The Mythical “Great Moderation”

Posted by shbanchang on December 29, 2011

The Mythical “Great Moderation”

by Doug Noland
Credit Bubble Bulletin
PrudentBear.com
December 02, 2011

I won’t be dismissing this week’s policy and market developments. We’re in a phase where the markets react to – and, really, are positioned for – extreme policy intervention. So this week’s announcement of concerted liquidity measures by the world’s major central banks plays directly to a very captive audience. Markets responded in dramatic fashion. Spanish 10-year yields sank 104 bps, Italian yields dropped 58 bps and French yields fell 42 bps. Here at home, stocks went into melt-up mode and risk spreads narrowed rather dramatically. While European stocks surged, the euro curiously rallied only 1.15%.

I don’t anticipate that central bank dollar liquidity swap arrangements will have much lasting impact. Neither the Germans nor the ECB have the resources to mount a successful European bailout. In desperation, Europe will surely come to more agreements to marshal only greater resources toward crisis management. I just believe the scope of the Credit dislocation is too great.

A little background is in order. Italian sovereign 10-year yields surpassed 13% in 1995. Spain’s yields traded above 9% in 1992. One can make a strong case that the developed world, including the U.S., was a fiscal train wreck in the making some twenty years ago. Italy, for example, sported a debt-to-GDP ratio of 125% back in 1995 (up from 97% to end 1990). Huge deficit spending saw Spain’s debt-to-GDP ratio jump from about 44% in 1991 to 67% by 1996. Greece’s ratio surged from just over 80% in 1991 to 110% by 1993. With a then huge 5.0% of GDP deficit back in 1992, gross U.S. federal debt had jumped to 55% of GDP in 1993. Miraculously, as the nineties progressed, the U.S., Italy, Greece and others ran budget surpluses. Market yields collapsed.

By the late nineties, the talk had turned to a “New Era” and “New Paradigm.” Dr. Bernanke popularized “The Great Moderation.” U.S. central bankers were the quickest to point to enlightened policymaking as having tamed inflation, in the process allowing a New Age productive economy to grow above previous “speed limits.” One has to only read Mr. Greenspan’s 2007 “The Age of Turbulence…” to get a sense for how outdated some of the old notions seem not many years later. Heading right into the 2008 crisis, Greenspan was still trumpeting the newfound resiliency of the U.S. economy.

Technology advancements over the past couple decades have been nothing short of phenomenal. There is also no doubt that so-called “globalization” had momentous impacts on economies and markets. I have been skeptical that adept policy had much to do with global inflation, economic growth or market dynamics. And for more than twenty years now I’ve been convinced that financial innovation has been the great untold story, largely explaining everything from policymaker overconfidence, the proliferation of leveraged speculation, serial assets Bubbles, U.S. de-industrialization and the rise of China and the “developing” world.

A historic expansion of private sector debt (and attendant tax receipts bonanza) turned early-nineties fiscal deficits into marvelous surpluses. The explosion of financial sector leveraging played an instrumental role in the collapse of U.S. yields. The ballooning balance sheets at Fannie, Freddie, the Federal Home Loan Banks, and Wall Street securities firms’ created unprecedented demand for debt securities. The proliferation of asset-backed securities (ABS), mortgage-backed securities (MBS), sophisticated Wall Street debt structures (CDOs, CLOs, special purpose vehicles, auction-rate securities, etc.), and endless derivatives equipped Wall Street risk intermediation with the most powerful tools to transform endless risky debt securities into “AAA” instruments – with this contemporary “money” enjoying virtually unlimited demand.

A unique financial and regulatory backdrop essentially created a circumstance where extraordinary demand for Credit was supplied at collapsing borrowing costs. And home prices inflating at multiples of after-tax mortgage borrowing costs created unprecedented demand for mortgage Credit (and housing units).

The nineties saw incredible growth in “repo” (repurchase agreement securities financing) and hedge fund leveraging. These unstable debt structures showed their perilous side in 1994 and then again in much more dramatic fashion with the 1998 LTCM blowup. Fatefully, policymakers intervened and both the hedge fund community and the “repo” markets were incentivized to expand to astounding dimensions and power – at home and globally. Repeated policy interventions “stabilized” these sophisticated leveraging structures – at a staggering cost to long-term financial and economic stability.

Financial innovation, leveraging and policy accommodation nurtured the U.S. mortgage finance Bubble, which spurred over-consumption and massive U.S. Current Account Deficits. Our Credit system unleashed upon the world unfathomable amounts of dollar balances, along with the mechanisms and policy doctrines to spur Credit systems all around the world. I has always been my view that it was this profligate financial environment that really solidified European monetary integration. A backdrop comprising a sound dollar and restrained global finance likely wouldn’t have accommodated the type of fiscal and monetary convergence necessary to transform 17 national currencies into an experimental currency unit named the euro.

Italian 10-year yields collapsed from almost 14% in March 1995 to 4.0% by the end of 1998. Real GDP went from slightly negative in 2002 to above 3% in 1999 and 2000. Italy’s budget deficit declined from 9.5% in 1993 to less than 1.0% by year 2000. Similar dynamics transpired in Greece, Spain and throughout the European Union. Strong growth, weak inflation, booming stock and bond markets, policymaker brilliance and general exuberance (“reflexively”) created a New Paradigm of good will, cooperation and currency integration in euro land.

Finance and economics are similarly dangerous. In both “disciplines” it is impossible to convince anyone that what the consensus believes is a really good idea will come back as a very big problem in, say, 10, 20 or even 30 years. Warnings of dire long-term consequences simply will not resonate, whether one is an elected politician or PhD policymaker.

Fannie and Freddie’s market intervention and balance sheet growth back in 1994 set the stage for near Credit system implosion in 2008. And there was Mr. Greenspan’s belief that derivatives work to disperse risk, while hedge funds create a more liquid marketplace. Dr. Bernanke’s references to “helicopter money” and the “government printing press”. Hundreds of Trillions of derivatives. A global “repo” market of tens of Trillions. A global leveraged speculating community now with more than Trillion of assets (and multiples more in positions). A global “reserve” currency governed by a central bank without rules and a penchant for experimentation. U.S. deindustrialization, Current Account Deficits and Fiscal Deficits. Global currency pegs and currency regimes. Many risks are easily ignored for years until disaster strikes.

U.S. household mortgage debt is on track to decline in 2011 for the third consecutive year. Despite the most extreme fiscal and monetary measures imaginable, the housing bear market persists. Japan’s Nikkei index closed today at 8,644, down some 78% from a high posted almost 22 years ago. Our NASDAQ Composite index closed this week at 2,627, about half of year 2000’s record 5,133. Burst Bubbles tend to have negative consequences for years and even decades – commensurate with the excesses during the preceding boom. And it is also true that aggressive policy responses are much more likely to inflate the next Bubble than they are to reflate the one in the process of bursting. There is extensive historical experience to support this thesis.

I believe the European debt Bubble has burst – and this would no doubt be a momentous development. For years, European debt was being mispriced in the (over-liquefied, over-leveraged and over-speculated global) marketplace. Countries such as Greece, Portugal, Ireland, Spain and Italy benefitted immeasurably from the market perception that European monetary integration ensured debt, economic and policymaking stability. Similar to the U.S. mortgage/Wall Street finance Bubble, the marketplace was for years content to ignore Credit excesses and festering system fragilities, choosing instead to price debt obligations based on the expectation for zero defaults, abundant liquidity, readily available hedging instruments, and a policymaking regime that would ensure market stability. Importantly, this backdrop created the perfect market environment for financial leveraging and rampant speculation – in a New Age global financial backdrop unsurpassed for its capacity for excess. The arbitrage of European bond yields was likely one of history’s most lucrative speculative endeavors.

The year 2011 – following by three short years the so-called “hundred year flood” of ‘08 – should put a dagger in the heart of The Mythological Great Moderation. Instead of lower inflation and enlightened policymaking nurturing greater financial and economic stability – they’ve done precisely the opposite. Today’s extraordinary uncertainty and financial instability are not conducive to financial leveraging, a circumstance posing a serious dilemma for a global system having grown dependent upon ongoing Credit excess. European bond markets have suffered the inevitable effects of de-risking and de-leveraging. And while policy measures, including those from this week, can exert rather dramatic risk market rallies, there is little politicians and central bankers can do to alter the market’s re-pricing of the region’s debt obligations. Don’t count on the ECB, IMF, or Fed to stabilize such a generally unstable financial, economic, social and political backdrop.

Policymakers in Europe have little flexibility and capacity to alter the dynamics of their bursting debt Bubble, and the markets are understandably dismissive of most measures and pronouncements. If only there were Eurobonds and an ECB committed to unlimited “buyer of last resort” support, Italian and other yields could drop back to previous manageable levels. But it’s past the stage where gimmicks will work, as the re-pricing of debt throughout the region has fundamentally altered the capacity to leverage, speculate and insure sovereign debt risk. Focusing on Italy, the re-pricing of Italian debt has made its debt load unmanageable. And if Italy is insolvent the European banking system is in serious trouble – and monetary integration is in serious jeopardy. The risk backdrop has changed profoundly, and a historic debt and speculative Bubble is bursting.

At the same time, the markets remain quite responsive to coordinated measures and, in particular, policy moves from Washington and Beijing. Importantly, ongoing U.S. and Chinese Credit Bubbles provide policymakers from these two powerful countries considerable firepower and flexibility.

The financial world has changed profoundly – and all nations should today be keenly focused on getting their respective Credit systems, fiscal positions and economies in order. And while I don’t expect policy measures to have much more than a fleeting impact on the European debt situation, the crisis is prolonging Credit excess and related imbalances in the U.S., China and much of the “developing” world. Dangerous Bubble dynamics see Treasury debt increase by about 0bn a month and Chinese lending grow about 0bn a month, and in both cases its late-cycle debt of dubious quality.

I was again this week reminded of the 2007/08 dynamic whereby policy responses to heightened systemic stress for months fostered market volatility, heightened speculation and an increasingly fragile backdrop. It would be a much healthier situation if U.S. financial asset prices were adjusting to new global financial realities. Instead, the U.S. government debt Bubble goes to only greater degrees of excess, with market participants anticipating only more extreme policy measures to come. Meanwhile, our stock market is priced as if recent growth and corporate earnings trends are sustainable. Looking at the world and the rising tide of debt revulsion in the marketplace, I would not extrapolate our nation’s recent debt trajectory.

My hunch would be that the underlying structure of an already maladjusted Italian economy suffered from more than a decade of mispriced finance and associated distortions. Only time will tell if years of excessive government spending and deindustrialization, along with poor demographic trends, have fashioned an acutely vulnerable and Credit-dependent economic structure. What we’ve learned about the Greek economy over the past two years is quite troubling. I fear for the Italian and U.S. economies. I agree with the German view that there is no solution to structural debt problems other than structural reform – and that the problem is global and not just European.

I’ll conclude with a couple quotes extracted from Otmar Issing’s insightful op-ed piece from Wednesday’s Financial Times, “Moral Hazard Will Result From ECB Bond Buying:” “Stressing the role of the central bank as the ultimate buyer of public debt should be seen as an indication of the pathological state of public finances not as a sign of strength… Pressing the ECB into the role of ultimate buyer of public debt of individual member states would create the biggest conceivable moral hazard.”

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10602

The Global Realm

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Tags: “Great, Moderation”, Mythical

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