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3 CREDIT BUBBLE
BULLETIN Bernanke merits a
rant Commentary and weekly
watch by Doug Noland
It has been labeled an
intellectual exercise and ridiculed as
"intelligentsia". I'll stick defiantly to the view
that it remains one of the most important issues
of our time: are the US Treasury and
government-related debt markets part of a historic
credit bubble and global financial mania?
There are reasons why former European
Central Bank (ECB) president Jean-Claude Trichet
over the years repeatedly stated "the ECB would
never pre-commit" on interest-rate policy. The
Federal Reserve last week moved further to the
opposite polar extreme, essentially pre-committing
to near-zero rates through late-2014.
The
ECB has historically believed that market
speculation based
upon future policy
expectations works to foment market excesses,
imbalances and attendant fragilities. In contrast,
the activist Federal Reserve believes that it has
a fundamental obligation to intervene and
manipulate to achieve market outcomes the
committee believes will spur growth.
Unprecedented operations back in late-2008
took the Fed's balance sheet from about $900
billion to $2.2 trillion. We were assured that the
Fed had an "exit strategy". I've always presumed
"no exit", and here we are today with Fed holdings
at $2.9 trillion. The economy is expanding,
financial markets are strong and consumer price
inflation is rather undeflationary - yet Dr Ben
Bernanke is again signaling he is prepared for
additional monetization.
The Fed has for
years operated with the premise that aggressive
"Keynesian" stimulus has been necessary to
stabilize a system hamstrung by post-bubble
headwinds. I've for as many years argued that the
problem was being dangerously misdiagnosed. From
my perspective, it has been much more a case of
ongoing misguided "inflationism" sustaining
history's greatest credit bubble.
And
history is unequivocal: inflationism has an
end-game problem. Again, it is analysis easily
dismissed, although I am nonetheless convinced it
will go a long way in determining what kind of
world we and our children have to look forward to.
While I was chronicling the emergence of
the mortgage finance bubble back in 2002,
Bernanke, then a Fed governor, was crafting the
Fed's case for novel reflationary policymaking.
Mortgage credit was already expanding at
double-digit rates when Bernanke introduced his
intellectual basis for the government printing
press and helicopter money. The subsequent decade,
replete with a historic credit boom and bust, has
seen radical monetary policy doctrine become the
mainstream. But didn't the policy experiment fail
miserably?
Accommodating gross mortgage
credit excesses in the name of system reflation is
one of the greatest blunders ever committed in
monetary management. The Fed has not been held
accountable - either in terms of a seriously
flawed analytical framework or the associated
policy mistakes. Instead, the Bernanke Fed has
become only more radical and domineering in the
markets.
Public confidence and trust in
the Federal Reserve have suffered mightily, yet
this has thus far had no impact. Importantly, the
power players in political circles and the
securities markets have benefited tremendously,
ensuring ongoing support for the Fed's
controversial reflationary policy course. The
financial mania has reached the point where the
completely unreasonable is accepted as perfectly
reasonable.
The housing bubble was
obvious, or at least this has become the commonly
held view. As someone who chronicled the bubble on
a weekly basis for a number of years, I have a
clearer view of how things went down. There was
actually tremendous hostility for bubble analysis.
I was "lunatic fringe". The analysis that the
government-sponsored enterprises (such as Fannie
Mae and Freddie Mac), mortgage insurers and
sophisticated Wall Street debt structures were
part of a historic episode of "Ponzi Finance" did
not resonate. And the more conspicuous the
mortgage finance bubble became, the more elaborate
the arguments against the bubble thesis.
Alan Greenspan, Fed chairman from 1997 to
2006, became fond of arguing that housing markets
were local and, hence, the notion of a national
housing bubble was misguided. I often wondered if
the king of all economic data ever took a glance
at the Fed's Z.1 "flow of funds" report.
The Greenspan/Bernanke Fed fashioned
"white papers" and such explaining how it was
impossible to recognize a bubble until after it
burst. To them, the proper and prudent policy
course was to avoid the risk of intruding on
prosperity and functioning markets, being ready
instead to implement a "mopping up" strategy in
the event such measures were ever required. It was
the ridiculous bordering on negligence.
When it comes to credit and bubble
analysis, the Fed has proven itself incompetent.
After the Fed-induced steep yield curve from 1991
to early-1994 fomented a destabilizing speculative
bubble, they should have focused keenly on how
their policy measures were inciting leveraging and
speculation.
After the 1995 Mexican
bailout further emboldened speculative excess and
fomented the catastrophic bubble throughout SE
Asia (and beyond), policymakers should have been
fixated on the risks associated with destabilizing
"hot money" flows, derivatives and a ballooning
global "leveraged speculating community". After
the 1998 Long-Term Capital Management (LTCM)
fiasco, the danger was conspicuous. It was also
conspicuously apparent that the LTCM bailout and
the Federal Reserve market backstop were
instrumental in inciting the tech bubble. And the
Fed's response to that burst bubble was integral
to the scope of the mortgage finance bubble. As
obvious as this chain of cause and effect has
been, the Fed dogmatically refuses to have any
part of such analysis.
I have seen
overwhelming support for the "global government
finance bubble" thesis. Fiscal and monetary policy
has been out of control for going on four years
now. And with parallels to the mortgage finance
bubble, the more prolonged the bubble period the
more dismissive the crowd becomes to the notion
that they might be participants to a manic bubble.
That's ok. As an analyst of speculative
bubbles, I am well aware of the nuances.
Objectively, it is possible to recognize bubble
dynamics in real time. Realistically, however, it
is the nature of things that this analysis will be
dismissed and disparaged. As I've written in the
past, "Bubbles tend to go to unimaginable extremes
- and then double!" I am comfortable with the
analysis that we are in the late stage of a
historic global financial mania.
Let's
talk a little bubble analysis. First of all, most
that use the term "bubble" are implying an
imminent bursting. I subscribe to a different
analytical framework. The baseline assumption,
especially in today's extraordinary global
financial and policy backdrop, is that bubbles
will enjoy momentum and longevity. Anchorless
global finance and incredible policy activism will
tend to support ongoing (compounding) excess.
My thesis further holds that the global
government finance bubble is the "granddaddy" -
the crescendo bubble that will conclude this
credit cycle. Students of previous monetary
experiments and manias appreciate that authorities
will commonly resort to increasingly desperate
measures in order to bolster waning confidence.
Last week I recalled reading accounts of how John
Law devalued hard money coinage that was competing
with his "Mississippi Bubble" paper monetary
scheme in a last chance gambit to force players to
stick with his faltering credit instruments.
Most bubble analysis focuses on valuation:
"A bubble is created when prices move beyond that
which is supported by underlying fundamentals."
Again, my framework is altogether
different: A credit bubble is about a mispricing
(under-pricing) of finance. This mispricing
supports the over-issuance of debt instruments.
And, importantly, credit inflation is
self-reinforcing, in that the associated increase
in purchasing power bolsters the fundamental
factors central to the bullish premise. Credit
excess begets credit excess. Tech stocks always
looked cheap compared to earnings growth rates,
and the greater the mania in tech-related equity
and debt securities the greater the capacity for
industry expansion to justify ever increasing
industry price-to-earnings ratios and stock
prices.
Throughout the mortgage finance
bubble, the expansion of mortgage debt led to
inflating home prices. The greater the number of
housing transactions, the greater the growth in
household equity extraction and consumption. GDP
and corporate profits surged, ensuring higher
stock prices and heightened demand for houses and
mortgage credit.
For the most part, home
prices at the time didn't look dangerously
extended compared to boom-time fundamentals (ie
surging household net worth, income growth, stock
prices, GDP prospects, and so forth). And the
meager risk premiums on mortgage-related finance
seemed to be justified by minimal credit losses,
robust housing price trends and prospects for
ongoing prosperity. Home prices only go up.
The bottom line was, however, that
multi-trillions of finance were mispriced based on
faulty market perceptions. In the end, faith that
Washington (the Fed, Treasury, congress, Fannie,
Freddie, Ginnie, the Federal Home Loan Bank,
Federal Housing Administration, etc) would never
tolerate a housing bust proved instrumental in the
market's mispricing of the debt underlying the
historic bubble. Government intervention, market
misperceptions, mis-priced finance,
self-reinforcing over-issuance and seductively
inflated fundamentals are credit bubble hallmarks.
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