``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.” –Murray Rothbard, Making Economic Sense
Many have touted today’s action in the marketplace as a manifestation of success from government intervention.
Given public’s predisposition to focus on the short-term and interpret heavily on current information, especially after repeatedly being seduced from the incentives provided for by inflationary policies, today’s appearance of success equals tomorrow’s seismic crisis.
Betting The House On Too Big To Fail
In the US, the “Too Big To Fail” syndrome is becoming deeply entrenched in the heavily regulated banking industry.
An article by Peter Eavis at the Wall Street Journal entitled “Uncle Sam Bets the House on Mortgages” gives as a stirring depiction of the growing intensity of systemic concentration risks.
(bold highlights mine)
``It is a stunning change, but is it good for the housing market, and to what extent will it boost profits over the long term for this elite trio: Wells Fargo, Bank of America and J.P. Morgan Chase?”
Graph 1: Wall Street Journal: Too Big To Fail Getting Bigger
``Right now, housing remains on government life support. Treasury-backed entities are guaranteeing about 85% of new mortgages, while the Fed buys 80% of the securities into which these taxpayer-backed mortgages are packaged.”
``The optimistic take is that this support, though large, will shrink when market forces regain confidence. But there is a darker possible outcome: The emergency assistance is entrenching a system in which the taxpayer takes the default risk on most mortgages, while a small number of large banks get a larger share of the fee revenue from originating and servicing mortgages.
``That is what is happening now. While big banks are originating lots of mortgages, they are selling nearly all of them to Fannie Mae and Freddie Mac. Indeed, combined single-family mortgages held on the balance sheets at J.P. Morgan, BofA and Wells actually fell 3.5% in the first half. Before the bust, these banks sold large amounts of loans to Fannie or Freddie, but they also held on to products like jumbo mortgages. The volumes for those large loans now have tumbled.”
What you have here is essentially the politicization of the US banking industry, where the top 3 banks have cornered the meat of the “economic rent” from mortgage servicing and issuance which it deals with the US government.
And this concurrently, becomes an issue of moral hazard, where these highly privileged banks, which operates on implied guarantees from US government that they are “too big to fail”, may indulge on more aggressive risk taking activities at the expense of US taxpayers.
Moreover, the US government stands as THE market for home mortgages.
Alternatively, this also posits that since the US government is a political entity and is less constrained by economic pressures, the pricing structure for transacting these mortgage securities have been above what the market is willing to pay for. Thus, government intervention translates to massive tax payer subsidies to cover losses meant to keep the banking system afloat.
Analyst Doug Noland in his Credit Bubble Bulletin recently dissected the Federal Reserves 2nd Quarter Flow of Fund and construed that instead of targeting stabilization for conventional mortgages, the Fed has been propping up private label Mortgage Backed Securities.
He says (all bold emphasis mine), ``So, the Fed is amassing quite a stockpile of “conventional” GSE MBS, but often these are “private-label” mortgages recently “refinanced” into GSE securities. And as the Fed buys the new GSE MBS, newly created funds become available to flow back to reliquefy the formerly illiquid ABS marketplace (along with agencies, Treasuries, corporates, and equities). To be sure, placing essentially federal government backing upon previously “private-label” mortgages dramatically changes the market’s perception of these securities’ worth (“moneyness”) – especially with fed funds pegged for an extended period at near zero and the Fed in the midst of a $25bn weekly purchase program in order to fulfill it commitment to purchase $1.25 TN of mortgage securities….”
``Not only is the vast majority of new mortgage Credit this year government-backed, Washington guarantees are being slapped on hundreds of billions of existing “nonconventional” mortgages. This intrusion and transfer of (Credit and interest rate) risk has terrible long-term ramifications. Although in the near-term this mechanism provides a powerful stabilizing force for both the Credit system and real economy.”
Here is an example of the “privatization of profits and socialization of losses” from which would most likely exact a heavy toll on US productivity and which would likewise be reflected on the economy, as the productive segments will be penalized dearly for the subsidies or the losses incurred by the US banking system.
Nevertheless all these accounts for the priorities of the incumbent officials and their penchant to salvage a preferred industry via the inflation route, as we discussed in Governments Will Opt For The Inflation Route.
Bernanke’s Fascism Risks An Inflation Crisis
One would have to wonder whether Fed Chair Ben Bernanke is a chronic prevaricator or has been captured by the industry he regulates or operates with a tacit vested interest on the industry or has been fanatically blinded by ideology to declare that the Fed won’t monetize debt and likewise yearn for expanded powers or control over more parts of the economy including the proposed regulation of banker’s pay. Mr. Bernanke failed to predict, was in denial of the crisis and panicked in front of Congress to ask for bailout money.
To quote John H. Cochrane And Luigi Zingales who wrote on a Wall Street Op-ed on the Lehman anniversary, `` these speeches amounted to the financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.”
Yet the justification to “help the agency act more decisively to reduce the chances of a recurrence” would only entrench the growing politicization, reduce the systemic efficiency and transition the US market economy into fascist state.
In the definition of Sheldon Richman, Fascism is ``where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically. In doing all this, fascism denatured the marketplace.” (bold emphasis mine)
Yet, the diminishing role of institutional check and balances and an increasingly centralized flow of power would only amplify the systemic concentration risks that could spark a runaway inflation crisis (given Bernanke’s tendency to inflate).
One man’s error could lead to another global systemic mayhem.
The Fed didn’t monetize debt?
Again Doug Noland on the Fed Fund Flow, ``In total, Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR). Who were the other major purchasers? The Fed monetized $647bn SAAR, the Household Sector bought $343bn SAAR, and Broker/Dealers accumulated $404bn. And while it is positive that American households are buying Treasuries and saving more, this does not change the fact that this so called “savings” was bolstered by income effects from massive government spending increases.”
For us, the outcome of inflation or deflation is a result of a deliberate policy. It’s only the fat tails or the extreme outcomes that function as a form of unintended consequences, similar to the meltdown post Lehman bankruptcy in 2008.
Moreover we don’t believe that inflation can only occur via a revitalized US consumer.
Such view myopically underestimates the role of fiscal channels [Noland: “bolstered by income effects from massive government spending increases”] or an increasing concentration or centralization of power by central banking [Richman: “Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically”].
In addition, given today’s increased globalization or deepened integration by global economies and financial system, there are transmission mechanisms or interlinkages from global governments undertaking the same inflationary tools [Noland: “Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR)”].
Hence while the risks of debt deflation seem a concern for some parts of the world, it does not apply to all. Yet if debt deflation is premised from a monetary phenomenon perspective, based on country specific issues, then the argument crumbles especially when applied to countries that have been least leveraged.
Not even a “ghost fleet of recession” or massive number of ships idly anchored in Asia in the absence of international trades arising from the recession would be enough to circumvent a steadfastly determined central bank to inflate a system.
A central bank can simply print a dollar per every dollar of liability, even if it means hundreds of trillions, if it deems it as beneficial.
Zimbabwe’s recent example should be a reminder that no amount of capacity utilization, unemployment rate, velocity of money [see last week’s Velocity Of Money: A Flawed Model], consumer spending or consumer debt and other traditional econometrics used by mainstream experts deterred a tyrant (operating on centralized power and a politicized economy) and an inflation obsessed central banker in Dr. Gideon Gono from fanning 89,700,000,000,000,000,000,000% hyperinflation in 2008.
While the US or UK may not be the same as Zimbabwe, an increasing centralization of power and politicization of the economy could neutralize any inherent advantages thereof. As former Fed Chief Alan Greenspan quoted in Bloomberg commented, ``It’s the politics in the United States that worries me, whether the Congress will basically feel comfortable” with the Fed withdrawing its stimulus, Greenspan said in a broadcast to Tokyo clients of Deutsche Bank Securities Inc. today. He later said that “if inflation rears its head, it will swamp long-term markets,” referring to bonds.”
In short, Mr. Greenspan appears sardonically worried about the US government’s addiction to inflation, a policy which incidentally, he applied extensively throughout his tenure. One might say that he inured the world with the “Greenspan Put” or Mr. Greenspan’s repeated policy of rescuing or providing support for the markets with artificially lowered interest rates during the 1987 stock market crash, the Gulf War, the Mexican Tequila crisis, the 1997 Asian crisis, the LTCM debacle, Y2K, the burst of the internet bubble, and the 9/11 terror attack.
Not until a significant part of the world becomes as deeply indebted as those afflicted by the recent bubble, will deflation become a meaningful threat to the global banking system or perhaps not until the destruction of the present currency system.
Yet deflation is a natural and rightful antidote to the excesses of inflation.
Exploding Bond Markets, From Periphery To The Core
Moreover, while debt deflation advocates continue to tunnel onto the banking system as the key source for benchmarking credit market conditions, they seem to forget the existence of the bond market as an alternative venue for credit access.
However, the difference is that credit via the bond markets won’t trigger the fractional reserve nature of today’s banking platform that would expand monetary aggregates. Nonetheless it helps push up prices of securities.
This from the Financial Times, ``European bond issuance has hit $2,000bn so far this year, the fastest ever pace of issuance, as companies race to refinance in the bond markets and banks remain reluctant to lend.
``European sovereigns, agencies and companies have sold 38 per cent more than the $1,450bn issued in 2008 in the year to date, according to analysts at data provider Dealogic, who add that issuance has never previously stood at such a high level so early in the year.
``Non-financial companies accounted for a record $446.3bn so far this year, 55 per cent more than in all of 2008….
``Financial issuers have sold a record of $542.8bn year to date, 24 per cent more than issued in 2008.”
In Asia, a somewhat similar dynamics could be at work as bond market growth has also been robust see figure 2.
Figure 1: ADB Bond Monitor: Hefty Growth in Bond Markets
According Standard & Poors as quoted by Researchrecap ``Notwithstanding a near universal attempt by central banks to ease monetary conditions, bank lending—still the predominant source of funds in the emerging markets—has varied from country to country. China is a standout, having reportedly injected as much as $1.1 trillion in new lending during the first six months of 2009. For many other markets, however, credit growth is decelerating (and, in some cases, contracting) in comparison with a year ago. This suggests that banks, even those that were largely unscathed by the financial crisis, are remaining cautious to stave off a potential increase in nonperforming loans.” (bold highlights mine)
In short given the fresh memory of the 2008 setback, some banking system in the region has opted to remain conservative in their lending practice. Nonetheless, the other route has been through the debt markets.
According to the ADB’s Bond Monitor, (bold underscore mine)
``Emerging East Asia’s bond market grew by 12.8% year-on-year (y-o-y) on an local currency (LCY) basis to USD3.94 trillion in the first half of 2009. The market also expanded by 5.2% quarter-on-quarter (q-o-q) in 2Q09 as financial markets showed signs of stabilization and the region’s growth showed signs of recovery. This lifted the growth rate for outstanding LCY bonds for the first half of the year…
``The strongest improvements in y-o-y bond market growth rates on an LCY basis in the first half of 2009 were in Hong Kong, China (19.4%); the People’s Republic of China (PRC) (14.8%); Republic of Korea (Korea) (13.1%); Indonesia (12.3%); and the Philippines (8.2%).”
Anyway, one of the publicly listed companies in the Philippines, the SM Investments, successfully sold $500 million worth of bonds from which two-thirds of the placements had been made local investors (FinanceAsia). This is a testament of the immense liquidity of the domestic system which had been reinforced by a faster growth clip in July (BSP).
In addition, domestic bank credit growth has remained vigorous in terms of trade and production, household consumption and bank repo lending activities (BSP).
And the growth in both the banking and bond markets have been indications of inflationary policies gaining continued traction in Asia. This as we repeatedly been saying is simply due to low systemic leverage, high savings rate, unimpaired banking system, current account surpluses and an apparent trend towards a deepening regionalization, and likewise, integration with the world economic system.
And as discussed in The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery, we proposed that growth dynamics would probably shift from the core (US consumers) to the periphery (emerging markets), ``money appears as being transmitted to support growth in the developing countries as part of the collaborative efforts to inflate the system.”
Morgan Stanley’s Joachim Fels, takes a parallel view in his recent outlook, ``near-zero interest rates in the US and Europe eased monetary conditions in those emerging market economies that peg to the dollar or the euro, adding to their domestic stimulus packages. Thus, it didn't come as a surprise that China was the first major economy to emerge from recession, given that it imports easy money from the US through the exchange rate link without having the US's financial sector problems.
``The point worth noting here is that we may all still be underestimating the effects of the stimulus that has already been put into place and is still playing out. If so, growth would not moderate from its current 4%+ global pace going into 2010 as in our base case, but accelerate further. The most plausible upside scenario, in our view, would be one where Asia keeps motoring ahead with domestic demand strengthening further in response to the stimulus, leading to a surprisingly strong revival of global trade.” (bold emphasis added)
Stages Of Inflation Redux
Instead of the deflation scenario, today’s sweet spot in inflation could actually signify as the initial phase of the three stages of inflation as also discussed in Warren Buffett’s Greenback Effect Weighs On Global Financial Markets.
To quote Henry Hazlitt, ``What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money. Putting the matter another way, the value of the monetary unit, at the beginning of an inflation, commonly does not fall by as much as the increase in the quantity of money, whereas, in the late stage of inflation, the value of the monetary unit falls much faster than the increase in the quantity of money. As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a "shortage of money." (bold emphasis mine)
What could be seen as some pockets of deflation today, could actually be the initial phases of inflation. And a continued rise in the commodities space even if it signifies as a currency “pass through” from the sagging US dollar would likely intensify the inflation expectations.
Then when the late stage of inflation have been reached, where the value of monetary unit falls faster (or consumer prices are rising faster) than the increase in the quantity of money which leads to the perception of “a shortage of money”, the central bank under the auspices of the government would either elect to print money at an ever accelerating “exponential” rate to meet such shortages-ergo the hyperinflation scenario, or opt to withhold feeding the boom (or by declaring a default) -the deflation scenario.
Again this will all be a result of policy choices.
So simply reading conventional metrics when governments have taken a lead role in the marketplace will lead to misdiagnosis and mass confusions on the disconnection between the market from economic reality. Analyzing how political trends will shape policy decision making will likely be a better alternative [see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?]
Anyway, a hyperinflation episode would also lead to deflation once the hyperinflated currency have been eschewed and replaced by another currency. The recent case of Zimbabwe which has abrogated its currency, the Zimbabwean Dollar, for the US dollar and South African Rand is a prime example.
At the end of the day, global policymakers will continue to bask on the triumphalism from present day policies and will most likely continue to keep the booze flowing.
Hence even if markets don’t move in a straight line they will likely respond positively to policy sustained policy accommodations over this early phase of the inflation cycle.
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