Perhaps the most dangerous thing about where the world seems to be headed now that central bankers have not only lost credibility in the minds of investors, but in their own minds as well, is that it’s not entirely clear what will happen to society if credit suddenly dries up.
That is, if the central bank put finally disappears and the market is once again free to purge speculative excess and correct the rampant misallocation of capital, the days of easy money will quickly come to an end as rational actors begin to make decisions based on prudence and fundamentals rather than on the assumption that because the cost of capital is effectively zero, and because central planners will never “allow” the system to fail, credit can safely be extended to unworthy borrowers.
We’ll likely get an early indication regarding the market’s tolerance for a return to some semblance of normalcy in the coming months as capital markets become less forgiving towards the exceedingly uneconomic US shale space. But as mentioned above, the truly interesting question is what happens when everyone else starts to get the bankrupt shale driller treatment because after all, in a world where everybody is living on cheap credit, metaphorically speaking we’re all just broke US oil producers, surviving on debt and the willingness of our neighbors to finance that debt.
It’s against that backdrop that we bring you the following excerpts from RBS’ Alberto Gallo, whose latest note takes a look at the history and proliferation of the fiat regime.
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Bretton Woods ended shortly after (1971), while Fannie, Freddie and various other programmes that followed marked the gradual change to a monetary system based on fiat currencies, and later on, on fiat credit.
The use of government subsidies to encourage private borrowing to purchase a house, a car, or any other goods was since then imitated in other developed countries. It was the start of the so-called let-them-eat-credit policies and the transformation of democracies into debt-based democracies. No government, wrote now RBI Governor Rajan, prefers the tough reality of declining growth or of a crisis. Debt is a much easier way to gather consensus, and to postpone structural issues.
“Politicians are resourceful people. Their political skill lies partly in proposing solutions that keep their constituents happy without venturing into the rocky terrain of real reform. In the case of inequality, politicians know intuitively that households ultimately care most about their consumption over time; incomes are only a means to obtaining that consumption stream. A smart politician can see that if somehow the consumption of middle-class householders keeps rising, if they can afford a new car every few years and the occasional exotic holiday, and best of all, a new house, they might pay less attention to their stagnant monthly paychecks. And one way to expand consumption, even while incomes stagnate, is to enhance access to credit.”
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For now, we’ll forgive the fact that that quote comes from a central banker that just days ago slashed rates by 50 bps in an epic dovish lean that surprised 51 out of 52 economists and simply note that the dynamic described above is exactly how a developed, powerhouse economy gradually becomes a banana republic and if EM continues to follow this blueprint, the roundtrip from frontier market to investment grade and then back to frontier “junk” won’t take long.