Inflationary Policies and Not Markets are the Culprit to Inequality!

``There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."--John Maynard Keynes, The Economic Consequences of the Peace (1919)

Figure 1: InvestU: Subprime Loans Explode from Greenspan Policies!

Now all of these rampant speculation and spendthrift ways wouldn’t have materialized UNLESS CONDITIONS PERMITTED THEM. In the words of Mark Twain, ``A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.”

It is the nature of BOOM CONDITIONS FUELED BY EASY MONEY POLICIES that such risky behavior exists in the first place. We previously discussed the Minsky Model under which credit cycles gradate from CONSERVATIVE “HEDGE” financing to wanton or BLIND GAMBLING (“Ponzi” finance). Or where streaks of successes eventually lead to greed, complacency to risk then evolves to future instability. Such patterns appear to repeat itself anew.

Figure 1 courtesy of Dr. Mark Skouzen of InvestU, depicts to us that as the US FEDERAL Reserves brought their interest rates to a four decade low, subsequently, the toxic subprime instruments ballooned!

According to Dr. Mark Skouzen (highlight mine), ``As Greenspan & Co. lowered the Fed Funds Target Rate from 6% to 1%, banks borrowed cheaply from the Fed window, and invested in risky mortgages. The subprime mortgage market took off like a rocket, from 2% to 14% of all mortgages over a five-year period (2000-2005). In 2003, the year of the great money flood, when the Fed cut rates to only 1%, the subprime lending went from 4% of total lending to more than 10%. That’s in one year!

``But there is no free lunch, as sound economists have warned repeatedly. At some point, the harvest time comes and the wheat must be separated from the tares. This is the crisis stage, where the boom turns into the bust. Now it’s harvest time, and we are weeping the effects of the Greenspan era.”

Oh of course, before we forget, we might add that subprime loans have essentially been BYPRODUCTS of Government Sponsored Enterprises (Freddie Mac, Fannie Mae). These institutional agencies handled most of the mortgage financing deals until they got entangled with accounting issues. This fundamentally paved way for the spawning of Wall Street’s version of Gremlins.

Figure 2 PrudentBear.com: Consumer Debt Exploded On Fed Actions!

A favorite analyst of ours Mr. Doug Noland of the Credit Bubble Bulletin wrote of such evolution (highlight ours), ``Issuance of GSE debt and Agency MBS stalled abruptly in 2004. Yet at that point Mortgage Finance Bubble Dynamics were in full force. After all, Inflationary Biases had taken firm hold in real estate markets across the country and throughout the Wall Street mortgage finance machinery. Indeed, the Street didn’t miss a beat with the hamstrung GSEs. The evolution of market perceptions of Moneyness to include ALL mortgage-related securities encouraged an historic issuance boom in “private-label” MBS and ABS. Wall Street was quite keen to more than fill the GSE void with its own brand of top-rated "structured finance." And flood it they did.”

Figure 2 courtesy of Prudentbear.com reveals that household mortgage debts exploded during the advent of the millennium as the FED undertook its massive “reflationary” campaign to stave off the risks of deflation.

Figure 3: Moneyandmarkets.com: Derivatives Explode Simultaneously with Greenspan Policies!

In addition, financial creativity led to the introduction of innovative instruments such as derivatives. Mortgage instruments were likewise bundled with other debt papers (consumer and corporate debts) into such highly complex structures.

Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England, aptly describes this phenomenon (emphasis mine), ``This is the age of what I call Vehicular Finance. The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on. These vehicles can fit together like Russian dolls. By way of illustration – and, I fear, slipping for a moment into alphabet soup – SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans.”

In essence, this age of Vehicular Finance has seen an explosion of the opaque derivative markets. Figure 3 courtesy of moneyandmarkets.com, reveals that coincidental with the surge in subprime and other household mortgage instruments, notional derivatives quadrupled in 2006 from 1998, with the gist of its growth coming from the period when the FED undertook its campaign to the flood the world with cheap money!

On the aggregate level, let us now refer to the FED’s Flow of funds to ascertain the pace of debt expansion in the US corporate sector.

Figure 4: Yardeni.com: US DEBTS to the Moon!

In figure 4 courtesy of Yardeni.com, the red line shows the occasion when the FED began its resuscitation campaign.

Here we see, the financial and non-financial sectors accelerated their debt accumulation to the tune of 110% and 215% of the GDP as of the first quarter of 2007!

What a coincidence! The FED cuts rate to historical lows, and consequently the debts markets from both the corporate, finance and consumer levels flew!

Figure 5: McKinsey Quarterly: Global Financial Assets outpace Real GDP!

I have shown you this before. Figure 5 courtesy of McKinsey Quarterly shows how global financial assets have been growing at a nifty clip.

In 2005, global financial assets were about 2.8 times global GDP. Where have the growth sectors been? According to the chart in 1995-2004, the Compounded Annual Growth Rate had been in Equity Securities (9.4%) and Private Government Debt (9.4%)! Government and Private debt accounted for 41% of total financial assets in 2005 and expected to be 44% of total assets in 2010!

Again, this simply shows that the massive amounts of leverages had been a worldwide phenomenon and NOT limited to the US.

Oh, my ramblings and may not be enough though. Well, to add some MEAT to our presentation…guess on who said this?

``American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage"

Well if you guessed former FED Chair Greenspan…then you are right! Bravo! The speech was delivered in February 23, 2004 to the Credit Union National Association meeting where Greenspan EXHORTED the public to go for Adjustable Rate Mortgages (ARMs)….the very problem we see sending ripples to global markets!

And I suppose those who listened to him or heeded his advice should now be asking for his scalp!

What are we then trying to show? In a word….INFLATION!

Celebrated economist Milton Friedman’s famous definition of inflation… “is always and everywhere a monetary phenomenon”.

Another prominent economist Henry Hazlitt’s explains further (highlight mine), ``Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. In fact, inflation is the increase in the supply of money and credit. If you turn to the American College Dictionary, for example, you will find the first definition of inflation given as follows: "Undue expansion or increase of the currency of a country, esp. by the issuing of paper money not redeemable in specie."

Which leads us to ask, who does the ACT of inflating….the markets? Or who is responsible for the creation of the incentives 1) to produce and intermediate credit on a multiplier scale, 2) to relay signals to the business community 3) to setup the conditions for lower lending standards, 3) to allow credit rating agencies to pass off dubious papers as AAA ratings, 4) to exhort consumption binges for the households and 5) to stir up the gambling instincts or go wild on speculative orgies?

Or, perhaps a more germane question should instead be, are the markets simply REFLECTING on the volatility IMPOSED THROUGH it via furtive monetary policies?

Now if some families in New York or in California fail to pay their house bills (for one reason or another) and undergoes foreclosure proceedings which eventually affect our provincial farmer’s access to financing, then who should get the blame? Is it fair then to shoot the messenger?