<blockquote>"
We’re witnessing the same analytical errors today that were made in the post-tech Bubble analysis: the willingness to inflate an even greater Bubble for the cause of mitigating the pain from the so-called deflationary risks associated with a bursting of THE Bubble. And with each reflation comes a heightened governmental role in both the markets and real economy – to the point where Washington is essentially backstopping the financial and economic systems.
I used to find it rather perplexing that our nation’s largest bond fund managers were among inflationism’s most vocal proponents. I was naïve; it now seems all so obvious. Of course, market operators prefer to have the Fed and Washington there reliably backstopping the markets. An activist central bank pegging interest rates and manipulating the cost (hence, the flow) of finance creates wonderful opportunities for the savviest traders playing the money game most adeptly. The expansion of Bubbles creates great opportunities and then, for the enlightened, the bursting of these Bubbles provides only greater profits. Mr. McCulley is fond of blaming the “shadow banking system” for our acute financial and economic fragility. Yet the responsibility lies more generally with a deeply flawed monetary policy regime – a regime hopelessly locked in interest-rate manipulation and inflationism.
To this day I find it perplexing that leading “free market” proponents have been so happy to have the Federal Reserve setting and manipulating the cost of finance throughout the real economy. By now, it should be crystal clear that such a regime cultivates a financial apparatus that systematically misprices risk, over-expands Credit, fosters over-leveraging, emboldens speculation, and massively misallocates and misdirects both financial and real resources throughout. After awhile, so much of the financial apparatus is focused primarily on seeking central bank-induced financial profits. Economic profits and real economy price signals become further marginalized. And with each bursting Bubble and resulting reflation, the government’s role in the system’s pricing mechanism becomes more ingrained, intrusive and destabilizing. The Bubbles change, while the price distortions and imbalances become deeply embedded in the underlying economic structure.
I see no reason to back away from the view that the fundamental dilemma today lies not so much in finance but with our deeply impaired economic structure. This structure is a manifestation of years of mispriced finance, Credit and speculative excess, and resource misallocation. From this perspective, it should be obvious that greater Fed-induced market price distortions and Treasury/Fed-induced Credit expansion will only exacerbate structural impairment and delay readjustment. If I had to point to a significant weakness in Minsky’s work, it would be the lack of analytical attention paid to the underlying economic structure (and why it is imperative to incorporate Austrian analysis into our analytical frameworks!)."</blockquote>
Counter-Cyclical or Counterproductive?By Doug Noland
June 05, 2009
SourceMy old “analytical nemesis”, Paul McCulley, is out with a long piece this week, “The Shadow Banking System and Hyman Minsky’s Economic Journey.” He begins by stating the rather obvious: “creative financing played a massive role in propelling the global financial system to hazy new heights…” Mr. McCulley then asks a most pertinent question: “How did financing get so creative?” His somewhat insightful article is deeply flawed in that it fails to provide a valid answer.
First and foremost, our Credit system ran amok because our “activist” central bank for years pegged and, over time, increasingly manipulated the cost of finance. The Fed essentially guaranteed liquid and continuous markets to an increasingly deregulated and unrestrained marketplace, while repeatedly moving aggressively to bail out the leveraged speculators. The Greenspan Federal Reserve championed “contemporary finance”, in the process creating astounding profit opportunities for those structuring, distributing and leveraging sophisticated Wall Street financial instruments. Dr. Bernanke promised to be there with helicopter money as needed.
The Fed, congress, and various Administrations championed financial deregulation – as financial operators salivated. And it certainly didn’t hurt that spurring mortgage borrowing and home ownership became a national priority, as the rapidly expanding government-sponsored enterprises transformed the liquidity and marketability of mortgage securities. Unfettered private Credit expansion created its own loose financial conditions, leaving Fed rate tinkering ineffectual for tightening Credit conditions and Federal Reserve doctrine unwilling to address mounting Credit and asset Bubbles.
To be sure, the Wall Street finance/mortgage finance Bubble propagated out of the massive post-tech Bubble inflationary effort. The so-called “shadow banking system” was only one rather conspicuous facet of a historic – and ongoing - experiment in government monetary management.
Mr. McCulley writes: “No, I’m not a socialist.” Ok. Over the years, I’ve referred to McCulley and his ilk as “inflationists.” An inflationist may not begin his trek as a socialist, but it’s the nature of such an endeavor to pretty much end up in that territory by the end of the day. Of course, the inflationists today are calling for more extreme and intrusive reflationary measures than those employed in previous crises and deflationary scares. It is now, apparently, necessary for the “full faith and Credit of the sovereign’s balance sheet” to stand behind our entire impaired private sector Credit system. At this fragile stage of the inflationary boom, the inflationists have no qualms “betting the ranch.”
Long-time readers know that I, like Mr. McCulley, am a huge admirer of Hyman Minsky. I have over the years deeply embedded Minskian analysis into my analytical framework in an effort to better comprehend the extraordinary financial and economic landscape. Others, including McCulley, have repeatedly invoked Minsky as part of their ideological rationalizations for bailouts and inflationism. And I today find great irony in Mr. McCulley’s piece: After touching upon Minsky’s preeminent analysis with respect to the nature of financial instability and “Ponzi Finance,” McCulley dogmatically prescribes unprecedented government intervention as the elixir to help restore system stability. It’s a flawed analytical framework that comes to a perilous recommendation. If Hyman Minsky were with us, he would surely share a similar view that Washington has trapped itself in a most dangerous “Ponzi Finance” dynamic.
We’re witnessing the same analytical errors today that were made in the post-tech Bubble analysis: the willingness to inflate an even greater Bubble for the cause of mitigating the pain from the so-called deflationary risks associated with a bursting of THE Bubble. And with each reflation comes a heightened governmental role in both the markets and real economy – to the point where Washington is essentially backstopping the financial and economic systems.
I used to find it rather perplexing that our nation’s largest bond fund managers were among inflationism’s most vocal proponents. I was naïve; it now seems all so obvious. Of course, market operators prefer to have the Fed and Washington there reliably backstopping the markets. An activist central bank pegging interest rates and manipulating the cost (hence, the flow) of finance creates wonderful opportunities for the savviest traders playing the money game most adeptly. The expansion of Bubbles creates great opportunities and then, for the enlightened, the bursting of these Bubbles provides only greater profits. Mr. McCulley is fond of blaming the “shadow banking system” for our acute financial and economic fragility. Yet the responsibility lies more generally with a deeply flawed monetary policy regime – a regime hopelessly locked in interest-rate manipulation and inflationism.
To this day I find it perplexing that leading “free market” proponents have been so happy to have the Federal Reserve setting and manipulating the cost of finance throughout the real economy. By now, it should be crystal clear that such a regime cultivates a financial apparatus that systematically misprices risk, over-expands Credit, fosters over-leveraging, emboldens speculation, and massively misallocates and misdirects both financial and real resources throughout. After awhile, so much of the financial apparatus is focused primarily on seeking central bank-induced financial profits. Economic profits and real economy price signals become further marginalized. And with each bursting Bubble and resulting reflation, the government’s role in the system’s pricing mechanism becomes more ingrained, intrusive and destabilizing. The Bubbles change, while the price distortions and imbalances become deeply embedded in the underlying economic structure.
I see no reason to back away from the view that the fundamental dilemma today lies not so much in finance but with our deeply impaired economic structure. This structure is a manifestation of years of mispriced finance, Credit and speculative excess, and resource misallocation. From this perspective, it should be obvious that greater Fed-induced market price distortions and Treasury/Fed-induced Credit expansion will only exacerbate structural impairment and delay readjustment. If I had to point to a significant weakness in Minsky’s work, it would be the lack of analytical attention paid to the underlying economic structure (and why it is imperative to incorporate Austrian analysis into our analytical frameworks!).
The inflationists today believe that massive (“counter-cyclical”) government market and economic intervention will help the system revive and repair itself. I see current policies as simply a desperate attempt to perpetuate unsustainable financial and economic structures. And system impairment will not have run its course until some semblance of a market-based cost of finance emerges to more effectively allocate financial and real resources throughout the economy. The wholesale socialization of risk may be “counter cyclical” but it is also terribly counterproductive.
After the 9/11 catastrophe, I expressed the view that - if our government was compelled to stimulate - it would be preferable to run temporary fiscal deficits instead of manipulating interest rates and the financial markets. Yet the manipulation of the quantity and cost of Credit is much easier for policymakers to implement, and the results (heightened liquidity, risk-taking, and inflating asset prices) can be rather immediate and heartening. Meanwhile, the associated costs are not evident let alone quantifiable. Yet such interventions – and resulting changes in the quantity and flow of finance - seductively take on a life of their own as they breed excesses, future crises and the inevitable call for only greater interventions and inflations.
Mr. McCulley concludes with the insight – and I’m paraphrasing here - that deregulated and innovative finance precludes the elimination of “Minsky Moments:” McCulley believes “it’s a matter of having the good sense to have in place a counter-cyclical regulatory policy to help modulate human nature.” I would strongly counter that it is absolutely imperative to have the good sense not to perpetuate Bubbles and inflate episodes of “Ponzi Finance” to the point where they risk systemic collapse. Bankrupting the entire country is a completely unacceptable outcome. At some point the inflationists should accept the reality that they are a big part of the problem – and not the solution. Is that what the bond market is beginning to tell us?