BEST OF DOUG NOLAND

October 17, 2005

Here at home, the challenge for the Fed was to actually tighten liquidity and Credit conditions – to bridle the Financial Sphere expansion. But the Greenspan Fed – much to Wall Street’s satisfaction – focused on the Economic Sphere and system fragility rather than the Financial Sphere’s overwhelming inflationary bias. Financial Sphere Bubble Dynamics ensured that "measured transparent baby-steps" was never going to work. Instead, it accommodated the Mortgage Financial Bubble blow-off, the Global Liquidity Bubble, and the Great Global Energy Inflation. Financial Sphere expansion (note: growth in bank Credit, ABS, Wall Street balance sheets, "repos," hedge funds and foreign official reserves) went to dangerous blow-off extremes and, hence, became much more difficult to control.

To what extent the Fed now recognizes its dilemma is unclear. And while the focus is on how high the Fed will (baby-step) push rates, this misses the larger issue: Financial Sphere expansion – The Credit Bubble – must be reined in. The mechanism creating the excess liquidity and Credit must be checked; dysfunctional Monetary Processes must be broken; and speculative impulses that have come to command liquidity dynamics in markets across the globe must be quashed. And if anyone has any notion that such a feat can today be accomplished without major financial and economic disruption, I suggest they read more financial history.

Major Financial Sphere Inflations are not amenable to slowdowns, let alone reversals (faltering liquidity, de-leveraging, marketplace dislocation, economic upheaval, etc.). But let’s not get too far ahead of developments. The first order of business is to recognize that the U.S. Credit system must redirect its emphasis. There is now little alternative than for our economy to devote significantly greater resources to locating, extracting, producing, refining, researching, and conserving energy resources. Especially since there is little existing slack in the Economic Sphere, the vast resources required for "Project Energy" must be redirected from other sectors. And it does not take rocket science to see how the distended housing and household consumption sectors play into The New Equation. Not only are they currently gluttons for system (Financial and Economic Sphere) resources, they are clearly integral aspects of burgeoning inflation problems (too much energy consumption and too much global liquidity).

Housing and retail stocks are signaling that an important inflection point has been passed. To some, developments point to a healthy moderation of growth that will temper inflationary pressures and lend support to the bond market. To others, the economy is at the edge of a cliff. I’m not so convinced of either. Barring financial crisis, it will take some time (and dislocation) before significant resources are redirected from the housing/consumption boom. In the meantime, the Time is of the Essence Project Energy (not to mention hurricane recovery) will place increasing demands on the system. Those zestfully awaiting the bursting of the housing Bubble for another (NASDAQ bursting-like) bond market gravy train may instead face something much less hospitable.

There are major Financial Sphere and Economic Sphere developments in the offing. There’s too much Credit being created and much of it misallocated. There is, as well, excessive and destabilizing speculation. These Credit Bubble facets - seemingly innocuous for quite some time - are finally imparting conspicuously deleterious effects on an increasingly maladjusted Economic Sphere. For good reason, the Fed is getting nervous. No longer can Federal Reserve and Wall Street analysts simply ignore Financial Sphere developments. And global central bankers have at this point surely given up hope that the Global Financial Sphere would commence the process of returning to some semblance of order and sustainability with the imminent slowdown in U.S. housing finance. Not only has U.S. mortgage growth accelerated this year, global central bankers are today facing the prospect of a global energy crises and systemic liquidity-induced asset Bubbles. They now likely recognize that ultra-loose global monetary conditions have lasted far too long and accommodated precarious excesses.