05/09/2002 Unstable markets *

It was a week of extraordinary volatility in the U.S. equity, Credit and currency markets. We view the confluence of highly unstable markets, and especially the wild volatility that saw the NASDAQ100 and Semiconductor indices surge 11% during Wednesday’s session, consistent with unfolding troubles in the derivatives marketplace. It was also a week that saw WorldCom debt cut to junk status, although after the debt had already dropped to 50 cents on the dollar. Additionally, S&P cut the ratings on Deutsche Bank and Credit Suisse, both key financial players, with downgrades also impacting related structured products. Other major players such as JP Morgan and Merrill Lynch are now on “negative watch.” Credit Suisse’s long-term counterparty rating was cut to A+ from AA-, and it is becoming clear that the issue of rating agencies and counterparty risk is going to be key going forward.

The stock market was hyper volatile, with the NASDAQ100 dropping 3% over the first two sessions of the week, surging 11% on Wednesday, and then sinking 7% over the next two sessions. For the week, the Dow declined 1% and the S&P500 dropped 2%. The Transports were hit for 4% and the Utilities dropped 3%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices were largely unchanged. In a noteworthy development, the broader market generally underperformed the major indices. For the week, the small cap Russell 2000 sank 4% and the S&P400 Mid-Cap index dropped 2%. Despite the wild volatility, the NASDAQ100, Morgan Stanley High Tech, Semiconductor, and The Street.com Internet indices were largely unchanged. The telecom collapse runs unabated, as the NASDAQ Telecommunications index dropped 6%. The biotechs continue to perform poorly, with the major index dropping 6%. The financial stocks were unimpressive, with the AMEX Securities broker/dealer index down 1% and the S&P Bank index declining 2%. Although bullion declined $1.20, the HUI gold index added 3% for the week.

Volatility in the Credit market was equally disconcerting. The yield on December eurodollar futures surged 25 basis points Wednesday, only to drop 23 basis points through the end of the week. Eurodollar yields declined 10 basis points for the week. Two-year Treasury yields ended the week up two basis points to 3.16%, jumping 20 basis points Wednesday and then sinking into week’s end. For the week, 5-year yields increased one basis point to 4.36%, 10-year Treasury yields jumped seven basis points to 5.12%, and the long-bond yield added seven basis points to 5.60%. Mortgage-backs outperformed, with yields adding one basis point, while implied yields on agency futures generally added four basis points. The benchmark 10-year dollar swap spread was unchanged at a narrow 55. The spread to Treasuries on Fannie Mae’s 5 3/8% 2011 notes narrowed 2 to 56. The dollar index ended the week with a very small gain, not able to sustain Wednesday’s 1% surge. The Canadian dollar traded to a 7-month high against the greenback, and the New Zealand dollar jumped to a 16-month high. And while Asian currencies generally perform well, the currencies of our Latin American neighbors falter. The Brazilian real dropped 2% this week (8.6% last month), while Brazil’s benchmark bond fell to a five-month low. The Mexican peso declined two-thirds of one percent this week to a seven-month low against the dollar. The Mexican Bolsa equity index declined 3% this week

Broad money supply (M3) surged $42 billion last week to a new record, and is up $64.3 billion over two weeks. Institutional money market fund assets were up $11.8 billion ($32.7 billion in two weeks), checkable deposits $6.2 billion, savings deposits $8.4 billion, and retail money fund deposits $8.9 billion, and large time deposits $4.4 billion. Confusing the issue, however, the Investment Company Institute reported more timely data that has money market fund deposits declining by $41 billion.

Countrywide Credit announced April data this week. For the month, “average daily loan applications remained robust at $845 million, an increase of 25 percent over April of last year... April’s total mortgage loan fundings of $14.1 billion were up 39 percent over the same period last year... Purchase fundings hit a record $7.2 billion in April, a 6 percent increase over the prior month and a 66 percent increase over April last year.” Refi fundings were up 14% year over year to $6.7 billion, while fundings for home equity loans jumped 135% y-o-y to $924 million. Subprime lending was up 38% y-o-y to $602 million. Elsewhere, “Trading volume at Countrywide Securities Corporation, our securities broker-dealer corporation, were $127 billion, a 30 percent increase over April 2001. Banking, our newest diversification initiative, continues to meet performance objectives with assets at Treasury Bank totaling $3 billion in April.”

BusinessWire May 8 - “U.S. Housing Markets, published by the Meyers Group has just released its First Quarter 2002 Flash Report, reporting that builders recorded more single-family permits this quarter than in any prior first quarter, setting a first-quarter record for the fifth consecutive year.” Total single family permits increased 4% year-over-year. By region, the Northeast saw permits increase 11% y-o-y. In the South, the largest region and accounting for 50% of total permits, permits were up 9%. Permits in Florida surged 21% y-o-y. Permits were up 4% in the Midwest and down 5% in the West. Colorado, with permits down 18%, had the weakest performance of any state.

Indications point to a very strong summer season for our nation’s housing markets. The Mortgage Bankers Association’s weekly application index increased 8% last week to the highest level in two months. The refi index jumped 14% (but still down 11% y-o-y), with 40% of total applications for refinancing. The purchase index jumped almost 4% to 382.7, a new record and up a noteworthy 21% year-over-year. For comparison, the MBA purchase application index averaged 232 during the first week of May for the eight years 1994 through 2001.

This week from the National Association of Realtors (NAR): “Existing-home sales are expected to slow following an unprecedented first quarter but are on track to set a new annual record in 2002.” Also this week from the NAR: “Sales of existing condominiums and cooperatives surged in the first quarter... The seasonally adjusted annual rate for existing condo and co-op sales was 838,000 units in the first quarter of 2002, up 16.6 percent from a 719,000-unit rate in fourth quarter.” This surpassed the previous seasonally adjusted record set during last year’s third quarter by better than 8%. Sales were up 12.3% y-o-y. “NAR President Martin Edwards Jr. said the numbers are astounding. ‘After setting an annual record for condo sales last year, the jump during the first quarter -- even with a boost from unseasonably mild weather -- is really incredible. It shows we have exceptionally strong market fundamentals.’” National median condo prices jumped 15.3% y-o-y to $135,300. Once again, we see housing data that confirm the national character of the current real estate inflation. By region, first quarter sales were up 13% y-o-y in the West, with median prices jumping 10.8%. Sales were up 16.8% in the Northeast, with prices up 19.8%. Sales were up 16.1% in Midwest, as prices rose 10.7%. Sales were up 9.3% y-o-y in the South, with median prices jumping 17.8%.

The media was abuzz as (from Bloomberg) “U.S. productivity grew in the first three months of 2002 at the fastest pace in almost two decades as companies operated with leaner payrolls while the economy rebounded from recession. The Labor Department’s measure of work performed by one person in an hour rose at an 8.6 percent annual rate from January through March.” I hesitate to comment on the productivity data, as I am not knowledgeable as to the intricacies of the calculation. But it does seem rather obvious that before we celebrate we should be reminded of the composition of first-quarter GDP “growth” that lay behind the increased productivity. For starters, total GDP was up 3% y-o-y during the first quarter. However, private domestic investment declined 8% and exports were down 11% y-o-y, so one is left to ponder the nature of a “productivity” boom for an economy that has experienced a major decline in investment and exports. Year over year GDP growth is almost totally explained by the 7% increase in government spending and the 4% increase in services. Additionally, 64% of the y-o-y increase in Services “output” was in two categories, Medical and Other. While I can conceptualize improved productivity in manufacturing, I have a more difficult time when it comes to government and medical spending.

While it received little media attention, the government’s April index of import prices rose at a 1.4% rate (expectations of 0.6%), the second month of price gains and the strongest increase since February 2000. While import prices remain down year-over-year, with the dollar having experienced a significant decline there is every reason to expect import prices to demonstrate an inflationary bias going forward. Interestingly, there is certainly anecdotal information pointing toward heightened general inflationary pressures globally. If nothing else, it appears that the general global environment is changing and central banks are recognizing that there are today heightened risks of excess liquidity sloshing around the system. Back in 1998/99 when the Fed and GSEs were aggressively reliquefying, strong global deflationary pressures dampened the effects of U.S. domestic credit excess. Much of the world actually gladly welcomed exported inflation from the U.S. We sense these dynamics will not hold going forward. And it is also increasingly clear that, while the Fed is content to sit and wait for the recovery in manufacturing to take firm hold, other central bankers apparently recognize that risks are increasing and that to wait for the lagging sector would be waiting too long. Central bankers are moving independently and leaving the Fed way behind the curve.

Frankfurt, May 9 (Bloomberg) – “The European Central Bank said inflation in the dozen countries sharing the euro isn’t slowing as much as it expected last year, suggesting its next move will be to raise borrowing costs. ‘Recent developments in consumer price inflation have been less satisfactory than was expected at the end of last year,’ the ECB said in its report for May. The ECB needs to ‘remain vigilant with regard to the further evolution of the key factors determining the outlook for prices.’” Also from Bloomberg: “German import prices gained at the fastest pace in 10 months while French producer prices increased more than twice analysts’ expectations in March, a sign inflation may be slow to come down in coming months... “Money supply growth, which policy makers use to predict inflation, deserves ‘particular attention’ as bank lending recovers from last year’s slowdown, the ECB said in its monthly report... M3, which includes overnight deposits, securities maturing in less than two years, repurchase agreements and money market funds, rose 7.3 percent in March, ECB figures last month showed.”

The Reserve Bank of Australia (RBA) surprised markets this week by raising rates 25 basis points to 4.5%. The RBA included some interesting language in their release, as it appears they are coming to appreciate heightened risks: “ The significant strengthening in the domestic economy that has become evident in recent months suggests that the longer-term risks to the inflation outlook have increased.” In addition, “Household spending has also been supported by increases in wealth, primarily resulting from rising house prices. House price rises of around 15 to 20 percent have been recorded in a number of cities over the past year and, while increases of this magnitude are not exceptional for a single year, strong price rises have been ongoing for several years. Hence the cumulative increases over the past five years have been substantial, and are similar in real terms to those that occurred over the second half of the 1980s. Associated with the general rise in house prices in recent years has been a rapid expansion in household borrowing, which grew by 16.5 percent over the past year.”

Bloomberg, May 7 – “South Korean producer prices rose in April at the fastest pace in 2 1/2 years as oil and transportation costs rose, the latest sign inflation is gathering pace. Producer prices rose 1 percent from March, the biggest increase since October 1999, the Bank of Korea said.” Also from Bloomberg: “Bank of Korea Governor Park Seung made the following comments on the bank’s decision to raise its key interest rate a quarter-point to 4.25 percent. Economists expected rates to stay unchanged: On reasons for the increase: ‘Indicators such as production, shipments, inventories, consumption, exports and investment are showing signs of improvement. We judged that the economy is showing stable signs of recovery. ‘Although prices are stable now, there is too much liquidity in the system. The rate increase was an inevitable step toward achieving economic stability in the second half of the year,’ Park told a press conference. ‘In particular, there is concern over a future excess of liquidity, given the current rapid growth of the monetaryaggregates, which is led mainly by a steep increase in household lending at low interest rates. ‘We make our monetary policy decisions considering a time lag of about six months (before they take effect). A preemptive measure was inevitable, looking at the second half and next year. ‘The move may not fit with the trend in the U.S. economy and the stock market. Some may wonder whether we’re going for a tightening direction or pouring cold water on the economy as it revives. That’s not the case.”

A couple of headlines this week from Bloomberg on Mexican inflation – “Mexican Companies Are Raising Prices as Peso Hits 7-Month Low” and “Mexico April Inflation Rate Rose From March to 0.6%”... “Mexico’s April inflation rate rose at the second-fastest pace of the year, as importers raised prices to make up for the falling value of the currency. Consumer prices rose 0.55 percent in April, putting the trailing 12-month inflation rate at 4.7 percent, the central bank said in a statement.” Other inflation headlines this week included, “Retail Prices Rise in Britain at Fastest Pace in Four Years,” “Riksbank’s Bergstoem Sees Wages Boosting Prices,” “Portugal Revises Growth and Inflation Forecasts,” “Hungarian Central Bank Raises Inflation Forecast,” “Russia Consumer Prices Rise 1.2% in April,” “Uruguay Inflation Rises to Five-Year High,” “Columbia April Inflation Raises Higher-Than-Expected.”

The nightmare inflation scenario now appears to be unfolding in Argentina, with the headline, “Inflation Estimated to Reach 90% in 2002.” Also from Bloomberg: “Argentine consumer prices rose 10.4 percent in April, the biggest monthly jump in more than a decade, as the currency devaluation drove up the cost of food and fuel. April’s inflation rate is almost equal to that of the first three months of the year combined. Prices rose 21.1 percent in the first four months of the year, the National Statistics Institute said. Producer prices rose 19.7 percent in April from March and rose 60.7 percent since the beginning of the year. April’s inflation rate was the fastest since September 1990, when it surged 15 percent, and brings the year-to-date rise in prices to 21 percent...” Bloomberg quoted an economist: “This is a straight road toward another social explosion. It’s just a tremendous hit to the wallets of the poorest sectors of society.”

It’s been one of those weeks... On a personal note, I made an oral presentation of my PhD thesis proposal before the approval committee Tuesday. Let me tell you, I don’t think the Board of Directors of Goldman Sachs would have received it less warmly. The analysis obviously did not resonate at all. It was explained to me that the analysis had to have a much narrower focus. I was told that I needed to read other PhD theses to understand how I was going to have to produce mine. And I don’t even believe there was one positive comment made to me throughout the entire presentation or Q&A. The committee’s chief concern, however, was how I was going to incorporate econometrics and statistical analysis to prove direct causal effect of finance to the real economy. An email afterwards from one individual on the committee (that was actually the most sympathetic to my proposal) stated, “I also do not think that Doug has either the data nor understanding to express his ideas mathematically/econometrically.”

The whole experience could not have been more frustrating. I had no intention of disseminating my oral presentation (the written thesis proposal was a separate 16 page document) outside of the committee, but since it went over like a big lead balloon to the academics, I figured it doesn’t hurt to throw it out for general consumption. I apologize that much of the analysis has been seen before in this venue, but hopefully a little repetition isn’t too painful.

Endogenous Credit, Money, Monetary Processes, Financial Fragility and the Wall Street Bubble.

I would like to begin by admitting I don’t know the first thing about academia. I have a lot to learn, so please don’t hold any shortcomings or inappropriateness of my presentation against my worthy advisor. I will briefly discuss my background, as my experience will play a significant role in my thesis. I have worked as a PriceWaterhouse CPA and in corporate finance. This is my 14th year working in the financial markets. I have worked in the Treasury department at Toyota’s U.S. headquarters, for a hedge fund, and I am presently employed by David Tice & Associates, a U.S. investment company. I have been a trader, analyst, portfolio manager, and now market strategist.

I made the decision to return for my PhD because I have a passion for economics. It is a goal I have had for some time, and my passion has only grown stronger each year. But, candidly, I found the thought of studying the current curriculum in the U.S terrifying. I am here because of Dr. Steve Keen. After sharing emails, reading sections of the manuscript to his book Debunking Economics, and spending some time with him here in beautiful Sydney, I decided that the University of Western Sydney likely offered the best environment for me to pursue my love of money and credit. I will be putting my heart and soul into this project.

I believe my experience provides a somewhat unique capacity to make a contribution. I have witnessed first-hand truly historic developments in money, finance and markets. I accepted a position with a successful bearish San Francisco hedge fund manager back in late 1989. He had built an impressive track record shorting the stocks of companies where he could recognize impending problems. He was also a brilliant macro thinker, and he was correctly convinced that the U.S. economy and financial system were basket cases after the 1980s excesses. Well, our fund was up better than 60% in 1990, and we were considered geniuses. We were turning investors away, and our prospects could not have looked brighter, especially with the unfolding S&L collapse, major bank failures throughout the Northeast, and fiscal deficits spiraling out of control. The major U.S. money center banks were in trouble with even Citibank at risk, and there was a growing threat that an escalating real estate collapse in California could bring down the impaired U.S. banking system. The banking sector was sliding into its worst crisis since the Great Depression, and the U.S. economy was quickly sinking into recession. I would sometimes find myself daydreaming of what it was going to be like to be wealthy.

But things don’t always turn out as we expect. The Fed collapsed interest rates aggressively and reflated the system. Extraordinary financial innovation reinvigorated the Credit system. Our genius hats were replaced with dunce caps. Not only did I not become wealthy, I spent the next six years in a futile attempt to save our business. We closed down the fund in mid-1996. It was a tough and humbling ordeal. More importantly, it was a tremendous and invaluable learning experience.

In Bill Gates’ book The Road Ahead, he makes an interesting comment, saying that he likes to hire talented and hard-working individuals from failed companies because he knows that going through such an experience they would have spent every hour analyzing all angles and aspects of their company’s desperate predicament. Well, I can say that I spent what seemed like every minute of each day and many sleepless nights over many years trying to understand every detail of how a deeply impaired U.S. system was transformed into the most powerful financial and economic powerhouse the world has ever known. While everyone else on Wall Street spent the last decade seeking to profit from the greatest bull market in history, my quest has been to gain understanding as to what was driving the financial markets and economy. The bad news is I refer to the 1990s as my “lost decade.” The good news is I feel comfortable saying that I doubt there are many others that have spent as much time analyzing the intricacies of the contemporary U.S. financial system. I’ve studied the institutions, the money, Credit and equity markets, “structured finance,” derivatives, credit insurance, etc. That’s what I bring to the party.

In my thesis proposal I discuss the U.S. government-sponsored enterprises – The GSEs and specifically the mortgage lenders Fannie Mae and Freddie Mac that operate with implied government guarantees. I have analyzed these companies since the early 1990s. Using Freddie Mac as an example, I watched as total assets increased from $35 billion in March 1990 to $646 billion in March of this year. This company has another $600 billion of off-balance sheet exposure, all supported by less than $16 billion of shareholder’s equity. GSE assets began the 1990s at about $450 billion, and have since grown to about $2.4 trillion. There are few historical examples of credit excess surpassing what has transpired with the U.S. government-sponsored enterprises over the past decade. Perhaps John Law’s Mississippi Bubble scheme is comparable.

I witnessed how these institutions, Wall Street securities firms, and other non-banks took up the slack from an impaired banking system. I watched money flood into the hedge fund community that was literally printing money from borrowing at the Fed’s very low short-term interest rates (as the Fed worked to recapitalize the banking system) and lending long-term at much higher market rates. Back when I joined the industry there were a few hundred hedge funds with capital estimated at between $40 and $50 billion. Today there are said to be more than 6000 hedge funds, estimated capital exceeding one-half trillion dollars, and, with leverage, untold security holdings. I witnessed how hedge funds and Wall Street proprietary trading desks became aggressive buyers of securities, and how Wall Street investment bankers satisfied this demand. I witnessed how the “hot trade” – whether it was corporate bonds, Mexican bonds, Mortgage-backs, or some other securities – would lead to a boom in issuance and a resulting impact to the real economy. But I could also see how all this leveraged speculation was going to be a problem whenever the Fed raised rates and the resulting losses forced the speculators to unwind some of their trades. When the Fed raised rates in 1994, there were huge trading losses, a few hedge fund failures, and a general liquidity crisis. I watched as this deleveraging led to the Mexican collapse and the bankruptcy of Orange County, California.

At the time, the nascent U.S. bull market was brought to its knees, and even Alan Greenspan stated behind closed doors in late 1994 that he believed the Fed had pierced developing speculative bubbles in both the U.S. stock and bond markets. But this was not so, as by the end of the year liquidity had returned and the Wall Street securities boom had resumed. With a keen eye on the U.S. financial system, there was no doubt in my mind that the government-sponsored enterprises were playing an instrumental role in resolving the liquidity crisis, as they began aggressively expanding their balance sheets. They increased total assets by an unprecedented $151 billion during 1994, almost three times the amount from 1992. Basically, they became the liquidity – or the key “buyers of last resort” for the speculators. And with the evolution of this powerful liquidity backstop, along with the Fed, U.S. Treasury, and IMF’s aggressive Mexican bailout, I watched an emboldened leveraged speculating community become much larger and considerably more aggressive.

We did some small-scale derivative trading, so we would receive regular faxes from a couple derivative desks with terms sheets detailing the latest hot trade. I saw the popularity of leveraged trades in Mortgage-backs and Mexican cetes during 1993, then change to leveraged bets throughout SE Asia during 1995 and 1996. Later, the leveraged speculating community placed big bets in Russia. Whatever the hot trade, the consequences were generally the same: boom and later spectacular bust. The 1998 collapse of Russia and Long-Term Capital Management almost led to a system crash. Alan Greenspan has used the terminology “seizing up” to describe the illiquidity that was the result of the leveraged speculators forced to unwind positions. Well, that time around the bailout was for LTCM, the Fed again lowered rates dramatically, and the GSE’s increased assets by $305 billion during 1998 and another $315 billion during 1999. The system went from liquidity crisis to liquidity sufficient to finance an historic technology bubble. It was systemic “reliquefication” in its most extreme and dangerous form.

In my thesis proposal I stated that the U.S. financial system has evolved to be “the most powerful financing mechanism in history.” I do not believe this is hyperbole. More specifically, I am referring to the relationship of the GSEs, Wall Street “structured finance,” and the money market fund complex. Let me briefly walk you through the mechanics of GSEs borrowing from the money market to acquire mortgage-backed securities in the marketplace. (the following are only bullet points to my discussion):

- The GSEs issue liabilities to the money market funds and use these borrowed funds to purchase securities from the hedge funds.

- The hedge funds then receive these funds as money market fund deposits.

- With the money market funds under no reserve or capital requirements, money market fund deposits can be “multiplied” repeatedly and rapidly with the issuance of additional GSE liabilities. I refer to this as the “infinite multiplier effect.” Money and credit today are little more than journal entries in this enormous electronic ledger. There are many players making entries and the Fed does not control the process.

This really is an extraordinary development in monetary history. Back in 1998, I spoke with many analysts and economists and tried to explain this process and its significance. Almost without exception, I was informed that only banks have the ability to create money and credit. The GSEs and other “non-banks” were simply middlemen taking money from savers and lending it to borrowers. As logical as this conventional doctrine sounds, it is nonetheless incorrect.

Today, the key to monetary analysis is to appreciate that banks are but one of many types of financial intermediaries operating in contemporary financial systems. Various players within the financial sector enjoy the capacity of borrowing – of creating new liabilities – then lending these loanable funds. It must be recognized that the nature of financial sector liabilities – not just bank deposits - created in the lending process becomes critical for monetary analysis. The residual of the lending - of the credit creation process – may be bank deposits, money market fund deposits, mortgage-backed securities, structured instruments, or other securities, depending on the lender and the nature of the intermediation process.

No longer can we focus blindly at bank lending or at a narrow definition of money as reliable indicators of general credit conditions. And doctrine clinging to the premise that the Federal Reserve controls the money supply through bank reserves and open market operations is today simply flawed analysis. Instead, the money market has become the epicenter of financial sector liability creation and loanable funds intermediation, as well as the center of the financial sector payment system. Bank reserves are largely irrelevant, and the reality of the situation is that we now operate with an unharnessed monetary regime without the discipline of convertibility or a central bank controlling the volume of expansion. We are today truly in uncharted monetary territory.

Gurley and Shaw were ahead of their time in recognizing that the system was evolving toward non-bank financial intermediation, and that a key issue was the need for expanding monetary controls to more comprehensive financial controls. But the bottom line was that during the fifties and sixties non-banks issued inferior liabilities. This key factor has basically only changed during the past decade or so. Non-bank liabilities were generally less liquid, involved additional risk, and were not a means of payment like bank deposits. Yes, non-banks were lending – expanding credit – but they were not creating money. And, importantly, their lending activities were constrained by the limited demand for their inferior liabilities.

Money market funds have changed everything. Their deposits are perceived as a safe store of nominal value, they are highly liquid, and they are well integrated into the contemporary payment system. Actually, since deposits in these accounts are generally used for settlement of securities transactions, a strong case can be made that for many, money market fund deposits are superior to bank deposits.

James Tobin – in his classic 1963 article “Commercial Banks as Creators of Money” – argued against the notion that banks possess a “widow’s cruse” – that banks did not enjoy the ability to create endless demand for their own liabilities. He expounded his view by poking holes in the traditional textbook exposition of the “money multiplier.” Tobin’s focus was on the limitations imposed on bank deposit creation by profitable lending opportunities. The economy only presented so many profitable projects worthy of bank finance. Money creation was thus constrained by the quality of potential bank assets, along with reserve requirements. Well, that was wonderful analysis in the 1960’s, but extraordinary financial innovation has rendered it outdated.

Nowadays, the government-sponsored enterprises – because of the implied backing by the U.S. taxpayer - have virtually unlimited capacity to issue top-rated securities to be intermediated through money market funds. This is an historic development. At the same time, bankers or other loan originators can make risky loans and immediately package and sell them to Wall Street. Wall Street investment bankers then create a trust to acquire these loans. This trust purchases interest rate protection in the derivatives market, credit protection from credit insurers, and calls upon a money center bank and pays a small fee for a back-up credit line or liquidity protection. Now, the trust has created the necessary structure that allows it to go to the rating agencies and receive a triple-AAA rating. Equipped with this top rating, the trust issues pristine liabilities – asset-backed commercial paper - to the money market, raising funds to acquire loans.

Through this process, risky loans are transformed into perceived safe money and, importantly, loan quality poses no limitation on money creation. With structured finance, virtually any type of loan – commercial, consumer, mortgage, prime or subprime - can be monetized.

It is this mechanism - with the capability of transforming essentially endless risky loans into perceived safe financial assets - that has so profoundly changed the nature of monetary analysis. And since there is basically insatiable demand for this “money,” – the residual of lending - contemporary credit systems enjoy virtually unlimited capacity to create credit. That is, of course, as long as the perception of the soundness of money is maintained.

With contemporary credit systems cut loose from both traditional inherent constraints and central bank controls, the analytical focus changes. We must now be concerned as to where this credit is being directed – how this created purchasing power is spent. What are the resulting inflationary manifestations? Is the additional purchasing power going to consumer goods and services, manifesting into higher prices or larger trade deficits? Is it going into capital investment? Or is it going into asset markets, fueling bull markets in stocks, bonds and/or real estate?

Today, overwhelming evidence in the U.S. supports the view that extraordinary credit excess has been directed to asset markets. For one, we have witnessed a proliferation of enterprising specialized asset-based lenders. We have observed the explosion of assets held by the government-sponsored mortgage lenders, the explosion of hedge fund and securities firm assets, and the explosion of lending in the repurchase agreement market – the Wall Street market for financing security holdings. Actually, I will argue that the credit system has evolved to the point where financing asset markets has become the key financing mechanism for the U.S. Bubble economy.

And this is key: Today, no longer is bank lending to finance business investment the primary monetary transmission mechanism. Rather, securities markets dominate, and financing real estate lending and securities speculation are the leading transmission mechanisms of liquidity to the real economy. With such a profound change in the nature of finance, it is not surprising that the resulting inflationary manifestations and the character of economic growth have been so altered. But this is no economic miracle. Clearly, these momentous financial changes have not been recognized or appreciated by conventional doctrine.

The upshot to credit and speculative excess is the accumulation of unprecedented financial claims, too often backed by inflated asset prices instead of sound investment. It’s been a dramatic transformation. Inert loans that were traditionally held to maturity by prudent bankers, are today instead more often marketable securities created by aggressive investment bankers and held by speculators. Financial fragility has been created by credit and speculative excess, with resulting unstable debt structures and severe distortions to the structure of demand and the nature of investment. This is the essence of a bubble economy.

Derivatives have played a critical role in fostering credit and speculative excess, as the global over-the-counter derivatives market has surpassed an unfathomable $100 trillion. As a proponent of derivatives, Alan Greenspan often uses the terminology “the unbundling of risk.” Recently (April 22, 2002) he remarked, “New financial products have enabled risk to be dispersed more effectively to those willing, and presumably able, to bear it. Shocks to the overall economic system are accordingly less likely to create cascading credit failure.” Yet, sound analysis takes a diametrically opposed view: Derivatives and “financial engineering” generally isolate, extract, and specifically “Bundle” risk (interest rate, Credit, currency, equity, and commodity). Moreover, derivatives allow the isolation and transfer of risk too often to thinly capitalized financial players and speculators. This may enhance credit creation and credit availability during the boom, but the outcome is that potentially weak players accumulate enormous risk. This, covertly, adds significant additional systemic risk that surfaces come the unavoidable downturn.

It is also apparent that an uncontrolled credit system has a proclivity of focusing on asset markets – because asset-based lending offers easy and seemingly endless profits during the boom. But this process is very unstable. Credit excess fuels asset inflation, higher collateral values, additional spending, and heightened demand for credit. This self-feeding process, however, is highly susceptible to monetary disorder, where credit excess feeds dysfunctional lending and speculative bubbles. But such a system comes into immediate trouble when asset prices decline. In the case of post-asset bubble Japan, it becomes very difficult for an impaired financial system to generate sufficient money and credit for the real economy. In the case of the U.S., where it appears significant asset price risk has been transferred to a limited number of financial intermediaries and the murky derivatives marketplace, the risk becomes a failure of a key player, consequent market dislocation, collapsing confidence, and a potential breakdown of a monetary system that has come to rely so heavily on “structured finance.” And only making matters worse, acute financial fragility today impels extreme accommodation from the Federal Reserve, which fosters additional excess and greater systemic risk, especially in mortgage and consumer finance.

This brings us to a key aspect of contemporary monetary analysis. Between the trillions of dollars of risky loans made – predominantly to the asset markets – and the trillions of “safe” money and top-rated securities issued through financial sector intermediation, there are myriad thinly capitalized financial intermediaries and financial players. Money creation is risk intermediation, and monetary excess manifests into a system increasingly fragile and vulnerable to financial accident. A loss of confidence in the intermediaries or the “moneyness” of money holds the potential for systemic dislocation. We have seen precisely these unfortunate circumstances unfold throughout SE Asia, Russia, Turkey, and recently Argentina. I see similar vulnerabilities in the U.S. currently.

There was no appreciation of the risks developing in any of these economies – little understanding of dangerous credit excess, the destabilizing leverage and speculation that had developed in these credit systems, or the resulting financial and economic bubbles. The objective of my thesis is to develop an analytical framework to assist in the process of identifying dangerous monetary processes before they impart irreversible instability. I think there has been a breakdown in analysis. Under the auspices of healthy free markets and deregulation, there has been the creation of a dysfunctional and destabilizing financial apparatus that operates to the detriment of the public interest. At the same time, economic and analytical doctrine has lagged so far behind Wall Street innovation that a strong analytical case cannot be made of the contemporary system’s shortfalls. With my thesis, I hope to take a small step in rectifying this most serious dilemma.