SOUND OR UNSOUND ? / PRUDENTBEAR.COM

Sound or Unsound?

by Doug Noland

June 13, 2014 



Add meltdown in Iraq to the long list of geopolitical risks.

As follow-up to last week’s quarterly “flow of funds” analysis, I’ll take a brief look at the Rest of World (“ROW”) category. ROW now holds an incredible $22.971 TN of U.S. Financial Assets. To put this number into some perspective, ROW holdings began the nineties at $1.874 TN. Ballooning U.S. Credit and attendant unprecedented Current Account Deficits saw ROW holdings surge $4.335 TN, or 230%, during the nineties. Over the past 22 years, ROW holdings of U.S. Financial Assets have inflated $21 TN, or over 1,000%. Essentially, the U.S. has unrelentingly flooded the world with dollar balances. This helps explain a lot.

The consequences of the massive inflation/devaluation of the world’s reserve currency have for a long time been readily apparent. For starters, our huge trade deficits with Japan and U.S. pressure for the Japanese to stimulate domestic demand played a prevailing role in Japan’s fateful late-eighties Bubble. The Greenspan Fed’s early-nineties stimulus measures then supported the inflation of myriad foreign Bubbles, certainly including Mexico 1992-1994. The Mexican bailout then ensured catastrophic “Terminal Phase” Bubble excess throughout the Asian Tiger “Miracle” Economies in 1996. An unstable global financial “system” nurtured serial major Bubbles, including Russia, Argentina, Iceland, Brazil, etc. throughout the nineties.

After ending the ‘90s at $6.209 TN, ROW holdings of U.S. Financial Assets doubled (again) in just over six years. The mortgage finance Bubble period (2002-2007) saw ROW holdings surge $8.7 TN, or 116%, to $16.2 TN. It’s my view that the historic dollar devaluation during this period played a major role in precarious Bubble excess throughout the Eurozone (especially at the periphery). The crisis year 2008 saw U.S., European and global financial chaos. During that year, ROW holdings dropped an unprecedented $813bn to $15.386 TN.

In the 21 quarters since the end of 2008, ROW holdings have jumped $7.585 TN, or 49%. The world was once again literally flooded with dollars. The global government finance Bubble thesis posits that these dollar balances (coupled with speculative flows) inundated the emerging markets, fueling unprecedented Credit expansion, financial Bubbles and economic malinvestment. China, in particular, succumbed to Bubble Dynamics on an historic scale.

I have what should be a rather basic question: Is global finance sound or unsound? Is contemporary “money” and Credit sound? The issue of sound money and Credit has occupied a lot of thinking and written pages over centuries. Today, everyone seemingly couldn’t care less. Anyone that argues against conventional thinking on the subject is considered a wacko.

Back in 1999 everyone was crazy bullish and there was the outward appearance of a New Age miracle economy. I didn’t buy into the exuberance for one simple reason: It was obvious to me that the underlying finance fueling the boom was unsound. In late-2007, with stocks at record highs and the economy and markets trumpeted for their impressive resiliency, I was convinced a major crisis was imminent. Why? Because there was absolutely no doubt that the underlying “money” and Credit was alarmingly unsound.

So, here we are in mid-2014. The financial mania is back, bigger and bolder than ever. U.S. and global markets are again lauded for resilience in the face of myriad issues. Here at home, it’s Miracle Economy 2.0. Meanwhile, the underlying finance driving the boom is the most unsound and dangerous ever. It’s as clear to me today as it was in 1999 and 2007.

It’s curious that the issue of unsound money and Credit is not today central to the economic debate. After all, history is unequivocal. Unsound “money” ensures financial, economic and social instability. It guarantees problematic price instability, deep structural economic impairment and income and wealth inequalities. Especially after the 2008 crisis, one would think the sound money debate would be front and center. Yet somehow the doctrine of inflationism completely dominates economic curriculums, thinking, policy and discourse. The specious doctrine that deflation is the overarching risk goes unchallenged.

Simplistically, the consensus view (doctrine) holds that the financial system and economy are best served by inflation (CPI) rising steadily at a rate of two to three percent annually. A little inflation is thought to grease the wheels. A steadily rising price level is believed to ensure that the economy can consistently grow out of potential debt problems. This fallacy is highly pertinent and should be addressed.

In a closed economy with generally stable finance and economic output, one might make a believable case for the benefits of steady annual 2-3% inflation. But especially during the past 25 years, we’ve seen major developments that wreak havoc on simple models and premises. 

“Globalization” ensures the closed system model is invalid. There have been as well myriad profound changes in the nature of economic output. The technology revolution, the proliferation of services throughout the economy and the rapid growth in healthcare are just the most obvious areas that have profoundly altered the nature of economic output – along with the ability of contemporary economies to readily boost the supply of things (absorbing purchasing power). Moreover, the past 25 years have been a period of extreme financial innovation.

I have argued that it is a myth that contemporary central bankers control CPI (for starters, they don’t control Credit/purchasing power or output). Indeed, if they strive for 2-3% annual inflation these days they will ensure acute financial and economic instability. In the U.S., 2-3% inflation equates with flooding the world with dollar balances and devaluing the world’s reserve currency. Moreover, modest consumer price inflation equates with a massive inflation of Federal Reserve “money” – liquidity that has profoundly altered risk perceptions, asset prices and market behavior throughout the system. As we’ve seen with 18 months of QE3, 2% consumer inflation can equate to 30% stock market inflation and double-digit price gains in national home price indices. Two percent CPI has equated with an unprecedented flow of finance into higher-yielding securities, instruments and products, in the process fueling a massive mispricing of corporate debt. Modest inflation (“stable prices”) has equated with virulent monetary disorder across the globe.

China international reserve assets have surged $700bn over the QE3 period to a record $3.948 TN. It is worth noting that Chinese reserves began 2002 (start of mortgage finance Bubble) at about $200bn. In many ways, the Chinese Bubble is the mirror image of the U.S. Credit Bubble. China is today also at the epicenter of unsound global “money” and Credit. It is my view that if not for the massive inflation of U.S. Credit (dollar devaluation), it would have been impossible for the Chinese Credit system to have operated without any constraint for so long. Unfettered cheap Chinese finance has allowed massive overinvestment throughout scores of industries (not to mention apartment units!). The world now faces the consequences: “disinflationary” pressures on many things as well as the specter of major unfolding Chinese financial issues.

June 13 – Wall Street Journal (Daniel Inman, Fiona Law and Enda Curran): “The commodity-backed loans at the center of a probe into an alleged financial scam at a Chinese port are part of a ramp-up in offshore borrowing by Chinese companies that Beijing is looking to tamp down. As Chinese authorities tightened credit at home in the past year, local firms instead looked abroad for financing. Asian-Pacific banks alone had $1.2 trillion in loan exposure to China at the end of 2013, up two-and-a-half times from 2010, according to Fitch… A chunk of the borrowing has been by Chinese firms taking out short-term overseas loans backed by commodities, part of an effort to lock in gains by borrowing offshore at lower rates, and investing the money at higher rates on the mainland. This lending has complicated Chinese policy makers’ attempts to slow rapid credit growth in the nation's so-called shadow banking sector… Foreign banks have stepped up commodity-backed lending to China in recent years, a profitable business that now is looking increasingly shaky.”

I cannot blame all the world’s problems on unsound U.S., Chinese and global finance. The frightening unfolding Shia vs. Sunni debacle in Iraq and the Middle East obviously predates Western central banking, the dollar reserve system and unconstrained finance. Yet I look around the world and see initial consequences of the world’s greatest episode of unsound finance and financial mania. Asia is a tinderbox, and I fear that Chinese leadership will be tempted to lash out as their Bubble deflates. I look at Russia and the ongoing “Ukraine” crisis and I see deep Russian animosity towards their view of U.S. dominated global finance and economic arrangements. It seems obvious to me that Russia, China and others will increasingly see it in their best interest to change the “world order.”

I am an analysts and not a pessimist. I actually have an optimistic nature. Without it I wouldn't be able to do what I do – including chronicling the world’s greatest Credit Bubble on a weekly basis for about 15 years.

But I look around the world today and am more worried about the future than ever before – Iraq, the Middle East, China and Asia, the emerging markets, Europe, Ukraine and Russia. The “social mood” is sour at home and abroad. Animosity. Anti-Americanism. Anti-Capitalism. Fragmentation. Conflict.

Compounding the problem, I see wildly distorted global central bank-induced Truman Show securities markets. I see a mirage of prosperity fueled by surging values of all kinds of financial (and real) assets. And I see endless electronic debit and Credit entries – contemporary finance – that is supposed to equate with unprecedented global wealth. Yet there’s a massive gulf between perceived and real wealth. I see incredible bullishness and denial in the face of deep structural issues for both U.S. finance and our economy. I see the mirage of U.S. prosperity dependent more than ever before on highly accommodating central bankers and unending bull markets. I just don’t buy the view of the U.S. as an oasis of prosperity impervious to global degradation.

On an almost globalized basis, there is this very troubling divergence between highly speculative and inflated securities markets - and a really uncertain future. I’ve argued that central bankers can’t make things better – that their monetary inflation only makes things worse. 

It seems obvious that a most protracted period of unsound “money” has created one hell of a mess. As for geopolitical risk, Ukraine and Russia remain issues. Asia is an accident waiting to happen. And, now, instability in the Middle East risks a blowup that could wreak havoc on global energy markets – not to mention a horrific human tragedy.