Page 1 of 3 CREDIT BUBBLE BULLETIN Inflationism's seductive battle cry
Commentary and weekly watch by Doug Noland
Standard & Poor's move last week to lower the outlook for Britain's credit
rating brought the spotlight on the even more disastrous US debt situation. And
it doesn't help that the US dollar has found itself under renewed pressure of
late, with even the British pound gaining about 5% this week against our
currency. Rather ironically, two of our nation's prominent economists called
this week for the Federal Reserve to move even more aggressively to spur credit
expansion and stoke inflation.
Start first with a May 22 Bloomberg report by Dakin Campbell and
Mark Crumpton:
Bill Gross, the co-chief investment officer of Pimco ...
said the US 'eventually' will lose its AAA rating, but not any time soon. Both
the UK and the US have prospective deficits of 10% annually as far as the eye
can see ... At some point over the next several years' the debt of each 'may
approach 100% of GDP, which is a level at which country downgrades tend to
occur,' he said ... Gross's comments today come two months after he said the US
government will need to spend as much as $4 trillion in additional capital to
cushion a slowing economy. The Federal Reserve said March 19 that it would
purchase $1.8 trillion in Treasuries and housing-related debt to lower
borrowing costs. 'We need more than that,' Gross said at the time. The Fed's
balance sheet 'will probably have to grow to about $5 trillion or $6 trillion,'
he said.
Three days earlier, on May 19, Bloomberg's Rich Miller
reported:
What the US economy may need is a dose of good old-fashioned
inflation. So say economists including Gregory Mankiw, former White House
adviser, and Kenneth Rogoff, who was chief economist at the IMF (International
Monetary Fund). They argue that a looser rein on inflation would make it easier
for debt-strapped consumers and governments to meet their obligations. It might
also help the economy by encouraging Americans to spend now rather than later
when prices go up. 'I'm advocating 6% inflation for at least a couple of
years,' says Rogoff … who's now a professor at Harvard ... 'It would ameliorate
the debt bomb and help us work through the deleveraging process.' …Given the
Fed's inability to cut rates further, Mankiw says the central bank should
pledge to produce 'significant' inflation ... That would put the real,
inflation-adjusted interest rate…deep into negative territory, even though the
nominal rate would still be zero. If Americans were convinced of the Fed's
commitment, they'd buy and borrow more now, he says ... In advocating that the
Fed commit itself to generating some inflation, Mankiw ... likens such a step
to the US decision to abandon the gold standard in 1933, which freed policy
makers to fight the Depression ... Inflationary increases in wages - and the
higher income taxes they generate - would make it easier to pay off debt at all
levels. 'There's trillions of dollars of debt, in mortgage debt, consumer debt,
government debt,' says Rogoff ... 'It's a question of how do you achieve the
deleveraging. Do you go through a long period of slow growth, high savings and
many legal problems or do you accept higher inflation?'
It is
difficult to comprehend how - with credit and inflation lessons that should
have been learned by this stage in the cycle - inflationism remains so
ingrained in economic orthodoxy. Yet the long and sordid history of inflation
should have had us on guard. Inevitably, the typical policy response to the
hardship wrought from an inflationary credit boom is the hope for some positive
impact from one "final" bout of inflation.
I'll commence this week's discussion making the point that the issue is not
whether the US "inevitably" loses its AAA rating. Rather, the focal point of
the current economic debate should be on whether our well-intended policymakers
(fiscal and monetary) have charted a course that risks bankrupting the entire
economy. I'll continue to argue that the paramount policy priority should be
avoiding such an outcome. And I will add that there is ample confirmation these
days of the inherent propensity for inflationary developments to proceed toward
the worst-case scenario.
Dr Rogoff, advocating 6% (consumer price) inflation, believes a rapidly rising
price level would "ameliorate the debt bomb and help us work through the
deleveraging process". I disagree on both counts. Trillions of government debt
issuance only worsens potential "debt bomb" consequences. There is a school of
thought that holds that policymaking is today lessening the debt-service
burden. This may be somewhat true for the household and financial sectors. I
would argue, however, that the benefits to American households are actually far
outweighed by the systemic risks associated with the redistribution of
multi-trillions of debt and assorted risks to the federal government (inclusive
of the Federal Reserve). And this is an especially inopportune time to
aggregate escalating systemic risk in Washington.
This aspect of the "debt bomb" - or, in my nomenclature, credit bubble dynamics
- is not readily discernable today. While federal debt will likely expand an
astounding 13% of gross domestic product (GDP) this year, the optimists take
comfort that total federal debt as a ratio of GDP is not yet at a problematic
level (and much less than Japan!). Yields are rising, but Washington has no
problem selling its paper today. Nonetheless, a crisis of confidence in the
Treasury market would be catastrophic. The consensus view believes that
Fed-induced low mortgage rates (and resulting refinance boom!) are spurring
system repair. I would argue that the associated massive redistribution of
mortgage risk (credit, interest rate and liquidity), especially to the failed
government-sponsored enteprises (such as mortgage guarantors Fannie Mae and
Freddie Mac), is a real time bomb.
Rogoff and others believe policymakers are these days "ameliorating" the
deleveraging process. My analytical framework takes a contrasting view. The
critical "deleveraging" process at this point would amount to weaning the US
bubble economy off of its currently required US$2.0 trillion or so of annual
credit growth. The issue is at its heart embedded deep within the economic
structure and will not be cured through additional credit inflation. Current
policymaking is shifting the debt burden from the private sector to the federal
government sector - and, in the process, increasing the total system
(non-productive) debt burden by another $2.0 Trillion or so annually.
Moreover, I would argue that this momentous government intervention (Fed and
Treasury) in the pricing of finance further corrodes our system's process of
allocating financial and real resources. The "debt bomb" is not being diffused.
Rather, the fuse is being somewhat lengthened as the bomb enlarges.
Professor Mankiw believes that if US consumers understood that prices were
going to rise they would borrow more and accelerate purchases - and this would
better our economic plight. But our economy doesn't produce enough of what they
would likely want to buy, so our current account deficit would rapidly reflate.
The dollar is already weakening, which means upward pricing pressure for
imports (not to the benefit of the household sector or for system stability
more generally). Besides, I would argue that rising inflation expectations lead
quickly to purchases of foreign stocks, bonds, gold, energy, commodities and
other "undollar" assets. As we've witnessed in the markets over the past few
weeks, the latent (weak dollar-induced) inflationary bias in non-dollar
asset-classes can emerge and quickly feed on itself.
At the end of the day, it is our maladjusted economic structure in concert with
speculative market dynamics that will likely dictate future inflationary
characteristics. The notion that there is a system price level easily
manipulated by our monetary authorities to produce a desired response is an
urban myth. During the 2000-2004 reflation, I would often note that "liquidity
loves inflation". The salient point was that the Fed could indeed
create/inflate system liquidity. It was, however, quite another story when it
came to directing stimulus to a particular liquidity-challenged sector. Almost
inherently it would flow instead to where liquidity - and resulting
inflationary biases - were already prevalent.
If the dollar bear has resumed, the global inflation/monetary disorder issue
could quickly reemerge. Federal Reserve efforts to reliquefy our system would
be expected to prove self-defeating in a backdrop of significant dollar and
Treasury market weakness. Such a scenario would expose what I believe is a
major flaw in the conventional economic view that there is a trade-off
available between the difficulties inherent to a long economic workout and the
acceptance of a higher level of inflation. I fear the current policy path
ensures an especially arduous and protracted adjustment period - along with
myriad problems associated with an unwieldy inflation backdrop.
I also want to take exception with Mankiw's likening of a Fed push toward
higher inflation to the decision to abandon the gold standard in 1933. This
gets back to the disagreement I've had with the "inflationists" for years now:
in the name of Keynesian economics, inflation proponents have repeatedly called
for massive stimulus in response to the bursting of THE bubble, while in
reality this activist policymaking was instrumental in only extending and
worsening a systemic credit bubble. This was especially the case after the
bursting of the technology bubble and is again true today following the
bursting of the Wall Street finance/mortgage finance bubble. Now, more than
ever before, "Keynesian" inflationism is THE bubble. When it eventually bursts
Washington policymakers will have little left to offer.
WEEKLY WATCH
For the week, the S&P500 gained 0.5% (down 1.8% y-t-d), and the Dow added
0.1% (down 5.7%). The Morgan Stanley Consumer index rose 1.6% (up 0.1%), while
the Utilities dipped 0.3% (down 12.7%). The Morgan Stanley Cyclicals rallied
2.5% (up 11.0%), while the Transports fell 1.5% (down 15.0%). The volatile
Banks declined 2.6% (down 19.5%), while the Broker/Dealers gained 4.2% (up
23.4%). The broader market ended the week somewhat higher. The S&P 400
Mid-Caps gained 1.0% (up 2.4%) and the small cap Russell 2000 added 0.4% (down
4.4%). The Nasdaq100 gained 0.6% (up 12.5%), and the Morgan Stanley High Tech
index advanced 1.7% (up 22.0%). The Semiconductors jumped 3.4% (up 18.0%), and
the InteractiveWeek Internet index gained 1.5% (up 32.4%). The Biotechs rallied
0.7% (down 4.2%). With Bullion jumping $26, the HUI gold index surged 10.9% (up
25.4%).
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