EDITOR NOTE: This brilliant article takes its opening riff from a simple question that most investors have probably asked themselves at one point or another: what happens if the Federal Reserve ceased to exist? Well, not surprisingly, given the sheer number of institutions and countries relying on Fed policy, we’d see a major collapse across the global financial system. Every asset of monetary value would have to reflect real supply and demand; furthermore, they would be subject to real risk. In short, the entire economy, across the board, would be subject to “reality,” as artificial mechanisms to disproportionately transfer risk and financial opportunity to a handful of beneficiaries would no longer exist. The economy would, once again, present “equity” in both opportunity and peril.
What would happen if the Federal Reserve ceased to exist? We all know the answer: global markets would instantly collapse and the global financial system, now entirely dependent on Fed stimulus, intervention, manipulation, free money for financiers and endless printing of trillions of dollars out of thin air, would crash, leaving nothing but a steaming, fetid pile of corruption infested by the cockroaches scurrying around gobbling up the few crumbs left.
What would happen if the Federal Reserve ceased to exist? The Treasury would sell its bonds on the open market, where buyers and sellers would set the yield on the bonds. Private banks would take deposits and lend money at rates set by supply and demand.
We all know what would happen: yields and interest rates would explode higher in response to risk having to be priced in and every flimsy, worm-eaten enterprise that depended on zero-interest rates would collapse in a heap and every putrid, staggering zombie corporation would crumble to dust, and its phantom assets, illusions generated solely by the artificial spew of the Fed, would fall to their real value, i.e. near zero.
Let's modify the question slightly: what would happen if the Fed's policies stopped working? In other words, what if the Fed's spew no longer created the illusion of risk-free gambling in bubble-valuation assets? What if risk raised its Gorgon-like head despite every intervention, every manipulation, and every foul burp of propaganda from the Fed?
Please glance at this chart of the delusional faith in incremental change . The faith in the Fed's omnipotence that magically reduces the perception of risk to zero is ultimately a faith in incremental change: the Fed tweaks the dials of bond purchases and its spew of free money for financiers , and voila, risk is banished and risk assets get another rocket booster.
Alas, risk cannot be banished, it can only be transferred to others. The Fed's endless spew and its constant tinkering with incremental adjustments have created a delusional faith that these tweaks will work forever and ever.
All that's actually happened is the Fed's spew has transferred the skyrocketing risks generated by its policies to the entire economy. The economy has been capacious enough to absorb the astronomical risks generated by Fed policies, but the economy has been stuffed to the gills with Fed-generated risk, and now the bursting of the risk bubble is upon us.
Put another way, there's no closets left to hide the risk in. Now the risk will escape the Fed's rusting, hubris-soaked chains and decimate the financial sector, which is now the dominant force in the economy. Once the delusions of no-risk gambling and phantom valuations implode, the real economy with undergo a devastating cold turkey withdrawal from the Fed's malevolent spew of free money for financiers masquerading as "stimulus."
Extremes get more extreme until risk breaks out; then the reversal will be as extreme as the bubble expansion. Delusions, illusions, phantoms of value: these are not real. Want to know what's real? Risk.
Originally posted on Of Two Minds