How to run an economy

If you have not seen Richard Koo’s video about how banks and regulators acted in a previous existential crisis, you should.  It is very instructive. Here it is.

Based on my observations over the past decade and Koo’s comments, here is my playbook for fiscal & monetary policy. I call it   How to run an economy.

 

Banks:

Bankers should act responsibly. They should be accountable to their shareholders. Don’t make stupid loans (Latin America in the 80s, US subprime mortgages in the 2000s, mortgages with less than 20% down in 2013-now). Sometimes when the music is going, you don’t have to dance.
The above is true unless a bank is insolvent or nearly so.
If banks are nearly insolvent they should lie and cook to books to misrepresent their health. They’ll need a diversion to distract investors from the evidence — a large gap between as-reported earnings vs earnings from operations (earnings before bad stuff).
The larger a bank is the more important that they lie because many $T in credit derivatives may implode, bringing the global banking system down in 24 hours or less.
Bank regulators should be complicit in the lie in order to sell it (see Koo video). Take now for example. It would be really convenient for the Fed to have had undocumented discussions with bank leaders, advising them against recognizing losses on their energy loan portfolio. More helpful still if the Fed were to also recommend against building loan loss reserves since that might give the impression the bank sees losses ahead.
If a systemically important bank fails, the C-levels and board should see their assets seized and jail time.  If you want bankers to act responsibly, create an incentive to do so. Fines to shareholders don’t do it.

 

 

Fiscal Policy:

When banking systems are at risk of implosion (year 2000 through now in the U.S., Europe, Japan, and 2011-now in China), do not tighten policy. Run up massive budget deficits to keep the music going. If in Europe, find a way to convince Germany to go along with this. Just say “Deutsche Bank”. That should do it.
After a banking crisis is done, begin tightening fiscal policy to pay down the debt racked up during the crisis. Hey, stop laughing. OK, politicians won’t do this because they won’t get re-elected. The solution involves political reform wherein long term responsible policy can be enacted and not overturned by myopic politicians. Wait for it, it’s coming…
More likely the debt gets written off central bank balance sheets (who does this hurt?), and some form of free money program is put in place to relieve the cashflow burden on households loaded with debt.  This is where fiscal policy meets monetary policy.
Hello inflation spike.  This leads to another problem: those locked out of hard asset markets (housing, stocks) are left behind. Builds societal instability. Here is where your political overhaul happens.

 

Monetary Policy:

When banking systems are at risk of implosion, do not tighten policy. In fact, create an interest rate environment for banks to make record profits (U.S. 2008-now). Force banks to keep those profits and build a mountain of cash that will then be used to repair the balance sheet when you recognize the brown ink / dog sh*t on their balance sheets. Sadly, bank regulators in the U.S. recently gave the green light for banks to begin pairing that cash pile down. Bankers will deploy large swathes of it in share buybacks. Want to know why you will bail out another large U.S. bank next year?  This is why.
When banking systems are at risk of failure, hold “stress tests” that are a farce, designed to sell the lie the system is OK. Be sure to have some banks fail or nearly fail in order to make it credible. Careful!  Don’t fail any of the banks that are systemically important unless you tell them how much capital they need to raise and have it cleared with their board before releasing the results.  That way the bank can release a statement the same day as the stress test result are announced — saying they have already raised the capital to shore up their balance sheet.
After the risk has passed, don’t begin normalizing monetary policy –>> instead begin inflating away all the debt on central bank balance sheets (any that did not get written off).  Sorry pension funds that bought long dated sovereign debt.  You’re going to suffer large losses on that asset base. Sorry investors that went in search of yield by walking out the yield curve when the sky was falling.

 

I hope you found this interesting.

 

Here’s the rub —- why you can’t bet on stock markets going to the moon over the next 1-2 years.  China.  Almost every solution above involves weakening your currency. If you do that in China, you’ll see money flee the country at an accelerating pace, leaving banks insolvent in another 1.5 years (or so). The same is not true of the US, Japan and Europe.  I suspect / expect things to gradually get out of control where central bankers can no longer contain the contagion.

 

The Greedometers (my proprietary algos) provide a means of  understanding where we are in this gradual process of central bankers losing control — and of what this means to the S&P500.