Page 1 of 3 CREDIT BUBBLE BULLETIN From bear to bear
Commentary and weekly watch by Doug Noland
I was inspired to put a few thoughts together after pondering Jim Grant's
interesting op-ed piece in last Saturday's Wall Street Journal, "From Bear to
Bull".
Along with Mr Grant, I don't want to be associated with the term "permabear".
It implies a dogmatic lack of objectivity - the kiss of death for sound
analysis. I've been bearish for awhile and I remain so. My view is firmly
analytically based. Yet it doesn't mean that I expect the stock market to
always go south or the current recession to last indefinitely. Indeed, I am
firmly in the global reflation camp, going so far as to posit the emergence of
a powerful global government finance bubble.
I remain bearish because, from my analytical framework, deleterious credit
system developments suggest worse yet to
come - perhaps much worse. The global credit boom has not fully run its course,
so the depths of the downturn remain indeterminable.
Total US system credit almost doubled during the nineties to US$25.4 trillion.
System credit has again doubled to end Q2 at $52.8 trillion. I view this - in
conjunction with corresponding global excesses - as history's greatest credit
bubble. Over the past 12 months, US Treasury debt increased $1.9 trillion and
government-sponsored enterprises' mortgage-backed securities (GSE MBS) jumped
$400 billion - and counting. I believe unprecedented credit-related
maladjustment over decades continues to manifest itself in a severely impaired
US bubble economy.
Such deep structural impairment is rectified only through a long and sobering
period of retrenchment and rejuvenation, with adjustment not gaining critical
momentum until bubble-era destabilizing monetary processes are discontinued,
stable financial flows are established, and significant economic liquidation
has transpired.
From my analytical perch, I don't yet see the beginnings of significant
structural readjustment. Determined to limit the level of hardship,
policymakers have moved aggressively to sustain previous financial and economic
structures. Both from a domestic and international standpoint, sound financial
and economic footing will not have a chance until some semblance of a
disciplined monetary regime supplants the current "system" of synchronized
credit inflation.
There is a popular view that holds that the US economy benefits from an
inherent upward trajectory, a dynamic some say ensures a resumption of growth
as soon as financial crisis headwinds tail off. And then there is history -
always elucidated so eloquently by Mr Grant - that suggests the worse the
economic downturn the more robust the subsequent recovery. I tend to dismiss
the "inherent upward trajectory" thesis and believe the historical reliable
recovery viewpoint requires important qualifications.
First, the "inherent upward trajectory" thesis does not square well with my
analytical framework. First, I believe that the credit/financial system
generally dictates the workings/"trajectory" of economic system activity. This
has especially been the case over the past two decades on the back of profound
developments throughout contemporary money and credit. The bursting of the Wall
Street/mortgage finance bubble marked a momentous inflection point in credit.
The "trajectory" of credit - its type, flow and quantity - going forward will
be markedly different from the past 20 years, which will translate into a much
altered economic landscape. These days, caution is in order when it comes to
extrapolating past economic performance.
I would also caution against using historical parallels. This time is
different. History's greatest credit bubble, unmatched changes to the
underlying structure of the US "services" and unbalanced global economy, and an
unrestrained and rudderless global monetary "system" are just the most
conspicuous characteristics that set the current backdrop apart from anything
previously experienced.
Jim Grant quoted one of my favorite economic analysts, Michael Darda: "The most
important determinant of the strength of an economy recovery is the depth of
the downturn that preceded it. There are no exceptions to this rule, including
the 1929-1939 period."
It is worth noting that the level of nominal gross domestic product (GDP) from
1929 was not attained again until 1941 - after bottoming seven years earlier in
1934 (five years after the crash!). Statistically, GDP posted relatively strong
growth in 1935, 1936, 1937, 1939, 1940 and 1941 - but in aggregate this period
of "strength" only returned output back to the late-'20s level. And anyone
turning bullish in 1931 - two years after the financial bubble burst - would
have had to endure a nominal GDP drop of another 25% and even worse percentage
declines in the stock market. It was many years after the bursting of the
financial bubble before bullishness had much relevance.
For comparison, Q2 2009 nominal GDP was about 3% below the peak level from last
year, with the consensus view holding that this will be almost fully recovered
next year. It is hard to read dire expectations from current economic
forecasts. And keep in mind that non-financial credit grew 6.0% last year and
expanded about 4.5% annualized during this year's first half. We have by no
means experienced the worst-case scenario from a credit standpoint.
Last week's "Durable Goods" report and housing data confirm sluggish recovery.
Considering the double-digit federal deficit and zero interest-rate monetary
policy, economic performance remains unimpressive. Expectations have been
bolstered by stock market gains, and one would expect ultra-loose monetary
conditions to support output. But I'm sticking with the view that the housing
and consumption sectors of our economy will lag. Recall that the second quarter
saw contractions in both US household credit and mortgage borrowings.
The consumption-based US economy evolved over many years and is today poorly
positioned for the unfolding global reflationary backdrop. Granted,
policymakers reversed the downward financial and economic spiral, but stemming
a crisis and fostering sound and sustainable recovery is not necessarily the
same thing.
In past crises, government reflationary policymaking would help recapitalize
the private-sector credit system. Almost immediately, a Federal Reserve-induced
manipulation of financial conditions would spur borrowing, lending, and
leveraged speculation (not necessarily in that order). Private credit growth
would recover almost immediately, especially in housing related credit. Indeed,
home mortgage debt growth jumped to 9.4% in 1999 (post-Long-Term Capital
Management reflation) and 13.4% in 2002 (post-technology bubble reflation).
This rapid increase in mortgage credit corresponded to strong financial sector
expansion - with financial sector borrowings increasing 16.2% in 1999 and 9.6%
in 2002.
In my analytical vernacular, for two decades mortgage credit demonstrated a
robust "inflatationary bias". This credit characteristic provided the Federal
Reserve a powerful mechanism for monetary stimulus. And the results were
predictable: in crisis, the Fed would aggressively cuts rates, in the process
creating a strong incentive for leveraged speculation in mortgage securities
(and other risk assets). Meanwhile, the dramatic loosening in mortgage credit
would incite a refinance boom and enormous equity extraction - not to mention a
strong upsurge in home sales and construction.
The timely refinance, home equity, construction and home transaction booms
worked both to increase system credit and boost economic output. And it was not
long before this powerful reflationary dynamic created a self-reinforcing rise
in home prices, household financial wealth, household consumption and business
investment. It was like clockwork, ensuring virtually uninterrupted credit
expansion, the mildest of economic downturns, deeply ingrained confidence, and
the greatest credit bubble in the history of mankind. The Fed misused its power
to manipulate private credit expansion, system spending, market psychology and
financial speculation.
There is at this point ample confirmation that, with the bursting of the Wall
Street/mortgage finance bubble, this previously steadfast inflationary dynamic
has turned impotent. The combination of securitized finance, the proliferation
of leveraged speculation, contemporary unconstrained finance, and activist
central banking nurtured a financial and economic environment unlike any in
recent history. But analysts should no longer extrapolate from this previous
boom period. Previous credit and economic dynamics no longer apply.
And if the nuances of the past 20 years (or more) argue against extrapolation,
I contend that the emergence of the government finance bubble only further
complicates drawing historical inferences. First of all, massive monetary and
fiscal stimulus has supported system-wide incomes, spending, and corporate
revenues. Policies also incited an unwind of bearish positions and a rather
robust, albeit speculative, stock market rebound. Thus far, zero rates and
trillion dollar deficits have created the illusion of normalcy - when it comes
to both the markets and real economy. This creates an "analytical" hook that
will snare many.
In contrast to previous mortgage-credit dominated reflations, the evolving
global reflation will prove unique for its lack of self-reinforcing dynamics
here at home. Before, a trillion of net additional mortgage credit would
reliably inflate home prices and induce more borrowing, consumption and
investment - all of which worked to bolster self-reinforcing confidence in the
underlying credit apparatus and the overall soundness of the general boom-time
economy. Today, faith in this private-sector credit machine is broken, while
housing bubble/consumption psychology is badly shattered.
The $2 trillion of federal credit over the past year may have stabilized
national income, but it has not reflated home prices or rejuvenated household
and mortgage credit growth. I don't expect another $2 trillion to have a much
bigger impact, creating a backdrop where the lack of a self-reinforcing
private-credit growth dynamic creates acute systemic vulnerability to any
withdrawal of massive federal government spending. Moreover, any backup in
market yields - perhaps in anticipation of Federal Reserve "exit strategies" -
would weigh heavily on private-sector credit recovery.
I'll look to remove the bear from my lapel when a sounder credit backdrop
emerges at home and globally. It's just not moving in that direction. I don't
see trillions of federal government credit as sustainable or constructive - and
wouldn't extrapolate recent system stabilization out to a sustainable economic
recovery. I don't see any semblance of restraint or monetary discipline - the
requirements of a sustainable monetary regime - in key domestic credit systems
internationally. And I wouldn't assume that the worst of credit dislocation is
behind us.
And, I'll add, the worst-case scenario at this point would include a robust
global rejuvenation of credit and asset bubbles, rapid synchronized economic
recovery, and a rebirth of bullish expectations. I do see all the makings for a
grinding, debilitating, secular bear market.
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