Something is rotten in Denmark.
it seems like noland agrees. he writes like the beginning of the end is near
prudentbear.com
The Dollar, Financial “Profits” and Reflation
It’s been some time since I partook in a bout of fruitless shadow sparing with my “analytical nemesis” Paul McCulley. But I have a fundamental disagreement with his analysis that I believe lies at the very heart of the most important economic issue of our time. Mr. McCulley is (from reading his latest) determined to “dig in his heels,” and so will doug. He believes the Fed executed sound policy in fighting “deflation” back in 2002. My view is that the Fed recklessly stoked Credit Bubble – especially mortgage finance and leveraged speculation - blow-off excesses. He believes the Greenspan Fed made things better, while I believe the Fed’s reflation strategy greatly compounded previous policy mistakes and exacerbated systemic fragilities. There can be no reconciliation of these diametrically-opposed policy views today, tomorrow or the next day. One of us is going to be “proved” wrong. (And I plan on fighting historical revisionism, Fed apologists and neo-Friedmanites as long as anyone will read my analysis).
As an analyst, ideology is The Seductive Antagonist. It is there to bias my objectivity and provide a convenient blurred lens with which my mind is happy to use to fabricate a view of the world and how it works (while fellow ideologues rejoice and adulate). I am certainly not a Keynesian, although I similarly wouldn’t subscribe to an ideology that yearns to burn him at the stake. Keynes was a great economist. And I will go further by stating my view that there is a time and place for aggressive “Keynesian” government intervention. Politicians are bound to make mistakes, as are monetary policymakers, bankers, businesspersons, market participants and markets – although the determined goal must be to avoid major errors. In a post-Bubble environment, monetary and fiscal stimulation hold the potential to play a constructive role in supporting spending, buttressing confidence and medicating a sick Credit system.
Still, much rests on a paramount issue: While aggressive stimulation (monetary as well as fiscal) may prove helpful in a post-Bubble environment, it is at the same time most harmful during the Bubble. Aggressive stimulation must be administered with great forethought and circumspection. Like war, there must be a plan to “win the peace” – ensure that stimulation is fostering sound Monetary Processes, as opposed to dysfunctional speculation and asset inflation – and there must be an endgame. There is great systemic risk in directing overwhelming force against the wrong target.
Moreover, I will argue strongly that “Keynesian” stimulation is surreptitiously destructive and potentially disastrous when it prolongs and exacerbates late-stage excesses, distortions and imbalances. And as inherently mesmerizing as this process – fighting the inevitable consequences of faltering Bubbles with only more potent stimulation - becomes for politicians, the prospering business and market “class,” an increasingly indebted and inflated asset-exposed general populace, and error-prone (and nervous) central bankers, great care must be taken to avoid a quagmire. The late-twenties period provides a poignant case in point. And we conveniently disregarded the lesson from Japan as to how important it is to avoid financial and economic Bubbles. In fact, our policymakers took “lessons not learned” to a whole new level by concocting a theory that aggressive stimulation early is the best remedy – “Keynesianism” and analysis at its absolute worst. There will be a huge cost for wasting most of our policy ammo.
It therefore becomes a requisite focal point of both analysis and policymaking to study and address Bubble dynamics. Most regrettably, the Greenspan Fed has abrogated its responsibility with its fallacious assertion that Bubbles are only recognizable after the fact. Meanwhile, virtually all analysts having anything to do with Wall Street, the lending business or the general Credit system similarly keep their distance from Bubble examination and contemplation – at least publicly. It is, after all, more expedient to parse the problem and solution in terms of “fighting deflation” (who in this country doesn’t think that is a good idea?), while driving us smack into an analytical dead end.
But while the public debate can be ordained to No Man’s Land, this can only for so long misrepresent the reality of pernicious – although certainly not commonly recognized – developments. Admittedly, for most days, weeks, months, quarters and, even, years, one can live a happier, more productive and profitable life playing right along with the charade that all is well and that our business leaders, market professionals, politicians and Alan Greenspan have everything well under control. George Soros’ Theory of Reflexivity helps us appreciate how everyone believing that things are well under control, by God, helps immeasurably to ensure that things remain under control. By their very nature, financial and economic booms become Confidence Games, the seriousness of the stakes involved and the acts to sustain confidence corresponding to the age of the boom. History teaches us that markets are predisposed to occasional manic periods of over-shooting; economies can dangerously over-shoot; and Credit systems can disastrously over-shoot. The great challenge today is to not be blindsided by the inevitable tornado adjustment period. They do, by there nature, develop when most think they see nothing but clear skies.
Mr. McCulley avers that the Fed “acted appropriately,” if belatedly, in firing its “anti-deflationary weaponry” back in 2002 and the “risk of deflation is now relieved.” I see things much differently. The issue was not “deflation” but a vulnerable Credit Bubble, and the corporate debt crisis of 2002 was not symptomatic of global deflationary pressures as much as it was an inevitable consequence of previous excesses and malfeasance. There was no cure, and the cancer has spread.
And what do we have to show for the past 24 months of reflation? Well, we witnessed a full-fledged rush to yield and risk-taking, with booms throughout the junk and emerging bond markets. There has been a proliferation of higher-yielding quasi-money market funds that could very well prove one of the poorest risk vs. return vehicles Wall Street has ever created. Derivatives – especially the key currency, interest-rate and Credit risk markets – have mushroomed. The hedge fund and leveraged speculating community have seen massive inflows and taken on unparalleled leverage. The GSE Bubble only grew more problematic. There has been an unprecedented boom in mortgage REITs that has all the appearances of late-stage leverage and real estate Bubble folly. The system has added an additional $2 Trillion of suspect mortgage debt at very low yields. California home prices have surged 50%, with further dramatic inflation for already inflated “upper-end” properties throughout the country. We’ve borrowed well over $1 trillion from foreign-sourced creditors. This borrowing has by and large financed consumption, with alarmingly minimal productive investment. Crude oil has surged to $55, the Goldman Sach Commodities index has doubled, and the price of doing business in the U.S. has further inflated.
I will be the first to concur that deflation does seem quite “relieved” at this point. But relief from a faltering Credit Bubble is spelled M-A-S-S-I-V-E & U-N-R-E-L-E-N-T-I-N-G R-E-F-L-A-T-I-O-N. This is truly a war that cannot and will not be won. In this regard, there are two critical and interrelated developments that support my view that reflation is approaching the brink: Both the dollar and financial “profits” are faltering.
I have written in the past how the traditional Banking system – dominated by bank loan officers and benign bank loans – was supplanted by Contemporary Finance with its cadre of investment bankers, marketable securities, derivatives, Credit guarantees/insurance and leveraged speculators. It was this multi-decade transformation of debt into marketable instruments that set the stage for a historic mania and financial folly. What a Bubble it all became. And the Fed’s war against deflation was precisely the policy mistake to needlessly stimulate spectacular “blow-off” excesses. These excesses – a.k.a. “reflation” - involved massive dollar support, massive mortgage lending, massive speculation in Credit market instruments, and massive leveraging. There was no need for the Fed to inflated its balance sheet or instigate “unconventional measures” with the ongoing massive inflation of dollar debt holdings on foreign and domestic balance sheets.
The faltering dollar - concurrent with dissipated returns for the over-crowded leveraged speculating community and rapidly faltering “profits” for the bloated financial sector – could now spell serious trouble for the reflation process. It is tonight worth noting that key financial institutions – including Fannie, Freddie, Citigroup, JPMorgan, AIG, and MBIA, to name a few – have good reason to now adopt a more risk-averse posture in the marketplace. Beyond important regulatory issues, the proprietary trading desks haven’t been able to show returns commensurate with the risks they have been taking. At the same time, the ballooning mortgage lenders are in the process of destroying lending profits for themselves and others (including banks and Credit card companies). Meanwhile, the hedge funds – with investor expectations so high – have been struggling to make ends meat with the very distinct possibility that things are about to turn much worse. Speculative losses would beget de-leveraging, further losses, outflows, and further de-leveraging.
The financial sector is looking increasingly suspect, which questions its capacity to continue to generate the massive Credit growth required to Retain Reflation. The Great Credit Bubble is today vulnerable to risk aversion from its myriad financial players – its “risk intermediators” – that must transform increasingly risky loans into perceived safe and liquid instruments. And anytime we are left to question the sustainability of reflation we must immediately contemplate Acute Financial and Economic Fragility.
If one scripted how the final stage of a historic Bubble in marketable debt instruments might appear, I think it would much resemble the way things are these days. I will conclude with the most important point – one not addressed by Mr. McCulley, or anyone else for that matter. A truly momentous failure of analysis and policymaking revolves around the issue of systemic liquidity created in the process of leveraged speculation of debt instruments (having gone to “blow-off” extremes). Highly leveraged speculative finance has become the key source of liquidity for both the financial system and economy. Similar dynamics were at the heart of the 1929 financial crash and subsequent Great Depression. This will be a pressing – if unappreciated – issue in the unsettling days, weeks and months ahead. |
