The Avalanche and the Phase Transition of the Financial System

We’ve been running with the idea that the financial system is now so big and unwieldy that efforts to stimulate will prove increasingly fleeting. Past attempts to ‘do something’ have led to an increasingly complex and distorted economy. More of the same is just making things worse.

So we weren’t surprised to see this headline in the Financial Times this morning…

‘China faces stimulus dilemma’

Doubts already! The only dilemma with previous stimulus calls was how big it should be. Not anymore. Late yesterday, China announced a cut in interest rates, the first since 2008. The People’s Bank of China cut the benchmark one-year lending rate 0.25% to 6.31%. The interest rate paid on deposits also fell 25 basis points, to 3.25%.

Instead of rejoicing in the typical fashion – a sharp and boisterous rally – the market did nothing. Even worse, some people questioned the validity of further stimulus. What is going on?

From the Financial Times article:

‘…many economists and analysts from inside and outside the government are warning of the dangers involved in a fresh round of stimulus and easy credit that could reinflate a property bubble and exacerbate the stark structural imbalances already present in the Chinese economy.’

As we point out on a weekly basis, China has massive problems. Tinkering with interest rates won’t help in the slightest. After experiencing their own credit bubbles, the US and Japan both lowered interest rates until they couldn’t fall any further. Then they just printed money.

But the money didn’t go where the Fed’s wanted it to. You can never reinflate a burst bubble. That should be one of the laws of economics – we’ll call it YCNRABB. The ‘rescue money’ always goes somewhere else. In the US and Japan, it went into government bonds.

And in Europe, the rescue funds for Greece, Spain, Italy, etc. have travelled through those markets and right back to the safety of the German bond market. Today, major government bond prices (US, UK, Germany, Japan) are at, or very close to, all-times highs. Think about that. The bond market is hundreds of years old. The bond market is saying that the risk of lending to governments is lower now than at any point in modern history.

Our response would be to tell the bond market it’s lost the plot. That bonds are an accident waiting to happen is not hard to predict. It’s the timing that kills you. The Japanese bond market has buried many investors over the years betting on its demise.

We don’t think faith in Western government’s fiat paper promises will prove as resilient. That’s not telling you much. Japanese bonds have levitated for a decade now…

There’s plenty of reason to think markets will remain in a state of fear for some time yet. Ben Bernanke, Chairman of the Fed Reserve, basically told the market not to expect more money printing anytime soon. Speculators are yet to work out that the market needs to fall considerably before the Fed will step in.

Over in Europe, faith in economic stimulus is also waning. It’s dawning on people that Spain is too big to bail out. If Spain does get a handout it can’t be a creditor to the EFSF, or the other acronym, the ESM. That means the rest of Europe needs to stump up more cash. You can bet the Germans won’t be happy about that.

Ever greater attempts to stimulate create ever greater amounts of complexity. Financial markets are like a stricken boat. Global capital is a hapless passenger, lurching from one side to the other, looking for safety. Strangely enough, in this on-the-run analogy gold is our lifeboat…or more accurately it’s our path to dry land. With no counter party risk, it lies outside the system…off the boat, away from the boiling seas.

With gold appearing volatile, it’s worth remembering that gold is inert. It doesn’t change. It’s the value of paper currencies that change. Perhaps a picture will illustrate the point. This was sent to us a few weeks ago by DR reader and mate, Wesley LeGrand.

As complexity gets…more complex, expect volatility to rise. Jim Rickards alerted us to this theme of complexity in his recent book, Currency Wars. Rickards makes the observation that financial markets resemble a highly complex system. Nothing revolutionary there.

But his definition of a complex system is a little concerning:

‘Our definition of complex systems includes spontaneous organisation, unpredictability, the need for exponentially greater inputs and the potential for catastrophic collapse.’

He then goes on to explain the characteristics of a complex system. Two crucial ones are ’emergent properties’ and ‘phase transitions’.

A simple way to define an emergent property is to say the whole is more than the sum of its parts. We’re not sure Jamie Dimon would agree but that sounds like a reasonable description of global financial markets.

The phase transition is where things begin to get interesting. According to Rickards, the system must be in a critical state to experience a phase transition.

‘This means that the agents in the system are assembled in such a way that the actions of one trigger the actions of another until the whole system changes radically. A good example of a phase transition in a critical state system is an avalanche.’

All it takes is just one more snowflake to land – and chaos ensues. Nassim Nicholas Taleb popularised the term ‘Black Swan’ to explain the randomness and severity of such events. Rickards takes it a step further, and says you can view such events not as ‘Black Swans’ but as an inevitable result of complexity theory.

He suggests that only by making the system less complex can you lower systemic risk. Breaking up the banks into small, less complex entities would be a good start. It’s unlikely to happen though.

‘Instead US banks are bigger and their derivatives books are larger today than in 2008. This makes a new collapse, larger than the one in 2008, not just a possibility but a certainty. Next time, however, it really will be different. Based on theoretical scaling metrics, the next collapse will not be stopped by governments, because it will be larger than governments. The five-meter seawall will face the ten-meter tsunami and the wall will fail.’

But don’t worry, we’ll leave you with this recent quote from Warren Buffett.

‘We’re not smarter than the people in 1930. We’re not harder working than the people in 1930. We’ve just got a system that works.’

A system that works?

Look out…

Have a great long weekend!


Greg Canavan
for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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