by Doug Noland
Asia Times
Jan 12, 2010

Let's start by setting the backdrop. The world is operating without a stable monetary regime. There is no gold standard. There is no functioning Bretton Woods currency stability regime. There is no longer even an ad hoc dollar reserve "system" that tended - at least on occasion - to discipline foreign credit systems and restrain excesses.

Like never before, credit systems around the world operate unrestrained. It is my long-held view that pricing mechanisms - and capitalism generally - function poorly in a backdrop of unrestrained (inherently mis-priced) credit.

Most importantly, there is today no common understanding that stable international finance is wholly dependent upon individual credit systems being operated with discipline and restraint. Quite the contrary, as the universal policymaking view these days is that aggressive stimulus and monetary looseness are essential for supporting financial and economic recoveries. The world is devoid of a monetary anchor and operating in a unique monetary environment that foments speculation, financial excess, imbalances, economic maladjustment, and potent bubble dynamics. As we begin 2010, inflationism is still seen as the solution instead of the problem.

The year 2008 marked the collapse of the Wall Street/mortgage finance bubble. It specifically did not mark the end of the Chinese bubble, the global credit bubble, or even the greater US credit bubble. Last year saw the emergence of the global government finance bubble - quite possibly a monumental development. Accordingly, 2010 should be viewed as a bubble year. This implies a bipolar perspective when contemplating probable outcomes: on one end, the bubble expands and makes it through the year, or, on the other, the bubble bursts and financial systems and economies sink right back into crisis. As a long-time analyst of bubbles, I caution against predicting the timing of their demise.

Last year saw intense speculation reemerge in US and global financial markets. It is the nature of speculation to intensify as long as it is accommodated by loose financial conditions. Similarly, it is the nature of bubbles to expand and become more robust unless inflation dynamics are quashed through some type of monetary tightening. Excess begets excess ... and the more protracted - hence powerful - the bubble the greater the degree of tightening necessary to eventually rein it in. The more heated and expansive the bubble, the greater the dislocation associated with its bursting. I see no appetite anywhere in the world this year to aggressively suppress bubbles.

The unfolding bubble in China is historic, and their policymakers appear poised to tinker. Tinkering doesn't quell bubbles - certainly not seasoned ones. I have espoused the view that the Chinese credit bubble has entered the dangerous "terminal phase" of excess. How this dynamic and the course of policymaking play out is a major issue 2010. I expect Chinese authorities to work diligently in an effort to ration the amount of credit available for real estate speculation. At the same time, the stated goal of stimulating domestic consumption implies huge growth in Chinese household debt.

I am generally skeptical in the efficacy of credit rationing. This was a focal point of a great debate in the US back in the late-1920s. One (dovish) camp believed that the focus should be on limiting the flow of credit financing stock market speculation, while at the same time working to maintain ample credit to fuel the booming economy. The problem is generally that years of expanding credit create a (financial and economic) system with both a huge credit appetite and a potent propensity for inflating the quantity of new credit.

Attempts to limit speculative credit - or even lending to certain sectors - is generally ineffective in itself and fails to address the major issue of runaway total system credit growth. Indeed, after bubble dynamics have taken firm hold, attempts to restrict credit by the nature of its use will tend to distract policymakers and delay efforts to contain systemic excesses. From my point of view, determined, decisive and independent monetary management provides the only hope for reining in "terminal phase" credit bubble excess. Such an approach seems in very short supply these days, and I'll be surprised if much of it emerges in China in 2010.

Here at home, Federal Reserve chairman Ben Bernanke apparently doesn't discern bubble risk. Incredibly, in his Sunday morning speech he even argued that Fed rate policy was about right during the 2002-2006 period - and that a low Fed funds rate wasn't the cause of the US housing bubble. We can also assume the he believes his speeches (including his November 2002 - "Helicopter Ben" - "Deflation: Making Sure 'It' Doesn't Happen Here") did not create a major moral hazard issue.

The markets have no fear that the Fed will tighten in response to financial speculation. I believe the Fed examines today's real estate markets and fears "deflation". I would imagine they see a stock market still 25% below all-time highs and worry of "disinflation". They see stagnant (at best) household debt growth, declining bank credit, and still impaired securitization markets and see no credible inflation threat. Looking in the rear-view mirror, they just don't see problematic financial leveraging and lending excesses. They would surely view the reemergence of asset inflation as confirmation of their adept policymaking.

The Fed's overriding focus is stimulating sustainable recovery. They will err on the side of caution when it comes to removing crisis-period liquidity measures. I will assume that they will not be raising rates meaningfully until they are confident that the markets and economy have first adjusted well to ending quantitative easing operations. Meaningful financial tightening is nowhere in sight. The Bernanke Fed still believes that monetary policy is a "blunt tool" and, as such, is inappropriate for dealing with bubbles. They prefer stronger "regulation". So, who is responsible for regulating Washington credit excesses?

The Fed's analytical framework and rear-view approach will not serve them well. Today's domestic credit excesses are concentrated in the Treasury and agency markets. In a replay of mortgage finance bubble dynamics, Federal Reserve policies today accommodate the government finance bubble. Bernanke's talk of helicopter money and the government printing press was fundamental to creating an environment where the markets operated confidently knowing the Fed was there to provide a market liquidity backstop. The Fed's fingerprints were all over the historic mispricing and over-extension of mortgage credit. Today, "quantitative ease" and the perception of potentially unlimited Federal Reserve monetization (balance sheet growth) have greatly distorted the pricing mechanisms for government borrowings and debt instruments generally.

Because of the Fed's words and deeds, the marketplace is dysfunctional when it comes to pricing risk. These days the price of government credit has no relationship to the interaction of its supply and demand. If Washington seeks to borrow a couple hundred billion - or a few trillion - it really has little impact on yields. In an ominous replay of the mortgage finance bubble, government intervention has severely distorted the capacity of the marketplace to properly price risk, allocate resources, and discipline market participants (borrowers and speculators).

The Fed should have "leaned in the wind" in response to double-digit mortgage credit growth in years 2002 to 2006. Instead, the Fed did the exact opposite, believing at least for awhile that the expansion of mortgage credit was a mechanism to ameliorate deflationary pressures. Furthermore, it had convinced the marketplace that it was there to protect against any potential credit bust. And then, once the housing/mortgage bubble really gained a foothold, the Fed was unwilling to rein in the monster it had unleashed. The marketplace had become so dysfunctional that the best "trade" to profit from the inevitable bust was to load up (and further feed the mortgage bubble) on government-sponsored enterprise (GSE) obligations.

Similar dynamics now promote the government finance bubble. In a more orthodox financial world, our central bank would be expected to "lean against the wind" as our federal government sets course on destroying its (our) creditworthiness. Not these days, as the Fed holds short-term rates steadfastly at near zero, balloons its balance sheet with GSE mortgage-backed securities (MBS), and again convinces the marketplace that its balance sheet will always be there as a liquidity backstop.

Despite the prospect of the Fed ending its MBS purchase program in March, GSE MBS spreads to Treasuries ended last week near 17-year lows. The marketplace must expect that Fannie and Freddie are to resume their balance sheet growth (and market liquidity-backstop function!); that the Fed will state its intention to provide future support for the MBS market; or a combination of both. There is no end in sight when it comes to the nationalization of mortgage finance. Clearly, the MBS marketplace is rife with government intervention and price distortions. It has, once again, succumbed to dangerous bubble dynamics and how it functions through the year is a major issue for 2010.

As I mentioned again last week, combined Treasury and GSE MBS debt expanded US$2.8 trillion in the 15 months ended September 30, 2009. The emergence of the global government finance bubble was crucial for the stabilization of the US and global economy. US recovery is dependent upon the continuation of this bubble, and this bubble is dependent upon massive government fiscal and monetary stimulus. Optimism is now running high. Such a dynamic can be self-fulfilling for awhile, and the US economy could make the bulls look smart in 2010. But this is very unlikely to change the very bearish secular thesis.

The nature of the unfolding economic recovery is another issue for 2010. Will private-sector credit creation begin to expand sufficiently and, in the process, allocate ample credit for sound investment and meaningful non-government job growth? Will a self-reinforcing credit cycle commence, or is the system now trapped in government debt bubble dynamics?

A respectable December for the retailers has optimism for consumer rejuvenation running high. The S&P Homebuilding Index was up 14.6% last week, as the marketplace positions for a traditional economic rebound. But major questions for 2010 remain: how vulnerable is the housing market to higher mortgage yields? How long will the marketplace finance massive deficit spending and GSE debt issuance before demanding significantly higher yields?

My thesis that the unfolding reflation will be altogether different than past reflations may be tested in 2010. So far, massive government stimulus has stabilized both asset markets and national incomes, and some pent up demand throughout the economy is expected. At the same time, savers are receiving about nothing on their savings, while energy and many other prices continue their ascent. Surging financial asset prices have boosted household confidence and net worth. Yet a meaningful rise in market yields could easily pressure bond, stock and home prices. To what extent mortgage credit growth can recover and foster a self-reinforcing housing recovery is a key financial and economic issue for the year ahead.

Unprecedented market interventions by the government played a decisive role in stabilizing mortgage finance, housing markets, and household spending. It played a similar role in stabilizing the municipal debt market. That cash-strapped state and local government regained access to inexpensive borrowings was instrumental to financial and economic stabilization. If a traditional recovery ensues, perhaps state and local governments can grow out of their debt problems. A more reasonable bet is that municipal finance faces serious and festering structural debt issues. California is an absolute fiscal mess. Do loose financial conditions continue to accommodate what will be enormous 2010 state and local borrowing requirements?

Today, the markets are infatuated with risk assets. From the perspective of bubble analysis, this is not all too difficult to explain. The first week of the year saw about $45 billion of corporate debt issues. Despite enormous new supply, investment grade debt spreads are at pre-Lehman crisis levels. The same can be said for junk bond and emerging debt spreads. Credit conditions are loose for most creditworthy borrowers, which feeds market demand for these debt instruments - which translates into even greater credit availability. In such an environment, even commercial real estate doesn't look so bad. But is such an accommodating financial landscape sustainable?

It is always impossible to know what developments will surface to upset the applecart: there are any number of festering financial, economic, political, and geopolitical issues that might impede the unfolding bubble. At the same time, it is not unreasonable to suspect that policymakers might tend to delay dealing with tough issues. The federal deficit is out of control, and monetary policy is outrageously loose. There is an "exit strategy" with assorted doors. There is the looming issue of Fannie Mae and Freddie Mac. The Federal Housing Administration and Ginnie Mae need to be reigned in.

Looking back, policymakers of all stripes missed their opportunities to make tough but necessary decisions in 2009. And now 2010 just doesn't have the feel of a year that will witness a lot of decisive policymaking. In Washington, the focus will turn to the 2010 elections. The Fed will worry about its reputation and independence. Fearing for their jobs and fearful of mistakes, timid will win over bold. Bubbles treasure timid.

Until proven otherwise, I'll project 2010 as a year of escalating monetary disorder - disorder globally across a broad spectrum of markets. A global bubble would seem to ensure unsettled currency markets. Dollar optimism runs surprisingly high to begin the New Year. Yet the scenario of a dollar problem leading to a jump in US borrowing costs still doesn't seem all that nutty to me. Another spike in energy and commodities wouldn't surprise me, but the best bet is numbing volatility. The emerging markets are poised for a wild year. And, of course, all eyes on interest rates.

As I mentioned above, a bubble year suggests the likelihood of bipolar outcomes. I'll conclude by admitting that I get that uneasy feeling that our central bank is quite determined to avoid learning lessons. ... 2Dj01.html