If Stability Breeds Instability, What Does Instability Breed?

May 19, 2010

Okay, so all the financial engineering of the past 20 years didn’t add much to our stock of wealth did it? True, it was part of GDP and inflated many incomes in the financial sector But in the role that many, including Fed Chairman Greenspan, saw for it, that of spreading risk and creating greater financial and economic stability, it failed. It aided and abetted the creation of a huge bubble, than aggravated the pain of the inevitable bust.

Hyman Minsky, whose thesis was that long periods of economic stability would lead to instability created by the financial system was right and Greenspan was wrong. We now know that. But we’re not sure what the instability is leading us toward.

The knee jerk response is that it will create a lengthy period of risk aversion. The way the stock market has soared back, and bond spreads have calmed down seems to belie that. But the raised lending standards of banks, the relative absence of financially-motivated equity buyouts, low venture capital fund activity, and the avoidance of equity mutual funds by the investing public support the actuality of increased risk aversion in financial markets.

One novel and optimistic viewpoint revolves around the thought that we had a glimpse of what a depression looks like, and through prompt governmental reactions were able to avoid it. According to this view, this success in preventing economic disaster should minimize the lurking worry about economic depression that has hung over the markets since 1932. This view notes that during the 1950’s and 1960’s, as we conquered every recession, the valuation level of equity assets rose. Perhaps that will happen again, they say.

The fear of depression died gradually and only by the late 1960’s was it no longer significant. Then inflationary fears took over in the 1970’s and were conquered only slowly with some very big medicine. There followed the so-called Goldilocks economy…not too hot, not too cold, just right. The tech boom came along and became a bubble. But we overcame the dot.com bust that followed, then created the mother of all modern bubbles, in real estate. It was fed by easy credit, relaxed lending standards, and financial engineering that created securitization (which created anonymity between borrowers and lenders), CDO’s, CMO’s, and credit default swaps The latter became a huge side-bet market, similar to the side bets that are prevalent in a noisy game of craps. Just as you didn’t have to be the person rolling the dice to play, you didn’t have to own the bonds to bet for or against their default.

Then…Kazam!!…subprime mortgages became a problem and a possible depression was in front of us. Hey! Wow! Good reaction time team! Stimulus packages, easy money, many pieces of special legislation, prevent big failures……and to hell with the cost. Now that we know how to run that play let’s go on to the really big game!

Translated: Now that we have proved that we know how to conquer inflation and prevent depression the world is our oyster! Spend! Borrow and spend! Buy stocks! Speculate! Have some financial fun!

I don’t think this will happen, nor do I think it is a credible view. It lacks any reference to the continuing high cost of what we have done to avoid depression, namely our soaring debt with no plan to bring it under control. Financial markets are of true global scope, and with our federal debt increasingly held by foreigners, these markets will force the creation and execution of such a plan. We have just witnessed in Europe what financial markets can force politicians to do. Our politicians are not immune. Even California may be forced to do something! It’s enough to dampen the most optimistic scenarios.

Yes, ladies and gentlemen, significantly higher taxes are in your future. At every level, from local to federal. And they will be accompanied by inter-generational and ideological squabbles as we start to grapple with the unavoidable problems of entitlements. If you have been chagrined by the high degree of political and ideological turmoil in recent years, you ain’t seen nothin’ yet! All the while the baby boomers will be retiring, putting increased burdens on the younger population. (Europe’s demographics are much worse than ours, and Japan is out of sight.)

Just what kind of taxes will be imposed, while not irrelevant, is not our major concern, which is the increased tax load in general and its effect on growth. (My personal preference is a sizeable value added tax because it’s not subject to avoidance, is very efficiently collectible, and can be well-tailored to protect the most vulnerable populations.)

It’s not going to be a lot of fun. We will be seeing first-hand and in real time the conclusions of Professors Rogoff and Reinhart in their book, This Time is Different, to wit: countries that have debt to GDP ratios of 100% experience a reduction of their annual economic growth of about one percentage point. Yep. That’s where we will be very shortly, and that’s what is happening, even as I write this

By year-end 2010 we will be urgently seeking sustainable growth forces to take command of the economy. The effects of stimulus actions will be gone. Unemployment will still be high ………. and we have to raise taxes at all levels of government. Lousy timing.

Back to what it is that instability breeds, we can now see the true cost of avoiding financial collapse and depression. If the long-term trend growth of the developed world is 3%, and we may be pushing that by at least 0.5%, we have probably knocked off as much as full percentage point for some years to come. That’s big time stuff. As is the political infighting that comes from a combination of high unemployment and a lack of fiscal capacity to do anything about it.

Another outcome of instability is increased regulation. Our wonderful congress is very busy trying to fix the blame for letting the horses out of the barn before they do anything about closing the door. My personal view is that much needs to be done in securing better and more effective regulation of financial institutions. Banks should be prohibited from proprietary trading. Derivatives need to be standardized, derivatives trading should be on an exchange with the parties remaining anonymous to each other, hedge funds must be registered and forced to be transparent, credit and debit cards must be at reasonable cost, and we must have a super regulator whose job it is to continuously assess systemic risks.

A final thought on inflation and interest rates: this morning the core inflation rate was reported as zero, which means the Fed can keep interest rates low for some time to come. In my opinion, inflation is likely to remain dormant for a considerable period ahead. In fact, I believe that the so-called bond market vigilantes are a bigger threat to the bond market than inflation and Federal Reserve action. Europe is currently getting a taste of this, and unless we get our act together to reduce deficits we will too. Time is running out.

To summarize: the aftermath of instability will be that risk aversion will subside slowly, taxes will rise significantly, political turmoil will increase, and the intermediate-term economic growth rate will be frustratingly low. Not a confidence inspiring environment. Nor one in which returns to shareholders are likely to be high.