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5 CREDIT BUBBLE
BULLETIN More than one step
backwards Commentary and market
watch by Doug Noland
I'll admit to
occasionally being annoyed by the clan over at
Pimco. Clearly, there's more than a little envy at
work here. They are extremely smart, master market
operators and skilled theoreticians. Those guys
are really good at articulating the financial
issue de jour, as well as backing it up
with some reasonable-sounding solutions. But do
they somehow not appreciate that they are part of
the problem?
Pimco is - here we go again -
the most vocal Wall Street proponent for strong
reflationary policy measures and government
interventions to battle so-called "deflation"
risk. In 2002, they were the head cheerleader for
reflationary measures that historians will
surely view as a monetary
policy blunder for the ages. Then, the deflation
threat was said to reside with downside risk to
the general price level; today it's with sinking
home prices. Overwhelming force is again
prescribed to fight the latest symptoms, while
sidestepping diagnosis of the underlying ailment.
Furthermore, as someone who incorporates
Minskian analysis deep into my analytical
framework, I view their (and others') application
of Minsky's work as largely superficial - and
rather self-serving at that. For one, the often
referred Minskian concept of "stability is
destabilizing" simply hasn't been relevant to the
US credit system in several decades. More
importantly, implementing the Keynesian/Minskian
policy toolkit to perpetuate bubbles and existing
malignant structures and processes - in contrast
to instruments that would help buttress the system
through arduous post-bubble adjustment periods -
has been a momentous analytical and policymaking
failure over recent years.
I believe
strongly that if Hyman Minsky were alive today he
would see the huge investment fund managers, the
hedge fund community, and Wall Street firms as the
fundamental force behind today's acute financial
and economic fragility. He would surely see the
current financial order as dysfunctional and
unsustainable. And I am quite confident he would
view the current trajectory of financial system
and policy development as laying the groundwork
for the next crash and depression.
Back in
late-2001, I titled a Bulletin "Financial
Arbitrage Capitalism." I coined this term in what
I referred to at the time as "updating" Minsky's
stages of financial capitalism. Minsky theorized
that a troubling stage of "money manager
capitalism" had evolved from the earlier
manifestations of manager capitalism, financial
capitalism, and commercial capitalism.
Minksy on money manager capitalism:
The emergence of return and
capital-gains-oriented block of managed money
resulted in financial markets once again being a
major influence in determining the performance
of the economy. However, unlike the earlier
epoch of finance capitalism, the emphasis was
not upon the capital development of the economy
but rather upon the quick turn of the
speculator, upon trading profits … As managed
money grew in relative importance, more and more
of the market for financial instruments was
characterized by position-taking by financial
intermediaries. These positions were
bank-financed. The main financial houses became
highly leveraged dealers in securities, beholden
to banks for continued refinancing. A peculiar
regime emerged in which the main business in the
financial markets became far removed from the
financing of the capital development of the
country. Furthermore, the main purpose of those
who controlled corporations was no longer making
profits from production and trade but rather to
assure that the liabilities of the corporations
were fully priced in the financial market ...The
question of whether a financial structure that
commits a large part of cash flows to debt
validation leads to a debacle such as took place
between 1929 and 1933 is now an open question
...
In the present stage of development
the financiers are not acting as the ephors of
the economy, editing the financing that takes
place so that the capital development of the
economy is promoted. Today’s managers of money
are but little concerned with the development of
the capital asset of an economy. Today’s
narrowly focused financiers do not conform to
Schumpeter’s vision of bankers as the ephors of
capitalism who assure that finance serves
progress. Today’s financial structure is more
akin to Keynes’ characterization of the
financial arrangements of advanced capitalism as
a casino. The Schumpeter-Keynes vision of the
economy as evolving under the stimulus of
perceived profit possibilities remains valid.
However, we must recognize that evolution is not
necessarily a progressive process: the financing
evolution of the past decade may well have been
retrograde. (Minsky, 1993)
I am even
more convinced today than some six years ago that
a whole new financial structure has evolved - and
that it is definitely "retrograde". The title
"Financial Arbitrage Capitalism" is fitting for a
credit system and economy now dominated by an
expansive "leveraged speculating community"
seeking profits from variations and permutations
of "borrowing cheap and lending dear"; by bond and
investment fund managers whose entire focus is
beating some indexed return; by rapidly expanding
Wall Street balance sheets and influence; and by
the entire wave of new credit instruments,
derivatives, and sophisticated models and
strategies used for the paramount purpose of
capturing "above-market" returns and resulting
huge financial rewards.
Transformation
of credit mechanism The current system has
experienced a broad transformation to a credit
mechanism dominated by market-based instruments,
in contrast to the traditional predominant
position held by the banking system all the way
through Minsky’s "money manager" era. Today, the
financial apparatus is beholden not to a coherent
banking system but instead to an ambiguous thing
called "marketplace liquidity" and the unwavering
confidence such a mechanism requires. Importantly,
momentous changes to the prevailing incentive
system are also consistent with designating a new
phase of Minskian capitalism.
Late in
Minsky’s life, he expounded upon the role rising
stock and corporate debt prices were playing in
dictating various behaviors in the credit system,
markets and real economy. With financial arbitrage
capitalism, the bounty of seemingly limitless
(until recently) speculative profits has created a
reward system encouraging unprecedented debt
creation, leveraging, and myriad forms and layers
of financial intermediation.
I have
labeled this current stage with the Minsky term
"retrograde" specifically because only through the
expansion of all facets of this credit bubble -
debt creation, leveraging, and risk intermediation
- will adequate new "profits" and debt service
capacities validate and sustain the
ever-increasing layers of debt and financial
"arbitrage." Minsky noted a fundamental weakness
of money manager capitalism: "Unlike the earlier
epoch of finance capitalism, the emphasis was not
upon the capital development of the economy but
rather upon the quick turn of the speculator, upon
trading profits." Financial arbitrage capitalism
takes these defects to an entirely new level.
Today, the major financial incentives dictating
behavior are largely disengaged from the process
of "capital development" and, furthermore, operate
completely divorced from real economic profits
overall. Or, more simply stated, current rewards
spur the over-expansion of non-productive credit -
specifically debt instruments not supported by
underlying wealth-creating assets (think subprime
and high-yielding mortgages generally).
Mortgage credit is the bedrock of
financial arbitrage capitalism. The mortgage
finance bubble provided - and continues offering
to this day - the greatest bounty of speculative
profits the financial world has known. It comes as
no surprise that Pimco and Wall Street are these
days fixated on home values and the pricing of
mortgage-backed and mortgage-related securities
and derivatives. That trillions of real and
financial resources were so badly misallocated
through the mortgage finance bubble years will
definitely not dissuade the argument that
trillions more will be necessary to avert the
scourge of deflation. Apparently, the more
egregious the misallocation and resulting
impairment to the financial and economic
structures the more imperative it is to throw more
non-productive credit Inflation at the problem -
the mandatory fight to avert deflation.
For some time now, it has been my view
that financial arbitrage capitalism was sowing the
seeds of its own destruction. The incentive
structures were so deeply flawed; the analyses of
the inner workings of this system were critically
flawed; and policymaking was devastatingly flawed.
The combination of rampant non-productive credit
growth, unprecedented system leveraging and
speculative excesses, and resulting economic
maladjustment ensured untenable system fragility.
Still, the more apparent the underlying fragility
becomes the greater the impetus to sustain the
existing financial and economic order. And the
more conspicuous previous analytical and policy
mistakes appear the greater the tendency to see no
other alternative than to compound them. Mistakes
beget ever-bigger mistakes. There is a desperate
need to step back and come to grips with how
dysfunctional this has all become.
Some
seven or so weeks ago the existing financial and
economic order was in perilous jeopardy. Wall
Street-backed finance was
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