Wednesday, November 16, 2011

Destructive inflationism - Asia Times Online

I was struck recently by a question posed by CNBC's Simon Hobbs to Marc Faber - investor, analyst and financial writer extraordinaire: "In Steve Jobs' new biography, Walter Isaacson talks about a conversation that he had with Rupert Murdoch, and Steve Jobs says that for commentary and analysis the axis today is not liberal versus conservative. The axis now is constructive versus destructive. Which side of that line do you think you fall on?"

I'll assume that Mr Hobbs sees Marc Faber residing more in the "destructive" camp - and I presume many would consider my

analysis "destructive" as well. We're now in this strange and uncomfortable period of heightened angst, anger and vilification, whether it is in Athens, throughout Europe, or across the US from New York City to Oakland, California. European policymakers have been keen to blame short-sellers and speculators for their bond market woes. The rating agencies are under attack on both sides of the Atlantic. And analysts such as Mr Faber and myself are generally viewed with contempt by those determined to view the world through rose-colored glasses.

From Websters: "Destructionist: One who delights in destroying that which is valuable; one whose principles and influence tend to destroy existing institutions; a destructive."

I tend to view the recent use of "destructionist" in similar light to the vilification of the so-called "liquidationists" and "bubble poppers" (a Ben Bernanke term) from the spectacular "Roaring Twenties" boom and bust cycle. There are those who believe that enlightened policymaking can implement an inflationary cycle and successfully grow out of debt problems. Then there are others that see failed policy doctrine and credit inflation as the root cause of a dangerous dynamic that risks a catastrophic end. Revisionist history has been especially unfair to Andrew Mellon and other "bubble poppers" who warned of the impending dangers associated with the runaway monetary, credit and speculative excess in the years immediately preceding the 1929 crash.

I am of the view that inflationary policy doctrine ("inflationism") is in the process of impairing the creditworthiness of the financial claims that constitute the foundation of the global financial system. Massive issuance of non-productive debt and central bank monetization have irreparably distorted the global pricing of finance and the resulting allocation of financial and real resources.
This backdrop has nurtured destructive speculative dynamics. From my perspective, it is the "destructionist" forces of "inflationism" that today pose grave risk to global capitalism. And, to be sure, the "socialism" of credit risk is at the heart of the monetary and economic quagmires imperiling Europe, the US and nations around the world.

From Wikipedia: "Destructionism is a term used by Ludwig Von Mises, a classical liberal economist, to refer to policies that consume capital but do not accumulate it. It is the title of Part V of his seminal work Socialism. Since accumulation of capital is the basis for economic progress (as the capital stock of society increases, the productivity of labor rises, as well as wages and standards of living), Von Mises warned that pursuing socialist and statist policies will eventually lead to the consumption and reliance on old capital, borrowed capital, or printed 'capital' as these policies cannot create any new capital, instead only consuming the old."

From the "Austrian" perspective, runaway credit booms destroy wealth instead of creating it. There is as well an important facet of inequitable wealth redistribution that returns to haunt the system come the unavoidable bursting of the bubble and the associated devaluation of "printed capital". I believe the current course of reflationary policymaking is doomed specifically because the ongoing massive expansion (inflation) of financial claims is not associated with a corresponding increase in capital investment and real wealth-creating capacity. Governments around the world are - and will be in the future - required to issue massive amounts of new debt to sustain maladjusted financial and economic structures, in the processes prolonging wealth-destructive over-consumption and destabilizing global imbalances. The "Austrians" use the apt analogy of consuming one's furniture for firewood.

As she has a habit of doing, The Financial Times' Gillian Tett wrote an exceptional piece on Friday. "Subprime moment looms for 'risk-free' sovereign debt: When future financial historians look back at the early 21st century, they may wonder why anybody ever thought it was a good idea to repackage subprime securities into 'triple A' bonds. So, too, in relation to assumptions about the 'risk-free' status of western sovereign debt. After all, during most of the past few decades, it has been taken as a key axiom of investing that most western sovereign debt was in effect risk-free, and thus expected to trade at relatively undifferentiated tight spreads. Now, of course, that assumption is being exposed as a fallacy ... As the turmoil in the eurozone spreads, forcing a paradigm shift for investors, the intriguing question now is whether we are on the verge of a paradigm shift in the regulatory and central bank world, too."

Italian yields jumped 16 basis points (bps) on Friday to 6.35%, tacking on another 34 bps for the week. The spread to bunds surged 69 bps this week to 453 bps. One is left pondering how the Italian bond market would have fared had the European Central Bank (ECB) not surprised the market with a rate cut and not continued to aggressively buy Italy's debt. On Tuesday from the FT: "A trader of Italian government bonds said: 'It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices.'"

Just to think that there were "just no buyers and therefore no prices" in the world's third-largest sovereign debt market. To have Greek yields last week approach 100%. To have speculative positions in sovereign debt early in the week lead to the eighth largest bankruptcy filing in US history. And there were heightened market concerns as to the safety of "segregated" brokerage assets (in response to MF Global issues) and the integrity of the credit default swap (CDS) marketplace (Greece and beyond). To have G20 policymakers, again, fail to reach a consensus as to how to approach the European debt crisis. To have Greece spiraling out of control.

Well, the wrecking ball has been just chipping away at the bedrock of market faith in contemporary finance. And then to read one of the world's preeminent financial journalists contemplating market "fallacies" and a paradigm shift with respect to the nature of sovereign debt risk.

No doubt about it, it was another troubling week in global finance. But not to worry; the ECB surprised markets with a rate cut and Federal Reserve chairman Bernanke stated that the Fed was readying its mortgage-backed security (MBS) bazooka. The more destabilized world finance becomes, the more our captivated markets fixate on synchronized global reflationary policymaking. For now, faith in policymaking seems to be holding up better than confidence in finance.

There are important reasons why financial crises traditionally often originate in the so-called "money market". Money market assets are generally the most intensively intermediated financial claims. Risk intermediation is critical to the process of transforming loans with various risk profiles into financial claims essentially perceived as risk-free in the marketplace.

As I attempted to address last week, this perception of "moneyness" is an extremely powerful force in finance, the markets and economics more generally. The credit mechanism and resulting flow of finance can work miraculously when markets perceive "moneyness", although things can unravel dramatically when the marketplace begins to fear what it thought was safe and liquid "money" are instead risky and potentially illiquid Credit instruments. Just as there is a thin line between love and hate, there can be an even finer line between Credit boom and bust.

From the concluding sentences of Ms Tett's article: " ... if regulatory systems had not encouraged banks and investors to be so complacent about sovereign risk in the past, markets might have done a better job of signalling that structural tensions were rising in the eurozone - and today's crunch would not be creating such a convulsive shock. It is, as I said above, wearily reminiscent of the subprime tale. And, sadly, that is no comfort at all."

I, as well, see disconcerting parallels to subprime. Especially late in the mortgage finance bubble, a huge and expanding gulf had developed between the market's perception of "moneyness" for mortgage securities and the true underlying Creditworthiness of the debt. Importantly, it was the ongoing massive expansion of mortgage credit that supported home prices and economic growth - all working seductively to further seduce the marketplace into perceiving ongoing "moneyness".

The "terminal phase" of credit bubble excess saw systemic risk expanded exponentially, as the quantity of credit ballooned and the quality of this debt deteriorated markedly. It was both a historic mania and astonishing example of (Minsky) "Ponzi Finance".

These days, sovereign debt (Treasuries, in particular) is being issued in incredible quantities (and at amazingly low yields). The vast majority of this debt is non-productive and of rapidly deteriorating quality. Yet the markets for the most part are sufficiently content to continue perceiving "moneyness".

Part of this "moneyness" is due to the credit cycle reality that, similar to subprime, things tend to look ok even in the perilous late stage of a credit boom. And, importantly, the markets perceive that the Fed, ECB, People's Bank of China, Bank of Japan, Bank of England, and other global central bankers will continue to monetize (accumulate) this debt - in the process ensuring stable valuation and abundant liquidity in the marketplace ("moneyness").

Here's where it gets really troubling from my analytical framework: the more this "new paradigm" takes hold - of the market now recognizing the fallacy of the traditional assumption of "risk-free" sovereign debt (especially in regard to $2.5 trillion of Italian federal borrowings) - the greater the scope of central bank monetizaton anticipated by the markets.

This expectation for reflationary policymaking is increasingly underpinning speculative risk asset markets globally. Especially when it comes to Treasury debt, the markets' perception of "moneyness" is related much more to the expectation of ongoing central bank purchases than it is with (rapidly deteriorating) credit fundamentals. Ironically, the greater the upheaval in global sovereign debt and risk markets, the more willing the markets are to further accommodate Treasury bubble excess.

Increasingly, the key dynamic underpinning global risk markets is the expectation for the Fed and global bankers to ensure the "moneyness" of Treasury and global sovereign debt. Indeed, "risk on" or "risk off" now rests chiefly on the markets' immediate, perhaps whimsical, view of the capacity for the world's central banks to sustain the faltering sovereign credit boom.