This blogger began reading Doug Noland during the 'dot bomb' bust ten years ago. During that bear market, Noland consistently analysed events through the prism of an underlying credit bubble that was the product of an unholy alliance between the US Fed, US securities markets and the government sponsored entities Fannie Mae and Freddie Mac.
Following the bust, he precisely described the reflation dynamics that were driving housing markets and predicted with near paranormal accuracy how the unholy trinity behind credit creation was going to come apart in the near future. It took seven years but turned Noland's analysis into prophecy.
In short, Doug Noland predicted and described the GFC earlier and with greater precision than anyone else, anywhere (including the laudable Steve Keen, who just happened to teach Doug Noland at UWS!)
Why this intro? Well, Noland writes weekly at Prudent Bear and his latest missive is a screamer:
Beginning back with early-nineties banking system impairment, the Greenspan Federal Reserve nurtured Wall Street financial engineering and the rapid expansion of non-bank marketable debt. The GSEs, securitization markets and derivatives were viewed as instrumental for fostering the needed Credit expansion in the face of severe banking and fiscal headwinds. The Fed unleashed a lion.
No longer was monetary policy focused on creating and extracting banking system reserves in an effort to influence bank lending (and through bank Credit, growth and inflation). The old rules for governing a largely contained financial system no longer applied. A New Era was born. The Fed now could manipulate short-term borrowing costs and immediately stimulate flows into the securities markets, speculator risk-taking and leveraging, asset inflation, mortgage refinancing and equity extraction, home price gains, additional household net worth, spending... It became The Age of the Maestro, The Masters of the Universe, the enterprising investment banker and opportunistic mortgage originator. Traditional measures of economic health – the Current Account, savings rates, sound investment, productive capacity, stable money and Credit, balanced financial flows – were discarded. What mattered now were the markets, market perceptions and how the Fed could be counted on to orchestrate and sustain a boom.
If there is one insight that you should take from this blog make it the above description of how US (and global) capital markets credit creation actually works. That is opposed to how they should work in theory.
To understand the difference, we can turn to a post made last week at this blog:
The global economy is a three-ringed circus. The inner ring is real commerce, production, consumption and trade. This is the layer at which fundamentals like supply and demand operate. The second ring is a layer of financial transactions - the shifting of savings and creation of credit, as well as currency exchanges that most of us think of as global capital movements. This is the level at which macro-economics operates. The third ring is the global meta-economy of derivative gambling that leverages off and arbitrages prices in the first two rings. In part this is Noland's global banking universe of marketable securities, as well as other derivatives.
The outer ring is the problem. Because of its leverage, opacity and magnitude, it massively amplifies any sudden movement in the underlying two rings.
So what you might ask? What does it matter to us if markets work this way?
Well, it matters all right, for the reason that our banks and regulators have spent the best part of two decades believing in and integrating with the outer ring of this system. Despite their reputation for prudence, Australian banks manage some $13-14 trillion in off-balance sheet derivatives that have enabled them to control the currency and interest rate risks in their portfolio of $500 billion in offshore marketable securities.
Before the GFC, the Australian RMBS market was also dependent upon the global marketable securities marketplace for over half of its' sales.
Regulators ignored this historic process of debt-accumulation under the rubric of the Pitchford Thesis - that Current Account Deficits no longer mattered in an era of floating currencies, so long as the debt was in the private sector - a near perfect fit with Noland's description of the abandonment in the US of traditional measures of economic health.
The inevitable result was that when global liquidity was interrupted - as sooner or later it always is, and sooner rather than later in this system - the only way to backstop the liquidity that is now the lifeblood of the Australian banking system was fiscal guarantees to the big banks that pretty much are the local financial system.
Now, as the bank debate rages, we face a choice: Confront the regulatory error that allowed banks' to become dependent upon the unstable outer ring of global marketable securities, or, expand the guarantees that backstop the integration in the name of greater competition, and throw traditional measures of economic health to the wind.
To understand what it is we are choosing, let's return to Noland:
I’ve argued for years now that the Fed had adopted a radical approach to monetary management - and it was disturbingly apparent that our central bank had become enamored with history’s most powerful monetary policy mechanism. And with dynamic marketable debt increasingly supplanting the boring old bank loans as the main driver of system Credit expansion (especially as the nineties progressed), the Federal Reserve had to take an increasingly aggressive and activist approach to ensuring ample marketplace liquidity and unwavering market confidence. The ’94 bursting of the bond/MBS Bubble, SE Asia, LTCM, the tech bust… The Fed nurtured a historic Credit Bubble and the larger the Bubble inflated the greater role monetary policy had to play to ward against a devastating crisis of confidence. Policy was conspicuously radicalized in the aftermath of the 2008 collapse of the mortgage/Wall Street finance Bubble.
But the chickens are bound to come home to roost. Especially after the past two years’ unprecedented global expansion of government debt, marketable debt securities that now absolutely dominate the world. The specter of market illiquidity reemerged with this spring’s Greek contagion crisis, and it was sufficiently scary. The ECB intervened to support struggling debt issuers and a vulnerable banking system. The Fed, fearing a more systemic crisis, played its QE2 trump card. The markets perceived this move as an unending commitment from the Fed to provide a liquidity backstop. Risk markets have inflated across the globe.
It is my view that a world financial apparatus dominated by marketable debt instruments is inherently unstable. Implement a monetary policy regime to manage marketplace liquidity and asset prices at your own peril. Be prepared for market dependency and ever-increasing liquidity injection requirements. Such a regime will reward the savviest speculators and ensure acute systemic vulnerability.
Australian monetary policy has already been compromised by this liquidity-driven system in the tearing up of the RBA's rules for repo transactions and shadow game they and APRA are deploying in Invisopower!, the hiding of who owes what where. But for the time being at least, our major choice is different in that it is a fiscal backstop that is needed to stabilise the system under duress.
The corollary of this fiscal liquidity guarantee is that whoever controls the health of the Budget, controls the health of the banking system. It doesn't take Einstein to conclude that that equals an unhealthy dependence upon China.
Yet a vociferous band of economists, journalists and analysts are calling for us to do just that.
Do we really want to go further down this track of unstable, securities-based credit creation? It has already created one of the greatest housing bubbles in history and skewed our financial system and economy toward mortgages and offshore debt.
It's now threatening to undermine our strategic commitment to the United States through a doubling down on the China-dependent Budget liquidity backstop.
Not to mention running the risk that if the great China experiment catches a cold, we'll cough once then drop dead on the spot.
Shouldn't we rather ask ourselves how do we stabilise what we've already got without throwing away our system?