Crisis, what crisis?
by Doug Noland
CREDIT BUBBLE BULLETIN
Jan 24, 2012
George Soros’ The Crisis of Global Capitalism … was published back in late-1998, following a dreadful period of global instability. Such concerns for the most part dissipated over the years with the resuscitation of global market and economic booms. The market value of global debt, equities and commodities skyrocketed. Bigger booms and busts followed and, not surprisingly, global Capitalism is today under only more intense fire.
Strangely enough, there remains a fine line between a ”crisis of global Capitalism” and utter euphoria in the financial markets. The European Central Bank’s (ECB’s) $620 billion first round Long-Term Refinancing Operation (LTRO) – along with expectations for an even more grandiose 3-year lending facility (LTRO II) next month – has the markets abuzz. Crisis resolved? The unleashing of another global reflationary backdrop on which to capitalize?
Participants certainly appreciate that the Federal Reserve has a hankering for QE3; the Bank of England (BOE) appears poised for unending quantitative easing; the Bank of Japan continues to flood its system with liquidity; the Chinese will likely soon resume stimulus measures; and ”developing” central banks around the world have moved to combat a weakening global backdrop with their own brand of monetary largess. Especially after global risk markets have ushered in 2012 in robust fashion, the optimists and speculators can be excused for believing that all the crisis chatter might yet again signal ”liquidity abundance, government backstops and spectacular market booms ahead.”
Prime Minister David Cameron yesterday provided his take on Capitalism in what has become a fascinating political debate in the UK. Here at home, the outcome of the November election could very well be decided by which of two opposing visions of a capitalistic economy best resonates with a divided populace. These are critical times.
The Financial Times this week ran several interesting essays in their ”Crisis in Capitalism” series. Today from former ECB and Bundesbank economist Otmar Issing: ”Too Big to Fail Undermines the Free Market Faith… The crisis has provided strong arguments for opponents of the financial system. Interventions to avoid its collapse have severely undermined not only confidence in financial markets but also in the market economy as a whole. Once a financial institution has become so big or interconnected that its insolvency threatens the stability of the system, politicians must intervene. The problem of ‘too big to fail’ has made society – more precisely, the taxpayer – hostage to the survival of individual financial institutions. As a result, the basis of free markets has been shaken. A market economy rests on the principle that individuals are free to act within boundaries set by a legal system… The rules of the game should be clear. Those who succeed are free to take the profits (after taxation); those who make losses have to bear the consequences, with bankruptcy the ultimate sanction. Thus, ‘too big to fail’ not only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.”
Also today, from Mohamed El-Erian: ”The Crisis Raises Legitimate Questions About Capitalism Itself… The majority of writers agree that the crisis in capitalism is caused by two distinct failures: the inability of the system to deliver sustained prosperity through economic growth and jobs; and the perception that it is grossly unfair and socially unjust. …To fail on both counts, and to do so in such a spectacular manner, is indeed a ‘crisis.’ It raises legitimate questions about the model itself. There are three main reasons for this. Firstly, capitalism has always, and will always be, prone to traditional market failures. The answer is to accept this, and work harder at reducing the chances of a catastrophic failure… Secondly, during the past decade, in another part of the world, a set of countries embarked on their own capitalist economic revolution… Lastly, too many of the institutions that are critical for the smooth functioning of capitalism utterly failed to deliver when they were needed most… Each of these areas can be corrected. Theoretically at least, what has occurred is less a calamity of the system as a whole, and more an issue of how it was run.”
Perhaps it’s only semantics, but while Mr El-Erian writes ”what has occurred is less a calamity of the system as a whole, and more an issue of how it was run,” I would instead focus on how it is ”BEING run.” And when Mr Issing writes, ”The problem of ‘too big to fail’ has made society… hostage to the survival of individual financial institutions,” I would focus these days somewhat less on ”institutions” and more on ”global debt and securities markets.” I know many analysts are of the view that system fragilities are being addressed through greater bank capital cushions and more stringent regulation. This is fighting the last war. I believe that a profoundly greater risk to global Capitalism goes largely unappreciated and unaddressed.
Larry Summers this week on CBNC repeated a common view: Capitalism is inherently flawed, but it still beats the alternative. Longtime readers know I take exception with the view that Capitalism is ”flawed.” One could similarly contend that the eyeball is flawed – that it is much too soft and fragile for having such a vital function. In reality, it is the nature of its operation and functionality that dictates its vulnerable structure. So it is incumbent upon those of us relying on eyeballs to guard against potential dangers, such as excessive sunlight (sunglasses), metal shavings (safety glasses) and disease (regular self-assessment and trips to the optometrist when things begin to appear out of whack).
There is certainly no doubt that Capitalism has vulnerabilities. Much less obvious is that its greatest vulnerability lies with the nature of Credit. This reality goes unappreciated by most – and largely undiscussed by the few conversant in the formidable nuances of Credit analysis. Ignoring the inherent instability of Credit is akin to staring at the lovely sun. Ironically, those that seem to best appreciate the nature of Credit instabilities – along with the risk posed to Capitalism – also tend to be those working keenly to extract the greatest amount of financial wealth from grossly distorted financial markets. Indeed, profiting from the consequences of two decades of policy measures in response to market instabilities has engendered one of history’s greatest periods of wealth accumulation (much of it through the transfer of wealth). And as the scope of policy prescriptions and market interventions turns only more incredible, the whirlwind of speculation seeking market riches becomes more intensive than ever. The markets ebb and flow and convulse, while the Crisis of Capitalism drifts nearer to the abyss.
I am convinced that a capitalistic system must have a monetary anchor to be sustainable. A functioning market pricing mechanism is fundamental to resource allocation, saving and investment, wealth creation and, in the end, social stability and cohesion. Stable money and Credit is a prerequisite. One can also think in terms of two distinct pricing systems. There is the pricing of goods and services throughout the ”economic sphere.” There is, as well, the pricing of finance/Credit/risk in the ”financial sphere.” It is the pricing mechanism within the financial sphere that has become so badly out of whack to the point of posing dire risk to global Capitalism.
As I’ve noted in the past, we live in period unique in financial history: There is globally no limits placed on the quantity or quality of Credit creation. There is no gold standard; no Bretton Woods monetary regime; nor even an ad-hoc ”dollar standard” working to regulate global Credit expansion. Markets for pricing finance and risk have turned progressively distorted and, in the end, dysfunctional. This was a predictable outcome for a global ”system” bereft of a monetary anchor. Policymakers have repeatedly responded to dysfunction and inevitable booms-turned-bust with unprecedented market intervention. This continues to only exacerbate financial market pricing distortions and attendant imbalances. What began as tinkering has regressed to the point of policymakers attempting to take virtual command over the pricing of finance. Capitalism now hangs in the balance.
I am prepared to defend Capitalism until my dying days. I expect this endeavor to be no less of a challenge than it’s been the past 12 years trying to explain the great dangers associated with a runaway Credit Bubble. Over the long-term, for Capitalism to succeed in the real economy requires a functioning pricing mechanism and sound Credit system. Distorting the price of finance ensures speculative Bubbles, the misallocation of real and financial resources, and resulting economic maladjustment. In this regard, policymakers have bordered on gross negligence.
Massive fiscal and monetary stimulus, along with unprecedented market interventions, has completely overwhelmed the capacity of the markets to effectively price risk. Instead of learning from past mistakes, policymakers are more determined than ever to dictate market pricing. Rather than recognizing the prevailing role ”activist” central banking has played in fomenting dysfunctional markets, policymakers believe market outcomes beckon for only greater activism. Until governments can begin to extricate themselves from the manipulation of interest rates and risk market pricing more generally, this long cycle of destructive booms and busts will run unabated.
Mr El-Erian posited that ”capitalism has always, and will always be, prone to traditional market failures. The answer is to accept this, and work harder at reducing the chances of a catastrophic failure.” Well, what lies at the heart of these ”traditional market failures”? I have a very difficult time with the notion of accepting market proclivities and correcting institutional failings when there is scant evidence that policymakers or the economic community appreciate the inherent instabilities of Credit or the dangers of unsound finance. Would less debt, leverage, government market intervention and market speculation reduce the risk of catastrophic failure? Why then the incessant inflationist solutions of massive deficit spending, interest-rate manipulation, central bank monetization and progressive government control over the markets and real economies?
Mr Issing states that ”the rules of the game should be clear. Those who succeed are free to take the profits…; those who make losses have to bear the consequences, with bankruptcy the ultimate sanction.” Yet the overarching problem today is that the global government finance Bubble has inflated past the point of being too big to fail. And the rules of the game have become dangerously clear: policymakers will do any and everything to sustain a global Credit system some years ago exposed as dysfunctional and a risk to Capitalism. Governments are conspicuously against the bearing of consequences, and market participants are being heavily incentivized to play it that way.