The Market Mind Hypothesis, page 48
What would a perfect storm look like with these red flags?
11.3
Watersnoodramp: The Endgame
You may know society is doomed when you see that in order to produce, you need to obtain permission from men who produce nothing; when you see that money is flowing to those who deal, not in goods, but in favors; when you see that men get richer by graft and by pull than by work, and your laws don’t protect you against them, but protect them against you; [and] when you see corruption being rewarded and honesty becoming a self-sacrifice.Ayn Rand Atlas Shrugged
Although it had been subject to flooding before, the Netherlands experienced its worst flood disaster in 1953. It became known as the “Watersnoodramp” (Figure 11.2). A perfect storm, when a high spring tide is accompanied by severe winds, broke the dikes.
Source: https://www.isgeschiedenis.nl/toen/watersnoodramp-van-1953/
Figure 11.2: Watersnoodramp Netherlands.
It also affected other countries, including the UK. The US has had its own disasters and recently commemorated Hurricane Katrina which struck in August 2005. So have other countries, including China.
The damage from a flood is not only caused by the initial bursting, but also by the aftermath. Normal life grinds to a halt. The land is left barren with crops flushed away. Goods, particularly clean water, are scarce. Prices rise, often to extreme levels.
The economic variation of this type of ‘liquidity event’ is a debt deflation followed by stagflation. The debt deflation starts once the debtlanders and the community at large realise that central planning not only fails but is actually damaging, with a ‘shocking’ final fix. We know now that central planning is causal in a negative way because it denies price discovery, the natural bridging between physical fundamentals and psychological capital. In terms of the market’s mind, it leads to a mental breakdown with physical consequences.
There are two phases to this breakdown, the first showing the aforementioned cracks and holes. In situations where the ‘powers that be’ are starting to lose that power, they take desperate measures, the kind that ‘move the goal posts’ and jeopardise credibility, trust, and other foundations of their edifice. We have seen plenty of those over the years, including the EU Troika plugging holes while blatantly ignoring referendums. Another example is Japan introducing a new CPI measure which would make it easier for the BOJ to achieve its inflation target. And now we have a Swiss (yes, Swiss) bank’s CoCo bonds being flushed away. Holes start off as cracks. The cracks have been plastered over for a while, and the observed holes have not yet connected. Men-of-system will also make all attempts to keep the storm at bay. Their loss of control will be part of the early signs of panic, but we have not seen that sufficiently yet. Still, due to their intrinsic nature—namely going against Mother Nature—dikes are vulnerable.
The trigger will occur when mood’s butterfly effect reaches its final state. It means, for example, that the savers (can or will) no longer plug the holes. This state also painfully exhibits the limitations of monetary policies. First, liquidity depends on money creation. The latter primarily occurs when the private sector has confidence and takes out loans that get recycled as deposits, i.e. money. The relatively high uncertainty in an economic environment characterised by high debt, low growth, political polarisation, and increasing interest rates means that appetite for risk is muted. With relatively high levels of debt that require servicing, this becomes risky itself from a liquidity perspective. Second, and related to the first point, the pursued policies are causing a shift in mood surrounding money and debt. This started already to change when we had low interest rates. Although one could borrow cheaply, NIRP/ZIRP means that depositing funds even if temporarily gets punished. So, when holders of cash and money-like debt no longer see them as fungible ‘assets’ and start to treat them differently, it causes shifts in capital flows to which currencies are particularly vulnerable. Third, open market operations have resulted in too unevenly distributed, that is concentrated, holdings of (public) liabilities. The JGB holdings by the BOJ are a prime example. As a result, the (patched-up) weaknesses in the coastal defences become exposed. The holes will multiply and grow.
Which section is most vulnerable? Among the historically grown imbalances are the bailouts which were politically preferred to defaults and restructuring.5 The emerging economic conditions put pressure on cash flows and will ultimately lead to bankruptcies, particularly of ‘zombie’ debtlanders. That will increase the (credit) risk premia, even for those former ‘safe haven’ sovereign bonds. Combined with other, increasingly violent, capital flows, this will then instigate the panic mode. The panic will take hold once the dikes break which affect the inhabitants most closely located to or working on the waterworks (e.g. banks, insurers, real estate, and other leveraged debtlanders). Banks underperformance, let alone failures like SVB, First Republic, and Credit Suisse, are thus another warning signal. Men-of-system will then resort to fiscal expansion with debt monetization, capital controls, transaction taxes, and further financial repression. We are already seeing some of this now, including stagflation-lite. As history does not repeat but rhymes, current circumstances are not the same as the nineteen-seventies. Stagflation-lite is thus not characterised by the traditional high level of the so-called “Misery Index” which is simply the sum of inflation and unemployment. Rather it reflects a slow economy with such a level of inflation that it pushes real growth and real returns into negative territory which, in turn, threatens cash flows relative to interest payments (especially if rates have gone up). For investors it has implications for how to structure portfolios, as historic correlations and other relations between assets break down.
Men-of-system will reach the point that their implicit admission of guilt, i.e. ‘we have been part of the problem all along and we’re now resorting to the final fix’, can no longer be ignored. In short, the final fix by the men-of-system will lead to a drought in private capital, increased risk premia, and currency crises. It will devastate everybody (so any totalitarian strong man should wipe that smirk off his face).
11.4
Painful Lessons
The reader will ask, quite rightly, whether anything good came out of the Watersnoodramp? Well, better designed dikes, for one. This culminated, for example, in the Deltawerken (Delta Works), a series of multi-decade construction projects in the southwest of the Netherlands. But there were more important intangible benefits as well, especially the return of a healthy respect for the forces of nature, including allowing those forces to operate naturally on the Dutch landscape and waterways.
In a similar vein, that is what the economic system requires. We need our version of King Canute to show the men-of-system that ultimately there are limitations and consequences to controlling tides and waves mechanically. Their overconfidence combined with a lack of respect for the delicate (and, yes, spontaneous) market dynamics, is what jeopardises our economic foundations. Thinking about migration crises, certain regions in the economic landscape have become deserted, whereas others have become overcrowded. Waterways overflow, get drained or run dry. We observed this recently in bonds: first the men-of-system forced value investors out by lowering rates to the zero bound (and below). Next, they indicated that they would force momentum investors out by pushing inflation higher. When that eventually exceeds their comfort levels, they slam on the brakes with 75 bps hikes. Similar mass movements were engineered in other asset classes and investment methods, including the migration to mindless (i.e. price-insensitive) passive investing and LDI. Finally, their regulations facilitated electronic trading which is now an oligopoly of a few HFT firms. Again, engineering begets mechanisation and vice versa. Eventually there will be ‘no body’ left. Financial engineering has weakened the market’s body and manipulation has confused its mind. To replace the market by private-public monopolies is part of the final fix in this engineering ‘feat’.
Some time ago, the journal Portfolio Institutional suggested that volatility spikes “raise serious concerns about whether or not market participants really understand the liquidity environment”. To address this within our analogy setting, we first need to be clear about the role of beliefs and (experiential) knowledge in rational behaviour (see also Chapter 4). Our analogy focuses on the association between water and liquidity and how it extends to capital. There are multiple dimensions to understanding water. ‘Water = H2O’ is an example of what philosophers call posteriori necessity, a physical fact. Physical facts inform our beliefs at the cognitive or psychological level. However, philosophy has also made strong arguments against identity physicalism, the view that every physical fact is fully identical to the associated mental fact. Specifically, the physical fact of water = H2O is not identical to the phenomenal (known) fact that water feels wet (and then only in its liquid form). So the belief that water = H2O contains both a physical and a phenomenal aspect. Per the central 4E cognition theme of this book, this is extended:
one may need to add a relational element, to account for the fact that certain beliefs may depend on the state of the environment as well as the internal state of the thinker. It has been argued, for example, that to believe that water is wet, a subject must be related in an appropriate way to water in the environment. This relation is usually taken to be a causal relation … where the causal roles stretch outside the head into the environment. (Chalmers, 1996, p. 21)
Market mood infuses these mental aspects in our intersubjective environment. It acts on capital like the elusive forces of nature that can move water, turn it from liquid to solid form, or let it evaporate. The consensus on market liquidity is that it is the condition where a real asset can be painlessly exchanged for capital, i.e. money. This physical fact, ‘real asset = capital’, does however not fully describe how market liquidity feels like. That experience is crucial to understand liquidity, just like you need to feel the water getting too hot or too cold to know that it is time to get out. If we include the condition that market liquidity means that you can exchange your asset without affecting the price, then—in reference to Warren Buffett’s famous quip—you need a sense of when the tide is coming in or is going out, which will show who has been swimming naked.
So the belief that capital is liquid, e.g. that it is ‘freely floating’, involves sensations as part of our natural mentality. As I have argued, this phenomenal dimension is essential in price discovery. Sensations complete the market mind’s holism, the interdependence of the various aspects of its mentality. Unfortunately, abusing markets and turning them into mechanical automatons has repressed the natural sensations of freely floating capital, for example, the associated natural fear that too much of it can make you drown. Others, like the pains from creative destruction, have been anaesthetised or otherwise medicated away. More broadly, we lost the sense of what it means to be in markets because they lost much of their purpose.
The perfect storm and the subsequent “deluge” are thus not triggered by some physical economic event, not even multiple ones. They are triggered by the mental breakdown, the sudden realisation of the inconsistencies in the economic worldview, the current belief system that designed the waterworks. It is captured in the age-old saying that you cannot have your cake and eat it too. It is also the culmination of our butterfly effect.
To conclude, whatever you think is our caterpillar, it turned into a Death’s-head butterfly. And it flapped its wings a long time ago. The resulting perfect storm is brewing but it is currently still offshore. However, water has started to seep through the dikes and Hans Brinker has been yelling for a while now. Who is listening?
Like nature’s laws, the psychophysical laws of economics will eventually prevail. Water will find its own way and the debtlands will see their inevitable cleansing.6 Sometimes floods are the only (hard) way to learn and all we can do is accept and deal with the consequences. On that note, water can also be a creative force of destruction which will enable us to rebuild and improve the economic landscape. Perhaps we should then start with a mind~body perspective of the economy and markets, and treat them in organic rather than mechanical terms? Now that is a different caterpillar all together.
Finally, the worst case may not be the most likely case. So, the Investment Note (Conflicting Beliefs on “The Worst Case”) nuances it.
Investment NoteConflicting Beliefs on ‘The Worst Case’
That mechanical economics is not only wrong but also becoming expensive, is a red thread running through this book. It is not just that some of its practices distort prices, leading to costly misallocation. The broader distortion, by way of prescribing a machine-like economic system, leads to a reality mismatch. It makes no sense to the dualist view through which most people perceive their reality. In other words, if the balance between mind and matter becomes unhinged, values (in the broadest sense) become distorted. In the economic domain, money is particularly vulnerable to this. Thus my warning that the fiat currency system will fall in any endgame of what others have called the Everything Bubble.
In the interim, many readers will wonder how the regularly observed excessive divergences between the real economy (Main Street) and the financial economy (Wall Street) can exist, particularly with the debt overhang as a Sword of Damocles. Let’s assume that there will be no recovery in the former and that ‘reality’ will set in. That is, the fundamentals of the real economy will not improve and eventually will force the expectations in the financial economy to converge. Let’s call this a reset. How likely is it, and when will it occur? I don’t have an answer, but I will offer my suspicion. Maintaining this status quo is the battle between two separate pairs of beliefs which are roughly defined as follows:
‘we cannot fool ourselves all of the time’ + ‘history rhymes’,
‘it’s called ‘political economics’ for a reason: financial repression works’ and ‘it’s different this time’.
Although we cannot dissect them fully in epistemological terms, like we did in Chapter 4, the first set of beliefs implies a disbelief in central planning which, in turn, has major implications for the trust in the monetary system, with historic evidence of previous economic collapses. The second set of beliefs basically implies that the economic mind and body can sustainably exist and operate in different worlds, facilitated by the now-familiar monetary drugs and therapies. This would suggest that the health profile of the economic system I have presented in this book may be correct but is not worrying, and that we can ignore historic evidence. Alternatively, of course, the financial economy could hold the true belief in that the real economy will come out of the doldrums. In other words, Mr Market’s discounting, and so on would in that case have worked again (with a bit of help). It would also mean that I am wrong in my assessment of his health.
What this battle boils down to, particularly due to the much higher (debt) stakes, is increasingly binary: it seems ‘rational’—in a somewhat cynical way—to bet that men-of-system will be able to control this because everything will just turn null-and-void if they won’t (i.e. there is no point betting they will fail). In other words, a reset will not occur because it is in nobody’s interest. This suggests an expectation for a continuation of the divergence.
Still, my worry is that growing population of butterflies out there, furiously flapping their little wings in a climate that has only gotten worse since the GFC.
Chapter 12
On Closure: Farewell and Good Luck
The natural device for squeezing as much unacknowledged ideology as possible out of the subject is open professional criticism. Obviously, then, one must protect and encourage radical critics.
Robert Solow
12.1
Parting Words
It is one thing to show a man that he is in an error, and another to put him in possession of the truth.
John Locke
Remember, all I’m offering is the truth, nothing more.
Morpheus (in The Matrix)
If mechanical economics is the answer, then our problems show we have been asking the wrong questions. I have tried to correct this by raising and answering the right questions in the titles of these chapters. Among my key answers is that mechanical economics, motivated by physics envy, cannot explain the psychophysical nature of market dynamics because it ignores that the minds of economic agents are conscious. According to mechanical economics, spatiotemporal embodiment, enactment, embeddedness, and extension play no role in constituting the agents in markets. Specifically, the key physical constitutions of markets are not computers but embodied brains which enable agents to experience markets. Such experiences—by being in the market—are deeply intense, multi-temporal, while unified (just like the returns in their portfolios). Mechanical analysis fails to capture this in a meaningful way. Its models—mostly via static regressions—only offer partial computational explanations based on given moments, i.e. via snapshots. These subsequently shape policies, strategies, and other practices. No wonder our economic challenges are mounting. It’s not simply a question of ‘the map is not the territory’. Rather, a map is used for something that isn’t a territory. Keeping reflections by Kant, Von Weizsäcker, and others in mind, claiming—like the MMH—that the economic system is an extension of us seems more ontologically modest than claiming it is a machine (which is different from us). As I said, mechanical economics makes an ontological error, a commitment that is becoming very expensive:
