I should point out that Doug isn't a gold bug but he does understand credit risk and therefore that is why I follow his articles. GRIM

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• by Doug Noland
• July 02, 2010

My thesis holds that the market’s structural debt fears are shifting from the Eurozone to here in the U.S. The Euro gained 1.5% this week against the dollar. The Swiss franc jumped 2.7%. European debt markets showed hopeful indications of stabilization. For the week, Greek (5-yr) Credit default swap (CDS) protection dropped 130 bps to 840 bps. Portuguese CDS fell 50 bps to 280 bps, and Spain CDS declined 10 bps to 255 bps.

It is worth noting that credit protection (5-yr CDS) is higher for the states of California (342bps), Illinois (360bps), and Michigan (283bps) than it is for troubled Portugal (280bps). New Jersey (276bps) and New York (276 bps) are priced above Spain and just a little less than Portugal. A strong case can be made that these debt markets are on the cusp of a crisis of confidence.

The New York Times’ Paul Krugman attracted some attention this week with his article, “The Third Depression”: “We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense. And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending… In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.”

With energy and commodities under renewed selling pressure this week – with gold even dropping $44 - unsettled global markets provided additional fodder for those focused on so-called deflationary risks. U.S. economic data has indeed gone from unimpressive to increasingly alarming. The recovery is in trouble, and there will be increasing calls for additional fiscal and monetary stimulus.

Mr. Krugman writes of a “stunning resurgence of hard-money and balanced-budget orthodoxy.” I haven’t seen it. Nor do I see policymakers “obsessing about inflation.” Rather, I see “post-Bubble” policymaking confronting a predictable predicament: massive government debt issuance, liquidity creation, and market interventions that are counterproductive and potentially quite destabilizing. We’ve reached the stage where even massive inflationary stimulus provides only ephemeral effects.

For almost two years now, global policymakers have partaken in sovereign debt excess unlike anything experienced in history. Central bankers have monetized and provided marketplace liquidity to an extent never before deemed possible. These interventions and market intrusions have, predictably, led to additional distortions and more problematic imbalances. Markets, having luxuriated in policymaker-induced reflation, are now focused on hangover effects.

The problem today is not some misguided focus on inflation and balanced budgets. Hard money? Come on. The key issue is instead the evolving and worsening stresses associated with an historic boom in (all varieties of) marketable debt. To be sure, the markets are increasingly questioning the creditworthiness of various types of government debt from Greece to California. It should be recognized as a major issue that Credit concerns have made their way to the realm of sovereign and U.S. state obligations – the heart of contemporary “money” and Credit mechanisms.

Mr. Krugman – along with many – believes the solution is only greater stimulus through the further expansion of government deficits and central bank balance sheets. Their prescriptions are misguided and have been proved misguided. Yet the layers of complexities involved – not to mention ideology – preclude the possibility of an enlightened debate and a desperately needed change in the direction of post-Bubble policymaking.

Regrettably, the “Keynesian” approach has already been implemented too many times and in regrettably undisciplined excess. And it’s become a spent force. Policies implemented earlier in this decade to combat so-called “deflation” risk instead fueled spectacular Bubble excess. In the process, the Creditworthiness of non-government mortgage finance was virtually destroyed – along with swaths of the Credit system. The 2008 vintage of deflation fighting is now working to destroy the creditworthiness of government obligations. The stakes are incredibly high. Rather than recognize the problems associated with ongoing Credit excess, the inflationists (as they’ve tended to do throughout history) cling to the notion that the issue is insufficient government borrowing and spending. And there will be no reasoning with them.

In a CNBC interview earlier in the week, New York Governor Patterson rose above the economics profession with his comment that the problem was “An Unavailability of Spending Crisis.” It’s not that politicians wouldn’t prefer to stimulate; it’s that they increasingly fear they are losing the capacity to pile on more debt. Officials recognize that they risk destroying their state’s (or city’s, county’s, nation’s) creditworthiness. Dr. Bernanke has often referred to the role that a shortage of money played in exacerbating the Great Depression. He argues that this dearth of money was primarily a post-Bubble policy blunder. I would counter that a runaway (“Roaring Twenties”) Credit Bubble ensured a post-Bubble money and Credit crisis of confidence.

These days, markets have begun to protest ever expanding debt levels, and investors/speculators will now demand additional returns to compensate for heightened risk. They’ll want more liquidity. In a sign of today’s changed environment, ballooning government deficits may very well lead to rising risk premiums on debt throughout the system. And higher borrowing costs, as Greece can attest, can radically alter a borrower’s risk and solvency profile. And - especially in speculative, trend-following markets - faltering debt values tend to set in motion an exodus from those instruments, resulting in illiquidity and market dislocation. At this point, the best policymakers can do is to focus on the longer term and endeavor to enact economic policy that will over time support our debt load – rather than further expand and impair it.

In the markets, financial conditions continue to tighten, although this flies in the face of conventional thinking that near-zero Fed funds and ultra-low Treasury yields equate to “easy money.” Risk aversion is increasingly entrenched, which ensures that “money” is becoming a lot less easy to come by. In particular, the leveraged players continue to be stung – hurt by faltering global risk markets, illiquidity, and acute instability throughout.

And with policymakers – fiscal and monetary – at this point largely hamstrung, one is hard-pressed to fashion a scenario where the leveraged players are anytime soon incited into re-risking and re-leveraging. Over the past couple of months, the speculator community has gone from playing government-induced reflation for all it’s worth - to wishing they could somehow unwind long positions and perhaps even go short. When the markets’ marginal source of liquidity is in the process of changing from leveraged long to bearishly short, the marketplace faces a period of tough conditions.

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10398