Searle: Some USD 'stew', courtesy of Doug Noland:
"We’re big fans of Mr. Prechter and consider him one of the few around today deserving of the status market and social “guru.” We certainly share his focus on the perils of Credit excess and inflated asset markets. But while we may see eye-to-eye on the problem, it is not so clear to us that the consequence of a Credit Bubble is a predestined “deflation.” Indeed, we can look to the disparate environments in post-Bubble Japan and post-Bubble Argentina as evidence that collapsing Bubbles may end in a long, draw-out mild deflation or, in the case of Argentina, rapid financial implosion and devastating inflation. From the standpoint of attempting to analyze which of these polar extremes may best apply to Post-Bubble America, we are increasingly convinced that the dollar’s performance will play an instrumental role. Rather than focusing on inflation/deflation, the primary analytical focal point of Credit Bubble analysis today lies elsewhere.
Japan made truly incredible economic progress for several decades, before succumbing to extreme financial excess in the late eighties. Sadly, they “drank the poison” and basically destroyed their financial system in a few short years. Yet, post-Bubble Japan remained endowed with great wealth-creating manufacturing capacity. The Japanese multinationals have not only survived; they have prospered. With enormous trade surpluses, the economy has been able to muddle through a wrenching decade-long financial quagmire. Importantly, the related trade surplus and household saving attributes (Japan as Creditor nation) played an instrumental role in supporting the Japanese currency. The yen today trades at about 120 to the dollar. This is just off its 10-year average and above where it began the nineties. Importantly, (and especially for retirees) the frugal Japanese saver has maintained her purchasing power. There has been no run on Japanese financial assets.
Importantly, the Japanese Credit Bubble was a severe domestic debt problem, but international investors and speculators played a relatively insignificant role. The fate of the financial system and economy did not rest tenuously on yen confidence. The post-Bubble banking system has been an unmitigated disaster, but the Japanese economy’s debt structures – supported by decades of sound investment and enormous household savings – proved resilient."
Stagnant private sector Credit growth was partially offset by large government borrowings, playing a critical role in tempering financial fragility and stabilizing the system. Excesses, both real and financial, had not reached the point where contracting private-sector debt growth would lead to unmanageable collapse. Fortunately, I would argue, the Japanese government used is fiscal and monetary powers to ease an arduous post-Bubble transition, rather than to sustain the Bubble. And while certainly encumbered, Japanese society has remained cohesive through a protracted and difficult adjustment period. The general population has not rioted or spent much time in protest, but rather fell back on financial discipline and its hard-work ethic. There has been too much (typical post-Bubble) talk of policy incompetence and not enough recognition of a most impressive performance by the Japanese people.
At the other extreme, an arguably much less formidable and pervasive Bubble in Argentina has left the financial system and economy in absolute tatters. Many savers have been completely wiped out, and the social fabric has been severely frayed. Argentine citizens have lost confidence in the government and the country’s institutions. Sadly, bank runs have become commonplace. The Argentine peso has lost 70% of its value, with inflation running rampant. Foreign bankers, investors and speculators have abandoned the country, with international institutions (and “globalization”) under justifiable attack from Argentine citizens, politicians, and monetary authorities. The economy has sunk into deep depression, with little benefit from a collapsing currency. Indeed, the sinking Argentine peso has been a major hindrance, in stark contrast to the experiences of post-Bubble South Korea, Thailand, Russia and Brazil.
The boom-time Argentine economy came to depend on foreign-sourced finance, much of it of speculative character. Once addicted, all involved were steadfast in refusing to recognize the sickness. Foreign borrowings financed too much consumption and too little of the type of sound investment capable of creating the necessary economic wealth to repay Creditors. Once this course was chosen, it was only a question of the dimensions of the inevitable financial and economic dislocation. Reliance on foreign borrowings in combination with economic maladjustments over time combined to create acutely fragile debt structures. Indeed, it was precisely the nature of the speculative capital flows fostering non-productive Credit excess that proved fatal to the Argentine financial system. Frail debt structures and economic maladjustment left the currency, Credit system, and economy hopelessly vulnerable to both the inevitable reversal of speculative flows and attendant capital flight. Confidence in the peso’s peg to the dollar became of momentous consequence. Almost overnight, Argentine financial assets were no longer an acceptable medium for international exchange. Importantly, none of these types of issues have played a role in post-Bubble Japan.
So we have very difficult and complex questions to contemplate in our pursuit of What Will Be Post-Bubble America. Most regrettably, the Greenspan Fed, Wall Street, the GSEs and Washington politicians are resolute in their determination to stonewall the adjustment process. Importantly, this dangerous course of prolonging the Bubble is categorically based on continued Credit excess – inflating dollar financial claims. This should not today be in dispute, and incessant Credit inflation is why we remain fixated on dollar vulnerability and devaluation. There may certainly come a day when faltering confidence and a run on dollar financial assets wreaks (Argentine-style) havoc on the U.S. Credit system – especially its acutely fragile “Structured Finance” parallel “banking” system – but the system today retains its capacity for unchecked and rampant inflation of dollar claims (Credit inflation).
But as we’ve highlighted repeatedly, these new claims could not be of poorer quality. Nor could current Credit inflation impart greater distorting affects on the real economy. Recall that during the third-quarter Household Mortgage Debt expanded at a rate of 11.8%, while Corporate Debt was virtually unchanged. And that a meaningful portion of these new claims are acquired by leveraged speculators only adds an additional layer of debt structure vulnerability.
There is absolutely no way for the U.S. financial sector or economy to inflate out of this desperate quagmire. I continue to be amazed that individuals that should know better call only louder for greater U.S. inflation. It should be obvious that the dilemma we are facing has nothing to do with insufficient money or inadequate Fed-created liquidity. The Credit system continues firing on overdrive, while there remains in inflationary bias in wages and income. The dollar is the weakest in years, while gold and commodities are performing the best in some time.
In an attempt to simplify a very complex environment to accessible terms, I see two critical issues today. First, the U.S. “service sector”/consumption-based Bubble economy has about reached the end of its rope. The consumer is piling on debt at a precarious and unsustainable pace (“blow-off”). Furthermore, the degree of Credit excess necessary to sustain spending/“output” at boom-time levels (in the context of a severely maladjusted economic system) is increasingly destabilizing. Credit excess-induced created purchasing power stimulates over-consumption, massive trade deficits, and uneconomic “investment,” with only a trickle financing sound investment. If one were to calculate a Stable Finance Ratio of “sound investment to total Credit growth” it would undoubtedly be crashing to an all-time historic low. Conversely, a Financial Fragility Ratio of “foreign liabilities to economic wealth creating assets” would now be rising exponentially. Continued rampant Credit inflation has in reality become dangerously counter-productive, and we look to the dollar level and gold price as confirmation of this view.
Second, the “structured finance” monetary regime that retains its dominance at the epicenter of our nation’s financial system (The Master of the Great Credit Bubble) is absolutely and unalterably dysfunctional. Indelible Monetary Processes specifically direct finance to where it is not needed – to sectors where there remains an inflationary bias. The entire U.S. financial system, then, has become trapped in a consumer and Mortgage Finance Bubble that has the corporate debt and stock market Bubbles appearing quite manageable in comparison.
As monetary analysts, we’ve never respected nor trusted “Structured Finance.” This is because it’s all about lending volume and financial speculation – the nemeses of sound money and economic and financial stability. The Aggressive Loan Originator (and his cohorts Clever Securitizer, Oblivious Credit Insurer, Gumptious Rating Agency, and Enterprising Leveraged Speculator) has supplanted the anachronistic Prudent Loan Officer and his preciously mundane Bank Loan. Along with volume, the Structured Finance mob covets yield. As such, Structured Finance has a rather intense fancy for subprime. Poor credits provide an almost limitless captive audience – at least during the self-reinforcing, Credit excess-induced boom. Consumption-based lending, as we have witnessed, knows no bounds (when one governs over the world’s reserve currency!). Structured Finance also has a devoted love affair with asset-based lending and speculating. As we have witnessed, inflating asset (equities, homes, mortgage-backs, agency bonds, baseball teams, etc.) prices provide unbounded lending opportunities during the boom; again, music to the ears of Structured (“Speculative”) Finance.
But why does Structured Finance treat sound investment with such utter disdain? Because of volume constraints and, to a lesser extent, yield inadequacies; in contrast to consumption and asset-based lending, there are definite bounds on the amount of sound investment. The more that is financed, the more vulnerable profits and the less sound the underlying Credits. Indeed, business profits provide rather tenuous collateral after Bubbles have passed their peak. It would truly be wonderful if we could today rev up the manufacturing sector and right the system. Beguiling perhaps, but this is not today a viable alternative. The financing of sound investment would prove woefully inadequate in terms of the quantity of Credit required to sustain the U.S. Bubble. Moreover - and a major issue today for the dollar and financial fragility - Structured Finance simply does not have the luxury of turning its back on the Consumption and Asset Bubbles it has so fervently nurtured. For the U.S. Bubble Economy it remains inflate or die. Reckless Japanese Credit inflation was terminated before it was too late. Argentina’s was not.
The inescapable consequences of the U.S. Credit Bubble Dilemma include only more Credit and speculative excess, heightened financial fragility, deeper economic maladjustment and impairment, and a further debasement of our currency. Considering what we have and continue to observe, I do not feel it is at all outrageous to assert that our system has set a perilous course toward the collapse of the world’s reserve currency. This is the harsh reality that we should recognize as a nation as we contemplate Post-Bubble America. And no amount of inflation will change the facts of economic life. There are no available shortcuts but many risky gimmicks to prolong the Bubble, hence only making the inevitable day of reckoning all the more painful and Balkanizing. There is nowadays only louder call for stimulating and “reflating,” but there is absolutely no discussion of the consequences. There is so much a stake. It is our view that the longer we travel down this dangerous course the more rapidly the Post-Bubble America pendulum swings away from a Japanese scenario in the direction of Argentina."
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