Post by LWPD on Sept 13, 2011 18:11:52 GMT -5
Below is a good article/interview by Bill Gross (Founder of PIMCO) explaining why the policies of the Federal Reserve have successfully lowered the cost of capital, at the price of stifling the creation of credit. In this tradeoff, borrowing costs have been made artificially low, but the profit incentives for financial institutions to lend and leverage risk has deteriorated. This has a negative effect on the real economy.
Courtesy of Financial Times
‘Helicopter Ben’ risks destroying credit creation
By Bill Gross
“Helicopter Ben” Bernanke is a second-generation pilot. As he himself acknowledged in his now well-known 2002 speech, the term was an original of economist Milton Friedman.
Whether father or child, the concept of showering money over national economies to combat deflation has been an accepted principle of monetarism for decades. A helicopter, however, is not your average aeroplane, and the usual laws of aerodynamics do not necessarily apply in all cases. Similarly monetary policy at the zero interest rate bound introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.
This potential paradox arises not just from observation of the Japanese experience over nearly two decades, but from an analysis of our modern-day financial system and its potential inadequacies. Fractional reserve banking, where only a portion of bank deposits are backed by hard cash, as well as unreserved collateral-based lending on overnight repo have allowed for an expansion of credit beyond the bounds of a central banker’s imagination.
Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance. Renowned economist Hyman Minsky explained that this was one of the inherent flaws of the Keynesian neo-classical synthesis. Borrowers wanted lengthy loans to match the practical lives of their plant and equipment, but lenders were disposed towards shorter maturities because of the resultant financial volatility. Over a secular timeframe, a grand compromise was struck somewhere between seven and eight years in terms of nations’ typical average maturity, but lenders demanded an additional feature – a positive yield curve with a substantially lower policy rate that would allow “rolldown” and incremental yield – especially if levered. Thousands of billions of dollars of credit were extended on this basis, some of it as short as a one-week or one-month maturity extension, but all of it – almost everywhere, nearly all of the time – on the basis of a positive yield curve encompassing potential rolldown and incremental returns.
However, in recent weeks, at least in the United States and perhaps soon elsewhere in the Fed dominated global monetary system, the rules have changed. Pilot Bernanke has changed planes from a fixed wing to a rotor-based helicopter by “conditionally” freezing policy rates for at least the next two years. As such the front end of the curve has for all intents and purposes become inert and worst of all flat as opposed to steeply positive. Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on. A bank can no longer borrow short and lend two years longer at a profit.
Common-sensically, an observer might simply suggest that the bank lend even longer with similar risk as before the conditional freeze, but regulators frown on these maturity extensions and discourage them either explicitly via regulations or implicitly via moral suasion.
The conundrum is not limited to leveraged lending institutions. Even investment firms such as Pimco have client guidelines in many cases that impose maturity caps. Short maturity accounts, for instance, might logically benefit by purchasing three- or four-year maturities at presumably similar historical risk as two-year notes, but prospectuses, and slow to change committee structures forbid the maturity extension. The net result, for both banks and investment firms is to reduce financial system leverage. This should be positive on a long-term basis, but negative in the near-term as credit is in effect destroyed as opposed to created.
By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming operation twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.
The Fed’s old M3 yardstick of credit growth which includes repo monetisation would likely similarly decline. If so the posit of American economist Hyman Minsky of an unstable financial system based on the leveraging of a positively sloped yield curve – and deleveraging when it was not – would be obvious for all to see. Helicopter Ben should be careful – another Blackhawk Down might be in our near-term future.
Courtesy of Financial Times
‘Helicopter Ben’ risks destroying credit creation
By Bill Gross
“Helicopter Ben” Bernanke is a second-generation pilot. As he himself acknowledged in his now well-known 2002 speech, the term was an original of economist Milton Friedman.
Whether father or child, the concept of showering money over national economies to combat deflation has been an accepted principle of monetarism for decades. A helicopter, however, is not your average aeroplane, and the usual laws of aerodynamics do not necessarily apply in all cases. Similarly monetary policy at the zero interest rate bound introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.
This potential paradox arises not just from observation of the Japanese experience over nearly two decades, but from an analysis of our modern-day financial system and its potential inadequacies. Fractional reserve banking, where only a portion of bank deposits are backed by hard cash, as well as unreserved collateral-based lending on overnight repo have allowed for an expansion of credit beyond the bounds of a central banker’s imagination.
Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance. Renowned economist Hyman Minsky explained that this was one of the inherent flaws of the Keynesian neo-classical synthesis. Borrowers wanted lengthy loans to match the practical lives of their plant and equipment, but lenders were disposed towards shorter maturities because of the resultant financial volatility. Over a secular timeframe, a grand compromise was struck somewhere between seven and eight years in terms of nations’ typical average maturity, but lenders demanded an additional feature – a positive yield curve with a substantially lower policy rate that would allow “rolldown” and incremental yield – especially if levered. Thousands of billions of dollars of credit were extended on this basis, some of it as short as a one-week or one-month maturity extension, but all of it – almost everywhere, nearly all of the time – on the basis of a positive yield curve encompassing potential rolldown and incremental returns.
However, in recent weeks, at least in the United States and perhaps soon elsewhere in the Fed dominated global monetary system, the rules have changed. Pilot Bernanke has changed planes from a fixed wing to a rotor-based helicopter by “conditionally” freezing policy rates for at least the next two years. As such the front end of the curve has for all intents and purposes become inert and worst of all flat as opposed to steeply positive. Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on. A bank can no longer borrow short and lend two years longer at a profit.
Common-sensically, an observer might simply suggest that the bank lend even longer with similar risk as before the conditional freeze, but regulators frown on these maturity extensions and discourage them either explicitly via regulations or implicitly via moral suasion.
The conundrum is not limited to leveraged lending institutions. Even investment firms such as Pimco have client guidelines in many cases that impose maturity caps. Short maturity accounts, for instance, might logically benefit by purchasing three- or four-year maturities at presumably similar historical risk as two-year notes, but prospectuses, and slow to change committee structures forbid the maturity extension. The net result, for both banks and investment firms is to reduce financial system leverage. This should be positive on a long-term basis, but negative in the near-term as credit is in effect destroyed as opposed to created.
By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming operation twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.
The Fed’s old M3 yardstick of credit growth which includes repo monetisation would likely similarly decline. If so the posit of American economist Hyman Minsky of an unstable financial system based on the leveraging of a positively sloped yield curve – and deleveraging when it was not – would be obvious for all to see. Helicopter Ben should be careful – another Blackhawk Down might be in our near-term future.
