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Thursday, April 29, 2010

Transcript: 377 How to measure financial fragility

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Ten years ago Alan Greenspan was in the middle of ratcheting up the interest rates to historic real highs. His tea leaves told him inflation was on the way. Instead of inflation, it was the dot.com crash. Within a year he was well on his way to ratcheting them down. The nominal federal funds rate had been fairly steady through the latter half of the 1990s at between five and a half and six percent. It dipped then rose at the behest of the Maestro to six and a half percent.

The inflation was in the oil price rise. The interest rate hike only exacerbated the demand shock. By 2001 the quarter point steps were heading to the basement. Below two percent by the end of the year. At one percent in 2003. Enter housing boom. By mid 2004 they were on their way back up, getting to five and a half percent shortly after the onset of 2006. Then the crash. Then they came back down.

1990s. Stable interest rates investors and entrepreneurs could count on. 2000s, bouncing interest rates that produced, well, nothing good. A chart of the nominal rates is in the transcript. Notice that the huge spikes in the 1970s and 1980s should be reduced by the rate of inflation. The historically highest real rates were in the Greenspan push of the early 2000s.

It is our view that rising oil prices and a slowing economy that corresponded to this cost Al Gore the election and put George W. Bush in office. That and the Florida vote. But that's another story.

The Demand Side view is historical. Historically speaking, we are in a period of muddling through, or trying to muddle through. Trying to get banks to do what we think they should. While the damage to the economy continues, and conservative estimates have it operating around six percent below capacity. Our estimate is closer to 20 percent. This is analogous to not watering the future and expecting that somehow the plants will grow up and give us a crop anyway.

We have recently reviewed Goldman Sachs from the perspective of Hyman Minsky. The real point was that the increased leverage and reduced regulation that led us into the current economic collapse was built in. In order to compete, as a result of apparent stability, and with bonus results for many years. In popular history, the idiots of the early aughts are the insightful prognosticators of today. The geniuses of Greenspan, Rubin, Summers and the arrayed big banks are now the criminally negligent.

In Demand Side history, the low interest rates and massive tax cuts, along with the huge deficits which began in the 2000's with Greenspan and Bush, DID NOT PRODUCE PROSPERITY OR STABILITY, BUT THE OPPOSITE. The decade of the aughts produced zero new jobs for 30 million new people. It continued the massive accumulation of debt until private debt reached levels above that of pre-crash 1929. We say this not to point the finger at George W. Bush or Alan Greenspan as culpable individuals, but to point out that these policies did not work and to some extent the individuals involved were place-holders, produced by the institutional interests abetted by a vapid academic economics and willing political functionaries.

The markets are behaving as if there is a recovery, but they are also behaving as if there is immense liquidity looking for a home and competing with desperate investors slash savers. We are in the midst of witnessing yet another example of the ineffectiveness of monetary policy.

But also the absence of a comprehensive coherent explanation of what went wrong and how to fix it. Maybe it makes emotional sense to attack and defend, but ... Well, in as few words as possible, and borrowing from Gary Dymski and Robert Pollin, an economy not positioned at full employment can be brought there through several possible channels.

Relying exclusively on the market mechanism, Market Fundamentalism suggest the existing unemployment will generate declines in wages which will lead firms to both lower prices and hire more workers. The increases in employment and lower prices will then promote increases in aggregate demand.

Seeing the sad inadequacy of this excuse for economics, interventionist approaches can take the form monetary interventions to lower interest rates, leading firms to borrow more for investment and beginning the upward recovery segment of the business cycle. Therefore we have zero interest rates and all manner of so-called quantitative easing. To no apparent effect on investment or demand

or intervention can take the form of fiscal stimulus, spurring aggregate demand directly. This is being tried right now, to some effect. This is, in fact, what we at Demand Side proposed a couple of years ago, believing that demand would then instigate investment. And it is what Christina Romer advocated in the speech we highlighted on last week's podcast.

But two years older and wiser and having dipped our toes in the analysis of Hyman Minsky, Demand Side today does not believe fiscal stimulus and deficit spending will lead to anything more than the current stagnation.

These schemes depend on the consensus analysis that at their base markets are efficient and stable. And absent from them is an appreciation of financial relations.

This is not lacking in the analysis of Hyman Minsky, what might be called post-Keynesian analysis, although I'm not sure that's what he would call it. The more we look into it, the more we are convinced that this line of reasoning and investigation is the direct lineage of John Maynard Keynes.

Minsky identified the financial structures as key to the surge and ebb of market capitalism. Hedge, speculative and Ponzi financing. The first is what we normally think of a company doing, borrowing in a form that will be paid back with the expected cash flow from the investment that is being financed. The second -- speculative financing -- is very common. Most companies have a web of financial structures for their operations, many of them short-term, with the expectation of rolling over the debt as it comes due. You can imagine the turmoil that might occur if interest rates spiked or roll-over financing suddenly dried up. The third -- Ponzi financing -- abandons pretense of using cash flows from the investment either directly or in steps, and stakes its hopes on appreciation of the asset value. Bubbles are made of this. The current meltdown is probably the world's largest known version.

"Identifying which category any firm falls into provides a measure of its individual financial fragility; classifying all firms in an economy according to these categories provides a means of assessing the level of economywide financial fragility at any point in time. Clearly, fragility is heightened when the proportion of speculativve and Ponzi units is high. Both speculative and Ponzi units have an inelastic demand for borrowed funds, and rely on the money market to maintain solvency. These units' economic viability is thus threatened by rising interest rates. ... The alternative path for such firms to raise funds is to draw down liquid reserves or sell other assets. But when assets are sold concurrently by many firms ... the price of the assets sold falls as well. In addition, speculative units selling their income-generating assets could transform themselves into Ponzi units.

In short, the higher the proportion of speculative and Ponzi financial units, the greater the fragility of the economy. Fragility in the Minskian sense has two components. First, the economy becomes less capable of absorbing shocks, so shocks are more likely to induce a financial crisis and incipient debt deflation. But in addition, the degree of borrowers' and lenders' risk also rises, and this should inhibit the growth of debt-financed invesment activity."

Now to be clear about two terms we let drop. Borrowers' risk arises to the extent that purchasers of capital assets must debt-finance their investment projects and hence increase their exposure to default risk, the chance a return on investment will be below tghe expected return. Lenders' risk arises from moral hazard and uncertainty. Minsky uses these to get at the price of assets.

And now to our own learning curve. Demand Side is based on hedge financing of investments that produce, at least on average, a net gain. It is from the prospect of profit, which is based on the strength of demand, that businesses invest. From this angle, it is the enormous leverage and overhanging debt produced by the unregulated boom that kills the economy by killing demand. In Minsky's finance-centric view, it is the financial crisis that kills the economy unless the government is willing and able to bail out the banks.

But it seems to us that profit, sound finance and growth all depend on productive investment, which itself is a producer of demand and jobs. And this investment does not exist only in the private sphere. In fact, we question whether the technological advancement so favored by private investors is really so productive. Smart phones replace regular cell phones and in one fell swoop Apple booms and the laggard technologies bust. Huge investment. But productive.

Shumpeter's creative destruction, in one view, can be the replacement of one adequate technology by another more adequate technology at the same time people are starving in Africa and struggling in Latin America. Technology needs not only new ideas, but a customer base.

The simplest example of productive investment is a tool which improves the productivity of labor. The cash flow from increased output pays off the financing of the tool. It is fairly simple to see infrastructure, education and health care in these terms, but what about the favored investments of the private sector? What about technological gadgets and housing?

Housing is not an asset which produces a positive cash flow. Its value is appropriately the rental value. In earlier times the purchase of a house was actually less than the comparable rent, reflecting the financial commitment of the homeowner. Subsequently it became much greater, entirely as a result of the anticipated capital gain. This financial asset aspect of housing is what spawned a nation of Ponzi investors.

At Demand Side we are fond of straying far ahead of the popular debate. And you will not find too many others, though they do exist, who advocate such broad public investment as we do. We have some roots, however. In John Maynard Keynes General Theory, 1936, page 378, you will find.


"A somewhat comprehensive socialization of investment will provide the only means of securiing an approximation of full employment."


Elsewhere, we notice the NBER

Business Cycle Dating Committee statement:
The Business Cycle Dating Committee of the National Bureau of Economic Research met at the organization’s headquarters in Cambridge, Massachusetts, on April 8, 2010. The committee reviewed the most recent data for all indicators relevant to the determination of a possible date of the trough in economic activity marking the end of the recession that began in December 2007. The trough date would identify the end of contraction and the beginning of expansion. Although most indicators have turned up, the committee decided that the determination of the trough date on the basis of current data would be premature. Many indicators are quite preliminary at this time and will be revised in coming months. The committee acts only on the basis of actual indicators and does not rely on forecasts in making its determination of the dates of peaks and troughs in economic activity. The committee did review data relating to the date of the peak, previously determined to have occurred in December 2007, marking the onset of the recent recession. The committee reaffirmed that peak date.
NBER always waits some time before declaring a recession over.

It took the National Bureau of Economic Research (NBER) Business Cycle Dating Committee over a year and half after the 2001 recession ended to call the trough of the cycle. And it took 21 months after the 1990-1991 recession ended for NBER to date the end of the recession.

The previous NBER announcements make it clear that NBER will not date the trough of the recession until certain economic indicators - like real GDP - are above the pre-recession levels. Any downturn before economic activity reaches pre-recession levels will probably be considered a continuation of the recession that started in December 2007.

All of which recalls our suggestion that the question of whether the economy is in recovery has yet to be decided and will be decided by what happens in the future, not the past. Our second suggestion is that the business cycle is broken. Sitinig a trough absent a strong improvement in investment is meaningless.


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