01/25/2002 Experiment on Top of Experiment *

Early week selling switched to buying, as the Dow and S&P500 ended the week up less than 1%. Economically sensitive issues shined, with the Transports jumping 5% and the Morgan Stanley Cyclical index gaining 4%. Defensive issues faced more of a struggle, with the Utilities declining 1% and the Morgan Stanley Consumer index increasing 1%. The broader market was soundly in the black, with the small cap Russell 2000 rising 1% and the S&P400 Mid-Cap index gaining 2%. Technology stocks were mixed, with the NASDAQ100 adding 1%. The Morgan Stanley High Tech index was unchanged, while the Semiconductors gained 2%. The Street.com Internet index dropped 3% and the NASDAQ Telecommunications index declined 1%. The Biotechs generally added 2%. The financial stocks were also mixed, with the AMEX Securities Broker/Dealer index declining 1%, while the S&P Bank index jumped 4%. Although bullion dropped $4.30, the HUI gold index added about 2%.

Credit markets were less than thrilled by Dr. Greenspan’s retreat from ultra-dove or the continued barrage of stronger than expected economic data. For the week, June euro-dollar rates jumped 22 basis points to 2.4%. December euros surged 30 basis points. Two-year yields jumped 23 basis points to 3.1%, while 5-year yields spiked 26 basis points to 4.41%. Yields on the 10-year Treasury note increased 18 basis points to 5.07% and long-bond yields rose 11 basis points to 5.47%. Benchmark mortgage-back yields added 12 basis points and implied yields on agency debt increased 15 basis points. The spread to Treasuries for Fannie Mae’s 5 3/8% 2011 note narrowed 2 to 66. The benchmark 10-year dollar swap spread was unchanged at 71. With global currency markets in heightened disorder, the dollar index surged 2% this week. We now have unsettled conditions and disturbing volatility permeating global equity, currency and Credit markets. UK gilts came under pressure today with the release of stronger than expected growth. Led by a service sector expanding at an annualized rate of 3.6%, the UK economy grew at an annualized rate of 1.7% during the fourth quarter. For the week, UK 10-year yields jumped 18 basis points back to 5%. Yields jumped similarly throughout Europe and in Australia. With the yen sinking to a three-year low against the dollar, Japanese bond yields rose to near one-year highs.

December existing home sales were reported at an annualized rate of 5.19 million units, up 5% from last December. A total of 5.25 million previously owned homes were sold for the year, surpassing 1999’s record 5.21 million. For comparison, there were 3.19 million existing homes sold during 1991, with total sales surpassing four million units for the first time during 1996. December’s average price jumped $7,200 to $190,100, up 6.5% year-over-year. The number of homes on the market dropped to 1.82 million (4.2 months supply), down from September’s 2.17 million and the lowest inventory since January. The most recent weekly retail sales report from Bank of Tokyo-Mitsubishi had sales up 3.8% from last year, the strongest year-over-year performance since August. Yesterday’s report on initial jobless claims had the lowest number of new claims since July.

January 24 Moody’s – “Home-equity backed securitization issuance could reach $105 billion in 2002, up 8% from 2001’s issuance of $97 billion, says Moody’s Investors Service in its recently published 2001 Review and 2002 Outlook: Home Equity ABS report. ‘The combination of a favorable interest-rate environment and continued home price appreciation is the basis for the strong growth projections,’ said Moody’s Henry Engelken and Carlos Maymi, co-authors of the report… In reviewing last year’s issuance volume… ‘2001 was a blockbuster year for the home equity industry. Issuance for the year grew 63% to $97 billion, reversing a two-year trend of declining volume… ‘The increase in home equity issuance is attributable to the subprime sector where issuance profitability benefited from a steepening yield curve and origination [growth] fueled by borrowers who took advantage of slightly lower mortgage rates to cash out after continued home price appreciation.”

The Treasury Department reported that the government’s December budget surplus shrunk to $26.6 billion from last year’s $32.7 billion. With the first few months of fiscal 2002 now behind us, we are in a better position to see how the fiscal situation is unfolding. After three months, receipts are running up about 1% at $462 billion, with personal income tax receipts up about 3% at $226 billion. Outlays have jumped 8% to $464 billion. Worth noting, expenditures are up significantly despite interest costs dropping 16% y-o-y to $45.9 billion. By major category, defense spending is up 12% to $84.3 billion. Social Security and “Income Security” are up 9% to $177 billion. The greatest spending gains, however, are seen with “Health” and Medicare expenditures that are running up 12% to $105.6 billion. First of all, there is nothing remotely “deflationary” in this data. Secondly, it doesn’t take a wild imagination to see how rising interest rates, heightened defense spending, continued health care inflation, and changing demographics could combine for a return to major deficits. The Whitehouse is now projecting a 2002 deficit of $106 billion, a remarkable revision from the year ago estimate for a surplus of $231 billion. Bloomberg is calling the 2.3% of GDP deterioration from last year’s $127 billion surplus the most abrupt fiscal decline since the Korean War. The government is suffering from the same affliction hampering corporate profits: revenues are growing at a much slower rate than costs.

Excerpt from Alan Greenspan’s Jan. 24 testimony before the U.S. Senate Budget Committee: “The extraordinary rise in receipts over the past decade resulted from the exceptional performance of the U.S. economy and the associated rise in the market value of assets, which helped lift receipts from 17-1/2 percent of GDP in fiscal year 1992 to a postwar high of nearly 21 percent of GDP in fiscal 2000. The increase in receipts in the second half of the 1990s was particularly impressive--especially for individual income taxes, which grew about 11 percent per year, on average, between 1995 and 2000. The surge in individual taxes was attributable in part to the strong growth in incomes from production and to the tendency of rising levels of income to shift a greater share of taxable income into higher tax brackets.

But individual taxes also received a boost from the enormous rise in the value of financial assets during that period—directly through taxes on higher capital gains realizations and indirectly through the taxes collected from the exercise of stock options, from stock-price-related bonuses to workers in the financial industry, and from withdrawals from capital-gains-augmented IRAs and 401(k) plans. Estimates based in part on data from the Statistics of Income and other sources suggest that such market-related receipts accounted for only about 15 percent of total individual receipts in fiscal 1995; but because they grew about 25 percent per year, on average, between 1995 and 2000, they accounted for more than one-third of the increase in total individual receipts over that period. Receipts that are more directly related to production in the broader economy--that is, those associated with wages and salaries, business and professional incomes, dividends, and interest income--rose 8-1/2 percent per year, on average, between 1995 and 2000, one-third the pace of receipts on stock-market-related taxable incomes. Had equity asset values risen only as fast as nominal GDP between 1995 and 2000--that is, about 6 percent per year--taxes related to stock-price levels would have been approximately $130 billion less in fiscal 2000, even without taking account of the reduced receipts that would have resulted from a presumably less buoyant economy.”

From (www.marketnews.com) Gary Rosenberger’s Reality Check column: “With wages flattening or (if you throw in bonuses and options) declining, employment costs continue to rise in the slipstream of soaring medical benefits costs, say compensation consultants. Consultants report the strain from medical benefits are severe and companies are clamoring to find ways to contain them. Wages, excluding bonuses and options, continue to rise but at a far slower rate than it had been prior to Sept. 11, they say. Healthcare professionals account for some of the heftier salary gains and appear to be inoculated from recession…” A consultant “maintains that for the vast majority of workers salaries continue to rise, albeit at more subdued levels. A principal from Ernst & Young “observed that some professions seemed immunized from the economic downturn, and continue to see hefty wage gains. ‘We’re still seeing it pretty lucrative in healthcare, nursing and pharmaceuticals -- all that is still wide open.’ …Ernst & Young’s latest survey shows wage growth slowing only modestly… ‘Wage growth may have dropped only a tenth of a percent, but it’s going to fewer people. Wage increases that were projected at 4.3% for the year are down to 4.1% or 4.2%…’ It’s more on the benefits front where companies are striving to rein costs that have galloped out of control.” A consultant stated that medical benefits costs are increasing in the double digits. ‘Prescription drug costs have absolutely exploded in the last year and a half to two years’… while medical costs are rising between 10% and 14%, prescription drug programs are ‘trending upward of 19%.’ Some of her clients have complained about 20% to 30% increases in medical benefits – ‘I haven’t seen that since the late ‘80s,’ she said.” The pressure on insurers to increase premiums is intense.”

The Port of Los Angeles, the nation’s busiest port, reported December inbound container shipments of 216,700, up 13% year-over-year and 27% above levels from December 1999. Port of Long Beach inbound containers were up 6% y-o-y. Interestingly, outbound containers combined for their strongest performance since March, with Los Angeles and Long Beach exports both up just over 5% y-o-y. For the month, 209,000 containers were returned empty, just over half of inbound arrivals.

Freddie Mac reported a huge fourth quarter, with total assets surging $45.4 billion, or 32% annualized (second only to 1998’s tumultuous fourth quarter). For the year, total assets increased an unparalleled $158 billion (34%!) to $617 billion. Looking back, Freddie ended 1992 with less than $60 billion of assets. During the past four years, Freddie’s total assets have surged almost $423 billion, or 217%. Curiously, “Investments” and “Other Assets” jumped $25 billion during the quarter to $122 billion, rising $48 billion (65%) for the entire year. Short-term liabilities increased 36% over twelve months to $250 billion. Freddie Mac and Fannie Mae (F&F) combined to expand total assets by $78.5 billion (23% annualized) to surpass $1.4 trillion during the fourth quarter. For comparison, the Federal Reserve System had an unusually big quarter expanding its assets by $30 billion. Year-2001 was easily a record for F&F, with combined (25%) asset growth totaling an astounding $282.7 billion (versus 2000’s $173 billion and 1999’s $155 billion). Combined total assets expanded by $455 billion, or 47%, over two years, and $831 billion, or 142%, over four years. I am simply unaware of any Credit scheme in history of this caliber, even including John Law’s infamous Mississippi Bubble. Looking at F&F’s “total book of business” (retained portfolio and guaranteed mortgage-backs in the marketplace), combined exposure increased during 2001 by $426 billion to $2.7 trillion, double year-2000’s growth. These two institutions ended 2001 with combined Shareholder’s Equity of about $38 billion.

It is no easy task to comprehend the dimensions of the GSE Bubble or the domestic and international ramifications when it bursts. The four-year $831 billion (142%) F&F balance sheet expansion compares to total U.S. bank loan and lease growth of $923 billion (31%). Over this four-year period, bank “Commercial and Industrial” (C&I) loans increased $171 billion, or 20%. F&F’s $282.7 billion asset expansion during year-2001 compares to total bank loan and lease growth of $51.8 billion (1%), while C&I loans actually contracted by $62 billion (6%). Looking at F&F’s “total book of business” we see a four-year increase of $1.17 trillion, or 76%. These numbers become even more insane with the inclusion of Federal Home Loan Bank System assets. After making an estimate of fourth-quarter asset growth for the third of “The Big Three GSEs,” total GSE exposure has likely increased by more than $1.5 trillion during the past four historic years. F&F assets are up 630% during the past ten years. Unbelievable.

But according to Fannie Mae’s Franklin Raines, “as good as housing was in the last decade, the best is yet to come… This could well be the ‘Decade of the American Dream’.” I will have to say that Mr. Raines took his propaganda to a new level this week as he presented a speech “The Economic Power of Housing – The American Dream Decade:”

“And look what happened in 2001. The economy just had its worst year in a decade. Housing had its best year in history. This is a new phenomenon. Typically when the economy sneezes, housing comes down with double pneumonia. These days, housing is not only healthy; it’s providing a remedy. And this is not a fluke but a trend. The point I want to make today is this: During the last decade, while the market was transfixed by technology, housing was transformed into a real economic powerhouse. And where the tech bubble was built on hopes and dreams, the housing boom is built on real consumer demand for a highly desired product, and a real tangible, appreciating asset…”

An inflating asset, no doubt. Unfortunately, the housing boom has been unmistakably “built” on extreme and conspicuous Credit excess. And I will be the first to admit that as long as Fannie and Freddie are expanding their balance sheets at a 25% rate the housing sector will appear healthy, Credit losses will remain minimal, the bulls can go on raving about how well the markets react to news such as the Enron debacle, and the financial markets generally will enjoy sufficient liquidity. But is such blatant excess sustainable?

The GSE Bubble poses great and increasing risk to the U.S. and global financial system. These institutions are putting American citizens in financial harms way on several levels, as much as their propaganda would like to try to convince us otherwise. Furthermore, this is an issue that should be debated based on the merits of sound finance and economics. I am very troubled that Mr. Raines appears determined to make this a “class” and racial issue. It is neither. Mr. Raines’ speech invoked “the Escamilla family of Houston, Texas” that, “with little cash on hand” bought an $80,000 home “thanks to some creative financing.” Then there is Leilani Hodnet “with little income and savings…purchased a new, two-story, four-bedroom home.” “Many police and firefighters don’t have the salary or the savings to afford a home in the communities they serve. But under a new initiative…public servants can now qualify for a mortgage with as little as $500 down…” Is it not fair to place the responsibility for inflated home values that have priced so many out of the market directly on GSE lending excess? So is the solution to be found by providing low down payment mortgages so individuals with minimal savings can take on large mortgages? And how do these examples reconcile with GSE mortgage lending limits that have inflated to over $300,000? The issue of rampant and destabilizing Credit excess can and should be separated from helping those in need.

There appear to be two key facets of this most fascinating world of finance that strike me as especially worth pondering – forces which underpin monetary disorder and further delay necessary and unavoidable financial and economic adjustments. First, we have unwavering and vociferous commitment from the GSEs to stay the course of reckless Credit expansion. As long as they remain successful in such pursuits, we should err on the side of expecting resulting money and Credit excess to support consumer spending, with further deterioration of our horrendous trade position as one possible 2002 surprise. And there will surely be ramifications from their previous record year of excess. Second, it appears that there is an agreement to use yen devaluation as a measure to stimulate the moribund Japanese economy and help mitigate deflationary pressures in Japan. This has and will continue to act as an impetus for regional currency weakness (“Beggar thy neighbor?”) and perhaps prove a catalyst for more general financial dislocation. With the degree of leverage, speculation and derivative exposures in the marketplace, a significant decline in the yen could have considerable unexpected consequences. For now, this backdrop provides support for the U.S. Credit Bubble and, as well, for the unsustainable anomaly of dollar overvaluation in the face of uncontrollable structural current account deficits and acute financial fragility.

Years of rampant global Credit excess have created an unusual bipolar world of maladjustment. On one side are the manufacturing and exporting economies – particularly Asian technology and component producers - that face continued overcapacity, pricing pressures, and post-Bubble relative poor overall performance. These countries generally some time ago lost access to meaningful amounts of global finance; hence they today seek their advantage primarily through weaker currencies and strong exports. Meanwhile, the sphere of “service-sector” and asset Bubble-focused consumption economies still enjoys continued support from buoyant (if dysfunctional) domestic Credit systems and sustained global speculative financial flows. Years of hallowing have left manufacturing and export sectors relatively less significant to the “consumption” economies as a whole, while at the same time largely isolating these economies from deflationary forces in the goods producing arena. The U.S. economy in particular benefits from an exceedingly robust Credit market, a continued inflationary bias in asset markets, and a strong currency that ensures self-reinforcing access to enormous international speculative financial flows. On the surface, the weak yen/Asian currencies and a strong dollar conveniently address individual country needs. Unfortunately, however, such factors only dictate a continuation of dysfunctional global monetary processes that augment rather than correct trade and financial flow imbalances. It should be recognized that a system lacking self-correcting mechanisms - indeed one that exacerbates dangerous distortions and imbalances - is destined to be fraught with unending bouts of crisis and doomed to inevitable collapse. That is precisely where we are today and why the overriding issue is the continued precarious accumulation of massive dollar liabilities by global financial players.

We have referred to the GSE Bubble as “The Great Experiment.” Institutions with the implied backing of the U.S. government (thus far) taking full advantage of a contemporary financial apparatus providing unlimited capacity to expand money and Credit, while financing asset markets where lending excess only begets more excess. One could not develop a more potent mix for runaway Bubble excess. The GSEs, and Wall Street structured finance broadly, have become the leading forces in a wildcat domestic Credit system that continues to run out of control and completely outside of market discipline. Due to peculiar circumstances domestic and international, economic and financial, disregarded U.S. inflationary manifestations emanate in inflated asset prices, massive over consumption, consequent unprecedented trade deficits, and severe structural distortions. Concurrently, escalating U.S. current account deficits have been easily financed as global dollar liquidity is directly “recycled” back through aggressive GSE international borrowings. There is, furthermore, the powerful dollar liquidity “recycling” mechanism through enormous (if unquantifiable) borrowings by the leveraged speculating community that, in many cases, surely are used to finance holdings of agency and related securities. Historically, such gross financial imbalances would have long ago been squelched (and structural economic distortions nipped in the bud) as foreign institutions moved to convert inflating dollar liabilities into gold or other more secure reserve assets. Nowadays, dollar liabilities just keep ballooning and then balloon some more.

With each passing quarter, agency debt is becoming an increasingly significant international reserve asset, the GSE Bubble a more paramount global issue. Certainly, no one at the time would have believed how far the global monetary system could degenerated after President Nixon put a stake through the heart of the Bretton Woods currency regime with his 15 August 1971 suspension of convertibility of the dollar into gold. By default, this initiated an historic Experiment with a global monetary “system” lacking a stabilizing gold anchor or adequate rules, mechanisms, agreements, or even understanding as to how growing imbalances would be addressed and corrected. Yet this precarious and faltering Experiment only spiraled completely out of control (with U.S. Credit excess and resulting trade deficits) over the past eight years, in what is akin to an acutely destabilizing market speculative “blow off.” These types of dislocations occur specifically because of some underlying market disorder; cause considerable upheaval with a climactic burst of activity in the direction of the long-term trend; but then abruptly usher in a market collapse and profoundly changed environment.

I will be the first to admit to being slow in recognizing the tight link between the Fed and GSE-orchestrated domestic “managed” money and Credit scheme with the international “managed” currency and Credit scheme. This is a despicable arrangement when pitted against the disciplining and self-correcting Bretton Woods global currency regime backed by quantifiable gold reserves. It is in reality preposterous that over the past 30 years a proven gold-backed system was completely supplanted by an unstable non-regime with reserve assets increasingly the IOUs of recklessly aggressive U.S. quasi-governmental mortgage lenders (determined to perpetuate unprecedented expansion). Say what you will, but I cannot imagine a more perilous interwoven “system” of uncontrolled domestic and international Credit excess -- “Experiment on Top of Experiment.”

Like so many facets in this most extraordinary environment, there is determined blind faith that The System (domestic and international) functions soundly, with clear disregard for what are precarious accumulating excesses long overdue for major adjustment. And with the extreme and systemic nature of current global financial and economic imbalances, we do consider it a distinct possibility that things come to a head this year. Increasing currency volatility seems to lend credence to this view. It then becomes valuable to consider the issues that were paramount to the original adoption of the Bretton Woods regime, as well as the events and circumstances of its collapse. We do find ourselves at more unease each passing week with the parallels between today’s extreme global trade and financial imbalances – which have over time imparted increasingly perverse effects on domestic economies and financial systems - and those of the late twenties and early thirties. Then, as now, uncontrolled and self-reinforcing imbalances set a collision course with systemic breakdown, collapse that would later provide the impetus for the adoption of the Bretton Woods regime. From the below extractions two sentences are underscored: “The conflicts of the 1930s had developed because there were no international standards to guide the actions of individual countries in the exchange markets.” And in regard to the escalating imbalances that preceded the breakdown of Bretton Woods, “Against this background, nearly any spark could have touched off a new round of international monetary disturbances.”

I found hopefully valuable insights in what would be expected to be a rather tempered analysis in the International Economic Report of the President, March 1973:

“It is for the purpose of expanding world trade and investment, and the benefits they can bring to all countries, that we need a more effective monetary system. Fundamental reforms will be needed to adapt our existing arrangements and institutions to today’s realities… The recurrent monetary crises of recent months underline this need… The existing international monetary system dates back to 1944, when 43 nations signed an agreement at Bretton Woods, New Hampshire. But in recent years the system’s stability has given way to recurrent crises; the suspension of the convertibility of the dollar into gold on 15 August 1971 gave public recognition to the fact that the Bretton Woods era was at an end…

It is hoped that the broad outlines of a new international monetary system can be agreed upon… The problems facing the negotiators are not simply those of monetary mechanics; they also involve fundamental political and economic interests of each country. There is no way for a country to have absolute sovereignty over its own balance-of-payments position without affecting the economic and political interests of other nations. Whenever a country makes a decision to initiate or to avoid adjustment of its balance of payments, it disturbs the balance of payments of other countries and thus the interests of other governments. Consequently, governments recognize the need for international rules and procedures to guide them in balance-of-payment policies. This recognition was the basis for the Bretton Woods Agreement, as well as for the present monetary negotiations…

Most countries agree that it will be difficult to establish a stable international monetary system unless the basic balance of payments of the United States and other major countries are in equilibrium. At the time of the Bretton Woods Agreement world monetary leaders were concerned about avoiding the international monetary difficulties of the prewar era. The Bretton Woods system was highly successful in achieving that goal… Because nations and international financiers had confidence in the system, it was able to survive periods of major strain. Thus the Bretton Woods arrangements were a key element in achieving the postwar period’s sustained economic growth (p. 14).

There were times, especially in the early 1930s, when some countries interfered excessively with the operation of the currency exchange markets… These actions contributed to the collapse of international trade in the 1930s. Between 1929 and 1933, world trade plummeted from $65 billion to less than $25 billion. The experiences of the 1930’s remained vivid in the minds of the Bretton Woods negotiators. The conflicts of the 1930s had developed because there were no international standards to guide the actions of individual countries in the exchange markets. At Bretton Woods, nations recognized that it was in their own interest to agree on such rules and procedures. Under the Bretton Woods system, most countries established par values for their currencies in terms of gold…

The Weaknesses of the Bretton Woods System: There is international consensus that the rules and procedures, as they evolved, did not put sufficient emphasis on promoting balance-of-payments adjustments. Under the Bretton Woods system, countries losing or gaining reserves through intervention were supposed to undertake adjustment measures to bring their payments into balance. Domestic fiscal and monetary policy came to be considered, especially among the industrialized countries, as the most appropriate means for adjusting a balance-of-payment disequilibrium…

Yet each nation needs to temper its domestic policies to meet its international responsibilities. The US experience shows that fiscal and monetary excess can clearly contribute to payments deterioration. The excessively expansionary policies of the years from 1966 to 1968 built up inexorable inflationary pressures which contributed to a weakening of the US payments position… There was no accepted criteria for deciding when there was a need to correct an imbalance and when a parity change through a revaluation or devaluation was desirable.” (p. 15)

One of the ironies of the Bretton Woods system is that the exchange rigidities which were built into the system to avoid the political and economic problems encountered in the prewar period created political and economic problems of their own… Dislocations developed in the structure of production for both deficit and surplus countries during the years leading up to the 1971 realignment. These dislocations might well have been less severe if earlier adjustments had been made...” (p. 17) By 1967…the cumulative effect of these deficits had reduced US reserves from the $26 billion level in 1949 to $14.8 billion, and had increased US liabilities to foreign institutions to $16.7 billion… the deficit in 1970 reached $10.7 billion. In 1971 the deficit climbed to a record $30.5 billion, and our liabilities to all foreign official institutions had reached four times the level of our reserves… Given the magnitude of the flows that occurred and its dwindling gold reserves, the United States clearly had to move in August 1971 to suspend convertibility of outstanding dollar liabilities into gold… Against this background, nearly any spark could have touched off a new round of international monetary disturbances. The spark was provided in January 1973 by speculative pressure on the Italian lira…

While there is general agreement that the Bretton Woods system broke down because of the failure of the adjustment process, it is also clear that the design of an alternative adjustment process will be the most difficult subject during the negotiations… The reason the United States was forced into ending convertibility of outstanding dollars into gold or SDRs…was that it became obvious not only that large amounts of dollars were outstanding relative to the value of US reserve assets, but also that some countries with excessive amounts of reserves were experiencing further large increases. This was contributing to the credibility problems of the dollar, and adding fuel to speculative fires in the private markets…

The US (post Bretton Woods) proposal assumes that countries would not shirk their responsibilities to adjust. It is anticipated that countries probably would take action and begin implementing adjustment policies well before limits were signaled which called for international pressure for adjustment. The United States believes that the durability and equity of a reformed monetary system require provisions for effective pressure or inducements to ensure that a country does not persist in avoiding adjustment. If a deficit country refuses to correct its imbalance, credit might be cut off, as under the old system… The US proposals assume a generalized system of convertibility, with countries standing ready to convert officially held balances of their currencies into international reserve assets.”

And extracted from the International Economic Report to The President, February 1974:

“Adjustment and convertibility have been crucial issues since the onset of the monetary reform discussions. The Japanese and those European countries which have been running payments surpluses stressed the need for more certain and prompt convertibility of foreign currency holdings to primary reserve assets. These countries feel that a revised monetary system should eliminate what they consider to be the privilege of the United States and other reserve currency countries to finance deficits by increasing their liabilities.”

In stark contrast to today, there was in the 1970s some recognition that increasingly destabilizing global speculative “capital” flows were directly related to the heightened borrowings of deficit countries. From Anne O. Krueger’s analysis The 1974 Report of the President’s Council of Economic Advisors: International Issues (The American Economic Review, September 1974): “Yet, in fact, speculative capital flows and world inflationary pressures were both partly the consequence of huge prior accumulation of dollar assets by foreigners, particularly in 1971. That accumulation, in turn, had its origins in the overvaluation of the dollar and the other features of fixed exchange rates under the dollar standard...throughout the Report, world inflationary pressures of 1973 are treated as if they were completely independent of past American behavior.”

Just as contemporary money is predominantly created through the lending process, it is today critical to appreciate that it has been continued enormous international borrowings by (predominantly the U.S.) deficit nations that have created the massive global pool of too-often quite mobile, speculative, and destabilizing liquidity. There is a common misconception that an institution such as Fannie Mae simply intermediates between savers and borrowers. It is much more accurate to understand that they are directly involved in monetary expansion as they issue debt/create liabilities. There is a similar misconception that the U.S. borrows “capital” – or the savings – of our trading partners. I think it is much more accurate to view the deficit finance process as the creation of additional U.S. liabilities that circulate globally, and not the relinquishment of foreign “savings.” It is not global “capital” rushing to invest in the productive economy, but U.S. deficits creating global liquidity that today conveniently finds its way right back into U.S. markets. The same unlimited capacity to create money and Credit domestically operates internationally as well, with the GSEs, in particular, fabricating the global liquidity that fuels potentially unlimited demand for their own debt instruments. Interestingly, this key concept of the unstable nature of global finance was recognized during the 1970s. Geoffrey Bell has an extensive discussion of “multiple credit creation” in his 1973 book The Euro-dollar Market. He also had adept insight into the key role played by financial innovation – particularly the fledgling but booming euro-dollar market – in the increasingly destabilizing financial flows that were imparting heighten risk on the global financial system and economy at that time.

“It is too early to ascribe any definitive reasons for the breakdown in the Bretton Woods system and to weight these with any real feeling of confidence. However, three factors stand out: the steadily deteriorating balance-of-payments position of the United States; the reluctance of governments to alter exchange rates up or down…and the pressure on exchange rates and domestic monetary conditions through capital movements with the euro-dollar market playing the decisive role in this respect. In the absence of a smoothly functioning mechanism for correcting balance-of-payments imbalances, especially between the United States and the rest of the world, the chances were that an impasse would have been reached at some stage, the inevitable outcome being a widespread currency crisis.”

I am confident that financial historians will look back at this period in utter amazement. How could the trillions of dollars of open-interest in euro-dollar futures, the unfathomable growth in the global “swaps market” and other derivatives, the explosion of foreign holdings of agency and U.S. securities, and escalating dollar asset and liability imbalances on the books of the international banking/brokerage community not have been heeded as a glaring warning of inevitable crisis? There is simply no doubt that unparalleled financial “innovation” has played an instrumental role in fostering runaway Credit and speculative excess domestically in the U.S., as well as internationally as required to finance massive and unrelenting U.S. borrowings. Unfortunately, we today see no indication that these excesses are being tempered. Indeed, all signs point to full speed ahead into a world of unknown risk and guaranteed tumult. I for some time presumed that when the global community began to better appreciate the nature of the U.S. Credit Bubble a market response would set in motion the necessary adjustment. I am today forced to assume that the “global community” and the GSE/Wall Street “structured finance” contingent are tightly interlinked, with the market mechanism a casualty of Experiment on Top of Experiment run terribly amuck. This, most regrettably, has gone much beyond a precarious domestic Credit scheme and a foray into inconvertible currencies.

I will conclude with a Chairman Greenspan quote for the history books:

“I’ve been worried about the trade deficit for many years. It’s a problem which should be creating more difficulty with respect to our international financial position, but it hasn’t. And the reason it hasn’t is that the investment capabilities of institutions within the United States – companies – has attracted a sufficiently large amount of capital, investment capital from abroad to maintain the financing year after year after year. I assume at some point it has to come to a halt. But I’ve been saying that for a number of years, and I’m impressed with the attractiveness of American investment opportunities. It seems endless.” January 24th, 2002

Is Dr. Greenspan referring to true investment opportunities or interest rate speculations? If his reference is to enterprises generating true economic profits, we are left to ponder how annual foreign investment sufficient to offset $430 billion plus current account deficits are maintained in an environment with faltering business earnings. But if in “opportunities” he includes financial “profits,” yes, at times, they do indeed appear “endless.” This certainly is one seductive Bubble.