Page 1 of 3 CREDIT BUBBLE BULLETIN No dialing back
Commentary and weekly watch by Doug Noland
US Treasury Secretary Timothy Geithner was being questioned last week by CNBC's
Steve Liesman: "Mr Secretary, how much concern do you have right now - how much
pressure are you under right now to dial back on these programs. Dial back
spending. Dial back - getting to the audience question right there that I think
is critical and that is really indicative of how Americans feel: Get the
government out of the private sector. How much pressure are you under right
now?"
Treasury Secretary Geithner: "No one is going to be more eager than I am.
You're just not going to care about that more than me. We do not want to be in
any of these institutions a day longer than is necessary. And look at what we
have already done. We already have US$80 billion of capital coming back into
the Treasury. If you look at what I said today in my testimony on the
Hill, we've seen these emergency programs we put in place already be used at a
tiny fraction of their scale in emergency. We designed these things so that
they would not be used a day longer than necessary.
"But we're going to be careful not to withdraw too soon. Again, the classic
mistake countries make in crisis is that they put on the brakes too early and
reignite the recession, ultimately at much greater fiscal cost and much greater
damage to the economy. So that's the balance we've got to get right. And we are
not now at the point - even though the challenge is shifting - we're a bit
moving now from emergency to the harder challenge, frankly, of repair and
recovery. That's going to change the mix of what we do. We're going to get out
and walk these things back as soon as we are confident we can get out of this
thing."
And last Thursday, Bloomberg's Jody Shenn reported: "'Credibly' privatizing
[government-sponsored enterprises, or GSEs] Fannie Mae and Freddie Mac ... may
be too difficult given the precedent set by the Treasury Department's financial
assistance, according to a Government Accountability Office analysis. 'The
financial markets likely would continue to perceive that the federal government
would provide substantial financial support to the enterprises, if privatized
as largely intact entities, in a financial emergency,' the GAO said ...
'Consequently, such privatized entities may continue to derive financial
benefits, such as lowered borrowing costs, resulting from the markets'
perceptions.' The Treasury today reiterated that the government intends to make
recommendations on Fannie Mae and Freddie Mac next year ... 'Any transition to
a new structure would need to consider the enterprises' still-dominant position
in housing finance and be implemented carefully (perhaps in phases) to ensure
its success," the GAO said."
My interest is not in taking shots at today's policymakers. They have been
faced with incredible challenges and proceed now on a course they hope and
believe is best for returning the country to sound footing. And while I
disagree strongly with the current path of policymaking, it has been
predictable. From a policymaking perspective, the greatest error came with the
Alan Greenspan / Ben Bernanke Federal Reserve's failure to act to rein in
systemic credit excess, asset inflation, and financial bubbles. Many belatedly
recognized the Fed's failings, yet few today appreciate that the costs and
risks of flawed analysis and theories only keep mounting.
I retain keen interest in debunking the Fed's thesis - articulated most clearly
by then Fed governor and now chairman Bernanke - that central banks should
avoid the business of popping bubbles and instead focus on post-bubble "mopping
up" strategies. It was, after all, post-Russia/Long-Term Capital Management
"mopping up" that fueled the tech bubble, and then the post-tech and 9/11
mopping that fostered the Wall Street/mortgage finance bubble. And the latest
big mop-up job sets the stage for perhaps the greatest bubble of them all - the
global government finance bubble.
They appear as free lunches at the time, but there are myriad financial and
economic costs associated with government intrusions into the marketplace. Most
are subtle and tend to remain quiescent for years. When (market pricing,
resource allocation and economic impairment) distortions do eventually manifest
into a crisis, policymaking will have a strong proclivity to treat misdiagnosed
ills with only greater government manipulations and intrusions. The greater the
degree of intrusion into the markets, the greater the ongoing costs involved.
Huge intrusions ensure open-ended government involvement and increasing
governmental command over the economic system.
As much as I believe Secretary Giethner is speaking earnestly, there is no way
at this point that government influence in the marketplace can be meaningfully
"dialed back". The damage has been done - historic distortions to both the
financial system and real economy. The damage began with the activist Fed under
then chairman Greenspan manipulating interest rates, promising market
liquidity, and pandering to the leveraged speculators. The damage worsened as
the government-sponsored enterprises came to dominate our nation's market for
housing finance. The damage turned unmanageable when the markets listened back
in 2002 to Dr Bernanke profess the virtues of helicopter money and whatever
other unconventional measures the central bank might deem worthwhile.
Federal government finance (Treasuries, agency debt and GSE mortgage-backed
securities) has expanded about $2.0 trillion over the past year. I expect it to
inflate another $2.0 trillion over the coming 12 months. The private sector
credit apparatus is simply not up to the task of generating the necessary $2.5
trillion (or so) of total system credit expansion necessary to sustain the
current economic structure. In this post-Wall Street bubble environment, only
government and government-related credit retains sufficient "moneyness" in the
marketplace. Systemic reflation today depends on a massive inflation of this
government helicopter "money".
Last week's GAO analysis of the GSEs was spot on and certainly applies to more
than just the government-sponsored enterprises: "The financial markets likely
would continue to perceive that the federal government would provide
substantial financial support to the enterprises, if privatized as largely
intact entities, in a financial emergency." Over five trillion dollars - and
counting - of GSE securities are valued and traded in the marketplace as
(money-like) government-backed obligations. Policymakers would not today risk
the negative financial and economic ramifications from dialing back from
Washington's explicit and implicit guarantees.
As much as moral hazard and "too big to fail" are recognized as fundamental
facets of previous bubble excess, our policymakers have nonetheless been
compelled to expand only further toward backstopping the entire credit system
(and economy). Obviously, the GSE's were too big to really fail, while markets
appreciate that policymakers now believe it was a mistake to allow Lehman to
collapse. The markets - more than ever before - operate with the view that
policymakers have no tolerance for a major financial institution failure.
When one contemplates the issue of "getting the government out of the private
sector", these various market liquidity support programs being wound down are
an insignificant issue. Fundamentally, for the economy to move toward sounder
and sustainable footing would require at least a semblance of a market-based
credit pricing mechanism. Regrettably, the vast majority of system credit today
is "public". Government intrusion chiefly dictates the cost of finance and the
allocation of financial and real resources. Furthermore, I would argue that the
limited amount of private sector debt being issued these days is reliant upon
the system-stabilizing effects of massive government debt issuance and
spending.
As I have stressed repeatedly, in the neighborhood of $2.5 trillion of
non-financial credit growth is required to stem systemic implosion - a massive
credit expansion with only our federal government up to the challenge. It is
this fundamental facet of bubble economies - a maladjusted economic structure
sustained only through ongoing credit excess - that prohibits Washington from
extricating itself from very public "private sector" intrusions. Fixated on the
notion of sustainable recovery, policymakers will not be dialing back from
massive borrowing, spending, or market backstopping endeavors. This gets to the
core of the unquantifiable costs of failing to rein in credit and asset bubbles
during the boom.
As I have written over the years, the entire notion of "mopping up" is as
flawed as it is dangerous. Clearly, the notion of inflationism remains as
seductive as it has throughout history. If deflation ever becomes a risk, the
central bank must aggressively raise the price level to preclude a downward
spiral. We heard this dogma in the early nineties, heard it again earlier this
decade, and have had it repeated too often over the past year. The answer is
always another bout of credit inflation.
The more intense the necessity to reflate, the greater the government's
evolving role throughout both the financial and economic systems. This is a
fact of life, human nature and politics. At the end of the day, inflationism
tends toward socialism.
There is only one way to reverse this course; it is anything but painless. The
economy must be weaned off of credit and financial excesses and government
intrusions and be allowed to proceed through the arduous task of adjustment and
rebalancing. Choosing instead a course of sustaining current financial and
economic structures implies a huge and ever-expanding role for the government.
Efforts to stoke a quick recovery imply massive government intrusion and
inherent fragility. There will be no dialing back.
Many hope the private-sector can regroup and again rise to the occasion. It is
expected that as recovery gains a foothold, private sector borrowing and
lending will increase, tax receipts will rise, and the government will enjoy
the luxury of dialing back as the system normalizes. I don't expect this
dynamic to work as it has traditionally because of the confluence of bubble
economy credit requirements, acute private sector credit system impairment and
market mistrust, and the government's predominant influence on the recovery.
The dynamic today is one of a shallow recovery induced by a flood of government
borrowing and spending and marketplace intrusions. Rampant financial
speculation has reemerged, which leaves the marketplace increasingly vulnerable
to any serious move to dial back. In a normal recovery, the system tends to
gain strength and stability over time. Credit requirements are usually
manageable, while speculative excesses have been largely wrung out of the
system. In stark contrast, today's combination of huge credit expansion and a
highly speculative financial backdrop ensures only more acute systemic
fragilities over time. The distorted marketplace will simply not function well
at even the notion of fiscal and monetary exit strategies.
Conceptually, somewhere along the line there reaches a tipping point where
government intrusions no longer act as a stabilizing force. They become
invariably destabilizing, as the quantity of government monetary inflation
becomes massive and uncontrollable. This is the nature of inflationism,
although this dynamic is nowhere to be found in Keynesian doctrine.
It is my view that this tipping point was reached some time back. It is with
this analysis in mind that I fear the emerging government finance bubble risks
destroying the creditworthiness of our entire economy.
WEEKLY WATCH
For the shortened week, the S&P500 increased 2.5% (up 15.4% y-t-d), and the
Dow gained 1.7% (up 9.5% y-t-d). The Morgan Stanley Cyclicals surged 4.3% (up
56.0%), and Transports jumped 5.3% (up 12.4%). The Morgan Stanley Consumer
index increased 2.5% (up 14.8%), while the Utilities slipped 0.5% (down 2.5%).
The Banks added 0.4% (up 2.5%), and the Broker/Dealers jumped 3.3% (up 48.0%).
The S&P 400 Mid-Caps rose 3.8% (up 26.2%), and the small cap Russell 2000
jumped 3.9% (up 18.8%). The Nasdaq100 gained 2.8% (up 39.1%) and the Morgan
Stanley High Tech index jumped 4.0% (up 55.6%). The Semiconductors rose 3.6%
(up 51.4%). The InteractiveWeek Internet index advanced 4.1% (up 58.6%). The
Biotechs added 0.3% (up 43.4%). With Bullion gaining another $11 to close above
$1,000, the HUI gold index rose 4.0% (up 40.9%).
One-month Treasury bill rates ended the week at 8 bps, and three-month bills
closed at 14 bps. Two-year government yields dipped 3 bps to 0.80%. Five-year
T-note yields fell 6 bps to 2.23%. Ten-year yields were down 10 bps to 3.34%.
Long bond yields were 9 bps lower to 4.18%. Benchmark Fannie MBS yields sank 14
bps to 4.29%. The spread between 10-year Treasuries and benchmark MBS narrowed
4 to 95. Agency 10-yr debt spreads narrowed 5 to 19 bps. The implied yield on
December 2010 eurodollar futures dropped 13.5 bps to 1.68%. The 2-year dollar
swap spread declined 4.0 to 31.75 bps; the 10-year dollar swap spread declined
4.25 to 16.75 bps; and the 30-year swap spread declined 3.25 to negative 16.25
bps. Corporate bond spreads were mostly narrower. An index of investment grade
bond spreads narrowed 13 bps to 162, while an index of junk spreads widened 2
to 690 bps.
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