Market Forces and Intervention
Both inter- and intra-market correlations have lately become extremely pronounced. In the stock market it has become very difficult for investors to produce 'alpha', this is to say outperformance based on judicious stock picking. Generally speaking, the so-called 'risk assets' group comprised of stocks, commodities and lower rated bonds tends to perform best when the market's inflation expectations are rising, in short whenever additional money printing is expected. It tends to perform poorly when inflation expectations are declining, or putting it another way: whenever the authorities give corrective market forces some breathing room.
After four decades of unbridled credit expansion post Bretton Woods, too many sectors of the economy have ended up with their balance sheets destroyed as a result of capital malinvestment. The banking system itself is continually under threat of a deflationary collapse due to the enormous amount of credit and fiduciary media created during the serial booms and bubbles.
Central banks have originally been founded for the purpose of forestalling a contraction of the money supply back to its specie backing during busts. Later deposit insurance schemes were introduced and the system was moved step by step toward fiat money, where bank notes no longer represent a claim on specie, but have become a claim on nothing in particular. All of this was done to keep bank runs at bay, take the risk out of fractional reserve banking and make massive government deficit spending possible.
In a fiat money system, an outright deflation of the extant fiduciary media would see the money supply contract back to its 'covered' base (i.e., to currency and the deposits for which currency backing exists). This would be a cathartic event, given that of the roughly $7.1 trillion in money substitutes in the US banking system only $1.64 trillion are actually 'covered' vs. $5.45 trillion in uncovered money substitutes (or 'fiduciary media').
Currency, covered and uncovered money substitutes in the US banking system (data via Michael Pollaro). The surge in covered money substitutes owes to the sharp increase in excess bank reserves at the Fed.
The 1907 panic in the US, where JP Morgan organized and financed a banking consortium to keep a bank run from spreading was probably the crucial event leading to the third – this time successful – installation of a central bank (the groundwork for this had already been laid with the National Banking Act in 1863, which was strenuously opposed by the then 'hard money' Democrats). The timing of its founding also conveniently happened to precede the beginning of WW I by less than a year. The result of seemingly taking the risk out of fractional reserve banking soon became manifest in one of the biggest boom-bust sequences in history.
As noted above, the move to a 'pure' fiat money system happened step by step. After the breakdown of Bretton Woods, credit and money supply inflation really took off like never before. In 1995, the Fed reduced required bank reserves to practically nothing by allowing 'sweeps' (where sight deposits are swept into so-called 'money market deposit accounts' overnight so they can masquerade as saving deposits), which gave the inflation of fiduciary media yet another shot in the arm (for details on this see this paper py Charles Hatch – pdf). Securitization later gave rise to even more pyramiding of money claims.
Every recession was countered with more monetary expansion, with the real economy's growth falling ever more behind relative to the credit and money supply expansion. This is illustrated by the following chart comparison (even though the GDP series is flawed, it gets the major point across):
Total credit market debt owed vs. real GDP, 1971 to today – click for higher resolution.
Another way of looking at this is to divide GDP by total credit market debt, i.e., a ratio chart that shows the decline of economic growth relative to debt growth. Note here that GDP contains government spending as well, while excluding all spending on intermediate goods (in other words, it includes what represents a burden on the economy, while excluding a significant portion of economic activity), but if we were to substitute the total of the gross domestic output per industry accounts for GDP, this would not alter the trend this chart depicts.
