Mass Delusion and the Myth of Deleveraging
Prudent Bear''s Doug Noland marks the fifth anniversary of the collapse of Lehman Brothers -- and the near-collapse of the global financial system -- by asking whether the system''s flaws have been fixed.
Next Wednesday the Fed will reveal its much-anticipated "tapering" plans. Japan''s Nikkei news service Friday reported that the Administration "was set to name" Larry Summers to replace the retiring chairman Bernanke. And Sunday marks the five-year anniversary of the failure of Lehman Brothers. Well, it does seem "a good time to ponder how the U.S. economy was nearly brought to ruin" as well as an appropriate juncture to focus again on the role of monetary policy.
The following quote is from Alan Blinder, Princeton University professor and former vice-chairman of the Federal Reserve, writing in the Wall Street Journal, September 11, 2013:
"Next Sunday marks the fifth anniversary of the fateful day that investment bank Lehman Brothers filed for bankruptcy, signaling the start of a frightening financial meltdown. It''s a good time to ponder how the U.S. economy was nearly brought to ruin. But will we? Or are we already forgetting? Consider the stark historical contrast between the 1930s and this decade: Years of financial shenanigans in the 1920s, some illegal but many just immoral, conspired with a variety of other villains to bring on the Great Depression. Congress and President Roosevelt reacted strongly, virtually remaking the dysfunctional U.S. financial system, including establishing the Securities and Exchange Commission to protect investors, the Federal Deposit Insurance Corp. to protect bank depositors, and much else. The financial beast was comparatively tamed for almost 75 years. Years of disgraceful financial shenanigans in the 2000s, some illegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators...Far from being tamed, the financial beast has gotten its mojo back--and is winning. The people have forgotten--and are losing."
Blinder then laments the lack of reform in "mortgages and securitization," derivatives, the rating agencies and proprietary trading. "In sum, the Dodd-Frank Act is taking on water fast. What can be done to help Americans remember the horrors that led to its passage?"
With stock prices near all-time highs and home price inflation back on track, who is keen to "remember the horrors"? Why would anyone today be willing to upset the applecart? With Washington fiscal and monetary stimulus having reflated the asset markets, what limited appetite that existed for so-called "financial reform" has virtually disappeared. It would be laughable if it weren''t so maddening. The GSEs still completely dominate mortgage finance, which implies ongoing market distortions. They are basically as big - and as thinly capitalized - as ever. The nation''s goliath banks have grown only more dominant.
With the Fed such a massive buyer of Treasuries, there has been no market discipline imposed upon a spendthrift Washington. A more than doubling of outstanding federal debt in five years (issued at record low market yields) implies broad market distortions and economic maladjustment. At a record (ballpark) $2.4 TN in assets, the historic inflation of hedge fund industry assets runs unabated. This has propelled the number of billionaires, along with skyrocketing prices for art, collectibles and trophy properties. And at $632 TN (from BIS data), the global derivatives marketplace is as unfathomably monstrous as ever. As for the rating agencies, truth be told, they have little impact on the global Credit Bubble.
Mr. Blinder and others would like to believe that we''ve been persevering through a post-Bubble "Great Recession" with parallels to the Great Depression - but with, thankfully, the benefit of wonderfully enlightened policymaking. Former Treasury Secretary Hank Paulson, discussing the 2008 crisis during a Friday morning CNBC appearance, referred to a "massive Credit Bubble that went bust" - "a 100-year flood with excesses building for years and years."
At risk of sounding "lunatic fringe," the reality of the matter is we''re suffering these days from a period of mass delusion. U.S. and world GDP have never been greater. Fueled by record securities prices, U.S. household Net Worth stands today at a record level. U.S. total income in rather short order recovered from 2009''s modest decline. Real estate prices around much of the world are at or near record highs. Total outstanding Credit - in the U.S. and globally - is at a record high and inflating.
From a systemic standpoint, the notion of "de-leveraging" has been a myth. And for five years now unprecedented global imbalances have worsened. Chinese and EM Credit Bubbles and attendant Bubble economies have inflated to historic proportions. Indeed, there is a fine line between "frightening financial meltdown" and unleashing history''s greatest inflation of global securities prices. The only justification for the "100-year flood" thesis is wishful thinking.
To be sure, the backdrop has virtually nothing in common with the 1930s. As I''ve written previously, if one is searching for parallels, I would look to the 1920''s. Replaying errors at key junctures during the "Roaring Twenties," current monetary policymaking would be more appropriately focused on restraining Bubble excess. Instead, it''s the polar opposite approach with ongoing massive experimental inflationary measures.
I''m not a fan of Alan Blinder''s framework, and I am averse to historical revisionism: "The financial beast was comparatively tamed for almost 75 years. Years of disgraceful financial shenanigans in the 2000s, some illegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators."
Seeds for the 2008/09 crisis were being planted many years prior to the "shenanigans in the 2000s." Vulnerabilities associated with unbridled global Credit, "activist" monetary management and speculative excess go back to Greenspan''s aggressive post-1987 stock market crash reflationary measures. There were the resulting junk bond, M&A and real estate booms and busts that left a deeply impaired U.S. banking system in the early-nineties. There were the (post-reflation) bond market and derivative Bubbles that faltered in 1994. And we cannot forget the spectacular 1990s booms and busts in Mexico, SE Asia, Russia, Brazil and Argentina (to name only a few). The 1998 LTCM collapse exposed egregious leverage and derivative speculations. And then the decade concluded with a wild speculative Bubble in technology stocks and telecom debt. Somehow, in the face of increasingly apparent shortcomings, monetary policy became only more "activist" and experimental.
It''s not credible to look at "2000s" (mortgage finance Bubble) excesses in isolation. "No help from any co-conspirators"? Did not Bernanke''s "government printing press" and "helicopter money" monetary ideologies play prominently in the 2002-2007 doubling of mortgage debt? Clearly, loose "money" and monetary policy "activism" were fundamental to the previous 25-year period of serial booms and busts. And each bust provoked aggressive reflationary measures in the name of warding off the "scourge of deflation." Every reflationary cycle further emboldened and inflated the "global leveraged speculating community," a dynamic that ensured the scope of subsequent booms became bigger and more systemic. Has contemporary inflationist monetary policy not already proven itself immoral?
The most important unlearned lesson is that Federal Reserve (and global central bank) monetary inflation and market interventions carry great risks. For 25 years the Fed has repeatedly employed post-Bubble reflationary measures while inflating the greatest Credit Bubble in history. Back in the 1960s, it was said that Alan Greenspan associated the severity of the Great Depression with the Federal Reserve repeatedly placing "Coins in the Fusebox" throughout the Roaring Twenties Bubble period.
The latest talk is that the FOMC may be considering adding a lower bound inflation rate target to its list of factors for setting monetary policy. The experimental Fed last year employed the use of an unemployment rate target. So, the Fed could now perhaps state its intention of sticking with aggressive monetary accommodation so long as either unemployment is above a certain rate or inflation remained below a targeted level. The Fed continues its stroll down a very slippery slope.
This is just an excerpt from a longer article that should be read in its entirety. I left out a lot of good stuff to make this post manageable.
Noland gets it right: nothing was fixed after 2008, just as nothing was fixed after the housing, tech stock and junk bond bubbles burst. The response has been the same each time, only progressively more aggressive and experimental. That the financial, economic and political mainstream think that the system has been reset to "normal" because asset prices are back where they were just before the 2008 crash is, well, crazy. With financial imbalances bigger than ever before - and continuing to expand - the only possible outcome is an even bigger crash.
Each of the previous bubbles in this cycle have been unique so there''s no reason to expect this one to look like the others, but there is reason to believe that this one, centering on government bonds, will be more far-reaching when it bursts. The tech stock crash mainly impacted speculators, while the housing bust primarily hit the financial sector. But the bursting of the government bond bubble will push up interest rates, which means everyone''s cost of money will rise, maybe dramatically. And with about $400 trillion of interest rate swaps outstanding, sudden interest rate volatility will do to that part of the casino what the mortgage bust did to credit default swaps: blow it up.