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3 CREDIT BUBBLE
BULLETIN Throwing good after
bad Commentary and weekly watch
by Doug Noland
With market focus returning
to credit issues, I'll attempt to somewhat refine
and reiterate my macro thesis. Unique from a
historical perspective, the world has been
operating for some time now without mechanisms to
limit either the quantity or quality of credit
creation. There is no gold standard, no Bretton
Woods currency management regime, or even an ad
hoc functioning dollar reserve system. I believe
it was about a decade ago I began referring to
"global wildcat finance".
Myriad complex
forces nurtured such an extraordinary backdrop.
The "technology revolution" and "globalization"
were, of course, prominent factors. Financial
innovation played a major role, as did
increasingly "activist"
policymaking.
The era of the Alan
Greenspan-led Federal Reserve radically changed
how much of the world viewed the role of monetary
policy. Within credit systems, dynamic marketable
debt and Wall Street structured instruments
increasingly replaced the staid bank loan as the
driver of system credit creation. Meanwhile, the
centerpiece of American monetary management
shifted to market intervention and the assurance
of ample marketplace liquidity. Global financial
systems and policymakers jumped aboard this
powerful trend.
Much of the world remains
gripped in a multi-decade credit bubble. There
have been, of course, assorted "hiccups" all along
the way: the United States, Japan, Mexico,
Thailand, Indonesia, South Korea, Malaysia,
Russia, Argentina, Brazil and Iceland come quickly
to mind. Tightly interrelated US and global credit
systems almost succumbed back in 2008. At the end
of the day, however, the most aggressive - and
synchronized - reflationary policymaking
imaginable rejuvenated global credit bubble
dynamics and spurred yet another round of
financial excess (the "global government finance
bubble"). This has in no way alleviated structural
credit system fragilities and vulnerabilities.
Not all credit is created equal. Over the
years, I've differentiated between "productive"
and "non-productive" credit. Japan has been mired
in a prolonged post-bubble stagnation experience.
Japanese boom-time credit excesses were quite
extreme - including momentous asset bubbles.
Fortunately, however, the Japanese credit boom
included the financing of substantial investment
in high-quality manufacturing capacity. This has
provided an important foundation for their economy
and impaired credit system as the nation has
struggled though years of wrenching financial
crisis and recession.
As an exporting and
savings-rich economy, Japan has enjoyed the great
benefits associated with a stable currency
throughout its protracted post-bubble duress.
Japanese domestic savings have financed federal
deficits, as opposed to the reliance on foreign
investors, "hot money" inflows or international
bailouts. The Japanese experience has been dismal
but manageable. The economy has been able to
persevere through years of minimal private sector
credit growth and limited foreign investment. It's
been a historic boom and bust, although things
could have definitely been much worse.
Other Asian economies - and regional
credit systems - were able to bounce back
relatively quickly from devastating crises - on
the back of robust production-based economies and
strong trade positions. A core of "productive"
credit has underpinned financial systems and
economies throughout the region.
I would
argue that the capacity to produce real economic
wealth matters a great deal - in terms of
sustainable economic recoveries, stable
currencies, and robust credit systems. The nature
of bubble economy economic distortions matters
greatly in how a system is able to respond to
credit crisis. Will the post-bubble response
emphasize ramping up production, trade and savings
to work one's way through a crisis? Or, instead,
will it be more a case of depending largely on
additional credit creation/inflation?
Let's turn to the Greek debt situation.
Greece is mired in crisis a year after an enormous
bailout package. The Greek economy is performing
quite poorly in spite of ongoing huge federal
deficit spending. Prospects for deficit reduction
are grim, which is making everyone nervous. There
is today insignificant capacity to boost
production - thus limiting the capacity for real
wealth creation to stabilize economic and
financial systems. Greece required a big handout
last year; they need another this year; and
they'll be seeking ongoing assistance for years to
come. Greece enjoyed a huge credit-induced boom -
and regrettably little of the debt was
"productive". Not surprisingly, the Greek economy
and credit system are proving the opposite of
robust.
Especially over the past decade,
"developed" and "developing" credit booms took
divergent paths. I have railed over the risks
associated with US credit excess fueling asset
bubbles and financing consumption and intractable
current account deficits. Over the years, others
followed our path, perpetuating uncontrolled and
dangerous expansions of "non-productive" credit.
While China and much of the "developing" world
invested heavily in manufacturing capacity and
export industries, too often the European
periphery luxuriated in asset inflation,
consumption and bubble economy dynamics.
In analysis directed chiefly at US
dynamics, I've noted in the past how credit
bubbles inflate myriad price levels (assets
prices, system incomes, expenditures, government
receipts/spending, corporate profits, imports, and
so forth) and, over time, alter the underlying
economic structure.
Financial systems and
bubble economies in time become increasingly
dependent upon increasing amounts of credit
expansion to sustain inflated price structures and
to ensure sufficient system-wide spending levels.
And if the bias is to de-industrialize and move
toward a services and consumption-based economy,
loose finance and inflating asset prices
definitely grease the wheels of economic
restructuring. At the end of the day, the
resulting economic structure will have developed a
gluttonous appetite for ongoing credit creation.
Eventually, a credit bust will entail staggering
amounts of ongoing credit assistance.
Greece is in trouble - and the entire
European periphery is in trouble. Protracted
private-sector credit booms significantly elevated
price levels and distorted economic structures.
The events of 2008 incited a crisis of confidence
in the underlying credit, which instigated a cycle
of massive government debt issuance. The public
sector debt splurge, having only a temporarily
stabilizing impact, then hastened a problematic
crisis of confidence in government debt, first in
Greece, then Ireland and Portugal - and
increasingly pointing toward Spain and Italy.
I have drawn parallels between Greece and
US subprime - as the initial cracks in respective
bubbles. I expect the global sovereign debt crisis
to unfold over months and, likely, years. Studying
the unfolding European debt crisis is imperative
both from the standpoint of crisis contagion as
well as to garner early insight into how an
American debt crisis might unfold.
Thus
far, we've received important confirmation of the
thesis that there's no simple prescription for
resolving sovereign credit busts. They will surely
prove incredibly expensive, controversial, and be
resolved over many difficult years. The
conventional view that a recapitalization of the
banking system will go a long way towards
sustainable recovery is proving overly optimistic
- and much too simplistic.
Indeed,
inadequate bank capital is not the greatest source
of system fragility. Instead, the key issue is the
amount of ongoing additional system credit
required both to stabilize inflated price levels
and to ensure expenditures sufficient to hold
economic collapse at bay. I would argue that this
amount is dictated by the scope (and duration) of
previous boom-time credit excesses and economic
maladjustment.
Instead of the initial
US$150 billion or so bailout resolving the Greek
crisis, as had been expected, there's growing
recognition that it's little more than an initial
down-payment. A "drop in the bucket" and "seeming
black hole" are perhaps too pessimistic.
Importantly, expectations that early
resolution to the Greek crisis would thwart
contagion effects throughout the periphery have
proven miscalculated. Many European policymakers
must now wish that Greece had been cut loose a
year ago. But just saying "no" becomes only more
difficult - more political, the consequences more
uncertain, and possible outcomes increasingly
dangerous. Unfortunately, it is the nature of the
way these things unfold that the stakes seem only
to rise year-to-year. Somehow, next thing you
know, it's the classic dilemma of open-ended
financing for insolvent borrowers - the dreadful
trap of "throwing good money after bad".
The scope of the Greek debt problem is
proving much greater than was appreciated not long
ago (recall that Greece enjoyed 2-year yields of
about 2% in early 2009 compared with today's 24%).
The problem in Portugal is much larger, and ditto
for Ireland. I expect, over time, the marketplace
to come to appreciate similar dynamics for Spain,
Italy and others, including the US. Ominously,
stabilization here at home has required zero
rates, massive Federal Reserve monetization, and
double-digit-to-GDP federal deficits for going on
three years now.
Think of it this way:
prolonged booms in private-sector credit inflated
both asset prices and nurtured maladjusted bubble
economies throughout the "developed" world. This
unprecedented expansion of household and corporate
debt fueled a bonanza of tax and other receipts
for the government sector (which, in bubble
economy fashion, was extrapolated and spent
lavishly).
When the bubble burst in 2008,
federal finances - in Washington, Athens, Madrid
and elsewhere - seemed, fortuitously enough, in
good shape. This bubble distortion emboldened
policymakers - and emboldened policy emboldened
the markets. And we jumped head first right back
into bubble dynamics.
Going unappreciated
was the extent to which previous bubble excess had
inflated receipts and distorted the true
underlying fiscal situation of most governments -
along with the extent to which bubble economy
structures had become credit gluttons. Unbeknownst
to policymakers at the time - and remaining
unappreciated, especially here at home - is how
aggressive (fiscal and monetary) stimulus packages
set a course for severely impairing the
creditworthiness of the underlying sovereign debt.
What was thought to be a couple of years of
elevated spending to resolve post-bubble issues
has evolved into ongoing public-sector borrowing
and spending that does little more than hold the
next crisis at bay.
The unprecedented
expansion of sovereign debt throughout the
"developed" world is all that sustains the entire
private and public debt pyramid. I see
overwhelming support for the bubble thesis, with
(Minsky) "Ponzi finance" footprints all over
credit systems, the markets and real economies.
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