The Cost of Code Red By John Mauldin

April 26, 2014

Speculative Bubbles

(It is especially important to read the opening quotes this week. They set up the theme in the proper context.)

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

– Ludwig von Mises

“No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.”

– Ludwig von Mises

“[Central banks are at] serious risk of exhausting the policy room for manoeuver over time.”

– Jaime Caruana, General Manager of the Bank for International Settlements

“The gap between the models in the world of monetary policymaking is now wider than at any time since the 1930s.”

– Benjamin Friedman, William Joseph Maier Professor of Political Economy, Harvard

To listen to most of the heads of the world’s central banks, things are going along swimmingly. The dogmatic majority exude a great deal of confidence in their ability to manage their economies through whatever crisis may present itself. (Raghuram Rajan, the sober-minded head of the Reserve Bank of India, is a notable exception.)

However, there is reason to believe that there have been major policy mistakes made by central banks – and will be more of them – that will lead to dislocations in the markets – all types of markets. And it’s not just the usual anti-central bank curmudgeon types (among whose number I have been counted, quite justifiably) who are worried. Sources within the central bank community are worried, too, which should give thoughtful observers of the market cause for concern.

Too often we as investors (and economists) are like the generals who are always fighting the last war. We look at bank balance sheets (except those of Europe and China), corporate balance sheets, sovereign bond spreads and yields, and say it isn’t likely that we will repeat this mistakes which led to 2008. And I smile and say, “You are absolutely right; we are not going to repeat those mistakes. We learned our lessons. Now we are going to make entirely new mistakes.” And while the root cause of the problems, then and now, may be the same – central bank policy – the outcome will be somewhat different. But a crisis by any other name will still be uncomfortable.

If you look at some of the recent statements from the Bank for International Settlements, you should come away with a view much more cautious than the optimistic one that is bandied about in the media today. In fact, to listen to the former chief economist of the BIS, we should all be quite worried.

I am of course referring to Bill White, who is one of my personal intellectual heroes. I hope to get to meet him someday. We have discussed some of his other papers, written in conjunction with the Dallas Federal Reserve, in past letters. He was clearly warning about imbalances and potential bubbles in 2007 and has generally been one of the most prescient observers of the global economy. The prestigious Swiss business newspaper Finanz und Wirtschaft did a far-reaching interview with him a few weeks ago, and I’ve taken the liberty to excerpt pieces that I think are very important. The excerpts run a few pages, but this is really essential reading. (The article is by Mehr zum Thema, and you can read the full piecehere.)

Speculative Bubbles

The headline for the interview is “I see speculative bubbles like in 2007.” As the interviewer rolls out the key questions, White warns of grave adverse effects of ultra-loose monetary policy:

William White is worried. The former chief economist of the Bank for International Settlements is highly skeptical of the ultra-loose monetary policy that most central banks are still pursuing. “It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin,” he warns.

Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?

The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.

But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?

Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.

So, the first quantitative easing in November 2008 was warranted?

Absolutely.

But they should have stopped these kinds of policies long ago?

Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultraloose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.

But wouldn’t large-scale debt write-offs hurt the banking sector again?

Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking

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