Prolonged Credit Bubbles inflate myriad price levels and fuel atypical (and Bubble-dependent) spending, investing and financial flow patterns. Importantly, the resulting financial and economic Bubbles are sustained only through ongoing Credit inflation and associated asset price inflation. A Credit slowdown exerts downward pressure on inflated price and activity levels. Invariably, declining asset prices become problematic, especially late in the inflationary cycle, as falling price levels incite de-leveraging and risk aversion. Mature Bubbles require ongoing leveraging and risk-embracement - or else. And it is today almost unbelievable that asset Bubble risks are so easily disregarded.
When the mortgage finance Bubble burst in 2008/09, policymakers essentially confronted two alternative courses of policymaking. Washington could have allowed the economy to go through a wrenching de-leveraging and economic adjustment period. Considering the degree of Credit excess and economic maladjustment fomented by the protracted boom, to wean the U.S. (and global) economy from rampant Credit excess would have taken some years.
As one would expect after a massive Credit inflation, the post-Bubble workout period would have featured significant downward pressure on price levels and economic activity. The end result, however, would have been a more balanced economy that produces more, while requiring significantly less ongoing Credit expansion and financial leveraging. There would have been difficult, trying years, although the upshot would have been a sounder economic structure, reduced systemic fragilities and diminished global imbalances. But this scenario was politically unpalatable. Dr. Bernanke spent much of his academic career building a thesis that massive monetary inflation would eliminate much of the traditional downside of bursting Bubbles. What most today refer to as "deflation" I call the inevitable consequence of inflationary Bubbles.
Policymakers, of course, chose scenario #2, resuscitating Credit Bubble dynamics and asset inflation. This involved basically nationalizing mortgage debt; backstopping the financial system; doubling Federal debt in four years; zero rates and inequitable wealth redistribution from savers to borrowers; incentivizing speculation; and the monetization of Trillions of Treasuries and MBS. As it has been throughout history, monetary inflation was viewed as the readily available expedient. The massive shot of federal debt and Fed liquidity supported home prices, inflated stock and bond prices and incentivized financial leveraging. Importantly, monetary and fiscal policy inflated aggregate household incomes, in the process ensuring a resurgent consumer, inflated corporate cash flows and earnings. In short, resuscitating the Credit Bubble and asset inflation was the least painful path to sustaining the Bubble Economy structure and avoiding protracted economic restructuring.
The inflationists fail to appreciate Monetary Disorder's myriad negative consequences. It's the nature of liquidity to gravitate to where it believes it will most benefit from prevailing inflationary forces and dynamics. And with global central banks backstopping the securities markets, liquidity is today further incentivized to play securities inflation as opposed to seeking risky real economy investment returns. Furthermore, I would argue that speculative and inflated asset markets - along with an expanding Great Divergence - only magnifies the uncertainties already inhibiting investment and economic growth for many key economies. On a more micro basis, inflating stock and bond prices prod company managements to boost returns through stock buybacks and dividends - as opposed to hiring and expanding operations.
With the crowd today celebrating the stock market's record run, I warn of a return of Bubble Dysfunction. Despite a troubling global economic backdrop, equity prices have surged to record highs while Credit market risk premiums have collapsed to multiyear lows. Risk markets have appeared to dislocate. And I believe the Fed will rue the day it spurred the flight of savers out of safety and into these markets. The Fed believed encouraging risk-taking would be good for economic recovery, somehow ignoring the clear risk of fueling yet another Bubble.
Well, the Fed is now dealing with historic - and, I believe, precarious - securities market Bubbles. And they're Bubbles that will demand unending QE - or else risk a very problematic Bubble deflation. This is a dysfunctional Bubble that likes good economic news but loves weak data that ensures more monetary inflation for longer. And the greater the Great Divergence - the Greater the Dysfunction - the more the speculator community can leverage and speculate, confident that central banks are trapped by highly speculative markets, weak economies and acute fragilities. I was really, really hoping the Fed, global central banks and international markets wouldn't drift down this troubling path.
