Home > Uncategorized > Central banking: Edward Harris on why raising interest rates in an overleveraged economy is very risky

Central banking: Edward Harris on why raising interest rates in an overleveraged economy is very risky

Even more about central banking. Why so much? Partly because people are writing very good stuff about it (like the AAA piece from Edward Harris below (excerpt)). Partly because we seem to see the end of the era of ‘pure’ inflation targeting. And (part of this last trend?) partly because soon Merkel and Macron will sit together to redesign the Eurosystem. Previous posts: ideas of Willem Buiter, Richard Werner, Thomas Mayer excerpts from a recent paper by Mike Konczal and Josh Mason and ideas from the German Handelsblatt shadow council.

As the Federal Reserve meets today [last week: M.K.] to decide how to communicate its messaging on future rate hikes and balance sheet reduction, financial stability will play a key role. Yesterday, I wrote about the Bank of International Settlements new warnings on financial stability. And just this morning, I read a piece from Goldman Sachs Asset Management EMEA division head Andrew Wilson, warning that the risk of overheating was real. So let’s put some framing around this issue and ask how the Fed reacts as the data come in down the line.

In the past decade on Credit Writedowns, I have had a lot of good commentary from different writers on financial stability. And most of it is based around Hyman Minsky’s Financial Instability Hypothesis. As someone who used to work in debt capital markets and do financial models for private equity investing and corporate finance for mergers and acquisition, I find the Minsky analysis a huge benefit in thinking about the macroeconomy that standard macro modelling techniques don’t incorporate. So I want to use this as the prism through which to look at the Fed’s reaction function to predict future yield curve flattening and the resulting economic impact.

Long cycles end with higher risk

First, here’s what Minsky’s hypothesis is all about. Let’s use excerpts from Randall Wray’s 2012 piece to make the case here. You can read the full piece here. And I will summarize in layman’s terms afterwards; but here’s what I want you to take away with my own highlights added in bold:

In his publications in the 1950s through the mid 1960s, Minsky gradually developed his analysis of the cycles. First, he argued that institutions, and in particular financial institutions, matter. This was a reaction against the growing dominance of a particular version of Keynesian economics best represented in the ISLM model. Although Minsky had studied with Alvin Hansen at Harvard, he preferred the institutional detail of Henry Simons at Chicago. The overly simplistic approach to macroeconomics buried finance behind the LM curve; further, because the ISLM analysis only concerned the unique point of equilibrium, it could say nothing about the dynamics of a real world economy. For these reasons, Minsky was more interested in the multiplier-accelerator model that allowed for the possibility of explosive growth…

…he examined financial innovation, arguing that normal profit seeking by financial institutions continually subverted attempts by the authorities to constrain money supply growth. This is one of the main reasons why he rejected the LM curve’s presumption of a fixed money supply. Indeed, central bank restraint would induce innovations to ensure that it could never follow a growth rate rule, such as that propagated for decades by Milton Friedman. These innovations would also stretch liquidity in ways that would make the system more vulnerable to disruption. If the central bank intervened as lender of last resort, it would validate the innovation, ensuring it would persist… profit-seeking innovations would gradually render the institutional constraints less binding. Financial crises would become more frequent and more severe, testing the ability of the authorities to prevent “it” from happening again. The apparent stability would promote instability.

With his 1975 book, …Minsky distinguishes between a price system for current output and one for asset prices. Current output prices can be taken as determined by “cost plus mark-up”, set at a level that will generate profits…

There is a second price system, that for assets that can be held through time; except for money (the most liquid asset), these assets are expected to generate a stream of income and possibly capital gains…The important point is that the prospective income stream cannot be known with certainty, thus is subject to subjective expectations…. Minsky argued that the amount one is willing to pay depends on the amount of external finance required—greater borrowing exposes the buyer to higher risk of insolvency. This is why “borrower’s risk” must also be incorporated into demand prices.

Investment can proceed only if the demand price exceeds supply price of capital assets. Because these prices include margins of safety, they are affected by expectations concerning unknowable outcomes. In a recovery from a severe downturn, margins are large as expectations are muted; over time, if an expansion exceeds pessimistic projections these margins prove to be larger than necessary. Thus, margins will be reduced to the degree that projects are generally successful. Here we can insert Minsky’s famous distinction among financing profiles: hedge (prospective income flows cover interest and principle); speculative (near-term income flows will cover only interest); and Ponzi (near-term receipts are insufficient to cover interest payments so that debt increases). Over the course of an expansion, these financial stances evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions.

Translation: Institutions matter. You can’t look at an economy without considering the structure of its financial arrangements because – contrary to the thinking that an economy is always in or trying to get back to some equilibrium – it’s really a messy world out there. Once you look at financial institutions in particular, you see that they are important in that they use debt and credit to bolster current output, sometimes by very large amounts.

But we also have to realize that their ‘price system’ is inherently more unstable and uncertain than the “cost plus mark-up” system of current output. And this, by definition, creates an inherent instability. How? The longer a cycle goes on, the more leveraged financiers feel cheated, as if they are constantly leaving money on the table; the margin for error they incorporate into their debt models simply proves time and again too large. And so they reduce that margin for error in order to reduce the money they leave on the table for debt investors.

Let me put this in corporate finance terms: as the cycle lengthens, projected levels of enterprise value to earnings before interest, tax, depreciation and amortization [EBITDA] increase, and so too do debt to EBITDA calculations, which serve as the margins for error in leveraged financial models. Right now, private equity firms are paying 10.7x earnings [EBITDA] for middle market companies. In my day as a leveraged finance associate 20 years ago, if that number was half as big it would have been considered high. So that gives you a perspective.

Now let’s remember that what makes this the most dangerous point in the cycle is that, as the margin for error is decreasing, monetary policy is tightening, increasing downside risk. Investors with 3-5 year investment exit time horizons are hoping that the cycle lasts through at least 2020 or 2022 because if they are caught in an investment for which they paid almost 11 times earnings when the cycle comes to an end, the losses will be enormous.

In the wider economy, the IMF has noted that more and more companies in the US are so-called “Zombies”, where interest coverage ratios are low. The Bank for International Settlements estimates that the zombie share of firms has doubled to 10% of US companies, with a combined market capitalization of $2.3 trillion 

  1. Craig
    December 17, 2017 at 8:55 pm

    Speculative finance must be controlled as to leveraged amount allowed and its purpose.
    Finance needs to get over it. It has always been the problematic business model so the new final monetary authority must and will control it by keeping it ethical and sane.

  2. December 17, 2017 at 9:07 pm

    Given what you have written here, and Minsky’s work, what do you make out of Janet Yellen’s “no financial crises in our lifetime?”

    I’ve already expressed my skepticism in response to Dean Baker’s upbeat post about a week ago, and in fact, this August I had the same feeling about the run-up in US asset prices and the stock market I did in the late 1990’s and then again, early 2007: something, many things, seem too good to be true and so I had a look and Case-Schiller – since no one seemed to be talking about that – and it’s high, one of the three highest in its long history. Another reason for my August bout of searching for the fault lines was that to me, the underlying economy – income distribution and labor’ share of the pie wouldn’t lead one to believe the run up was sustainable…but we do have to factor in Trump expectations, the tax cut…that could keep things on the unsustainable path for how much longer…a year…three?

    Thanks.

  3. December 17, 2017 at 9:31 pm

    But Minsky also said the effective money supply in an economy like ours is fiscal deficits plus the change in debt which is credit. This is why CB’s must monetize fiscal deficits when private credit is collapsing and why fiscal authorities should always run deficits during depressions. In a depression/deep recession, credit stalls and so the money supply actually shrinks. This is why prices contract (deflation) and why government must print to balance the disappearance of credit demand for goods and services without fear of causing inflation. This is what Minsky taught and it is the aspect of Minsky most widely ignored by mainstream economists. Steve Keen posts a Minsky quote where he explicitly states credit is part of the money supply. I guess this is the part Krugman says is not like any economics he understands, loanable funds and all that.

  4. Risk Analyst
    December 18, 2017 at 10:07 pm

    Harris describes a framework awarded high credibility from the last financial crisis, but then comes to the wrong conclusion from it. The Fed has as its instruments the ability to set very short term interest rates and imperfectly influence longer term rates. What should the Fed do with that in the face of low unemployment, increasing leverage, unsustainably increasing asset price markets, and rising financial instability concerns within the context of a very large and analytically opaque fiscal stimulus entering the equation. The theme for Harris seems to be to do nothing out of fear of short term consequences. But in Minsky’s framework, shouldn’t we attempt to deal with rising risk as it happens rather than layering on another year of manufactured financial stability from the Fed? Do we need to wait until we are in the Ponzi finance part of the cycle until we act? I don’t think so. I believe Harris has the correct framework but comes to the wrong conclusion.

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