Today we present an excerpt from Doug Noland's weekly Credit Bubble Bulletin. This week Doug is responding to an op-ed piece by Marty Feldstein which suggests that the Fed ought to stop decreasing interest rates now.
We agreed with Feldstein's proposal for what we 'think' are the same reasons, and had come to the same conclusion some time ago. By lowering interest rates so precipitously, the Fed has taken a broad brush to solve a problem that might better have been addressed by a more selective remedy, which in some ways the Fed undertook with the opening of the Discount Window and the bailout Bear Stearns, although we disagree with specifics as we have already related.
The overall lowering of rates 'helps' the real economy which is also in a recession. The additional collapse of the credit Ponzi scheme by the banks is a significant complicating factor. We believe the recession we are entering is the child of past Fed actions in attempting to ameliorate prior financial slumps.
Clearly the Fed had a policy decision to make, and their decision was to throw the long term concerns and principles to the wind, and give a full force effort to holding the banking system together, inflation be damned. Anyone who suggests they have been conservative would probably like to see our economy run more like an Old West card game called Faro.
Doug suggests one step in addition to Marty's and that is that the Fed should increase interest rates now presumably to fight inflation and to strengthen the dollar, lowering commodity prices.
We've included Doug's entire argument because we wanted to make sure we had it right, since we're operating on short timeframes this weekend. What Doug is prescribing is to take the patient, which was brought in with an acute appendicitis, and after the Fed has removed it with a garden shovel, to take a cattle prod and try to get the patient back on its feet.
Nothing could more closely fulfill Jefferson's warning of 'first through inflation and then through deflation' the money controlling powers would destroy the middle class, making it serfs in the nation their forefathers created out of wilderness. Now that the speculative class have gained the bulk of the wealth, let's allow them to keep it, and make it all the more valuable through deflation, putting the middle class into early graves, for really little or no gain for the country. What good is a strong dollar when the real economy is in deep depression, and only a privileged few have them?
We are going to suggest, carefully we hope since Doug is a friend and a highly respected analyst, that raising rates now is the just counterpart, the flip side of the coin, to the mistake the Fed has made.
Using interest rates, the public money supply, to address a problem specific to the banking sector, a massive and pervasive case of credit fraud and at best the unintended consequence of irrational regulation and almost sociopathic venality, just once again uses the public as a bludgeon to try and hammer down the problem like a nightmarish game of whack-a-bubble. There needs to be an effort to specifically 'fix' the bank system, not by repair by through reform. Any remedy just keeps the game going is making the patient more feeble and imbalanced, requiring a more stringent and risky remedy at the end.
Put simply, anything that does not reform the banking system as part of the program, even in the near term, just compounds the problem through unintended consequences, with the larger public taking it right in the neck.
We thought the Naked Capitalist made a well thought proposal even better and more specific than the one which we had put forward some weeks ago.
1. Force as much OTC activity as has reasonable trading volume onto exchanges. That means at a minimum interest rate swaps, currency swaps, and credit default swaps. Yes, this will require standardization and some buyers will lose access to variants they might have liked. Too bad. Protecting the economy and the taxpayer is more important than indulging every investor’s pet need.
This of course will also considerably lower the profitability of the industry. Again, too bad. They screwed up and cost the populace a ton of dough. There are consequences for mistakes of that magnitude. They should consider themselves lucky not to have been subject to public beheadings.
Lower profits for banks has positive consequences. It means less talent and other resources are sucked into the FIRE economy (and remember, the FI in that equation are at best service providers to the real economy, and worse, when they become too large, parasites).
2. Prohibit off balance sheet vehicles.
3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.
4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets.
Hedge funds would continue to be unregulated. I might also prohibit any unregulated entity from going public. Speculators playing with investors’ money is tempting enough; having them have even less skin in the game via a public floatation makes it easier for them to get so large as to pose a danger. Yes, this can create problems of succession, but Wall Street dealt with it for a hundred years or so. These guys ought to be smart enough to figure it out.
I’d also have pretty draconian penalties for breaking the rules, the sort that can have individuals involved and their supervisors forfeit a lot of dough and go to jail.
Thus I’m not as pessimistic about the ability to leash and collar the industry, perhaps because I lived in it briefly when it was more heavily regulated and it functioned much better for society as a whole than it does now. And the bankers still made a very nice living, although nowhere near as egregious as the pay scales of late. The real constraint is political will, and I don’t think things have gotten bad enough yet for the public to demand an end to rule by finance. But that attitude will change if real estate prices fall another 10%.
We would go a step or two further, but this would be a great start. We need to separate the capital allocation system from the speculation system. We need to place strong accountability in the speculation system, in a sense firewalling off the real economy from the excesses of easy money speculation.
Is it really all that simple? Yes, it is. But it will be made to seem complex and dangerous because the banks fought against Glass-Steagall for years, and spent hundreds of millions doing it, to have the type of system exactly which we have today. They wish to be able to tap Other People's Money (OPM) in order to socialize their losses, while keeping inordinate gains and accumulate fabulous wealth when they are right.
And they will continue to corrupt the country as collateral damage to the national intellect by distorting reality and buying the best minds, until the republic is a shell of itself. Such is the work of parasites, which is exactly the type of unproductive and madly inefficient financial system which we have today.
Setting the Backdrop for Stage Two
by Doug Noland
Martin Feldstein, Harvard professor and former chairman of the President’s Council of Economic Advisors, wrote an op-ed piece in Wednesday’s Wall Street Journal – “Enough with Interest Rate Cuts” – worthy of comment.
“It’s time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage. Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.
The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money. The usual concern is that lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the U.S. in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly. But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices.
Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains. Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates. An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol.”
While I concur with the basic premise of the article (stop the cuts!), the substance of Mr. Feldstein’s analysis leaves much to be desired. First of all, I find it strange than he would address the issues of overly accommodative Federal Reserve policy, commodity price risk, and inflationary pressures without so much as a cursory mention of our weak currency. The word “dollar” is nowhere to be found – not a mention of our Current Account Deficits. The focus is only on interest rates - and such one-dimensional analysis just doesn’t pass muster in our complex world.
Most remain comfortably oblivious to today’s inflation dynamics. Mr. Feldstein mentions increased demand from China and India. He seems to imply, however, that portfolio buying (financed by low interest rates) by “commodity investors and speculators” is providing the major impetus to rising inflationary pressures generally. Perhaps price gains could have something to do with the $2.5 TN increase in global official reserve positions over the past two years (85% growth). I would also counter that destabilizing speculative activity is an inevitable consequence – rather than a cause - of an alarmingly inflationary global backdrop.
I’ll remind readers that we live in a unique world of unregulated Credit. Excess has evolved to the point of being endemic to an apparatus that operates without any mechanism for adjustment or self-correction. There is, of course, no gold reserve system to restrain domestic monetary expansions. Some years back the dollar-based Bretton Woods global monetary regime lost its relevance.
And, importantly, the market-based disciplining mechanism (“king dollar”) that emerged at times to ruthlessly punish financial profligacy around the globe throughout the nineties has morphed into a dysfunctional dynamic that these days nurtures self-reinforcing excesses. The “recycling” of our “Bubble dollars” (in the process inflating local Credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of Global Monetary Dysfunction.
A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless “system” of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting U.S. Current Account Deficits and resulting dollar impairment have unleashed domestic Credit systems around the globe to expand uncontrollably. Today, virtually any major Credit system can and does inflate domestic Credit to create the purchasing power to procure inflating global food, energy, and commodities prices.
The long-overdue U.S. Credit contraction and economic adjustment could change this dynamic. But for now there are reasons to expect this uninhibited Global Credit Bubble to instead run to precarious extremes - and for resulting Monetary Disorder to become increasingly problematic. Destabilizing price movements and myriad inflationary effects are poised to worsen. The specter of yet another year of near-$800bn Current Account Deficits coupled with huge speculative flows out of dollars is just too much for an acutely overheated and unstable global currency and economic “system” to cope with.
I hear pundits still referring to a “deflationary Credit collapse.” Well, the U.S. Credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns; opened wide its discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations. Here at home, the GSEs’ regulator spoke publicly about Fannie and Freddie having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 TN this year (certainly including “jumbo” mortgages). The Federal Home Loan Bank system was given the ok to continue aggressive liquidity injections and balloon its balance sheet in the process. And now (see “GSE Watch” above) we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200bn this year, while Washington’s Ginnie Mae is in the midst of a securitization boom.
Together, the Fed and Washington have effectively nationalized a large portion of both mortgage and market liquidity risk. It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7bn during the first quarter (20.7% annualized) to $1.642 TN, with six-month growth of $163.3bn (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2bn during Q1 (24.7% annualized) to $1.189 TN, with half-year growth of $143.2bn (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that Bank Credit overall has expanded at a 12.6% rate over the past 38 weeks. Meanwhile, GSE MBS issuance has been ramped up to a record pace. And let’s not forget the Credit intermediation function now being carried out by the money fund complex – with assets having increased an unprecedented $371bn y-t-d (41.3% annualized) and $900bn over the past 38 weeks (47.7% annualized). It is also worth noting the $184bn y-t-d increase (29% annualized) in foreign “custody” holdings held at the Fed. Sure, the Credit system remains under significant stress, with additional mortgage and corporate Credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The Credit system is simply not in deflationary collapse mode.
I could not be more pessimistic with regard to our economy’s prognosis. And certainly much more severe Credit problems lay ahead. I could argue further that recent Credit system developments are indeed consistent with the unfolding “worst-case scenario”. Yet I tend this evening to see benefits from analyzing the current backdrop in terms of the conclusion of the first Stage of the Crisis. The key aspect of this “first Stage” was a breakdown in Wall Street’s highly leveraged risk intermediation and securities speculation markets. The speed and force of the unwind was extraordinary and in notable contrast to traditional banking crises that track real economy developments. “Resolution” came only through the Federal Reserve and federal government assuming unprecedented risk – and at a cost of a policymaking mix of interest-rate cuts, marketplace interventions, and government guarantees. It is worth pondering some of the near-term ramifications.
First of all – and as the market recognized this week – yields have been driven to excessively low levels. Fed funds are today ridiculously priced in comparison both to the inflationary backdrop and to global rates. Mr. Feldstein is calling for a halt to rate cuts when it would be more appropriate for the Fed to move immediately to return rates to a more reasonable level. They, of course, would not contemplate as much. So I will presume that today’s non-imploding Credit system – replete with government-backed mortgage securitizations, government-guaranteed bank Credit, presumed government-backstopped money funds and a recovering debt issuance apparatus – will suffice in the near-term in generating Credit sufficient to perpetuate our enormous Current Account Deficits. This is no minor point.
I have in past Bulletins made the case that U.S. Credit and Economic Bubbles had become untenable – the scope of Credit and risk intermediation necessary to support the maladjusted economy had become too large. Extraordinary measures to effectively “nationalize” mortgage and market liquidity risk change somewhat the direction of the analysis. I would today argue that the risk of a precipitous economic downturn has been reduced in the near-term. As a consequence, U.S. Credit growth could surprise on the upside with risks to global Price Instability increasing markedly.
I would argue firmly that – in the face of a rapidly weakening economic backdrop - global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to Credit creation – that then begets only more heightened inflationary pressures. There are certainly indications that the over-liquefied global “system” is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.
With crude hitting a record $117 today, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to Monetary Instability, our financial markets might just prove the unappreciated wildcard. When the Fed and Washington radically altered the rules of U.S. finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of “Stage one” arises a major short squeeze in the Credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s “hedging” activities, we’re clearly in Uncharted Waters. It is not beyond reason that a disorderly unwind of “bearish” Credit market positions could incite a mini bout of liquidity, speculation, and Credit excess that exacerbates Global Monetary Instability - while Setting the Backdrop for Stage Two of the Crisis.
Doug Noland's Credit Bubble Bulletin
