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     Jan 31, 2012

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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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