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4 CREDIT BUBBLE
BULLETIN 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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