Have We Reached Peak Wall Street?

An argument its dominance is in decline
Monday, March 31, 2014, 7:14 PM

Though the mainstream financial media and the blogosphere differ radically on their forecasts—the MFM sees near-zero systemic risk while the alternative media sees a critical confluence of it—they agree on one thing: the Federal Reserve and the “too big to fail” (TBTF) Wall Street banks have their hands on the political and financial tiller of the nation, and nothing will dislodge their dominance.

Given how easily the bankers bamboozled the Washington establishment into bailing them out in 2008 to the tune of tens of trillions of dollars in backstops, guarantees, subsidies and zero-interest loans, this is a reasonable assumption. Especially when coupled with the free hand the Fed has to reward the banks with zero-interest loans and limitless liquidity.

Add in the unsurpassed political power of the banks’ lobbying and campaign contributions and the hog-tying of regulatory agencies, and it’s no wonder few see any threat to the Fed/financial sector’s dominance.

There’s also a compelling narrative that supports the Fed’s policies of keeping interest rates near-zero by printing money to buy mortgages and Treasury bonds: were the Fed to allow interest rates to normalize back up to the historically average range, credit-based consumption and housing sales would dry up, pushing the nation into a recession or even a depression.

What’s left unsaid is that such a contraction in credit would severely undermine the banks’ profits and solvency, and that it's that which is driving the Fed policy more than a concern for Main Street. Take a look at what happened to phenomenally robust financial profits in 2008: a contraction in credit caused financial profits (and solvency) to absolutely crater.

Interestingly, the collapse of financial profits back to 1.5% of GDP (gross domestic product) merely returned the financial sector to the level of profit it had earned in the 1960s and 70s. No one reckoned the high-growth 1960s were a depression, yet the collapse of financial profits back to the level of the go-go 1960s triggered the systemic insolvency of America’s financial sector.

This chart reveals the key driver of Fed policy: the enormous profits of Wall Street and the TBTF banks are based on an extraordinary expansion of leveraged credit that is visible in the red line—the ratio of total credit to GDP.  This line traces out the birth of financialization in the early 1980s and the implosion of leveraged debt in 2008.

Simply put, the only way the financial sector (Wall Street and the banks) could continue to grab almost 5% of the nation’s entire output as profit is if the Fed keeps interest rates near-zero and floods the system with the limitless liquidity of expanding credit and money-printing. Here is a snapshot of the Fed’s balance sheet, which reflects its unprecedented expansion of money:

This chart shows that the Fed manipulates interest rates by buying equally unprecedented amounts of mortgages and Treasury bonds:

Thus there are three reasons why analysts extrapolate the Fed’s current policies in a straight line into the future:

  1. Any contraction in credit would once again imperil the financial sector’s profits and solvency.
  2. Since Wall Street is politically dominant, the Fed will not allow credit to contract.
  3. Mainstream economists and politicians fear a recession triggered by credit contraction more than they fear a collapse of the U.S. dollar.

Analysts extrapolating Fed money-printing into the future conclude this expansion of the U.S. money supply will eventually devalue the U.S. dollar.  The mechanism for this devaluation is easy to understand: potential buyers of Treasury bonds will begin wondering if the piddling inflation-adjusted returns on Treasury bonds are worth the risk that their bonds will be redeemed with currency that is worth a fraction of the value they bought them with.

The Fed could respond to this bond buyers’ strike by printing even more trillions to buy even more Treasury bonds than it already buys every year, but the fact that the Fed might be forced to become the buyer of last resort is hardly a vote of confidence in the policies that support financial profits at the expense of market discovery of price and value.

Stripped of obfuscating complexity, a bond is a claim on future national income, and a bet that the currency used to redeem the bond in the future will have the same value as the currency initially traded for the bond.  If doubt arises about this, buying the bond or owning the currency is a bad bet.

As a consequence, many observers have concluded that the Fed can’t stop printing money and keeping interest rates near-zero (because those policies enable the financial sector to skim its hundreds of billions of dollars in profits) and so the U.S. dollar is doomed to devaluation and eventual loss of its status as the world’s primary reserve currency.

The Reserve Currency

What is a reserve currency?  Although the subject deserves a book-length explanation, let’s pare it down to the essentials.

First, we need to understand that currency (money issued by nations) is a commodity like any other. The global currency exchange (called the FX market) discovers the price of currencies by supply and demand, just like the markets for wheat, oil, lumber or other commodities.  Various nations can arbitrarily peg their own currency to another currency, but ultimately the value of every currency is set by supply and demand.

Second, we need to differentiate between a trading currency and a reserve currency. Many people confuse the two. Let’s say a Chinese company buys sugar from Brazil and a Brazilian company buys electronics from China. The firms exchange Renminbi (yuan) and Brazilian Reals.  These are trading currencies, as they facilitate trade between two nations.

A reserve currency is a currency that nations hold as reserves to protect their own currencies from market shocks and as collateral for credit issued by the nation holding the reserve currency.

Gold is one form of reserve/collateral. In a gold-backed currency, the currency is directly pegged to physical gold. When the U.S. dollar was gold-backed, other nations could trade $35 for an ounce of gold.

Nowadays, there are no explicitly gold-backed currencies, though many nations hold gold as a form of collateral.

A reserve currency acts in a similar fashion, as a predictable store of value that can be easily bought and sold on the global marketplace.

When markets lose faith in a currency’s value, traders sell the currency before it loses any more value.  This selling lowers the value, creating a self-reinforcing feedback loop of selling triggering more selling.  This creates a currency crisis as the currency rapidly loses value. To stop the crisis, the issuing nation must sell collateral (gold, reserves of other currencies) to sop up all the selling. If the nation fails to stem the crisis, its currency collapses once its reserves are gone.

What does all this mean? What it boils down to is the global currency markets impose a discipline on money-printing. If a country prints its own currency with abandon and does not build up equivalent reserves/collateral to back that expansion of currency, eventually the nation’s money-printing devalues the currency.  Once the currency loses most of its value, the country no longer has the means to buy oil or other goods from other nations.

There is one general exception to this discipline: the nation that issues the reserve currency can print more currency and as long as there is sufficient demand for that currency as reserves, the issuing country has the “exorbitant privilege” of issuing intrinsically worthless paper and exchanging it for very valuable commodities such as oil, electronics, autos, etc. (For more on this topic, please see Understanding the "Exorbitant Privilege" of the U.S. Dollar)

Currently, the primary reserve currencies are the U.S. dollar and the euro.

Though some analysts argue that the reserve currency is a burden whose benefits are outweighed by its liabilities, the privilege of being able to issue your currency and exchange it for real goods and services without regard for one’s own collateral reserves should not be underestimated.

Simply put, the U.S. dollar’s status as a reserve currency is a key component of U.S. global dominance. Were the dollar to be devalued by Fed/Wall Street policies to the point that it lost its reserve status, the damage to American influence and wealth would be irreversible.

What if Wall Street is Recognized as a Strategic Threat to the Nation?

As a result, I discern another possibility to the consensus view that the Fed/Wall Street will continue to issue credit and currency with abandon until the inevitable consequence occurs, i.e. the dollar is devalued and loses its reserve status.

I propose an alternative narrative for consideration, in which the other power centers of the U.S. government (known as the Deep State) awaken from their ignorance of finance and awaken to the fact that Fed/Wall Street policies constitute a strategic threat to the dominance and prosperity of the U.S. nation-state.

In this view, Wall Street’s power has peaked and is about to be challenged by forces that it has never faced before. Put another way, the power of Wall Street has reached a systemic extreme where a decline or reversal is inevitable. 

Part 2: The Implications of a 'War of Elites' focuses on how, as a result of its over-reach, Wall Street is at risk of encountering blowback from forces that the financial sector assumed were benign or under its control. Now that Wall Street poses a strategic threat to the viability of the American Project, its dominance may well be about to be challenged in ways few imagine possible.

What would such a power struggle look like? How would it unfold? What would the costs be to society? How will the rest of us be affected?

Click here to access Part 2 of this report (free executive summary, enrollment required for full access).

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LesPhelps's picture
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Currency as a commodity

It's important to never make light of the reality that currency is not a commodity "like any other."  It is a commodity, but has different characteristics.  Perhaps primary among these is that it has no intrinsic value other than the value that people perceive it to have.  You cannot eat it, use it to provide energy or make jewelry out of it.  When people decide it is worth nothing, you toss it or burn it.

FreeNL's picture
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The only thing that has not

The only thing that has not peaked yet is evil. Give it another few years i suppose.  

charleshughsmith's picture
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money as commodity

Hi Les: Good point--I should have clarified that currencies trade like commodities, not that they *are* commodities. To some degree, fiat currency is a claim on a nation's future wealth and income stream. That is difficult to assess, so the price discovery of open markets is an approximation of trust/faith in that claim.

Interesting comment about Peak Evil.  I am proposing that financialization has consumed all the oxygen in the room, so everyone living off financialization has less room to maneuver.

agitating prop's picture
agitating prop
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The 'deep state' is likely

The 'deep state' is likely not at all ignorant of economics. The warfare state's function is to expand markets, force the dollar down the throats of all other nations.  It doesn't matter if the dollar loses value, it will still serve as the reserve currency. Nations that don't comply will be bombed into compliance. 

As long as the U.S. is in pillage protect and pulverize mode, the dollar is likely to retain reserve status AND maintain purchasing power relative to other currencies. 

We're not talking about the various ships of state bending to market dynamics, using different navigational tools that could have them colliding with one another. What you have here is loosely aligned federation of pirates, flying the skull and cross-bones. Regardless of how witless their front men politicians appear, they will all plunder and punish together. 

Wall Street is going to remain surprisingly vital, as a consequence,  IMHO. 

charleshughsmith's picture
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very speculative

Just want to stipulate that my conjecture of rising disunity in the Deep State is speculative, and as agitating prop says, maybe the status quo will lumber on for years or decades to come. That said, various other forces in the world that cannot be bombed into compliance (for example, China, Brazil, and Russia) have made clear their desire to assemble an alternative to the USD, so we have to remain alert to the complexity.

BeingThere's picture
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Peak Evil?

The fact that people living of financialization has less room to maneuver makes me a bit nervous. They were trying to get the Ukraine into the IMF austerity binge for those in the position to make money on it's public sector. It could be dangerous since these are the same people who make money in the fog of war.

That said, if Wall Street is the only option, we're all in deep trouble. The only way this could work out even half way decently is if those in power walked this back a bit, but not to worry, they won't.


Time2help's picture
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Peak Evil

Not yet...but give it time.

AKGrannyWGrit's picture
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4- Horsemen

The Four Horsemen

  • White Horse - Conquest
  • Red (blood) Horse - War
  • Black Horse - Famine
  • Pale (sickly green) Horse - Death

Fits doesn't it!

AK Granny

gillbilly's picture
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Just heard an interview with Michael Lewis on NPR. He has a new book out "Flashboys" on the topic of hyperfrequency trading. He mentioned there is a new exchange IEX (investor's exchange) that is designed to put all trade orders at the same speed, hence, eliminating HFT.  I guess investors are pouring into this market in droves. Charles are you or anyone else familiar with this exchange? Comments?

Denny Johnson's picture
Denny Johnson
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gillbilly...I thought this a good read on the subject:

and a somewhat farcical follow up on CNBS, this makes more sense if you read the above first:

davefairtex's picture
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IEX - Peak Wall Street

I really enjoyed watching the clip.  I especially liked the bit where the reporters suggested that more regulation was the answer, and the response from Katsuyama was that the regulators don't need to do anything - he was confident enough to just let the market decide.

The fact that large buy-side people are behind IEX tells me this likely has legs, and the other exchanges are finally going to have to stop relying on money from the HFT front-runners for co-location fees and give the buy side customers an even break, or have their lunch eaten by IEX.

As a trader, I really like the idea of having an order placed between the bid/ask.

This is a speed-of-light problem, some people understand it (and those are the people making money), and some don't - and those are the ones being picked off.  And now that everyone knows they're being robbed, it won't take long until the sharks don't have anyone left to feed on.

I came out of this wanting to route all my orders to IEX.

Perhaps this is a sign of Peak Wall Street.

cmartenson's picture
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An Awesome Mini Victory
davefairtex wrote:

I came out of this wanting to route all my orders to IEX.

Perhaps this is a sign of Peak Wall Street.

While I think the time to have begun cracking down on HFT was 2008, better late than never.

I am taking some satisfaction in the fact that Virtu, one of the leading HFT abusers, was inches away from going public via IPO and has now pulled its offering in the wake of the heightened publicity.  At least they don't get to grab that particular brass ring right now.

Of course we've been all over the HFT issue here for years having had Joe Saluzzi on a couple of times, Erik Hunsader of NANEX, and generally using HFT as a prime example of why we don't trust these markets.

And even though IEX is now in the game, they are very small potatoes compared to average daily volume and it is still true that 99% of all quotes on the daily tape are put there by trading algorithms.  So even with the revelations, I flat out don't trust these markets and think they are still structurally unsafe, by which I mean the liquidity from 99% of the apparent volume can go away in an eyeblink.

charleshughsmith's picture
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HFT and Peak Wall Street

Gillbilly, I do see the HFT "scandal" (only 5 years in the  making, ahem) as evidence of peak Wall Street, and also how the process of blowback is not predictable or linear --we can predict blowback/pushback and a loss of trust, but we can't predict the trigger or the timing.  The fact that Michael Lewis is a well-known financial writer helps, but as he himself said in his interview with Charlie Rose on PBS last night, he was overwhelmed by the response.  In other words, this awareness of rigged markets had been simmering along at perhaps 2% , and once it reached the critical 4% Pareto level (64/4 rule being a reduction of the 80/20 rule) then suddenly the 64% are aware that the market is being openly labeled rigged by a knowledgeable public figure.

kaimu's picture
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Aloha! One way I measure "Peak Status Quo" is to follow the US Treasury Daily Statements combined with the goings on at the US FED, mostly the QE part. While HFT and jobs numbers are nothing more than crony capitalist diversions the real story is the QE. We all know and have heard all about QE from Bernanke and now Yellen. It is well publicized. What of the US Treasury QE? I distil the US Treasury QE down to one line item. It can be found under TABLE III-A.

Take a look at what happened at the US Treasury on the last two days of March.

MARCH 28, 2014

MARCH 31, 2014






While the US FED is decreasing its QE stimulus the US Treasury is increase its QE stimulus. You can boil both QEs down to one purpose and one purpose only for the status quo … STAY IN POWER!

Remember the number above are only for FY2014 H1, the first six months of the fiscal year. We are on tap for our first fiscal year $2TRIL net debt increase.

Never in US History has so much debt and taxes been expended to keep PEAK STATUS QUO in power. At the current debt and spending rates at the US Treasury historians would think we were engaged in WW3! In reality we have been since the day Congress signed off on TARP!

Hey, its April-l-l-l!!

"It was a bright cold day in April, and the clocks were striking thirteen!" - George Orwell, 1984

Adam Taggart's picture
Adam Taggart
Status: Peak Prosperity Co-founder (Offline)
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Posts: 3312
Our past podcasts on HFT

As continued grounding for this discussion, I highly recommend revisiting several of the HFT-focused discussions has hosted in the past:

1) Joe Saluzzi: HFT Parasites are Killing the Market Host

2) Eric Hunsader: Investors Need to Realize the Machines Have Taken Over

3) Joe Saluzzi on High-Frequency Trading: The Equity Market Is Now Controlled by the Machines

gillbilly's picture
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Posts: 423
Thank you

Denny for the links. I agree wtih Dave, the video was entertaining. There was a certain desperation and anger in the reaction to the book and the exchange. A couple of things that weren't mentioned that I gleaned from the NPR story was the irony of the fact that HFT really came into its own and took off after the 2007 crash, not before. How ironic, since after the crash the call was for more honesty and transparency.

Charles, I see IEX as a small first step in the stepping away and down from complexity. Something you wrote about before as an inevitability. Interesting stuff.

IEX only formed in 2013 and it has been doubling it's business every month. The funniest part about this is that they wanted to use the internet url "" but realized it would get filtered out as a porn site. Lol The NYSE has expressed interest in buying it... some think it's to restore confidence and honesty back to the markets. Hmmm, the waters are muddy...

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