Doug Nolan's Credit bubble Chronicles
prudentbear.com
(first part of article is an interesting review of Friedman/Schwartz's chapters on
post 1929 credit policies and its relation to today's situation)
Financial Fragility poses an intractable problem for the
Greenspan Fed. Ironically, things have finally come full circle,
with Financial Fragility having materialized specifically through
years of rampant money and credit excess ineptly
accommodated by the central bank. Financial Fragility is
structural and its endemic. credit is not an antidote
but instead a potent stimulant And, importantly, the forces of
Financial Fragility will only be strengthened and become even
more stubbornly entrenched by the present policy course of
perpetuating monetary excess. More for Financial Fragility. Financial
Fragility is comprehensive and very complex, but emanates from
the massive amounts of over borrowing by the household,
corporate and financial sectors. Clearly, the massive
accumulation of foreign liabilities is a source of great fragility,
and Greenspan policy ensures its perpetuation. Financial
Fragility is also the term I will use to describe the deep structural
distortions to the U.S. economy, and corporate America in
particular. The recent episode of collapsing junk bonds and the
faltering corporate debt market were an unmistakable
manifestation of the acute vulnerability that has developed to
even the shallowest of economic downturns. This is an
ominous parallel to the 1930’s.
The current troubles in the manufacturing sector should also be
seen under the umbrella of Financial Fragility. Years of
overheated and unsustainable demand concomitant with
distortions in the economy’s investment process and over
borrowing have left their indelible mark. Fed policy strives to
sustain unsustainable demand. And with an overvalued dollar,
rising costs, and stiff foreign competition, there is a real story
here as U.S. industry rapidly loses its global competitiveness.
Again, current policy is powerless.
The US automobile industry is a case in point. Looking at
January industry data (that, by the way, was considerably
stronger than expected), we see that weak sales by the Big
Three were offset by continued strong demand for foreign
nameplates.
And we certainly don’t see the technology industry quagmire
ameliorated by more “easy money.” Instead, the great and now
punctured technology bubble will be a case study for decades
to come as to the negative financial and economic
consequences of reckless money, credit, and speculative
excess. Amazingly, however, there is still barely recognition that
things ran so terribly amok. There appears no appreciation as to
the extent of damage inflicted by an unprecedented flood of
speculative capital into this sector. If the lending and
speculative juices do get flowing again and $100’s of billion of
additional dollars fall into the black hole of the
“telecommunications arms race,” the consequence will be only
an extension of this historic period of gross resource
misallocation and precarious Financial Fragility. Perpetuating
this boom creates considerable potential for the destructive
process of “throwing good money after bad.” This is but one of
the most obvious costs of what will be Greenspan’s failed
experiment to repeal the business cycle.
And right here I would like to make what I believe is an important
point. A key aspect of Financial Fragility is the accumulation of
debt obligations (by households, businesses, financial
institutions, and the American economy as a whole) that are in
no way supported by sufficient underlying economic
wealth-creating capacity. While the $100’s of billions of dollars
that flooded into the Internet and Telecom bubble have been
spent and great resources squandered with little economic
value to show for it, the financial claims for the economy as a
whole remain as if this money and credit melee went off
swimmingly in a sound investment boom. Broad money supply
ended last week at almost $7.2 trillion, about $1.75 trillion (32%)
more than where it began 1998. What wealth producing assets
are backing this monetary explosion? It appears a fatal
characteristic of bubble economies that financial obligations
grow exponentially at the same time that the true economic
wealth creation collapses.
There is this most regrettable notion in this country that how money
is spent is not relevant. Amazingly, even the Greenspan Fed shows
scant concern for the quality of investment or our economy’s habitual
over consumption. Apparently, the belief is that the quality of
spending is basically inconsequential because it’s pretty darn simple
to make more money at a whim. It seemingly was not appreciated in
Mr. Friedman’s analysis nor by current central bankers that this is
very much just “running a tab.” While the resources are wasted,
particularly at the latter stages of booms, the financial obligations
remain. Simply creating more financial obligations only delays and
makes worse the unavoidable financial and economic adjustment. At
some point there will be a call on these obligations. Financial
Fragility lies in wait. A failure of current policy is that it nurtures
those with a proclivity of “running a tab.”
Most important to this process, our foreign obligations now
grow by almost $40 billion monthly, a truly staggering sum.
Borrowing huge sums for consumption – by individuals and
households at the micro level, or the U.S. economy at the macro
level – should be patently recognizable as part and parcel to
Financial Fragility. This is unsustainable and very much a
critical structural issue that must be resolved, although the
current central bank policy only exacerbates this disaster and
ensures a dollar crisis at some point.
While the severity of structural economic distortions are
becoming more conspicuous by the week, the heart and soul of
Financial Fragility lies imperceptibly within the U.S. financial
sector. Here, unprecedented leveraging and unfathomable
derivative positions has created the proverbial house of cards.
We have in the past often stated that when the financial sector
loses its ability to leverage, the game is over. The financial
sector ended the third quarter with $8.15 trillion of borrowings,
an increase of $2.7 trillion, or 50%, in less than three years.
However, this is the key area where Greenspan has great
influence and the ability to prolong the game, albeit with
incredible costs. And while the historic GSE bubble grows to
unimaginable proportions, only time will tell as to what extent the
US household sector takes the bait and piles on another layer of
mortgage debt. We are in the midst of a major refinancing boom
with attractive interest rates and years of extraordinary housing
inflation providing the fodder for potentially unprecedented
borrowings. Back in 1998 the average household was said to
have extracted $15,000 of equity during refinancing. Taking a
very conservative view with 5 million households pulling $20,000
of equity, $100 billion of additional purchasing power is created.
This number could easily go much higher. Not only is such
credit creation potentially destabilizing and inflationary, it will no
doubt prove a very difficult burden come the inevitable piercing
of the real estate bubble. Federal Reserve rate cuts are a fire
hose showering gasoline onto the real estate finance bonfire,
greatly exacerbating Financial Fragility.
The bottom line is that for years the financial system and
economy have fallen terribly off course. Endemic over
borrowing, massive over consumption, reckless speculation
and incredible malinvestment have brought us to today’s critical
juncture. The situation beckons for what would be a difficult but
necessary business cycle downturn, the only means of
beginning the process of getting back on a track of sound
money and healthy economic expansion. Perpetuating the
current destructive process is an unmitigated disaster. Fighting
Financial Fragility with only more monetary excess is a war that
cannot be won. In fact, the present course guarantees that
things go terribly wrong.
I will end with several additional quotes that I see as particularly
timely in this most fascinating environment.
“If we are dealing with a closed system, so that there is only the
condition of internal equilibrium to fulfill, an appropriate banking
policy is always capable of preventing any serious disturbance
to the status quo from developing at all…But when the condition
of external equilibrium must also be fulfilled, then there will be no
banking policy capable of avoiding disturbance to the internal
system.” John Maynard Keynes 812
“…We have seen that having a widely accepted medium of
exchange is of critical importance for any functioning complex
society. No money can serve that function unless its nominal
quantity is limited.” Milton Friedman, Money Mischief 1992 MM42
“There is no subtler, no surer means of overturning the existing
basis of society than to debauch the currency. The process
engages all the hidden forces of economic law on the side of
destruction, and does it in a manner which not one man in a
million is able to diagnose.” John Maynard Keynes, 1920 (MM
189)
“(Federal Reserve Bank of Dallas President Robert) McTeer
concluded his speech by driving home the message that
consumers do their part to keep the economic expansion going.
He implored the audience: ‘Go out and buy something.’ Dow
Jones News 2/2/01
“If we all join hands together and buy a new SUV, everything will be
OK.” Robert McTeer, Associated Press, 2/2/01 |
