A stock market tinderbox created by egregious money and credit excess caught fire this week. With speculative juices boiling, the AMEX Broker/Dealer index surged 16%, The Street.com Internet index, Semiconductors and the NASDAQ Telecommunications index all jumped 7%, and the Morgan Stanley High Tech index advanced 6%. The NASDAQ100 jumped 5%. Year to date, the NASDAQ 100, Morgan Stanley High Tech, and Semiconductor indices have gained 9%, 17%, and 76%. Many stocks with short positions experienced significant gains, particularly late in the week. By S&P industry group, this week the investment bank/brokerage sector surged 18%, aluminum 17%, electric instruments 13%, paper and forest products 10%, and communications equipment 8%. The speculative issues dramatically outperformed, with the Dow and S&P500 adding 2%. The Morgan Stanley Consumer index and the Utilities increased 2%. There was a rush to the economically sensitive issues, with the Morgan Stanley Cyclical index and Transports adding 5%. The small cap rally continues, with the Russell 2000 gaining 3%. After last week’s big run, some profit taking took the AMEX Biotech index about 5% lower. And while the brokerages fueled a 6% gain for the Bloomberg Wall Street index, the S&P Bank index added only 1%.
A bit of reality returned to the credit market today, on the back of increasingly worrisome inflation news, rebounding consumer confidence, rising industrial output, and a stronger than expected report on June retail sales. Not the makings of a soft-landing. Treasury yields, from 2-year to 10-year, jumped at least 10 basis points today. The yield on the benchmark Fannie Mae mortgage-back yield increased 14 basis points. Spreads widened somewhat today, but remained little changed for the week. To be sure, we see the credit market vulnerable going forward. The dollar generally rallied about 1% for the week. Gold dropped almost $3, but gold stocks were largely unchanged.
Broad money supply (M3) expanded by $22 billion last week, and has now increased $215 billion, or at a rate of 8.6%, during the past 20 weeks. Once again, the “institutional sector” is largely responsible, as institutional money funds increased $8 billion and large time deposits added $12 billion. We see that commercial paper outstanding increased $19 billion last week, with the financial sector adding $10 billion of CP. Bank credit expanded by $7 billion, with commercial and industrial loans increasing $4 billion and real estate loans adding $2 billion. It also appears that it was a big week for corporate and agency debt issuance, so the credit system continues to fire on all cylinders.
We will begin with a quote that came this week from Alan Greenspan and then dive into the analysis of Joseph A. Schumpeter.
“I am pleased to have the opportunity to meet with you today and address the remarkable changes that have been occurring in our economy. The current expansion has not simply set a new record for longevity. More important, the recent period has been marked by a transformation to an economy that is more productive as competitive forces become increasingly intense and new technologies raise the efficiency of our businesses. With the rapid adoption of information technology (IT), the share of output that is conceptual rather than physical continues to grow…One result of the more-rapid pace of IT innovation has been a visible acceleration of the process that noted economist Joseph Schumpeter many years ago termed ‘creative destruction’ – the continuous shift in which emerging technologies push out the old. Today our capital stock is undergoing an increasing pace of renewal through investment of cash flow from older-technology capital equipment and facilities into cutting-edge, more efficient vintages. This process of capital reallocation across the economy has been assisted by a significant unbundling of risks in capital markets made possible by the development of innovative financial products, many of which themselves owed their viability to advances in technology.” Alan Greenspan July 11, 2000
“We know, of course, that history incessantly repeats itself. But it is amazing and perhaps a little sad to observe that economists, swayed by the prevailing humors of the hour, also repeat themselves and that, blissfully ignorant of their predecessors, they believe in each case that they are making unheard-of discoveries and building up a brand-new monetary science. However, there are some things to be gleaned from a history of analysis.” Joseph A. Schumpeter, History of Economic Analysis, 1954
The title of Alan Greenspan’s speech was “Structural Change in the New Economy.” It was obvious that it was not going to be one of our favorites as soon as the initial headlines appeared on Bloomberg: “Greenspan says worker insecurity is likely to remain intense;” “Greenspan comments suggest he sees less pressure on wages.” These headlines brought back memories of President Bush’s public shopping trip and silly comments about the wonder of price scanners at checkout counters – a striking revelation of being “behind the times” and having lost touch with real world developments.
Increasingly, it is apparent that Greenspan has both lost touch and drifted away from serious economic analysis. And the greater his detachment, the more he seems impelled to adopt “New Era” doctrine. After all, only within his nebulous “New Era,” can he rationalize the highest prices and most speculative stock market in history, a virtually nationwide real estate bubble, $400 billion current account deficits, soaring consumer and business debt levels, and a reckless financial sector that has been expanding its borrowings by more than $1 trillion annually, while accumulating upwards of $100 trillion of derivative positions. Of late sounding the true “New Paradigmer,” Greenspan is digging in his heels and now espouses the infamous notion “this time it’s different.” Not only has he developed into an enthusiast of the New Economy, he, amazingly, champions “New Era Finance” as well. Such leaps of faith are grossly inappropriate for a central banker, let alone the Chairman of the US Federal Reserve.
Greenspan, along with many of the prominent “New Era” zealots, often invokes the work of the great economist Joseph Schumpeter. We hold Schumpeter’s analysis in the highest regard, and believe he would be quite appalled that his work is associated with “New Era” propaganda. We certainly protest what we view as a misrepresentation of Schumpeter’s analysis by the “New Paradigmers” incessant use of his name in justifying the boom, while they conveniently ignore historic money, credit and speculative excess. Schumpeter vehemently held that credit and debt structures played critical roles in the recurring booms and busts inherent in a capitalist society. Greenspan and the “New Paradigmers,” on the other hand, will rarely go so far as to utter the word credit, and at the same time many profess the end of business cycles. Schumpeter would not be impressed. So, we say forget the “New Era” nonsense, and instead we strongly recommend Schumpeter’s classic book (first printed during the depression) Business Cycles – A Theoretical, Historical and Statistical Analysis of the Capitalist Process.
I apologize for the length of these quotes and the sometimes-awkward context, but Schumpeter’s work provides brilliant and exceedingly pertinent insights on money, credit and finance. If he were alive today, he certainly would not be intellectually partnered with the likes or Greenspan, Larry Kudlow or others who invoke his name to justify the bubble, while they also resolutely ignore the fundamental issue of financial stability.
“Consumers’ borrowing is one of the most conspicuous danger points in the secondary phenomena of prosperity, and consumers’ debts are among the most conspicuous weak spots in recession and depression.”
“In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks.”
“This relation (between innovation and credit creation), which is fundamental to the understanding of the capitalist engine, is at the bottom of all the problems of money and credit, at least as far as they are not simply problems of public finance.” Joseph A. Schumpeter – Business Cycles, published 1939
The Greenspan Fed’s “New Paradigm” view of new technologies and financial structures provides (misguided) justification for accommodating money and credit excess. It is, ironically, precisely during periods of dramatic innovation, with technological advancement and financial experimentation and excursion, that central bankers must be on the highest guard against abuses of money, credit and dangerous speculation. Why does Greenspan no longer address consumer debt levels that continue to grow rapidly, especially now that rising interest rates lead to higher debt service ratios? Why is the unprecedented growth of financial sector liabilities never mentioned?
“If innovation is financed by credit creation, the shifting of the factors is effected not by the withdrawal of funds – “canceling the old order” – from the old firms, but by the reduction of the purchasing power of existing funds which are left with the old firms while newly created funds are put at the disposal of entrepreneurs: the new “order to the factors” comes, as it were, on top of the old one, which is not thereby canceled. It will be shown later how this will affect prices and values and produce a string of important consequences which are responsible for many characteristic features of the capitalist process. This side of credit creation may also be clarified by means of the analogy with the issue of government fiat, although in all other respects the differences are much more important than the similarities.” Joseph A. Schumpeter – Business Cycles, published 1939
Schumpeter’s “reduction of purchasing power of existing funds” is what is now labeled inflation. Today, further concrete evidence of rising inflationary pressures was provided by the National Association of Business Economics survey. “Investment continues at a breakneck pace, aided in part by the push to adopt e-commerce technologies. The productivity gains associated with those investments, however, do not appear to be enough to hold pricing pressures in check,” cautions NABE President Diane Swonk, who is Chief Economist at Bank One Corp. “About a third of our NABE panel was able to pass along price hikes in the second quarter, the highest percentage in five years. This mimics a pattern seen in the first quarter and suggests that something has clearly changed in the ability of firms to raise prices over the last six months.” There is absolutely no doubt that previous and continued credit excess now produces a “ string of important consequences,” much to the detriment of boththe financial sector and economy.
“By confining the manufacture of credit to banks (within his model), we are roughly conforming to fact. But this restriction is not necessary. In various ways, firms may create means of payments themselves. A bill of exchange or a note is not, in itself, such a means. On the contrary, it generally requires financing and thus figures on the demand rather than the supply side of the money market. If, however, it circulates in such a way as to effect payments, it becomes an addition to the circulating medium. Historically, this has occurred repeatedly. An example is afforded by the practice which prevailed in the Lancashire cotton industry until at least the middle of the nineteenth century. Manufactures and traders drew bills on each other which, after acceptance, were used for the settlement of debts due to other manufacturers and traders, much as bank notes would be. This should be taken into account in any estimate of the quantity of credit creation…” Joseph A. Schumpeter – Business Cycles, published 1939
Here, Schumpeter provides a brilliant and pertinent explanation of the mechanism whereby non-banks can become creators of “circulating medium” (money) and credit. Importantly, in the contemporary “New Era” financial environment with $1.5 trillion of outstanding commercial paper, almost $1.7 trillion domiciled in money market funds, and numerous other sophisticated vehicles and structures, there has been a profound evolution of the entire payment system. Clearly, today sources of money and credit creation outside the banking system “circulate in such a way as to effect payments.” Indeed, the proliferation of aggressive non-bank credit creation has provided momentous fuel for this historic boom. With this in mind, we note that Fannie Mae and General Electric, two leading nonbank instigators of money and credit excess, reported record earnings this week. We see that Fannie Mae expanded total assets by $22 billion during the 2nd quarter (15% annualized rate), almost double the $11 billion during the first quarter. GE earnings were fueled by almost $16.5 billion in revenues from GE Capital, a 23% year-on- year increase.
“We insisted above on the differences between the issue of government fiat and credit creation by banks, not because of the difference between the creating agencies but because of the difference in the purposes usually associated with the two, which is what accounts for the difference in effects. For it must never be forgotten that the theory of credit creation as, for that matter, the theory of saving, entirely turns on the purpose for which the created – or saved – means of payment are used and on the success which attends that purpose. The quantity-theory aspect or, as we might also say, the aggregative aspect of the practice is entirely secondary. The trouble with John Law was not that he created means of payment in vacuo, but that he used them for purposes which failed to succeed. This will have to be emphasized again and again.” Joseph A. Schumpeter – Business Cycles, published 1939
One of the great dangers of the ongoing US credit bubble is that money and credit excess continue to fuel a consumption binge and massive malinvestment – capital destruction. Ballooning debt levels, particularly from the financial sector, creates an enormous volume of additional financial wealth. Yet these claims are not backed by actual economic wealth producing assets. The result is an illusion of a sound and sustainable prosperity, and an increasingly distorted and fragile economic and financial structure.
“It is important for the functioning of the system that the banker should know, and be able to judge, what his credit is used for and that he should be an independent agent. To realize this is to understand what banking means…Even if he confines himself to the most regular of commodity bills and looks with aversion on any paper that displays a suspiciously round figure, the banker must not only know what the transaction is which he is asked to finance and how it is likely to turn out, but he must also know the customer, his business, and even his private habits, and get, by frequently, “talking things over with him,” a clear picture of his situation. But if banks finance innovation, all this becomes immeasurably more important.” Joseph A. Schumpeter – Business Cycles, published 1939
“Whatever our theories, we must all recognize that the leading functions are not simple matters which people can be expected to perform as effectively as they can be expected to leave an employment that offers a lower for one that offers a higher wage, or to produce beans instead of peas if it pays better; but that they are difficult to fulfill, so much so that many of those who attempt to fill them are hopelessly below the mark in a sense in which even the subaverage workman, craftsman, farmer is not. This is, of course, so with entrepreneurs. But in their case we take account of it by recognizing from the start that a majority of would-be entrepreneurs never get their projects under sail and that, of those who do, nine out of ten fail to make success of them. In the case of bankers, however, failure to be up to what is very high mark interferes with the working of the system as a whole. Moreover, bankers may, at some times and in some countries, fail to be up to the mark corporatively: that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops. This in itself is sufficient to turn the history of capitalist evolution into a history of catastrophes. One of the results of our historical sketch will, in fact, be that the failure of the banking community machine accounts for most of the events which the majority of observers call “catastrophes.”
“Not less important for the functioning of the capitalist machine is it that banks should be independent agents…This means, practically speaking, that banks and their officers must not have any stake in the gains of enterprise beyond what is implied by the loan contract.” Joseph A. Schumpeter – Business Cycles, published 1939
It is certainly our view that the US financial sector has regressed into “wildcat banking/lending/finance.” Unfortunately, “New Era Finance” has terribly diminished the role of the traditional loan officer, while the investment banker, venture capitalist, money manager and derivative player have taken control of the “banking” process. Accordingly, our nation’s leading bankers are anything but “independent agents” as they endeavor to profit from and perpetuate the dangerous American credit and asset bubble. Borrowing a term from Dr. Henry Kaufman, with the Fed acquiescing and Wall Street taking charge, our system is left acutely vulnerable to “unguarded credit.”
“But under the circumstances of that period (the 1920s boom) and in the glow of its uncritical optimism, neither costs nor interest charges mattered much. It seemed more important to get quickly the home one wanted – or the skyscraper the prospective rents of which in any case compared favorably with the rare on mortgage bonds – than to bother whether it would cost a few thousand dollars – or in the case of the skyscraper, a million or so – more or less, provided money was readily forthcoming at those rates. And it was. First mortgages on urban real estate represent, on the one hand, not all the loans that were made available for building and, on the other hand, also financed not only other types of building but other things than building. But it is still permissible to point to the fact that they increased from, roughly, 13 billion in 1922 to, roughly, 27 in 1929…This increase is out of all proportion, not only with the increase in what can in any reasonable sense be called savings, but also with the expansion of bank credit in other lines of business, and illustrates well how a cheap money policy may affect other sectors than those in which it is conspicuously successful in bringing down rates.” Joseph A. Schumpeter – Business Cycles, published 1939
“In the prosperity phase, investment from innovating activity increases consumers spending almost as quickly as producers spending. ‘…old firms will react to this situation and…many of them will ‘speculate’ on this situation. A new factory in a village, for example, means better business for the local grocers, who will accordingly place bigger orders with wholesalers, who in turn will do the same with manufacturers, and these will expand production or try to do so, and so on. But in doing this many people will act on the assumption that the rates of change they observe will continue indefinitely, and enter into transactions which will result in losses as soon as facts fail to verify that assumption…New borrowing will then no longer be confined to entrepreneurs, and…” From Joseph A. Schumpeter’s Business Cycles, 1939 ‘deposits’ will be created to finance general expansion, each loan tending to induce another loan, each rise in prices another rise’…this is a well-known cumulative process Schumpeter called “the secondary wave.” In it is included the clusters of errors, waves of optimism, and overindebtedness
“The American debt situation and the American bank epidemics – there were three of them – are in a class by themselves. Given the way in which both firms and households had run into debt during the twenties, the accumulated load – in many cases, though not in all, very sensitive to a fall in price level – was instrumental in precipitating depression. In particular, it set into motion a vicious spiral within which everybody’s efforts to reduce that loan for a time, only availed to increase it. There is thus no objection to the debt-deflation theory of the American crisis, provided it does not mean more than this. The element it stresses is part of the mechanism of any serious depression. But increase of total indebtedness at the rate at which it had occurred in this country is neither a normal element of the mechanisms of Kondratieff downgrades nor in itself an “understandable” incident, like speculative excesses and the debts induced by these. It must be attributed to the humor of the times, to cheap money policies, and to the practices of concerns eager to push their sales; and it enters the class of understandable incidents only if we include specifically American conditions among our data. Similarly, bank failures are of course very regular occurrences in the course of any major crisis and invariably an important cause of secondary phenomena…Those epidemics cannot, however, be considered as wholly explained by the ordinary mechanism of crises or by the mechanism plus the fact of excessive indebtedness all round or even by all that plus the stock exchange crash. The American epidemics become fully understandable only if account be taken of the weaknesses peculiar to the American banking structure…”Joseph A. Schumpeter – Business Cycles, published 1939
To any serious observer, the parallels between the 1920’s and the past decade are as obvious as they are disconcerting.
“It is of the utmost importance to realize this: given the actual facts which it was then possible for either businessman or economists to observe, those diagnoses – or even the prognosis that, with the existing structure of debt, those facts plus a drastic fall in price level would cause major trouble but that nothing else would – were not simply wrong. What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.” From Joseph A. Schumpeter’s Business Cycles, 1939
Please read this final quote very carefully. It is our sense that it has profound implications for our system going forward. Clearly, a lot of us “have felt it” – “that those fundamental data from which diagnoses and prognoses” are being made, are “themselves in a state of flux.” With Schumpeter’s quote in mind, we are left to ponder. Is it appropriate for central bankers to base policy on so-called productivity advancements, while an economy is in the midst of historic credit growth, as well as financial and economic boom (especially considering $30 billion plus monthly trade deficits)? Are the much vaunted “labor per unit of output” productivity measures used for years appropriate today for an economy now overwhelmingly service sector and asset inflation-based? Is GDP growth an appropriate measure of an economy’s performance during a bubble period replete with endemic over consumption and suspect investment? Do measures of corporate profitability provide reliable evidence of a sound and vibrant business sector during a bubble period, especially when a significant portion of corporate profitability emanates from lending and financial services? Is CPI a relevant measure of price stability during a period of historic asset inflation and unprecedented trade deficits? Should money and credit be completely ignored as long as inflation at the consumer level is rising only moderately?
It is certainly our view that the so-called “New Era” is built on a foundation of misconceptions and erroneous analysis – a frail structure of debt and securities. As history has proven time and time again, such a circumstance will end with “the ground giving way.”