Greenspan on Bubbles

Doug Nolan

Bloomberg’s Tom Keene (Monday, June 27, 2016): “If I take Paul Krugman and Alan Greenspan’s primal cry, ‘we want simple models.’ Is our solution now to think simple or is there a value to the complexity of globalization and the complexity of institutions? Which way should we turn now?”

Alan Greenspan “You want to have as simple a model as you can get that actually captures the complexity of the forces in play… The FRBUS (Federal Reserve Board US) model… that model works exceptionally well for the non-financial area… The financial model was awful. It captured nothing. It didn’t grasp what the issue is. And I tried to reproduce what I would do in ‘The Map and the Territory 2.0’… And I demonstrate what we have going - that we don’t measure correctly - are bubbles and their implications. Bubbles per se are not toxic. The 2000 bubble collapsed. We barely could see a change in economic activity. On October 19, 1987, the Dow Jones went down 23% in one day. You will not find the slightest indication of that collapse of that bubble in the GDP number – or in industrial production or anything else. So I think that you have to basically decide what is causing what. I think the major issue in the financial models has got to be to capture the bubble effect. Bubbles are essentially part of of the fact that human nature is not wholly rational. And you can see it in the data very clearly.”

As Mr. Greenspan spoke on Bloomberg Radio Monday morning, the UK’s FTSE 100 Index was trading just above 6,000. Europe’s STOXX 600 Banks Index was down 7.2% for the session at 120. Germany’s DAX index was quoted at 9,370. Also suffering post-Brexit effects, S&P500 futures were trading just above 2000. Bloomberg ran the headlines: “Greenspan: Brexit ‘Terrible Outcome in All Respects.’” “Greenspan: Euro is Unstable Currency.” The former Fed chairman was extraordinarily gloomy on the UK, Europe and the world. Markets that morning appeared wholly rational.

Yet market rationality was not wholly apparent the rest of the week. The FTSE rallied a full 10% off of Monday’s lows. European banks jumped almost 7.0%. The DAX ended the week at 9,776, up 6.2% from Monday’s lows. The S&P500 rose 5.0% from the Monday low, and the biotechs rallied more than 10%.

I’m no fan of Alan Greenspan, but he remains impressively sharp for a man of 90. I appreciate his analytical focus on Bubbles, though his framework is deeply flawed. At their core, Bubbles are about Credit excess and market distortions. Major Bubbles almost certainly have a major government component. They are indeed toxic, seductively so. Had the Greenspan Fed not backstopped the markets and flooded the system with liquidity post the ’87 Crash, Credit would have tightened and bursting Bubble effects would have been readily apparent throughout the data. Instead, late-eighties (“decade of greed”) excess ensured spectacular Bubbles in junk debt, M&A and coastal real estate. It’s been serial Bubbles ever since.

One could reasonably argue that Bubble toxicity has for almost 30 years been diluted with the tonic of recurring Credit and speculative excess. Non-financial debt expanded 9.2% in 1988, a slight increase from ‘87’s 9.0%. Corporate borrowings accelerated to a blistering 10.9% the year following the crash, as much of the economy maintained a strong inflationary bias. After slipping to 4.8% with the bursting of “tech Bubble” in 2000, non-financial debt growth jumped to 5.8% in 2001, 6.7% in 2002, 7.7% in 2003 and 9.2% in 2004. Beginning in 2001, household mortgage debt expanded at a double-digit annual pace for six straight years, as mortgage finance and housing demonstrated powerful Bubble Dynamics.

Alan Greenspan these days laments public anger, entitlements and stagnant productivity growth – all on a global basis. But what should we expect after decades of Bubble-induced resource misallocation, malinvestment and wealth redistribution? Myriad Bubble-related issues have finally risen to surface. The dilemma for policymakers is that there’s no New New Bubble of sufficient proportions to reflate the global economy. Frantic efforts to reflate through securities markets inflation have at this point nurtured interminable financial and economic fragilities.

Conventional analysis views the U.S. equities market as notably resilient, with trading action confirming the ongoing bull market. From my perspective, this week’s trading is further evidence of dysfunctional markets. The U.S. stock market casino in particular has reached the point of being incapable of discounting the deteriorating fundamental backdrop. And any doubts that securities markets are now virtually commanded by global central banks can be put to rest. Policymakers continue to foment dangerous Bubble Dynamics. Is it human nature and the markets that have a propensity toward irrationality, or is the culprit instead hopelessly flawed monetary management?

There’s surely no better mechanism available for quick gains in the marketplace than a short squeeze. Throw in a global pool of speculative finance of now unimaginable dimensions – coupled with heavy hedging and shorting activity and a proliferation of Crowded Trades – and one has the firepower necessary for wildly unstable markets with a propensity for destabilizing melt-ups. That’s where we’re at. Performance pressure has become so intense that no rally can be missed.

It’s been Only 19 Weeks since I titled a CBB “Crisis Management.” Market tumult back in January and February forced global central bankers into ever more desperate measures. Risk markets rallied strongly, though policy measures have demonstrated notably shorter half-lives. Moreover, policies are clearly having much more pronounced impacts on the Financial Sphere than upon the Real Economy Sphere.

June 30 – Financial Times (Adam Samson): “The universe of negative-yielding government debt has increased by more than $1tn in the last month to reach a high of almost $12tn in one of the most tangible results of Britain’s decision to leave the EU… Low sovereign bond yields reflect gloomy economic outlooks and expectations of central bank stimulus. In turn a record $11.7tn of global sovereign debt has now entered sub-zero territory — an increase of $1.3tn since the end of May…”

UK yields sank to record lows this week, with 10-year gilt yields ending down 22 bps this week to 0.86%. And despite the big equities rally and surging risk markets generally, the British pound has taken Brexit seriously, sinking 3.0% this week to a 30-year low. With London as Europe and much of the world’s financial center, investors needn’t be bothered with fundamental factors such a perpetual Current Account Deficits and massive external debts. Suddenly many things have changed.

In a way, the UK is the poster child for financial Bubble maladjustment. I would strongly argue that it’s no coincidence that after residing at the center of contemporary finance, it is the UK that now finds itself at the epicenter of disenchantment with European integration and globalization more generally. The UK economy has deindustrialized, as the economic focus shifted to finance and services. As a global financial hub, enormous amounts of wealth have gravitated to London, enriching the fortunate few while papering over deep structural deficiencies. Meanwhile, with much of the population suffering from economic stagnation and egregious wealth disparities, the backlash against “globalization” has reached a turning point.

I would contend that globalization is not the true culprit, just as I argue that Capitalism is certainly not the root of all evil. The problem lies with unfettered finance and monetary mismanagement. Pricing mechanisms and resource allocation, the lifeblood of free-market Capitalism, will not function well within a backdrop of unlimited cheap finance. Similarly, so-called “globalization” is destined for failure in a backdrop of limitless financial claims.

I remain a proponent of “free trade.” Yet in the long-term it’s imperative that trading relationships involve exchanging things for things, rather than IOUs for things. I would go so far as to argue that this simple concept would go a long way toward nurturing healthy trading relationships, sound economic underpinnings and a more stable global financial backdrop.

For decades now, the U.S. and UK became accustomed to exchanging IOUs for goods and services. It has worked miraculously, or seemingly so. Consequences have included deep economic maladjustment and a world inundated with debt/financial claims. Look no further for the root cause of endemic financial instability and serial boom and bust dynamics that now afflict the entire world.

I wish to be clear: I am not arguing for barter between individual nations. Trade deficits and surpluses can exist between individual countries. But overall, countries should avoid running persistently large overall Current Account Deficits. Deficits with some countries should be offset by surpluses with others. Persistent trade deficits should be countered with tighter monetary policy.

The pound closed Friday trading near 30-year lows. British IOUs, in currency terms, have been devalued about 10% since Brexit. How robust is Britain’s economic structure if it loses the benefits associated with being Europe’s financial hub and with it financialization more generally? 

Benefiting from the prospect of aggressive monetary stimulus and devaluation, UK stocks participated in this week’s global equities rally. Notably, UK bank stocks were slammed hard again Monday and closed Friday down for the week.

Bank stocks again badly lagged during this week’s global rally. Deutsche Bank (the IMF’s “most important net contributor to systemic risks”) dropped another 7% this week (to a 30-year low), increasing 2016 losses to almost 44%. Italian bank stocks sank another 5.4% (down 54% y-t-d), as talk turned to contentious issues such as rescue packages and measures to avert bank runs. While European equities indices rallied, Europe’s STOXX Bank index declined 2.4% (down 31% y-t-d). And despite Japan’s Nikkei 225 equities index rallying 4.9%, the TOPIX Banks Index slipped 0.4% (down 37% y-t-d). The S&P500 jumped 3.2% this week approaching record highs, while the banks (BKX) rallied only 1.1% and the broker/dealers (XBD) ended the week little changed.

Central banks lined up this week to offer support for vulnerable financial markets. Post-Brexit mayhem created a critical juncture, and policymakers got the market bounce they desperately needed. Clearly, central bankers retain the capacity to incite powerful short squeezes. There was considerable hedging going into the UK referendum, and the unwind of derivative trades and short positions provided fuel for this week’s recovery.

But it’s one things inciting higher prices in an over-liquefied Financial Sphere and quite another stimulating sustainable activity in the maladjusted Real Economy Sphere. Indeed, I’ve argued that a fundamental risk associated with inflationist monetary policies is the widening divergence between inflated securities markets and deflating economic prospects. This schism widened meaningfully this week.

Certainly, fixed income, the precious metals and global bank stocks view the world much differently than equities. Pondering such an extraordinary backdrop, I’ll return to Greenspan. 
Bubbles are toxic and, regrettably, toxicity has been accumulating for several decades. Fissures in global finance – the Financial Sphere - have uncovered pernicious forces undermining economies and societies around the world.

It was also a fascinating week in the commodities and currencies. Gold stocks (HUI) surged 8.9%. Silver jumped 11.6% and copper rose 5.0%. The commodities currencies caught bids versus the dollar, with the Brazilian real gaining 4.1%, the South African rand 3.5%, the Mexican peso 3.0%, the Norwegian krone 1.1%, the Canadian dollar 0.7%, the New Zealand dollar 0.7% and the Australian dollar 0.4%. EM equities were notable strong. Stealth U.S. dollar weakness and/or anticipation of QE4?

Everyone knows the U.S. economy is the “least dirty shirt.” We all appreciate that U.S. financial markets win by default in such a messed up world. “Money” has to go somewhere. 
London may be Europe’s financial hub and the UK the poster child for globalization/financialization. But a strong case can be made that the U.S. economy is more dependent on Wall Street and securities market inflation than anyone. More than ever before, take away asset price inflation and the U.S. economic structure will reveal serious deficiencies. 
And even after succumbing to desperate measures, global central bankers are at this point failing at global reflation.

I’m remain comfortable with the view that Brexit is a catalyst for a crisis of confidence in Europe and European integration. And despite a surprising burst of equity market exuberance, I suspect Brexit will, as well, be recognized as a key inflection point for the realm of globalization/financialization. This bodes ill for U.S. and Chinese economies.

Global markets at this point seem rather convinced that a lot more QE is in the offing. Bond markets are confident that this liquidity deluge will have minimal lasting real economy impact. 
It’s a replay of 2007/08, when mortgage finance, global M&A and equities kept dancing, but safe haven bonds knew the party couldn’t last. Objectively, $12 TN of negative yielding bonds is about the strongest evidence I could have imagined that central bank inflationism and a multi-decade global Bubble are nearing the end of the line.

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