With confidence rattled by waves of earnings disappointments, including today's announcement of a $19 billion loss at Nortel, bear market conditions returned to U.S. and global equity markets this week. For the week, the Dow declined 3% and the S&P500 dropped 4%. Economically sensitive issues suffered, with the Transports sinking 6% and the Morgan Stanley Cyclical index sliding 5%. The Morgan Stanley Consumer index declined 3%, while Utilities were down 1%. The broader market was under pressure, with the small cap Russell 2000 declining 3% and the S&P400 Mid-Cap index dropping 4%. The technology sector took the brunt of this week's resurgent bear, with the NASDAQ100 sinking 10% and the Morgan Stanley High Tech index sliding 9%. The Semiconductors were hit for 10%, while The Street.com Internet and NASDAQ Telecommunications indices sunk 14% and 13%, respectively. The Biotechs dropped 7%. Financial stocks were weak as well, with the S&P Banking index declining 3% and the Securities Broker/Dealer index declining 7%. Although gold dropped about $2, the HUI gold index mustered a 2% gain for the week.

The return of the equity bear was greeted warmly in the Treasury market, with generally the biggest weekly gains since March. With the marketplace now expecting another 50 basis point cut at the June 27th Fed meeting, short Treasuries performed exceptionally well. For the week, two-year Treasury yields declined 18 basis points to 3.98%, the lowest yield since the dark days of the October 1998 financial crisis. The 5-year note saw its yield sink 21 basis points to 4.70%, while the key 10-year yield dropped 13 basis points to 5.24%. The yield curve continues to steepen, with long bond yields declining only 7 basis points this week to 5.68%. The spread between two and 30-year Treasury yields has increased to 170 basis points, the widest in seven years. In a development worth keeping an eye on, the benchmark 10-year dollar swap widened 4 basis points to 84. Mortgage-back and agency securities underperformed noticeably, with yields generally declining about 8 basis points. Corporate bonds also underperformed, with spreads on Nortel bonds widening to 425 basis points over Treasuries. The dollar weakened this week, with a decline of about 1% for the dollar index.

Broad money supply (M3) increased $26 billion last week. Over the past 31 weeks, (since the most recent "reliquefication" was commenced back in October) broad money supply has surged $634 billion, a growth rate of 15.4%. Interestingly, over this same period the monetary base has increased $15 billion and total bank reserves have declined slightly. Bank credit is up $23 billion over the past two weeks, with $20 billion explained by an increase in securities holdings.

Previous consumer lending excesses are becoming increasingly problematic. This week from Bloomberg: "The loss rate on U.S. credit card bonds surged to the highest in four years as more consumers failed to make payments amid rising unemployment and higher energy costs, Standards & Poor's said. The charge-off rate on $337 billion in U.S. credit card securities tracked by the bond rating firm rose to 6.7 percent in April, the highest since February 1997 and 0.6 percentage point higher than in March. It's also more than the 6.2 percent peak reached in 1992, at the end of the last U.S. recession, S&P said."

May numbers are in from Fannie Mae. At $54 billion, Fannie's enjoyed another record month of total mortgage purchases. While Fannie's own mortgage portfolio expansion slowed markedly to a rate of about 5% (from April's 20%), the growth rate for outstanding Fannie Mae mortgage-backed securities (not held by Fannie Mae) surged to almost 39% (from April's 23.3%). The company must have liquidated a significant amount of mortgage-backed securities near the end of the month, as "average investments" held by Fannie Mae during May grew by almost $13 billion, a rate of 22%, to $705 billion.

The following are excerpts from Federal Reserve Bank of New York President William McDonough's June 12th speech in Chicago at the Mid-America Committee Leadership Luncheon:

"We had reached a point - by the end of 1999 - in which 4% of the American economy was being financed by foreign investors, because that was the size of the current account deficit as a percent of Gross Domestic Product. It's not sustainable. We simply had too much demand in the economy. Another thing that was happening - investors that we normally think of being more astute, were assuming that the very high and growing level of profitability, which came from the dramatic increase in the growth rate was sustainable forever. And therefore the cost of capital was coming down to a level at which it was unsustainably low, and which the rewards of capital over any extended period of time wasn't high enough. The view that I have just described is what led the Federal Reserve beginning in June 1999 to say, 'if we are responsible for sustainable economic growth - not bubbles and bursts - sustainable economic growth, we had to slow the economy down.'

So we began tightening monetary policy in June 1999. And by June 2000 we had raised the overnight interest rate - the so-called Fed Funds rate - from 4.75 to 6.5%. We had quite an amount of restraint in the American economy. At that time, the second quarter of 2000, the beginning of the lagged monetary policy impact was taking place, something that the Fed had not counted on, or anybody else, is that we had a dramatic increase in energy prices. And that hurts the American economy in general, but it especially hurts an economy, which is at such full-bore and in which the personal savings rate had gone negative. If you've got to start borrowing for gasoline, you can't spend it on something else. And so we have a transfer of resources from consumers to essentially people who save - the producers of oil including those outside of the United States.

The combination of Fed monetary policy tightening and the energy crisis probably happened - but there might be a causal relationship - at the same time you had a realization in financial markets that at least some equity prices were simply too high. Particularly at the technology sector, as you well know, which is not surprising because in the technology sector - I'm not talking about Motorolas, Microsofts or Intels, - but you are very familiar with start-up technology companies. They were usually started by an entrepreneur who knew a lot about technology and nothing about running a business. It was financed by an amateur venture capitalist who probably gained some fame at KKR or someplace, with a lot of money around he or she went out and started his or her own venture capital fund knowing very little about venture capital investing. So you had amateur entrepreneur financed by amateur investor, and then my best friends in the securities industry decide this was such a good story why don't we take them to the public market. So you went from venture capital to an IPO - thank God without ever passing through the banking system. This is not terribly rational. And it couldn't endure and it didn't. So that you had a very significant collapse."

Mr. McDonough then took a few questions from the audience, the first being the following: "…the question I would like to ask you has to do with the immediate past and the future. We just came out of what everybody recognizes now was an enormous stock market bubble. Based on what is going on with the money supply now, and the overextension of consumer credit and private sector debt, are we exchanging one bubble for now a Credit Bubble?"

McDonough: "The short answer is no. There is a fair amount of consumer credit. All of the pushing we can do to the data indicates there is not an actual or potential problem…"

Listening to Mr. McDonough's 40-minute talk, I was left with the impression that he provided an open and earnest assessment of his view of the state of the U.S. economy, recognizing the obvious problems associated with a low savings rate, high current account deficit, and some of the other apparent deficiencies in the U.S. economy. At the same time, I view his presentation as additional confirmation that the Federal Reserve really has little idea what it is dealing with today or the acute difficulties that lie ahead.

As a follow-up to my most recent commentaries, the Fed and economic community continue to focus on symptoms of the problem without recognizing or addressing their true causes. There is this common perception that, with the system now in the process of ridding itself of technology sector speculative excess and inventory overhang, it is soon back to business as usual and a return to unending prosperity. Many Fed officials are now even making public statements expecting 3 to 4% growth to resume and productivity growth to bounce back to boom-time levels. Unfortunately, it's just not going to work out that way. For one, it is simply not the case that the U.S. economy and financial system are today at considerable risk because of "amateur" entrepreneurs and irrational investors. In the grander scheme of things, the technology IPO fiasco is a manageable problem of relatively minimal significance (the telecom debt issue is another story!). Mr. McDonough did brush against the true problem when he stated that "with a lot of money around",many decided to start venture capital firms. Well, with way too much money and easy credit around, too many individuals, businesses, bankers, policymakers, money managers and speculators changed behavior, financial position, and risk profiles.

Ok, now with the recognition that monetary forces were involved, why not focus on the critical issues: What has been the source for all this money? What are the processes involved, and what are the respective consequences for the continuation and possible termination of such processes? Of course, I have warm feelings for the individual with the question "are we exchanging one bubble for now a Credit Bubble?" He went right to the heart of the issue, and I would only argue that we have in fact been in a credit bubble for sometime now. It is just the most conspicuous manifestations that have changed with the bursting of the technology bubble, while underlying money, credit, and speculative excess run unabated elsewhere.

McDonough and the Federal Reserve appear to have little appreciation that the technology bubble, and stock market bubble generally, were only consequences of acute monetary disequilibrium. This is, in fact, at the very core of my analysis. Yet, it should be patently obvious to central bankers that a system simply does not generate such spectacular speculative impulses and asset bubbles without some type of severe underlying financial system disorder. I would also like to stress that the Fed remaining so blind to this dilemma of credit derangement fosters a much more precarious situation than is obvious at first blush. Believing that the bursting of the tech bubble is the overriding source of systemic risk, the Fed has lowered interest rates aggressively to accommodate the financial system and encourage additional credit and spending growth. This misdiagnoses is analogous to a very sick patient in dire need of bed rest and extensive rehabilitation instead being administered powerful steroids and instructed that it's better to keep going at full tilt. Disregarding the illness while aggressively treating symptoms not only postpones the requisite healing process, it risks grave consequences to the vulnerable patient. As such, the consensus view that incessant doses of "easy money" provide the cure for any and every ill could not be more ungrounded or fraught with danger.

Misidentifying the root of the problem, the Fed has responded to what its officials now admit was an inevitable tech collapse with policies that significantly and dangerously exacerbate the underlying monetary disorder. A monstrous credit bubble that should have been squelched years ago is given yet another parlous lease on life. We have clearly gone into uncharted waters, with few examples outside of the fateful financial disequilibrium of the late 1920s offering meaningful comparisons. Unfortunately, the parallels to that infamous period are as significant as they are numerous. But I want to be clear on one point: my use of the 1920's comparison is not because of corresponding stock market speculative bubbles, which in the case of the 1929 crash ushered in an adjustment process that spiraled into the Great Depression. Again, stock market bubbles are only "symptoms." The comparison is instead of crucial significance today because throughout both periods runaway credit systems and extraordinary monetary dislocations had profound and deleterious effects on both financial stability and the underlying structure of the economy. The great risk today, as it was in 1929, is acute financial fragility. Importantly, in both periods monetary authorities - misdiagnosing illnesses - unknowingly augmented already dangerous processes that manifested into only more extreme credit and speculative excess, asset market distortions, catastrophic financial instability, and precarious economic imbalances.

Once set in motion, the only hope of avoiding credit bubble disaster in the late '20s and during this boom was decisive action by the Federal Reserve. In both periods, however, the priority of the Fed instead turned to sustaining the boom. Let there be no doubt, this is precisely how systemic risk comes to grow exponentially. It is furthermore worth noting the global character of these similar financial bubble processes. Both periods share the predicament whereby heightened global financial and economic frailty actually worked to the advantage of sustaining U.S. bubble excess. Such a circumstance, unfortunately, only underpinned destructive domestic monetary processes in the late 1920s, as it does today. Importantly, the entire global financial system and economy are today placed at great and expanding risk to the inevitable bursting of the runaway U.S. Credit Bubble.

For adding substance to this line of analysis, Benjamin M. Anderson's Economics and the Public Welfare, 1914-1946 (published in 1949) is invaluable. After receiving his PhD and teaching economics at Harvard, Dr. Anderson worked for years at Chase Manhattan Bank, where he wrote the weekly Chase Economic Bulletin from 1920 to 1937. Each time I read from this wonderful piece of historical analysis I discover previously unappreciated and pertinent insights, while becoming only more impressed by the depth of Dr. Anderson's understanding of economics, monetary theory, and financial markets, as well as his keen appreciation of history. He brilliantly illuminates the extraordinary nature of the environment that prevailed in the 1920s. Ominously that period increasingly parallels our own. His writings provide great perspective on how financial systems and economies evolve over time, with the potential to drift terribly off course while very few recognize or appreciate how unsound the whole process has become. When reading the following quotes, try to be cognizant that the similarities to today are not coincidence, but are related to the likeness of the underlying financial disorders.

"The economic life of the world in 1913 went on in an atmosphere of good faith. Men with liquid capital used the capital themselves confidently in business enterprises or loaned their capital at market rates of interest to other who would use it in productive operations. There were no billions of dollars of "hot money" such as characterized the decade of the 1930s, moving nervously about from one financial center to another… Industry, commerce and finance depend on credit. Credit was in general soundly based on movable goods which had dependable markets, on corporate securities, usually moderate in volume, buttressed by balanced budgets." 23

"There was no such thing in prewar days as the kind of international cooperation which we saw in the 1920s, under which a dangerous boom was prolonged and turned into an almost uncontrollable inflation through the cooperation of the Bank of England and the Federal Reserve System of the United States." 24

"The very inelasticity of our prewar system made it safer than the extreme ductility of mismanaged credit under the Federal Reserve System in the period since early 1924. The whole world was, moreover, far safer financially when each of the main countries stood on its own feet and carried its own gold."

"There is no need whatsoever to be doctrinaire in objecting to the employment of bank credit for capital purposes, so long as the growth of this is kept proportionate to the growth of the industry of the country, so long as the prices and quality of the shares and bonds are closely scrutinized by the lending officials…"

"With the decline in profits in a sufficiently important minority of businesses, a boom must come to an end. Businesses facing losses contract their operations to cut their losses. If they fail to do this voluntarily, their creditors force their hands. Credits are based on earning power. As earning power diminishes creditors grow nervous and begin to press for collection, liquidation is forced, and reaction and crisis come." 76

"The Federal Reserve System was created to finance a crisis and to finance seasonal needs for pocket cash. It was not created for the purpose of financing a boom, least of all for financing a stock market boom. But from early 1924 down to the spring of 1928 it was used to finance a stock market boom." 146

"New, Strange Counter Forces Offset Federal Reserve Restraints. When the Federal Reserve authorities tried to withdraw funds from the money market, the market found new and strange sources from which to draw funds." 196

"But Break Long Overdue. But there is no point to assigning any particular cause for the break's coming at the particular time it did. It was overdue, and long overdue. A great collapse was certain the moment that doubt and reflection broke the spell of mob contagion, while the fantastic structure of prices was doomed the moment any considerable number of people began to use pencil and paper." 216

It is fascinating to read analysis focused on issues such as the "employment of bank credit...kept proportionate to the growth of industry", "the extreme ductility of mismanaged credit", with a "decline in profits…a boom must come to an end", the Fed and other central bankers cooperation leading to "uncontrollable inflation", the "market found new and strange sources from which to draw funds", and that "the structure of prices was doomed". Again, it is no coincidence that these have become critical issues today. After all, these are all key aspects of Credit Bubble analysis, as relevant to the late 1920s as they are to 2001. The crux of the matter was evidenced in the late 1920s, as it is today, in the monetary aggregates and credit data.

Between June 1922 and April 1928, total commercial bank deposits increased $13.5 billion, or 44%, to $44 billion. Dr. Anderson focused on "an $11.5 Billion Unneeded Expansion of Bank Credit in Five Years (1922 to mid-1927)." He was adeptly attentive to what types of assets this explosion of bank credit was financing. Analyzing data over this period from "reporting banks" (with $20 billion of deposits), holdings of government securities increased by 26%, "other securities," 42%, and "loans against securities" up 59%. "All other loans and discounts" increased by 21%. Notably, "loans against securities plus investments in securities" increased by $3.75 billion, or more than double the $1.51 increase in non-security related loans for these "reporting banks."

"This expansion of bank credit was not needed by commerce, and commerce did not take it…the rapidly expanding bank credit went into capital uses and speculative uses. It went into real estate mortgage loans on a great scale. For the member banks of the Federal Reserve System, real estate mortgage loans stood at $460 million in 1918. This figure had risen to approximately $3 billion by the middle of 1927…the most startling increase, however, in the assets of the banks was in bank investments in bonds and in collateral loans against stocks and bonds."

Over a similar period, currency in circulation increased about $250 million, or 6%, narrow money supply increased about $5 billion, or about 19%, while broad money supply increased almost $16 billion, or 30%. "There were those who looked with great complacency upon our immense expansion of bank deposits in the 1920s on the theory that it took the form chiefly of time deposits and that time deposits represented savings. The view was largely fallacious." 140

Dr. Anderson, in an important observation, recognized the major impact on credit availability from financial innovations, as well as from a shift from demand deposits into time deposits with lower reserve requirements (especially by the powerful New York banks). A 30% increase in reserves supported a 44% increase in total deposits. For the seven years from April 1921 to April 1928, demand deposits increased "roughly 33.8 percent", while time deposits increased 135 percent. (p 149). Over this period, "time deposits in the country banks increased only 68%," while they surged 144% in the New York district. These divergences were clear indications of the underlying financial disorder cultivated by an aggressive financial sector dealing in the securities markets. From Dr. Anderson: "It was not easy to convince investment bankers and bond dealers in the period 1925-1929 that it was commercial bank expansion which was generating the demand for the securities they were selling." Replace "commercial bank" with "financial sector" and the preceding quote could not be more applicable today. How can a negative savings rate and booming demand for new security issuance coexist?

Over the past three and one-half years (1998 to present), money market fund assets have almost doubled to $2.1 trillion. Curiously reminiscent of the unusual deposit divergences from the late '20s, retail money fund assets have increased by about $400 billion, or 67%, while institutional money funds have surged $600 billion, or 154%. Institutional money fund assets have expanded at a rate of 55% since the end of last October. Over the past three and one-half years, broad money supply expanded $2.1 trillion, or about 40%. Financial sector commercial paper borrowings have increased 60% to $1.23 trillion. Total GSE assets have increased a stunning $960 billion, or 87%, to $2.06 trillion. Asset-backed securities have jumped 76% to almost $1.9 trillion. Securities broker/dealer assets have increased 53% to $1.2 trillion. In just 13 quarters, total financial sector borrowings jumped $3.2 trillion, or 58%. Could monetary disorder be more conspicuous today? There has simply never been anything approaching such extreme financial credit creation (and resultant financial sector leverage). Borrowings to finance financial asset holdings during this period truly put those of the late 1920s to shame.

"Speculation in real estate and securities was growing rapidly, and a very considerable part of the supposed income of the people which was sustaining our retail and other markets was coming, not from wages and salaries, rent and royalties, interest and dividends, but from capital gains on stocks, bonds, and real estate, which men were treating as ordinary income and spending in increasing degree in luxurious consumption. The time for us to pull up was already overdue…We could prolong it for a time by further bank expansion and by further cheap money policies, but only at the cost of creating a desperately difficult situation at a later time." Here Dr. Anderson recognizes bubble economy distortions, as well as the great cost associated with letting them run uncontrolled.

And while there has certainly been much attention given to the late '20s stock market bubble and the enormous margin debt and broker call loans that financed speculation, this analysis is not necessarily clear or complete, especially as it pertains currently. In my Credit Bubble analysis, the central issue is the explosion of financial credit - borrowings to fund the holdings of financial assets, and the resultant financial assets and inflationary spending power created in this process. It is not of overriding importance whether these borrowings initially funded stocks or credit market instruments, but that the creation of additional financial credit had significant and dangerous consequences to the soundness of a financial system and to the overall structure of the economy. And while the consensus would surely argue (having "learned" from the history of the 1920s) that borrowing to finance stock market speculation is dangerous, this view misses the more important point: It is the enormous expansion of financial credit created in the process of borrowing against holdings of credit market instruments that has the much greater potential to impact the entire credit mechanism, spawning monetary processes with momentous effects on credit availability and the fostering of self-reinforcing credit bubble dynamics.

It is specifically the expansion of borrowings by the financial sector (the creation of financial credit) that is the source of "all this money around" that is causing so many individuals, firms and markets to change behavior and wreak havoc. In the late 1920s it was largely the banks and Wall Street creating financial credit as they increased speculative positions in the stock and bond markets. Today, the banks, Wall Street brokerages, the international banking community, hedge funds, the powerful government-sponsored enterprises, and others aggressively expand borrowings to fund holdings of mortgages, credit card receivables, auto loans, equipment leases, corporate and junk debt, CDOs, etc. that is behind the historic explosion of money supply we have witnessed over the past few years. As I have tried to explain previously, when Fannie Mae or Goldman Sachs (for example) borrow in the money market to fund the purchase of a new mortgage or agency security, additional deposit "money" is created in the process.

As was made clear with the above data, bank credit in the late '20s became tremendously skewed toward financing securities, either directly or indirectly. Accordingly, surging deposit growth (bank liabilities) was predominantly the residual of aggressive financial credit creation. Loan growth (bank assets) directed at stocks and other securities fueled a self-feeding credit and asset bubble, with speculative monetary processes becoming more entrenched over time. As Dr. Anderson made very clear, this lending and resultant creation of deposits was not used to finance commerce, but to fund speculation and consumption. It is also worth noting that this financial leverage falters with declining security prices.

Especially at the late stages of credit bubbles, a waning of business profits interplays with an enriched and emboldened community of speculators operating in an environment most conducive to their trade. The "easy money" is to be made in the financial sphere instead of industry, with a powerful financial apparatus having developed specifically for this popular endeavor. This, indeed, gets right to the heart of the issue, both in 1929 and today: The grave risk comes not from stock market speculation, but the development of intractable processes whereby incredible leverage and massive financial claims are created by a dysfunctional system, concomitant with the destruction of true economic wealth through endemic malinvestment and over consumption. While perceived financial wealth was expanding tremendously (in the '20s and '90s), true economic wealth creating capacity was in actual decline. Revisionist historians do not appreciate this from the 1920s, believing instead that if only the banking system would have been protected from stock market losses and the Fed would have expanded the money supply depression would have been avoided. This ignores both the existence of a Credit Bubble and its resulting distortions and destruction of economic wealth. As we have argued repeatedly, today's predicament will not be resolved by the creation of additional money and credit. This is going to come as quite a shock to many.

I will not argue that the severity of the Great Depression was necessary (there were clearly policy errors), or that another such episode is inevitable. What I will argue, however, is that a significant adjustment period is both unavoidable and long overdue. I expect that this will be a two-sided affair. There will most certainly be a narrowing of the momentous gap between perceived financial wealth and true economic wealth. Additionally, the dysfunctional financial processes underpinning this unsound bubble will need to be interrupted. In short, this historic period of monetary disorder must be brought under control before the adjustment process can proceed. There is, unfortunately, no way around the fact that this will be both difficult and prolonged. For too long Federal Reserve policies have nurtured financial disorder, and the scars are long and deep.

I believe (with some justification), that those at the top of the Federal Reserve believe that such a difficult adjustment process is avoidable. Certainly, leading officials recognize the grave danger of collapsing asset prices and debt deflation dynamics (lesson learned from the 1930s). As such, it is quite likely that they envisage a solution whereby inflated asset markets (equity and real estate) are stabilized, while allowing Fed-induced economic growth and general inflation to "catch up." With contemporary tools and aggressive monetary management, asset bubbles apparently need not collapse when they can be frozen in time. I think Greenspan has intimated as much in past comments. Dr. Anderson refers to similar flawed logic during the late 20's as the Federal Reserve "playing God." There is surely a heavy price to be paid for grossly subverting market forces.

Hopefully it will become apparent to these officials that such a policy course is flirting with disaster. First of all, they should by now appreciate (especially after 1994 and the LTCM fiasco in 1998) the major influence endemic leveraged speculation has come to play throughout the credit market, a situation significantly augmented by recent aggressive Federal Reserve accommodation. This bubble can only be ignored for so long. In fact, my greatest criticism of the Greenspan Fed has been that it has for too long played right into the hands of the leveraged speculating community, creating a monster that at some point must be subdued and somehow disabled. It should be recognized that it is the leveraged speculating community that has and continues to play a major role in a dysfunctional system providing virtually unlimited credit availability (consumer, mortgage and security) - the purveyor of the unlimited financial credit that is at the very epicenter of the Great Credit Bubble. Avoiding, at considerable cost if necessary, speculative financial flows from becoming a dominating factor throughout the credit creation process should have been an indelible lesson from the 1920s. Such "Hot Money" is unsustainable and, by its very nature, distortive, fragile and unpredictable.

As was the case after the 1929 stock market crash, the termination of such flows can have tremendous negative consequences for asset prices and markets, the viability of financial intermediaries, the soundness of the financial system generally, and the functioning of an imbalanced and vulnerable bubble economy. Our system will not be on a corrective path toward financial and economic stability until financial order has been restored and these dysfunctional monetary processes are significantly restrained. Savings must become the driving force behind sound investment, replacing the current mess commanded by financial credit and endemic speculation. There are critical structural issues that preclude a Federal Reserve-orchestrated inflation from rectifying this type of problem.

It should also be increasingly clear to Fed officials, as well as the marketplace, that it takes enormous additional money and credit creation just to sustain such levitated asset prices and maladjusted economy. I suspect that this is one key aspect of the current situation that has caught many by surprise, as they mistook a speculative stock market for an historic Credit Bubble and U.S. bubble economy. There is absolutely no doubt today that attempts to sustain levitated U.S. asset prices and dysfunctional processes by perpetuating this bubble economy creates further impairment and risks potential financial collapse. It is our sense that the marketplace is beginning to recognize this predicament.