Saturday, September 29, 2007

Hot or Cold: Two Opposing Descriptions of Our Financial Situation

Prudent Bear and Doug Noland have again said something better than I can. Below I give you the best part, which is a comparison between the bull and bear outlook.

bull and bear
[Thanks to steuben.com for the image.]

I definitely belong to the bear side, i.e. we have either already created, or we are about to create, History's Greatest Credit Bubble. I differ only in one way. I am not as sure as Doug that what he labels "Wall Street Alchemy" is all that bad, in and of itself. Assuming the economy can withstand the pressure from this credit collapse, which is not a given, I think that securitization is here to stay, and that it will find a way to price the risk instruments in such as way as to render them useful.

I agree with him that this Alchemy is a credit-creation machine; but so was reserve banking, and everyone thought that couldn't last. One side of the Austrian school of economics continues to blame reserve banking for all of our troubles. I'm not so quick to accuse.

I think government intervention had more to do with this predicament than people think. First, the Fed (a government-type agency in nature, even if they are supposedly independent) is at the origin of much credit creation that is the inspiration for the products and market participants that sell it. Secondly, restrictions on banking activity have caused it to grow outside the body of institutions that originally created and controlled it, into a domain where anything goes, at least for now.

As for this particular inflationary asset-price cycle, I tend to frame it inside a mix of securitization expansion and misguided Fed policy. See a speech by Governor Mishkin for a gorgeous example of Greenspan's handiwork.

Here are the two opposing outlooks on the same data. You have the bulls (Conventional View), and the bears (Prudent Bear's view):

"The Conventional View Paradigm: -- “Perfect/Efficient” Markets Paradigm
· Economic performance governs market behavior
· Underlying economic fundamentals are sound
· Fed commands system liquidity
1. Capacity to initiate reflations/reliquefications on demand
2. Disregard asset Bubbles until they come under stress
· Current Account Deficits are largely irrelevant.
· The system enjoys unlimited capacity to leverage and limitless liquidity.
· Contemporary models-based finance presumes continuous and liquid markets
·The present-day U.S. financial system is more stable, with banks actively disbursing risk throughout the markets.

"Our Paradigm – History’s Greatest Credit Bubble
· Unconstrained Credit systems are inherently unstable.
· Markets are inherently susceptible to recurring bouts of instability and illiquidity.
· Wall Street financial innovation and expansion created what evolved into a precarious 20-year Credit cycle, replete with self-reinforcing liquidity abundance and speculative excess.
· “Wall Street Alchemy” – the transformation of risky loans into enticing securities/instruments - has played a momentous role in fostering myriad Bubbles.
· Unrelenting Credit and speculative excesses have masked a deeply maladjusted U.S. “services” Bubble Economy.
· The prolonged U.S. Credit Bubble and resulting interminable Current Account Deficits have cultivated myriad global Bubbles.
· Recessions are an integral aspect of Capitalistic development – and busts are proportional to the preceding booms.
· Today, speculative-based liquidity commands the financial markets and real economy, creating unparalleled fragility.
· Late-cycle “blow-off” excesses are the most perilous because of their deleterious affects upon the underlying structure of the financial system and economy."

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