A speculative bubble like no other - 22 March 2007
BANKERS to the world's central banks, the Bank for International Settlements (BIS) recently published a study entitled Monetary and Prudential Policies at a Crossroad?
It notes that:
"Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth. The serious costs of financial repression around the world have been well documented. But financial liberalization has also greatly facilitated the access to credit...more than just metaphorically. We have shifted from a cash flow-constrained to an asset-backed economy."
Though we basically agree with the analysis and the conclusions of the study, we radically disagree with that one sentence.
"Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth," says the BIS.
But the indispensable first condition for proper resource allocation at a national as well as global scale is avoidance of excessive money and credit creation. In many countries, and in particular in the United States, they are excessive as never before.
If Mr. Bernanke complains about irregularities of M2, this is nothing in comparison with the fact that credit and debt growth in the United States has exploded for more than two decades. When Mr. Greenspan took over at the helm of the Fed in 1987, outstanding debt in the United States totaled $10.5 billion. In less than 20 years, this sum has quadrupled.
In reality, this significantly understates the rise in debts because, for example, highly leveraged hedge funds with trillions of outstanding debts are not captured. In 1987, indebtedness was equivalent to 223% of GDP, which was already pretty high. Lately, it is up to 317% of GDP.
In actual fact, there used to be a very stable relationship between money or credit growth and GDP or income growth until the early 1980s. Growth of aggregate outstanding indebtedness of all nonfinancial borrowers – private households, businesses and government – had narrowly hovered around $1.40 for each $1 of the economy's gross national product. Debt growth of the financial sector was minimal.
The breakdown of this relationship started in the early 1980s. Financial liberalization and innovation certainly played a role. But the most important change definitely occurred in the link between money and credit growth to asset markets. Money and credit began to pour into asset markets, boosting their prices, while the traditional inflation rates of goods and services declined.
The worst case of this kind at the time was, of course, Japan.
Do not be fooled by the sharp decline in consumer borrowing into the belief that money and credit has been tightened in the United States. Instead, borrowing for leveraged securities purchases (in particular, carry trade and merger and acquisition financings) has been outright rocketing, with security brokers and dealers playing a key role.
Over 2006, their net acquisitions of financial assets ran at an annual rate of more than $600 billion, more than double their expansion in the past. Federal funds and repurchase agreements expanded in the third quarter at an annual rate of $606.3 billion, or an annual 26%. The main borrowers were brokers and dealers.
During the first three quarters of last year, their assets increased $427 billion, or 27% annualized, to $2.57 billion. A large part of the money came from the highly liquid corporations.
In short, there is no reason to wonder about low and falling long-term interest rates.
All this confirms that financial conditions remain extraordinarily loose. Even that is a gross understatement. Credit for financial speculation is available at liberty. Expectations for weaker economic activity only foster greater financial sector leverage.
Why such unusually aggressive speculative expansion in the face of a slowing economy?
The apparent explanation is that the financial sector intends to make the greatest possible profit from the coming decline of interest rates, promising further rises in asset prices against falling interest rates. While the real economy slows, the leveraged speculation by the financial fraternity goes into overdrive. Principally, there is nothing new about such speculation.
New, however, is its exorbitant scale.
In the US financial sphere, the year 2006 has set new records everywhere: records in stock prices, records in mergers and acquisitions, records in private equity deals, record-low spreads, record-low volatility. Manifestly, there is not the slightest check on borrowing for financial speculation. There is epic inflation in Wall Street profits.
One wonders what can stop this unprecedented speculative binge. Pondering this question, we note in the first place that the gains in asset prices – look at equities, commodities and bonds – have been rather moderate. To make super-sized profits, immense leverage is needed. We think the speculation is unmatched for its scope, intensity and peril. Plainly, it assumes absence of any serious risk in the financial system and the economy. The surest thing to predict is that the next interest move by the Fed will be downward.
In our view, the obvious major risk for speculation is in the economy – that is, in the impending bust of the gigantic housing bubble. Homeownership is broadly spread among the population, in contrast to owning stocks. So the breaking of the housing bubble will hurt the American people far more than did the collapse in stock prices in 2000-02.
For sure, the US economy is incomparably more vulnerable than in 2001. Another big risk is in the Dollar.
"Sometimes I think
that the job of central bankers is to prove Kurt Richebächer wrong," says Paul Volcker, former chairman of the US Federal Reserve. So far, however, central bankers have failed to do so.
Chief economist at Deutsche Bank in the 1980s, Dr. Richebächer was a regular contributor to The Wall Street Journal and many other respected journals. His analysis of the global economy and financial markets was published each month in the much admired Richebächer Letter.
Kurt Richebächer died at his home in Cannes, France, in Sept. 2007.