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knife edge economics

February 28, 2010 40 comments

by: Keynesius Fraudius
2.27.2010
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This essay proposes a set of assumptions to explain a set of empirical observations related to past, present, and future broad market behavior. There is no attempt to integrate geopolitical events such as war. The theory is called knife edge economics. It was first published privately to EarthBlog News subscribers in the spring of 2009 and disseminated publicly in late December 2009 via in an introspective look at the future of America. This essay offers an elaboration from that point.

knife edge economics

assumptions:

A collapse occurred in 2008 due to an ever increasing amount of debt which became too large to finance.

The FED is never going to tell the truth. Neither is the Treasury. Neither is the Banking system.

As short term interest rates were raised, the housing market collapsed, ending a multi decade long sting of FED induced serial bubbles which all required ever more debt.

The last bubble, the real estate bubble, was by far the largest bubble. The last remaining bubble is the unpayable debt still called a currency (the US dollar).

The collapse of the real estate bubble caused massive insolvency in the banking system, the government and the population. This set off a chain reaction of derivative failures with losses dwarfing available capital. This required public bailouts and state control of public corporations.

The collapse has already occurred, and all that can be done at this point is to alter the look and feel of the collapse, and affect real wealth and capital allocation as the collapse continues.

The entire global financial system at this point resembles a balloon. As new debt is created in the US, the capital is deployed overseas causing the balloon to expand and all asset prices to rise and the US dollar to fall because US banks are buying foreign assets and selling dollars. As the balloon deflates, capital returns to the US causing a rise in the US dollar and a deflation of all asset prices. The idea that capital returns to America seeking safety is an MSM red herring.

If the FED did not have a printing press available, the entire global financial system would have already completely collapsed amid massive insolvency into a deflationary depression and total system failure.

Since the FED does have a printing press, we have printed more money and increased the already unpayable debt so as to attempt to regain solvency of member banks and affiliated institutions.

Stability is achieved by ensuring low volatility. Low volatility is ensured by active short term market management.

If the volatility as measured by the VIX is low, the knife edge is wide. If the volatility is high, the knife edge narrows.

As the knife edge narrows (as volatility increases), the risk of falling off on one side or another increases.

The two sides of the knife edge are a: a hyperinflationary depression  b: a deflationary collapse

If the knife edge thins and collapse occurs, which side of the knife will be determined by how much money is printed (debt is increased).

If the knife edge remains wide (if the volatility remains low) , the collapse can be made to look like an extended period of economic and social decay lasting as long as one or two decades, ending at a point that resembles a collapse, but arriving there without a dislocation.

To the people, it will feel more of less the same. The experience will be high unemployment and a much lower standard of living due to unaffordability or lack of money.

The final outcome is either default or devaluation via inflating the debt away, or changing to a new devalued currency.

The FED, the Treasury and member banks along with Central Banks and affiliated institutions overseas are all working in concert using active management techniques of all kinds as a means to achieve policy objectives.

The primary policy objective is market stability.

The rate of quantitative easing (money printing) determines long term interest rates. Long term interest rates determine whether the FED is in control, or out of control.

The policy is to print enough money to keep long term interest rates low, so the real estate market and banking system can avoid continued collapse and regain solvency.

Artificially suppressing long term interest rate has the effect of depressing the US dollar which has the effect of boosting US share prices and commodity prices.

Using knife edge economics as a predictive tool, the ten year note and the VIX are leading indicators regarding collapse or decay. If the ten year yield remains low, then the FED would be assumed to be in control and the dollar would be free to slowly depreciate. The knife edge as measured by the VIX would remain wide, the FED would have more room to maneuver and commodity, stock and other real asset prices would be expected to move higher.

Another way to look at this would be that policy effect on asset prices is only a reflection of a depreciating dollar against all assets. In other words, assets like stocks may be going up, but only insofar as to reflect the decline in the worth of the dollar, which may or may not be well indicated by the US dollar index. The dollar would depreciate in this way possibly for a decade or more until the unpayable debt was inflated away.

If however there was to be a surge in the 10 yr rate, this would indicate a loss of FED control and would argue for much lower stock and commodity prices, along with a risk of a repeat of October 2008.

The FED solution for a market based surge in the 10 yr interest rate and a volatility increase would be to accelerate QE.  If printing money does not reduce the interest rate then knife edge economics would argue the FED is losing control and would risk hyperinflation to regain it with the alternative being insolvency and absolute system failure as was almost experienced in 2008.

Generally speaking, knife edge economics would explain current FED policy as endeavoring to promote stability through any active or passive means necessary. Keep the 10 yr yield low. Manage equity prices for stability and within bands. Allow the dollar to depreciate for an extended period of time, causing asset prices to slowly inflate to regain solvency within the system.

Editors note: EarthBlog News does not provide financial advice.  We are proposing an analytic structure to explain market behavior.

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