The Government Finance Bubble:

What are we really dealing with here? First of all, the system is suffering through the breakdown in contemporary “Wall Street finance.” As wrenching and destabilizing as it continues to be, this process should be differentiated from outright financial collapse. Confidence in Wall Street “money” (their previously perceived safe and liquid securities/instruments) has been shattered. Myriad sophisticated Credit instruments have been discredited and thus will no longer provide a viable mechanism for system Credit expansion. Importantly, however, confidence has been sustained for system “money” more generally.

As I’ve noted in previous writings, analysts made a momentous blunder earlier this decade when they mistook the collapse of the technology Bubble (and attendant recession and corporate debt problems) for the onset of “deflation.” Reflationary policymaking without regard to the nature of inflationary consequences proved disastrous. We’re about to repeat this error.

Ignoring the Acute Inflationary Bias unfolding in mortgage finance was the greatest mistake in both analysis and policymaking from the ill-fated 2001-2004 period. It should have been clear at the time that rates were way too low and mortgage finance way too loose. This was especially the case when compared to the rapid pace of home price inflation. Most regrettably, the strong inflationary biases that had taken hold in the mortgage and housing marketplaces (“Bubbles”) were too easily exploited as a monetary policy expedient for systemic reflation. Excess in some local housing markets was viewed as a small price to pay for thwarting systemic deflationary pressures.

Despite today’s histrionic fixation on “deflation,” current dynamics have some similarities to the post-tech Bubble period. Granted, the collapse of Wall Street finance is of much greater scope and consequence than the bursting of the tech Bubble. Yet I would counter that The Burgeoning Bubble in Government Finance is poised to make the Mortgage Finance Bubble appear tiny in comparison.

There has been no run on bank deposit “money;” not with the FDIC, Treasury, and Federal Reserve there to backstop confidence. The marketplace’s love affair with agency debt runs unabated – compliments of federal government receivership and guarantees. Money market fund assets are right at record levels, confidence bolstered by Fed and Treasury assurances. And despite the prospect of a $1 TN borrowing requirement this year, the Treasury can still tap liquid markets for short-term funds at about 20 bps. The Fed’s balance sheet has ballooned, although nothing to compare to the unfolding explosion of Trillions of Treasury borrowings, obligations and guarantees (both implied and explicit).

The Government Finance Bubble is enormous and powerful - and should be anything but underestimated. Akin to the previous Bubble in Wall Street finance, the epicenter of this Bubble is here in the U.S. But I would argue that this unfolding Bubble dynamic has greater potential to engulf the entire world than even U.S.-style mortgages and derivatives did starting back around 2002. Welcome to the new world of synchronized stimulus, deficits, and reflationary policymaking. I don’t believe true systemic deflation (as opposed to collapsing asset Bubbles) is a high probability scenarios as long as the Government Finance Bubble is rapidly inflating. All bets are off, however, if confidence in government debt falters. The worst case scenario – that should be avoided at all costs – is a massive inflation of government claims that sets the stage for a devastating bust.

It is imperative for policymakers to ensure that the Government Finance Bubble does not follow in the footsteps of the runaway excess associated with Wall Street/mortgage finance. Yet it’s clear that policymaking (monetary and fiscal) is setting a course to guarantee just such an outcome. And, as has been the case for some time now, markets are keen to fall in love with – and aggressively accommodate – whatever might be the Bubble of the Day.

The Wall Street/Mortgage Finance Bubble ran to such incredible extremes that its subsequent implosion has created the near ideal backdrop for the explosion of Government Finance (as the tech implosion did for mortgage finance). Some notable pundits espouse throwing “Trillions” at the problem in hopes of finding a solution. They fail to be appreciated that Trillions today will only create the need for ongoing Trillions. But this is the nature of vulnerable inflationary booms. The solution is always incorrectly gauged as a shortage of money, Credit and spending.

There is hope that massive government reflation will reinvigorate the asset markets and resuscitate Wall Street finance. I view this as highly unlikely - and these lofty goals incredibly dangerous. It is more likely that the historic Bubble in private-sector Credit creation – with its focus on myriad sophisticated instruments, structures and leveraging – will recover little of its former power and glory. In past episodes of financial turmoil, our policymakers would simply entice private sector financial operators (notably the Wall Street firms, hedge funds and bond fund managers) with alluring borrowing costs, spreads and speculative profits. Strong inflationary biases permeated Wall Street finance, the leveraged speculating community, and U.S. asset prices more generally. Accordingly, almost on demand, private-sector Credit creation would quickly evolve into the main source for fueling system (i.e. asset) reflation. Moreover, asset price inflation was the focal point for perceived wealth creation and economic stimulus.

Today's Post-Credit Bubble Backdrop and The Nature of the Government Finance Bubble ensure quite atypical dynamics (and analytical surprises). For one, the flow of finance to the asset markets will be insufficient to reinvigorate asset inflation (post-Bubble realities of burst confidence, altered market psychology, impaired Credit mechanisms and economic angst/dislocation). This is critical analysis. It was the strong inflationary biases throughout the asset markets that fostered the self-reinforcing Bubble in private-sector Credit. And private-sector Credit was behind past inflationary financial and economic Bubbles - that have left the system today so fragile (and pundits clamoring for more inflation!). Structural realities dictate that Government Finance cannot simply enter the fray and miraculously make things right. A moderate amount of stimulus would be expected to assist the post-Bubble economic adjustment, while inordinate government Credit inflation and market intervention will only work to compound systemic fragility.

The public sector is now essentially on its own when it comes to stoking this bout of reflation. Moreover, it is being called upon after a couple of decades where private-sector Credit grossly inflated home prices, securities values, various other asset prices, household incomes, consumer borrowing and spending, corporate profits, and government receipts and expenditures. The Government Finance Bubble is being called upon to reflate with little assistance from private Credit, while at the same time it is faced with a Deeply Maladjusted Economic Structure still overly dependent upon inflationary Credit expansion. Throwing mega-Trillions at our distorted economy is just asking for trouble.

It is in this context that I fear that the Trillions of Government Finance spent to save the world from “deflation” will, in the end, require perpetual needs for Trillions more. There will be no kick-starting asset Bubbles or a return of private-sector Credit excess. Instead, it will be a case of throwing repeated doses of government-directed finance/purchasing power at the system. Temporary but fleeting economic boosts will then require only stronger doses of artificial stimulus.

We’ve commenced a new cycle dominated by government electronic printing presses in all their various forms. The inflationary consequences will be a different variety than we’ve grown accustomed to from previous reflations. But the bottom line is – and there’s ample history to support this view – that once the “printing presses” get humming along it’s going to be darn difficult to slow them down.