The Curse of Moneyness
February 20, 2015
As to new financial instruments, however, experience establishes a firm rule, and on few economic matters is understanding more important and frequently, indeed, more slight. The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory.
The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets. This was true in one of the earliest seeming marvels: when banks discovered that they could print bank notes and issue them to borrowers in a volume in excess of the hard-money deposits in the banks’ strong rooms. The depositors could be counted upon, it was believed or hoped, not to come all at once for their money. There was no seeming limit to the debt that could thus be leveraged on a given volume of hard cash. A wonderful thing.
The limit became apparent, however, when some alarming news, perhaps of the extent of the leverage itself, caused too many of the original depositors to want their money at the same time. All subsequent financial innovation has involved similar debt creation leverage against more limited assets with only modifications in the earlier design. All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”
John Kenneth Galbraith, "A Short History of Financial Euphoria"
As further proof that I don’t pander to readers, I’m back this week with additional monetary theory. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” I doubt Dr. Galbraith ever contemplated global central banks injecting Trillions of new liquidity directly into securities markets. Clearly, this cycle has seen absolutely momentous policy innovation – some subtly and much spurred obtrusively with post-Bubble policy convulsions. Understanding the nuances of the latest and greatest “reinvention of the wheel” provides a constant analytical challenge.
Financial innovation occurs more subtly and incrementally. Pay really close attention or you’re bound to miss it all. There are variations of financial instruments, institutions, market norms and government involvement. Success, real or perceived, ensures the envelope is pushed – in the markets and with policy. As we’ve witnessed, cumulative incremental policy experimentation over time can result in fundamentally revamped doctrine. In the markets and in real economies, incremental (“frog in the pot”) changes over the life of protracted booms can amount to profound transformations. And that is exactly what’s been experienced with “money” and monetary management.
The nineties saw the age-old issue of fractional reserve banking completely turned on its head.
The “evolution” to market-based Credit fashioned what I refer to as the “infinite multiplier effect” – “money” and Credit created, miraculously, out of thin air like never before. With their implicit government backing, the GSEs enjoyed unlimited capacity to issue new debt liabilities – fed by insatiable demand from both home and abroad. During the mortgage finance Bubble, Wall Street relished in the capacity for seemingly limitless issuance of “money”-like mortgage- and asset-backed securities, most guaranteed by the GSEs that were backed by the federal government.
The phenomenal policy response to the bursting of the mortgage finance Bubble unleashed the “global government finance Bubble”. The world has now seen the evolution of unfettered electronic “money” advance to its final act, with profound yet unappreciated ramifications. For the past twenty-five years, each new Bubble has seen the scope of “money” widen to the point of ensuring Credit expansion sufficient to reflate increasingly impaired financial and economic systems. Yet each reflationary episode only compounded global financial imbalances and economic maladjustment. These days, concerted desperate reflationary measures see perilous expansion at the heart of “money” and at the very foundation of global Credit.
When, in the early-nineties, the U.S. banking system (impaired from “decade of greed” excess) had lost the capacity to create sufficient “money” (largely deposits), an extraordinarily accommodative Greenspan Fed ensured that non-bank “money” (largely “repo” and short-term GSE liabilities) creation took up the slack.
In the post-tech Bubble landscape, the notion that policymakers would be willing to condone “helicopter money” and the “government printing press” ensured “money” creation broadened to the realm of the securitization marketplace. Since the bursting of that historic Bubble, it has been left to unprecedented expansion of central bank Credit to provide the necessary “money” to keep the ever-rising mountain of global debt from imploding. For something so important, it’s stunning how little attention is paid to the saga of contemporary “money.”
Over the years, I’ve argued that booms fueled by high-risk “junk” bonds don’t warrant undue concern. Invariably, the marketplace’s response to over-issuance includes a waning appetite for risk. Demand for new junk debt begins to dissipate, ushering in a period of Credit tightening and risk aversion. Importantly, attention to risk and attendant finite demand for increasingly risky debt instruments work to limit the duration of the boom cycle. This ensures that excesses and resource misallocation have insufficient time to impart deep structural maladjustment. The market pricing mechanism promotes self-regulation and adjustment.
Importantly, it goes unappreciated that “money” is incredibly dangerous when compared to even high-risk Credit. Money is special. Enjoying insatiable demand, “money” is prone to gross over-issuance. It is for the most part detached from market regulation and self-correction.
Moreover, when this “money” gravitates to asset and securities markets, resulting pernicious inflationary effects are either ignored or misunderstood in policy circles (in contrast to traditional consumer price inflation). Credit is inherently unstable. The perceived stability of money masks a dangerously capricious nature.
Governments widen the domain of perceived money-like instruments at the system’s peril.
There are heavy costs that come with printing Trillions, guaranteeing market liquidity, monkeying with risk perceptions and directly inflating securities markets. Once commenced, a self-reinforcing cycle of monetary over-issuance (“inflation”) will be sustained so long as confidence holds. Indeed, global “do whatever it takes” monetary management has had momentous effect on market faith in “money” and the perceived safety (“moneyness”) of risk assets worldwide.
In desperation, the world’s major central banks have resorted to the “nuclear option” of issuing Trillions of new “money” backed by nothing more than their willingness to create endless additional quantities. Also unique from a historical perspective, central banks inject this new “money” directly into securities markets. Distortions to global markets and economies have been unparalleled. Having evolved incrementally over decades, the previously unimaginable is today accepted as reasonable and rational. Central bank “money” – along with pledges to print as much as necessary - dictates market behavior like never before.
As a long-time market analyst, I can attest to profound changes in the way markets operate. Traditionally, a boom experiences progressively riskier behavior. The quality of Credit issued over the course of the boom deteriorates - as the scope of speculation and leveraging elevates.
Risk grows exponentially in the boom’s final phase. As such, it is the riskiest segments of the marketplace that are to be monitored closely for indications of a cycle’s turning point. Risk aversion at the “periphery” traditionally marks an infection point. Simplistically, the expanding quantity of Credit required to sustain the boom inevitably confronts the harsh reality of waning demand for increasingly suspect Credit instruments.
Traditional analysis, however, has been usurped by the phenomenon of concerted unfettered central bank “money” printing. These days, stress at the periphery ensures ever more aggressive monetary inflation. And with today’s specter of incessant global financial and economic fragilities, market operators appreciate that policymakers are trapped in a policy of round-the-clock liquidity injections and market interventions. Persistent trouble at the “periphery” and latent fragility at the “core” cultivate history’s most prolonged global Credit and speculative cycles.
Growth in the global leveraged speculating community took off in the early-nineties. The Greenspan Fed had slashed rates and aggressively intervened in the government debt markets.
As Greenspan willingly manipulated rates, the yield curve and marketplace liquidity, longer-dated government and mortgage bonds began to reap the benefits of “moneyness” like never before. After more than twenty years of incremental policy activism, market intervention across all classes of has become commonplace for central bankers around the world. I have referred to this anomaly as “The Moneyness of Risk Assets.”
There’s another very important aspect of Monetary Analysis that also evolved from the nineties.
As market-based “money” and Credit took shape in the U.S., the unfolding Credit boom had a profound impact on the world’s monetary anchor. Globally, persistently huge U.S. Current Account Deficits unleashed a dollar liquidity onslaught. This profoundly altered the incentives and general backdrop for financial speculation. On the one hand, easy “hot money” returns began spurring spectacular booms and busts (i.e. Mexico, the Asian “Tigers,” Argentina, Iceland, etc.). On the other, an unstable late-nineties global securities market backdrop propelled “king dollar” and increasingly precarious U.S. securities Bubbles.
The U.S. “tech” (and king dollar) Bubble burst in 2000, provoking previously unthinkable monetary stimulus. I would strongly contend that without the unsound dollar (and Fed policy), the world would have adopted a more skeptical view of the euro monetary experiment. And without such a strong euro (relative to the dollar), Greek and the European periphery debt would have never enjoyed The Curse of Moneyness. It would be a different world today.
The latest and (to that point) greatest U.S. Credit boom burst in late-2008/2009, unleashing only more egregious monetary inflation. By this point, monetary mismanagement and ongoing massive Current Account deficits ensured a deeply flawed global “reserve currency”. This extraordinary backdrop was fundamental to the perception of “moneyness” for China’s currency and Chinese Credit more generally. Only in a highly abnormal global monetary backdrop would the marketplace afford a strong Chinese currency in the face of a four-fold surge in Chinese bank Credit (not to mention “shadow” liabilities) to $28 Trillion. Only a defective global financial system would ascribe “moneyness” upon Credit instruments fueling the greatest economic maladjustment, asset inflation and systematic corruption of all-time. The ongoing historic Chinese Credit boom has forever changed the world.
Last weekend’s Financial Times (Tom Burgis) included a thought-provoking article, “Nigeria Unravelled - Oil should have made the country rich. Instead, it has distorted its economy, corrupted its political class, paved the way for Boko Haram — and killed off a thriving textile industry.”
The piece was actually less about oil and more about how cheap Chinese textiles smuggled into the country destroyed Nigeria’s domestic textile industry – and the communities it supported. I couldn’t help but to ponder how global monetary mismanagement, oil and commodities price booms, and massive Chinese overinvestment have conspired to wreak bloody havoc around the world.
While the weekly expansion of radicalism garners headlines, Greece remained the markets’ focus again this week. Basically, there remains some concern for “Grexit,” although market participants have been trained to heavily downplay such risks. And, sure enough, it appears a compromise has been reached that will at least kick the Greek can down the road for a few months.
And, interestingly, the analysis does come back to money. Fundamental to sound money is that debts do settle. One cannot just accumulate debt and expect confidence in the underlying obligations to hold forever.
Yet in today’s world debts don’t settle – they just keeps expanding and expanding – Greece, the U.S., China, Japan, Brazil, EM and “developed.” Greece does not have the economic wherewithal to service its huge debt load. The inflationists call for the Germans and the eurozone more generally, to use the “moneyness” of their obligations to provide additional assistance to Greece. The Germans and others understand that additional wealth transfers risk impairing EU Credit more generally – the old “throwing good money after bad.”
The problem these days is that it’s quite difficult to identify good money to throw – or, better yet, to save for a rainy day.