Worse Than Irrelevant - By Doug Noland

July 10 – Financial Times (Michiyo Nakamoto and David Wighton): “Chuck Prince yesterday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup was ‘still dancing’. The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market. He also denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back, in spite of problems with some financings. ‘When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,’ he said… ‘The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.’”

Worse Than Irrelevant

By Doug Noland
July 13, 2007
Source

For lack of a better adjective, I’ll say it was a rather “idiosyncratic” week for the markets and otherwise. Monday, Citigroup’s CEO Chuck Prince made curious comments regarding the boom in M&A finance (quoted by the FT – see above): “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing… The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.”

Not all that comforting. I could only chuckle when a journalist from the Wall Street Journal, appearing on CNBC, compared Mr. Prince to a ticket scalper outside a concert venue imploring potential buyers with assurances that the show was going to be so good they wouldn’t want to miss out.

On Wednesday, Alphonso Jackson, the Secretary of Housing and Urban Development (HUD), was on Bloomberg television warning that the U.S. mortgage default crisis may impact one-fifth of all subprime loans. This is no small sum considering that there are $800bn of outstanding subprime MBS (from Bloomberg). And what do you know, on Friday a Bloomberg article had Secretary Jackson meeting with Bank of China officials in Beijing urging the Chinese to “buy more mortgage-backed securities after a surge in defaults by risky borrowers in the world’s largest economy eroded demand for such instruments.” Another ticket scalper in an age of scalpers, though one apparently forced to admit something like this: “Ok, I know you know this show isn’t going to be pretty but, please my friend, I really need you to help me out on this one.”

And when it comes to “selling a bill of goods,” I refuse to let Dr. Bernanke’s Tuesday speech, Inflation Expectations and Inflation Forecasting, before the Monetary Economics Workshop of the National Bureau of Economic Research, go unanswered. For starters, I don’t recommend reading it. It is academic, written specifically for so-called monetary economists, and basically propounds doctrine that is Worse Than Irrelevant with respect to current inflation dynamics. I found it disturbingly detached from reality.

I’ll plead once again that the issues of “money”, Credit, and inflation are much too vital to the long-term health of free-market democracies to be left to a select group of policymakers and “ivory tower” dogma. I would instead argue that it is imperative that citizens become sufficiently educated on the perils of Credit inflation, financial excess, and unsound “money.” This would provide our only hope against the inflationary tendencies of politicians, the Fed, and the Financial Sphere – tendencies that turn highly toxic when mixed with high octane contemporary “money.” Whether by design or, perhaps more likely, his theoretical indoctrination, Dr. Bernanke’s inflation discussion continues to evade and obfuscate when it comes to the central monetary issues of our day.

Dr. Bernanke: As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve’s dual mandate from the Congress, is a good thing in itself, for reasons that economists understand much better today than they did a few decades ago.”

That’s all well and good, but to commence fruitful discussion and debate first requires up-to-date, understandable, and reality-based definitions of “inflation” and “price stability.” It should be clear by now that sticking with Milton Friedman’s “too much money chasing too few goods” over-simplification does more analytical harm than good. “Money” was already too much of an unclear, amorphous and indefinite concept during Dr. Friedman’s heyday. The ongoing “evolution” of contemporary “money” only lunged ahead madly over the past decade or so. Moreover, adherence to a Friedmanite monetary perspective leads one to an ill-advised focus on “narrow money” and confined “core” consumer price inflation, along with a false notion of the government’s capacity to manage both. Today, “good monetary policy” and “price stability” are erroneously associated with perpetual - if perhaps only moderate - inflation in a narrow index of aggregate of consumer goods and services prices that represents such a small (and shrinking) part of total economy- and market-wide expenditures.

It’s more productive to start with “inflation” as a multitude of potential effects emanating from the creation of Excess Purchasing Power (Credit). These may include various price effects, although excess purchasing power also typically engenders elevated real investment, imports, and/or market speculation. Inflation’s price influences may develop in “core” consumer prices, or perhaps become more prevalent in energy and food prices – depending on many factors including supply/demand dynamics and the nature of the flow of funds/purchasing power. Especially if a Credit system is heavily focused on real (i.e. real estate, commodities, sport franchises, art, collectables, etc.) and financial (bonds, stock, “structured” instruments, commodities-related, etc.) assets, asset prices will be a prevailing Inflationary Manifestation. Contemporary “price stability” must be examined in the context of system-wide price levels, Credit growth by sector and in aggregate, and the scope and nature of speculation – and to be reality-based it should begin with the asset markets.

We have today a unique finance-driven economy that becomes more finance-dominated each passing year (month). Analytically, it is important to conceptualize the evolving nature of finance generally and appreciate that a finance economy will be an atypically mutating economic animal. The pool of available finance grows ever larger; the flows of finance become all the more powerful; the speculative impulses more intense and diffuse; the inflationary impacts more dramatic; and the real economy effects more pernicious - yet almost by design effects upon the general (“core” CPI) price level are nominal and lagging.

In particular, incredible amounts of financial “wealth” (financial sector inflation) are being generated, distributed and expended quite unequally (a key Credit Bubble-induced inflationary dynamic). At the same time, highly-populated emerging economies are engulfed in Credit Bubble dynamics, with obvious inflationary consequences for global food and energy prices. It is not hyperbole to suggest that financial, economic and inflationary dynamics have been radically transformed over recent years to the point of leaving policymakers and conventional economic doctrine in the dark.

Today, the U.S. and global economies are buffeted by powerful inflationary forces unlike anything experienced in decades - if ever. Years of unrelenting Credit and speculative excess have created a vast global pool of enterprising “purchasing power” (including hedge funds and other leveraged speculators, sovereign wealth funds, pension funds, mutual funds, insurance companies, etc.) searching high and low for robust returns. At the same time, the perception that the U.S. dollar is now a perpetually devaluing currency has created a powerful inflationary bias in myriad “non-dollar” asset classes (and economies) across the globe. Dr. Bernanke and the Fed would be better off disposing of their old academic articles and notions of inflation and starting from scratch.

In a week when Dr. Bernanke applauded a tradition of “good monetary policy” and “price stability,” U.S. financial markets were notable for demonstrating acute instability. Dr. Bernanke states that, “undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.” He then reiterates the commonly accepted view that - because of the Fed’s ongoing commitment and success in fighting inflation - inflation expectations “have become much better anchored over the past thirty years.” Well, this may have been somewhat the case for a period of time, but it is foolhardy to believe it holds true these days. After all, seemingly the entire world prescribes to the view of ongoing asset and commodities inflation. And these expectations - in conjunction with liquidity and Credit abundance – provide one of the more highly charged inflationary backdrops imaginable.

I don’t recall Dr. Bernanke’s mentioning asset inflation in his speech, although he does sanguinely address the inflationary (non-) ramifications from the surge in oil prices. “…A one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent ‘wage-price spiral.’ With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices.” And “the long-run effect on inflation of ‘supply shocks,’ such as changes in the price of oil, also appears to be lower than in the past,” along with “inflation is less responsive than it used to be to changes in oil prices and other supply shocks.”

The major issue I have with such conjecture is that it blindly disregards the key issues and prevailing dynamics of contemporary finance. Oil has always been the most important commodity in the world, yet it has never been as economically and financially critical across the globe as it is today. The huge inflation in oil and energy prices has had much to do with the massive expanding global pool of dollar balances (mostly emanating from our Current Account Deficits), the depreciating value of the dollar, and the associated massive liquidity over-abundance throughout Asia. Energy and related inflation has had and will, going forward, have only greater geopolitical consequences. It is nonsensical today to concentrate on oil inflation’s (to date) impact on “core” U.S. consumer prices.

Liquidity-induced oil price inflation has been exacerbated by the interplay of boom-time global demand increases (especially in Asia). Knock-on effects then included the liquidity/purchasing power accumulated by OPEC and other exporters, as well as liquidity created in the process of leveraged speculation internationally. Importantly, inflating energy prices have fostered Credit creation through myriad channels. For one, U.S. companies, governments, individuals and the economy overall have borrowed more for energy purchases, in the process working to sustain destabilizing Current Account Deficits in the face of a weakening dollar. There has been no “supply shock” specifically because easily accessed cheap Credit has provided sufficient added purchasing power to ensure uninterrupted robust energy demand (“monetization”).

Across the globe, more borrowed finance has been needed to acquire energy resources and companies; more has been borrowed to explore, develop and extract oil and to pursue sources of alternative energy. The rising values of energy assets (including oil company stock prices and energy derivatives) have created additional collateral to borrow against. And, more recently, the surge in energy prices has led to more broad-based secondary effects, including the large transportation and food sectors – which will work to encourage additional borrowing and broadening price effects. It would be a huge analytical blunder to expect that “energy prices should not lead to a permanent increase in inflation but only to a change in relative prices.”

Importantly, rising oil prices were initially an inflationary effect which, accommodated by easy “money,” then spurred greater Credit creation and increasingly potent inflationary forces. Inflation begets inflation, and the Fed can continue to downplay asset and commodities inflation at our currency’s peril. Both may be exerting only modest pressure on “core” consumer price indices these days, but such a narrow-minded focus completely misses the point.

The Fed is forever fond of gauging “long-run inflation expectations” by measuring the difference in yields between nominal and inflation-indexed bonds. In the current financial backdrop, this is comforting but flawed analysis. It may illuminate the markets’ best guesswork with respect to prospective CPI levels, but when it comes to actual “inflation expectations” I would suggest the Fed monitor a “basket” of indicators including the price of gold, oil, energy, and general commodities indices, the relative value of “commodity” currencies, global equities and real estate prices and, importantly, the global demand for Credit. Furthermore, a reasonable view of “inflation expectations” could be gleaned through the study of speculative leveraging throughout global financial and asset markets. The key inflationary focus today should be on factors and dynamics driving Credit growth and speculative excess.

While on the subject, it’s worth noting that speculative excess in the U.S. stock market has reached the greatest intensity since early-2000. The nature of current synchronized global market speculation is extraordinary to say the least; virtually all markets everywhere. Here at home, all the fun and games, squeezes and intoxication should have the Fed alarmed. Surely, a destabilizing market “melt-up” is the last thing our vulnerable system needs right now.

And when I commented above that Dr. Bernanke’s (and the Fed’s) inflation doctrine was “Worse Than Irrelevant,” I had today’s global financial backdrop in mind. To be sure, a policy of pegging short-term rates with promises of fixating two eyes on “core” CPI and no eyes on asset prices/Credit/or speculative excess has been fundamental in nurturing history’s greatest Credit Bubble. Or, from another angle, relatively stable consumer prices have ensured runaway Credit inflation and speculative asset Bubbles. And the marketplace’s inability to orderly adjust to rising global bond yields, surging energy prices and mounting inflationary pressures, and unfolding Credit market tumult portend problematic market dislocations at a future date.