Page 1 of 3 CREDIT BUBBLE BULLETIN A red
herring
Commentary and weekly watch by Doug Noland
There was a flurry of media interest this week in the issue of central banking
and asset bubbles. Federal Reserve governor Frederic S Mishkin gave a speech
yesterday, "How Should We Respond to Asset Price Bubbles?" Friday's's Wall
Street Journal ran front-page with Justin Lahart's article, "Bernanke's Bubble
Laboratory". Also today, the Financial Times' Krishna Guha penned an extensive
piece "Troubled by Bubbles: central bankers re-examining the hands-off
approach," one of several thoughtful FT pieces on the issue this week.
From Ms Guha's article: "In the aftermath of the dotcom crash in 2002, Alan
Greenspan famously argued that central banks had little power to stop bubbles
inflating and then bursting. All
policymakers could do, said the then Federal Reserve chairman, was to 'focus on
policies to mitigate the fallout when it occurs'. His most vocal supporter was
Ben Bernanke, then a Fed governor. As an academic, Mr Bernanke had championed
the view that central banks should ignore asset prices except insofar as they
affect forecasts for inflation and growth. 'Even putting aside the great
difficulty of identifying bubbles in asset prices, monetary policy cannot be
directed finely enough to guide asset prices without risking severe collateral
damage,' he said in 2002."
Professor Mishkin's speech offered at best only a flicker of hope that the
Federal Reserve is moving away from failed Greenspan/Bernanke doctrine:
Financial
history reveals the following typical chain of events: Because of either
exuberant expectations about economic prospects or structural changes in
financial markets, a credit boom begins, increasing the demand for some assets
and thereby raising their prices. The rise in asset values, in turn, encourages
further lending against these assets, increasing demand, and hence their
prices, even more.
This feedback loop can generate a bubble, and the bubble can cause credit
standards to ease as lenders become less concerned about the ability of the
borrowers to repay loans and instead rely on further appreciation of the asset
to shield themselves from losses. At some point, however, the bubble bursts.
The collapse in asset prices then leads to a reversal of the feedback loop in
which loans go sour, lenders cut back on credit supply, the demand for the
assets declines further, and prices drop even more. The resulting loan losses
and declines in asset prices erode the balance sheets at financial
institutions, further diminishing credit and investment across a broad range of
assets.
I was encouraged that the terminology "structural
changes in financial markets," "credit booms," and "feedback loops" were
included in the initial paragraphs of Mishkin's paper. This, presumably, would
have had the analysis at least heading in the right direction. Yet the
inclusion of credit matters turned out to be little more than analytical
palliative. Today, Fed policymakers have no choice but to concede that
underlying credit conditions are an issue. Meanwhile, they appear content to
take the tack that not all bubbles are created equal; that some are more
impacted by credit than others; that some are associated with more financial
system risk than others - and, at the end of the day, it's impossible for the
Fed to recognize and differentiate among them until after they have burst.
Scant real progress has been made.
The conclusions from Professor Mishkin's paper differ only subtly from previous
doctrine:
First, not all asset price bubbles are alike. Asset price
bubbles that are associated with credit booms present particular challenges,
because their bursting can lead to episodes of financial instability that have
damaging effects on the economy. Second, monetary policy should not try to
prick possible asset price bubbles, even when they are of the variety that can
contribute to financial instability. Just as doctors take the Hippocratic oath
to do no harm, central banks should recognize that trying to prick asset price
bubbles using monetary policy is likely to do more harm than good. Instead,
monetary policy should react to asset price bubbles by looking to the effects
of asset prices on employment and inflation, then adjusting policy as required
to achieve maximum sustainable employment and price stability ...
Third, because asset price bubbles can arise from market failures that lead to
credit booms, regulation can help prevent feedback loops between asset price
bubbles and credit provision. Our regulatory framework should be structured to
address failures in information or market incentives that contribute to
credit-driven bubbles.
Such an "academic" approach will bear
little fruit. Clearly, all the theorizing in the world will have no impact
whatsoever on the burst technology and mortgage finance/housing bubbles. There
are, however, present-day issues of pressing vital concern. First of all, if a
new regulatory approach is central to combating "episodes of financial
instability", I strongly suggest Professor Mishkin and the entire Bernanke Fed
move immediately toward assuming GSE oversight (which they will avoid like the
plague). Fannie, Freddie, and the FHLB have in total increased their
"businesses" by over US$900 billion during the past year - and have been
getting geared up to move full speed ahead. The GSE's top regulator, commenting
on CNBC back in March, stated that Fannie and Freddie "could do over $2.0
trillion in business this year if the market needs that money." That was a
blaring warning that "regulation" will remain a major part of the problem.
I'll posit that the entire issue of "central bankers versus asset bubbles" has
become little more than a red herring. While it is as of yet too early in the
unfolding financial and economic crisis for "consensus opinion" to have reached
a similar conclusion, in reality contemporary monetary management can already
be proclaimed an unmitigated failure. Cloaked in ideology and a flawed
conceptual framework, the Greenspan/Bernanke Fed sat idly by as history's
greatest credit inflation and myriad resulting bubbles irreparably damaged the
underlying structure of the US credit system and real economy (before going
global). And while the Fed executes its latest round of post-asset bubble "mop
up", precarious credit bubble dynamics are left to run similarly roughshod
through global financial and economic systems. Better to downplay the asset
bubble issue for now, as we contemplate the nature of what will be a much
altered post-global credit approach to central banking.
From Mishkin:
The ultimate purpose of a central bank should be to
promote the public good through policies that foster economic prosperity.
Research in monetary economics describes this objective in terms of stabilizing
both inflation and economic activity. Indeed, these objectives are exactly what
is embodied in the dual mandate that the Congress has given the Federal
Reserve.
In no way do I believe "the ultimate purpose of a
central bank" is to "foster economic prosperity", and I certainly don't expect
any such grandiose mandates to survive in the post-bubble environment. On many
levels the notion that central bank policies are instrumental in creating
prosperous economic conditions is problematic. For one, it grossly over
promises in regard to the long-term benefits derived from the government's
manipulation of interest-rates. Secondly, it virtually guarantees an
accommodative policy regime and, inevitably, a strong inflationist bias.
Thirdly, such a nebulous objective invites overly discretionary policymaking,
along with an activist and experimental approach to monetary management.
Fourthly, such an approach ensures that policymaking errors beget greater and
compounding errors.
From Mishkin:
After a bubble bursts and the outlook for economic
activity deteriorates, policy should become more accommodative ... If monetary
policy responds immediately to the decline in asset prices, the negative
effects from a bursting asset price bubble to economic activity arising from
the decline in wealth and increase in the cost of capital to firms and
households are likely to be small. More generally, monetary policy should react
to asset price bubbles by looking to the effects of such bubbles on employment
and inflation, then adjusting policy as required to achieve maximum sustainable
employment and price stability.
This passage, in particular,
goes right to the heart of several key failings of current doctrine. The entire
framework of ignoring asset bubbles when they are expanding and "mopping up"
when they burst is a recipe for disastrous policy mistakes. And how was this
not made unmistakably clear when the post-tech bubble "mop up" stoked the
fledgling mortgage finance and housing bubbles?
The problem with post-asset bubble "accommodation" is that it specifically
accommodates the very credit infrastructure and related monetary processes that
financed the preceding boom. It works to validate the present course of
financial innovation (think "Wall Street securitizations," "CDOs" and "carry
trades"), while emboldening those at the cutting edge of risk-taking (think
"leveraged speculating community"). To be sure, the same Wall Street credit
infrastructure that financed the tech bubble was empowered to regroup,
reemerge, and aggressively expand to grossly over-finance much more expansive
credit and speculative booms in mortgage-related securitizations and housing.
These days, powerful forces have been unleashed to over-finance the world.
Courting speculation
Moreover, a commitment to aggressively cut rates in response to faltering asset
bubbles openly courts leveraged bond market speculation - a market dynamic that
especially engenders artificially low market yields and exacerbates liquidity
excess during the late-stage of asset bubbles (think bond market "conundrum").
The last thing a central bank should encourage is an entire industry dedicated
to placing leveraged bets on the direction of Federal Reserve policy responses.
A strong case can be made that US Treasury and agency markets have become one
massive bubble.
The overriding flaw in the Greenspan/Bernanke approach has been to openly
disregard credit bubble dynamics, in particular the increasingly profound role
played by Wall Street-backed finance in fueling credit, market liquidity and
speculative excesses. I believe the ultimate objective of a central bank is to
foster monetary stability in the broadest sense. In this regard, asset bubbles
should be viewed primarily as important indicators of some type of underlying
monetary disorder. The key analytical focus must be on the underlying credit
and speculative dynamics fueling the asset price distortions - to better
understand and rectify the source of "disorder" - and the earlier, the better.
The most dangerous policy approach is to further incentivize a system that has
already demonstrated a proclivity for credit and speculative excess -
employment, output and "deflation" concerns notwithstanding. And never ever
succumb to the temptation of using the leveraged speculators as a mechanism for
stimulating the markets, the credit system and the real economy. In this
regard, contemporary finance has created an especially seductive trap for
policymakers.
Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of
policymakers to recognize the existence of a bubble until after it pops. It is
my view that the entire notion of asset prices dictating monetary policy is
flawed. The focus should instead be on the underlying sources of monetary fuel
- the credit growth and financial flows underpinning asset inflation and
spending boom. In the case of the technology bubble, the Fed should have been
focused on the massive issuance of telecom junk debt and leveraged loans, the
fledgling CDO and "structured credit products" markets, NASDAQ and NYSE margin
debt, derivative-related leveraging, and the enormous speculative flows
over-financing the industry boom. The unfolding mortgage finance bubble was
conspicuous as early as 2002, with the onset of annual double-digit mortgage
credit growth and the rapid expansion of Wall Street mortgage-related
securitizations and derivatives.
Central bankers can and should avoid being in the difficult position of having
to respond directly to inflating asset markets. Instead, there must be
carefully fashioned, communicated and administered "rules of the game". To
begin with, it is incumbent upon the Fed to clearly articulate to the public
(and their elected officials) the overwhelming benefits of stable credit and
financial conditions. It must be conveyed that credit and speculative excesses
are destabilizing, fostering boom and bust dynamics and structural impairment.
The public must come to appreciate that the effects of destabilizing credit
inflation come in many forms, including asset price inflation and bubbles,
current account deficits, currency debasement, traditional consumer price
inflation, and various distortions to underlying financial and economic
structures.
Rules-based system required
The Fed could then take a more active role in supervising and regulating system
credit within some predetermined parameters - a "rules-based" as opposed to
discretionary approach to monetary policymaking. For example, if total mortgage
credit exceeded some threshold, say 5% or 6% annualized, the Fed would have a
mandate to move to restrain at the margin real estate lending (through various
means, including increased reserve and capital requirements, higher interest
rates and other punitive measures). Ditto for corporate and public sector debt
growth. Specific margin lending limits would be enforced, and derivative and
securities leveraging strategies would be closely monitored and regulated as
necessary.
Similarly, credit growth beyond some predetermined threshold - be it bank
credit, broker/dealer liabilities, finance company borrowings, securitizations,
and so forth - would elicit a meaningful rebuke from monetary policy. The
punchbowl would be closely guarded. There would be general parameters for major
sectors, as well as for total system credit growth.
I expect the idea of the Fed regulating credit to be unappealing to many if not
most. I offer it as food for thought. It is, after all, my strong belief that
unconstrained credit and speculation are the bane of free-market capitalism.
For the economic sphere to remain generally unencumbered dictates a somewhat
encumbered financial sphere. Unfortunately, radical and ill-conceived
government intrusion into all aspect of our financial and economic lives will
be the likely post-bubble reality.
I was compelled to share some thoughts with respect to the "asset bubble"
debate. Actually, the subject matter is now little more than a distraction from
more pressing credit and pricing issues. Somewhat strangely, US asset inflation
is no longer the overriding concern. Instead, I ponder the ongoing issue of the
current extraordinary financial backdrop: a global economy that continues to
operate in a unique environment without a functioning monetary regime. There is
no mechanism - gold standard, Bretton Woods, or otherwise - to in any way limit
the quantity or quality of global financial claims inflation. It has become
full-fledged unfettered "wildcat" finance unlike anything the world has ever
experienced.
It is tempting to fixate on the asset bubble issue. Yet a more pressing need is
for the Federal Reserve and global central bankers to begin working towards the
implementation of some type of functioning monetary "regime", with the
intention of returning some semblance of order to international finance. And
similar to anticipating new US central banking doctrine, one can bet
confidently that change will not arrive ahead of "post-bubble impetus". No
doubt about it, heightened monetary disorder - the cost associated with the
Fed's US credit system bailout - is increasingly on display. Destabilizing
speculation is returning with a vengeance, and it's anything but limited to
commodities markets.
WEEKLY WATCH
For the week, the Dow gained 1.9% (down 2.1% y-t-d), and the S&P500 rose
2.7% (down 2.9%). Economically-sensitive issues were strong. The Transports
jumped 3.4%, increasing y-t-d gains to 17.5%. The Morgan Stanley Cyclicals
surged 3.9% (up 2.0%). The Morgan Stanley Consumer index rose 2.4% (down 4.7%),
and the Utilities added 1.4% (down 5.1%). The broader market enjoyed another
week of strong gains. The small cap Russell 2000 increased 2.9% (down 3.2%).
The S&P400 Mid-Caps rose 3.5%, putting 2008 gains at 3.0%. Technology
stocks remained strong. The NASDAQ100 gained 3.6% (down 2.6%), with one-month
gains of 10%. The Morgan Stanley High Tech index surged 5.3% (down 1.2%), with
one-month gains of 11.4%. The Semiconductors rose 5.8% (up 3.3%); the
Street.com Internet Index 3.9% (down 0.3%); and the NASDAQ Telecommunications
index 5.1% (up 2.9%). The Biotechs added 0.7% (down 4.2%). The Broker/Dealers
gained 2.2% (down 15.7%), while the Banks dipped 0.4% (down 8.9%). With Bullion
rallying $17.60, the HUI Gold index gained 2.8% (up 6.2%).
One-month Treasury bill rates jumped 18 bps this week to 1.85%, and 3-month
yields gained 11 bps to 1.84%. Two-year government yields jumped 20 bps to
2.44%. Five-year T-note yields increased 14 bps to 3.11%, and 10-year yields
rose 8 bps to 3.85%. Long-bond yields increased 5.5 bps to 4.58%. The 2yr/10yr
spread ended the week at 141 bps. The implied yield on 3-month December '08
Eurodollars jumped 19 bps to 2.98%. Benchmark Fannie MBS yields added 3 bps to
5.40%. The spread between benchmark MBS and 10-year Treasuries narrowed 5 to
155 bps. The spread on Fannie's 5% 2017 note narrowed one to 58 bps, and the
spread on Freddie's 5% 2017 note narrowed one to 57 bps. The 10-year dollar
swap spread declined 1.5 to 58.75. Corporate bond spreads were mostly narrower.
An index of investment grade bond spreads narrowed 10 to 93 bps, and an index
of junk bond spreads narrowed 9 to 615 bps.
Corporate debt issuance surpassed $30 billion for the sixth straight week.
Investment grade issuance included Philip Morris $6.0bn, Simon Properties
$1.5bn, Harley-Davidson $1.0bn, United Technologies $1.0bn, Eaton $750 million,
Starwood Hotels $1.0bn, Nisource Finance $545 million, PNC Bank $500 million,
Sovereign Bank $500 million, Ace INA Holdings $450 million, Entergy $375
million, Columbus Southern Power $350 million, Centerpoint Energy $300 million,
BJ Services $250 million, Tampa Electric $150 million, and Empire Electric $90
million.
Junk issuers included Laureate Education $1.0bn, Sandridge Energy $750 million,
Nortek $750 million, I-Star Financial $750 million, AES Corp $625 million,
Hovnanian $600 million, Jabil Circuit $400 million, and Copano Energy $300
million.
Convert issuance this week included SBA Communications $550 million, Health
Management Association $225 million, and JA Solar $400 million.
International dollar bond issuance included HBOS $2.0bn, Evraz Group $2.0bn,
Petro-Canada $1.5bn, Canadian Pacific Railroad $700 million, and Mangrove RE
$210 million.
German 10-year bund yields jumped 18 bps to 4.18%, as the DAX equities index
gained 2.2% (down 11.3% y-t-d). Japanese 10-year "JGB" yields rose 14 bps to
1.69%. The Nikkei 225 surged 4.1% (down 7.1% y-t-d and 18.9% y-o-y). Emerging
debt markets were mixed, while equities were mostly much higher. Brazil's
benchmark dollar bond yields declined another 4.5 bps to 5.98%. Brazil's
Bovespa equities index jumped 4.5% to a record high (up 13.9% y-t-d). The
Mexican Bolsa gained 2.7% (up 6.6% y-t-d). Mexico's 10-year $ yields rose 10
bps to 4.88%. Russia's RTS equities surged 8.5% (up 8.2% y-t-d). India's Sensex
equities index rallied 4.2%, cutting y-t-d losses to 14.1%. China's Shanghai
Exchange added 0.3%, with 2008 losses now at 31.1%.
Freddie Mac 30-year fixed mortgage rates declined 4 bps to 6.01% (down 20 bps
y-o-y). Fifteen-year fixed rates were unchanged at 5.60% (down 32bps y-o-y).
One-year adjustable rates dropped 9 bps to 5.18% (down 30bps y-o-y).
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