Out of Thin Air
By: Doug Noland
Friday, May 29, 2015
In its basic form, Credit is someone's promise to pay "money" at some point in the future.
Credit instruments are an "IOU." Importantly, new Credit/"IOUs" create additional purchasing power.
Especially late in prolonged Credit booms, financial instruments and claims come to account for enormous amounts of system "wealth." Crises are the process of rectifying the divergence that develops between financial wealth and actual underlying economic wealth. This process invariably unmasks the systematic wealth redistribution that gathered momentum throughout the boom cycle.
Borrowing language from Murray Rothbard, money (and Credit) can be created "Out of Thin Air."
Such Credit expansion is referred to as "Credit inflation." And, importantly, the resulting inflation in purchasing power can exert various price and other inflationary effects. It's a popular misconception that consumer price inflation is the prevailing and more dangerous type of inflation. Never has this been more apparent than right now.
Traditionally, banks and governments were the culprits responsible for Credit expansions that on occasion turned into runaway booms and devastating busts. There are excellent historical accounts and analyses of centuries of Credit Bubbles. Even so - and even post-2008 - central bankers remain more determined than ever to disregard Credit theory, history and analysis.
The current global Credit Bubble is unlike anything in history (and the analysis incredibly challenging). I've tried to explain its origin was the Federal Reserve's response to the early-nineties banking crisis. The Greenspan Fed spurred non-bank Credit growth that evolved into a historic Credit expansion. The upshot was a Bubble in Credit instruments intermediated through Fannie Mae, Freddie Mac and the Federal Home Loan Bank System. Closely related was a corresponding general boom in securitizations and derivatives, along with myriad Credit instruments involved in securities finance/leveraging ("repos," Fed funds, financial CP, special purpose vehicles, etc.). Over the years, I referred to this powerful new financial apparatus as "market-based Credit" and "Wall Street finance."
Updating Minsky's analysis, I coined the term "Financial Arbitrage Capitalism" to describe the period of the nineties through 2008. The extraordinary post-mortgage finance Bubble reflation compelled another analytical "update." We are now well into our seventh year of "Global Government Finance Quasi-Capitalism." There should be little mystery surrounding so-called "secular stagnation," as well as social stress and geopolitical friction.
The creation of "money" and Credit ("Out of Thin Air") throughout the market-based Credit apparatus evolved into history's most powerful Credit mechanism. It also proved fatefully contagious.
Unprecedented access to cheap mortgage (along with auto, Credit card, student loan, etc.) borrowings was granted to millions of individuals with deficient Credit histories. Similar dynamics created unimaginably easy Credit Availability for business borrowers. For sovereigns, the boom in market-based finance doomed the likes of Argentina, Iceland and Greece (to name only a few). Predictably, the resulting busts have been progressively more spectacular.
"Market-based" Credit has always been somewhat of a misnomer. Sure, the nineties saw Trillions of new Credit instruments trade freely in the marketplace at impressive valuations (i.e. narrow spreads to Treasuries). Yet the entire marketplace was constructed upon the explicit and implied guarantees from the Treasury and Federal Reserve. The resulting "moneyness" of this Credit apparatus ensured excesses neared catastrophic extremes.
The consensus view holds that today's financial backdrop is benign. Policymakers have learned from previous mistakes. There is nothing comparable to the excesses of subprime and Lehman Brothers.
The reality is that governments globally have now overtly commandeered so-called "market-based finance." Securities markets are openly manipulated. Trillions of securities have been monetized.
Prices and risk perceptions throughout global securities and derivatives markets have been perverted like never before. The upshot has been a globalized Bubble of unprecedented scope.
Looking back, the 2008/09 crisis was a case of major market distortions coming home to roost.
Today's global market distortions greatly overshadow those of 2008.
Backed by concerted government manipulation and intervention, global "money" and Credit have become fungible. Tens of Trillions of electronic debits and Credits spur the free-flow of "money" in and about global markets. Never have such enormous quantities of global securities and financial instruments been perceived as safe or low-risk ("money-like").
There are a few critical aspects to the backdrop worth keeping in mind. For all intents and purposes, it's become one enormous global Bubble - the U.S., China, EM, Europe and Japan.
Unfettered fungible "money" and Credit - "Out of Thin Air" - have provided both the fuel and the glue.
Especially after BOJ and ECB QE/currency devaluations - and the resulting flow of speculative finance to "king dollar" securities markets - tightly interrelated global Bubbles essentially converged into one. With China's renminbi tied to the U.S. dollar, the two super financial and economic Bubbles have for awhile now been closely interlinked. As cracks have surfaced in China - surely exacerbated by global competitive currency devaluations - Chinese and American Bubbles have become only further melded.
Throughout history, booms have been a source of major increases in perceived wealth and power. Yet Credit inflations and Bubbles are at their roots about wealth redistribution and destruction. Given sufficient time and opportunity, the creation of "money" and Credit "Out of Thin Air" will have profoundly adverse consequences and ramifications. And, indeed, this runaway global Credit inflation's deleterious effects are these days on display.
I'll borrow a Larry Lindsey quote from last week's CBB: "Because the government will not voluntarily let itself go out of business. It will use all of its powers - I'm not talking about just our government but any government - will use all of its powers in order to fund itself..."
So much of the world's wealth now hinges upon the global Credit Bubble. It's a given that governments around the world will use all their powers to fund themselves. Will they also use all their powers to protect their nation's wealth - real as well as perceived wealth that has inflated so profoundly during this boom? When government officials in today's increasingly hostile world focus on "security" matters, do they place financial security in equal footing with military security? And this gets to the heart of a critical facet of the globalized adoption of market-based finance: inflated securities market prices have become fundamental to a nation's wealth, national interests, political and social stability, and national security. In an increasingly polarized and spiteful world, who is now willing to take away the punchbowl?
At this point, global central bankers remain united in their cause. Military leaders are not. On the one hand, central banks around the world face similar pressures and remain motivated to work in concert to sustain both domestic Bubbles and the greater global Credit Bubble.
Government and military officials, though, are increasingly focused on a spectrum of pressing security issues - military, cyber, economic and financial. With the global pie no longer expanding, policies have turned inward looking and insecure. Integration and cooperation are giving way to antagonism and aggression. We saw it again this week.
And this framework helps explain what can appear a confounding paradox: In an increasingly troubling and uncertain world, global securities markets seemingly couldn't be more upbeat. At this point, markets remain fixated on central bankers. And the more antagonistic the geopolitical backdrop, the more confident market players have become that timid central bankers will fall in line.
There's too much to lose. Thursday WSJ headline: "Fed's Williams Says Never Use Rates to Prick Bubbles." Only use rates to inflate Bubbles.
My deep concerns for the global Credit Bubble are coming to fruition. The Chinese Bubble got completely away from officials. They recognized their predicament too late and too reluctantly.
Meanwhile, a complex geopolitical backdrop has unfolded. No longer is reining in Credit Bubble excess viewed as a priority. Chinese domestic fragilities were much greater than previously appreciated - and there's today no tolerance for risking a bust. Meanwhile, opting out of the inflating global Bubble would not be in China's interest. With the U.S., Japan and Europe desperately inflating a securities market Bubble, Chinese officials may have decided the risks of being the lone Bubble Popper were too great.
I believe future historians will look back at Russia's invasion of Ukraine as a major geopolitical and financial inflection point. Putin's speeches laid it out rather clearly: Russia can only be pushed around for so long. There is a line that can't be crossed - and the U.S. and the "West" crossed that line. Putin slammed the U.S. for blatantly violating Russia's vital national interests in neighboring Ukraine.
A year ago economic sanctions were going to discipline an "isolated" Russia. In a world of integrated markets and economies, changes in behavior could be dictated without resorting to tanks and bombers. Moreover, in this dispute between Russia and the West, China was viewed as neutral at worst. Putin's rants against U.S. domination of global finance, trade and security arrangements could be dismissed as a lunatic's senseless tirade.
The U.S. is now involved in an increasingly tense standoff with the Chinese in the South China Sea. Presidents Putin and Xi have become fast friends. And I just don't see aggressive behavior from Russian and Chinese governments as coincidental. They will both err on the side of belligerence.
Last year's Ukrainian crisis corresponded with serious cracks throughout the emerging markets, not to mention a collapse in crude (that Russia claims was orchestrated as punishment) and commodities. It quickly became an inopportune juncture for the Chinese to rein in their Credit Bubble. Instead, opportunity beckoned to begin building a formidable non-U.S. alliance and competing (non-dollar) global financial structure. This would require ongoing Chinese economic expansion and a stable currency. The Chinese must have viewed the benefits of a new global structure as exceeding the risks associated with accommodating additional Bubble excess. Moreover, imposing sanctions on Russia awakened the Chinese to the risks of something similar befalling their economy.
Global market Bubbles have benefited from the Chinese backtracking from Bubble containment. In the short-term, this lessened the risk of a Chinese financial accident. Similarly, having the Chinese focused on their currency attaining international reserve status has also reduced near-term risk of a disorderly currency devaluation. This has as well been pro-global Bubble.
Meanwhile, intermediate- and long-term risks are rapidly escalating. Regrettably, China has prolonged its "Terminal Phase" of excess, with dire consequences. Extending the life of the global Bubble comes with similar risks. At the same time, the building of a non-U.S. alliance and competing global financial infrastructure unfolds in earnest. Clearly, the Chinese military is preparing for a world that is changing in profound ways. The U.S. military has begun to adjust as well.
Global markets remain unsettled. The Chinese stock market Bubble has all appearances of an accident in the making. A Greek accident could be only days away. European periphery debt markets appear more fragile. EM seems more vulnerable. Currency markets are highly unstable. The dollar, bunds and Treasuries caught decent safe haven bids this week.
The age old problem with creating "money" is that once commenced in earnest it's extremely difficult to curb. There comes a point where the soundness of the underlying Credit structure begins to be questioned. Such questioning is well overdue. Do central bankers have any idea of their role in fomenting geopolitical turmoil? Just print "money" Out of Thin Air.