“Volatility is the best policeman of risk assets,” a fund manager told Zoltan. That’s exactly right. Macro regimes, seen as upcycles followed by downcycles, are encoded in VIX futures prices — in the price of systematic volatility. In order to isolate this cyclical component, we descale VIX by the double log transform and we smooth over 100 days. This allows us to see the cycle encoded in the price level — VIX is the price of insurance against market risk. The alternating macro regime is manifest from the dominant pattern in the level of the graph. The dotted line is y=log log 20, the traditional threshold for VIX as an index of fear.
Do all market winters have overbearing policemen? The dot-com winter’s cop is visible the level of the graph. So for the GFC winter. We define the dot-com winter as the period between March 2000 and the end of 2003; we define GFC winter as the period lying between the collapse of Bear Stearns in 2008 and Draghi’s ‘whatever it takes’ speech in 2012. Between the two, the former is a better model for the present market winter, which we date as beginning on the first trading day of 2022.
The GFC winter was embedded in a much more dramatic political economy. The initial US-centric accounts out of the boom and bust turned out to be too provincial. Europe not only emerged as the ultimate source of macroeconomic instability — Shin showed that the banking glut was transatlantic and whose most aggressive actors were the European banks — but also the site of an extended crisis of its own. The European crisis, of course, can be said to have ended with Draghi’s dramatic announcement that he would ‘whatever it takes’ to compress the sovereign risk spreads.
The dot-com winter was much less dramatic. But it was a real crisis that was generative of many future systems of power, as I described in Seeing Like BlackRock.
Wall Street and Silicon Valley were plunged into crisis in the early years of the 21st century. Out of this crisis would emerge three structures of power that would condition world order in the following decades. In 2003, JP Morgan solved the problem of manufacturing safe assets at scale from residential mortgages. In the same year, Google articulated the business model of platform surveillance just as the surveillance state was being articulated by the NSA. Also in 2003, the SEC issued the proxy voting rule mandating asset managers to vote in the best interests of the asset owners they represented at shareholder meetings.
Policy Tensor, Seeing Like Black.
I described the third system of power in that essay — run by professional class elites from E 62nd St — as having its roots in 2003 because of the structural centrality of the proxy voting rule to the rise of what has been called ‘asset manager capitalism’. And, by 2003, the Big Three asset managers controlled 10% of the S&P 500. But I concede that any connecting thread between the crisis and the SEC’s guidance is as good as non-existent. While it is correct to trace the rise of universal owners to that crucial regulatory innovation, we must not imagine asset manager capitalism as coming out the dot-com winter. To the contrary, it was the success of passive investing that led to rise of the asset managers.
What then was this slower, less-emotive crises of the dot-com winter? Part of the puzzle of the dot-com winter is surely that there was a major productivity revival in the early 2000s — a bonanza that was not shared with workers; all of it was confiscated in the interest of the investors.
Yet, the market winter persisted. In fact, investors did not recoup their losses until May 2006. If there was ever an incongruence between underlying economic dynamism and poor stock market returns, it was during the dot-com winter.
It was a strange world. The recession was mild; even if the recovery was jobless. Perhaps the second wave of productivity may have to do with corporate belt-tightening in those days. In any case, workers did not get any raises. After 9/11, Bush would launch his war on Saddam that would come to grief right around the time cheer briefly returned to risk assets.
The market would rally for almost exactly one year between the summer of 2006 and the summer of 2007 — by which time productivity growth had vanished and mortgage defaults were already on their way to wreck the secured funding flywheel. JP Morgan has found the RMBS solution to the problem of sourcing raw-material for the mass production of collateral only in 2003. In 2004-2006, the mass manufacture of RMBS by Wall St had inflated a massive bubble in housing finance — the GFC was caused, in the final analysis, by the coupling of the dealer leverage cycle and the housing finance cycle. By 2007, the party was already up and the “big shorts” were beginning to get their margin calls. The market moved sideways until the Bear Stearns bankruptcy, when a slower slide began before the big sell-offs that followed the Lehman bankruptcy on September 15, 2008.
The present market cycle is governed by a different crisis, of course. Zoltan may be overstating the case that the Fed is de-facto seeking to use the wealth effect in reverse in order to cool the economy. What is clear is that the Fed’s tolerance for market pain is high. They just have to gut inflation because it threatens the credibility of the Fed as an inflation-fighting central bank.
The homology between the two previous graphs is not a coincidence. Both are periods of doldrums due to Knightian uncertainty about the macroeconomy. The great uncertainty in late 2007 and early 2008 was the health of the Wall St banks. The great macro uncertainty today is inflation. At the Bank of England, their risk scenario is a spike of “several percentage points.” Governor Bailey was apologetic that he could not prevent inflation from rising to double digits. “I should emphasise that I do not feel at all - obviously - happy about this,” Bailey told the Parliament’s Treasury Committee.
The centrality of inflation to the present moment is not only due to the Fed’s response function. Inflation now threatens to upend American political economy. CNN reports that 59% of Americans disapprove of Biden’s handling of the economy. These catastrophically bad numbers attest to the crisis engulfing the Biden presidency and the Democratic Party. A new inflationary macro regime is taking shape, complete with the reorientation of Business away from the Democratic Party. The unity of interests that came behind the Biden solution, may turn out to have been a brief affair. It is not clear that the Dems’ awesome fundraising advantage, revealed in the last election, will continue to hold if the crisis intensifies.
The contours of the inflationary political economy are becoming visible as the crisis thickens. Bezos was blunt.
“[The] Administration tried their best to add another $3.5tn to federal spending,” Bezos wrote on Twitter. “They failed, but if they had succeeded, inflation would be even higher than it is today, and inflation today is at a 40-year high.”
Bezos is worth more than $100bn and controls the Washington Post. Elon Musk, worth more than $200bn, looks like he might gain control of Twitter if he fails in his attempts to weasel out. Musk announced that he can no longer support the Democrats.
As West Coast money abandons the Democrats, further inflationary shocks may emerge from Eastern Europe, where the West is now committed to a competition in pain tolerance with Putin. As I have explained before, Putin’s position in Russia is practically invulnerable, while, among world leaders, Biden is most at risk of losing his job. Moreover, Russia and the United States are the only two states in the world that can survive largely unscathed in autarchy. The upshot is that Putin may be able to tolerate the economic war unleashed by the West.
Meanwhile, global inflation, including and especially food inflation, is at least partly under the influence of Russian policy. The Economist, not a rag particularly infamous for over-the-top headlines, warns of the coming food catastrophe in this week’s leader. Putin can use the food weapon, the oil weapon, the gas weapon, the neon weapon and so on, to deliver pain to the West. Given the state of Russo-Western relations, I don’t see why he would flinch. In any case, developments in the Ukraine war itself, quite independent of Moscow’s intent, may yet deliver double-digit inflation to the advanced economies. Poor nations of the globe seem set to become collateral damage. We should expect a wave of social unrest and political instability, and perhaps migratory pulses; both of which are becoming more and more likely as global heating destroys the hitherto predictable climate faced by situated populations.
So, inflation may yet surprise on the upside in a nasty way. If so, the channel would be through commodities, which, as I’ve mentioned before, doubles up as the only place for investors to find protection under such a scenario. If, fortunately, inflation dissipates from here, we should see a big market rally. But nothing I say here is investment advice.
Then there’s crypto. I doubt very much that the crypto sell-off is over. The main question there, it seems to me, is whether Tether will break the buck in earnest; and if so, whether that might trigger a wider conflagration in crypto, if not elsewhere. To be sure, it is hard to see how a crypto rout could have major macroeconomic consequences. But the truth is that we just don’t know. It is, after all, possible that a large institution, perhaps systemically important, may be quite exposed to crypto. We’ll only know when the tide goes out. Indeed, an LTCM-type crisis is be expected from this corner. So, the Fed may be pulled in to provide liquidity and make some people whole again.
Another possible fire that the Fed may find itself putting out could obtain in commodities. The trading houses, whose story is well told by Blas and Farchy, have a culture of betting the house on directional trades. A big move in commodities either way could find one or two belly up. We may look back on the LME-nickel market drama as a prelude to a wider crisis.
So, we have a picture of a series of escalating crises engulfing elite institutions. And these crises are taking place amid a further breakdown of elite-mass relations. I won’t spare you. The outlook is pretty grim. We’ve come a long way indeed since early 2021, when so much seemed suddenly possible. Now we must adapt to the new, harsher realities.