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Credit Bubble Bulletin

Monetary Madness

by Doug Noland

July 27, 2012






In commemoration of M2 surpassing $10.0 TN for the first time – not to mention the unfolding confrontation between ECB President Draghi and Germany’s Bundesbank - this week’s CBB will focus on Monetary Analysis. It is worth noting that M2, the Fed’s narrow measure of “money” supply, surpassed $1 TN for the first time in 1975. It made it past $2 TN in 1983, $4TN in 1997, $8 TN in 2008 and $9 TN in April 2011. M2 has inflated another Trillion during the past 15 months.





To set the backdrop, it is worth noting that early economic thinkers were obsessed with money. These days, monetary analysis is little more than a footnote in contemporary economic doctrine. Generations ago, great minds were trying to come to grips with monetary phenomena. They came to appreciate that money and Credit had profound impacts on economies and societies, although throughout history even the most astute struggled with the complexity of it all. These days, “monetary stimulus” is seen as good for the markets and, yes, good again for GDP. Inflation, if it ever were to return, is not so good. Today’s monetary analysis is not good but it is shallow.






Thinkers of things economic long ago appreciated that the functioning of economies was literally transformed by the introduction of money. An economy dominated by barter operated altogether differently after units of exchange entered the fray. They further understood that the introduction of bank lending – where new purchasing power and bank liabilities were created by the act of borrowing – added great complexities to how economies functioned. Finance mattered and it mattered a lot. Keen attention was paid to the role Credit played in economic cycles.




For centuries, the seemingly straightforward issues of money and Credit were recognized as extraordinarily, incredibly complex. Analyses that various monetary fiascos and inevitable collapses came to similar conclusions: sound money and Credit were paramount. Credit and speculative excesses were recognized as primary culprits to financial collapse and the Great Depression. Regrettably, incredibly important lessons learned through devastation and hardship were relegated to the dustbin of history.




Early analysis of “wildcat banking” was quite insightful. Especially as banks proliferated along with the development of the Wild West, individual banks’ bills of exchange and promissory notes garnered considerable attention. These types of bank liabilities differed greatly, based on their backing and the perceived soundness of individual institutions – depending as well on the phase of the Credit cycle. In the end, there were too many bank failures, too much worthless wildcat currency and too little confidence in these Credit instruments and institutions.




Importantly, however, wildcat fiat “money” was initially a crucial facet of impressive wealth creation. Many a prospector borrowed from a local bank to clear land, buy seeds and invest in animals and tools. Many businesses flourished. Early economic thinkers, however, also recognized that unsound money would inevitably prove destabilizing and detrimental. Monetary inflations could not be controlled. Lending volumes – along with outstanding fiat currency - would inevitably grow larger and larger, financing speculative activities and uneconomic ventures – fueling inflation and sowing the seeds of boom and bust dynamics. This is a common theme throughout monetary history, although monetary analysis is always burdened by the fact that every cycle has its own financial and economic nuances. The nature of the analysis is prone to historical revisionism.





But I’ll conclude the shallowest analysis of monetary history - and jump right to the present. I’ve for years posited that we live in an extraordinary period of “global wildcat finance.” Fiat electronic Credit – much of it marketable debt instruments – has expanded unlike anything previously experienced. In the “developed” West, inflated real and financial assets were a primary inflationary consequence. In China and “developing Asia,” an unprecedented expansion of manufacturing capacity was integral to the incredible inflation of incomes and wealth. As for fundamental “nuances” of this monetary and economic Bubble, one can point to so-called “globalization,” the explosion of computer and communications technologies, enterprising financial innovation, deregulated Credit and speculation, and monetary policy activism.







Myriad forces worked to break the traditional link between monetary excess and rapidly rising consumer prices. The “developing” world, enjoying access to unlimited cheap finance, built manufacturing capacity to inundate the world with manufactured goods and technology products. Global financial excesses allowed developed nations to indulge in cheap imports by issuing endless IOUs, while transforming economic systems from production-based to Credit-driven consumption and services. And the seeming New Paradigm victory over “inflation” emboldened New Age central bankers. They unwittingly nurtured an epic monetary inflation, and as this Credit Bubble has begun to buckle they have moved with extraordinary force to sustain it. Especially after the 2008 crisis response, global policymakers lost control.






The eurozone is today locked in a disastrous monetary crisis. The marketplace simply no longer trusts the liabilities issued by some its members. Analysts continue to lambast European officials for failing to learn from our successful navigation through the 2008 crisis. This is flawed analysis.






Europe is suffering from a late-cycle sovereign debt crisis. In ‘08/’09, U.S. policymakers enjoyed unprecedented demand for Treasury (and even agency) debt securities. Through the massive issuance of federal government debt along with Federal Reserve monetization, the U.S. system was able to sustain ongoing Credit growth. U.S. non-financial debt expanded $1.9 TN in 2008 and, despite huge mortgage write-downs, U.S. non-financial Credit still grew almost $1.1 TN in 2009. With federal debt expanding a then record $1.4 TN, total non-financial debt expanded 3.1% in 2009. Washington was willing to jeopardize the creditworthiness of federal debt and the Fed was willing to risk its reputation - and a downward spiral was thwarted. A new phase of monetary inflation was commenced, this time through the massive injection of federal government and Federal Reserve finance.






There are unappreciated costs associated with injecting such massive sums of unproductive Credit into a (maladjusted) system, which I return to below. Today, because they now lack creditworthiness in the marketplace, Spain and Italy no longer have the capacity to inject sufficient new Credit into their economic systems. This is a potentially devastating dynamic, as the lack of sufficient ongoing monetary inflation is illuminating deep structural economic impairment following years of Credit excess and attendant maladjustment.






Earlier this week, with Spanish and Italian yields spiking higher and their markets turning illiquid, the European debt crisis was again spiraling out of control – only months after the ECB implemented its latest $1.3 TN liquidity facilities. And, once again, acute financial stress has provoked tough talk. ECB president Draghi Thursday morning stated, “the ECB is ready to do whatever it takes to preserve the euro. Believe me, it will be enough.” German Finance Minister Schaeuble said he supported Draghi’s statement, while Chancellor Merkel and President Hollande came forward Friday with their own “bound by the deepest duty” to do everything to protect the euro. And then there was this afternoon’s unconfirmed report that Mr. Draghi is prepared to present a “game changing” multi-prong plan at next week’s European Central Bank governing council meeting that will include ECB bond purchases and a banking license for the ESM.







Shifting 180 degrees from earlier in the week, rather than fearing Credit collapse the markets moved quickly in anticipation of yet another crisis-induced bout of monetary inflation. And, seemingly, only the Bundesbank remains capable of taking a measured approach. Friday morning (before afternoon reports of a Draghi’s “game changer”), from a Bundesbank spokesperson: “There haven’t been any changes in our positions on bond purchases of the Eurosystem, bond purchases by the EFSF, or giving a banking licence to the ESM. The Bundesbank has repeatedly expressed in the past that it views bond purchases critically because they blur the line between monetary and fiscal policy. The Bundesbank continues to view the SMP [securities market program] in a critical fashion. The mechanism of bond purchases is problematic because it sets the wrong incentives. A banking license for the bailout fund would factually mean state financing via the printing press and would be a fatal route, which therefore is prohibited by the EU treaty.”







No doubt about it, the Bundesbank is increasingly isolated. They are at odds with most European politicians and they are at odds with other central bankers. They are clearly not on the same page with Mr. Draghi. And no group of government officials anywhere more clearly appreciates myriad risks associated with monetary inflations. The German/“Austrian” view of economics just has a very different perspective, and it goes way beyond some fixation on Weimar hyperinflation. The focus is on how real wealth is created and how wealth is destroyed. Monetary inflations are powerfully destructive. And as a deepening European crisis applies incredible pressure on politicians throughout the region – certainly including Germany's Merkel and Schaeuble – I suspect the Bundesbank will hold its ground. They are both right on the analysis and have the support of the German people. They understand that the German economy cannot support the massive debt of the entire eurozone.







Italian 2-year yields jumped from 3.80% on Monday morning to 5.18% by Wednesday morning. By Friday afternoon they had sunk back down to 3.6%. Spanish stocks dropped 5.8% last Friday, declined 1.1% Monday and another 3.6% on Tuesday. They gained 0.8% Wednesday, before jumping 6.1% Thursday and 3.9% Friday. Italian stocks dropped about 10% in three sessions, before rallying 10% in the next three sessions. U.S. stocks dropped 3% in three sessions and then gained 3.5% in two. German 10-year yields ended the week up 23 bps. Throughout already volatile global debt, equities, currencies and commodities markets, things have turned only more unstable.






And there is no doubt in my mind that ongoing monetary injections – albeit European, American, Chinese, or others – come with the cost of increasingly unstable – I would argue perilously dysfunctional - global financial markets. And there should be little doubt where Mr. Draghi was directing his “trust me, it will be enough” tough talk (kind of reminded me of, “go ahead, make my day”). The Europeans believe hedge fund and other speculator bets against their bonds, stocks and euro currency are a major contributing factor to the region’s woes. There wasn’t an issue back when speculators were leveraged long Europe’s (Greece’s, Spain’s, Italy’s, etc.) securities during the upside of the cycle.






This week demonstrated an even more powerful “risk on, risk off” dynamic. For lack of attractive alternatives, ongoing global monetary injections ensure only more “money” flows to the global leveraged speculating community. From there, the bets on red or black - either on or against policymakers’ capacity to sustain global risk market Bubbles - become bigger by the week. Draghi and European policymakers this week hit the panic button – and those with bearish hedges and bets were again forced to run for cover. Risk on wins again.





And as policymaking turns increasingly desperate, it is almost guaranteed that “risk on, risk off” turns only more unwieldy. Indeed, it is clear at this point that the more global policymakers turn to monetary inflation to thwart the downside of the Credit cycle the greater the amount of fuel injected into a dangerous global speculative Bubble. In anticipation of next week’s scheduled Federal Reserve and ECB meetings, CNBC’s Steve Liesman today referred to “Monetary Madness.” I’ll use the term to describe the past couple decades.