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.

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