PIMCO’s founder and co-chief investment officer Bill Gross presents an interesting perspective on the U.S. government’s policy of credit inflation policy over the last fifty years in the Financial Times this morning.
“Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance.”
This statement captures two of the three major fundamental components of the government’s policy of credit inflation that has existed since the early 1960s. The first is that in a period of credit inflation, financial institutions are willing to take on “riskier” assets because the inflation that is created helps to “buy” them out of riskier deals.
The second fundamental component is that the financial institutions finance these “longer and riskier yields” with “short-term” funds “at a near risk-free rate.” That is, the financial institutions mis-match credit risks and maturities on their balance sheets.
Gross does not ignore the third component: this component is financial leverage. This financial leverage can, of course, turn a modest yield spread that is present in the yield curve into a very lucrative return on equity. And, the more leverage used the higher the return on equity can become.
“Thousands of billions of dollars of credit were extended on this basis, some of it as short as a one-week or one-month maturity extension, but all of it—almost everywhere , nearly all the time—on the basis of a positive yield curve…”
And, there you have the scenario for the credit inflation of the last fifty years.
Mr. Gross points out that the post-Keynesian economist Hyman Minsky identified this problem in the model developed within the Keynesian “neo-classical” synthesis. Minsky’s concern, and this was one reason he is considered to be a post-Keynesian economist and not a Keynesian economist, was that leveraging this way resulted in a build up of excessive amounts of debt in the economy. In this Minsky drew on the work of the economist Irving Fisher who wrote about credit inflations and debt deflations.
Minsky, like Fisher, argued that during the period of credit inflation the cumulative build-up of debt would at some point become unsustainable and the debt load would have to be reduced. This would lead to a cumulative contraction of debt, or the period of debt deflation.
That is, regardless of the fiscal policy of the government, the build up and contraction of credit in the economy would cause major economic restructuring, both on the upside and the downside. That is, credit cycles would result from a government policy that supported s positive slope to the yield curve.
Within this framework, the financial collapse of the 2008-2009 period can be thought of as the culmination of the “credit inflation” cycle. Debt burdens became excessive and, with the ultimate break in the cycle, the period of de-leveraging began.
We now find ourselves in the period of financial de-leveraging -- the period of debt deflation.
What is of concern to Bill Gross is that the Ben Bernanke and the Federal Reserve may be acting in a way that might exacerbate the period of debt deflation.
Whereas Bernanke has attempted to avoid a second Great Depression by throwing everything he and the Fed could against the wall to see what stuck and to avoid a second 1937-38 depression by throwing everything he and the Fed could against the wall to see what stuck (more here), Gross is arguing that Bernanke and the Fed may be doing just the opposite in the latter case.
In essence, Gross is arguing that in attempting to keep interest rates so low for such a long period, the Fed is creating a “flat” yield curve and this, according to the ideas presented by Minsky, may result in the further de-leveraging of the financial system which would be detrimental to an economic recovery.
In other words, “the posit of American economist Hyman Minsky of an unstable financial system based on the leveraging of a positively sloped yield curve—and de-leveraging when it was not—would be obvious for all to see.”
“The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years (through an interest-rate “twist” policy) the more credit destruction occurs, to a U.S. financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.”
Carrying this argument one step further, Gross could be arguing that by following its policy of extremely low interest rates for an extremely long period of time, Bernanke and the Federal Reserve are risking a second dip in economic activity akin to the 1937-38 depression.
Mr. Bernanke and the Federal Reserve want to preserve the commercial banking system and get the banking system lending again. Their policy efforts have been to flood the financial system with so much liquidity that bank failures can be handled effectively and smoothly without disrupting the whole banking system and that so much liquidity will be around that commercial banks will eventually begin to loosen up their lending again.
What Gross is arguing that the banking system will not begin lending in an aggressive way with the yield curve as flat as it is, and if the flatness of the yield curve extends out to seven and eight years, very little lending will take place at all. Taking on riskier loans just does not pay in such an environment and the mis-matching of maturities produces only a minimal spread. In order to achieve competitive returns on equity, given these spreads, financial institutions would have to take on massive amounts of leverage -- something that the banks themselves don’t want to do right now and something that the regulators would not allow them to do.
Mr. Gross closes by saying that Mr. Bernanke needs to be careful keeping interest rates so low and trying to “twist” the yield curve to reduce longer-term yields to the levels now seen in the short-term end of the market. The fear is that Bernanke may produce, not a “take-off,” but a crash.