No Inflating Out of this Quagmire:
Credit Bubble Bulletin, by Doug Noland
December 19, 2003
This truly is a most incredible environment; we’re in uncharted, turbulent waters, where – with the occasional lifting of the dense fog - things just aren’t as they seem. A lot of the “old rules” simply no longer apply. Reputations will be confidently wagered in the face of extraordinary uncertainty, and there will be losers.
And it is fascinating to watch these dynamics in play and to sort through such divergent views. The discerning Bill Gross recognizes that the U.S. is leading the worldwide charge to reflate. He sees opportunities in commodities, tangible assets, foreign currencies, real estate, TIPS, and non-dollar bond and equities. Robert Prechter, focused on the recent contraction in the monetary aggregates and fixated on his own analytical framework, takes the opposite view: “Deflation – a drop in the money supply – is now a reality…” ISI’s renowned Ed Hyman has a much different take: declining money supply “may reflect a portfolio shift into stocks, bonds, and real estate.” He has a sanguine view on stable prices and continued economic expansion. Barton Biggs recently averred to a CNBC audience, “I think we’re having a perfect recovery, and we’ve got a perfect economic environment.” And then there’s Art Laffer making Mr. Biggs appear a pessimist by comparison. He, this time, takes direct aim at the “latest negativism” propagated by those of us worried about our devaluing currency. His take is that the Fed is following masterful monetary policies, with the Fed’s tight reins on the monetary base adeptly controlling the inflationary engines. According to Laffer, the dollar is declining because of improving economic and investment prospect around the globe.
These seasoned players are all examining the same environment through their individual analytical prisms and coming to extremely divergent conclusions. My sense is that incorporating a sound analytical framework has never been more important. From my own Credit Bubble Analytical Framework, I am compelled this evening to give strongest weight to the analysis of Mr. Gross (while completely dismissing the ruminations from Art Laffer). Mr. Gross resides in the Credit system’s “Catbird seat” and fully appreciates the precarious nuances of contemporary finance and the risks of excessive debt at home and abroad. And he certainly hits the nail mostly on its head when he writes this month that “when too much debt infects the heart of capitalism you either default or inflate it away and the latter is by far the easiest (although not necessarily the wisest) policy.” (Mr. Gross’s parenthetical remarks)
I would argue that attempting to inflate away global debt problems, while definitely the “easiest” course, is as well definitely the un-wisest. Such follies only postpone the inflating amount of pain associated with the inevitable day or reckoning. The gist of the dilemma is that central bankers some years back lost control of the processes of Credit inflation, as well as their manifestations and consequences. American central bankers are, instead, under the control of the U.S. financial and economic Bubbles, as are the Chinese of theirs. And the Bank of Japan - with one bleary eye on U.S. Bubbles and the other on its own post-Bubble financial and economic quagmire - apparently sees little alternative than a massive inflation.
The resulting Credit, liquidity, and speculative excess are now distorting borrowing, spending, and investing decisions all over the world. Today, global central bankers are not achieving a traditional (re)inflation as much as they are, at this point, successfully sustaining myriad Bubbles. I believe this is a most important analytical distinction.
Especially with respect to contemporary finance, inflation is a Credit phenomenon and not a central bank-controlled monetary base phenomenon. Central banks can nurture, incite and energize Credit inflation, but these days have little capacity to manage or control its manifestations. Moreover, the general Credit system and systemic liquidity creation have been commandeered by Wall Street speculative finance. The Fed, and global central bankers to a lesser extent, retains incredible power. But this power is wielded through the blunt object of empowering the speculative community.
The Fed does today enjoy a captive audience – a global speculating community and sophisticated financing operations -- unlike anything experienced in history. A year ago this past summer this community was increasingly betting against systemic stability (shorting stocks, corporate bonds, buying derivative insurance against deflating asset prices). The vicious dynamics of debt collapse were in play. The Fed and central bankers responded in force (fighting “deflation”), and the speculative community reversed bearish plays to place bets on “reflation.” The results were sea changes in risk-taking, Credit availability for corporate America, and liquidity for economies and markets across the globe. Reflation speculations have been huge winners. As always, successful speculating is self-reinforcing and captivating. The ever-expanding speculator community has burst forth with larger size and much greater domination.
One major risk – the potential for higher rates to incite problematic deleveraging and derivative problems – began to manifest over the summer. The GSEs, once again, responded forcefully, and the Fed has since taken this risk out of the equation (for now). A second major risk – a rampant U.S. Credit inflation-induced flight out of the dollar impacting U.S. interest rates and securities markets – has been quelled by unprecedented foreign central bank purchases. Resulting historic liquidity excess has inflated asset prices globally. Things have never appeared so good – to the naked analytical eye.
Today, the Powerful Speculator Community has good reason to believe it has three important things working in its favor. 1) The Fed will act in their (the speculator’s) best interest, keeping short-rates low for as long as possible, while moving quickly to lower rates in the event of future systemic risk. 2) The Enormous and Powerful GSEs will continue to act as quasi-central banks, aggressively buying unlimited quantities of securities in the event of any systemic liquidity/interest rate stress. The implied Fed and GSE liquidity guarantees have never appeared as credible. 3) The Bank of Japan, the Bank of England, the Fed, Asian central banks generally, and perhaps global central bankers en masse, are today committed to sustaining the global speculative Bubble in Credit instruments. These powerful, unprecedented, layers of market support have evolved over time; they are revered by the fortunate speculators; and they are an important fact of life for economies and markets all over the world. The Great Credit Bubble is clearly now a global phenomenon.
And while this week’s market action brings holiday cheer, there were unmistakable signs of a new degree of excess. Despite surging stocks and continued strong economic data, Treasury and corporate prices rose (yields sank). The general financial and economic environment beckons for higher rates and restraint, but receives the opposite. Yet we should not be surprised, as we’ve witnessed dysfunctional (boom and bust) market dynamics for years now. The stock market is, as well, demonstrating conspicuous speculative Bubble dynamics. Typical and healthy pullbacks are not forthcoming, giving way instead to price surges and speculative runs. And I would argue that speculative Bubbles in both the equity and Credit markets place the faltering dollar at significant risk. The dollar sinks in the face of booming financial markets and unprecedented foreign central bank purchases. The worst is yet to come.
Over the years we’ve witnessed several of these “reliquefications.” This one, however, is much more extreme and global. Previous “reliquefications” usually ran their course in a year to 18 months, creating only bigger problems and bigger forthcoming “reliquefications.” The current one is no youngster, but it is, admittedly, a different animal than we’ve analyzed before.
Global reflation has taken firm hold. Yet, as I have followed developments closely, I am more convinced than ever that it is simply not possible for central banks to “inflate their way out” of this quagmire. There is no general price level to raise, and there is no general income level to inflate. Such notions are from a bygone era. And, importantly, central banks have been playing right into the hands of the Commanding Leveraged Speculating Community. The harsh reality is that the longer and more aggressively global central bankers inflate, the greater the leverage and speculation. Importantly, there is no inflating out of gross financial leveraging and major speculative Bubbles.
Global speculative stock markets are increasingly destabilizing, and I would strongly argue that there has been renewed vigor in leveraged Credit market speculation. Resulting inflationary manifestations are sporadic and especially uneven. Global central bankers, more than ever, are held hostage to inflated asset markets. And sure, asset Bubbles do foster income growth. One need only ponder how much California (and national) real estate brokers have made this year. It has been a banner year for those profiting from asset inflation, including real estate agents, Wall Street bankers, builders, farmers, mortgage brokers, and insurance salesmen.
But let’s not get carried away and convince ourselves that this is either healthy or sustainable. One dynamic of asset Bubbles is that they are sustained by only increasing amounts of new Credit creation. And with each new inflation and speculation – commodities, equities, farm land, emerging markets, fine art, etc. – comes additional Credit growth requirements. The more global central bankers stimulate Credit inflation, the greater next year’s requisite Credit inflation to sustain mushrooming Bubbles, distortions and imbalances. And having monetary policy fuel speculative Bubbles is risky, reckless business. The higher home prices, the greater stock and bond values, and the more extreme commodity inflation, the greater the required Credit and speculative excess to sustain them and the increasingly vulnerable financial and economic systems. Global central bankers have painted themselves into a dark corner.
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