In his weekly blog post on July 6, 2012, Doug Noland has described the real risk of a credit bubble and compared it with the real risk of asset inflation. In his description, asset inflation is the initial reaction to monetary and fiscal avoidance of austerity. The cost is a heightened and delayed reaction to excess credit and money supply which will create a maladjusted economy characterized by a lack of solvency among the many and wealth held by only a few. Here is a link to the entire post and here is a major section of his post for future reference.
"Policymakers will, as we’ve witnessed again recently from European
politicians and central bankers, respond to heightened systemic stress
by ratcheting up their responses. Yet, and also no surprise, these
increasingly desperate measures will have depleted and fleeting effects –
and really tend only to heighten market instability. The big unknown
remains the timing of when market confidence in the capacity of policy
measures to incite market rallies is finally depleted. Without this
carrot, I expect we’ll be facing an altered global market environment.
The structure of today’s marketplace (especially with respect to the
proliferation of hedging and derivative trading strategies) is
conducive to short squeezes. This is compounded by the policy
environment backdrop whereby market players (sophisticated and
otherwise) fully recognize that policymakers are determined to backstop
the markets. This incentivizes speculation and, I would argue, has
nurtured Bubble Dynamics. Understandably, trumpeting global market
resilience in the face of European debt tumult and slowing global growth
has become common. I continue to fear that the confluence of
complacency, policy impotence, and endemic global market speculative
excess creates unappreciated systemic fragilities.
Extraordinarily divergent macro views have solidified. Some see the
makings for a new secular bull market. I instead see an increasingly
susceptible global Credit Bubble and attendant historic financial
mania. A critical facet of this thesis remains that policymakers will
go to incredible lengths to sustain Credit, financial and economic
booms. And while this guarantees difficulty in assessing the timing of
when catastrophe might strike – it seemingly ensures such an outcome.
With unsettled markets only adding to confusion, I thought it
appropriate this week to touch upon Credit theory to try to bring a
little clarity to the muddled macro backdrop – Trying to Stay Focused on
the Big Picture.
During the halcyon upside of the Credit cycle, ever increasing
quantities of Credit disburse purchasing power throughout financial and
economic systems. The Credit-induced increase in spending supports
income growth, consumption, corporate profits, investment, government
receipts/expenditures and economic output. Asset inflation is seen as
fundamentally driven and, furthermore, as confirmation of the bullish
viewpoint. One can say that Credit growth is self-reinforcing – or
“recursive.” Importantly, the upside of Credit booms ensures seemingly
positive “fundamentals” that validate the system’s financial asset price
structures and, more generally, the expansive Credit and financial
infrastructure.
The Credit boom ensures notions of economic “miracles,” “New Eras,”
and “New Paradigms.” Policymakers are generally seen as astute;
economic doctrine as advanced and enlightened. The inflationary bias
associated with the Credit cycle’s upside provides policymakers great
flexibility - and seemingly ensures policy effectiveness. And
especially after a few episodes where policy responses free the system
from the jaws of crisis, players throughout the markets and economy (not
to mention the general public) come to believe in the capacity of
policymakers to avoid trouble and sustain the boom. The social mood is
one of general optimism, cooperation and cohesion. The pie is perceived
to be getting bigger, and most are for the most part satisfied that
they’re enjoying their fair share. And, of course, “bull markets create
genius.”
The unavoidable may be avoided for years, yet the brutality of a
Credit cycle’s downside in the end will be commensurate with the
duration and scope of boom-time excesses. And the changed Credit
environment changes so many things. The maladjusted economic structure
will eventually give way, ushering in a cycle of deteriorating
fundamentals - including stagnant household incomes, faltering profits
and deteriorating government finances. The pie will not only be
shrinking, but most will come to see a fortunate few unfairly taking an
ever increasing share to the detriment of everyone else. The system
will be viewed as inequitable, unjust and flat out broken. The social
mood turns sour, as most incomes stagnate (or worse) and perceived
financial wealth withers. Faith in institutions will wane. Post-Bubble
policymakers will invariably be viewed as inept. Optimism is
supplanted by pessimism. As always, wrenching bear markets create
disdain and hostility.
Credit’s downside, along with accompanying bear markets, over time
instills wreaking ball havoc upon the Credit structure. In the final
analysis, Credit is everything and always about confidence. During the
Credit expansion, constructive fundamentals and general optimism bolster
the perception that Credit is sound and that most Credit instruments
will be vehicles of wealth generation. As a Credit bust ensues and the
economic and asset price backdrop deteriorates, ever-increasing swaths
of Credit instruments are viewed as impaired or even dubious. The
entire Credit and financial structure, having grown to incredible
stature during the boom, turns brittle and unstable – with trouble
generally starting out on the “periphery” before eventually rotting away
at the “core.”
Policymakers will not accept defeat without one hell of a fight.
Dreadful policy errors will be repeated and compounded. Government
officials will go to increasing inflationary lengths to bolster incomes
and economic output, support asset markets, and stimulate Credit
growth. Such measures typically enjoy initial success, though such a
policy course will invariably lead to an expanding governmental role in
the economy and an interventionist role in the Credit and asset
markets. To be sure, increasingly unsound finance will be mispriced and
poorly allocated.
Stubborn refusal to admit policy mistakes along with increasing
desperation ensure things will only get worse. Over time, it all
regresses into a perilous confidence game. Government intervention and
monetary stimulus inflate confidence for awhile, although such actions
only weaken the underpinnings of the Credit structure. In reflecting
upon the late-twenties excesses that set the stage for collapse and
depression, Keynes referred to the “whirlwind of speculation.” I expect
there will be a point when the markets begin to narrow the gulf between
the (speculative) market’s perception of policy efficacy and the
outright limits of governmental control and market intervention. “When
the development of a country becomes the byproduct of the activities of
a casino, the job is likely to be ill-done.”"