Page 1 of 3 CREDIT BUBBLE BULLETIN The US and inflationism
Commentary and weekly watch by Doug Noland
When the yen was under selling pressure late last year, media focus turned to
Japan's structural weaknesses and serious debt problem. The yen reversed course
and is up 4.6% in the year to date, by far the best performance among the major
currencies. To begin 2010, the markets have turned on the Greek and periphery
European bond markets. Attention quickly shifted to European
structural weakness and their serious debt problems. The US dollar has been
rallying, which has for the most part kept attention away from the United
States' structural weaknesses and serious debt problems - for now.
From Friday's Financial Times’ Nicole Bullock: "As protesters and strikers took
to the streets of Athens this week demonstrating against cutbacks aimed at
stemming the Greek debt crisis, questions were being asked in the US about
whether similar financial stress could erupt in states there. The economic
downturn has decimated tax collections, ripping large holes in budgets that
state lawmakers have slashed spending to plug ...
"Similarities have been drawn between US states and some eurozone members
because they are grappling with an global economic slowdown and large budget
deficits. With warnings from states from New York to California that they are
running out of cash or suspending bill payments, it is logical to ask whether
they will default - the same question that Greece is facing. In spite of these
strains, experts in the $2,800 billion municipal bond market where state and
local government raise money, are urging calm. This helps to explain why yields
in the municipal bond market have been stable to lower."
Bloomberg news ran an article on Friday, "Tax-exempt Yields Slide to Two-Month
Low ... " Seemingly insatiable demand allows top-rated municipal issuers to
sell 10-year bonds these days at about 3.0%. Muni risk premiums collapsed in
2009, right along with investment grade corporates, junk bonds, agency debt,
and agency MBS. Risk spreads remain depressed.
A Bloomberg reporter last week asked me "whether markets are underestimating
risk? Is the VIX too low? What does it mean?" I gave him too long of an answer.
I tried to explain my view that massive Treasury and agency mortgage-backed
securities (MBS) issuance - in concert with enormous Federal Reserve
monetization - stabilized an inherently unsound credit system. This
unprecedented expansion of government finance either reflated (in the case of
financial assets) or stabilized (in the case of real estate) asset markets,
which stabilized the level of finance flowing to the real economy. Much of the
post-bubble credit system remains impaired, resulting in an especially uneven
flow of finance throughout.
Are markets underestimating risk? Well, I would view low risk premiums as
simply an indicator of market confidence that Washington policymakers (Treasury
and Fed) will forge ever ahead with their reflationary scheme - and that these
measures will - until they don't - underpin securities prices and the real
economy. The markets are assured that ongoing trillion-dollar deficits and
near-zero interest rates will safeguard an amount of system credit expansion
sufficient to bolster asset prices, incomes, corporate cash flows, government
receipts, and economy-wide spending.
Market risk premiums are indicating faith that historic government-induced
reflation will support the values of credit instruments (financial assets)
throughout entire the system. Students of Hyman Minsky will recognize the
existence of "Ponzi Finance" dynamics.
For now, the markets are confident that the Ben Bernanke Federal Reserve and
the US Treasury enjoy all the flexibility they require to sufficiently expand
system credit. And it is this confidence that has ensured marketplace
accommodation of massive US federal government credit expansion. Greek - and
other European - policymakers, on the other hand, enjoy little capacity to
reflate. This leaves market participants fearful of credit constraints feeding
a cycle of economic weakness, asset market problems and general angst.
In my readings of the history of monetary management and central banking, I was
repeatedly struck by the long history of European scorn for US monetary
practices. Going back to at least the 19th century, there has been a
longstanding view that we lacked both monetary discipline and the proper
framework to ensure a stable credit system and currency. Traditionally, our
policymakers lacked an understanding of credit and, when in a jam, would
invariably resort to inflationism.
I was reminded of this history this week when I read European policymaker
responses to an International Monetary Fund (IMF) paper proposing that central
banks consider raising their inflation targets to 4%. The IMF paper,
co-authored by IMF chief economist Olivier Blanchard (MIT and Harvard),
suggests that crisis-period policymaking would have benefited from a higher
pre-crisis inflation level. ECB member and Bundesbank president Axel Weber said
the IMF was "playing with fire" and that such a proposal was "grossly negligent
and harmful." European Central Bank (ECB) executive board member Juergen Stark
called the proposal "most unhelpful" and stated that "there is no evidence
whatsoever to support that deviating from price stability and aiming at an
inflation rate of 4% would enhance economic prosperity or growth." He added, "I
do see the temptation for governments to ask for higher inflation in order to
monetize the dramatic buildup of public debt in nearly all advanced economies."
Nowhere does the temptation for higher inflation seem as indomitable as it does
here at in the United States. And the markets are fine with it. In the old
days, at least the bond "vigilantes" would have objected. But we live in the
financial age where "spread trades", myriad credit instruments, and speculator
profits are all bolstered by reflationary policymaking. Throughout the system,
many feel they would benefit from some additional inflation, while few fear
they would be disadvantaged. Federal Reserve monetization is cheered.
Inflationism dogma is as beloved as ever.
Former Fed governor Frederic Mishkin teamed up with Goldman's Jan Hatzius,
Deutsche Bank's Peter Hooper, New York University's Kermit Schoenholtz, and
Princeton's Mark Watson for a paper presented last week at the University of
Chicago. Their work introduces a new measurement of financial conditions. This
research also details their study that suggests that financial conditions
tightened at the end of 2009 and remain "impaired" because of problems in the
so-called shadow banking system. Dr Mishkin (now at Columbia) was on CNBC on
Friday morning trumpeting the view that "monetary policy needs to be
accommodative ... for an extended period."
From the Wall Street Journal's Jon Hilsenrath's: "One of the most important
drivers of the economists' financial-conditions index was the asset-backed
securities markets, where commercial real estate loans, car loans and many
other kinds of bank loans were financed during the credit boom." And from these
economists: "The new financial conditions index would be the only means
available to assess the impact of policy choices with interest rates near zero"
Well, I'm compelled to disagree with both the focus of this research and the
premise that financial conditions are anything but loose. The post-bubble
asset-backed securities (ABS) market is today an especially poor indicator of
system financial conditions. It would be akin to significantly weighting
private-equity financing of technology startups as an indicator of general
financial conditions after the bursting of the technology bubble. The housing,
mortgage and ABS manias/bubbles have burst and will not be meaningful
reflationary forces, at least directly. It is a major, yet predictable, error
to use unavoidable post-bubble credit impairment as justification for loose
financial conditions and policymaker accommodation of new excesses and
The pricing and expansion of mortgage credit was by far the most important
indicator of problematically loose financial conditions from 2002 through the
bubble period. Today, financial conditions should be gauged primarily by the
market pricing and associated expansion of government finance. It is the
unfolding government finance bubble that today poses great systemic risk - not
the ABS, "repo" or other components of the wreckage formally known as the
"shadow banking system". That was the old bubble.
First and foremost, policymakers should be focused on ensuring that they do not
foment even more dangerous bubbles and systemic fragilities. The
creditworthiness of our entire credit system and the credibility of our
monetary management and "money" are at stake.