The era of credit expansion

Today, Paul Volcker enjoys the status of a hero – his reign was the last time after all when a central banker resisted political pressure and stopped a pernicious inflation from getting further out of hand by jacking up interest rates and targeting money supply growth directly until the rise in CPI subsided.

He did so even though it entailed some significant short term economic pain – in this he is clearly different from his successor Alan Greenspan, the originator of the so-called ‘Greenspan put’ – market lingo for ‘unlimited guarantee of opening the monetary spigot at the slightest hint of a downturn’. Clearly, Ben Bernanke is cut from similar cloth.

However, we would argue that Volcker must be seen in a far more critical light as well. What he did he did mainly for the banks. The commercial banks, just as the State with which they are in bed, love inflation. It is the greatest ‘money for nothing’ or ‘free lunch’ racket ever invented. But they hate it when the public notices what is going on and begins to dump the underlying currency. An inflationary policy is only ‘successful’ for its purveyors if the frog can be boiled slowly.

The moment interest rates begin to rise and prices for goods and services begin to gallop away, it ceases to be a viable policy. In the late 1970’s the inflationary policy was on the ropes, as exactly that had begun to happen. While Volcker deserves recognition for slaying the inflationary beast at the time, in reality he just created the preconditions for even more inflation – this time of the ‘boiling the frog slowly’ type.

Naturally, this happened not just due to Volcker’s intervention. He just created the initial set of conditions – otherwise, the bankers simply got lucky. As it happened, the early 80’s saw the  invention of the personal computer, and all that flowed from it. Suddenly, large productivity gains helped to mask the price effects of inflation to such an extent that the banks could inflate like never before – while the central banks backstopping them and making the inflation possible by creation of bank reserves from thin air could claim that they pursued a ‘policy of price stability’. Thus a veritable Moloch of a financial economy was created, in which debt began to expand into the blue yonder.

Below are a few charts illustrating this. Note here how a proliferation of financial claims towers ever larger over the underlying amount of activity in the real economy – this means that more and more income must be devoted to debt service. This is an inevitable outcome of our inflationary monetary system – an outcome that Volcker has made possible by rescuing the monetary system in the late 70’s / early 80’s.

The global notional value of over-the-counter derivatives has, according to the BIS, expanded to $ 614 trillion (note this excludes exchange traded derivatives, which adds another big chunk. All in all the notional amount of all derivatives probably exceeds $1 quadrillion by now). While notional amounts make this sound more scary than it is (due to netting out, the total value at risk is probably just 4%-5% of the total), one must ask: why such large numbers and such vast growth in the first place?

The answer is that the totally unstable monetary system of irredeemable free-floating currencies based on fractionally reserved credit expansion creates numerous financial risks that simply would not exist under a stable free market based system. The  system as it is not only encourages speculation – people are practically forced to speculate if they want to preserve the purchasing power of their savings – it also creates risks that in turn lead to ever more ‘financial innovation’ aimed at insuring against those risks, resp. profiting from them. In the final analysis this represents a giant waste of time , energy and resources – all of which could be more profitably employed in real, wealth-generating economic activities in a stable system.

US credit market debt as a percentage of GDP , 1929-2010. The current era of credit expansion dwarfs anything seen before. This chart is from the Absolute Return Partners report of December 2009(pdf) – click chart for higher resolution.

UK credit market debt vs. GDP – this looks even worse. If not for the BoE engaging in quantitative easing on a grand scale in 2009, and the UK treasury de facto nationalizing a large chunk of the UK banking system, this debt-berg would likely have collapsed in a deflationary heap in late 2008-2009 – click chart for higher resolution.


US MZM (Money of Zero Maturity) and GDP indexed to 100 in 1981. An ever bigger tsunami of financial claims must be supported by a relatively ever smaller amount of real economic output. Note here that we regard neither MZM a particularly good measure of money, nor do we regard GDP as a particularly good measure of economic activity – but this chart still gets our point across – click chart for higher resolution.



It should be obvious even upon a cursory inspection of the facts that this can not possibly be sustained. Common sense dictates that the ever widening chasm between financial claims and real wealth creation can not continue to widen forever. And yet, what governments have done when the Moloch collapsed in 2008, was to simply divert even more resources to the financial system – using the spurious claim that this ‘was the only alternative’.

That this claim is spurious should be self-evident. All our infrastructure, our factories, our real estate – in short, all the real wealth accumulated over the centuries – would still be standing if a number of big banks had declared bankruptcy. All of it would still be here. What would would be different compared to the bail-outs would be who ends up paying for the folly of the bankers.

Below is a chart depicting the US federal deficit. Like few other charts it shows where the costs have ended up – namely on the balance sheet of the government, which in turn possesses exactly zero economic resources. It will have to confiscate this money from taxpayers over time.

The annual US federal deficit over the past 110 years. Can you spot the consequences of the bail-out? – click chart for higher resolution.


A secular contraction has begun

In spite of the last-ditch effort to save what is plainly an unsustainable system yet again, we can already discern the approaching end game. What the sovereign debt crisis in Europe demonstrates is that we are fast approaching the limit. We can observe the increasing systemic instability indirectly in many financial markets. See for instance the statistics presented in the excellent ‘Pictures of a Stock Market Mania‘ by Alan Newman. Estimated annual dollar trading volume on US stock exchanges has increased to over 400% of GDP – an all time record, dwarfing anything seen before.

This number has increased steadily over the past decade, concurrent with the onset of the secular bear market and the biggest expansion in debt and money supply in any decade in history. Concurrently, the volatility in stocks and commodities has increased to new post war records as well – only during the contraction of the 1930’s were stocks even more volatile. Note here that this means when analyzing markets, it is a good idea to look beyond post WW2 history.

Many analysts fail to do so, and are thus continually surprised by events such as the 2008 crash (this in turn tends to surprise their clients into large losses). We believe that the so-called ‘flash crash’ of early May was also a warning sign pointing to increasing systemic instability – in all likelihood there will eventually be an even more volatile event rattling the markets.

The flood of money which has entered the economy since the gold anchor was dropped in the 1970’s, flows from risky to less risky securities and back again in ever greater frequency and amplitude. For now, the faith in the solvency of the biggest welfare/warfare nations such as the US and Germany remains intact – and we would suggest that this will continue for a while yet. The capital flows involved are too large to be taken up by the gold market alone, thus the bonds of the ‘last Mohicans’ are likely to continue to see inflows as systemic instability increases.

Ben Bernanke recently professed himself to be ‘puzzled’ by the rise in the gold price. We should probably not be surprised by this. After all , this is the same man who persistently failed to spot the existence of a real estate and mortgage credit bubble in the US in the mid 2000ds. We would suggest that gold’s price rise demonstrates the declining faith in government’s ability to rescue the collapsing system. One after another the dominoes are beginning to circle the drain – and a small percentage of market participants has decided to avail itself of the insurance of last resort – the only money central banks will never be able to print into oblivion, the epitome of liquidity when all else fails.

The beginning secular contraction will likely be fought tooth and nail by governments until the ‘too big to bail’ situation finally happens. As Bob Janjuah of RBS remarked in his recent missives, he fully expects the Fed to embark on yet another huge quantitative easing program (to the tune of $3 to $5 trillion, according to Janjuah’s rule of thumb estimate) once the S&P 500 index falls back to the 800-850 region, an opinion previously espoused by Marc Faber.

The train of thought behind these forecasts is simple: they have already shown us they will do whatever they think it takes to keep the inflationary system  from going bust. So there’s no reason whatsoever to expect anything different in the next downturn phase. We concur. Also, the long term path laid out by Marc Faber (eventually, the establishment will  resort to war) is fully in keeping with historical precedent. So as the contraction proceeds, we can look forward to ‘interesting times’, in the Chinese curse sense.

One thing however remains clear: no matter how much more funny money and real resources are thrown at the collapse, it will proceed anyway. Per definitionem, an unsustainable system cannot be sustained forever.

Charts by Deutsche Bank, Absolute Return Partners, Federal Reserve of St. Louis



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One Response to “The Financial vs. the Real Economy”

  • xcut:

    It’s worth pointing out that even though outstanding notional amounts are up to 614 TRN, gross market value is down to 21 TRN from a 2008 high of 32 TRN. This suggests that there is less speculation and more hedging going on.

    CDS is obviously significantly down. By the time all the regulation comes in, the market will have sorted itself out significantly. So the politicians can then concentrate on useless nonsense like banning shorts (sounds like the policy of a gentleman’s club!)

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