What Happens When The Central Bank Dies?

One common point of agreement between nearly all deflationists is that the central bank is not all powerful. In the end, either the public will demand the central bank be reigned in or the market will decide the central bank is no longer in control and ignore their policies. As has been shown, central banks track short-term interest rates in the market. When the Fed and other central banks cut rates, they are almost always following, not leading the market. Even in 2008 and beyond, in some cases the market went to negative interest rates on U.S. Treasuries or German bonds, which indicates that central banker's zero interest rate policy (ZIRP) was not an invention of the central bankers, but of market participants.

I have pointed out before that many hyperinflationists have great trust in the central bank's power. While they believe the central bank will fail, they nonetheless look upon the central bank as the King Kong in the market. They believe that central banks will fail in their goal not because they utterly fail to implement their policies, rather they will fail because their policies are wrong. (The exception here are the hyperinflationists whose believe the path to hyperinflation is loss of faith in the currency, similar to what happened during the Asian Crisis of 1997 when currencies like the Thai baht and Indonesian rupiah collapsed. Hyperinflation is a consequence, not the cause of the currency collapse.) Deflationists take a different view: the central bank will be unable or unwilling to implement inflationary policies. The modern financial system is a credit system, not a fiat currency system. The central bank can create fiat currency at will, but it cannot create borrowers and lenders at will. Coupled with declining social mood, which causes people to lose faith in institutions generally.

Taking it one step further, what happens if "the market" loses faith in the central bank?

Signs of the Top

How will it all end? Faith in central banks today is equivalent to faith in the word dot-com in 1999 or faith in the eternal rise of housing prices in 2006. With the support of a powerful narrative—that central banks can support asset prices and effectively backstop financial crises (eliminating tail risk)—sentiment is driving the markets higher in the face of cyclically improving but historically weak and unstable fundamentals (plagued by debt deleveraging and aging demographics).

Ultimately, the stability of the system depends on central banks' credibility, markets'sentiment, and policy responsiveness to prevent minor drawdowns from becoming full-blown crashes. My friend Mohamed El-Erian has written extensively on the importance of the central bank "brand" and warned of the danger of a broken narrative. Markets tend to overshoot in both directions and will most likely fall even farther than fundamentals warrant when and if central banks lose control of popular sentiment.

It is not only the credibility of sovereign nations burdened with debt that can reach a Bang! moment. The credibility of and faith in central banks is just as fragile. Today we see humorous images of dollar bills with Ben Bernanke's face on them, with the words "In Ben We Trust." Unfortunately there is truth in that jest. Whether it is Mark Carney at the BOE or Mario Draghi at the ECB or the future chairperson of the Fed, central bankers are in the hot seat when it comes to global stability. The world no longer worries first and foremost about the products corporations make or the services they perform. Rather, it is focused on the amount of easy money the central banks can dish out.

What happens when that amount is no longer enough and market forces turn?

Here Charles Gave is talking about what happens when the central bank loses control, but still exists, like the Federal Reserve in the 1970s. I suspect we will see a crisis one order of magnitude larger that challenges the very existence of the central bank and the idea of central banking.

Most people think of losing faith in the central bank as the step towards hyperinflation or high inflation, which it well may be. The central bank says interest rates should be low, but the market takes them higher. The deflation camp considers another possibility: that the Fed will be unable or unwilling to stop a deflation. If people come to view the banking system or the central bank as insolvent, then the central bank cannot save them. If there is a rejection of credit, bailing out credit markets is futile—they are on their way to total destruction. It would be akin to giving the passengers on the Titanic financial bailouts as the ship was sinking. The hyperinflationists step in here and say at that point, the Fed will press CTRL-P and "save" the debt. Add one or two zeros to the U.S. dollar. For every $1 in your bank account, you would now have $100. However, this would destroy the financial sector because the debts would remain constant. It would be a massive transfer of wealth from the people holding debt (foreign central banks and pension funds holding U.S. Treasuries, the Federal Reserve itself, the entire financial system) to the holders of titled property. Those who hold title to land, factories, whether in debt or not, would see their asset prices remain constant on a relative basis, but their debts would be reduced greatly or completely eliminated.

Ignoring economics for a moment, consider politics. Since the Federal Reserve is a private entity owned by the member banks, since the federal government has been captured by the financial interests, which outcome is more likely from a political standpoint (assuming no mass movement to change the power structure)? I submit the most likely outcome is to preserve debt and/or to transfer title to the debt holders. Mass bankruptcies concentrate title of property in the hands of the banks and the financial system. The Fed's job is to prolong this process as long as possible because the holders of title are the "winners" during inflation and hyperinflation. In this way wealth is concentrated at the top (consider how the banks now own millions of foreclosed homes). When the system is finally reset, the financial sector owns the property. You will have to go to the bank to borrow $300,000 to buy a home which is owned by the bank. The bank will create $300,000 in new money which it loans to you. You turn around and give the $300,000 to the bank (plus $1500 in fees), and you will still owe the bank $300,000 plus interest!

Whether by fire or ice, hyperinflation or hyperdeflation, the system will ultimately be destroyed. Declining social mood will make sure of it, the only question is whether people lose faith in the credit system while maintaining faith in fiat (the physical U.S. dollar), or whether total faith is lost and the currency collapses into oblivion. I lean towards deflation because of the way the current system is constructed, but it could go either way depending on the herd (and we could very well see both, a deflation followed by hyperinflation, for example). Even if on paper it makes no sense for a perfectly solvent bank to fail, if there is a run on the bank, it will fail because the herd is able to change reality. The force of change is so great that it renders the previous analysis useless. Even if I was 100% sure that deflation was what had to happen, what should happen, I still would not predict it with 100% confidence because if the public panics out of the U.S. dollar, then hyperinflation will be the result. One cannot reason with the mob, one is either following or getting out of the way.

When the herd panics on a scale large enough to topple governments and financial systems, it will quickly seek out new reference or stability points, Schelling points, and it will move to them regardless of the fundamentals. In the financial world, this will likely be gold in the case of inflation or deflation.