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Yesterday I
presented at the Undiscovered Managers’ Wealth Management
Symposium in
Chicago. I would like to thank
Mark Hurley for inviting me to speak, as well as the attendees
for attentively listening to my long presentation. I have included my
talk in its entirety below.
Contemplating the Evolution From the
Way We Were to The Way It Is
“I generally
try not to venture too far from my Bloomberg screen, and I’m
not much for public speaking. Actually, when the
folks from Undiscovered Managers initially invited me to
speak, I at first hesitated. But they cleverly
enticed me with the words “Paul McCulley is going to be
presenting.”
Well, that’s all it took, and I immediately signed
up. There was no
way I was going to pass up the opportunity to go head-to-head
with my analytical nemesis - the most outspoken “inflationist”
on Wall Street.
And despite my disappointment that Mr. McCulley is not
speaking, one of my objectives this morning is to convincingly
refute his call for only greater monetary and fiscal
stimulus. Such
policies are little more than administering greater doses of
narcotic to the desperate junky, while disregarding the
underlying malady.
It is my view that The Inflationists are indeed engaged
in a desperate – and perilous - crusade to sustain an
unsustainable Credit Bubble.
I imagine most
everyone would agree that we are faced with an exceptionally
challenging environment.
There are these perplexing, contradictory views – are
we facing deflation or inflation? Is this post-bubble or
bubble; recession or recovery; bear market rally or the return
of the bull? Is
the economy fundamentally healthy or an unfolding
disaster? Is the
financial system sound or hopelessly unstable? There are convinced
pundits and seemingly convincing analyses supporting
diametrically opposed views. So, what the devil is
going on here, and is there any hope for making some sense of
it all?
Well, I want to
be quite upfront on this: I am here today as a
salesman. But
don’t worry; there’s no need to hide your wallet. I am hoping to sell
you on an analytical framework. It’s very much a
work-in-progress, but I’m convinced that there is a better
mouse trap. I
believe The Inflationists are wrong – dead wrong. I believe the recent
focus on “deflation” risk is misguided. I believe the
generally sanguine consensus view is flawed and confused,
specifically because it stems from an outdated and inadequate
analytical framework.
While
recognized by few, years of study have me absolutely convinced
that we are in the midst of one of history’s great Credit
Bubbles. As such,
the greatest risks today are associated with the continuation
of runaway lending, speculation and financial leverage. Failing to appreciate
the root cause of the boom, the optimists invariably
extrapolate unsustainable Bubble excess. Examples include the
Internet stocks, NASDAQ, the dollar, and now the housing
markets. We now
are in the throes of a historic Mortgage Finance Bubble that,
like the preceding telecom debt and equity Bubbles, will end
in tears. The
consensus view that the
U.S.
financial system and economy are fundamentally sound is
dangerously mistaken.
The U.S. Credit system today is truly out of control,
and the Fed is trapped in disastrous policies perpetuating the
Bubble.
I believe that
if one views the world through the lens of a sound analytical
framework, it becomes clear that the Credit Bubble places the
U.S.
financial system, economy, and dollar at great risk for years
to come.
I chose not to
use a lot of slides today. My various charts of
Credit growth all look quite similar; they are all mountains
that just grow more steeply toward the sky. Some of my favorites
are included in your material, but it’s not a valuable use of
our time to go through them individually. I’m here to sell
concepts – to push a way of thinking about this most
fascinating environment.
But I will
begin by throwing out a few figures to put the ongoing Credit
Bubble into some perspective. During the past six
years total Credit market borrowings have surged $10 Trillion,
or about 50%, to more than $32 Trillion. Over the same period,
financial sector Credit market borrowings – including the
banks, Government-sponsored Enterprises, Securities firms,
asset-backed securities issuers, and mortgage-backed
securities trusts – have doubled to $10.5 Trillion. Total mortgage
borrowings are up $3.5 Trillion, or 66%, since the beginning
of 1998.
And just last
week the Federal Reserve released Credit data from the first
quarter. I will
briefly share a few highlights. Total mortgage
borrowings increased at an annualized pace of $916 billion or
10.8%. To put
this into perspective, this is about three times the rate from
1997. And the
first quarter’s $900 billion plus pace compares to the $204
billion average during the first eight years of the
1990’s. Financial
sector borrowings expanded at a 9.7% rate during the first
quarter. State
& Local governments increased borrowings at a 10.1%
pace. In
contrast, non-financial corporate borrowings expanded at 3%
annualized.
Importantly,
while attention these days is focused on the potential for
deflation and the apparent necessity for even more aggressive
fiscal and monetary stimulus, what is not appreciated is that
we have commenced a period of major divergence between weak
economic performance and only greater Credit excess. I would argue this is
indicative of the terminal stage of a protracted
Bubble.
The consensus
view holds that this is a post-Bubble recovery
environment. But
my analytical framework conveys to me that the previous
corporate bond, telecom, and equity Bubbles were off-shoots of
a much more momentous Bubble that today runs out of control
through the Credit system. I would argue that the
Federal Reserves’ aggressive accommodation, to mitigate the
fallout from booms turned bust in Mexico in 1995, Russia and
LTCM in 1998, and then the technology and equity collapses,
has nurtured only much larger and dangerous Bubbles in
Mortgage Finance, Leveraged Speculation, and Risk
Intermediation.
To hopefully
bring some clarity and continuity to this unconventional and
sometimes confounding analytical framework, I have chosen to
break my presentation into four sections: First, The Way We
Were. Second, The
Way It Is. Then,
Ramifications for The Way It Is. And I will finish up
with Today’s Critical Issues.
The Way We
Were:
Traditionally,
the monetary system was a Decentralized System Dominated by
Local Bankers. Bankers operated with a prudent, “Loans for the
Long-term” perspective. Gain on sale accounting and
marked-to-market did not exist. It was a controlled
banking/monetary system.
Loan growth was limited by reserve requirements and
there was a limited supply of loanable funds. Supply and
demand for these limited funds dictated interest rates, with
the price of Credit a fundamental stabilizing force. Credit Availability
was generally dictated by business profitability and the
expected return on investment.
Bank deposits
were the primary liability created during the lending
process. Or,
stated differently, deposits were the major monetary IOU
issued during financial sector expansion. Hence there was a
strong correlation between “money” supply, the general Credit
environment, and economic performance.
Within this
monetary regime, the Federal Reserve governed currency
expansion and the payment system. The monetary system
was anchored by bank reserves. The Fed carefully
controlled these reserves that were “multiplied” during the
lending process into new deposits. Management of bank
reserves was basically control over system liquidity and the
broader financial environment.
The economy
could be analyzed as an Industrial Economy. Goods-producing
industries were at the epicenter of the economic system – the
horse pulling the financial and services carts. Financial
expansion paralleled GDP expansion, or stated differently, the
expansion of financial claims was largely matched by the
expansion of production capacity. The trade position was
normally balanced.
Excesses were temporary and largely
self-correcting.
Let’s focus for
a minute on Monetary Processes, or the means and channels
whereby liquidity is directed from the Credit system to the
economy and markets.
They were relatively unambiguous back during The Way We
Were.
Liquidity was generally injected through bank lending
to fund business and capital investment. It was a Decentralized
(“local banker”) Credit system, spreading liquidity fairly
evenly throughout the real economy. Business profits were the
driving force for monetary expansion. These processes
demonstrated cyclicality, but were generally
self-regulating.
Asset inflation was the cart and not the horse, pulled
by business lending. Finance flowed first to
business, then to income growth, and then to asset
prices. In stark
contrast to today, the financial sector was lackluster. The “action” was in the
real economy.
It is worth
highlighting the notion of “stabilizing speculation.” With a
controlled and self-adjusting Credit system, emerging
imbalances would actually be held in check by speculators
placing bets that these imbalances would be corrected and
short-lived. In
fact, Milton Friedman years ago asserted that “destabilizing
speculation” was implausible. This is a most
important and pertinent issue. Dr. Friedman’s premise
was almost tenable under The Way We Were’s monetary system,
but such a hypothesis would be absurd today. More on the
contemporary prominence of “destabilizing speculation”
shortly.
And this leads
us to Inflationary Manifestations, or the consequences of
monetary inflation.
Previous causes were not difficult to identify, and it
was generally a case of Too Much Money – chiefly bank deposits
and currency - Chasing Too Few Goods. Excessive lending and
resulting money growth was the culprit, precipitated by the
industrial sector bargaining for limited resources. A deficit
running government sector inflated prices generally as it
imposed larger demands on resources, while pressuring interest
rates as it competed for limited loanable funds. Government deficits
led to a general “crowding out.”
Trade deficits
were an issue, but they were self-correcting. With a limited supply
of loanable funds, heightened demand for borrowings pressured
interest rates and tempered demand. At the same time,
international central bankers recognized the benefits of, and
were committed to, a balanced global system.
Pricing
pressures were generally controllable through the
straightforward management of bank reserves and government
spending.
Carefully managed bank reserves provided a Credit
system anchor.
And it was not unreasonable to focus on an aggregate
price level, with Inflation Manifestations observable and
generally indisputable.
On a Side
Point: This
simple Credit system, comprised of inert bank loans, a
cautious central bank managing bank reserves, and balanced
liquidity predictably entering the economy through the
industrial sector, was conducive to economic modeling. But that was The Way
We Were. We live
in a profoundly changed world today. I will refer to it as
The Way It Is.
This section of my analytical framework draws heavily
from the brilliance of Hyman Minsky, and specifically from his
groundbreaking theories of the Wall Street Paradigm and Money
Manager Capitalism.
The Way It Is:
We operate
today with a dynamic, expansive securities-based Credit
system, with myriad institutions, Credit instruments,
vehicles, and markets.
The contemporary financial system is profoundly
distinct from The Way We Were’s bank lending-dominated
monetary system.
We are thus today forced to take a very broad-based
view of finance and the divergent consequences of an
especially vigorous and enterprising financial
system.
Over time, the
Enterprising Loan Originator and the Aggressive Investment
Banker supplanted the Traditional Prudent Local Banker. This evolution has
transformed the old boring bank loan into a prized speculative
asset. Loans are
absolutely no longer “inert,” but rather a treasured commodity
in the age of aggressive marked-to-market, gain on sale,
securitization, and the “repo” market. This evolution has
witnessed the cautious “Loans for the Long-term” perspective
remade to the aggressive “It’s All About Volume.” There is today little
concern for Credit quality as long as the loan can be
sold. Credit
quality is “managed” on a portfolio diversification basis,
with individual loan quality virtually
irrelevant.
Decades of
notable financial evolution have culminated with what I refer
to as Wall Street Alchemy. This wizardry of
transforming endless risky loans into precious “money” and
“safe” securities is subtle yet profound. Our system today
operates with virtually insatiable demand for loans, with
contemporary risk intermediaries the major players. Look at the GSEs: Fannie and Freddie’s
books of business have more than doubled to $3.1 Trillion in
six years, and if we include Federal Home Loan Bank System
assets, we’re now talking almost $4 Trillion of GSE
intermediation.
The assets of “Structured Finance” – or, at least, the
combined GSE, ABS, and MBS footings – have more than doubled
since 1998 to $8.3 Trillion.
This
Unbounded Risk Intermediation imparts momentous changes
throughout the Credit creation process. First of all, the
system today enjoys an Unlimited Supply of Loanable
Funds. This
offers a stark contrast to The Way Were Were’s tightly
controlled banking system liquidity.
These days
financial sector expansion is in no way constrained by bank
reserve requirements.
First of all, money market deposits are “multiplied”
outside reserve requirements (“infinite multiplier
effect”). The
GSEs, as quasi-government entities with implicit debt
guarantees, have unlimited access to market borrowings. They enjoy
unconstrained IOU expansion, or liquidity creation. Leveraged speculators
also create liquidity - the creation of loanable funds -
through the expansion of financial sector liabilities. The
broader financial sector possesses a blank checkbook to issue
additional IOUs - contemporary “money” and Credit. Banks are now only one
player in the “money” and Credit creating process and no
longer the most dominant. The GSEs and
“structured finance” have been bestowed Kings of “money”,
Credit and liquidity.
And,
importantly, there has been a complete breakdown in the
relationship between the supply and demand for loanable funds
and the price of Credit. As we have witnessed
over the past year, it is possible to enjoy unprecedented
demand for mortgage borrowings satisfied at collapsing
rates. And with
an unlimited supply of loanable funds in the marketplace,
government fiscal deficits inflate financial claims without
any offsetting “crowding out.” This is a Brave New
Financial World.
With an
unlimited supply of loanable funds at Fed-orchestrated
“pegged” borrowing rates, it is perfectly rational for the
financial sector to go for volume and aggressively
leverage.
These dynamics have nurtured a systemic focus on asset
and consumption-based lending, with real estate and financing
leveraged speculation as today’s most conspicuous examples.
And with the explosion in risk intermediation and speculation,
key risks are now managed principally through the derivatives
markets. But
these New Age risk markets are viable only with the specious
assumptions of liquid and continuous markets.
Financial
evolution has fed, and been fed by, the evolution of Federal
Reserve policies.
With the transformation to a non-bank, market-based
Credit system and the resulting irrelevance of bank reserves,
there has been corresponding fundamental revolution with
regard to the Fed’s policy “tool kit.” Our central bank is
now compelled to peg short-term interest rates and promise to
forewarn the marketplace of any intention to adjust the
peg. It has also
become necessary for the Fed to guarantee marketplace
liquidity.
Especially to accommodate the explosion of the
derivatives markets, the Fed must guarantee continuous and
liquid markets.
Nowadays,
Federal Reserve operations work mainly by aggressively
manipulating rates, yield spreads and, increasingly, market
perceptions. In
the process, the new “tool kit” bolsters leveraged speculation
and unparalleled Credit Availability. The key analytical
point is that the effects of today’s operations are so much
more disparate and unpredictable than when the Fed was
managing the bank reserve “anchor”. I would argue
that the Fed is now held hostage to the markets - financial
and real estate - and particularly to endemic Credit market
leveraged speculation.
In short, financial and central bank evolution has
parented a mutant, uncontrollable Credit system. There is no financial
system anchor, while the Fed’s new “tool kit” emboldens
speculators and nurtures excess.
I would argue
that this unrestrained financial environment has over many
years affected major structural changes to the real economy –
foremost fueling the evolution to a Service Sector Bubble
Economy.
I view the
service sector economy foremost as a “monetary” (in the
broadest terms) economy.
The nucleus of today’s economic system is boundless
Credit expansion and resulting asset inflation, rather than
goods production and business (capital) investment. It is my view that the
significance of this transformation cannot be overstated. I was not surprise
that a recent surge in television advertising and ad rates
were one of the early indications of reflation’s
“success”. This
will also be another banner year for attorneys, real estate
agents, insurance salesmen, and mortgage brokers, all direct
beneficiaries of Credit and asset inflation.
I would
argue that while profits remain the centerpiece of
Capitalistic processes, financial and speculative profits
today reign supreme.
Manufacturing and capital goods profits become less
relevant to the economic system by the year; financial and
speculative profits seemingly become more commanding by the
month.
And while the
New Economy has proved resilient and appears at times almost
miraculous, there is no avoiding the reality that our system
is acutely vulnerable to any slowdown in Credit growth. The “seizing up” of
the Credit market during the LTCM crisis, the Telecom debt
collapse, and last year’s general corporate Credit crisis are
examples of inherent systemic fragility.
It is important
today to appreciate what I believe have degenerated into
Dysfunctional Monetary Processes. We operate with a
centralized, uncontrollable Credit system. There is a systemic
propensity to channel excess liquidity to sectors and asset
classes that offer the best opportunity for volume and/or
demonstrate an inflationary bias. Such processes
consistently - virtually by definition – foster runaway booms
and unavoidable busts.
Today,
liquidity is injected into the real economy primarily through
the asset markets, as opposed to financing business spending
and capital investment.
During the past year, total mortgage Credit has
increased a record $937 billion, ten times the increase in
non-financial corporate borrowings. Our financial system
has become hopelessly disposed to fueling destabilizing asset
Bubbles, and our central bank steadfastly refuses to address
this most critical issue.
Importantly,
financial speculators have come to dictate Credit Availability
and system liquidity, with today’s Mortgage Finance Bubble a
most conspicuous case in point. Recognizing that we
have experienced an historic evolution in both the Credit
system and the structure of the real economy, we then must
appreciate that contemporary financial excess creates quite
divergent consequences – or Atypical Inflationary
Manifestations.
Sound analysis
demands that we look broadly at the consequences of Credit
growth. The
key is the concept of Credit inflation - the new financial
claims that create purchasing power - and Credit inflation’s
divergent effects.
These include myriad price effects throughout the
economy and markets, with recognition that financial and
non-financial asset inflation is a fundamental manifestation
of contemporary financial excess. And, importantly,
Credit inflation will also impact both the amount and nature -
or, better said – the quantity and quality of economic
“output.” Our
focus is the inflation of a broad range of financial claims,
with keen attention to the expansion of financial sector
liabilities. We
therefore minimize the relevance of narrow measures of money
supply, the Fed’s balance sheet and, especially, bank
reserves.
Today, the
system suffers most from a case of Too Much Credit and
Liquidity Chasing Inflating Assets. With financing asset
markets the dominant Monetary Process, there is a strong
systemic bias for Credit inflation to manifest into Asset
Bubbles. We now
see exactly this dynamic throughout real estate finance, as
well as in the Credit market with inflating Treasury, agency,
and mortgage debt prices.
Financial
excess will manifest into over-investment in the “hot”
sectors.
Unbridled speculation dominates, thus we face incurable
sectoral boom and bust dynamics. If it’s not technology
or telecom, it will be real estate, healthcare, or
energy.
Mortgage
finance excesses stoke over-consumption and resulting
interminable trade deficits. Consequences include
the massive accumulation of foreign liabilities and a
vulnerable dollar.
I would add that this was a seductively manageable
problem when
U.S.
asset markets were the vehicle of choice for the global
speculators (recycling global dollar liquidity immediately and
directly back to the
U.S.
financial sector), but this is no longer the case today.
Importantly,
our dysfunctional Credit system distorts pricing mechanisms,
creating extreme and unsound divergences. For example, the
global economy suffers from widespread industrial overcapacity
and downward pricing pressures throughout the manufactured
goods arena. At
the same time, there is strong domestic price inflation in
major sectors such as housing, energy, tuition, insurance, and
healthcare.
Similarly,
there are extreme divergences in sectoral performance that
impart major structural distortions to the real economy. Obvious examples
include the protracted real estate boom versus the ongoing
manufacturing bust. But, then again, this is the very nature
of maladjusted Bubble economies.
Returning to my
earlier side point, there is absolutely no way to effectively
model the contemporary Credit system or economy. The economics
profession must adapt and move beyond “The Way We Were” and
its fixation on modeling and econometrics. Analyzing a
complex, evolving market-based financial system with myriad
institutions and instruments is surely at least as much art as
it is science.
.
Ramifications for The Way It
Is:
“Updating”
Minsky’s “Money Manager Capitalism,” I have coined the term
“Financial Arbitrage Capitalism.” The focal point is the
current eminence of Credit market speculation. We operate today with
an energized marketable securities-based financial
system. At this
point, it should be inarguable that contemporary finance
incessantly nurtures leveraged speculation and resulting asset
Bubbles.
This atypical
strain of inflation is quite problematic as it is seductive
and off-limits.
After all, who in
Washington today
would be willing to call for restraint in mortgage
lending? Not the
Fed and certainly not Congress. To make matters worse,
most mistake asset inflation for “wealth creation” and covet
it rather than fear it.
Asset-based
lending is self-reinforcing. Credit excess begets
higher asset prices that provide greater collateral values
that beget only greater Credit and speculative excess. Early economic
thinkers a few hundred years ago appreciated that a monetary
system backed by real estate was inevitably unstable. It may work like magic
at first, as the added
collateral promotes increased lending. But such monetary
backing provides unlimited collateral for borrowing, with
lending excess eventually inflating land prices and
stimulating only greater destabilizing inflation. They knew that once
commenced, there was neither a way to control the nature of
the inflation nor a generally acceptable way to turn it off.
The old economic
thinkers clearly understood inflation dynamics much better
than our contemporary economists.
The Way It Is
operates with uncontrolled “money” creation. This really is an
extraordinary experiment with money. It is not backed by
gold, precious metals, or even constrained by reserve
requirements; nor is there any effort whatsoever to restrict
its supply.
The critical function of “money” creation has been
assumed by enterprising loan originators and risk
intermediaries focused on asset-based lending, commanding an
anchorless system supplying unlimited liquidity. Lacking the discipline
and fortitude to deal with lending and speculating excess, the
Federal Reserve is today impotent to manage our “money.”
Today’s
Dysfunctional Credit System responds abnormally to stimulus.
Under Financial Arbitrage Capitalism, financial speculators
have come to dictate system-wide Credit Availability. The Fed now must
basically peg borrowing costs and guarantee a positive spread
for the speculators in agency and mortgage-backed
securities. This
has created an environment where it is much more attractive
“playing” financial spreads than it is investing in the real
economy with its uncertain business profits.
We experience
today a most virile strain of Destabilizing Speculation. Federal Reserve
accommodation nurtures unmanageable and dangerous lending and
speculative excess.
And, in an important contrast to The Way We Were,
the emboldened speculators nowadays confidently place enormous
bets that these excesses will run unchecked.
A couple of
contemporary dynamics are worth briefly mentioning. First, “Liquidity
Loves Inflation.”
Finance tends to flow in self-reinforcing excess to
the sectors demonstrating an inflationary bias. Today, the Fed wields
impressive power to “reliquefy.” However, this new
purchasing power adores the mortgage markets - homes, as well
as securities - but despises manufacturing and capital
investment.
Secondly, market dynamics rule. Asset inflation – or
what we refer to as bull markets – will tend to gain momentum
and become increasingly unstable over time, culminating with
dangerous speculative “blow-offs.” We have witnessed
these dynamics repeatedly. Examples include
SE Asia,
Russia,
Argentina,
junk bonds, emerging market debt, Internet stocks, telecom
debt, NASDAQ, and equities generally. Recently, a classic
speculative “blow-off” has commenced throughout mortgage
finance – a Bubble of historic dimensions.
The key point
is the following:
If greater amounts of liquidity are released
throughout this dysfunctional financial system, the results
will be only further destabilizing speculation and more
spectacular booms and busts. The Inflationists
dangerously disregard this unfortunate reality.
Perhaps it is
helpful to think in terms of a Manic Financial Sphere
face-to-face with a Despondent Economic Sphere. It is today much
easier to achieve financial profits than true economic
profits. So any
liquidity deluge flows to, and “animal spirits” fixate on, the
“business” of finance.
The realm of Financial Arbitrage Capitalism is
specifically fixated on financial and speculative gains, with
no regard for true economic investment or profits. Moreover, the degree
of “easy money” and financial excess necessary to stimulate
the maladjusted and Despondent economy will excite only more
dangerous excesses for the Manic financial
system.
This leads us
to the critical issue of Financial Fragility. First of all, there
are distinct “Problems with Volumes.” The system that has
evolved will basically do everything in excess. Accordingly,
consumption and asset-based lending win the popularity
contest, as they offer seemingly limitless profit
opportunities and less perceived risk than financing business
investment.
One consequence is weak debt structures created by too
much debt of increasingly poor quality – underpinned by
inflating asset prices.
There is, as well, the paramount issue of Endemic
Financial Leveraging, which I view as a gross Bubble of
speculation. And
there is the systemic fragility associated with heightened
risk intermediation, with systemic risk expanding
exponentially as greater quantities of increasingly risky
loans are extended and “intermediated.”
There are
important issues related to the Proliferation of Structured
Finance. For one,
there is heightened risk intermediation by thinly capitalized
institutions not appreciating Credit Bubble
dynamics.
Regarding the
Proliferation of Derivatives, I have in the past used a flood
insurance analogy:
If inexpensive and easily accessible flood insurance
becomes available, this development will arouse a
self-reinforcing building boom along the river. The newly offered
insurance will increase individual risk-taking behavior and
set in motion dynamics that pyramid systemic risk. Yet the insurance
business will thrive, the riverside economy will boom, and it
will appear to happy onlookers as a “miracle economy.” That is, until the
inevitable flood arrives.
For the
system, derivatives provide the means for altering, disguising
and transferring risk, but not the mitigation of risk. And, unfortunately for
systemic stability, this risk is too often transferred to
speculators and highly leveraged players without the
wherewithal to manage this risk in the event of a systemic
crisis.
Moreover, derivatives and structured finance nurture
risk-taking.
Specifically, they cultivate aggressive lending and
leveraged speculation.
And a few
comments are in order regarding the Government-sponsored
Enterprises (GSEs).
These are very problematic, unmanageable institutions
at the very heart of today’s Bubbles. The GSEs enjoy
unlimited access to Credit, thus operating with an
extraordinary capacity to expand liabilities and create system
liquidity.
They are the major force fueling a historic Mortgage
Finance Bubble, fostering destabilizing asset-inflation,
over-consumption, endless trade deficits, and severe economic
maladjustment.
Moreover, they are the leading creators of system
liquidity.
This role becomes paramount during periods of systemic
stress. I argue
that they now operate as the key “Buyers of First and Last
Resort” throughout the Credit market, essentially
functioning as a Dual Central Bank. They have evolved into
the Liquidity Backstop, emboldening the leveraged
speculating community. This is an especially
powerful and dangerous role for the GSEs. But, at the same time,
they are the “Guardians of the American Dream.” Especially in
today’s environment, the GSEs are politically invulnerable,
and the debt market knows this.
And this
transitions smoothly to the U.S. Bubble Economy. Recall the old adage
“You are what you eat”?
Well, I say “An Economy is How it Lends.” Financial Arbitrage
Capitalism and its Dysfunctional Monetary Processes guarantee
endemic unsound lending and the wholesale misallocation of
resources. The
character of liquidity now significantly impacts the nature of
demand. The underlying structure of the economy is dictated
by, and developed for, Credit-induced over-consumption, while
the general economy has evolved to be asset inflation and
services-centric.
This ensures extreme investment and structural
distortions.
The outcome is
a lot of non-tangible “output” and “productivity,” along with
an enormous inflation of financial claims. The problem is there
is little in the way of true economic wealth to support this
inflation.
Therefore, today’s “monetary” economy is acutely
vulnerable to any reduction in the growth of
Credit.
Today’s Critical
Issues:
The
paramount issue is the intractable Credit Bubble – the
antithesis of the stability offered by The Way We
Were. The old
banking system was relatively simple to govern, while today’s
complex, expansive Credit system is virtually unmanageable.
There are today three interrelated Bubbles. First, the Mortgage
Finance Bubble.
Second, the Leveraged Speculation Bubble throughout the
Credit system.
And third, the Risk Intermediation/“Structured Finance”
Bubble
There is also
the critical dilemma that we Can’t Even Turn These Bubbles
Down, Let Alone Turn Them Off. Mortgage
Finance is today the horse, while the economy is the
cart. The Bubble
throughout mortgage finance has become the overriding source
for system liquidity and income growth.
Regarding GSE
risk intermediation: The thinly-capitalized GSEs balloon
exposure and use resulting boom-time experience to claim they
will never suffer severe Credit losses. The GSEs have
basically become the market, and the day they turn more
cautious is the day the Bubble is in serious jeopardy. Unprecedented mortgage
Credit growth has national prices levitated and many major
localities in dangerous Bubbles. Any reduction in
liquidity risks setting in motion a telecom-style
bust.
Closely related
is the issue of the Credit insurers. These thinly
capitalized financial guarantors have written well over $1
trillion of insurance.
But what would be the consequence - what impact on
Credit Availability - if the insurers were to back away from
writing new policies?
I argue this is yet another Bubble; it only functions
well during expansion.
We have
nowadays a Hot and Cold Problem. There is no
functioning thermostat to even the temperature throughout the
economy.
Speculative finance will feed over-heating in one area,
while out of favor areas freeze.
We face extreme
divergences in relative prices. ECB chief economist
Otmar Issing made some pertinent comments recently when he
stated that the issue today was not deflation but the
divergence of relative prices inherent to Capitalistic
systems. I would argue that our deranged Credit system is
fostering extreme and destabilizing price divergences. A few examples
include:
Healthcare versus manufactured goods prices;
Silicon Valley home prices compared to
Dallas; natural
gas versus computers.
And there is the divergence between stagnant wage
growth of goods-producing workers versus surging income for
real estate agents and mortgage brokers.
We face
Unrelenting Credit booms and Busts: The U.S. and global
financial systems are anchorless and rudderless. I would argue that
uncontrolled Credit systems cultivate price distortions that
are malignant to Capitalistic economies. Free markets and the
effective allocation of resources require a stable monetary
regime. Here
at home, the unstable
U.S.
financial system and economy are trapped in historic Mortgage
Finance excess.
To maintain this Bubble and the attendant Bubble
economy will require enormous unrelenting Credit
expansion. This inflation of financial claims portends a
serious dollar problem.
I would argue
that the Demise of King dollar changes “everything.” We will now face
rising prices for our massive imports. There will be an
ongoing inflationary bias in commodity prices, especially for
energy and precious metals. The specter of endless
U.S. Credit inflation – dollar debasement – has also set in
motion significant speculative flows to non-dollar assets and
markets. This
dynamic has already played a crucial role in the collapse of
global yields and risk premiums, evidenced by heightened
Credit Availability for many economies including
China,
India,
Brazil,
and
Russia.
I am not sure
what it all means, but this is not “deflation.” In aggregate,
we remain in a protracted period of enormous Credit and
speculative excess, with ultra-easy Credit Availability for
most individuals, companies, governments, economies, and
certainly the global speculators. Moreover, this
inflation is accelerating. We today face a
Bubble crisis not a deflation problem. Could the bursting of
these Bubbles end in a deflationary Credit collapse? Absolutely. But I want to make
what I believe is an important point: While it may be
possible to mitigate deflation risk with further monetary
accommodation, there is absolutely no curing runaway Bubbles
with only greater Credit and financial excess. It’s
impossible, impossible, impossible. The Fed and The
Inflationists are fighting a losing battle. They have not only
misidentified the adversary, they are aggressively Arming the
true Enemy.
This is truly a
case of The Implausibility of Federal Reserve and
Inflationists’ Ambitions. Additional money
and Credit will not right previous wrongs. With current
institutional and market structures, it is absolutely
impossible to evenly disburse inflation throughout the
economy.
Today is not “The Way We Were,” with a stable monetary
transmission mechanism and a functioning aggregate price
level. “The
Way It Is” operates with Dysfunctional Monetary Processes,
severe structural economic imbalances, and Atypical
Inflationary Manifestations. Additional stimulus is
only further destabilizing.
First of all,
more stimuli feed unsustainable asset inflation. It augments
non-productive Credit creation, the inflation of dollar claims
with little corresponding increase in true economic
wealth.
Additional inflation also creates erratic and
unsustainable income growth throughout the economy. It fosters an
unsustainable divergence between Credit expansion and the
wealth-creating capacity of the real economy, intensifying
already acute financial fragility. The point being,
reflationist policies only exacerbate Bubbles and
distortions, while further inflating the unserviceable debt
held by our foreign creditors. As an economy, we are
not adequately investing – and our domestic price structure
makes it very difficult to compete globally. But we at some
point will no longer enjoy the wonderful privilege of trading
dollar financial claims for imported goods. We will need
to trade goods for goods.
I believe we
risk an Unfolding Dollar Debacle. The key analytical issue is
the unrelenting and uncontrollable inflation of non-productive
Credit – dubious dollar claims on the
U.S.
economy. This is
the dollar debasement that will continue to weigh on our
currency. And
with the passing of King Dollar we face endless oversupply of
new dollar claims in the face of waning global demand. The recent dollar
speculative Bubble – with resulting artificial demand
supporting the dollar in the face of ballooning supply - has
now burst. But rather than adjusting to the new supply/demand
dynamic, the Fed and U.S. financial sector are inflating the
supply of dollar claims only more recklessly. These dynamics ensure
a most serious dollar crisis.
The Fed is
Playing a Very Dangerous game. Since 1998, the
“activist” Federal Reserve has been aggressively engaged in
Sustaining an Unsustainable Bubble. They almost reached
the end of their rope this past fall. Even ultra-low rates
and extreme Credit and speculative excess were insufficient to
bolster the financial system and stabilize the economy. A desperate Fed
responded by again changing the rules of the game. It not only implicitly
promised the marketplace that it would maintain the short-term
rate peg indefinitely, but the Fed would consider capping
long-term yields as well. This is a truly
historic development – and another huge mistake in a series of
flawed policies.
I fear this maneuver has recklessly opened the lending
and speculating floodgates, inciting the final parabolic
“blow-off” for the Great Credit Bubble. If this is the case,
we are witnessing the absolute worst-case scenario unfold
right before our eyes.
In conclusion,
I actually sympathize with intensive “Keynesian” stimulus
policies, but only as measures to assist the system through
the difficult post-Bubble adjustment process. Aggressive stimulation
today, on the other hand, is little more than John Law-style
inflationism that foolishly perpetuates Bubble excess. Postponing the Day of
Reckoning only ensures a more catastrophic crisis and painful
adjustment later on.”
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