Doug Noland: Monetary Fiasco

All great monetary fiascos are forged upon a foundation of misperceptions and flawed premises. There’s always an underlying disturbance in money and Credit masked by supposed new understandings, technologies, capabilities and superior financial apparatus.

During the nineties “New Paradigm” period, exciting new technologies and “globalization” were seen unleashing a productivity and wealth miracle. The Greenspan Fed believed this afforded the economy an accelerated speed limit. With inflation and federal deficits believed conquered, there was little risk associated with low rates and an “asymmetrical” policy approach to support the booming economy and financial markets. The Fed significantly loosened the reins on finance precisely when they needed to be tightened.

The nineties were phenomenal from a financial perspective. Total system Debt about doubled to $25.4 TN. Remarkably, Financial Sector borrowings surged more than 200% to $8.2 TN. Outstanding Agency (GSE) securities ballooned from $1.267 TN to end the decade at $3.916 TN, for growth of 209%. Securities Broker/Dealers (liabilities) jumped 212% to $1.73 TN. “Fed Fund and Repo” expanded 112% to $1.655 TN. Wall Street “Funding Corps” rose 387% to $1.064 TN. Securities Credit surged 414% to $611 billion.

And the most incredible aspect of the nineties boom in “Wall Street Finance”? Pertinent to today’s backdrop, the 1990’s Bubble unfolded over years with barely a notice. Everyone was mesmerized by the Internet, exciting new technologies and the white-hot IPO market. I was fixated on what I was convinced was evolving into epic financial innovation and a historic Credit Bubble. Yet attempts to explain this backdrop to other financial professionals, academics, economists, journalists and even Fed officials went absolutely nowhere. Repeatedly I heard frustrating variations of “Doug, you don’t understand.” “Only banks create Credit.” “The Federal Reserve controls the money supply.” “Fannie and Freddie are only financial intermediaries – they don’t impact system Credit.” “Financial system borrowings don’t matter. Doug, you’re double-counting debt.”

Even back in the nineties, it was largely ideological. Everyone had adopted a doctrine of how finance worked and it was very rare that someone would take a deep dive into developments and the analysis and then challenge orthodoxy. As I’ve noted in the past, it was not until Paul McCulley coined “shadow banking” in 2007 that analysts and policymakers belatedly began to take notice.

[Note: A government-sponsored enterprise (GSE) is a financial services corporation created by the United States Congress.  The desired effect of the GSEs is to enhance the availability … of credit.  The two most well known GSEs are Fannie Mae and Freddie Mac.  Ref Wikipedia]

Somehow history’s greatest period of financial innovation and Credit excess transpired without drawing the attention of conventional thinkers or even policymakers. Especially by 2006 and 2007, it was the “naysayers” that had been completely discredited. The conventional view held that financial innovation and policy enlightenment had fostered extraordinary financial and economic system stability. Analysis that the GSEs, MBS, ABS, speculative leveraging, securities finance and the derivatives marketplace had nurtured acute systemic fragilities was completely pilloried. The notion back in 2006 and 2007 that the world was at the brink of a major crisis was considered absolute wackoism. Incredibly – and well worth contemplating these days – virtually no one saw the deep structural impairment associated with the protracted Bubble in “Wall Street Finance.”

An even more momentous monetary fiasco has been perpetrated since the 2008 crisis, constructed upon a foundation of even more outlandish misperceptions and flawed premises. It was dumbfounding that virtually everyone disregarded the financial, economic and social ramifications associated with a doubling of mortgage Credit in just over six years. Throughout the boom, the issue of a systemic mispricing of mortgage Credit concerned virtually no one – not the marketplace and certainly not financial regulators. These days, analysis of a deeply systemic mispricing of financial assets on a global basis garners a yawn. Ramifications for an unprecedented inflation in central bank Credit and associated market manipulation go largely unappreciated. Somehow, it is accepted as obvious fact that the expansion of central bank Credit entails overwhelming benefits with minimal risk.

The financial world has come a long way since 2012. ECB president Mario Draghi Friday stated, “We will do what we must to raise inflation as quickly as possible” and use “all the instruments available.” This pronouncement is a historically notable upgrade from 2012’s “whatever it takes,” especially with it coming amid European economic recovery and a securities market boom (i.e. bond yields near record lows).

Meanwhile, sentiment in the U.S. was captured with a simple CNBC headline: “Expect a ‘One-and-Done” Fed Rate Hike.” After delaying a little 25 bps bump in rates for seemingly forever, the Fed now sees it necessary to communicate the most dovish (potential) rate hike in the history of central bankering. And with the People’s Bank of China apparently in the midst of protracted monetary loosening, global markets are back in a holiday mood.

In not too many weeks it will be 2016. The financial crisis hit in 2008. A fundamental CBB maxim over the years is that once commenced monetary inflation becomes virtually impossible to suspend. While the Fed has paused QE, from a global Bubble perspective the BOJ and ECB still combine for about $125 billion monthly QE, with Draghi hankering to upsize. The Fed hasn’t raised rates in about a decade, with Fed funds stuck near zero now for almost seven years. The ECB, BOJ and “developed” central banks around the world are stuck at near zero short-term rates.  Apparently, negative rates are on the way.

There are a number of myths and misperceptions underpinning the great “global government finance Bubble.” For starters, there’s the “so long as inflation (CPI and PPI) remains low and contained, unlimited central bank Credit expansion can be called upon to stabilize markets and economies.”

There is no bigger misperception than the belief that with Fed liabilities largely contained within the U.S. banking system (as a banking system asset) this Credit has minimal impact on the markets and real economy. Many early CBBs attempted to tackle the complex issue of how GSE Credit was distorting the financial system and economy (as well as international financial flows).

Most directly, the expansion of GSE liabilities created purchasing power that spurred a self-reinforcing inflation in mortgage Credit, home prices and sales transactions. Through myriad channels, this Bubble was boosting purchasing power throughout the economy. Less obvious – and certainly unrecognized at the time – mortgage Credit growth was inflating corporate profits and boosting incomes. And through various channels, expanding mortgage Credit was instrumental in expanding the amount of finance flowing into the markets. Importantly, the booming liquidity backdrop incentivized a self-reinforcing Bubble in asset prices, risk-taking and speculative leveraging.

When reading academic papers on “Monetary Finance” (thanks R.C.), it’s clear that the economics community misses key dynamics of central bank monetary inflation. Simplistically, conventional thinking holds that if the federal government issues debt that is then purchased by the central bank, all is good so long as it’s not done in egregious excess. As long as there’s slack (insufficient demand) in the economy, risk remains minimal. This is consistent with the conventional view that’s taken hold in global markets that enlightened central bankers have mastered the science of non-inflationary stimulus of aggregate demand.

It’s interesting that contemporary academic theories and models supportive of Central bank “monetary financing” focus chiefly on traditional concepts of “aggregate nominal demand” and “inflation.” So long as demand is insufficient and inflation low, “monetary financing” is seen as both highly desirable and low-risk. Supposedly there is essentially no limit to the size of the central bank’s holdings of government debt so long as aggregate demand is below potential and inflation is contained. The academics avoid the critical issue of monetary inflation’s highly complex (I would argue unpredictable) impact on security and asset market dynamics, including leveraged speculation and Bubbles.

At the heart of today’s misperceptions is the view that the Federal Reserve is able to purchase Treasury debt without creating inflationary effects so long as Fed Credit is held inertly on the banking system’s balance sheet. Apparently, the federal government can deficit spend and the Fed can monetize this debt with minimal risk because of economic slack and tame inflation. There are today effectively no restraints on the Treasury’s debt load, as there is no reason for the Fed to liquidating its Treasury holdings. As thinking goes, the current backdrop affords central bankers an essentially unlimited capacity to monetize debt, in the process stimulating aggregate demand back to potential. And at some point the Fed (and global central banks) will extinguish their sovereign debt holdings and erase federal government debt obligations altogether

Between 2008 and 2014, the Federal Reserve’s balance sheet swelled $3.604 TN, from $951 billion to $4.555 TN. Over this same period, banking system total assets expanded $3.753 TN (to $16.898 TN). Loans, the banking system’s largest, expanded only $789 billion (to $9.087 TN). The fastest growing asset, Reserves at the Fed, surged from $21 billion to $2.357 TN.

There’s a misperception that banking system holdings of “Reserves at the Fed” signifies that this liquidity has not departed the banking system. In reality, the banking system came to hold Reserves at the Fed as banks created new deposits for customers in exchange for Fed liquidity. Since 2008, Bank Deposits (checkable, small & savings and large time) have expanded $3.982 TN, or 46% (to $12.470 TN to end 2014).

The surge in bank deposits (reflected in M2) is evidence of a historic post-2008 monetary inflation. Why this inflation in purchasing power has not translated into rising CPI is a complex issue (massive global investment/overcapacity, unlimited supply of technologies and digitalized output, a services-based economy, inequitable wealth distribution, “financial engineering”, etc.). Clearly, with the Fed manipulating interest rates and backstopping securities markets through massive QE purchases, “money” has been incentivized to flow into securities and asset markets (over real economy investment). Furthermore, the Fed targeting higher securities market prices has incentivized leveraged speculation and “financial engineering,” both working to draw finance into the “Financial Sphere” as opposed to the “Real Economy Sphere.”

This gets to the heart of the most dangerous myth and misperception: that central banks control inflation. I would contend that the Fed some time ago lost control of inflationary dynamics. The move to unfettered global market-based finance was transformative. Runaway financial Bubbles provided virtually unlimited finance for unprecedented growth in manufacturing capacity (i.e. China, Asia, EM, technology, healthcare and all things energy/commodities). At the same time, these Bubbles became magnets for finance, again with major ramifications for inflation dynamics. Moreover, the financial Bubble backdrop ensured major wealth disparities, one more profound factor in today’s highly unusual inflationary backdrop.

For the past two decades, global central bankers have nurtured and accommodated securities market-based finance. The resulting Bubble stimulated growth and perceived wealth creation like never before. Unprecedented post-2008 measures ensured Bubble Dynamics turned increasingly unwieldy. Concerted open-ended QE in 2012 provided the final straw: market Bubbles are out of control. Draghi will not raise consumer price inflation with QE, although he very well could further stoke securities markets inflationary Bubbles. A weaker euro may somewhat raise consumer inflation, yet such “beggar thy neighbor” policies are a zero sum game. Chinese manufactures saw their currency gain another 1% versus the euro this week.

Original Post 21 November 2015

Categories: Doug Noland, Perspectives

%d bloggers like this: