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Oxygen & Markets - Why The Collapse Is Coming

Via EconomicNoise.com,

Analogies or metaphors are often effective in explaining complex issues. In this instance, oxygen and markets are used to do so. Markets are anthropomorphized, requiring them to have oxygen to survive.

Oxygen for financial markets comes from two sources — the economy and the Federal Reserve:

Economic Oxygen and Markets

The strength of an economy creates wealth. Without a strong economy no nation grows wealthy or stays wealthy. Asset valuations are ultimately grounded in the economy, at least in the long run. Rising employment, standards of living and financial asset prices accompany strong economies. Without these pre-requisites, long-term wealth cannot be created.

Today the relationship between economic oxygen and markets is unsustainable. The economy is not and has not been providing enought oxygen to sustain current levels.

Enter the paramedics we refer to as the Federal Reserve. They show up with their oxygen tanks to resuscitate the patient. The Fed injected enormous amounts of liquidity into the system with two initial purposes — bail out the banking system and stimulate the economy. Large amounts of funds offset banking system insolvency (at least for the time being). But liquidity is at best a temporary stay for a sick economy, despite Keynesian protests to the contrary. However these injections of emergency oxygen revived financial asset markets.

Federal Reserve Oxygen and Markets

Regardless of what one may think about the Fed, it can have positive and negative effects. The Fed failed in re-starting the economy. Economic growth and well-being is a function of individual economic actors and the incentives and disincentives they confront. When times are judged propitious, economic actors take advantage. When they are not expansion activity declines, sometimes reversing.

There is little the Federal Reserve can do to change outlooks other than to mislead economic actors by altering price signals. To the extent that the Fed is successful, the success is based on deceit. Market participants acting on false data are acting against their long-term interests. Eventually they realize that the decisions made were based on unsustainable and false signals. This misguidance only adds to the original problems and necessitates an even bigger correction once it commences. Ludwig von Mises observed these conditions as follows:

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

For markets, the Federal Reserve is akin to an emergency visit from a paramedic. The oxygen provided can revive the patient but it cannot heal the patient. Markets have had their long and steep rise because of the Fed oxygen and the inflation effect which was directed into financial rather than real assets. However, the paramedic has been unable to make the patient breath unattended. The patient is still unable to survive on his own.

Our Current Oxidized Condition

The Fed failed in its attempts to juice the economy. Offsetting their efforts was the avalanche of bad regulations, uncertainty about new ones, fear of inevitable tax increases and the massive overhang of debt. Businesses cut back on investing and hiring. Many bought back outstanding stock to make performance look better. ObamaCare turned many full-time workers into part-time workers. An expansion in welfare benefits prevented depression-era food lines but also, for the lessers skilled workers, made welfare a career option.

In short, nothing the Federal Reserve did or could do could offset the awful fiscal and regulatory environment.

That was not the case in financial markets. The money that poured into the banking system added to their reserves. Little of it went toward new loans. The rest had to go someplace. Instead of going into real assets and jobs, it went into financial assets, especially equity markets. Financial repression was a deliberate Fed policy to further drive money into stocks. By reducing interest rates to zero, people had less incentive to pay down their debts. Lower interest rates serve to drive equities even higher based on traditional valuation models. Even retirees were forced into equities in search for income.

What Comes Next?

Economies around the world are in shambles. All central banks and banking systems are overextended. So too are political entities. The geo-political situation is worse than any time since World War II.

Any of the aforementioned conditions is enough to cause a major correction in financial asset pricing, particularly when these assets have been driven artificially beyond what most consider normal valuations. Central banks are out of bullets that can be effective. Arguably they ran out five years ago. The US economy cannot recover until taxes and regulations are addressed and incentives for growth and investing return. In the meantime more companies have either given up on the US or are hedging their bets by moving all or parts of their operations out of the country.

The only thing that government can offer at this point is doctored economic statistics and claims that the economy is just fine. The Federal Reserve can still print money, but that cannot help the economy or offset bad fiscal policy. Even the printing of money has limits in terms of its effectiveness. Eventually devaluation of currency and inflation of prices is the result.

There is nothing that government or the Federal Reserve can do to remedy overvalued financial assets. Printing more money may support financial asset prices for a while longer but this behavior has long-term bad consequences. The ultimate determinant of wealth — the economy — is not being addressed. Political ideology has turned on free markets and they are key to wealth creation and getting out of this mess.

Markets are coming down and probably dramatically. Ultimately that conclusion holds regardless of what the Fed does. If the Fed continues to inflate, nominal asset prices may continue up for a while but they will not keep pace with inflation. Alternative stores of remaining wealth will be sought, places which will protect against the hyperinflation warned about by Mises.

There is no way to escape the hangover created by the Fed binge. That doesn’t mean the government will not try. Such efforts will succeed in making matters worse, at least in the long-term.

The nature of politics is to kick the can down the road. We are nearly out of road. The scam is likely at its end regardless of what is tried. The piper is coming for what he is owed.