Page 1 of 3 CREDIT BUBBLE BULLETIN Trichet challenges inflationism
Commentary and weekly watch by Doug Noland
The acute fiscal challenges across all industrial economies are no surprise. Our
economies are emerging from the worst economic crisis since the second world
war, and without the swift and appropriate action of central banks and a very
significant contribution from fiscal policies, we would have experienced a
major depression. But now is the time to restore fiscal sustainability. The
fiscal deterioration we are experiencing is unprecedented in magnitude and
geographical scope. By the end of this year, government debt in the euro area
will have grown by more than 20 percentage points over a period of only four
years, from 2007-2011. The equivalent figures for the US and Japan are between
35 and 45 percentage points. The growth of public debt has been driven by three
phenomena: a dramatic diminishing of
tax receipts due to the recession; an increase in spending, including a pro-active
stimulus to combat the recession; and additional measures to prevent the
collapse of the financial sector. - European Central Bank president
Jean-Claude Trichet, Financial Times, July 23, 2010
The title of Trichet's remarkable op-ed piece in Friday's FT was direct and to
the point: "Stimulate No More - It Is Now Time For All To Tighten". The head
European central banker has spoken publicly and in no uncertain terms:
unrelenting government stimulus is today fraught with great risk. Trichet
should be commended for courageously taking to the next level one of the most
important debates of our time.
From Trichet: " ... Given the magnitude of annual budget deficits and the
ballooning of outstanding public debt, the standard linear economic models used
to project the impact of fiscal restraint or fiscal stimuli may no longer be
reliable. In extraordinary times, the economy may be close to non-linear
phenomena such as a rapid deterioration of confidence among broad
constituencies of households, enterprises, savers and investors. My
understanding is that an overwhelming majority of industrial countries are now
in those uncharted waters, where confidence is potentially at stake.
Consolidation is a must in such circumstances."
Perhaps his stern message was directed at US Federal Reserve chairman Ben
Bernanke and the Barack Obama administration. More likely, it was in response
to the recent chorus of calls for even more extreme government stimulus and
intervention. Especially from some notable American economists, there has been
a movement afoot to press Washington (and global policymakers) to completely
throw caution to the wind in a crusade of further government spending programs
and monetization.
From the astute Trichet: "With hindsight, we see how unfortunate was the
oversimplified message of fiscal stimulus given to all industrial economies
under the motto: 'stimulate', 'activate', 'spend'!"
Meanwhile, the markets last week seemed to demand that the Fed chairman arrive
for his congressional testimony with a lengthy list of additional measures the
central bank is prepared to immediately implement to ensure buoyant markets and
a robust recovery. Over the years, top European central bankers argued against
US-style "activist" central banking. The ECB decisively won this debate, yet
the Fed is today under intense pressure to become only more radically
"activist". Trichet must have been compelled to interject.
With Friday's noon release of the European bank "stress test", Trichet's
message didn't garner the attention it deserved. Not unexpectedly, "test"
results were met with skepticism. The most popular complaint seemed to be that
they lacked credibility because the tests didn't factor in the banks' capital
exposure to sovereign debt risk. Well, I doubt there are many banking systems
around the world these days that would perform satisfactorily in the event of a
domestic sovereign debt crisis. The US banking system would surely not function
well in the event of a crisis of confidence - and spike in yields - throughout
US Treasury, agency debt and mortgage-backed security (MBS) markets.
These days, the marketplace can fixate on deflation risk and feel comfortable
holding US debt instruments. With perceptions of scant inflation risk and a Fed
predisposed toward additional monetization, bonds are viewed as a low-risk
proposition. And, of course, with market yields at historic lows it is
especially easy to dismiss the seriousness of today's unfolding fiscal
problems.
I'm of the view that the US fiscal predicament has been decades in the making
and is much worse than generally appreciated. At about 66% of GDP, most believe
our federal government's fiscal position is quite manageable - and is certainly
better than many others. At worst, market participants perceive there are still
a few years before they must concern themselves with US debt service issues.
There is, as well, faith in the prospect of economic recovery rectifying our
massive deficits. I fear we have reached the stage where our deficits are
unmanageable: in this post-mortgage/Wall Street finance bubble backdrop,
economic recovery will disappoint and prospective governmental receipts and
expenditures will really disappoint.
Hear me out on this. I - along with others - believed our fiscal position back
in the early 1990s was a disaster in the making. Were we wrong? Our federal
debt expanded 134% during the '70s to US$779 billion. The '80s saw federal
borrowings increase another 247% to $2.701 trillion. "Fortunately", gross
domestic product (GDP) inflated massively as well, ending the eighties up 457%
in 20 years to $5.482 trillion.
As a percentage of GDP, federal debt ended the '60s at 33.8% and the '70s at
30.4%. Enormous deficits, however, saw this ratio deteriorate markedly during
the '80s, ending 1989 at 49.3%. A few years of record deficits resulted in this
ratio jumping to 58.9% by 1993. Miraculously, the economy set course on a
protracted boom, and governmental receipts skyrocketed. By 2001, federal debt
had dropped to 41.8% of GDP. Many were contemplating the ramifications of
Washington paying back all its borrowings.
My thesis holds that the rapid deterioration of our fiscal standing was only
interrupted by an extraordinary (and unrepeatable) 15-year boom in
private-sector credit creation. In particular, this historic debt expansion was
dominated by a profound change - including a massive expansion - in financial
sector risk intermediation.
Between 1993 and 2008, assets of government-sponsored enterprises (notably
mortgage guarantors Fannie Mae and Freddie Mac) ballooned from $631 billion to
$3.4 trillion. Over this period, the agency MBS market expanded from about $1.4
trillion to end 2009 at $4.96 trillion. The asset-backed securities market
surpassed $4.5 trillion in 2007, up from about $400 billion to begin 1993.
Broker/dealer assets began 1993 at less than $400 billion and grew to about
$3.1 trillion. After ending 1993 at $3.3 trillion, total US financial sector
borrowings closed 2008 above $17 trillion. In the 10 years 1998 through 2007,
total mortgage debt jumped from $5.13 trillion to $14.5 trillion, a historic
gain of 183%. These were "once-in-a-lifetime" financial and economic
developments.
This enormous increase in debt-inflated asset prices inflated incomes, inflated
spending, and inflated government receipts and expenditures. In particular, the
huge expansion of household and financial sector debt was chiefly responsible
for filling government coffers from Washington to Sacramento. Politicians
extrapolated this bonanza and spent unwisely. But the 2008 bursting of the
mortgage/Wall Street finance bubble abruptly ended this cycle of credit
inflation. Much of the debt intermediated through the US credit system was
discredited. The housing mania was terminated, resulting in a collapse in
demand for mortgage credit.
In the post-bubble backdrop, private-sector (household and financial sector)
credit has contracted, and there is little prospect for meaningful expansion
for some years to come. Unlike in the early '90s, there will be no miraculous
new type of finance to fuel booms in the economy, asset prices, and government
receipts. Financial innovation and the reckless expansion of Wall Street
finance will not bail out Washington. We're basically left with a massive
expansion of government debt until the markets decide to impose discipline.
Our recovery has been completely dependent upon government spending and
ultra-loose monetary policy. This has entailed an incredible increase in
Treasury borrowings. The markets assume our rapidly deteriorating fiscal
situation will improve as the economy recovers.
On the spending side, the economy is now dependent on massive federal stimulus.
I don't expect any self-imposed restraint on government expenditures. And,
importantly, it would take renewed expansion of private-sector debt to
meaningfully boost the ratio of governmental receipts to expenditures.
Washington - or the states - can't spend their way to fiscal recovery. Instead,
we're witnessing a fiscal train wreck. Our policymakers, economists, and
pundits should read Trichet carefully and contemplate a course other than
inflationism.
WEEKLY WATCH
For the week, the S&P500 jumped 3.5% (down 1.1% y-t-d), and the Dow gained
3.2% (unchanged). The broader market was quite strong. The S&P 400 Mid-Caps
jumped 5.0% (up 5.1%), and the small cap Russell 2000 surged 6.6% (up 4.0%).
The Banks rose 1.8% (up 12.2%), and the Broker/Dealers jumped 3.1% (down 8.9%).
The Morgan Stanley Cyclicals surged 7.1% (up 4.3%), and the Transports gained
6.1% (up 6.6%). The Morgan Stanley Consumer index rose 2.9% (up 1.2%), and the
Utilities increased 2.3% (down 1.9%). The Nasdaq100 gained 4.0% (up 0.8%), and
the Morgan Stanley High Tech index increased 3.4% (down 2.5%). The
Semiconductors rose 4.4% (up 1.3%). The InteractiveWeek Internet index jumped
5.1% (up 5.6%). The Biotechs increased 3.6%, increasing 2010 gains to 11.7%.
Although bullion declined $5.50, the HUI gold index rallied 1.8% (up 5.1%).
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