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.
The consequence?
“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
