Financial Sphere Bubbles
by Doug Noland
November 15, 2014
Alan Greenspan, interviewed by the Financial Times’ Gillian Tett at the Council on Foreign Relations, October 29, 2014:
Greenspan: “One of the things that I used this book (“The Map and the Territory”) to write was to develop a concept of how do you shift from a system where everybody is acting rationally – which is what all our models basically said – to one where reality is where people are acting intuitively, various different types of forms. Irrationality is in many respects systematic – you can model it. And indeed I show in many cases why for example fear is demonstrably a much stronger force than euphoria… This is the type of thing that I think we’ve got to understand. And one of the reasons why I say, as a conclusion in this book, that the non-financial parts of our economy behave very well. They are highly capitalized, and essentially it is a financial system which is totally divorced – a different function than the type of things we do in the non-financial area. One (the financial sector) has to do with the allocation of savings into investment. That is where “animal spirits” really run wild.”
I am compelled this week to return to Greenspan’s comments. They provide a good opportunity to take a deeper dive into my favorite “Financial Sphere vs. Real Economy Sphere” analytical framework. There’s no more important subject matter – anywhere.
It’s nebulous. Yet let’s attempt to put some broad parameters around the concept of “Financial Sphere.” It broadly comprises the “Credit system” and “financial markets.” It encompasses “financial assets” – certainly including all securities (equities and fixed-income) and Credit instruments more generally. Importantly, “financial markets” includes myriad types of financial obligations and derivatives.
The “Financial Sphere” includes the financial liabilities of the household, corporate and government sectors. It includes the assets and liabilities of the financial sector, including the banks, securities broker/dealers, finance companies and insurance companies. These include liabilities traditionally viewed as the “money supply”, including currency, bank deposits and money fund assets. It includes the assets and liabilities (debt and MBS) of the GSEs. The Financial Sphere encompasses the assets and liabilities of the “leveraged speculating community.” Importantly, especially over recent years, the Financial Sphere also includes Federal Reserve liabilities.
The “Financial Sphere” is tasked with critical functions. Through lending, it provides the purchasing power necessary to drive both spending in the Real Economy and purchases throughout the assets markets (real and financial). Financial Sphere includes various forms of risk intermediation, including intermediating interest-rate, Credit, market and, perhaps most importantly, liquidity risks. This crucial risk intermediation function can be seen prominently in the asset/liability structure of banking system, along with GSE, securities broker/dealer and securitization (“trust”) balance sheets. Money funds, mutual funds and exchange-traded funds (ETFs) play an important intermediation role. The expansive global derivatives marketplace has come to provide a profound intermediation role within the Financial Sphere. The hedge funds and global speculator community, with their prominent use of securities-based leverage and their short-term trading focus, have also come to operate as integral “Financial Sphere” participants - providing the marginal source of securities marketplace liquidity.
Let’s cut to the chase: it’s my view that Depressions and deflationary collapses are primarily the consequence of a crisis of confidence in the soundness and viability of the Financial Sphere.
And I would argue Financial Spheres collapse only after prolonged periods of Bubble excess - protracted excess invariably made possible with active governmental interventions, manipulations and inflations. Basically, the issue is a general loss of confidence – a loss of faith in the Financial Sphere’s capacity to expand sufficient system Credit and/or to effectively intermediate risk – a lack of confidence in the underlying Credit and financial structure – a loss of confidence in policymaking. As in the Real Economy Sphere, the degree of dislocation during the Financial Sphere bust is proportional to preceding boom-time excesses. The scope of cumulative boom-time Financial Sphere expansion, risk intermediation and related financial and economic system distortions chiefly determines the degree of systemic fragility (i.e. the risks of a crisis of confidence and financial collapse).
The contemporary Financial Sphere is unrecognizable from those of the past. Traditionally, there would be a supply of money available in the system along with a Credit apparatus largely dominated by bank lending and government debt issuance. The conventional view holds that a gold standard regime ensured that gold backing limited the issuance of a country’s currency.
That’s fine. Yet I tend to think more in terms that a commitment to sustaining a gold standard regime cultivated norms, behaviors and standards that worked to keep the general Financial Sphere in check. Importantly, there were mechanisms that encouraged self-correction and adjustment.
Traditionally, the Financial and Real Economy Spheres expanded/inflated in tandem. After all, the chief function of the financial sector was to provide Credit and finance for economic enterprise. Even in the event of overheated conditions in finance and the real economy, Financial Sphere ballooning would translate into a synchronized economic boom with generally rising price levels.
It’s fair to say that things changed heading into and after the U.S. dropped dollar convertibility into gold in the early-‘70s. Yet the most profound Financial Sphere transformation unfolded during the nineties. Monetary policy evolved (i.e. rate and yield curve manipulation, market backstopping) that incentivized financial leveraging and asset market speculation. The GSEs, with their implicit federal backing, became a major factor spurring explosive Financial Sphere inflation, both from a Credit expansion and risk intermediation perspective. “Activism” on the part of both the Fed and GSEs nurtured unprecedented growth in “Wall Street finance” – including securitizations and derivatives. Readily available cheap funding; reliable market liquidity backstops; and a general inflationary bias spurred incredible growth in the hedge fund community and global leveraged speculation more generally.
There’s a couple of key points: First, unique from a historical perspective, the contemporary Financial Sphere operated completely unhinged from gold backing; restraints imposed by currency regimes; and even bank reserve and capital requirements. Traditional central bank angst for rapid Credit expansion, current account imbalances and speculative excess were tossed out the window. Instead, central bankers became proponents for Credit expansion, aggressive risk intermediation and inflating securities markets.
The second key point is related to the first and is just as critical: The unrestrained Financial Sphere became increasingly divorced from the real economy. In particular, Fed and GSE-related market distortions incentivized asset-based lending, leveraging and speculation. Not surprisingly, this newfangled Credit system dominated by asset-based lending and speculating became increasingly unstable. A period of serial asset Bubbles took hold, domestically and internationally.
A book (or two) could – should – be written documenting and explaining the momentous consequences of Bubble Dynamics overwhelming the Financial Sphere of the world’s reserve currency. In short, beginning back in the nineties, massive U.S. Current Account Deficits and unfettered speculative finance flooded the world with dollar-based liquidity. By late in the decade, spectacular bursting EM Bubble contagion coupled with a (Fed-incited) runaway securities boom in the U.S. fueled a destabilizing king dollar dynamic. Later, post-“Tech” Bubble (“helicopter money”) reflationary measures spurred dollar devaluation, in the process unleashing powerful Credit booms throughout the Eurozone, Asia and more generally around the globe.
Meanwhile, increasingly unstable global finance and extreme economic imbalances ensured that global central banks adopted Federal Reserve policy activism. This process took a giant leap with the 2008 crisis. The Bernanke Fed’s adoption of unprecedented monetary measures unleashed global central bankers to pursue experimental “do whatever it takes” policies completed divorced from traditional central bank doctrine. Fed policies and resulting dollar devaluation provided EM and China unprecedented capacity to inflate Credit and fuel financial and economic booms: the “global government finance Bubble.”
Bernanke presided over further momentous Financial Sphere developments. For one, the Financial Sphere became more of a global phenomenon, spurred on by concerted reflationary monetary policy measures. Furthermore, a globalized Financial Sphere was the product of closely interlinked securities and derivatives markets; the proliferation of cross-border financial flows; readily accessible cheap securities-based lending on a globalized basis; and, more generally, by the vast and inflating pool of speculative finance that tied together global financial markets.
If globalized finance dominated by policy “activism” and distortions wasn’t enough, the Global Financial Sphere Bubble became only further divorced from real economies. And it is here that I believe future historians will see the catastrophic flaw in Bernanke’s policy doctrine: the belief that “money” printing and zero rates would inflate a general price level and reflate the economy out of debt problems; that the so-called “wealth effect” from inflating securities prices would spur spending, risk-taking and sustainable economic recovery.
From the perspective of my “Financial Sphere vs. Real Economy Sphere” analytical framework, inflating the contemporary Financial Sphere in hope of spurring sustainable economic recovery is an absolute fool’s errand. It’s nothing short of reckless. To inflate Financial Sphere excess based on Real Economy Sphere indicators (i.e. GDP, the unemployment rate or CPI) is lunacy. After all, we have ample historical evidence of a Financial Sphere dynamics detached from the real economy. And especially after the past two years, we know the separate Spheres have price dynamics completely divorced from each other (wild securities price inflation vs. disinflationary forces commanding consumer price aggregates).
As I’ve repeated on numerous occasions, there is no general price level for the Fed or global central bankers to manipulate and control. The domain of their reflationary policies is within the Financial Sphere and financial asset prices. And we’ve already witnessed how aggressive Global Financial Sphere inflationary measures can actually fuel disinflationary forces in real economies. I would argue that Financial Sphere inflation is little more than wealth redistribution. Moreover, the inequitable distribution of wealth (from most to a fortunate few) is a major force behind underperforming economies (“insufficient demand”) around the globe. I would further contend that Financial Sphere inflation spurs resource misallocation, certainly including mal- and over-investment around the globe. The Global Financial Sphere Bubble has certainly been instrumental in stoking a protracted capital investment Bubble in China and throughout Asia.
I’m sick of hearing the sympathetic “central banks are only game in town.” It’s just hard to believe at this point that flawed central banking is not held accountable for the mess it’s made of things. Greenspan and Bernanke argue that it’s not the responsibility of central banks to prick Bubbles. The Bernanke doctrine held that Bubbles could be allowed to run, with enlightened post-Bubble “mopping up” measures waiting to reflate markets, price levels and economies. But bursting Bubbles and the resulting realization of gross wealth redistribution and economic stagnation leave politicians in a bind. Massive “mopping up” monetization and deficit spending are dangerously divisive issues. Central banks become the “only game” because they operate largely outside the political process, have the unique capacity to create rules as they go along, and dictate policies in an area that very few understand. Today’s sophisticated inflationism is even more seductive than its predecessors.
When the Financial Sphere runs amuck, things can really run amuck. Over relatively short periods of time market prices can become precariously detached from real economy fundamentals. After all, pricing dynamics are quite divergent between the Financial Sphere and the Economic Sphere. In the real economy, supply and demand interact in determining price. Additional supply leads to lower prices. Lower prices lead to more demand. The Financial Sphere is a different animal. More supply of finance leads to higher prices of financial assets. Higher financial asset prices spur greater demand. Central bank intervention to spur Credit growth and asset price inflation will incite speculative Bubbles. Aggressive post-Bubble “mopping up” will ensure only bigger Bubbles.
The Fed and global central bankers gambled that Financial Sphere intervention, manipulation and inflation would spur real economy reflation. It’s clear they’re playing a losing hand – it is also apparent that they are not willing to admit their flaws, failings or predicament. The harsh reality is that central bankers cannot escape Financial Sphere fragility.
When Global Financial Sphere fragility turned acute back in the summer of 2012 (i.e. Italy, European banks and the euro), Draghi, Bernanke and Kuroda adopted unprecedented measures. They bought some time but at major costs, including the U.S. securities Bubble, a Bubble in European sovereign debt and unprecedented global leveraged speculation (how big is the “yen carry trade”?). Several weeks back there were indications that Global Financial Sphere fragility was resurfacing. And there were indications from Fed officials that more QE could be forthcoming, while Draghi and Kuroda came with more shock and awe monetary stimulus.
The latest Fed, ECB and BOJ show did wonders for U.S. and Japanese stock prices. Yet yen and euro devaluation bolstered king dollar, much to the expense of commodity-related companies, currencies and countries. Russia’s ruble was hit again this week, as geopolitics turned only more disconcerting. There was also further indication of acute fragility unfolding in Brazil. The Brazilian real dropped 1.65% and 10-year (real) yields jumped another 36bps to 12.92%. Venezuela 10-year bond yields surged 123 bps to 19.73%. It’s also worth noting that Mexican stocks were hit for 2.8%. All in all, evidence mounts of serious EM vulnerability. I’m sticking with the view that the global Bubble has been pierced and that contagion risks are mounting. As for U.S. equities, the level of bullishness and complacency is just incredible.
Apparently nothing can get in the way of the mighty year-end rally.