Page 1 of 3 CREDIT BUBBLE BULLETIN
Asia's savers not the culprit
Commentary and weekly watch by Doug Noland
"The extraordinary risk-management discipline that developed out of the
writings of the University of Chicago's Harry Markowitz in the 1950s produced
insights that won several Nobel prizes in economics. It was widely embraced not
only by academia but also by a large majority of financial professionals and
global regulators. But in August 2007, the risk-management structure cracked.
All the sophisticated mathematics and computer wizardry essentially rested on
one central premise: that the enlightened self-interest of owners and managers
of financial institutions would lead them to maintain a sufficient buffer
against insolvency by actively monitoring their firms' capital and risk
positions." Alan Greenspan, March 27, 2009, Financial Times
Former US Federal Reserve chairman Greenspan remains the master of cleverly
obfuscating key facets of some of the most
critical analysis of our time. The fact is that "the sophisticated mathematics
and computer wizardry" fundamental to contemporary derivatives and risk
management essentially rested on one central premise: that the Federal Reserve
(and, more generally speaking, global policymakers) was there to backstop
marketplace liquidity in the event of market tumult.
More specific to the mushrooming derivatives marketplace, participants came to
believe that the Fed had essentially guaranteed liquid and continuous markets.
And the bigger the credit bubble inflated, the greater the belief that it was
too big for the Fed ever to let fail.
It was clearly in the "enlightened self-interest" of operators of Wall Street
finance and throughout the system to fully exploit this market perversion. With
unimaginable wealth there for the taking, along with the perception of a
Federal Reserve "backstop", why would anyone have kidded themselves that there
was incentive to ensure individual institutions "maintained a sufficient buffer
against insolvency"? By the end of boom cycle, market incentives had been
completely debauched.
The Greenspan Fed pegged the cost of short-term finance (fixing an artificially
low cost for speculative borrowings), while repeatedly intervening to avert
financial crisis ("coins in the fusebox"). There is absolutely no way that
total system credit would have doubled this decade to almost US$53 trillion had
the activist Federal Reserve not so aggressively and repeatedly intervened in
the markets. To be sure, the explosion of derivatives and attendant speculative
leveraging was central to the historic dimensions of the credit bubble.
Greenspan on Friday made it through yet another article without using the word
"credit". "Free-market capitalism has emerged from the battle of ideas as the
most effective means to maximize material wellbeing, but it has also been
periodically derailed by asset-price bubbles ... Financial crises are defined
by a sharp discontinuity of asset prices. But that requires that the crisis be
largely unanticipated by market participants ... Once a bubble emerges out of
an exceptionally positive economic environment, an inbred propensity of human
nature fosters speculative fever that builds on itself ... " He might cannily
dodge the topic, but Greenspan recognizes all too well that credit has and
always will be central to the functioning - and misfunctions - of free-market
capitalistic systems.
With respect to the past, present and future analyses, I believe the spotlight
should be taken off asset prices. Such focus is misplaced and greatly muddies
key issues. Much superior is an analytical framework that examines the
underlying credit excesses that fuel asset inflation and myriad other
distortions.
Ensure us a stable credit system and the risk of runaway asset booms and busts
disappears. Today's financial crisis - and financial crises generally - are
defined by a sharp discontinuity of the flow of credit. Major fluctuations in
asset markets - on the upside and downside - are typically driven by changes in
the quantity and directional flow of credit. Central bankers should focus on
stable finance and resist the powerful temptation to monkey with asset prices
and markets. As common sense as this is, today's flawed conventional thinking
leaves most oblivious and poised for mistakes to beget greater mistakes. (See
Asia Times Online, March 23, 2009).
When it comes to flawed conventional thinking, few things get my blood pressure
rising more than the "global savings glut" thesis. Two weeks ago from Alan
Greenspan, this time via The Wall Street Journal:
" ... The presumptive cause of the world-wide decline in long-term rates was
the tectonic shift in the early 1990s by much of the developing world from
heavy emphasis on central planning to increasingly dynamic, export-led market
competition. The result was a surge in growth in China and a large number of
other emerging market economies that led to an excess of global intended
savings relative to intended capital investment. That ex ante excess of savings
propelled global long-term interest rates progressively lower between early
2000 and 2005.
"That decline in long-term interest rates across a wide spectrum of countries
statistically explains, and is the most likely major cause of, real-estate
capitalization rates that declined and converged across the globe, resulting in
the global housing price bubble. By 2006, long-term interest rates and the home
mortgage rates driven by them, for all developed and the main developing
economies, had declined to single digits - I believe for the first time ever. I
would have thought that the weight of such evidence would lead to wide support
for this as a global explanation of the current crisis."
It is difficult these days for me to accept that Greenspan, his successor as
Fed chairman, Ben Bernanke, and others are sticking to this misplaced view that
a glut of global saving was predominantly responsible for the proliferation of
US and global bubbles. The failure of our policymakers to understand and accept
responsibility for the bubble must not sit well internationally.
Long-time readers might recall that I pilloried this analysis from day one. The
issue was never some glut of "savings" but a historic glut of credit and the
resulting "global pool of speculative finance". In today's post-bubble period,
it should be indisputable that the acute financial and economic fragility
exposed around the globe was the result of egregious lending, financial
leveraging, and speculation. True savings would have worked to lessen fragility
- instead of being the root cause of it.
Unfortunately, there is somewhat of a chicken and egg issue that bedevils the
debate. Greenspan and Bernanke have posited that China and others saved too
much. This dynamic is said to have stoked excess demand for US financial
assets, pushing US and global interest rates to artificially low levels. This,
they expound, was the root cause of asset bubbles at home and abroad.
I take a quite opposing view, believing it is unequivocal that US credit excess
and resulting over-consumption, trade deficits, and massive current account
deficits were the underlying source of so-called global "savings."
Again, if it had been "savings" driving the process, underlying system dynamics
wouldn't have been so highly unstable and the end result would not have been
unprecedented systemic fragility. Instead, the seemingly endless liquidity - so
distorting of markets and economies round the world - was in large part created
through the process of unfettered speculative leveraging of securities and real
estate.
As is so often the case, we can look directly to the Fed's Z1 "Flow of Funds"
report for credit bubble clarification. Total (non-financial and financial)
system credit expanded $1.735 trillion in 2000. As one would expect from
aggressive monetary easing, total credit growth accelerated to $2.016 trillion
in 2001, then to $2.385 trillion in 2002, $2.786 trillion in 2003, $3.126
trillion in 2004, $3.553 trillion in 2005, $4.025 trillion in 2006 and finally
to $4.395 trillion in 2007.
Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by
mid-2003 (in the face of double-digit mortgage credit growth and the rapid
expansion of securitizations, hedge funds, and derivatives), where they
remained until mid-2004. Fed funds didn't rise above 2% until December of 2004.
Mr Greenspan refers to Fed "tightening" in 2004, but credit and financial
conditions remained incredibly loose until the 2007 eruption of the credit
crisis.
It is worth noting that our current account deficit averaged about $120 billion
annually during the nineties. By 2003, it had surged more than four-fold to an
unprecedented $523 billion. Following the path of underlying credit growth (and
attendant home price inflation and consumption!), the current account deficit
inflated to $625 billion in 2004, $729 billion in 2005, $788 billion in 2006,
and $731 billion in 2007.
And examining the "Rest of World" (ROW) page from the Z1 report, we see that
ROW expanded US financial asset holdings by $1.400 trillion in 2004, $1.076
trillion in 2005, $1.831 trillion in 2006 and $1.686 trillion in 2007. It is
worth noting that ROW "net acquisition of financial assets" averaged $370
billion during the 1990s, or less than a quarter the level from the fateful
years 2006 and 2007.
ROW data, in particular, diagnoses the flooding of dollar balances to the rest
of the world - and the "recycling" of these flows back to dollar instruments.
This unmatched flow of finance devalued our currency, and in the process
inflated commodities, foreign debt, equity and assets markets, and global
credit systems more generally.
In somewhat simplistic terms, ultra-loose monetary conditions fed US credit
excess, excessive financial leveraging and speculating, asset inflation,
over-consumption, and enormous current account deficits. And this unrelenting
flow of dollar balances to the world inflated the value of many things priced
in devalued dollars, thus exacerbating both global credit and speculative
excess. The path from the US credit bubble to the global credit bubble is even
more evident in hindsight.
Back in November 2007, Greenspan made a particularly outrageous statement.
So
long as the dollar weakness does not create inflation, which is a major concern
around the globe for everyone who watches the exchange rate, then I think it's
a market phenomenon, which aside from those who travel the world, has no real
fundamental economic consequences.
Similar to more recent
comments on the "global savings glut," I can imagine such remarks really rankle
our largest creditor, the Chinese. As we know, the Chinese were the major
accumulator of US financial assets during the bubble years. They are these days
sitting on an unfathomable $2.0 trillion of foreign currency reserves and are
increasingly outspoken when it comes to their concerns for the safety of their
dollar holdings. There is obvious reason for the Chinese to question the
reasonableness of continuing to trade goods for ever-greater quantities of US
financial claims.
Interestingly, Chinese policymakers are today comfortable making pointed
comments. Policymakers around the world are likely in agreement on a key point
but only the Chinese are willing to state it publicly: the chiefly dollar-based
global monetary "system" is dysfunctional and unsustainable.
Greenspan may have actually convinced himself that dollar weakness has little
relevance outside of inflation. And the inflationists may somehow believe that
a massive inflation of government finance provides the solution to today's
"deflationary" backdrop. Yet to much of the rest of the world - especially our
legions of creditors - this must appear too close to lunacy. How can the dollar
remain a respected store of value? Expect increasingly vocal calls for global
monetary reform.
The desirable goal of reforming the international monetary system,
therefore, is to create an international reserve currency that is disconnected
from individual nations and is able to remain stable in the long run, thus
removing the inherent deficiencies caused by using credit-based national
currencies.
Zhou Xiaochuan, head of the People's Bank of China,
March 23, 2009.
WEEKLY WATCH
For the week, the S&P500 surged 6.2% (down 9.7% y-t-d), and
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