - as yesterday showed - are a variable in the equation.

When anyone, Chinese or otherwise, exchanges other goods for RMB or claims to RMB, he or she is buying an instrument whose value can only be defined by the PBOC’s balance sheet. Which consists largely of long-term liabilities of entities with a notable propensity to pay off old debts by issuing new ones. (At some point, we may have to start thinking of the US government as just another SOC.)

The RMB is certainly undervalued with respect to the dollar. But this relationship tells us nothing about the RMB’s relationship to other assets.

As China modernizes and as frictional effects decrease, the fact that yuan and yuan savings instruments are not an effective store of wealth - at least not compared to any asset whose price can keep pace with the growth of the Chinese money supply - creates demand for alternative stores of wealth.

In other words, assets like Shanghai A shares and real estate are, in a very literal sense, competing with the Chinese monetary system.

No human economy has ever existed which did not include at least one asset whose valuation relative to other goods cannot be explained by direct supply and demand. I always laugh, for example, when goldbugs claim that gold is the only workable currency because of its “intrinsic value.” Dollars have intrinsic value too - you can snort coke with them. If anyone ever manages to float a fiat currency whose supply is fixed, gold will trade for $20 an ounce and people will be using it for doorstops.

(The fact that no one will sell you gold for $20 an ounce today is not caused by the fact that today’s currencies have negligible intrinsic value. It is caused by the fact that they are financially unstable, their supply is expanding rapidly, and traders do not, at present, believe that any sustained contraction is a politically credible possibility. See, for instance, this story from Malaysia.)

In any case, if there is any force that seems most likely to rein in the PBOC, it is the humble Chinese saver. (Is there a Chinese equivalent of “Mrs Watanabe”?)

History records many attempts to turn stock markets, and real estate, into monetary systems - to overvalue them in the same way that paper currency is overvalued now, or that gold was overvalued under the classical gold standard (and is still, to a lesser degree, overvalued now). All of these efforts failed, for a very simple reason - an asset which is not intrinsically scarce cannot absorb monetary valuation.

When stock markets are overvalued relative to the cost of borrowing money, for example, the result is textbook Austrian malinvestment. Factories cannot sustain a price higher than the cost of building a new factory. Nor can skyscrapers, although there are some real estate markets (like the one I’m lucky enough to live in) which exhibit real scarcity.

No - the Chinese state needs to offer its citizens a genuinely scarce monetary asset, whose price actually increases and whose supply does not, when more of them buy more of it. The RMB at present does not fit this description. Nor do Shanghai shares.

I know very little about China and its government, and I have no way to predict when this issue will become acute, or how the PRC will respond to it. But it strikes me as a very good candidate for the eventual proximate cause of the end of BWII.

Back in early 2007, Moldbug wrote about the actions and motives of central banks.  Most of what he said came true.

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The same tools that economists use to describe flows between nations can be used to describe flows between any two sets of actors - regardless of their internal organization or management structure.

As I’ve said before, it strikes me as far more useful to draw the line not between the US and China, but between the central banks and everyone else. Hank and Ben cannot tell the PBoC what to do, but their broad general goal - preserving global prosperity - is identical.

So we have two pseudo-nations: “CB Nation,” whose incentives are fundamentally political, and “Debt Nation,” whose citizens behave as normal economic actors.

CB Nation can produce currency at near-zero cost. Predicting its behavior as if it was a private, profit-seeking entity is absurd, and leads to absurd results. There is no way to model CB Nation as though it was a nation of private investors. CB Nation’s actors are somewhat heterogeneous, but all of them exist in order to distort price signals for political purposes.

When we look at the flows between CB Nation and Debt Nation, we see that CB Nation is buying a vast quantity of securities issued by Debt Nation. Dipping into its infinite paper mine, it is purchasing across the maturity and risk spectrum. All prices of all financial instruments are affected by this so-called “savings glut.”

Since CB Nation is a monopoly producer of currency, it’s interesting to see what would happen to Debt Nation if CB Nation suddenly started behaving as an economic actor.

CB Nation, as an economic actor, has no interest in buying securities below their market price. Let’s assume that our newly economics-savvy CB Nation has no special entrepreneurial expertise, and thus no reason to think that its predictions of the future are better than those made by the markets in Debt Nation.

Therefore, CB Nation immediately stops buying the securities of Debt Nation. If you have no information about a market it is irrational to speculate in it. The “savings glut” disappears, and no more currency flows from CB Nation to Debt Nation.

The effective disappearance of CB Nation leaves Debt Nation with a fixed supply of currency. (In fact it is slightly less than fixed, because the debts to CB Nation still need to be paid off.) Prices of Debt Nation securities (and other assets) return to free-market levels, revealing a natural yield curve that is probably extremely high and upward-sloping, but which cannot be measured while CB Nation is still intervening.

The result, of course, is that almost anyone in Debt Nation with any kind of debt is insolvent. If Debt Nation has reasonable bankruptcy laws, they work out the defaults in a year or two, and normal economic activity resumes. Otherwise, Debt Nation becomes a sort of giant open-air debtors’ prison.

Obviously, since CB Nation is in fact a political actor, this is not about to happen. However, the Fed’s little experiment in raising short-term rates is a kind of small-scale hint at the above process.

In the game between CB Nation and Debt Nation, CB Nation has all the cards. The only question is how much pain CB Nation wants to inflict on Debt Nation. To answer this question, one needs to understand the political dynamics within CB Nation. Events in Debt Nation are only relevant to this question inasmuch as they have a political effect on CB Nation.

Thus the role of indicators such as “inflation,” “unemployment,” etc. In economic terms these indicators are worthless - they are great vats of aggregate fudge. However, as a means of predicting the actions of CB Nation, they are excellent.

The behavior of a rational investor in Debt Nation depends considerably on his assessment of the politics of CB Nation. The main unanswered question is how CB Nation will behave in case of an increase in both “inflation” and “unemployment.”

Obviously, anyone who has the correct answer to this question can profit almost infinitely. Which is why CB Nation cannot and will not answer the question, at least not honestly. This essential uncertainty in CB behavior is a natural cause of the business cycle.

And, incidentally, a great way to cream people whose quantitative models depend on the assumption that the past will mirror the future. By definition, you can’t model an irrational actor - irrational is not the same thing as stochastic. What the quants forgot is that the enemy gets a vote.