Page 1 of 3 CREDIT BUBBLE BULLETIN 25 years and counting
Commentary and weekly watch by Doug Noland
The US ran small current account surpluses in 1980 and 1981. By 1984, the
current account had turned to a (at the time massive) negative US$94 billion.
The deficit ballooned further to $118 billion in 1985, $147 billion in 1986 and
$160 billion in 1987. Prior to 1983, the largest current account deficit had
been the $15 billion posted in the inflationary year 1978
Fears of mounting "twin deficits" were at the time viewed as a factor behind
the dollar weakness and the jump in yields that precipitated the 1987 stock
market crash. The simultaneous rapid escalation in current account deficits and
stock prices in the
1980s was no coincidence. Credit was expanding rapidly. Total (consumer and
mortgage) household debt growth jumped from 1982's 5.6% to 1983's 11.1%, 1984's
12.6%, 1985's 16.1%, 1986's 11.5% and 1987's 10.4%. On the business side,
borrowings expanded 9.9% in 1982, 9.1% in 1983, 16.2% in 1984, 11.0% in 1985,
11.4% in 1986%, and 7.7% in 1987. Things really heated up after the Alan
Greenspan Federal Reserve's post-crash reflation: junk bonds, leveraged
buy-outs, Michael Milken, Ivan Boesky, and the "decade of greed".
By decade, the US posted cumulative deficits of $3 billion in the seventies,
$778 billion in the eighties, and $1.230 trillion during the nineties. And
while the 2009 deficit will have shrunk significantly on a year-over-year
basis, the year's more than $400 billion shortfall will put the past decade's
cumulative current account deficit at a staggering $5.83 trillion. Taking a
different perspective on the issue, the Fed's Z1 "Flow of Funds" report has the
rest of world (ROW) holding $943 billion of US financial assets at the end of
1985. ROW holdings ended last September at $15.052 trillion.
I have referred to this massive worldwide agglomeration of (largely US)
financial claims as the "global pool of speculative finance". It is the primary
fuel for what has become pervasive and unrelenting global boom and bust
dynamics.
An op-ed piece by David Backus and Thomas Cooley in Monday's Wall Street
Journal caught my attention:
In the 1920s, capital began flowing from
Massachusetts to North Carolina, a process that continued until after World War
II as textile mills migrated to the South from New England. Beginning in the
1950s, capital moved again as textile manufacturing moved to Mexico, India and
Malaysia. Capital has long moved to where it can be used most productively, and
by and large, that has been a good thing. Whether capital moves within a
country or between countries, its flow addresses imbalances between available
local capital and uses for capital (otherwise known as investments).
Through much of history, the major capital flows have been from rich countries
to poorer ones. England financed canals in this country and railroads in
Australia and India. That's no longer the case. The most notable importer of
capital in recent times has been the United States ... Germany, Japan, China
and Switzerland have been significant exporters of capital. Over the past 10
years, oil-exporting countries have been exporters of capital. These facts are
collectively referred to as "global imbalances".
The standard view in policy circles is that they represent a serious threat to
economic stability rather than a sensible market reallocation of capital. In
the standard view, such imbalances are "unsustainable" and the longer they
last, the more drastic and painful will be the ultimate "adjustment". After 25
years of such threats, you might think positions would change. Instead, the
same people are now arguing that these capital flows were one of the root
causes of the financial crisis.
I strongly believe years of
massive US current account deficits created a global financial backdrop that
foments historic booms and busts. Our system's credit excesses were indeed the
root cause of the imbalances that ensured financial crisis. And I have to admit
that I have difficulty these days grasping how analysts could see it any other
way. A big stock market recovery and resurgent optimism have emboldened views
that should have been thoroughly discredited.
For years, I've been amazed at the prevalence given to the view that our
current account deficits were the result of global "capital" clamoring to own
our assets. Messrs Backus and Cooley even refer to the current account deficit
as "the net amount of capital flowing into the country". It has been painful to
see like-minded analysis in the past from both Greenspan and his successor at
the Fed, Ben Bernanke - who surely must know better. Bernanke persists in
blaming our asset bubble problem on the surfeit of international "capital" that
pushed global yields down.
Traditionally, large and persistent current account deficits were recognized as
important evidence of excessively loose monetary conditions. During periods of
stable global monetary regimes (under gold standards or even Bretton Woods
after 1944), policymakers understood that balanced trade flows were a critical
facet of overall financial stability. Trade imbalances nurtured pernicious
financial dynamics. Only in the last 25 years has creative thinking concocted a
hypothesis that such deficits are not only not dangerous - but they are
indicative of a healthy allocation of "capital" and the superiority of the US
markets and economy. And the bigger our deficits, the more vocal the apologists
became in rationalizing our lack of financial discipline.
I have argued over the years that there is no "chicken or the egg" issue. It is
our credit system that creates new financial obligations (credit) that then
leave the country in enormous quantities to finance purchases of oil,
manufactured goods and other imports, commodities, and foreign securities and
direct investment. These dollar-denominated global financial flows (US IOUs),
by their nature, must find their way back to the US credit system -
predominantly through the acquisition of our debt securities and other
financial assets.
It is not a case of the Chinese exporting their "capital" to the US - they
instead send us goods in exchange for our debt. They reinvest dollar financial
claims received both from exporting goods and being on the receiving end of
massive "hot money" and direct investment inflows. I refuse to refer to the
recycling of US financial obligations back into our securities markets as an
injection of "capital". These are electronic journal entries and have little to
do with "capital" in the traditional meaning of the word.
The inflationists focus almost exclusively on deflation risk. They use this
recurring argument that (fiscal and monetary) stimulus is necessary to
stabilize prices and avoid a downward debt spiral. They are inherently current
account deficit apologists. Despite rapidly rising mortgage debt growth and
2001's $400 billion current account deficit, the inflationists argued for
massive monetary stimulus back then to combat deflationary forces.
Not surprisingly, considering the monetary backdrop, current account deficits
expanded even more rapidly - $459 billion in 2002, $522 billion in 2003, $631
billion in 2004, $749 billion in 2005, and $804 billion in 2006. Fed funds
began 2006 at 4.25% and mortgage credit expanded almost $1.4 trillion during
the year.
In hindsight, it should be apparent that unrestrained global credit and
consequent asset inflation, bubbles, and boom and bust dynamics were the
pressing systemic risk - not deflation. Fighting the burst tech bubble and
"deflation" through the massive inflation of mortgage credit was an unmitigated
disaster. Problems were "papered over" and a much greater bubble emerged. While
the apologists were trumpeting the wonders of "Bretton Woods II," massive US
current account deficits were exporting US credit bubble dynamics to the rest
of the world.
Trillions of combined federal government debt issuance and Federal Reserve
monetization have become this cycle's ammo for battling "deflation". I have
stated my belief that this unprecedented inflation of government credit is both
delaying necessary economic adjustment and creating a very dangerous bubble
backdrop. I have argued that reducing our economy's dependence on massive
credit expansion is fundamental to creating a more stable financial and
economic environment. Comprehensive economic restructuring is essential for
reducing credit dependency and dramatically shrinking our current account
deficits. But with the markets up and the economy rebounding, focus on
structural problems and imbalances has been relegated to the "permabears" - who
have apparently learned little during the past 25 years.
WEEKLY WATCH
For the week, the S&P500 declined 0.8% (up 1.9% y-t-d), while the Dow was
little changed (up 1.7% y-t-d). The volatile Banks dipped 0.7% (up 9.3%), and
the Broker/Dealers fell 1.6% (up 2.5%). The Morgan Stanley Cyclicals dropped
1.8% (up 5.1%), and Transports declined 1.0% (up 2.0%). The Morgan Stanley
Consumer index added 0.3% (up 1.1%), and the Utilities gained 0.8% (down 0.3%).
The S&P 400 Mid-Caps declined 1.2% (up 2.3%), and the small cap Russell
2000 fell 1.0% (up 2.0%). The Nasdaq100 dropped 1.5% (up 0.2%), and the Morgan
Stanley High Tech index fell 1.2% (down 0.3%). The Semiconductors sank 6.3%
(down 4.2%). The InteractiveWeek Internet index declined 1.0% (down 0.1%). The
Biotechs added 0.9% (up 4.2%). With bullion down $7, the HUI gold index sank
5.2% (up 2.0%).
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
