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05 December 2013

The Fed & The Credit Bubble: Those That Refuse To Learn History Are Doomed to Repeat It


By Doug Noland 

"To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also - to an extent that is not always fully appreciated - the experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge." Ben S Bernanke, Essays on the Great Depression 2000.  

 No longer is the understanding of the Great Depression the "Holy Grail" of economics." It's been supplanted by understanding today's extraordinary ongoing global Credit and speculative Bubble cycles.  

 Dr. Bernanke and others focus primarily on what they believe were policy errors during the Thirties, with surprisingly little attention paid to "Roaring Twenties" policies and excesses. If only the Fed had understood the need to open up the monetary floodgates, they claim. Fed money printing could have been used to recapitalize the banking system, rectify insufficient demand and reflate consumer and asset prices. The Great Depression could have and should have been avoided.  

Indeed, today's policymakers believe they are adeptly fighting and winning an epic battle against 1930's-type deflationary forces. They are determined to "do whatever it takes." Having failed to learn from misguided 1920's policies that sustained dangerous financial Bubbles and attendant economic maladjustment, they today replay them.

 A Federal Reserve that was created in 1913 to regulate Credit fatefully accommodated a historic Credit boom that became increasingly unwieldy in the latter years of the '20s. Over time, speculation and asset Bubbles were recognized as increasingly problematic. Yet there was a critical compounding problem: the ongoing downward pressure on commodities and consumer prices. Global financial and economic backdrops had become increasingly unstable and confusing. Competing interests, analytical frameworks and ideologies ensured policymaker impotence at the Federal Reserve. In the end, a historic Bubble was allowed to run unchecked.  

Benjamin Strong, president of the New York Fed and the leading figure at the Fed, administered his famous stock market "coup de whiskey" in 1927. The results were spectacular. The Dow Jones Industrial Average more than doubled in 18 months. Yet Fed stimulus had little impact other than to significantly exacerbate the divergence between inflating asset prices and weakening fundamental prospects. Looking back, a rather obvious lesson went unlearned: No shots of whiskey, especially into a speculative backdrop. Market operators are today fully intoxicated by the latest Trillion dollar body shot. 

Policymakers today struggle with a serious dilemma uncomfortably reminiscent of what manifested during the late-Twenties: How to administer monetary policy in a backdrop with downward pressure on some prices (as opposed to the general price level in the late-20s) yet intensifying speculative excess propelling a securities market Bubble. Similar to today, policymakers were confounded by a complex interplay of Credit, speculative and economic dynamics. There was general acceptance that market speculation was posing an increasingly dangerous systemic risk. Yet faltering global growth and a weak pricing backdrop were viewed as the more pressing issues.  

 The longer it was left unchecked the more apprehensive central bankers were to pricking the Bubble. Moreover, virtually everyone was oblivious to the degree of fragility associated with protracted financial excess - fragility that was greatly exacerbated by a final speculative blow-off.  

 There was a crucial debate within the Fed: How to spur Credit growth for the real economy without feeding market speculation. One school of thought held that proper Credit allocation was the key. The Fed should channel Credit for investment in the real economy, while working to tighten broker call lending and other speculative Credit feeding into stocks. An opposing view held that such Credit allocation efforts were destined to fail. No matter the avenue of how money and Credit initially made their way into the system, there was little the Fed could do to thwart the intense magnetic pull into an inflating market Bubble. As the guardian of system stability, the Fed needed to pop the speculative Bubble - and the sooner the better.

My objective is not to rehash history but to offer insight to help explain today's confounding environment. Top Fed officials have stated their objective of focusing monetary policy on system reflation, while relying of regulatory means to ward off potential asset Bubbles. They have apparently discerned no Bubbles in bonds and fixed income over recent years. Now, with U.S. stocks having become a primary recipient of QE3 liquidity, the Fed's policy doctrine has turned more openly suspect.

With the average stock (The Value Line Arithmetic index) up 40% in 12 months, "global government finance Bubble" excess has certainly turned more publicly conspicuous. Predictably, there is more than ample rationalization and justification. Valuations are not at "Bubble extremes", is the popular refrain. But at least there's some superficial attention paid to the "Bubble" issue. At the same time, the predominant attitude in the markets seems to be "if there's a lot of talk of Bubbles, then the markets surely have much further to run." I found Byron Wein's Wednesday comment on CNCB telling: "You don't stay out of the market waiting for the moment of truth."  

 There are several aspects of the "granddaddy of all Bubbles" thesis that have been more prominent of late. As noted previously, with the equity market Bubble now in full force, the Bubble in securities markets has turned fully systemic. As part of the irony of speculative Bubbles, market participants assume more intense speculation ensures central bankers will tread even more gingerly when it comes to withdrawing stimulus. In the U.S. as well as on a global basis, central bankers must now contend with excess liquidity gravitating to unwieldy speculative financial Bubbles. Friday from Bloomberg: "Abe No Friend to Emerging Bonds as Nikkei Jumps Most Since 1972." With Japanese investors jumping on the equities train, flows into emerging bond funds are running half the pace of recent years. We'll have to see how significantly the push into equities comes at the expense of bond flows.  

The late-stage of protracted Credit Bubbles takes on troubling dynamics. The late-stage of protracted speculative Bubbles takes on troubling dynamics. When the two combine on a more globalized basis - as they did in the late-twenties - the upshot is a precarious situation and monumental policy dilemma. 

First of all, after repeated market bailouts over the years market participants have become fully conditioned to presume central banks will eagerly backstop global securities markets. This is one of those rare instances where the global economy is seen as vulnerable and atypically susceptible to any general waning of financial market liquidity. This backdrop seemingly provides market operators a bright green light to speculate. So-called "moral hazard" has never been as predominant. I have argued that "too big to fail" risk distortions have evolved to encompass global securities markets generally. 

There is by now abundant evidence supporting the thesis of a global environment uniquely conducive to systemic speculative excess. Clearly, speculative dynamics have built powerful momentum over the years - while policymakers have essentially promised to look the other way. Is the Fed really pre-committing to keeping rates near zero for another several years? 

While there's a good book to be written on late-stage Credit cycle dynamics, I'll attempt a few pertinent insights. In general, things really run amuck late in a Credit boom - and policymakers extend the Bubble's duration at all of our peril. To be sure, finance is over-issued and misallocated. The poor allocation of Credit throughout the real economy ensures maladjustment and progressive stagnation (i.e. less economic bang for the Credit and speculation buck). And as we've witnessed, if policymakers throw only looser "money" at the problem the end result will be more speculative asset markets and runaway Bubbles. Maladjusted economic structure coupled with asset Bubbles ensure a problematic redistribution of wealth toward a small segment of society. Meanwhile, the mountain of suspect financial claims grows ever taller.  

 Today's conventional economic thinking ("inflationism") believes that so-called "insufficient demand" can be rectified by monetary policy. Yet the additional late-cycle "money" printing gravitates predominantly to inflating securities markets. At the corporate level, various forms of financial engineering are employed with the objective of supporting higher stock prices. On the one hand, little of the liquidity makes its way to the type of sound investment necessary to support sustainable wealth creation. On the other hand, that much of the population fails to benefit from monetary inflation becomes an important facet of late-cycle economic stagnation.

 A globalized boom, as has been the case over the past couple decades, adds another important dynamic. Loose "money" and Credit globally ensure ongoing investment boom distortions in the more manufacturing-based economies (China and Asia, in particular). This helps explain - today, as it did in the late-Twenties - some of the downward price pressure on manufacturing goods in the face of abundant system Credit and marketplace liquidity. To be sure, prolonged Credit and speculative booms progressively raise of the risk of devastating busts. And a policy course focused on "money" printing and reflation to combat perceived deflation risks only more precarious Bubbles and economic maladjustment.  

 The Fed plans to use "forward guidance" to hold down long-term interest rates as it winds down QE. Perhaps such talk will exert some impact on Treasury bond prices. I doubt when they were formulating this strategy the Fed anticipated a stock market melt-up scenario. An increasingly unstable equities market Bubble will require ongoing real liquidity buying power beyond assurances of low rates. That's the nature of speculative Bubbles.

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