Even after the Greek debt-swap deal that apparently solved the entire European crisis, Greek 10-year bonds are still trading woefully. The spread above German bunds is still over 1,600 basis points, 86% higher than just one year ago. To some, that is an improvement since the 10-year spread was nearly 3,500 basis points just before the debt-swap. Regardless of any recent improvement and the fact that these numbers are bordering on meaningless, anyone that followed the artificial price regime of the European Central Bank (ECB) these past two years as it sought to deny financial and fiscal reality has regretted it. Unfortunately, most of the European banking complex took that trade.

What do we make of banks that have become essentially insolvent because of their “investments” in Greek and Southern European debt (the same banks that invested in securitized tranches of subprime mortgage structures)? This is not a non-trivial number of banks, both in size of cohort and size of assets. We know this because the ECB was recently forced to hand out nearly a trillion euros in its two LTRO operations (on top of the $100 billion in swaps from the Federal Reserve). It is further confirmed under the European Target II system, whereby “peripheral” or PIIGS countries are currently in the death throes of massive currency flow deficits. In other words, the banking systems in each of the inflicted countries have experienced enough of a run on organic funding sources that even the mercantile trade within the Eurozone is under enormous funding stress. Investors in the inflicted countries themselves refuse to put their money in their own banks.

The central point here is that the banking systems of peripheral countries are now completely dependent on the European equivalent of the discount window. In the US, using the discount window is confirmation of severe illiquidity bordering on bankruptcy. Though there is not a widely known stigma yet associated with LTRO usage, there is an emerging spread between heavy users and those that avoided it. Lack of organic funding or capital flight away from these needy banking systems is nothing more than perceptions of these banks being “shaky”. Bank runs of this kind are visual confirmations from the people closest to the situation that little faith exists in questionable banks to be successful intermediaries and their ability to remain in business without generating large losses in any and all parts of their capital structure. Skeptical investors have good reason, these banks failed the most basic part of their intermediation function – lending hundreds of billions to obligors that clearly cannot repay fully.

In the case of PIIGS banks (and even Belgian and French banks) the lack of confidence stems from overexposure to their own countries’ sovereign debt. Getting back to Greek bonds, I have asked the question of how many banks purchased the country’s debt based on nothing more than “faith” in the ECB to first keep up a constant manipulation of prices and then avoid an outright default (as was promised right up until the end). MF Global was not the only bank that followed such an investment strategy.

In terms of monetary policy and in light of the massive scale of debt losses (estimated losses on Greek bonds are somewhere around 75%), the intervention into Greek debt prices and then bailouts were actually counterproductive. In the name of stability the ECB ended up generating significantly more instability . By first keeping Greek bond prices artificially high, the ECB tempted banks to hold on to their existing holdings, or, like MF Global, to add even more. Banks were further enticed by loosened collateral restrictions that continued to allow Greek bond postings long after it was prudent to do so. These interventions kept up banks’ exposures to the very instruments that were causing the banking crisis, eroding investor confidence to the point that normal funding now is nearly impossible.

For their part, banks became complacent about the real risks associated with holding debt that was erstwhile destined for default. Knowing full well that artificial prices in 2010 and early 2011 were nowhere near reflective of actual value, the risks of holding such debt were downplayed by the oversized commitment of the ECB and Eurozone authorities to their own and their collective detriment. But throughout the global debt crisis the ECB played out the monetary textbook of depressions: that markets no longer reflect true values and must be overridden by an “enlightened” program of intervention.

So the intervening years of chronic crisis in 2010 and 2011 were really a struggle about who was right, the market or the central banks. In the case of Greece, the market was correct that default was a foregone conclusion. Certainly it can be beneficial to avoid a disorderly default, but it does not take nearly three years to accomplish an orderly wind-down, especially since no one in a position of authority ever wanted to admit what was obvious. Instead of returning to common sense, banks followed the path of easy money over hard choices, siding fully with the central bank.

There is a parallel process being played out here in the US (among various other places). The stock market, in particular, has seen what looks like the death of hedging. Short interest is at a multi-year low. The VIX, a measure of implied volatility in stock options and thus taken as a measure of “fear”, is once again at lows. Low implied volatility could mean, among other things, that investors are not hedging against expected short-term dramatic moves. Taken together, with other anecdotal sources, there is a high degree of complacency in US stock investors.

We saw this early last year as well, though the degree of complacency has been surpassed in 2012. Some take it as a simple confirmation that we are out of the woods, that the recession is really over and the recovery is here, and further that the banking crisis has finally been put to rest in a flood of new currency. I believe it is nothing more than a replay of central bank counter-productivity.

What we have seen during the past four years of central bank interventions is rapidly rising asset prices across the board. Though those price increases prove temporary, while they are in play they steamroll higher with little opposition. Whether or not actual central bank liquidity is creating these moves or they are just a self-fulfilling prophecy of expectations about these kinds of markets does not matter. What matters is that we have a well-established pattern and precedent for investors – get out of the way of Fed and ECB balance sheet expansion or pay dearly. These asset price increases make hedging an expensive proposition. Money managers are responding accordingly, creating an additional feedback loop adding to the upward trend. Given the strikingly low trading volumes and near 45-degree ascent of stock prices in the US, these moves (the third in the central bank intervention series) act out like mammoth short-squeezes, accomplishing central bankers’ main goal of rising asset prices.

Modern monetary textbook action centers in large part around the “wealth effect”, where rising stock prices are supposed to tempt consumers into becoming more free with their pocketbooks – by accumulating more debt or saving less (or both). This is believed to be the “holy grail” of monetary effects on the real economy. Getting the level of consumption to increase helps fill the so-called gap in aggregate demand. Stock prices, like real estate in the last bubble period, are key to this economic “salvation”.

From where the Fed stands, the market’s mammoth short squeeze helps accomplish this primary goal. The main economic problem, the weaker than expected recovery, has been that the “wealth effect” has not had much effect at all on consumer spending. Part of this has been due to the lack of available credit, but a significant shortcoming has been the large market and economic swings that have occurred regularly. In order for the “wealth effect” to have any realistic chance of impacting consumer spending patterns, investors not only have to feel optimistic about those rising prices, they need to believe that those prices will actually be around for more than a few months. It is vital that asset prices breed confidence.

Recent market history does not inspire confidence. Judging by the constant flow of money away from domestic retail equity mutual funds, households are not at all persuaded by temporal fits of mammoth short squeezes. The extremely volatile moves of these past four years has blunted any or all of the impact of the potential “wealth effect” by keeping confidence at a minimum, and therefore ensuring, due to the constant withdrawal from stocks by the larger public, that any positive psychology that is derived from asset prices applies to a smaller and smaller segment of the investing public.

The volatility problem, I believe, is directly related to monetary policies and perceptions about monetary policies. As I said above, money managers have taken to the pattern of removing their hedges during monetary expansions. While that does enhance the positive trend of “risk” assets, nothing fundamentally changes about the real underlying risks. So whenever a new episode of risk-flaring occurs, there is a rush to hedge (also a Pavlovian response that is now ingrained by four years of consistent patterning) concurrent with the rush to the exits by investors.

In this important manner, the central bank intervention, acting through the patterned responses of investors, accentuates each market movement. While stocks are rising, hedging falls out of favor allowing that market trend to go much farther than it otherwise might have given a more constant desire to hedge against it. On the other side, with hedging activity so low and complacency so high, any increase in perceptions of fear turbo-charges the otherwise normal impulse to lighten up on positions. The result is immense volatility in large, uninterrupted moves upward and downward traced back to unintended consequences of central bank liquidity programs.

What has effectively happened, in both US stocks and PIIGS credit instruments, is that investors are herded all in one direction or another. Instead of a steady boat sailing through rough seas, everyone on board goes from one side to the other and back again at exactly the same time, augmenting the instability of the tempest in which the vessel is already operating. In the “new normal” of constant intervention, there are no broad interpretations and opinions of prices and conditions since central bank policies only allow one “correct” viewpoint. However, as in the case of Greece or perceptions of the global recovery every summer, when central banks are again proven wrong, everyone shoots to the opposite side en masse – the dreaded crowded trade.

Volatility is the anathema to what central banks are trying to accomplish, yet their policies create the very conditions where large scale volatility not only reigns, it is impossible to operate without it. This is a paradox of central planning in this new normal. To overcome significant fundamental deficiencies in the economy and banking systems requires this herding paradigm since it is believed that the market’s prices, and thus outside opinions, are both wrong and dangerous (since bond prices are the source of contagion, only one opinion, the central bank’s, about bond prices is allowed, and central banks have gone to great lengths to enforce that opinion). Once everyone is on the “right” side of asset prices, either fundamentals have to improve or the inevitable recoil will occur. But the fundamental improvement itself is partially dependent on “normal” conditions, which are not really possible given the oversized impacts of all the herding and the large price swings that result. Massive volatility perpetuates uncertainty and dampens the appetite for both real and financial risks.

To date monetary policymakers are trying to get the public to believe that this is the only course, that, in essence, they are damned if they do, damned if they don’t. The former connotes the failure, thus far, of enacted policies to achieve desired results (a full, self-sustaining recovery, or even a banking system that can operate outside of massive discount window-type support). The latter is simply an assumption based on the view that without liquidity programs the world will end, or at least the financial and economic systems that support Western society will cease to exist. I find that viewpoint to be in opposition to empirical reality, that what ails us, economically and financially, is the inherent contradiction and instability of monetary interventions that lead to counterproductive results. Western economic and financial society, to function properly, actually requires a high degree of stability that can never be achieved by central planning and manipulation. Either markets have to be set free, or they will have to be completely controlled. Those are the only two options for a return to something approaching normalcy.

Try as they might, central bankers cannot just get everyone to agree “all is well” and act accordingly. Markets may be wrong some of the time in setting the important price regime that governs the flow of money through the real economy, but that means that they are right at least some of the time. Since markets cannot be wrong all of the time, any tendency to see an actual decline in asset prices is not necessarily inaccurate, whether that spreads contagion or not. We see this dichotomy break out in other places, notably the demonization of nameless speculators pushing up oil prices. So oil prices are inaccurate results of hot-money evil-doers, but stock prices are unambiguous confirmations of just how successful monetary policies can be. Again, central banks only allow one interpretation. In the end, however, oil and food prices, just like stock and bond prices, are simply reflections of monetary intrusion, and thus growing instability.

Markets may be signaling that all is well, or they may be signaling nothing more than the now-established pattern of money printing in this new normal, where all the old rules are quaint anachronisms (especially the fading notion that healthy markets don’t move straight up for weeks and months without pause). This includes, of course, the idea of market discipline, where declining prices actually connote failure and the need to rebalance and re-allocate. Accepting that interpretation, even though it is traditional and seems out of date in the age of central planning, might actually restore stability. Accepting reality and preparing for it just might be better than ignoring reality and having it forced on you, saving the world the trouble of having the entire banking system as a ward of the various new discount window schemes. But better than that, markets might actually move up on their own, though at a much more measured pace, and stay there .

Asset price declines are not the end of the world, just as rapidly rising asset prices are not utopia. Declining prices are, in their own useful way, necessary components of healthy and stable capitalism. I think the real path to recovery is to allow the financial economy to experience the deflation and financial gravity that it wants to exhibit. If central banks want to get involved they should focus on keeping the fallout within the financial economy, keeping contagion from spreading to the real economy – bank failures do not necessarily lead to real economy deflation. If nothing else, actually allowing financial economy losses would help rebalance the system toward the productive economy over the financial economy, the exact prescription for what ails this global malaise.

If our problems can be summed up (and oversimplified) as too much debt for the achieved level of productive endeavors, then reducing debt through failures and increasing the level of productive capacity through rebalancing seems like the right direction to go. There is little doubt as to why markets do not want to accept manipulated prices that maintain the level of debt while reducing the incentives for productive projects, recognizing that doing so leads to a self-sustaining feedback loop of intervention, manipulation and instability. Not every investor is a free-money chasing global bank conforming to the “correct” opinion.