Rallying stocks and a startling surge in wholesale prices failed to unnerve the Credit market. For the week, two-year Treasury yields declined two basis points to 1.60%, with five-year yields declining seven basis points to 2.85%. The 10-year Treasury yield dipped six basis points to 3.89%, while the long-bond saw its yield decline four basis points to 4.84%. Benchmark mortgage-backs and agency debt performed well, with yields generally declining 8 basis points. The spread on Fannie’s 5 3/8 2011 note narrowed almost two to a notably narrow 29. The 10-year dollar swap spread dropped 1.5 to 40.5, and one must go all the way back to August 1997 to see the last time this spread traded below 40. Corporate spreads were generally stable this week. Heightened inflationary pressures are apparently good news for those calling for “reflation” and playing the corporate spread game. The dollar ended the week about unchanged.
The holiday (and inclement weather) made for a somewhat slower week of corporate issuance. Wal-Mart issued $1.5 billion of debt, Morgan Stanley sold $2 billion of 10-year bonds (147 bps over Treasuries), American Express $750 million of notes, Deutsche Bank $800 million of notes due 2015 (158 bps over Treasuries) and Duke Energy sold $500 of 5-year notes (100 bps over Treasuries). Citgo sold $550 million of junk debt, although at yields considerably higher than initially expected. MBNA issued $500 million of 10-year notes to yield 6.134%, 225 basis points over Treasuries. Morgan Stanley also sold 850 million of 7-year euro-denominated bonds this week and was joined by Bank America which issued 1 billion of 5-year euro debt. Russia’s largest company, Gazprom, enjoyed bids of $6 billion for its sale of $1.75 billion of 10-year bonds (another example of heightened inflationary pressures – in this case rising energy prices – fostering Credit growth).
Broad money supply (M3) declined $7.5 billion last week. With Demand and Checkable Deposits declining $23.2 billion, M1 gave up recent strong gains. Savings Deposits surged $37.5 billion, Small Denominated Deposits dipped $1.8 billion and Retail Money Fund deposits declined $3.3 billion. Institutional Money Fund deposits dropped $19.2 billion, while Large Denominated Deposits added $2.3 billion. Repurchase Agreements and Eurodollars declined slightly. Foreign Holdings of U.S. Debt Securities increased $4.7 billion. Total Commercial Paper (CP) borrowings declined $6.7 billion ($21.3 billion over two weeks), with total Financial sector issuance down $11.2 billion. Non-financial CP borrowings increased $4.5 billion. Elsewhere, Bank Total Assets declined $6.1 billion following the previous week’s $71.6 billion surge. However, Bank Credit advanced $19.9 billion. Securities holdings were up $10.6 billion (up $44.8 billion in two weeks) and Loans and Leases gained $9.2 billion. Real Estate loans were up $12.2 billion (up $35.1 billion in three weeks), while Commercial and Industrial loans declined $1.8 billion (down $9.4 billion over three weeks). Bloomberg’s year-to-date tally of U.S. Domestic Debt issuance now stands at $319 billion (up 37% from the comparable 2002 period). Over $10 billion of ABS was issued this week.
Weekly bankruptcy filings were 29,931, up 9% y-o-y. MasterCard is estimating 2003 bankruptcies at 1.652 million, 5% above 2002’s record. After the big November and December post-strike catch-up, January’s imports into the ports of Long Beach and Los Angeles slowed somewhat to a still strong 432,867 containers. This was up 11% y-o-y. Notably, export containers were up 6% y-o-y, the best performance since May. All the same, outbound empty containers were 59% of full inbound containers.
Yesterday’s economic news was especially dismal. The December Trade Deficit shot up to a record $44.2 billion, 14% above the consensus forecast. The deficit, now running completely out of control, was up an eye-opening 62% year-over-year, with a 2002 trade gap of $435.2 billion. The intractable deficit was up 21.4% for the year and an incredible 300% from the $108 billion deficit recorded during pre-Bubble – and not that many years ago - 1997. For the year, our deficit with Canada was $49.8 billion, Mexico $37.2 billion, Western Europe $89.2 billion, the Pacific Rim $215 billion, South/Central America $17.9 billion, and OPEC $34.5 billion. 2002 Imports from China surged 22.4% to $125.2 billion, while Imports from Japan declined 3.9% to $121.5 billion. Imports from Canada decreased 2.6% to $210.6 billion, while Imports from Mexico increased 2.6% to $134.7 billion.
Compared to year ago levels, December Goods Imports were up 20% to $103.9 billion, as exports inched up 1% to $55.6 billion. For December, Goods Imports were 87% greater than Goods Exports. Amazing. By Import category, Capital Goods were up 9.9% y-o-y in December (telecom equipment 25.3%, Semiconductors 8.2%), Industrial Supplies 35% (crude oil 59.6%), Consumer Goods 25.3% (pharmaceuticals 62.5%, apparel 23.6%), Automotive 14.5%, and Services 17.9%. By Export category, Capital Goods was down 5.6% y-o-y (telecom equipment down 29.7%) and Consumer Goods declined 2.4%. Industrial Supplies Exports jumped 10.5% (price increases), Automotive was up 6.6%, Food & Beverages increased 8%, and Services were up 2.7%.
Recent comments from Treasury Secretary John Snow on the U.S. current account deficit: ‘At the current levels of the current account deficit, I’m not particularly troubled by it. It’s something we should keep our eye on, but it’s the $400 billion annual or so that it’s running is really a small part of the size of the total US economy and is certainly manageable… What it really means in its simplest terms is that Americans value the world goods more than they value the dollars that they’re expending to get those goods. At some point, people can run into too much debt, I grant you that.’” (Especially after yesterday’s monster of a trade deficit, we suggest our new Treasury Secretary go back and check his math. We see current account deficits soon surpassing 5% of GDP. The alarm bells are sounding.)
February 20 – Bloomberg: “U.S. state and local governments face mounting losses on interest-rate swaps they entered to pay off variable-rate debt, Standard & Poor’s said. The transactions involve selling bonds with interest rates that change every few days or weeks, giving access to the lower rates in the short-term debt market. The swaps, agreements to exchange fixed- for variable- rate payments on the bonds’ principal, were meant to guard against rises in short-term rates. Instead, the swaps have exposed state and local governments to another financial risk, said Peter Block, a director at S&P. ‘Issuers in the last two years have taken a gamble that they would be hedged, and they’re not.’ The risk resulted from assumptions about the index on which the swaps were based. State and local governments often use the London interbank offered rate, or Libor, a benchmark set by three-month U.K. bank loans.”
February 19 – Dow Jones (Stan Rosenberg): “While ratings of cities have been more stable than those of states over the past 12 to 18 months, cities will face more fiscal pressure in the future as the economic recovery remains sluggish, rating agency Standard & Poor’s said…Budget-strapped states, no longer able to defray revenue shortfalls, are by necessity, ‘passing the pain to municipalities.’ The city of Atlanta, dropped to double-A-minus from double-A, represented S&P’s only downgrade among the largest cities since January 2002. During the same period, just two cities - single-A-rated New York and triple-A Dallas -had their outlooks revised to negative from stable. But that situation won’t last, S&P said. ‘For cities, rising health care costs, homeland security, underperforming pensions and multi-year wage contracts will continue to pressure budgets…Strong steady growth in state aid is leveling off and in some instances declining.’”
Week 35 of the Great Mortgage Finance blow-off saw refi applications about steady at 180% of the year ago level. Purchase applications were up 6% for the week (up 14% y-o-y). Golden West Financial’s mortgage portfolio expanded at a 13% annualized rate during January, with a notable 90% of originations consisting of adjustable rate mortgages (Feeding the Great California Housing Bubble). January Housing Starts were reported at 1.85 million units, four percent above the consensus forecast to the strongest level since May 1986 (1.854 million). Led by a major construction boom in the West (California), national Single family Starts were up 13.1% y-o-y to the highest rate since November 1978. Single-Family Starts were up 40.3% y-o-y in the West, 19.4% in the Midwest, and 2.9% in the South. Unusually cold weather was blamed for the 15.6% y-o-y decline in Northeast Single-family Starts. 2002 Housing Starts of 1.706 million were up 6.4% from 2001 to the highest level since 1984. January Building Permits were up 6% y-o-y (1.781 million), with Single-Family Permits up 9.1% y-o-y. The West reported y-o-y Permits up 32.4%, while Northeast Permits were down 12.9% y-o-y.
February 18 - Minneapolis Star Tribune (Jim Buchta): “After more than 15 years working for boom-and-bust Silicon Valley technology companies, Sonia Armstrong couldn’t hack it anymore. So she pursued a job with a more certain future: Selling subprime mortgages for Wells Fargo.” In my mailbox this week arrived a “No Down Payment? No problem” promotion from mortgage company Assistance for America. This is a division of Renaissance Acceptance Group, previously Cardiac Control Systems that filed for bankruptcy in 1999. Lots of folks working to profit (and find a new lease on financial life) from the Great Mortgage Finance Bubble…
Wednesday’s Wall Street Journal: “If Fan and Fred were completely private financial institutions - with no government guarantee, implicit or explicit - they would have to almost double their capital to more than $99 billion from $52 billion now. And even that increase would only bring them to the minimal capital that banks must maintain for mortgages, but perhaps still short of earning a AAA rating. The result? Return on equity would fall from 25% to 12% or 13%, which is what comparable banks earn, thus transforming Fan and Fred into much less profitable financial companies.” (The Journal’s ruminations recall for me an old Saturday Night Live bit, “The Bears.” “Hey, who’d win if (Chicago Bears’ coach Mike) Ditka took on Godzilla?”)
February 19 – Bloomberg: “Conseco Inc. is asking a bankruptcy judge to release its finance unit from servicing $23 billion in mobile-home loans, saying uncertainty about the money-losing agreements threatens the unit’s sale. Conseco Finance says in a court filing it was losing $15 million a month on agreements to manage loan-payment collections before the Dec. 17 bankruptcy filing… The loan portfolios have been a ‘monumental distraction,’ Conseco Finance says in an emergency filing with U.S. Bankruptcy Court in Chicago… The Federal National Mortgage Association, which holds $7 billion of certificates on the mobile home loans, has objected to Conseco Finance’s request, saying the servicing is a valuable asset.”
February 20 - Dow Jones (Dawn Kopecki and Eric Ahlberg): “Mortgage finance company Fannie Mae placed a $70 million bid Wednesday for the servicing rights to $23 billion in manufactured-housing mortgages in the bankruptcy of Conseco Inc. Trouble with Conseco Finance’s money-losing mobile home mortgage portfolio helped propel its parent company into Chapter 11 bankruptcy protection… ‘We did this to resolve an impasse in the court over the disposition of the manufactured housing servicing platform in bankruptcy,’ said Fannie Mae spokeswoman Janice Daue… Conseco Finance is the largest servicer of manufactured-housing contracts in the U.S. with more than 55% of the entire market. The unit is scheduled to be sold off at a Feb. 28 auction with the final sale hearing set for March 5. Bear Stearns & Co. and General Electric Capital Corp., a major competitor of Fannie Mae’s in the secondary mortgage markets, have been named as potential bidders for the finance unit. Fannie Mae is the largest beneficial holder of roughly $10 billion of Conseco Finance’s asset-backed manufactured-housing certificates.”
So, Fannie has interest in somewhere between $7 billion and $10 billion of the $23 billion of Conseco securitizations (recalls rumors back in the tumultuous fall of 1998 that Fannie was acquiring entire Conseco (and other) securitization deals before they were offered in the marketplace.) And Fannie may dive headfirst into the mobile home loan servicing business? Oh, what a tangled web…and sliding only more quickly down the slippery slope of subprime (with the Credit insurers).
February 21 - Dow Jones: “FM Watch, the anti-Fannie Mae/Freddie Mac coalition, said with respect to Fannie Mae’s bid to enter the mortgage-servicing business that it ‘plans to take appropriate action to make sure that this incursion is stopped.’ ‘Fannie Mae’s decision to enter the mortgage servicing business through this maneuver is the perfect indication of just how far Fannie has strayed from its original mission of providing liquidity to the secondary mortgage market for conventional mortgage loans.’”
February 20: “Fitch Ratings places the ‘A’ medium-term notes rating, ‘A-‘ preferred stock rating, and ‘F1’ commercial paper rating of Countrywide Home Loans, Inc. Rating Watch Negative. Fitch also places the ‘A’ convertible debentures rating of parent company Countrywide Financial Corp. (CFC) on Rating Watch Negative. Over $18 billion of rated debt is affected by this action. Today’s action is due to concerns within Fitch regarding the increasing risk of impairment that is present within mortgage banking companies’ balance sheets. This risk is particularly prevalent for those companies that have significant business concentrations in mortgage banking, such as CFC, with high levels of capitalized mortgage servicing rights (MSRs) as a percentage of equity. At initiation, MSRs are derived from the present value of expected future income to be received over the expected life of the mortgages. The value is based on assumptions regarding prepayment rates, discount rates, ancillary fees, and costs to service.” Countrywide’s servicing portfolio has surged to $469 billion, a cause for concern considering issues raised post-Conseco’s collapse.
February 18 - Dow Jones (Agnes T. Crane): “While everyone from Federal Reserve Chairman Alan Greenspan to the nation’s largest purchaser of home mortgages insist there is no national housing bubble in the U.S., percolating hot spots in regional residential real estate markets are cause for concern…According to a recent study by TimesSquare Capital Management…‘a number of major housing markets are vulnerable to severe price declines, due to a troublesome combination of above-average appreciation in recent years and growing unemployment.’ The study highlights a number of metropolitan areas that have experienced higher home price rates from the first quarter of 1997 to the third quarter of 2002 that were well above the national average of 42%. For example, New York City home prices rose 67% in that period, Jersey City, N.J., increased 75%, Boston, 69% and San Francisco, 88%…”
February 17 – Financial Times (Sheila McNulty): “The debt crisis in the US gas and power sector continued to grow over the past year and has become more acute, with $477.6bn in outstanding borrowings, research commissioned by the Financial Times reveals. The energy traders are responsible for a large portion of that debt, according to SNL Financial, an independent research firm that says $116.65bn of the sector’s debt is held by what - pre-crisis - were the top nine traders, companies such as Dynergy and El Paso, both Texas-based, and Duke Energy of North Carolina.”
In the category “just couldn’t leave well enough alone,” Barron’s Gene Epstein has returned to his “the consumer is in great shape” disinformation campaign. It’s all so tiring… We suggest that he refrain from his “debt service as a percentage of income” fixation and look deeper than this one clearly deceiving ratio (again, it’s too similar to how Bubble-induced earnings growth was used to justify exorbitant P/E ratios). There is no denying or muddling the fact that Household Sector Debt is up more than 110% during the past decade. And, fueled by unprecedented mortgage borrowings, total Household debt growth has been accelerating. To illustrate: Household Sector borrowings increased on average $71 billion per quarter during the first eight years of the nineties. But during the past 19 quarters, average quarterly borrowings have jumped to $138 billion (reaching $199bn during the third quarter and $185bn for 2002 Q2!). It’s not a “debt service” issue, but an issue of sustainability. And we suggest that Mr. Epstein take note of the unfolding subprime collapse (the marginal consumer borrowers and lenders) and follow the experiences of NextCard, Metris, AmeriCredit, Conseco and others. All is well in consumer finance? And just wait until the Mortgage Finance Bubble blow-off runs its course… And, most importantly, don’t disregard that it is specifically unparalleled consumer Credit excess that is the fuel behind the much-trumpeted income growth – household income expansion that is conveniently used to justify rising consumer debt loads. It’s self-reinforcing and unsustainable, and exactly why they’re called Bubbles…
Credit card behemoth MBNA financial shook a bit of confidence when it reported that managed net loan Credit losses jumped 41 basis points during January to 5.59% (up 46 basis points y-o-y). Delinquencies were up another 12 basis points to the highest level in twelve months. Other managed Consumer (non-Credit card) losses were reported at 8.46%, with delinquencies at 6.11% (this detail was provided for the first time).
February 19 – European Central Bank: “In the third quarter of 2002 the annual growth rate of financing of the non-financial sectors in the euro area decreased to 3.9%, down from 4.1% in the previous quarter and from 5.5% one year earlier. The corresponding growth rate of debt financing was 4.7%... The annual growth rate of debt financing by households increased slightly, from 5.8% in the second quarter of 2002 to 6.1% in the third quarter…”
February 19 – Washington Post (Jonathan Weisman): “President Bush will sign legislation this week setting a 2003 budget that raises federal spending by 7.8 percent over last year, capping a remarkable two years in which the federal budget increased by 22 percent. Although Bush has made controlling spending a recurring theme in recent months, the $791.5 billion spending bill for 2003 that he plans to approve by Thursday night will be one for the record books. The 2003 rate of discretionary spending increases -- the part of the budget subject to Congress’s annual oversight - will be the second-fastest since 1985. It is topped only by the 2002 increase… The government has not experienced a two-year leap in spending of this magnitude since expenditures jumped 24.5 percent between 1976 and 1978. ‘We have a long way to go to, quote, rein things in,’ said G. William Hagland, budget adviser to Senate Majority Leader Bill Frist.”
Certainly not unrelated to ballooning mortgage borrowings and (trade and fiscal) deficits, we see evidence of intensifying inflation manifestations in the strongest increase in Producer Prices since 1990. Wholesale price jumped 1.6%, compared to a sanguine consensus forecast of 0.5%. The core PPI (ex food and energy), jumped 0.9%, the strongest gain since December 2000. Pricing pressures were strong throughout, with Finished Goods up 1.6%, Intermediate Materials up 1.3% and Crude Materials up 6.9%.
February 20 – Fannie’s Franklin Raines: “In 2002 we think mortgage originations were about $2.6 trillion. We think they’ll be about $2 trillion this year. That’s a lot. I never thought in my lifetime I’d see $2 trillion worth of mortgages originated. Overall it will be a good year for the mortgage business… I don’t think there’s a danger of inflation…What we know is that for the average person a strongly growing economy is more important than anything else. I’m in favor of stimulus and enough stimulus to really get the economy moving to soak up this excess capacity as soon as possible…”
It feels rather silly nowadays to refer to the eighties as the “Decade of Greed.” Like NASDAQ, the GSEs, mortgage finance, and shopping malls, we appreciate today that what appeared at the time gross excess ended up looking quite feeble in comparison to the “blow-off” excesses that were to follow. But our focus on Fiat Money and Credit Inflation in America demands that we return briefly to the 1980s. Of course, we should really commence our analysis with the sixties (“guns and butter”) inflation, the consequent collapse of dollar gold-convertibility, and the resulting 1970’s (“garden-variety”) inflation surge. But, for our purposes this week, let’s set our sights on the cutting-edge, uncommonly seductive (“non-garden…”) strain of Credit inflation that began to take root in the period 1984 to 1989. Over this six-year period, total Credit Market Debt outstanding surged 72% to $12.8 Trillion. Importantly, this bout of Credit inflation was all-encompassing and uniform. We see that Total Mortgage Debt jumped 69% to $3.56 Trillion, Non-financial Corporate debt 67% to $2.4 Trillion, and Federal Government debt 65% to $2.25 Trillion. Structured Finance was in its thriving infancy, hardly stymied by its prominent role in the ’87 Crash.
And despite brief fears of a potential post-’87 stock market crash depression, subsequent (Greenspan, along with the Japanese and global central bankers) “easy money” propelled the U.S. and global industrialized economies into a robust late-decade inflationary boom (to which the Japanese are still suffering and the U.S. eagerly sustaining). With the advantage of hindsight - and after witnessing the extraordinary developments transpiring since – we now realize that the general economy had not by late (post-crash) 1987 suffered from the type of prolonged period of maladjustments that create vulnerability to economic depressions. Additionally, and of momentous importance, the Credit system had not regressed to the type of derangement capable, over a period of years, of creating the colossal and fragile debt structures susceptible to collapse. Monetary Processes dominated by speculative financial flows were not yet indelibly entrenched.
Yet by 1990, previous inflationary distortions, that culminated with the rampant Credit inflation and financial excess of 1988/89, had left the financial system and economy acutely susceptible to severe problems. Facing an insolvent (and imploding) S&L industry, a collapsing junk bond market, the coastal real estate inflations turning problematic busts, the residual of the oil patch inflationary boom and subsequent bust, and an increasingly impaired banking system, there was (as we have often discussed) real risk of financial and economic collapse in the early nineties. The economy was already at this point desperate for another inflationary jolt, but the banking system was in dire straits and largely incapacitated. Not to worry. With Alan Greenspan quite eager, the rapidly ascending Wall Street Money and Credit Inflation regime was more than willing to capture and resolutely clutch the monetary reins. An historic inflationary jolt was delivered – more powerful and intoxicating than anyone could ever have imagined.
The Roaring Nineties can be viewed as the Decade of Structured Finance. From the beginning of 1993 through 2002’s third-quarter, GSE assets were up $1.9 Trillion, or 345%, mortgage-backed securities $1.8 Trillion, or 143%, and asset-backed securities $1.89 Trillion, or 465%. Since the end of 1992, ballooning broad money supply doubled to $8.55 Trillion. As a percentage of GDP, total “Structured Finance” financial claims/Credit creation (GSE assets, and outstanding ABS and MBS) jumped from 35% to 75% ($2.23 Trillion to $7.84 trillion). Inarguably, we have witnessed truly one of history’s great Money and Credit Inflations. Its unusual nature allowed it to run rampant and unchecked; instead of repressed, it was celebrated as a New Era. Indeed, this strain of inflation had all appearances (and propaganda) of unleashing a quantum leap in sophisticated finance and risk management, combining powerful new computing technologies with sophisticated statistical analysis and modeling. Behind all the “sophistication” and “complexity,” however, there has been an old familiar bottle and a liberated genie of virulent (electronic) Credit inflation.
Now bear with me, as I interrupt our analysis with excerpts from Fiat Money Inflation in France, a brilliant and provocative little book originally written in the 1870’s by American “historian, educator, and diplomat” Andrew Dickson White (with a wonderful forward in the 1959 publication by eminent economist and statesman Henry Hazlitt). White begins: “Early in the year 1789 the French nation found itself in deep financial embarrassment: there was a heavy debt and a serious deficit. The vast reforms of that period, though a lasting blessing politically, were a temporary evil financially. There was a general want of confidence in business circles; capital had shown its proverbial timidity by retiring out of sight as far as possible; throughout the land was stagnation… There was a general search for some short road to prosperity: ere long the idea was set afloat that the great want of the country was more of the circulating medium; and this was speedily followed by calls for an issue of paper money.” (pages 23/24) What began with a 400 million issue of assignats (government issued fiat currency) fully backed by property (confiscated for this purpose), ended six years later with “forty-five thousand millions of assignats. The nation in general, rich and poor alike, was plunged into financial ruin from one end to the other.”
From the following extracts (and we highly recommend this timeless classic in its entirety!), I hope readers will capture the essence of the powerful allure of monetary inflation and how, once commenced, it takes on a precarious life of its own. Unless quashed, it will lurch to ever more dangerous extremes. And the longer it runs unchecked, the more distorted the system, thereby the greater the dislocation and hardship required to return to monetary and economic order. The larger the mistakes made by the monetary authorities, the more likely they will accept greater, increasingly desperate inflations as their only option. The recurring folly of monetary “management.”
Money and Credit Inflation is, all the while, seductive, misunderstood, too easily misinterpreted, and held as seemingly to the great betterment of many and the benefit of virtually all. Importantly, the inflation expedient feeds and emboldens speculation like an expanding snowball set loose from a mountaintop. It can be captivating, exhilarating, and even entertaining, but the final uncontrollable avalanche wreaks absolute havoc on things both real and financial. How monetary inflation seems to work wonderfully – like magic – so manageable, similar to the ease of adjusting the thermostat. Then one day, somehow, it’s at the same time too hot and too cold; then it’s boiling hot in one room and freezing in the next. The small adjustments that always did the trick before have become impotent. Major alterations only exacerbate the extremes; and then things fall into disarray and beyond control. History may not repeat, but, at times, the rhymes are darn right eerie.
“What chiefly strikes today’s readers is the astonishing similarity of the arguments put forward by our own contemporary inflationist to those of the inflationists of eighteenth-century France… But these parallels strike us so forcibly today, not primarily because White underlined them for his hearers in 1876, but primarily because the course of inflation everywhere – economically, psychologically, politically, and morally – does in fact follow the same pattern… The most striking parallel between the events recorded in Andrew White’s essay and the situation in the modern world is psychological. It is the persistence of delusions.” Henry Hazlitt 1959 (pages 8/9/11)
“What the country needs is more ‘purchasing power.’ And as this remedy fails, and quite different results follow, the sole solution of the inflationists is still more money, still more ‘purchasing power.’ The broad patterns of all inflations, historic and modern, is the same. The first result is commonly the ‘recovery’ that the inflationists, like others, are seeking. It is not until later that its disappointing and poisonous effects become apparent.” Henry Hazlitt 1959 (page 11)
“It would be a great mistake to suppose that the statesmen of France, or the French people, were ignorant of the dangers in issuing irredeemable paper money. No matter how skillfully the bright side of such a currency was exhibited, all thoughtful men in France remembered its dark side. They knew too well, from that ruinous experience, seventy years before, in John Law’s times, the difficulties and dangers of a currency not well based and controlled. They had then learned how easy it is to issue it; how difficult it is to check its overissue; how seductively it leads to the absorption of the means of the workingmen and men of small fortunes; how heavily it falls on all those living on fixed incomes, salaries, or wages; how securely it creates on the ruins of the prosperity of all men of meager means a class of debauched speculators, the most injurious class that a nation can harbor – more injurious, indeed, than professional criminals whom the law recognizes and can throttle; how it stimulates overproduction at first and leaves every industry flaccid afterward; how it breaks down thrift and develops political and social immorality. (page 29)”
“In vain did Maury (a prominent Assemblyman) show that, while the first issues of John Law’s paper had brought prosperity, those that followed brought misery; in vain did he quote from a book published in John Law’s time, showing that Law was at first considered a patriot and friend of humanity; in vain did he hold up to the Assembly one of Law’s bills and appeal to their memories of the wretchedness brought upon France by them…” (page 46)
“France was now fully committed to a policy of inflation; and, if there had been any questions of this before, all doubts were removed now by various acts very significant as showing the exceeding difficulty of stopping a nation once in the full tide of a depreciating currency.” (page 48)
“The great majority of Frenchmen now became desperate optimists, declaring that inflation is prosperity… The nation was becoming inebriated with paper money. The good feeling was that of a drunkard just after his draught; and it is to be noted as a simply historical fact, corresponding to a physiological fact, that, as draughts of paper money came faster the successive periods of good feelings grew shorter.” (page 51)
“’It is true that at first the assignats gave the same impulse to business in the city as in the country, but the apparent improvement had no firm foundation, even in the towns. Whenever a great quantity of paper money is suddenly issued we invariably see a rapid increase of trade. The great quantity of the circulating medium sets in motion all the energies of commerce and manufacturers; capital for investment is more easily found than usual and trade perpetually receives fresh nutriment… If…the new paper is of precarious value, as was clearly seen to be the case with the French assignats…it can confer no lasting benefits. …this prosperity would necessarily collapse and be succeeded by a crisis all the more destructive the more deeply men had engaged in speculation under the influences of the first favorable prospects.” (page 56/57)
“A still worse outgrowth was the increase of speculation and gambling… For at the great metropolitan centers grew a luxurious, speculative stock-gambling body, which like a malignant tumor, absorbed into itself the strength of the nation and sent out its cancerous fibers to the remotest hamlets. At these city centers abundant wealth seemed to be piled up. In the country at large there grew a dislike of steady labor and a contempt for moderate gains and simple living.” (page 59)
“From this was developed an even more disgraceful result – the decay of a true sense of national good faith.” (page 63)
“It will doubtless surprise many to learn that, in spite of these evident results of too much currency, the old cry of a ‘scarcity of circulating medium’ was not stilled; it appeared not long after each issue, no matter how large. But every thoughtful student of financial history knows that this cry always comes after such issues – nay, that it must come – because in obedience to a natural law, the former scarcity, or rather insufficiency of currency, recurs just as soon as prices become adjusted to the new volume, and there comes some little revival of business with the usual increase of credit.” (page 83)
“None felt any confidence in the future in any respect; few dared to make a business investment for any length of time, and it was accounted a folly to curtail the pleasures of the moment, to accumulate or save for so uncertain a future. This system in finance was accompanied by a system in politics no less startling, and each system tended to aggravate the other.” (page 91)
“From the early reluctant and careful issues of paper we saw, as in immediate result, improvement and activity in business. Then arose the clamor for more paper money. At first, new issues were made with great difficulty; but, the dike once broken, the current of irredeemable currency poured through; and swollen beyond control. It was urged on by speculators for a rise in values; by demagogues who persuaded the mob that a nation, by its simple fiat, could stamp real value to any amount upon valueless objects. As a natural consequence, a great debtor class grew rapidly, and this class gave its influence to depreciate more and more the currency in which its debts were to be paid. The government now began, and continued by spasms to grind out still more paper; commerce was at first stimulated by the difference in exchange; but this cause soon ceased to operate, and commerce, having been stimulated unhealthfully, wasted away. Manufacturers at first received a great impulse; but, ere long, this overproduction and overstimulus proved as fatal to them as to commerce.” (page 106)
“Out of the inflation of prices grew a speculating class; and, in the complete uncertainty as to the future, all business became a game of chance, and all businessmen, gamblers.” (page 108)
“And, finally, as to the general development of the theory and practice which all this history records: my subject has been Fiat Money Inflation in France: how it came; what it brought; and how it ended. It came by seeking a remedy for a comparatively small evil in an evil infinitely more dangerous. To cure a disease temporary in its character, a corrosive poison was administered, which ate out the vitals of French prosperity. It progressed according to a law in social physics which we may call the ‘law of accelerating issue and depreciation.’ It was comparatively easy to refrain from the first issue; it was exceedingly difficult to refrain from the second; to refrain from the third and those following was practically impossible.” (page 110)
“All this vast chapter in financial folly is sometimes referred to as if it resulted from the direct action of men utterly unskilled in finance. This is a grave error. That wild schemers and dreamers took a leading part in setting the fiat money system going is true; that speculation and interested financiers made it worse is also true; but the men who had charge of French finance during the Reign of Terror and who made these experiments, which seem to us so monstrous, in order to rescue themselves and their country from the flood which was sweeping everything to financial ruin were universally recognized as among the most skillful and honest financiers in Europe.” (page 85)
“Never was theory more seductive both to financiers and statesmen.” (page 28)
Returning to our analysis of contemporary Fiat Money and Credit Inflation in America, we see evidence of some profound developments. First, we have reached the point where enormous Credit Inflation provides only minimal stimulation. Moreover, the maladjusted financial and economic systems function sporadically and poorly with only “minimal stimulation.” As such, we’ve reached the intractable “too hot here and biting cold there” syndrome.
Second, dissimilar to the eighties variety of “all encompassing and uniform” inflation, recent (and foreseeable) inflation is overwhelmingly in the mortgage and government sectors. Investment, sound or otherwise, will no longer be a prominent “manifestation.” We are left to ponder how major a role this will play in future consumer goods/services pricing pressures. For the first three quarters of 2002, Non-financial Corporate Borrowings expanded $40 billion, or 1.1% annualized; Federal and State and Local Government borrowings increased $251.4 billion, or 7.0% annualized; and Total Mortgage Borrowings surged $620 billion, or 10.9% annualized. Why would we not expect today’s strain of inflation – virtually devoid of “supply side” spending/investment in goods and service-producing enterprises – to harbor disparate inflationary manifestations compared to those that we (and the markets) have become comfortably accustomed?
Third, the massive leveraged speculating community - that really received its critical impulsion from Greenspan’s powerful early nineties inflation to “recapitalize” the impaired U.S. banking system and reflate the faltering economy (and then again from the Mexican bailout inflation, the post-Russia/LTCM inflation, the pre-Y2K inflation, the bursting NASDAQ Bubble inflation, the post-9/11 inflation, etc.) – is an increasingly distorting and destabilizing influence demanding of continued rampant inflation (rising securities prices and continued speculative gains). Furthermore, with previous stock and corporate bond Bubbles having burst, the “good old days” when herds of leverage speculators were anxious acquirers of securities has evolved into a much less “cohesive” and market-friendly environment that includes a significant component of selling and shorting stocks and bonds. And, of course, the halcyon days of King Dollar have ended. Speculators from near and far will no longer ponder only what type of U.S. securities make for the best bets, now having the world of currencies, commodities and markets in which to explore for trading gains. At the same time, the enormous global financial conglomerates that were beating down the door to play the great American securities inflation are in dollar retreat.
Nonetheless, chairman Greenspan and Wall Street have good reason to confidently indulge in blind faith for the future success of the latest round of inflation. It’s worked repeatedly in the past. And, in the final analysis, aren’t we just dealing with debit and Credit entries on some enormous electronic ledger? And we’ve, after all, over the years watched myriad companies, industries, governments, markets and entire economies rescued by the magic of journaling some more entries - Credit “reflation.” And what is the recourse for the over-borrowed, susceptible to an overdue bout of frugality, American household sector? Well, just a minor adjustment to the thermostat and let the warmth of a refi boom temper nipping debt service to a comfortable level.
But if it all seems too good to be true… The Catch has been - is today and always will be - that it takes unending Money and Credit Inflation to keep this sordid Game going. And the system better not skimp on quantities of new Credit, especially in the enormously distended mortgage sector. As always, over time the source, nature and consequences of the created purchasing power (Money and Credit Inflation) transform, mutate and diverge. For now, we see the distinct inflationary manifestations of massive trade deficits, dollar vulnerability, heightened pricing pressures, and general pricing disorder. Today’s Credit inflation is both extreme and aberrant; manifestations, necessarily, will be likewise. The alluring nineties manifestations – surging stock and bond prices, rising perceived wealth for virtually everyone, plush government revenues, booming investment, an historic technology growth cycle, and consequent enormous foreign-sourced (investment and speculative) financial flows – were sure a lot more enticing than a faltering dollar, economic stagnation, and general “stagflation.”
But no amount of Fiat Money and Credit Inflation in America will bring back the glorious nineties inflationary boom with its favored manifestations. It’s simply impossible. As students of the history of inflationary booms and busts, we appreciate that the old medicine has not only lost its magic, it’s evolved into a strain especially poisonous to the diseased patient.
I’ll conclude with a couple of final extractions from Henry Hazlitt’s Introduction (1959):
“It begins to be believed that the value of the monetary unit is going to continue to fall – that it will be less next year than this year, less next month than this month. Once such a belief has taken hold, the decline in the value of the monetary unit is anticipated. The value of the monetary unit begins to fall faster than the supply is or can be increased. The monetary managers are from then on in a necessarily losing battle. The more they increase the supply of money, the more public opinion anticipates still further increases…” (page 19)
“Inflation, in its final stages, always ends in prostration, in what modern economists call a ‘stabilization crisis.’ The explanation of this stabilization crisis is not mysterious. During the inflation…prices do not respond in simple proportionality to the increase in the money supply. Some prices race beyond this, anticipating a further inflation. Even if inflation is halted at some point and no deflation sets in – that is, even if the increased supply of money is merely locked where it is and not reduced – the stabilization crisis sets in because these anticipatory prices collapse. The stabilization crisis, like the drunkard’s hangover, is part of the price that must be paid for every inflationary orgy.” (page 20)
Thanks for reading!