by Doug Noland
It would be reasonable - and it sure is tempting - to dedicate this week's bulletin to a skeptical look at Europe's latest plan for credit crisis resolution. I would not be without plenty of company. So I'll instead go in a different direction. This week I found my thoughts returning back about 12 years to my earliest bulletins. Inspired by the great Austrian economist Ludwig von Mises, my introductory article discussed the need for a contemporary theory of money and credit. Not only was modern economics devoid of monetary analysis, there were critical changes unfolding within US credit that were going completely unappreciated.
Importantly, credit creation was gravitating outside of traditional bank lending channels and liability creation. The system of government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac and the Federal Home Loan Bank, had evolved into major risk intermediaries and credit creators. I began by arguing against the conventional view that "only banks create credit". Securitization markets were exploding in volumes, both in mortgage and asset backed securities.
I was focused on the lack of constraints on this new credit mechanism that operated outside of traditional bank capital and reserve requirements. In contrast to the antiquated bank deposit "multiplier effect" explained in economic texts, I referred to this powerful new dynamic as an "infinite multiplier effect". Borrowing from Murray Rothbard, new credit was created "out of thin air".
The more I studied monetary history, the more I appreciated the importance of both money and credit theory. It became clear to me that money had for centuries played such a profound role in economic cycles (and monetary fiascos). Yet this type of analysis was extinct. Even within the economics community, there was not even a consensus view as to a definition of "money".
There had been decades of bickering about what monetary aggregate to use in econometric models (M1, M2 or the newer M3), along with what measure of "money" supply should be monitored and managed by the Federal Reserve. Especially in light of all the financial innovation and new financial instruments, the economics profession and the Fed punted on monetary analysis. Out of sight and out of mind.
Even if one was focused on the issue, the importance of traditional monetary analysis was lost in myriad new complexities. Yet my study of monetary history and research of contemporary credit convinced me that the analysis of "money" likely had never been more critical to the understanding of (extraordinary) market and economic behavior.
I was intrigued by Mises' work on "fiduciary media", the financial claims that had the economic functionality of traditional (narrow) money. I began to view contemporary "money" as "money is as money does". I was especially struck by monetary analysis from the late American economist Allyn Abbott Young. Young wrote brilliantly about the historical "preciousness" of money.
The more I studied, contemplated and pieced together analysis from scores of monetary thinkers, the more it became clear to me that "money" was critically important because of its special attributes. In particular, money created unusual demand dynamics: essentially, economic agents always wanted more of it and this insatiable demand dynamic created a powerful proclivity to issue it in excess quantities. Keep in mind that a boom financed by junk bonds will pose much less risk (its shorter lifespan will impart less structural damage) than a protracted bubble financed by "AAA" agency securities and Treasury debt.
Centuries of monetary fiascos made it clear that money had better be backed by something of value and of limited supply (ie gold standard) to ensure that politicians and bankers did not fall prey to the same inflationary traps that had repeatedly destroyed currencies and economies across the globe.
While it became fanciful to speak of "new eras" and "new paradigms", I saw a world uniquely devoid of a monetary anchor. There was no gold standard and no Bretton Woods monetary regime. I saw an ad hoc dollar reserve standard, one that was for awhile somewhat restraining global credit, begin to disintegrate from the poison of runaway US credit excess and intransigent current account deficits.
Marketable debt accounted for the majority of new credit creation, and these new financial sector liabilities were enjoying extraordinary demand in the marketplace. This marketable debt could also be readily leveraged (at typically inexpensive rates "pegged" by the New Age Federal Reserve) by a mushrooming leveraged speculating community, adding only greater firepower to the credit boom. Over time, the US credit system exported its bubble to the rest of the world.
From my perspective, contemporary "money" was just a special - the most "precious" - type of credit. "Money" had become nothing more than a financial claim that was trusted for its "moneyness" attributes: chiefly, a highly liquid store of nominal value. This new "money" was electronic and incredibly easy to issue in unfathomable quantities.
The vast majority of this credit was created in the process of asset-based lending (real estate and securities finance), and the more that was issued, the greater the demand for these "money-like" financial claims. The world had never experienced "money" like this before, and I suspected that the world would never be the same.
In this brave new financial world dominated by one incredible global electronic general ledger of debit and credit journal entries, "moneyness" became little more than a market perception. If the market perceived a new financial claim was liquid and "AAA", then there essentially became unlimited demand for this "money."
Not unexpectedly in such circumstances, this "money" was issued in gross excess. Most of it was created in the process of financing the real estate and securities markets. At the late stage of the boom, a hugely distorted marketplace saw trillions of risky subprime mortgages sliced and diced into mostly "AAA" "money"-like credit instruments. Importantly, a distorted marketplace believed that Washington would back GSE obligations and that the Treasury and Fed would ensure the stability of mortgage and housing markets.
The 2008 crisis was really the result of Wall Street risk intermediation and structured finance losing its "moneyness." When the mortgage finance bubble burst, the market quickly questioned the creditworthiness and liquidity profile of trillions of debt instruments. As finance abruptly tightened, asset-market bubbles popped and maladjusted economies faltered. The "moneyness" phenomenon came back to haunt financial and economic systems.
Not only had years of monetary inflation impaired underlying economic structures, a huge gulf had developed between the markets' perception of the "moneyness" of the debt instruments and the bubble state of the asset markets underpinning an acutely fragile (Hyman Minsky) "Ponzi Finance" credit structure.
I have posited that the policy response to the 2008 crisis - monetary and fiscal, at home and abroad - unleashed the "global government finance bubble." Essentially, massive government debt issuance, guarantees and central bank monetization restored "moneyness" to US and global credit. I have argued that this course of policymaking risked impairing the creditworthiness - the "moneyness" - of government debt markets, the core of contemporary monetary systems.
At its heart, the European crisis is about the escalating risk that the region's debt could lose its "moneyness". Starting with the introduction of the euro, the market perceived that even Greek debt was money-like. Despite massive deficits, a distorted marketplace had an insatiable appetite for Greek, Irish, Portuguese, Spanish and Italian debt. Importantly, the markets believed that European governments and the European Central Bank (ECB) would, in the end, back individual government and banking system obligations.
US Treasury and Federal Reserve backing restored "moneyness" to trillions of suspect financial claims back in 2008 - and since then massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted US economic structure. The markets enjoyed an incredible windfall, and many these days expect European politicians and central bankers to similarly reflate eurozone credit and economies.
I believe strongly that the credit recovery and tepid US economic recovery came at an extremely high price: dynamics that ensure the eventual loss of "moneyness" for US government credit, the heart of our monetary system.
Many expect Germany to use the "moneyness" of their credit to ensure the ongoing "moneyness" for European debt more generally. The conventional view is that, at the end of the day, German politicians will do a cost versus benefit analysis and realize it will cost them less to backstop the region's debt than to risk a collapse of European monetary integration.
The Germans, however, appreciate like few other societies the critical role that stable money and credit play in all things economic and social. The Germans have refused the type of open-ended commitments necessary for the marketplace to begin to trust the credit issued by the profligate European borrowers (and an incredibly bloated banking system).
European politicians have been desperately seeking some type of structure that would ring-fence the sovereign crisis to protect the "moneyness" of, in particular, Italian and Spanish borrowings. Increasingly, the consequences of a loss of "moneyness" at the periphery were weighing heavily upon the European banking system, with heightened risk of impairing "moneyness" at the core. This was critically important, as it was quickly limiting the options available for monetary crisis management.
For example, faltering confidence in Italian debt and what an Italian debt crisis would mean to European and French banks was impacting market confidence in French sovereign credit. So any crisis resolution structure that placed significant additional demands on French sovereign debt risked impairing the "moneyness" of French credit at the core of the European debt structure. Understandably, the markets feared the crisis was spiraling out of control.
Will it work? I highly doubt it, but it does buy some time - and the markets were content. It appeared to take near-term implosion risk off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets.
I assume the Chinese will move cautiously and, as always, work only in their self-interest. China will want assurances their European investments are safe, which means they will want to avoid exposure to periphery and Italian credit just like everyone else. I suspect that European Financial Stability Facility debt will struggle to retain "moneyness", as markets fret over ongoing European credit deterioration and the future of the euro currency.
There may be grand plans and grand designs for a credible "ring-fence", but the critical issue of how to ensure ongoing Italian debt "moneyness" continues to prove elusive. Global risk markets were in virtual melt-up mode last week, yet Italian 10-year yields jumped 13 basis points (bps) to 6.01%......
By Reuven Brenner
Although the unresolved timing and the unknown question in the briefly proposed Greek referendum raised havoc in stock and bond markets around the world, if a referendum regarding austerity measures linked to the country's debt crisis was in fact put to the Greek people the long-term effect could be greatly beneficial.
With a referendum, the European Community could have moved rapidly toward a model of democracy that Switzerland has been long practicing on its federal, canton and municipal levels, namely "direct democracy". Swiss citizens can sign petitions asking for initiatives on most spending, regulatory and fiscal issues, and with enough signatures, politicians must comply and call a referendum.
Not everything is "perfect" with this system - it may slow some
By "properly", I mean that constitutions of countries using the tools of direct democracy must be pretty clear that these tools cannot be used selectively by opportunistic politicians, as it seems to have been the case in the recent crisis.
The Icelandic voters have refused in two referenda the solutions that the European Union and the International Monetary Fund proposed - with the case now before the EU courts in Bruxelles. Of course, if they could, Iceland's population and Greece's would always vote against paying the bills after taking on too much debt, and its politicians spending and promising as if there were no tomorrows - or always kind strangers picking up the bills.
In a previous article, almost a year ago, I noted that in spite of the fact that Transparency International Corruption Index in 2005 ranked Iceland as No 1 out of 159 countries, and the United Nations ranked it on top of their Human Development Index in 2006, then third in 2007, by October 2008 all three of Iceland's main financial institutions crashed. Although they claimed that they were victims of UK, Dutch, and US bankers, a closer look suggests that local corruption did them in. Iceland's political landscape was closer to a Third World setting than the Nordic idylls advertised by international bureaucracies and academia.
Iceland's big banks, Landsbanki Islands and Bunadarbanki Islands (then the Kaupthing Bank), were privatized in an auction - or kind of auction: the country's National Audit Office quickly pointed out that the banks were sold at suspiciously low prices to friends of the then government in power and had no banking experience.
One was a politician who once ran two small knitwear factories in the 1970s for only a few months. Another had not only been in legal trouble in Russia, but was also awarded a conditional prison sentence in Iceland for fraud. The latter's son, a wheeler-dealer, was a co-investor.
Although the local media discussed these Third World-type arrangements, Iceland's democracy brought no remedies. Iceland's voters did not demand a referendum on the above deals - which could have prevented the island's eventual hardships. The politicians called the referendum only when the bills came due - pretty much as Greece briefly indicated it might do now.
And yet, a potentially drastic political innovation may come out from the present close-to-defaulting European states: the gradual shift to accountable - rather than opportunistic - "direct democracy".
Do EU's members want to rely on this mechanism when it concerns their debt payments? Then they would have to agree that they would succumb to this process also when governments decide on their spending and on their regulations. This should be from now on in the EU agreement - and enforced. Canada can offer some clues how, as explained below.
If this would be the outcome of the present crisis - the benefits would overwhelm any present fiscal problems. Although I am not holding my breath, since such a change would drastically diminish the power of politicians in each EU country - and Bruxelles too.
But - who knows? - it would not be the first time that a crisis would bring about such process and constitutional changes. In 1995, I was asked to be one of seven member commission to examine the impact of Quebec's potential divorce from Canada. The then ruling separatist party in Quebec, decided to ask this question in the referendum (which almost broke up Canada, the federalist option winning with a very slim 50,000 votes):
Do you agree that Quebec should become sovereign after having made a formal offer to Canada for a new economic and political partnership within the scope of the bill respecting the future of Quebec and of the agreement signed on June 12, 1995?
Polls released before the October 30 referendum showed that one third of undecided voters thought that the referendum was about Quebec negotiating a better deal with the rest of the provinces, with their Canadian passports and rights to elect members to the Canadian parliament maintained. Soon after the slim defeat, the federal government woke up and passed a "Clarity Act" defining the conditions under which the Government of Canada would enter into negotiations that might lead to divorcing any province whose voters may so decide.
But it was clear that whatever these voters might decide, they had to pay their share of the federal debt before pursuing some tribal dreams. Perhaps the present crisis would lead the EU to re-write its rules linking the extent of governments' spending and repayment debts to rights of secession, and put the appropriate clauses in all financial agreements....
On Poor Greece:
Watching the international blackmail of Papandreou and Greece to cancel his referendum plan has been pretty ugly – I imagine the diplomatic style and atmosphere of the Munich conference was similar. The joy in the financial markets at the cancellation of the referendum may be foolish.
The Greeks have effectively given up all effective sovereignty over their economy. To do that without having voted on it is quite a difficult step for any people to take, particularly a people as nationalistic as the Greeks. There will be blow-back.
There has been little reporting or understanding of what happened on the ground in Greece over the last week. 372 Foreign “advisers” moved in to take over Greek ministries, in some cases even sequestering minsters’ offices. They have absolute financial control of budgets and have to approve and sign off spending before money is paid out. In effect, these advisers are now the government of Greece. 28% of these “advisers” are civil servants from other Euro states. The majority are of bankers, and executives of private financial institutions, accountancy and consultancy firms.
Anybody who thinks this is going to work out is raving mad.....