Bill Gross On Minsky’s Take Of The Liquidity Trap: From “Hedge” To “Securitised” To “Ponzi”

Monday, February 6th, 2012

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.

Continue reading here.

Tags: Aberrations, Bill Gross, Central Planners, Economic Models, Faulty Assumptions, Financial Intermediaries, Grice, Hyman Minsky, Jpm, Liquidity Trap, Liquidity Traps, Monetary Theories, PIMCO, S Central, Seminal Analysis, Time Events, Treasury Rates, Unknown Territory, Us Bank, Zirp
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The Fed’s Asset Purchases

Monday, November 8th, 2010

The Fed’s Asset Purchases

by Dr. Scott Brown, Chief Economist, Raymond James

November 8 – November 12, 2010

As expected, the Federal Open Market Committee has embarked on another round of planned asset purchases. In its November 3 policy statement, the FOMC wrote that it expects to buy another $600 billion in long-term Treasuries by the end of 2Q11 ($75 billion per month), in addition to the $35 billion per month in reinvested principal payments from its portfolio of mortgage-backed securities. There has been much criticism of the move in the financial press. Certainly, there are risks in the Fed’s strategy. However, it’s hardly reckless or ill-advised.

The Federal Open Market Desk in New York plans to distribute its purchases across the following eight maturity sectors based on the approximate weights below:

Why it the Fed expanding its balance sheet? The economy is in a liquidity trap. Short-term nominal interest rates are near 0%. In a liquidity trap, fiscal policy is more effective at boosting growth than monetary policy. However, with fiscal stimulus unavailable, or possibly negative, monetary policy is the only game in town – and it can be effective, not through increasing the money supply, but by altering expectations.

Tags: 8 November, Approximate Weights, Asset Purchases, Chief Economist, Controversies, Dr Scott, Federal Open Market Committee, Fiscal Policy, Fiscal Stimulus, Fomc, Liquidity Trap, Liquidity Traps, Maturity Range, Money Supply, Mortgage Backed Securities, Nominal Interest Rates, Open Market Committee, Principal Payments, Raymond James, Treasuries
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Roubini Global Economics: Re-emergence of global protectionism

Sunday, March 8th, 2009

By RGE Monitor

As governments around the world fight rising unemployment, falling exports and bank credit crunch, and several central banks are facing liquidity traps, many are turning to restrictions that privilege national producers. These populist measures attempt to minimize growth impact, social unrest and pain from the credit crunch that poses a risk to several ruling governments, especially those facing elections soon. Furthermore, some officials hope that such restrictions will reduce the leakage of the scarce funds used in bank bailouts and fiscal stimulus to other countries.

But as history shows, the impacts of trade protectionism on exports and job creation if any are small in the short-term and instead may lead to global retaliation, and in the long-term result in inefficient allocation of labor and capital and trade distortions, affecting potential output and employment. But given the increased capital flows and labor migration in recent years and dependence on external capital in developed and developing countries to drive domestic demand, asset markets and growth, rising financial and labor protectionism pose an even greater risk of exacerbating the current global recession as trade protectionism did in the recession of 1930s. Increased global integration since the 1930s also indicates the consequences of protectionism will also be larger.

The US and EU’s stance will provide clues to other countries policy towards globalization. So it might be somewhat alarming that US anti-recession policies propose protectionist elements, and Western Europe has rejected a bailout package for Eastern Europe while implementing policies that pose risk to EMU’s ongoing trade, capital and labor integration.

However, there are at least some signs of global policy co-operation to suggest that a return to the Smoot-Hawley era might be less probable. Countries around the world have been coordinating since the crisis began to cut interest rates, inject liquidity into the banking system and contain rising spreads in the money markets. Other instances include countries implementing fiscal stimulus packages, the Fed extending swap lines to South Korea, Singapore, Mexico and Brazil; surplus Asian countries increasing their contribution to the pool of regional swaps; Japan filling IMF’s coffin to help increase assistance to crisis-hit countries in spite of its dire economic situation; and Western European countries willing to offer a case-by-case bailout to some of the Eastern European countries.

Trade protectionism
Plunging global manufacturing activity and consumer demand along with the trade finance crunch, commodity correction and exchange rate fluctuations are already bound to cause a contraction in global trade in 2009. Increasing instances of imposition of trade barriers by countries to restrict imports and promote exports will only exacerbate and prolong the decline in global trade and make export-dependent economies worse-off. Furthermore they may do little to help the imposing countries. However, sharp devaluations in some countries, especially emerging markets may increase import substitution.

Trade barriers such as tariffs are the most common element of protectionism that countries use in difficult times as witnessed during the food shortages in 2008. Countries like Indonesia, India, Vietnam, Ukraine, Russia, Argentina, Ecuador and Turkey have raised import tariffs, duties or laid restrictions on import licenses or quotas.

In their fiscal stimulus packages, several countries are also offering distortionary subsidies, and credit and other incentives for exporting firms to sustain trade flows, especially countries with high export dependence and low domestic demand. But trying to promote exports amid global demand and industrial activity slump might only add to the global excess capacity and deflation pressures.

One of China’s first steps was to reinstate and then increase export rebates which create disincentives to sell goods at home, a move that might only increase the domestic imbalances, as might the government’s efforts to buy grain and metals to support prices.

As WTO bound rates, especially for developing countries, have fallen significantly in recent years, governments have ample room to raise tariffs closer to the bound rate levels without violating WTO rules. And with policymakers preoccupied with domestic economic challenges, Doha trade talks might not be revived in the near-term despite the exhortations of the G7, G20 and other groupings.

Plunging sales and tightened access to domestic and foreign credit have also led many auto companies to seek bailouts from their home governments. Amidst scarce resources and to promote domestic firms over competitors, governments are offering financial assistance to just the domestic auto firms over the foreign-owned ones despite the relative inefficiencies of several of these national champions compared to other global players.

After the US government’s bailout of domestic automakers, GM and Chrysler, several countries including UK, China, Brazil, and Canada and in EU such as Sweden, France, Germany, Italy and Spain have followed suit to help their own auto companies. Western European auto sector support, a move that may hurt Eastern European countries, is seen as a challenge to EU’s single-market ideology even if they have passed EU competition rules. In China’s case, government policy aims to finally consolidate the industry.

But restricting assistance to some firms via loans or loan guarantees, tax incentives to firms and households buying autos, subsidies to undertake R&D and invest in renewable energy is highly distortionary and undermines domestic as well as trade efficiency, particularly if the beneficiaries do not make the difficult cuts required as part of the funding.

There have been growing calls for a global fiscal stimulus policy partly to support global trade, as coordinated action will have a better chance of boosting aggregate demand especially for smaller, open economies. Given that the global supply chain is highly integrated today, import demand by one country will boost exports for other countries and therefore their incomes and import demand, which in turn will boost the source county’s exports. However, to prevent import leakages and promote production and jobs at local firms, fiscal stimulus in countries like US, Spain and France encourage spending on domestically produced goods at the expense of foreign-owned firms and nationals working at those firms.

The US fiscal stimulus package limits sourcing infrastructure spending related goods from WTO signatories like EU, NAFTA and Japan while excluding non-signatories like China, Brazil, India, Russia, Ukraine, Turkey and many other developing countries. Since close to 55% of the infrastructure spending will take place after 2009-10, the impact of this measure on jobs and growth will be limited in the short-term. But this has nevertheless led other countries implementing fiscal stimulus and infrastructure spending to retaliate with similar measures to protect their own jobs and firms. As a result, this will impact jobs at importing firms and also the demand for US exports and jobs, sometimes affecting output and jobs in the same industries and sectors that the policymakers were aiming to protect. As it is, Obama and the Democratic Congress’ stance to renegotiate trade deals to incorporate non-tariff barriers like labor and environmental standards, and promote influence of labor unions has already cautioned the world on the US trade policy going forward even if Obama emphasized the importance of trade on his recent visit to Canada.

Moreover as exports are slowing, several developing countries such as in Asia and Latin America are increasingly favoring an undervalued currency. The initial currency plunge may have been due to deleveraging but given the export collapse, few countries are likely to allow much appreciation. And this is leading other countries to follow suit with the risks being particularly high in Asia, as these export oriented economies might favor competitive devaluations. Some Japanese officials have argued for intervention to weaken the yen, which only recently slipped from the heights where they intervened in the early part of this decade.

The Chinese yuan, which rose about 6% against the US dollar early in 2008, and appreciated more in real terms, returned to its de facto peg at mid-year and even depreciated somewhat. Treasury Secretary Timothy Geithner’s confirmation testimony re-ignited US China currency tensions by noting that President Obama views China as a currency manipulator, a tag that would allow trade retaliation. China has similarly publicly expressed concerns about the value of its large stock of US debt (over $700 billion) acquired in the process of managing its currency. Given the collapse in China’s exports, it is unlikely to allow a stronger currency which might give it little choice but to keep buying US assets, albeit likely at a slower pace than in early 2008.

However, the probability of these measures becoming significant enough to lead to a trade war like the 1930s might be low given that counties understand that retaliation effects will counter-productive for domestic growth and jobs. Moreover, the WTO surveillance mechanism, absent during the 1930s, will help countries go to the WTO court if they face import barriers and thus prevent trade wars.

Financial protectionism
Global credit crunch and de-leveraging has reduced capital flows to emerging markets. Risk averse foreign investors are redeeming and repatriating funds where credit risk is perceived to be less or using the resources to offset other losses. The Institute of International Finance (IIF) estimates that net private sector capital flows to Emerging Markets in 2009 will be $165bn in 2009, less than half the 2008 inflow of $466bn and $929bn in 2007. The decline in capital flows is equivalent to about 6% of the combined GDP of EMs, way larger than the 3.5% of GDP during Asian crisis and 1.5% of GDP during the Latin American crisis.

Foreign commercial bank lending, which accounted for the largest share (over 50%) of capital flows to EMs in recent years, similarly accounts for much of the decline – such flows are expected to fall to $61bn in 2009 from $167bn in 2008 and $410bn in 2007. Portfolio flows to EMs will continue to contract in 2009 after declining to $89bn in 2008. FDI, the second largest component of capital flows to EMs in recent years, may not be as resilient as many economists assume and will drop to $198bn in 2009 from $263bn in 2008 and $304bn in 2007 as MNCs face lower corporate profits, lower export-related investment amid plunging global demand, credit crunch and decline in M&A and Private Equity activity.

Similarly the reduction in commodity prices will reduce the outflows from oil exporters to developed and developing economies – portfolio and direct investment from the GCC were a key capital source for some emerging economies, especially in the Middle East.

Hence, capital flows to EMs will contract at a time when domestic capital markets and bank lending activities are subdued. When exports and current account balances are easing, weaker capital accounts will pose risk to several EMs in financing or rolling over their external debt and maintaining stable asset prices and currencies. In fact, many short-term hot inflows and foreign bank borrowings to finance domestic consumption, corporate investment and drive asset markets such as real estate and stock markets and fuel economic growth.

Thus, ongoing bank losses and credit crunch will lead foreign banks to reduce credit availability, and at worse to cut credit lines to subsidiaries thus weighing down on domestic demand, raising bank defaults by firms and households and worsen the recession. Emerging Europe, which has seen foreign bank borrowing and foreign bank assets/GDP ratio surge in recent years, is the main victim of this trend. Going forward, Japan may be only one of several countries to apply its government savings to increase foreign exchange liquidity of corporations, many of whom lost out as FX markets became more volatile.

Therefore amidst capital outflows, end of the global liquidity boom, growing risk of increased global regulation and doubts over the benefits of financial globalization on risk sharing and financial stability, a rise in financial protectionism will only exacerbate the global credit crunch and financial crisis in several countries, posing the risk of slowing the pace of financial globalization.

As increasing number of banks are being bailed out, governments such as the UK, Germany, France, Greece, Denmark are imposing stringent conditions to lend their scarce capital to domestic firms and households rather than foreign ones and also direct credit to priority or recession hit sectors.

The stance of EU and US to monitor lending by banks is forcing them to increase lending in domestic markets relative to foreign ones. This is influencing banks’ commercial decisions, distorting credit allocation and reducing credit growth in EMs especially in emerging Europe like Hungary and Romania, and countries such as Russia, Ukraine and UK that are highly dependent on foreign bank borrowing. However in countries like China, state banks are responding to the government’s commands to lend, even if most of it is short-term, but foreign banks are more reluctant.

Banks including RBS, Citigroup, UBS, BoA are reducing lending abroad and even selling their overseas subsidiaries, especially the non-core assets in EMs to offset losses and manage their shrinking balance sheets. Risk-averse and loss-making banks also want to repatriate capital to their home markets where risks are perceived to be relatively less with an upside of having access to government assistance in times of crisis.

Additionally, governments are also imposing several capital controls to restrict capital outflows including on cross-border banking and corporate M&A activities even as they are easing capital inflow rules to support their currencies and finance their external balances. Further such controls are possible. Iceland, Ukraine, Argentina, Indonesia and Russia have imposed restrictions on the availability of foreign exchange.

Some governments have higher capital requirements and capital charges for foreign banks especially emerging market banks relative to domestic banks, leading banks to move assets to their domestic markets. To cope with domestic currency shortages, several countries have laid restrictions on currency conversion by importers and domestic banks and firms to meet their foreign currency needs.

The threat to financial globalization could be exacerbated by asset protectionism. On the one hand, many governments have worried that foreigners with surplus cash (especially sovereign wealth funds) might be able to snap up key assets more cheaply and end up with controlling stakes. France even created their own fund to provide capital lest foreigners buy up French companies too cheaply and both developed and developing countries have imposed new restrictions on investment in the last year.

On the other hand, the increasing need for capital by corporations and financial institutions may reduce political concerns. Yet it should perhaps not escape notice that the recent conversion of Citigroup’s preferred shares to common stock by Singapore’s GIC will leave it with a 11.1% voting share, an amount which would have raised congressional shackles a year or so ago. Perhaps the fact that the US may soon control 36% of shares dilutes these concerns.

Sovereign funds themselves are not as high-profile, a development that may be due to past losses, the need for greater liquidity and uncertainty about the value of assets. And at the same time, with less new funds available from the reversal in capital flows and commodity prices, past savings are being depleted to support domestic banks and finance fiscal stimulus packages. China may be a partial exception. It emerged in recent months as a capital source for several cash strapped resource companies, providing loans in exchange for oil supply contracts and using the opportunity to diversify its foreign assets.

Labor protectionism
Rising lay-offs and worker protests in UK, Ireland, Greece, France, Latvia and several other European countries is increasing political pressure to protect jobs for nationals. As a result, governments face pressure to lay off foreign workers rather than domestic ones, promote outflow of immigrants, put restrictions on firms to hire nationals over immigrants such as for the US banks using TARP funds, and in the fiscal stimulus packages create jobs for nationals than foreign workers and offer safety nets.

With slumping global manufacturing and exports, the International Labor Organization estimates up to 50 million workers will become unemployed due to the global recession while immigration itself will slow as job market and wages weaken in the host countries. These factors along with recent trends – rising income inequality, stagnant wage growth, impact of immigration on depressing job opportunities and wages for nationals, and impact of globalization and offshoring on job and income security – will rekindle workers’ anxiety and undermine the recent boom in labor migration.

The movement of labor within the EU, intra-Americas, to the GCC region and between developed and developing countries in general has led to a corresponding boom in the flow of skills and remittances that has also helped finance external accounts of several developing countries. These remittance flows are now under pressure as RGE Monitor’s Mikka Pineda details in a recent outlook for Filipino remittances in 2009.

In the GCC, where imported labor facilitated fast paced economic growth during the oil boom, there are reports that many work visas are being cancelled and the UAE has instituted policies to protect the jobs of nationals. This will reduce remittance flows to other countries in the MENA region and to South Asia. In the UAE, which will probably face the sharpest declines, job losses will exacerbate the slowing in domestic demand and reduced demand for housing even as though new restrictions may actually do little to increase employment of nationals as they are difficult to fire.

As Russia contracts, Central Asians working in Russia are losing jobs and are facing greater pressure from nationalist groups. With remittances as high as 30-50% of GDP in many Central Asian countries, the reduction in remittances will exacerbate the contraction.

As the global downturn worsens, so will workers’ anxieties about job and income losses, strengthening the need to increase spending on unemployment insurance, worker retraining and other social safety nets in the government’s fiscal stimulus packages around the world to keep the labor market flexible during the downturn while also creating long-term policies to cushion workers from changes in the economic structure that the recovery and globalization in general would bring about.

Source: Arpitha Bykere and Rachel Ziemba, RGE Monitor, March 4, 2009.

Tags: Asset Markets, Bailout Package, Brazil, BRIC, BRICs, Canadian Market, Central Banks, Credit Crunch, Emerging Markets, Fiscal Stimulus, Global Integration, Global Recession, India, Inefficient Allocation, Labor Migration, Liquidity Traps, National Producers, Populist Measures, Roubini Global Economics, Scarce Funds, Smoot Hawley, Social Unrest, Term Result, Trade Distortions, Trade Protectionism, World Fight
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