Security is mostly a superstition. It does not exist in nature, nor do the children of men as a whole experience it. Avoiding danger is no safer in the long run than outright exposure. Life is either a daring adventure or nothing.
Helen Keller
We believe that the government is preventing economic catastrophe but what’s actually happening is that we’ve begun to play a much more dangerous game than we ever have. We believe we have eliminated a risk to our financial system and economy but we haven’t. You cannot eliminate risk, only transfer it or distill it. The risk will always remain because the risk is actually a risk of change. Nothing is constant, even if the government says it should be or even if it passes a law to require it. And the longer we pretend otherwise the greater the chances that all of that change will come back in a single moment destroying everything.
This is actually how we got into this situation in the first place, but precious few seem to see that. The bankers who are now asking the US taxpayer to pay for their mistakes, all believed that their sophistication allowed them to act imprudently without fear of consequence. Acting on incentives created by congressional Democrats, they allowed themselves to be persuaded that the credit risk of a homeowner didn’t have to affect the value of their mortgage. They issued mountains of debt at values which didn’t actually take into account all the risks involved.
Because there was so much money to be made if one suspended disbelief and embraced the illusion, many of my peers were also persuaded of the wisdom of that ‘new paradigm’. Everyone believed that the risk had been eliminated, but it hadn’t. It had only been hidden, and distilled. And instead of dealing with small portions of day by day change that each of them could manage in their businesses, when the bill came due they had to deal with all the change at once… and catastrophe ensued.
Now we’ve begun to embrace a new ‘new paradigm’ based on the same kind of fantasy. We’ve come to believe that the ‘riskless’ US government can take on these economic and liquidity risks for us without consequence, and then eliminate them. It can’t. All that will happen is what happened before. The risk will be hidden for a time and thoroughly distilled, until that moment when we are forced to pay the piper. And when that moment comes it will mean the collapse of our government, and the end of the American experiment.
Those readers who’ve worked with me have heard me ramble on for years about how mortgage and credit traders were just swapping volatility for liquidity risk. Traders were giving up changes to their day on day P&L and in the process gaining a massive exposure to a potential liquidity crisis. It was a classic “short-vol” trade. They were making money day over day, but putting off all of their small losses until some day in the future. Those losses wouldn’t be seen day to day but would still accumulate, and eventually they would all arrive at once. They believed they had eliminated their risk but the truth is they were only distilling it. And eventually, as it always does, the bill came due.
Today, by embracing the ‘too big to change’ philosophy, the government is doing the same thing. They are not eliminating a risk as they believe they are, they’re only distilling it. Instead of dealing with the consequences of this most recent change as reduced economic growth, some insolvencies, and a fall of asset prices, they are suspending disbelief and acting as if the government truly is a ‘riskless’ entity. Viewed through the lenses of history that fallacy is obvious…it isn’t. Governments collapse all the time, and ours isn’t immune from doing the same. And by ‘doubling down’ and taking on a short-vol trade, we are all but assuring the inevitability of that collapse.
The government has assumed the risk of the imprudent banks and insurance companies. And because the paradigm looks so appealing to politicians, they are now also planning to assume the risk of the auto industry as well. And with the damn broken, that sort of thing will happen more and more until it’s a common part of American governance. The downstream consequences to our currency value and the government’s budget deficits will continue to be ignored. We’ll never see the day on day effects because we are distilling away the risks involved. But as they always do, they will continue to accumulate until the result is an unsustainable collapse, and that will spell the end of our economy and our government.
Our congress is run by the most irresponsible and economically ill informed people in its entire history, in both political parties. Neither party understands anything except the payback mechanisms of Washington. For all his empty rhetoric and shiny speeches about change, President Elect Barak Obama doesn’t actually want anything to change at all. Rather, what he wants to do is expand the scope of government so as to eliminate as much ‘risk of change’ as possible. But he can’t eliminate risk, only distill it. And he plans to do so with enthusiasm.
In fact, he’s not only suspended disbelief in the inevitability of risk, but he has based his entire political philosophy upon the denial of its inevitability. For him it’s a deeply held moral belief that no one should face consequences for their imprudence, so long as they have some measure of political influence. He believes that all risk of change should be transferred from the ill informed public to the elite experts in government who best know how to handle it. And the US voters have embraced that denial wrapped in the rhetoric of ‘hope’. We ‘hope’ he’s right about how risks can be avoided instead of just distilled and we have ‘faith’ in his expert’s ability to save us from it. But the tragic reality is that we’ve all heard this song before.
The throngs of Wall Street traders who suspended their disbelief during the mortgage run-up believed in the experts too. So did the investors who took it on the chin during the dot.com boom. They all operated under the mistaken belief that they had eliminated a risk when they had just distilled it. They had taken on the short-vol trade without realizing what a short-vol trade really was or what it would inevitably mean.
The risks remain inevitable but under the congressional Democrats and Barak Obama, the US government is planning to enthusiastically pretend otherwise. They’ve planned a trillion dollars in new spending, and untold hundreds of billions in ‘special circumstance’ loans and credit for various failing industries. They plan to reward high risk home buyers who bought more house than they could afford, by taking on their risks as well. The auto-industry, the airlines, and the most poorly run states have all gathered around to have the federal government take on some of their imprudent risks. And every day the line grows longer.
And in the meantime the government is giving up small day to day changes which could probably be managed, like an economic slowdown, or the restructuring of the auto, airline or housing industries, for a risk that will come due down the road. They are making a short-vol trade, and in the process they are making the collapse of America inevitable. The government cannot prevent the risk of change; they can only hide it or distill it, the same as the rest of us. They can pretend it isn’t so for a while, but not forever. The consequences are utterly inescapable, and still we charge down the road in the dark, pretending there is no precipice.
The inevitable cost of the ‘too big to fail’ philosophy, will be a consequence which is ‘too big to handle’.
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