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3 CREDIT BUBBLE
BULLETIN Austerity takes a
hit Commentary and weekly watch
by Doug Noland
In respect for economic
history and brilliant but long-dead monetary
thinkers, some years back I assigned the
"inflationist" label to the outspoken Keynesians.
New York Times columnist Paul Krugman now calls
his analytical/policy adversaries the
"austerians", an entertaining update to the
wretched "liquidationists" and "bubble poppers"
from bygone eras.
In this epic battle of
inflationists versus austerians, I'll place my
bets on the superior constructs of the "austerian"
analytical
framework. And, as the
perennial optimist, I remain hopeful that
contemporaneous analysis will at some point help
(re-)expose the many flaws and misrepresentations
of inflationist ideology.
To be sure,
those promoting only more aggressive fiscal and
monetary stimulus ignore credit theory and
financial history. There is absolutely no
discussion of credit bubbles or financial manias -
as if there's no evidence that either has ever
existed.
Dr Krugman proposes only more
egregious deficits and central bank monetization
without factoring in myriad risks, including the
risks of credit revulsion, currency collapse and
global financial meltdown. Rather than 2008
developments alerting officials to systemic credit
collapse vulnerability, the inflationists have
hung their (and everyone's) hats on the specious
"100-year flood" premise.
When the
inflationists point to consumer price inflation as
the predominant risk to their suggested policy
course (and then quickly dismiss it), it just
strikes me as disingenuous. They somehow ignore
how the current policymaking course is
increasingly impairing the creditworthiness of the
heart of our and the world's financial systems.
They disregard how these policies have patently
contributed to unprecedented global economic
imbalances.
Moreover, the inflationists
somehow remain oblivious that policy interventions
have fomented dangerous speculative dynamics
throughout global securities markets.
Quite complex dynamics have become
critical to macro analysis. From my study of
credit inflations, it is clear that unfettered
credit growth attains a propensity for exponential
expansion throughout the upside phase of the
credit cycle. Pro-cyclical policymaking,
especially in our age of unconstrained global
finance, fundamentally exacerbates credit boom and
bust cyclicality.
The current interplay of
global credit cycles is extraordinary: Europe's
credit bubble is bursting, China's (and the
developing world's) is booming, and ours (the
United States') is somewhere in between.
Importantly, in the late phase of credit
excess, in what I refer to as the "terminal
phase", things tend to go haywire. First, the
amount of new credit balloons uncontrollably,
while the resulting heightened risk of a bust
invariably ensures aggressive pro-bubble policy
interventions. Second, as the quality of the new
credit deteriorates, the overall increase in
system credit risk turns parabolic, imperiling
highly exposed (leveraged) financial sectors.
Third, this bulge of risky new finance tends to be
distributed haphazardly throughout the real
economy.
In short, well-entrenched
monetary processes responsible for huge amounts of
risky finance foster malinvestment, economic
fragility, wealth-redistributions, and
destabilizing speculation. "Activist" inflationary
policymaking exacerbates these deleterious
processes, and the inflationists completely
disregard ample global evidence of this harsh
reality.
There is just no getting around
the fact that efforts to sustain credit cycles
turn perilous. As should be obvious these days,
prolonging the "terminal phase" of credit excess
poses great risk to underlying credit systems, the
financial markets and real economies.
Here
in the US, Keynesian policies ensure a historic
expansion of government debt, blunt stimulus that
inflates incomes and consumption while doing
little to incentivize sound investment (hence a
self-sustaining, job creating recovery). Massive
government-imposed distortions instead foment
market and economic uncertainty, in the process
thwarting necessary economic restructuring.
In Europe, several futile years of policy
measures meant to stem the downside of the credit
cycle have done little to stabilize the
"periphery" - while doing irreparable damage to
the "core". Globally, unprecedented fiscal and
monetary activism has only aggravated imbalances
and fostered highly speculative securities
markets.
My thesis holds that long-term
refinancing operations (LTRO) and concerted global
central bank liquidity measures from late-2011
were destabilizing for global markets, while
providing quite limited, at best, medicine to
underlying credit stress.
There was added
confirmation last week that, despite unprecedented
policy measures, Europe is sinking into a
problematic economic downturn. There was also
evidence of heightened vulnerability in the
highly-speculative global "risk on" market
dynamic. And with securities markets increasingly
susceptible, sentiment toward global economic
prospects has begun to shift.
Crude oil
sank $6.44, or 6.1%, last week. The Goldman Sachs
Commodities Index dropped 4.5% to the lowest level
since January. The New Zealand dollar was hit for
3.3%, the Australian dollar fell 2.8%, the
Brazilian real 2.1%, the Indian rupee 1.7%, the
Russian rouble 1.6%, the Canadian dollar 1.6%, and
the Swedish krona was down 1.5%. The US dollar
index gained 1.0%.
Payroll data again
disappointed, with US job growth having now
declined for three straight months. There will of
course be various bullish and bearish spins on the
data, yet it should be clear that the US economy
is lacking sufficient momentum to bolster global
economic prospects.
With downside risks
abounding and economic locomotives not evolving,
the global economy is now at heightened
vulnerability.
My bearish thesis back in
December was premised on the view that an impaired
European banking system would prove a catalyst for
a problematic tightening of credit conditions in
Europe, as well as in the developing economies
where Europe's banks were important financiers.
Moreover, the European debt crisis was a
likely catalyst for a bout of global speculator
de-risking/de-leveraging, implying a tightening of
liquidity throughout global markets. However, the
$1.3 trillion LTRO and other global central bank
interventions incited a dramatic change in the
global liquidity backdrop.
"Risk off" was
abruptly ousted by "risk on". A major
short-squeeze, reversal of risk hedges and
speculative leveraging together created a tsunami
of liquidity. And as markets rallied, a view took
hold that a new multi-year bullish liquidity cycle
had commenced. Somehow, it even turned euphoric.
The first quarter saw record global
corporate debt issuance, along with huge flows
into global risk markets. Investors and
speculators alike turned remarkably bullish,
determined to fixate on the favorable policy
backdrop while dismissing global fragilities. Even
the non-believers couldn't afford to not jump
aboard.
Such a speculative backdrop
bolsters the perception of ongoing liquidity
abundance, in the process setting the stage for
eventual disappointment, risk-aversion,
de-leveraging and a return of market liquidity
issues.
Perhaps it's premature to declare
"The Revenge of Risk Off". But it's moving in that
direction. Clearly, the sanguine view of global
economic prospects was based upon an ongoing
favorable financial backdrop. The LTRO was to have
bolstered the capacity of European banks to lend,
while continued heady global securities markets
were to inspire both general confidence and
booming corporate debt issuance.
To boot,
there remained significant capacity for stimulus
throughout the developing economies. Weaker data
in China was seen in a positive light, ensuring
looser policies and an unending Chinese boom
(along with unrelenting Chinese demand for
everything desired, real and financial).
A
more bearish view of the world might begin to look
at China in the context of a historic, and
increasingly fragile, credit bubble. A shift in
sentiment might also find global players pondering
Chinese corruption, market integrity, financial
sector solvency, and political stability. And
while loose policies can prolong "terminal phase"
excesses, there undoubtedly reaches a point where
financial distortions and economic imbalances
overwhelm the (overestimated) capacities of policy
measures.
My sense is that China is
somewhere between inching and lurching closer to
such a point. And, increasingly, bullish and
bearish global views on China are wildly
divergent, fostering market uncertainty. A
problematic global scenario would see a bout of
de-risking/de-leveraging coincide with waning
confidence in the vaunted model of Chinese
financial and economic engineering.
At the
minimum, doubts are growing in the optimistic view
that economic resiliency in China and recovery in
the US will counter European weakness.
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