SA contributor Mark Ungewitter urges us to revisit Hyman Minsky's financial instability hypothesis. Despite, or perhaps because of the market euphoria, we think that's always a good idea.
He quotes a whitepaper by the Jerome Levy Economics Institute on this material at some length, spelling out the three stages of financial instability, based on the degree of leverage employed. We summarize:
- Hedge finance: An economy with a stable financing regime engages mainly in hedging.
- Speculative finance: During a long period of stability, leverage increases and the focus shifts from leverage to speculation.
- Ponzi finance: The authorities attempting to reign in the inflationary effects of speculation by embarking on monetary constraint, resulting in many speculative schemes turning into Ponzi schemes that will collapse at some time.
He argues (rightly) that the financial instability hypothesis is a model that stresses internal dynamics of capitalist economies. The latter point is key, according to Ungewitter:
The market economy is driven more by internal dynamics than by exogenous shocks. As leverage increases, the financial system assumes a life of its own, influencing economic decisions and exaggerating the business cycle in both directions.
Ungewitter then takes issue with the world's central bankers. According to him, they haven't woken up to these truths. In part, he is right. The central bankers did precious little to prevent the financial crisis.
But is it because these central bankers believe in equilibrium economics and see shocks therefore as external, as Ungewitter argues?
I think most central bankers would be aware, some keenly so of the ability of the financial system to generate shocks, and if they weren't, they're certainly aware of it now.
Where we disagree with Ungewitter is in his arguing that the central bankers don't acknowledge their own role in the Minsky process.
It's a pity he doesn't spell this out, although he offers a host of investment implications that do not necessarily follow from the Minsky analysis that preceded it.
Instead, what follows is a series of propositions without much (indeed, any) substantiation. For instance, he just argues that the Fed has become an agent of instability through its attempts to bootstrap the economy by priming the pump.
This is good in arresting financial panics, but not as an ongoing policy, according to Ungewitter. Why isn't entirely clear, but the Fed doesn't have an exit strategy (Does it need one? Is this even true?) presumably because it will lead to inflation as:
Global monetary authorities are all playing the same game: competitive devaluation. But there is no free lunch. The world cannot export to itself, so the likely outcome is inflation.
That's easier said than demonstrated. If the Fed is playing a devaluation game, then it's really doing a pretty poor job. The dollar has risen against just about any currency in the world, yet the US is the economy having emerged the strongest from the financial crisis.
It gets stranger:
The object of inflation is decided by the market, not by central bankers. The object of inflation might be consumer prices… but it might also be stocks, commodities, gold, real estate, or even bonds… The Fed is wrong in presuming that CPI is the one and only guide to monetary policy. This flawed thinking is perpetuating the current state of disequilibrium. (One can argue that easy money is actually depressing CPI by encouraging excess capacity).
How the market decides this isn't spelled out. Neither whether this implies that monetary policy has to target stocks, commodities, gold, real estate, or even bonds? Should the Fed raise interest rates if commodities misbehave?
How does easy money depress the CPI and encourage excess capacity? Excess capacity in what? Questions that bubble up, but one does not find any answers in Ungewitter.
The only thing that is clear is that he doesn't like easy money in normal times. But what easy money is (or normal times), or how it contributes to a state of disequilibrium, or what the central banks are supposed to do, one doesn't get any insights on that from reading this article.
So we go back to Minsky and the crucial concept, leverage. It is leverage that is the critical condition that leads a stable financial system to pass over into an unstable one.
But is leverage the fault of easy money, as Ungewitter implicitly assumes? The answer is not necessarily. We take two measures from BlackRock which can serve as a proxy for leverage.
The first is the financial multiplier, which it takes as the ratio of overall asset value to money. If this ratio rises, investors are putting money to work, so it's a measure of risk-taking.
But perhaps they're just buying relatively safe assets? In order to determine this, BlackRock comes up with a second indicator, the risk ratio. This is the value of risk assets relative to that of perceived safe assets. The safe assets here are money and government bonds (less central bank holdings).
Now look how these concepts have developed in the face of the most unprecedented monetary expansion of the last century:
Do you notice a great increase in leverage despite the easiest of easy money? Neither do we. That did happen in the 1990s, and again in the 2000s. Easy money could have been a contributor, but from the latest period, the minimum we know is that there is by no means a necessary causality.
We think the financial sector is able to generate leverage all by itself, although it is bound by the rules of the game. These have been tightened post-financial crisis, and loosened in the 1990s.
Perhaps it turns out that, rather than take directions (and or money, perhaps even easy money) from the Fed, what the markets really need is clear rules of the game that prevent the build-up of excesses.
We were in that universe for half a century after the Great Depression, but then the rules of the game were loosened. Other countries still have pretty good rules of the game and haven't suffered from excesses.
It can be easily shown that rules matter. For instance, we agree with Minsky that leverage is probably what matters most (even if risk can be increased without leverage, but let's not make things too complicated here).
We know that derivatives can hugely increase leverage, and how they are treated in accounts greatly matters. There are two main standards here, but unfortunately these lead to dramatically different rules:
- GAAP (Generally Accepted Accounting Principles) allows a financial institution to use the collateral it receives from a counterparty to offset a derivatives exposure ("netting").
- IFRS (International Financial Reporting Standards) doesn't allow such netting.
Under netting, the financial institution with a $100 derivative receiving $90 from a counterparty, the borrowing would only be $10 ($100 - $90). The GAAP rule treats the $90 cash collateral as a payment to cover the exposure, but it overlooks the (all too real) possibility that it can be re-used to leverage up the financial institution.
Hence it's no surprise that Vice Chair Hoenig of the FDIC (the Federal Deposit Insurance Corporation) recently argued that GAAP allows banks to conceal their risk of their derivative portfolios (and it indeed makes quite a difference, see here).
This is just one example from a change in rules of the game, in this case both very respectable (GAAP and IFRS) having a rather large impact on the existence of leverage in the financial system without the Fed having been anymore easy or tight with respect to monetary policy.
One is spoilt for choice for more examples, but if one wants to grasp the progress being made in terms of safeguarding the financial system in the biggest economies, we refer you to the Financial Stability Board (FSB).
This institution tracks progress in major economies in a "dashboard" (which you can find here in PDF). It notes progress, but lots to be done still.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.