Castles in the Air over the Eccles Building

“If you have built castles in the air, your work need not be lost; that is where they should be. Now put the foundations under them.” – Henry David Thoreau

Last week the Federal Reserve Open Markets Committee (FOMC) held its September policy meeting in its usual haunt – the Eccles building on the corner of 20th and Constitution in DC. At the time we were guessing that they would raise rates by some smidgen (see “Clutch Time at the Fed“) and that the market would respond violently. Why raise rates? Because to not do so when “inflation” (by the Fed’s preferred but clearly flawed measure) is running at 1.8% (target of 2.0%) and unemployment sits at 5.1% (a rate not seen since April 2008) would be tantamount to admitting that the emperor has no clothes. If the “goals” of the committee have been fully met, why are they still in an emergency policy mode? I have my theories … back to that in a moment.

It has been pointed out in many places (and we’ve certainly discussed it here before) that the fractional reserve banking system is fundamentally built on fraud. In a society with legitimate property rights, no two people can hold sole claim to the same asset at the same time. Yet that is exactly what we have with fractional reserve lending. My deposit in a demand account is available to me on demand. And yet the bank lends these deposits (at interest) to borrowers who do not have to return them to the bank on demand. Q.E.D.

So why doesn’t the system collapse? Well, as long as we don’t all go down to the bank and demand our deposits back, then the fraud isn’t uncovered in any meaningful way. The system can churn along and the banks can survive with these massively leveraged loan books drawing in some interest and paying hefty salaries. But as soon as there is a serious demand to get cash out the whole thing unwinds.

It’s happened here before. We’re not just talking 1929 and the It’s a Wonderful Life scenario. In 2008 the US saw bank runs on Wachovia, IndyMac, Washington Mutual, and Bear Stearns (yes, even investment banks can suffer a run). More recently the entire country of Cyprus saw a bank run and had to shut the whole financial system down, leaving depositors to eventually be “bailed-in”. That is, when the dual claim fraud was finally unraveled, it was the depositors who realized that their claim on their assets (i.e. money in the bank) was not real.

When you build castles in the air, you’d better get the foundations under them fast

Of course the fractional reserve principle isn’t confined solely to the modern banking system. Financial derivatives have ensured that people can take leveraged bets on asset price movements. That is, with $1000 one can take out a position worth $10,000 or $100,000 (in some extreme cases). If the price only moves by a small amount then the gains and losses don’t exceed the $1000 initial stake. But if prices collapse badly in the wrong direction, said “investor” is wiped out and the counter-party has yet to collect their full payment.

It is this latter part that is the more disconcerting for the system. Those of us who are old enough remember the Long Term Capital Management (LTCM) debacle of the 90s. These guys used leverage to make significant returns early on, but when things went south they went south quickly. Before the end LTCM had over $100 billion in open positions, but only $400 million in actual capital. That means that a 0.4% move in aggregate asset prices would wipe out all remaining capital, and a 0.5% move would mean that somebody out there was owed $100 million but there would be no money to pay up.

So what happens to businesses when they are owed money but not paid? Well, you can bet that the vendors to whom they in turn owe money will also not be paid. Eventually the whole “daisy chain” of credit comes crashing down, all because the guy at the end of the line couldn’t make good. The same is true in the financial markets and banking. When you build fragility into the system (by allowing and encouraging leverage) one little bobble, one little “Black Swan” – and the whole thing unwinds.

OK, back to the Fed. Why would they hold rates at near zero even though their official goals have essentially been met? Nobody wants to take the blame. Consider the following two charts of the S&P 500. The first is year-to-date, the second is the past 10 years.



Say what you will about “Technical Analysis” – I may well say worse – but there is at the very least an inherent recognition that fundamentals don’t drive prices, the buying and selling decisions of the masses drive prices. In a perfect world fundamentals will drive those buying and selling decisions, but in a massively contorted, over-financialized, free-money, margin-driven world … who knows. The technicians would see the recent price action as a collapse and consolidation; a closing wedge pattern that clearly points towards a “big decision” in the very near future. By the way, the final “spike and collapse” in the chart is the momentary euphoria after the Fed’s decision. Not much follow-through there.

(Side note: in the world of algorithm and high-frequency trading, I’d bet dollars to doughnuts that if there is a collapse it will hit a positive feedback cycle and things will go pear-shaped faster than we’ve ever seen before.)


In terms of overall price action, the recent move is rather small. But what if there’s more to come? If everything was fine the S&P wouldn’t have dropped like a rock when things got sideways in China. If everything was fine we wouldn’t need emergency interest rates. If everything was fine, everybody wouldn’t be so frantic to explain that everything is fine.

So is this the next great stock market collapse? How should I know? My point is simply that if the Fed had hiked rates and the market collapsed then the Fed would have taken the blame. (Rightly so, of course, it is their fault that the market is so far removed from fundamentals anyway.) Nobody wants to take the blame.

Not to worry though, Janet – the scapegoat approaches. In just eight calendar days there is a very real chance that the Federal government will shutdown over a budget impasse. You only have to hold on until then. Will a shutdown cause the market to collapse? No – the market should cheer such an outcome. But, if the government shuts down and the market collapses then Ms. Yellen will have her scapegoat. “It’s those darn Republicans in Congress. If they had just kept the deficit spending going everything would have been fine. My central planning of interest rates has been clearly flawless. Yet those malcontents and scapegraces in Congress couldn’t hold it together and now everybody will suffer.” … or something like that.

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