BEST OF DOUG NOLAND

December 13, 2005

I look forward each month to new commentaries from Pimco’s Bill Gross and Paul McCulley. Mr. Gross, trading kingpin at the world’s largest bond fund, and my "analytical nemesis" Mr. McCulley, nominated by Dr. Bernanke for one of the vacant Federal Reserve governor posts and one of the more astute commentators on all matters Fed and financial, at least possess the wherewithal to analytically dazzle. And after a few months of rather uninspiring articles (I should have known better than to briefly ponder that Mr. McCulley had "thrown in the towel"), they are back this month with a creative vengeance. And while I often take strong exception with the direction of their analysis, it’s usually quite thought-provoking. Besides, when I am searching for something to write about they are seemingly right there and happy to deliver. They are exceptionally formidable "opponents" – recalling memories back when I was a scrawny 15 year old with my daily scratching and clawing against the much more powerful upperclassmen to earn a spot on the Cottage Grove Lion’s varsity basketball team. They motivate me.

Mr. McCulley is an especially clever Fed watcher/proponent. Now plainly in the Bernanke camp, he blends insightful analysis with really creative rationalization for today’s flawed American experiment in central banking. This month he provides his clearest analysis yet of how a deregulated financial apparatus has profoundly altered the nature of Credit (he says "savings") intermediation, with the capital markets now the marginal provider of Credit and liquidity both at home and abroad. He also astutely writes that deregulation of the Credit system has changed "the central banking game," with the Fed’s role much diminished from the days when it enjoyed "colossal power" over the price and availability of Credit. Good enough.

One may be tempted to presume that we may be closer than many think in our analyses, but it occurs to me that our views have converged only on the most obvious and indisputable points. Mr. McCulley remains firmly entrenched in his hypothesis that the Fed has attained the promised land of price stability, and it is this postulate that provides the foundation for his analytical framework. He goes so far as to link the achievement of price stability to the collapse of risk premiums and the propensity for Bubbles. I take very strong exception to this analysis, and there really can be no reconciliation between his "price stability" view and my assertion of the polar opposite, Monetary Disorder – none.

It is the foundation of my analysis that the "evolution" to an unrestrained capital markets and asset-based Credit system has, not unpredictably, nurtured a highly unstable monetary environment. More specifically, Credit has become progressively more readily available, is being systematically under-priced, and that these dynamics over time radically impact the nature of spending, investment, and resource allocation. The dangerous proclivity of self-reinforcing asset Bubbles and an expanding and increasingly powerful leveraged speculator community (and their expansive global pool of speculative finance) are natural outgrowths of just such a monetary backdrop. And while a flexible, deregulated and risk-taking economy is its boon ("Economic Sphere" analysis), Limitless Profligate "Wildcat Finance" is the Bane of Capitalism ("Financial Sphere" analysis). As we have witnessed, when the effects of Credit inflation become increasingly powerful and unwieldy, policymakers abandon any hope of reining in excesses - succumbing instead to untoward rationalizations and justifications (just read today’s speech from chairman Greenspan!)…..

The Fed has created a quagmire, although precarious financial excess still enjoys the beguiling capacity to masquerade as the golden age of prosperity. Not only has the Fed lost control of the Credit system to a highly speculative (and leveraged!) and powerful marketplace, it has waved a big white flag of policy risk aversion. Meanwhile, the Greenspan Fed’s "risk management" approach provides cover for adopting open mandates to both aggressively act to avoid recessions and to partake in post-Bubble reflations. I agree that we do not want central banks micromanaging the asset markets – markets will inevitably fluctuate. But it is a fundamental responsibility of the Fed to champion financial stability and safeguard the integrity of our financial system…..

The inflationists have a keen affinity for regulation. This should be explored and, I contend, strongly rebuked. Taking Bubble suppression out of the policy mandate, (the anti-Bubble popper) Dr. Bernanke believes that a diligent regulatory environment can be left to effectively restrain Credit excess. It is certainly captivating to fancy that the Fed can bypass the risky proposition of Bubble intervention, leaving individual market regulators to rein in bouts of excess. The problem is it is completely unrealistic and without a historical basis. The fundamental problem with asset inflation is that there are scores of constituencies that absolutely love it and few if any that have a problem with it. Who has confidence that our Washington lawmakers would have the resolve to support more obtrusive regulation of the stock market, leveraged lending, hedge funds, M&A, or mortgage finance? Not going to happen – or at least not until after busts, which is precisely why an independent Federal Reserve was created to regulate the nation’s Credit system in the first place. The Fed and Congress couldn’t even adequately regulate Fannie and Freddie, and the GSE’s were operating with obvious reckless abandon right there in their own backyard.

It’s now been more than three years since Dr. Bernanke suggested in his initial Fed speech that regulation is a preferred approach to "Bubble popping." Well, where’s the beef? He’s certainly had ample opportunity to initiate reform or call for a stricter regulatory mandate. But he’s understandably not interested in committing career suicide. And, oh that’s right, he also recently stated he didn’t believe there was a housing Bubble. Meanwhile, in three years home prices in California and other hot markets have doubled, and the regulators have been powerless. The same for derivatives, hedge funds and ABS – all doubled while regulation doddered. Mr. McCulley advises cracking down on exotic mortgages, apparently believing that this would temper housing excess and restrain system excesses generally. Nice try, but it’s too late for that. U.S. "exotic" mortgage Credit has become immaterial in the grand scope of Global Credit Bubble and Liquidity Excess fueled by a universal real estate lending boom, a "repo"/securities finance boom, M&A boom, derivatives boom, hedge fund boom, energy boom, commodities boom, equities boom, emerging markets boom, and general global economic boom.