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3 CREDIT BUBBLE
BULLETIN Payback
time Commentary and weekly watch
by Doug Noland
I'll apologize in advance, as
this analysis would not be easy to follow even if
it were written well (which it is not). I highly
recommend Bill Gross' latest, "Two-Bits,
Four-Bits, Six Bits, a Dollar". His analytical
focus is directed right at key market issues: the
importance of the system credit creation baton
being "handed off" from the public sector back to
the private sector; market impact from the planned
June termination of the Federal Reserve's
quantitative easing (QE) program; and the
prospective pricing of enormous supplies of
Treasury debt in a post-QE world.
I
take keen interest in Mr Gross's thesis that "the
odds of ultimate QE success seem critically
dependent on several criteria". (1) "initial
sovereign debt levels that are relatively low ...
"; (2) "the ability of a country to print globally
acceptable scrip - especially
enhanced if that nation has
the reserve currency status now ascribed to the US
... " And (3) "the willingness of creditors to
believe in future real growth as a rebalancing
solution to current excessive deficits and debt
levels ... " Mr Gross writes that "most observers"
agree with the view that the Fed's quantitative
easing plan was implemented "under the favorable
conditions of (1) and (2)," while (3) is "more
problematic".
There is a tremendous amount
riding on this line of analysis. And in terms of
"ultimate success" in the policy of aggressive
public sector credit creation and monetization, I
believe that conventional thinking is missing
fundamental facets of credit and economic
analysis. Without a doubt, I fear optimism
surrounding the popular perception that we entered
this crisis with a favorably low sovereign debt
level is misplaced. Truth be told, our government
debt levels were pushed artificially low by the
previous historic expansion of "private" sector
borrowings.
This debt backdrop has
created a dynamic whereby Gross's "(1)" appears to
be a favorable policymaker asset: that the federal
government sector enjoys unusual capacity to
promote economic recovery through expansive
borrowing and spending programs. Yet, in the end,
this flexibility will afford policymakers much too
long a rope - ironically amounting to a dangerous
liability for the US credit system and economy,
along with global stability overall. I have
posited that severe structural fiscal issues from
the early 1990s were papered over by an
unprecedented expansion of private-sector
borrowings - debt that was intermediated through
innovative Wall Street finance. It's now payback
time.
Corporate Credit expanded
9.9% in 1997, 11.7% in '98, 10.7% in '99, and 9.3%
in 2000. During this four-year credit boom,
corporate debt surged 49% to $6.595 trillion.
Credit growth slowed meaningfully following the
bursting of the tech/corporate debt bubble,
although policy-induced reflation ensured
double-digit growth returned in 2006 (+10.5%) and
2007 (+13.1%).
Yet corporate excesses pale
in comparison to the binge perpetrated by the
American consumer. Household debt expanded 8.4% in
'99, 9.1% in 2000, 9.6% in '01, 10.8% in '02,
11.8% in '03, 11.0% in '04, 11.1% in '05, 10.1% in
'06 and 6.8% in 2007. A historic credit bubble saw
household debt balloon 134% in nine years to
$13.803 trillion. This surge in finance spurred
consumption and consumer-related investment, along
with fostering a surge in asset prices and
attendant capital gains. Tax receipts inundated
government coffers from local municipalities to
the halls of congress. Politicians at all levels
luxuriated in the windfall, expanding spending
programs while trumpeting fiscal soundness.
The
new-found - and seemingly unending - capacity to
intermediate risky mortgage, household, and
corporate borrowings was integral to prolonging
the boom. US financial sector debt basically
expanded at double-digit annual rates from 1993
through 2007. During this period, financial sector
credit market borrowings jumped from $3.024
trillion to $16.208 trillion, or 436%. The "golden
age" (1993 through 2007) of Wall Street finance
saw assets of government-sponsored enterprises
such as mortgage guarantors Fannie Mae and Freddie
Mac jump 474% to $3.174 trillion; agency
mortgage-backed securities 251% to $4.464
trillion; asset-backed securities 1,080% to $4.532
trillion; broker/dealers' assets 709% to $3.092
trillion; net repurchase agreements 447% to $2.157
trillion; and Wall Street off-balance sheet
"funding corps" 465% to $1.849 trillion.
It
is today an analytical imperative to appreciate
some of this credit inflation's key effects.
Importantly, federal government receipts inflated
from $1.148 trillion in 1992 to $2.655 trillion by
2007. A federal deficit of more than $300 billion
in '92 was transformed into surpluses - and talk
of paying down the entire federal debt - by the
end of the 1990s. More importantly, the expansion
of private sector debt inflated expenditures and
price levels throughout the economy and markets -
spending and imports; home, stock and private
business values; household incomes; corporate
revenues and cash flows; and government receipts
and expenditures. In the single best illustration
of the scope of bubble inflationary effects,
non-financial debt growth expanded from less than
$600 billion annually in the mid-'90s to $2.5
trillion by 2007.
The concept of "payback time"
rests on the thesis that the incredible inflation
of mortgage and Wall Street finance nurtured a
maladjusted bubble economy (with myriad inflated
price levels/distorted spending
patterns/imbalances/credit dependencies) that
became reliant on $2 trillion or so of annual
system credit expansion.
Not
only did the "private" sector boom dramatically
inflate the amount of system credit required to
sustain spending, incomes and asset prices (to
hold downward debt spiral dynamics at bay), it
also severely impaired the creditworthiness of
non-governmental debt issuers. Moreover, important
facets of Wall Street risk intermediation were
discredited (GSEs, collataralized debt
obligations, auction-rate securities, and so
forth). Large swaths of private sector debt have
lost "moneyness" in the marketplace, and it will
be quite some time (think Japan) before the moon
and stars line up again for a replay of this
bubble.
As we've witnessed for going
on three years, massive government sector
borrowings now completely dominate system credit
creation (more than 100% of total non-financial
credit growth). This public sector borrowing and
spending binge has indeed sustained/reflated
bubble economy price levels, although the prospect
for any handoff to the private sector remains
bleak.
To be meaningful on a
systemic basis (promoting a "handoff"), annual
private sector debt growth today would have to
grow from around zero to many hundreds of
billions. Yet in today's post-bubble environment
for private credit (with household and corporate
borrowers hesitant to borrow and the marketplace
disinclined to finance another boom) the
likelihood of a major resurgence in mortgage and
corporate credit expansion is remote.
I
would argue that the government's (Treasury and
Federal Reserve) reflationary policymaking is
fomenting systemic risks that actually ensure that
the marketplace will lack the sufficient future
appetite for private financial obligations - a
prerequisite for a credit creation "handoff".
Federal Reserve liquidity
operations have been fundamental to the
marketplace's accommodation of escalating federal
borrowing requirements. And each passing year of
rising federal deficits ensures an even larger
gulf between the total amount of system credit
creation required to sustain the boom and the
limited capacity of the private-sector to begin
carrying the load. Furthermore, the longer the
government finance bubble is prolonged, the
greater the systemic dependency for this type of
finance both from a financial and economic system
perspective. Or, explained somewhat differently,
the larger the government finance bubble the
smaller the potential private sector Credit
impact.
Federal Reserve monetization
has also exacerbated global financial system
liquidity excess, as increasingly speculative
global finance comes further unhinged from even a
semblance of a stable "reserve" currency. Surging
global food and energy prices are an increasingly
conspicuous consequence of activist global
policymaking, a dynamic that is no friend to US
household vitality or creditworthiness (or,
inevitably, bond prices). And here the dimensions
of the previous "private" credit bubble (as
opposed to the seemingly favorable federal debt
position) are the determining factor with respect
to the scope of quantitative easing operations.
Irrespective of government debt ratios,
post-bubble economic maladjustment and credit
impairment create fragilities that ensure our
central bank errs on the side of ultra-low rates
and aggressive monetization. I see the unfolding
boom in federal finance as anything but mitigating
our structural debt and economic problems.
The
federal government sector did commence the
post-mortgage/Wall Street finance bubble period
with manageable marketable (not including
contingent liabilities) debt levels. From a credit
bubble perspective, however, this is proving a
liability. The marketplace has accommodated the
greatest three-year expansion federal debt in
history, reinvigorating bubble dynamics and
re-inflating systemic fragilities. And despite
Fed-induced artificially low borrowing costs, our
government's so-called "favorable" debt ratio has
deteriorated rapidly.
The government sector is now
well on its way toward impairing its
creditworthiness. And while diminished, the
dollar's status as reserve currency ("ability of a
country to print globally acceptable scrip") has
been instrumental in the ability of global central
bankers to "recycle" the unending surfeit of
dollar balances right back into our securities
markets. In this respect, I would argue another
"asset" is proving a quite unfavorable
bubble-fomenting liability. These days, our
government finance bubble has counterparts all
around the world, in an environment of monetary
disorder and increasingly unwieldy global finance.
WEEKLY WATCH For a notably volatile week,
the S&P500 added 0.1% (up 5.1% y-t-d), and the
Dow gained 0.3% (up 5.1%). The S&P 400
Mid-Caps gained 0.5% (up 6.8%), and the small cap
Russell 2000 rose 0.4% (up 5.3%). The Banks
dropped 2.4% (up 0.1%), while the Broker/Dealers
fell 1.5% (up 1.6%). The Morgan Stanley Cyclicals
(up 2.9%) and Transports (down 0.9%) were little
changed. The Morgan Stanley Consumer index added
0.1% (down 0.4%), while the Utilities added 0.5%
(up 1.1%). The Nasdaq100 gained 0.6% (up
6.4%),while the Morgan Stanley High Tech index
slipped 0.3% (up 5.6%). The Semiconductors
declined 0.8% (up 11.7%). The InteractiveWeek
Internet index fell 0.8% (up 3.9%). The Biotechs
added 1.0% (up 0.1%). With bullion up $20, the HUI
gold index rallied 3.3% (unchanged).
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