Page 1 of 5 CREDIT BUBBLE BULLETIN Froth comes off latte economy
Commentary and market watch by Doug Noland
The announcement that Starbucks plans to close 600 stores and fire 12,000
employees is emblematic of the major restructuring that lies ahead for the
deeply maladjusted US bubble economy. Throughout the real economy, businesses
that had previously luxuriated in robust profits during the credit and asset
inflation-induced boom now see earnings and cash-flows rapidly erode. During
the boom, Starbucks aggressively spent on capital expenditures, while expanding
its employee base, product offerings and real estate commitments. "Money" was
easy, revenues were easy, and growth was easy.
For the economy overall, the enormous expansion of mortgage
(and other) credit poured spending power throughout, especially in the services
sectors. This purchasing power was multiplied by additional borrowings by the
likes of Starbucks and others, as well as by the real estate developers
borrowing, building and leasing space to tens of thousands of coffee shops,
retailers, restaurants, hotels, casinos, nail salons, health clubs and such. It
amounted to a historic borrowing and "investment" boom in building out a
massive consumption/services-based infrastructure. Now, with the credit bubble
having burst, the economic viability of broad swaths of this economic structure
is in question.
Years of credit, asset price, and consumption-based investment inflation
created a deeply ill-structured real economy. Simplistically, the US bubble
economy was structured for a particular variety of inflation. As long as Wall
Street could inflate mortgage and other asset-based credit, along with real
estate and stock prices, additional purchasing power would be created and
distributed for spending throughout the economy. Sufficient business and
government cash flows ensured adequate household income growth to go along with
booming - and self-reinforcing - asset price gains. As such, household net
worth (asset values less liabilities) swelled by about $4 trillion annually for
the finale bubble years 2003-2006.
And as the world's reserve currency, our credit system was able to generate
endless new (and mostly top-rated) financial claims that so easily financed our
import-buying binge. Meanwhile, with business profits generated with such ease
in the booming finance, consumption and asset sectors of our economy, the US
and global credit booms worked deleteriously to hollow out our nation's
manufacturing base. But what difference did it really make if the economy's
"output" were goods or services?
For years, we've protested against this combination of over-investment in
consumption-based infrastructure and the hollowing of manufacturing capacity.
And for the longest time, most have scoffed at our analysis and pointed to the
rising stock market and generally inflating asset prices as indicators of the
efficiency, productivity and profitability of the so-called "new economy". We
warned of the eventual perils of over-borrowing and the lack of household
savings, while Alan Greenspan, when US Federal Reserve chairman, and others
argued that it didn't matter because we had become so efficient at investing
our limited savings. Besides, the world would always seek the superior quality
and liquidity of our securities markets.
Yet the optimists failed to recognize that only massive - and increasing -
amounts of system credit would sustain the inflated boom-time asset prices,
household incomes, corporate cash flows, and government receipts that had
become essential for levitating the various facets of the bubble economy. The
deteriorating quality associated with the massive inflation of our financial
claims should have been obvious. And today - as symbolized by Starbucks - the
required credit stimulus is no longer forthcoming, leaving scores of
enterprises throughout the economy attempting desperate measures to cut
expenses and maintain viability.
The finance, automotive and airline industries are also notable for having come
to rely on a very different inflationary environment than the one we face these
days. Today's unfolding retrenchment will place only further downward pressure
on business profits, household incomes, asset prices, and government receipts -
forcing additional spending restraint and deeper retrenchment. At the same
time, this self-reinforcing retrenchment will create only greater financial
strain on an already impaired credit apparatus, ensuring even greater credit
troubles and tighter financial conditions, especially for the business sector.
To attempt a response to the above question of what difference did it really
make that our economy's "output" was services rather than goods - it made a
huge difference. At the end of the day, at the conclusion of the credit boom, a
finance and consumption-based economy is left with enormous financial claims
backed by woefully inadequate wealth-creating assets. During the boom,
Starbucks could earn seemingly endless profits by selling US$4 lattes. The
stock price went to the moon; financial wealth was abounding. Now, with
discretionary spending being sharply reduced by the confluence of sinking asset
prices, tightened credit, and inflating energy and food prices, the enterprise
value of Starbucks and scores of other businesses has been greatly diminished.
Worse yet, for the economy overall, there is little in the way of real economic
value remaining for billions of "output" Starbucks and other services providers
created over the long boom. Only the financial obligations (the original
asset-based borrowings) remain, while the market is increasingly suspect of
their true state of underlying quality and value.
The harsh reality is that Starbucks is a microcosm of scores of enterprises
that have come to comprise the core of the US bubble economy. The economic
viability of so many businesses, and even industries, will be in jeopardy in
the unfolding credit and financial landscape. The stock market is still in the
early stage of discounting the unfolding credit and economic bust. I'll
reiterate that we expect the unfolding economic adjustment to be of such a
magnitude as to be classified as an economic depression as opposed to a more
typical recession.
Consider the following statements: "US and European central bankers are
intensifying pressure on counterparts in emerging-market countries to step up
the fight against inflation. Federal Reserve Vice Chairman Donald Kohn
yesterday urged countries where 'rapid' economic growth is elevating prices to
respond. Hours earlier, Bank of England Governor Mervyn King said global
monetary policy looks 'a little lax'. Bank of France Governor Christian Noyer
said the day before that 'coordinated, resolute action' is needed to encourage
more exchange-rate flexibility as a way of tackling inflation. The comments
reflect concern among central banks in major industrialized economies that
their own campaigns against inflation will be undermined by a failure of others
to combat price pressures. Demand in emerging markets is already propelling the
cost of commodities such as oil, tin and corn to records. 'The bulk of
inflation is coming from emerging markets,' said Stuart Green, a global
economist at HSBC � 'The concern in developed economies is that
inflation is rising because of pressures outside of their remit and that
monetary policy overseas is too loose.'" Simon Kennedy, Bloomberg. June 27.
"The reasons for the trajectory and persistence of increases in prices of food
and energy this year, as global growth has moderated, are not entirely clear.
The upward trend in prices of food and energy over the past several years,
however, importantly reflects the pressures posed by rapidly growing demand in
developing economies against relatively inelastic global supplies of
commodities." US Federal Reserve Board vice chairman Donald Kohn, June 26,
2008.
"We are living through the unthinkable � The list of casualties is very
different. What has suffered most is the credibility of the most sophisticated
financial systems in the world." Mohamed El-Erian, Pimco Co-CEO, June 25, 2008
Finger pointing under
way
Now that inflation manifestations have shifted from asset prices to energy,
food and general consumer prices, the finger-pointing has begun. I am compelled
to return to my old "core" versus "periphery" analysis. As Mr El-Erian is
suggesting, the "core" of the global credit system is in the process of being
discredited. To be sure, the world is increasingly loath to accumulate
additional "core" risk assets. Especially in the case of dollar financial
claims, this major devaluation and, increasingly, revulsion is tantamount to a
major inflation in the pricing of energy, metals, food, and myriad resources
that are in increasingly global short supply.
This supply shortage is related to at least two now powerful dynamics. First,
there are the booming emerging economies at the "periphery" - booms largely
fueled by unfettered credit systems and acute inflationary forces unleashed
initially by runway credit excess at the "core." And, second, there is today's
acute speculative excess in almost anything energy- and resource-related.
This is also a consequence of dysfunction at the core, namely the massive US
current account deficits and resulting rapidly expanding global pool of
speculative finance coupled with the discrediting of Wall Street finance. There
is today much too much global liquidity (running away from sophisticated
financial instruments) chasing too few global resources whose supply is not
easily expanded (inelastic).
I find it rather incredible that US and European policymakers are increasingly
pointing blame and calling upon their emerging economy cohorts to aggressively
combat inflation. With the US today stuck with intractable $700 billion current
account deficits and European credit systems still churning out double-digit
credit growth, the periphery is not the root cause of today's escalating global
inflationary pressures.
The global credit system has run amuck, a process that evolved from years of
credit and speculative excess generated by, and tolerated at, the core. It is
today unreasonable to expect the Chinese, or Asians generally, to bring their
booming economies to their respective knees to fight global inflation anymore
than we can expect the Fed to tighten the economic screws to the point of
balancing our current account and punishing the destabilizing speculators.
Today's inflationary dynamics have been developing for decades. Only discipline
and stability at the core of the global financial system would have stemmed the
strong inflationary bias of contemporary electronic fiat "money" and credit.
But the core was instead egregiously undisciplined and unstable, setting the
stage for the type of runaway inflation we are now experiencing. The core came
to love and rationalize asset inflation and consumption. The periphery was
forced along for the ride and happy to oblige.
And now we find ourselves in the midst of another leg down with regard to the
credibility of US (and, increasingly, British) financial assets and economic
structures overall. And while recent market tumult has not had the intensity of
March's acute de-leveraging, the ramifications of recent developments are more
problematic. For one, the markets are now coming to grips with the reality that
much of the massive apparatus of various types of credit insurance is insolvent
and has little chance of recovery. While the nature of these companies'
obligations may not require bankruptcy filings in the near-term, the market
nonetheless recognizes that much of the future protection guaranteed by these
companies/financial players has become worthless.
The "monoline" insurers do not have the resources to fulfill their huge future
obligations. The players behind the credit default swap (CDS) marketplace do
not have the wherewithal to fulfill their unfolding obligations. And the
mortgage insurers do not have the resources to pay their share of the rapidly
escalating costs of a historic real estate bust.
And if the mortgage insurers are indeed bust, the GSEs have a major dilemma.
Not only do they have very large exposures to
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