Most Unfavorable of Legacies

By: Doug Noland | Sat, Dec 17, 2005
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It was relatively quiet and somewhat mixed for U.S. stocks. For the week, the Dow gained about 1%, and the S&P500 added 0.6%. The Transports gained 1%, and the Utilities rose 1.5%. The Morgan Stanley Cyclical index added 0.8%, and the Morgan Stanley Consumer index jumped 1.4%. The broader market underperformed. The small cap Russell 2000 dipped 0.8%, and the S&P400 Mid-cap index slipped 0.3%. Technology stocks were mixed. The NASDAQ100 dipped 0.2%, while the Morgan Stanley Technology index added 0.4%. The Street.com Internet Index added 0.4%, while the Semiconductors gave back 0.4%. The NASDAQ Telecommunications index was about unchanged. The Biotechs declined 1%. The financial stocks were strong. The Broker/Dealers gained 1.4%, and the Banks jumped 1.6%. Although bullion was hit for $23.15, the HUI gold index declined only 0.5%.

The markets are keen to believe that Fed "tightening" cycle is about complete, and the Fed did not dissuade them. For the week, two-year Treasury yields declined 5 basis points to 4.35%, and five-year government yields fell 6 basis points to 4.37%. Bellwether 10-year yields basis sank 8 points for the week to 4.44%. Long-bond yields dropped 8 basis points to 4.65%. The spread between 2 and 10-year government yields fell to 9bps. Benchmark Fannie Mae MBS yields dropped 9 basis points to 5.8%, this week slightly outperforming Treasuries. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note declined one to 37.5, and the spread on Freddie's 5% 2014 note declined one to 38. The 10-year dollar swap spread declined 2.5 basis points to 54. The implied yield on 3-month December '06 Eurodollars fell 9.5 basis points to 4.765%.

December 16 - Bloomberg (Mark Pittman and Caroline Salas): "Hertz Corp., the car rental company being acquired in a leveraged buyout...led borrowers of $13.7 billion in the U.S. this week, pushing 2005 bond sales above last year's total. Hertz...sold $2.7 billion of debt yesterday, the second-largest junk bond offering this year... Corporate bond sales for the year climbed to $656 billion, compared with $639 billion in 2004, according to data compiled by Bloomberg. A record $675.7 billion of corporate bonds were sold in 2001."

Investment grade issuers included Goldman Sachs $1.6 billion, Lehman Brothers $1.5 billion, CIT $1.25 billion, ILFC Capital Trust $1.0 billion, Countrywide Financial $1.0 billion, Cardinal Health $500 million, American Honda Finance $500 million, BNFS Funding $500 million, Genworth Global $300 million, Brandywine $300 million and United Dominion Realty $200 million.

Junk bond fund flows reversed, with outflows of $319 million this week. Junk bond issuers included Hertz $2.4 billion, CSC Holdings $1.0 billion, Omnicare $750 million, Centennial Communication $550 million, ZFS Finance $400 million, Hopson Development $350 million, CIT Group $300 million, Atlas Pipeline $250 million, Atlantic & Western $250 million, Spansion $250 million, Verasun Energy $210 million, Kimball Hill $200 million, Skilled Healthcare $200 million, Eurofresh $170 million, Block Communication $150 million and Pipe Acquisition $130 million.

Convert issues included Intel $1.4 billion, Omnicare $850 million and Ceradyne $110 million.

Foreign dollar debt issuers included Peru $1.25 billion, VTB Capital $1.0 billion, Landsbanki $500 million, Banco BMG $300 million, Advanced Agro Public $250 million, LPG International $250 million and Telecom Personal $240 million.

Japanese 10-year JGB yields fell 3 basis points this week to 1.525%. Emerging debt and equity markets continue to cruise into year-end with spectacular gains. Brazil's benchmark dollar bond yields declined 8 basis points to only 7.16%. Brazil's Bovespa equity index added 1%, with a y-t-d gain of 27%. The Mexican Bolsa jumped 3% to another record, with 2005 gains rising to 37%. Mexican govt. yields dropped 8 basis points to 5.48%. Russian 10-year dollar Eurobond yields were unchanged at 6.49%. The Russian RTS equity index gained 1.6%, increasing y-t-d gains to 79%.

Freddie Mac posted 30-year fixed mortgage rates dipped 2 basis points to 6.30%, an increase of 62 basis points from one year ago. Fifteen-year fixed mortgage rates were down 2 basis points to 5.85%, yet were up 74 basis points in a year. One-year adjustable rates declined one basis point to 5.16%, an increase of 97 basis points from one year ago. The Mortgage Bankers Association Purchase Applications Index declined 3.5% last week. Purchase Applications were down 1.5% from one year ago, while dollar volume was up 2.3%. Refi applications sank 9.7% to the lowest level since June 2004. The average new Purchase mortgage dropped to $235,500, and the average ARM sank to $344,900. The percentage of ARMs rose to 33.5% of total applications.

Broad money supply (M3) added $1.1 billion (week of December 5) to a record $10.12 Trillion. Over the past 29 weeks, M3 has inflated $495 billion, or 9.2% annualized. Year-to-date, M3 has expanded at a 7.2% rate, with M3-less Money Funds expanding at an 8.2% pace. For the week, Currency slipped $0.6 billion. Demand & Checkable Deposits declined $13.9 billion. Savings Deposits surged $27.8 billion. Small Denominated Deposits gained $2.1 billion. Retail Money Fund deposits fell $3.3 billion, and Institutional Money Fund deposits declined $7.1 billion. Large Denominated Deposits rose $4.9 billion. Year-to-date, Large Deposits are up $262 billion, or 25.8% annualized. For the week, Repurchase Agreements fell $12.4 billion, while Eurodollar deposits gained $3.4 billion.

Bank Credit jumped $30.8 billion last week to $7.467 Trillion, largely recovering last week's decline. Year-to-date, Bank Credit has inflated $703 billion, or 11.0% annualized. Securities Credit added $0.3 billion during the week, with a year-to-date gain of $138.4 billion (7.7% ann.). Loans & Leases have expanded at a 12.6% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 14.9%. For the week, C&I loans added $2.7 billion, and Real Estate loans jumped $14.6 billion. Real Estate loans have expanded at a 14.7% rate during the first 49 weeks of 2005 to $2.894 Trillion. For the week, Consumer loans dipped $0.6 billion, while Securities loans rose $8.3 billion. Other loans increased $5.4 billion.

Total Commercial Paper dropped $26.5 billion last week to $1.627 Trillion. Total CP has expanded $212.8 billion y-t-d, a rate of 15.7% (up 16.4% over the past 52 weeks). Financial CP fell $18.6 billion last week to $1.482 Trillion, with a y-t-d gain of $197.6 billion, or 16% annualized. Non-financial CP declined $7.9 billion to $144.8 billion (up 12.3% annualized y-t-d).

ABS issuance remained a robust $25 billion last week, including $18 billon Home Equity ABS (from JPMorgan). Year-to-date issuance of $775 billion is 26% ahead of comparable 2004. Home Equity Loan ABS issuance of $505 billion is 24% above comparable 2004.

Fed Foreign Holdings of Treasury, Agency Debt declined $0.89 billion to $1.510 Trillion for the week ended December 14. "Custody" holdings are up $174.7 billion y-t-d, or 13.6% annualized. Federal Reserve Credit fell $2.0 billion to $811.6 billion. Fed Credit has expanded 2.8% annualized y-t-d.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $528 billion, or 15.1%, over the past 12 months to a record $4.035 Trillion. Mexico's reserves were up 10.6% over the past year to $67.0 billion.

Currency Watch:

The dollar index fell 1.7% this week to a 6-week low. On the upside, the Japanese yen gained 4.3%, the Hungarian forint 3.0%, the Iceland krona 2.9%, and the Indian rupee 2.0%. On the downside, the Brazil real fell 3.6%, the Indonesian rupiah 2.0%, the New Zealand dollar 1.8%, and the Argentine peso 0.9%.

Commodities Watch:

December 13 - Bloomberg (Meggan Richard and Anuchit Nguyen): "Rubber prices may reach the highest in 21 years as violence in Thailand prevents the world's biggest supplier from meeting China's surging demand. Plantation owners in Thailand, which supplies 38 percent of the world's rubber, are being hampered by fighting between police and Muslim activists seeking a separate Islamic state in the 90 percent Buddhist country."

December 13 - PRNewswire: "CME, the world's largest and most diverse financial exchange, announced today that on Friday, December 9 it surpassed one billion contracts... Year to date, CME has traded 1 billion contracts, an increase of more than 32 percent from this time last year."

January crude oil fell $1.33 to $58.06. January Unleaded Gasoline declined 3.2%, and January Natural Gas ended the week down 4.6%. For the week, the CRB index dipped 0.4%, reducing y-t-d gains of 14.9%. The Goldman Sachs Commodities index fell 1.1%, with 2005 gains declining to 39.8%.

China Watch:

December 14 - Financial Times (Richard McGregor): "China is poised to announce its economy is significantly larger than the government's official measure following a national economic census which found a large underestimation of the country's thriving and largely private services sector. The revision is also expected to show the economy is less reliant on investment and more driven by consumption than previously projected, two trends that Chinese leaders have been trying to encourage."

December 15 - Market News International: "The latest raft of Chinese economic data offered little evidence to support expectations of a widely forecast slowdown, with production and investment data if anything showing signs of reacceleration. ....[F]ixed-asset investment - one of the government's most closely watched indicators - grew 27.8% in the January to November period, gathering speed from the 27.6% recorded during the first ten months. 'Growth momentum remains strong - there's no sign of slowdown,' said Qu Hongbin, an economist with HSBC in Hong Kong. 'Things are definitely not slowing.'"

December 13 - Bloomberg (Nerys Avery): "China's industrial production rose in November at the fastest pace in five months, a larger-than-forecast increase that may swell inventories and cause price declines for manufacturers. The 16.6 percent gain was higher than the 16.1 percent recorded in October..."

December 12 - Bloomberg (Nerys Avery): "China's money supply expanded at the fastest pace in almost two years in November, the central bank said. M2, which includes cash and all deposits, grew 18.3 percent from a year earlier after expanding 18 percent in October... That's the biggest gain since March 2004..."

December 14 - Bloomberg (Nerys Avery): "China's retail sales rose 12.4 percent in November as higher incomes spurred spending... Sales increased to a record 591 billion yuan ($73.2 billion) after gaining 12.8 percent in October, the Beijing-based National Bureau of Statistics said in an e-mailed statement. Growth has stayed between 12 percent and 13 percent for eight straight months."

December 12 - Bloomberg (Simon Kennedy): "China has overtaken the U.S. as the biggest exporter of information-technology products, the Organization for Economic Cooperation and Development said. China last year exported $180 billion of goods such as digital cameras and laptop computers, compared with $149 billion from the U.S...."

Asia Boom Watch:

December 14 - Bloomberg (Mayumi Otsuma and David Tweed): "Business confidence in Japan rose to the highest in a year and companies plan to increase investment at the fastest pace since the bubble economy burst in 1990... The Bank of Japan said today its Tankan index of confidence among large manufacturers climbed to 21 in the fourth quarter from 19 in the third. The index for non-manufacturers such as retailers and developers rose to 17, the highest in 13 years."

December 14 - XFN: "Department store sales in Tokyo rose 4.3% in November from a year earlier to Y172.7 bln, the Japan Department Stores Association said. That was the biggest year-on-year increase since September 2000 when sales rose by 5.4%, the association said."

December 12 - Bloomberg (Kartik Goyal and Cherian Thomas): "India's industry grew in October at the fastest pace in four months as rising incomes and consumer borrowing spurred sales... Production at factories, utilities and mines increased 8.5 percent from a year earlier after expanding a revised 6.9 percent in September..."

December 15 - Bloomberg (Seyoon Kim): "South Korea's jobless rate fell to an eight-month low in November, adding to expectations that growth in Asia's third-largest economy may accelerate. The seasonally adjusted unemployment rate dropped to 3.6 percent after falling to 3.9 percent in October..."

December 15 - Bloomberg (Chan Sue Ling): "Singapore's retail sales grew in October at the fastest pace in six months as shoppers stocked up ahead of festivals and cheaper car prices lured buyers. The 10.2 percent increase from a year earlier..."

Unbalanced Global Economy Watch:

December 14 - Bloomberg (Peter Woodifield): "London's most expensive homes appreciated at their fastest rate in at least two years, driven by a shortage of properties and bankers anticipating bigger bonuses, Knight Frank LLP said. The average price of flats costing more than 1.5 million pounds ($2.7 million) and houses priced at 3 million pounds or more rose 1.3 percent last month. Prices were up 7 percent at the end of November from a year ago..."

December 16 - Bloomberg (Matthew Brockett): "Business confidence in Germany, Europe's largest economy, rose to the highest in more than five years in December as export-driven growth fueled spending at home."

December 15 - Bloomberg (Jonas Bergman): "Swedish unemployment in November fell for the fourth month in five as companies increased hiring amid rising foreign and domestic demand for Swedish goods and as the government spends more on training programs. The rate fell to 5.0 percent...from 5.6 percent in October..."

December 14 - Bloomberg (Bradley Cook): "Russia's economy grew an annual 7 percent in the third quarter, the fastest pace for a year, led by retailers and construction companies. The retail and wholesale industries expanded 12 percent, compared with the year-ago period."

December 14 - Bloomberg (Bradley Cook): "Russia will have a budget surplus of between 7 percent and 8 percent of gross domestic product this year, Finance Minister Alexei Kudrin said today, Interfax reported."

December 12 - Bloomberg (Ayla Jean Yackley): "Turkey's economic growth accelerated to an annual 7 percent in the third quarter, the fastest pace this year as a boom in the construction industry and corporate investment spurred growth. The economy expanded for the 15th consecutive quarter, accelerating from growth of 4.2 percent..."

Latin America Watch:

December 13 - Dow Jones (Claudia Assis): "Until recently, most low-income Mexicans trod only one path to home ownership bliss: Sweat equity. They built their own homes brick by brick, the result of years of scraping together to afford a concrete foundation, then four walls, then a roof. Now, a burgeoning mortgage-backed securities market is giving Mexico other ways to build houses for the lower and middle classes, and showing investors another door to Latin America's second-largest economy. 'You have a huge demand for housing in Mexico, and it is still a hugely unattended market. With the capital markets, you have an enormous pool of money available to fuel it,' said Mark Zaltzman, chief financial officer at mortgage bank Su Casita."

December 16 - Bloomberg (Patrick Harrington): "Mexico's unemployment rate fell more than-expected in November from the previous month as surging automobile production spurred hiring. Mexico's jobless rate in November fell to 2.99 percent from 3.57 percent in October..."

December 14 - Bloomberg (Romina Nicaretta and Andrew J. Barden): "Brazil's stock market rally and expanding economy are fueling a boom in the construction of luxury apartments in Sao Paulo. Sales of high-priced units, some with as many as 17 underground parking spots, jumped 76 percent to 6,300 in the past two years... Brazil's largest residential complex, scheduled to open in 2007, will include 120 stores, a helicopter pad and a spa bigger than a football field. Half its 150 apartments already sold at prices that range from 1.5 million reais ($681,447) to 10 million reais. 'Some segments of the society are making a fortune,' Carlos Daniel Coradi, president of bank industry consultant Engenheiros Financeiros & Consultores said in an interview in Sao Paulo."

December 13 - Bloomberg (Carlos Caminada and Romina Nicaretta): "Brazil, tapping into a surge in its foreign reserves, will pay back before year-end the remaining $15.5 billion it owes the International Monetary Fund. The central bank was scheduled to make the payments in 2006 and 2007 and will save $900 million in interest costs by paying ahead of schedule..."

December 14 - Bloomberg (Simon Casey): "Chile, the world's largest copper-producing nation, will increase its mineral exports this year by 28 percent to $21.5 billion after prices for the metal used in wiring and pipes reached a record."

December 15 - Bloomberg (Alex Emery): "Peru's economy expanded 7.2 percent in the 12 months though October compared to the same period a year ago, led by mining and construction."

December 14 - Bloomberg (Andrea Jaramillo): "Colombia's imports rose 18 percent in October from a year earlier, boosted by sales of electronic appliances and car and car parts. Imports rose to $1.71 billion in October..."

Bubble Economy Watch:

December 13 - Bloomberg (Kevin Carmichael): "The U.S. government reported the widest November budget deficit ever, led by a jump in spending for reconstruction after the hurricanes... The deficit expanded to $83.1 billion compared with a shortfall of $57.9 billion in November 2004, the U.S. Treasury said in Washington today. Spending rose 15.3 percent to $221.9 billion and revenue rose 3.2 percent to $138.8 billion. Both figures also were November records, the Treasury said."

December 13 - Bloomberg (Steve Matthews): "Construction companies plan to hire workers at the fastest pace in 27 years as they rebuild areas devastated by hurricanes and benefit from a strong economy in Western states, according to a quarterly survey by Manpower Inc. The net employment outlook for construction was 29, the highest since the third quarter of 1978..."

December 14 - Bloomberg (Steve Matthews): "More than half of U.S. chief executive officers said they plan to increase capital spending during the next six months as their outlook for the economy improves after Hurricane Katrina... An index measuring the CEOs' outlook rose to 101.4, the second-highest level since the survey started in 2002, from 88.2 in September following Katrina, according to a report...by the Business Roundtable in Washington... The survey showed 56 percent of executives expect their companies to increase capital spending in the next six months. U.S. businesses are sitting on a mountain of cash that can be tapped to propel investment in new equipment next year..."

December 16 - Bloomberg (Kristy McKeaney): "U.S. spending on Visa brand cards rose last week compared with the same week last year... In the week ending Dec. 11 purchases with Visa debit and credit cards rose 15.1 percent to $30.789 billion compared with the same week last year."

Speculator Watch:

December 16 - Dow Jones (Steven Vames): "In just a few days, the global markets most popular carry trades have gone from being 'hot' to being a 'hot potato.' For investors involved in carry trades - borrowing money in low interest-rate currencies, switching into high-rate currencies, and pocketing the rate difference - the past few days have been nothing short of a rout due to currency movements. It's been particularly bad because the yen, the mother of all borrowing currencies due to near-zero interest rates and high liquidity, has staged such a massive rally. That creates losses for those who have borrowed yen and switched to other currencies, because they then need more of the other currencies to switch back to yen and pay back their loans. Evidence of the unwinding of carry trades has been seen not just with the rally in the yen and other low-rate currencies such as the Swiss franc, but also by concurrent selloffs in higher-yielding currencies such as the New Zealand and Australian dollars, the Brazilian real, and even the U.S. dollar."

"Project Energy" Watch:

December 14 - Financial Times (Thomas Catan: "Royal Dutch Shell yesterday raised its annual spending forecast by 27 per cent to $19bn (£10.8bn), citing increasing costs and the need to find new oil and gas reserves. Europe's second largest oil company will next year invest at least $4bn more than previously envisaged and said it was likely to keep spending at that level for several years. Shell's increase in expenditure comes as the industry looks to plough more of its record profits into finding and producing oil and gas."

December 14 - Bloomberg (Sonja Franklin): "EnCana Corp., Canada' biggest natural-gas producer, hired U.K. architect Norman Foster to design its new headquarters in downtown Calgary. London-based Foster and Partners was picked last week as the lead architect for the twin 60-story buildings... The proposed complex will be the largest office tower west of Toronto and Canada's highest since the 68-story Scotia Plaza was built in Toronto 17 years ago... The Calgary Herald today cited unidentified officials who put the cost at C$540 million ($469 million)."

Mortgage Finance Bubble Watch:

December 16 - LA Daily News (Gregory J. Wilcox): "The median price of a Southern California home hit a record $479,000 in November and sales remained near all-time peak levels... Continued strong demand and concern that mortgage rates will keep moving up drove the market, said the analysis from...DataQuick... The November median price, the point at which half the homes cost more and half less, increased an annual 15.4 percent. Prices moved up in all six Southern California counties, with the gains ranging from a high of 23.2 percent in San Bernardino County to a low of 6.4 percent in San Diego County. Price records were set in Los Angeles, Ventura and Riverside counties. Riverside County's median price passed $400,000 for the first time, settling at $405,000. DataQuick's...John Karevoll said the record prices were surprising this late in the year and reflected robust new home-buying activity."

December 13 - Dow Jones: "The National Association of Realtors expects sales of new and existing U.S. homes to drop to "high plateau" levels in 2006, while home prices continue to rise. Existing home sales, expected to rise 4.7% to a record 7.10 million this year, are projected to fall 3.7% in 2006 to 6.84 million, the second-biggest figure on record, the NAR said Monday. The realtors' group foresees a similar trend for new homes, with sales projected to drop 4.8% next year to 1.23 million, also the second-biggest number on record. 'Home sales are coming down from a mountain peak, but they will level out at a high plateau - a plateau that is higher than previous peaks in the housing cycle,' NAR Chief Economist David Lereah said. 'This transition to a more normal and balanced market is a good thing.' Housing construction is also expected to fall back after reaching this year the highest point since 1972."

Most Unfavorable of Legacies:

"Goldman Sachs achieved its best annual results in 2005, generating record net revenues, net earnings, and diluted earnings per common share." Total Revenues jumped 45% from 2004 to $43.4 billion, with Interest Income up 78% to $21.25 billion. "The firm repurchased 63.7 million shares of its common stock at an average price of $111.57..., including 20.5 million...in the fourth quarter." "Investment Banking generated net revenues of $3.67 billion, its best annual performance in four years... Fixed Income, Currency and Commodities (FICC) generated record net revenues of $8.48 billion, 16% higher than the previous record. Equities generated record net revenues of $5.65 billion, 21% higher than 2004. Asset Management achieved record net revenues of $2.96 billion, 16% higher than the previous record... Securities Services achieved record revenues of $1.79 billion, 38% higher than the previous record set in 2004." Compensation & Benefits were up 51% y-o-y to $2.44 billion.

Lehman Brothers reported 4th quarter (11/30 yearend) Net Income of $823 million, up 41% from Q4 2004. Full year earnings were up 38% to $3.26 billion. The company "achieved record net revenues in every segment and in every region for the year." Net Income was up from 2004's $2.369 billion, 2003's $1.7 billion, 2002's $975 million, 2001's $1.255 billion and 2000's $1.831 billion. Record International revenues of $1.4 billion were 39% of total revenues. Asia revenues surged 46% over the past year to a record $534 million. Investment banking revenues jumped 34% y-o-y to a record $817 million. Mergers & acquisition backlog ended the year at $236 billion, compared to $73 billion to end 2004. Equity trading revenues of $740 million were the strongest since booming 2000. Fixed Income trading revenue of $1.6 billion was down 14% sequentially, but up 22% from the year ago quarter. Slower MBS and spread compression were blamed. 2005 Net Revenues increased 26% y-o-y to $14.63 billion, with Interest Income & Dividends up 73% to $19.04 billion. Total Assets expanded at a 27% rate to $410 billion. Total Assets were up 14.8% during the past year and 31.4% over two years. The company repurchased 14.1 million shares during the quarter.

Combined Goldman Sachs and Lehman Brothers profits have almost tripled (up 188%) since 2002, to $8.89 billion. It is little wonder that Wall Street absolutely loves the idea of Ben Bernanke and his obsession with deflation risks and abhorrence of deflating asset Bubbles. The AMEX Securities Broker/Dealer (XBD) index has surged 168% since Dr. Bernanke's October 2002 speech, "Asset Price 'Bubbles' and Monetary Policy." During Greenspan's watch, Securities Broker/Dealer Assets ballooned from 1988's $136 billion to September 30th's $2.105 Trillion. Broker/Dealer Assets are up 58% since the end of 2002 (11 quarters), and are on pace to balloon a record $350 billion this year. To put this number into some perspective, Broker/Dealer Assets expanded $412 billion during the first 10 years of Greenspan's chairmanship. The XBD index is up 29% y-t-d.

We live in an extraordinary period. This experience is certainly providing even greater appreciation for the power of asset inflations and booms to captivate society and beguile policymakers. To be sure, Credit Bubbles must absolutely be reined in as early as possible - before the risk of popping them becomes more than policymakers can bear. Amazingly, the historic windfall profits being lavished on Wall Street and the energy sector (among others) are trumpeted by the optimists, when they should be recognized as byproducts of pernicious Credit inflation and Dysfunctional Monetary Processes. The third quarter's 9.1% rate of non-financial debt growth and the 14% pace of household mortgage Credit expansion garner virtually no attention from the economic or analytical community. And $200 billion quarterly Current Account Deficits are now promulgated as proof of our robust economy outpacing our feeble trading partners. The well-oiled and inspirited propaganda machine functions superbly from Wall Street to Washington D.C.

When it comes to masterful propaganda, none compare to our departing Federal Reserve chairman. His recent speech, "International Imbalances," is one of the most convoluted and disingenuous analyses he has delivered in his almost 18-year tenure - and, of course, no one calls him on it. Our massive Current Account Deficit and our Untenable Foreign Debts are the greatest danger to the well-being of our society over the coming years. We should demand of him a discussion of these most important topics in language assessable to ordinary citizens and politicians. Not unpredictably, Mr. Greenspan has devoted great resources to concocting sophisticated justifications and rationalizations that place his Most Unfavorable of Legacies in doctored favorable light.

A lengthy book should be written exploring Mr. Greenspan's 'analyses' of the U.S. Current Account and other imbalances. It really is the greatest work from the Master Obfuscator, deserving of considerably more time than I have this Friday afternoon and evening.

From chairman Greenspan: "The rise of the U.S. current account deficit over the past decade appears to have coincided with a pronounced new phase of globalization that is characterized by a major acceleration in U.S. productivity growth and the decline in what economists call home bias... The decline in home bias is reflected in savers increasingly reaching across national borders to invest in foreign assets. The rise in U.S. productivity growth attracted much of those savings toward investments in the United States..."

"What is special about the past decade is that the decline in home bias, along with the rise in U.S. productivity growth and the rise in the dollar, has engendered a large increase by U.S. residents in purchases of goods and services from foreign producers. The increased purchases have been willingly financed by foreign investors with implications that are not as yet clear."

The Current Account Deficit is foremost the consequence of ultra-loose monetary conditions, uninhibited asset-based lending and resulting asset inflation, over-consumption, domestic mal-investment, and unprecedented global (especially Asian) investment in manufacturing capacity. Contemporary Wall Street finance/intermediation; the explosion of the global leveraged speculating community; mushrooming derivatives markets; and ballooning global central bank dollar securities holdings have all played critical roles in ensuring a smooth and continuous recycling of escalating global dollar flows right back to booming U.S. securities markets. Not coincidently, none of these factors sees the light of day in Mr. Greenspan's artful promulgation.

If productivity growth has been so phenomenal over an extended period, why then is our economy hopelessly incapable of satisfying domestic demand? And his newfound focus on "home bias" needlessly clouds the issue. The notion of some 'vast international savings transfer to finance U.S. investment" is delusional, at best. The U.S. Credit Bubble, with resulting Current Account Deficits, is the predominant creator of global liquidity and not an absorber or international 'savings.' The dynamic process of a Global Liquidity Glut is one of massive trade imbalances, unprecedented global Credit creation, aggressive financial intermediation and leveraged speculation. Why does Mr. Greenspan avoid the issue of dollar accumulation by the global leveraged speculating community, and why is there no effort by the Fed to identify the holders of the now $10.7 Trillion of U.S. financial assets held by "Rest of World?" He notes that "At some point, foreign investors will balk at a growing concentration of claims against U.S. residents." In reality, the nearer term risk is a reversal of speculative flows by global speculators and a bout of Risk Aversion to the unfathomable amount of dollar claims issued or guaranteed by the U.S. financial sector (certainly including the banks, broker/dealers, GSE, MBS, ABS, the "repo" market, Wall Street "structured finance," and derivatives).

From the Clever Theorist: "Were we to measure current account balances of much smaller geographic divisions, such as American states...the trends in these measures and their seeming implications could be quite different than those extracted from the conventional national measures of the current account balance."

"Increasing specialization goes back to the beginnings of the Industrial Revolution. Movement away from economic self-sufficiency of individuals and nations arose from the division of labor, a process that continually subdivides tasks, creating ever-deeper levels of specialization and improved productivity. Such specialization fosters trade. Trade, especially intertemporal trade--that is, the trade of goods and services today in exchange for goods and services at some future date--tends to give rise to a range of surpluses and deficits across individuals and nonfinancial businesses... As a result, the dispersion of such imbalances relative to incomes, or national product, can be expected to increase as the scope of trade expands from within regions, then nation-wide, and finally across national borders."

To downplay the seriousness of our untenable Current Account, Mr. Greenspan often invokes the analysis of the irrelevance of trade deficits between individual U.S. states. I want to explore this area of analysis, using the Economic Sphere and Financial Sphere framework. The free market trade of goods/services between individual states/nations offers great (Economic Sphere) specialization and division of labor benefits. Trade between national economies, however, involves major departures from interstate trade, departures that have a most prominent (although not easily discerned) Financial Sphere component. Of course, nations have different currencies, although New Economy proponents would have us believe that contemporary derivative markets have greatly lowered the cost of hedging currency risks. Much less straightforward, individual nations have differing financial systems, Credit mechanisms and instruments, traditions of financial intermediation, and mores of policy intervention/central banker activism.

Imagine trade between Oregon and California. At the outset, Oregonians trade salmon, lumber and apples to Californians for their avocados, lettuce and wine. Everyone is better off and satisfied with the mutually-beneficial relationship. Over time, however, the Californians begin to pay for Oregon-produced goods with financial claims/IOUs ("intertemporal trade"). Since California's claims have traditionally functioned both as "money" to consummate large transactions throughout the region and as a store of wealth/value ("reserve currency"), they are readily accepted by Oregon producers. These exporters easily exchange their IOUs for Oregon "currency" at their local banks (these institutions issuing new claims - liabilities - and taking possession of the California IOUs - assets, expanding their balance sheets in the process). The Oregon economy enjoys the added purchasing power that trade finance has rendered.

Meanwhile, the California economy benefits as its claims are remitted back to the state for the purchase of goods, houses, or perhaps to be deposited at local banks where these new funds immediately create purchasing power to be lent for buying consumer goods, capital equipment or property. The more the California banking system lends, the greater the funds individual state banks receive as incoming deposits and then loan (claims inflation). Instead of California's mounting trade deficit draining liquidity as one might presume, the rising funding requirements of "intertemporal" trade ensure self-reinforcing Financial Sphere inflation and consequent system liquidity excess.

Importantly, California's lending institutions have demonstrated a long history of growth and solvency. State policymakers have repeatedly intervened to guarantee a constant flow of new Credit creation, safeguarding robust financial markets and economic expansion. As such, the state commands a decided competitive advantage when it comes to issuing perceived safe and liquid ("money"-like) financial claims and, hence, an advantage in operating liquid markets with active outside participation. Unless restrained by policymakers or by some mechanism to limit monetary expansion, the financial and regulatory backdrop will foster a proclivity for progressive over-issuance. This dynamic will only be reinforced over time by the continued expansion of economic output and rising home prices. The broad and highly liquid markets that evolve to trade and intermediate myriad California claims will only fortify Golden State hegemony. Over time, the monetary expansion turns powerfully self-sustaining. The booming economy and rising home prices stimulate only greater "intertemporal" trade, resulting in additional inflation in both California's and its trading partners' financial claims. In particular, rising asset prices incite heightened demand for and the supply of Credit.

The monetary inflation associated with "intertermporal trade" will foster subtle yet profound financial and economic distortions, gaining momentum over time. The structure of the California boom-time economy will become increasingly maladjusted as its lenders and borrowers gravitate toward housing and speculating on ongoing asset inflation, while spending patterns are altered by Credit-induced "wealth creation." Specialty asset lenders and leveraged speculators flourish, while asset-based finance evolves into the predominant source of liquidity for both the Financial and Economic Spheres. All the while, the economy relies increasingly on imports from Oregon and elsewhere (other states become eager to exchange goods for the hot Golden State IOUs) to satisfy demand.

Deep structural economic maladjustment is fomented by both protracted boom-time investment and consumption distortions. Trade, mortgage and asset lending profits boom, while Credit excesses lavish "cash flow" on businesses throughout (and the state coffer). The general backdrop encourages more lenders and more aggressive lending and speculating, and a corrosive breakdown in market pricing mechanisms. Resources - both real and financial - are poorly allocated. Housing inflation increasingly spreads to other asset markets, although boom-time "core" prices are held in check by imports and the expanding supply and demand for services and luxury goods (and new technologies).

Importantly, California financial institutions - self-appointed governors of the expanding "global" pool of California IOUs - expand exponentially, in the process growing more financially and politically powerful. A prospering California becomes asset market and speculation-centric, as well as totally dependent on imports and, importantly, on unending claims inflation. The Oregon economy booms and this expanding Bubble spreads to neighboring Washington and Idaho. Banks throughout the region emulate California lending practices, and the speculative fever spreads like wildfire. Nothing motivates like watching your neighbor get rich.

The Oregon and California economies become increasingly interdependent and, most importantly, hooked on unending monetary (claims) inflation. Superficially, both respective booms may appear sound. And, certainly, the unusual arrangements coupled with rising financial wealth offer much for the exuberant New Paradigm crowd. Some fundamental aspects of the boom are too easily disregarded. First, the "global" system becomes dependent upon increasing and unending Credit creation, a fragility that is unmercifully masked throughout the life of the boom. Second, the Financial Sphere becomes hooked on rising asset prices, fragility that is similarly hidden until it's much too late. And third, California will inevitably fail to honor its outstanding claims - the nature of the Financial Sphere inflation guaranteeing that the inflation of spurious claims (in particular, boom-time inflated asset prices, malinvestment and fraud) escalates concurrently with waning productive investment (especially in the context of a post-boom environment). And while the unsustainable nature of the California claims Bubble may appear increasingly conspicuous, the reality that fortunes are being made in short order will prove especially enticing during the late-stage blow-off period.

I sincerely apologize for these analytical ramblings. But when I read Greenspan and Bernanke I become quite frustrated by what I believe is convoluted and dangerously suspect analysis. Mr. Greenspan states that "being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset," when it should be clear by now that markets are demonstrating greater propensity for self-reinforcing excess than necessary adjustment or self-correction. Mr. Greenspan ends his "Imbalances" speech warning of the dangers of federal deficits and protectionism. Yet these are predictable Credit Bubble outcomes emanating from inflationary distortions and wealth redistributions that his policies have cultivated.

And from Greg Ip's (Dec. 7) Wall Street Journal article, "Long Study of Great Depression Has Shaped Bernanke's Views:" "The lessons of Fed bubble-pricking in the 1920s and the Bank of Japan's in the 1980 is that 'asset price crashes have done sustained damage' only when the central bank failed to respond, or 'actively reinforced deflationary pressures.' Mr. Greenspan had reached the same conclusion."

Well, I don't buy it for a moment and furthermore am aware of no historical episode of a major Credit Bubble not ending in some degree of problematic collapse. It is becoming increasingly incontrovertible that the Greenspan/Bernanke "post-Bubble" view and policy prescriptions have been disastrously misguided. They have instead been actively reinforcing ongoing Credit Bubble inflationary forces. And the sad irony is that they have assured just the type of major monetary system breakdown Professor Bernanke has spent his career convincing himself and others that an aggressive Fed could avoid.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
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