Page 1 of 3 CREDIT BUBBLE BULLETIN Money and the eurozone crisis
Commentary and weekly watch by Doug Noland
It would be reasonable - and it sure is tempting - to dedicate this week's
bulletin to a skeptical look at Europe's latest plan for credit crisis
resolution. I would not be without plenty of company. So I'll instead go in a
different direction. This week I found my thoughts returning back about 12
years to my earliest bulletins. Inspired by the great Austrian economist Ludwig
von Mises, my introductory article discussed the need for a contemporary theory
of money and credit. Not only was modern economics devoid of monetary analysis,
there were critical changes unfolding within US credit that were going
completely unappreciated.
Importantly, credit creation was gravitating outside of traditional
bank lending channels and liability creation. The system of
government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac and
the Federal Home Loan Bank, had evolved into major risk intermediaries and
credit creators. I began by arguing against the conventional view that "only
banks create credit". Securitization markets were exploding in volumes, both in
mortgage and asset backed securities.
I was focused on the lack of constraints on this new credit mechanism that
operated outside of traditional bank capital and reserve requirements. In
contrast to the antiquated bank deposit "multiplier effect" explained in
economic texts, I referred to this powerful new dynamic as an "infinite
multiplier effect". Borrowing from Murray Rothbard, new credit was created "out
of thin air".
The more I studied monetary history, the more I appreciated the importance of
both money and credit theory. It became clear to me that money had for
centuries played such a profound role in economic cycles (and monetary
fiascos). Yet this type of analysis was extinct. Even within the economics
community, there was not even a consensus view as to a definition of "money".
There had been decades of bickering about what monetary aggregate to use in
econometric models (M1, M2 or the newer M3), along with what measure of "money"
supply should be monitored and managed by the Federal Reserve. Especially in
light of all the financial innovation and new financial instruments, the
economics profession and the Fed punted on monetary analysis. Out of sight and
out of mind.
Even if one was focused on the issue, the importance of traditional monetary
analysis was lost in myriad new complexities. Yet my study of monetary history
and research of contemporary credit convinced me that the analysis of "money"
likely had never been more critical to the understanding of (extraordinary)
market and economic behavior.
I was intrigued by Mises' work on "fiduciary media", the financial claims that
had the economic functionality of traditional (narrow) money. I began to view
contemporary "money" as "money is as money does". I was especially struck by
monetary analysis from the late American economist Allyn Abbott Young. Young
wrote brilliantly about the historical "preciousness" of money.
The more I studied, contemplated and pieced together analysis from scores of
monetary thinkers, the more it became clear to me that "money" was critically
important because of its special attributes. In particular, money created
unusual demand dynamics: essentially, economic agents always wanted more of it
and this insatiable demand dynamic created a powerful proclivity to issue it in
excess quantities. Keep in mind that a boom financed by junk bonds will pose
much less risk (its shorter lifespan will impart less structural damage) than a
protracted bubble financed by "AAA" agency securities and Treasury debt.
Centuries of monetary fiascos made it clear that money had better be backed by
something of value and of limited supply (ie gold standard) to ensure that
politicians and bankers did not fall prey to the same inflationary traps that
had repeatedly destroyed currencies and economies across the globe.
While it became fanciful to speak of "new eras" and "new paradigms", I saw a
world uniquely devoid of a monetary anchor. There was no gold standard and no
Bretton Woods monetary regime. I saw an ad hoc dollar reserve standard, one
that was for awhile somewhat restraining global credit, begin to disintegrate
from the poison of runaway US credit excess and intransigent current account
deficits.
Marketable debt accounted for the majority of new credit creation, and these
new financial sector liabilities were enjoying extraordinary demand in the
marketplace. This marketable debt could also be readily leveraged (at typically
inexpensive rates "pegged" by the New Age Federal Reserve) by a mushrooming
leveraged speculating community, adding only greater firepower to the credit
boom. Over time, the US credit system exported its bubble to the rest of the
world.
From my perspective, contemporary "money" was just a special - the most
"precious" - type of credit. "Money" had become nothing more than a financial
claim that was trusted for its "moneyness" attributes: chiefly, a highly liquid
store of nominal value. This new "money" was electronic and incredibly easy to
issue in unfathomable quantities.
The vast majority of this credit was created in the process of asset-based
lending (real estate and securities finance), and the more that was issued, the
greater the demand for these "money-like" financial claims. The world had never
experienced "money" like this before, and I suspected that the world would
never be the same.
In this brave new financial world dominated by one incredible global electronic
general ledger of debit and credit journal entries, "moneyness" became little
more than a market perception. If the market perceived a new financial claim
was liquid and "AAA", then there essentially became unlimited demand for this
"money."
Not unexpectedly in such circumstances, this "money" was issued in gross
excess. Most of it was created in the process of financing the real estate and
securities markets. At the late stage of the boom, a hugely distorted
marketplace saw trillions of risky subprime mortgages sliced and diced into
mostly "AAA" "money"-like credit instruments. Importantly, a distorted
marketplace believed that Washington would back GSE obligations and that the
Treasury and Fed would ensure the stability of mortgage and housing markets.
The 2008 crisis was really the result of Wall Street risk intermediation and
structured finance losing its "moneyness." When the mortgage finance bubble
burst, the market quickly questioned the creditworthiness and liquidity profile
of trillions of debt instruments. As finance abruptly tightened, asset-market
bubbles popped and maladjusted economies faltered. The "moneyness" phenomenon
came back to haunt financial and economic systems.
Not only had years of monetary inflation impaired underlying economic
structures, a huge gulf had developed between the markets' perception of the
"moneyness" of the debt instruments and the bubble state of the asset markets
underpinning an acutely fragile (Hyman Minsky) "Ponzi Finance" credit
structure.
I have posited that the policy response to the 2008 crisis - monetary and
fiscal, at home and abroad - unleashed the "global government finance bubble."
Essentially, massive government debt issuance, guarantees and central bank
monetization restored "moneyness" to US and global credit. I have argued that
this course of policymaking risked impairing the creditworthiness - the
"moneyness" - of government debt markets, the core of contemporary monetary
systems.
At its heart, the European crisis is about the escalating risk that the
region's debt could lose its "moneyness". Starting with the introduction of the
euro, the market perceived that even Greek debt was money-like. Despite massive
deficits, a distorted marketplace had an insatiable appetite for Greek, Irish,
Portuguese, Spanish and Italian debt. Importantly, the markets believed that
European governments and the European Central Bank (ECB) would, in the end,
back individual government and banking system obligations.
US Treasury and Federal Reserve backing restored "moneyness" to trillions of
suspect financial claims back in 2008 - and since then massive federal debt
issuance and Federal Reserve monetization have reflated asset markets and
sustained the maladjusted US economic structure. The markets enjoyed an
incredible windfall, and many these days expect European politicians and
central bankers to similarly reflate eurozone credit and economies.
I believe strongly that the credit recovery and tepid US economic recovery came
at an extremely high price: dynamics that ensure the eventual loss of
"moneyness" for US government credit, the heart of our monetary system.
Many expect Germany to use the "moneyness" of their credit to ensure the
ongoing "moneyness" for European debt more generally. The conventional view is
that, at the end of the day, German politicians will do a cost versus benefit
analysis and realize it will cost them less to backstop the region's debt than
to risk a collapse of European monetary integration.
The Germans, however, appreciate like few other societies the critical role
that stable money and credit play in all things economic and social. The
Germans have refused the type of open-ended commitments necessary for the
marketplace to begin to trust the credit issued by the profligate European
borrowers (and an incredibly bloated banking system).
European politicians have been desperately seeking some type of structure that
would ring-fence the sovereign crisis to protect the "moneyness" of, in
particular, Italian and Spanish borrowings. Increasingly, the consequences of a
loss of "moneyness" at the periphery were weighing heavily upon the European
banking system, with heightened risk of impairing "moneyness" at the core. This
was critically important, as it was quickly limiting the options available for
monetary crisis management.
For example, faltering confidence in Italian debt and what an Italian debt
crisis would mean to European and French banks was impacting market confidence
in French sovereign credit. So any crisis resolution structure that placed
significant additional demands on French sovereign debt risked impairing the
"moneyness" of French credit at the core of the European debt structure.
Understandably, the markets feared the crisis was spiraling out of
control.
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