A political crisis was the last thing the stock market needed. For the week, the Dow declined 2% and the S&P500 4%. The Transports declined 2% and the Morgan Stanley Cyclical index 3%. Bucking the trend, the defensive Morgan Stanley Consumer index and the Utilities added 2%. The small cap Russell 2000 and S&P400 Mid-cap indices sank 5%. Biotechs were clipped for 8%. Throughout the technology sector, it was a rout. For the week, the NASDAQ100 dropped 13%, the Morgan Stanley High Tech index 14%, and the Semiconductors 15%. The Street.com Internet index was hit for 18%, and the NASDAQ Telecommunications index 12%. The financial stocks were mixed, with the Bloomberg Wall Street index dropping 4%, while the S&P Bank index declined only 1%.
Treasury prices rose unimpressively in the face of a faltering stock market. For the week, Treasury yields declined between 3 and 4 basis points between 2 and 10-year maturities, while the long bond yield actually increased a basis point. Mortgage-back yields generally declined 2 basis points. Notably, agency securities underperformed, with yields actually rising one basis point this week. The benchmark 10-year dollar swap began to move, widening 7 basis points for the week. Ominously, the 10-year swap spread widened 5 basis points today. The dollar had a slight gain for the week and gold suffered a small decline.
"Plenty of money never fails to make trade flourish; because, where money is plentiful, the people in general are thereby enabled, and will not fail to be as much greater consumers of everything, as such plenty of money can make them." Jacob Vanderlint, Money Answers All Things, 1734.
"The use of banks has been the best method yet practiced for the increase of money." John Law
"The paper credit which, with such encomiums to themselves they boast to have set up, what effects has it produced, but only to lull the nation asleep, while the ready money that should even carry on our common business, has been exported? …Can this imaginary wealth stand the shock of a sudden calamity?" C. Davenant
"When a State has arrived at the highest point of wealth…it will inevitably fall into poverty by the ordinary course of things. The too great abundance of money, which so long as it last forms the power of States, throws them back imperceptibly but naturally into poverty." From Richard Cantillon's Essai
It is our basic premise that the U.S. monetary system (as well as global) is both fundamentally and severely flawed, and that an extremely unstable system again finds itself acutely vulnerable. Particularly here in the U.S., the preponderance of monetary expansion has come to revolve around asset price inflation. This is unsustainable and should today be recognized as a big problem. It is furthermore our strong contention that the very foundation of current economic prosperity is overwhelmingly monetary in nature. The boom has not been the consequence of new technologies, New Economies, New Eras or New Paradigms, and, as well, it is certainly not due to some miraculous increase in productivity. Instead, this has been primarily a historic financial bubble fueled by extreme money and credit inflation - or stated another way: absolutely reckless lending and speculative excess.
The boom has created little in the way of true economic wealth, but instead only the seduction of a massive inflation in perceived financial wealth; just mountains of financial claims. In fact, the source of this fateful boom is conspicuous in the data. Since 1995, broad money supply has increased a staggering $2.6 trillion, or 60%. Total credit market instruments have surged an astounding $9.3 trillion, or 54%, to $26.5 trillion. And, most unfortunately, since 1998, extraordinary excess has regressed into an absolute monetary fiasco, with broad money supply having jumped $1.5 trillion (27%) and credit market instrument $5.3 trillion (25%). It is, furthermore, our view that we are now falling head first into a monetary crisis, the inevitable consequence of nurturing years of runaway credit bubble excess. It is, moreover, quite disconcerting to recognize how ill prepared we are as a country - citizens, businessmen, politicians and central bankers.
We have before compared the present cycle to John Law's great Mississippi Bubble in France around 1720. Law, of course, introduced paper money and a "managed currency" system that fostered manic financial speculation and a spectacular bubble. This unsound boom abruptly gave way to an inevitable devastating financial and economic bust, discrediting John Law, his monetary theories and banks generally. This week, I am again highlighting monetary theory, hoping to shed further light on the gravity both for what has transpired and for what lies ahead. For valuable insights into Law's system and monetary theory in general, one of our favorite sources is Dr. Douglas Vickers' Studies in the Theory of Money 1690-1776, first published in 1959. We will use a few quotes and analysis that are particularly pertinent today: note that a key aspect of Law's failed system was a monetary authority with responsibility for regulating money supply.
"The central theoretical argument behind (John) Laws' banking proposals was concerned with the regulation of the supply of bank money to the demand for it in such a way that the desired and physically potential volume of trade may be realized ("by this money the people may be employed") and the value of the currency maintained." Douglas Vickers, The Theory of Money
"This paper money will not fall in value as silver money has fallen or may fall…But the commission giving out what sums are demanded, and taking back what sums are offered to be returned; this paper money will keep its value, and there will always be as much money as there is occasion or imployment for, and no more." John Law
"This principle of the issue of notes and their return to the issuing authority dependent on the needs of trade was to recur in the later history of banking theory. The fallacy now, as later, lay in the failure to recognize that the reflux of notes gave the issuing authority power to contract its outstanding issue, but did not in any way compel it to do so. The assumption upon which the contrary proposition is based is that businessmen's demands for currency for trade purposes could be regarded as independent of the actions of the monetary authorities. It was on precisely the fact that interdependent relationships within the monetary system did exist, however, that the purely theoretical adequacy of Law's proposal foundered. Douglas Vickers, The Theory of Money
This is a key paragraph from Dr. Vickers. Importantly, John Law's Mississippi Bubble was destined to fail as it lacked appreciation for "interdependent relationships within the monetary system" - or monetary processes. Law admitted as much after the spectacular collapse in 1720: "There are good reasons to think that the nature of money is not yet rightly understood."
From the current feeble understanding (and lack of interest) in the nature of monetary processes, it is clear that there has been a most unfortunate disregard for history; the many harsh lessons forgotten over the past 280 years. We don't know if the current monetary boom is, like Law's scheme, a big monetary experiment gone terribly awry, or if it has simply been a case of a reckless and wildcat financial sector combined with ineptness and negligence from the Greenspan Federal Reserve. Either way, there are clear and quite disconcerting parallels between these two booms. I will try to highlight some of the key monetary aspects that I believe clearly illuminate the serious flaws and vulnerabilities in the current monetary system.
"In the first place, the essence of Law's scheme was his proposal for the monetization of certain existing assets…in the second place, Law's proposal to base the issue of notes on the security of the value of land begs the essential question of the stability of value of the land itself. Quite apart from changes in real asset values dependent upon growth or variation in their intrinsic income-producing potential, the money value of the assets could change as did the availability of the notes of issue themselves. The theoretical possibility existed of an unlimited expansion of the note issue, pari passu with an induced and cumulative upward movement in the money values of the assets eligible as security." Douglas Vickers, The Theory of Money
John Law, like today's Federal Reserve, did not appreciate the momentous role played by the ease of availability of money and credit, and the inflationary effect on prices from the over issuance of money and credit instruments. This is particularly the case for asset prices when they are the actual "backing" for monetary expansion. It should be obvious that monetary processes in such a situation work to foster a self-feeding boom (and endemic speculation) where money and credit excess begets asset inflation that begets greater collateral values for only more monetary excess. Also, for Law as well as currently, there was a lack of understanding as to the momentous role played by the widespread acceptability of financial instruments as a store of value, as well as the profound importance of general confidence in precipitating boom and bust dynamics.
"John Law's theory of the value of money was a variant of the familiar supply-and-demand theory. It was by maintaining a stable relationship between the demand for money and its supply that the stability of value of the proposed bank money was to be preserved. More particularly, the value of money meant its value in exchange, and it is this conception which was most important for exchange, and it is this conception which was most important for Law's general theory of monetary circulation. But money was understood as having both an exchange value and what might be termed an asset or wealth value. As to the latter, the stability of value depended, in the first place, on the stability of value of the asset backing…But there did not exist, unfortunately, a direct and logical harmony or stabilizing relationship between these wealth and exchange values respectively. This was because the distribution of the demand for the asset security on wealth account would not necessarily be the same as the distribution of the demand for money on transactions or income account. It was more likely, indeed, that disturbances in the transactions supply and demand would arise and would set up a disequilibrating action and reaction on the asset values. Quite apart from fluctuation in the volume or frequency of trading exchanges, discontinuities in payments habits could be expected to arise. (Admittedly, not the easiest paragraph to get through.) Douglas Vickers, The Theory of Money
But the need for the projected stability of both the wealth value and the exchange value of money turned finally on the same requirement: namely, it was desired that money should serve as a measure in exchange and as a store of value in the sense that "it could be kept without loss" and the possession of it should confer on the owner the right and the ability to "purchase other goods as he had occasion for, in whole or in part, at home or abroad." Money should be the link between places and occasions geographically and temporally separate." Douglas Vickers, The Theory of Money
"The increasing supply of new money there was based not on real asset values as had been proposed in theory, but on public confidence in scrip and share values on the one hand and on legal sanctions as to the acceptability on the other." Douglas Vickers, The Theory of Money
"It was noted in our earlier discussion of John Law's similar proposals that he had failed to see that the valuation of the security against which bank notes were to be issued would not remain independent of the issue of the notes themselves." Douglas Vickers, The Theory of Money
Some leading apologists for the Fed (and the great monetary inflation generally) have argued that the omnipotent Fed has successfully followed a so-called "Price Rule," where the central bank navigates an increase in money supply in a manner as to maintain stable consumer prices (sounds like John Law's scheme to us!). At the same time, money and credit excess are completely ignored. There is also not even contemplation for the profound ramifications of the creation of massive financial obligations (including $1.7 trillion in money market assets), much of which are assumed to provide a store of value for their holders. It is even strongly argued that the Fed should ignore the stock market and asset inflation generally. It should be obvious by now that disregarding asset inflation, as well as the resulting distortions to the financial system and economy, and the role played by complex monetary processes, has been a momentous analytical and policy error.
"There existed, and had to be taken into account, something of a money illusion. After examining the excesses of John Law's schemes of money creation, and after pointing out that 'by a glut of paper, the prices of things must rise,' (George) Berkeley continues: Whence also the fortunes of men must encrease in denomination, though not in value; whence pride, idleness and beggary.' The money-wealth illusion was a disincentive to productive effort, and it led ultimately to the general lowering of the prosperity of the economy. This situation, moreover, induced directly a wasteful import demand for luxury commodities and led to the kind of strain on the country's balance of payments…" Douglas Vickers, The Theory of Money
"It was not the circulation of a large supply of money as such which was troublesome, but the overissue as compared with the real requirements of trade and industry." George Berkeley from Vickers' The Theory of Money
"Circulating paper" was recognized as the "true evil" in the "ruinous schemes of France and England" (France's Mississippi Bubble and England's South Sea Bubble) specifically because the overwhelming purpose of extreme money and credit creation was for speculating in stock and real estate prices, with little regard for actual industry. The current U.S. bubble could not more closely parallel those infamous bubbles in regard to credit excess thriving predominantly outside of industry. When this bubble bursts, many will certainly ponder the incredible resources wasted in constructing office buildings, mansions, sports complexes, entertainment venues and the like.
Interestingly, very pertinent analysis was provided by one of the "first economists," who by the way, was a contemporary of John Law and made a fortune in Law's bubble (by recognizing the inflationary forces and the fundamental flaws in the scheme, he sold before the collapse!). Richard Cantillon's brilliance was captured in his Essai, written between 1730 and 1734. His work provided a great leap forward in monetary process analysis:
"Market prices, money prices, and levels of activity and employment were not to be regarded as homogenous variables. The Essai is interested in the structure of market prices, the structure of market supply conditions, and the structure of activity in the economy. The corollary of this is that the movement of the economic process itself depended on the structure of its own determining forces. As Cantillon argued at length, the description of the process will necessarily differ, following, for example, an increase in the supply of money, depending on the direction from which the stimulus to change has come, and depending also on the differing dispositions, notably consumption habits, of the persons through whose hand the higher flow of money and incomes passes. Douglas Vickers, The Theory of Money
"If mines of gold or silver be found in a State and considerable quantities of minerals drawn from them, the proprietor of these mines, the undertakers, and all those who work there, will not fail to increase their expenses in proportion to the wealth and profit they make; they will also lend at interest the sums of money which they have over and above what they need to spend. All this money, whether lent or spent, will enter into circulation and will not fail to raise the price of products and merchandise in all the channels of circulation which it enters. Increased money will bring increased expenditures and this will cause an increase of market prices." From Richard Cantillon's Essai
"Several propositions emerge from this statement. In the first place, the increased consumption which occurs is understood to be made "in proportion to" the increase in incomes enjoyed by the 'entrepreneurs' and workers involved, that is, 'in proportion to the wealth and profit they make.' Secondly, it is clearly supposed that whatever proportion of this increased money income is not spent directly by the income receivers will be lent on the money and capital markets so that, in the outcome, all the additional money supply will be maintained in circulation. There is a division of incomes into consumption on the one hand and investment on the other. On the one hand, there is a progression from an increased money supply to increases in turn in incomes, consumption, and commodity prices and, on the other hand, a similar progression of induced effects except that savings and investment replace consumption." Douglas Vickers, The Theory of Money
"Cantillon here envisages, moreover, not merely a change in the size of the stock of money, but an altered rate of flow of money in circulation…Cantillon points out that the varying proportions in which prices will rise in the various 'channels of circulation' and the altered structure of prices which will result from the process, will depend on the point at which the injection of new money enters the economic system and on the different consumption habits and dispositions to spend of the successive income recipients. The differential impact on the economic system of the increased stream of money payments will depend at each stage of the process on 'the idea of those who acquire the money.'" Douglas Vickers, The Theory of Money
We believe the analyses in the previous two paragraphs are particularly powerful and certainly quite relevant for the current bubble. Critically, Wall Street has been the epicenter for unprecedented money and credit excess throughout this boom cycle, and especially during the latter stages. Accordingly, the "channels of monetary circulation" have been extraordinarily speculative in nature and directed specifically at asset markets. (Predominantly stocks, credit market instruments and real estate). This is a key factor - the creation of inherently unstable monetary flows - that goes completely unappreciated by the economic community. It is anything but a small matter that the flow of monetary excess is masterminded by securities firms, the GSEs, and the aggressive lenders (that through securitizations push their loans onto the marketplace). It should be clear that such a system creates monetary flows and economic consequences quite divergent from traditional lending, where local bankers endeavor to make sound loans and fully expect to live with their lending decisions until maturity. Indeed, a basic premise of our analysis is that speculative Wall Street money and credit excess - dysfunctional "channels of monetary circulation" - have been behind the historic Internet/telecommunications/technology bubble that is today in grave danger. Such flows have created highly destabilizing booms and busts in stock prices, as well fostering extreme overspending that has manifested into the present environment of over competition and rapidly deteriorating profits throughout the entire industry. Wall Street excess set in motion monetary processes that led to devastating structural distortions throughout the entire savings and investment process, with terrible harm to both the financial system and economy.
"The important thing for the dynamic monetary analysis is that each such divergence becomes what we have called a proximate cause of change. The ultimate causes of change subsists in the 'humours and fancies of men' and in the changes in the level and structure of consumption expenditures following changes, for example, in the level and rate of flow of money and thus in the level of incomes." Douglas Vickers, The Theory of Money
"The continuance of the monetary inflation process, as distinct from its inception, is therefore price-induced via the increased profit margins in the several lines of production. Moreover, there enters at this point a further concept as to entrepreneurial action. In establishing or extending new lines of manufacturing or other activity, entrepreneurial decisions are dependent not only on a realized level of profitability, but also no such anticipations of future demand…" Douglas Vickers, The Theory of Money
"As a result of the expansion the economy has not only been lifted on to a higher level of activity, but the structure of activity itself has been changed." Douglas Vickers, The Theory of Money
It has been estimated that the hedge fund community has ballooned to almost one-half trillion dollars in assets (and much larger positions!). Add to this the trillions of dollars of assets that have accumulated at the securities firms (their own holdings as well as managed client assets) and money center banks (and let's not forget the ultra-powerful GSEs!), and the frightening enormity of the leveraged speculating community become apparent. The unfathomable leverage created though speculating in rising financial asset prices and interest-rate arbitrage is simply unparalleled in financial history. As such, the role played by the leveraged speculators throughout the monetary process cannot be overstated. Unfortunately, never before have such powerful mechanisms existed to "leverage" the "humours and fancies of men", and it is simply unbelievable that the speculating community was allowed to completely alter the dynamics of monetary systems and economies, none more than here at home.
Above, we touched upon the financial and economic distortions that develop naturally from the massive speculative flows. It should also be recognized that the leveraged speculating community has come to be the virtual provider of liquidity for the financial markets at this late stage in the cycle - the creator of the monetary fuel to keep inflated asset prices (stocks, credit market securities, real estate, etc.) levitated. Thus, there is today a critical dilemma posed by the leveraged speculating community's rise to dominance: financial system liquidity is acutely vulnerable to any reduction in the growth of leveraged players' holdings. In short, the great U.S. Bubble is now hopelessly dependent on continued extreme and speculative credit excess for survival.
This creates today an extremely tenuous (dangerous) financial environment. Importantly, with the technology bubble in collapse, the heavily exposed leveraged speculating community is finding itself increasingly impaired. Impairment is a keen problem for highly leveraged players with little "room for error." Up to this point, losses have been somewhat mitigated by major rallies in the credit market (particularly mortgage-backs and agency securities) and the dollar. So the good news is tech and junk bond losses have thus far not been "terminal" for the aggressive speculators; the potentially very bad news, however, is that the leveraged players remain today highly exposed to selling in fixed-income or to any sudden downturn in the U.S. currency. And with the upside in the credit market and the dollar seemingly limited at this point, we suspect that the leveraged speculators (outside, of course, of the GSEs!) would like to move to rein in risk. The problem is that the leveraged speculating community has basically become The Market for mortgage paper, agency securities, and dollar denominated assets generally. While we see deteriorating financial conditions forcing the leveraged players to move to liquidate positions and offload risk, we just don't know "to whom." As goes the leveraged players, so goes financial system liquidity.
A further pertinent quote from Richard Cantillon:
"If more money continues to be drawn from the mines all prices will owing to this abundance rise to such a point that not only will the landowners raise their rents considerably when the leases expire and resume their old style of living, increasing proportionably the wages of their servants, but the mechanics and workmen will raise the prices of their articles so high that there will be a considerable profit in buying them from the foreigner who makes them much more cheaply. This will naturally induce several people to import many manufactured articles made in foreign countries, where they will be found very cheap; this will gradually ruin the mechanics and manufacturers of the state who will not be able to maintain themselves there by working at such low prices owing to the dearness of living."
"When the excessive abundance of money…has diminished the inhabitants of the state, accustomed those who remain to a too large expenditure, raised the produce of the land and the labour of workmen to excesses prices, ruined the manufactures of the state by the use of foreign productions on the part of landlords and mine workers, the money produced by the mines will necessarily go abroad to pay for the imports: this will gradually impoverish the State…The great circulation of money, which was general at the beginning, ceases; poverty and misery follow and the labour of the mines appears to be only to the advantage of those employed upon them and the foreigners who profit thereby."
As discussed in previous commentaries, it is our view that the leveraged speculating community has today enormous exposure to the dollar. This now keeps us continually fearful of a major financial accident. And with massive current account deficits combining with years of severe structural damage to the U.S. financial system and underlying economy, there is no way around the fact that dollar confidence hangs in the balance. The current political environment certainly does not help. It is not a case of if there will be a dollar crisis, but when.
And while we're discussing potential crises, we pulled some "fun facts" from a Fannie Mae release from earlier this week:
"Speaking to reporters in conjunction with Fannie Mae's 16th annual meeting with its Asian debt and equity investors, Raines said that since 1998 the company has issued a total of $179.7 billion in non-callable Benchmark Notes and Benchmark Bonds. Raines said that international investors have been central to the success of these issues. Since the inception of the Benchmark program, international investors have purchased 33 percent of all Benchmark Notes and Benchmark Bonds issued, with approximately 14 percent going to Asian investors."
"Howard noted that international investors, including Asian institutions, already have taken advantage of Fannie Mae Benchmark Securities in a variety of market transactions. 'The exceptional liquidity and price transparency of Benchmark Bills, Benchmark Notes, and Benchmark Bonds encourage their use by investors as trading, hedging, duration management and financing vehicles,' said Howard. 'Futures and options on Fannie Mae Benchmark Securities are traded on the Chicago Board of Trade, and we have seen the development of a strong term repo financing market for the securities."
The enormous holdings of U.S. financial assets by foreign investors/speculators is quite disconcerting, posing great systemic risk in the event of any change in perceptions as the soundness of the dollar and the U.S. economy and financial system generally. Granted, the GSE's and financial sector's aggressive overseas borrowings have worked marvelously in "recycling" massive trade deficits while dollar confidence has remained strong. These borrowings, however, have considerable potential to be highly destabilizing come a change in sentiment. Furthermore, only time will tell as to the extent of agency securities held by the leveraged speculating community. We presume they are massive, and perhaps the speculators will continue to gravitate to these securities, thus perpetuating the U.S. real estate bubble. But that will truly only provide fuel for the absolute worst-case scenario for the U.S. financial system and economy. I take no pleasure in "yelling fire in a crowded theater," but I am fully committed to "calling them as I see them." The way things are developing, it certainly does not take a wild imagination to envision a 1998-style financial crisis where, simultaneously, stocks sink, credit markets turn illiquid, and the dollar buckles. Such a scenario would be devastating to the leveraged speculating community, as well as the acutely fragile U.S. financial system. We've truly entered a "high risk zone."