The Matrix

Jean Baudrillard was a French philosopher who wrote Simulacra and Simulation. This was the inspiration for the movie The Matrix. In the movie, people live ignorantly in a projected image that they believe is reality. In the same way, we could  argue that there is no real economy anymore -- just false images.

We know the Federal Reserve’s manipulation of asset prices severely hampers our perceptions of market realities. We have a neat metaphor for this linnking the market to an impossible object -- 2-D figures that cannot exist in three dimensions. “Famous examples include the Necker cube, the Penrose triangle, the devil’s tuning fork and the artwork of M.C. Escher,”. My favorite is the Penrose staircase (see illustration).

The fundamental characteristic behind the impossible object is uncertainty of perception. Can you go up the staircase or down? it is important in understanding the distortions of markets.

We live in a world that is nominally capitalistic. There are profits and losses. There are businesses and stock markets. There are interest rates and prices for commodities like oil and gold. We have the glitter and tinsel of capitalism. But do we have the real thing?

Real market prices reflect a process of price discovery. Buyers and sellers freely do their thing, and the results of their actions are the trails of prices those transactions leave behind. The signals these prices emit are what we rely on to plan and invest.

In today’s modern financial system, this process is arrested to a degree that makes the whole thing a fiction or illusion. In a world where global central banks manipulate the cost of risk,the mechanics of price discovery have disengaged from reality.

Consider the Federal Reserve’s recent announcement for so-called QE3. The Fed will buy mortgages in the form of unlimited $40 billion monthly purchases. It will also continue to keep interest rates low through “at least mid-2015.”

These types of “envy policies” that would be frowned upon by These monetary experiments create all kinds of problems. Super-low interest rates create big funding gaps in pension plans, for example, which could lead to social unrest as those pensions can’t make good on their promises. Super-low interest rates also lead to the creation of a lot more debt on an already leveraged financial system, with little bang for the buck. Each dollar added in debt leads to ever smaller increments of economic growth. What the Fed is doing, essentially, is piling up lots of risks in the system to pump up stock prices in the short term. 

It is very hard to justify the risk-to-reward payoff of this monetary experiment. The defense of quantitative easing rests largely on an assessment of what would have happened to the economy absent its support. Nonetheless, we should fear the law of unintended consequences, because it takes a very small shift in perception to result in uncontrollable socioeconomic change. We may get higher asset prices today, but at the expense of inflation, class warfare, social unrest or something even worse tomorrow.

If the Federal Reserve follows through on its promise to buy mortgages to the tune of $40 billion per month, it will own the entire market in a decade. The Federal Reserve is already the largest holder of U.S. Treasury debt. Keep in mind the Federal Reserve is hardly an economic agent in the sense of normal buyers and sellers. It has its own agenda and an unlimited playbook. It is, in short, the illusionist.

The market is no longer an expression of the economy... it is the economy. In other words, central bank strategy is trying to supplant the needs and wants of the market economy with its own ugly designs. It is as if the economy were a horse that pulled a cart, but the Fed wants to use the cart to pull the horse.

Our fiscal well-being is now prisoner to financial and monetary engineering of our own design. Central banking strategy does not hide this fact with the goal of creating the optical illusion of economic prosperity through artificially higher asset prices to stimulate the real economy. In doing so, they are exposing us all to hyper-reality, or what Baudrillard called ‘the desert of the real.’ 

In Fed speak, this is what Bernanke calls the ‘wealth effect,’  he explained the concept: ‘If people feel that their financial situation is better because their 401(k) looks better or for whatever reason... they are more willing to go out and spend, and that’s going to provide demand that firms need in order to be willing to hire and to invest.’”

Bottom line: We must be careful when we weigh “market” prices. We have to think more creatively about what is real and what is smoke and mirrors. Don’t believe the Fed’s goosing of the market is the real thing. Don’t fall for credit-induced prosperity. More so than in the past, market prices can go up and down for reasons having nothing to do with the fundamentals. Yet in the long run, the fundamentals are the only thing that’s real.