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Worst Case Scenario: What is It?

This article provides insight as to the way the Fed and all central banks think.

A worst-case scenario is a concept in risk management wherein the planner, in planning for potential disasters, considers the most severe possible outcome that can reasonably be projected to occur in a given situation.

The book Worst Case Scenario Extreme Edition provides hands-on strategies for surviving an elephant stampede, a 16-car pile-up, a mine collapse, and a nuclear attack. Discover how to take a bullet, control a runaway hot air balloon, break a gorilla's grip, endure a Turkish prison, free a limb from a beartrap, chased by a pack of wolves, or buried alive.

Alas, the book does not cover worst case Fed scenarios brought about by Fed policies.

Insight into Central Bank Thought Processes

The following video explains the way the Fed thought in 2006 and thinks again today regarding "worst case scenarios"

Please play the video. It's a real hoot.

The alleged "stress tests" in Europe and the US are bogus.

Currently, the ECB believes Italy will never leave the eurozone and the EU cannot break up.

The Fed does not believe they have blown another bubble.

The interesting thing is the Fed is the very purveyor of bubbles. They do not see it and never will.

The result is bubbles of increasing amplitude over time.

Fed Uncertainty Principle

Let's do another flashback,. This time to April 3, 2008 to my article Fed Uncertainty Principle.

Most think the Fed follows market expectations. Count me in that group as well.

However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences?

More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?

The Observer Affects The Observed

If market participants expect the Fed to cut rates when economic stress occurs, they will take positions based on those expectations. These expectation cycles can be self-reinforcing.

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

Fed Uncertainty Basis Principle:
The fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Hubris

It is the height of hubris for the central banks to believe they can prevent the worst case scenario from happening when they have no idea what the worst is.

Heck, central banks cannot even see obvious bubbles.

What's the Worst?

I don't know but how about a eurozone breakup, an Italian default, and simultaneous wars with Iran and a nuclear attack on or by North Korea, all happening at once.

Even then it's easy to add to that picture with something to make things worse.

I do not suggest my worst case scenario is about to happen or even likely. Yet, Italy can easily leave the Eurozone with disastrous consequences.

There could be a war scenario with North Korea or Iran. Trump could start a very messy global trade war with the entire world.

How about a $trillion derivatives blow-up?

The Likelihood of Unlikely

It's easy to make a case that any one of the above events are unlikely, but is it unlikely that all of them are unlikely?

Is the Fed prepared? The ECB?

Certainly not. Neither the Fed nor ECB sees obvious bubbles. Neither understands that things that "can't" happen, will happen.

If you don't have any Gold, I suggest reconsidering.

Mike “Mish” Shedlock

A liquidity crisis can only happen with FRL. That's the problem. There does not need to be, and in fact shouldn't be "a lender of last resort". That compounds the problem.

In theory fractional reserve lending done with adequate down payment and good assets as collateral works well as long as there are leverage limits and adequate credit quality. Without FRL the economy wouldn't function very well at all. I don't think this is the issue.

No Mish. From 1857 the capitalists have recognised that without central banks to pick up the financial pieces capitalism has extreme difficulty resurrecting itself. For all it's faults the FED is necessary. But this is entirely the wrong question. The right question is whether the FED this time round, already laden, has the capacity to pick up the pieces this time round.

By definition - Free market capitalism and the Fed cannot coexist!

Not to belabor a point. but about fractional reserves. I can agree that they do expose a real solvency issue with banks, however in a panic with or without fractional reserves if everyone hordes money and refuses to let go of it, credit dries up. I see there are other people who agree with you , I googled 1907 and fractional reserve lending but I keep coming to the conclusion that this speaks to solvency more than liquidity.

And totally agree the Fed is the opposite of Free market. By definition they are controlling the price of money.

In a panic where everyone hordes all money, I can buy the world, along with everything and everyone in it, for a penny. Which is a pretty decent incentive for me to limit my hording to, at most, all my money minus a penny…..

Of course, I’m pretty confident any reader of an investment blog would whip out two pennies and outbid poor, stingy me.. And so on and so on…

IOW, the whole “hording” problem is, like all Hobgoblins invented to scare people into accepting intrusive government by their anointed overlords, entirely imaginary.

Free people left alone to maximize utility, don’t just magically freeze up and starve to death on account of weird, theoretical constructs believable only by those too dense to bother looking into the silly assumptions said constructs rest on. America went from wilderness to the Greatest Country on earth without any Fed. So, obviously, lack of a Fed doesn’t cause some form of scary, magical “panic;” on anything resembling an existential scale. Prices on speculative goods rise and fall. Those who borrowed, and lent, against presumed collateral in such goods prior to a fall, may lose their money, lose their house, lose their food, lose their life. Like people have always done. And will always do. None of which is neither here nor there.

Fractional money did not emerge in the banking system in the first half of the 19th century but from industry and bill broking and before that from goldsmith's who discounted the receipts for the gold they were hoarding. The purpose of banks was to centralise individual hoards and central banks to regulate the issuance of notes based on those hoards to prevent over lending. If you suggest that free markets and central banks cannot co-exist history has many examples of the consequences of unregulated financial markets including 2008.

The 2008 crisis had nothing to do with markets being "unregulated" - in fact, mortgage lending was one of the most regulated industries in existence at the time. It had everything to do with the Fed's pumping and blowing another bubble after the bursting of the previous bubble (the tech mania). Other forms of government intervention - such as pushing the GSEs and banks to lend to non-creditworthy borrowers - also played a major role (mainly in terms of which sector the monetary bubble-blowing ended up being concentrated in).

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