Over the weekend, we commented on Dylan Grice's seminal analysis which excoriates the central planning "fools", who are perpetually caught in the "lost pilot" paradigm, whereby the world's central planners increasingly operate by the mantra of “I have no idea where we’re going, but we’re making good time!” and which confirms that in the absence of real resolutions to problems created by a century of flawed economic models, the only option is to continue doubling down until terminal failure. Basically, the take home message there is that once "economists" get lost in trying to correct the errata their own models output as a result of faulty assumptions (which they always are able to "explain away" as one time events), they drift ever further into unknown territory until finally we end up with such monetary aberrations as "liquidity traps", "zero bound yields" and, soon, NIRP (which comes after ZIRP), if indeed the Treasury proceeds with negative yields beginning in May under the tutelage of the Goldman-JPM chaired Treasury Borrowing Advisory Committee. Today, it is Bill Gross who takes the Grice perspective one step further, and looks at implications for liquidity, and the lack thereof, in a world where one of the three primary functions of modern financial intermediaries - maturity transformation (the other two being credit and liquidity transformation) is terminally broken. He then juxtaposes this in the context of Hyman Minsky's monetary theories, and concludes: "What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is two per cent of par and the downside substantially more?" In other words, Pimco is finally grasping just how ZIRP is punking it and its clients. It also means that very soon all the maturity, and soon, credit risk of the world will be on the shoulders of the Fed, which in turn labor under a false economic paradigm. And one wonders why nobody has any faith left in these here "capital markets"...
Some of Gross' thoughts in the FT:
Zero-based money is at risk of trapping the recovery
Isaac Newton may have conceptualised the effects of gravity when that mythical apple fell on his head, but could he have imagined Neil Armstrong’s hop-skip-and-jumping on the moon, or the trapping of light inside a black hole? Probably not. Likewise, the deceased economic maestro of the 21st century – Hyman Minsky – probably couldn’t have conceived how his monetary theories could be altered by zero-based money.
Minsky, originator of the commonsensical “stability leads to instability” thesis; the economist with naming rights for 2008’s “Minsky Moment”; the exposer of the financial fragility of modern capitalism; probably couldn’t imagine the liquidity trap qualities of zero-based money, because who could have conceived 30 or 40 years ago that interest rates could ever approach zero per cent for an extended period of time? Probably no one.
Nor, more importantly I suppose, can Ben Bernanke, Mario Draghi or Mervyn King. In their historical models, credit is as credit does, expanding perpetually after brief periods of recessionary contraction, showering economic activity with liquid fertiliser for productive investment and inevitable growth.
If they were to adopt Minsky’s framework, they would visualise a credit system expanding from “hedge” to “securitised” to “Ponzi” finance, pulling back after 2008 to the stability of the less levered “securitised” segment, but then expanding again as government credit substituted for private deleveraging, providing a foundation for future growth of the finance-based economy.
Well, maybe not. In modern central bank theory, liquidity traps are a function of fear and unwillingness to extend credit based upon the increasing probabilities of default. This world is the second half of Will Rogers’ famous maxim uttered in the Depression: “I’m not so much concerned about the return on my money, but the return of my money.”
The modern capitalistic model depends on risk-taking in several forms. Loss of principal – as in default – necessitates the cautious extension of credit to those that presumably can use it most efficiently. But our finance-based Minksy system is dependent as well on maturity extension. No home, commercial building or utility plant could be created if the credit liability matured or was callable overnight. Because this is so, lenders require and are incentivised by a yield premium for longer term loans, historically expressed as a positively sloping yield curve.
What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is two per cent of par and the downside substantially more?
Maturity extension for Treasuries, and then for corporate and private credit alike, becomes riskier. The Minsky assumption of rejuvenation once the public sector stabilises the credit system then becomes problematic. Instability may slouch back towards stability, but that stability may resemble more closely the zero-bound world of Japan over the past 10 years than the dynamic developed economy model of the past half century.
The global economy’s quest for a modern day Keynes or Minsky may be frustrated by zero-based money that rations credit just as fiercely as it does risk. Minsky’s economic theory is now at the zero-bound.
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