The failure of central banking

The failure of central banking [¹]

By Stephen S. Roach, Chairman, Morgan Stanley Asia | 22 October 2007

For the third time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In each case— the equity bubble in 2000, the housing bubble in 2005, and the credit bubble in 2007— central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.

The current post-bubble shakeout is hardly an isolated development. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward. That set in motion a chain of events that has allowed one bubble to beget another— from equities to housing to credit.

When the bubble burst in early 2000, the optimists said not to worry. After all, Internet stocks accounted for only about 6% of total U.S. equity-market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing 2 1/2 years, and an overextended corporate America led the U.S. and global economy into recession.

[ Normxxx Here:  And, again, early on, the housing bust was predicted to be "short-lived."  ]

Similarly, today's optimists are preaching the same gospel: Why worry, they say, if subprime is only about 10% of total U.S. securitized mortgage debt? Yet the unwinding of the far broader credit cycle gives good reason for concern— especially for overextended American consumers and a U.S.-centric global economy. Central banks have now been forced into making [huge— over a half Trillion dollars] emergency liquidity injections, leaving little doubt of the mounting risks of another financial crisis. The jury is out on whether these efforts will succeed in stemming the rout in still overvalued credit markets. Is this any way to run a modern-day world economy? The answer is an unequivocal "no."

It is high time for monetary authorities to adopt new procedures— namely, taking the state of asset markets into explicit consideration when framing policy options. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.

[ Normxxx Here:  But here, Steve is calling for a far higher caliber of regulator than anything that has been evidenced.  ]

That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one-dimensional fixation on CPI-based inflation and also give careful consideration to the extremes of asset values. This is not that difficult a task. When housing markets go to excess, when subprime borrowers join the fray, or when corporate credit becomes freely available at ridiculously low "spreads" [[i.e., when the "wild men" of finance take over: normxxx]], central banks should run tighter monetary policies than a narrow inflation target would dictate [[but that takes a fair amount of political courage!: normxxx]].

The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to lurch from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy. It could also spur the imprudent intervention of politicians, undermining the all-important political independence of central banks. The art and science of central banking is in desperate need of a major overhaul— before it's too late.

From bubble to bubble— it’s a painfully familiar saga. First equities, then housing, now credit. First denial [[of the painful dénoument: normxxx]], then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the third time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting— most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.

Sub-prime is today’s dot-com— the pin that pricks a much larger bubble. Seven years ago, the optimists argued that equities as a broad asset class were in reasonably good shape— that any excesses were concentrated in about 350 of the so-called Internet pure-plays that collectively accounted for only about 6% of the total capitalization of the US equity market at year-end 1999. That view turned out to be dead wrong. The dot-com bubble burst, and over the next two and a half years, the much broader S&P 500 index fell by 49% while the asset-dependent US economy slipped into a mild recession, pulling the rest of the world down with it. Fast-forward seven years, and the actors have changed but the plot is strikingly similar. This time, it’s the US housing bubble that has burst, and the immediate repercussions have been concentrated in a relatively small segment of that market— sub-prime mortgage debt, which makes up around 10% of total securitized home debt outstanding. As was the case seven years ago, I suspect that a powerful dynamic has now been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the US economy as a whole.

Too much attention is being focused on the narrow story— the extent of any damage to housing and mortgage finance markets. There’s a much bigger story. Yes, the US housing market is currently in a serious recession— even the optimists concede that point. To me, the real debate is about "spillovers"— whether the housing downturn and credit crunch will spread to the rest of the economy. In my view, the lessons of the dot-com shakeout are key in this instance. Seven years ago, the spillover effects played out with a vengeance in the corporate sector, where the dot-com mania had prompted an unsustainable binge in capital spending and hiring. The unwinding of that binge triggered the recession of 2000-01. Today, the spillover effects are likely to be concentrated in the much larger consumer sector. And the loss of that pillar of support is perfectly capable of triggering yet another post-bubble recession.

The spillover mechanism is hardly complex. Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation. In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market. The spillover is a principal characteristic of such a post-bubble shakeout. Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in many of the past months. The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth below the 3.7% average gains over the previous three years [[though, so far, not markedly: normxxx]]. Yet the slowdown in capex has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging over 3.2%— only a modest downshift from the astonishing 3.7% growth trend of the past decade can be noted.

Therein lies the risk. To the extent the US economy is now flirting with "growth recession" territory— a sub-2% GDP trajectory— while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back. The case for a consumer spillover is compelling, in my view. A chronic shortfall of labor income generation sets the stage— real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion. At the same time, reflecting the asset-dependent mindset of the American consumer, debt and debt service obligations have surged to all-time highs whereas the income-based saving rate has dipped into negative territory for two years in a row— the first such occurrence since the early 1930s.

Equity extraction from rapidly rising residential property values has squared this circle— more than tripling as a share of disposable personal income from 2.5% in 2002 to 8.5% at its peak in 2005. The bursting of the housing bubble has all but eliminated that important prop to US consumer demand [[and the credit market collapse has marked it "paid": normxxx]]. The equity-extraction effect is now going the other way— having already unwound one-third of the run-up of the past four years. In my view, that puts the income-short, saving-short, overly-indebted American consumer now very much at risk— bringing into play the biggest spillover of them all for an asset-dependent US economy. Steadily weakening retail sales growth may well be a hint of what lies ahead.

It didn’t have to be this way. Were it not for a serious policy blunder by America’s central bank, I suspect the US economy could have been much more successful in avoiding the perils of a multi-bubble syndrome. Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last three asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then, only four years later, he did it again— this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing— the extension of credit to unworthy borrowers. [[and he was quick to reassure all that unfettered securitization had materially reduced the credit risk in the markets: normxxx]] Far from the heartless central banker that is supposed to "take the punchbowl away just when the party is getting good," Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Fancy that!

Greenspan or not, downside risks are building in the US economy. The sub-prime carnage is getting all the headlines these days, but in the end, I suspect it will be only a footnote in yet another post-bubble shakeout. America got into this mess by first succumbing to the siren song of an equity bubble. Fearful of a Japan-like outcome, the Federal Reserve was quick to ease aggressively in order to contain the downside. The excess liquidity that was then injected into the system after the bursting of the equity bubble set the markets up for a series of other bubbles— especially residential property, emerging markets, high-yield corporate credit, and mortgages. Meanwhile, the yen carry trade added high-octane fuel to the levered play in risky assets, and the income-based saving shortfall of America’s asset-dependent economy resulted in the mother of all current account deficits. No one in their right mind ever though this mess was sustainable— barring, of course, the fringe "new paradigmers" who always seem to show up at bubble time. It was just a question of when, and under what conditions, it would end.

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame— the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

The exit strategy is painfully simple: ultimately, it is up to Ben Bernanke— and whether he has both the wisdom and the courage to break the daisy chain of the "Greenspan put." If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking. In the meantime, prepare for the downside— spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.

[ Normxxx Here:  For a theory of successive bubble blowing, see iTulip: "Ka-Poom! Theory"  ]