The 'Great' Debate

By: Doug Noland | Fri, Nov 30, 2001
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Unsettled conditions continued throughout the financial markets this week, with the better than two-month rally looking more vulnerable to unbullish underpinnings each passing day. For the week, the Dow, S&P500, Transports, and Morgan Stanley Consumer indices all declined about 1%. The Morgan Stanley Cyclical and S&P400 Mid-Cap indices were unchanged, while the small cap Russell 2000 added almost 1%. Technology stocks generally performed well, with the NASDAQ100 adding 1% and the Morgan Stanley High Tech and Semiconductor indices gaining about 2%. The Street.com Internet index was unchanged, while the NASDAQ Telecommunications index declined 2%. Biotech stocks generally added 1%. Financial stocks suffered with Enron and other festering problems, as the AMEX Securities Broker/Dealer index sank 4%, the S&P Bank index declined 3%, and the Utilities dipped 2%. With bullion adding about a buck, the HUI Gold index seemed to discount better things on the horizon by jumping almost 6%.

Stunning Credit market volatility runs unabated, with two-year Treasury yields sinking 40 basis points this week. Two-year yields began the month at 2.37%, surged to as high as 3.18% at Monday's close, only to end the month at 2.75%. Wow… Five-year Treasury yields declined 22 basis points to 4.06% this week, while 10-year yields dropped 25 basis points to 4.75%. Long-bond yields declined 9 basis points to 5.28%. Mortgage-backs underperformed, with yields declining 17 basis points. The agency debt market was particularly unsettled, with the spread on the Fannie Mae benchmark 5 3/8% 2011 bonds widening four basis points this week to 74. The benchmark 10-year dollar swap spread narrowed four this afternoon, to end the week one wider at 70. At one point this morning this spread traded at almost 76. Bank and finance debt spreads generally experienced moderate widening this week.

The dollar ended the month ominously, suffering a 2% loss against the euro for the week. The dollar index dipped more than 1 ½% for the week. Commodities are showing a pulse, with the CRB index jumping today to the highest level since September.

The Enron tentacles reach far and wide, with a Dow Jones new story this afternoon stating "primary insurers could be on the hook for as much as $2 billion in claims against directors and officers policies, surety bonds and financial guarantees…" Add insurance exposure to that of scores of lenders, swap and derivative counter-parties, investors and wide-ranging commercial exposures, and you've got one ugly mess that will take years to resolve. Also this afternoon, S&P stated, "Credit derivative exposure to Enron totals $6.3 billion."

With overnight borrowing rates at one point today spiking to 900%, four-year floating debt yields surging to 72%, and peso futures contracts indicating a 37% decline by year-end, the market is now anticipating an imminent Argentine devaluation. One-year peso contracts are indicating a 75% depreciation, the type of collapse that, unfortunately, cannot be ruled out with the specter of a grueling financial crisis. Elsewhere, the South Africa rand sank to an all-time low, suffering (according to Bloomberg) the largest two-day fall (5%) since the Russia default in 1998.

Well, another week, another $21 billion of broad money-supply (M3) expansion. Broad money has now surged $303 billion (20% annualized) over the past 10 weeks to $8.024 trillion, with year-to-date growth (46 weeks) at $875 billion, or 13.8% annualized. It's just difficult to comprehend that M3 surpassed $5 trillion for the first time only back in 1997, while expanding by about $340 billion during the entire year of 1996. M3 growth during the past fifty-two weeks of $1.013 trillion is up a stunning 14.5%. While repurchase agreements declined almost $14 billion last week, demand deposits jumped $10.1 billion, large time deposits increased $9 billion, and institutional money fund assets added $10 billion. Institutional money funds have now increased $134 billion (70% annualized) over ten weeks and $361 billion (52% annualized) y-t-d. The Investment Company Institute has total money market fund assets surging $205 billion in 11 weeks to $2.333 trillion. For comparison, M1 (narrow money) has increased $16 billion over ten weeks and $56 billion y-t-d (5.8% annualized) to $1.16 trillion.

This week the Federal Housing Finance Board (FHFB) reported that the national average single-family house price in October was up 9.4% year over year to $219,600. This percentage increase is important, as it is used by Fannie Mae and Freddie Mac to annually adjust the maximum size of mortgage loans - the conforming loan limit - they will purchase. Both institutions immediately increased their conforming loan limit to $300,700. During the past three years, the average national price reported by the FHFB has increased 25.3%, or $44,400, with the GSE conforming loan limit increasing $60,700, also 25%. The FHFB national average price is up 40% over five years. This is clearly a built-in mechanism for fueling a self-reinforcing housing Bubble.

With rates jumping sharply over the past couple weeks, it is not surprising to see the Mortgage Bankers Association this week report a 14% decline in applications to refinance (although refi volume remains up almost 600% y-o-y). Yet, purchase applications actually jumped almost 10% last weak, and purchase dollar volumes were up almost 11% y-o-y. Both existing and new home sales came in above expectations this week, with exiting home sales up 2% from last year and new home sales down about 5%. Inventory remains low, with existing homes at 4.5 months supply and the inventory of new homes at 4.3 months. It appears weakness at the upper-end is matched by continued booming activity at the lower-end.

A few extracts from Federal Reserve Governor Laurence Meyer's talk Tuesday before the St. Louis Chapter of the National Association of Business Economics:

"The risk we face when interest rates are already low - in what I think today would certainly be regarded as the worst-case scenario - is that the nominal federal funds rate could be driven to zero, the practical limit to nominal interest rates. And this is precisely, of course, the situation that's confronted the Bank of Japan, and it's referred to now in the literature as the 'problem of the zero nominal balance.' So what is the appropriate response: It seems to me that the appropriate response in this case is to respond sometimes asymmetrically - respond more aggressively to downside than to upside shocks. And particularly in the face of adverse shocks, substitute what I would call 'speed' for cumulative decline in rates. And the danger in waiting is that inflation might drift lower limiting the ability to drive the real federal funds rate into negative territory, as might be necessary in the worst-case scenario… So the implication then, as I said, is to move more aggressively not less aggressively."

"The process (Fed's post-Sept. 11th liquidity operations) went very smoothly in part because this wasn't the first time we've been confronted by a situation in which there were disruptive developments in financial markets and periods of stress and big increases in demands for liquidity. I remind you, for example, about the events in the fall of 1998 when fixed income markets basically seized-up. As an example, I remind you of the tremendous increase in the demand for liquidity around the time of the Millennium turnover. So one of the reasons that I think the Fed was able to operate as effectively as it was in the circumstances was that we've faced the situations similar to this in our role as liquidity provider. And its one thing we know how to do very well. We know how to put liquidity into the economy very well. As I point out in the paper, we used every tool, including injecting liquidity, that we had and even invented a new one along the way, which was we used swap lines with foreign central banks…we used them specifically to inject dollar liquidity into the economy."

"It's a combination of two things: Good monetary policy is not keeping interest rates stable, it's achieving price stability and cushioning short-term fluctuations in output. Interest rates have to do whatever is necessary to get that job done."

"I always love to point out how difficult it is to determine if there's an asset bubble. There's much debating. Of course, Alan Greenspan has come up with the absolutely definitive rule to determine whether or not there is an asset bubble. And we are all thankful. And the rule is, if asset prices fall by 40% or more, then there was an asset bubble (laughs). Now, this is not facetious; this is a very profound point. The point here is that it is very difficult at the time, with all of the things developing, to be certain whether or not there is an asset bubble. You sometimes only know for sure afterwards."

Dr. Meyer's comments go right to the heart of some of the key economic issues of our time. We have witnessed the evolution of central banking to aggressive "asymmetrical" responses, a determination to "cushion" of fluctuations in output while committing to early and aggressive marketplace liquidity "injections," with no level of interest rates apparently too low - and at the same time disregarding asset Bubbles (and, as such, the degree of speculation and leveraging) until after they burst, where then even more frantic asymmetrical responses are assured. In their entirety, one locates all the ingredients for a recipe of monetary policy disaster.

Reading Dr. Meyer's and other Fed officials' musings, I am struck by their continued use of the phrase "price stability." Perhaps a basket of consumer staple prices has in the aggregate been relatively quiescent, but in the bigger picture this has obviously been very much the exception to the rule. Has the Fed been following the extreme volatility of prices throughout the financial markets? Viewing prices generally, extraordinary volatility has been the hallmark of this cycle, and it's taking its toll. In this vein, I have been reading several analyses of "money" and what is developing into an interesting "inflation vs. deflation" debate. Along with disagreeing with basic premises held by the Fed, I cannot generally find accord with either side of the inflation/deflation argument. Both sides seem to ask the wrong questions and, furthermore, look to the wrong places for answers. But that is precisely why this environment is incredibly fascinating. There is no "rule book," operator's manual, or trusted navigation equipment to guide us as we sail nervously in the tempest of "uncharted waters."

So I guess I am compelled to "throw my hat into the ring" for The "Great" inflation/deflation Debate by first introducing a quote from the truly great Joseph Schumpeter:

"Even today, textbooks on Money, Currency, and Banking are more likely than not to begin with an analysis of a state of things in which legal-tender 'money' is the only means of paying and lending. The huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption is then built up step by step by introducing claims to money or credit instrumentsBut logically, it is by no means clear that the most useful method is to start from the coin…in order to proceed to the credit transactions of reality. It may be more useful to start from these in the first place, to look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences - so that 'money' payments come in only as a special case without any particularly fundamental importance. In other words: practically and analytically, a credit theory of money is possibly preferable to a monetary theory of credit." J.A. Schumpeter, History of Economic Analysis, 1954, p. 717

If Dr. Schumpeter saw "the credit transactions of reality" and a "credit theory of money" back then, what would be his vision today? Clearly, any meaningful discussion of money, inflation/deflation, or "price stability" must begin with the recognition that we operate in a credit-based monetary regime both domestically and internationally. Moreover, today's credit and payment systems are unlike any in history. I read too often variations of the "simplistic" analysis "that inflation is an increase in the money supply and deflation is a decrease in the money supply." And while I do understand such an inclination, as far as contemporary economies and financial systems are concerned, this view is more accurately recognized as incorrect than simple. It is not additional money that creates inflationary manifestations but the expansion of Credit. It is credit creation that produces increased purchasing power. Money is not a causal factor, but the residual of the lending process. Reading a recent article (Marketnews International's Christian Distasio) on the ECB's view, it was refreshing to see the statement "private credit growth is regarded as the component that can cause the most inflationary pressure, as it translates quickly into real demand." Yes, but let's not forget to ask the essential follow-up question: "Demand" for what?

It is critical to appreciate that conventional monetary doctrine is very much a holdover from days long past - initially developed mainly under the auspices of gold-based domestic and international monetary arrangements - and then expanded along with the evolution of regulated fractional reserve banking. (Monetary theorizing has, as well, too often been adulterated by ideology and politics) Back when gold coins were used for most transactions, the number of coins (and gold-backed currency) in circulation was a salient issue. Later, when bank lending became an essential part of both an economy's transactions and payment system, the quantity of deposits ("money") created through the bank lending process was of vital significance in regard to price and economic stability. When money (currency and checkable deposits) balances were a significant portion of household net worth, hence potential purchasing power, there was further sound justification for "money" as the centerpiece of monetary theory. And as long as bank lending reigned supreme as the foundation of the Credit system - with bank deposits the residual of lending - money expansion could rightly remain the focal point of monetary analysis. As many of the great thinkers did at the time, money and Credit could be used almost interchangeably. But today's credit system has made a quantum leap from gold coins and bank lending. The essence of money has changed profoundly.

It is also helpful to appreciate that traditional analyses ("Keynesian," "Monetarist," and "Austrian") evolved with a focus on capital investment and production as the predominant monetary transmission mechanism within an economy. I have often argued that contemporary analysts place too much emphasis on this facet of economic doctrine. For one, the U.S. economy today is of course much less reliant on production and capital goods industries than during the days of Keynes, Fisher, and Mises. What's more, and this point seems grossly unappreciated, is the fact that when these Masters were working out their monetary thinking not only did banks command the credit system, lending was in fact concentrated on financing business capital investment and funding commerce generally. To follow monetary expansion and consequent effects, one could basically focus on bank lending to the business sector and the resulting expansion of bank deposits. If lending was done in excess, inflationary manifestations typically arose in accentuated business investment, rising basic commodity prices, expanding commercial booms, and over time heightened wage demands and general inflationary pressures. Monetary processes were relatively incomplex, inflationary effects generally systematic and of limited variability within the economic system. Bank lending to business drove monetary processes, patently disparate to contemporary consumer, real estate and speculator borrowing booms financed by an unbridled explosion of marketable securities and other financial instruments.

Today, lending (excess) permeates all aspects of the economy and financial system, from using a credit card for purchases such as a massage or a facelift, to borrowing online to acquire a used automobile or new home, or to using a repurchase agreement (or broker loan) to take a leveraged position in Fannie Mae bonds or mortgage-backed securities. In all cases, credit creation augments purchasing power, and it is this uncontrolled expansion of Credit/purchasing power that is at the root of today's myriad financial and economic maladies. With a literal explosion in the amounts and types of products, services and assets (including financial) now available for purchase (by consumers, entrepreneurs, businesses, governments, investors, speculators, etc.), one should not be surprised that the more important inflationary manifestations would be distortions to the structure of demand across wide-ranging markets, rather than simply causing rising prices in a narrow basket of consumer items (many of which are produced overseas or priced globally). Has the greatest volume of lending been directed at toothpaste, bread, and haircuts, or would sensible analysis pay more heed to demand and prices effects for dwellings and securities? For indication of domestic monetary conditions, should we look to imported goods prices or the rising costs of insurance, health care, and college tuition? Clearly, we would expect the major effects of unprecedented credit excess during this cycle to show most ostensibly outside of CPI. The essence of inflation has changed with the evolution of the economy and Credit system.

Marketable securities today dominate the contemporary U.S. Credit creation process, with Wall Street "structured finance" and the GSEs supplanting traditional bank lending as the nucleus of the Credit system. This is a momentous development in the structure of finance, thus far ignored by conventional theory and analysis. The expansion of myriad, often "sophisticated" (dubious?), financial sector liabilities is key to this Credit Bubble, not the increase in bank liabilities (deposits) as has been the case traditionally. Sometimes "money" is the residual of the contemporary lending process, sometimes it's not - it depends on the type of financial sector liability created. At times "money" is an accurate gauge of general credit expansion; but generally it is much more valuable as a key indicator of critical underlying Credit system developments (such as reckless GSE Credit creation operating with an "infinite multiplier effect" through money market fund intermediation!). Money remains of critical importance, just not today with respect to general prices or as a causal factor in either inflation or deflation. The belief that "the behavior of the money supply causes deflation, or its equally evil twin, inflation" simply no longer holds true.

Money is no longer dominant in the transaction process (money as a "medium of exchange"), nor is it necessarily the residual of the Credit creation process. Credit is today paramount in transactions throughout the economy and financial system and, importantly, as well for settlements within the payment system. A fixation on bank deposits (traditional "money") in the payments clearing process ignores the fact that money market funds have developed into the critical epicenter of a sophisticated financial sector payment clearing mechanism. The contemporary clearing system "clears" payments between financial institutions (banks, GSEs, brokers, money market funds, asset/mortgage-backed security trust conduits, equity funds, corporations, foreign institutions, etc.) by netting and adjusting various financial sector assets and liabilities (not exclusively bank deposits!). Bank reserves are no longer much of an issue, and payment deficits can generally be met by additional borrowing in the money market or simply by increasing inter-institution credits.

The critical role of money today is found in its perception as a liquid and safe "store of value." The critical risk associated with the wholesale abuse of the "moneyness" of money is today's acute financial fragility. Purchasing power, hence potential inflationary manifestations, resides mainly with Credit. The complexity of monetary processes has increased exponentially, with inflationary effects deviating wildly and with extreme variability within both the economy and, importantly, throughout the financial system and a multitude of markets. The Fed's narrow focus on CPI as an indication of "price stability" is as archaic as it is dangerous central banking.

This fixation on CPI and the illusion of "price stability," as well as the inflation/deflation Debate, proceed seemingly oblivious to the paramount issues of destabilizing price volatility, extraordinary systemic disproportionalities and maladjustments, extreme relative price divergences, and historic asset inflation (most notably real estate and financial instruments).

Quoting eminent Austrian economist Oskar Morgenstern (1902-1977):

"Back to Cantillon - This is a brief remark about macroeconomics. There is a limited interest in studying such aggregates as total capital, total quantity of money, wage sums, aggregate demand, and what not. Harking back to Ricardo, it was Keynes who gave impetus to this kind of analysis after the study of individual behavior had made promising headway since the 1870s. This was contrary to the general advance in science which has always been in the making of more and more distinctions, of finer and finer interrelationships, of greater detail and definition. The concentration on undifferentiated aggregates as, say, that of the total quantity of money, is a step backward into a more primitive world of thought. It runs counter to what must be done. Only when a decisive analytical step forward is taken from time to time does there occur great unification.

Consider an inflationary, or as a matter of fact, any increase in the total quantity of money. If no account is given where this additional money originates from, where it is injected, with what different magnitudes and how it penetrates (through which paths and channels, and with what speed), into the body economic, very little information is given. The same total addition will have very different consequences if it is injected via consumers' loans, or via producers' borrowings, via the Defense Department, or via unemployment subsidies, etc. Depending on the existing condition of the economy, each point of injection will produce different consequences for the same aggregate amount of money, so that the monetary analysis will have to be combined with an equally detailed analysis of changing flows of commodities and services. This is what Cantillon saw clearly in the 1730s (published in 1755), though he did not elaborate his ideas. It is one of the distressing factors in the history of economic thought that his deep insight was lost. Carl Menger's article on money (1892) contains a great deal that is in the spirit of Cantillon…(his) famous but unpublished lectures on the history of economic thought, emphasized Cantillon's 'paths of infusion.'" (Selected Economic Writings of Oskar Morgenstern, 1976, p. 297-298)

Along these lines, it would be a gross injustice not to touch on the wealth of insight left by the great Ludwig von Mises. After all, he did author the masterpiece The Theory of Money and Credit (although by reading some contemporary "Austrian" monetary analysis one would think Mises penned The Theory of Only Narrow Money). Central to Mises's analysis was to look to broad monetary forces ("transmission mechanisms") - money substitutes and "fiduciary media" with the economic functionality of money "proper."

"I have developed a theory of the changes in purchasing power and its social consequences. I have demonstrated that money acts as a dynamic agent…" Ludwig von Mises, Money, Method, and the Market Process - Essays by Ludwig von Mises, 1990, p. 77)

"What distinguished Mises's approach, for example, from Irving Fisher's quantity theory of money was precisely his refusal to make the analytical jump (made by Fisher and others) from changes in the aggregate money stock to changes in the general 'price level.' Mises insisted upon a strict adherence to methodological individualism. Any explanation of statistically calculated changes in total employment and output or in the 'price level' needed to be dissected into the 'step-by-step' sequential process of individual market actions, reactions and plan adjustments and readjustments following an increase (or decrease) in the money supply. Thus, the macroeconomic aggregates were to be decomposed into their micro-macroeconomic components by rigorously analyzing the 'transmission mechanism' of monetary injection." Richard M. Ebeling, introduction to Money, Method, and the Market Process - Essays by Ludwig von Mises, 1990

"Mises was then writing at a time when such credit expansion was primarily in the form of discounting short term bills of exchange. Consequently, such loans were always business loans. The first consequence was always a bidding up of the prices of certain raw materials, capital goods and wage rates, for which the borrowers spend their newly acquired credit. This has led some writers on the subject to believe that all such loans went into the lengthening of the production period. Some did, of course, but Mises recognized that the lower interest rates attracted all producers who could use borrowed funds. Consequently all the resulting malinvestment does not result in longer processes. The effects depend on just who the borrowers are and how they spend their new credit in the market." Percy L. Greaves, Jr., introduction to On the Manipulation of Money and Credit, Ludwig von Mises, 1978

"Discrimination in lending is no substitute for checks placed on credit expansion, the only means that could really prevent a rise in stock exchange quotations and an expansion of fixed capital. The mode in which the additional amount of credit finds its way into the loan market is only of secondary importance. What matters is that there is an inflow of newly created credit." Ludwig von Mises, Human Action, p. 796)

What matters today is the inflow of newly created Credit, with the analytical focus directed to "who the borrowers are" and where, which, what and how "they spend their new credit." Additionally, inquiring minds want to know what are the consequences produced from these changing flows on various markets? These, I would think, are the "right" questions to ask, not whether we're "in inflation" or "in deflation." To begin the analysis, we can look briefly at Federal Reserve Credit data to get some indication of aggregate Credit expansion. Here we see that total Credit market borrowings increased by $6.06 trillion, or 27%, in just three years (6/30/98-6/30/01). More important, we must try to determine "who the borrowers are." We see that the financial sector increased borrowings by $2.9 trillion in three years, or almost 50%, to $8.8 trillion. From this, we see that total agency (GSE) securities increased $1.6 trillion, or 54%, to $4.6 trillion, while Securities Broker/Dealer liabilities increased $396 billion, or 46%, over three years to $1.28 trillion. Outstanding asset-backed securities increased $716 billion, or 59% to $1.94 trillion. Total "security Credit" increased $242 billion, or 45%, to $782 billion. Where and how did the financial sector lend? By category, we see that total mortgage Credit increased by $1.85 trillion (34%) to $7.25 trillion and non-mortgage consumer Credit expanded $324.3 billion (26%) to $1.58 trillion. Non-financial corporate borrowings increased $687 billion, or 39%, to $2.44 trillion.

From this data, it is inarguable that we have experienced massive and endemic Credit inflation, with the most significant increase in purchasing power created in the financial sphere and in the consumer/real estate sector. It is, thus, no shocking revelation that this cycle has seen its greatest inflationary effects in financial asset prices (stocks and credit market instruments), real estate values and trade deficits. One would expect that rampant asset inflation has severely distorted demand and changed relationships throughout the economy, significantly elevating demand for "luxury" goods, high-end homes and autos, travel and entertainment, with corresponding "Misean" maladjustments in "investment" spending throughout these sectors. And with securities (Credit and equity) market values now about four times the economy's nominal GDP (as distorted as this measurement has become!), to speak of deflation without recognizing the historic nature of the U.S. asset Bubble is flawed analysis. This huge Bubble in U.S. asset prices is a critical piece of the Credit inflation puzzle, ignored at great peril.

Returning to Dr. Morgenstern's brilliant insights, "depending on the existing condition of the economy, each point of injection will produce different consequences." Accordingly, it is necessary to step back and appreciate the bigger picture. We are in the midst of an enormous global technology bust after years of (1920's-style) historic excess. This is also a critical piece of the Credit inflation puzzle. A strong case can be made that this Bubble (and the Japanese/Asian manufacturing booms generally) was significantly exacerbated by inflationary forces emanating from the U.S. financial sector, and clearly by endemic global Credit excesses. Perhaps some would argue that this is today "deflation," but such analysis is, at best, inadequate. It is critical to appreciate that uncontrolled domestic and global credit systems have for too long been locked in dynamic processes fueling sector booms and busts, and it is just nonsensical to refer to the unavoidable busts as "deflation." Sector busts should be differentiated, as the inevitable consequences of previous Credit inflation and not "deflationary" forces to be rectified by lower interest rates, more "liquidity," and additional runaway monetary expansion. All the same, this powerful technology bust has major ramifications for the U.S. Credit Bubble. The Fed, erring with its apparent misjudgment that THE Bubble was in the technology sector, now only further accommodates the true Bubble endemic to the entire U.S. Credit system as it aggressively plays its self-appointed role as "liquidity provider" and "shock absorber." Seeing a faltering NASDAQ/technology sector, relatively tame consumer prices, and currently weak aggregate economic performance, the Fed erroneously believes circumstances have conveniently granted them a "blank check" with regard to interest rate and liquidity policies.

There is one momentous dilemma, with each greater inflationary boom turned more precarious bust only stoking the most extreme Fed accommodation. The Fed has gone "mad." And while it's clear that lower rates will have trivial impact on the globally faltering technology and manufacturing sectors (outside, of course, of rekindling speculative juices!), it doesn't take a leap of understanding to appreciate that the great costs of further inflating the U.S. Credit and real estate Bubbles far outweigh any minimal benefits. This is, of course, econ 101 for those schooled in the principles of Credit Bubble analysis, with a discipline and a determination to spot excesses early and avoid asset Bubbles at considerable cost if necessary. The Greenspan Fed, on the other hand, has it all backwards, ignoring Credit, becoming panic-stricken by talk of "deflation," believing that it can manage "prices" and manipulate marketplace liquidity, while having ridiculously accepted the Greenspan doctrine that asset Bubbles are only recognizable after the fact. That the Fed can today speak of "price stability" while ignoring extreme inflationary manifestations in the Credit and assets markets is indicative of a complete breakdown of sound analysis. And at this point, it's really not much more than a case of a doctor, with a very large dose of bad medicine failing to cure his patient, resorting to doubling the dosage. This is precisely where Dr. Meyer and the Greenspan Fed are making a monumental blunder with their "blank check" approach, and why we have argued that the dramatic reduction in rates has been flawed policy. There are enormous accumulating costs to such failed policies.

During this year's first half, the U.S. financial sector increased borrowings at an almost $800 billion (9.5%) annual rate, with mortgage debt expanding at a $670 billion (9.7%) rate. Not surprisingly, the massive speculative Bubble in U.S. Credit market instruments and related lending Bubble throughout mortgage finance are acutely sensitive to lower interest rates. Indeed, the Fed's greatest impact is only to exacerbate the Bubble in a contemporary Credit system commanded by marketable Credit instruments and financial sector leveraging (by their very nature acutely sensitive to lower rates!), as policy works most keenly on borrowers profiting from the alluring combination of declining borrowing costs and inflating asset prices - financial speculators and mortgage borrowers. These are today the critical Misean "transmission mechanisms," Cantillonian "paths of infusion," and Morgensternian "points of injection." The problem is that these monetary processes are hopelessly dysfunctional. Furthermore, these mechanisms have been used in negligent excess almost continually for more than three years now, in what is developing into an unmitigated financial disaster. In reality, we have reached a point where the rest of the inflation/deflation (as well as the "V"/"L" economy) Debate is moot. For the true "Great" Debate, there is one Credit inflation that matters - only one massive Bubble to analyze. It has become only a question of how long the Fed, the GSEs and Wall Street can keep the Great U.S. Credit Bubble levitated without sparking a run on the dollar.

In this regard, we need to return to the topic of "money" and the key role it plays in financial fragility. Why has money expanded by an incredible and unprecedented $1 trillion over the past year? Because that's what it took for the financial sector to keep the Bubble levitated. A tremendous amount of ink has been expended over the years in discussing the nature and characteristics of money. We will go into more detail in the future, but the defining characteristic of money today is largely that there is insatiable demand for it. This is a vulnerability fully recognized and exploited by those today frantically supplying Credit. Give an individual quantities of junk bonds, Fannie Mae notes or mortgage-backs, and at some point (today it would not take long!) she will say, thanks but no thanks, I'll just take "money" instead. Money bestows to its holder the perception of a safe, liquid store of nominal purchasing power, something that is always in demand - that is, as long as the perception of "moneyness" holds. So, we have a precarious situation now where it takes incredible amounts of new Credit to keep the U.S. Credit and economic Bubbles from going bust. Yet the household sector has little appetite for the type of risk created (mortgage, asset-backs, corporate, agency debt, etc), by necessity, in enormous quantities. So it becomes a matter of necessity for U.S. financial sector "intermediaries" to "monetize" this debt largely into bank and money market deposits, where there remains insatiable demand. This leaves the financial sector to shoulder the risk or try to off-load elsewhere. But where and to whom?

We will have much more to say on the topic of "intermediaries," "risk intermediation," and "monetization" in the future, without a doubt. As Enron learned the hard way, this is a very risky business in a most risky environment. Traditionally, money retained its "moneyness" either because of the intrinsic value of its gold backing, or the soundness of the assets (loans and securities) supporting bank deposits. Today, especially in the money market arena, the guise of "moneyness" rests not with the quality of the underlying loans, but with GSE and government guarantees, liquidity and "swap" arrangements, interest rate and default derivative contracts, credit insurance and various other "financial engineering" techniques. This is a bad deal, with the quality of our "money" suffering irreparable impairment. We are, though, today increasingly confident that this most unfortunate "Great Experiment" with our monetary system is now in its endgame. We have reached an unsustainable juncture where the enormous amounts of Credit necessary to sustain the Bubble require the U.S. financial sector to "intermediate" (accept) huge amounts of increasingly problematic risk (interest rate, default, currency, market price, etc). At the same time, the combination of continued rampant Credit excess and the required massive risk "intermediation" ensures the type of wild marketplace volatility and unrelenting boom and bust dynamics that prove terminal for risk intermediaries such as Enron, Conseco, Providian and likely a whole host of financial players.

I also read an analysis recently that stated that deflation is "impossible." Well, we certainly can't rule out a "deflationary" dislocation in the global financial system. When I look at the unfolding crisis in the U.S. credit system, and see quite troubling developments globally from Argentina to Japan, I do not discount the potential for a financial accident. Certainly, if the perception of "moneyness" for the $2.3 trillion worth of U.S. money market fund deposits wanes, the entire Credit system is at risk of buckling. More likely, fears of U.S. financial sector vulnerability and/or a U.S. real estate bust will usher in changing perceptions as to the soundness of the U.S. dollar. Unfortunately, in all likelihood the perceptions as to the "moneyness" of U.S. financial sector liabilities and the confidence in the soundness of the American currency will go hand in hand. And as foreign financial players calculate their exposure to Enron and perhaps take a more incredulous view of U.S. intermediaries, "risk management" techniques, and the contemporary Wall Street-commanded Credit System in its entirety, perhaps fissures will begin to form in the foundation of dollar confidence. But rest assured that the Fed is in full crisis management mode, which unfortunately guarantees that the worst-case scenario continues to unfold over time.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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