Page 1 of 3 CREDIT BUBBLE BULLETIN Too much asset inflation
Commentary and weekly watch by Doug Noland
Stock prices surge to record highs, while credit market risk premiums collapse to multi-year lows.
We're now well into the fifth year of unprecedented monetary and fiscal stimulus - with, incredibly, no end in sight. Predictably, economic results have been disappointing. Also, and just as predictable, the most outspoken proponents of aggressive "Keynesian" measures are these days claiming the limited success is due to stimulus not being administered in sufficiently powerful doses. This is regrettably consistent with the history of
monetary inflations. They corrupt money, minds, markets and economies.
Thoroughly relishing his "I told you so" moment, Paul Krugman titled his Friday New York Times piece "Not Enough Inflation": "Ever since the financial crisis struck, and the Federal Reserve began 'printing money' in an attempt to contain the damage, there have been dire warnings about inflation - and not just from the Ron Paul/Glenn Beck types. Thus, in 2009, the influential conservative monetary economist Allan Meltzer warned that we would soon become 'inflation nation.' In 2010, the ... Organization for Economic Cooperation and Development urged the Fed to raise interest rates to head off inflation risks ... In 2011, Representative Paul Ryan ... raked Ben Bernanke ... over the coals over looming inflation and intoning solemnly that it was a terrible thing to 'debase' the dollar. And now, sure enough, the Fed really is worried about inflation. You see, it's getting too low."
Well, I'll follow Dr Krugman's "told you so" lead. In Credit Bubble Bulletin writings more than four years ago, I pleaded that the Fed not orchestrate a credit bubble resurgence and warned of the major risks associated with the unfolding "global government finance bubble". Rising consumer price inflation has never been the major risk from deficits and Fed monetization. Rather, the risks were of a similar nature to those that fashioned the 2008 crisis and so-called "great recession": gross over-issuance of mis-priced finance, speculative excess and destabilizing asset bubbles. We're now in a full-fledged unwieldy bubble environment on a global basis.
Lots of energy has been expended debating "inflation vs deflation". Deflation adherents have the ball and are running with newfound confidence. The proponents of fiscal responsibility and sound finance are pilloried - and are these days left pondering "what the heck just happened?" Ridiculously, Rogoff and Reinhart, with their apt warning of the dangers associated with high national debt levels, are tarred, feathered and very publicly rebuked. In Europe and here at home, "austerity" has become a four-letter word and economic "analysis" has regressed to little more than ideological mudslinging. Meaningful discussion/debate would immediately shift focus to inflationism and asset bubbles.
A serious dialogue regarding what ails global finance and economies would begin with the premise that finance fundamentally changed during the '90s. There was a proliferation of non-bank credit instruments (asset-backed securities, mortgage-backed securities, "repos," derivatives, etc) and much of this new credit was directed to the securities and real estate markets. This new finance was inherently unstable. The Fed responded, fundamentally shifting its policy doctrine in order to underpin booming financial markets. In the process, central banks nurtured financial speculation and the emergence of a commanding "global leveraged speculating community." The world of finance had never experienced such powerfully destabilizing innovations in credit, monetary policy and market dynamics.
The following data remain key to macro credit analysis: 1995: $654 billion; 1997: $793 billion; 1998: $999 billion; 1999 $1.012 trillion; 2002: $1.429 trillion; 2004: $2.096 trillion; 2006: $2.388 trillion: 2007: $2.552 trillion. These were the annual increases in US non-financial credit - the amount of new credit fuel driving an evolving Bubble Economy Structure. Between 1995 and 2007, non-financial credit inflated from $13.141 trillion to $32.621 trillion, or 148%. This massive and prolonged credit inflation remade the global financial landscape, not to mention the structure of the US and global economy.
Prolonged credit bubbles inflate myriad price levels and fuel atypical (and bubble-dependent) spending, investing and financial flow patterns. Importantly, the resulting financial and economic bubbles are sustained only through ongoing credit inflation and associated asset price inflation. A credit slowdown exerts downward pressure on inflated price and activity levels. Invariably, declining asset prices become problematic, especially late in the inflationary cycle, as falling price levels incite de-leveraging and risk aversion. Mature bubbles require ongoing leveraging and risk-embracement - or else. And it is today almost unbelievable that asset bubble risks are so easily disregarded.
When the mortgage finance bubble burst in 2008/09, policymakers essentially confronted two alternative courses of policymaking. Washington could have allowed the economy to go through a wrenching de-leveraging and economic adjustment period. Considering the degree of credit excess and economic maladjustment fomented during the protracted boom, to wean the US (and global) economy from rampant credit excess would have taken some years
As one would expect after a massive credit inflation, the post-bubble workout period would have featured significant downward pressure on some price levels and on economic activity. The end result, however, would have been a more balanced economy that produces more, while requiring significantly less ongoing credit expansion and financial leveraging. There would have been difficult, trying years, although the upshot would have been a sounder economic structure, reduced systemic fragilities and diminished global imbalances. But this scenario was politically unpalatable. The now Federal Reserve chairman Ben Bernanke spent much of his academic career building a thesis that massive monetary inflation would eliminate much of the traditional downside of bursting bubbles. What most today refer to as "deflation" I call the inevitable consequence of inflationary bubbles.
Policymakers, of course, chose scenario #2, resuscitating credit bubble dynamics and asset inflation. This involved basically nationalizing mortgage debt; backstopping the financial system; doubling Federal debt in four years; zero rates and inequitable wealth redistribution from savers to borrowers; incentivizing speculation; and the monetization of trillions of Treasurys and mortgage-backed securities. As it's been throughout history, monetary inflation was viewed as the readily available expedient.
The massive shot of federal debt and Fed liquidity supported home prices, inflated stock and bond prices and incentivized financial leveraging. Importantly, monetary and fiscal policy inflated aggregate household incomes, in the process ensuring a resurgent consumer, inflated corporate cash flows and earnings. In short, resuscitating the credit bubble and asset inflation was the least painful path to sustaining the bubble economy structure and avoiding protracted economic restructuring.
I have over recent years posited that annual non-financial growth would have to return back to the neighborhood of $2.0 trillion to rejuvenate a more system-wide economic expansion. Last year saw total non-financial credit jump to $1.848 trillion (up from 2011's $1.351 trillion and the low-mark $1.078 trillion during 2009). Monetary policy in particular has inflated stock, bond and even real estate prices.
The surge in system credit growth has benefited state & local finances. Exemplifying how credit and asset inflations seemly improve fundamentals, the more recent jump in private-sector credit expansion has somewhat improved the near-term fiscal outlook at the federal level. Considering the degree of fiscal and monetary stimulus and asset market recovery, economic performance has been notably unimpressive.
We're now witnessing some of the downside of resuscitating credit and asset bubbles. First, an enormous infrastructure evolved over the past two decades that profited from asset inflation. In my nomenclature, the asset markets enjoy a much more robust "inflationary bias" than maladjusted real economies. As we've seen, massive stimulus will generate perhaps a couple percent of US GDP growth while spurring stock and bond prices to all-time record highs.
The Fed dug itself a deeper hole last week when it opened up the possibility of actually increasing its $85 billion monthly "money" printing. When I argued a few years back that a Federal Reserve "exit strategy" was little more than a myth, never did I imagine the monetary insanity that was about to unfold. But, then again, this is consistent with the nature of inflationism. Once it takes root, monetary expansion enjoys powerful momentum and powerful constituents. The bias is always to get bigger, with system deficiencies amply available for justification and rationalization.
The Fed and global central banks have made an incredible mess of things. Global asset markets today enjoy robust inflationary biases, while stagnant real economies suffer from deep structural deficiencies and maladjustment. Dismal economic performance and related fragilities provoke hyper-aggressive "activist" monetary measures that now work predominantly to feed financial speculation and inflate asset bubbles. This has nurtured the Great Divergence - a huge and expanding gulf between inflating asset prices and anesthetized real economies. And, importantly, by stoking the Great Divergence, monetary stimulus today exacerbates global fragilities and instabilities.
Krugman and others argue that the Fed is not doing enough and point to Europe as evidence of the fallacy of so-called "austerity". When I look at Europe, I see the dire consequences of credit excess and asset bubbles on full display. In particular, Spain is locked in depression after housing and mortgage finance bubbles so badly distorted the Spanish real economy. For too long, easy "money" and buoyant asset markets masked deep structural issues in Greece, Portugal, Spain, Italy, France and throughout the eurozone.
It is worth noting a couple of inflationism's major fallacies. First, there is a belief that monetary expansion can inflate THE price level. An inflating aggregate price level is then seen boosting economic activity, in the process allowing borrowers to grow their way out of excessive debt levels. The Bernanke Fed has taken inflationism way beyond Keynes, believing that direct intervention to inflate risk market prices boosts wealth effects and stimulates economic activity.
First of all, there is no overall price level for central bankers to manipulate. It might work in models, but it's just not the way economic systems function - definitely not in contemporary economies.
Especially in a highly globalized economy - and even more particularly with the many nuances of the technology, "digital" and services-oriented structure of contemporary economies - a big inflationary increase in "money" will have widely disparate impacts on myriad price levels throughout the economy and asset markets. As already noted, securities and asset markets today see the strongest price effects. And, for example, if surging securities markets and associated loose finance spur only further over- and mal-investment, the end result could be further downward price pressure on key goods prices (that is, technology and products from China).
The inflationists fail to appreciate monetary disorder's myriad negative consequences. It's the nature of liquidity to gravitate to where it believes it will most benefit from prevailing inflationary forces and dynamics. And with global central banks backstopping the securities markets, liquidity is today further incentivized to play securities inflation as opposed to seeking risky real economy investment returns.
Furthermore, I would argue that speculative and inflated asset markets - along with an expanding Great Divergence - only magnifies the uncertainties already inhibiting investment and economic growth for many key economies. On a more micro basis, inflating stock and bond prices prod company managements to boost returns through stock buybacks and dividends - as opposed to hiring and expanding operations.
Last week I found myself thinking back to the 2004-2006 marketplace and the Fed's last "tightening" cycle. The Fed had (again) missed its timing, having waited too long to begin removing extraordinary accommodation, only to then move too timidly. After bumping rates 25 basis points (bps) in June 2004 to 1.25%, rates were still at only 4.25% to begin 2006. Meanwhile, mortgage credit and home prices were inflating almost exponentially. The Fed boosted rates another 25 bps in January, March, May and June (to 5.25%). After beginning 2006 at about 4.4%, 10-year Treasury yields jumped to almost 5.25% by June.
Then an intriguing dynamic unfolded. In the face of a runaway mortgage finance bubble, 10-year yields reversed course and were back down to about 4.4% by early December 2006. I recall at the time thinking that it was as if the Treasury market recognized mounting bubble risk. And, ironically, as the bond market began discounting the gathering storm, the drop in market yields worked only to throw gas on ("terminal") late-stage mortgage finance bubble excess.
Importantly, the over-liquefied and speculation-rife bubble markets had turned hopelessly dysfunctional. Having missed its timing, the Fed had in the process lost control of asset inflation and bubble dynamics more generally.
With the crowd today celebrating the stock market's record run, I warn of a return of bubble dysfunction. Despite a troubling global economic backdrop, equity prices have surged to record highs while credit market risk premiums have collapsed to multi-year lows. Risk markets have appeared to dislocate. And I believe the Fed will rue the day it spurred the flight of savers out of safety and into these markets. The Fed believed encouraging risk-taking would be good for economic recovery, somehow ignoring the clear risk of fueling yet another bubble.
Well, the Fed is now dealing with historic - and, I believe, precarious - securities market bubbles. And they're bubbles that will demand unending QE - or else risk a very problematic bubble deflation. This is a dysfunctional bubble that likes good economic news but loves weak data that ensures more monetary inflation for longer.
And the greater the Great Divergence - the greater the dysfunction - the more the speculator community can leverage and speculate, confident that central banks are trapped by highly speculative markets, weak economies and acute fragilities. I was really, really hoping the Fed, global central banks and international markets wouldn't drift down this troubling path.
The S&P500 jumped 2.0% (up 13.2% y-t-d), and the Dow gained 1.8% (up 14.3%), both to record highs. The S&P 400 MidCaps gained 2.1% (up 14.2%), and the small cap Russell 2000 rose 2.1% (up 12.4%). The Morgan Stanley Consumer index rose 1.6% to an all-time record high (up 20.6%), while the Utilities slipped 0.3% (up 16.6%). The Banks increased 0.6% (up 11.0%), and the Broker/Dealers surged 4.5% (up 23.2%). The Morgan Stanley Cyclicals were up 2.3% (up 12.0%), and Transports rose 1.7% (up 17.2%). The Nasdaq100 surged 3.7% (up 10.7%), and the Morgan Stanley High Tech index jumped 3.4% (up 8.3%). The Semiconductors advanced 3.6% (up 17.4%). The InteractiveWeek Internet index jumped 2.9% (up 12.9%). The Biotechs gained 1.7% (up 26.0%). With bullion gaining $9, the HUI gold index increased 0.3% (down 37.6%).