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The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

Modern monetary theory has been…

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Faltering "Financial Sphere"


Heightened systemic risk has decidedly returned to global financial markets. For the week, the Dow dipped about 1% and the S&P500 declined slightly less than 1%. The Transports lost 1%, and the Morgan Stanley Consumer index was about unchanged. The Morgan Stanley Cyclical index and Utilities were hit for about 3%. The broader market was under pressure, with the small cap Russell 2000 and S&P400 Mid-cap indices down 2%. Technology stocks held their own, with the NASDAQ100 slightly positive and the Morgan Stanley High Tech index adding 1%. The Street.com Internet index gained 2% and the Semiconductors rose 3%. The NASDAQ Telecom index declined 1%. The Biotechs shed 3% for the week. Financial stocks were under pressure, with the Broker/Dealers dropping 3% and the Banks 2%. With bullion sinking $8.0, the HUI gold index dropped 5%.

The rout continues throughout interest-rate markets. Two-year Treasury yields shot 29 basis points higher to 2.61%. Five-year Treasury yields rose 32 basis points to 3.94%. Rising to the highest level since July 2002, 10-year yields jumped 26 basis points to 4.77%. The long-bond yield rose 18 basis points to 5.47%. Mortgage-backed securities are in the midst of aggressive liquidation, with benchmark Fannie Mae MBS surging 36 basis points (highest since July 2002). The spread on Fannie MBS has widened 17 basis points (to 10-year Treasuries) over the past three weeks. The 10-year dollar swap spread increased 7 basis points this week to almost 55, the widest since last August. Agency, corporate and junk spreads all widened against Treasuries this week. The implied yield on December 3-month Eurodollars jumped 34.5 basis points to 2.545%.

Bloomberg tallied a slow $5.5 billion of corporate issuance this week, as systemic stress become more acute. Investment Grade Issuers included ABN Amro $1 billion, Goldman Sachs $835 billion, PepsiCo $500 million, Zions Bancorp $300 million and Interstate P&L $100 million.

Junk issuance included Labranche & Co. $460 million, AMR Real Estate $350 million, Polypore $225 million, Primedia $175 million, Witing Petroleum $150 million, and Itron $125 million.

Convert issuance included Imclone Systems $600 million, Cooper Cameron $230 million, Land America $125 million, Oscient Pharmaceuticals $125 million, Cap Auto REIT $100 million, Palm Harbor $65 million and CTS $60 million.

Foreign dollar debt issuers included Rhodia SA at $650 million.

Panic took over in some key emerging debt markets today. Brazilian benchmark bond yields surged 158 basis points to 12.85%, with yields up more than 200 basis points for the week. Russian 10-year Eurobond yields jumped 50 basis points today to 6.95%, with a 2-week rise of 106 basis points. Mexican bond yields were up 46 basis points for the day and 71 for the week to 6.61%.

Freddie Mac posted 30-year fixed mortgage rates jumped another 11 basis points this week to 6.12%. Long-term fixed rates were up 72 basis points in six weeks to the highest level since the week of September 12. For the week, 15-year fixed-rate mortgage rates rose 12 basis points to 5.47% (up 77 bps in 6 weeks). One-year adjustable-rate mortgages could be had at 3.76%, up only 1 basis points for the week (up 40 bps in six weeks). The Mortgage Bankers Association Purchase application index rose 4% last week. Purchase applications were up 16% y-o-y, with dollar volume up 29%. Refi applications gained almost 5%. The average Purchase mortgage was for $218,700, and the average ARM was for $282,200. ARMs accounted for 32.1% of applications last week.

Broad money supply (M3) jumped $45.4 billion. Year-to-date (17 weeks), broad money is up $290.6 billion, or 10.1% annualized. For the week, Currency increased $1.0 billion to $669.9 billion. Demand & Checkable Deposits billion surged $25.7 billion. Savings Deposits billion dipped $3.4 billion. Saving Deposits have increased $179.0 billion so far in 2004 (17.3% annualized rate). Small Denominated Deposits declined $1.5 billion. Retail Money Fund deposits gained $4.3 billion. Institutional Money Fund deposits rose $6.1 billion and Large Denominated Deposits gained $6.8 billion. Repurchase Agreements increased $3.9 billion, and Eurodollar deposits added $2.4 billion.

Total Bank Credit dipped $1.8 billion to $6.515 Trillion (week of April 28). Bank Credit is up $269.5 billion during the first 17 weeks of the year, or %13.2 annualized. For the week, Securities holdings increased $2.2 billion. Loans & Leases $ billion declined $4.0 billion, with Real Estate loans about unchanged. Real Estate loans are up $129 billion y-t-d, or 17.8% annualized. For the week, Commercial & Industrial loans rose $6.3 billion and Consumer loans added $600 million. Security loans declined $5.6 billion. Elsewhere, Total Commercial Paper declined $5.5 billion to $1.332 Trillion. Financial CP declined $1.3 billion to $1.218 Trillion, with Non-financial CP dropped $4.2 billion to $113.7 billion. Year-to-date, Total CP is up $63.5 billion, or 14.5% annualized.

Fed Foreign "Custody" Holdings of Treasury, Agency debt rose $10.1 billion to $1.194 Trillion. Year-to-date, Custody Holdings are up $27.6 billion, or 34.6% annualized.

Currency Watch:

The dollar had its strongest one-day gain against the yen today in 5 years (according to Bloomberg). For the week, the dollar index gained less than 1%. "Commodity" currencies were the hardest hit this week, with the Brazilian real dropping 4%, the Argentine peso 3%, the Chilean peso 2.5%, and the Australian dollar 2.4%. Tumultuous currency markets these days appear to me as a case of speculative trading run amuck.

Commodities Watch:

May 5 - Bloomberg (Bruce Blythe): "New York gasoline futures rose for an eighth day as concern about summer fuel shortages offset a report of a bigger-than-expected increase in supplies... 'Refinery capacity is short, and I think the only way that we're going to see the gasoline problem solved is with demand reduction from price,' said Mike Busby, manager of oil and refined-products trading for Northville Industries Corp.... 'In other words, high enough prices to significantly reduce demand, and we're not there yet."

Commodities markets were as tumultuous as debt, equity and currency markets. And while the metals markets were under heavy selling pressure, the energy markets remain on fire. For the week, the Goldman Sachs Commodity index surged 5%, increasing y-t-d gains to 16.6%. The CRB index rose about 0.5%, increasing 2004 gains to 7.1%.

Central Bank Watch:

May 6 - Bank of England: "The global economic upswing has been maintained. In the United Kingdom, output growth has been at or above trend and business surveys are consistent with income growth and unexpectedly strong house price inflation. Investment prospects have improved. CPI inflation has been below the 2 percent target and is likely to remain so in the near term. But earnings growth has picked up and commodity prices have risen sharply. With a small and diminishing margin of spare capacity, inflationary pressures are likely to build despite a higher level of sterling than at the beginning of the year. Against that background, the committee judged that an increase of 0.25 percentage point in the repo rate to 4.25 percent was necessary to keep CPI inflation on track to meet the target in the medium term."

Asia Inflation Watch:

May 6 - Bloomberg (Jonathan Stearns): "Chinese Premier Wen Jiabao said he is taking 'forceful' steps to slow growth and inflation without triggering a slump in the world's seventh-largest economy. China needs to 'reduce the speed, but not a sudden braking' in an economy that grew 9.1 percent in 2003, the fastest pace in seven years, Wen told a business forum during a visit to the European Commission in Brussels. The premier said in March that the government is targeting a 7 percent expansion this year. China is stepping up efforts to cool growth after investment in roads, factories and other fixed assets jumped 43 percent in the first quarter. The boom has led to shortages of oil, coal and power, choked the transportation system and driven up prices of raw materials. Steel rod costs jumped 37 percent in the year to March, while coking coal prices increased 39 percent."

May 6 - Bloomberg (Will Kennedy): "Freight rates for dry-bulk ships that carry coal, iron ore and grain fell to a seven-month low this week on concern China's efforts to slow the economy and a smaller South American grain harvest will reduce demand for ships. The Baltic Dry Index, a global measure of dry bulk freight rates across different ship sizes, fell 3.9 percent to 3909 on Wednesday from a week earlier. That was the lowest since Oct. 8."

May 6 - Bloomberg (Daisuke Takato): "Japan's economy probably grew 1 percent in the first quarter of 2004, or at an annual 3.9 percent pace, driven by exports, business investment and consumer spending, NLI Research Institute in Tokyo said. Gross domestic product for the first three months to March will probably show that the economy expanded for the fifth straight quarter..."

May 7 - Bloomberg (Clare Cheung): "Hong Kong's retail sales rose in March as gains in the property and stock markets made people more inclined to spend and tourism boomed. The 9.4 percent growth in sales slowed from 13 percent in February..."

May 6 - Bloomberg (Seyoon Kim): "South Korean producer prices last month had their biggest gain in five years as increases in the costs of crude oil and other commodities prompted manufacturers to charge more for chemicals and other industrial goods, the Bank of Korea said. Producer prices rose 5.5 percent from a year earlier after climbing 4.4 percent in March... Seoul. That's their largest increase since November 1998... Producer prices of agricultural and fisheries goods rose 23 percent in April from a year earlier..."

May 5 - Bloomberg (Koh Chin Ling): "Taiwan's consumer prices had their biggest gain in a year last month as spending picked up, the government said. The consumer price index rose a seasonally adjusted 1 percent from the previous month, having been little changed in March, the Directorate-General of Budget, Accounting and Statistics said... That's the largest increase since March 2003. From a year earlier, prices rose 0.9 percent in April. 'Since the beginning of this year, our consumer prices have been increasing,' said Tsuei Chou-Ying, a division chief at the statistics office..."

May 5 - Bloomberg (Francisco Alcuaz Jr.): "Philippine inflation accelerated to a two-year high in April as Petron Corp. and other oil companies raised pump prices, making transport more expensive. The consumer price index, which measures the cost of goods and services, rose 4.1 percent from a year earlier...That's the biggest gain since December 2001."

Global Reflation Watch:

May 6 - The Wall Street Journal (Alexandra Peers): "Pablo Picasso's 1905 portrait 'Boy With a Pipe' sold for $104.2 million in an auction at Sotheby's Holdings Inc. last night, shattering the existing record for art and ushering in a new era in pricing for 20th-century paintings. In a tense, tuxedoed contest at the company's Manhattan headquarters, Bidding began at $55 million and swiftly escalated to $93 million, with five bidders vying for it. The winner, who pays the final bid plus Sotheby's commission, bid anonymously through Warren Weitman Jr., chairman of Sotheby's North American operations. "

May 7 - Bloomberg (Kevin Carmichael): "Canadian payrolls swelled by 49,600 in April, reversing two months of declines and dropping the jobless rate to 7.3 percent, its lowest level since September 2001..."

May 7 - Bloomberg (Duncan Hooper): "U.K. wages rose at the fastest pace in three years in April, a survey of recruitment consultants showed, threatening to push consumer price inflation higher. An index tracking wage settlements for permanent employees rose to 57.5, marking a fifth month of accelerating pay deals..."

May 7 - Bloomberg (Sam Fleming): "The number of people in England and Wales who went bankrupt surged 27 percent in the first quarter compared with the same period a year ago, government figures showed, indicating some consumers are struggling to cope with their debts."

May 5 - Bloomberg (Simone Meier): "Swiss consumer prices in April rose at the fastest pace in two years as retailers introduced new summer fashion after end-of-season discounts held down inflation in previous months. Consumer prices, the key gauge for inflation, rose 0.8 percent from March..."

May 5 - Bloomberg (Andrew J. Barden): "Argentina's inflation rate surged to a 15-month high in April as growing consumer demand in South America's second-biggest economy gave retailers the room to raise price on everything from food to clothes. Consumer prices rose 0.9 percent after rising 0.6 percent in March, a government report showed. The increase was the biggest since January 2003..."

May 5 - Bloomberg (Heather Walsh): "Chile's economy expanded in March at its fastest monthly rate since 1998, accelerating after manufacturers boosted output to keep pace with stronger sales at home and overseas. The economy expanded an estimated 6.3 percent in March..."

California Bubble Watch:

May 6 - "The percentage of households in California able to afford a median-priced home stood at 21 percent in March, a 7 percentage-point decrease compared to the same period a year ago when the Index was at 28 percent, according to a report released today by the California Association of Realtors...The minimum household income needed to purchase a median-priced home at $428,280 in California in March was $97,340, based on a typical 30-year, fixed-rate mortgage at 5.48 percent and assuming a 20 percent downpayment. The minimum household income needed to purchase a median-priced home was up from $82,080 in March 2003..."

May 5 - PRNewswire: "More than half of California's 12.5 million homes face wildfire dangers that pose a financial loss potential well in excess of $106 billion, according to state fire statistics. California Department of Forestry research indicates that more than 7.2 million California homes are categorized in the three highest fire risk levels -- more than 6 million of which are located in urban areas. 'More homes are susceptible to wildfires than homeowners realize,' said Candysse Miller, executive director of the non-profit Insurance Information Network of California."

U.S. Bubble Economy Watch:

May 5 - Bloomberg (Bill Arthur): "First-time U.S. homebuyers will be permitted to buy a house without making a down payment, under a bill approved by a House of Representatives subcommittee. Under the 'zero down payment' bill, people who seek Federal Housing Administration-insured loans will be able to include the down payment and closing costs in their loan amount. Many people who can afford monthly payments in a home save for years to come up with the down payment, said Representative Robert Ney...chairman of the House Financial Services housing subcommittee... With a little help, they can get into their own home 'ten years earlier,' Ney said. 'It's good for their families and good for their communities.' The program will assist 'more than 150,000 families in just the first year,' he said."

My Comment: Such legislation recalls the push, right up until the bear market, to direct the Social Security Trust Fund to invest in equities. After asset prices have risen for years, there is the inevitable final rush by politicians to encourage everyone to participate in the perceived gravy train; stocks always go up over the long-term - home prices always go up. But today, at the manic ("terminal") stage of mortgage finance excess, it is an unfortunate disservice to aggressively encourage those without savings to take on huge debt burdens and the responsibilities of homeownership. It is a notable attribute of Bubbles that they are perpetuated by myriad social forces, including financial and political institutions.

May 7 - Bloomberg (Gregory Ruben): "U.S. summer vacations will cost more as hotel vendors and retailers of items like insect repellent boost prices to capitalize on rising consumer confidence, the Wall Street Journal reported. A double room at the Ritz Carlton Hotel in Montego Bay, Jamaica will cost $225 this summer compared with $169 last summer, and a one-day adult pass for Disney World in Orlando, Fla. rose 5 percent to $54.75, the paper reported. That is the largest increase in dollar terms in 15 years, it said."

May 7 - Dow Jones: "U.S. consumers plan to step up their borrowing in coming months, according to a poll of consumer credit habits released Friday. The Cambridge Consumer Credit Index reached a record 68 in May, up substantially from April's reading of 59. The survey tracks individual intentions on debt for the past month, the current month and over the next half-year. A higher index number means more debt and a lower number means less debt. 'The increase was concentrated in lower income brackets, suggesting more of a concern about needing to use credit to pay basic bills than optimism about using more credit for major purposes' said Allen Grommet, the index's senior economist."

May 7 - Bloomberg (James Kraus): "New York City's economy grew at a 5.2 percent annual rate in March, the fastest since September 2000, the New York Daily News reported, citing a New York Federal Reserve report."

May 6 - Bloomberg (Margot Habiby): "Southern California's ports and airports will experience a transportation bottleneck by 2006 unless significant improvements are made because of record international trade levels, the Los Angeles Times reported, citing a study. Chronic delays that may be caused by lack of land and transportation budget cuts could force some shippers to bypass Los Angeles as their U.S. port of entry, the report by the Los Angeles County Economic Development Corp. said. The Los Angeles Customs District is expected to handle $262 billion in goods this year, up 11 percent from last year's record, the newspaper said."

March Construction Spending was up a much stronger-than-expected 1.5% from February. Total Construction Spending was up 8.6% y-o-y, the strongest reading since 2000. Residential was up 14.8% y-o-y and Office was up 11.5%. Manufacturing was down 8.8% from March 2003. Private Sector Construction Spending was up 9.0% y-o-y and Public was up 7.1%.

The April ISM Non-manufacturing Index jumped to a new all-time record with a record prices component.

U.S. Financial Sphere Bubble Watch:

Moments after the release of Tuesday's FOMC statement, CNBC's Ron Insana put a question to Pimco's astute Bill Gross: "From an investor's perspective, what do you do in the bond market as a consequence of what the Fed decided and said today?"

Mr. Gross's interesting response: "Well, I think you begin to sell them. You know, if the market is still rallying, that's what I'm going to do in the next five to 10 minutes. What the Fed has done is what I told you they were going to do. They are trying to sedate the bond market, to attach this measured upward movement in Fed funds to the containment of inflation. I would argue that inflation is not contained. Twenty to twenty-five percent increases in housing in California and elsewhere; commodity indices at all-time record highs; a CPI that in the next month or two, on a 12-month basis, will approach 3%. That's not containment of inflation. So, a bond investor should sell this rally if it's still going on to this minute and move money elsewhere to a central bank in Euroland that is more rational."

Well, with today's 288,000 gain in April payrolls (625,000 in two months!), much more than a promise of "measured" Fed rate increases is now required to sedate The High-Anxiety Bond Market. Strong job gains, understandably, now have interest-rate markets panicked that a full-fledged economic boom is in the works. For some time, the nation's housing and construction markets having been booming, the service sector has been booming, consumption has been booming, government spending has been booming, and even the hollowed manufacturing sector has been in a strong recovery. And while massive monetary and fiscal stimulus was fostering an especially unbalanced (and unsound) boom at home and abroad, the Fed and, hence, the bond market were willing to ignore the general environment and fixate on comforting jobs stagnation. No more.

This has been an extraordinary 18 months of reflation. It has been powerful as well as conspicuous. Prices of about everything - real and financial, at home and abroad - were pushed higher by truly unprecedented global credit and speculative excess. Yet the Greenspan Fed clung stubbornly to its flawed analytical framework - the same one that created the boom and near-bust they have of late been so determined to rejuvenate. Of all the indicators of the monetary environment, they chose one of the few not demonstrating a strong inflationary bias (employment - held in check largely by the unbalanced nature of the boom and an uncompetitive U.S. cost structure). It is a most unfortunate case of following previous errors with only greater blunders. And now the bond market is providing important confirmation that the Fed has sacrificed a lot of credibility along the way. As much as the Fed wanted to lead, they will now have no choice but to follow the markets.

It's been quite a party, and the Fed now clearly has its hands full as it attempts to restore order. And while the Fed is determined to avoid a replay of 1994, the markets are well on their way. Yields are surging across the globe, and The Great Reflation Trade of 2003 is coming unglued. Derivative markets have quickly come under heightened stress. U.S. bonds are being crushed; MBS crushed; and various interest-rate speculations crushed. I even read market analysis that speculated that the GSEs were selling mortgage-backeds. Oh lord. And the emerging markets are turning into a rout - equities, debt and currencies all being aggressively liquidated. The "commodity currencies" and some commodities are under heavy selling pressure as well. All the previously "hot trades" are turning to dry ice.

Tuesday, bond futures traders were said to have booed when the Fed missed yet another opportunity to get the rate increase cycle underway. In many respects, we would be so much better off if this process would have commenced last year. And the more the Greenspan Fed works to assuage the marketplace, the farther out of step with reality it finds itself. Considering the unfolding environment, I found yesterday's speech from Mr. Greenspan - Globalization and Innovation - especially pertinent (and in some cases ironic).

From Greenspan: "The United States economy appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past. This observation raises some key questions about the longer-term stability of the U.S. and global economies that bear significantly on future economic developments, including the future competitive shape of banking... Has something fundamental happened to the U.S. economy and, by extension, U.S. banking, that enables us to disregard all the time-tested criteria of imbalance and economic danger? Regrettably, the answer is no. The free lunch has still to be invented. We do, however, seem to be undergoing what is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has temporarily altered the specific calibrations of those criteria. Recent evidence is consistent with such a hypothesis of a transitional economic paradigm, a paradigm somewhat different from that which fit much of our earlier post-World War II experience. Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move effortlessly from one state of equilibrium to another. Adam Smith's 'invisible hand' remains at work on a global scale. Because of a lowering of trade barriers, deregulation, and increased innovation, cross-border trade in recent decades has been expanding at a far faster pace than GDP. As a result, domestic economies are increasingly exposed to the rigors of international competition and comparative advantage. In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures."

It is my sense today - from both a day-to-day market analyst perspective as well as one of a more macro economic and financial "theorist" - that we must be especially mindful to partition our analysis of the financial and economic "spheres." For Mr. Greenspan (the ideologue), it comes naturally to follow a sentence addressing "globalization" with others trumpeting "unregulated global markets" and "Adam Smith's 'invisible' hand" "at work on a global scale." He speaks of paradigm and structural shifts where he melds technological advancement and changes in economic structures with financial innovation. He speaks of moving "effortlessly from one state of equilibrium to another." The end result, apparently, is a global environment demonstrating "a notable decline in world economic volatility." "In tandem with increasing globalization, monetary policy, to most observers, has become increasingly effective in achieving the objectives of price stability."

From my analytical framework, I come up with a quite different analysis and a profoundly divergent conclusion. The past two decades have witnessed truly incredible technological advancements, while "globalization" (Greenspan's definition: "The extension of the division of labor and specialization beyond national borders.") has significantly increased the capacity to produce low-cost goods. (The period following the first World War and concluding with the 1929 stock market crash provides a disconcerting historical parallel.) But the paramount Greenspan Fed's error - invited by a fixation on "productivity" and the downward price pressures exerted by the manufactured goods and technology arenas ("economic sphere") - was to relax and nurture historic innovation, expansion, speculation and general self-reinforcing excess throughout the "financial sphere."

And while I can contemplate paradigm shifts in the underlying structure of economies, I in no way subscribe to fanciful notions of New Age Finance. Two decades of unprecedented financial deregulation, innovation, and expansion have fostered the classic manifestations of destabilizing speculation, gross over-leveraging, and financial and economic Bubbles. The more things change, the more they stay the same. And it has been the unappreciated "grease" of unprecedented credit and liquidity creation that has fueled booms and busts, as well as having provided the almighty capacity to provoke additional booms to mitigate the fallout from the preceding busts.

Mr. Greenspan often refers to the great "efficiency" of contemporary global finance. He has repeatedly trumpeted the virtues of derivatives and gone so far as to exalt the liquidity-creating capacity of hedge fund finance. Just yesterday he again blessed hedge funds, derivatives and the "advent of a number of different intermediary institutions" that are taking risks that in the past would have been left almost exclusively to banks.

I am convinced that the central flaw in the Fed's viewpoint is to misinterpret an historic expansion in leveraging and speculating for sound and sustainable "financial innovation." During more than a decade of repeated global financial and economic crises, the Federal Reserve and global central bankers have successfully perpetuated the global financial Bubble. The Fed, in particular, has aggressively manipulated interest rates and the yield curve to incite leveraged speculation. The consequence has been a massive leveraged speculating community that has evolved into the key monetary transmission mechanism - the leading source of liquidity for financial markets and economies. Over the past 18 months, this "mechanism" has created global liquidity like never before.

As one would expect (considering the past year's financial backdrop), the global "economic sphere" appears today in about the most robust position in some time. Yet, the "financial sphere" - with the leveraged speculating community having assumed the key source of liquidity creation - again faces dynamics that challenge its stability. In this regard, a couple of points are worth making. First, it should come as no surprise that the "financial sphere" is faltering. There is a fundamental flaw in the strategy of using "reflation" to rejuvenate faltering Credit and speculative Bubbles - inciting only greater speculative leveraging and fragility. What's the endgame? Second, whether the Fed appreciates it or not, this "game" has now become immeasurable more difficult. The Fed (and the complicit Asian central banks) got the whole leveraged community - having mushroomed through the years with compound growth rates - all lathered up and all aggressively playing the same "reflation trade" - at 1% Fed funds. As to the scope of the global reflation, it has been a case of pretty much betting the ranch.

In past periods of heightened systemic stress, the Fed has always had the option of cutting rates and disseminating complimentary gains to the financial sector and speculator community. Such an option is not today available to mitigate worsening systemic stress. When the technology Bubble burst and financial wealth was being destroyed by the equity bear market, the Fed had the powerful capacity to offset these losses with the liquidity and wealth effects of surging bond and Credit instrument prices. Going forward, it is much more likely that equity losses will be compounded by rising yields and declining credit market wealth.

In this regard, I have always believed that the proliferation of hedge funds and proprietary trading, ballooning derivative positions and trading, and even the mushrooming GSEs - for that matter - have all been a bull Credit market phenomena. And while such a sophisticate financial scheme has many thinking New Paradigm, the reality of the situation is that they are all products of the Great Credit Bubble. Everything works swimmingly - that is as long as all the major players balloon together: the leveraged speculators, the derivative players, and the GSEs. And - fostering powerful expansion dynamics - the New Age Finance has had all the characteristics of something miraculous. Behind the curtain, the Fed had firm control of the pump, inflating the Bubble with each well-timed and choreographed reduction in interest rates.

But we are now commencing what will surely be an arduous Credit system bear market. Rates are spiking higher and the leveraged players and derivative traders feeling the heat. Hundreds of billions have flowed into the speculating community with inflated return expectations and minimal appreciation of the risks involved (especially systemic risks). Massive proprietary trading strategies have been implemented with the dangerous risk profile of "heads I win; tails you lose." What's more, the speculators' traditional liquidity backstop/"buyers of first and last resort" - the GSEs - are in a pickle and not likely in a position to aggressively balloon their holdings. Meanwhile, the real economy is booming with an enormous supply of new mortgages as far as the eye can see.

From my perspective, it has always been only a matter of time until the Bubble realities of a massive supply of new Credit (required to sustain both inflated assets prices and maintain an unbalanced Bubble economy) and faltering demand for these Credits (rising rates, de-leveraging and derivative dynamic-hedging) led to problematic dislocation. For years, the demand part of this equation was artificially inflated by an historic speculative Bubble. We are now on course for potentially radically altered supply and demand dynamics. And this is truly the worst-case-scenario - with a booming consumption/asset-Bubble U.S. economy, 1% Fed funds, and synchronized global markets.

Over the coming days and weeks, we will monitor the situation carefully, with a keen eye on our Credit system and domestic Credit systems around the world. I hesitate at this point to conclude that a 97-style financial domino collapse is in process. My sense is that current tumult is much more associated with the unwinding of trades by the leveraged speculating community. This is in contrast to previous dislocations, currency collapses, mass capital flight, and consequent Credit system implosions that left domestic institutions, financial systems and economies starved of liquidity and then quickly insolvent. This looks different to me. And while interest rates are surging, I don't yet see the characteristics of a global liquidity crisis. I sense that domestic Credit systems remain for now generally robust - or at least less vulnerable than previously - and capable of dispensing adequate Credit and liquidity, this despite the tumult in the capital markets.

Moreover, I do not at this point expect a major reversal in sentiment that would see a return to King Dollar speculative flows into dollar financial assets. Yes, the dollar is today gaining some lost ground as various bets are unwound. But this is a much different dynamic than the previous flight to play (Fed-induced) inflating U.S. financial asset prices. The prospects for enduring U.S. asset inflation are, these days, especially poor. Yet until our Credit system eventually buckles, unrelenting government and mortgage finance excess may very well finance ongoing massive current account deficits. This will work to support global system liquidity - offsetting liquidity lost with deleveraging. And while rates have risen meaningfully, they are not at this point sufficiently onerous to significantly restrain the U.S. mortgage finance Bubble or Asian growth. But it is reasonable to presume that these two respective historic Bubbles are in the process of experiencing their best days.

More from Greenspan: "We have, I believe, a reasonably good understanding of why Americans have been able to reach farther into global markets, incur significant increases in debt, and yet fail to produce the disruptions so often observed as a consequence...Can market forces incrementally defuse a buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of market flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity prices, interest rates, and exchange rates presumably would change to reestablish global balance..." "Fortunately, our meager domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock thus has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States."

History will not be kind. As The Great Credit Bubble succumbs, our central bank will have to face up to the harsh reality that we have not saved or invested wisely - quite the contrary ("efficiency of our capital stock"? Give me a break). And absolutely no degree of "market flexibility" will mitigate our financial and economic misdeeds. There will be no painless defusing of U.S. imbalances. There has been no repeal of the Law of Economics. Finance is finance is finance.

And to add insult to injury, as a society, we face adversity with the prospect of having little in the way of even moral support from sympathetic friends around the world. And to think that we now approach an arduous financial and economic environment - with an increasingly hostile, uncertain and problematic global backdrop - leaves an especially bad taste in my mouth. I hope future historians will grasp the essence of what went astray and comprehend that there were poor decisions made all along the way. It didn't have to happen this way. It shouldn't have.

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