Page 1 of 3 CREDIT BUBBLE BULLETIN The greatest cost
Commentary and weekly watch by Doug Noland
An astute analyst posed the following question last week: "The current debate
is centered on whether the [US Federal Reserve] can take back the liquidity in
time in order to prevent inflation. Suppose it can. Suppose they execute this
perfectly. But if the Fed is able to flood the system with the liquidity (thus
reducing the severity of the downturn) and take it back before it causes
inflation, it seems there is a free lunch. We get something for nothing. So,
assuming a perfectly executed game plan by the
Fed, is there a cost? Do they keep rates low for a time, only to raise them a
lot a year down the road - is that the cost? Or is there another cost?"
I'm short on time today, so I'll attempt a brief response.
First of all, while it often appears otherwise, finance provides no free lunch.
The mispricing of credit and misperceptions of risk in the marketplace have
deleterious effects, although their true impact may remain unexposed for years.
Indeed, the more immediate (and always seductive) consequences of loosened
financial conditions tend to be reduced risk premiums, higher asset prices, and
a boost to economic "output". Conventional analysis of monetary policymaking
still focuses on "inflation" and "deflation" risks. I would strongly argue that
our contemporary world has already validated the analysis that acute financial
and economic fragility are major costs associated with market pricing
distortions.
When the Federal Reserve collapsed interest rates following the bursting of the
technology bubble, the results seemed constructive. Stock and real estate
prices inflated; a robust economic recovery ensued. There was at the time some
recognition of the potential for real estate excesses. But this was seen as
such a small price to pay in the fight against the scourge of deflation. It was
not until 2007 that the nature of the true costs of a massive "reflation" began
to come to light.
Many would today argue that it was simply a case of the Fed's failure to take
the punchbowl away in time. Such analysis misses a key facet of bubble
dynamics. Once the mortgage finance bubble gained a foothold, there was
absolutely no way policymakers were going to be willing to risk bursting such a
consequential bubble.
I see ample support for my view that bubble dynamics have taken root throughout
government finance. This unprecedented inflation includes Federal Reserve
Credit, Treasury borrowings, agency debt, mortgage-backed securities issued by
government-sponsored enterprises (GSEs) such as home-loan guarantors Fannie Mae
and Freddie Mac, Federal Housing Administration and Federal Deposit Insurance
Corporation insurance, massive pension and healthcare obligations, the myriad
new market support programs, and so forth. This government finance bubble is
domestic as well as global. Amazingly, the scope of the unfolding bubble dwarfs
even the mortgage finance bubble. And, importantly, it is reasonable to presume
that the Federal Reserve will find itself in the familiar position of being
trapped by the risk of bursting a historic bubble.
So I see the probabilities as very low that the Fed will reverse course and
impose tightened liquidity conditions upon the marketplace. Actually,
reflationary pressures may force the Fed to increase its Treasury holdings in
an effort to maintain artificially low interest rates. At the same time, I
don't see higher inflation as the greatest cost associated with this
predicament. Much greater risk lies with the acute systemic fragility that I
believe is inherent to major bubbles.
Similar to mortgage finance 2002-2007, the marketplace is significantly
mispricing the cost - and failing to recognize the risks - of a massive
inflation of government finance. And while every bubble has its own dynamics
and nuances, the unfolding government finance bubble has even more precarious
Ponzi finance dynamics than the mortgage bubble.
The markets are on tract to accommodate US$2 trillion or so of Treasury
issuance this year. This incredible amount of debt creation is in the range I
would expect necessary to temporarily stabilize the US ("services") bubble
economy. Importantly, this amount of new finance both plugs financial holes and
works to stabilize inflated income levels. From last week's income data, one
can see that personal income was up 0.3% year on year to $12.04 trillion. And
while 0.3% is very meager growth, without massive government fiscal and
monetary expansion (inflation) the economy would have suffered a destabilizing
income contraction. Keep in mind that personal income has inflated 65% since
1998 and 33% from 2003.
I'll try to explain my belief that dangerous Ponzi finance dynamics are in play
with the current course of policymaking. First, I view panicked policymakers as
seeing no alternative than to try to sustain the current (deeply maladjusted)
economic structure. A more natural course of economic adjustment - from finance
and consumption-driven bubble economy to a more balanced system - was going to
be much too painful to endure. So a massive government inflation was commenced
in desperation - with the grandiose objective of revitalizing securities
markets, housing prices, and the overall US economy. I just don't see how this
reflation goes much beyond stoking a susceptible artificial recovery.
First and foremost, with government finance now completely dominating the
credit system, I can't even begin to contemplate how this process might nurture
an effective allocation of financial and real resources. Indeed, I see today's
manifestations of credit bubble dynamics as an extension of similar mispricing,
misperceptions, and over-issuance that led to last autumn's near financial
collapse.
Admittedly, the massive extension of government credit and obligations works
wonders in stabilizing a devastatingly impaired system. Inflationism is always
seductive; trillions of dollars worth is absurdly seductive. Yet this extra
layer of debt does little to effect change to the underlying economic
structure. Actually, a strong case can be made that it only delays and
sidetracks the necessary adjustment process. And, importantly, this enormous
additional layer of system debt exacerbates system vulnerability.
At the end of the day, a system is made or lost on the soundness of its
underlying economic structure. I posit that a sound economic structure is
reliant upon only moderate credit growth and risk intermediation. Our system
requires massive credit expansion and intensive risk intermediation. I would
also posit that there are no benefits - only escalating costs - to throwing
massive credit inflation upon an unhealthy economic structure. And, returning
to Ponzi dynamics, one of the major costs to such inflationism is a massive
expansion of non-productive credit - obligations that are created without a
corresponding increase in real economic wealth producing capacity. The debt can
only be serviced by the creation of more debt obligations.
The danger is that markets too easily and for too long accommodate massive
credit expansion during the boom. Federal Reserve policies are fundamental to
this dynamic. But at some point and out of the Fed's control, as Wall Street
learned, greed inevitably turns to fear and a reversal of speculative flows
marks the onset of the bust. And it's the massive inflation of non-productive
credit that ensures the unavoidable crisis of
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
