From the monthly archives:

July 2014

Not that long ago, politicians and economic leaders trumpeted the idea that they had prevented the worst economic collapse since the Great Depression.  In the same breath, they generally gave the impression that they had taken steps to prevent another financial collapse similar to the 2008 financial crisis.  Those steps apparently encompassed punishing banks with new regulations on their profitable risk-hedging and trading strategies, including passage and/or implementation of Dodd-Frank and Basel III.

With politics as the background, here is what the world’s biggest financial numbers look like today with a discussion of how they looked in the past.  It’s not pretty.

The Numbers

The following is a bubble plot of what is most likely the largest financial figures the world has ever seen.  A table of the figures is given a little later.

The Financial World's Biggest Values

Currency in Circulation

The smallest of the bubbles is the amount of U.S. currency in circulation, at about $1.3 trillion, followed by euro currency in circulation at around $1.5 trillion.  Globally, there is around $5 trillion of all currency in circulation. Amazingly, in 1990 there was a mere $1 trillion; in 2002, $2 trillion; now, just twelve years later, $5 trillion.

EU and U.S. Debt

Next on the list is government debt in the EU and the U.S.  Total European government debt stands at around $15.7 trillion, while total U.S. federal government debt stands at around $17.6 trillion.  If you add in state and local government debt, the total U.S. government debt balloons another $5 billion or so.

The expansion of western governments’ debt has expanded astronomically in recent years, with, for instance, the size of U.S. federal government debt up an amazing $10 trillion over just the past ten years.

The Financial World's Biggest Values, Table

Offshore Accounts vs Derivatives Contracts vs Debt

At about twice as big as EU and U.S. federal government debt is the size of the offshore accounts of individuals smart enough to stash cash offshore – an astounding $32 trillion in 2013. This figure is surely low, with the 2014 estimate at around at least $35 trillion. Total offshore account values may surpass $40 trillion by the end of 2015.

Yet ahead of cash stored offshore by smart (some might say “wealthy”) individuals is that of an investment bank. The estimated value of Goldman Sachs’ derivatives contracts is about $49 trillion.
Besting the notional value of Goldman Sachs’ derivatives by about $11 trillion is the sum of all corporate, government, and consumer debt in the U.S., at about $60 trillion. On top of all U.S. debt is the notional value of all JPMorgan Chase’s derivatives contracts, estimated at about $70 trillion.

Worldwide GDP and Global Debt

Slightly ahead of JPMorgan Chase’s massive derivatives business is worldwide GDP, estimated to end 2014 at $75 trillion. It would not be surprising if JPMorgan Chase’s derivatives business surpasses total measured global GDP in 2015, if not sooner (in fact, it would be surprising if it didn’t).

At about $100 trillion is total government debt across the globe, up an astounding $30 trillion since the 2008 financial crisis. Dwarfing government debt is the sum of all consumer, business, and government debt at $225 trillion. The massive accumulation of debt began in the 80s, and is still growing at an exponential rate.

Derivatives – U.S. Top 25 and Global

Just ahead of all worldwide debt is the top 25 US banks’ exposure to derivatives at about $238 trillion. The master of them all is the notional value of all derivatives contracts in the world, ranging from a low of $700 trillion to as high as $1,500,000,000,000,000. Yes, that’s $1.5 quadrillion.

What Exactly Did Politicians and Government Bureaucrats “Fix”?

So, what exactly is it political and economic leaders are talking about when they say their policy moves “fixed” the world from a financial crisis? The simple answer is – who knows? Some elected officials probably think making it harder on banks to trade in commodities or limiting trading by banks with their own money somehow is making the financial system better.

Judging by the financial numbers, what it looks like happened is policymakers simply kicked the can down the road, at least when it comes to reducing the future costs of government debt.
Eventually, the rooster will come home to roost. When that day comes – i.e. the day when individuals lose trust in the highly leveraged financial system, it will not be pretty. Maybe the “just keep spending” economists will be right that the financial day of reckoning will never come. It’s an unlikely maybe, but hey, everyone can hope.

 

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Central bankers have the option of increasing rates quickly.  They also have the option of taking a plodding approach. Although central bankers could, in theory, increase interest rates just as easily by 200 basis points as they could 25 basis points, investment bankers appear convinced that the latter will be the case for the foreseeable future.

Are investment bankers right?  Could investment bankers be underpricing the risk of central bankers increasing interest rates quickly, beyond just simple baby steps of 25 basis points at a time? Here’s why most investment bankers think the Federal Reserve (and other central bankers) will be slow to increase the target interest rates they control. The graphic below depicts the tightening cycles of the Federal Reserve over the previous 40 years.

(As a note of explanation, the vertical axis is the percentage change in the effective federal funds rate from the beginning of the respective tightening cycle.  Each line on the graph represents a tightening cycle, with the label for each line representing the year in which the tightening cycle started.  The horizontal axis represents the number of days a given tightening cycle has lasted.)

fed tightening cycles

For illustration purposes, take 2004 as an example.  Mr. Greenspan’s Federal Reserve started raising rates in May 2004.  The rate increased from 1 percent to about 5.25 percent over the course of the tightening cycle.  The cycle lasted almost 1,200 days – about three and a quarter years.  As evidenced by the housing market bust, the Fed, under the leadership of Mr. Greenspan, was quite slow at increasing the interest rates, taking almost 800 days to increase the rate from 1 percent to 5 percent and doing nothing for the next 400 days.  The story of an increasingly cautious Fed is readily apparent.  Essentially, with every new cycle over the past 20 years, the Fed has become less “tight”, with a gradual shift downward in the strength of the given cycle.

Does It Matter That the Federal Reserve Has Become More Timid?

In addition to risk taking that otherwise would not have taken place, a more timid Fed has created, in the minds of investors, the expectation that the U.S. central bank will be slow to increase rates. Are investment bankers underpricing the risk that Ms. Yellen’s Fed will be bold and ahead of the curve?  The simple answer is probably not. Even Federal Reserve members’ own expectations are incredibly cautious, with, at the high end, some members putting the federal funds target rate at 2 percent in two years from now.  That’s 2 years and only 2 percent!

A cautious Fed, of course, has not always been the case.  For instance, a bold Mr. Volker quickly increased rates during the hyperinflation years of the early 80s.  But there are no Mr. Volkers at the Fed right now.

Overall, investment bankers, and even the Fed members themselves, have forgotten that the federal funds rate could go from 0.25 percent to 2 percent overnight, rather than take two years to get there.  Although investment bankers may not have underpriced the chance of the federal funds target rate increasing quickly (since it’s basically zero), perhaps the Fed hasn’t forgotten it’s ability to be courageous in the face of unwarranted risk taking.

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