Next Economic Crisis Already Underway

Wolfgang Munchau of the Financial Times wrote a very important comment piece in Monday’s Financial Times. In it he said that central banks are targeting asset prices to avoid the brunt of cyclical downturns. This policy is inducing asset bubbles and creating a more volatile real economy with unpredictable negative consequences.

I want to expand upon his comments here because his analysis fits well with a number of macro points I have made in the past. First a quote from the Munchau piece:

We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner…

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation…

…there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

For all we know, there may not be a safe way down.

The argument Munchau is making should be familiar to you as ‘the asset-based economy’ (which I will now retroactively add as a tag to prior posts). To date, the best outline I have provided for you was in a post earlier this month called,”A brief look at the Asset-Based Economy at economic turns.”

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.

This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.

Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.

The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.

As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.

The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.

This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.

But, given Munchau’s comments, I want to add a few of my own to flesh out what is happening here. First, this is not just an American phenomenon. The post I wrote on London house prices earlier Monday shows that asset prices are being targeted as a vehicle for economic reflation in Britain as well. The US and the UK are far from alone as nearly every major central bank has been using an extremely accommodative monetary policy to prevent a deflationary bust.

Munchau invokes Hyman Minsky’s model of financial instability to help explain how this sets us up for a volatile future because traditional macroeconomic theory is inadequate for understanding what got us to this point. In essence, the idyllic state of economic and price stability we know as “the Great Moderation” is really just a financialization of the economy. However, a large financial sector leads to excessive dependence on asset prices to fuel growth, which in turn leads to an accumulation of debt.

The financialization leads to both a widening gulf of income in society as the monied class profits (look no further than record financial sector bonuses during a weak recovery for proof). I believe it also leads to regulatory capture and crony capitalism. The debt buildup precipitates asset price deflation during busts — and the potential for a deflationary spiral in the real economy. As a result, central banks flood the economy with money to prevent this outcome. This flooding of the economy with liquidity in bad times, therefore, has the unintended consequence of making monetary policy asymmetrical.

The asymmetry results in extreme volatility in asset price. All the while, debt keeps accumulating. Clearly, this increases the likelihood of a major bust and depression. Hence Stability (the great Moderation) creates Instability (a pronounced Boom-Bust cycle).

The question is: where does this all lead? Munchau asks this question at the end of his post and suggests that “there may not be a safe way down.” His discussion about likely policy responses evokes memories of my “Scylla and Charybdis” post. Here is the key part from it:

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet. Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline. Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices. But, Copper is near a seven-month high. Oil is near a seven-month high. And all of the agricultural and industrial commodities are taking off again. As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces. This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

Scylla and Charybdis

So, how do I see this push and pull of deflationary and inflationary forces playing out? There are two outcomes I am looking for.

Outcome Number One

No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem. However, what if it is the lack of borrowing which is at fault? Then, we are going to see no traction from monetary policy.

Outcome Number Two

Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low. The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.

Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.

What you should draw from this is the following:

1. The Great Moderation is revealed as an illusion once we reach the zero bound, where interest rates are near zero. At this point the asset-price reflation can no longer rely on interest rates alone, but must also use increasingly heavy-handed tactics to get the economy going. This is where we now are.
2. Terminal Debt is fast approaching. Steve Keen believes we are at a Terminal Debt stage, where no more debt can possibly be accumulated to revive growth. However, I have presented you with evidence that this is not necessarily the case (see posts here and here). Nevertheless, it is fast approaching.
3. The central bank is damned if it does and damned if it doesn’t. This was the takeaway of the Scylla and Charybdis post: All roads lead to a W-style Japanese depression or a deflationary bust because deflation is secular (Terminal Debt) while inflation is cyclical (asset prices). An inflationary scenario will invite a policy response which kills the recovery.
4. This is good for government bonds but not for risky assets. Longer-term, this is a good environment for government bonds. They are the risk-free asset in an environment of secular deflation. Shares are not a good investment in this situation despite huge rallies. Remember, we saw huge bear market rallies after 1929 and again in Japan after 1990.

I believe we are in the reflationary period of a longer-term depression right now. As a result, there is substantial downside risk for the economy going forward. Like Munchau, I don’t have any magic bullet solution to this dilemma – although I do have a number of ideas. Feel free to chime in with your thoughts on the way forward.

Comments

[Albertarocks:]

Great article as always Mr. Harrison. You invited us to chime in, so here goes:
I've posting a link below to an interesting chart that shows a phenomenon going on right now that I haven't heard much talk about. I think shows a real pickle developing for the FED. They probably got into this situation due to Geithner and Bernanke's policy of fixing one problem at a time and worrying about tomorrow's problems tomorrow.

stockcharts.com/h-sc/u...

To me, it seems pretty clear that the relationship between the dollar and the stock markets took a remarkable turn in 2003. Prior to that, a strong dollar meant a strong economy, a strong stock market and a high degree of confidence in the United States from the entire world.

Since 2003, the relationship has become "inverse", and rather loosely so at first. But look at the relationship from early 2006 onward! It has become locked in this solidly inverse relationship. Absolutely locked! To my way of thinking, it means that if Bernanke even "dares" to support the dollar it will rise and the stock markets will.... well..... they will do the opposite.

No doubt the FED is aware of this and are therefore reluctant to support the dollar. They're damned if they do and damned if they don't. But either way they're damned, as well they should be. They earned that fate decades ago.

So maybe they're just going to let the dollar continue to tank, keep interest rates artificially low so their buddies can use all the dirty tricks in the book to "use" the American dollar in the dollar carry trade, allow the stock market to soar forever, screw every American with the insidious tax they disguise by calling it "inflation" - or - they face the music, support the dollar, thereby honoring their commitment when they borrowed money from foreign bond holders and let the markets "fall" where they may. And fall they would.But either way, I think this chart shows an interesting but downright scary predicament.

Oct 20 12:57 AM

[Albertarocks:]

I should have added that although I had spotted this relationship a month or two ago, I didn't know what it meant until I read Michael Clark's comments on a different thread. He got me thinking about this from his perspective although I've never conversed with him... I just read his thoughts. I need to give him credit for suspecting this was the case before he even saw this chart. For all I know, he still hasn't seen it. But I give him credit for being one astute dude.

Oct 20 01:03 AM

[John Lounsbury:]

Edward - - -

The famous words of the credit bubble can be heard again. "While the music plays we will continue to dance." And when the music stops, the carriage that brought us here will turn into a pumpkin.

Very good article. You clearly describe the nightmare that results when the production and accumulation of money overwhelms economic activity, while the production and accumulation of wealth is ignored.

Oct 20 01:09 AM

[Michael Clark:]

Alberta: I think you've got the dilemma in a nutshell. They could reward us for saving and paying off our debt -- instead they are 'rewarding' us for taking on more debt, continuing our insolvency, while the banks are rewarded for failing....and those living on a fixed income can go to hell. Honoring our debts? That seems to be the last things on the mind of the thieves running the system.


On Oct 20 12:57 AM Albertarocks wrote:

> So maybe they're just going to let the dollar continue to tank, keep interest rates artificially low so their buddies can use all the dirty tricks in the book to "use" the American dollar in the dollar carry trade, allow the stock market to soar forever, screw every American with the insidious tax they disguise by calling it "inflation" - or - they face the music, support the dollar, thereby honoring their commitment when they borrowed money from foreign bond holders and let the markets "fall" where they may. And fall they would.

Oct 20 02:48 AM

[Michael Clark:]

Isn't it about time for a class-action suit against Bernanke for willfully destroying the value of the dollar and for willfully stealing interest from American savers?

Does the Fed Chair have a charter granting him dictatorial powers over stocks, bonds, and currency markets? Or is the Fed limited to manipulation of the economy via the Fed Funds rate? How did Greenspan/Bernanke get so much power? Is it written in their charter? I don't know.

Oct 20 02:59 AM

[Michael Clark:]

Edward: Another great post. I always enjoy reading your work. I like this, especially...deflation is secular, inflation cyclical. That's how you get stagflation. A high cycle inflation within a secular deflation. Gold will like that.

The central bank is damned if it does and damned if it doesn’t. This was the takeaway of the Scylla and Charybdis post: All roads lead to a W-style Japanese depression or a deflationary bust because deflation is secular (Terminal Debt) while inflation is cyclical (asset prices). An inflationary scenario will invite a policy response which kills the recovery.

Oct 20 03:07 AM

[bluesky123:]

Here's what Arizona is doing to kick this next economic crisis in the tail. As reported yesterday by the Arizona Republic in "State now in race to home-grow, recruit jobs", the small city of Surprise Arizona has created a $5.6million fund for biotech start ups. The Arizona Economic Resource Organization, an economic development support group, just announced plans for a $200 million fund to finance startups. Now, that's cool.

The solution for America is laughably simple. Every state should follow Arizona's lead. Get behind business creation and innovation. Stop lamenting the state of the world and proffer solutions. Create what Arizona is doing in every state and you'll create ten thousand new incredibly dynamic, brilliant companies every year. All this self-flagellation is really boring me. Yawn.

www.azcentral.com/ariz...

Oct 20 04:26 AM

[Al-USA:]

Excellent article and there will be no solution because instability is designed into the economic model called Capitalism.

The masses were "sold" a "bill of goods": if, during the prolonged boom period of capital, starting from 1982 to about 2000, the economic model of capitalism failed to increase the living standards, or wages, of the masses and instead provided the illusion of wealth by substituting with massive debt, or credit, what will happen now? Now, in this crisis of capitalism, or crisis of overproduction?

Barbarism, that is what could happen. One only needs to look at the genesis of the last two world wars to see the results of capitalism when it reaches a senile state which it is now fast approaching, in my opinion. Boom and bust, and world wars or worse... Good luck to all.

Oct 20 05:08 AM

[Michael Clark:]

I can't argue with that.


On Oct 20 05:08 AM Al-USA wrote:

> Excellent article and there will be no solution because instability
> is designed into the economic model called Capitalism.
>
> The masses were "sold" a "bill of goods": if, during the prolonged
> boom period of capital, starting from 1982 to about 2000, the economic
> model of capitalism failed to increase the living standards, or wages,
> of the masses and instead provided the illusion of wealth by substituting
> with massive debt, or credit, what will happen now? Now, in this
> crisis of capitalism, or crisis of overproduction?
>
> Barbarism, that is what could happen. One only needs to look at
> the genesis of the last two world wars to see the results of capitalism
> when it reaches a senile state which it is now fast approaching,
> in my opinion. Boom and bust, and world wars or worse... Good luck
> to all.

Oct 20 05:54 AM

[Faisal Humayun:]

I would not entirely agree to the fact that Government Bonds are a good investment...AAA Corporate bonds are giving better returns...moreover, the Government itself has a high probability of going bust in trying to service the huge debt...

So I would say that short term Government bonds are still fine..

Long Term Government Bonds are a disaster...

Oct 20 06:04 AM

[Moon Kil Woong:]

Worse yet than the Greenspan Put that encorages rampant risk taking is the fact that persistently low interest rates is an incentive to overspend and a disincintive to save. Thus after decades of this we are finding out that America as a whole is going flat broke. This is not just the government but its citizens as well. Furthermore, by constantly lying about inflation and covering up persistent con-core inflation (oil, commodities, etc.) we are finding out that even if we saved the federal Reserve has so deflated our money we have less today in real terms and can't afford what we do have and need.

Health care has grown from 5% of GDP to 14% (some say 20% but lets take the conservative number). Basic neccesities have left America with no disposable income whatsoever. All the disposable income is from tapping into savings or outright debt. It has been this way for decades.

The only real solution is to stop the federal Reserve. Although it is not set up to be an instrument of mass destruction, it has become this was simply because it is in their own political interest to appease those in power with false supercharghed booms and protect the banking cartel that they represent to the detriment of each and every American save themselves.

Oct 20 06:23 AM

[Value Added:]

Terminal debt is fast approaching. Combining that with the reality that politicians know they stand to lose re-election in a depressed economy, results in the only play remaining for policy-makers: printing more money, injecting more liquidity into the market, and further stretching the bubble. The question that remains in my mind is this - which will come first, a rapid collapse of asset prices, or a hyperinflation shock? It could play out either way, and I think both could happen simultaneously, with some asset classes collapsing and others inflating. The only thing I am absolutely sure of, is that it won't be pretty.

Oct 20 08:35 AM

[Albertarocks:]

On Oct 20 02:48 AM Michael Clark wrote:

> Alberta: I think you've got the dilemma in a nutshell.<

stockcharts.com/h-sc/u...

On Oct 20 12:57 AM Albertarocks wrote:

> So maybe they're just going to let the dollar continue to tank, keep interest rates artificially low so their buddies can use all the dirty tricks in the book to "use" the American dollar in the dollar carry trade, allow the stock market to soar forever, screw every American with the insidious tax they disguise by calling it "inflation" - or - they face the music, support the dollar, thereby honoring their commitment when they borrowed money from foreign bond holders in the first place, and let the markets "fall" where they may. And fall they would.<


There's one more scenario that might evolve as a result of the markets suddenly getting a clear picture of reality. If Bernanke won't do the right thing and just insists on maintaining the status quo, it's possible the market will react in spite. It's possible that the relationship between the dollar and the markets that existed prior to 2003 will return, but this time they won't be going up in tandem, they'd be going down in tandem. IOW, is it possible that the markets will return to sanity, suddenly see the situation clearly for what it really is, and start a horrific slide in tandem with a falling dollar? That sounds like a contradiction, since a falling dollar is inflationary, and in a normal inflationary scenario, the stock markets rise. But the world isn't rational these day, is it?

Maybe the worst of all worlds is about to unfold. I wouldn't be surprised that we see something we've never seen before (as we are right now with stock markets reportedly at multiples never seen before), because the interference by the FED in the markets and the economy in general has never been at these extreme levels.

Oct 20 09:42 AM

[Gregman2:]

Excellent article. "This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt." Until there's a total blow out of the overstated values of real estate, relative to real debt levels, we'll just be hobbling along. The fact is real wages in the West (relative to global wages) cannot support the artificially high debt levels that our institutions are relying on, as their 'claimed' net book values.

Oct 20 08:54 PM