Sandy, Bernanke and Money

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October 30, from Dr. Jeff Masters of Weather Underground: “In a stunning spectacle of atmospheric violence, Superstorm Sandy roared ashore in New Jersey last night with sustained winds of 90 mph and a devastating storm surge that crippled coastal New Jersey and New York. Sandy’s record size allowed the historic storm to bring extreme weather to over 100 million Americans, from Chicago to Maine and from Michigan to Florida. Sandy’s barometric pressure at landfall was 946 mb, tying the Great Long Island Express Hurricane of 1938 as the most powerful storm ever to hit the Northeast U.S. north of Cape Hatteras, NC. New York City experienced its worst hurricane since its founding in 1624, as Sandy's 9-foot storm surge rode in on top of a high tide to bring water levels to 13.88' at The Battery, smashing the record 11.2' water level recorded during the great hurricane of 1821.”

The Financial Times (Stephen Foley) Friday reported that “Trillions of dollars of stock certificates are feared ruined after Hurricane Sandy flooded a vault at the Depository Trust & Clearing Corp, the Wall Street-owned organisation that manages important parts of the US trading infrastructure… As businesses in the affected areas continued efforts to pump out flooded basements, the DTCC admitted on Thursday that its vault remained underwater and officials had still not been able to assess the damage.”

Of course, with loss of life and such destruction, stock certificates are the least of our worries. And the world somehow survived with U.S. equities markets inoperable for a couple days. But, really, why not a little forward thinking here? Today, millions in the Northeast wait for electricity, and the New York area struggles with incredibly long gas lines, widespread fuel shortages and emptying grocery shelves. Phone service is intermittent, while millions wait for subway and train service to resume. In the past two days, estimates of the economic damage from Sandy have doubled to as much as $50bn. I’m no expert, but the scope of devastation and associated economic costs would appear to just dwarf Katrina.

In the face of human hardship, the big debate seems to be whether Sandy will be a positive or negative for GDP. Will rebuilding provide a needed boost to the U.S. economy? Is it good for stock prices? In the end, does a (Frederic Bastiat) “broken window” lead to wealth creation? Keynes, of course, argued that in desperate times the government should simply pay workers to dig and fill holes. We have instead incredible amounts of sand, debris and water.

My work focuses on risk. Sandy has been called a “once in a lifetime storm,” “a storm of unprecedented proportions.” It is worth noting that of the top ten costliest storms (prior to Sandy) to hit the U.S, eight (Katrina, Ike, Wilma, Ivan, Charley, Rita, Frances and Jeanne) have come over the past eight years. Allison hit in 2001 and Andrew slammed Florida as a Cat 5 back in 1992. At $108bn, record Katrina (2005) costs are more than triple those of runner-up Ike (2008). As for size, at 945 miles of tropical force winds, Sandy is said to be the largest ever to hit the U.S. Sandy is followed by Igor’s (2010) 920 miles, Olga’s (2001) 865 miles, Lili’s (1996) 805 miles, and Karl’s (2004) at 780 miles. Storms have become much bigger and the big storms much more frequent and atypical. The associated costs have grown exponentially. A decade or so ago, I would use my fictionalized “little town on the river” parable. I highlighted how a speculative Bubble in flood insurance led to a huge building boom along the riverfront. From both financial and economic perspectives, the boom distorted risk perceptions and, in the process, momentously increased systemic exposure to the inevitable devastating flood.

I’ll avoid the politics of climate change. I just believe it has become a reality and will profoundly impact our future. From my perspective, global warming adds an important additional layer of systemic risk upon already historic global financial and economic risks. I am amazed at how the world remains in this remarkable mode of disregarding risks of all kinds.

I admit to a fascination for weather and the issue of global climate change. Perhaps it dates back to my youth and love for watching how a big Pacific storm system would unleash crashing waves on the beautiful Oregon coastline. From my reading, a major North Atlantic storm was inevitable – the classic “when and not if.” And the probabilities were increasing by the year. Hurricane Irene (sixth most costly hurricane!) last year was a warning unheeded. Some years back I casually studied the flood maps for the New York region and was quick to revisit them last week when the National Weather Service warned of “Frankenstorm.” The vulnerability was well-understood, as were the fragile levees in New Orleans prior to Katrina. I’ll let others explain why the North East was not better prepared. For me, it’s part of a national affliction.

From a market perspective, Sandy was a so-called “tail” event – or “black swan.” Similar to the 2008 crisis, conventional wisdom would claim it as both an unpredictable and low probability occurrence. A “hundred-year” financial crisis followed by a “hundred-year” storm – what are the odds of that? Not worth worrying about – at least beforehand. Yet I’ve argued that the 2008 crisis was predictable. Indeed, a catastrophic bursting of the mortgage finance bubble was inevitable; it was just the timing that was unknown. While the true long-term odds of a Sandy or a bursting mortgage Bubble scenario were alarmingly high, the near-term probabilities were viewed as quite low. And we live in a world where the overwhelming focus is on the near-term. Like the focus of financial market professionals, it’s imperative to keep one’s eye on the ball: what’s going to happen next week or, for politicians, the next election cycle? Endemic short-sightedness comes with huge associated costs, some visible right now on cable news.

After beginning 1990 at $12.8 TN, Total System Marketable Debt ended June 2012 at $55.0 TN. And Washington politicians and central bankers are now doing everything they can to sustain the Credit boom and avert the downside of an historic Credit cycle. Similar efforts are afoot globally. In Europe, we are witnessing the dire consequences unleashed when the markets resist buying suspect Credit instruments. And, importantly, when the Credit spigot is inevitably tightened, economic revelations soon follow. Suddenly, economic structure matters. Is the system generally robust or fragile? And if the economy proves fragile, the systemic predicament will soon be compounded by huge debt and confidence issues.

From a Credit Bubble and economic structure perspective, Sandy and climate change are very relevant. The prolonged Credit boom has had a particularly profound effect on the North East. From beachfront homes and mansions, to automobiles, marinas, boats, and recreation and related businesses, the boom greatly increased the potential for catastrophic storm losses. This is in addition to the inflated economy-wide cost structure that will see repair and rebuilding costs profoundly higher than would have been the case in the past.

I would further argue that exorbitant costs are an important reason why more was not done to protect against a major Atlantic storm. The piper will now require payment. Our economy’s entire resource allocation system has been so distorted for too long. Finance flowed way too easily into home building, recreation and consumption. Our nation’s infrastructure has been badly underfinanced and neglected. This was made sadly clear with Katrina and again with Sandy. Our nation’s power grid is a bad joke.

Insurance companies will take a hit. From an economic perspective, a much greater cost will be borne by the millions of individuals and businesses impacted by Sandy and her aftermath. There will be enormous uninsured losses that will push many individuals, families and businesses to - or past - the edge. The impact on cash-strapped municipal governments is unclear, although most analysts seem to assume that Washington will be there with open checkbook in hand. In the grand scheme of things, the associated costs will barely impact the massive federal debt load. Along with recession or, even, subpar growth, Sandy will provide politicians another reason to defer fiscal restraint.

But let’s get back to climate change. Unfortunately, the issue gets bogged down on whether warming and associated extreme weather is a manmade or natural phenomenon. As such, most would surely argue that global warming and the prolonged/increasingly vulnerable global Credit Bubble are mere coincidental phenomena. In particular, my trips to China have left me fearing an unfolding environmental catastrophe. In a sad way, it doesn’t really matter if global warming is a human phenomenon or not. It’s pretty clear that no one is going to meaningfully confront the issue anyway. Politicians, central bankers and governments are trapped in “do whatever it takes” late-cycle reflationary measures. You can bet on it. Many have. And the global Credit Bubble dynamic will ensure that the world remains short-sided and blind to myriad serious risks until it’s too late.

We’re today in the midst of the manic financial Bubble phase. Especially here in the U.S., the markets will finance virtually anything. There’s hardly a junk bond the market doesn’t love. CDOs are back. Relatively higher-yielding municipal debt induces salivation. There are, then, no worries regarding the ability to finance Sandy recovery and rebuilding efforts. Costs really don’t matter. Wealth destruction is basically irrelevant. If it’s “money” that’s needed, well, we’ve got the Bernanke Fed. And why not just rebuild on the water’s edge and buy cheap federal flood insurance. “Broken windows,” broken subways, broken transformers, broken communication hubs, and broken neighborhoods are sure to incite a borrowing and spending boom. Dr. Bernanke’s “mopping up” strategy in action.

Yet caution is in order. There will be more storms, some weather-related. And there will come a post-Bubble environment and a profoundly altered backdrop. Previous Credit excesses, suspect debt and market revulsion will make it profoundly more difficult to finance all types of spending. Deeply entrenched structural shortcomings will have surfaced conspicuously. And, importantly, I would expect previous consumption-based borrowing and spending excesses to restrict the system’s ability to finance needed investment and infrastructure projects. Along with economic structure, market confidence really matters.

The market’s love for all things debt today ensures a lot of hatred down the road. Over-issuance and malfeasance risk destroying faith in money. And when that day of reckoning finally arrives, “Keynesian” stimulus will have already exhausted its capacities in a futile effort to sustain an unsustainable Bubble. And perhaps people, businesses and investors will belatedly contemplate risk and head to safer grounds.

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About Douglas Noland