Digging a Little Deeper into “Financial Sphere” Analysis:
Doug Noland
Listening to Larry Kudlow (& Company) yesterday afternoon - lambasting “market analysts” for selling stocks based on a slightly weaker-than-expected GDP report – I thought to myself, “Financial Sphere Larry, Financial Sphere.” It is my contention that financial developments these days lead the economy and not vice versa. Those focused on the current generally robust and seemingly sound “Economic Sphere” (decent growth, strong profits, and relatively tame CPI) are these days at a decided analytical disadvantage when it comes to appreciating the many nuances of the financial market environment. The Financial Sphere is sputtering and convulsing, and if this situation is not rectified, the widening schism between the Financial and Economic Spheres will be resolved in favor of finance. But is it amenable to rectification?
Admittedly, the concept of “Financial Sphere” and “Economic Sphere” is more than somewhat nebulous analysis. On a macro scale, we can think of the Financial Sphere in terms of Credit and financial systems, certainly including the markets, where myriad institutions, players and individuals borrow, lend, invest and speculate in securities, debt instruments, currencies and, more generally, speculative assets including homes, businesses and collectables. It has a great deal to do with confidence, perceptions and faith in the Fed and global central bankers. The Economic Sphere comprises scores of businesses, entrepreneurs, investors, governments, employees, and consumers involved in all aspects of production, distribution and consumption of real economic output – goods, services, commodities, structures and fixed investment. The Economic Sphere never appreciates how its behavior and fortunes are dictated by the Financial Sphere.
There is, of course, interplay and overlap between “The Spheres.” But in some regards their activities are rather distinct. On a more micro level, a company such as GM has intertwined operations in both Spheres. It invests in plant & equipment, manufacturing a variety of vehicles and other products. It is, as well, a formidable player in the Financial Sphere. For some time the company has expanded lending and financial operations. Indeed, as GM struggles with an increasingly hostile Economic Sphere, it will continue to significantly reduce its real investment in production capacity in favor of expanding its financial services operations and holdings. What is burdening GM is burdening America, and a ballooning Financial Sphere should be recognized as a byproduct of underlying structural maladjustment.
When it comes to envisaging important distinctions between the two Spheres, GM provides additional insight. In years past, GM offered dedicated employees the promise of retirement pension and health care benefits. To meet future obligations, the company would invest in productive plant and equipment (the Economic Sphere) that were expected to provide sufficient future (economic) profits. Most unfortunately, the major inflation in the cost of these retirement benefits coupled with deteriorating manufacturing profits has created a funding black hole (spiraling asset and liability mismatch). GM (like many) has been compelled to make a dramatic shift to leveraged holdings of securities and other financial assets in an effort to keep pace with its ballooning liabilities. The upshot is a Rapidly Expanding Financial Sphere, especially in comparison to the stagnant Economic Sphere. Somehow, holdings of auto receivables and MBS are to provide the wherewithal to procure future real goods and services for its retirees.
Credit Bubble analysis is focused on the Rapidly Expanding Financial Sphere, as well as its distorting effects throughout the Economic Sphere. What is the nature of the increase in financial claims; what are the ramifications for spending and investing decisions; do the consequences include unsustainable asset price booms; how do inflationary forces distort risk perceptions and market pricing mechanisms; what is the scope and how destabilizing are the resulting speculative market dynamics? “Inflation” is fundamentally the expansion of financial claims (generally Credit). In this context, the premise of an inflationary environment should not be contested and is actually far removed from the popular “inflation vs. deflation debate.” And I would add that talk of the “promised land of secular price stability” arises from a focus on a narrow index aggregating selected consumer prices within the Economic Sphere. Such a cramped focus neglects paramount contemporary inflationary manifestations and is thus anathema to Financial Sphere and Credit Bubble Analysis.
It used to be that The Spheres were Kindred Spirits. Financing profitable investment in the Economic Sphere was the commanding source of expansion for the Financial Sphere. Economic profits and prudent lending were, in conjunction, self-adjusting mechanisms, not repealing the business cycle but at least suppressing boom and bust dynamics. Moreover, tight control over Financial Sphere expansion (implemented post ‘30’s financial collapse) for some time nurtured both financial and economic stability. The Spheres shared common interests and growth dynamics. Sound economic investment was the key to financial stability; sound finance the lifeblood of balanced, sustainable economic growth.
But memories faded, historical revisionism prevailed and, over time, the Financial Sphere was set free and left to its own powerful devices. Once unleashed, it was an historic case of a progressive multi-decade bias to asset-based lending and securities speculation. Computerization, financial innovation and the evolution of “financial engineering” played a seminal supporting role. To be sure, the seeking of Financial Sphere “profits” became the commanding mechanism driving both lending and “investing” decisions, with real economic profits relegated to a fading and rather distorted second fiddle.
In contrast to the self-adjusting nature of economic profits (over and mal-investment fostering eventual profit disappointment and retrenchment), unfettered Financial Sphere expansion is seductively self-reinforcing over protracted periods (decades). By its very nature, financial sector expansion generates unending “profits” as long as the inflation (creation of additional financial claims) is sustained. The ballooning Financial Sphere has for some time suppressed the downside of business cycles. However, an unrestrained Credit Cycle nurtures speculation, surreptitious boom and bust dynamics, and financial and economic vulnerability to any ebbing of Credit and financial excess. Inflationary Bubbles in the Financial Sphere – such as those that culminated with the “Roaring Twenties” or 1980’s Japan – are manifestly more dangerous than inflation in the Economic Sphere.
There are myriad issues related to this momentous financial and economic development, most I have surely repeated several times too many. But I am never one to let repetition dissuade my attempts at pertinent insight. Today, the Financial Sphere is massively inflated with respect to the Economic Sphere. This excess finance – Monetary Disorder – has inflated financial returns, while destabilizing pricing mechanisms within the asset markets and real economy. The massive pool of finance is today faced with paltry opportunities for true economic returns, as well as a natural proclivity for over-investing at every opportunity. Speculative excess has gone to unprecedented extremes and there are, of late, initial indications that Bubbles are strained and possibly beginning to burst. Recent market turbulence is associated with newfound crosscurrents of heightened risk aversion, on the one hand, and the necessity for massive and continuous Financial Sphere expansion on the other. It is an especially volatile, unpredictable mix.
Importantly, these types of colossal inflations involve a profound redistribution of wealth. For awhile, the finance-induced boom and consequent asset inflations appear to provide at least some benefit to all. The fleeting notion of shared wealth enhancement, however, is replaced by increasing real disparities and animosities. We are seeing this today. While many in California, Florida, Manhattan and elsewhere enjoy a housing wealth bonanza, many less fortunate are being priced right out of home ownership. While the finance, housing and energy industries wallow in windfall “profits,” our nation’s auto and airline industries are left for financial ruin. As the U.S. and its inflationary partners in Asia boom, a more financially stable Europe stagnates. Its citizens are growing restless. Here at home, the American consumer enjoys an endless consumption windfall, while Asian societies accumulate massive and untenable holdings of dollar IOUs. Our Creditors are growing impatient, while our lawmakers look for scapegoats. A seemingly wonderful reflation has turned - for the duration - problematic.
Today, careful observation identifies heightened stress on many levels. And to Mr. Greenspan and others than warn against protectionism, I can only say they are correct but offer specious reasoning. The scourge of protectionism is one predictable consequence of inflation’s unjust distribution and transfer of wealth between nations.
For some time the U.S. Financial Sphere inflated largely in isolation. The Japanese Credit system was in post-Bubble intensive care, along with many financial systems throughout Asia, Latin America, and elsewhere. U.S. financial sector expansion and resulting Current Account deficits were easily and readily “recycled” directly back to booming (“King Dollar”) U.S. securities markets. This played a major role is dampening the global consequences of U.S. inflation. It supported a dollar Bubble, as well as garnering the Federal Reserve extraordinary control over the inflationary process. For example, the Greenspan Fed facilitated major “reflations” post-LTCM, NASDAQ bust, and 9/11 without the burden of risking a surge in inflation, a spike in market yields or a run on the dollar.
The backdrop is profoundly different today. There are myriad domestic Credit system inflations internationally, in what amounts to a major Global Financial Sphere Inflation. Energy and commodity prices have spiked and there is a general inflationary bias throughout the commodities markets. As I have noted many times previously, the distinguishing characteristic of the Greenspan/Bernanke 2002 reflation was its effect on global currencies, Credit systems and speculation – The Globalization of the U.S. Credit Bubble. I contend that the Fed will now face significant risk if it attempts to adjust the inflation throttle either up or down and has largely lost control of the inflationary process
For more than two years the perception held that the masterly Fed was in complete control. This was, however, only a deception made of inflating asset prices, narrowing risk premiums, and economic boom reemergence. The investment community – certainly including the massive leveraged speculating community – was lined up right behind the “transparent” Fed. Risk-taking was made incredibly profitable and it was done in self-reinforcing excess – with everyone confidently on the same side of the risk-taking boat. Everything became a “crowded trade” – from equities, to junk, to converts, to CDS, to MBS, to manic homebuying. Various markets became closely correlated, risk commoditized, and the benefits of diversification largely lost (despite what risk models contend).
I contend that this reflation was of the “blow-off” “terminal phase” variety. Hedge fund assets surpassed $1 Trillion, bank Credit exploded, Securities firms’ balance sheets ballooned, “repo” positions surpassed $3 Trillion, the Credit default swap market mushroomed, and excesses throughout mortgage finance went to historic extremes (no down payment, interest-only, subprime, home equity, etc. financing $1 Trillion-plus annual mtg Credit growth). The U.S. Current Account Deficit surged to 6% of GDP, financed by the explosion of largely Asian central bank holdings. Inflationary pressures were liberated from the U.S. Financial Sphere, while euphoric speculation became endemic to U.S. (equities, Treasuries, corporates, junk, MBS, homes, CDS, etc) and global asset markets.
There has been a major dilemma associated with allowing the Financial Sphere to be commandeered by speculative market dynamics. Years of excess only culminated into a period of spectacular excess. Importantly, the amount of risk created during the Credit system’s blow-off period grows exponentially as a huge increase in riskier Credits (i.e. mortgages, junk) is financed by mushrooming speculative leveraging (i.e. “repos,” MBS, CDOs, “spread trade”). At this point, there is no turning back, with the entire Credit system succumbing to Minskian “Ponzi Finance” dynamics. Debt structures become increasingly fragile, reliant upon progressively inflated asset prices and only more aggressive financing methods. It becomes only a case of what precipitates the crisis.
I’ve always appreciated the bull fighting analogy as it applies to the stock market: The agitated bull turns most ferocious and unpredictable after he has taken his first spear from the Matadore. Yet, when it comes to financial stability, the stock market always receives more attention than it deserves. Keen focus over the coming days and weeks will be directed at assessing the severity of the damage done to the Credit system. It has been hurt by GM, CDS, junk, wild interest-rate volatility, and consequent heightened risk aversion. But it has come charging forcefully back with lower Treasury and mortgage yields. This is positive for mortgage Credit and general market liquidity, but a negative for the spread trade and interest-rate hedging strategies. A strong case can be made that this collapse in yields is, over the intermediate term, only further destabilizing for the Economic Sphere. Liquidity and Credit availability for corporate borrowings are faltering, with only greater excess throughout mortgage finance.
At other times, I would argue that the recent blow would not prove deadly. But this is a “blow-off” period with unprecedented speculative and leveraging excess, with everyone crowded on the same side of the boat, and with the Financial Sphere Inflationary Bubble sustained only by continued massive Credit inflation and speculation. The key risk players need to willing and able to expand; they are not. The speculating community needs to willing and able to stay the course on one side of a crowded (and increasingly rocking) boat; why would they? And if the system does begin to seriously falter, the Fed will need to get everyone lined up to play yet another “reflation;” with unprecedented risk and uncertainty.
The system is today wound so tight. The unpredictability of the Marred Bull also brings to mind the old bull in a china shop. Prices throughout the financial markets are now being whipped around and about, inflicting corrosive damage upon confidence and portfolio values. With all the derivative-related hedging and risk speculating, markets demonstrate increasing leverage both on the up and downside. One week, hedging related selling pushes yields sharply higher, followed not long afterward with the forced unwind of these hedges and hedging against lower rates that pulls yields abruptly lower. Dynamics in equity, currency, Credit and commodities markets are only somewhat different. The defining feature of the Financial Sphere at this time is a massive and destabilizing pool of “hot liquidity” seeking to make a decent return but increasingly fearful of getting run over.
So, to proffer a response to the above question - Is it amenable to rectification? – I don’t think so. Could a crisis develop quickly or be delayed for awhile? I feebly answer “yes.”
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