21 March 2009

Mistakes Beget Greater Mistakes:~ Noland

March 18 - Bloomberg (Kathleen Hays and Dakin Campbell): "Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve's purchases of Treasuries and mortgage securities won't be enough to awaken the economy. 'We need more than that,' Gross said... The Fed's balance sheet 'will probably have to grow to about $5 trillion or $6 trillion,' he said."

"The problem with discretionary central banking is that it virtually ensures that policy mistakes will be followed by only greater mistakes." Here, I'm paraphrasing insight garnered from my study of central banking history. Naturally, debating the proper role of central bank interventions - in both the financial sector and real economy - becomes a much more passionate exercise following boom and bust cycles. The "Rules vs. Discretion" debate became especially heated during the Great Depression. It was understood at the time that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone.

I believe the Bernanke Fed committed a historic mistake this week - compounding ongoing errors made by the Activist Greenspan/Bernanke Federal Reserve for more than 20 years now. I find it rather incredible that Discretionary Activist Central Banking is not held accountable - and that it is, instead, viewed critical for the solution. Apparently, the inflation of Federal Reserve Credit to $2.0 TN was judged to have had too short of a half-life. So the Fed is now to balloon its liabilities to $3.0 TN, as it implements unprecedented market purchases of Treasuries, mortgage-backed securities, agency and corporate debt securities. And what if $3.0 TN doesn't go the trick? Well, why not the $5 or $6 TN Bill Gross is advocating? What's the holdup?

Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking.

Today's consensus view holds that inflation is the primary risk emanating from aggressive fiscal and monetary stimulation. It is believed that this risk is minimal in our newfound deflationary backdrop. Moreover, if inflation does at some point begin to rear its ugly head the Fed will simply extract "money" from the system and guide the economy back to "the promised land of price stability." Wording this flawed view somewhat differently, inflation is not an issue - and our astute central bankers are well-placed to deal with inflation if it ever unexpectedly does become a problem.

Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit inflation (securities issuance), it is difficult for me to accept the shallowness of today's analysis. In reality, the paramount risk today has very little to do with prospective rates of consumer price inflation. Instead, the critical issue is whether the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs.

The counterargument would be that Treasury and Fed stimulus are short-term in nature - necessary to revive the private-sector Credit system, asset markets and the real economy. That, once the economy is revived, fiscal deficits and Fed Credit will recede. I will try to explain why I believe this is flawed and incredibly dangerous analysis.

First of all, for some time now global financial markets and economies have operated alongside an unrestrained and rudderless global monetary "system" (note: not much talk these days of "Bretton Woods II"). There is no gold standard - no dollar standard - no standards. I have in the past referred to "Global Wildcat Finance," and such language remains just as appropriate today. Finance has been created in tremendous overabundance - where the capacity for this "system" to expand finance/Credit in unlimited supplies has completely distorted the pricing for borrowings. As an example, while Total US Mortgage Credit growth jumped from $314bn in 1997 to about $1.4 TN by 2005, the cost of mortgage borrowings actually dropped. It didn't seem to matter to anyone that supply and demand dynamics no longer impacted the price of finance. Yet such a dysfunctional marketplace (spurred by unrestrained Credit expansion) was fundamental in accommodating Wall Street's self-destruction.

Today, the markets will lend to the Treasury for three months at 21 bps, 2 years at 84 bps and 30 years at 371 bps. I would argue that this is a prime example of a dysfunctional market's latest pricing distortion. As it did with the Mortgage Finance Bubble, the marketplace today readily accommodates the Government Finance Bubble. And while on the topic of mortgage finance, with the Fed's prodding borrowing costs are back below 5%. This cost of finance also grossly under-prices Credit and other risks.

I would argue that market pricing for government and mortgage finance remains highly distorted - a pricing system maligned by government intervention on top of layers of previous government interventions. These contortions become only more egregious, and I warn that our system will not actually commence its adjustment and repair period until some semblance of true market pricing returns to the marketplace. Yet policymaking has placed peddle to the metal in the exact opposite direction.

The real economy must shift away from a finance and "services" structure - the system of "trading financial claims for things" - to a more balanced system where predominantly "things are traded for other things." Such a transition is fundamental, as our system commences the unavoidable shift to an economy that operates on much less Credit of much greater quality. But for now, today's Washington-induced distorted marketplace fosters government and mortgage Credit expansion - an ongoing massive inflation of non-productive Credit. I would argue this is tantamount to a continuation of Bubble Dynamics that have for years misallocated financial and real resources. In short, today's flagrant market distortions will not spur the type of economic wealth creation necessary to service and extinguish previous debts - not to mention the Trillions and Trillions more in the pipeline.

Market confidence in the vast majority of private-sector Credit has been lost. The Bubble has burst, and the mania in "Wall Street finance" has run its course. The private sector's capacity to issue trusted ("money-like") liabilities has been greatly diminished. The hope is that Treasury stimulus and Federal Reserve monetization will resuscitate private Credit creation. The expectation is that confidence in these instruments will return. I would counter that once government interventions come to severely distort a marketplace it is a very arduous process to get the government out and private Credit back in (just look at the markets for mortgage and student loan finance!). This is a major, major issue.

The marketplace today wants to buy what the government has issued or guaranteed (explicitly and implicitly). Market operators also want to buy what our government is going to buy. In particular, the market absolutely adores Treasuries, agency MBS, and GSE debt. There is no chance such a system will effectively allocate resources. There is no prospect that such a financial structure will spur the necessary economic overhaul. None.

There is indeed great hope policymakers will succeed in preserving the current economic structure. On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize. The economy will be, it is anticipated, not far behind. And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom - perhaps enough even to appear to stabilize the system. But seeming "stabilization" will be in response to massive Washington stimulus and market intervention - and will be dependent upon ongoing massive government stimulus and intervention. It's called a debt trap. The Great Hyman Minsky would view it as the ultimate "Ponzi Finance."

As I've argued on these pages, our highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay. It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities. Private sector Credit creation simply will not bounce back sufficiently to play much of a role. Mortgage, consumer, and business Credit - in this post-Bubble environment - will not return to much of a force for getting total system Credit near this $2 TN bogey. In this post-Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance. But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an erosion of confidence and a run on both government and private Credit instruments. Also as I've written, once the government printing press gets revved up it's very difficult to get it to slow down. This week currency markets finally took this threat seriously.


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