The Fed's Doomsday Machine

Artificial Abundance and  Moral Hazard 

by Charles Hugh-Smith

A loss of faith in key institutions cannot be fixed with more cheap credit or subsidized mortgages.

Today's topic is important but a bit tricky; you may want to refill your beverage container before buckling in.

Moral hazard is the separation of risk from consequence. A person who knows they won't suffer the consequences of a risky bet gone bad will behave quite differently from a person who knows the full consequences of a risky bet gone bad will fall on them.

A person who is insulated from risk will have an insatiable appetite for risky bets because any gains will be theirs to keep but any losses will be covered by someone else--for example, the Federal Reserve or taxpayers.

Correspondent Jeff N. recently alerted me to the equivalence of the perception of abundance and moral hazard. Jeff was responding to An Abundance of Bad Decisions(June 13, 2013), which noted that decisions made in the euphoria of abundance were generally bad because they were based on 1) projecting the good times would last for the indefinite future and 2) the Status Quo, having delivered abundance, was working fine and should not be challenged or changed.

As a result, both critical thinking and innovation atrophy, as neither are needed in times of abundance. Indeed, they pose an active threat to the Status Quo and are thus marginalized or suppressed.

In eras of extended abundance, the populace slowly loses the ability to think critically and develop concepts outside the narrow confines of the Status Quo.

When the abundance/prosperity ends, as it always does, the populace has lost the ability to make difficult choices and realistically assess cost-benefit. Magical thinking and nostalgic references to past glories dominate the conventional mindset.

In How Empires Fall (April 17, 2013), I noted that two of the key characteristics of an empire in terminal decline are complacency and intellectual sclerosis, what I have termed a failure of imagination.

Michael Grant described these causes of decline in his excellent account The Fall of the Roman Empire, a short book I have been recommending since 2009:

There was no room at all, in these ways of thinking, for the novel, apocalyptic situation which had now arisen, a situation which needed solutions as radical as itself. (The Status Quo) attitude is a complacent acceptance of things as they are, without a single new idea.This acceptance was accompanied by greatly excessive optimism about the present and future. Even when the end was only sixty years away, and the Empire was already crumbling fast, Rutilius continued to address the spirit of Rome with the same supreme assurance. 

This blind adherence to the ideas of the past ranks high among the principal causes of the downfall of Rome. If you were sufficiently lulled by these traditional fictions, there was no call to take any practical first-aid measures at all.

In other words, if our idea of intellectual rigor and honesty is Paul Krugman dancing around the Neo-Keynesian Cargo Cult campfire mumbling nonsensical claims of grand success, we are well and truly doomed.

I went on to suggest that central banks and deficit-spending political Elites have created an artificial sense of abundance by printing or borrowing trillions of dollars and flooding their economies with this false abundance.

This bogus prosperity has led to a continuation of bad decision-making, as it has nurtured a magical-thinking faith that abundance can be conjured with monetary tricks. This is the essential feature of cargo cults, the magical-thinking belief in the return of abundance without having to chart a new path of authentic reforms.

What Jeff N. pointed out is The Federal Reserve's Cargo Cult Magic of artificial abundance acts just like systemic moral hazard. In Jeff's phrase, "reducing the perception of the cost of the action’s consequences" induces the same cost-risk-benefit mindset as moral hazard.

In other words, the Bernanke Put--the implicit promise that the Federal Reserve will never let the stock market significantly decline--is the exact equivalent of giving someone $100,000 in a casino and telling them they can't lose because the casino has their back. How prudent do you reckon the gambler's bets will be? His perception of the costs and consequences of his betting have been fatally distorted, and once everyone in the casino has been given the same assurance, the systemic risks skyrocket as every player starts making risky bets in the confidence that they can't lose.

The Fed has created a Doomsday Machine. The Fed has nurtured moral hazard in every sector of the economy by unleashing an abundance of cheap credit and low interest mortgages; the implicit promise of "you can't lose because we have your back" has been extended from stocks to bonds (i.e. the explicit promise the Fed will keep rates near-zero forever) and real estate.

An abundance based on the central bank spewing trillions of dollars of cheap credit and free money (quantitative easing) is artificial, and it has generated systemic moral hazard.

This is a Doomsday Machine because the Fed cannot possibly backstop tens of trillions of dollars of bad bets on stocks, bonds and real estate. Its power is as illusory as the abundance it conjured.

Once the losses mount, the punters who believed the Fed had their back will realize it was all a con. They will lose faith in the Fed and its promises of permanent abundance, low rates and rising asset prices.

This loss of faith will trigger what I call the delegitimization of both the markets and the institutions which have essentially promised a permanent upward bias in assets, i.e. the Federal Reserve and the other central banks that have conjured the same illusion.

This loss of faith in key institutions cannot be fixed with more cheap credit or subsidized mortgages; delegitimization triggers a fatal decoherence in the entire Status Quo.