Hyman Minsky

Today you can’t go 10 minutes without tripping over an investment manager using the phrase “Minsky Moment” as shorthand for some Emperor’s New Clothes event, where all of a sudden we come to our senses and realize that the Emperor is naked, central bankers don’t rule the world, and financial assets have been artificially inflated by monetary policy largesse. Please. That’s not how it works. That’s not how any of this works.

"... the Fed is overpromising and over-reaching on what it can actually deliver. It has always been quite a leap of faith to believe that ever-rising asset prices would create a wealth effect adequate enough to boost consumption, so as to make progress on the Fed’s dual mandates without causing adverse financial markets conditions.... After the 2008 crisis, policymakers have tried to end this mindset by becoming more proactive in trying to prevent financial crises. Though well-intentioned, this new approach has arguably led to Fed policy itself becoming a source of systemic risk... Markets are likely headed for a difficult period as the FOMC tries to gradually wean investors off of its liquidity addiction. It is too late for the FOMC to do much other than to try to limit the damage.... The bottom line could simply be that QE means ‘risk-on’, while ending QE means ‘risk-off’."

The mainstream media is latching on to the idea that all is not well in the world of 'markets'. The FT's Gillian Tett notes that, as we have vociferously explained, almost every measure of volatility has tumbled to unusual low levels, "this is bizarre," she notes, "financial history suggests that at this point in an economic cycle, volatility normally jumps." But investors are acting as if they were living in a calm and predictable universe, "[Investors in] the options markets are not pricing in any big macro risks. This is very unusual." In reality, as Hyman Minsky notes, market tranquility tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash. Tett concludes, that pattern played out back in 2007... and there are good reasons to suspect it will recur.

After the crisis, many expected that the blameworthy would be punished or at the least be required to return their ill-gotten gains—but they weren’t, and they didn’t. Many thought that those who were injured would be made whole, but most weren’t. And many hoped that there would be a restoration of the financial safety rules to ensure that industry leaders could no longer gamble the equity of their firms to the point of ruin. This didn’t happen, but it’s not too late. It is useful, then, to identify the persistent myths about the causes of the financial crisis and the resulting Dodd-Frank reform legislation and related implementation...."Plenty of people saw it coming, and said so. The problem wasn’t seeing, it was listening."

We have a few things to say about the recent debunking of established monetary theories. Effectively, the BoE joined forces with the rebels in economics who’ve long argued that standard models are bunk. Moreover, the BoE’s report discredits many well-known pundits, some more so than others. We’ll pick on one from the “more so” category: Paul Krugman.

More Reasons QE Is a Dud

With everyone and their mom confused at how bonds can rally when stocks (the ultimate arbiter of truthiness) are also positive, we have seen Deutsche confused (temporary technicals), Bloomberg confirm the shortage, and BofA blame the weather (for a lack of bond selling). Today, we have two more thoughtful and comprehensive perspectives from Gavekal's Louis-Vincent Gave (on why yields are so low) and Scotiabank's Guy Haselmann (on why they' stay that way).

Bank of America, whose stubborn, and quite abysmal "short Treasurys" call, has been one of the worst sellside trade recos in recent history and cost investors countless losses, has an update. Only instead of doing a mea culpa and finally admitting it was wrong, the bailed out bank has decided to provide humor instead. Namely it too has joined the ranks of countless others providing an "explanation" (or in its case, an "excuse") for the relentless bond bid. The punchline: "cold weather."

Having warned just 6 weeks ago that high-yield credit and small high-tech firms may be in a bubble, Fed Governor Tarullo, ironically speaking at the Hyman Minsky Financial Instability Conference, suggested that the recuction in share of national income for "workers" (i.e. income inequality) is troubling. Furthermore, he added, "changes reflect serious challenges not only to the functioning of the American economy over the coming decades, but also to some of the ideals that undergird the nation's democratic heritage." His speech, below, adds that since there has been only slow growth so far, expectations for a growth spurt are misplaced and that the Fed-policy-driven recovery has "benefited high-earners disproportionately."

"It is clear to us that speculative and Ponzi finance dominate China’s economy at this stage. The question is when and how the system’s current instability resolves itself. The Minsky Moment refers to the moment at which a credit boom driven by speculative and Ponzi borrowers begins to unwind. It is the point at which Ponzi and speculative borrowers are no longer able to roll over their debts or borrow additional capital to make interest payments....  We believe that China finds itself today at exactly this juncture."

In the last few years we have discussed the huge real estate bubble in China: "Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash." Amen! As they say, it is better to be wrong, wrong, wrong and then right than the other way around! In case you continue to be a skeptic, here are a few observations...

The Bank of Japan will, for the first time in history, "own" all of Japan's GDP on its balance sheet some time in 2018 when its "assets" as a percentage of GDP surpass 100%, and then proceed in linear fashion to add about 10% of GDP to its balance sheet with every passing year until everything inevitably comes crashing down.

The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve. However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness. Four considerations suggest the Fed will continue to be unsuccessful in engineering increasing growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP)...

Some confidence tricks have characteristics that don’t quite fit the Fonz. Take the swindles known as Ponzi schemes. These are tricks that need an endless supply of participants to sustain confidence and stay alive. Once the participant pool depletes as it eventually must, the tricks are revealed as scams. Whereas Fonzies can persist indefinitely (at least in theory), Ponzis eventually collapse. Note that the U.S. has already passed its Ponzi point by Minsky’s definition. According to Minsky, borrowing qualifies as Ponzi finance whenever fresh issuance is needed to fund interest on existing debt.  Based on the common assumption that the U.S. would miss its interest payments without regular increases in the statutory debt limit, this is indeed the case

What perhaps Minsky couldn’t conceive of was the point at which debt, deficits and interest rates would go to such extremes that the creation of credit itself, which was and remains the heart of capitalism, would be threatened. No longer might the seventh inning stretch lead to a Coke, some “Cracker Jacks” and the resumption of the old ballgame. Instead, zero-bound interest rates and debt/GDP ratios in a majority of capitalistic economies would begin to threaten, not heal, the nature of finance and investment in the real economy. Investors, leery of not only overleveraged investment banks such as Lehman Brothers, but overextended countries such as Greece, Cyprus and a host of Euroland lookalikes would derisk as opposed to rerisk as per the Minsky model. As well, with interest rates close to the zero bound, investors in intermediate and long term bonds would become dependent on Big Bank to do their bidding. When that QE buying power became jeopardized via tapering and the eventual ninth inning conclusion of asset purchases, then the process of maturity extension and the terming out of historically modeled corporate lending was prematurely threatened.