Bridge to Nowhere

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Veteran floor trader Art Cashin has argued for the past week or two that the stock market has come to believe in a “rationality put.” In other words, investors expect that at the brink of disaster, reasonable people will ultimately vote against choosing the disaster alternative.

The current situation surrounding the imminent debt ceiling decision and the pending budget debate is a case in point. None but the most strident libertarian wants to see the government shut down – minimized perhaps, but not shut down. Yet both parties are spending considerable time in front of reporters and TV cameras ascribing such base motives to the opposition party that they might have to settle for shut down as the lesser of two evils.

In an already precarious economic environment, even a brief shut down could have seriously disruptive effects. Virtually all commentators agree that an extended shut down would push the economy back into recession. Nonetheless, investors remain quite calm.

Despite this shut down concern, Syria, and the explosion of central bank balance sheets around the world, the U.S. stock market is barely 2% off its all-time high. There is a remarkable level of confidence that responsible authorities will come to the rescue before any dire situation devolves into catastrophe. It’s logical to suspect that such complacency has been born of the parade of successes that legislators and central bankers have produced over the past five years in pulling economies and strategically important institutions back from the brink of disaster.

It is important to recognize, however, that the problems that have pushed us to the brink have not gone away. The debt problems in the U.S., Europe, Japan and elsewhere have been papered over with more debt. The budgetary problems, which are effectively also debt problems, have been partially addressed by austerity, which is wearing extremely thin in many parts of the world. The majority of these budgetary problems have been deferred, leading to the well-worn phrase “kicking the can down the road.”

Denial and deferral efforts by governments and central bankers remind me of the construction of a bridge to nowhere. Here in Arizona the Hualapai Tribe has built the Grand Canyon Skywalk, a platform built out over the canyon with a transparent bottom. Visitors can walk out and look straight down to the canyon floor. Clearly the structure meets engineering standards and is properly anchored to the canyon rim. Analogously, whether today’s level of debt is properly anchored is subject to debate. It is obvious, however, that the skywalk of new debt over already existing problems cannot be extended too far without collapsing, unless it can be anchored on the other side. At this point, there is nothing firm on the other side to which to attach the rescue skywalk. There is simply a pledge issued by various central bankers to do whatever it takes or to continue balance sheet expansion on a data dependent basis–in other words, to keep extending the skywalk indefinitely. It wouldn’t take structural engineers long to fathom the folly of such planning. Why is it so much more difficult for financial engineers to perceive the obvious?