Page 1 of 3 CREDIT BUBBLE BULLETIN Clinging to misguided mentalities
Commentary and weekly watch by Doug Noland
Nobel Prize economist Paul Krugman - of Princeton and the New York Times -
wrote a noteworthy piece this week: "Misguided Monetary Mentalities", published
in the New York Times on October 12.
"One lesson from the Great Depression is that you should never underestimate
the destructive power of bad ideas. And some of the bad ideas that helped cause
the Depression have, alas, proved all too durable: in modified form, they
continue to influence
economic debate today.
What ideas am I talking about? The economic historian Peter Temin has argued
that a key cause of the Depression was what he calls the 'gold-standard
mentality'. By this he means not just belief in the sacred importance of
maintaining the gold value of one's currency, but a set of associated
attitudes: obsessive fear of inflation even in the face of deflation;
opposition to easy credit, even when the economy desperately needs it, on the
grounds that it would be somehow corrupting; assertions that even if the
government can create jobs it shouldn't, because this would only be an
'artificial' recovery.
In the early 1930s this mentality led governments to raise interest rates and
slash spending, despite mass unemployment, in an attempt to defend their gold
reserves. And even when countries went off gold, the prevailing mentality made
them reluctant to cut rates and create jobs. But we're past all that now. Or
are we? America isn't about to go back on the gold standard. But a modern
version of the gold standard mentality is nonetheless exerting a growing
influence on our economic discourse. And this new version of a bad old idea
could undermine our chances for full recovery."
First of all, Dr Krugman states that "the bad ideas that helped cause the
Depression ... continue to influence economic debate today." Well, let's say
they were actually "bad ideas." Even then his implication would be only
somewhat true. There may be some feeble little impact on what has regressed to
one lopsided "debate." But, regrettably, ideas regarding sound money and credit
long ago lost their influence on actual economic policymaking.
Dr Krugman, like so many economists of our time, is an inflationist. He, like
so many before him, sees easy credit and the government printing press as the
solution to unemployment and other economic problems. And - in our age of
electronic "money" and unbounded global finance - there are apparently no
longer any bounds to US fiscal and monetary stimulus.
Former Federal Reserve chairman Alan Greenspan and current chairman Bernanke
are inflationists. The inflationists have been running the show since easy
credit was employed to juice the system after the 1987 stock market crash. The
consequences of that bout of policy-induced excess led to a more potent
inflationist policymaking elixir in the early-nineties to mop up the financial
mess. Since then, ever more emboldened credit inflation has been required to
battle crisis after crisis after crisis. Easy money and credit - the bane of
capitalism - were allowed to overwhelm the workings of the system. The point of
Trillion dollar deficits and zero interest rates has been reached - with the
undeterred inflationists now bent on this sorry state of affairs continuing
indefinitely.
By now, one would hope the inflationists would challenge their own views,
doctrines and mentalities. Instead, they trumpet the same old failed policy
responses - only in much larger dimensions and with greater conviction. And
that is precisely the flaw in inflationist doctrine: once it gets rolling it
becomes extremely painful to rein in the forces pushing for only greater
inflation. The more spectacular the inflationary boom and bust - the more
strident the inflationists become.
History is strewn with enough collapses, worthless currencies and social
upheaval that I find it ridiculous that the inflationists would today be taking
shots at sound money and credit. It is the inflationists clinging to misguided
monetary mentalities. The principle of sound money and credit has no reason to
have to defend itself.
Inflationism doctrine is riddled with failings: easy credit distorts system
pricing mechanisms; foments destabilizing speculation; spurs societal wealth
transfer; distorts the underlying economic structure; fosters financial
fragility; and debases the currency - to name just a few. History - including
recent history - validates this analysis.
Yet there are two particular facets of today's inflationism that make
"Keynesian" policymaking extraordinarily dangerous. First, the global backdrop
is one of unchecked credit and the absence of any disciplining global monetary
regime. Policy mistakes are free to run longer and with enormous global
financial and economic consequences. Second, policymakers and pundits herald
incredible post-bubble policy responses, while failing to recognize that
aggressive stimulus is, once again, fostering problematic bubbles. For too long
the inflationists have been negligent in their disregard for bubble dynamics.
From Dr Krugman: "Consider first the current uproar over the declining
international value of the dollar. The truth is that the falling dollar is good
news. For one thing, it's mainly the result of rising confidence ... ".
While confidence in the global reflationary backdrop may be rising, the dollar
is in trouble. And many dollar apologists will claim the greenback has no
immediate replacement and thus will retain its status as the world's reserve
currency. This line of reasoning misses the key point: the dollar reserve
global monetary "regime" has broken down as a mechanism for supporting stable
global credit and economic performance. Unchecked global finance now rules, a
consequence of the massive and ongoing devaluation of the world's reserve
currency.
Only the inflationists could argue the dollar's current predicament is "good
news". I don't see it. I don't view a world economy rebalancing or becoming
more stable. Instead, we're witnessing the unleashing of another furious global
boom and bust cycle. Crude oil traded above $78 this week as gold responded to
the weak dollar by surging to an all-time record high. US wealth is being
shifted overseas, and Americans' savings are being devalued. We are losing
financial power by the day. Good news? More easy credit to the rescue?
The inflationists are keen to argue that, with "inflation" remaining so low,
policymakers enjoy unusual latitude to stimulate. By this point, haven't we
learned that rising CPI is not a primary contemporary risk associated with
ultra-loose monetary policy? The mispricing of risk, unchecked speculation,
asset-bubbles, financial fragility, and economic maladjustment have already
proven themselves as deleterious effects of loose money. I group these types of
responses to unstable finance ("money and credit") as "monetary disorder."
Anyone watching global markets these days must recognize that monetary disorder
remains powerfully entrenched.
Krugman Concludes: "We do seem to have avoided a second Great Depression. But
giving in to a modern version of our grandfathers' prejudices would be a very
good way to ensure the next worst thing: a prolonged era of sluggish growth and
very high unemployment."
The first Great Depression was triggered by financial collapse - a historic
boom and bust. The jury is still out on the second. The inflationists believe
their policy prescriptions strengthen system underpinnings. I believe another
bout of global credit and speculative excess increases the likelihood of
eventual financial meltdown. And I believe a dollar crash significantly
increases the risk of a very problematic US financial crisis. Worse than benign
neglect won't suffice. Dr Krugman doesn't think it makes any sense to consider
raising rates. I don't think it makes any sense to disregard the reality that
fiscal and monetary policy went to dangerous extremes.
The time has come for a more level-headed and even-handed approach. As much as
they abhor the notion of sound money and credit, the inflationists need to back
away from their dogma before it's definitely too late. A prolonged period of
slow growth and sluggish employment is not the worst-case scenario.
WEEKLY WATCH
The S&P500 gained 1.5% (up 20.4% y-t-d), and the Dow added 1.3% (up 13.9%).
The Morgan Stanley Cyclicals jumped 2.6% (up 62.8%), and Transports rose 3.8%
(up 13.7%). The Morgan Stanley Consumer index gained 1.7% (up 20.1%), and the
Utilities added 1.3% (up 0.3%). The Banks slipped 0.3% (up 6.7%), and the
Broker/Dealers dipped 0.6% (up 59.1%). The S&P 400 Mid-Caps added 0.8% (up
31.5%), and the small cap Russell 2000 increased 0.2% (up 23.4%). The Nasdaq100
gained 0.7% (up 43.6%), while the Morgan Stanley High Tech index slipped 0.2%
(up 58.6%). The Semiconductors declined 1.1% (up 52.2%). The InteractiveWeek
Internet index added 0.2% (up 65.5%). The Biotechs jumped 1.9% (up 43.9%). With
Bullion adding $3, the HUI gold index traded unchanged (up 47.5%).
One-month Treasury bill rates ended the week at 4 bps, and three-month bills
closed at 6 bps. Two-year government yields dipped 2 bps to 0.83%. Five-year
T-note yields were little changed at 2.28%. Ten-year yields were 2 bps higher
to 3.41%. Long bond yields increased 2 bps to 4.25%. Benchmark Fannie MBS
yields rose 5 bps to 4.35%. The spread between 10-year Treasuries and benchmark
MBS yields widened 3 to 94 bps. Agency 10-yr debt spreads narrowed 3 to 5 bps.
The implied yield on December 2010 eurodollar futures was little changed at
1.755%. The 2-year dollar swap spread increased 2.5 to 38.75 bps; the 10-year
dollar swap spread increased 1.25 to 18.75 bps; and the 30-year swap spread
increased 2 to negative 7.25 bps. Corporate bond spreads narrowed further. An
index of investment grade bond spreads narrowed 4 bps to 138, and an index of
junk spreads narrowed 31 bps to a 13-month low 568 bps.
Investment grade issuers included Anheuser-Busch $5.5bn, US Central Credit
Union $2.5bn, Deere $1.25bn, Cantor Fitzgerald $500 million, and New York Life
$500 million.
Junk bond funds enjoyed inflows of $203 million (from AMG). Junk issuers
included American Tower $600 million, Talecris Biotherapeutics $600 million,
Sinclair Television $500 million, Trico Shipping $400 million, Drummond $250
million, Alon Refining $210 million, and Lion's Gate $230 million.
I saw no converts issued.
International dollar-denominated debt issuers included KFW $3.0bn,
Inter-American Development Bank $2.25bn, Banco Do Brazil $1.5bn, Royal Bank of
Scotland $3.5bn, Barrick Australia $1.25bn, Colombia $1.0bn, Korea Expressway
$700 million, Odebrecht $500 million, Intelsat Jackson $500 million, and Sri
Lanka $500 million.
U.K. 10-year gilt yields jumped 15 bps to 3.60%, and German bund yields
increased 8 bps to 3.28%. The German DAX equities index added 0.6% (up 19.4%
y-t-d). Japanese 10-year "JGB" yields rose 4.5bps to 1.325%. The Nikkei 225
rallied 2.4% (up 15.8%). Emerging markets ran further into new 2009 highs.
Russia's RTS equities index gained another 2.7% to a 2009 high (up 122.9%).
India's Sensex equities jumped 4.1% to a new 2009 high (up 79.6%). China's
Shanghai Exchange gained 2.2%, boosting 2009 gains to 63.5%. Brazil's benchmark
dollar bond yields were little changed at 4.90%. Brazil's Bovespa equities
index jumped 3.4% to a 2009 high (up 6.47% y-t-d). The Mexican Bolsa gained
2.3%, also to a 2009 high (up 37.3% y-t-d). Mexico's 10-year $ yields were
unchanged at 5.10%.
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