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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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'Off With Their Heads'

The week ended ominously for financial markets at home and abroad. Global equities and the U.S. dollar came under significant selling pressure, while Treasuries and gold benefited from safe haven buying. Markets throughout Latin America came under heavy selling pressure, with Mexico and Brazil dropping more than 3% today. The Argentina Merval index sunk 6%, as concerns mounted of imminent corporate defaults. Argentine government bonds suffered their worst decline in three weeks.

From the transcripts of CNN's Evans, Novak, Hunt & Shields (from Bloomberg) quoting Treasury Secretary O'Neill (to air tomorrow): "Argentina is now in a very slippery position. And we're working to find a way to create a sustainable Argentina, not just one that continues to consume the money of the plumbers and carpenters in the United States who make $50,000 a year and wonder what in the world we're doing with their money." We don't think this is the type of language the markets are hoping to hear.

For the week, the Dow and S&P500 dropped 2%. The Morgan Stanley Cyclical index dipped 2%, while the Transports and Utilities declined 1%. Defensive stocks outperformed, with the Morgan Stanley Consumer index adding 1% for the week. Biotech stocks were generally unchanged. Technology stocks came under heavy selling pressure, with the NASDAQ100, Morgan Stanley High Tech, Semiconductors, and NASDAQ Telecommunications indices all sinking 6%. The Street.com Internet index was hit for 9%. Financial stocks also came under pressure, with the S&P Bank index declining 2% while the AMEX Broker/Dealer index dropped 6%. The HUI Gold index jumped 6%. For the week, 2-year Treasury yields declined 5 basis points to 3.64%, 5-year yields 11 basis points to 4.42%, and 10-year T-note yields 14 basis points to 4.84%. Long-bond yields declined 6 basis points to 5.43%. Agency yields declined 11 basis points, while Fannie Mae benchmark mortgage-back securities underperformed with yields dropping only 6 basis points. Spreads on mortgage-back securities have widened noticeably during the past two weeks. Spreads on more speculative corporate and financial debt also widened this week. The dollar index dropped another 2% this week, while gold added $5.20.

Despite three straight months of declining imports, the weakest level of exports in 16 months drove June's trade deficit to a stubbornly high (and problematic) $29.4 billon. It was certainly an interesting week "intellectually", with the Wall Street Journal addressing the "dangerous" GSEs and the IMF warning of the potential for a "sharp depreciation" in the dollar. Excerpts from the IMF: "Directors observed that judgments about whether domestic and external financial imbalances in the U.S. economy would be resolved in an orderly manner depended importantly on prospects for underlying productivity growth. These prospects would play a crucial role in determining whether the favorable economic performance of the late 1990s could be resumed and inflation pressures remain contained. The deterioration in the external current account balance to a large extent had been driven by the surge in U.S. productivity growth during the second half of the 1990s which had boosted the relative return on capital and attracted substantial capital inflows to the United States. Although evidence suggests a reasonably favorable outlook for underlying productivity growth—reflecting continued gains in technological innovation and in the adoption and diffusion of technology—Directors cautioned that less optimistic productivity prospects could trigger a less favorable outcome and pose a significant challenge for U.S. policy.

Directors indicated that the size of the U.S. external current account deficit did not appear sustainable in the longer term and that it raised concerns that the dollar might be at risk for a sharp depreciation, particularly if productivity performance proved disappointing. A sudden correction in the current account deficit was seen as possibly having adverse effects on the United States and the rest of the world economy…Directors expressed concern about the decline in personal saving and rise in household and corporate debt levels in recent years. They cautioned that if productivity growth turned out to be far weaker than the growth rates experienced since the mid-1990s, the economic slowdown could be prolonged, adversely affecting household and business balance sheets."

Bloomberg ran a story this week, "U.S. College Tuition, Fees Rise Faster Than Inflation." The article reported that students at the University of Tennessee would see a 14% jump in tuition costs next year, Univ. of Iowa 9.9%, Purdue Univ. 7.5%, and the Univ. of Michigan 6.5%. "The rising cost of college is nothing new to parents who've socked away money for years for the day their children head off to a university. In the 10-year period ending in the 2000-2001 school year, average tuition and fees at public colleges increased 51%…"

The credit card industry mailed out 434 million solicitations during May, up 30% year over year. Year-to-date mailings exceed 2 billion, an increase of 61% from last year. The average response rate continues to deteriorate, and is now about 0.4%. Capital One was responsible for 29% of the solicitations after sending out 125 million mailings, with Bank One at 70.5 million, JPMorgan/Chase at 32 million, Providian 31 million, MBNA 28 million, Bank of America 20 million, and American Express at 12.9 million. Bank America this week announced that it was taking a $1.25 billion charge and exiting the auto lease and subprime mortgage business, in further confirmation of the poor economics of such lending businesses.

July housing starts jumped to a better than expected 1.672 million units, the strongest pace since February 2000. Year over year, single-family starts were up almost 16%, with multi-family starts up 13%. Regionally, starts were up 16% in the Northeast and 25% in the South. Year to data, total starts are running about 2% above last year. For comparison, July's starts were slightly ahead of starts from the booming market in July 1999, but slightly below July 1998. July starts were also about 15% higher than the average annual starts during 1995 to 1997. Wednesday the National Association of Home Builders reported that their monthly housing index jumped to the highest level in nine months. All three index components jumped sharply, as current sales rose to 68 from 61, expected home sales 69 from 66, and prospective buyer traffic 45 from 40. Quoting the president of the industry trade group, "home buyers are taking note, preferring to invest in housing rather than in a declining stock market." Countrywide Credit, after posting its third strongest month ever during July, has stated that August application activity is exceeding July levels.

July numbers are out for Fannie Mae, and they certainly confirm the historic nature of the continuing boom in mortgage finance. For the month, Fannie Mae's business volume (purchases of mortgages and mortgage-backs) totaled $54.4 billion, the fourth consecutive month of $50 billion plus volume. Fannie now estimates year-2001 total single-family originations at $1.63 trillion, easily a new record. Fannie's "total book of business" (it's own mortgage portfolio and guaranteed mortgage-backs sold into the marketplace) expanded at a 21% rate during July to $1.46 trillion (supported by total shareholder's equity of about $20 billion). Year-to-date, Fannie's total book of business has increased $145 billion (almost 20%), compared to $51 billion during the comparable period last year. Fannie is on pace to expand its total book of business by a staggering $250 billion this year, which brings to mind Treasury Secretary's O'Neill's assertion a few months back that Fannie Mae is only 10% of the mortgage market.

It is certainly also worth noting that Fannie expanded its own mortgage portfolio at a 24.4% annualized growth rate during July to $675 billion, the strongest growth since January. Year-to-date, Fannie's portfolio has expanded $67.8 billion, a rate of 20%. During the past 12 months, Fannie has expanded its mortgage portfolio by almost $117 billion, or 21%. For comparison, the Federal Reserve System has expanded total assets by $18.1 billion (5% annualized) year-to-date (31 weeks) to $626 billion, and $38 billion (6.5%) over the past 12 months. One would need to go back three years for the Federal Reserve to match Fannie Mae's 12-month balance sheet growth.

In an entertaining editorial piece titled "When Fannie Met Freddie," the Wall Street Journal this week called for the full privatization of Fannie Mae and Freddie Mac: "The only purpose now served by Fan and Fred's growing debt is to dramatize the already long list of reasons to truly privatize these companies once and for all. The task they were called to do - provide liquidity for the housing market - has been accomplished. Fan and Fred are not only unnecessary but dangerous. Off with their heads, so to speak." Well, Wall Street Journal editorial staff, isn't it quite late in the game to be voicing concerns about this extended GSE Bubble? Geez… In actuality, calling for decapitation of the GSEs today is about as reasonable as had the Journal, writing an editorial at the top of NASDAQ in early 2000, called on all readers to immediately purchase derivative put positions to lock in the bull market. Sounds good, but it's just not feasible. It's been a crazy party; now make absolutely sure no one stumbles or develops a hangover.

It may make for good copy, but true privatization "once and for all" is today hopelessly impractical and absolutely devoid of any relevance to the real problem. Nationalize perhaps, as they have created and assumed too much risk and too great a role in the U.S. financial system to now operate as private institutions. Unnecessary they are no longer. However, we'll take the Journal's proposal as confirmation that precarious excesses have become so conspicuous - with the tremendous systemic risk created by the GSE/housing Bubble - that we have finally commenced "cover you butt time." I particularly detest "CYBT," as it frustratingly always follows a protracted period where tremendous excesses were disregarded and underlying problems often obfuscated. But I guess when the thing blows up the Journal will be able to come back and say "we told you so."

The Journal also enquired, "Who's minding the store?" and pointed a finger directly at the Office of Federal Housing Enterprise Oversight. Please. This agency has from day one been placed in a most-impossible position, in what has always appeared to be little more than the convenient creation of an inevitable "fall guy" for the benefit of timid central bankers and politicians. It is both disingenuous and absurd to hold this small and impotent group responsible, when clearly the only institutions that had the muscle to rein in the enormously powerful GSE contingent were the Fed, Congress, and the Executive Branch. All three institutions have shunned their responsibilities all along, and we can assure you that it was not because they were not aware of the issues. For too long this precarious GSE Credit inflation and the "gray area" of the "implied government guarantee" has been much too expedient for all involved, including the Greenspan Fed, Congress, the White House, and, of course, Wall Street (none of which even garnered a mention in the Journal piece). Having a ringside seat, the Street could have voiced concerns along the way, instead of all the unrelenting bullish propaganda. We would, of course, be asking too much for the prospering pusher to come forward and implicate his supplier.

The article pointed out that "burgeoning" Fannie and Freddie debt has reached $2.4 trillion, or 23% of GDP. Yet there is certainly no reason to exclude the borrowings from the Federal Home Loan Bank System, the third of the "Big Three," which brings my running total of GSE debt to an astonishing $3.2 trillion. From the Journal: "But since this debt is assumed to be underwritten by taxpayers' money, it makes sense to ask how risky that debt is. We have and the answer isn't reassuring. In fact, it reminds us a lot of the savings-and-loan situation in the 1980s, and you know what happened to them." Of course, enormous, thinly capitalized, heavily leveraged institutions, borrowing aggressively short-term and lending with reckless abandon in long-term mortgage and mortgage-related markets, while operating in an unregulated "wildcat" derivatives marketplace, feeding and being likewise fed by an historic financial and economic bubble, should be considered quite dangerous indeed. But this is not new terrain.

In the past we made the GSE and S&L comparison ourselves but, unfortunately, the scope of this problem has gone much beyond anything comparable to even the massive thrift insolvencies and requisite unprecedented taxpayer bailout. We just hope there are not other less conspicuous issues waiting to surface down the road, especially in regard to these institutions aggressive push into "community lending." When the Journal speaks of "the only purpose now served" by the GSEs, we sense that they do not appreciate the dominant position these institutions now command over the U.S. credit mechanism and Bubble economy. We doubt they recognize the unthinkable ramifications for "cutting off the heads" of the life source for the momentous real estate bubble. There is also the major issue of the critical role assumed by the GSEs in "recycling" the massive U.S. trade deficits back into the U.S. financial sector (especially since tech stocks and equities generally have lost their appeal to foreign investors/speculators). Without question, GSE credit creation is the critical source of liquidity sustaining the U.S. securities-based credit system, and consumption-based service sector economy. There is no turning back.

Assuming that 30% of GSE debt has been purchased by foreign sources, this would put total holdings nearing $1 trillion. When these holders decide to reduce exposure, who is left to buy? A bursting of the GSE Bubble will have dire consequences not only for the U.S. housing market, but also the U.S. financial system and economy, as well as the vulnerable dollar. Any serious waning of confidence in agency securities will precipitate a very problematic systemic crisis.

While it never garnered much attention, the huge losses associated with the S&L and bank failures during the early 1990s were actually quite easily monetized. Domestic depositors of failing thrifts, remaining confident in the stable value of insured deposits, generally were content to sit and let the government shift these liabilities to "healthy" banks. Upon transfer, the government would compensate the "healthy" banks with corresponding payments, which the banks would immediately use to purchase Treasury securities. Basically, the government transferred liabilities (deposits) and newly created assets (government bonds) in what proved a too successful case of monetization. Aggressive Fed rate cuts and a general disinflationary environment at the same time worked wonders for the value of government debt holdings, the dollar was not an issue and everyone was happy. There might have been huge economic losses associated with the S&L debacle, but depositors were largely made whole, the banking system was recapitalized, and the government had little difficulty financing huge deficits. It was very much a domestic issue. Importantly, trade deficits during the early 1990s were relatively contained, and our net foreign debt position was rather modest as a percentage of economic output.

Without a doubt, an S&L-style GSE collapse would bring to the surface the structural weaknesses that have been festering for years under the surface of the U.S. financial system and economy. Actually, we contend that all that is necessary is a termination in GSE credit growth to usher in the bursting of the historic real estate Bubble, a piercing of the massive Bubble in leveraged speculative holdings of U.S. credit market instruments, and the commencement of a general systemic liquidity and currency crisis. A potential GSE collapse would be a much nastier animal than the S&Ls. For one, with so much GSE debt held by foreign sources, such a situation is not conducive to domestic monetization. Second, GSE liabilities are generally either marketable securities or money market borrowings backing uninsured money market fund deposits. Third, the GSEs are major derivative players. Fourth, GSE credit has become the irreplaceable fuel for an increasingly parlous U.S. housing Bubble.

I want to digress somewhat to incorporate two other op-ed articles from Wednesday's WSJ that I view as also speaking to important misconceptions with significant pertinence for current unsettled markets. The articles are Theory vs. Reality, by Charles W. Kadlec, managing director of J.&W. Seligman & Company, and Adios, Peso? by Robert J. Barro, professor of economics at Harvard University and senior fellow of the Hoover Institution at Stanford:

First, (Dow 100,000: Fact or Fiction author) Mr. Kadlec's Theory vs. Reality, goes right to the heart of what we see as most critical issues: "Monetary authorities all over the world are failing to provide predictable, stable monetary policy. The failure is evident in Turkey and Brazil, whose currencies are the latest to plummet on foreign-exchange markets…However, the root of the instability can be traced to policies of the world's three key central banks: the Bank of Japan, the European Central Bank, and the U.S. Federal Reserve…Today, the three leading central banks of the world have each failed to provide monetary stability…The failure of central banking underlines the failure of current economic theory to provide a reliable guide to monetary policy."

From these extractions, one might get the impression that we have stumbled upon an analyst after our own hearts; but it's not so. Mr. Kadlec actually takes the Fed to task for "the fact that it kept interest rates too high, and monetary policy too tight, far too long." First, it is patently flawed analysis to claim today's problems are in anyway related to money being "too tight, far too long," and I am determined to fight this type of dangerous "revisionism." The problem, as we all know, was an extended period of extreme accommodation of credit and speculative excess. It is also unreasonable to conclude that central banks all over the world suddenly began making poor decisions. It is the structure of the current global monetary regime and ungoverned financial systems, and specifically the inability to control credit and speculative excess that is at the root of the problem. As we have stated repeatedly, additional easy money is not going to get us out of the mess. And not until there is recognition that current U.S. and global financial systems are dysfunctional will there be any hope for a return to monetary stability. Like the U.S. economy, the issues are very much structural.

We do agree with Mr. Kadlec's statement, "the collision between theory and reality suggests a skeptical view of conventional theory is warranted," but at the same time adamantly oppose his contention that what is needed is a monetary system based on a "price rule." I will go so far as to categorically state that his and others' focus on a "price rule" is both seriously flawed and dangerous analysis. Mr. Kadlec states: "In the Bretton Woods era, the Fed was committed to targeting the price of gold. By maintaining a stable rate of exchange between the dollar and gold, monetary policy achieved its goal of providing a stable price environment and predictable monetary stability." This analysis hits on a popular and critical misconception: that price stability and stable monetary regimes are solely the result of central bankers targeting prices and regulating the money supply. Importantly, monetary regimes, whether it was Bretton Woods or the "The Classical Gold Standard of 1880 to 1914", owed their success to the prudence and discipline of individual countries for maintaining tight quantitative and qualitative control over money and credit creation. Individual countries were dependent on their institutions, institutions dependent on their employees. And it was not a case of the Fed targeting the price of gold or fine-tuning interest rates, but that convertibility along with financial prudence disciplined individual banking systems (and governments). Lending by individual banks was disciplined by the specter of convertibility and the loss of precious reserves. Individual countries were disciplined by the recognition that excessive lending and domestic consumption, with resulting trade deficits, would foreshadow an outflow of gold and tighter credit conditions.

It was convertibility (not price targeting) providing the true "anchor" that created a self-correcting mechanism within individual credit systems, each acting to ward off excesses before they became extreme or ingrained. Yes, there were still difficult periods (especially at the periphery) and the ebb and flow of business cycles, but the structure and cohesion of the global monetary regime remained intact. This was due to the commitment, diligence, and responsible actions by the major participants at the core of the regime that assured booms didn't get out of hand, hence the subsequent retrenchments too deep or problematic. It should be clear that such a self-correcting mechanism is like night and day compared to the current system of self-serving and self-feeding monetary excess, extreme booms and unavoidable problematic busts.

Furthermore, when it was backing the global monetary regime, gold was obviously the key global commodity in regard to monetary stability. We live today in a much different era without a monetary anchor. So what price(s) do the "price rule" proponents propose we "target?" Do we have the Fed continue to focus on consumer goods prices, while unprecedented credit excess creates destabilizing asset Bubbles, first in the greater technology sector and now throughout real estate finance and the credit market? Are not asset Bubbles and endemic trade imbalances the telltale signs of monetary instability? Isn't a key goal of monetary stability to foster sound and balanced growth, the exact opposite of what we see today with a collapsing technology sector (bursting Bubble) concurrent with a dangerously expanding real estate Bubble?

There is today simply no way to achieve any semblance of monetary stability, either domestically or internationally, as long as individual countries are incapable of controlling credit excess. This is particularly the case when the greatest instigator of excess is the keeper of the world's reserve currency. And there will be no end to this extraordinary period of monetary instability (domestic and international) until we see an end to this regrettable era of rampant credit excess, endemic speculation, and unrelenting financial adventurism. Mr. Kadlac makes the point that mortgage rates in 1964 were at 5.8%, compared to today's 7%. Well, in 1964 did we have major institutions like Fannie Mae expanding credit at a 24% rate? Did we have double-digit 12-month broad money supply growth? Did we have near zero household savings? Was the U.S. running better than 4% ($450 billion) current account deficits? I see no link between a "price rule" and a return to an environment of prudence, discipline, responsibility, and financial sanity.

While no one dares utter the word "regulation," the bottom line is that there will be nothing but continued financial turmoil and economic tumult until this period of "wildcat" finance is replaced with a regime of tempered, balanced and responsible credit expansion. Even after the collapse of the NASDAQ Bubble, I still see a marketplace that rewards reckless lending and credit excess. These dysfunctional financial processes must be broken. There is certainly no magical elixir to be found with GSE privatization or nebulous price level targeting, and at the same time no one seems to be willing to admit the system is broken and needs fixing. Monetary stability comes only with lending stability, which certainly does not include wild lending excess directed to asset markets and financial leveraging and speculation.

We then had Mr. Barro's thoughtful analysis, Adios, Peso?, of Argentina's current dilemma. "Since 1991, Argentina has been operating under two key principles for the public sector. The first is 'Do not devalue,' enshrined in the convertibility law, which created a type of currency board that fixed the value of the peso at $1…The second principle is 'Do not default.' Obligations to bondholders are regarded as contracts that a serious country always honors. So, just as holders of Argentine money can count on one peso being worth $1, holders of Argentine bonds can be confident of receiving a contracted stream of payments."

The currency board arrangement operated quite well for a number of years, offering enticing prospects for international investors and speculators. With global capital flowing readily into Argentina, a virtuous circle developed as robust economic growth fueled strong financial markets, a favorable fiscal position, and seductive appearance of monetary stability. The currency regime operated without stress, with the combination of deposit convertibility and the assumption of continuous liquidity for Argentine marketable securities providing a very powerful backdrop. But the success of such an arrangement, especially in the current global environment, only planted the seeds of its own destruction, as companies and various government bodies accumulated huge amounts of dollar denominated debt. The flaw in the system was its failure to appreciate the differences between "money" and credit, and allowing basically uncontrolled international borrowings. Argentina is, however, anything but alone in making the critical and erroneous assumption of marketplace liquidity. And, importantly, even a strict regime of currency convertibility, in and of itself, does in no way ensure a stable monetary system.

The key weak link in such a system is the unavoidable financial vulnerability associated with accumulated foreign currency borrowings. Bank deposits ("money") may be backed by dollar reserves, but that certainly doesn't ensure that Argentine companies and government units will be granted continuous access to international markets for additional borrowings or to refinance short-term debt obligations. Marketplace liquidity is outside of official control. In my view, it was a flawed system based on erroneous theory, with the system over time falling hostage to the vagaries of international capital markets increasingly engulfed in a morass of instability and dislocation. When capital flows to Argentina reversed, the "virtuous circle" was abruptly transformed into the "vicious cycle." The entire credit mechanism faltered in illiquidity, the economy was strangled by the lack of new credits, and destabilizing runs commenced both domestically and internationally in a rational effort to avoid what was presumed to be an unavoidable devaluation and default.

Since June, investors withdrew $10 billion of deposits, while the Argentine central bank lost 21% ($4.4 billion) of its reserves last month alone. Unemployment has jumped to 16%, with auto sales dropping 40% year over year. The government, understandably, is desperate to avoid the financial collapse that would likely follow devaluation and widespread debt default. While they have few options currently, I would expect that officials now recognize that it is simply unacceptable to leave oneself exposed to such circumstances. It, and similar contemporary monetary structures, is a "fair weather" regime that seemingly falters with the first sign of waning confidence. Mr. Barro argues "for full dollarization that include(s) the use of U.S. dollar bills in Argentina." I would argue the exact opposite; that further tying its credit system and economy to the U.S. dollar only assures continued monetary and economic instability. As much as this goes against conventional thinking, I see as the best long-term solution for Argentina and the other troubled periphery countries to absolutely avoid pegs to the U.S. dollar, while pursuing disciplined fiscal and monetary policies as isolated as possible from destabilizing international capital flows. These seductive flows of "hot money" too easily becomes the epicenter of credit expansion during the halcyon days of a boom, only to morph into a ravaging tsunami that devastates any financial system or economy in its path when the environment turns less hospitable.

On that note, let's return to the GSEs. One of the critical issues today is the potential for a tidal wave to develop with a bursting Bubble in agency debt issues, mortgage-backs, and other U.S. denominated financial instruments. It's not farfetched, as we saw a hint of such a scenario in the fall of 1998. Perhaps this is only a minor risk presently. Yet, such a development should be recognized as a higher probability event now with the dollar having now suffered a sharp reversal. It is certainly also our perception that the marketplace is moving swiftly up the learning curve in appreciating the danger of continuing gross credit excesses and the resulting perilous Bubble throughout the U.S. real estate sector. Conspicuously, it is a credit system that remains dangerously out of control. I also sense that there is increased recognition of the extreme nature of U.S. economic imbalances, maladjustments, and the severe structural damage imparted on the U.S. economy over this protracted boom. This is clearly not an inventory issue, or anything remotely typical of a normal business downturn. It is, instead, a case of endemic runaway Credit and speculation-induced booms and busts. Interestingly, recent dollar weakness has developed despite indications that global economic weakness is gaining momentum while the U.S. economy remains thus far relatively resilient. This is again consistent with our sense that the marketplace is increasingly cognizant of the severe structural problems facing the U.S. Bubble economy.

The big unknown remains how long unprecedented GSE credit excess sustains the U.S. Credit and economic Bubble. These companies operate with powerful "pegs" all too similar to the currency pegs that were critical factors in the credit and speculative Bubbles that ballooned and burst throughout SE Asia and emerging markets. In one respect, there is a "ratings peg," with these companies granted top status from the various ratings agencies regardless of the amount of outstanding borrowings. This "blank check" is one recipe for trouble! Second, GSE debt is basically "pegged" in the marketplace within a very narrow spread to Treasuries. Third, these institutions, as buyers of first and last resort, basically "peg" the relative value of mortgage securities throughout the marketplace. As such, they in effect promise "convertibility" of mortgages and mortgage-backs on demand into "money." All throughout, these "pegs" assume make that bold assumption of marketplace liquidity. These various "pegs" are at the heart of these companies' capacity, through massive and unrelenting credit creation, to provide an unlimited supply of top-rated securities and endless financial system liquidity. They easily accomplish what would without them be a virtually almost impossible task at this juncture, the transformation of risky mortgage loans into safe "money" while ensuring endless liquidity in the face of the ongoing technology collapse. I do not believe one can overstate the role this mechanism has and continues to play in levitating an acutely vulnerable U.S. financial and economic Bubble. I do not know of any better historical example of financial alchemy, or any as dangerous. These "pegs" will not be broken quietly.

Over the past few years we have witnessed many instances of credit-induced "virtuous circles" abruptly becoming "vicious cycles." By now, analysts should have a much better understanding and appreciation of the dynamics of credit and speculative excess, as well as bursting Bubbles. While I can't say I am too enthused by the analysis in the Journal, I have considerable more respect for the marketplace in sensing out these types of issues. And while these types of Bubbles always last much longer than one would imagine and, in this most extraordinary environment, go to astounding extremes, they nonetheless also always end at some point and often with a bang. This historic GSE Bubble is certainly long in the tooth. It increasingly has the appearance of the type of environment that could test the vulnerability of a highly leveraged U.S. credit system.

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