Page 1 of 3 CREDIT BUBBLE BULLETIN Counter-cyclical or counterproductive?
Commentary and weekly watch by Doug Noland
My old "analytical nemesis", PIMCO managing director Paul McCulley, is out with
a long piece this week, "The Shadow Banking System and Hyman Minsky's Economic
Journey." He begins by stating the rather obvious: "Creative financing played a
massive role in propelling the global financial system to hazy new heights ...
" Mr McCulley then asks a most pertinent question: "How did financing get so
creative?" His somewhat insightful article is deeply flawed in that it fails to
provide a valid answer.
First and foremost, our credit system ran amok because our "activist" central
bank for years pegged and, over time, increasingly manipulated the cost of
finance. The US Federal Reserve essentially guaranteed liquid and continuous
markets to an increasingly deregulated and unrestrained marketplace, while
repeatedly moving aggressively to bail out the leveraged speculators. The Alan
Greenspan Fed championed "contemporary finance", in the process creating
astounding profit opportunities for those structuring, distributing and
leveraging sophisticated Wall Street financial instruments. Bernanke promised
to be there with helicopter money as needed.
The Fed, Congress, and various US administrations championed financial
deregulation - as financial operators salivated. It certainly didn't hurt that
spurring mortgage borrowing and home ownership became a national priority, as
the rapidly expanding government-sponsored enterprises, notably Fannie Mae and
Freddie Mac, transformed the liquidity and marketability of mortgage
securities. Unfettered private credit expansion created its own loose financial
conditions, leaving Fed rate tinkering ineffectual for tightening credit
conditions and Federal Reserve doctrine unwilling to address mounting credit
and asset bubbles.
To be sure, the Wall Street finance/mortgage finance bubble propagated out of
the massive post-tech bubble inflationary effort. The so-called "shadow banking
system" was only one rather conspicuous facet of a historic and ongoing
experiment in government monetary management.
McCulley writes: "No, I'm not a socialist." OK. Over the years, I've referred
to McCulley and his ilk as "inflationists". An inflationist may not begin his
trek as a socialist, but it's the nature of such an endeavor to pretty much end
up in that territory by the end of the day.
Of course, the inflationists today are calling for more extreme and intrusive
reflationary measures than those employed in previous crises and deflationary
scares. It is now, apparently, necessary for the "full faith and credit of the
sovereign's balance sheet" to stand behind our entire impaired private sector
credit system. At this fragile stage of the inflationary boom, the
inflationists have no qualms betting the ranch.
Long-time readers know that I, like McCulley, am a huge admirer of Hyman
Minsky. I have over the years deeply embedded Minskian analysis into my
analytical framework in an effort to better comprehend the extraordinary
financial and economic landscape. Others, including McCulley, have repeatedly
invoked Minsky as part of their ideological rationalizations for bailouts and
inflationism. And I today find great irony in McCulley's piece.
After touching upon Minsky's preeminent analysis with respect to the nature of
financial instability and "Ponzi Finance", McCulley dogmatically prescribes
unprecedented government intervention as the elixir to help restore system
stability. It's a flawed analytical framework that comes to a perilous
recommendation. If Hyman Minsky were with us, he would surely share a similar
view that Washington has trapped itself in a most dangerous "Ponzi Finance"
dynamic.
We're witnessing the same analytical errors today that were made in the
post-tech bubble analysis: the willingness to inflate an even greater bubble
for the cause of mitigating the pain from the so-called deflationary risks
associated with a bursting of THE bubble. And with each reflation comes a
heightened governmental role in both the markets and real economy, to the point
where Washington is essentially backstopping the financial and economic
systems.
I used to find it rather perplexing that our nation's largest bond fund
managers were among inflationism's most vocal proponents. I was naive; it now
seems all so obvious.
Of course, market operators prefer to have the Fed and Washington there
reliably backstopping the markets. An activist central bank pegging interest
rates and manipulating the cost (hence, the flow) of finance creates wonderful
opportunities for the savviest traders playing the money game most adeptly. The
expansion of bubbles creates great opportunities and then, for the enlightened,
the bursting of these bubbles provides only greater profits. McCulley is fond
of blaming the "shadow banking system" for our acute financial and economic
fragility. Yet the responsibility lies more generally with a deeply flawed
monetary policy regime, a regime hopelessly locked into interest-rate
manipulation and inflationism.
To this day, I find it perplexing that leading "free market" proponents have
been so happy to have the Federal Reserve setting and manipulating the cost of
finance throughout the real economy. By now, it should be crystal clear that
such a regime cultivates a financial apparatus that systematically misprices
risk, over-expands credit, fosters over-leveraging, emboldens speculation, and
massively misallocates and misdirects both financial and real resources
throughout.
After awhile, so much of the financial apparatus is focused primarily on
seeking central bank-induced financial profits. Economic profits and real
economy price signals become further marginalized. And with each bursting
bubble and resulting reflation, the government's role in the system's pricing
mechanism becomes more ingrained, intrusive and destabilizing. The bubbles
change, while the price distortions and imbalances become deeply embedded in
the underlying economic structure.
I see no reason to back away from the view that the fundamental dilemma today
lies not so much in finance but with our deeply impaired economic structure.
This structure is a manifestation of years of mispriced finance, credit and
speculative excess, and resource misallocation. From this perspective, it
should be obvious that greater Fed-induced market price distortions and
Treasury/Fed-induced credit expansion will only exacerbate structural
impairment and delay readjustment.
If I had to point to a significant weakness in Minsky's work, it would be the
lack of analytical attention paid to the underlying economic structure (and why
it is imperative to incorporate Austrian analysis into our analytical
frameworks).
The inflationists today believe that massive ("counter-cyclical") government
market and economic intervention will help the system revive and repair itself.
I see current policies as simply a desperate attempt to perpetuate
unsustainable financial and economic structures. And system impairment will not
have run its course until some semblance of a market-based cost of finance
emerges to allocate more effectively financial and real resources throughout
the economy. The wholesale socialization of risk may be "counter-cyclical", but
it is also terribly counterproductive.
After the 9/11 catastrophe, I expressed the view that - if our government was
compelled to stimulate - it would be preferable to run temporary fiscal
deficits instead of manipulating interest rates and the financial markets. Yet
the manipulation of the quantity and cost of credit is much easier for
policymakers to implement, and the results (heightened liquidity, risk taking,
and inflating asset prices) can be rather immediate and heartening.
Meanwhile, the associated costs are not evident let alone quantifiable. Yet
such interventions and resulting changes in the quantity and flow of finance
seductively take on a life of their own as they breed excesses, future crises
and the inevitable call for only greater interventions and inflations.
McCulley concludes with the insight, and I'm paraphrasing here, that
deregulated and innovative finance precludes the elimination of "Minsky
moments". McCulley believes "it's a matter of having the good sense to have in
place a counter-cyclical regulatory policy to help modulate human nature."
I would strongly counter that it is absolutely imperative to have the good
sense not to perpetuate bubbles and inflate episodes of "Ponzi Finance" to the
point where they risk systemic collapse. Bankrupting the entire country is a
completely unacceptable outcome. At some point the inflationists should accept
the reality that they are a big part of the problem and not the solution. Is
that what the bond market is beginning to tell us?
WEEKLY WATCH
For the week, the S&P500 gained 2.3% (up 4.1% y-t-d), and the Dow jumped
3.1% (down 0.2% y-t-d). The Morgan Stanley Cyclicals surged 6.8% (up 23.5%),
and the Transports rose 4.6% (down 5.3%). The Morgan Stanley Consumer index
increased 1.7% (up 4.0%), and the Utilities gained 1.0% (down 8.8%). The
broader market was again quite strong. The S&P 400 Mid-Caps jumped 3.6% (up
10.7%) and the small cap Russell 2000 surged 5.7% (up 6.2%). The Nasdaq100 rose
4.0% (up 23.2%), and the Morgan Stanley High Tech index gained 3.1% (up 32.8%).
The Semiconductors slipped 0.2% (up 27.6%), while the InteractiveWeek Internet
index jumped 3.7% (up 45.0%). The Biotechs surged another 4.6% (up 4.9%).
Financials were mixed, with the Banks down 0.9% (down 16.4%) and the
Broker/Dealers up 3.7% (up 33.3%). With Bullion slumping $24, the HUI gold
index dropped 7.6% (up 21.6%).
Some tumultuous trading in the interest rate markets. One-month Treasury bill
rates ended the week at 8 bps, and three-month bills closed at 19 bps. Two-year
government yields surged 38 bps to 1.30%. Five year T-note yields jumped 49 bps
to 2.83%. Ten-year yields rose 37 bps to 3.83%. The long-bond saw yields end
the week up 30 bps to 4.63%. The implied yield on 3-month December '09
Eurodollars surged a notable 42 bps to 1.365%. Benchmark Fannie MBS yields shot
58 bps higher to 4.90%. The spread between benchmark MBS and 10-year T-notes
widened 21 bps to 107 bps. Agency 10-yr debt spreads were little changed at 32
bps. The 2-year dollar swap spread increased 8.25 to 49 bps; the 10-year dollar
swap spread increased 19.25 to 38 bps; and the 30-year swap spread increased
17.75 to negative 13.75 bps. Corporate bond spreads were mostly tighter. An
index of investment grade bond spreads narrowed 22 to 171 bps, while an index
of junk spreads narrowed 45 to 876 bps.
The corporate debt issuance boom runs unabated. Investment grade issuers
included GMAC $4.5bn, Express Scripts $2.5bn, BAE Systems $1.5bn, Met Life
$1.4bn, PNC $1.0bn, Prudential $1.0bn, Chevron $700 million, Pricoa $500
million, Ace Ina Holdings $500 million, Enterprise Products $500 million,
Mariner Energy $300 million, Ameriprise Financial $300 million, and Dartmouth
$250 million.
Junk bond fund inflows jumped to $714 million this past week (from AMG), 12
straight weeks of positive flows. The long list of junk issuers included Tenet
Healthcare $925 million, US
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