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5 CREDIT BUBBLE
BULLETIN Reflation
contemplation By Doug Noland
COMMENTARY "The same voices
that supported tough macroeconomic policies to
deal with the excesses of spending and borrowing
in east Asia, Russia and Latin America are today
pushing for a significant relaxation in the US to
deal with the so-called subprime crisis. Interest
rates should be slashed quickly and US$150 billion
put into taxpayers' pockets by April at the
latest, they say. The goal seems to be to avoid a
2008 recession at all costs. As Larry Summers,
former treasury secretary, put it, failure to act
would make Main Street pay for the sins of Wall
Street." - Ricardo Hausmann,
director of Harvard University's Center for
International Development,
Financial Times, January 31, 2008.
There's
no free lunch in finance nor from inflation. For
now, though, Wall Street celebrates the Ben
Bernanke Fed's rapid-fire slashing to a 3% funds
rate. The bank index has now rallied 28% off of
recent lows, the Homebuilders 59%, Retailers 25%,
Transports 19% and the Broker/Dealers 25%.
There is an overwhelming consensus view
that aggressive rate cuts are precisely the policy
prescription to stem housing-price declines, to
hold recessionary forces at bay, and to reliquefy
the Credit market. Underlying fundamentals are
sound; we just need a helping hand to get through
this credit "rough patch", they say. The Fed
finally "gets it," Wall Street pundits assure us.
Over the short run, there are some obvious
benefits to inflationary negative real interest
rates. Mortgage borrowing costs have fallen
sharply, creating a more conducive environment for
home sales while inciting yet another refinance
boom. Stocks benefit from the paltry yields of
competing assets, including bonds, deposits, and
money market funds. Many top-tier companies will
see their cost of funds decline. Markets in
general receive a boost of confidence from the
belief that the Fed is now attentive and
aggressively on the path of supporting higher
asset prices.
Only time will tell how this
latest "reflation" eventually plays out. It's my
view that Wall Street is taking a typically rather
short-sighted and shallow analytical approach to
the issue. The consensus believes that further
significant house price declines would be
catastrophic for a highly leveraged household
sector and acutely fragile credit system. Others
note the equally obvious fact that this is a
particularly inopportune time for the economy to
slip into recession. Apparently, the risks of
failing to aggressively ease monetary policy
greatly outweigh the limited inflationary risks.
If it were only that straightforward. There is
never a good time to collapse a bubble.
I
believe actual risks are altogether different from
what Wall Street perceives. First of all, the
potential enduring benefits from a sharply lower
Fed Funds rate are exaggerated. Housing markets
will benefit only marginally from what has so far
been but a moderate decline in mortgage borrowing
costs. Meanwhile, much tighter credit conditions
and negative sentiment will restrain mortgage
lending for years come. Remember, "reflations"
notoriously have only minimal impact on the bubble
markets recently having gone bust, generally
exerting powerful effects instead on fledgling
bubbles and other inflationary biases.
First post-crash reflation
bid Importantly, we're now in the midst of
the first Wall Street finance post-crash reflation
attempt. It is analytically imperative to
recognize that - because of the newfound impotence
of structured finance - the current reflation will
be different in kind from those that preceded it.
Wall Street-backed finance was predominately in
the business of lending, securitizing, leveraging
and hedging in asset markets (especially real
estate, stocks and debt securities). Therefore,
reflations operating within a backdrop of a
bubbling Wall Street credit apparatus demonstrated
a very powerful asset market inflationary bias.
Moreover, with abundant reflationary liquidity
flowing predictably to US housing and securities
markets, inflationary forces were (atypically)
contained with minimal impact on general consumer
prices.
Now, however, the bust in the
securitization markets will for some time exert a
major drag on US asset inflation, while unleashing
greater liquidity to play havoc with a vast
multitude of prices at home and abroad.
Furthermore, previous reflations - where US asset
prices demonstrated the prominent inflationary
bias - worked to promote underlying demand for
dollars (to purchase US assets), despite the fact
that dollar-denominated credit was being inflated
in excess. Today, in stark contrast, prevailing
inflationary biases are global in nature,
exacerbating dollar selling pressure within a
backdrop of ever-increasing dollar oversupply.
Again, the point is to contrast unfolding
reflationary ramifications to those from the past.
For years, the "buy the dip" crowd enjoyed
a huge if unappreciated advantage: Wall Street
finance was itself a major inflating bubble. Each
bursting "mini" bubble - bonds 1994, Mexico, SE
Asia, LTCM, Tech, Enron, etc - garnered a coveted
reflationary response from the Fed. And in each
instance monetary accommodation and resulting
easier monetary conditions significantly bolstered
Wall Street credit and liquidity creation. Over
and over again, betting with the Fed - buying
stocks, homes, junk bonds or other risk assets -
was handsomely rewarded. And while the Fed
received credit for successful reflations, each
recovery owed a greater degree of thanks to
booming Wall Street finance.
The consensus
view will prove much too optimistic when it comes
to the household sector's response to this latest
reflation. Housing markets will benefit only
marginally from lower mortgage rates. Meanwhile,
savers will be hit with a significant drop in
income. When the Fed cut rates in 2001, money
market fund assets were about $1.8 trillion. Last
week they surpassed $3.3 trillion. The household
sector had about $4.3 trillion of deposits to
begin 2001, which grew to $7.1 trillion by the end
of the third quarter. Sharply lower rates will
impact consumption and hurt tax revenues.
Granted, previous reflations saw interest
income decline. Yet this drag was more than offset
by inflating asset prices coupled with huge
windfalls from refinance-related equity extraction
and mortgage payment reduction. Today, millions of
households face an extraordinary confluence of
negative home equity, an inability to refinance,
and a major decline in investment income. Expect
this reflation to have a greatly subdued impact on
credit availability- mortgage, consumer, and
business. And if, as I suspect, the leveraged
speculating community becomes increasingly
impaired, the current reflation will as well prove
much less of a mechanism for inciting securities
leveraging and resulting marketplace liquidity.
A reasonable case can be made that we have
commenced what will be the last major "refi" boom
in awhile. The short-term stimulus derived will be
at the expense of future demand. I'd be surprised
if mortgage rates have much room left on the
downside (large risk premiums are a new reality),
while the amount of available homeowners' equity
is being depleted by the combination of declining
prices and ongoing equity extractions. On a side
note, for the system as a whole, this is a
particularly dangerous time to incite a major
extraction of home equity. As the housing bust
unfolds, reduced homeowners’ equity will only
further heighten the vulnerability of the mortgage
sector and the credit system more generally.
Continuing inflationary
effects Worse yet for the American
consumer, today's prominent fledgling bubbles and
inflationary biases encompass global markets for
energy, food, minerals and other commodities. The
Bric (Brazil, Russia, India and China) and
emerging market bubbles are historic in nature and
will be only further destabilized by the Fed’s
actions and resulting dollar weakness. It is worth
noting that there is as of yet little indication
that the bursting of the US credit bubble has had
meaningful restraining influence on overheated
Bric (and, for that matter, global) credit
systems. And it is this unappreciative 20% or so
annualized Bric credit growth that will continue
to foment very powerful inflationary effects on
energy, food, and commodities prices. In concert
with the weak dollar, the US consumer will be hit
even harder by rising prices for an increasing
array of products.
Analytical evidence
strongly supports the view that the current
reflation will disappoint on the asset inflation
front, while undermining the fragile household
sector with a double-whammy of reduced income and
higher costs. Indeed - and despite the
overwhelming view otherwise - rising consumer
prices will likely prove a prevailing consequence
of the current monetary and fiscal reflation, only
worsening the backdrop and compounding the policy
predicament over time.
At this stage, the
finance-driven US bubble economy is notably
unbalanced, inefficient and dependent on credit,
imports, and foreign finance. Throwing large
quantities of inflationary purchasing power at it
today will have much different consequences than
such efforts had during previous asset and
investment booms.
As Mr Hausmann noted
above: "The same voices that supported tough
macroeconomic policies to deal with the excesses
of spending and borrowing in East Asia, Russia and
Latin America are today pushing for a significant
relaxation in the US ..." There is obviously no
tolerance for any tough policy medicine in this
country today. Regrettably, this only ensures a
much more protracted period of economic
stagnation, inflation, uncertainty and eventual
arduous adjustment.
These days, there is
great relief in the markets that our troubled
financial institutions enjoy a virtual bottomless
pit of "capital" to garner from overseas
investors. This dynamic is, however, only an
inflationary expedient that forestalls the
necessary reallocation of resources away from
finance, consumption, and "services" to the
goods-producing sector.
Policies
destined to fail The current fixation on
the housing market misses the more important issue
that our economy will soon be forced to restrain
its credit creation and significantly bolster the
production of tradable goods and services.
Policies to promote mortgage credit and
consumption are not only destined to fail, they
are inhibiting the necessary adjustment and
reallocation process. And low Treasury yields and
today's manageable deficits instill false
confidence that fiscal policy enjoys great
latitude in fostering counter-cyclical
stimulation. I fully expect impending massive
deficits, inflation concerns and a dollar crisis
to eventually
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