Page 1 of 4 CREDIT BUBBLE BULLETIN The myth of great moderation
Commentary and weekly watch by Doug Noland
I won't be dismissing last week's policy and market developments. We're in a
phase where the markets react to - and, really, are positioned for - extreme
policy intervention. So the announcement of concerted liquidity measures by the
world's major central banks plays directly to a very captive audience. Markets
responded in dramatic fashion. Spanish 10-year yields sank 104 basis points
(bps), Italian yields dropped 58 bps and French yields fell 42 bps. In the
United States, stocks went into melt-up mode and risk spreads narrowed rather
dramatically. While European stocks surged, the euro curiously rallied only
I don't anticipate that central bank dollar liquidity swap arrangements will
have much lasting impact. Neither the Germans nor the European Central Bank
(ECB) have the resources to
mount a successful European bailout. In desperation, Europe will surely come to
more agreements to marshal only greater resources toward crisis management. I
just believe the scope of the credit dislocation is too great.
A little background is in order. Italian sovereign 10-year yields surpassed 13%
in 1995. Spain's yields traded above 9% in 1992. One can make a strong case
that the developed world, including the US, was a fiscal train wreck in the
making some 20 years ago. Italy, for example, sported a debt-to-GDP (gross
domestic product) ratio of 125% back in 1995 (up from 97% to end 1990).
Huge deficit spending saw Spain's debt-to-GDP ratio jump from about 44% in 1991
to 67% by 1996. Greece's ratio surged from just over 80% in 1991 to 110% by
1993. With a then huge 5.0% of GDP deficit back in 1992, gross US federal debt
had jumped to 55% of GDP in 1993. Miraculously, as the '90s progressed, the US,
Italy, Greece and others ran budget surpluses. Market yields collapsed.
By the late '90s, the talk had turned to a "New Era" and "New Paradigm". The
Federal Reserve's Ben Bernanke popularized "The Great Moderation". US central
bankers were the quickest to point to enlightened policymaking as having tamed
inflation, in the process allowing a New Age productive economy to grow above
previous "speed limits." One has to only read by then former Fed chairman Alan
Greenspan's 2007 The Age of Turbulence to get a sense for how outdated
some of the old notions seem not many years later. Heading right into the 2008
crisis, Greenspan was still trumpeting the newfound resiliency of the US
Technology advancements over the past couple decades have been nothing short of
phenomenal. There is also no doubt that so-called "globalization" had momentous
impacts on economies and markets. I have been skeptical that adept policy had
much to do with global inflation, economic growth or market dynamics. And for
more than 20 years now I've been convinced that financial innovation has been
the great untold story, largely explaining everything from policymaker
overconfidence, the proliferation of leveraged speculation, serial assets
bubbles, US de-industrialization and the rise of China and the "developing"
A historic expansion of private-sector debt (and attendant tax receipts
bonanza) turned fiscal deficits of the early-'90s into marvelous surpluses. The
explosion of financial sector leveraging played an instrumental role in the
collapse of US yields. The ballooning balance sheets at Fannie Mae, Freddie
Mac, the Federal Home Loan Banks, and Wall Street securities firms' created
unprecedented demand for debt securities.
The proliferation of asset-backed securities (ABS), mortgage-backed securities
(MBS), sophisticated Wall Street debt structures (CDOs, CLOs, special purpose
vehicles, auction-rate securities, etc), and endless derivatives equipped Wall
Street risk intermediation with the most powerful tools to transform endless
risky debt securities into "AAA" instruments - with this contemporary "money"
enjoying virtually unlimited demand.
A unique financial and regulatory backdrop essentially created a circumstance
where extraordinary demand for credit was supplied at collapsing borrowing
costs. And home prices inflating at multiples of after-tax mortgage borrowing
costs created unprecedented demand for mortgage credit (and housing units).
The '90s saw incredible growth in "repo" (repurchase agreement securities
financing) and hedge fund leveraging. These unstable debt structures showed
their perilous side in 1994 and then again in much more dramatic fashion with
the 1998 Long-Term Capital Management blowup. Fatefully, policymakers
intervened and both the hedge fund community and the "repo" markets were
incentivized to expand to astounding dimensions and power - at home and
globally. Repeated policy interventions "stabilized" these sophisticated
leveraging structures - at a staggering cost to long-term financial and
Financial innovation, leveraging and policy accommodation nurtured the US
mortgage finance bubble, which spurred over-consumption and massive US current
account deficits. The United States' credit system unleashed upon the world
unfathomable amounts of dollar balances, along with the mechanisms and policy
doctrines to spur credit systems all around the world.
It has always been my view that it was this profligate financial environment
that really solidified European monetary integration. A backdrop comprising a
sound dollar and restrained global finance likely wouldn't have accommodated
the type of fiscal and monetary convergence necessary to transform 17 national
currencies into an experimental currency unit named the euro.
Italian 10-year yields collapsed from almost 14% in March 1995 to 4.0% by the
end of 1998. Real GDP went from slightly negative in 2002 to above 3% in 1999
and 2000. Italy's budget deficit declined from 9.5% in 1993 to less than 1.0%
by year 2000. Similar dynamics transpired in Greece, Spain and throughout the
European Union. Strong growth, weak inflation, booming stock and bond markets,
policymaker brilliance and general exuberance ("reflexively") created a new
paradigm of good will, cooperation and currency integration in euro land.
Finance and economics are similarly dangerous. In both "disciplines" it is
impossible to convince anyone that what the consensus believes is a really good
idea will come back as a very big problem in, say, 10, 20 or even 30 years.
Warnings of dire long-term consequences simply will not resonate, whether one
is an elected politician or PhD policymaker.
Fannie and Freddie's market intervention and balance sheet growth back in 1994
set the stage for near credit system implosion in 2008. And there was Mr
Greenspan's belief that derivatives work to disperse risk, while hedge funds
create a more liquid marketplace; Bernanke's references to "helicopter money"
and the "government printing press"; hundreds of Trillions of derivatives. A
global "repo" market of tens of trillions of dollars; a global leveraged
speculating community now with more than $2 trillion of assets (and multiples
more in positions); a global "reserve" currency governed by a central bank
without rules and a penchant for experimentation. US deindustrialization,
current account deficits and fiscal deficits. Global currency pegs and currency
regimes. Many risks are easily ignored for years until disaster strikes.
US household mortgage debt is on track to decline in 2011 for the third
consecutive year. Despite the most extreme fiscal and monetary measures
imaginable, the housing bear market persists. Japan's Nikkei index closed today
at 8,644, down some 78% from a high posted almost 22 years ago. Our NASDAQ
Composite index closed this week at 2,627, about half of year 2000's record
Burst bubbles tend to have negative consequences for years and even decades -
commensurate with the excesses during the preceding boom. And it is also true
that aggressive policy responses are much more likely to inflate the next
bubble than they are to reflate the one in the process of bursting. There is
extensive historical experience to support this thesis.
I believe the European debt bubble has burst - and this would no doubt be a
momentous development. For years, European debt was being mispriced in the
(over-liquefied, over-leveraged and over-speculated global) marketplace.
Countries such as Greece, Portugal, Ireland, Spain and Italy benefitted
immeasurably from the market perception that European monetary integration
ensured debt, economic and policymaking stability.
Similar to the US mortgage/Wall Street finance bubble, the marketplace was for
years content to ignore credit excesses and festering system fragilities,
choosing instead to price debt obligations based on the expectation for zero
defaults, abundant liquidity, readily available hedging instruments, and a
policymaking regime that would ensure market stability.
Importantly, this backdrop created the perfect market environment for financial
leveraging and rampant speculation - in a New Age global financial backdrop
unsurpassed for its capacity for excess. The arbitrage of European bond yields
was likely one of history's most lucrative speculative endeavors.
The year 2011 - following by three short years the so-called "100-year flood"
of '08 - should put a dagger in the heart of the mythological "Great
Moderation". Instead of lower inflation and enlightened policymaking nurturing
greater financial and economic stability - they've done precisely the opposite.
Today's extraordinary uncertainty and financial instability are not conducive
to financial leveraging, a circumstance posing a serious dilemma for a global
system having grown dependent upon ongoing credit excess.
European bond markets have suffered the inevitable effects of de-risking and
de-leveraging. And while policy measures, including those from this week, can
exert rather dramatic risk market rallies, there is little politicians and
central bankers can do to alter the market's re-pricing of the region's debt
obligations. Don't count on the ECB, International Monetary Fund, or Fed to
stabilize such a generally unstable financial, economic, social and political
Policymakers in Europe have little flexibility and capacity to alter the
dynamics of their bursting debt bubble, and the markets are understandably
dismissive of most measures and pronouncements. If only there were eurobonds
and an ECB committed to unlimited "buyer of last resort" support, Italian and
other yields could drop back to previous manageable levels.
But it's past the stage where gimmicks will work, as the re-pricing of debt
throughout the region has fundamentally altered the capacity to leverage,
speculate and insure sovereign debt risk. Focusing on Italy, the re-pricing of
Italian debt has made its debt load unmanageable. And if Italy is insolvent the
European banking system is in serious trouble - and monetary integration is in
serious jeopardy. The risk backdrop has changed profoundly, and a historic debt
and speculative bubble is bursting.