MONEY AND CREDIT AND THE CURRENT BACKDROP / PRUDENTBEAR.COM

Money and Credit and the Current Backdrop

by Doug Noland

April 27, 2014


Trouble brewing. Over the years, money and the “moneyness” of Credit have remained focal points of my Macro Credit Analytical Framework. From my perspective, money is fundamentally defined by perceptions. “Money” is a financial claim perceived as a safe and a liquid store of nominal value. Understandably, this definition is troubling to monetary purists. Yet in the spirit of Ludwig von Mises and his notion of broad money/“fiduciary media,” my view of contemporary “money” is focused on an array of financial claims and their functionality.

Importantly, money has throughout history proven itself dangerous. And the insatiable demand it enjoys is at the root its vulnerability. Folks simply just can’t get enough of it, which ensures it will eventually suffer from over-issuance. On occasion it will be created in catastrophic excess and be completely discredited. Traditionally, monetary inflations occurred through the over-issuance of currency, bank lending/deposits and government debt. Leading up to the tech Bubble, the over-expansion of GSE liabilities provided a key unappreciated source of inflationary “money.”

Traditionally, to safeguard the attributes of safety and store of value, money was backed by gold or real economic wealth (i.e. capital investment). Uniquely, contemporary “money” is to a large extent backed by nothing. This explains why I generally use “finance” rather than “capital” – in the context of financial flows as opposed to capital flows. Contemporary finance – “money” and Credit – amounts to electronic debit and Credit entries in this massive global general ledger. Traditional “capital” has been relegated to a thing of the past. Today, too much of “finance” retains its value based solely on the perception of central bank and government backing. This is a recipe for serious trouble.

Back in 1999, I really enjoyed Peter Warburton’s book “Debt and Delusion: Central Bank Follies that Threaten Economic Disaster.” Peter and I shared similar concerns back then. We believed central bank manipulation of interest rates, accommodation of Credit and speculative excesses and market intrusion were destabilizing the global financial system and economy. Peter and I saw crises as inevitable. And we both had no idea to what extent the Fed and global central banks would be willing to “print money,” monetize debt and manipulate markets.

It was five years ago (April 2009) that I began warning of the unfolding “global government finance Bubble.” I feared the “Granddaddy of All Bubbles.” The Fed resorted to previously unimaginable measures; for me the worst-case scenario. I never believed they would be able to “exit” from their ballooned post-QE1 balance sheet. I assumed ongoing balance sheet growth. I never imagined they would resort to massive monetary inflation in the face of record stock prices, conspicuous speculative excess (tech Bubble 2.0, biotech, etc.), highly speculative Credit markets, along with surging prices for real estate, farm land, art and collectables, Manhattan apartments, etc.

For those aghast at the course of contemporary monetary management, we clung to the view that markets would discipline central bankers if they pushed the envelope too far. Instead, the markets have cheered central banks into only deeper market intervention, manipulation and “money” printing. The critical lesson is that central bank-induced market excess can over a protracted period transform a marketplace from an effective self-adjusting/correcting mechanism into a dysfunctional speculative Bubble where Excess Begets Excess.

In the past, I’ve posited that a Bubble financed by junk bonds, while problematic, would not get to the point of creating deep systemic risk. The basic premise is that marketplace demand for high-risk debt is limited. When issued in excess, there will come a point where the market loses its appetite for taking on additional risk. Importantly, a junk Bond Bubble would not inflate long enough nor big enough to impart deep structural maladjustment upon the overall financial system and economic structure.

I grew increasingly concerned about the nineties Bubble specifically because of the far-reaching mutation of contemporary Credit. “Moneyness of Credit” had become a critical issue. With both their explicit and implied federal guarantees, the GSEs (chiefly Fannie, Freddie and FHLB) enjoyed unlimited market demand for their debt and MBS issues (especially during periods of market tumult!). The Fed pegging rates and backstopping market liquidity ensured the fundamental transformation of contemporary Credit. GSE securities – and securitizations/“Wall Street Finance” more generally – had been afforded money-like qualities. With the markets (leveraged speculators!) perceiving safe and liquid financial instruments, a New Age Credit system enjoyed insatiable market demand – hence the capacity to fuel a historic Credit and economic boom.

The New Millennium’s “mortgage finance Bubble” took “Moneyness of Credit” to a whole new level. With the Greenspan Fed aggressively reflating – and Fed governor Bernanke talking helicopter money and the government printing press – an increasingly speculative marketplace had reason to believe that the Fed, GSEs and the Treasury would fully backstop mortgage Credit. Mortgage debt in general was perceived as money-like – and unprecedented issuance ensured total outstanding mortgage debt doubled in just over six years. That phase of the Credit Bubble took nineties excesses to a new level, ensuring a much more systemic impact on the overall financial system and, even more importantly, the economic structure.

Fundamental to the “Granddaddy” “Global Government Finance Bubble” thesis has been my view that gross excess had finally reached the heart of the global financial system: government debt and central bank “money.” Yet the important ramifications for what I believe is the final phase of a historic Credit Bubble go unappreciated.

First of all, “money’s” attribute of insatiable demand plays prominently. By the end of the year, the Fed’s $4.5 Trillion balance sheet will have expanded 400% in six years. And there seems today little that would get in the way of the Fed expanding to $10 Trillion. The Bank of Japan is similarly unrestrained in its “money” printing operations, and the same would likely hold true for the ECB if it proceeds with its own QE. However, the same cannot be said for most “developing” central banks.

Today’s markets would react negatively to any major expansion of central bank Credit from the likes of Brazil, Russia, Turkey, India, Indonesia or South Africa. This market dynamic provides a huge competitive advantage to developed central banks, markets and economies. Increasingly, this competitive advantage along with the increasingly destabilizing global role of Federal Reserve “money” is a source of heightened global animosities. Increasingly, EM economies see developed “money” printing as a force for rising inequality.

In a broader context, I believe QE (developed central banking monetary inflation) promotes inequitable wealth distribution. Here at home, monetary policy that prominently inflates asset prices provides a wealth advantage to those with significant assets. Moreover, asset inflation provides a competitive advantage to those that are most sophisticated in generating speculative profits from government policies. The Fed’s QE operations – where massive liquidity has been injected directly into the markets – has generated an incredible wealth transfer, where a small segment of population is enriched while much of society sees little benefit.

So I view this Credit Bubble phase as especially damaging in terms of international relations along with latent domestic social tension. I view the rapidly deteriorating geopolitical backdrop in this context. Many EM countries today see themselves as suffering from an unjust global financial system. The wealth illusion during the Bubble phase has given way to faltering Bubble disillusionment. Moreover, I expect the damage this monetary inflation has wrought upon the fabric of society to become more apparent after the next downturn. At this point, the wealth redistribution issue has been well-masked by the re-inflation of asset prices (securities and real estate) and the perception that the economic recovery is generally sound and sustainable.

I argue strongly that central bank Credit is by far the most powerful “money” when it comes to inflating securities prices and distorting market perceptions. When the Fed expands its “money,” it creates inflationary purchasing power (especially for securities markets), while also emboldening the view that this unlimited source of “money” will continue to underpin the markets and economy. This makes Fed “money” the most dangerous monetary fuel yet, and certainly the most seductive. The Fed has convinced itself that its capacity to inflate asset prices provides profound system benefits. The Fed believes its QE operations stabilize the markets and promote growth. I see QE as extraordinarily destabilizing, in terms of securities market prices and risk perceptions.

I see money and Credit theory as particularly instructive in the current market environment. Going on six years of QE have fueled a long inflationary cycle in securities prices. QE3 sent enormous amounts of liquidity into equities, in the process inciting “terminal phase” excess. In particular, a torrent of speculative finance stoked a full-fledged technology Bubble. In a replay of the late-nineties, the interplay of rampant monetary inflation and intense speculative excess has fueled a destabilizing “arms race” of over- and malinvestment throughout the “tech” sector. From my analytical framework, such monetary disorder ensures a bust. Today’s backdrop is reminiscent of early 2000.

Meanwhile, “developed” central bank monetary inflation fomented historic boom and bust dynamics throughout EM. I believe the reversal of flows from EM and the resulting deteriorating financial and economic backdrop are largely responsible for the rapidly deteriorating geopolitical backdrop. Indeed, I fear the worsening situation in Ukraine reflects a troubling new era of global disagreement and conflict. Monetary instability, economic fragility and wealth inequalities have ushered in another “cold war” that hopefully remains cold. I don’t expect our exuberant markets to remain so complacent forever.