Doug Noland: Crazy, Dangerous Things

By Doug Noland on April 18, 2020

Was the “Roaring Twenties” the “golden age of capitalism” or a historic Bubble? Was the Great Depression chiefly an inevitable consequence of boom-time financial and economic excess and deep structural impairment – as “Austrian” analysis holds? Or, instead, was the catastrophic downturn the consequence of policy negligence (tight monetary policy and then failure to aggressively expand the money supply after the 1929 crash) – as Bernanke and Milton Friedman analysis professes?

This should have been the crucial debate almost two decades ago. I would say it is the monumental debate of our times – except for the fact that there’s no debate.

The nineties were a fascinating time for top-down macro analysis. The decade began with a severe banking crisis, the inevitable consequence of the late-eighties Bubble. The economy was in deep recession. The Greenspan Fed slashed rates and manipulated the yield curve, surreptitiously recapitalizing the banking system while nurturing non-bank Credit creation (securitizations, derivatives, hedge funds, the repo market and “Wall Street finance”). This wave of financial innovation came at a critical juncture, helping to finance massive Current Account Deficits, speculative excess and U.S. deindustrialization.

Throughout the decade, I was a devoted reader of the great German economist Kurt Richebacher’s monthly “The Richebacher Letter.” I became enamored with facets of the Austrian School of Economics – certainly its focus on Credit and economic structure. Dr. Richebacher was critical of the Fed’s interest-rate manipulation, U.S. over-consumption, persistent Current Account Deficits, and the dearth of productive capital investment (i.e. deindustrialization). Richebacher’s analysis resonates more today than ever.

Crazy, Dangerous Things have taken root in policy circles. Traditional norms are being tossed on the compost heap. Deficits don’t matter; the size of central bank balance sheets doesn’t matter; what central banks purchase doesn’t matter; money doesn’t matter. When I contemplate how we could have sunk to such a place, my thoughts return to Dallas Fed president Robert McTeer’s post-“tech” Bubble comment in 2001… “If we all go join hands and buy an SUV, everything will be all right.” The following year Dr. Bernanke, with his government printing press and “helicopter money,” joined the Federal Open Market Committee.

This should have been the crucial debate almost two decades ago. I would say it is the monumental debate of our times – except for the fact that there’s no debate. We’ve reached the point where even the craziest monetary ideas have been readily adopted. I would much prefer not to sound like some wacko extremist. But as a student of financial history, I group Dr. Bernanke in with the infamous monetary charlatans. He is, however, a monetary saint comparatively to today’s MMT crowd.

There are many frightening aspects to the pandemic. From a health perspective, there is terrible death and illness – yet clear justification for intermediate-term optimism. We’ll eventually have effective testing, vaccines and treatments for this dreadful virus. Meanwhile, social, political and geopolitical ramifications evoke anything but optimism.

The pandemic arrived at a critical juncture in history. A multi-decade global experiment in unfettered Credit, monetary management, economic structure, and “globalization” was demonstrating heightened late-phase instability. Relations between nations were turning more antagonistic, as growth in the global “pie” stagnated. Nationalism and strongman leadership have been on a steep rise – in a backdrop of heightened insecurity, uncertainty and instability. In particular, hostilities were unfolding between the world’s superpower and the aspiring superpower – both led by strikingly forceful presidents. China’s historic financial and economic Bubbles were faltering, raising the odds that Beijing would target foreigners (the U.S. in particular) as the source of national woe. In the U.S., a deeply divided nation was turning even more so, with widening wealth inequalities feeding frustration and distrust.

Even before COVID-19, central banks and their “money” creating operations were considered fundamental to the solution for myriad problems at home and abroad. With stocks at inflated record highs and boom-time unemployment near 60-year lows, the Fed nonetheless slashed rates and restarted QE. Despite ongoing double-digit Credit growth, the People’s Bank of China (PBOC) cut rates and pursued aggressive monetary injections. Not many weeks after the ECB ended a historic ($2.6 TN) QE operation, it abruptly restarted the printing press. Money supply in the U.S., China and elsewhere surged parabolically. I’ve referred to 2019 as a “Monetary Fiasco,” though it proved merely a warmup.

Federal Reserve Assets were up $288 billion last week to a record $6.638 TN, with a six-week gain of $2.126 TN. M2 money supply expanded $78 billion, with a six-week gain of $1.236 TN. Fed Assets were up $2.436 TN (62%) over the past year, with M2 up $2.221 TN (15.3%).

April 17 – Bloomberg (Christopher Condon and Matthew Boesler): “Federal Reserve Bank of Cleveland President Loretta Mester said the U.S. central bank is too focused on limiting damage to financial markets and the U.S. economy to be concerned that its actions will encourage excessive risk-taking by investors. ‘Yes, we are moving into unprecedented territory, but remember we’re trying to lend to firms that through no fault of their own were impacted by the virus,’ Mester said… Before the crisis, the Fed had warned about the high level of indebtedness at U.S. companies. Critics have said that in buying so-called junk debt the Fed will only encourage future risky lending. ‘I don’t think we can be that concerned about those kinds of moral hazards,’ Mester said. ‘This is a hugely and negatively impactful shock, and we have to do all we can to make sure we’re not doing permanent damage to the underlying fundamentals of the economy.”

It’s terrible. The U.S. has lost 22 million jobs in three weeks, in one of the steepest downturns on record. No one wants to see such hardship, and we all would prefer to limit “permanent damage to the underlying fundamentals of the economy.” But how can we completely turn our backs to permanent damage to “money,” as well as trust in our central bank, markets and finance more generally? If we need crazy fiscal deficits to temporarily support the unemployed, small business, and state and local governments, so be it. But today’s unending tarmac of “C 130 Hercules money” droppers is fraught with extreme risk.

U.S. Continuing Claims for Unemployment almost doubled from the initial subprime eruption in June 2007 to the heart of the crisis in late-2008. The unemployment rate jumped from 4.5% to 6.5% prior to the Fed unleashing an (at the time) unprecedented Trillion plus QE stimulus program. It was an appalling hardship for millions of workers through no fault of their own. Yet thousands of uneconomic businesses that proliferated during the “easy money” mortgage finance Bubble period needed to be shuttered. It’s tempting to invoke “the downside of Capitalism” or the unfortunate reality of the business cycle. But it’s not that simple, and it certainly wouldn’t be fair to Capitalism. The Fed orchestrated a false boom, and Bubble collapse was unavoidable. From an “Austrian” perspective, a massive Monetary Inflation saw “money,” Credit and real resources poorly allocated, asset Bubbles proliferate, and deep financial and economic structural impairment propagate.

April 12 – Financial Times (Jonathan Tepper): “We have never seen countrywide lockdowns to prevent the spread of a virus. It is right that governments compensate citizens for quarantines that prevent them from working and central banks prevent a short-term liquidity crisis from becoming a crisis of solvency. But the response must not be a cover to bail out bust borrowers and out-of-pocket speculators. Yet last week we witnessed unprecedented moves by the US Federal Reserve to buy low-rated bonds and even exchange traded funds of junk debt. Markets reacted with glee at being rescued yet again. One strategist on Wall Street even called it a ‘gift from the Easter bunny’. Former Treasury secretary Timothy Geithner once described Walter Bagehot’s Lombard Street as ‘the bible of central banking.’ According to that 1873 book, central bankers are supposed to avert panic by lending early and without limit to solvent companies, against good collateral, and at a penalty rate. However, when it came to the crunch in 2008 Mr Geithner consciously disregarded that sacred text. He and then Fed chairman Ben Bernanke lent freely to possibly insolvent groups at zero rates. Those actions encouraged moral hazard on a grand scale. Instead of promoting prudence, central bankers since then have continuously spiked the punchbowl.”

The harsh reality is that over the past decade the Fed and central bankers have inflated a historic global Bubble. The world now faces an unavoidable precarious adjustment, where policy responses to collapsing Bubbles carry the high risk of destroying trust in money, finance and policymaking. The Fed and Treasury have opened Pandora’s Box. There are no rules – or a tested framework for how to proceed.

April 16 – Reuters (Howard Schneider): “U.S. small businesses may need as much as $500 billion a month to fully ensure their survival through the widespread closures and disruptions slamming their revenue during the coronavirus crisis, Atlanta Federal Reserve bank President Raphael Bostic said… That ‘baseline’ figure derived from staff analysis, he said, would be a starting point for discussions about how to expand a $350 billion small business lending program that was exhausted in about two weeks. ‘Using that as a benchmark might give us some guidance. … It would not be good to lose them,’ Bostic said…”

April 11 – Bloomberg (Naomi Nix): “U.S. governors are urging Congress to give states $500 billion in ‘stabilization funding’ to meet budget shortfalls resulting from their efforts to stem the spread of coronavirus. Maryland’s Larry Hogan and New York’s Andrew Cuomo said… the stay-at-home orders most states have implemented were necessary to protect the public but hurt states’ economies. Hogan, a Republican, and Cuomo, a Democrat, are chairman and vice-chair, respectively, of the National Governors Association. ‘To stabilize state budgets and to make sure states have the resources to battle the virus and provide the services the American people rely on, Congress must provide immediate fiscal assistance directly to all states,’ the pair said.”

In a rally for the history books, the S&P500 gained 15.5% in two weeks. The Nasdaq Composite rose 17.7% over this period, and the small cap Russell 2000 16.9%. The Nasdaq100’s 17.3% rise pushed this index positive for the year.

How is it possible for stocks to mount such a rally in the face of a looming global economic depression? No Conundrum. Early in the mortgage finance Bubble period, I would write “liquidity loves inflation!” Throw “money” into an unsound system and it will instinctively gravitate to areas demonstrating robust inflationary biases. These days stocks fit the bill. Equities markets are bolstered by the deeply entrenched view that the Fed will do whatever it takes to sustain inflated prices, along with a market structure (i.e. ETFs, derivatives, 401k plans and pension contributions, hedge funds, algorithmic trading, stock buybacks, etc.) that promotes trend-following flows.

This dangerous dynamic has turned perilous. The acute stress associated with the bursting Bubble ensures the Fed will be injecting additional Trillions over the coming months, with markets confident the liquidity spigot will remain wide open for as far as eyes can see. Witnessing U.S. equities divorced from underlying economic fundamentals in not that unusual – yet never to the degree of largely dismissing an unfolding global depression.

COVID-19 is the catalyst for the bursting of history’s greatest global Bubble. And no amount of fiscal and monetary stimulus will immunize the U.S. economy from the unfolding economic downturn. After a decade of historic excess, global economies face unprecedented fragility. Importantly, officials internationally lack the flexibility enjoyed by policymakers from the world’s reserve currency government.

Here in the U.S., a unique dynamic sees massive monetary inflation chiefly funneled into U.S. securities markets, bypassing most of the population and much of the economy. This powerful dynamic attracts international flows, including trade deficit-associated international dollar balances, in the process underpinning the dollar in the face of incredible monetary inflation and Current Account Deficits.

The South African rand dropped 4.5% this week, followed by a 3.3% decline for the Turkish lira, 2.4% for the Brazilian real, 1.7% for the Chilean peso, 1.6% for the Mexican peso, 1.6% for the Czech koruna and 1.4% for the Malaysian ringgit. When emerging market central banks move to orchestrate monetary stimulus, disparate Inflationary Dynamics ensure the flow of this newly created “money” contrast markedly to that of the U.S. Wealthy individuals and financial institutions sell local currencies to purchase dollars, yen and euros, while weakened currencies trigger inflationary pressures in the real economy.

“Roach Motels” was the EM moniker back in the nineties. International finance would flow freely into EM booms, only to be eventually trapped by collapsing currencies, illiquidity and capital controls – come the arrival of the bust. A historic EM bust is now unfolding. The IMF, World Bank and other international institutions will be lending like crazy, yet the sources for the Trillions required to reflate EM Bubbles are anything but obvious.

April 17 – Wall Street Journal (Jonathan Cheng): “Since the Cultural Revolution ended in the mid-1970s, China’s economy, fueled by market reforms, has notched up more than four decades of unbroken gains, enlarging the domestic economy by roughly a hundredfold and transforming the world. That winning streak is over. China on Friday reported a 6.8% year-over-year contraction in its economy for the first three months of the year—the first quarterly decline in gross domestic product since official record-keeping began in 1992 and likely the first since Mao Zedong’s death in 1976… The fall was even steeper compared with the previous quarter: a 9.8% pullback as the coronavirus that first emerged in the central Chinese city of Wuhan spread across the country and around the world, delivering an economic blow unprecedented in modern times. ‘The scale and breadth of China’s economic contraction are staggering,’ said Eswar Prasad, an economics professor at Cornell University and the former head of the International Monetary Fund’s China division. ‘There is little prospect of China driving a revival of global growth.’”

The Chinese economy contracted at a 9.8% rate during Q1. Auto sales were down 48% in March, with Q1 air passenger traffic slumping 54%. Home sales are said to have recovered only to about 40% of pre-virus levels. A Friday morning Bloomberg headline: “China Suffers Historic Economic Slump with Hard Recovery Ahead.” And from the Associated Press: “China Opening Up But Consumers Stay Home.”

China has changed profoundly since their last economic downturn. I question how quickly Chinese consumers recover sufficient optimism to borrow and spend at pre-COVID levels. There is some pent-up demand along with inventories to replenish. Yet a very bearish case can be made for the maladjusted Chinese economy. Faltering confidence and a bursting housing Bubble would ravage domestic demand. Meanwhile, already struggling with overcapacity, China’s massive export sector faces the grim prospect of a global depression and collapsing EM demand. Such prospects should have the global community fearing Chinese financial system and currency fragilities. The renminbi was under modest pressure again this week.

Europe has its own acute fragilities. Italian yields jumped 20 bps this week to 1.79%, with spreads to German bunds widening 33 bps. Yield spreads widened 47 bps in Greece, 19 bps in Portugal and 16 bps in Spain. And this is in the face of ECB bond buying. Stocks were down 3.2% in Italy and 2.8% in Spain this week.

April 16 – UK Telegraph (Ambrose Evans-Pritchard): “The eurozone’s emergency plan to fight Covid-19 has unravelled within days. Italy’s prime minister has rejected the central element of the €540bn package as a ‘trap’. No Italian leader in the current febrile mood could accept it and survive for long… ‘The deal is an admission of European inadequacy,’ said professor Adam Tooze, of Columbia University. The plan eschews joint debt issuance and amounts to extra debt foisted on states already at the outer boundaries of debt sustainability, pushing them further into a ‘bad equilibrium’. Jean-Paul Fitoussi, of Science Po in Paris, says the package amounts to ‘collective suicide’… ‘If there is no real mutualisation of debt, we will either slide further underwater, or take the inevitable politically incorrect step and say, ‘Enough is enough, let’s get out’,’ he said. Above all, it misjudges the simmering anger in Italy… If each state remains responsible for its own pandemic debt issuance, the effect is to turn a symmetric health shock into an asymmetric economic shock for different EMU states, further widening the gap and pushing Club Med to the brink. UniCredit says Italy’s public debt will jump by 33 percentage points to 167% of GDP this year with Portugal rising to 146%, and Greece 219%. The ball is now back in Germany’s court.”

At the end of the day, I don’t expect the Germans and Italians to share a common currency. I have expected the hardship that would accompany the piercing of the global Bubble to again place European monetary integration at risk. At its current trajectory, Italy is moving quickly to an unmanageable debt situation. And it is difficult for me to envisage the Germans and Dutch agreeing to mutual European debt issuance.

The euro traded at an almost three-year low 1.08 vs the dollar in February, spiked to a high of 1.15 on March 9th, then reversed sharply to 1.06 on March 23rd, back to 1.12 by the end of March, and closed down 0.6% this week at 1.0875. A euro breaking lower on heightened concerns for Italian/periphery debt and euro zone integration would add fuel to the dollar’s upside dislocation. With king dollar already benefiting from the U.S.’s competitive advantage in fiscal and monetary stimulus, an additional push from euro weakness would place added pressure on faltering EM currencies – including the renminbi.

WTI crude this week sank 20% ($4.49) to an 18-year low $18.27 – despite much vaunted OPEC+ supply cuts. But it’s not only sinking crude prices confirming unfolding global economic depression. Having rallied only marginally off March panic lows, this week’s 2.2% drop pushed the Bloomberg Commodities Index to a 23.3% y-t-d decline.

And while the U.S. equities rally continued, other indicators were less than bullish. Investment-grade and high-yield CDS prices moved higher this week (partially reversing the previous week’s major decline). Latin-American sovereign CDS jumped markedly higher. Mexico CDS surged 45 to 270 bps, up from 72 bps in late-February and not far below the 293 bps March 23rd closing high. Brazil CDS jumped 35 to 291 bps, and Colombia CDS rose 30 to 247 bps. Turkey CDS surged 89 to 649 bps, South Africa 31 to 408 bps, and Russia 15 to 178 bps.

Markets this week provided confirmation of ongoing global instabilities – with crude and commodities, in the euro zone’s periphery and EM, as well as with dismal Chinese data. Global COVID-19 data similarly don’t inspire confidence. From my vantage point – eyeing key vulnerabilities globally – it is as if the U.S. stock market has become a sideshow oddity. I hope all the optimism surrounding opening the economy is justified. I just look at the daily new infections and death data – and the national infection maps – and am skeptical we’ll attain a semblance of normalcy anytime soon. And with a deeply divided country becoming only more so – and COVID-19 turning increasingly political – it’s destined to be a disturbingly strange election year.

COVID-19 is, as well, becoming a major geopolitical issue – in alarming fashion.

April 17 – Fox News (Bret Baier, Gillian Turner, and Adam Shaw): “The U.S. is conducting a full-scale investigation into whether the novel coronavirus, which went on to morph into a global pandemic that has brought the global economy to its knees, escaped from a lab in Wuhan, China, Fox News has learned. Intelligence operatives are said to be gathering information about the laboratory and the initial outbreak of the virus. Intelligence analysts are piecing together a timeline of what the government knew and ‘creating an accurate picture of what happened,’ the sources said. Once that investigation is complete — something that is expected to happen in the near-term — the findings will be presented to the Trump administration. At that point White House policymakers and President Trump will use the findings to determine how to hold the country accountable for the pandemic.”

Original Post 18 April 2020

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