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3 CREDIT BUBBLE
BULLETIN S&P starts the
process Commentary and weekly
watch by Doug Noland
The good news from
Standard & Poor's was that the company
reaffirmed the United States' "AAA" sovereign debt
rating. The bad news was that its outlook was
revised to "negative".
From Standard &
Poor's: "We believe there is a material risk that
US policymakers might not reach an agreement on
how to address medium- and long-term budgetary
challenges by 2013; if an agreement is not reached
and meaningful implementation does not begin by
then, this would in our view render the US fiscal
profile meaningfully weaker than that of peer
'AAA' sovereigns."
US bond prices actually
moved up on the news (in the face of last Monday's
weak stock market), and yields ended lower for the
week. It's true that the markets were not caught
unaware of our
nation's fiscal woes. And
similar to other potentially negative fundamental
developments, markets participants are these days
content to play the here and now - and leave
structural issues for some later date.
From my perspective, S&P's summary
point for why the US retains its top rating
provided the most contestable aspect of their
report: "The economy of the US is flexible and
highly diversified, the country's effective
monetary policies have supported output growth
while containing inflationary pressures, and a
consistent global preference for the US dollar
over all other currencies gives the country unique
external liquidity."
Clearly, our
"flexible and highly diversified" economy was
unsuccessful in thwarting a crisis of confidence
for much of our private sector debt - a debacle
that nearly led to the collapse of our credit
system, stock market and economy back in 2008. And
having witnessed our monetary policy propagate a
20-year cycle of booms and busts, I'll stick to
the view that the Federal Reserve is more of a
liability than an asset when it comes to
prospective debt quality.
Loose monetary
policy from the Fed accommodated the greatest
expansion in mortgage debt in history - and now
zero rates and monetization are well on their way
to supporting a historic boom in government debt.
And, of course, a decade of dollar weakness raises
the question as to the true underlying "global
preference" for our currency.
There's
going to be one hell of fight in Washington over
the details of deficit reduction. With too many
eyes on 2012 elections, it's sure to be a
challenging environment - to say the least - to
muster bi-partisan compromise. Prospects for any
serious near-term spending cuts are slim to none -
and the markets are more than fine with this. The
marketplace believes it has at least a couple
additional years before the debt situation turns
problematic (hence, market-impactful). In the
meantime, participants are confident that the odds
of big - and destabilizing - spending cuts prior
to 2013 are slim. This is all in the market.
During the heart of mortgage finance
bubble (2001 through 2007), total mortgage debt
expanded about $7.8 trillion, or 115%. Mortgage
excesses evolved to dominate the workings of the
credit system, becoming the majority of total
system non-financial debt growth. This source of
finance provided crucial inflationary fuel for
home prices, equity extraction, household net
worth, incomes, corporate earnings/cash flows,
government receipts/expenditures, imports and
global financial flows. Over time, these flows -
and resulting inflationary effects - became deeply
embedded in asset prices, incomes, and system-wide
expenditures. During each passing year of mortgage
excess, myriad distortions more deeply affected
the underlying economic structure. And every year
the increasingly maladjusted "bubble economy"
ensured both a more intense addiction to excess -
and a more problematic process of weaning away
from mortgage credit. These dynamics, to this day
unappreciated by analysts and policymakers, are so
crucial for understanding what got us to where we
are and for appreciating that we're repeating a
similar process with federal credit.
Policymakers, the rating agencies and,
apparently, the marketplace never recognized how
(Ponzi finance) bubble dynamics were distorting
price structures throughout the economy. The
credit system doubled mortgage debt and the
markets pretended the quality actually improved
(the price of mortgage debt increased!). Amazing
as it is to contemplate, it seems that virtually
no one appreciated the degree of distortions and
underlying fragility.
In hindsight, it
should now be clear that the mortgage finance boom
inflated home prices to unsustainable levels. As
important, this atypical expansion of finance
inflated incomes and government tax receipts,
while distorting the pattern of spending and
investment (good old-fashioned "Austrian"
analysis).
I would argue that today's
atypical expansion in federal finance is having
crucial, yet less obvious, impacts on incomes,
asset prices and expenditures. Ebullient markets
are confident in the slow but ongoing healing
process thesis (slow is good, ensuring protracted
ultra-easy monetary policy). In reality,
fragilities quietly and methodically continue to
mount. The system is in desperate need of balance
and restraint - but is receiving the opposite.
From S&P's report: "In our baseline
macroeconomic scenario of near 3% annual real
growth, we expect the general government deficit
to decline gradually but remain slightly higher
than 6% of GDP in 2013. As a result, net general
government debt would reach 84% of GDP by 2013."
It is worth highlighting that some
forecasts for Q1 growth have dropped to as low as
1.5%, a dismal showing considering unrelenting
extreme fiscal and monetary stimulus (and
resulting stock market gains). Not surprisingly,
the boom in federal finance is having a more muted
economic impact when compared with that from
previous mortgage excess.
The mortgage
bubble inflated the perceived net worth of most
homeowners, while inciting huge booms in
construction and consumption. Today's boom has
certainly been instrumental in stabilizing incomes
(at an inflated level), although asset price gains
are benefiting a narrower cross-section of the
general population. Meanwhile, a large portion of
the populace is today suffering from meager
(negative real) returns on their savings - while
losing out to rising inflation.
I'm
confident that S&P's baseline case is too
optimistic.
"Austerity" at the state and
local level - and perhaps even a little from
Washington - is poised to restrain an unbalanced
recovery. While no one wants to admit as much, US
and global economies are increasingly susceptible
to highly speculative and unstable global risk
markets. And with US private-sector credit growth
remaining almost non-existent, I believe S&P's
and others' estimates for the growth in federal
receipts will prove overly optimistic ("output"
financed by federal government borrowing and
spending will not resolve fiscal troubles).
The odds of a recession over the next few
years are not low. And I would argue strongly that
the longer the government finance bubble runs the
more difficult the adjustment when this vital
source of finance is scaled back. At the end of
the day, massive expansions of a particular strain
of credit - albeit mortgage, household, corporate,
or government - are destabilizing and difficult to
normalize from.
And I refuse to take
seriously recent intentions to begin addressing
this problem until I hear leadership - from the
Halls of Congress, from the Oval Office and from
both parties - commit to sticking with spending
restraint even in the face of recessionary
conditions (weak economy and/or markets). This is
where the rubber will meet the road.
We're
now two years into both an economic recovery and
one heck of a market boom, so politicians will
talk tough and extrapolate a favorable backdrop.
Yet, it wasn't many months ago that both parties
were too willing to go with another round of
borrowing and spending stimulus. I fear both
parties will have a very difficult time parting
ways with the notion of government as
economic/market backstop. I'm not sure the public
is really ready to part ways.
Greece's
two-year borrowing costs surpassed 23% last week.
They were around 2% in November 2009, back when
markets were more tolerant of sovereign borrowing
transgressions. And, yes, I know we're not Greece.
And I'm not suggesting that Treasury borrowing
costs are heading to 20%. But just as mortgage
risk - as well as sovereign risk for Greece,
Portugal, Ireland, and Spain - was mispriced
throughout the bubble period, I expect that there
will be re-pricing of Treasury (and related) risk
in the future. An over-liquefied marketplace today
under-prices credit, inflation and liquidity risk,
in the process accommodating incredible
double-digit to GDP deficits. My base-line case
has Treasury borrowing costs at some point
unsettling Standard & Poor's, the
Congressional Budget Office and the markets.
I'll argue that today's debt-to-GDP ratios
are understating the severity of the debt problem
in many ways: measures of debt do not include the
enormous contingent liabilities; debt service
costs have been pushed down by the Federal Reserve
and global monetary policies; and GDP is being
inflated by government spending excess and a lot
of other "output" that won't support the capacity
of our economy to repay its obligations. But like
so many aspects of this bubble, there is gray area
enabling the optimists to take the other side of
the argument.
The late-nineties
technology/Internet bubble was spectacular, and
many (including former Federal Reserve chairman
Paul Volcker) worried that it was of sufficient
scale to bring the system down. Yet, from a credit
standpoint, it really wasn't systemic. The bubble
fueled huge distortions in the tech sector,
boosted home prices in a select group of cities
and flooded California with tax receipts (which
they quickly spent). The mortgage finance bubble
was the first systemic bubble - impacting incomes,
asset prices, corporate cash flows and government
finances throughout the economy. The
creditworthiness of federal debt proved the key -
really, the momentous - advantage the system used
to survive the bursting of the mortgage/Wall
Street bubble.
The government finance
bubble is the second - and concluding - systemic
bubble. It's bigger in dimensions than the
mortgage bubble and is having more problematic
systemic effects on incomes and the financial
markets. In particular, acute vulnerabilities
resulting from the previous bubble period now
ensure that, in particular, the municipal debt and
mortgage markets remain susceptible to any
retrenchment in federal spending (or rise in
market yields). And, importantly, there is no
potential creditworthy debt issuer of last resort
waiting in the wings to bail out the system when
market confidence in US government debt falters.
Ironically, the bigger the bubbles get the less
conspicuous they appear to most.
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