Is the Credit Crisis Really Over? Minsky Would Say No

The “end of the credit crisis” apostates looks to be a small and shrinking group (and we don’t mean just the downbeat but nevertheless accurate Nouriel Roubini or Michael Panzner).

I’m amazed our number is as small as it is, given the overwhelming counterevidence in the form of the increase in the Term Auction Facility by $50 billion and expanding the types of assets that can be pledged for the TSLF to include asset backed securities consisting of auto loans and credit card receivables. This may be a direct effort to stand in for the moribund asset backed commercial paper market. Oh, and in case you somehow missed it, the ECB joined in with a $20 billion addition, bringing the size of its program to $50 billion and Swiss National Bank increased its facilities by $6 billion to a new total of $12 billion. If things are so hunky dory, why is the officialdom throwing large amounts of money at a problem that is over?

Calculated Risk weighted in with “Credit Crisis: In the Eye of the Hurricane,” which gave some cautionary views from Jamie Dimon, Goldman, and even the Wall Street Journal. The Telegraph questioned the sanguine reading in the latest issue of the Bank of England’s Financial Stability Report:

“We’re at the end of the beginning, not the beginning of the end,” says Standard Chartered chief economist Gerard Lyons. “The next chapter will be a period of financial consolidation and economic challenges. The Bank clearly hopes that it can restore confidence to the financial markets so they are in better shape to handle future economic problems.”

Hence, Sir John’s bold statement that the “likely path ahead is confidence”. For as long as the markets are self-fulfilling, the Bank might as well be upbeat on the credit crunch.

Others are less convinced. Danny Gabay, a former Bank official now at Fathom Financial Consulting, remains a sceptic: “I’m surprised a major central bank is taking this position at this early stage. The original source of the shock – three-month Libor – remains where it was. I’d be a lot more convinced if Libor was at half where it stands today.”

A particularly persuasive reading comes from Doug Noland at Prudent Bear. A student of Hyman Minsky, he takes his theory of “Monday Manager Capitlaism” one step further into “Financial Arbitrage Capitalism,” which means that the inmates are not merely running the asylum, they’ve learned how to position themselves not as crooks, but as prison facilities managers, expand their operations to other locales, and secure government funding.

In all seriousness, the problem that Noland alludes to is that finance is now driving the real economy. And given how speculative our financial system has become, this is leading to poor capital allocation and increased volatility, both of which will dampen growth. Keynes considered reducing volatility to be a major goal of policy, since it would lower the risk premia investors required, and more favorable interest rates would promote greater investment and with it, growth (note that Keynes did not propose the countercyclical measures that have become associated with his name). But high volatility produces the reverse effect: investors demand higher returns to compensate for heightened risk, which reduces invesment. But traders find it hard to make money in quiet markets; a certain level of fluxuation is their friend. So Wall Street’s interests can and increasingly do conflict with those of Main Street.

Looking at the world through the Minksy-via-Noland lens exposes the flaw in the credit optimists’ thinking. Keeping the game going in its current form requires an increase in leverage. The private sector had hit the point where credit had expanded beyond the ability of the underlying assets to support it. but rather than let asset prices fall to a level commensurate with their cash flow (or try to temper the deleveraging), central banks are instead trying to validate inflated asset values via artificially low interest rates and credit support to dodgy debt. That effort will eventually fail and eventually is likely not all that far off. The negative real rates will fuel new speculative activity, exacerbating the problem of overly high leverage relative to GDP. As AutoDogmatic pointed out:

That very complex of unusually high foreign buying of US debt (that is, lending to us) is now being choked off by its own consequences: the collapse of all the US credit markets…

The upshot is we aren’t going to be able to increase our borrowing to fix the problems now. And we can’t enter a war to generate the necessary stimulus (a-la FDR) because we’re already completely extended fighting two of them….virtually all of the capital investment in America in the past three decades went into the military and military-related expenditures overseas, rather than truly productive areas like manufacturing back here at home, so we have nothing we can gear up to generate surplus output.

We are thus faced with the farcical situation where the government has already begun “bailing”, but it is having to borrow even more to do so. Since we’re past the point of exhaustion (beyond the “Minsky moment”) already, this borrowing is apt to have increasingly disastrous effects. Look at the $160 billion emergency stimulus bill congress passed a few months ago (with checks having started going out in the mail a few days ago). The government is immersed in a record-breaking fiscal deficit — so bad the Treasury Borrowing Committee is crying “uncle” — so where is it going to get the money to pay these checks?

More borrowing, of course. But what happens when you add more borrowing when the supply of lenders is shrinking? Interest rates go up.

The Fed currently has a policy of holding interest rates down, to hold together the creaking financial system. As we discussed, borrowing is already dramatically ramping up because of structural spending needs, the war, and now bailouts. These two objectives are in conflict. Something will have to give.

Whether the Fed allows it or not, interest rates will rise. The Fed may succeed in artifically holding down interbank rates, but this will not help most of us. Soon we will be faced with the ultimate farce of mortgage rates dramatically rising because of all of our national borrowing, even though much of it has been piled on to help out those harmed by the housing bubble!

And to Noland’s discussion of the progression, or more accurately, devolution, of financial 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….

Today, the financial apparatus is “beholden” – not to a coherent banking system but instead – to an ambiguous thing called “marketplace liquidity” ….. 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….

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….

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…

Will policymaking succeed over the intermediate- and long-term? Not a chance. Policymakers do today retain capacity to convince the marketplace of their power to inflate the value of debt securities and asset prices more generally. But reflationary polices and other assurances will not rescue the system, specifically because there is today nothing to stem the ongoing distortions to the underlying real economy. Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary Credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices – but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it’s only real economy fundamentals that will determine the soundness and sustainability of a system’s Credit and Financial Structure.

Additional non-productive debt growth will definitely not alleviate the Acute Fragility associated with “Ponzi Finance” Credit system dynamics. Additional non-productive debt growth will also not stabilize dollar devaluation, nor will it help in stabilizing myriad problems at home and abroad associated with our monstrous Current Account Deficits. Instead, any extension of this period of Financial Arbitrage Capitalism will ensure the prolonging of borrowing and consuming excess, the gross misallocation of resources, massive trade deficits, a ballooning international pool of unwieldy speculative finance, and even wilder Global Monetary Disorder.

Indeed, Washington’s validation of the current dysfunctional Credit system structure could very well lay the groundwork for extreme global price distortions, volatility, and social/political unrest. On the current course of things, it’s difficult for me to not think in terms of NASDAQ 1999 or subprime 2006. Throw additional liquidity on overheated Credit, inflationary, and speculative “biases” and be prepared for the spectacular. When Financial Arbitrage Capitalism’s excesses were spurring acute U.S. securities market inflation, the system enjoyed a period of perceived rising wealth to go with a boom in Wall Street securities issuance (to help offset inflated demand). When this Structure’s excesses were directed at the Mortgage Finance Bubble, the upshots were inflating home prices along with attendant construction and consumption booms. Now, however, with acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability.

I argued back in 2002 that the overriding systemic issue was not “deflation” but rather myriad risks associated with an unfolding U.S. Credit Bubble. Now, some years later, these risks have expanded alarmingly, as runaway Credit Bubbles have ballooned both at home and abroad.