Wednesday, September 2, 2015

Here Is What Keeps Fed And Elected Officials Up At Night ......

Here Is What Keeps Fed And Elected Officials Up At Night

Back when society's balance sheet was reasonably solid, the occasional bear market was no big deal. A 20% drop in the average S&P 500 stock would scare investors and lead to slight declines in consumer spending and government capital gains tax revenue, but the overall economy would barely notice such a minor speed bump.

But that was then. Like a person with an impaired immune system, today's developed world is so highly leveraged that a shock of any kind risks catastrophic complications. Which is why governments and central banks now meet every incipient crisis with quick infusions of newly-created cash and lower interest rates. We can't risk letting markets be markets any more.

Among the many things that might go wrong if equities fluctuate normally, state and local budgets that depend on capital gains revenues and sales taxes (both of which tend to fall in bear markets) would take a potentially serious hit.

And the current correction, if it turns into something more extreme, would send already-high unfunded pension liabilities into the stratosphere. This would, in a world of honest governance, require either massive cuts in benefits or equally massive infusions of taxpayer cash, with all the attendant turmoil that that implies.

So today, a bear market related fall-off in capital gains would cause a double crisis, cutting pension fund investment returns (and thus raising the level of underfunding) and cutting tax revenues, diminishing states' ability to even keep up with their current pension funding schedule.

In the scenario that keeps governors up at night, the spike in unfunded liabilities raises interest rates on the municipal bonds states and cities issue to cover day-to-day spending, throwing budgets even further out of balance and sending the worst offenders into a death spiral that ends in default. Illinois and California are likely headed into default in the not to distant future.

That market perturbations are no longer tolerable explains Europe's reaction to Greece's crisis — years of negotiations and debt acrobatics when a strong, confident currency union would have just kicked the miscreant out. And it explains China's serial yuan devaluations, multi-hundred-billion-dollar equity buying program, and sudden cuts in interest rates and bank reserve requirements. Managing markets has become a full-time job for elected officials whose predecessors barely used to pay attention.

And it will only get worse. Every intervention either involves more debt up front or encourages more borrowing in the future. Leverage and fragility go up, making the next crisis that much more dangerous and intervention that much more necessary.

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