An excellent article Thursday in the Financial Times, “In the new liquidity factories, buyers must still beware,” by Mohamed El-Erian, the CEO of Harvard Management Company. He explains that a great deal of the liquidity in the markets is created not by the monetary authorities, but by the participants themselves, and works through a simple example, a private equity fund.
This is a useful piece, in that it provides an illustration anyone can use at a cocktail party, but has broad implications. The instruments and structures differ, but the process of creating ‘endogenous” liquidity is the same: borrow to buy assets, which when done on a large scale, leads asset prices to rise. We’ve pointed to other articles, most often in the FT, that describe liquidity creation on steroids, which results in risky borrowers getting overly favorable terms (subprime borrowers are far from alone).
El-Erian says, straight out, that the “leverage factories” have rendered the Fed’s 17 interest rate hikes ineffective. As he notes later, this makes a tough job even more difficult. Leverage cuts both ways. It amplifies gains and losses. All this leverage puts central bankers in an awkward position, for if they slow money supply growth, it could precipitate deleveraging, which would lower liquidity further than they had intended, which in an extreme case could lead to an economic slowdown or a financial panic (I doubt a full-fledged crisis, but imagine more weeks like the one we had February 26).
Yet buried in the article is a tough view:
Higher policy interest rates disrupt this process only if they undermine economic growth, curtail the flow of investor funds to “alternatives” and widen risk spreads in debt markets. Otherwise, successive rate increases coincide with (rather than arrest) the increase in endogenous liquidity, as was the case in 2004-2006.
In other words, the debt creation process has become so well entrenched that the Fed is going to have to slow growth to break it. That isn’t a pretty process, and it is also profoundly unpopular. Ian Macfarlane, the recently retired head of Australia’s Reserve Bank described the dilemma that asset bubbles pose:
…what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?…
Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.
First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.
Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.
Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….
Even though Macfarlane went on to discuss the central bank’s other tool, moral suasaion, and indicated it wasn’t very powerful, Macfarlane actually did a very good job of largely talking the housing bubble down in Australia (in combination with a few interest rate increases). One has to wonder why the Fed hasn’t taken this approach, at least privately.
From El-Erian:
Market drivers of liquidity currently exceed influences coming from traditional monetary policy instruments. But this is not to say that these instruments are no longer effective. They still are, but at wider levels of economic fluctuations and with less precision – thus raising interesting issues for policymakers and investors.
Over the past two years, markets have developed powerful liquidity factories as more investors have embraced debt in an attempt to increase the impact of their investments. The process has been facilitated by stable global economic conditions, widespread use of derivatives and low borrowing costs. As overall market leverage has increased, the impact on markets has more than offset the US Federal Reserve’s 2004-2006 campaign of 17 successive interest rate increases.
A way of illustrating the forces at work is to follow the journey of a dollar as it is reallocated by investors away from a traditional public equity investment and towards private equity. To make the illustration particularly vivid, let us focus on a “public-to-private” deal led by a leveraged buy-out fund in the context of an unchanged monetary policy stance.
The journey starts with the liquidation into cash of a dollar’s worth of public equity holdings, which is then allocated to the LBO fund. By -accessing the debt markets, the fund enhances the purchasing power of the dollar (typically 3-4 times) as it ventures into the public markets looking for a company to “take private”. On the closure of the deal, the augmented amount ends up as cash in the hands of the seller(s) of the targeted company.
This journey results in higher leverage driven by a multiplier that is internal to the markets. This “endogenous” process expands the economy’s balance sheet and boosts asset prices. The boost to asset prices is enhanced by the adaptive nature of investor expectations. Having observed the beneficial impact of an LBO bid on a targeted company’s share price, investors adjust. Rather than just being reactive, they actively seek and reprice companies and sectors that may end up on the target list of LBO funds – thus generalising the positive catalyst on share prices.
Higher policy interest rates disrupt this process only if they undermine economic growth, curtail the flow of investor funds to “alternatives” and widen risk spreads in debt markets. Otherwise, successive rate increases coincide with (rather than arrest) the increase in endogenous liquidity, as was the case in 2004-2006.
Monetary policy’s recent failure to mop up liquidity does not mean it has become ineffective. Rather, this episode illustrates the unusual potency of the current private equity phenomenon. But, to be sustained over time, the phenomenon needs to develop sources of permanent capital. While recent initiatives by Blackstone and Fortress suggest that private equity firms are pursuing such sources, they are the exception rather than the rule.
The time will come when endogenous liquidity shifts from being accommodating to being restrictive. This occurs naturally over a number of years as a critical mass of companies held in private hands seeks to “exit” back into the public markets.
Timing could be accelerated by a disruption in underlying economic conditions and a sustained spike in risk aversion. As the debacle in the sub-prime mortgage sector illustrates, the resulting credit withdrawal could be quite dramatic.
Given these considerations, it is not surprising that successive increases in US policy rates have not had the impact predicted by traditional models. It is also understandable that, notwithstanding inflation indicators, policymakers have been cautious about raising rates too far lest they trigger a sharp reversal in endogenous liquidity. Looking forward, it would seem reasonable to expect them to require unambiguous evidence of a significant slowdown in economic activity before embarking on a sustained loosening of monetary policy.
What about investors? So far, the increase in endogenous liquidity has rewarded risk-taking beyond what would be warranted by fundamentals. It is prudent to remember that leverage can work against investors on the way down as much as it has worked for them on the way up. When this occurs, the best-positioned investors will be those that have mitigated risk through appropriate asset diversification and the purchase of insurance.
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I make no claims to understanding high finance and macroeconomics. Still, I continue to believe that traditional definitions are perilous when rules are being rewritten.
Hence, I ask, “Inflation of what?” From my vantage point, the ‘endogenous liquidity’ discussed in above is yet one more indicator that inflation has shifted from a concern strictly of the markets for goods, services and distribution to both than AND the capital markets. “Asset bubbles” are a form of inflation in an economy that is increasingly like a casino. When people use their home equity, for example, as ATM machines, the asset prices in the capital markets — and the instruments created — become another form of money and a critical aspect of prices.
When we were kids, inflation was restricted to the prices of things folks bought like homes and food and clothes and cars. Today, inflation surely includes those prices. But, in a world of endogenous liquidity and asset bubbles, we should add those capital market assets to the market basket to which we look to monitor inflation. Put differently, if we got beyond the bullshit of ‘core inflation’ and asked about all the prices that matter — especially to the top 20% who run the economy — then I’d argue inflation is much higher than official government statistics tell. (This is yet another example of built in government statistical lies. Like the poverty rate — which, any reasonable and knowledgeable person would say is half of what it should be — hence, whenever you read how many folks live in poverty, you ought to double the number.)
In addition, when El-Erian describes ‘undermine economic growth’, I think we need to peel back the onion. What constitutes ‘economic growth’? In the old, ancient days, it was mostly about fundamentals that had to do with real growth (R&D, new distribution, new markets, jobs and so forth) instead of ‘asset bubble’ growth. Yet, today we know that the quick buck artists of private equity and CEO suites and so forth are far less interested in fundamentals than they are in ‘liquidity events’. Again, a casino.
It’s all a con game. Blackstone uses endogenous liquidity to ensure its partners live like royalty. Then, to insure those same partners make money on the way out as well as the way in, they basically ‘go public’ themselves because they know the public won’t price up the private companies in a market filled with asset prices unsubstantiated by any fundamentals at all. So, they issue Blackstone stock instead of selling the companies in their inventory. And, of course, when the whole thing finally crashes because it’s built on air, Blackstone partners have gotten incredibly rich and the losses have been ‘socialized’.
It stinks.