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5 CREDIT BUBBLE
BULLETIN Crisis intermission - now for stage
two Commentary and weekly watch
by Doug Noland
Martin Feldstein, Harvard
professor and former chairman of the US
President's Council of Economic Advisors, wrote an
op-ed piece in last Wednesday's Wall Street
Journal - "Enough with Interest Rate Cuts" -
worthy of comment.
"It's time for the
Federal Reserve to stop reducing the federal funds
rate, because the likely benefit is small compared
to the potential damage. Lower interest rates
could raise the already high prices of energy and
food, which are already triggering riots in
developing countries. In order to offset the
inflationary impact of higher imported commodity
prices, central banks in those countries may raise
interest rates. Such contractionary policies
would reduce real incomes
and exacerbate political instability.
"The
impact of low interest rates on commodity-price
inflation is different from the traditional
inflationary effect of easy money. The usual
concern is that lowering interest rates stimulates
economic activity to a point at which labor and
product markets cause wages and prices to rise.
That is unlikely to happen in the US in the coming
year. The general weakness of the economy will
keep most wages and prices from rising more
rapidly. But high unemployment and low capacity
utilization would not prevent lower interest rates
from driving up commodity prices.
"Many
factors have contributed to the recent rise in the
prices of oil and food, especially the increased
demand from China, India and other rapidly growing
countries. Lower interest rates also add to the
upward pressure on these commodity prices, by
making it less costly for commodity investors and
commodity speculators to hold larger inventories
of oil and food grains. Lower interest rates
induce investors to add commodities to their
portfolios. When rates are low, portfolio
investors will bid up the prices of oil and other
commodities to levels at which the expected future
returns are in line with the lower rates. An
interest rate-induced rise in the price of oil
also contributes indirectly to higher prices of
food grains. It does so by making it profitable
for farmers to devote more farm land to growing
corn for ethanol."
While I concur with the
basic premise of the article (stop the cuts!), the
substance of Mr Feldstein's analysis leaves much
to be desired. First of all, I find it strange
than he would address the issues of overly
accommodative Federal Reserve policy, commodity
price risk, and inflationary pressures without so
much as a cursory mention of our weak currency.
The word "dollar" is nowhere to be found; not a
mention of our current account deficits. The focus
is only on interest rates, and such
one-dimensional analysis just doesn't pass muster
in our complex world.
Most people remain
comfortably oblivious to today's inflation
dynamics. Mr Feldstein mentions increased demand
from China and India. He seems to imply, however,
that portfolio buying (financed by low interest
rates) by "commodity investors and speculators" is
providing the major impetus to rising inflationary
pressures generally. Perhaps price gains could
have something to do with the US$2.5 trillion
increase in global official reserve positions over
the past two years (85% growth). I would also
counter that destabilizing speculative activity is
an inevitable consequence, rather than a cause, of
an alarmingly inflationary global backdrop.
I'll remind readers that we live in a
unique world of unregulated credit. Excess has
evolved to the point of being endemic to an
apparatus that operates without any mechanism for
adjustment or self-correction. There is, of
course, no gold reserve system to restrain
domestic monetary expansions. Some years back, the
dollar-based Bretton Woods global monetary regime
lost its relevance. And, importantly, the
market-based disciplining mechanism ("king
dollar") that emerged at times to ruthlessly
punish financial profligacy around the globe
throughout the nineties has morphed into a
dysfunctional dynamic that these days nurtures
self-reinforcing excesses.
The "recycling"
of our "bubble dollars" (in the process inflating
local credit systems, asset markets, commodities
and economies across the globe) directly back into
our securities markets rests at the epicenter of
global monetary dysfunction.
A historic
inflation in dollar financial claims was the
undoing of anything resembling a global monetary
system, and now this anchorless "system" of
wildcat finance is the bane of financial and
economic stability. To be sure, massive and
unrelenting US current account deficits and
resulting dollar impairment have unleashed
domestic credit systems around the globe to expand
uncontrollably. Today, virtually any major credit
system can and does inflate domestic credit to
create the purchasing power to procure inflating
global food, energy, and commodities prices.
The long-overdue US credit contraction and
economic adjustment could change this dynamic. But
for now there are reasons to expect this
uninhibited global credit bubble to instead run to
precarious extremes, and for resulting monetary
disorder to become increasingly problematic.
Destabilizing price movements and myriad
inflationary effects are poised to worsen. The
specter of yet another year of near $800 billion
current account deficits coupled with huge
speculative outflows of dollars is just too much
for an acutely overheated and unstable global
currency and economic system to cope with.
I hear pundits still referring to a
"deflationary credit collapse". Well, the US
credit system implosion was largely stopped in its
tracks last month. The Fed bailed out Bear
Stearns, opened wide the Fed discount window to
Wall Street; and implemented unprecedented
liquidity facilities for the benefit of the
marketplace overall. Central banks around the
globe executed unparalleled concerted market
liquidity operations.
Here at home, the
GSEs' regulator spoke publicly about Fannie and
Freddie (mortgage agencies) having the capacity to
add $200 billion of mortgages to their balances
sheets, with the possibility of increasing their
guarantee business as much as $2 trillion this
year (certainly including "jumbo" mortgages, that
is, larger than the present limits set by Fannie
Mae and Freddie Mac). The Federal Home Loan Bank
system was given the OK to continue aggressive
liquidity injections and balloon its balance sheet
in the process. And now (see "GSE Watch" below) we
see that the Federal Housing Administration (with
its new mandate and $729,550 loan limit) is likely
to increase federal government mortgage insurance
by as much as $200 billion this year, while
Washington’s Ginnie Mae (Government National
Mortgage Association) is in the midst of a
securitization boom.
Together, the Fed and
Washington have effectively nationalized a large
portion of both mortgage and market liquidity
risk. It is, as well, worth noting that JPMorgan
Chase expanded assets by $80.7 billion during the
first quarter (20.7% annualized) to $1.642
trillion, with six-month growth of $163.3 billion
(22.1% annualized). Goldman Sachs expanded its
balance sheets by $69.2 billion during Q1 (24.7%
annualized) to $1.189 trillion, with half-year
growth of $143.2 billion (27.4%). Even Wells Fargo
grew assets at an almost 14% pace this past
quarter. And we know that bank credit overall has
expanded at a 12.6% rate over the past 38 weeks.
Meanwhile, mortgage-backed securities
(MBS) issuance by government-sponsored enterprises
(such as Fannie Mae and Freddie Mac) issuance has
been ramped up to a record pace. And let’s not
forget the credit intermediation function now
being carried out by the money fund complex, with
assets having increased an unprecedented $371
billion year to date (41.3% annualized) and $900
billion over the past 38 weeks (47.7% annualized).
It is also worth noting the $184 billion y-t-d
increase (29% annualized) in foreign "custody"
holdings held at the Fed.
Sure, the credit
system remains under significant stress, with
additional mortgage and corporate credit
deterioration in the offing. But, at least for
now, policymakers have successfully stemmed
systemic deleveraging. The credit system is simply
not in deflationary collapse mode.
I could
not be more pessimistic with regard to our
economy's prognosis. And certainly much more
severe credit problems lay ahead. I could argue
further that recent credit system developments are
indeed consistent with the unfolding "worst-case
scenario". Yet I tend right now to see benefits
from analyzing the current backdrop in terms of
the conclusion of the first stage of the crisis.
The key aspect of this first stage was a
breakdown in Wall Street's highly leveraged risk
intermediation and securities speculation markets.
The speed and force of the unwind was
extraordinary and in notable contrast to
traditional banking crises that track real economy
developments. "Resolution" came only through the
Federal Reserve and federal government assuming
unprecedented risk, and at a cost of a
policymaking mix of interest-rate cuts,
marketplace interventions and government
guarantees. It is worth pondering some of the
near-term ramifications.
First of all, and
as the market recognized this past week, yields
have been driven to excessively low levels. Fed
funds are today ridiculously priced in comparison
both with the inflationary backdrop and with
global rates. Mr Feldstein is calling for a halt
to rate cuts when it would be more appropriate for
the Fed to move immediately to return rates to a
more reasonable level. They, of course, would not
contemplate as much.
So I will presume
that today's non-imploding credit system, replete
with government-backed mortgage securitizations,
government-guaranteed bank credit, presumed
government-backstopped money funds and a
recovering debt issuance apparatus, will suffice
in the near-term in generating credit sufficient
to perpetuate our enormous current account
deficits. This is no minor point.
I have
in past Bulletins made the case that US credit and
economic bubbles had become untenable; the scope
of credit and risk intermediation necessary to
support the maladjusted economy had become too
large. Extraordinary measures to effectively
nationalize mortgage and market liquidity risk
change somewhat the direction of the analysis. I
would today argue that the risk of a precipitous
economic downturn has been reduced in the
near-term. As a consequence, US credit growth
could
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