CREDIT BUBBLE BULLETIN
Kicking the can
Commentary and weekly watch by Doug Noland
Asia Times Online :: Asian news and current affairs
So, are policymakers making things better - or is policymaking simply kicking the can down the road? While this aspect of policy has not been adequately scrutinized, I am of the view that the Federal Reserve's 2007 easing signals (beginning with the August 17, 2007, discount rate cut following an unscheduled meeting) directly contributed to the severity of the 2008 global financial crisis.
Recall that the CRB Commodities Index traded from about 300 in September 2007 to a record high of 474 by July 2008. Crude oil prices almost doubled to trade to US$147, a destabilizing price shock for an increasingly susceptible US economy. Global liquidity overabundance had the emerging markets on a rip. And in the face of a mounting crisis, US stocks were on a mini-roar. The S&P500 rallied to a record high in October 2007. Liquidity-driven
market excess - across the spectrum of asset classes all across the globe - had created unparalleled systemic vulnerability. In the end, the global financial system came to be detached from fundamentals. Instead, they were hinged tenuously on one gigantic "risk on" liquidity trade.
Sometimes it does seem like deja vu all over again. I have addressed the discomforting parallels between the eruption of subprime problems in the spring of 2007 (the first crack in the mortgage/Wall Street finance bubble) and this past spring's Greek crisis (the initial crack in the global government finance bubble).
It is worth noting that an aggressive loosening of monetary policy in 2007 - and into 2008 - had no positive effect on the underlying quality of US mortgage credit, although it likely prolonged the mortgage issuance boom (total mortgage credit expanded almost $1.1 trillion during 2007!). Irreparable damage had been done during the bubble. Aggressive "activist" policymaking could only prolong market distortions and speculative excess.
The reemergence of financial stress with the Greek crisis incited an aggressive response from the European Central Bank (ECB) (liquidity support), the Fed (the second round of quantitative easing - or QE2), and global central bankers more generally (reluctance to move away from overly stimulative policies). Clearly, liquidity operations, the Greek bailout, and ultra-loose financial conditions did not improve the credit quality of Ireland's debt (or that of Portugal, Spain, and others). Yet, succumbing to market demands, the ECB on Thursday (again) postponed the initiation of its "exit strategy" to at least April 2011. The markets triumphed yet again in a skirmish with policymakers - and celebrated with a big, emboldened rally.
This summer's introduction of QE2 (and the death of "exit strategy") fostered a dramatic loosening of financing conditions. Treasury yields collapsed. Mortgage and municipal borrowing costs sank to record lows. Meanwhile, corporate credit spreads dropped to levels not seen since before the 2008 crisis. Corporate issuance boomed, with record junk sales. The S&P500 has rallied about 21% off of this summer's lows and the S&P400 Mid-Cap index has gained 27%. Such a financial backdrop should be constructive for confidence, spending, and economic recovery, and recent data has, unsurprisingly, been generally upbeat. But Friday's US non-farm payroll report provided a timely reality check.
Considering the unmatched degree of fiscal and monetary stimulus, US economic performance remains ominously dismal. Rising mortgage yields and a rising tide of austerity throughout municipal finance portend challenges for an economy already at 9.8% unemployed.
We've been witnessing further evidence of the seductiveness of bubbles. Massive fiscal stimulus and ultra-loose monetary policy are supporting the most tepid of recoveries. Meanwhile, inflating securities prices ensure investors and analysts view the glass as at least half full. Policymaking works to inflate stock prices, and then policymakers take comfort that buoyant markets are a confirmation of the adeptness of their policies. Is it not apparent that the big winner here is financial speculation?
The bubbling Chinese economy faces its own issues. Entrenched bubbles scoff at "tinkering" and timid policymaking - and China's mighty credit bubble is proving no exception. On Friday, China's Politburo released a statement proclaiming that next year they "will adopt proactive fiscal policies and prudent monetary policy". The country's officials are increasingly aware that aggressive tightening is warranted. Home price inflation has proved resilient, while general consumer price inflation has become well-entrenched. Food price spikes have emerged as a serious problem.
When I read of Chinese policy moves intended to suppress credit and financial flows going to speculative endeavors - while actively promoting lending to more productive enterprises and to ensure ongoing economic expansion - I am reminded of the failed course of US monetary management in the latter years of the "Roaring Twenties". It is the nature of bubble economies that they become credit gluttons. Credit growth and financial flows grow increasingly unwieldy - and the greater the inevitable imbalances the greater the overall credit expansion required to sustain the boom. Efforts to sustain boom-time prosperity - while at the same time attempting to harness asset inflation and suppress increasingly destabilizing speculation - are prone to spectacular failure.
Chinese authorities recognize they have a problem - a serious monetary dilemma compounded and complicated by the US's QE2. The Politburo statement adds further evidence that more aggressive tightening measures will commence in 2011. Yet the markets have turned numb to such warnings. And I'll be the first to admit skepticism that the Chinese will administer the necessary harsh medicine. Chinese authorities have waited too long and allowed "terminal" bubble excess to gain a powerful foothold. With the Fed and ECB kicking the can down the road, the markets can be forgiven for believing that Chinese policymakers will lack the fortitude to truly tighten system credit and liquidity.
Global markets could be at a bit of a crossroad here. Commodities are on the move again, and mounting inflationary pressures - especially in China and Asia - are a serious issue. And it wouldn't take much renewed dollar weakness to push this issue to the forefront. The European peripheral debt crisis has muddied the waters somewhat, but the upward bias on global yields was back in play this week. The US municipal bond market has stabilized. Yet the small decline in yields following the big spike higher would seem to suggest further vulnerability. A huge list of municipal issuers is lined up to sell debt.
The gamey US stock market has placed a big wager on the "risk on" trade. With QE2 in the early phase, greed has thus far held fear at bay. It surely won't take months of disappointing data to spark QE3 banter. And there's nothing like a world of synchronized speculative asset markets to embolden those banking on global policymaker liquidity backstops - the Fed, the ECB, BOJ in Tokyo, the People's Bank of China ... Perhaps US equities will begin to decouple from global asset inflation when the fragile US economy and credit system come to be viewed as relatively more vulnerable to surging commodities prices and rising global yields.
An important facet of my thesis holds that - with the post-Greek crisis global focus on structural debt issues - the US is in the process of becoming a major focal point. In the grand scheme of things, Ireland may be only loud noise. Gold, silver and commodities prices don't seem to be signaling sustainable dollar strength or overall confidence in the way things are heading.
It took months for mortgage credit contagion to spread from subprime to attack the heart of the US credit system. Perhaps it's a stretch to analyze in terms of an unfolding bursting of a global government finance bubble - as opposed to a European peripheral debt crisis. I just don't think so. And I fully expect that after market ebbs and flows - and near panics that incite more speculator-emboldening central bank market interventions/liquidity injections - the markets will inevitably discipline Washington. In the meantime, we are left with a game of counting the number of global policymakers kicking the can down the road.
Kicking the can
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