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The Problem With Modern Monetary Theory

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Financial Dysfunctions

Mortgage refinancing Applications
Financial Sector Debt Outstanding
Foreign Holdings of US Financial Assets

Liquidity returned to the stock market this week, with a major rally throughout the technology sector. For the week, the NASDAQ100 gained 5%, the Morgan Stanley High Tech index 6% (y-t-d gain 4%), and the Semiconductors 8%. The Street.com Internet index surged 15%, while the NASDAQ Telecommunications index added 3%. The biotech bubble expanded, with this week's 9% jump increasing year-to-date gains to 98% (52-week 193%). The blue chips were strong as well, with the Dow adding 2% to its recent gains, while the S&P500 increased 3%. The economically sensitive issues shined, with the Transports surging 9% and the Morgan Stanley Cyclical index jumping 7%. The Utilities and the Morgan Stanley Consumer index increased 2%. Market strength was quite broad, as the small cap Russell 2000 jumped 6% and the S&P400 Mid-cap increased 5%(y-t-d 19%). The financial stocks were very strong as well, with the S&P Bank index gaining 7% and the Security Broker/Dealers 6%.

Recovering stock prices were not good news for the Treasury market, in what continues to be a quite unsettled credit market. Treasuries came under heavy selling pressure today. For the week, although 2-year yields remained unchanged, 5-year Treasury yields jumped 7 basis points and the key 10-year yield surged 11 basis points. Long-bond yields increased 12 basis points. Mortgage-backs and agencies again outperformed, with yields rising between 3 and 7 basis points. The benchmark 10-year dollar swap spread narrowed 6 basis points to 108. Junk bond spreads generally narrowed a few basis points, while high-quality corporate spreads narrowed as much as 8 basis points. Global currency markets are extraordinarily volatile also, with the dollar this week coming under the most selling pressure in some time. Today the European central bank again intervened to support the euro. The dollar index dropped almost 2% this week. Emerging markets, particularly in Latin America, appear to experiencing a problematic loss of liquidity.

"Every era of speculation brings forth a crop of theories designed to justify the speculation, and speculative slogans are easily seized upon. The term "new era" was the slogan for the 1927-1929 period. We were in a new era in which old economic laws were suspended…We were troubled also in 1928-29 by the weird doctrine…that it was the business of central banks to maintain a fixed commodity price level, and that central banks must not concern themselves with the stock market and must not tighten credit to restrain stock market excesses because that would reduce commodity prices." Benjamin M. Anderson, Economics and the Public Welfare 1949

"We were told, moreover, by Professor Irving Fisher that we were on a "higher plateau" of stock exchange prices." Benjamin M. Anderson, Economics and the Public Welfare 1949

As I have written previously, it is my view that we are at the precipice of a financial and economic crisis unlike anything seen in this country since the collapse of the 1920's bubble. Of course, to possess such a view today is tantamount to lunacy in the eyes of the unwavering bullish consensus. That's fine. After all, leading economists, Wall Street prognosticators, media pundits, government officials and Federal Reserve members could not have been more wrong in their analysis of the late 1920s boom. So, how could they have only envisaged "permanent prosperity" when the economic train was steamrolling directly into the Great Depression?

Granted, after the publishing of Milton Friedman's and Anna Schwartz's The Monetary History of the United States, it became accepted doctrine that the Depression was to be blamed squarely on the Federal Reserve's failure to expand money supply after the downturn commenced. This is both erroneous and most unfortunate analysis, but we'll save that discussion for another day. Suffice it to say, the causes of the Great Depression predominantly emanated from the extreme nature of excesses during the preceding boom, and the resulting financial fragility and economic distortions and imbalances both in the U.S. and globally. Importantly, it is my view that spectacular booms are actually almost always a manifestation of extraordinary underlying inflationary forces. Specifically, destabilizing circumstances within the credit system lie behind sharply rising asset prices - and that asset inflation plays an increasing (and self-reinforcing) role over time, as a typical business cycle expansion develops into a precarious Bubble Economy. And with contemporary monetary systems "backed" by assets such as real estate, stocks, and marketable credit securities, money and credit excess feed systematically into higher asset prices. Asset inflation then begets only more inflation as additional collateral value provides for even greater borrowing and spending - creating a self-feeding "Bubble Economy." In Bubble Economies, the great inflation is specifically not in consumer goods prices, but instead in stocks, bonds, homes, office buildings, sports franchises, media properties, vintage automobiles, yachts, collectables, and a myriad of other assets.

A crucial dilemma, particularly during periods of prominent financial asset inflations, is that rising financial wealth (inflation) is so alluring, and no one has a vested interest in identifying the inflationary source, let alone bringing it to an end. Of course, it is exactly the opposite, with huge vested interests determined to perpetuate asset bubbles. Certainly, Wall Street and Washington have an overly passionate love affair with asset inflation. I feel almost silly writing such a notion - that someone would endeavor to stop asset prices from rising. But thwarting asset inflation is a fundamental prerequisite to financial and economic stability, and precisely why we seek an "independent" central bank. Of course, with a culture of "optimism," new technologies or notions of New Eras provide a seductive explanation for inflating asset prices; apparently, and quite problematically, even for current central bankers.

So, to answer the question: How could so many intelligent and knowledgeable individuals have completely misunderstood the 1920's boom? Well, they were convinced that surging stock and real estate market prices were, in the great wisdom of the marketplace, "discounting the future" - that rising prices were an undeniable confirmation of sound underpinnings and a paradigm shift of improved fundamentals. Yet, bullish analysis could not have diverged more diametrically from what would prove a very harsh future reality. Missed was A Rather Simple Maxim: Bubbling asset prices are specifically the consequence of extraordinarily unsound factors - the inflationary manifestation of an increasingly dysfunctional credit system and a central bank having lost control of the monetary system.

We are great fans of Benjamin M. Anderson's Economics and the Public Welfare, first published in 1949, and will share a few paragraphs of his book to illuminate the similarities between now and the 1920's. Dr. Anderson was a brilliant student of money, banking and credit, and became a leading economist and writer, including a stint at Chase National from 1920-1939. From the foreword by Arthur Kemp: " In this history, Anderson touches upon practically every aspect of commercial banking and, in almost every instance, he takes a position that might be called, for lack of a better name, "sound banking principles," which means he regarded the banking business as a regulated but private enterprise, not as an instrument for economic, social, and political experimentation by government." His views and analysis of the excesses from the 1920's could simply not be more pertinent today.

"Where the Federal Reserve banks bought tens of millions for a few days, in connection with the first three liberty loans, they bought hundreds of millions and held them for many months in 1922, 1924, and 1927. And where the Bank of England had primarily used its open market operations for the purpose of tightening its money market in prewar days, the Federal Reserve System used them deliberately for the purpose of relaxing the money market and stimulating bank expansion in 1924 and 1927. At a time when unusual circumstances called for extra caution, they abandoned old standards and became daring innovators in the effort to play God."

Consistent with our premise that most spectacular asset inflations are credit-induced and indicative of an inherently unsound environment, the current Fed has repeated the same critical policy errors made in the 1920's - they "abandoned old standards and became daring innovators." Instead of implementing "extra caution" over the years, within the context of a global financial system with an incredible proclivity of fostering spectacular credit and speculation-induced booms and devastating busts (U.S. late 80's, Japan 80's, Mexico, SE Asia, Russia and Latin America and, of course, the U.S. (again) in the 90's), the Fed could not have been more accommodating of money, credit, and speculative excess. Additionally, with unparalleled financial innovation and expansion (particularly derivatives, "structured finance," and leveraged speculation generally), these unusual circumstances shouted for "extra caution." We got the exact opposite. Then, with the inevitable collapsing of bubbles globally, caution was absolutely "thrown to the wind" as the Fed accommodated the greatest credit and speculative excess in history over the past two years. Most likely as justification for inept policy, New Era thinking was adopted at the top of the Fed.

"Stock prices were already high in the summer of 1927. There was an unhealthy tone. There was a growing belief that stocks, though high, were going much higher. There was an increasing readiness to use cheap money in stock speculation. The situation was still manageable. The intoxication was manifest, not so much in violent behavior as in slightly heightened color and increasing loquacity. The delirium was yet to come. It was waiting for another great dose of the intoxicant." 185

Our current experience is a circumstance disconcertingly similar to the events leading to the Great Depression. The apex of the 1920's U.S. financial and economic boom transpired within an acutely vulnerable global financial backdrop. Indeed, it was financial and economic frailty encompassing the world that played a key role in fateful central bank acquiescence, particularly in 1927. Again, if the global environment were not so precarious and commodity deflation prevalent, it is highly unlikely that the Federal Reserve would have nurtured the late 1920's rampant money and credit growth, the fuel for historic stock market speculation and a Bubble Economy. I argue that were it not for the acute financial and economic fragility globally, going back to the early 1990's but particularly during 1998, the Fed would have not accommodated historic money and credit excess - the fuel for history's greatest financial and economic bubble. It is also my view that if it were not for weak global demand and the resulting downward pressure for prices in the energy sector, basic commodities, technology components, and manufactured goods (global disinflation/deflation) during recent years, domestic consumer price pressures would have likely kept the Fed much more vigilant (and isolated from silly notions of New Eras.)

"Investor's Money vs. Bank Expansion. It was not easy to convince investment bankers and bond dealers in the period 1925-29 that it was commercial bank expansion which was generating the demand for the securities which they were selling. They insisted, and correctly, that real investors' money was coming in, and that a great many securities were being bought outright. They were impressed by the statistics showing the growth of stock and bond collateral loans in the banks, the growth of bank ownership of bonds, and the growth of bank deposits, but they still insisted that they were selling to investors. But here is a typical case where one could trace every step of the process. An old lady in Missouri held a mortgage which she had inherited from her father. A Missouri Joint Stock Loan Bank floated a bond issue in New York, receiving cash for it, part of which came out of a syndicate loan which the underwriters placed with New York banks, and for which they got a deposit credit. The deposit was transferred to a great Missouri city, and from there to the smaller place where the old lady lived, and the mortgage which she held was refunded at a lower rate of interest by the Joint Stock Land Bank, and she was paid off. She first placed the money on deposit with the local bank, and then wrote a kinsman in a New York bank, sending a check which she asked to have placed in good bonds for her. Here was true investor's cash coming out of savings. The old lady's father had saved that money sixty years before. It was a displaced old investment. Newly created money sweeping out of New York had displaced her investment, and her investment funds came back to New York for reinvestment."

This is a powerful paragraph, although it may take more than one reading to appreciate (another "dense quote from a long-dead economist"). It came to mind when we read that $15.5 billion "poured" into mutual funds this week. Actually, I often ponder the mechanisms the allow broad money supply to expand by over $400 billion this year, while the household savings rate has turned negative and our economy runs massive trade deficits. What is the source of all this "money" when households aren't saving and dollars leave the country in droves? Well, the source is blatant and unrelenting money and credit excess. And with large amounts of liquidity again flowing into mutual funds, all we can say is that we have "been to this movie before." The title is "Reliquefication," and it is no coincidence that fund flows are concomitant with the strongest level of mortgage refinancings in about 16 months. If this sounds familiar, that's because it's a remake of the popular "hit" from the autumn of 1998. The financial sector (particularly the GSEs), responding to faltering financial conditions, creates enormous new liabilities as they aggressively increase holdings of financial assets, spreading liquidity both near and far. While it may appear to mutual fund managers that real investor money is flowing into mutual funds and buying stocks, the root source of this liquidity is unadulterated inflationary money creation.

The GSEs (like Pavlov's dogs) aggressively expand holdings at any sign of financial distress, a situation that has basically remained in force throughout much of the past two years. This is a key example of how, particularly in the present environment, underlying (and intensifying) systemic problems actually foster only heightened excess that manifests into increased system-wide money and credit creation. As the GSEs aggressively purchase mortgage securities and other debt instruments, mortgage rates (and market rates generally), as we have seen, decline sharply. This "intervention," importantly, sets off a series of processes. First of all, open market purchases of mortgages, mortgage-backs and other debt securities provide the previous holders (banks, Wall Street firms, hedge funds, etc.) liquidity to pay down debt and/or to purchase other securities (credit card and other asset-backed securities?). Forceful mortgage purchases by the GSEs also encourage the leveraged speculators to take positions, while it also leads to active speculative and hedging-related trading in the interest-rate derivative market. These are powerful liquidity creating mechanisms within the financial system.

And, importantly, sharply lower mortgage rates also incite a refinancing boom, a particularly potent force of "reliquefication" currently, after homeowners have experienced significant capital gains from extraordinary housing inflation. In 1988, it was estimated that the average individual refinancing her mortgage extracted $15,000 of equity to "buy a hot stock - take a vacation." This provided incredible, if unappreciated, fuel for what became an historic speculative bubble that pushed the economy over the edge into full-fledged historic "bubble" status. Ironically, the present "reliquefication" is directly in response to the collapse of the Internet/telecom/tech bubble fueled by the 1998 "reliquefication." What a dysfunctional system…

"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, rents 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."

"It must be said, by the way, that the widow's mortgage itself was being undermined by the extravagances of the period from 1924 to 1929. Excessive money developed speculation in every field, and very specially in the field of real estate…Real estate mortgage bonds were issued at a tremendous pace. Real estate values soared and real estate mortgages of all kinds were so rapidly multiplied that in 1932-33 the widow might well have wondered whether she would not have done better to sell her mortgage in 1929, buying stocks with the money…methods which they had found conservative and safe for forty years or more had not protected them or their clients when the whole fabric of real estate values had been undermined, and when they had given guaranties for a multiple of their capital."

We don't believe one can overstate the role played by the real estate finance "superstructure" as the critical source of fuel for the current bubble economy. Importantly, there is also a crucial unrecognized element in the interplay between global and domestic financial fragility and the great U.S. credit bubble. With fragile financial systems throughout the world (in many cases already ravaged by credit-induced boom/bust dynamics), there remains unusually strong demand for "safe" securities. This is certainly the case for risk-averse investors, but even more importantly for the gargantuan leveraged speculating community looking for relatively stable and highly liquid securities for their sophisticated interest arbitrage operations. Agency securities and mortgage-backs are wonderful fodder for speculation.

Certainly, no other financial system has the ability to produce virtually unlimited quantities of highly rated (triple-A) securities. And what other country can compete with our team of rating agencies, credit insurers, investment bankers and "financial engineers." Our system is further greatly advantaged by rating agencies' and the marketplace's presumption of an implied government guarantee for the debt of the GSE, as well as the fact that the U.S. economy remains entrenched in its inflationary Bubble Economy status. It is certainly our view that the U.S. boom is much more the result of "manufacturing" $trillions of securities than it is producing computers and software - not even close. Lots of economies produce technology… And, as we are seeing once again, when financial markets (particularly the current corporate bond market) falter, the GSEs, and financial sector generally, move immediately to create only greater liquidity for real estate speculation and additional housing inflation. Then, through various avenues, this inflationary money and credit creation finds its way into both the stock market and real economy, as well as globally through only larger trade deficits. This is the most conspicuous and direct mechanism where weak system underpinnings foster heightened asset inflation and unsound economic expansion. The consensus would like us to believe that housing prices are rising because of new technologies and increased "productivity." Nope, it's pure inflation. Yes, it could be prolonged for a time by further financial sector "expansion and by further cheap money policies, but only at the cost of creating a desperately difficult situation at a later time."

"There must be a proper balance in the international balance sheet. If foreign debts are excessive in relation to the volume of foreign trade, grave disorders can come. Moreover, the money and capital markets must be in a state of balance. When there is an excess of bank credit used as a substitute for savings, when bank credit goes in undue amounts into capital uses and speculative uses, impairing the liquidity of bank assets, or when the total volume of money and credit is expanded far beyond the growth of production and trade, disequilibria arise, and above all, the quality of credit is impaired. Confidence may be suddenly shaken and a countermovement may set in."

Here is another extremely important and pertinent paragraph. How can one look at the present situation and not fret about unprecedented "disequilibria"? Still, there remains a deeply ingrained perception in this country that we can run $400 billion-plus current account deficits in perpetuity - that foreigners will always want to invest in the U.S.'s wondrous New Economy (trade real goods for our "paper"). This has been one momentous assumption. Well, with the tech sector faltering, we would have thought by now that there would be inklings of a change in perceptions - that some would begin to question the veracity of the notion of a New U.S. Economy. And with a less euphoric view both at home and abroad of new technologies and so-called New Economies, what are the ramifications for the U.S. dollar? We find it difficult to believe that they are constructive.

Actually, we have never bought into the idea that global investors, enamored with the New Economy, were "investing" hundreds of billions continuously into our markets. Inflows that, by the way, conveniently offset our ballooning trade deficits. Instead, we have long suspected that what has actually been developing is the greatest leveraged speculation (interest and currency arbitrage) in history - borrowing at low overseas interest rates to speculate in U.S. credit marketable securities and instruments. If we are correct, there is "clear and present danger" of a severe financial accident for the U.S. dollar and the U.S. financial system generally. The way we see it, in accounting parlance - "debits equal credits." Or, domestic credit excess creates overheated demand for imported goods, which leads to a flood of dollars globally. These dollars, however, must go somewhere, so they are placed (recycled) right back with the aggressive U.S. financial sector that created them to begin with. It is not a coincidence that the dramatic increase in financial sector debt is matched by the increase in foreign holdings of U.S. financial assets. Again, "debits equal credits" - that foreign inflows have been the result of problematic trade deficits, not trade deficits the result of investment inflows, as some prominent supply-side economist like to claim.

Moreover, we strongly believe that money and capital markets have been in a most severe "state of imbalance," with massive credit excess being used flagrantly as a substitute for savings. Moreover, credit has gone in undue amounts into ill-advised capital uses and speculative uses, impairing the assets and liquidity of the financial sector. The quality of credit has been irreparably impaired to such a truly enormous degree that this circumstance will inevitably manifest into a full-fledged liquidity crisis for the U.S. financial sector and dollar denominated assets generally. The combination of a bloated and increasingly impaired financial sector, with faltering system liquidity and at the same time with massive liabilities held by foreign investors and leveraged speculators, should be seen for exactly what it is: a recipe for financial disaster.

Since June, the dollar has rallied strongly. This has been a most opportune occurrence for a U.S. financial system coming under heightened stress with a very unstable stock market and a very problematic faltering of liquidity throughout the junk bond and corporate financing marketplace. Dollar strength also provided quite a nice cushion for foreign investors suffering losses on technology stocks. It is certainly our view that the dollar has been in the midst of an historical speculative bubble, fueled by massive leveraged "hot money" flows. Moreover, flows from the leveraged speculators have been augmented by dynamic hedging programs emanating from unfathomable derivative positions, in what developed into a self-reinforcing currency market dislocation. Such dynamics are inherently unstable and unsustainable, while creating extreme vulnerability to sharp reversals. Not only is the marketplace today acutely susceptible to abrupt swings in market perceptions as to the soundness of the U.S. financial system and economy, it is furthermore at risk of extreme dislocation in the event of any panic unwinding of highly leveraged positions and forced selling from dynamic hedging strategies. Remember SE Asia? "Confidence may be suddenly shaken and a countermovement may set in."

While "reliquefication" succeeded in working its magic with stock prices this week, the dollar and Treasury markets quietly suffered their worst bout of selling in some time. This is not mere coincidence. After all, it is not inconspicuous that the reckless U.S. financial sector has set course for another round of inflationary money and credit excess. Clearly, throwing more liquidity on the real estate bubble and at the consumer sector will not come to any positive end; especially with labor markets taut and wage pressures accelerating, not to mention a dangerous housing bubble, high energy prices, and what are clearly heightened general inflationary risks. In fact, we cannot imagine a more dysfunctional circumstance: a faltering corporate bond market and unfolding credit crunch on the one hand, and continued egregious excess in mortgage and consumer finance on the other. Although the "die is cast" on the fate of the Great U.S. Credit Bubble, the financial sector is (not surprisingly) determined to prolong the bubble economy, with devastating consequences for the soundness of the real economy and the stability of the financial sector. Such a dysfunctional financial system and economy are certainly not good for the U.S. dollar. It is hard to believe that these increasingly evident circumstances can go unnoticed in the marketplace. It is, at the same time, not difficult to imagine foreign central banks increasingly losing patience with the destabilizing international dollar flows and the overbearing and dysfunctional U.S. financial sector.

We'll conclude with a final sentence from Dr. Benjamin M. Anderson, one that is painfully frustrating and much too applicable more than 50 years later.

"Between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much (as during WWI), and in the years which followed we paid a terrible price."

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