Is the Central State Too Big to Fail or Too Big to Survive?

We are currently in the relatively brief interim when systemic risk has apparently been eliminated by financial alchemy. This cannot last for purely ontological reasons.

We can summarize the Central State/Banks' "fix" to the 2008 global financial meltdown as one gargantuan expansion of debt, the risks of which have been distributed to taxpayers and what's left of the private financial system.

As noted in yesterday's entry on risk, growth and security ( The Grand Tradeoff of Risk/Innovation/Growth and Financial Security), risk cannot be eliminated; it can only be suppressed temporarily or transferred to others. 

The Central States and their Central Banks have suppressed the risks created by this unprecedented expansion of debt with what amounts to financial alchemy: the States issue new debt (sovereign bonds) and the Central Banks buy the debt with newly created money. The sovereign bonds then sit on the Central Bank balance sheets as assets.

Presto-Magico, interest rates remain near-zero, enabling further expansion of sovereign and private debt. Risk appears to have been eliminated, since the Central Bank balance sheet is not exposed to any market influence. Theoretically, the Federal Reserve balance sheet could expand from $2.9 trillion to $29 trillion, and the risk of such expansion would not be priced into the market or economy.

But since risk cannot be eliminated, it can only be distributed, what is actually happening is the Central Banks are distributing the risks of their alchemy to the entire economy.

The same can be said of expanding sovereign debt arising from unprecedented fiscal deficits and subsidies/guarantees issued to every politically potent constituency, cartel and fiefdom: the risks of all this vast expansion of State debt is being distributed to future taxpayers who must ultimately foot the bill.

The risks are currently being masked by the near-zero interest rates engineered by the financial alchemy described above.

One interesting feature of risk is that it shares dynamics with pressurized systems: If you increase the pressure in a home's water supply system, eventually the weakest element will burst, relieving the pressure. Which joint is the weakest is not easy to identify until after the fact. 

In many cases, the weakest element is perceived as the safest. Case in point: the rapid expansion of risk, credit and leverage in the 2000s ended up blowing apart the mortgage market, the very element that was widely assumed to be low-risk and "safe."

We can expect a similar systemic blowout in what is currently considered "safe," for example municipal bonds and sovereign debt. As noted yesterday, in focusing on econometric data such as GDP or corporate profits, we lose sight of the truly key system dynamics. Yes, by all means "follow the money," but even more importantly, "follow the risk."

The key institutional delusion of Central States and Banks is that risk that is distributed is magically contained. Economist Joseph Stiglitz characterized this convenient delusion as an "intellectual bubble" in Crisis, Contagion, And The Need For A New Paradigm (Zero Hedge). He summarized the delusion as this: by "spreading risk, diversifying risk, risk is contained."

Risk cannot be contained, it can only be masked for a time. In the long view, we are currently in the relatively brief interim when systemic risk has apparently been eliminated by financial alchemy. This cannot last for purely ontological reasons, and history is overloaded with examples of financial alchemy that blows up in the faces of the erstwhile magicians.

Ultimately, this leads to this question: is the Central State too big to fail, or too big to survive? The conventional view is that the State is so big that it can absorb essentially infinite amounts of debt, guarantees, backstops and promises without risk.

If we understand any debt-dependent state and economy is a pressurized financial system in which the pressure (risk) is constantly rising, then we must conclude that Central States and Banks are not too big to fail, they are too big to survive.

Distributing risk does not contain or eliminate it; it simply increases the pressure in the system and the ferocity of the ultimate blowout. 

*Post courtesy of Charles Hugh Smith at Of Two Minds.