The Alchemy of Risk, Revisited

In a meeting last week an asset manager predicted that whenever the next major market drawdown occurs, a massive central bank intervention will immediately follow. This will prop up asset prices. The drawdown will be brief and v-shaped.

Th natural follow-up question: how long can this go on?

In theory, of course, it can go on forever. As long as market participants are willing to believe in the infallibility of ever-wise and benevolent central bankers, the Fed can effectively outlaw market crashes.

But that implies central bankers can somehow destroy financial risk. We know from market history risk can never be destroyed. It can only be transformed and laid off elsewhere.

So, what kind of risk transformation underlies this process?

What’s happening is financial risk is being transformed into political risk. Or, if you prefer, market volatility is being transformed into political volatility.

In an old Epsilon Theory note, Ben Hunt describes central banks as “creatures of capital:”

Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital — not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

Pop quiz: What do President Donald Trump and Alexandria Ocasio Cortez have in common?

Answer: They’re creatures of Labor.

In the case of Trump that might seem like a controversial statement. But think about it. Do trade barriers serve Capital or Labor? Does restrictive immigration policy serve Capital or Labor? Cheap imports and immigrant labor sure are good for Capital. Not so much for Labor.

There’s certainly more nuance to it than that. There’s an argument to be made that Trump merely duped the voting public into seeing him as a creature of Labor. But for the purposes of this post that’s irrelevant. In politics, all that matters is what the crowd believes. (Enough of the crowd to sway an election, anyway)

Trump speaks the language of Labor in front of crowds of steel workers and the like who have spent decades on the pointy end of globalization. Likewise when Ocasio Cortez talks about “economic dignity” she’s speaking the language of Labor.

The way Labor traditionally puts the hurt on Capital is through collective action. Ideally that’s political participation and modest civil disobedience. But in the worst cases it’s violent revolution. (Talk about tail risk)

Speaking of tail risk–a similar dynamic is afoot in China.

China’s economy is more or less run as a closed system. This is extremely important for the CCP, which needs to be able to push imbalances around the system to keep it from collapsing. There’s an argument to be made that the Chinese economy is a perpetual game of whack-a-mole with the CCP always needing to pop a bubble here and let another one inflate there.

This is another dynamic that can in theory go on forever but for villagers-with-pitchforks risk. There’s a practical reason the Chinese government has constructed a massive surveillance state.

It’s the tail hedge.

Two Kinds of People

There are two kinds of people in this world. If you drill down deep enough into someone’s psychology you will find she is hardwired psychologically for either momentum or value (a.k.a trend or mean reversion).

Some Characteristics Of Momentum People

Of the two types of people, momentum people are more sociable. They are innate trend followers. For momentum people, it’s always best to stick with what’s working.

Their business and lifestyle decisions reflect this. “Get while the getting’s good,” is what they think during an economic boom. They prefer to “cut losers and let winners run.”

Momentum people are pro-cyclical. They are fun at parties during boom times. It’s easy to be the life of the party when you are making a lot of money.

Some Characteristics Of Value People

Value people by contrast are a pain in the ass. They are often curmudgeonly and unpopular. This is no accident. Value people are innately contrarian. Mean-reversion underlies a value person’s worldview. For a value person, “things are never as good as you hope, or as bad as they seem.”

A value person’s business and lifestyle decisions reflect this. Value people pare risk and accumulate cash during boom times. They take risk and deploy cash during bear markets.

Value people are counter-cyclical. They are never much fun at parties because they’re always out of phase with the crowd.

Which Are You?

In the end it doesn’t really matter whether you are a momentum or value person. You can succeed in life and business either way (well… assuming you don’t over lever yourself).

What matters is that you recognize whether you are wired as a momentum person or a value person, and that you avoid putting yourself in positions that are a fundamental mismatch for your psychology.

For example, I think I would probably make the world’s worst venture capitalist (spoiler alert: I am a value guy). Not because I would lose money but because it would be hard for me to invest in anything in the first place.

The high base rate for failed venture investments would loom large over every decision. The incessant cash burning would haunt my nightmares.

Unhelpful, Misguided, Amateurish

A reader responds to my MMT post:

[t]he above is a terrible unhelpful, misguided and amateurish review of MMT. Your understanding of the role of inflation and the actual operational positions espoused by its proponents is useless. Perhaps it’s driven by politics or some ideology but you could probably learn a bit by spending a bit more time on it all.

Fair enough.

Look. I’m not an economist. I write as a practitioner in financial markets. As such, I’m mainly concerned with incentive systems and how they impact strategic decision making by individuals and institutions.

Politicians are always and everywhere incentivized to run deficits and print money. Hand politicians a license to run deficits of arbitrary size and they will print and print and print. This isn’t left versus right political thing. This is a human nature thing.

Under MMT, it would be up to self-interested politicians and their appointed bureaucrats to ensure we don’t end up with hyperinflation. Self-interested politicians and appointed bureaucrats hardly have an unblemished track record when it comes to economic management.

Now, I should be clear here that my commenter is correct. My opposition to MMT is absolutely ideological. Specifically:

  • I don’t believe bureaucrats are capable of pulling off the operational balancing act MMT requires.
  • More importantly, I don’t believe bureaucrats ought to be empowered to try and pull off the operational balancing act MMT requires in the first place.

In my estimation, the downside risks are catastrophic. We could end up on The Road To Serfdom. We could end up with hyperinflation. Anyone regularly involved in decision making under uncertainty knows that the way you manage the risk of ruin is either to hedge it or to avoid taking it in the first place.

That’s not to say MMT can’t work. The theoretical viability of MMT is something for economists to argue over.

My argument is much, much simpler. Given what we know about human nature and fallibility, and given the historical track record of economic planners and administrators, the potential negative outcomes from a real-world implementation of MMT (you know, total economic collapse) far outweigh the potential benefits.

As a wiser man than me once said: “you were so preoccupied with whether you could, you didn’t stop to think whether you should.”