Tuesday, May 5, 2009

Free Lunch?

Greetings good citizen,

The markets are enjoying another ‘big’ up day, this time because month-over-month home sales have increased. Citing a combination of depressed prices, government incentives and loosely defined ‘first time buyers’, not only have sales picked up but so have housing ‘starts’.

Naturally, a single month of data does not a ‘recovery’ make, especially in light of the looming problems in the auto industry.

The housing markets are nowhere near the bottom (price wise) and building more homes when there is so much unsold inventory on the market is ‘speculative’ at best, nothing to get excited about.

Sadly, ‘good news’ is where you find it…even if you have to ‘spin’ it yourself.

With that said there is a rather ‘diverse’ set of offerings on tap tonight. We begin with commentary from someone we haven’t heard from in a while…

The greatest cost
Commentary and weekly watch by Doug Noland

An astute analyst posed the following question last week: "The current debate is centered on whether the US Federal Reserve can take back the liquidity in time in order to prevent inflation. Suppose it can. Suppose they execute this perfectly. But if the Fed is able to flood the system with the liquidity (thus reducing the severity of the downturn) and take it back before it causes inflation, it seems there is a free lunch. We get something for nothing. So, assuming a perfectly executed game plan by the Fed, is there a cost? Do they keep rates low for a time, only to raise them a lot a year down the road - is that the cost? Or is there another cost?"

I'm short on time today, so I'll attempt a brief response.

First of all, while it often appears otherwise, finance provides no free lunch. The mis-pricing of credit and misperceptions of risk in the marketplace have deleterious effects, although their true impact may remain unexposed for years. Indeed, the more immediate (and always seductive) consequences of loosened financial conditions tend to be reduced risk premiums, higher asset prices, and a boost to economic "output". Conventional analysis of monetary policymaking still focuses on "inflation" and "deflation" risks. I would strongly argue that our contemporary world has already validated the analysis that acute financial and economic fragility are major costs associated with market pricing distortions.

When the Federal Reserve collapsed interest rates following the bursting of the technology bubble, the results seemed constructive. Stock and real estate prices inflated; a robust economic recovery ensued. [But only or traders, the ‘real’ economy continued to languish.] There was at the time some recognition of the potential for real estate excesses. But this was seen as such a small price to pay in the fight against the scourge of deflation. It was not until 2007 that the nature of the true costs of a massive "reflation" began to come to light. [I would add that this was due to the failure to incite a ‘corresponding’ economic expansion in the ‘real’ economy.]

Many would today argue that it was simply a case of the Fed's failure to take the punchbowl away in time. Such analysis misses a key facet of bubble dynamics. Once the mortgage finance bubble gained a foothold, there was absolutely no way policymakers were going to be willing to risk bursting such a consequential bubble.

I see ample support for my view that bubble dynamics have taken root throughout government finance. This unprecedented inflation includes Federal Reserve Credit, Treasury borrowings, agency debt, mortgage-backed securities issued by government-sponsored enterprises (GSEs) such as home-loan guarantors Fannie Mae and Freddie Mac, Federal Housing Administration and Federal Deposit Insurance Corporation insurance, massive pension and healthcare obligations, the myriad new market support programs, and so forth. This government finance bubble is domestic as well as global. Amazingly, the scope of the unfolding bubble dwarfs even the mortgage finance bubble. And, importantly, it is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic bubble.

So I see the probabilities as very low that the Fed will reverse course and impose tightened liquidity conditions upon the marketplace. Actually, reflationary pressures may force the Fed to increase its Treasury holdings in an effort to maintain artificially low interest rates. At the same time, I don't see higher inflation as the greatest cost associated with this predicament. Much greater risk lies with the acute systemic fragility that I believe is inherent to major bubbles. [What he’s saying here is the global financial system will still be in danger of collapsing…and when it does, hyperinflation will be the least of our problems.]

Similar to mortgage finance 2002-2007, the marketplace is significantly mispricing the cost - and failing to recognize the risks - of a massive inflation of government finance. And while every bubble has its own dynamics and nuances, the unfolding government finance bubble has even more precarious Ponzi finance dynamics than the mortgage bubble.

The markets are on track to accommodate US$2 trillion or so of Treasury issuance this year. This incredible amount of debt creation is in the range I would expect necessary to temporarily stabilize the US ("services") bubble economy. Importantly, this amount of new finance both plugs financial holes and works to stabilize inflated income levels. From last week's income data, one can see that personal income was up 0.3% year on year to $12.04 trillion. And while 0.3% is very meager growth, without massive government fiscal and monetary expansion (inflation) the economy would have suffered a destabilizing income contraction. Keep in mind that personal income has inflated 65% since 1998 and 33% from 2003. [So, while overall income is ‘growing’ on paper, it is the failure of this income to be distributed where it is needed that will result in ‘systemic collapse’.]

I'll try to explain my belief that dangerous Ponzi finance dynamics are in play with the current course of policymaking. First, I view panicked policymakers as seeing no alternative than to try to sustain the current (deeply maladjusted) economic structure. A more natural course of economic adjustment - from finance and consumption-driven bubble economy to a more balanced system - was going to be much too painful to endure. So a massive government inflation was commenced in desperation - with the grandiose objective of revitalizing securities markets, housing prices, and the overall US economy. I just don't see how this reflation goes much beyond stoking a susceptible artificial recovery. [Which is shorthand for saying we will once again experience another ‘recovery’ that is ‘transparent’ to the ‘real’ economy.]

First and foremost, with government finance now completely dominating the credit system, I can't even begin to contemplate how this process might nurture an effective allocation of financial and real resources. [Read: jobs and wealth creation.] Indeed, I see today's manifestations of credit bubble dynamics as an extension of similar mispricing, misperceptions, and over-issuance that led to last autumn's near financial collapse.

Admittedly, the massive extension of government credit and obligations works wonders in stabilizing a devastatingly impaired system. Inflationism is always seductive; trillions of dollars worth is absurdly seductive. Yet this extra layer of debt does little to effect change to the underlying economic structure. Actually, a strong case can be made that it only delays and sidetracks the necessary adjustment process. And, importantly, this enormous additional layer of system debt exacerbates system vulnerability. [We’re talking ‘wringing moisture from dry towels’ here good citizen…and guess who gets to be the ‘towel’?]

At the end of the day, a system is made or lost on the soundness of its underlying economic structure. I posit that a sound economic structure is reliant upon only moderate credit growth and risk intermediation. Our system requires massive credit expansion and intensive risk intermediation. I would also posit that there are no benefits - only escalating costs - to throwing massive credit inflation upon an unhealthy economic structure. And, returning to Ponzi dynamics, one of the major costs to such inflationism is a massive expansion of non-productive credit – obligations that are created without a corresponding increase in real economic wealth producing capacity. The debt can only be serviced by the creation of more debt obligations.

The danger is that markets too easily and for too long accommodate massive credit expansion during the boom. Federal Reserve policies are fundamental to this dynamic. But at some point and out of the Fed's control, as Wall Street learned, greed inevitably turns to fear and a reversal of speculative flows marks the onset of the bust. And it's the massive inflation of non-productive credit that ensures the unavoidable crisis of confidence. Can the underlying economic structure service the mounting debt load or, instead, is it the massively inflating debt load that is sustaining a vulnerable economy? And it is in this vein that I fear the government finance bubble is on track to destroy the creditworthiness of the entire economy. And this Ponzi dynamic is the greatest cost to what I fear is a continuation of unsound policymaking.

In keeping with the theme of my past few posts, no nation ever succeeded in inflating its way to prosperity. If we keep waiting for the adults to finally show up and put their foot down, we’re going to be waiting a long time.

Someone has to step up to the plate, say ‘no’ and mean it! The debacle that is playing out on the global stage right now is due to the bad kids getting in one another’s face and screaming ‘fuck you, pay me!’

Instead of saying ‘no’ and giving these kids the spanking they richly deserve, the ‘government mommy’ has retired to the kitchen to try make enough brownies to keep these brats ‘happy’, while the little kids are stuck out in the backyard in the pouring rain…because nobody is watching out for them.

One need not be a genius to see that this won’t end well.

I’m not a ‘goldbug’, I’m more a Whiskey and gunpowder type, however here we have another disturbing development courtesy of The Mogambo guru

I also highly recommend that you take the time to consider the implications of this piece.

Logically, our collective fortunes are based on the overall prosperity of the society we belong to, simply put, there is no way for the individual to ‘escape’ times of financial reckoning .

If everyone does well, so will you. If only the connected prosper, everyone else suffers, something that will inevitably be visited upon the temporarily prosperous…

Thanks for letting me inside your head,


No comments:

Post a Comment