It was a highly speculative week for the U.S. stock market. The AMEX Biotech index jumped 5%, increasing its year-to-date gain to 100%. The AMEX Securities Broker/Dealer index surged 12%, as its year-2000 gain jumped to 53%. The S&P Midcap 400 index added 3%, increasing year-to-date gains to 23%. The NASDAQ100 advanced 4%, as its year-2000 gain returned to double-digits, while the Morgan Stanley High Tech index added 2%, with its year-to-date gain increasing to 21%. The Morgan Stanley High Tech index now sports a 52-week gain of 79%, dwarfed, however, by the 172% gain for the AMEX Biotech index. This week both The Street.com Internet index and the NASDAQ Telecommunications index advanced 5%, while the small cap Russell 2000 added 3%. Value stocks and the bluechips performed much less spectacularly. The Dow added less than 1% and the S&P500 added just over 1%. The Utilities jumped 4%, increasing year-to-date gains to 22%. The Morgan Stanley Cyclical index was unchanged, while the Morgan Stanley Consumer index declined 1%, and the Transports dropped 4%. Although the banks did underperform the highflying brokerage stocks, the S&P Bank index nonetheless added 2% this week. The gold stocks mustered a 2% gain for the week.
Volatility has returned to the credit market. After rising earlier in the week, 2-year Treasury yields then sank 16 basis points as yields dropped 11 basis points for the week. Five-year yields declined 10 basis points, while 10-year yields dropped 4 basis points. Mortgage and agency yields jumped almost 10 basis points then reversed sharply yesterday and today to end the week down between 4 and 6 basis points. Spreads also reversed after widening during the first-half of the week. The benchmark 10-year dollar swap spread narrowed three basis points today and ended one basis point lower for the week at 124. The dollar finished the week largely unchanged, although currency markets were also unsettled. The dollar dropped more than 1% today against the euro and Swiss franc, and lost ground again this week to the Japanese yen. Energy prices continue to rise, with crude oil increasing another 4% this week to $33.38 a barrel.
"Sooner or later, the crisis must break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media (i.e., banknotes and checking accounts not fully backed by money). The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments." Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
"There is no regularity as to the recurrence of paper money inflations. They generally originate in a certain political attitude, not from events within the economy itself. One can only say, with certainly, that after a country has pursued an inflationist policy to its end or, at least, to substantial lengths, it cannot soon use this means again successfully to serve its financial interests. The people, as a result of their experience, will have become distrustful and would resist any attempt at a renewal of inflation." Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
"According to the Circulation Credit Theory, it is clear that the direct stimulus which provokes the fluctuations is to be sought in the conduct of the banks. Insofar as they start to reduce the "money rate of interest" below the "natural rate of interest," they expand circulation credit, and thus divert the course of events away from the path of normal development. They bring about changes in relationships which must necessarily lead to boom and crisis. Thus, the problem consists of asking what leads the banks again and again to renew attempts to expand the volume of circulation credit.
Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and that they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory. I could not understand why the banks didn’t learn from experience. I thought they would certainly persist in a policy of caution and restraint, if they were not led by outside circumstances to abandon it. Only later did I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks. Only later did I also become convinced that fluctuations in general business condition were completely dependent on the relationship of the quantity of fiduciary media in circulation to demand.
Each new issue of fiduciary media has the consequences described above. First of all, it depresses the loan rate and then it reduces the monetary unit’s purchasing power. Every subsequent issue brings the same result. The establishment of new banks of issue and their step-by-step expansion of circulation credit provides the means for a business boom and, as a result, leads to the crisis with its accompanying decline. We can readily understand that the banks issuing fiduciary media, in order to improve their chances for profit, may be ready to expand the volume of credit granted and the number of notes issued. What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation credit in spite of the spectacular failure of such efforts in the past.
The answer must run as follows: According to the prevailing ideology of businessmen and economist-politician, the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal." Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
"Every single fluctuation in general business conditions – the upswing to the peak of the wave and the decline into the trough which follows – is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit through an increase in the supply of fiduciary media. The fact that these efforts are resumed again and again in spite of their widely deplored consequences, causing one business cycle after another, can be attributed to the predominance of an ideology – an ideology which regards rising commodity (today stock and real estate?) prices and especially a low rate of interest as goals of economic policy. The theory is that even this second goal may be attained by the expansion of fiduciary media. Both crisis and depression are lamented. Yet, because the causal connection between the behavior of the banks of issues and the evils complained about is not correctly interpreted, a policy with respect to interest is advocated which, in the last analysis, must necessarily always lead to crisis and depression.
Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic "equilibrium." This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis.
The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy." Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
"…The practice of intervening for the benefit of banks, rendered insolvent by the crisis, and of the customers of these banks, has resulted in suspending the market forces which could serve to prevent a return of the expansion, in the form of a new boom, and the crisis which inevitably follows. If the banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit? If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs – not only banks but also other businesses – would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit." Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
We are obviously fascinated with Mises’ money and credit analysis (and strongly recommend "Von Mises on the Manipulation of Money and Credit") and how brilliantly he concentrated on distortions emanating from the expansion/manipulation of "fiduciary media," or instruments (money substitutes) that have the economic functionality of traditional "money." Unfortunately, contemporary economic analysis is devoid of these great insights. Mises’ analysis broadened the universe of financial instruments whose expansion he recognized as fueling inflationary manifestations. We are quite confident that were Mises alive today, he would as well focus on broad money supply and credit expansion as the inflationary fuel for this unsound boom. And although during Mises’ life the banks were the main mechanism of money and credit creation, today one must clearly look at the financial sector and its vast array of liabilities and structures for the inflationary source of the great U.S. financial and economic bubble.
Looking again with consternation at the most recent data, we see a continuation of an astonishing period of monetary excess. Bank credit increased by almost $10 billion last week, continuing the rapid expansion that has seen a nearly 11% growth rate so far this year. Broad money supply (M3) expanded by another $21.4 billion last week. Demand and checkable deposits (components of M1) increased by about $14 billion. During the past 25 weeks, broad money has expanded by $317 billion, or at a 10% annualized rate. Fully one-half of this expansion is explained by just two components, "institutional money funds" and "large time deposits." Over this 25-week period, "institutional money funds" have expanded by $83 billion, or at an annualized rate of 28%, while "large time deposits" have grown $75 billion, or at a rate of 22%. Year-to-date, these two "institutional" components have increased a total of $178 billion, or at an 18% annualized rate. For comparison, during the same period last year, "institutional money funds" and "large time deposits" combined to expand by $36 billion, or 5%. During the past twelve months, broad money supply has increased by a staggering $625 billion, or nearly 10%. During this period, "institutional money funds" increased $146 billion, or 26%, and "large time deposits" surged $162 billion, also 26%.
Not coincidently, we see that five leading Wall Street firms – Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, and Lehman Brothers – continue to aggressively expand their balance sheets. These companies combined to increase total assets (and liabilities!) by about $220 billion during the first-half, an annualized growth rate of 24%. Also during the first-half, non-federal debt (non-federal government and non-financial sector) expanded by $610 billion, or at a rate of 9%, the largest expansion since the first quarter of 1999. Non-federal debt has also expanded by 9% ($1.198 trillion) during the past year and 20% ($2.379 trillion) during the past twenty-four months. And while we do not yet have financial sector debt numbers for the second quarter, as we have highlighted in past commentaries, financial sector debt exploded by $2.16 billion, or 40%, for the 1998 and 1999 period.
We are now in the sixth year of extraordinary credit-induced excess (although a strong case could be made to include the financial excess years of 1992/1993). And while bank credit expanded by $1.45 trillion, or 44%, during the second-half of the 1990s, even greater fuel for the financial and economic bubble originated through credit creation from both non-bank financial institutions and the capital markets. During this five-year period (1995-1999), the Government-Sponsored Enterprises increased total assets (largely loans and "investments") by $938 billion, or 120%. Mortgage-backed securities or, in Federal Reserve parlance, "federal mortgage pools" expanded $820 billion, or 56%. Outstanding "asset-backed securities" surged $1.05 trillion, or 186%, while "funding corporations" expanded $568 billion, or 156%. Aggressive expansion of security broker/dealer assets was also instrumental in fueling the bubble, as total assets increased $545 billion, or 120%. Finance company assets increased $357 billion, or 59%. And as money market funds took on a prominent role, particularly in funding financial sector balance sheet expansion, holdings surged $982 billion, or 163%.
During this five-year bubble period, total financial sector debt increased almost $3.8 trillion, or 99%. Total outstanding credit market debt increased $8.4 trillion, or 49%, to an astonishing $25.6 trillion. This unprecedented monetary expansion fueled enormous asset inflation, with stock market values surging $9.27 trillion, or 204%, to $13.8 trillion. Combining credit market debt instruments with total stock market value, total marketable securities surged $17.7 trillion (81%) to $39.4 trillion.
With this amazing data in mind, we would like to highlight an article written this week by noted economist Dr. Irwin Kellner from CBSMarketwatch titled, "Consumers’ Rational Exuberance." While we are regular readers and appreciate Dr. Kellner’s articles, we will critique this particular analysis as it clearly illuminates a key area of erroneous thinking held by the bullish consensus. Quoting from his writing, "The drop in July’s personal savings rate to an all-time monthly low of negative 0.2% is not as ominous as it might appear. Nor is the fact that people have saved very little of their take-home pay all this year." The gist of Dr. Kellner’s argument is that a household sector holding incredible "wealth" is demonstrating only "rational exuberance" as it binges on borrowing and consumption. With household wealth having "more than doubled in the past nine years…clearly, people can spend more than they earn in a given month -- or even over longer periods of time -- as long as they have assets that they can convert into cash." "Holdings of stocks certainly fall into this category. The major market averages have more than doubled over the past five years alone…This alone has added a big chunk to people’s buying power – to say nothing of their confidence. Rising home prices have helped, too."
And while Dr. Kellner’s analysis is seemingly straightforward and reasonable, it actually goes right to the heart of a momentous flaw in current economic thinking. Ludwig von Mises would be aghast. In the past we have emphasized how monetary inflation generally manifests into three forms: consumer goods and services inflation, rising asset prices and trade deficits. Unfortunately, current thinking looks askance at only rising consumer prices, while trumpeting the virtues of the rising asset prices and imports. We, however, subscribe to the brilliant analysis of Dr. Kurt Richebacher, who states that consumer price inflation is the least dangerous form of credit inflation as it is easily rectified by strong monetary tightening from the central bank. Moreover, it is most critical to recognize that asset inflation is powerfully seductive (Larry Kudlow, Dr. Kellner and many of the bulls mistakenly view asset inflation as "wealth creation"!) and of much greater danger to the soundness of an economy and stability of its financial system. With asset inflation having a broad and determined constituency including the general public, bankers, Wall Street, corporate America and politicians, the resulting damage is allowed to unfold over long periods, while hardly even garnering the attention of central bankers. As such, this week’s report that spending expanded at double the rate of income growth, while the savings rate went negative, is clear evidence of asset inflation fostering a severely dysfunctional economic and financial environment. Yet, current bullish "New Paradigm" thinking has turned sound analysis on its head. Instead of understanding that a negative savings rate is indicative of a severely distorted bubble economy, the bullish consensus sees the continued borrowing and spending binge as evidence of a sound and stable prosperity. It is this momentous gap between the perceived supreme health of the current environment and the actual reality of massive financial and economic imbalances that is disturbingly reminiscent of the bubbles of 1929 in the U.S., 1989 in Japan, and 1996 in SE Asia.
The key point that is lost by the bullish consensus (as well as the Federal Reserve) is that unsustainable processes drive current overheated demand. Indeed, money and credit excess have irreparably distorted market pricing mechanisms, fostering rising stock and home prices and a massive misallocation of resources. At the same time, this massive inflation has created unprecedented financial wealth that only works to perpetuate the financial and economic bubble. This massive inflation has created the perception of unprecedented wealth creation for the household sector that now, according to Federal Reserve data, has net worth (household sector and non-profit organizations) at an unfathomable $42 trillion. (Is there any mystery why the household sector binges on borrowing and consumption?). To appreciate the forces behind current spending, it is critical to recognize that household net worth increased a staggering $4.75 trillion last year, fully 50% of GDP. For comparison, household net worth advanced a total of $4.3 trillion during the entire first-half of the 1990’s, averaging 15% of GDP annually. Household net worth increased $725 billion during 1994, $2.8 trillion in 1995, $2.5 trillion in 1996, $3.8 trillion in 1997, and $3.3 trillion in 1998.
As great economic thinkers have appreciated for centuries, there is significant danger in allowing excessive credit growth, as credit excess begets only more credit and a runaway boom destined for bust. And as Mises recognized, the extent of the unavoidable bust is directly proportional to the excesses committed during the preceding boom. Importantly, the longer monetary excess is allowed to continue, the further economies and financial systems diverge from conditions of sustainable growth and stability. Articulated brilliantly by Mises, "every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic "equilibrium".
As we have witnessed during this boom cycle, credit excess creates disturbances, including the increase in perceived household wealth. This perception of profound wealth further stimulates excessive borrowing and spending, which leads the economy only deeper into a boom/bust cycle. And, as is presently observable, the more protracted the period of unfettered credit-induced boom, the greater the monetary inflation feeds directly into rising wages and income, again working to exacerbate the precarious expansion and more permanently distort the underlying economic system. Additionally, Mises’ analysis focused on "entrepreneur errors" that were a function of decision making in a distorted marketplace, as well from the extrapolation of unsustainable boom-time trends. And the longer the calculation of the entrepreneurs is misguided by credit-induced distortions, the greater the over investment and malinvestment by the business sector, and the further the economy travels down an unsustainable track. Certainly, signs are proliferating within the economy of the significant costs to be paid for previous errors. With current difficulties being experienced within the Internet, retail and movie cinema sectors as good examples, we can add these sectors to a lengthening list of trouble spots. These, however, are merely harbingers of much greater dislocations to come. Quite simply, the business sector, particularly within technology and telecommunications, is geared up for demand that is absolutely unsustainable.
And while credit-induced imbalances and distortions wreak subtle havoc on the real economy, equally dangerous disturbances are inflicted on the financial system. It may appear harmless for an individual consumer to borrow against a surging home price or increasing stock values. It is, however, an altogether different matter when the entire household sector increases its debt load substantially to fund consumption, not only above income but also much beyond what an economy can produce. For one, this process presently adds additional debt on an already over leveraged system, again in a self-reinforcing bubble. What’s more, over time this monetary expansion has been increasingly backed by rising asset values. The greater the expansion, the more fuel for additional asset inflation; and this creation of additional "collateral" only fosters more borrowing and higher debt loads. And as this self-reinforcing process stokes destabilizing asset inflation (i.e. California and New York real estate prices!) and resulting over consumption, the outcome is much larger quantities of increasingly poor quality debt for the financial system. When debt is created to finance sound investment with stable future cash flows, that’s one thing. When enormous credit excess is created to finance consumption and rising asset prices, that’s something completely different! (see May 26th commentary "Ponzi Finance"). Today, it is critical to recognize that the U.S. economy and financial system have diverged spectacularly from equilibrium, are in the midst of a credit bubble financing consumption and an asset bubble, and that this process is self-reinforcing and destabilizing.
We also have the sense that the bulls do not appreciate that "one person’s asset is another’s liability." And while the household sector is perceived to be enjoying a bonanza from historic financial asset inflation, the majority of this "wealth creation" is simply the other side of the explosion of liabilities from both the business and financial sectors. And with both sectors locked in a process of extreme over borrowing where the proceeds are funding questionable expenditures, it should be clear that these respective credit bubbles are creating a mountain of liabilities of increasingly dubious character. The extreme leverage that has developed within the financial sector is certainly a house of cards, and Wall Street is recklessly financing incredible numbers of businesses with negative cash flows and little hope of ever generating economic profits. We simply cannot imagine an environment with greater "entrepreneur errors" or the funding of more uneconomic enterprises. Our analysis also leads us to believe that there is a clear relationship between the household sector’s lack of savings and the financial sector’s increasing leverage. Indeed, financial sector leverage has increasingly been the financing vehicle for the household sector’s consumption binge, and it is our view that this is what is behind the strange anomalies in the monetary aggregates. There is also the major issue of foreign creditors financing our consumption binge ($400+ billion expected year-2000 current account deficit), and the unavoidable future costs associated with such profligacy. On all fronts, these factors foster acute financial fragility and extraordinary economic vulnerability.
Borrowing from Mises, according to the prevailing ideology of businessmen, economists, politicians, and, of course, Wall Street, the reduction of interest rates and the maintenance of asset inflation is considered an essential goal of economic policy. How else can one explain the Fed’s accommodation of $1.1 trillion of broad money supply expansion over the past 24 months without even the slightest show of concern for unprecedented money and credit excess? This ideology, having strengthened over the course of many crisis resolutions, holds that the Fed will always possess the power to manipulate money and credit. One would think that the Japanese experience over the past decade would have illuminated one of the serious flaws in this line of reasoning: A monetary system that has fallen victim to financing a runaway asset bubble becomes acutely vulnerable to any decline in asset prices. After all, it becomes very difficult to borrow against an asset deflating in value. Furthermore, indebted consumers turn very cautious when they see the value of their assets sink while debt levels remain constant. In such an environment, it is only natural that individuals and businesses reduce spending and strive to reduce debt. On the other hand, it takes enormous credit growth to maintain inflated asset prices at the tenuous late stage of a bubble. And right there is the big dilemma.
Presently, there are three distinct and historic asset bubbles, all falling within the "umbrella" of the great U.S. credit bubble. First, there is the obvious stock market bubble. As consequential although not generally appreciated, there is also a real estate bubble that has grown over the years to become one of history’s great asset inflations. And third, also remarkable if not at all recognized, is the momentous leverage and speculative bubble in the U.S. (global) debt market. Importantly, continued extraordinary monetary expansion will be required to sustain inflated prices in all three of these sweeping asset bubbles. Why, one may ask, is broad money supply growing at a ridiculous rate of 10%? Well, we would argue that this is apparently the degree of monetary expansion necessary to keep these fragile bubbles from deflating, as the financial sector is determined to perpetuate the boom. However, as we have written, it is now to the critical point where such egregious monetary excess "presents a clear and present danger" to financial stability, both at home and abroad. In this regard, we have witnessed a major inflation in the key global market for crude oil that is only now being recognized as more than a temporary price "blip." We also note that global currency markets have demonstrated exceptional volatility and unsettled trading, with Asian currencies and markets demonstrating particular weakness. There is also the problem with the weak euro. These should all be interpreted as ominous indications of mounting global financial instability.
Increasingly, the risks of the present course of U.S. and global monetary excess must resonate with central bankers in Europe, Japan, and elsewhere. Going forward, we certainly expect increasing bouts of dislocation in currency markets that will reverberate throughout global debt and equity markets. If nothing else, we are entering what we view as an extraordinary period of uncertainty, as questions and indecision develop regarding the sustainability of the U.S. bubble. We certainly believe that the "stakes have changed" globally. No longer will all economies perceive they are benefiting equally from the U.S. led game of global money and credit profligacy. And now that it is becoming increasingly clear that the U.S. has been and appears poised to remain the big winner, we ponder the possibility of global central bankers breaking rank. After all, one of these days central bankers may determine that the endless flow of dollars flooding the world is inflationary, destabilizing and detrimental – that the U.S. bubble must be reined in. That day would prove an historic inflection point for the U.S. dollar, as well as for the American credit and equity markets. Whether that day is near at hand remains unclear. There is now, however, no longer any doubt that we are moving squarely in that direction.
