Prudent Bear Market Commentary: Good Read
Market Commentary
Cantillon's Lessons from John Law's Mississippi Bubble
July 16, 1999
Wow, it was another wild and difficult week for the bear camp. The Dow was largely unchanged, gaining 15 points, while the S&P 500 rose about 1%. The Morgan Stanley Consumer index gained 1%, the Morgan Stanley Cyclical index and Utilities were flat, while the Transports dropped about 1%. Much of the market performed stronger than the bluechips. The small cap Russell 2000 index gained about 2%. Throughout the technology sector, the buyers' panic continued as a general market dislocation has certainly been exacerbated by derivatives and short covering. For the week, the NASDAQ 100 gained 3%, raising its 1999 gain to 34%. It is just hard to believe that the NASDAQ 100, which closed today at a record 2459, began 1996 at just above 500. Today Microsoft gained 5 points, adding $25 billion in market capitalization. Also this week, the Morgan Stanley High Tech index gained 2%, and the Semiconductors 4%, bringing year-to-date gains for these groups to 42% and 51%. Internet stocks, however, faltered some this week with The Street.com Internet index declining 4%. The financial stocks were generally unimpressive, although the bank index had a strong session today. For the week, the S&P Bank index lost about 1% and the Bloomberg Wall Street index experienced a fractional decline.
It is our strongly held view that today's historic stock market bubble emanates from an unprecedented, and we will add, dangerous explosion of credit. Much of this credit, importantly, has been created by our overzealous financial sector leveraging the purchase of financial assets. During the first quarter, the financial sector increased borrowings at an annual rate of $1.2 trillion. For comparison, at the beginning of this decade, in 1991, our financial system increased borrowings by $171 billion, and by 1995 annual borrowings were $456 billion. It is this explosion of financial credit that today largely explains how our country can somehow have a financial system and economy marvelously spewing liquidity despite a negative household savings rate, a corporate sector funding deficit, massive trade deficits and unprecedented demand for borrowings generally. And in this regard, the greatest creators of this liquidity continue to be Fannie Mae and Freddie Mac.
This week, Fannie Mae and Freddie Mac reported 2nd quarter earnings and Wall Street celebrated the determination of these lending behemoths to maintain very aggressive growth. We, on the other hand, continue to be quite alarmed at the incessant ballooning of these companies' balance sheets, and the resulting distortions this creates for our financial system and economy. In the past, we have explained the key role these institutions played in rescuing the system during last fall's near debacle. Using their unlimited access to the capital markets, they stepped in and undertook the crucial role of buyer of last resort, providing liquidity to faltering credit markets that were jeopardizing the US financial and economic bubble. This wave of liquidity not only saved a number of leveraged speculators, and was also a big help for many Wall Street firms, but the incredible growth of credit emanating from Fannie and Freddie provided great fuel to the financial system and economy, fostering greater excesses throughout. Certainly, Fannie and Freddie share major responsibility for the latest round of liquidity-driven stock market speculation, not to mention the real estate boom that has gathered considerable steam this year. But despite obvious signs of dangerously overheated asset markets and increasing economic distortions, these institutions continue their dangerous melee of credit excess, adding more jet fuel to a financial system running completely out of control.
During the first half of this year, Fannie and Freddie combined to increase by $102 billion mortgages held for their own portfolios. For perspective, total American household mortgage debt growth was $230 billion for all of 1997, and $125 billion in 1993. Over the past 12 months, mortgage loans held on Fannie and Freddie balance sheets have increased $226 billion, or more than 40%. For comparison, Fannie and Freddie mortgage loans grew $66 billion during the first half of 1998, and $56 billion for the entire year of 1997.
The dominant role now played in our financial system and economy by Fannie and Freddie, as well as asset-backed securities, is well illustrated by comparing their combined lending to the total growth in bank credit. In the first half of 1999, mortgage loans held by Fannie and Freddie have grown $102 billion. In total, there were almost $400 billion of mortgage-backed securities and almost $140 billion of asset-backed securities (largely credit card, auto and home equity loans) issued during the first half. This compares to total bank loans and leases that expanded by $20 billion. In fact, total bank credit, a number followed closely by economists, has barely grown at all this year. And this has, actually, led many to assume that last year's rapid credit growth had come to an end and that an economic slowdown was at hand. This, however, has not at all been the case as the wild boom runs on. Certainly, the past six months has been an historic case for the predominance of credit creation outside of the banking system.
In this environment, traditional money supply data is also losing its usefulness. In the past, with bank lending the dominant source of new credit growth within the economy, money supply was a good indicator of the general credit environment, hence a telltale sign of economic activity. Today, with investment bankers and capital markets the king of credit creation, money supply data is a woefully inadequate indicator of conditions within the financial system and economy. This has particularly been the case so far this year and, again, it has been a trap for many economists who have believed that slower money growth was indicative of waning demand and a weaker economy.
Interestingly, here again we see Fannie and Freddie playing a key role. Last year, when Fannie and Freddie were borrowing aggressively from the money markets to fund their ballooning balance sheets, this was a major factor behind the rapid growth in money market fund assets, which are included as a component of broad money supply. Now, however, Fannie and Freddie are bypassing money markets and borrowing extensively from the debt markets, so this credit expansion occurs largely outside of instruments included in money supply.
Whether it is counted as money supply or not, basically funds just spin around the system creating more and more credit outside of the banking system and, apparently, outside the view of most economists. Fannie and Freddie raise funds through the debt markets, and use these funds to buy financial assets/make mortgage loans, and the funds continuously circulate through the financial system where they are borrowed again, and again, and again. As we said, funds just spin around with the velocity of electronic transfers, unfettered by bank reserve requirements in what can be called "the infinite multiplier effect." With this in mind, we would like to briefly highlight a piece of the work of Richard Cantillon.
Cantillon was an astute Irish banker who became very wealthy through his keen understanding of John Law's Mississippi Bubble in France back in the early 1700's. John Law, by the way, introduced paper money and stock market speculation to France in what many believe to be history's most spectacular speculative bubble turned ugly bust. Anyway, Cantillon wrote about the experience afterwards and his manuscript is considered one of the first books analyzing economic phenomena. Cantillon's great contribution to economic thinking include theories on credit, banking, currencies, the money supply and the important role played by velocity of money. Cantillon also focused on capital markets, and how rapid movements of money into or out of securities had a profound impact on the effectiveness of a certain supply of money – and, most importantly, the structure of prices. As was stated by Cantillon: "To some degree, an acceleration, or a higher velocity of money circulation, will have a similar effect as an increase in the supply of money."
Although there is scant notice of his work today, we believe his analysis is profoundly relevant more than 250 years later. Today, our much-heralded contemporary financial system, with instantaneous velocity and booming securities markets outside the traditional realm of banking, is a mechanism with an unparalleled propensity to create devastating credit excesses. And, again this week in the stock market, we see clear evidence of the resulting distortions to the pricing mechanism. Particularly with regard to Fannie and Freddie, asset-backed securities, and the stock market bubble, we have and continue to create financial claims that are but a house of cards not unlike John Law's Mississippi Bubble. With a completely unbridled financial system, electronic money simply spins around creating an almost unfathomable mountain of securities – be it corporate debt instruments, such as traditional debt issues, IOU's from Fannie, Freddie, GMAC and GE Capital; asset-backed securities comprised of consumer credit card, auto and mortgage loans, as well as equipment leases and rock star royalty payments. And, of course, stock market securities including shares, stock options and derivatives.
In this scheme, it appears wealth is created out of thin air; just have Fannie create more IOU's, or have Wall Street bring more IPO's to market – either way, we become more prosperous. At the same time, during the boom there are all appearances of endless liquidity as virtually everyone moves to exchange money for securities that seem only to rise in value. Well, this does work like magic during the boom but, unfortunately, sows the seeds for catastrophe down the road when it is realized that the exponential growth in claims is not in any way supported by the wealth producing ability of the underlying economy. Cantillon understood this clearly. He knew that manic speculation and the excessive creation of security claims produced by John Law's scheme of managed money were destined for collapse. He converted his security gains into gold and silver coins near the height of the boom and left France. Soon after, confidence began to falter and the speculative bubble was pierced. Holders of securities attempted to convert this paper into something of real value, but few got out before the stunning collapse.
According to The New Palgrave Dictionary of Economics, "The collapse of the system ruined many in all walks of life and made the word ‘bank' anathema in France for well over a century. Though Law's system reduced unemployment and stimulated output, it was at the expense of doubling the price."
We will conclude with the final profound paragraph from Cantillon's manuscript. It was written in the 1720's, after the collapse of John Law's bubble that saw a desperate panic out of securities, a collapse of monetary "velocity" and bank credit, and the onset of a depression that lasted for years to come. We, unfortunately, find uncomfortable parallels between John Law's Bubble and today's American Bubble.
"It is then undoubted that a Bank with the complicity of a Minister is able to raise and support the price of public stock and to lower the rate of interest in the State at the pleasure of this Minister when the steps are taken discreetly, and thus pay off the State debt. But these refinements which open the door to making large fortunes are rarely carried out for the sole advantage of the State, and those who take part in them are generally corrupted. The excess banknotes, made and issued on these occasions, do not upset the circulation, because being used for the buying and selling of stock they do not serve for household expenses and are not changed into silver. But if some panic or unforeseen crisis drove the holders to demand silver from the Bank, the bomb would burst and it would be seen that these are dangerous operations."
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