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5 CREDIT BUBBLE
BULLETIN Liquidation is only solution to
crisis Commentary and weekly
watch by Doug Noland
There was ample
material last week for an entire book delving into
critical financial issues of our day - US Treasury
Secretary Henry Paulson's proposal on Monday for
financial regulation overhaul; testimony on
Wednesday by Federal Reserve chairman Ben Bernanke
on housing and Bear Stearns before Congress' Joint
Economic Committee; the appearance on Thursday by
Bernanke, New York Fed president Timothy Geithner,
Treasury Under Secretary Robert Steel and
Securities and Exchange Commission chairman
Christopher Cox before the Senate Banking
Committee; and the later appearance before the
same committee by JP Morgan chief executive Jamie
Dimon and Bear Stearns CEO Alan Schwartz - quite
enough for a book; I'll attempt
a couple pages.
From a Bernanke reponse:
One of the prevailing theories at
the time of the Depression was the so-called
"liquidationist thesis" - which said basically
"let's let the system return to normal. Let's
liquidate banks; let's liquidate labor." This
was Andrew Mellon, the Treasury secretary [from
1921 to 1932]. It was partly on the basis of
that theory that the Federal Reserve stood by
and let a third of the banks in the country
fail, which caused the money supply to drop
sharply, and prices to fall rather sharply, and
led ultimately to the severity of the financial
crisis.
I think financial instability,
which was not addressed by government or anyone
else, was a major contributor, both to the
Depression in the US and abroad. I believe the
difference today is that we will address
financial issues and try to maintain the
integrity and stability of our financial system.
We will not let prices fall at 10% a year. We
will act as needed to keep the economy growing
and stable. So, I think there are some very
significant differences between the thirties and
today, and we learned a great deal from that
episode. (April 2, 2008, before Congress' Joint
Economic Committee.)
Not surprisingly,
chairman Bernanke invokes a notable policy error -
committed in the heat of an extraordinarily
difficult (post-bubble) early-1930s period - as
justification for government measures to sustain
today's US bubble economy. Bernanke and the
"Friedmanites" just love to pillory Andrew Mellon
and the "liquidationists" (and would gladly throw
in Friedrich Hayek and fellow Austrian economist
Ludwig von Mises). They avoid (like the plague),
however, the much more pertinent policy debate
that transpired throughout the Roaring Twenties.
Mellon was among a group of elder
statesman that had become increasingly concerned
throughout the decade by the Wall Street
speculative boom and its inevitable consequences.
The son of a banker, his family's wealth was
nearly lost in the Panic of 1873. Actively
involved in banking and business from the age of
17, he had witnessed first hand the consequences
of the recurring booms and busts that were the
impetus behind the creation of the Federal Reserve
in 1913. Blaming Mr Mellon and the
"liquidationists" for the Great Depression - as
opposed to the extraordinary financial excesses
and failed policies of the bubble period - does
disservice to history as well as to sound
analysis.
There were astute thinkers
during the twenties who believed the economy was
being severely distorted from a protracted
inflationary period that had commenced during
World War I. Although it was not manifesting in
consumer prices (because of new technologies,
products, overheated investment, etc), excessive
money and credit were fueling dangerous
inflationary bubbles in asset prices -
particularly in real estate and the stock market.
The astute recognized the boom as a period
of acute financial and economic instability.
Certainly, the great "Austrian" economists
appreciated clearly how credit and speculative
excess had come to grossly distort incomes,
corporate profits, relative prices and investment.
The underlying structure of both the financial and
economic systems was being corrupted.
Importantly, during that fateful period a
group of seasoned thinkers (businessmen,
policymakers, and economists) believed adamantly
that policies endeavoring to sustain the distorted
pricing mechanisms and structures - and the
resulting inflated and maladjusted US economy -
were both inadvisable and doomed for failure. As
such, so-called "liquidation" was a central facet
of the unavoidable (post-inflationary boom)
adjustment period for the highly distorted
financial, labor and product markets. Profligate
borrowing, spending, and leveraged speculation
would come to their eventual end, requiring
reallocation of both financial and real resources.
It was only a matter of the degree of excess and
the proportional adjustment.
Invitation
to disaster To further inflate an
unsustainable boom with additional cheap credit
guaranteed only more problematic financial
fragility, economic imbalances/maladjustment and
resulting onerous adjustment periods. The astute
were adamantly against the (Benjamin Strong)
Federal Reserve’s efforts to actively manage the
economy (and markets) in the latter years of the
twenties, fearing that to prolong the reckless
Wall Street debt and speculation orgy was to
invite disaster (the "old timers" had witnessed
many!). History proved them absolutely correct,
yet historical revisionism to varying extents has
been determined to disregard, misrepresent, and
malign their views and analytical focus.
Bernanke’s analytical framework of the causes of
the Great Depression is seriously flawed.
Regrettably, all the best efforts by the
Federal Reserve and Washington politicians to
sustain the US bubble economy are doomed to
failure. It’s not that they are necessarily the
wrong policies. More to the point, the basic
premise that our economy is sound and growth
sustainable is misguided. We’ve experienced a
protracted and historic credit inflation and it
will simply be impossible to keep asset prices,
incomes, corporate cash flows, and spending
levitated at current levels. The type and scope of
credit growth required today has become
infeasible. The risk intermediation requirements
are too daunting. Sustaining housing inflation and
consumption levels has become unachievable. And
the underpinnings of our currency have turned too
fragile.
I'm all for long-overdue
legislative reform. Who isn’t? But I’ll say I
heard nothing this week that came close to
addressing the key underlying issues. We have
longstanding societal biases that place too much
emphasis on housing and the stock market, while we
operate with ingrained policymaking biases
advocating unregulated finance underpinned by
aggressive activist central banking and government
market intervention. In a 20-year period of
momentous financial innovation, our combination of
"biases" proved an overly potent mix. And it is
worth noting that Wall Street security/dealer
balance sheets expanded three-fold in the eight
years since the repeal of the (Depression-era)
Glass-Steagall Act.
The focus at the Fed
and in Washington is to sustain housing, the stock
market, and inflated asset prices generally - to
bankroll the consumption- and services-based
bubble economy. Bernanke believes that if
financial company failures can be averted - and
with the recapitalization of the US financial
sector as necessary - sufficient "money" creation
will preclude deflationary forces from gaining a
foothold.
He assures us the Fed will not
allow double-digit price declines, despite the
reality that such price moves have already
engulfed real estate markets. To be sure,
prolonging current financial instability increases
the likelihood of significant price level
instability going forward. And while the federal
government "printing presses" will be working
overtime going forward, it is also apparent that a
key facet of Washington’s strategy is to
"subcontract" the task of "printing" to Fannie
Mae, Freddie Mac, the Federal Home Loans Bank, the
banking system, and "money funds" - sectors that
today still retain the capacity to issue
money-like debt instruments with the explicit or
implied stamp of federal government (taxpayer)
backing.
Desperate
undertaking Basically, the strategy is to
substitute government-backed debt for the now
discredited Wall Street-backed finance. I’m the
first one to admit that this desperate undertaking
stopped financial implosion in its tracks.
However, the problem with this whole approach -
because of our "societal," financial, and
policymaking biases - is that our credit system
will just be throwing greater amounts of
(government-supported) debt on top of already
fragile credit structures underpinned largely by
home mortgages. Wall Street-backed finance buckled
specifically because this (Ponzi finance) debt
structure was untenable the day increasing amounts
of speculative credit were no longer forthcoming.
The underlying inventory of houses doesn’t have
the capacity to generate debt service - only the
mortgagees taking on greater amounts of debt.
The underlying economic structure is now
THE serious issue. The last thing our system needs
right now is trillions more mortgage debt,
although it would work somewhat to sustain
consumption and our services-based bubble economy.
The inherent problem with a finance, housing,
consumption, and services-dictated economic
structure is that it inherently generates
excessive debt backed by little of real tangible
value or economic wealth-creating capacity. System
fragility is unavoidable.
It may appear an
economic miracle, but for only as long as
increasing amounts of new finance are forthcoming.
At the end of the day, one is left with an
extremely fragile structure both financially and
economically.
Yet as long as Wall Street
"alchemy" was capable of creating sufficient
"money" to fuel the boom - and the world was
content in accumulating (increasingly suspect)
dollar claims - our bubble economy structure
remained viable. It is, these days, increasingly
not viable. The wholesale and open-ended
government backing of US mortgage debt - and
financial sector liabilities more generally - will
prove a decisive blow to already shaken dollar
confidence. And it is today’s reality that the
massive scope of credit growth necessary to
sustain the current bubble structure will
correspond to current account deficits and dollar
outflows that will prove (as we’re already
witnessing) only more destabilizing in markets and
real economies around the world.
No
substitute Government backing of our debt
does not substitute for a sound economic
structure. And it is the current structure that is
incapable of the necessary economic output to
satisfy domestic needs and to generate sufficient
exports to exchange for our huge appetite for
imported goods and energy resources. Today’s
services-based economy will no longer suffice.
Examining last week’s job data, one sees that
93,000 "goods producing" jobs were lost in March
after dropping 92,000 in February and 69,000 in
January. At the same time, Education, health,
leisure and hospitality jobs increased 178,000
during the first quarter. Yet it is more obvious
than ever that we need to consume less and produce
much more.
Back to the "liquidationists".
It is my view that our economy will require a
massive reallocation of resources. We will be
forced to create much less non-productive
(especially mortgage and asset-based) credit in
the financial sphere, while producing huge
additional quantities of tradable goods in the
economic sphere. In our expansive services sector,
there will no choice but to "liquidate" labor and
redirect its efforts. Throughout finance, there
will be no alternative than to liquidate bad debt,
labor and insolvent institutions - again in the
name of a necessary redirecting of resources.
After an unnecessarily protracted boom,
there will be scores of enterprises that will
prove uneconomic in the new financial and economic
backdrop. Liquidation will be unavoidable,
policymaker hopes and dreams notwithstanding.
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