Noland agrees with Heinz and Succo. we have deflation in our future
The Fragile Stability of Monetary Disorder
prudentbear.com
Atypical market developments again compel me to dive into some contemporary monetary theorizing. The nature of contemporary finance and economies provides some important nuances that often contradict conventional doctrine. Analysts that fail to appreciate some of the intricacies of contemporary “money” and Credit are left at a decided disadvantage. Hoping to make this more than an academic exercise, I will direct my analysis to the current financial environment, along with the ongoing “inflation vs. deflation” debate.
Interestingly, we are again in an environment of rather diametrically opposed views on the rate of “money” growth. Some argue that money growth has slowed significantly, while I have posited that we are in the midst of the “blow-off” in monetary expansion. Looking at the latest Fed figures, I do see that M2 has a rather tepid year-over-year increase of 4.2%. Yet the same Fed report has M3 expanding at a notable 9.4% rate over the past 26 weeks. Additionally, issuance of “money”-like asset-backed securities is booming at a record pace.
It is my view that, when it comes to contemporary monetary analysis (focusing on the entirety of the financial sector and not just the banks), broader (M3) is much better than narrower (M1 or M2). What’s more, year-over-year money growth calculations are rather tricky right now, as there was a significant “conversion” of monetary liabilities into higher risk (non-money) instruments that resulted in a decline in the “M’s” during last year’s fourth quarter (borrowers issued long-term debt to pay down short-term borrowings, as lenders concurrently sought higher-yielding instruments).
There are some other realities that cannot be ignored. The vast majority of contemporary “money” is comprised of electronic journal entries (debits and Credits). Of the almost $9.3 Trillion of M3, government issued currency accounts for $686.2 billion, or 7.4%. The remainder is made up of liabilities issued by various financial institutions, including Demand Deposits ($315 billion), other Checkable Deposits ($183 billion) Savings Deposits ($3.42 Trillion), Small Denominated Deposits ($795 billion), Retail Money Fund deposits ($736 billion), Institutional Money Fund deposits ($1.10 Trillion), Large Denominated Deposits ($ 1.04 Trillion), Bank Repurchase Agreements ($517 billion), and Eurodollar deposits ($345 billion). And there are now about $2.5 Trillion of outstanding asset-backed securities.
Banks are only one of myriad institutions that issue monetary liabilities, and reserve requirements are today virtually irrelevant to the process of issuing new “money.” A diverse group of financial institutions – including banks, GSEs, savings & loans, insurance companies, brokerages, money market funds, finance companies, “captive” finance units (i.e. GE, GMAC) and Wall Street structured entities (special-purpose vehicles, CDOs, MBS, ABS) are all tightly linked through the money and capital markets. These institutions issue new liabilities to each other and expand assets (increase holdings of other’s liabilities), creating marketplace “liquidity” throughout the expansion process. Funds are created and “transferred” among myriad institutions though adjusting journal entries (debiting and crediting accounts), and there is today absolutely nothing special about bank “money.” Many types of financial “intermediaries” debit and Credit accounts using the same processes as banks.
But having said all of that, the M’s are only one facet of monetary analysis. The examination and analysis of Credit are actually far the more important. Traditionally, money supply (bank deposits) expanded right along with bank lending (the commanding source of Credit growth). The Fed could manage Credit expansion through adjusting bank reserve positions, and bank deposit expansion was a good proxy for Credit growth. Generally, the monetary aggregates still expand as Credit expands. But - as was demonstrated clearly last fall - there are episodes where significant Credit growth is accomplished through the expansion of non-monetary liabilities (longer-term, riskier debt instruments).
Sound analysis requires diligent observation of the nature and degree of lending – what is being financed, to what extent, and to what end of Inflationary Manifestations. Are new financial claims backed by productive investment; is new lending financing asset inflation or financial speculation? Analysts of boom sustainability, along with financial and economic fragility want to know! And just as we must look to broad money as an indicator of the degree of Credit expansion, we must think broadly when it comes to inflation as well. Inflation is a Credit phenomenon with myriad and divergent manifestations.
There are a few things that should not be in dispute. First, total system Credit growth remains massive and at record levels. Second, the Mortgage Finance Bubble today dominates the Credit creation process, with historic over-lending fueling housing inflation and over-consumption. The Credit system is extraordinarily unbalanced; the economy is incredibly imbalanced; and today’s news of June’s $56 billion trade deficit is indicative of the extreme nature of current maladjustments. Third, there is a powerful confluence of unprecedented U.S. trade deficits, huge speculative flows to non-dollar asset classes, and historically low global interest-rates. Accordingly, the global liquidity backdrop today is as loose as one could imagine. There is no mystery surrounding the inflationary Asian boom or the spike in oil and commodity prices. Unstable financial markets are, as well, no surprise. And with global liquidity abundant and central banks almost universally quite accommodative, there is today good reason to assume that surging energy and commodity prices will be “monetized” through heightened global Credit excess. Inflationary pressures will continue to broaden.
Still, the old Inflation vs. Deflation debate is not much closer to being resolved today than it was several years ago. It is, however, my view that momentous developments over the past couple of years do add some degree of clarity to our analysis. It should be apparent at this point that inflation and general price instability will impact our lives more going forward than they have in decades. Not only has the war on inflation not been won, it is being lost. The enemy has dispersed and turned elusive, and there is absolutely no acceptable strategy for regaining control of the theater of combat. The Fed and global central bankers will, not irrationally or unjustifiably, continue to view the risk of debt collapse much greater than the risks of inflation, monetary disorder, and unstable markets. And the continuing environment of downward pressure on technology and manufactured goods prices will support central banker rationalizations.
Appreciating that inflation begets greater inflation, it is tempting today to extrapolate significantly higher inflation over the coming years. And with my view that the dollar will fall significantly from current levels, the likelihood of heightened inflationary pressures does only increase. But is there a meaningful risk of hyper-inflation developing? I don’t think so, and in fact I view the developments over the past two years as actually decreasing the probability for hyper-inflation. While heightened general inflation pressure is the most likely scenario, I would at this point expect the risk of a major pricing cataclysm is more on the downside (systemic debt collapse) than upside (hyper-inflation).
In my mind, the key issues have always been the sustainability of the Credit Bubble and with the risks associated with a Credit breakdown and resulting economic dislocation. And with the Mortgage Finance Bubble having been nurtured to “blow-off” extremes; with “money” supply expansion/intermediation having gone to “blow-off” extremes; with leveraged speculation having gone to extremes; with global over-liquidity having risen to “blow-off” extremes; and with extraordinary Monetary Disorder having been unleashed at home and abroad, I certainly view the probability for a devastating Credit collapse as much higher today than it was 24 months ago – significantly higher.
Returning to monetary analysis, I believe I understand the nature of hyper-inflation. Despite numerous complexities, it does very much revolve around the government printing press and uncontrolled fiat money inflation. Yet this dynamic has very little to do with contemporary “money” and Credit. And I think it is important to appreciate that current inflation is also divorced from Federal Reserve “printing” or “pumping.” The expansion of the Fed’s balance sheet has been basically inconsequential in comparison to total system-wide Credit expansion.
The Fed does not today “control” money creation. It has, however, been too successful in encouraging lending excess and inciting leveraged speculation. Moreover, the Fed has nurtured the mushrooming of the U.S. financial sector, and with it the “intermediation” of Trillions of risky loans into perceived safe and liquid “money” and Credit instruments. But we need, today, to be very cautious when it comes to extrapolating the Fed’s capacity for inciting both lending, speculating, and intermediation – the commanding forces underpinning today’s key inflationary manifestations. When financial crisis arrives - and de-leveraging and disintermediation commence - the Fed will certainly aggressively expand their balance sheet and incorporate “unconventional measures.” But years of runaway systemic excess (not to mention dollar vulnerability) leave the Fed today a rather atrophied and timid little player confronting A Big & Nasty Credit Bubble. The Fed will be surprisingly impotent in ameliorating bursting Bubbles, and the notion of “pushing on a string” will become topical.
Why did NASDAQ collapse in 2000? Well, cumulative market and industry distortions/imbalances from the preceding boom years – culminating with 1999’s spectacular Monetary Disorder and terminal “blow-off” excesses – ensured its eventual bust. It was only a matter of from what level of excess and how spectacular the bust. Today, very similar dynamics have come to apply with respect to the Mortgage Finance Bubble. Out in California (and elsewhere), reckless excesses ensure a housing Bubble collapse. But dangerous Bubble dynamics go way beyond mortgage finance. The ongoing explosion of liabilities owed to our foreign creditors risk a run on our currency and collapse in dollar confidence. The unparalleled ballooning of leveraged speculation risks unstable markets and dislocation. The derivative markets – where various market risks have been concentrated within a small group of institutions employing dynamic-hedging strategies – present a very real risk of systemic breakdown.
Not only do I view developments over the past two years as having significantly upped the ante on the dangers of Credit collapse, I believe the character of Fed-induced excesses and imbalances have significantly increased the likelihood of markets eventually “seizing up” – the LTCM debacle having provided an omen that should have been heeded. Today, with Bubble dynamics and speculative leveraging at full intensity, any significant move to de-leverage or liquidate dollar exposure would precipitate systemic liquidity crisis. And the way things are currently developing, a dislocation in the dollar/currency markets would appear to pose the greatest risk as the catalyst for such a financial dislocation. Most unfortunately, the contemporary U.S. Credit system has demonstrated zero capacity for self-regulation or adjustment.
The lack of a monetary “anchor” is a defining feature of contemporary finance. There is no mechanism (gold standard, reserve requirements, lending restrictions) to restrain issuance. Myriad financial institutions are capable of creating liquidity (backed by almost any quality of loan), a powerful dynamic that continues to be instrumental in sustaining the Credit Bubble. The “moneyness” of Credit (the capacity to create perceived safe and liquid Credit instruments from risky loans) is also a defining characteristic of contemporary finance. Combined, “anchorless” and “moneyness” have been instrumental in fostering the U.S. Credit Bubble and, thus, financing the U.S. Bubble economy. At the same time, these characteristics and consequent propensity for over-issuance and asset Bubbles have for some time been at the heart of dollar vulnerability.
Central banks have played a critical role in sustaining U.S. Bubble excess, as well as supporting the dollar. The Fed collapsed interest-rates and guaranteed marketplace liquidity. Last year in particular, Asian central banks ballooned dollar holdings. Not surprisingly, the now evident end result is only more acute Monetary Disorder – unwieldy Credit and speculative excess fostering only greater financial and economic imbalances – at home and abroad.
Watching, over the past few weeks, bond prices move higher along with surging crude has been something to behold. And then today, to again witness bond prices surge as the dollar gets hammered, provides further evidence that something is amiss in the financial markets. Dollar strains and heightened systemic stress are a boon to the Treasury market. Declining Treasury yields then provides a powerful anchor for other market interest-rates, especially mortgage borrowing costs. And mortgage lending – with the seemingly limitless capacity for the financial sector to transform increasingly risky loans into perceived safe and liquid instruments – lies at the very epicenter of unending liquidity excess. And the Bubble blows larger and tighter. I see little evidence that unfolding systemic stress is yet impinging Credit excess in the U.S. or globally.
Ironically, contemporary finance (along with New Age central banking) has created a strange Stability of Monetary Disorder. But it is this peculiarity that, at least at this point, dictates the continued inflation of non-productive Credit, dangerous financial sector leveraging, economic distortions, and excess dollar liquidity. I see no reason to back away from the view that we are on course for a dollar problem. And perhaps cataclysm in the currency markets will test the mettle of contemporary “money,” the “moneyness” of Credit, and the viability of prodigious derivative markets. Could such a scenario and associated acute financial fragility explain today’s 4.2% 10-year Treasury yield in the face of surging energy costs, a faltering dollar, and heightened inflationary pressures? |
