Inflation, stagflation and money supply

Italy’s Finance Minister, Tomasso Padoa-Schioppa, in mid April, told a gathering in Washington DC, of the International Monetary Fund’s governing body, that the sub-prime mortgage fiasco was not a unique problem for the global economy. Elaborating, he declared that there were several other obstacles on the path to global economic growth, including high US consumer spending, low interest rates and the lax lending that accompanied those rates.

So what exactly happened?

The sub-prime catastrophe centres on the United States housing market, but its effects have spilt over into credit markets and stock markets. What’s unfolding today is a result of what transpired immediately after a bunch of Muslims left their calling cards in Lower Manhattan.

Saturated with post terror trauma, the United States Federal Reserve System - facing an already struggling economy - began slicing rates dramatically. The so-called “Fed’s Fund Rate” fell to 1 per cent in 2003. The aim of which was to pump more money into the economy, which in turn, it was felt, would stimulate lending by banks and borrowing by individuals.

Was the Federal Reserve right?

Well, the strategy worked like a charm. The economy began to grow in 2002. Lower interest rates meant existing home borrowers could borrow more. Naturally, this led to rises in house prices. And those with poor credit ratings, who previously couldn’t borrow, suddenly found themselves being offered mortgages.

Happy days were here again.

New products, new problems

New financial products were being devised by Wall Street and old ones were being renovated, the most prominent of which was the so-called asset backed security (ABS). This new instrument ended up being marketed as “investments” to superannuation funds, hedge funds, foreign governments and even to local councils in Australia.

Simply put, an ABS is a bundle of assets that has consistent cash flows (such as an individual's home mortgage). Individual payments (mortgage payments, for instance), are aggregated with other recurring payments (of different types) and used to pay investors a coupon. The ABS is backed by the underlying property.

The advantage for the investor is that she can acquire a diversified portfolio of fixed-income assets that materialise on her bank statement as a single coupon payment. Pretty nifty, huh?

With the bubbling US real estate market, on the back of lower interest rates, a new form of ABS was created. Only these turkeys were being stuffed with more than their fair share of sub-prime mortgage loans, that is, loans to home buyers with dubious credit rating. Some securities were highly rated, some not, depending on just how much sub-prime stuffing was inserted into the ABSs.

When home prices stopped rising and inflationary expectations ramped up interest rates, many borrowers (who really had an awful credit rating and should never have been offered a mortgage in the first place) could no longer afford to make their mortgage repayments and were left with a mortgage bill bigger than the value of the house. This is politely called “negative equity”.

Problems ensued when lenders, facing no buyers for these bundled securities, were cut off from what had become a main funding source and were forced to close their doors. As a result, their stockpile of such and similar securities went from being easily traded to thinly traded to unmarketable.

Stuck with products they didn’t want and whose values were plunging, many lenders dumped these securities at great discounts in a mad dash for cash. Most opted for government debt. Yields on treasury bills (the inverse of their price) fell a whopping 1.5 per cent in a matter of days, given the massive interest in them.

A banker’s view of the crisis we’re about to experience

Echoing Mr Padoa-Schioppa, Charles R. Morris in Trillion Dollar Meltdown explains that apart from the sub-prime fiasco, other financial dominos are about to fall in the current avalanche, before order is restored to the financial sector.

Mr Morris, a banker and former lawyer has authored ten books. In this book, he succinctly relates just how bad the sub-prime catastrophe is, and why it will take a sustained effort to get us out of this swamp.

Morris weaves a convincing story linking the 1960s economic liberalism of John Maynard Keynes, the crippling stagflation of the 1970s, the laissez faire free-for-all of the 1980s and 1990s and the world of very cheap money and financial creativity gone insane that epitomised the last seven years.

The sub-prime crisis is only the first of many dominos that will fall this year. Disasters looming large in 2008 include: corporate debt, commercial mortgages and credit cards, he promises.

Morris explains that “not so long ago, the sum of all financial assets - stocks, bonds, loans, mortgages and the like - which are all claims on real things, were equal to global GDP. Now they equal four times global GDP. And derivatives, which are really claims on claims, have a notional value of 10 times global GDP”.

This is not sustainable.

The soaring ratio of credit to real output is a measure of leverage. His analogy is that of an inverted pyramid. The more claims that are piled on top of real output, the more wobbly the pyramid becomes. And when, not if, it becomes too wobbly, it will fall fast. He estimates that the value of all the coming write downs and defaults across the financial sector - including residential mortgages, commercial mortgages, corporate bonds, high yield (or more correctly termed “junk”) bonds, leveraged loans and credit cards - will total no less than $1 trillion.

Morris appraises recent economic history and describes how fashions change. What was once in vogue among governments and the business community, eventually gives way to another economic doctrine. The historic move from Keynesian economics to Monetarism will (Morris hopes) swing back to Keynes sooner rather than later.

He recalls how America’s infatuation with the Japanese economic model started in the days of Camelot, President John F. Kennedy’s time in the White House, and continued until the dying days of the Carter presidency. Both the government and the business communities were infatuated.

This envy reached a crescendo just about the time that Japan’s economy was tanking. A slowdown that would last more than 15 years. The decline in Japan as well as similar economic malaise in France and Germany convinced many in America that Keynesian activism was dead in the water, and that when it came to economic woes, many Americans believed that the government was far from being the solution. It was the problem.

And so like rats leaving a sinking ship, the scurry away from Keynesian economics began.

Even before the inauguration of Ronald Reagan as the 40th President of the United States, the arrival of Milton Friedman’s brand of economics was recorded in the United States Congress. An unknown Republican from Wisconsin named William A. Steiger, pushed through a cut in the capital gains tax in April 1978, a mere eight months shy of his death.

The media crowed that Steiger single-handedly unleashed the boom in venture capital investment that jump started Apple and Sun Microsystems. But the prosaic truth was that the surge in venture capital investment had its roots five years earlier, in 1973, when a law was passed requiring companies to park some money to fund its staff superannuation liabilities.

Super funds’ assets quickly ballooned to more than $1 trillion, and fund managers clamoured for more flexibility in the strict super fund investment rules. When the rules were eased in 1979, it was mainly super funds that were the source of most of the new venture capital. Morris argues that it’s bogus in the extreme to argue that a cut in capital gains tax spurred venture capital investment, as these super funds were immune from the ramifications of a capital gains tax cut, given were tax exempt.

Steiger’s tax cut sowed the seeds of mythology among the free market faithful, Morris asserts.

President Jimmy Carter’s appointment of Paul Volcker as Chairman of the Federal Reserve in 1979 came at a very troubling time for Wall Street in particular and the global economy in general. The job description of the financial economist, who divided his career between the Treasury and the Chase Manhattan Bank, was to slay the inflation dragon and restore financial order.

Inflation had traumatised long term investors, siphoning money away from bonds and stocks that financed businesses and fuelling hard asset bubbles in gold, art and real estate. Prior to his appointment, on spot markets, the dollar price of oil rose by 6 per cent a month and gold rocketed 28 per cent in a single month.

People were scared. Both business leaders and trade unionists feared stagflation (a recession accompanied by galloping inflation).

Paul Volker moved into the chairman’s office just as Milton Friedman’s sermon was claiming a large congregation in Washington, DC. Friedman held that monetarism would cap government meddling in the economy and that inflation could be controlled by solely controlling the stock of money. The stock being the sum of all bank deposits and circulating cash. If the Fed ensures that the stock of money mirrors the growth of economic activity, then everything would remain just sweet.

While Morris admits that Volcker applied certain monetarist rules to snap the back of inflation, he is resolute in his chant that monetarism didn’t break inflation. Volcker did. Friedman acolytes, Morris explains, hadn’t guessed that as the Fed cracked down on the supply of conventional money stock, sharp Wall Street suits would create new financial instruments to get around these restrictions. Which they did, with high yielding bonds, interest bearing cheque accounts and other innovations.

Morris argues that Volcker broke inflation by simply clamping down very hard and very consistently using three key weapons in his arsenal: interest rates, money supply and jawboning.

Within two years (by the end of 1982), the Fed funds rate fell to 8.7 per cent and the economy started to inch forwards. In response, the US Dollar soared. When in 1984 the economy needed some tightening of monetary policy, Volcker was backed (once again) by the free marketeer himself, President Reagan. Volcker managed to keep real GCP at a respectable 4.1 per cent while the inflation menace was tamed to 1.9 per cent. A 20-year low.

Wall Street was finally convinced. The world now fathomed what pain the White House will endure to protect the greenback. The stewardship of the United States economy was revered by the rest of the world.

Morris’ trepidation with the current state of the financial markets rests to a great extent with his naked hostility to Volcker’s replacement, Mr Alan Greenspan, while ignoring Greenspan’s replacement, Mr Ben Bernanke.

Greenspan, Morris alleges, was actively not involved as financial markets regulator for most of his time as Chairman of the Fed. During the leveraged buy out (LBO) boom - where Greenspan chose not to curtail bank lending for highly leveraged transactions until it was far too late as well as in the late 1990s when he refused to tighten stock margin rules - only served to show his preference for a hands off approach. This was more than enough to raise the ire of Morris.

Morris expects the financial disaster in 2008 to cost about $1.1 trillion. This being the total of residential, commercial, corporate and consumer loans which are expected not to perform. Given it’s too late to avert the coming catastrophe, he passionately pleads for active financial oversight to ensure the unwinding is orderly, but isn’t holding his breath.

Charles R. Morris has written a book revealing that the failings of some can have devastating repercussions on the many. To those who care about the state of global finance, this book is timely, well argued and best of all, a joy to read.