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     Jun 1, 2011

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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.

Continued 1 2 3


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2. China drops the Gwadar hot potato

3. How to handle a debt time-bomb

4. The counter-revolution club

5. Worm eats Apple

6. Hitler and the Chinese Internet generation

7. Thailand: No peace through polls

8. Show goes on in Iraq's political circus

9. Japan's private sector split on nuclear switch

10. BOOK REVIEW: Crisis of American international thought

( May 27-30, 2011 )



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