Credit excesses fuel speculative asset bubbles. In fact, all great speculative manias have been associated with rapid credit growth.
The greater the credit excesses the wilder the speculation.
1630s Dutch Tulip Mania Trading on credit notes for future delivery
1690s British Stock Market Boom Establishment of Bank of England, coin debasement, expansion of bills of exchange
1720 Mississippi Bubble Banque Royal, bank loans for stocks, paper currency
1720 South Sea Bubble Sword Blade Bank financing of stock
1820s South American Mining Mania Credit by unregulated country banks
1830s Jackson Boom Wildcat banking fueling fever for canals, land and railways
1907 Knickerbocker Trust Panic, New York
Unregulated trust companies
1920s U.S. stock market boom Installment credit, diluted gold standard, margin loans, lending against property
The following table from “Crunch Time for Credit? An inquiry into the state of the credit system in the United States and Great Britain” by Edward Chancellor highlights the source of credit fueling famous speculative manias.
Was the late ’90s stock market a credit-fueled mania?
According to financial historian Edward Chancellor, there are several indicators that a credit boom is underway and placing an economy at risk:
Rapid credit growthSpeculative buying (inflows) by foreignersInvestment and/or consumption boomDecline in credit quality Financial liberalizationInflux of new credit providers and increasing competition among themZeal for lending against assets (rather than income)Concentration of riskTendency by lenders/investors to underestimate risk
What does a credit boom look like?
The ‘90s stock market certainly resembled other stock manias of the 20th century
260 week run to peak for '29 Dow, '89 Nikkei and '00 S&P 500, Nasdaq
www.prudentbear.com Source: BEA, Federal Reserve Z-1
Credit flooded the corporate sector in the late ’90s, supplying financing to too many marginal companies and credit excess capacity, particularly in telecom.
When credit growth slowed in these sectors, the Federal Reserve tried to buoy the economy by easing monetary and credit conditions further. The result was a middling economy and a bubble in the home mortgage sector. For the first time in memory, rather than retrenching, consumers took on more debt during the recession.
Credit fueled our recent mania
Business Sector BorrowingQuarterly borrowings at annual rate, Q1 '70 - Q4 '04
Source: Federal Reserve
Telecom helped business borrowings explode in the late ’90s
When business borrowing collapsed, the mortgage sector more than made up for it
Mortgage & Business Sector BorrowingQuarterly borrowings at annual rate, Q1 '70 - Q4 '04
Source: Federal Reserve
Business Sector Borrowing
Household Mortgage Borrowing
More lending = more spendingCash out volume for prime conventional loans ($bill.)
From the previous pages it’s clear that the credit bubble is ongoing. The Fed’s aggressive posture simply shifted the stock bubble to new sectors. Asset price inflation, which is dependent on credit, continued and has crept back into the stock market as well.
What happens when the credit bubble bursts?
Savings RateSavings as % of disposable income, Q1 '90 - Q4 '04
What will drive the economy once the desire to save returns?
Greenspan once had it right about how credit booms can distort an economy: “The excess credit which the Fed pumped into the economy
spilled over into the stock market - triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a constant demoralizing of business confidence.”
Still no capitulation that typically follows a Super Bull
Source: Investment Company Institute
History has taught us:
Long bear markets are a natural outgrowth of long bull markets
Stocks remain expensive. Even if earnings grow at historic rates, stocks could provide poor returns over the next 5-10 years.
Credit is the driver of speculative manias. Historically, once credit becomes less available, asset prices suffer.
What could burst the credit bubble?
Higher interest rates
Credit creators become less willing to lend (delinquencies rise, spreads collapse)
Creditors become less able to lend (Regulators continue to constrain Fannie & Freddie)
Debt service becomes a drag on economy
Financial accident (hedge fund “blow up,” bank failure, market panic, derivatives incident)
Less foreign (& central bank) enthusiasm for US securities.
Are we nuts ?
Goldman Sachs Economist
“The FED should have done more to prevent the tech-stock bubble from getting too big in ‘98 & ‘99. The Fed should have raised interest rates in 1996-99 to fight asset price inflation. After all, with the benefit of hindsight, it’s pretty obvious that billions of dollars of investment spending have simply been wasted, Fiscal policy was too loose and so was Alan Greenspan's mouth. Greenspan may have helped investors abandon their caution with his enthusiastic endorsement of the new economy paradigm, Fed officials should view their job more broadly--not just to prevent inflation pressures, but also to prevent other types of economic imbalances that threaten the economy's stability.”
Bill Dudley, Goldman Sachs 8/27/01
The Bubble Trouble Remains
“Since early 2000, the US has gone through a mild recession and the most anemic recovery on record. Over that same period, America’s net national saving rate has plunged to a record low, the household sector debt ratio has risen to an all-time high, and the US current account has gone deeper into deficit than ever. All this smacks of a US economy that is living far beyond its means, as those means are delineated by domestic income generation. Far from purging the excesses of the late 1990s, the United States has upped the ante on structural imbalances as never before.”
Stephen Roach, Morgan Stanley 9/2/03
• Expanding money/credit simply attempts to re-ignite the bubble, problem is too much debt, not too little
• If money growth was the key to economic growth, then Latin America would be the world’s leader
• Constraints are now inflation, exchange rates, current account deficit and credit quality.
• Economy hasn’t crashed due to reckless mortgage growth that’s fueled a real estate bubble
• Once more credit no longer helps, you get “pushing on a string.” We’ll be lucky with Japan’s outcome
Historically, asset prices suffer when a credit crunch takes hold
Some Optimism …
“The world is a resilient place. And America stands for a special resilience and resolve that has shaped its destiny for 225 years. I have no doubt that the United States will weather this storm and come out the other side with an even greater sense of renewal and determination. That doesn’t mean it will be easy. Yet as day follows night, healing follows pain. And recovery will eventually also follow recession. This time is no different. Sadly, it’s just a lot more painful.”