Inflation Is Still the Lesser Evil

Kenneth Rogoff

06 June 2013

 This illustration is by Chris Van Es and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

CAMBRIDGEThe world’s major central banks continue to express concern about inflationary spillover from their recession-fighting efforts. That is a mistake. Weighed against the political, social, and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about. On the contrary, in most regions, it should be embraced.

 
Perhaps the case for moderate inflation (say, 4-6% annually) is not so compelling as it was at the outset of the crisis, when I first raised the issue. Back then, against a backdrop of government reluctance to force debt write-downs, along with massively over-valued real housing prices and excessive real wages in some sectors, moderate inflation would have been extremely helpful.
 
The consensus at the time, of course, was that a robustV-shapedrecovery was around the corner, and it was foolish to embrace inflation heterodoxy. I thought otherwise, based on research underlying my 2009 book with Carmen M. Reinhart, This Time is Different. Examining previous deep financial crises, there was every reason to be concerned that the employment decline would be catastrophically deep and the recovery extraordinarily slow. A proper assessment of the medium-term risks would have helped to justify my conclusion in December 2008 that “It will take every tool in the box to fix today’s once-in-a-century financial crisis.”
 
Five years on, public, private, and external debt are at record levels in many countries. There is still a need for huge relative wage adjustments between Europe’s periphery and its core. But the world’s major central banks seem not to have noticed.
 
In the United States, the Federal Reserve has sent bond markets into a tizzy by signaling that quantitative easing (QE) might be coming to an end. The proposed exit seems to reflect a truce accord among the Fed’s hawks and doves. The doves got massive liquidity, but, with the economy now strengthening, the hawks are insisting on bringing QE to an end.
 
This is a modern-day variant of the classic prescription to start tightening before inflation sets in too deeply, even if employment has not fully recovered. As William McChesney Martin, who served as Fed Chairman in the 1950’s and 1960’s, once quipped, the central bank’s job is “to take away the punch bowl just as the party gets going.”
 
The trouble is that this is no ordinary recession, and a lot people have not had any punch yet, let alone too much. Yes, there are legitimate technical concerns that QE is distorting asset prices, but bursting bubbles simply are not the main risk now. Right now is the US’s best chance yet for a real, sustained recovery from the financial crisis. And it would be a catastrophe if the recovery were derailed by excessive devotion to anti-inflation shibboleths, much as some central banks were excessively devoted to the gold standard during the 1920’s and 1930’s.
 
Japan faces a different conundrum. Haruhiko Kuroda, the Bank of Japan’s new governor, has sent a clear signal to markets that the BOJ is targeting 2% annual inflation, after years of near-zero price growth.
 
But, with longer-term interest rates now creeping up slightly, the BOJ seems to be pausing. What did Kuroda and his colleagues expect? If the BOJ were to succeed in raising inflation expectations, long-term interest rates would necessarily have to reflect a correspondingly higher inflation premium. As long as nominal interest rates are rising because of inflation expectations, the increase is part of the solution, not part of the problem.
 
The BOJ would be right to worry, of course, if interest rates were rising because of a growing risk premium, rather than because of higher inflation expectations. The risk premium could rise, for example, if investors became uncertain about whether Kuroda would adhere to his commitment. The solution, as always with monetary policy, is a clear, consistent, and unambiguous communication strategy.
 
The European Central Bank is in a different place entirely. Because the ECB has already been using its balance sheet to help bring down borrowing costs in the eurozone’s periphery, it has been cautious in its approach to monetary easing. But higher inflation would help to accelerate desperately needed adjustment in Europe’s commercial banks, where many loans remain on the books at far above market value. It would also provide a backdrop against which wages in Germany could rise without necessarily having to fall in the periphery.
 
Each of the world’s major central banks can make plausible arguments for caution. And central bankers are right to insist on structural reforms and credible plans for balancing budgets in the long term. But, unfortunately, we are nowhere near the point at which policymakers should be getting cold feet about inflation risks. They should be spiking the punch bowl more, not taking it away.
 
 
 
Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. His most recent book, co-authored with Carmen M. Reinhart, is This Time is Different: Eight Centuries of Financial Folly.


Banzai! Banzai! Banzai!

By John Mauldin

Jun 08, 2013


I shot an Arrow into the air
It fell to earth I know not where….

- Henry Wadsworth Longfellow



As kids, not knowing that we were being politically incorrect on so many levels, we would shout Geronimo!” when we were playing war or getting ready to do something reckless. (For those not familiar, Geronimo was a rather fearsome Apache chief who plagued Mexico and the American cavalry.) Sam Houston and his fellows cried, “Remember the Alamo!” as they rode down upon Santa Ana at San Jacinto. The British went to battle with “God Save the Queen [or King]!” Confederate soldiers took up the rebel yell as they charged live bullets and fixed bayonets. Every good war movie has its own memorable moment of the battle charge.

In Japan, the term Banzai! literally meansten thousand years” and can be used to wish someone long life and happiness. But during World War II, “Banzai! was shouted in battle. It was the Japanese equivalent of "Long live the king!" – but to soldiers on the other side it came to mean a suicidal, hell-for-leather attack.

If the central bankers of the world think they're hearing a battle cry of “Banzai!” from the lips of their Japanese brethren, they may not be far from wrong, because the Japanese are indeed on a mad charge to fight deflation at all costs. As with all good suicidal charges, at least in legend and lore, once the cry has gone up and the thundering charge has begun, there can be no turning back.

For the last three weeks, I have been making what I personally think is a rather strong case that the Japanese have embarked on what may be simultaneously the most outrageous, intriguing, and desperate monetary policy experiment by a major economic power in history. (Those letters are here, here, and here). The Japanese are rapidly coming to their own Endgame, the end of their ability to borrow money at interest rates that are economically rational. If interest rates on Japanese bonds rise to a mere 2.2%, 80% of tax revenues will go just to pay the interest on their debt. At a 245% debt-to-GDP ratio, they are in desperate straits, and they know it. And desperate times call for desperate measures.

To get to where they want to go, to grow their way out of their deflationary problem, the Japanese need both inflation and real growth. Real growth can come from massively increased exports, and inflation can even come from an increase in export prices. Both results can be obtained by weakening the yen. As I have shown, they need to devalue the yen by 15-20% a year for many years in order to break through to the other side.

That should be easy, at least in theory. Inflation, Milton Friedman famously said, is “always and everywhere a monetary phenomenon.” If you want to create inflation and devalue your currency, just print more money. A second shift in the print shop is in order, and if that doesn’t produce the desired results a third shift can be arranged, and then you can run full tilt on weekends. And soon maybe it will be time to build another print shop.

But that is the theory. In practice it may be harder for Japan to grow and generate inflation than it might be for other major nations. Today we'll focus on Japanese demographics. While the letter is full of graphs and charts, it does not paint a pretty picture. The forces of deflation will not go gently into that good night.

And now, let’s shoutBanzai!” together as we dive right into Japanese demographics.


The Demographics of Doom


Creating inflation is the goal, but Prime Minister Abe and Bank of Japan Governor Kuroda face a very difficult task. Unlike in Zimbabwe, Argentina, and a host of other countries with defunct fiat currencies, in Japan it is not simply a matter of racking up untenable amounts of debt and then printing tons of money. If it were that simple, inflation would be rampant in Japan, for the Japanese have borrowed more tan any country in modern history (relative to their size). And while their efforts to create inflation have been futile, it is not for lack of trying: the Japanese have been actively pursuing quantitative easing for many years. Carl Weinberg of High Frequency Economics, writing in the Globe and Mail, gives us a very succinct summary of the Japanese dilemma:

The National Institute of Population and Social Security Research projects that Japan’s working-age population will decline over the next 17 years, to 67.7 million people by 2030 from 81.7 million in 2010. We select 2030 as the endpoint of today’s discussion because almost all the people who will be in the working-age population by 2030, 17 years from now, have been born already. Immigration and emigration are trivial. The 17-per-cent decline in the working-age population is a certainty, not a forecast. It averages out to a decline of 0.9 per cent a year. In addition, these official projections show a rise in the population aged over 64 to 36.9 million in 2030 from 29.5 million in 2010. If the labour-force participation rate stays constant, we estimate the number of people seeking work in the economy will fall to 56.5 million by 2030 from 65.5 million today and 66 million in 2010.

What happens when a nation’s population declines and the proportion of working-age people decreases? In the first, simplest, level of analysis, the production potential of the economy declines: Fewer workers can produce fewer goods. This does not mean GDP must decline; productivity gains could offset a decline in the labour force. Also, an increase in the labour-force participation rate could mute the effect of a declining working-age population. However, even if the labour force participation rate were to rise to 100 per cent by 2030 from 81 per cent today (which it cannot, because some people have to care for the old and the young, and some are disabled or lack adequate skills or education), there would be fewer workers available in 2030 than there are today.

With fewer people working, the burden of servicing the public-sector debt will be higher for each individual worker. We project that the debt-to-GDP ratio and the debt-per-worker ratio will grow unabated over the next 17 years and beyond. Also, the rise of the ratio of retired workers to 32 per cent of the population from 23 per cent means that people who are still working in 2030 will have to give up a rising share of their income to support retirees. The disposable income of the declining number of workers will fall faster than the decline of production and employment. Overall demand of workers will decrease – with their disposable incomefaster than output for the next 17 years at least. Demand will also fall as new retirees spend less than in their earning years.

Based on demographic factors alone, the decline of aggregate demand between now and 2030 will exceed the decline of output, creating persistent and widening excess capacity in the economy. Prices must fall in an economy where slack is steadily increasing. In addition, advancing technology will likely increase output per worker in the future. With overall demand and output falling, productivity gains will lower labour costs and add to downward pressure on prices. Disinflation and deflation are the companions of demographic decline.

Andrew Cates, an economist for UBS, based in Singapore, published a penetrating study on the relationship between inflation and demographics this week. He notes that countries with older populations tend to have lower inflation. That is not what the textbooks suggest, but it's what the data reveals:

Sincé ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve from here. By extension it could be of greater significance for monetary policy settings and the broader outlook for global growth and financial markets as well.

Let’s first look at the evidence. In the chart below we show average inflation levels over the last 5 years plotted against the 5-year change in the dependency ratio. The latter is the ratio of the very old and the very young to the population of working age. A shift down in that ratio implies that the population in a given country is getting younger (and vice versa). The chart therefore shows that those countries that have been getting older in recent years have typically faced very low inflation rates and, in the case of Japan, deflation. In the meantime those countries that have been getting younger in recent years, such as India, Turkey, Indonesia and Brazil, have faced relatively high inflation rates.

Cates looks not just at Japan but takes a more global view. However, Japan does stand out in this chart. (I do not have a link, as this work is just available from UBS for now.) I added the red box to highlight Japan:



And while correlation is not causation, the following graph of inflation vs. population growth in Japan does make you think.



And let's throw in one more chart from Mr. Cates. He notes that textbook economics suggests that a falling workforce tends to put upward pressure on wages (labor is just an input resource on the supply side), and thus one ends up with cost-push inflation:

This, though, ignores other factors that are arguably of some relevance in the domestic inflation-generating process. Demographic influences for example will influence an economy’s natural demand for consumer durables, its housing stock and broader credit aggregates. The latter is certainly borne out by the reasonably close correlation that exists between credit and ageing in the chart below.




Finding Japanese Optimists


As negative as all of the above sounds, you can find those who think the Japanese economy can turn itself around, that inflation can be drummed up, and that Japanese interest rates – even given the amount of monetization they are contemplating – will not rise. Seriously.

Bloomberg News did a survey of five former Bank of Japan officials, all of whom believe that “any gains in government bond yields will be contained over the next two years.” Four of the five also don’t think 2% inflation is possible. Even with a wide-open printing press.

You can decide for yourself whether Abenomics can accomplish 3 or 4% nominal growth. Just go to this story with an interactive graph from Reuters Breakingviews). (The screen shot included below is just intended to tantalize you to head over there.) Play with variables in the graph and decide what you think is possible. If you start with today’s trends, potential GDP growth is much less than 1%.



But what if, like Andy Mukherjee at Breakingviews, you get more optimistic? Japanese women participate in the labor force at just 63%, about the lowest female participation rate among developed nations. What if the participation rate of women rises dramatically because of the 250,000 new daycare jobs Abe has promised? And what if older people decide to work longer? And maybe men will do more (even though they have one of the highest participation rates now). And the unemployment rate could drop by, say, 40%.

If you make such assumptions then you can get to a 1.5% growth rate (which, as I showed last week, is not anywhere near enough!). Abe has bet big that creating inflation will encourage people to no longer postpone spending in hopes that things will get even cheaper. Never mind that that is not how older people think. And those are the people in Japan with money to spend. Abe's program is yet another case of operating on the basis of textbook economic theory rather than the reality that is staring you in the face.

An aging population means that someone has to take care of parents as they get older. And in Japan (as in many other places) that responsibility usually falls to the women, which lowers the female participation rate. And where will they get those 250,000 daycare workers? And who is going to pay for them? Abe also promises that by 2020 the Japanese government will be running a surplus and that deficits will be down to the rate of nominal GDP growth within a few years. Which programs will get cut to pay for those daycare workers? And what about the serious need for nursing-home workers? There are far more old people in Japan than there are toddlers.

While we are on the matter of promises, Abe also says he will enter into free-trade agreement talks with the rest of Asia and the US and open up the Japanese economy. All this while his currency is plummeting 15% a year, upsetting his neighbors and drastically changing the terms of trade? Now he wants to play nice in the global-trade sandbox? I was on Bloomberg with Tom Keene this morning.

One of the other guests, talking about Japan’s opening up free-trade talks with the US, mentioned rice, which Japan famously protects, as a potential bargaining chip. So,” I responded, “Japan decides it wants to drop the value of the yen by 50% and then open up its rice trade?” I was not impressed. I am a fairly big proponent of free trade, but Japan’s getting religion on free trade now, when they are on the brink of crisis, seems a tad disingenuous.


I Shot an Arrow… into My Foot


Abe has proposed an economic reform package comprisingthree arrows”: aggressive monetary easing, labor and other structural reforms (which will be politically very difficult to achieve) intended to induce private-sector growth-promoting investment, and a flexible fiscal policy (whatever that means – I guess, since it's "flexible," it means whatever he decides it means). He gave a speech this week on those reforms, and the market promptly threw up. The “reforms” he touted were more of the same old same old. At dinner on Wednesday night, Art Cashin modified the opening line from the old Longfellow poem: “I shot an arrow into the air… and it landed in my foot.”

Not that I think Abe had much choice. He has a critical election next month. Touting a policy that allows employers a freer hand in firing workers is not likely to win over many voters, but he must get serious about reform if he is to have any hope of limiting the disaster he faces.

I truly do feel sorry for retirees in Japan. I am reminded of that wonderful Japanese movie from the '50s, The Ballad of Narayama. It depicted ubasute (姥捨, "abandoning an old woman"), a custom allegedly practiced in Japan in the distant past, whereby an infirm or elderly relative was carried up a mountain or to some other remote, desolate place and left there to die.

While not as straightforward, the last 20 years of policy choices are producing results that are going to feel to the elderly as if they have been abandoned. It's just a much more protracted approach and one that is not so personally intimate as that depicted in the movie.



Gentlemen, They Offer Us Their Flank


My friend the serious raconteur Bill Bonner tells the story of the Battle of the Marne in WWI, relating it to inflation. Quoting :

What's remarkable about inflation is that there is so little of it. It makes us think this [inflation/deflation] story may have a twist. You remember the famous German general von Kluck, from whom we get the expression, "You dumb kluck"?

Von Kluck was chasing the French down the Marne in 1914. Victory appeared close at hand; the French were pulling back. Von Kluck, who had orders to attack Paris, decided instead to pursue the French army. He was convinced they were beaten.

All he had to do was keep the pressure on ... and they would surrender.

Some of his field commanders, however, noted that they were picking up very few prisoners. Normally, an army that is beaten throws off many discouraged and confused soldiers. Since there were so few, the commanders reasoned that the French army was still intact; it was merely retreating in good order and could turn and surprise the Germans at any time.

The commanders were right. France's aging general, Gallieni, who was in charge of the Paris garrison, realized that the Germans were making a fatal mistake. By pursuing the troops down the Marne, rather than attacking Paris, they exposed themselves to a counterattack from the city itself.

"Gentlemen," he is said to have remarked to his staff, "They offer us their flank."

The French accepted the offer: they attacked. Using thousands of taxicabs, they quickly moved troops to the Marne Valley and caught the Germans unprepared. The Battle of the Marne turned the German army around and ultimately cost them the war.


Banzai! Banzai! Banzai!


The Japanese are charging the deflationary battle lines, crying "Banzai!" This attack is all or nothing. I think the Japanese are offering us investors their flank. This week’s action in the markets showed us that this battle will not be one-sided. It will often get ugly. But I want to keep reiterating what I have been saying for a long time: shorting the Japanese government is the trade of the decade. That is the largest position in my personal portfolio, and it is going to get larger, as I intend to fully swap the mortgage I just took out this week into yen. As I said to Tom Keene this morning, it is my intention (more accurately styled as hope) to let Abe-san and Kuroda-san pay for a large chunk of my new apartment through their policy of destroying the yen. I have to admit to feeling good when the yen backs up like it has this week, since that gives me a chance to get my trade on at a better entry.

Will I succeed? Time will tell, but I am joined by Japanese public pension funds that have announced they will reduce their holdings of local bonds while increasing their share of both domestic and, in particular, foreign equities. No time frame was provided in the data I saw, although indications are that they have already started. (Hat tip Kiron Sarkar.)
     
It is time to close this week’s letter, but these are topics we'll need to return to. But before we go, I want to include one more table I came across while researching this topic. It is a comparison of the dependency ratio among developed countries. This is the ratio of retired and people under 16 compared to the work force. As it turns out, Japan is not in last place. France, Italy, and Hungary have worse demographics. This chart fairly screams for an entire future letter.



Your proud new father of a bouncing baby (yen?) mortgage analyst,

John Mauldin


Copyright 2013 John Mauldin. All Rights Reserved.

 

Twenty-Year Anniversary of Market Backstops

Doug Noland

June 7, 2013


The global government finance Bubble has seen at least its second crack develop.
The Fed's Q1 2013 Z.1Flow of Funds” was notable for the surprising ongoing lackluster Credit expansion throughout much of the private-sector. Even with continuing double-digit percentage growth in Federal borrowings, Total Non-Financial Debt expanded at a 4.6% rate during the first quarter (down from Q4 2012’s 6.5%). Household debt contracted at a 0.6% rate, a reversal from Q4’s 2.2% expansion. Surprisingly, Household Mortgage Debt declined at a 2.3% pace versus Q4’s 1.0% rate of contraction. Non-mortgage Household borrowings remained relatively strong, with Q1’s 5.7% pace down only slightly from Q4’s 6.5%. Corporate borrowings slowed from Q4’s blistering 12.1% pace to 7.6%.


The federal government’s domination of U.S. Credit runs unabated. Federal debt expanded at a 10.3% rate during the quarter, down only slightly from Q4’s 11.2%. Keep in mind that federal debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011 and 10.9% in 2012. In nominal dollars, outstanding Treasury debt increased $337bn during the quarter, with a one-year gain of $1.078 TN. Treasury debt increased a staggering $6.655 TN, or 127%, during the past 19 quarters.

In seasonally-adjusted and annualized (SAAR) nominal dollars, Total Non-financial Debt expanded $1.850 TN, down from Q4’s SAAR $2.585 TN but still relatively strong. For comparison, Total Non-financial debt increased $1.872 TN in 2012, $1.325 TN in 2011, $1.472 TN in 2010, $1.058 TN in 2009, $1.921 TN in 2008 and $2.554 TN in 2007. At SAAR $1.198 TN, federal borrowings during the quarter accounted for 65% of Total Non-Financial Debt growth. For comparison, federal borrowings as a percentage of Total Non-financial Debt growth were 61% in 2012, 79% in 2011, 107% in 2010, 136% in 2009 and 64% in 2008. During the boom years 2006 and 2007, federal borrowings amounted to less than 10% of Total Non-financial Debt growth.

There are a few striking facets of the most recent Z.1 report from the Fed. Importantly, private-sector Credit continues to struggle in the face of ongoing ultra-loose financial conditions and inflating asset markets. Surprisingly, even with mortgage rates at all-time lows (along with the reemergence of house price inflation), Total Mortgage Credit contracted 1.9% annualized during Q1 to $13.091 TN. This follows Q4’s 0.4% gain, the first positive mortgage Credit growth since Q1 2008. Both Household and Commercial mortgage Credit contracted during the first quarter.

We’ll now watch with keen interest how the significant jump in borrowing costs impacts mortgage Credit and bubbling real estate markets more generally. Even a major refinancing boom and recovery in home prices was not enough to spur even positive growth in household mortgage borrowings. For households, low returns on savings have incentivized paying down mortgage debt. While this dynamic has helped improve the Household balance sheet, it has provided ongoing headwinds against a self-sustaining private-sector Credit resurgence. Said another way, despite years of zero rates, an historic increase in government debt and massive Fed monetization there is little to indicate a sustainable private-sector Credit expansion.

Total Bank Assets expanded $186bn during Q1 (to $15.244 TN), with Reserves at the Fed surging $299bn during the quarter to a record $1.790 TN. Bank loan growth slowed to a 1.3% pace, the slowest since the recession, as year-over-year loan growth slipped to 8.4%. Mortgage loans declined $38bn during the quarter after gaining $57bn during Q4. Miscellaneous Assets dropped $63bn (to $1.208 TN). Government securities holdings jumped $38bn, the strongest increase in a year.

Away from the banking system, Securities Broker/Dealer assets contracted slightly to $2.049 TN (down 0.7% y-o-y). Funding Corp assets were little changed at $2.166 TN (up 5.4% y-o-y). Securities Credit declined $28bn to $1.485bn (up 7.9% y-o-y). Finance Company assets declined slightly during the quarter (down 4.7% y-o-y) to $1.519 TN. Real Estate Investment Trust (REIT) assets were little changed for the quarter at $797bn (up 14% y-o-y). Credit Union assets expanded at a 9% rate during the quarter to $980bn (but up 3.8% only y-o-y).

With legislation in the works that would seek to “privatizeFannie and Freddie, it’s worth taking a look at this quarter’s GSE data. Total Agency Securities (debt and MBS) jumped $47bn during the quarter to $7.591 TN, with a one-year gain of $58bn, or 0.8%. Despite the ongoing contraction in overall mortgage borrowings, Total GSE Securities are little changed from 2010 levels. Total GSE assets (holdings) actually increased $4.4bn during Q1 to $6.300 TN. From a year ago, total assets were down 2.1%, or $133bn. GSE (insured) MBS actually increased $26bn, or 7.2% annualized, during the quarter to $1.463 TN. GSE MBS jumped $133bn, or 10%, over the past year. In three years, GSE MBS jumped $456bn, or 45%. It will be a very tall order to ever privatize a largely nationalized household mortgage industry.

I also have no doubt that it is going to be very difficult to wean U.S. and global markets off of Federal Reserve QE liquidity. Federal Reserve assets surged $289bn, or 39% annualized, during the quarter to a record $3.244 TN. The Fed’s balance sheet surpassed $1 Trillion for the first time back in 2008. Fed assets are now on track to reach $4.0 TN near year-end.

There were a couple key aspects of pastFlow of Fundsanalysis that came to mind as I made my way through recent data. I recall becoming increasingly concerned with mortgage Credit dominance over system Credit expansion back in 2005/06. And the longer that trend continued the greater my fear for the deep structural impacts that this unusual flow of finance was having on our financial system and the underlying real economy.

The dominance of Washington-based finance has similarly long overstayed its welcome. When the Fed was aggressively expanding its balance sheet in 2008/09, its purchases were essentially accommodating financial sector de-leveraging (the Fed providing a liquidity backstop for troubled banks, leveraged hedge funds, securities firms, REITs and such). Federal Reserve buying (monetization) over the past six months has been of an altogether different kind. Instead of accommodating de-risking/de-leveraging, the Fed purchases have instead incited risk-taking and leveraged speculation.

Even former Fed chair Alan Greenspan went public (CNBC) Friday with his call to begin tapering: “The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, which everyone agrees is excessive, the better The issue is not only a question of when we taper down, but when do we turn? And I think that the markets may not give us all of the leeway we would like to do that.”

Well, the Fed is supposedly one of these days going to “come to grips with this excessive level of assets on the balance sheet.” But there’s a heck of a dilemma developing. The Fed has been using its balance sheet to stoke the asset markets, in the process incentivizing risk-taking and leveraging. If the Fed does at some point decide to restrict asset purchases, where will the markets look to for their covetedliquidity backstop?”

I recall the 1993 bond market Bubble as if it were yesterday. I was confident in the analysis that extraordinary speculative leverage had accumulated through hedge fund trading and the derivatives markets. The Greenspan Fed’s low short-term rates and orchestrated steep yield curve created powerful market incentives and distortions.

I was convinced that an inevitable bond market reversal would unleash considerable turmoil and market dislocation. And I was right, to a point. When the Fed moved to reverse its loose monetary policy in early 1994, many were stunned by the dramatic jump in market yields all along the curve. After trading at 4% in early January, 2-year yields spiked to 7.7% by year-end.

There was considerable pain and even a few fund failures. The surge in yields even precipitated financial and economic collapse in Mexico. At the same time, I was surprised that a major speculative de-leveraging wasn’t having a more profound impact on overall financial conditions. I suspected at the time that Fannie Mae and Freddie Mac purchases were providing the leveraged players an important liquidity backstop. The 1994 experience had a profound impact on my Macro Credit and Bubble Analysis framework.


Flow of Fundsdata tell the story pretty well. GSE assets surged an unprecedented $148bn in 1994, or 23%, to $782bn. With little fanfare, Fannie and Freddie had morphed from insuring mortgage securities to highly leveraged holders of mortgages and debt that were more than happy to buy huge quantities of securities (at top dollar) in the midst of acute market turbulence. And the GSEs were anything but finished in 1994.

GSE assets increased $115bn in 1995, $92bn in 1996 and another $112bn in 1997. When markets were rocked by the collapse of LTCM and attendant speculative deleveraging, the GSE’s expanded holdings an unprecedented $305bn in 1998followed by another $317bn in Bubble year 1999. The GSEs added another $822bn during the tumultuous 2000-2002 period. By the end of 2003, GSE assets had inflated to $2.4 Trillion, in the process playing an instrumental role in transforming the marketplace for mortgage finance, market-based Credit and speculative finance more generally.

In the late-nineties, I was explaining to anyone that would listen (basically no one) that the GSEs had evolved into quasi central banks. With the revelation of accounting fraud and malfeasance at Fannie and Freddie, the leveraged speculating community had lost their liquidity backstop. By then, however, the mortgage finance Bubble had gained such powerful momentum that a euphoric marketplace saw no reason to fret.

But as mortgage Credit came to so dominate the financial and economic systems, with each quarterly analysis of the Z.1 in the 2006/07 period I would contemplate how the system might function during the next period of market de-risking/de-leveraging. There was no doubt in my mind that the backstop function would rest exclusively with the Federal Reserve. Further, I believed a bursting of the Mortgage Finance Bubble would likely require Trillions of market liquidity support. The rest is history. I look at 2013 as nearing the “Twenty-year Anniversary of the Liquidity Backstop

Well, this is year five of the “global government finance Bubble.” This Bubble encompasses the world’s securities markets. Having played such a profound role in fueling this Bubble, it’s not easy for me to conceptualize how central bank balance sheets will now be looked upon to backstop global markets in the next major de-risking/de-leveraging episode. A serious global de-leveraging would require multi-trillions of liquidity support, which I fear at this point might unleash currency and market chaosGlobal central bankers have been doing everything possible to avoid a de-risking scenario.

The liquidity backstop issue becomes especially pertinent to the MBS marketplace. Pressure is (again) mounting for Fannie and Freddie to further shrink their holdings. It would appear they’re out of the market backstop business for good. Moreover, pressure mounts for the Fed to wind down its foray into mortgage support (“Credit allocation”). Meanwhile, as the Fed apparently prepares to back away from its historic experiment in suppressing market yields, the situation becomes only more intriguing. MBS are a particularly problematic security in a rising yield and extraordinarily uncertain market environment. Perhaps this helps explain why MBS yields are up 74 bps since May 1st and mortgage borrowing costs this week jumped to a 14-month high.

U.S. home buyers are not alone in confronting rising borrowing costs, while MBS investors have plenty of global company when it comes to contemplating prospective market liquidity backstops. Bloomberg’s William Pesek titled his most recent articleSpecter of Another Bond Crash Is Spooking Asia.” “Developingmarkets were this week showing heightened instability bonds, currencies and equities. The thesis of problematic underlying financial and economic fragility is coming to fruition.

Indonesian equities were hit for 5.2%, the Philippines 4.6% and Thailand 2.9%. South Korea’s Kospi sank 3.8%, and China’s Shanghai composite dropped 3.9% this week. India was down 1.7% and Taiwan fell 1.9%. Brazil’s Bovespa dropped another 3.5% (20-month low) and Mexico’s Bolsa fell 3.3%. And while Eastern European equities held up better than “developingAsia and Latin America, stocks in Turkey were slammed for almost 9% after an eruption of public protests and a rather undemocratic crackdown.

Market instability was certainly not limited to “developingmarkets. Currency market instability now worsens by the week. The yen abruptly surged 3% against the dollar this week. The yen has a huge hedge fund short position and has surely been a source of cheap carry tradefinance (sell yen and use proceeds to buy higher-yielding securities elsewhere). Moreover, the notion of Japanese institutions and retail investors flooding the world with liquidity as they escape the collapsing yen has played a not insignificant role in recent Financial Euphoria.

Nowhere did the perception of boundless Japanese buying power boost market sentiment more than in peripheral Europe. Notably, when the yen launched its Thursday melt-up, Spanish, Italian and Portuguese bonds were taken out to the woodshed (yields up 25, 23 and 27 bps, respectively). For the week, Portuguese 10-year yields jumped 54 bps to a six-week high (6.14%) – having now reversed the entireKuroda BOJ rally". Italian and Spanish yields ended the week somewhat higher, while their equities markets came under pressure. Notably, Italian stocks were hit for 3.0%. It is worth noting that European financial Credit default swap (CDS) prices jumped higher again this week – and it appears this important risk market has turned increasingly unstable.

Returning to the Fed’s Z.1 report, the Household Balance Sheet provides some of the most pertinent Bubble economy analysis. Household Net Worth (assets minus liabilities) inflated $3.0 TN during the quarter to a record $70.349 TN. One has to go back to the Bubble year 2005 ($6.308 TN) to surpass the recent one-year $6.164 TN gain in Household Net Worth.

It’s worth pondering a few analytical facts. Never has there been such a creation of (perceived) household wealth in the face of weak economic growth. Never has there been such a divergence between stagnant private-sector Credit expansion and inflating securities and asset prices. Never has there been such a strong correlation between federal debt and securities prices. And, I would add, never has there been massive QE in a non-crisis (non-deleveraging) market environment - directly fueling asset inflation.

I have posited that the Greek/European debt crisis was the first crack in the “global government finance Bubble”. Well, we are now witnessing the next important crack unfold in the “developingmarkets and economies. And I don’t think it’s a stretch to suggest that another very important crack is emerging in the U.S. bond market (MBS, Treasuries and corporates). U.S. equities markets have shown resilience, not a shocking occurrence with sentiment so bullish and near-term QE effects so powerful.

With the rapidly deteriorating global financial environment hitting an already fragile economic backdrop, it would be better for systemic stability if some air started to come out of the U.S. equities Bubble. But as Bubbles become deeply entrenched and increasingly speculative, it's more the nature of distended speculative Bubbles to disregard faltering fundamentals until it’s too late.

Above I noted the lack of a self-sustaining private-sector Credit upturn. Four years ago, I was writing that Washington’s reflationary gamble “was betting the ranch.” Increasingly, the marketplace is coming to better appreciate the fragility four years of Credit and financial excess has wrought upondeveloping economies. "Money" has begun to flee some of these markets, and the lesson of rapidly evaporating liquidity is learned the hard way - again. Confidence that large international reserve holdings would provide a Liquidity Backstop for the “developingmarkets is waning. Here at home, the surge in market yields (and widening spreads) in the face of the Fed’s $85bn portends future liquidity issues.

I noted above the “Twenty-year Anniversary of Market Backstops.” I wonder if historians will look back at this period as a strange aberration in financial history.

If the Fed really plans on reining in its bloated balance sheet, then the markets will at some point have to contemplate a world without liquidity backstops. From my perspective, that would ensure higher global yields, wider Credit spreads and larger risk premiums generally. In such a world, I would expect corporate profitsinflated by enormous deficits and further inflated by Fed monetization and financial engineering – would deserve higher discount rates and significantly lower equities market valuations. But for now, the focus will be on how the emerging markets dislocation and the unfolding globalrisk offplay out.