Page 1 of 3 CREDIT BUBBLE BULLETIN Mistakes beget greater mistakes
Commentary and weekly watch by Doug Noland
The US Federal Reserve's purchases of Treasuries and mortgage securities won't
be enough to awaken the US economy, according to Pacific Investment Management
Co (PIMCO) chief investment officer Bill Gross. "We need more than that," he
was reported on March 17 by Bloomberg's Kathleen Hays and Dakin Campbell as
saying. The Fed's balance sheet "will probably have to grow to about US$5
trillion or $6 trillion," he said.
The problem with discretionary central banking is that it virtually ensures
that policy mistakes will be followed by only greater mistakes. Here, I'm
paraphrasing insight garnered from my study of central banking history.
Naturally, debating the proper role of
central bank interventions - in both the financial sector and real economy -
becomes a much more passionate exercise following boom and bust cycles.
The "rules versus discretion" debate became especially heated during the Great
Depression. It was understood at the time that our fledgling central bank had
played an activist role in fueling and prolonging the 1920s' boom - which
presaged the great unwind. Along the way, this critical analysis was killed and
buried without a headstone.
I believe the Ben Bernanke Fed committed a historic mistake last week -
compounding ongoing errors made by the activist Alan Greenspan/Bernanke Federal
Reserve for more than 20 years now. I find it rather incredible that
discretionary activist central banking is not held accountable - and that it
is, instead, viewed as critical for the solution. Apparently, the inflation of
Federal Reserve credit to US$2.0 trillion was judged to have had too short of a
half-life. So the Fed is now to balloon its liabilities to $3.0 trillion as it
implements unprecedented market purchases of Treasuries, mortgage-backed
securities, agency and corporate debt securities. And what if $3.0 trillion
doesn't go the trick? Well, why not the $5 or $6 trillion Bill Gross is
advocating? What's the holdup?
Washington fiscal and monetary policies are completely out of control.
Apparently, the overarching objective has evolved to be one of rejuvenating the
securities and asset markets. I believe the principal objective should be to
avoid bankrupting the country. It is also my view that our policymakers and
pundits are operating from flawed analytical frameworks and are, thus,
completely oblivious to the risks associated with the current course of
Today's consensus view holds that inflation is the primary risk emanating from
aggressive fiscal and monetary stimulation. It is believed that this risk is
minimal in our newfound deflationary backdrop. Moreover, if inflation does at
some point begin to rear its ugly head the Fed will simply extract "money" from
the system and guide the economy back to "the promised land of price
stability". Wording this flawed view somewhat differently, inflation is not an
issue - and our astute central bankers are well-placed to deal with inflation
if it ever unexpectedly does become a problem.
Our federal government has set a course to issue trillions of Treasury
securities and guarantee multi-trillions more of private-sector debt. The
Federal Reserve has set its own course to balloon its liabilities as it
acquires trillions of securities. After witnessing the disastrous financial and
economic distortions wrought from trillions of Wall Street credit inflation
(securities issuance), it is difficult for me to accept the shallowness of
today's analysis. In reality, the paramount risk today has very little to do
with prospective rates of consumer price inflation. Instead, the critical issue
is whether the Treasury and Federal Reserve have set a mutual course that will
destroy their creditworthiness - just as Wall Street finance destroyed theirs.
The counterargument would be that Treasury and Fed stimulus are short-term in
nature - necessary to revive the private-sector credit system, asset markets
and the real economy. That, once the economy is revived, fiscal deficits and
Fed credit will recede. I will try to explain why I believe this is flawed and
incredibly dangerous analysis.
First of all, for some time now global financial markets and economies have
operated alongside an unrestrained and rudderless global monetary "system"
(note: not much talk these days of "Bretton Woods II"). There is no gold
standard - no dollar standard - no standards. I have in the past referred to
"global wildcat finance", and such language remains just as appropriate today.
Finance has been created in tremendous overabundance - where the capacity for
this "system" to expand finance/credit in unlimited supplies has completely
distorted the pricing for borrowings. As an example, while total US mortgage
credit growth jumped from $314 billion in 1997 to about $1.4 trillion by 2005,
the cost of mortgage borrowings actually dropped. It didn't seem to matter to
anyone that supply and demand dynamics no longer impacted the price of finance.
Yet such a dysfunctional marketplace (spurred by unrestrained credit expansion)
was fundamental in accommodating Wall Street's self-destruction.
Today, the markets will lend to the Treasury for three months at 21 basis
points (bps), two years at 84 bps and 30 years at 371 bps (or 3.71%). I would
argue that this is a prime example of a dysfunctional market's latest pricing
distortion. As it did with the mortgage finance bubble, the marketplace today
readily accommodates the government finance bubble. And while on the topic of
mortgage finance, with the Fed's prodding, borrowing costs are back below 5%.
This cost of finance also grossly under-prices credit and other risks.
I would argue that market pricing for government and mortgage finance remains
highly distorted - a pricing system maligned by government intervention on top
of layers of previous government interventions. These contortions become only
more egregious, and I warn that our system will not actually commence its
adjustment and repair period until some semblance of true market pricing
returns to the marketplace. Yet policymaking has placed pedal to the metal in
the exact opposite direction.
The real economy must shift away from a finance and "services" structure - the
system of trading financial claims for things - to a more balanced system where
predominantly things are traded for other things. Such a transition is
fundamental, as our system commences the unavoidable shift to an economy that
operates on much less credit of much greater quality. But for now, today's
Washington-induced distorted marketplace fosters government and mortgage credit
expansion - an ongoing massive inflation of non-productive credit. I would
argue this is tantamount to a continuation of bubble dynamics that have for
years misallocated financial and real resources. In short, today's flagrant
market distortions will not spur the type of economic wealth creation necessary
to service and extinguish previous debts - not to mention the trillions and
trillions more in the pipeline.
Market confidence in the vast majority of private-sector credit has been lost.
The bubble has burst, and the mania in Wall Street finance has run its course.
The private sector's capacity to issue trusted (money-like) liabilities has
been greatly diminished. The hope is that Treasury stimulus and Federal Reserve
monetization will resuscitate private credit creation. The expectation is that
confidence in these instruments will return.
I would counter that once government interventions come to severely distort a
marketplace it is a very arduous process to get the government out and private
credit back in (just look at the markets for mortgage and student loan
finance!). This is a major, major issue.
The marketplace today wants to buy what the government has issued or guaranteed
(explicitly and implicitly). Market operators also want to buy what our
government is going to buy. In particular, the market absolutely adores
Treasuries, agency MBS, and government-sponsored enterprise debt (eg of
mortgage guarantors Fannie Mae and Freddie Mac). There is no chance such a
system will effectively allocate resources. There is no prospect that such a
financial structure will spur the necessary economic overhaul. None.
There is indeed great hope policymakers will succeed in preserving the current
economic structure. On the back of