Mass Delusion and the Myth of Deleveraging

Prudent Bear’s Doug Noland marks the fifth anniversary of the collapse of Lehman Brothers — and the near-collapse of the global financial system — by asking whether the system’s flaws have been fixed.

Blinder, Summers and Monetary PolicyNext Wednesday the Fed will reveal its much-anticipated “tapering” plans. Japan’s Nikkei news service Friday reported that the Administration “was set to name” Larry Summers to replace the retiring chairman Bernanke. And Sunday marks the five-year anniversary of the failure of Lehman Brothers. Well, it does seem “a good time to ponder how the U.S. economy was nearly brought to ruin” as well as an appropriate juncture to focus again on the role of monetary policy.

The following quote is from Alan Blinder, Princeton University professor and former vice-chairman of the Federal Reserve, writing in the Wall Street Journal, September 11, 2013:

“Next Sunday marks the fifth anniversary of the fateful day that investment bank Lehman Brothers filed for bankruptcy, signaling the start of a frightening financial meltdown. It’s a good time to ponder how the U.S. economy was nearly brought to ruin. But will we? Or are we already forgetting? Consider the stark historical contrast between the 1930s and this decade: Years of financial shenanigans in the 1920s, some illegal but many just immoral, conspired with a variety of other villains to bring on the Great Depression. Congress and President Roosevelt reacted strongly, virtually remaking the dysfunctional U.S. financial system, including establishing the Securities and Exchange Commission to protect investors, the Federal Deposit Insurance Corp. to protect bank depositors, and much else. The financial beast was comparatively tamed for almost 75 years. Years of disgraceful financial shenanigans in the 2000s, some illegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators…Far from being tamed, the financial beast has gotten its mojo back—and is winning. The people have forgotten—and are losing.”

Blinder then laments the lack of reform in “mortgages and securitization,” derivatives, the rating agencies and proprietary trading. “In sum, the Dodd-Frank Act is taking on water fast. What can be done to help Americans remember the horrors that led to its passage?”

With stock prices near all-time highs and home price inflation back on track, who is keen to “remember the horrors”? Why would anyone today be willing to upset the applecart? With Washington fiscal and monetary stimulus having reflated the asset markets, what limited appetite that existed for so-called “financial reform” has virtually disappeared. It would be laughable if it weren’t so maddening. The GSEs still completely dominate mortgage finance, which implies ongoing market distortions. They are basically as big – and as thinly capitalized – as ever. The nation’s goliath banks have grown only more dominant.

With the Fed such a massive buyer of Treasuries, there has been no market discipline imposed upon a spendthrift Washington. A more than doubling of outstanding federal debt in five years (issued at record low market yields) implies broad market distortions and economic maladjustment. At a record (ballpark) $2.4 TN in assets, the historic inflation of hedge fund industry assets runs unabated. This has propelled the number of billionaires, along with skyrocketing prices for art, collectibles and trophy properties. And at $632 TN (from BIS data), the global derivatives marketplace is as unfathomably monstrous as ever. As for the rating agencies, truth be told, they have little impact on the global Credit Bubble.

Mr. Blinder and others would like to believe that we’ve been persevering through a post-Bubble “Great Recession” with parallels to the Great Depression – but with, thankfully, the benefit of wonderfully enlightened policymaking. Former Treasury Secretary Hank Paulson, discussing the 2008 crisis during a Friday morning CNBC appearance, referred to a “massive Credit Bubble that went bust” – “a 100-year flood with excesses building for years and years.”

At risk of sounding “lunatic fringe,” the reality of the matter is we’re suffering these days from a period of mass delusion. U.S. and world GDP have never been greater. Fueled by record securities prices, U.S. household Net Worth stands today at a record level. U.S. total income in rather short order recovered from 2009’s modest decline. Real estate prices around much of the world are at or near record highs. Total outstanding Credit – in the U.S. and globally – is at a record high and inflating.

From a systemic standpoint, the notion of “de-leveraging” has been a myth. And for five years now unprecedented global imbalances have worsened. Chinese and EM Credit Bubbles and attendant Bubble economies have inflated to historic proportions. Indeed, there is a fine line between “frightening financial meltdown” and unleashing history’s greatest inflation of global securities prices. The only justification for the “100-year flood” thesis is wishful thinking. ...

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