Page 1 of 3 CREDIT BUBBLE BULLETIN Government quasi-capitalism
Commentary and weekly watch by Doug Noland
This week's bulletin evolved from notes prepared for a presentation I was to give. Instead, a lively Q&A session developed and I never got to my notes. So, I'll take this opportunity to share analysis that introduces "government finance quasi-capitalism".
Federal Reserve Bank of St Louis president James Bullard (February 21, 2013):
Let me just talk a minute about Jeremy Stein's speech - governor Stein is a Harvard finance
professor, surely one of the leading finance people in the world ... The first point to make would be that - my main take away from the speech - he pushed back some against the "Bernanke doctrine". The Bernanke doctrine has been that we're going to use monetary policy to deal with normal macro-economic concerns and then we'll use regulatory policy to try to contain financial excess. And Jeremy Stein's speech said, in effect, "I'm not sure that you're always going to be able to take care of the financial excess with the regulatory policy." And in a key line, he said, "Raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see or you might not be able to attack with the regulatory approach ... "
The Fed has been talking about asset bubbles since the "irrational exuberance" speech which was 1996. So it's nothing new. We had a big bubble in the '90s. A big bubble in 2000s. Those two bubbles ended very differently. The Fed's been talking, talking, talking about this. So it's certainly been a concern. It is a concern today. But it's like nothing new. This has been going on for 20 years. Frankly, there aren't good answers because we don't have great models of financial instability.
The Fed has been talking about bubbles for 20 years. I've been diligently studying bubbles and money and credit for longer. I'm here with a sense of humility. After all, I'm again relegated to wearing the proverbial "dunce cap", as I persevere through my third major bull market, "new era" and "new paradigm".
The great American economist Hyman Minsky is best known for "stability is destabilizing" and the "financial instability hypothesis" - the evolution of finance from "hedge finance" to "speculative finance" and finally to highly unstable "Ponzi finance".
Minsky delineated the "Stages of Development of Capitalist Finance":
In both Keynes and Schumpeter the in-place financial structure is a central determinant of the behaviour of a capitalist economy. But among the players in financial markets are entrepreneurial profit-seekers who innovate. As a result these markets evolve in response to profit opportunities which emerge as the productive apparatus changes. The evolutionary properties of market economies are evident in the changing structure of financial institutions as well as in the productive structure ... To understand the short-term dynamics of business cycles and the longer-term evolution of economies it is necessary to understand the financing relations that rule, and how the profit-seeking activities of businessmen, bankers and portfolio managers lead to the evolution of financial structures.
Minsky saw the evolution of capitalist finance as having developed in four stages: commercial capitalism, finance capitalism, managerial capitalism and money manager capitalism. "These stages are related to what is financed and who does the proximate financing - the structure of relations among businesses, households, the government and finance."
Commercial Capitalism: "The essence of commercial capitalism was bankers providing merchant finance for goods trading and manufacturing. Financing of inventories but not capital investment."
Early economic thinkers focused on seasonal monetary phenomenon. Credit and economic cycles were prominent, although relatively short in duration.
Finance Capitalism: "Industrial Revolution and the huge capital requirements for durable long-term capital investment ... The capital development of these economies mainly depended upon market financing. Flotations of stocks and bonds - securities markets, investment bankers and the Rothschilds, JP Morgan and the other money barons ... The great crash of 1929-1933 marked the end of the era in which investment bankers dominated financial markets."
Managerial Capitalism: "During the great depression, the Second World War and the peace that followed government became and remained a much larger part of the economy ... Government deficits led to profits - the government took over responsibility for the adequacy of profits and aggregate demand. The flaw in managerial capitalism is the assumption that enterprise divorced from banker and owner pressure and control would remain efficient ... As the era progressed, individual wealth holdings increasingly took the form of ownership of the liabilities of managed funds ... "
Money manager capitalism: "The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy ... Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits ... A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market..."
Late in life Minsky wrote: "Today's financial structure is more akin to Keynes' characterization of the financial arrangements of advanced capitalism as a casino."
The above quotes were from a Minsky paper published in 1993. That year was notable for the inflation of a major bond market speculative bubble. This bubble began to burst on February 4, 1994, when Fed raised rates by 25 basis points (bps). I still view 1994 as a seminal year in finance. The highly leveraged hedge funds were caught in a bond bubble; there were serious derivative problems; and speculative deleveraging was having significant global effects, most notably the financial and economic collapse in Mexico.
I was monitoring these market developments closely back in 1994. According to transcripts of the Federal Open Market Committee, the Fed at the time recognized its role in helping to fuel stock and bond bubbles. While the bond market suffered through a bout of serious de-leveraging turmoil, I was anticipating more problematic systemic liquidity issues impacting the real economy and stock market. Things unfolded differently.
Keenly following developments and data, it was not long before I recognized that Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLB) were acting as "buyers of last resort" in the marketplace. The assets of such government-sponsored enterprises (GSEs) expanded an unprecedented US$150 billion, or 24%, in 1994. That same year, total GSEs securities (debt and mortgage-backed securities) increased an unmatched $292 billion. Essentially, the GSEs had evolved from operating chiefly as insurance companies (backing securitizations) to assuming the critical role of quasi-central banks, willing to pay top-dollar for debt securities during periods of acute market stress.
The rapid expansion of the "leveraged speculating community" and the timely arrival of the GSE liquidity backstop fundamentally altered finance. Instead of a burst bubble disciplining the hedge funds and enterprising Wall Street firms, the leveraged players were emboldened by a newfound GSE backstop, the Treasury's bailout of Mexico and then Fed chairman Alan Greenspan's doctrine of aggressive "activist" asymmetrical policy responses.
With the Fed and GSEs having so skewed market incentives, financial speculation ran wild. A series of spectacular booms and busts were commenced, including Southeast Asia, Russia, Argentina and US and global tech stocks. The wheels almost came off in 1998. The Nobel laureate-packed hedge fund Long-Term Capital Management (LTCM) - with egregious leverage and trillions of dollars worth of derivatives spanning the globe - almost brought the global financial system to its knees. Time for another bailout. Becoming an even more powerful market liquidity backstop, GSE assets inflated $305 billion in 1998. That year saw total GSE securities jump $474 billion. In the post-LTCM bailout speculative melee year 1999, GSE securities increased $593 billion.
All in all, the '90s saw GSE assets jump almost four-fold during the decade from $450 billion to $1.7 trillion. Total GSE securities inflated from $1.3 trillion to $3.9 trillion. The combination of bailouts, liquidity backstops and speculative leveraging provided a most fertile environment for the expansion of "Wall Street finance". During the decade, outstanding asset-backed securities (ABS) jumped from $200 billion to $1.3 trillion. Securities broker/dealer assets rose from $236 billion to $1.0 trillion. Fed funds and repurchase agreements jumped from $360 billion to $925 billion. Hedge fund assets inflated ten-fold from $40 billion to $400 billion. After doubling in the year following the LTCM bailout, the "technology" bubble burst in 2000. During 2000-2001, GSE securities inflated another $1.0 trillion.
I began posting the Credit Bubble Bulletin in late 1999. I was absolutely convinced finance had been fundamentally altered, with momentous ramifications. From my research, I believed developments were unique in financial history: for the first time, global finance was expanding without limits to either its quantity or quality. The Fed, GSEs, "Wall Street finance" and global central banks had fundamentally changed how finance operated - and, importantly, how finance was interacting with the real economy. There had been decisive changes in financial market incentives. And the resulting new financial apparatus provided unlimited cheap finance that was primarily directed to the assets markets. This fundamentally altered our economy's underlying structure.
In 2001, developments compelled me to update Minsky's "stages of development of capitalistic finance": "money manager capitalism" had evolved into what I termed "financial arbitrage capitalism". Traditional money management had given way to the rise of sophisticated market-based financial instruments and financing arrangements. In particular, the new financial and policy backdrop had created auspicious market incentives and financial rewards for leveraging in high-yielding ABS and MBS. This fostered a proliferation of spread trade and myriad sophisticated derivative strategies - all working to fuel asset inflation and bubbles. Importantly, enormous easy-money speculative profits were increasingly divorced from economic returns in the real economy. Finance, generally, was becoming progressively detached from the real economy.
In response to late-cycle "money manager capitalism" developments, Minsky commented: "We must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde."
From my perspective, "financial arbitrage capitalism" and the attendant financial bubble were leading to historic economic maladjustment - surely fostering debt-financed overconsumption and the de-industrialization of our economy.
I first began warning of the mortgage finance bubble in CBBs back in 2002. With mortgage credit expanding at double-digit rates, this fledgling bubble had already achieved a strong inflationary bias. Ben Bernanke, later to become Federal Reserve chairman, emerged on the scene with radical theories of an electronic "government printing press" and "helicopter money". His so-called "post-bubble" "mopping up" monetary inflation was destined for greatness. As the Fed's reflationary expedient, mortgage debt proceeded to double in just over six years. The rest is history - the "financial arbitrage capitalism" that took hold with a vengeance in the early '90s hit the wall with the 2008/09 bursting of the mortgage finance bubble. Another round of increasingly desperate "post bubble" "moping up" reflationary measures unleashed incredible fiscal and monetary stimulus on an almost worldwide basis.
In an April 2009 bulletin, I began chronicling the "global government finance bubble". This bubble has made it to the foundation of contemporary "money" and credit - to the perceived safest credit instruments. At home and abroad, governments and central banks have assumed prevailing roles in both the markets and real economies.
For some time now, I have strongly believed we are in the midst of history's greatest and most dangerous bubble. As an analyst of bubbles, I've often quipped that they tend to go in unimaginable extremes - "and then they double". I have also posited that the more systemic the bubble the less obvious is becomes. In 2009, I fully expected the Fed/global central banks to throw everything they had at the crisis. Yet I never expected the European Central Bank to commit to open-ended buying of troubled debt. I never imagined four years later the Fed would resort to $85 billion monthly monetary inflation - with similar amounts from the Bank of Japan - in a non-crisis environment. The Fed went from preparing exit strategies with its assets at $2.5 trillion - to providing market assurances of no exit with its balance sheet on the way to $4.0 trillion.
After doubling mortgage debt in about six years, our system then doubled federal debt in four. I never imagined this amount of non-productive debt could be issued at historically low market yields. Instead of protesting, exuberant markets fell in love with reflationary measures.
Globally, it's been a period of unprecedented credit and speculative excess. Attendant maladjustment has been most pronounced throughout the "emerging markets". China has had four years of "terminal" credit bubble excess to wreak financial and economic havoc. Similar dynamics have severely impaired "developing" economies and credit systems, certainly including India and Brazil. For going on five years now, there's been ample confirmation of the "granddaddy of them all" bubble thesis. And in contrast to 2008, the next serious bout of turmoil will not be a private-debt crisis. It will arrive with few policy options other than even more desperate "money printing".