"The mother of evils is speculation--leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)
Leveraged financial systems are the ultimate confidence game. Real economic resources are borrowed from their owners and pyramided higher in the form of speculative loans and investments. Profits are created on paper as long as the value of those projects goes higher.
The entire system is inherently unstable and completely depends on maintaining the confidence of two groups of participants.
One group is the original providers of economic resources to the system, such as people who deposit funds in banks. Typically, banks borrow (some might say steal) these deposited funds and speculate with at least $9 dollars out of every $10 put on deposit. If the owners of those economic resources move to call in their original loans (i.e., withdraw their funds from the bank), then the ponzi collapses as banks only have 10 cents of cash for every dollar of deposits.
This is the 'bank run' scenario famously navigated by George Bailey at the Bailey Building & Loan and recently exemplified on a small scale in Cyprus.
The other group whose confidence must be maintained is the speculators who hold those financial assets (stocks, bonds, commodities, real estate) purchased with borrowed funds. Leveraged speculators realize paper profits when the value of those assets goes up relative to the value of their liabilities (i.e., the borrowed funds), thereby leaving larger residual equity.
However, this carry trade implodes when either a) asset prices significantly decline, or b) cost of servicing debt increases. If leveraged speculators fear either of these situations, then they must close out their speculative positions by selling the assets and paying back their loans before insolvency strikes.
This is the deflationary, correlated, waterfall price decline scenario witnessed in 2008.
Policymakers who choose to be complicit in this financial pyramid scheme must act in manners that instill confidence in the two groups cited above. For bank depositors, deposit insurance backstopped by the federal government (read: taxpayers) has largely done the trick thus far. People have mindlessly deposited their funds in banks with little worry about the reckless leverage building in the system.
For the leveraged speculators themselves, policymakers have largely turned to central banks to inject 'liquidity' and associated monetary stimulants whenever it is deemed that the collective speculative balance sheet is at risk of flipping upside down. The intervention has become so addictive that even the suggestion of further stimulants finds speculators salivating like Pavlov's dogs.
As with all ponzis, the only way this system persists is if policymakers are continually successful at medicating confidence among these two groups of participants--particularly those at the margin.
Does this seem a good bet?
The ultimate confidence game resembles the ultimate game of chicken.
position in SPX, Treasuries