Wil Bernanke Policy "Destroy Credit Creation"? Bill Gross is Worried It Will--The Role of Financial Innovation

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years.  The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates.  Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation.  Gross, in his Financial Times article (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6), argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs. 

The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis.  First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates.  The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin.  To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets.  Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit.   Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage.  And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets. 

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”.  In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation.  Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive.  Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”.  (See a review of Tilman’s book “Financial Darwinism” at http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high.  Thus, the banks worked with nice interest margins that were relatively stable and reliable. 

Liability management came into pay through the financial innovation of the 1960s.  Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources.  Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate. 

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations.  Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.” (See http://seekingalpha.com/article/289579-let-s-move-on-from-keynes-and-accept-the-new-liquidity.)

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent.  Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation?  Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices.  “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time.  “Flow” prices are to be differentiated from “asset” prices. 

“Flow” prices are in many ways “constructed” prices.  For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset.  The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”.  In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated.  And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services).  In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind. 

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy.  And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy. 

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place.  One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation. 

Two Ponts about Debt and the Economic Recovery

The Internet, print journalism, and the broadcast media contain story after story about the debt problems in the world. A wider audience just learned this week a new acronym: PIGS, or PIIGS if you will. This, we all know now, stands for Portugal, Ireland, Greece, and Spain, or, some include Italy.

The problem is debt!

The solution? Well, we don’t quite know that yet.

How did the problem arise? In my mind, the problem has arisen because of the attitude that has prevailed in the world over the last fifty years or so relative to how governments should conduct their fiscal affairs.

Beginning in the 1960s we saw more and more governments turn to budget policies that could stimulate employment and economic activity through the creation of spending that would add to the aggregate demand in their countries. These policies began with the argument that budget deficits should be produced only when the economy was below full employment. But, governments found these policies so attractive in terms of attempting to get re-elected that budget deficits were produced whether or not the economies of their countries were running below full employment.

This attitude created an environment of credit inflation, as well as price inflation, that did three things. First, it caused economic units to focus on finance and financial engineering. Second, it resulted in structural unemployment as many, many people were hired or re-hired back into “legacy” jobs and not the jobs of the future. This hurt lower income and less educated people the most. (See Bob Herbert’s column in the New York Times: http://www.nytimes.com/2010/02/09/opinion/09herbert.html.) Third, it ended up transferring a lot of the wealth of the country offshore to China, the Middle East, and other places.

There are two points I would like to make about all this credit creation and the piling up of debt.
The first point is that, ultimately, those people, companies, and nations that have little or no debt WIN over those that issue lots and lots of debt.

The situation is similar to that historically called “the Phillips Curve.” The Phillips Curve captured the tradeoff between unemployment and inflation and the economists that developed this tool used it to show how, for a little bit of inflation, a government could buy a lower amount of unemployment.

Milton Friedman destroyed their case by arguing that the Phillips Curve was dependent upon a given assumption about inflationary expectations. He showed that the tradeoff between inflation and unemployment remained stable only if inflationary expectations remained the same.

However, even if people are fooled in the short run, the presence of higher inflation than they expected would eventually lead to an increase in inflationary expectations. Thus, to get the same decline in unemployment the government would have to create a higher level of inflation. The tradeoff resulting in constantly rising inflation, which is what the United States observed through the 1960s and 1970s.

The same type of situation exists for the creation of debt. A company or a nation can benefit from the creation of “more leverage” or more deficit spending. However, as more and more credit is created, people, companies, or nations must issue more and more debt to keep retain or even increase the benefits of their debt creation relative to others. Credit inflation, once started, is self-feeding!

Of course, when the credit bubble bursts, as it did for the world in 2007 and 2008, all the debt built up becomes a huge burden, especially if economies dip into a period of price deflation. The solution to a situation like this? Well, one solution is inflation: make the real value of the debt burden less and less.

Again, the problem is that each cycle of re-flation tends to be greater than those of the past. But, this is the easy way out. Re-flation was the intellectual model that came out of the 1930s and, in its various forms, was incorporated by government’s worldwide beginning in the 1960s.

The problem is that re-flations ultimately never work, because the deeper and deeper people, companies, and nations get into debt, the more and more of them attempt to deleverage. If governments’ don’t want deleveraging to happen then they continue to re-flate. The cumulative effect of this is hyperinflation, and those countries that hyper inflate don’t win. The 20th century has many examples of the consequences of hyper inflation, the German case in the 1920s being the most pronounced.

But, before fully finishing this strand of thought, let me introduce my second point and it has to do with the effects of deleveraging. If the private sector realizes that it is over extended, debt-wise, then it will attempt to pay off debt or at least reduce its debt burden sufficiently so that it can operate once again. But, if economic units in the private sector begin to save more or sell assets in order to pay off debt, aggregate spending declines and this slows down or prevents an economy recovery from taking place.

John Maynard Keynes identified this “fallacy of composition” in the 1930s and labeled it “the Paradox of Thrift.” That is, while it is all well and good for individuals to increase their savings and pay off their debts, the very act of withdrawing spending from the economy reduces aggregate demand and the output of goods and services. So, even though it is good for people to save and pay off debt, individually, it is bad for the economy and everyone becomes worse off because of this prudent behavior.

The thing is, when they get badly burned, lose their homes, lose their jobs, and lose their wealth, people and businesses do “pull back”. And, their standards change. This, to me, is one reason why the stimulus policies of the 1930s were not very effective. They could not overcome the desire of people and businesses to restructure their balance sheets. People had to re-group. One sees the consequences of this in the 1950s: people and businesses were very, very conservative then in the way that they spent and managed their money. The near-term experience that dominated their thinking was the depression years of the 1930s. And, in many ways, this continued into the 1960s for the older generations.

So who benefits during the time that follows the bursting of the credit bubble? Those without a lot of debt!

To me, the creation of debt eventually impacted the world in two ways. First, during the last 50 years or so, many resources were diverted into financial engineering. Even companies that were primarily in manufacturing gave more and more attention to financial engineering. This distracted these companies from what should have been their main focus: manufacturing goods and industrial innovation. The emphasis on financial engineering changed the whole society and many of the best and brightest young people opted out of careers in engineering and applied science and went into the finance industry. Employment in financial firms grew dramatically relative to employment in manufacturing and production.

The second way the world was impacted is through the redistribution of wealth in the world. Massive amounts of wealth have been transferred over the past 20 to 30 years out of the West and into the Far East, the Middle East and Brazil. Who did American companies turn to in the financial crisis for capital? Who is Europe and America now turning for help? Where are we learning about this transfer? See the morning papers for starters: “China Lists $9.6 Billion in Shares of U. S. Companies”: http://www.nytimes.com/2010/02/09/business/global/09invest.html?ref=business.

This is not a winning strategy for those countries, businesses, and people who took on a lot of debt!