The massive injection of funds into the banking system by the Federal Reserve over the past four and one-half years has created, for some, a worry that price inflation will return again. This concern has lessened for many in the recent past because price indices have not shown any tendency to increase at a rate that would make these people uncomfortable.
Still, many of us continue to worry about what the Federal Reserve is doing has done. And, there is substantial worry about all the debt that the federal government continues to create.
Well, there seems to be more and more evidence that this new round of credit inflation is having more and more of an impact on the financial sector of the economy. And, let it be noted, like the period of the Great Moderation, the inflation that is taking place is in the financial markets and not in the markets for the production of physical goods. Credit inflation can impact the financial markets without having a lot of influence on economic growth.
This is certainly not something that can be observed if one works with the basic Keynesian model of the economy. Keynesian macroeconomic models do not include a "credit" sector. And, this is one thing that economists are struggling with right now. Hence, some parties can praise the Great Moderation because of its low rate of price inflation.
Yet, others see another picture. For example, Thomas Aubrey, in a fascinating new book titled "Profiting From Monetary Policy" (Palgrave Macmillan: 2013), writes that the period of the Great Moderation produced "one of the largest credit booms in financial history." (Page 158) And, this credit boom, which continued into the 2000s, set the stage for the Great Recession.
Now, we are seeing evidence of the credit boom of the 2010s. Friday morning on the front page of the New York Times we see the headlines, "Back on Street, Arcane Names Hiding Big Risk".
"The banks that created risky amalgams of mortgages and loans during the boom-the kind that went so wrong during the bust-are busily reviving the same types of investments that many though were gone for good."
The article provides the following statistics. "So far this year banks have issued $33.5 billion in bonds backed by commercial mortgages, slightly more than they did in early 2005, when the real estate market was flying high, according to data from Thomson Reuters."
Furthermore, "the structured product that has been the fastest to revive is the one that encountered the least trouble in 2008: collateralized loan obligations. In the first quarter of this year, banks issued about $26 billion in new collateralized loan obligations-more than in the same period in 2007, according to S&P Capital IQ."
But, "Not all markets have revived as quickly. The slowest bonds to return are those linked to home mortgages, the structured products that caused the most problems during the crisis." Still, "even here there are signs of life. Last month, JPMorgan became the first major American bank to issue a bond backed by residential mortgages."
Overall, "last year, revenue from securitizations was up 68 percent, according to the data company Coalition." My question is, "Why should we be surprised by this?"
The instruments and the markets had been created before. The fuel for these instruments and markets is the credit that is infused into the financial markets by the Federal Reserve to stimulate economic activity.
The Federal Reserve has almost guaranteed that they will continue the existing financial market conditions into 2014. Officials have declared that the Fed's target interest rate will remain close to zero into next year. What more do market participants' need?
Does the Fed and the government think that market participants don't learn. The markets have had over fifty years of experience with credit inflation.
The response to credit inflation? Well, you move into riskier assets. You take on more leverage. You finance long-term assets with short-term liabilities. And, you innovate, use or create financial innovation. None of these activities have to go into the production of goods and services.
Nathaniel Popper, the author of the Times article, goes on: "the revival also underscores how these investments have largely escaped new regulations that were supposed to prevent a repeat of the last financial crisis." Well, that is what financial institutions do. To me, this describes exactly what financial institutions have done since the 1960s. They have almost constantly worked to get around financial regulations. And, they are really good at it.
But, what is going on now moves even beyond what is being reported. What is being reported relates to what is going on in the commercial banking sector. The financial sector, now, is much more than that. In terms of what financial institutions are doing, according to recent figures, commercial banking activity makes up only about half of the credit being produced by the "financial industry" when one includes what is being done by alternative financial groups.
By reaching the front page of the New York Times, credit inflation is gaining recognition. This is the reality of the world today and must be accounted for. Just having the government create fiscal stimulus and having the Federal Reserve flood the financial system with bank reserves does not create economic growth. Until this is realized we will continue to experience the explosion in credit instruments throughout the economy.