Saturday, November 25, 2006

If These Are Bubbles, Where Is All That Hot-Air Money Coming From?

by Katy Delay

If These Are Bubbles, Where Is All That Hot-Air Money Coming From?
November 25, 2006

Katy Delay is a freelance columnist in economics and government, and maintains a blog at

Most people and even most economists believe it is the Fed that controls the money supply, and that it is Fed know-how that is maintaining our CPI within historically "reasonable" limits. A minority of us, however, think our present economy is in a falsely optimistic booming phase of a bubble-and-burst cycle started more than ten years ago by excessive credit and money creation, and that the excess dollars are camouflaging themselves in assets and speculation rather than in the CPI.

There's plenty of evidence to support this idea, starting with the dot com and stock market bubbles that burst in 2001, the global real estate bubble that has started to turn in the US and is still strong globally, and now the still growing US bubbles in corporate profits, bond issuance, M&A activity, finance industry bonuses, and hedge fund and credit derivative frenzies.

Statisticians will try to disprove the bubble conjecture pointing to stats from the Fed and relative government entities, because the figures don't all corroborate the nature of the bubbles we think we're observing. There are two hypothetical market dynamics that might explain this: (1) Money- and credit-creation mechanisms could exist outside Fed control; and (2) the excess purchasing media may be sidestepping the statistics. Hereafter are three scenarios that illustrate how this might be happening.

One Potential Non-Fed Source for Money: Mishandling of Securitization and Credit Derivatives

Doug Noland is one of my favorite bubble theorists. He maintains that money creation has gotten away from the Fed's monopoly at this point, and that it is now manipulated in great part by a pyramid-scheme-like banking game involving the mishandling of a good thing called the securitization of risk. His November 10, 2006 commentary (Monetary Developments vs. Monetary Aggregates) paints a gaudy credit bubble that I'll describe here in layman's terms.

Securitization is a fabulous tool invented by the financial industry to survive and evolve under existing banking regulations. As they were first envisioned, these transactions had -- and still have -- great potential as a safety net to insure healthy lender risk. Unfortunately, and probably through lack of experience, the financial community has let them evolve into a monstrous money-making machine. Here's how it works.

1. A bank receives deposits, and its function is to lend that money out at a profit. (We won't go into fractional reserve banking here, although this multiplies the problem when things go awry. For now, however, let's just assume the bank lends a fixed multiple of what it takes in.)

2. The bank (or other type of financial institution with access to funds) finds good borrowers with at least a decent credit score to whom they lend the money for purchases, say for a house, a car, or whatever the borrower fancies.

3. Instead of following up on the repayments through their own loan department like they used to, the banks now transfer those loans to an agency that will fulfill this task. At the same time, they package the loans according to the degree of risk, and then they sell the loans to the general marketplace.

4. The buyers of these packaged loans can then buy "insurance" to cover the risk, from individuals and companies who want to assume that risk for a price (a piece of the interest action) and who are supposedly able to come up with the cash should a default occur. So far so good.

5. The bank now no longer has any loans on the books, so it is free to make a second set of loans based on the same fractional-reserve multiple of the deposits it holds -- but this time in effect using 100% of the loan-package buyers' funds to do so, i.e. so far, this is still a good thing; but as we'll see, it's good only up to a point.

6. As you can imagine, this doubling, tripling or quadrupling of loans allows for an expansion of the lending industry; and the market pool of good borrowers (and the good borrowers' credit appetite) eventually maxes out. To palliate this inconvenience, and since the bank is no longer shouldering the risk from its own loans, the bank now lowers the bar for borrowing so that those with a lower credit score may become borrowers. This expansion has presently extended into what some believe is dangerous territory; but this is only half of the problem.

7. The other half occurs when the buyers of these packaged loans either do so with what is called leveraging, i.e. they buy on credit themselves; or they sell these loans to others who do the leveraging. Hedge funds, for example, have sometimes been a source of unwisely leveraged funds that are not yet under industry control. And hedge funds are very popular these days.

8. According to Doug, much of the credit risk involved at this higher level is also "insured" in the same manner as in Stage 4, only this time the insurers never actually pay for the loans they are "insuring." As with real "insurance," they only need to pay in case of default. And this so-called "credit derivative" process is repeated over and over again, in effect allowing the loan-package insurers to borrow to the degree of the "insurance" market's willingness to take on risk.

The fundamental unknown here is that because this type of risk insuring is a new industry, there are few standards such as those found in the ordinary insurance industry or in banking, where safety-net reserves are required. Therefore, the loan and credit insurers in Stage 8, above, who do not have to come up with the principal of an insured loan unless there is a default, are leveraged beyond reason. It's true, when things are booming in the economy, defaults are rare. But what happens if things start to turn sour?

Free market laissez-faire would have us accept that these market players know the risks they are taking and are in a position to accept the consequences. The problem is that, if there were a large enough blow-out in this important sector of the economy, the Federal Reserve is not going to stand by and watch the economy tank. If the past is any indication, they would very likely step in to inflate the problem away.

And a huge problem it could be indeed. These two industries, loan risk securitization and leveraging risk securitization, are booming at a pace that is off the charts. No one really knows to what degree the "leveraging insurers" are capable of covering their positions, i.e. whether or not they could actually come up with the dough in a pinch. Obviously, a normal economic downward cycle could become violent, if there has been distorted and excess credit creation beyond what these new industries can stand to lose; and in that case our figurative falling house of cards becomes real.

As Doug puts it: 'When current perceptions change - when $ trillions of Credit instruments are reclassified and revalued as risky instruments as opposed to today's coveted "money" - Dr. Bernanke will learn why a central bank's monetary focus must be in restraining "money" and Credit excesses during the boom. And the longer this destabilizing period of transforming risky Credits into perceived "money" is allowed to run unchecked, the more impotent his little "mop-up" operations will appear in the face of widespread financial and economic dislocation - on a global scale.'

Melodramatic? Maybe. But only maybe.

A Second non-Fed Source of Money: Influx of Other Countries' Excess Liquidity

There are other sources for the hot-air money. For example, there's the overflow of credit coming from outside the US, in other words the cumulative input of investment into US assets coming from the world's larger economies' collective loose monetary policy combined with their pegging support of the US dollar.

As an illustration, let's take just one asset class. Half of American Treasury debt is held in the hands of foreigners, a third of that being held just by the Japanese. The Japanese central bank has been pumping yen full throttle into their economy for several years now, with no end in sight. Complicating the Japanese problem is the fact that there is a dispute going on between the Bank of Japan and their Treasury Department. The Bank would like to continue raising rates and destroying all those excess yen, but the Treasury doesn't want that to happen, even going so far as changing the statistics the Bank uses to calculate inflation, which undermines the Bank's argument. [The changes were made in August 2006.]

Why isn't that money "benefiting" the Japanese economy? For two reasons. First, because Keynesian economics doesn't work; and second because it's no surprise that the Japanese investor prefers American debt. They can borrow at next to nothing and buy American Treasuries yielding over four percent. It's called the Japanese carry trade, and it's going on like there's no tomorrow.

But this game only works as long as the dollar holds its value next to the yen, and the trend is now towards a weaker dollar in spite of their pegging efforts. So why do they continue?

It's all a question of timing. If America and the dollar can hold onto their "tallest dwarf" status for the mid-term and only allow a smooth slip instead of a sudden drop, maybe foreign investors can continue holding onto our assets with impunity "until things get better" (or at least until the foreign speculator can pull out his marbles and go home.) That's what they're saying to themselves. But keep in mind that this combination of inflationary credit creation and short-term profiteering led us up to 1980.

Along this same line of reasoning is the recycling of at least partially inflated petrodollars. Petroleum prices are climbing probably for two reasons, the first being an increased worldwide demand, and the second the devaluation of the dollar through excessive credit creation. As the price of the barrel climbs, producers are raking it in at a record rate and must invest the dollars somewhere.

They may not want to push any more strings in their own economy, so they look for ways to exchange them for assets. Much of it is going into the purchase of companies around the world, and a lot more may be going into hedge funds, which brings us to the third point.

A Third Contributor Behind The Stats: Hot-Air Money Can Avoid the Statistics

Sears just revealed that one-third (sic) of their before-tax and minority-interest profit "came from investments as sales fell." According to an article by Coleman-Lochner at Bloomberg, Sears is no longer just a retailer, they are now the "Lampert Hedge Fund." This is tongue in check, but there's some truth to it.

Sears is most likely not the only one doing this. Profits have been huge all over the business spectrum, and the GDP and wage increases seem only moderate in comparison. Speculative investment profit and losses are not included in the CPI. Production can take a back seat to other activities when management judges that more hard capital investment and hiring just doesn't make economic sense.

Hedging and derivative investing are activities that may be useful to some degree, but they also tend to explode in times of excessive monetary supply. It's as if Fama's Efficient Market Hypothesis somehow causes the hot stuff to shoot to the top, momentarily making a few people very rich, alighting onto a few asset sectors, and then just disappearing into thin air in the form of losses on the next throw of the dice. The hot money bypasses the normal production channels, and the CPI remains relatively unaffected. In the Great Depression general prices were not rising; nor are they rising quickly now.

The Fed has become a group of mathematicians who believe firmly in the accuracy of their statistical tools, but who have forgotten the old rule: "Garbage in, garbage out." (See my blog post on the subject.) The push-the-string Keynesian policies of the Fed could indeed be causing the bubbles without their knowledge, because their interpretation of the statistics on which they judge their policy's performance understates the reality of the money they and the global system have created.

For a good understanding of money, the Great Depression, and the business cycle, I suggest reading a small booklet written by Edward C. Harwood called "Cause and Control of the Business Cycle," published by the American Institute for Economic Research. It's out of print, but they may still have a copy available if you ask. Tell them I sent you.

Opinions expressed are not necessarily those of David W. Tice & Associates, LLC. The opinions are subject to change, are not guaranteed and should not be considered recommendations to buy or sell any security.