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     Feb 5, 2013

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Late-90s redux
Commentary and weekly watch by Doug Noland

"Dow, S&P 500 Post Best January since the 1990s," noted a USA Today headline. According to Reuters (Sam Forgione citing Lipper data), "Investors poured $12.71 billion into US-based mutual funds and exchange-traded funds in the latest week, concluding the strongest four-week flows into stock funds since 1996"

And from Bloomberg (Sarika Gangar): "Sales of corporate bonds from the US to Europe and Asia are accelerating, marking their busiest January ever following unprecedented issuance in 2012 ... Berkshire Hathaway ... led issuers selling $409.5 billion of bonds this month, up from $226 billion in December and surpassing the

$407.2 billion sold in January 2009 ... Sales last year soared 20.5% to $3.96 trillion."

Excitement got the better of a CNBC anchor as he exclaimed, "The whole world is watching to see if the Dow can hit 14,000!"

The newfound optimism and references to the '90s do bring back memories. The S&P 500 jumped 316% during that decade ("total return" with reinvested dividends 423%). Fueling the boom, total system credit (non-financial and financial) inflated 96% to $21.25 trillion. This was quite an impressive expansion for a credit system that began the decade with a highly impaired banking system. Still, the credit aggregates tell only part of the story.

Having delved deeply into macro credit analysis beginning back in 1990, I was increasingly astounded by developments later in the decade. By the end of 1999, government-sponsored enterprise (GSE) assets had expanded 280% in 10 years to $1.72 trillion. Agency mortgage-backed securities (MBS) increased 160% to $2.29 trillion; asset-backed securities (ABS) were up more than five-fold to $1.31 trillion. Securities Broker/Dealer assets increased 320% to $1.0 trillion. Fed Fund and Repurchase Agreements rose 160% to $925bn, and Wall Street "Funding Corps" jumped 390% to $1.07 trillion. Money Fund Assets increased 270% to $1.58 trillion.

For comparison, US private depository institutions (chiefly banks) saw 40% growth during the decade to $6.85 trillion. To be sure, analysts focusing on traditional indicators such as bank reserves, bank loan growth and the monetary aggregates were running blind.

The world of finance had been transformed right before my weary eyes. The traditional bank loan-centric credit system was supplanted by Fannie, Freddie, the FHLBs, MBS, ABS, "repos", SPVs (special-purpose vehicles), "funding corps", derivatives, hedge funds and Wall Street finance more generally.

There was no doubt in my mind that these developments were momentous. It was out with "fractional reserve banking" and the "deposit multiplier" - and in with the "infinite multiplier" and the specter of an unlimited supply of finance. Out with the staid bank loan and in with the dynamic marketable debt security to be financed in the marketplace and leveraged for speculative profits.

No longer would our central bank have to prod banking lending with reduced funding costs, when a brief statement achieved the power to immediately incite risk-taking and leveraging throughout the securities markets. Unlike traditional bank finance, this new marketable-based Credit could be easily manipulated. For the investment banker, market operator and central banker, the new finance was just too seductive.

With New Age credit now available in limitless quantities, no longer would the system have the inconvenience of supply and demand determining the price of borrowing/finance. Now, it could largely be left to the judgment of a small cadre of (largely academic) central bankers - or, more simply, just leave it to their leader. Contemporary risk intermediation methods and securities financing outside of traditional bank lending and deposit channels had completely changed finance - and with it monetary policy doctrine.

And, almost to the individual, everyone back in the late-90s told me I was absolutely wrong. Conventional thinking held steadfastly to the view that "only banks create money and credit". I would explain how non-bank credit expansion was no longer restrained by traditional bank capital and reserve requirements, and I was informed in no uncertain terms that my theory was flawed.

Yet it wasn't really a "theory" as much as it was reality. Everyone was so enamored with "New Paradigm" and "New Era" thinking, it was easy to disparage my analysis. The markets were really strong - and the "naysayers" had become a joke. Candidly, I still have a bit of a chip on my shoulder from the whole experience. Some years later (2007), Pimco coined the phrase "shadow banking" and the analysis soon became obvious to everyone. The mortgage finance bubble was transformed to obvious. It was all obvious, in hindsight.

Each passing week, the current environment seems more "Late-90s-Like". Indeed, contemporary finance has gone through another momentous transformation, yet seemingly nobody is on top of the analysis. Perhaps no one wants to be. And my work has completely diverged from conventional thinking. I'm more comfortable in this lonely position these days - and by now well-versed in the idiosyncratic nature of conventional thinking/analysis.

A rather long book could be written on this subject, but I'll do my best to muster a brief summary. The key to the new finance of the nineties was that it was predominantly market-based. The GSEs, securitizations, "repos", and "Wall Street finance" were creating unlimited amounts of finance and directing it mostly to the assets markets (stocks, bonds, real estate, etcetera). Accordingly, asset inflation and asset bubbles were the prevailing inflationary manifestation throughout that particular credit boom.

The technology and Internet stock mania burst in early-2000. The panicked Federal Reserve went into post-bubble reflation/reliquefication mode. Unemployment rose to 6% in late-2002, and a new Fed governor spoke of the need for "helicopter money" and the "government printing press" to fight the scourge of deflation.

From my analytical framework, tech stocks were never THE "bubble", but rather the most conspicuous consequence of an unfolding bubble in credit. In 2002, I began my "mortgage finance bubble" warnings. To say I was alone in talking "bubble" back in 2002 was an understatement. Conventional thinking was fixated on deflation and economic stagnation. "muddle through" was viewed as the best case in a "post-bubble" deflationary environment. All risks were seen on the downside.

My analytical framework remained focused on this new "Wall Street finance" and its unique inflationary potential. Mortgage credit and house prices had already commenced an inflationary cycle. From this analytical perspective, aggressive ("activist") central bank intervention/manipulation would likely rejuvenate Wall Street finance and push mortgage finance excess to dangerous bubble extremes.

Indeed, if the Federal Reserve was to orchestrate a systemic bailout for this asset-based credit apparatus, one could expect the GSEs, securitizations, derivatives, hedge funds and Wall Street finance to bounce back fully emboldened and more powerful than ever. Such is the nature of bubbles.

Mortgage credit doubled in just over six years. Highly relevant to current analysis, this historic bubble prolonged an epic economic restructuring. The deindustrialization of the US economy gathered further momentum, while historic asset inflation and housing equity extraction helped spur only greater consumption and demand for services. Persistently large current account deficits became enormous. Our "bubble dollars" inundated the world.

When the mortgage finance bubble burst in 2008, there was seemingly no way to avoid a major financial and economic adjustment period - in the US and globally. With US household net worth trashed, the housing "ATM" shuttered, private-sector credit contracting and huge job losses on the horizon, major swathes of the US bubble economy were immediately made uneconomic.

Economic depressions have made regular appearances throughout history. Recessions are "cyclical" mechanisms that work to mitigate the buildup of system of excesses (spending and inventories, etc.) that accumulate during a boom period. Depressions, on the other hand, are more "secular". Traditionally, depressions are the inevitable consequence of prolonged credit booms and attendant deep economic structural maladjustment. Depressions are about credit failure and resulting major economic adjustment and rebalancing (today, think Greece and Spain).

I believed at the time the US economy faced a depression-like adjustment following the 2008 bursting of the mortgage finance bubble. With Fannie and Freddie bust and "private-label" securitizations and Wall Street obligations discredited, the heart of "nineties" New Age finance was pretty much dead.

It was clear that mortgage credit would contract - and that private-sector credit growth would be minimal at best. Most importantly, system credit expansion would be insufficient to sustain income and spending levels that had inflated tremendously during the protracted boom period. Falling incomes would be big trouble for the maladjusted economic structure and the US credit system overall. There were indications of how this dynamic would unfold during 2009.

In April 2009, I began warning of the risks of fueling a "global government finance bubble". I didn't fully appreciate what was unfolding back in '09. But it was clear that the Federal Reserve, Treasury and global policymakers were prepared to do just about anything.

Similar to mortgage finance in 2002, government finance was already demonstrating powerful bubble characteristics by 2008. The mortgage finance bubble had collapsed, yet a potentially even greater credit bubble was gathering momentum. After all, government finance enjoyed greater "moneyness" than ever - and over-issuance began in earnest. Massive federal deficits coupled with Federal Reserve monetization held the possibility for the biggest bubble of them all. It's already historic.

In somewhat of a replay of the '90s, our credit system has again experienced an historic transformation. The nineties version was about unfettered market-based credit. Today, it's unfettered government-based finance. Both are about risk obfuscations, misperceptions and mispricing.

Few appreciated how this finance distorted asset markets and the structure of the real economy from the mid-nineties through 2008. Few appreciate the nature of today's credit bubble. Seemingly no one recognizes how profoundly the government finance bubble is inflating system incomes.

For perspective, let's start with some expenditure data from the US budget. We know that the federal government ran unprecedented trillion-dollar plus deficits for four straight years, though I'd argue that the aggregate deficit doesn't do justice to the impact of surging federal spending levels.

For enlightenment, I'll highlight spending growth by major federal agency. In just four years (2007-2011), Social Security expenditures jumped 24% to $731 billion. National defense was up 28% to $706 billion. Income Security surged 63% to $597 billion. Medicare inflated 29% to $486 billion. Health Services was up 40% to $373bn. Veterans benefits and services surged 75% to $127 billion. Transportation was up 28% to $93 billion.

This unprecedented inflation in federal government spending has made all the difference in the world. Importantly, it has sustained the ongoing system-wide inflation of income levels. Record incomes have ensured record expenditures throughout the general economy, and this spending has been fundamental to sustaining what I believe is a deeply maladjusted economic structure. 

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