By Doug Noland at the Credit Bubble Bulletin
In a tiny subsection of the analytical world, analysis is becoming more pointed and poignant. I appreciate Bill Gross’s August commentary, where he concluded: “Say a little prayer that the BIS, yours truly, and a growing cast of contrarians, such as Jim Bianco and CNBC’s Rick Santelli, can convince the establishment that their world has changed.”
I’ll include the names Russell Napier, Albert Edwards and David Stockman as serious analysts whose views are especially pertinent. I presume each will exert minimal effect on “the establishment.”
Back to Bill Gross: “The BIS emphatically avers that there are substantial medium term costs of ‘persistent ultra-low interest rates’. Such rates they claim, ‘sap banks’ interest margins...cause pervasive mispricing in financial markets...threaten the solvency of insurance companies and pension funds...and as a result test technical, economic, legal and even political boundaries.’ ‘…The reason [the Fed will commence rate increases] will be that the central bankers that are charged with leading the global financial markets – the Fed and the BOE for now – are wising up; that the Taylor rule and any other standard signal of monetary policy must now be discarded into the trash bin of history.”
Count me skeptical that central bankers are on the brink of “wising up.” These days I have less confidence in the Fed than ever. For one, they are hopelessly trapped in Bubbles of their own making. Sure, crashing commodities and bubbling stock markets incite a little belated rethink. Yet I’ve seen not a hint of indication that policymakers are about to discard flawed doctrine. Devising inflationary measures – clever and otherwise - will remain their fixation. For a long time now, I’ve identified inflationism as the root cause of precarious financial and economic dynamics that will end in disaster. It’s been painful to witness the worst-case scenario unfold before our eyes.
Ben Bernanke (and his cohorts and most of the economic community) believes much of the hardship from the Depression would have been averted had only the Fed aggressively printed money after the 1929 stock market crash. Modern-day inflationism rests on the premise that central banks (in a fiat world) can control a general price level. This view ensures that Credit and speculative Bubbles, while potentially problematic, are not to be overly feared. Discussion of mal-investment and economic imbalances is archaic and irrelevant. And somehow the view holds that Bubble risk pales in comparison to “The Scourge of Deflation.”
After all, central bankers can always reflate system Credit and spur a generalized inflation. Stated differently, it is believed that central bankers and their electronic printing presses have the power to inflate out of deflationary Credit and economic busts. And repeated bouts of reflationary policies over recent decades have seemingly confirmed the merit of conventional doctrine. It has evolved to the point where the primary issue is whether policymakers have the determination to reflate sufficiently.
The onus, I suppose, is on my analysis (and other “contrarians”) to convince readers that This Time Is Different. Especially over the past three years, unprecedented central bank “money” printing has corresponded with heightened disinflationary forces globally. As I note repeatedly, the upshot has been unprecedented divergence between inflating securities/asset market Bubbles and deflating fundamental economic prospects. This divergence was widened notably over recent weeks. The fact that egregious monetary inflation has been pulled to the heart of contemporary “money” and Credit – central bank Credit and sovereign debt – is as well fundamental to the “End is Nigh” Thesis.
The work of the great Hyman Minsky plays prominently throughout my analytical framework. In particular, I appreciate his keen focus on “financial evolution.” Over time, it is inherent in finance (i.e. Credit and markets) to gravitate from the cautious and stable to the aggressive and increasingly unstable. It’s human, Credit and market nature. Minsky’s “Financial Instability Hypothesis” and the late-stage “Ponzi Finance” dynamic are more pertinent today than ever.
Finance has evolved profoundly over the past thirty years. Evolution in central bank monetary management has been equally momentous. Over time, the increasingly unhinged global fiat financial “system” turned acutely unstable. The Fed, in particular, resorted to market intervention and nurturing non-bank Credit expansion in order to sustain booms, inflated asset markets and deep structural economic maladjustment. This required the Federal Reserve’s adoption of doctrine ensuring liquid and stable securities markets – a historic boon to leveraged speculation, the evolving (and highly leveraged) derivatives marketplace and securities prices generally.
Fed and global central bank backstops buttressed the historic expansion in market-based finance. The proliferation of interlinked global market Bubbles drove outrageous policy experimentation. In time, the resulting globalized Bubble in market-based finance and speculation ensured that bolstering securities markets developed into the chief priority for the Fed and fellow global central bankers and officials. Just look at the Chinese over recent weeks.
Long-time readers know I am particularly fond of the “Financial Sphere vs. Real Economic Sphere” framework. It is valuable to view these as two separate but interrelated “Spheres,” with contrasting supply/demand, price and behavioral dynamics. In simplest terms, throwing excess “money”/liquidity at these respective “Spheres” over an extended period will foster disparate dynamics and consequences. And, importantly, over recent decades the Fed and global central bank policies have gravitated toward increasingly desperate “Financial Sphere” intervention and manipulation. The crisis response to the 2008/2009 crisis and then again in 2012 were decisive.
From Russell Napier “Most investors still believe that we live in a fiat currency world. They believe central bankers can create as much money as they believe to be necessary. Such truths are on the front page of every newspaper, but they may contain just as much truth as the headlines of their tabloid cousins. A belief in this ability to create money is the biggest mistake in analysis ever identified by this analyst. The first reality it ignores is that money, the stuff that buys things and assets, is created by an expansion of commercial bank, and not central bank, balance sheets. The massively expanded central bank balance sheets have not lifted the growth in broad money in the developed world above tepid levels. Until that happens, developed world monetary policy must be regarded as tight and not easy.”
This is thoughtful and important analysis. I’ll approach it from my somewhat contrasting analytical framework. From CBB day one, I’ve tried to significantly broaden how we define and analyze “money” and so-called “money supply”. I draw from Mises’ “fiduciary media” and inclusion of financial instruments with the “functionality” of traditional narrow definitions of money supply (i.e. currency, central bank Credit and bank deposits). For me, the perception of a safe and liquid store of (nominal) value is critical.
Moneyness is a market perception. The epicenter of danger lies in “money’s” virtual insatiable demand. It is prone to over-issuance. There is a powerful proclivity for government intervention, manipulation and inflation. The perception of moneyness is, in the end in a world of fiat, self-destructive.
After the past almost seven years, I don’t question central banks’ capacity to create “money.” And my framework doesn’t ascribe special status and power to commercial bank “money” or balance sheets. Besides, U.S. M2 “money supply” has inflated about $2.5 TN in three years, or 20%. Over three years U.S. Commercial Bank Liabilities have inflated the same $2.5 TN, or almost 20%.
The past three years have witnessed historic “money” and Credit expansion on a global basis. The fundamental problem is that global central bank (and governmental) policies over 30 years have profoundly distorted and undermined market incentive structures. This issue is not insufficient “money” – central bank, bank or otherwise. Finance has, however, been incentivized to flow in excess chiefly into the Financial Sphere, where it enjoys comforting policymaker control and support. As global maladjustment and imbalances (which engender disinflationary pressures) mount, why invest in the Real Economy Sphere when it appears so much safer and easier to chase returns in inflating central bank-supported securities market booms?
Why would company managements not use abundant corporate cash flow to repurchase shares when waning returns make it increasingly difficult to justify Real Economy investment? Why proceed with major new investment plans when ultra-easy M&A finance favors acquisitions? Why not just join The Crowd throwing “money” at tech startups and biotech where real economic returns are irrelevant anyway? Why not just “invest” in ETFs shares that buy shares in companies that repurchase their shares? Better yet, why not invest in “safe” bond funds that invest in safe companies that safely borrow “money” to buy back their shares and make acquisitions? Above all, don’t just sit there in “money” that returns near zero when there’s been such a proliferation of “money-like” financial instruments and products with the promise decent yields and returns? You see, it’s just not a quantity of “money” issue.
This vein of analysis offers layers of progressive complexity. Financial Sphere Bubbles over time engender major structural maladjustment. Throughout equities and debt markets, Bubble Dynamics ensure liquidity flows in progressive excess to the hot asset classes, sectors and products. If the Fed, central banks or the Chinese government seek to underpin such dynamics, momentum will eventually climax with precarious Terminal Phase “blow off” excess. This played prominently in techland in the late-nineties, housing/consumption during the mortgage finance Bubble period, in commodities and EM in the post-2008/09 crisis “global reflation trade,” and more recently (most conspicuously) in tech and biotech.
I have argued that it is a perilous myth that central bankers these days control a general price level. They instead incentivize massive financial flows into securities markets and fashionable sectors. Over time, ramifications and consequences reach the profound. For one, excess liquidity promotes over/mal-investment. It’s only the scope and nature that remain in question.
If major Bubble flows inundate new technology investment, the resulting surge in the supply of high-margin products engenders disinflationary pressures elsewhere. Policy responses to perceived heightened “deflation” risks then only work to exacerbate Bubbles, mounting imbalances and structural fragilities. This was a critical facet of “Roaring Twenties” analysis that was lost in time.
Bubbles categorically redistribute and destroy wealth, and I will turn more optimistic when policymakers finally “wise up” to this harsh reality. On the one hand, progressively destabilizing Financial Sphere monetary disorder ensures deep economic maladjustment (i.e. excessive Bubble-related spending in tech, housing related, EM, commodities and China). On the other, serial securities and asset market booms and busts spur destabilizing wealth redistributions – a boon to some and economic hardship (boom and bust collateral damage) to many. Both work to foster economic stagnation – deep structural impairment impervious to central bank reflationary measures.
Reflationary policies and attendant inflated market Bubbles can hold the consequences at bay for a while. Importantly, resulting monetary disorder works to exacerbate both Financial Sphere and Real Economy Sphere maladjustment with potentially catastrophic consequences. Economists have traditionally debated “money illusion” (notably Irvine Fisher and JM Keynes). “Wealth illusion” is today more appropriate. The U.S. economic structure remains viable – these days the “envy of the world” - only so long as perceived wealth from securities markets remains grossly inflated. The consumption-based U.S. economy requires record household sector perceived wealth (inflated Household Net Worth). And this requires ongoing loose financial conditions, strong Credit growth and buoyant financial flows.
Because of the importance of the data, I wanted to circle back briefly to document key data released in last month’s Q1 2015 Z.1 “flow of funds” Credit report.
As a proxy for the “U.S. debt securities market,” I combine Fed data for outstanding Treasury, Agency, Corporate and muni debt securities. I then combine this with Total Equities to come to my proxy of the “Total Securities” markets. During Q1, Total Securities jumped $759bn to a record $73.195 TN. Total Securities as a percentage of GDP jumped five percentage points to a record 414%. For perspective, this ratio began the nineties at 183%, concluded 1999 at 356% and then rose to 371% to end 2007.
The value of U.S. Household (and non-profits) assets jumped $1.611 TN during Q1. By largest categories, Financial Assets jumped another $1.07 TN and Real Estate assets increased $500bn. And with Household Liabilities little changed for the quarter, Household Net Worth (assets minus liabilities) rose $1.6 TN to a record $84.925 TN. Over the past year, Household Net Worth inflated about $4.6 TN, with a two-year gain of $12.6 TN. Since the end of 2008, Household Net Worth has ballooned a stunning $28.4 TN, or 50%.
One cannot overstate the integral role the inflation in Household Net Worth has played in the Fed’s reflationary policymaking. Household Net Worth ended Q1 at a record 481% of GDP. This compares to 447% to end Bubble Year 1999 and 476% in Bubble Year 2007.
As was the case again during Q1, during the inflationary boom period, strong inflationary biases ensure that “wealth” increases a multiple of underlying Credit growth. This dynamic was on full display during both the tech and mortgage finance Bubble episodes. I recall being amazed at how $1 TN of mortgage Credit growth would fuel a $4.0 TN inflation in Household Net Worth. This “virtuous” dynamic turned vicious during the bust. The amount of new Credit required just to stabilize an inflated and maladjusted system becomes enormous.
There is now chatter of the Chinese government intervening in the stock market to the tune of $100bn in a single session. We’ve seen how, despite repeated bailouts and debt reductions, the Greek black hole grows only bigger. Meanwhile, with commodities in freefall, it was another ominous week for EM. And these examples provide apt reminders of inflationism’s biggest flaw: once commenced, it’s about impossible to rein in. I would add that “money” printing will never resolve the issue of structural maladjustment. Monetary inflation will, however, ensure only greater quantities of “money” will be required come the inevitable bust. And those quantities will eventually bring to question confidence in “money.” Read monetary history.