Updating Government Finance Quasi-Capitalism

Doug Nolan

I found my thoughts this week returning to Hyman Minsky, financial evolution and Capitalism.

Updating my 2013 Government Finance Quasi-Capitalism thesis seemed overdue.

“Minsky saw the evolution Capitalist finance as having developed in four stages: Commercial Capitalism, Finance Capitalism, Managerial Capitalism and Money Manager Capitalism.

'These stages are related to what is financed and who does the proximate financing – the structure of relations among businesses, households, the government and finance'…"

Money Manager Capitalism: “The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy… Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits… A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...”

Late in life (1993) Minsky wrote: “Today’s financial structure is more akin to Keynes’ characterization of the financial arrangements of advanced capitalism as a casino.” More and more concerned by the proclivity of “Money Manager Capitalism” to foment instability and crises prior to his death in 1996, Minsky would have been absolutely appalled by the late-nineties “Asian Tiger” collapse, the Russia implosion, LTCM and the “tech” Bubble fiasco.

Minsky was no inflationist. His focus would have been to rectify the institutional and policy deficiencies that were responsible for progressively destructive mayhem.

Policymakers instead responded to instability and crisis with increasingly activist” (inflationist) measures. In particular, the Fed (and global central bankers) moved aggressively to backstop marketplace liquidity. At the same time, the government-sponsored enterprises (GSEs) began guaranteeing a large percentage of new mortgage Credit, while employing their balance sheets (liabilities enjoying implied federal backing) in similar fashion to central banks, as so-called “buyer of last resort” during periods of market tumult and speculative deleveraging.

These government-related liquidity backstops and guarantees fundamentally altered finance.

Back in 2001, I updated Minsky’s stages of Capitalistic Development with a new phase, “Financial Arbitrage Capitalism”. Evolving financial, institutional and policymaker frameworks had seemingly mitigated volatility and crisis. Then the 2008 debacle unmasked what had been an unprecedented buildup of risky Credit, problematic risk intermediation processes and the accumulation of leverage and speculative positions. Policymakers and the markets had been oblivious to catastrophic latent liquidity risk inherent to the new institutional structure.

“The worst crisis since the Great Depression” provoked extraordinary policy measures. In 2013, after witnessing previously unimaginable central bank interest-rate manipulation, monetization and the specific policy objective of inflating securities markets, I was compelled to again update Minsky’s stages: “Government Finance Quasi-Capitalism”.

As finance has a proclivity of doing, “Money Market Capitalism” evolved over time to become increasingly unstable. Policy responses then nurtured a freakish financial backstop that greatly incentivized leveraged speculation throughout the securities and derivatives markets. This process fundamentally loosened financial conditions and spurred risk-taking and spending.

After attaining significant momentum in the nineties, the progressively riskier phase of “Financial Arbitrage Capitalism” reached its zenith with the issuance of $1.0 TN of subprime CDOs is 2006/07.

The policy response to the 2008/2009 crisis was nothing short of phenomenal. A Trillion of QE from the Fed, zero rates and massive bailouts. Still, the Fed at the time claimed to be committed to returning to the previous policy regime as soon as practical. The Fed devoted significant resources toward mapping out a return to normalcy, going so far as releasing in 2011 a detailed “exit strategy” for normalizing rates and returning its balance sheet to pre-crisis levels.

But with the European crisis at the brink of turning global back in 2012, it had become clear by that point that thoughts of returning to so-called “normalcy” were illusionary. It may have been the ECB’s Draghi talking “whatever it takes,” but he was speaking for global central bankers everywhere. QE was no longer just a crisis measure. It would effortlessly provide unlimited ammo for which to inflate securities markets and spur risk-taking and economic activity. If zero rates were not providing the expected market response, no reason not to go negative. If buying sovereign bonds wasn’t getting the job done, move on to corporates and equities.

Such a deviant policy backdrop coupled with an already deeply distorted and speculative market environment ensured descent into a truly freakish financial landscape. Most obvious, markets have come to largely disregard risk. Serious cracks in China and Europe have been largely ignored by global markets. The increasingly alarming geopolitical backdrop is completely disregarded. Brexit was regarded - for about a trading session. Global economic vulnerability is on full display, though massive QE and negative-yielding developed country sovereign debt ensures a “money” deluge into the corporate debt marketplace. Concern for risk has hurt performance. Recurring bouts of concern puts one’s career at risk – whether one is a portfolio manager, financial advisor, trader, independent investor, analyst or strategist.

The financial and institutional arrangements that I collectively refer to as “Government Finance Quasi-Capitalism” have over time had profound impacts on the securities markets.

Policymakers have largely removed volatility from equities (VIX ends the week at 11.39) and fixed income. U.S. corporate debt issuance remains at near-record pace. Stock prices are at all-time highs in the U.S. and elevated around the world. Bond prices are near records almost everywhere. Risk premiums in general have collapsed. Why then is unease so prevalent throughout the securities markets?

For one, it’s impossible these days to gauge risk. How much are QE and rate policies impacting securities prices? Will global policymaker have the capacity to withdraw from unprecedented measures, or have they become trapped in disproportionate stimulus with no way out? How big is the downside? How will the future policy backdrop play out? The truth is that no one – certainly not the policymaker community – has any idea what the future holds for policy or the markets. A turn back in the direction of reasonableness and “normalcy” or a further spiral out of control?

There’s a strong argument that investing has been largely relegated to a thing of the past. If risk is completely unclear, it’s impossible to gauge risk versus reward. Furthermore, how are company fundamentals (i.e. earnings, cash-flow, etc.) impacted by massive monetary and fiscal stimulus? How about the macro economy? And if risk vs. reward is unknowable and valuation metrics so obscured, it’s delusional to refer to “investment”.

A defining feature of Government Finance Quasi-Capitalism is that speculation now completely dominates investment. An unintended consequence of policymakers suppressing volatility and masking risk is that active management has been severely disadvantaged relative to passive management. Traditional investment analysis and risk management have been a significant detriment to performance. Why bother, when fees are lower with passive anyway? So “money” has flooded into ETFs and other index products simply to speculate on “the market.” Passive management really couldn’t care less about China, European banks, Brexit, Japan, Bubbles or policymaking more generally.

The abnormal backdrop does a major disservice to those that appreciate the unstable backdrop and hence seek to proceed cautiously. Indeed, Government Finance Quasi-Capitalism has nurtured one of history’s great speculative Bubbles in perceived low-risk “investments.”

Trillions of liquidity injections coupled with volatility suppression has ensured that Trillions have flooded into dividend-paying stocks, “low beta,” “smart beta” and other perceived low-risk equity market strategies.

Government Finance Quasi-Capitalism has transformed Trillions of risk assets into perceived “money-like” instruments, throughout the securities markets and surely in derivatives. These massive flows into perceived safety have been instrumental in fueling the entire market to record highs in the face of persistent and growing risks. Previously, Financial Arbitrage Capitalism fomented “money” risk misperceptions and resulting liquidity crisis vulnerability in the “repo” market. Similar risks continue to mount in the Government Finance Quasi-Capitalism period throughout perceived low-risk equities, fixed income, corporate debt more generally and higher-yielding assets throughout the overall economy (i.e. commercial real estate).

U.S. household Net Worth is at record highs, while the ratio of Net Worth to GDP is near all-time highs. It’s worth noting that U.S. unemployment at 4.9% is outdone by China’s 4.1% and Japan’s 3.1%. Why then is there such social tension and geopolitical unease?

The Financial Arbitrage Capitalism period was notable for a momentous misallocation of real and financial resources. The economic structure suffered mightily, clearly evidenced by deteriorating productivity associated with deep structural deficiencies, along with underlying economic fragility. I would strongly argue that the ongoing Government Finance Quasi-Capitalism phase, with a massive inflation of government debt and only more grotesquely distorted markets, is even more dysfunctional at creating and distributing real economic wealth. Thus far it has succeeded in inflating perceived financial wealth, although this has only exacerbated the social and political problems associated with blatant wealth inequities.

Government Finance Quasi-Capitalism creates essentially unlimited demand for perceived low-risk corporate Credit (think Apple, Microsoft, Verizon, etc.), creating myriad market, financial and economic distortions. For one, it feeds financial engineering, including stock-repurchases and M&A. This dynamic exacerbates the big firm advantage and monopoly power more generally, at the expense of economic efficiency. I would contend it also is an increasingly important aspect of wealth inequality: the few really big get bigger and more powerful at the expense of everyone else. Financial flows are siphoned away from the general economy to be flooded into the hot sectors. A handful of cities – think SF, Seattle, Portland, Austin, L.A., and New York – lavish in prosperity while small town America is left to rot.

I have asserted that Bubbles only redistribute and destroy wealth. I have further posited that geopolitical instability is a dangerous consequence of the global government finance Bubble.

Both China and Japan are in the midst of respective precarious Bubble Dynamics. It’s no coincidence that animosities and geopolitical risks between the Chinese and Japanese are rapidly escalating. Tensions between Russia and the West have close ties to the global Bubble.

Turkey’s problems are exacerbated by its bursting Bubble. The Middle East, Latin America and Asia are all suffering from Bubble consequences. Brexit was Bubble fallout.

I am most nervous because I see no dialing back Government Finance Quasi-Capitalism.

Government intervention – in the U.S., Europe, Japan, China and EM – has been so egregious and overpowering that retreat has become unthinkable. Policymakers would have to admit to historic misjudgment – and then be willing to accept the consequences of reversing course.

Global markets and economies are now fully dependent upon aggressive fiscal and monetary stimulus. Bubbles are in the process of “going to unimaginable extremes – and then doubling!”

Bursting Bubbles will evoke finger-pointing and villainization. That’s when the geopolitical backdrop turns frightening.

This week, the Bank of England (BOE) surprised the markets with a move to even more aggressive monetary stimulus. Global central bankers these days all play from similar playbooks, although when presented with the opportunity each takes their whirl at experimentation. Bank of England Governor Mark Carney’s announcement that the BOE would commence corporate bond purchases solidified the market view that global central bankers will increasingly look to corporate debt for QE fodder. The BOE also announced a new lending facility, hoping to entice banks into lending more aggressively.

Minsky’s phases of capitalistic evolution were U.S.-focused. It’s disturbing that Government Finance Quasi-Capitalism has evolved into such powerful global phenomenon. This ensures market fragilities and economic maladjustment on a globalized and highly correlated basis.

Thus far, global central bankers have maintained a rather consistent and concerted approach.

Central banks seem to collectively recognize that they are together trapped in the same dynamic. This has encouraged cooperation and coordination. At some point, however, zero-sum game dynamics will prevail.

I’ve briefly touched upon the misallocation of real and financial resources, along with attendant social, political and geopolitical risks associated with economic stagnation and gross wealth inequalities. One can these days see the “third world” as increasingly chaotic. One can as well see EM regressing toward more “third world” tendencies. And in the developed U.S. and Europe, in particular, one can witness more EM-like tendencies of wealth inequality, polarized societies, corruption and political instability.

There’s another key facet of Government Finance Quasi-Capitalism: A troubled global banking sector. Sinking stock prices seem to confirm that banks are a big loser, as governments impose command over financial relationships and economic structure. This is a complex subject. I would argue that governments have placed banking institutions in a difficult – perhaps dire - predicament. In general, banks have become increasingly vulnerable to mounting financial and economic vulnerability. Highly leveraged banking systems from the UK to China will have no alternative than to lend, no matter the degree of policy-induced financial and economic instability. And the more government policies inflate asset prices (including U.S. housing), the more these assets Bubbles will depend on ongoing bank lending support.

Moreover, keep in mind that banking systems have been delegated the task of intermediating central bank Credit (largely) into bank deposits. Central bank issued Credit (IOUs) ends up chiefly on commercial bank balance sheets, banks having accepted central bank funds in exchange for new bank deposit “money”. So in this high-risk backdrop of government-induced market distortions, banks are building increasingly risky loan books (and “investment” portfolios) while sitting on specious (and inflating) holdings of central bank and government obligations. And this high-risk structure works only so long as Credit – central bank, government and financial sector – continues to expand.

Government Finance Quasi-Capitalism really amounts to a Hyman Minsky “Ponzi Finance” dynamic on an unprecedented global scale. Worse yet, the greatest impairment unfolds right in the heart of contemporary “money” and Credit.

It’s worth noting that despite Friday’s 4.9% surge Italian Bank Stocks sank 6.2% this week (down 51% y-t-d). Japan’s TOPIX Bank Index dropped 3.1% (down 32% y-t-d). Japanese 10-year JGB yields jumped 10 bps to a three-month high negative 10 bps. Ten-year Treasury yields rose 14 bps this week. There’s an increasingly unpredictable element to the U.S. Bubble Economy that should keep the Federal Reserve and the bond market uneasy. Currency market instability persists. The pound remains vulnerable, while the yen is curiously resilient. EM is a mystery wrapped inside an enigma. And if bond yields begin to surprise on the upside, a whole lot of “money” is going to be positioned on the wrong side of an extremely Crowded Trade.

0 comentarios:

Publicar un comentario