Page 1 of 3 CREDIT BUBBLE BULLETIN Inflationism: Bane of capitalism
Commentary and weekly watch by Doug Noland
I've never liked (or used) the terminology "shadow banking system". And while
there have been notable highs and lows throughout the hundreds of years of
industry history, banking when done well is a legitimate - as well as
invaluable - business. Banking is always a critical facet of capitalism. The
effective pricing and distribution of finance throughout an economy are
fundamental to the long-term success of capitalistic systems.
For years now, I've referred to our expansive mechanism of non-bank credit
creation as "Wall Street finance", and the proliferation of players operating
in this space the "leveraged speculating
community". Unfettered credit creation, endemic asset inflation, speculative
excess and an unmatched concentration of financial wealth and power was the
thrust of this historic bubble.
In stark contrast to sound banking, Wall Street finance was a destructive force
imperiling our capitalistic system through the distortion of market pricing,
spending patterns and resource allocation. Unsound non-traditional finance
fostered both a bubble and financial mania of historic proportions.
I have been a somewhat reluctant supporter of recent policymaking. Fearing
systemic collapse, it's been my view that there has been no real alternative
other than our government taking a major role in our post-bubble financial and
economic lives. I have also tried to limit criticism of our present team of
policymakers, with the view that the great policy mistakes were made during the
bubble years. Post-bubble policy mishaps are inevitable - and today's backdrop
explains why our "regulators" made catastrophic errors in accommodating the
long Wall Street boom.
I find it somewhat puzzling that our Federal Reserve chairman, Ben Bernanke, is
not held more accountable for his flawed theories and critical role in
accommodating precarious late-cycle financial excesses. James Lockhart,
chairman of the Office of Federal Housing Enterprise Oversight, which has
morphed into the Federal Housing Finance Agency, today enjoys a similar Teflon
coating. But, candidly, I have to admit to being bewildered that my "analytical
nemeses" over at investment management firm Pimco have seemingly never been
held in higher regard. I'm just waiting for the announcement that Pimco
managing director Paul McCulley will be joining the Fed. He's worked hard for
Over the years, Pimco and others have consistently trumpeted policy views that
they label "Keynesian". I've tried to offer counter arguments - and referred to
their flawed framework as "inflationism". Pimco, after all, was the leading
public voice espousing massive fiscal and monetary stimulus to ward off the
horrible evil of "deflation" after the bursting of the tech bubble. It
apparently didn't matter that mortgage debt was at the time expanding at
double-digit rates, or that a strong inflationary bias was taking hold in our
nation's housing markets, or that Wall Street finance was clearly on course for
Not unexpectedly, employing a so-called Keynesian stimulus to sustain an
unwieldy credit boom ended with disastrous results. The idea may have been for
the system to compensate for financial stress and lost output attendant with
the bursting of the technology bubble, but the much greater effect was to
stimulate already overheated financial mechanisms and asset markets.
The end result was spiking the punchbowl right when the party was getting out
of hand - ensuring terminal late-stage excesses wreaked absolute bloody havoc
on system stability. Back then, the inflationists conveniently avoided
discussing the myriad downside risks to artificially stimulating the credit
system. Apparently, it was a moot point because the risks associated with
"deflation" were so much greater. They were completely wrong on this.
So, fast forward to January 2009. There you go again - Mr McCulley and Pimco's
co-chief investment officer Bill Gross are right out there (the kings of all
media) espousing inflationism (aka "Keynesianism"). I'm the first to admit that
circumstances today are altogether different than 2002. For one, and in
contrast to 2002, the credit and economic systems are today actually in a
post-bubble environment. And most regrettably - and specifically because of the
extreme excesses that emanated from an artificially extended boom -
unprecedented government support has been necessary to thwart system implosion.
The collapse of Wall Street finance and myriad asset bubbles has significantly
broadened the scope of asset price declines, attendant debt problems and
economic disruption. No doubt about any of that. Yet at the same time, and as
it was in 2002, I find it regrettable that pundits paint deflation risks as so
catastrophic as to not even discuss the risks associated with a full-fledged
bout of inflationism.
I think it's nuts to advise our policymakers to target asset prices. I think
it's nuts to focus policy on stoking a quick economic recovery. I think its
nuts to even ponder the resurrection of the "shadow banks". I disagree with the
notion of trying to support prices in the debt securitization marketplace. Wall
Street finance - all the sophisticated securities, the trillion of derivatives,
myriad forms of credit insurance, all the leveraged speculation, and all the
nonsense - is bust and its not coming back as a force for directing finance to
- and inflating prices of - the asset markets. There is no quick fix here.
The financial sector is a black hole right now. With myriad asset bubbles
having burst, there is an enormous amount of debt today insufficiently backed
by asset values. At the same time, there is a tremendous amount of debt backed
by households, businesses, municipalities and our federal government. In
terminology I have used in the past, the credit bubble has left both the
financial sphere and the economic sphere grossly inflated. Total system debt
has been severely impaired.
There are enormous risks today associated with systemic reflation. For one, the
scope of problem - the various sectors that could obviously benefit from
artificial government stimulus - is almost unfathomable. There is very real
risk at this point that policymaking is about to set course for bankrupting the
country. The pundits are out there suggesting a trillion dollar economic
stimulus; trillions for the banks; hundreds of billions to support the
securitization markets; and hundreds of billions more for households,
businesses, and municipalities. There is a current need for "trillions" and
future needs for "trillions" more. Once the trillions start to flow there will
be no easy way to end them.
Policymakers and pundits are in dire need of a framework where some type of
"stimulus" cost/benefit analysis is at least attempted. I find the Pimco
inflation laundry list without a discussion of costs and risks hard to swallow.
At this point, focus on the securitization marketplace is a classic example of
throwing good "money" after bad. And with mortgage borrowing costs today at
historic lows, I don't believe housing markets should be policymakers' major
focus going forward. In short, a focus on rejuvenating asset markets is the
wrong course. Housing prices will be in retreat until they find a floor
supported by local incomes.
Unfortunately, the protracted credit boom severely distorted incomes (along
with asset prices). With the goal of avoiding national bankruptcy, I suggest
that policymakers focus on incomes as opposed to both asset markets and
incomes. And the key is promoting sound long-term investment in real economic
wealth creation. "Money" created today to artificially inflate asset prices and
incomes will simply require more inflationary fuel next year and the year
after. The focus instead needs to be on real investment in real things that
produce real wealth. Haven't we seen enough of the Illusion of financial
wealth? Have we not seen enough to understand that Inflation is the road to
ruin? Will we allow the Treasury market to go the way of private-label
I certainly don't like the idea of the government setting investment policy.
Let's face it, it's repulsive to have Washington dictating the allocation of
financial and real resources. But the reality of the situation is that the
bubble's aftermath has left financial and economic structures unworkable.