Paul McCulley is once-again preaching the gospel of Keynes/Minsky. McCulley believes Fed Chairmam Bernanke is well aware of stumbling blocks and pitfalls in the path forward. While also preaching Keynes/Minsky, Doug Noland is, as usual, much less favorably inclined toward Bernanke's abilities/penchants to steer a thoughtful course forward. I'm still inclined to follow McCulley's bet on Bernanke.
A Reverse Minsky Journey, Paul McCulley, Oct 7: … Double Bubbles … Keynes … words some 70 years ago… are near-perfect, and prescient description of what undergirded dramatic United States growth in recent years: (1) asset securitization, notably of subprime loans, and (2) the shadow banking system, defined as the whole alphabet soup of non-bank levered intermediaries. … The joint growth of these two beasts into double bubbles was grounded in the irrational belief, nay exuberance in:
- Borrowers' and lenders' presumption of indefinite continuance of the existing state of affairs, notably ever-rising home prices, regardless of ever-retreating affordability for the first-time home buyer …, and;
- Levered lenders' presumption of unlimited command over money at the (low) market rate of interest.
Those two presumptions, or conventions, in Keynes' lexicon, did indeed provide, as he intoned, "a considerable measure of continuity and stability." Conventional wisdom Rule 1 held that rising home prices would cover all lax, even fraudulent mortgage underwriting sins. Conventional wisdom Rule 2 held that the "depositors" of the shadow banking system, more properly known as asset-back commercial paper holders, would forever roll their investments, content and confident in the low default experience of shadow banks' assets, per Rule 1.
In 2007, facts inconveniently neutered both of these Rules …Just as Keynes predicted, when the conventional basis of valuation for the originate-to-distribute (to the shadow banking system) business model for subprime mortgages was undermined, the asset class imploded "violently." And the implosion was not, as both Wall Street and Beltway mavens predicted, contained. Rather it has become contagious, first on Wall Street, with all "risk assets" re-pricing to higher risk premiums, frequently in violent fashion, and now on Main Street, where the housing recession is taking a new leg down, with debt-deflation accelerating in the wake of a mushrooming mortgage credit crunch, notably in the sub-prime sector, but also up the quality ladder.
Yes, we are now experiencing a reverse Minsky Journey…, where instability will, in the fullness of time, restore stability, as Ponzi Debt Units are destroyed, Speculative Debt Units are severely disciplined, and Hedge Debt Units make a serious comeback (remember, in Minsky terms, Hedge Units are the good guys!). Meanwhile, rather than speaking of endogenous containment of the bursting of the double bubbles, the mission of policy makers, notably monetary policy, is to exogenously contain the contagion — cutting off the fat tails of systemic risk on Wall Street and of recession on Main Street.
Bottom Line… I have high confidence that Fed Chairman Ben Bernanke understands every Keynesian word quoted above! I also have high confidence that he fully understands that a reverse Minsky Journey lowers the neutral real Fed funds rate, in mirror image of how a forward Minsky Journey lifts it. He and his colleagues demonstrated that understanding in the most powerful way possible: deeds, not just words, with a 50 basis point cut in the Fed funds rate to 4¾% two weeks ago, when the Street consensus was for only 25 basis points.
There are many, many basis points of easing to come, as time and credit market dynamics prove that liquidity is indeed a state of mind, not some abstract measure of the money stock or pool of money putatively on the sidelines, ready to be put to work. Liquidity is all about the appetite of investors to assume risk with levered money and the appetite of savers to provide such investors the leverage they seek.
And until the housing sector recession — with inventories half the distance to the moon … and prices deflating in most major markets …, with debt-deflation/defaults in the wake — has run its course, liquidity will remain both scarce and expensive, even if it notionally remains plentiful.
Not So Benign Neglect , Doug Noland, Oct. 12: … The serious issues associated with the current "reflation" are many. For one, the dollar is structurally quite fragile while the most robust Inflationary Biases are in non-Dollar Asset Classes. Previously, Fed reflationary policies provided a competitive advantage for U.S. risk assets that worked to incite sufficient financial flows to support or even boost the greenback. This proved a huge ongoing advantage for our expansionary Credit system. Today, the negative ramifications associated with dollar weakness more than offset the Fed's capacity to inflate U.S. securities prices. The Fed's recent rate cut proved a bonanza for most foreign markets (currencies, commodities, equities, bonds, etc.), especially relative to dollar-denominated mortgage securities (the previous Bubble asset class of choice).The Flow of Finance will now pose extraordinary challenges and risks. The unfolding mortgage crisis (especially in "private-label"and jumbo) will prove stubbornly immune to "reliquefication" benefits. This dynamic places home prices, the consumer balance sheet, and the general U.S. economy in harm's way. At the same time, there are the stock market Bubble and an acutely vulnerable dollar. I will presuppose that the Fed is hopeful to ignore equities and currencies, while operating monetary policy with a focus on the Credit market and real economy. Such a policy course, however, implies at this point much greater currency, market instability, and inflationary risks than our central bankers seem to appreciate.
I would furthermore contend that the nature of current Risk Intermediation is seductively problematic. On a short-term basis, enormous bank and money-fund led financial sector expansion has been sufficient to over-inflate non-mortgage Credit. It’s been too easy — and Credit to sustain the boom too risky. Meantime, post-Bubble risk aversion festers in mortgage-related finance that will creep ever-closer to spilling over into an economic downturn and a reemergence of financial turbulence. We can expect foreign demand for our risk assets to remain tepid at best.
Despite current market euphoria, these processes are significantly elevating the systemic risks associated with today's ballooning financial sector balance sheet. A stock market Bubble beset by destabilizing speculative dynamics only compounds systemic vulnerabilities. Such a backdrop seems to beckon for a currency crisis, a risk that leaves our Federal Reserve policymakers with much less flexibility than they or the markets today appreciate. There are major costs associated with Not So Benign Neglect. The Fed had better at least start sounding like they've thought through some of the issues.
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