By Doug Noland
Today's non-farm payroll data provide fodder for those believing U.S. recovery is on track. I'll stick with the view that a 10% unemployment rate after more than a year of extraordinary fiscal and monetary stimulus is indicative of deep underlying structural impairment. Recent housing, household spending, mortgage delinquency, and state and local finances data all confirm our secular bearish prognosis.
I want to commend David Malpass for his spot-on op-ed piece in today's Wall Street Journal, "Near-Zero Rates are Hurting the Economy."
From the article: "The Federal Reserve implemented an emergency monetary policy after the 2008 Lehman bankruptcy to salvage the world financial system. In his testimony yesterday... Ben Bernanke said, 'We must be prepared to withdraw the extraordinary policy support in a smooth and timely way as markets and the economy recover.' This leaves all-out emergency monetary stimulus in place, but with a different, much weaker justification. With the system stabilized, the Fed hopes that artificially low interest rates and its purchases of mortgage-backed securities will spur growth. Instead they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles... more than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period and buying over $3 billion per day of expensive mortgage securities... Capital is being rationed not on price but on availability and connections. The government gets the most, foreigners second, Wall Street and big companies third, with not much left over. The irony of the zero-rate policy, coupled with Washington's preference for a weak dollar, is a glut of American capital in Asia (as corporations and investors shun the weakening U.S. currency) and a shortage at home... Much of its current stimulus is being diverted to commodities and foreign economies -- hence Asia's complaint about bubbles... Wall Street will threaten a tantrum if the Fed even thinks about damping the air-raid sirens. The Street utterly loves the Fed's largess..."
Mr. Malpass and others have recognized the dangerous flaws inherent in Federal Reserve doctrine. It became the Greenspan Fed's crisis management modus operandi to call upon Wall Street Credit creation and leveraging to lead systemic market liquidity and reflationary efforts. For more than two decades, this proved history's most powerful monetary mechanism. Dominant "Monetary Processes" provided the key to "success." With the Fed guaranteed to slash rates and the GSEs guaranteed to buy and back hundreds of billions of mortgages at the first sign of trouble, the mortgage and mortgage-related securities arena attracted a massive and reinforcing influx of funds (what Mr. Malpass would refer to as "capital").
From my analytical framework, mortgage finance demonstrated a powerful "Inflationary Bias". Related forces inflated the GSEs, Wall Street firms, the hedge funds, home prices, household net worth, equity extraction, over-consumption, and malinvestment. The inflationary bias inherent in U.S. mortgage securities (and related instruments) was instrumental to two decades of major U.S. structural transformation to a de-industrialized "services" economy. Distortions in the pricing of mortgage finance fostered a massive misallocation of financial and real resources - both at home and abroad. It also fueled a historic housing mania and attendant acute financial and economic fragility.
Mr. Malpass recognizes that the world has changed in fundamental ways. Today, "capital" flows first and foremost to Asia and commodities rather than to job-creating U.S. businesses. The more liquidity created here the more things inflate there. In my nomenclature, predominant Inflationary Biases and related Monetary Processes have been radically altered. Importantly, mania has given way to U.S. housing depression, while faith in sophisticated Wall Street Credit instruments has been shattered. The dollar has been severely impaired. There is no returning to previous cycle dynamics.
The reliable old Monetary Process - where Federal Reserve and GSE reflationary measures would immediately stoke rapid (and self-reinforcing) mortgage Credit growth, housing inflation, inflating household net worth, equity extraction, spending and government receipts - is no longer operable. Reflationary liquidity that for years gravitated predictably to our MBS and agency debt now prefers "undollar" asset classes, including emerging debt and equities, gold and metals, and commodities more generally.
The Fed's capacity for domestic monetary stimulus has been greatly diminished, with U.S. and global economic systems these days responding altogether differently to reflationary policymaking. Yet the Bernanke Fed refuses to respond to the altered landscape. Dangerously, the Fed adheres steadfastly to its old policy approach - only implementing it more radically. Our central bank balloons its balance sheet with mortgage-backed securities, while pegging interest rates all the way down to zero. Worse yet, the Fed has signaled that the markets can bank on near zero percent for a protracted period. Global dynamics have changed, yet the Fed has locked itself into a precarious policy approach. Dr. Bernanke testifies that U.S. asset prices don't appear overvalued. Meanwhile, price distortions and Bubble dynamics engulf the world.
The discussion of what went wrong in Dubai is quite interesting. Some want to simplistically blame a combination of a lack of transparency and stupid bankers. Yet Dubai's debt problems are complex and really are a microcosm of global Credit and economic woes. Market price distortions are the essence of financial Bubbles. In Dubai, lenders assumed implicit government backing for corporate debt obligations. In a region seeing more than its share of liquidity excess, intoxicated lenders saw little reason for looking through to underlying project economics. And the bigger the Bubble inflated the more convinced the markets became that wealthy regional governments would have no stomach for a regional crisis of confidence.
The Dubai debt crisis appears at this point largely contained and may not prove a catalyst for a new crisis phase. But it certainly highlights crucial and ongoing global issues. Market distortions fostered by Global Liquidity Excess and Market Perceptions of Implicit Government Backing recalls our own GSE fiasco. Superfluous and mispriced finance fed Bubbles and precarious Ponzi finance dynamics. The Wall Street and Dubai miracles worked until they didn't. As we witnessed firsthand with the Wall Street/mortgage finance Bubble, the scheme preserved as long as sufficient new cheap speculative finance was enticed to play. It became a confidence game.
For months now, I have posited the emergence of a Global Government Finance Bubble. Global Liquidity Excess and Market Perceptions of Implicit Government Backing are, once again, playing an instrumental role in fostering Ponzi Dynamics. The Fed and most observers are seemingly oblivious to Bubble risk here at home. Yet the Treasury and agency markets are the epitome of dangerously distorted Bubble markets. Unprecedented global imbalances, ballooning central bank balance sheets, pegged ultra-low rates, and unwieldy speculative financial flows foment liquidity excesses and market price distortions - especially in the enormous U.S. Treasury and agency markets. At the same time, the markets perceive an Implicit Guarantee: That China, Japan, "emerging" Asia and the Middle East can be counted on to support Treasury prices and ensure dollar weakness doesn't turn disorderly. Moreover, markets perceive that Federal Reserve rate and monetization policies will continue to underpin U.S. corporate, municipal and household debts.
Markets have thus far been content to largely overlook underlying economic fundamentals when it comes to valuing U.S. government debt obligations. Importantly, the multi-trillion dollar expansion of (mispriced) Treasury and agency securities has been instrumental in rejuvenating both the U.S. Credit system, markets and the real economy. Markets have readily accommodated a massive expansion of U.S. government debt and perceive that ongoing Treasury and Fed Credit creation will bolster recovery. This perception - built into collapsing Credit spreads and increased Credit Availability - has been instrumental in stabilizing domestic incomes, corporate cash flows, and asset prices (homes, stocks, debt and "risk assets" more generally). I would argue that only the emergence of a government finance Bubble held much greater debt problems - along with necessary economic adjustment - at bay.
While perhaps not obvious from an asset price perspective, there are unmistakable Bubble and Ponzi Dynamics at work. The entire U.S. financial and economic recovery rests on a flimsy foundation of a highly distorted Treasury and agency market Bubble. I am the first to appreciate that Bubbles notoriously survive longer and grow larger than we Bubble analysts would expect. At the same time, the world has moved up the Bubble analysis learning curve. I find it disconcerting that many that recognize the unfolding Bubble landscape still believe they have plenty of time to profit and then get out before the bust. But I also sense the more sophisticated players are following developments with an increasing degree of angst.
Doug Noland The Credit Bubble Bulletin PrudentBear.com
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