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4 CREDIT BUBBLE
BULLETIN Liquidity
bubble Commentary and weekly
watch by Doug Noland
Ray Dalio is one of
the foremost economic thinkers and investors of
this era. His hedge fund empire now manages $130
billion. He has taken on a higher public profile
of late, including notable interviews and speaking
engagements last week at Davos (43rd World
Economic Forum Annual Meeting). In previous Credit
Bubble Bulletins, I highlighted Mr Dalio's
"beautiful deleveraging" thesis. His comments on
Thursday and Friday from Davos raised some
eyebrows - and are certainly worthy of analytical
focus.
From his January 24, 2013, CNBC TV
interview: CNBC's Andrew
Ross-Sorkin: "When you talk about the
economic machine, what is that, exactly?"
Ray Dalio: "So everything is
a transaction, right? Every good, service or
financial asset, somebody's buying, and they buy
with money or they buy with credit. And so you go
in to a store and
you buy a suit. You buy it
with money or you buy with credit.
Credit
is a promise to deliver money. You and I can make
up credit. If I say, listen, you can have the suit
and you just pay me back later, that will
calculate as GDP, or a sale, but yet there's no
payment made. So, as a result, credit grows a lot
faster than money, and credit grows faster than
income. And when credit grows faster than income -
when debt grows faster than income - that can't go
on for long. At some point, you can't service [the
debt], because it's a promise to deliver money.
When that money can't - you can't come up - you
have a deleveraging.
So what happened in
2007 was they ran a bubble. We had credit growing
much faster than money - money or income. And we
had that bubble, and so now we're going through an
adjustment. Let me explain that adjustment... So,
in a deleveraging - and de-leveragings have
happened throughout time - it just didn't happen
in our lifetime before. But it happened in Japan;
it happened in the '30s; happened in Latin
America. They happen all the time.
How do
they work? Too much debt relative to income. So
there are four things you can do - all of them are
the same. You can either transfer wealth from the
haves to the have-nots. So Germany can help Spain.
You can do that or you can write down debts
because if there's too much debt you have to
reduce it. So you can write it down. But the
problem with writing it down is one man's debt is
another man's assets. So you write down assets,
and it feeds on itself and it has a problem. It
causes pain.
The third way you can deal
with it is that you can spend less. So, I'll
borrow less: austerity. And we go through
austerity.
And the fourth way you can deal
with it is you can print money. So central banks
can come and they can give money to Spaniards who
may not be able to pay the debt, and that helps
them do that.
So there are always those
four ways that happen. In all deleveraging they
all happen. So what we've gone through, the bubble
was obvious, because it couldn't extend - you
can't raise debt relative to income and the
leveraging couldn't continue. And the deleveraging
that was taking place had to happen in those four
ways. It has largely happened...
"The
capacity of lenders to lend, to meet the borrowing
requirements, has largely been adjusted. So,
Spain's borrowing has fallen. Italy's borrowing
has fallen. Those types of borrowings have
collapsed. With that is, of course, the collapse
of their economies. That's what the depression is.
You have to spend less, because you have less
ability to borrow. So that causes a collapse in
those economies. It was still, even with that, not
enough money to service the debt. So, I use Spain
as an example because it's representative. If you
take Spain, but the ECB came in and put in 450
billion of money. They put in about 350 billion to
the Spanish banks... That was the right thing to
do. The policy so far - there was a gap - an
irreconcilable gap - an unbridgeable funding gap.
So now what we have is a situation where the
borrowing needs and the debt rollover needs and
the borrowing are approximately in line, and a
cushion has been created. The ECB took over -
filled the gap where normally the free market does
fill it, and that has now moved it along to a
different condition...
"The way I look at
it is first of all, there's economics of the cause
effect and so this will be a long problem. Now
I'll talk the economics, and I'll talk about the
markets independently, but they're connected. The
economics means that there will be a long period
of adjustment and what will happen most
importantly is productivity. Does Europe work
hard, can they do the things that are necessary to
raise its living standards because it can't be on
money. And there will be a social challenge,
social, political challenge of 10 years or so,
maybe it's 15 years. Japan has made it go on for
longer. The fundamental thing that they need to do
most is to make sure that the nominal interest
rate is at or below the nominal growth rate.
"I won't get technical, but otherwise what
you're going to have is the debt compounding at a
rate which is faster than the economy is growing.
So, anyway, that picture - there was a tremendous
change, but it will be a terrible economy. Because
the balance is, the preventing of chaos, we came
very close to having chaos right at the edge of
it, because there was not a backstop. We got past
that point. So now as we move forward, we can -
that can be managed, and it's going to be very
difficult and very painful. As far as the markets
go, now, the question in the markets is, how do
events transpire relative to what's discounted...
"Currently what we have is a lot of money
[that] is in cash. And cash is a bad thing and
it's not natural that it came to be cash because
the central banks printed a lot of money - so they
put out a lot of cash. That's what Japan is doing,
too, because it needs to do that. So it produces a
lot of cash within the system. In addition,
because you have the risks, people want to be
safe. So they put their money in cash - and
there's a lot of cash hanging around... It's a
natural consequence, and what will happen is the
next big moves in the markets, and the next big
moves in the economy, will be based on how the
cash moves.
"Because [cash] is a bad
investment. It has a negative real return. It has
a return that's substantially lower than the
economy's growth rate. And at the same time, we're
in a situation where risks are being reduced. So
the fear, the desire, to hold that cash is
reduced. You can go out on the risk spectrum,
because they're reduced for the reasons we're
talking about. At the same time, if you're an
investor, you can start to move out of the cash,
because you're missing out on returns...
"As that happens, I think 2013 is likely
to be a transition year. Where that cash, large
amounts of cash... that will start to change. It
will also move. It will move to stuff. It will
move to all sorts of stuff. It will move to goods,
services and financial assets. So, that will
include most goods, services and financial assets.
People will spend more with the cash. They will -
and that will help the economy. It will move into
equities. It will move into gold. It will move...
out onto that curve.
"As that happens,
what happens is, it makes the Federal Reserve's
concerns begin to change. Because, by putting the
cash in they've lessened the risks. As the risks
have lessened and that movement starts to move
then the tilt starts to change. That's probably
something that won't happen immediately. This is
like a classic transition year, I think. And then
as you get later into the year, I think that we're
going to see more of that."
Clearly, Dalio
has been operating with an exceptional analytical
framework. His success speaks for itself. He
recognized the US mortgage finance bubble and
European bubble fragilities. He and his team have
understood how global markets and economies would
function throughout this extraordinary
environment. And Dalio has understood policymaker
doctrine, policy responses and market impacts.
As much as I respect Dalio's analytical
framework, I'll continue to take exception with
the general thesis that the US has been moving
through a successful "deleveraging" period. I have
argued deleveraging is largely a myth. I contend
unprecedented policy measures have only made the
grand scope of a historic bubble much more
unwieldy. In Davos on Friday, Dalio stated "we
don't have a credit bubble" but instead a "bubble
in liquidity". This is critical subject matter
worthy of discussion.
I have noted that
key facets of today's global credit bubble are
recognizable to very few. Some would argue that a
bubble doesn't exist today because credit is not
growing in excess of incomes and/or GDP. I have
argued that the bubble has evolved to become
deeply systemic, in particular by inflating
incomes and expenditures on a generalized basis.
Hence, ratios of debt-to-income and to output
won't be particularly illuminating. Actually, such
ratios have become deceptive.
At the heart
of today's bubble is the confluence of ongoing
massive issuance of non-productive government debt
and monetary policy-induced price distortions. I
have argued that this debt coupled with
policymaker systemic backstops has distorted
incomes, spending, and asset prices throughout the
US and global economy. And, importantly, this
systemic reflation has sustained maladjusted
economic structures and global imbalances.
In simple terms, it's a bubble primarily
because of the ongoing massive issuance of
mispriced credit - an unsustainable credit
inflation that fuels global market bubbles and
deep structural economic impairment and
imbalances. US and Chinese credit growth could
approach $2.0 trillion this year. Global hedge
fund assets will set new records.
At the
end of the day, my credit bubble framework/thesis
will be proven insightful or otherwise on the
issue of "economic structure". Fundamentally,
contemporary economies are structured differently
than in the past, and this has added layers of
complexity to already challenging analysis. What
counts these days as economic output? In gross
domestic product (GDP), a dollar of "services"
counts the same as a dollar of long-term capital
investment. But when it comes to credit, if I'm a
lender I'd much rather lend to someone investing
in long-term wealth creating capacity than someone
borrowing to buy season tickets to the
Philadelphia Eagles. From an economy standpoint,
would you rather lend long-term to Germany or
Spain?
Eventually, credit system
robustness or fragility will be determined not by
monetary and fiscal policy (or the "reserve"
status of one's currency) but by the wherewithal
of the real economy. For years, former Federal
Reserve chairman Alan Greenspan trumpeted the US
"productivity miracle" and the incredible
efficiency by which our limited amount of
"capital" was invested. And each year our nation's
"New Paradigm" economy consumed more than it
produced, ran up huge debts, played games with
risk intermediation, and watched asset prices
inflate and the credit bubble grow to dangerous
extremes.
From Dalio: "The fundamental
thing that [policymakers] need to do most is to
make sure that the nominal interest rate is at or
below the nominal growth rate."
Well, I
would argue that such a policy regime may help -
or it might actually make things a whole lot
worse. What are the consequences of extreme policy
measures? What is being incentivized - in the
markets and throughout the real economy?
More specifically, are artificially low
rates assisting in real economy restructuring
through the financing of sound investment? Are
they promoting the overall reduction in system
debt - or accommodating further profligate
borrowing and spending? Is the policy and market
backdrop incentivizing a more favorable mix of
investment versus consumption? Production vs.
services? Is the manipulated cost of finance
spurring greater distortions in market pricing
mechanisms and further economic malinvestment?
Is the policy backdrop supporting a more
robust credit system, with financial claims
increasingly backed by real economic wealth
creating capacity? Or is government sector
dominance only fostering greater quantities of
non-productive debt and myriad distortions and
imbalances? Does virtual government control over
the pricing of finance have, on balance, positive
or negative ramifications? Are underlying risks
being effectively recognized and priced in the
marketplace - or are risk perceptions dictated by
government liquidity and market backstops? Are the
securities markets promoting an effective
allocation of resources or are the markets more
akin to a "whirlwind of speculation?"
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