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September 11, 2009

And No Dialing Back
by Doug Noland

For the week, the S&P500 increased 2.5% (up 15.4% y-t-d), and the Dow gained 1.7% (up 9.5% y-t-d). The Morgan Stanley Cyclicals surged 4.3% (up 56.0%), and Transports jumped 5.3% (up 12.4%). The Morgan Stanley Consumer index increased 2.5% (up 14.8%), while the Utilities slipped 0.5% (down 2.5%). The Banks added 0.4% (up 2.5%), and the Broker/Dealers jumped 3.3% (up 48.0%). The S&P 400 Mid-Caps rose 3.8% (up 26.2%), and the small cap Russell 2000 jumped 3.9% (up 18.8%). The Nasdaq100 gained 2.8% (up 39.1%) and the Morgan Stanley High Tech jumped 4.0% (up 55.6%). The Semiconductors rose 3.6% (up 51.4%). The InteractiveWeek Internet index advanced 4.1% (up 58.6%). The Biotechs added 0.3% (up 43.4%). With Bullion gaining another $11 to close above $1,000, the HUI gold index rose 4.0% (up 40.9%).

One-month Treasury bill rates ended the week at 8 bps, and three-month bills closed at 14 bps. Two-year government yields dipped 3 bps to 0.80%. Five-year T-note yields fell 6 bps to 2.23%. Ten-year yields were down 10 bps to 3.34%. Long bond yields were 9 bps lower to 4.18%. Benchmark Fannie MBS yields sank 14 bps to 4.29%. The spread between 10-year Treasuries and benchmark MBS narrowed 4 to 95. Agency 10-yr debt spreads narrowed 5 to 19 bps. The implied yield on December 2010 eurodollar futures dropped 13.5 bps to 1.68%. The 2-year dollar swap spread declined 4.0 to 31.75 bps; the 10-year dollar swap spread declined 4.25 to 16.75 bps; and the 30-year swap spread declined 3.25 to negative 16.25 bps. Corporate bond spreads were mostly narrower. An index of investment grade bond spreads narrowed 13 bps to 162, while an index of junk spreads widened 2 to 690 bps.

Corporate debt issuance picked up markedly. Investment grade issuers included CVS Caremark $1.5bn, Prudential Financial $1.5bn, Met Life $1.0bn, Kinder Morgan $1.0bn, Midcontinent Express Pipeline $800 million, Agilent Tech $750 million, Avalonbay Communities $500 million, National Rural Utilities $500 million, Airgas $400 million, Puget Sound Energy $350 million, Timken $250 million, and Questar Pipeline $250 million.

Junk bond funds enjoyed inflows of $223 million (from AMG). Junk issuers included Cablevision $900 million, Global Crossing $750 million, Harrahs $720 million, Ferrellgas $300 million, Plains Exploration $400 million, and WR Berkley $300 million.

I saw no convert issues.

International dollar-denominated debt issuance was huge. Issuers included Hutchinson Whampoa $3.0bn, Commercial Bank of Australia $2.75bn, Spain $2.5bn, Svenska Handelsbanken $2.5bn, Iberdrola Ireland $2.0bn, Swedish Export Credit $1.5bn, Taqa Abu Dhabi $1.5bn, Tetroleos Mexica $1.5bn, Vale Overseas $1.0bn, and Petroplus $400 million.

U.K. 10-year gilt yields dipped one basis point to 3.61%, and German bund yields declined one basis point to 3.23%. The German DAX equities index jumped 4.5% (up 16.9%). Japanese 10-year "JGB" yields declined 2 bps to 1.30%. The Nikkei 225 gained 2.5% (up 17.9%). Emerging markets were quite strong. Brazil's benchmark dollar bond yields sank 26 bps to 5.19%. Brazil's Bovespa equities index rose 2.9% (up 55.4% y-t-d). The Mexican Bolsa surged 4.0% (up 31.6% y-t-d). Mexico's 10-year $ yields dropped 21 bps to 5.55%. Russia's RTS equities index surged 12.5% (up 89.4%). India's Sensex equities index gained 3.7% (up 68.6%). China's Shanghai Exchange jumped 4.5%, increasing 2009 gains to 64.2%.

Freddie Mac 30-year fixed mortgage rates dipped one basis point to 5.07% (down 84bps y-o-y). Fifteen-year fixed rates fell 4 bps to 4.50% (down 104bps y-o-y). One-year ARMs increased 2 bps to 4.64% (down 57bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 9 bps to 6.18% (down 75bps y-o-y).

Federal Reserve Credit rose $6.3bn last week to $2.070 TN. Fed Credit has declined $177bn y-t-d, although it expanded $1.181 TN over the past 52 weeks (133%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/7) declined $0.7bn to $2.828 TN. "Custody holdings" have been expanding at a 17.9% rate y-t-d, and were up $432bn over the past year, or 18.1%.

M2 (narrow) "money" supply rose $11.3bn to $8.294 TN (week of 8/31). Narrow "money" has expanded at a 1.8% rate y-t-d and 7.6% over the past year. For the week, Currency declined $2.3bn, while Demand & Checkable Deposits slipped $0.9bn. Savings Deposits jumped $28.1bn, while Small Denominated Deposits fell $9.5bn. Retail Money Funds declined $3.9bn.

Total Money Market Fund assets (from Invest Co Inst) fell another $15.4bn to $3.543 TN. Money fund assets have declined $287bn y-t-d, or 10.8% annualized. Money funds fell $38.4bn, or 1.1%, over the past year.

Total Commercial Paper outstanding increased $11.3bn (4-wk gain of $99bn) to $1.174 TN. CP has declined $508bn y-t-d (44% annualized) and $642bn over the past year (35%). Asset-backed CP gained $6.2bn to $484bn, with a 52-wk drop of $297bn (38%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $252bn y-o-y to a record $7.197 TN. Reserves have increased $432bn year-to-date.

Global Credit Market Watch:

September 8 - Bloomberg (Paul Armstrong and Esteban Duarte): "Corporate bond sales surged in Europe, driving this year's record issuance above $1.23 trillion... Issuance is now 11% ahead of the total for all of 2008... 'The market is back on fire after its usual summer lull,' said Juan Esteban Valencia, a credit analyst at Societe Generale... 'Appetite for credit remains unabated.'"

September 9 - Bloomberg (Laura Cochrane): "Emerging-market government and state-backed companies will likely sell more than $100 billion of bonds this year, according to Commerzbank AG. 'Investors are hungry for quasi-sovereign risk,' said Luis Costa, emerging-market debt strategist at Commerzbank...said..."

September 8 - Bloomberg (Steve Scherer): "Italian Prime Minister Silvio Berlusconi said curbing 'speculation' in financial markets is more important to Group of 20 leaders than controlling bonuses for bank executives. G-20 leaders meet in Pittsburgh later this month to discuss measures aimed at making the global financial system more stable after the worst financial collapse since the Great Depression."

September 10 - Bloomberg (John Glover): "Defaults among speculative-grade companies and issuers of so-called leveraged loans will peak at about 15% this year in Europe, Standard & Poor's said..."

September 10 - Bloomberg (Doug Alexander): "Stocks sales in Canada surged to the highest in a decade this year after Barrick Gold Corp. and Fairfax Financial Holdings Ltd. led the biggest one-day sale of equity in Canadian history."

Government Finance Bubble Watch:

September 11 - Bloomberg (Theophilos Argitis and Chris Donville): "Canadian Prime Minister Stephen Harper's government, which faces defeat in Parliament as early as next week, is delaying the country's exit from budget deficits... He also projected cumulative deficits of C$164.4 billion ($152.5 billion) by then, doubling his earlier forecasts."

September 10 - Bloomberg (Christian Vits): "European Central Bank council member Axel Weber said returning to the pre-crisis debt level may take decades. 'When I look at the longer years it took us to reduce government debt, it's pretty clear that reaching the same level of economic activity as before the crisis can be done pretty quickly by 2013,' Weber... said... 'Reaching the same level of debt to GDP will take at least one to two decades.'"

September 9 - Bloomberg (Rebecca Christie): "The Federal Deposit Insurance Corp. proposed a six-month, emergency-only extension to its debt guarantee program as regulators move to wean companies from federal aid approved at the height of last year's credit crisis."

September 10 - Bloomberg (Svenja O'Donnell): "The Bank of England plans to keep buying as much as 175 billion pounds ($290 billion) of assets to cement the economy's recovery from the worst recession in a generation."

Currency Watch:

September 7 - Bloomberg (Jonathan Tirone): "The dollar's role in international trade should be reduced by establishing a new currency to protect emerging markets from the 'confidence game' of financial speculation, the United Nations said. UN countries should agree on the creation of a global reserve bank to issue the currency and to monitor the national exchange rates of its members, the Geneva-based UN Conference on Trade and Development said... 'There's a much better chance of achieving a stable pattern of exchange rates in a multilaterally-agreed framework for exchange-rate management,' Heiner Flassbeck, co-author of the report... said... 'An initiative equivalent to Bretton Woods or the European Monetary System is needed.' The 1944 Bretton Woods agreement created the modern global economic system and institutions including the IMF and World Bank."

September 10 - Bloomberg (Jody Shenn): "Yuan deposits offer the largest interest-rate premium over dollar accounts in 17 months, adding to pressure on the Chinese government to end its currency's fixed-exchange rate... Inflows of hot money, funds that move across borders seeking short-term returns, may swell to more than $160 billion in the second half, compared with $42 billion in the first six months, Zhang Ming, a researcher at the Chinese Academy of Social Sciences, said..."

The dollar index sank 1.9% this week to 76.67. For the week on the upside, the New Zealand dollar increased 2.7%, the Japanese yen 2.6%, the Swedish krona 2.4%, the Swiss franc 2.2%, the South African rand 2.0%, the Danish krone 2.0%, the Euro 2.0%, the British pound 1.7%, the South Korean won 1.6%, the Australian dollar 1.4%, the Singapore dollar 1.2%, the Canadian dollar 1.1%, and the Norwegian krone 1.1%. Losing against the dollar, the Argentine peso declined 0.3% and the Turkish lira fell 0.2%.

Commodities Watch:

September 9 - Bloomberg (Millie Munshi and Veronica Navarro Espinosa): "Gold prices that jumped above $1,000 an ounce this week are signaling that investors are buying metals to hedge against declines in currencies, former Federal Reserve Chairman Alan Greenspan said. The gains are 'strictly a monetary phenomenon,' Greenspan said... Rising prices of precious metals and other commodities are 'an indication of a very early stage of an endeavor to move away from paper currencies,' he said... 'What is fascinating is the extent to which gold still holds reign over the financial system as the ultimate source of payment,' Greenspan said... 'China is turning out to be the 900-pound gorilla in the energy and commodity market,' Greenspan said. 'The increase in oil consumption in China has been quite extraordinary.'"

September 9 - Bloomberg (Aya Takada): "Japan, Asia's second-largest aluminum importer, agreed to increase the fee it pays to producers by at least 53% to the highest in 14 years as surging Chinese demand saps regional supplies."

September 8 - Bloomberg (Thomas Kutty Abraham): "A global tea shortage may increase by 10% next year as droughts in Kenya, Sri Lanka and India, the top exporters, damage crops and propel prices to a record, the world's biggest tea plantation company said."

Gold gained 1.1% to close at $1,006 (up 14.0% y-t-d). Silver jumped 3.1% to $16.79 (up 48.6% y-t-d). October Crude rose a volatile $1.18 to $69.20 (up 55% y-t-d). October Gasoline declined 1.3% (up 65% y-t-d), while September Natural Gas rallied 9.6% (down 47% y-t-d). December Copper declined 1.3% (up 101% y-t-d). December Wheat fell 1.0% (down 24% y-t-d), while December Corn recovered 4.4% (down 21% y-t-d). The CRB index gained 1.2% (up 9.4% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 2.8% (up 29.3% y-t-d).

China Bubble Watch:

September 10 - Bloomberg: "China's Premier Wen Jiabao said the nation 'cannot and will not' pull back from economic stimulus measures... 'China's economic rebound is unstable, unbalanced and not yet solid,' Wen said... He cautioned that some stimulus measures will 'fade' and others will take time to become effective. Wen's remarks reflect a commitment last week from the world's biggest nations to maintain unprecedented fiscal and monetary measures..."

September 10 - Bloomberg: "Bank of China Ltd., which led the nation's $1.1 trillion lending spree in the first half, said ample liquidity has caused 'bubbles' in stocks, commodities and real estate. 'The potential risk is that a lot of liquidity goes to the asset market,' Vice President Zhu Min said... 'So you see asset bubbles in commodities, stocks and real estate, not only in China, but everywhere.'"

September 10 - Bloomberg: "Bankers on Wall Street are suffering from 'over confidence' and are 'myopic' in the face of a continuing financial crisis, Bank of China Ltd. Vice President Zhu Min said. 'You go to Wall Street, the people feel the crisis never happened,' Zhu said... 'It's not only over-confidence, it's over- myopic. This is too much.' Zhu's criticism reflects the growing confidence of China...in scolding the U.S. for missteps that led to the financial crisis and mounting federal debt."

September 10 - Bloomberg: "China's bank loans will post steady growth in the second half of the year as big fluctuations would hurt the economic recovery, the official Xinhua News Agency reported, citing Bank of China Vice President Zhu Min. Zhu refuted speculation that banks will tighten credit in the second half, saying bank loans will grow steadily in the next six-to-12 months..."

September 10 - Bloomberg: "China's house prices in the nation's 70 biggest cities rose at the fastest pace in 11 months on record lending and climbing confidence. House prices increased 2% in August from a year earlier..."

September 8 - Bloomberg (Jacob Greber): "China's passenger-car sales surged a record 90% last month, as tax cuts and government subsidies spurred demand, bringing the nation closer to overtaking the U.S. as the world's largest auto market."

September 11 - Bloomberg: "China's industrial production grew at a faster pace in August, signaling a strengthening recovery in the world's third-biggest economy. Output gained 12.3% from a year earlier, after climbing 10.8% in July, the statistics bureau said..."

September 11 - Bloomberg: "China's power generation rose to a record in August... Power output increased for a third month, gaining 9.3% to 344.3 million megawatt-hours... Power generation had climbed 4.8% in July and 5% in June after contracting for three straight months."

September 9 - Bloomberg (Andrea Rothman): "China is taking aim at the heart of the global commercial aerospace industry with a jet dubbed 'The Big Plane,' seeking to crack the duopoly Boeing Co. and Airbus SAS hold... 'They have a good mix of technologies and westernized standards,' Christof Spaeth, senior vice president of Jet Aviation AG...said... 'So it might find its way from the home also to some international markets. It's not easy but there's a chance.'"

September 9 - Bloomberg (Sophie Leung): "Inflation in China may accelerate to at least 4% by the middle of next year, spurring the nation's central bank to raise interest rates, Deutsche Bank AG economists said. 'We believe inflation in China will rise faster than in most other major economies and will therefore justify earlier and stronger-than-expected rate hikes,' Ma Jun, a Hong Kong- based economist for China at Deutsche Bank, said..."

September 8 - Bloomberg: "Commercial Aircraft Corp. of China, the government-controlled planemaker, said its first commercial jet will 'surely be cheaper' than comparable Boeing Co. and Airbus SAS models, heightening competition in the world's fastest-growing aviation market... Comac will initially target Chinese customers for the single-aisle C919 before seeking to challenge Boeing and Airbus overseas..."

India Watch:

September 8 - Wall Street Journal (Nik Hil Gulati and Santanu Choudhury): "Car sales in India rose 26%... Sales climbed to 120,669 cars in August from 96,082 a year earlier, showed data issued Tuesday by industry lobby group Society of Indian Automobile Manufacturers."

September 11 - Bloomberg (Kartik Goyal): "India's industrial production increased for a seventh straight month as higher government spending and lower borrowing costs stoked demand for cars, motorbikes and other consumer goods. Output at factories, utilities and mines rose 6.8% in July from a year earlier..."

Asia Bubble Watch:

September 9 - Bloomberg (Michael Dwyer): "Asian central banks may find it difficult to tighten monetary policy 'meaningfully' due to political constraints caused by high unemployment, UBS AG said. Jobless levels may remain 'uncomfortably high' in the region for the next year or two, Duncan Wooldridge, chief Asia economist at UBS...wrote..."

September 9 - Bloomberg (Anil Varma): "Investors are boosting purchases of high-yield Asian debt after dollar money-market rates slid to record lows this year..."

September 11 - Bloomberg (Shamim Adam): "Asia faces greater risks from asset bubbles caused by global stimulus than from threats to economic growth, said Gail Fosler, president of the Conference Board. Governments need to be vigilant of the money flowing into their economies as investors buy assets such as real estate in emerging markets, Fosler...said... 'There is a tremendous amount of fiscal stimulus that is going into producing the supply response that you see in the global economy today and the growth in assets continues to be stunning... This sets the stage for asset bubbles to move out of the U.S. and into Asia and emerging markets in general."

Latin America Bubble Watch:

September 8 - Bloomberg (Mike Cohen): "Brazil, the world's largest producer, may spend $33 billion on new sugar mills and renovating existing plants by 2012, said Fabio Torquato, the international relations director of the Mercosur trading block in Brazil."

September 9 - Bloomberg (Jens Erik Gould): "Mexican President Felipe Calderon proposed spending cuts and increases in income, corporate and sales taxes as part of 'unprecedented' steps to offset diminishing oil revenue and prevent a credit-rating reduction. The 2010 budget proposal cuts spending by 218 billion pesos ($16.3bn), the Finance Ministry said..."

Unbalanced Global Economy Watch:

September 8 - Bloomberg (Jacob Greber): "Australian business confidence jumped in August to its highest level in almost six years..."

U.S. Bubble Economy Watch:

September 10 - Bloomberg (Bob Willis): "The U.S. trade deficit widened in July and imports gained by a record 4.7%, signaling a revival of commerce as the global recession eased. The gap between imports and exports grew 16%, the most in more than a decade, to $32 billion..."

September 9 - Bloomberg (Jeff Plungis): "wealthy individuals' Chapter 11 bankruptcy filings jumped 73% in the second quarter from a year earlier, according to the National Bankruptcy Research Center... More individuals or families with at least $1,010,650 in secured debt and $336,900 unsecured are using Chapter 11 of the U.S. bankruptcy code typically associated with business reorganizations."

September 9 - Bloomberg (Gillian Wee): "George Washington University is increasing holdings of commodities such as oil and natural gas out of concern that a return to inflation rates last seen in the 1970s may ravage the value of its $1 billion endowment. U.S. consumer prices may rise 8% annually within three to five years because of unprecedented government spending and deficits, said Donald Lindsey, the Washington school's chief investment officer... 'Inflation, once it starts, could get very difficult to stop,' Lindsey, 50, said... 'We could see a stagflation environment that's similar to the 1970s.'"

Central Banker Watch:

September 10 - Reuters (Alister Bull): "Federal Reserve Vice Chairman Donald Kohn said... the U.S. central bank was developing tools to move away from its extremely loose monetary policy, but such an exit would not happen any time soon. 'Any combination of these tools, in addition to the payment of interest on reserves, may prove very valuable when the time comes to tighten the stance of monetary policy,' Kohn said... 'As the FOMC has said, that time is not likely to come for an extended period...'"

September 9 - Bloomberg (Matthew Newman): "European Central Bank President Jean-Claude Trichet said while the financial crisis is not yet over, it's important for policy makers to consider how they will withdraw economic stimulus measures. 'It's not time yet to say that the crisis is over,' Trichet told reporters..."

September 9 - Bloomberg (Cherian Thomas): "Central banks must maintain low interest rates until consumer and company spending is 'robust' enough to support economic growth, said Subir Gokarn, the Standard & Poor's economist in the running for the deputy governor's post at the Reserve Bank of India."

GSE Watch:

September 10 - Bloomberg (Jody Shenn): "'Credibly' privatizing Fannie Mae and Freddie Mac... may be too difficult given the precedent set by the Treasury Department's financial assistance, according to a Government Accountability Office analysis. 'The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency,' the GAO said... 'Consequently, such privatized entities may continue to derive financial benefits, such as lowered borrowing costs, resulting from the markets' perceptions.' The Treasury today reiterated that the government intends to make recommendations on Fannie Mae and Freddie Mac next year... 'Any transition to a new structure would need to consider the enterprises' still-dominant position in housing finance and be implemented carefully (perhaps in phases) to ensure its success," the GAO said."

September 10 - Wall Street Journal (David Enrich): "Banks have been silent partners in the meteoric rise of the Federal Housing Administration. In the past year, the nation's financial institutions have snapped up securities backed by Ginnie Mae, a government-owned agency that guarantees payments on mortgages backed by the FHA... As of June 30, the roughly 8,500 federally insured banks and thrifts were holding $113.5 billion of Ginnie securities, compared with just $41 billion a year earlier..."

Real Estate Bust Watch:

September 10 - Bloomberg (Daniel Taub): "Foreclosure filings in the U.S. exceeded 300,000 for the sixth straight month... A total of 358,471 properties received a default or auction notice or were seized last month, according to... RealtyTrac Inc. That's up 18% from a year earlier..."

September 8 - Bloomberg (Jody Shenn): "About $134 billion of securitized 'option' adjustable-rate mortgages will reset to higher payments over the next two years...according to Fitch..."

September 9 - Bloomberg (Hui-yong Yu): "The default rate on commercial mortgages held by U.S. banks will rise to 5.4% in 2011, the highest since at least 1992... according to Real Estate Econometrics LLC."

Speculator Watch:

September 11 - Bloomberg (Gillian Wee): "Harvard University and Yale University, the wealthiest U.S. schools, got about 30% poorer in the past year as their endowments lost more money on investments than less-affluent schools. Harvard's fund declined to $26 billion in the year ended June 30, led by a 27.3% loss on investments and $1.7 billion in distributions... Yale's endowment fell to about $16 billion..."

September 8 - Bloomberg (Warren Giles): "Hedge funds lured $4.5 billion in August, double the net inflows the previous month... according to Eurekahedge Pte."

Crude Liquidity Watch:

September 10 - Bloomberg (Simon Packard): "House prices in Dubai plummeted 47% in the second quarter from a year earlier, the steepest drop of any market, according to Knight Frank LLC, as speculators left the Persian Gulf business hub."

And No Dialing Back:

CNBC's Steve Liesman: "Mr. Secretary, how much concern do you have right now - how much pressure are you under right now to dial back on these programs. Dial back spending. Dial back - getting to the audience question right there that I think is critical and that is really indicative of how Americans feel: Get the government out of the private sector. How much pressure are you under right now?"

Treasury Secretary Geithner: "No one is going to be more eager than I am. You're just not going to care about that more than me. We do not want to be in any of these institutions a day longer than is necessary. And look at what we have already done. We already have $80bn of capital coming back into the Treasury. If you look at what I said today in my testimony on the hill, we've seen these emergency programs we put in place already be used at a tiny fraction of their scale in emergency. We designed these things so that they would not be used a day longer than necessary.

But we're going to be careful not to withdraw too soon. Again, the classic mistake countries make in crisis is that they put on the brakes too early and reignite the recession, ultimately at much greater fiscal cost and much greater damage to the economy. So that's the balance we've got to get right. And we are not now at the point - even though the challenge is shifting - we're a bit moving now from emergency to the harder challenge, frankly, of repair and recovery. That's going to change the mix of what we do. We're going to get out and walk these things back as soon as we are confident we can get out of this thing."

My interest is not in taking shots at today's policymakers. They have been faced with incredible challenges, and proceed now on a course they hope and believe is best for returning the country to sound footing. And while I disagree strongly with the current path of policymaking, it has been predictable. From a policymaking perspective, the greatest error came with the Greenspan/Bernanke Fed's failure to act to rein in systemic Credit excess, asset inflation, and financial Bubbles. Many belatedly recognized the Fed's failings, yet few today appreciate that the costs and risks of flawed analysis and theories only keeps mounting.

I retain keen interest in debunking the Fed's thesis - articulated most clearly by then Fed governor Bernanke - that central banks should avoid the business of popping Bubbles and instead focus on post-Bubble "mopping up" strategies. It was, after all, post-Russia/LTCM "mopping up" that fueled the tech Bubble, and then the post-Tech and 9/11 mopping fostered the Wall Street/mortgage finance Bubble. And the latest big mop up job sets the stage for perhaps the greatest Bubble all them all - the Global Government Finance Bubble.

They appear as free lunches at the time, but there are myriad financial and economic costs associated with government intrusions into the marketplace. Most are subtle and tend to remain quiescent for years. When (market pricing, resource allocation and economic impairment) distortions do eventually manifest into a crisis, policymaking will have a strong proclivity to treat misdiagnosed ills with only greater government manipulations and intrusions. And the greater the degree of intrusion into the markets, the greater the ongoing costs involved. Huge intrusions ensure open-ended government involvement and increasing governmental command over the economic system.

As much as I believe Secretary Giethner is speaking earnestly, there is no way at this point government influence in the marketplace can be meaningfully dialed back. The damage has been done - historic distortions to both the financial system and real economy. The damage began with the activist Greenspan Fed manipulating interest rates, promising market liquidity, and pandering to the leveraged speculators. The damage worsened as the government-sponsored enterprises came to dominate our nation's market for housing finance. And the damage turned unmanageable when the markets listened back in 2002 to Dr. Bernanke profess the virtues of helicopter money and whatever other unconventional measures the central bank might deem worthwhile.

Federal government finance (Treasuries, agency debt and GSE MBS) has expanded about $2.0 TN over the past year. I expect it to inflate another $2.0 TN over the coming twelve months. The private sector Credit apparatus is simply not up to the task of generating the necessary $2.5 TN (or so) of total system Credit expansion necessary to sustain the current economic structure. In this post-Wall Street Bubble environment, only government and government-related Credit retains sufficient "moneyness" in the marketplace. Systemic reflation today depends on a massive inflation of this government helicopter "money."

This week's GAO analysis on the GSE's was spot on and certainly applies to more than just the GSEs: "The financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency." Over five Trillion - and counting - of GSE securities are valued and traded in the marketplace as (money-like) government-backed obligations. Policymakers would not today risk the negative financial and economic ramifications from dialing back from Washington's explicit and implicit guarantees.

And as much as moral hazard and "too big to fail" are recognized as fundamental facets of the previous Bubble excess, our policymakers have nonetheless been compelled to expand only further toward backstopping the entire Credit system. Obviously, the GSE's were too big to really fail, while markets appreciate that policymakers now believe it was a mistake to allow Lehman to collapse. The markets - more than ever before - operate with the view that policymakers have no tolerance for a major financial institution failure.

When one contemplates the issue of "getting the government out of the private sector," these various market liquidity support programs being wound down are an insignificant issue. Fundamentally, for the economy to move toward sounder and sustainable footing would require at least a semblance of a market-based Credit pricing mechanism. Regrettably, the vast majority of system Credit today is "public." Government intrusion chiefly dictates the cost of finance and the allocation of financial and real resources. Furthermore, I would argue that the limited amount of private sector debt being issued these days is dependent upon the system-stabilizing effects of massive government debt issuance and spending.

As I have stressed repeatedly, in the neighborhood of $2.5 TN of non-financial Credit growth is required to stem systemic implosion - a massive Credit expansion with only our federal government up to the challenge. It is this fundamental facet of Bubble economies - a maladjusted economic structure sustained only through ongoing Credit excess - that prohibits Washington from extricating itself from very public "private sector" intrusions. Fixated on the notion of sustainable recovery, policymakers will not be dialing back from massive borrowing, spending, or market backstopping endeavors. And this gets to the core of the unquantifiable costs of failing to rein in Credit and asset Bubbles.

As I have written over the years, the entire notion of "mopping up" is as flawed as it is dangerous. Clearly, the notion of inflationism remains as seductive as it has throughout history. If, God forbid, deflation ever becomes a risk the central bank must aggressively raise the price level to preclude a downward spiral. We heard this dogma in the early nineties, heard it again earlier this decade, and have had it repeated too often over the past year.

And the more intense the necessity to reflate - the greater the government's evolving role throughout both the financial and economic systems. This is a fact of life, human nature and politics. And at the end of the day inflationism tends toward socialism. And there is only one way to reverse this course; it is anything but painless. The economy must be weaned off of Credit and financial excesses and government intrusions - and allowed to proceed through the arduous task of adjustment and rebalancing. Choosing instead a course of sustaining current financial and economic structures implies a huge and ever-expanding role for the government. There will be no dialing back.

Many hope the private-sector can again rise to the occasion. It is expected that as recovery gains a foothold private sector borrowing and lending will increase, tax receipts will rise, and the government enjoy the luxury of dialing back as the system normalizes. I don't expect this dynamic to work as it has traditionally because of the confluence of Bubble economy Credit requirements, acute private sector Credit system impairment, and the government's predominant influence on the recovery.

The dynamic today is one of a shallow recovery induced by a flood of government borrowing and spending and marketplace intrusions. Rampant financial speculation has reemerged, which leaves the marketplace increasingly vulnerable to any serious move to dial back. In a normal recovery, the system tends to gain strength and stability over time. Credit requirements are manageable, and speculative excesses have been largely wrung out of the system. In stark contrast, today's combination of huge Credit expansion and a highly speculative financial backdrop ensures only more acute systemic fragilities over time. And the distorted marketplace will simply not function well at even the notion of fiscal and monetary exit strategies.

Conceptually, somewhere along the line there reaches a tipping point where government intrusions are no longer stabilizing. They become invariably destabilizing, as the quantity of government monetary inflation becomes massive and uncontrollable. This is the nature of inflationism, although this dynamic is nowhere to be found in Keynesian doctrine. It is my view that this tipping point was reached some time back. It is with this analysis in mind that I fear the emerging Government Finance Bubble risks destroying the creditworthiness of our entire economy.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com