Global Asset Inflation and Lessons to be Learned:
prudentbear.com
We are in the midst of the Greatest Global Asset Inflation Ever. Contrary to the entrenched conventional view, this development is the manifestation of extraordinary underlying Monetary Disorder and as such has profound ramifications. All the same, surging perceived wealth stokes the delusion that we live in The Golden Age of Free-Market Global Capitalism. These are especially precarious times, in particular with respect to the confluence of Bubbling asset markets, inflated expectations, an epidemic of leveraged speculation, and wide-open global Credit. In tandem with excesses, New Paradigm notions become only more outlandish.
“We have to recognize that the very reason capitalism exists is to have asset price increases. That is the point of capitalism, so we shouldn’t bemoan the fact that asset prices are increasing.” Louis-Vincent Gave, in a December interview with the estimable Kate Welling (Dec. 15, Welling@Weeden, “Brave New World or Bust”).
Well, we definitely should bemoan it. Not only is asset inflation certainly not “the very reason capitalism exists,” the recent Global Asset Bubble Affliction poses a very serious clear and present danger. The essence of Capitalism is the free market interplay of supply and demand to determine a structure of relative prices that create favorable incentives and just rewards – positive impetus for individual economic agents that in aggregate nurture behavior that is best for the system as a whole.
Economic Sphere profits should drive the process, not the circumstance today where a wildly inflating Financial Sphere completely dominates the creation and dissemination of perceived wealth and resources. Systemic Asset inflation and Bubbles nurture price distortions and patently unsound incentives. The essence of robust and dynamic Capitalism is a market system that adjusts and self-corrects, rewards and disciplines. Asset inflation and Bubbles have a powerful propensity to avoid self-correction, while meandering to dangerous and self-reinforcing extremes.
I find it rather ironic that the most outspoken contemporary proponents of free market Capitalism seem to have the least appreciation for its pressing vulnerabilities. In this regard, I will forever pin blame on the flawed analysis of the circumstances and developments that culminated with financial collapse and The Great Depression, analysis championed by Milton Friedman and, later, by his “disciples” including our new Fed Chairman.
It was too expedient (by the early 1960s) to paint the Roaring Twenties as the “golden age” of free market Capitalism and Federal Reserve monetary management, casting blame instead on post-boom Federal Reserve incompetence. Such a perspective conveniently whitewashed Credit system and speculative market dynamics that had fueled myriad financial market Bubbles (acute financial fragilities) and fashioned fateful Global Economic Bubble Vulnerabilities. Invaluable lessons learned at deplorable social cost were simply Wiped Away with a Wanton Stroke of Historical Revisionism. And it remains these days too easy for the ideologues to intransigently deride the notion of inherent Credit system and private sector instabilities, a circumstance not all too conducive to either sound analysis or enlightened policymaking. Especially in an era of unchecked private-sector “money” and Credit (the reality in which we must analyze and operate), along with momentous financial and technological developments, there is great risk in dismissing Capitalism’s vulnerabilities.
Regrettably, it seems to have been long forgotten that the very foundation of a stable free market system rests (at certain junctures tenuously) upon sound money and Credit. That such a notion sounds so antiquated is an indication of how far analysis has drifted off course. And, with regard to today’s unsound money and Credit, there has been ample failure in both the public (gross mismanagement and deficits) and private sector (reckless speculative excess, gross over-issuance of suspect Credits, and attendant malfeasance) domains. Such an unsound monetary backdrop, as we have witnessed, will foment unwieldy booms with a propensity for increasingly deleterious incentives, asset inflation, financial and real resource misallocation, destabilizing speculation, escalating non-productive debt expansion, unjust wealth redistribution, and progressive structural economic maladjustment. Sure, government policies – including untenable future obligations and derelict monetary management – have been prominent factors in fostering the boom. But Credit system dynamics will invariably play the prevailing role in shaping the financial and economic landscape. To disregard the structure and character of the Credit-creating mechanism – the Financial Sphere generally, is to do injustice to the analysis.
Even analysts that I respect too frequently point blame for the current state of affairs on the government “printing press.” If I could convince readers of one aspect of my less-than-conventional analysis it would be to appreciate that the vast majority of contemporary (electronic) “money” and Credit is created outside of the domain of the Federal Reserve and resides largely beyond its control. Most zealous free markets proponents stubbornly adhere to archaic analysis with a narrow fixation on Fed controlled “money.” In reality, unchecked non-productive Credit expansion is the nucleus of contemporary monetary inflation. It is also, most disconcertingly, The Bane of Free Market Capitalism.
The essence of our contemporary Credit mechanism – the fountainhead for how, where and to what purpose liquidity/incremental purchasing power is introduced into the system - is asset-based lending and speculating (as opposed to financing real economic investment). The character of the Capitalistic system cultivated by this financial apparatus would be quite alien to Adam Smith. He would undoubtedly protest the quality of contemporary “money” and rebuke the nature of present-day market-based incentives. The root of the problem is, as I see it, that the preponderance of contemporary Credit inflation (and resulting price/incentive distortions) emanates from the expansion of asset and securities-based finance. Such a system is fundamentally and irreversibly unsound. An unconstrained monetary system that is principally backed by the market values of speculative assets is inherently unstable and predisposed to boom and bust dynamics. There is simply no getting around this fundamental dilemma.
I have for some time lamented the myriad risks associated with the aggressive expansion of “Wall Street Finance,” in particular the evolution to “Financial Arbitrage Capitalism” and the attendant preeminence of global leveraged speculation. Wall Street - their powerful leveraging mechanisms, “structured finance” and “risk management” capabilities, and their prospering clients - now command the Credit apparatus. Importantly, they largely govern monetary (“money” and Credit) issuance, hence system rewards and incentives. What an incredible and – for them - absolutely wonderful arrangement. This dangerous reality receives zero attention, although it obviously has monumental ramifications.
I have also repeatedly blasted the Fed for its (pandering) “transparent baby-step” monetary management, stating that it graciously afforded a dysfunctional system way too much leeway to adjust, inflate, further capitalize and in the process attain only greater power and influence. It’s now been about two years since Greenspan telegraphed to the marketplace his intention to cautiously raise rates. A couple of years provided ample opportunity for Wall Street to position itself to thrive mightily from the current Global Credit and Asset Inflation.
The Securities Broker/Dealer index is up 16% y-t-d, 52% over the past year and 80% since the Fed reversed course and raised rates to 1.25% in June of 2004. There is ample additional evidence that financial conditions have loosened measurably in the face of rising short-term rates. Manifestly, the expansive asset-based Wall Street “money” and Credit-creating mechanism was more than left unchastened; it was profoundly buttressed and emboldened. Timid “baby-steps” garnered sufficient time for The Street and its client base to adjust their interest-rate arbitrages (i.e. switch to variable rate financing and instruments) and myriad carry trade positions (i.e. borrow in yen, Euros, or Swiss francs). At least as consequential, it provided everyone the opportunity to gear up for a huge (“blow-off”) Global Inflation Trade.
This (once in a lifetime?) play is providing an unprecedented litany of inflating assets and markets to (borrow and) speculate on: private equity and LBOs; global equities; emerging equities and bonds; high-yield and variable-rate debt, MBS and “structured instruments;” global real estate; crude oil and energy properties the world over; and precious and industrial metals and commodities generally. Since essentially all of these prices have been rising at a faster clip than global funding costs, there should be no surprise that liquidity conditions have refused to tighten.
The Fed has a big problem; global central bankers have a big problem. Now that “Global Wall Street Finance” is fully positioned to profit from all aspects of the Great Global Inflation Trade, it has every incentive to sustain rampant over-issuance (Credit inflation). So what if the Fed ratchets up borrowing costs a little; bond portfolio losses pale in comparison to the ongoing hefty returns being generated from inflating asset values almost across the board. Chairman Greenspan was masterful in manipulating leveraged speculating community returns to achieve his desired goals. Lowering short-term rates provided an immediate incentive for speculators to boost leveraged bond bets, in the process lowering bond yields, stimulating borrowing and risk-taking, and increasing system liquidity. It was all too magical – the most powerful and abused monetary transmission mechanisms ever.
I’ll conjecture that the (overconfident) Fed fully expected that it would retain the power to simply reverse this manipulation – cautiously raising rates, reducing speculator returns on the margin, and judiciously managing excesses. Think again. To accommodate mature Credit and Asset Bubbles is to guarantee that they expand, disperse and morph. Expectations that rising rates and restrained U.S. mortgage lending would tighten financial conditions generally, temper consumption and the U.S. Current Account Deficit, and work to impinge global liquidity excess are not coming to fruition.
Increasingly, the Fed and global central bankers must be observing the myriad avenues for rampant Credit and speculative excess (associated with The Global Inflation Trade) that have blossomed of late and wonder what the heck it will now take to rein things in. The Fed and global central bankers fell so far behind the curve. The ECB did move again this week and, more importantly, indicated that there was likely more on the way. And when, probably in the near future, Japan joins in, we’ll have the first concerted global “tightening” in quite some time. Little wonder global bond markets are on edge and currency markets are unsettled. Not surprisingly, frothy global equity markets were generally oblivious.
It is certainly not uncommon for highly speculative markets to spite major fundamental developments until it is too late. Indeed, this is the very nature of Credit-induced booms and Asset Inflations: system incentives and rewards become totally defective. It is well-known to speculators that the greatest potential returns often present themselves in a final “blow-off” frenzy. If such a dislocation does unfold throughout global equity markets, it would be very bad news for central bankers and an unwelcome development for international bonds, not to mention setting equity markets up for an unavoidable drubbing.
Milton Friedman was in the past fond of claiming that there was no such thing as destabilizing speculation. He was wrong. We continue to have a ringside seat for the reprehensible consequences of unsound money and Credit and the resulting Asset Inflations and Bubbles. My only consolation will be if lessons are learned and forever retained from the experience. |
