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Sebastian Mallaby: “Nobody Would Know Whom or What to Trust”

by John Rubino on August 2, 2010 · 13 comments

Here’s another take on the inflation/deflation debate from Council on Foreign Relations senior fellow and Financial Times columnist Sebastian Mallaby:

Forget Jesus and ask the hedge funds

The US stimulus debate features two warring camps. The Obama administration insists that a failure to stimulate will open the door to a double-dip recession. Its foes retort that continued stimulus could scare investors into dumping US Treasuries. Team Obama invokes the recent run of poor economic data, which point to a risk of renewed slowdown. The critics recall that the Treasury market dipped unnervingly last year, and that foreign central banks were rumoured to be tired of funding US deficits.

Faced with finely balanced dilemmas, some Americans are wont to ask: “What would Jesus do?” In this case a variant may help: “What would hedge funds do?”

Hedge-fund traders typically consider not just the probability of alternative scenarios; they look at the magnitude of the consequences flowing from each of them. If a trader thinks a market has an equal chance of falling or rising – but that a fall, if it happens, will be larger than any potential rise – the trader will seize upon that asymmetrical pay-out. He will bet on the market falling, and his actions may be self-fulfilling.

For the stimulus debate, this hedge-fund logic has clear implications. Even though the odds of a double-dip or a bond-market rout may be roughly equal, bond-market trouble would probably have larger consequences. Therefore the prudent policy is to rein in the stimulus.

What makes the prospect of a bond-market rout more frightening? To begin with, course correction would be harder. If we are heading for a double-dip, the evidence will come in, data release by data release. There will be time for the central bank to respond, time even to reopen the option of a stimulus.

To be sure, monetary and fiscal stimulus operates with a lag: ideally, you treat preventatively. But the problem of getting behind the curve is far greater with respect to market crises, which can come out of a clear sky, suddenly and with a vengeance. Once the crisis begins, falling bond prices drive up the cost of servicing the national debt, compounding the budget mess that caused the crisis in the first place. And whereas the International Monetary Fund and its allies can sometimes break the resulting vicious cycle in a small country such as Greece, they are not in a position to underwrite the $8,600bn US Treasury market.

More than that, a Treasury crisis could potentially have consequences more catastrophic by far than the loss of two or three percentage points of output. Lost output certainly matters, not least because workers shut out of the job market for too long tend to become permanently discouraged. But the discrediting of the global reserve asset would have ramifications all around the world – financial and political.

Investors everywhere would be left without their moorings. They have constructed their portfolios on the assumption that Treasuries are the risk-free asset; if their benchmark is destroyed, they will scramble for other stores of value – German bunds? Gold? – disrupting normal price relationships across the financial system. The disorientation could cause a repeat of the post-Lehman Brothers freeze-up. Nobody would know whom or what to trust. And unlike after Lehman, the US government, chief architect of the 2008 bail-out, would itself be compromised. This time really would be different.

Politically, the consequences could be almost as serious. Because of Treasuries’ status as a safe haven, the US government has benefited from capital inflows during moments of geopolitical stress. Even when Russia or China opposed US policies in such moments, they frequently enabled those policies by shifting assets into US Treasuries – thus they denounced the 2003 invasion of Iraq, but they also financed it. Because of these safe-haven flows, the US has been able to make military and foreign-policy decisions without worrying that its access to financing might dry up. If Treasuries lose their credibility, US leaders may no longer be able to take this privilege for granted.

In short, a crisis in the Treasury market would be seismic, and the mere possibility should terrify policymakers. This is the tail risk that deserves to wag the policy dog. It is a scenario that implies costs that would be so huge that they demand to be a part of the debate over the stimulus.

Some thoughts:

  • Agreed, the global markets losing faith in Treasury bonds would be the end of the road for the U.S. We’d be in worse shape than Greece, having to actually live within our means but without a big brother to bail us out during the transition.
  • It’s interesting to see the mainstream press toy with the idea that inflation and deflation aren’t the only, or even the biggest risks that a society runs when it borrows beyond a certain point. The real danger is a sudden currency crisis in which bond  investors just say “no more,” and head for the exits en masse. Since fiat currency is only a shared hallucination, this kind of meme can become a self-fulfilling prophecy.
  • But the idea that there are better and worse policy choices is overoptimistic. At this point there are only two alternatives, both of which lead eventually to the same place: If the US eases immediately, the kind of bond market meltdown described above becomes probable. If we switch to austerity, states and cities from coast to coast will default on their debt, sending us into a deflationary black hole — and forcing a new round of easing. All roads lead to the printing press.
  • http://miningstocktalk.com/ T

    Great commentary. It’s hard imagining what this country would look like without the great advantage of low treasury rates and a dollar reserve status.

    Here’s one possibility: http://miningstocktalk.com/mining-stock-talk-interviews-pasha-roberts-silver-circle/.


  • Rick

    Over time, reading various articles on how the economic system is working or is suppose to work has left me with one regrettable conclusion…

    The entire market is a circle jerk…no one knows anything about anything… this group believes this, and that group believes that…and they are all wrong, all of the time, with the occasional exception of the law of probability when by accident someone gets a winner…At that time of course that entity pronounces themselves as a prophet…until they get it wrong again, which is usually the next thing our their mouth…

    It is all opinions’ and happy talk based on what everyone wants to believe..Facts are useless in this world because everyone lies…the banks lie about accounting, the government constantly lies about data (housing is up, housing is down, the GDP is up, the GDP is down, sometimes you get completely different reports on the same page)…there is no definitive data based on real facts because no one can apparently deal with the real facts…

    They, the system are making the whole thing up as they go along aided by an assortment of TV channels, news pages, and blogs which are completely based on wishful thinking…this has become an entire industry that produces nothing of value…and it is not that everyone is lying…it is just painfully obvious that no one knows WTF they are talking about or what is going on, ever…

    Why not just replace the entire market system with a gigantic crap table…every once in a while someone gets lucky at the crap table and gets a winner…that is the one they talk about…the two hundred passed that they crapped out on, no one wants to talk about those…at least we do not have to hear about the what if’s…

  • Smitty

    The entire financial system is nothing but a lie build on top of the biggest lie of all, the fiat money system. It’s like the Wizard of Oz who was only a Wizard as long and everybody THOUGHT he was a wizard and didn’t look behind the curtain.

  • Bruce C.

    Even though more monetization could trigger the dumping of US Treasuries is obviously possible, I still think investors are too pragmatic to do that any time soon. I say this because, other than the claim in this article that, “foreign central banks were rumoured to be tired of funding US deficits,” I’m not aware of any recent evidence that the bond holders have had enough. All of the bills and agendas supported by the Obama administration has increased total US debt and will decrease US economic growth, which implies government revenues – the source of bond repayments, and yet bond rates are at historical lows. They have actually steadily decreased as more troops have entered Afghanistan, when the HC boondoggle was forced through, when unemployment compensation was extended again and again, when food stamp usage grew to an all-time high, when unemployment increased, when GDP growth slowed, as state governments are going bankrupt, when carriers moved to Hormuz, and as the stock market has started to rise.

    Frankly, I’d like to see some fiscal and monetary discipline imposed on the federal government, but until interest rates at least remain unchanged when the next preposterous idea is implemented by the chosen One I don’t think it’s gonna happen. Besides, the only hope the US gov. has to repay its debts is to devalue the dollar.

    One last thing: Every one I know who owns US Treasuries says that ‘if Treasuries go to hell then so will everything else, so what difference does it make? Sell Treasuries and buy what?’ (I know – gold – but that’s what they (i.e., real, live Treasury holders) say.)

  • Richard Wicks

    Hey Rick, yes, everybody does lie, but it’s not true that nobody knows what is going on.

    Turn off your television, turn off your radio, and start reading on the net. Eventually you’ll see something that reflects actual common sense – like dumping tons of money into the system has to eventually cause inflation because money is just another commodity, and when there is a lot of a commodity, it’s value goes down because it’s supply goes up.

    When you find a place that speaks in terms of common sense, start following it.

    The principle reason I believe that things end up so haywire, is that so many people believe lies and there are so many lies out there. Our media is designed to impoverish you, not to help you – same with our government.

    Don’t get angry about it, accept it and move on, and if you don’t want to do that, oh well, don’t say nobody warned you or explained what was going on. We live in a world of propaganda and lies and it’s not a democracy, get over it. People want to believe in bullshit, you can’t help them, don’t waste your time trying.

  • Dave

    When a system becomes non-linear like ours because of its complexity, anything could trigger a catastrophe. There is too much pressure in the system, and that pressure needs to be relieved. It seems to me that Cameron in the UK is taking the right tack in the UK. You have to raise taxes and cut spending, and be willing to take your medicine. Because of politics, here in the U.S., the politicians are continually kicking the can down the street, because they don’t want to lose their jobs. It’s not an either/or situation. Better to bleed now, than die later.

  • Dipp

    We might know years later through some ‘wikileaks’ that quantitative easing started in 2008 and never stopped in reality. This could be the reason for bond yields falling despite greater deficits and useless adventures abroad and at home.

  • Doug

    What year do you think this will hit the fan? Oil, gold, interest rates, and the stock market all seem a little too calm. It seems like something has got to give.

    • John Rubino

      Doug and Bill,

      Bubbles always inflate for longer than seems possible. Tech stocks “should” have stopped going up in 1998, and I wrote a book on the coming housing crash in 2003, four years too soon. The government debt bubble is the biggest of all, so it might go on for a long time. But when it bursts, it’s game over for fiat currency.


  • Tony D

    It’ll be interesting to see what happens to sentiment in the US as winter approaches from September onwards. Seems that current markets are not based on too much logic so the colder months are as good a trigger as any !! LOL.
    While I’m certainly no expert in the bond markets it seems that the talk around the bond market reminds me of the tech bubble circa 2000 where people knew there was a disconnect between common sense and what was happening so people found justifications to pile in, even when fundamentals were not there. Seems to be happening now, there is a disconnect between debt levels and rates of return that defies logic and signals that there will be a correction in that market one way or the other. An analogy might be 50 people piling into a 25 person lifeboat. Seems to me that the US needed the discipline of higher bond rates to force a reduction in government spending and as that hasn’t happened the Bond market may well be a powderkeg when it does go off. I live in Australia and I think I’ll wake up one morning to some amazing headlines.
    One suggestion is to buy some precious metals, not as an investment but as insurance as wealth protection will be the name of the game over the next couple of years.

  • J W

    The current group of squalid criminals,sociopaths,and economic illiterates in charge of the Federal Government are incapable of discerning chaos from rising interest rates. They think all of us are as stupid as them. Think God,guns,and gold. Ignore the rest.

  • Brad Thrasher

    This seems like a game of, “How dead?” Does it matter?

    The notion that the consumer is coming back defies reality. First, consumers in the developed nations are aging. Aging populations spend less. Second, the credit bubble burst. Where the heck are the paper money boys going to grow a new tsunami of credit worthy consumers?

    The answer of course is always China.

    By every estimate China’s consumers are at least a generation (20 years) away from becoming a consumption nation. Maybe you’ve noticed the Chinese government is resistant to consumerism.

    It’s going to get worse before it gets worse. Count on it.

    All the best,

  • http://billhopen.com billhopen

    is it my imagination or is the crash taking like forever to get here? its boring, got my seeds, gold, shotgun etc and the market is climbing! WTF…I hope we don’t just slog along for decades…of course I jest, but the point is ignorance is bliss or if not bliss…persistance, slogging along, making a buck, paying your rent or morgage….its hard to break up the familiar cycle and mindset of the avg ignorant joe…things will just get slowly crappy and he’ll still slog along. it won’t be untill there is no food in stores or the water and elec shut off that he will ever notice, and that may not happen for decades…mean while the bond mkt is just some blah blah blah on the news. In WV you slaughter a hog a kill a deer and tomatos and corn keep growing, they don’t know about the bond market. the price of gas, is about all that matters.

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