The knowledge virus

[8 min read]

‘A little knowledge is a dangerous thing’, to paraphrase Alexander Pope (An Essay on Criticism, 1711). Pope said a little learning is a dangerous thing. Learning and knowledge aren’t the same. But for the purposes of today’s letter, they’re close enough. Why?

Because political and financial authorities have just enough knowledge to think they’re doing the right thing. But in reality, they’re making it up as they go along. Guided by an instinct for control and a habit of hubris, they are taking all of us over a cliff. Civilisation may never recover from the disaster they are driving us towards.

Example one: the reverse repurchase market with the Federal Reserve. It’s an obscure corner of the financial system. Usually it doesn’t matter. But it does now. The Fed (and other central banks) have flooded so much cash into the financial system with Quantitative Easing (QE) that it has no place to go.

That’s what’s happening in the reverse repo market in the US. On Friday, market participants (mostly money market funds that invest in short-term corporate and government debt) parked US$756 billion in cash with the Fed overnight. In exchange, they received short-term Treasury bills. It was a record high in overnight reverse repos, although you can see from the chart activity has been spiking in recent weeks:

Too much cash, nowhere to go

To make a long story short — and to avoid going into an anatomy lesson about the guts of the global financial system — this is about short-term interest rates wanting to go negative. And it’s about how the Fed has caused that and why it wants to avoid it. It’s about too much cash chasing too few assets with a real yield. And how all that could lead to the crash we’ve been expecting at The Bonner-Denning Letter.

First off, interest rates don’t have a mind of their own. They are set, in a free market, by the demand for money and the supply of it. In an unfree market, where the central bank sets a target interest rate, they are manipulated. In this case, the Fed has pumped so much money into the bond market (the Fed’s balance sheet went over US$8 trillion last week), that bond prices have gone up and bond yields have gone down. Bond yields would go down even further (negative even) if the Fed had not intervened last week.

Negative yields on short-term debt are a problem for the US$4 trillion money market fund industry. Money market funds invest mostly in short-term corporate and government debt. They must earn some sort of yield on that to cover their operating expenses. If they don’t, there’s trouble. It’s called ‘breaking the buck’, where the net asset value of the fund falls below US$1.

The heart of the trouble is there’s too much cash in the system. In a reverse repurchase agreement, a financial player deposits cash overnight with the Fed. The Fed, in turn, gives that player short-term government bills or notes. What’s really going on?

On the one hand, the money market funds can’t find any other place to put the cash. They have to do something with it. The Fed increased the overnight deposit rate on reverse repos to 0.05% after its meeting last week. That partly explains the Thursday spike to three quarters of a trillion dollars.

On the other hand, the Fed has to prevent its target rate from going negative. And it wants to absorb some of the cash it’s flooded the system with. Hence the higher overnight interest rate on reverse repos. It’s mopping up cash to prevent rates from going lower.

What’s especially odd about this situation is that in a standard credit bubble, where there’s too much cash and credit created by artificially-low interest rates, the money finds an outlet. It inflates house prices (Australia), or commodities (oil), or speculative assets (non-fungible tokens, Bitcoin [BTC]). Excess credit creation is like water and the liquidity always finds an asset to inflate.

Only this time, it’s not finding anywhere to go. Money market funds could invest in stocks. But stocks are too volatile. The short-term swings in stocks would put the value of cash at risk. And money market funds attract cash because they are LIKE cash — easy to buy and sell quickly.

Besides, stocks are expensive. Yale economist Robert Shiller’s cyclically-adjusted price-to-earnings ratio, which smooths on the P/E ratio by looking at it over a number of years, is higher than at any time in history, save the peak of the dotcom bubble. Stocks are not cheap at this point in the cycle.

Is this how the greatest bubble in everything, ever, ends? When there’s no place left to put excess cash to work? Historically, bubbles pop when there’s some external shock. Or when the last greatest fool is in the market and there’s no one left to buy. Is that the case?

The greatest fool of all is the Fed. It may end up being the buyer of last resort in financial markets. The bubble it’s inflated looks increasingly unstable. Watch this space.

Meanwhile, a little knowledge in Victoria — that you can create a permanent state of emergency and indefinitely suspend democracy — seems to have taken hold at the highest reaches of state government. Multiple news outlets report that the Andrews government is talking with three crossbenchers in parliament to secure enough votes to make pandemic laws permanent.

If the reports are correct, the proposed changes would mean the government doesn’t have to seek parliamentary authority to extend the state of emergency measures. Those measures authorise it to impose lockdowns and other measures to control a pandemic. It would simply have that power on an executive basis, with or without the approval of the parliament (if I understand it correctly). And you’d assume it would have broad authority to decide what constitutes a pandemic, or even just a public health emergency.

Has there ever been a greater menace to the rule of law and freedom in Australia than the government of Dan Andrews? His lust for authoritarian control over millions of people is now verging on psychopathic. This is par for the course for most senior politicians. But Andrews is taking it to new, unprecedented levels in Australia.

When he is long gone and, hopefully, when the rule of law has returned to Victoria and Australia, people will study this episode carefully. It should never happen again, where one man or a few people have such widespread and arbitrary control over the lives and livelihoods of millions of people. It’s more dangerous than any virus ever could be.

Until then,

Dan Denning,
Editor, The Rum Rebellion

The Bonner-Denning Letter is co-authored by Port Phillip Publishing founder Dan Denning and legendary investment writer and publisher Bill Bonner. It connects the dots between markets, politics, and history as one of the only macroeconomic, ‘top-down’ newsletters in Australia. For a big picture perspective on the past, the present, and your investment future, click here for details on how to subscribe.

At the Mercy of the Foxes
Bill Bonner

Our subject today has a little of everything.

Ambition…betrayal…idealism…cynicism…democracy…revolution…corruption…you name it!

But today’s setting is not the USA. Still, we will turn to the US media for a big surprise, before taking up our parable.

Here’s a rare event…where the reporter got the story almost right. The Hill: ‘Biden approaches economic point of no return’:

‘…Inflation grew by 5 percent last month, the sharpest increase in 13 years. American families have noticed, with prices of gas, building materials, cars and food shooting upward significantly. Inflation is a scourge with a simple solution, but one the Biden administration feels it cannot afford: cutting spending and money-printing at the Federal Reserve. The latest inflation numbers are a blaring red warning sign that is both valuable and honest — it is the last point in which President Biden can put the brakes on before the specter of 10 percent (or higher) inflation.’

The elite control the government. And most of the money the Fed prints goes to them.

Giving it up would mean huge losses. Stock and bond prices would be cut in half, as money printing and rate rigging came to an end…earnings would be reduced too, as boondoggle programs were trimmed back.

And now, so much of the economy has come to count on ultra-low interest rates and stimmy money the Feds can’t ‘taper’ off.

Instead, they have to provide more and more fake money…until the whole system blows up.

Inflate and die, in other words.

Cunning foxes

A return to ‘normal’ won’t happen voluntarily.

But once you have corrupted your economy and your political system, it almost never does.

And so, we come to our marvellous story. What a delight! It caresses our cynicism so tenderly…and demonstrates our theory of government.

In a small, early democracy — like a New England town — a government may be run ‘for the people’ and ‘by the people’.

But in a larger setting, it doesn’t take long before a small group gets control. They are the people the great Italian economist, Vilfredo Pareto, called ‘the foxes’.

They manipulate elections…they ‘sponsor’ candidates…they run for office or lobby the legislators…promise payoffs, contracts, and giveaways…and control the media and the bureaucracy themselves.

They become a more or less permanent ‘deep state’…using the government itself to keep themselves in power.

Usually, the process is hidden behind empty slogans and claptrap politics.

But sometimes, it becomes as plain as day.

Pacific paradise

And so it has…in the bright sun of the Central American isthmus between Costa Rica and Honduras…between the Pacific and the Gulf of Mexico…

…somewhere between paradise and hell.

There, on the Pacific coast of Nicaragua, where the sea breezes keep the temperature from getting too hot…we’ve had a vacation house for many years.

The location is stunningly beautiful. The people are charming, gentle, and nice. And it is far enough from the capital, Managua, to avoid getting involved in politics.

Surfers surf…fishermen fish…retirees lounge by the pool…and neighbours gather in the evening to watch the fat, tropical ball sink into the vast Pacific…

But in Managua, the president — Daniel Ortega — huddles with his henchmen in his guarded compound…and goes over the list of those he will arrest next.

The Wall Street Journal reports:

‘Daniel Ortega, who is seeking a fourth consecutive term as Nicaragua’s president, has launched a broad campaign of repression, according to analysts, human-rights activists and Western governments.’

Iron circle

Danny Ortega’s clique of insiders — the ‘iron circle’ — is in a trap too. It has to use naked force in order to stay in power. And the more violence it uses…the more people are appalled…and the more violence it must use to keep them in line.

Mr Ortega was once a world improver, too…fighting, he said, for a freer, fairer society.

Had he been in power in the 1960s, he might have taxed banks to support his activist agenda. Instead, he robbed them and was put in the hoosegow in 1967.

He stayed in jail for seven years, until 1974, when a group of revolutionaries — called ‘Sandinistas’ — crashed a Christmas cocktail party in fashionable Managua and took hostages.

It was in order to liberate the hostages that the dictator of Nicaragua at the time — Anastasio Somoza — agreed to let Daniel Ortega go free.

Then the Sandinistas went on to chase Somoza out of the country.

World improver turned dictator

And after losing power…and then regaining it as a more modest ‘Christian, Democratic, Socialist’ candidate, Mr Ortega, now 75, holds power…and has become a dictator himself.

His family owns the TV stations. Opposition is outlawed.

And just to be safe, he recently began arresting everyone who looked as though they might pose a threat — including Hugo Torres.

As Ortega stifled dissent, almost all his old comrades turned against him. Torres was one of the commandos who liberated Ortega from jail and later led the Sandinista army against the American-financed ‘contras’.

But last Sunday, Ortega’s cops closed in. Remarkably, Torres was able to send out a video before they put the cuffs on:

‘Today’s paradox of life is that someone who abandoned his principles, Daniel Ortega, the man I helped free 46 years ago, is now my captor.’

If Mr Torres had been able to see what was coming, he might have thought twice about joining the Sandinistas in the first place…

‘Does it really matter who rules Nicaragua?’ he might have asked himself. Or, at least, he might have left Daniel Ortega behind bars.

Government is never ‘all of us’, he might have realised. Some rule and some are ruled. The key is not who rules, but how much ruling he can get away with.

Vicious circle

Mr Ortega has been ruling — in the name of the people, of course — for the last 14 years. He has no intention of giving up now.

Which is OK with us. We don’t much care who rules…or what they call themselves. Democrat. Republican. Sandinista. Communist. It doesn’t matter, we just don’t like anyone telling us what to do.

After working so long and so hard — and robbing banks is dangerous work! — Ortega must figure he deserves whatever power he has gotten. And there’s no reason some jumped-up Democrat should be allowed to take it from him.

But the more Ortega rules, the more he must rule, in order to remain the ruler.

The poor man is trapped.

If he permits a free and fair election, he will most likely be defeated.

Then he will be at the mercy of the foxes, too.

Regards,

Bill Bonner,
For The Rum Rebellion