Updating Government Finance Quasi-Capitalism
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.
And though it’s somewhat beyond his purview, Sharma thinks the civil disobedience and racial strife afoot in the U.S. can be explained, in part, by the antiestablishment sentiment that “is sweeping the world and lapping up on America’s shores.” The rising tide of antiglobalization and growing inequality of wealth have also added to the tensions in U.S. cities and elsewhere.
THE 42-YEAR-OLD SHARMA has spent the past 20 years with Morgan Stanley Investment Management, beginning as an analyst in Mumbai. He was raised in Delhi, the son of a military officer, and had been writing a newspaper column for India’s largest financial daily, the Economic Times, since age 17.
Today, he’s the firm’s chief global strategist and heads its emerging markets equity team. As such, he travels the world, averaging one week out of each month visiting developed and developing countries alike, talking to folks ranging from heads of state and central bankers to business leaders and people on the street. “You’d be surprised how much you can learn, from mall visits to barnstorming around the countryside, about what’s going on,” he avers.
Sharma and his team of 25 analysts, economists, portfolio managers, and other professionals also pore over all manner of economic statistics and government reports to get a bead on the latest trends. The unit, a pioneer in emerging market investing, runs some $20 billion in assets.
He’s a prolific author, writing essays and op-ed pieces in leading publications in the U.S. and Europe, such as The Wall Street Journal, the New York Times, and the Financial Times. And his latest book, The Rise and Fall of Nations: Forces of Change in the Post-Crisis World, published in June, seems to have captured the current global zeitgeist over disappointing economic growth. In it, Sharma describes four megatrends in the global economy that figure to impede global economic growth over the next five years from reaching the spirited levels of the pre-crisis period. Yet, in that period, the economic fortunes of some countries will wax, while those of others will wane. He ranks their prospects by a proprietary set of characteristics, or what he calls rules, such as debt-to-GDP ratios laid out in a chapter wittily called “The Kiss of Debt.”
“I purposely keep my forecast periods short, five years max, because there’s too much that can happen beyond that, in terms of technological and secular changes, to make longer predictions reliable,” he says.
He labels the megatrends that he sees at play “the four ‘Ds’ ”: depopulation, deglobalization, deleveraging, and de-democratization.
Depopulation, he explains, is a reflection of the decline in the working-age population in developed regions including Western Europe, Japan, Taiwan, and Korea. It likewise is affecting the world’s second-largest economy, China, which passed that fateful milestone last year. And while the U.S. is on the path to a shrinking workforce, immigration may well keep that wolf at the door for at least the next decade.
More often than not, a 1% drop in the labor force lops off 1% in economic output, Sharma points out, and boosts in productivity—output per man hour—have been limp of late in the U.S. and elsewhere.
He also sees a worrisome trend toward what he labels deglobalization. Since the 2008 crisis, world trade has trailed as a percentage of economic growth, and international capital flows have plummeted, largely because international banks have pulled back lending to within their home borders.
Trade has also suffered from a recrudescence of protectionism in the form of competitive currency devaluations and the erection of stealth trade barriers to counter alleged malefactions by competitors, such as goods-dumping and unfair subsidization of exports. Trump has made a centerpiece of his presidential campaign the alteration of various U.S. trade agreements that he claims have shipped U.S manufacturing jobs overseas. Even Hillary Clinton, the Democratic nominee for president, has withdrawn her support for the Trans-Pacific Partnership, a pact with 11 other Pacific Rim countries, the passage of which was once considered a slam-dunk.
His final “D,” de-democratization, has also impaired the recovery. In many countries, populaces have embraced autocratic leaders promising to relieve economic distress through decisive executive actions. “Such unchecked meddling often destroys investor and business confidence, and delivers less-healthy economic growth in the long term,” says Sharma.
IT ISN’T BY CHANCE, he claims, that a survey by watchdog group Freedom House shows that, over the past decade, the number of nations showing a decline in political and human rights exceeds those that have seen an increase. “This is largely the result of regimes trying to force-feed enhanced economic growth,” he explains.
Yet Sharma isn’t unduly pessimistic. He merely believes that economic growth expectations have to be tempered somewhat to accommodate the new reality of a post-boom world. He thinks that developing nations, for example, should be content with 4%-to-5% annual GDP growth, rather than, say, 7%. The new target for wealthy developed countries like the U.S. should be 1.5%, rather than more than 3%.
To rate the near-term prospects of different countries, he uses various measures of his own confection that are based on both his globe-trotting experience and deep-dive studies capturing the influence of a host of factors on national economic growth.
Demographic trends in working-age populations tend to be fairly straightforward. But he leavens that with adjustments for worker-participation rates, the percentage of women in the labor pool, openness to immigration, and freedom of opportunity. The U.S. gets high marks here despite all of the controversy currently surrounding immigration reform. Sharma points to the fact that 30% of the workers in Silicon Valley are foreign-born. Of the top 25 U.S. tech companies, as of 2013, 60% were founded by first- or second-generation immigrants, including Steve Jobs of Apple, Sergey Brin of Google, and Larry Ellison of Oracle.
Sharma also puts much stock in combing billionaire lists of different countries to gain insight into the vulnerability of different societies to populist unrest triggered by resentment over wealth inequality. He looks at how much of that wealth was inherited or achieved through other than honest means.
In the past five years, he notes, the wealth of U.S. billionaires as a share of GDP has risen to 15% from 11%.
But that doesn’t tell the entire story. Most of the U.S. plutocrats are what Sharma calls “good billionaires,” that is, self-made men and women who created their wealth by developing unique products and services that boosted jobs and economic growth.
“Bad billionaires,” he says, abound in countries like Russia and Mexico, where their wealth is largely the result of chicanery, family connections, and payoffs. “You tend to find the bad guys in rent-seeking industries like construction, real estate, gambling, telecom, oil, and mining, in which monopoly status or government favoritism protect them from real price competition,” says Sharma. “In such an environment, economic growth suffers because the poor and middle class account for a smaller share of national income and the rich don’t spend enough.”
Obviously, political leadership matters mightily to the economic fortunes of countries. Even many reformers who come to office after an economic crisis typically turn “stale” after a term or so in office. Surrounded by sycophants and toadies, they tend to become more dictatorial and rapacious with the passage of time.
Prime examples of this are Russia’s Vladimir Putin and Turkey’s Recep Tayyip Erdogan, who took office near the turn of the millennium during financial crises in their respective countries.
Both succeeded at reforming antiquated tax systems and cutting fiscal excesses to right their economies. But soon, both leaders morphed into full-blown autocrats seizing ever more levers of power, abridging civil liberties and stamping out free expression. Erdogan’s mass arrests of thousands in the wake of the recent failed military coup is merely of a piece with his long-running campaign of suppression of political opposition and stamping out of a free press.
ANOTHER OF SHARMA’S important markers is the aforementioned national debt-to-GDP ratio. His study of historic debt binges indicates that when the five-year increase in the private debt to GDP ratio exceeds 40 percentage points, that nation is headed for a severe economic slowdown and, in many cases, a severe credit crisis. China, which he says has gone on the biggest debt binge in human history, has seen its debt to GDP ratio increase by 80 percentage points in the five years following its pedal-to-the-metal stimulus program to counter the effects of the 2008 global crisis.
Of course, of paramount importance is how nations, in particular developing ones, invest their savings and foreign direct investment. Sharma argues that economic growth is best fostered by investment in manufacturing, with an eye toward moving up the export value chain by going from shoes and textiles to, eventually, cars and electronic goods. Manufacturing, if done right, creates an affluent middle class to build a consumer culture around. It also spurs innovation and leads to a buildout of infrastructure, such as roads, bridges, rail lines, ports, and power grids. He sees such countries as Mexico, India, Vietnam, Bangladesh, and Kenya moving smartly up this development escalator.
A strong manufacturing sector also serves to protect economies from much of the volatility of global economic cycles. That, of course, isn’t the case with economies reliant on what they can garner from exporting oil, natural resources, and other commodities.
The price swings in these markets are vicious, leading to gross overspending by countries in good times “that they think will go forever,” followed by economic despond during the inevitable commodity bear markets. Russia, Brazil, Saudi Arabia, Nigeria, South Africa, and even Australia and Canada are currently caught in this commodity black hole.
SHARMA ALSO KEEPS CLOSE WATCH OVER what he considers unhealthy investment binges in real estate and national stock markets. China, these days, is the poster child for such speculative excess, and that is an important signal of coming problems. Academic studies show that nearly two-thirds of recent serious recessions around the globe followed on the heels of busts in national real estate or stocks. “These binges leave little in the way of productive assets behind for future growth,” Sharma opines.
Media hype of different national economic prospects can also prove problematic for rating economies. The press usually follows the conventional wisdom of economists and experts at the World Bank and elsewhere, who typically miss key turning points. One can point to all sorts of busted media themes since the turn of the millennium. Among them: predicting the convergence of incomes between rich and developing nations and the inevitable rise of China to economic predominance in this century.
“I prefer to look closely at countries that are so disdained by media that they are virtually ignored,” he explains. Argentina fits his bill. After 14 years of Peronist misrule and economic mismanagement, the new president, technocrat Mauricio Macri, is making long-needed moves to tame hyperinflation, bring about budgetary order, boost investment in infrastructure, and settle nagging international debt disputes.
Sharma also scrutinizes capital flows in and out of countries to glean important shifts in national economic growth. He believes in “following the local money,” because local businessmen and investors tend to have a more granular, nuanced view of what’s going on in their own economy than do international lenders and foreign investors who are usually last to get the memo. That’s what makes recent bouts of capital flight in China so worrisome. The current economic problems in Russia were anticipated by a heavy flow of oligarch money out of Russia as long as two years before the oil market crash last year.
Macroeconomics is an unforgiving field in which even seasoned veterans like Sharma can get fooled. He admits to have been somewhat blindsided by the 1997 Asian financial crisis, which began in Thailand, and also by the speed of the recovery two years later, after the region’s currency values steadied and economic growth resumed.
Sharma has rueful memories of a large bank conference he addressed in Moscow in October 2010, in which he predicted serious economic troubles ahead for the nation because of Putin’s failure to diversify its natural-resources-based economy. The problem was that a poker-faced Putin was sitting on the dais as Sharma spoke, along with then French Minister of Finance Christine Lagarde, who kept shooting Sharma shocked sideways glances.
Sharma was savaged in the state-controlled press the following day as an ingrate from Wall Street, whose money Russia emphatically didn’t need. Yet, speaking and writing truth to power is part of Sharma’s remit.
That’s one of the aspects of his job that makes it interesting.