Saturday, November 11, 2006

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

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, however, think our present economy is in a falsely optimistic booming phase of a bubble-and-burst cycle started over ten years ago by excessive credit and money creation, and that the excess dollars are camouflaging themselves in assets rather than in the CPI.

[Thanks to for the image.]

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 now the still growing corporate bond, finance industry, credit derivative, and developing country asset bubbles.

If the theory were to be true, statisticians might search deep inside the Fed and other central bank stats for corroboration; but those figures don't seem to justify the size of the bubbles we think we're observing. Some other money and credit-creation mechanisms must be at work.

Doug Noland is one of my favorite bubble theorists. He maintains that money creation is outside the Fed's control 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 latest commentary (Monetary Developments vs. Monetary Aggregates of November 10, 2006) paints a gaudy credit bubble that I will try to describe in layman's terms.

He explains how the creation of money could have gotten away from the Federal Reserve's monopoly over the last couple of decades through the financial industry's invention of a tool that at first had great potential as a safety net to insure healthy lender risk. Unfortunately, it has evolved into a monster 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. Let's just assume it lends a fixed multiple of what it receives.)

2. The bank (or other type of financial institution) 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, the bank now transfers those loans to an agency that will fulfill this task, but that also will package the loans according to the degree of risk, and sell the loans to the general marketplace.

4. The buyers of these packaged loans then buy insurance to cover the risk from individuals and companies who want to assume it for a price and who are supposedly able to come up with the cash should a default occur. So far so good.

4. 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 multiple of the deposits it holds -- in effect, using the loan-package buyers' funds to do so.

5. As you can imagine, this allows for an expansion of the lending, and the market pool of good borrowers (and the good borrowers' credit appetite) eventually maxes out. However, 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 take out loans. This expansion has presently extended into what some believe is dangerous territory; but this is only half of the problem.

6. 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 up to now are not under industry control.

Furthermore, according to Doug, much of the credit risk involved at this higher level is also "insured" in the same manner, only this time the insurers never actually pay for the loans they are "insuring;" they only need to pay in case of default. This so-called "credit derivative" process is repeated over and over again, in effect allowing the loan-package insurers to borrow ad infinitum.

The fundamental unknown here is that because this type of risk insuring (called "securitization") is a new industry, there are few standards such as those found in the ordinary insurance industry or in banking. Therefore, the loan and credit insurers in Stage 6, 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?

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 house of cards become real and would fall.

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.'

Scary stuff. Melodramatic? Maybe. But only maybe.

For a good understanding of money, the Great Depression, and the business cycle, I highly recommend a book 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.


Anonymous Anonymous said...

The logic is correct but fails to capture that some one is holding the bag and taking the risk. The scheme fails to recognize that that some one is also aware of risk.

12:36 PM  
Blogger Katy said...

Yes, I agree that someone is holding the bag and purports to be (1) taking a conscious risk and (2) able to withstand the total range of possible consequences. My free market side says all of this is fine, as you seem to think it is.

My observant and more skeptical side says that if a large sector of the financial markets were to tank, the Fed would handle it like they handled LTCM in 1998, i.e. they would bail them out rather than see any major repercussions to the economy, under the "too big to fail" principle.

So you are correct in your description of the situation on the ground; but you fail to take into account tangential but essential factors such as the weakness of the Fed's respect for the usefulness of negative market phenomena, and of their proven past responses to this kind of normal but painful market realigning event.

In other words, if the Fed would just allow this overexpansion (in fact "these overexpansions," because borrowers are also in way too deep) to collapse in the normal market fashion and in a sterile non-reactive world, all would be okay, and the only people hurt would be your courageous risk takers. The rest of us would go on about our business. That would make the discovery of this new tool (securitization) equivalent to that of fractional reserve banking, in the sense that they both create a temporary expansion in money supply that is simply lifting us all to a new level of manageable debt accommodation.

But that isn't the way it will likely play out. What will probably happen is that the Fed will want to curb the negative effects such an event would have on the economy, and more importantly on the public's perception of the job the Fed is doing, and the Fed will react by pumping more liquidity into a system that is already full. This will have the effect of further debasing the dollar and sustaining the bubble economy -- all good for gold, in my view.

Of course, no one can begin to predict that this (or these event(s) will occur, and even if they do, their timing. Furthermore, if they were to play out over time, then maybe our fears are unwarranted. Personally, I'm betting on the bureaucrats to mess things up.

1:12 PM  

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