Revisting Financial Arbitrage Capitalism

I’ll admit to occasionally being annoyed by the clan over at Pimco. Clearly, there’s more than a little envy at work here. They are extremely smart, master market operators and skilled theoreticians. Those guys are really good at articulating the financial issue de jour, as well as backing it up with some reasonable-sounding solutions. But do they somehow not appreciate that they are part of the problem?

Pimco is – here we go again - the most vocal Wall Street proponent for strong reflationary policy measures and government interventions to battle so-called “deflation” risk. Back in 2002, they were the head cheerleader for reflationary measures that historians will surely view as a Monetary Policy Blunder for the Ages. Then, the deflation threat was said to reside with downside risk to the general price level; today it’s with sinking home prices. Overwhelming force is again prescribed to fight the latest symptoms, while sidestepping diagnosis of the underlying ailment.

Furthermore, as someone who incorporates Minskian analysis deep into my analytical framework, I view their (and others’) application of Minsky’s work as largely superficial - and rather self-serving at that. For one, the often referred Minskian concept of “stability is destabilizing” simply hasn’t been relevant to the U.S. Credit system in several decades. More importantly, implementing the Keynesian/Minskian policy toolkit to perpetuate Bubbles and existing malignant structures and processes – in contrast to instruments that would help buttress the system through arduous post-Bubble adjustment periods – has been a momentous analytical and policymaking failure over recent years.

I believe strongly that if Hyman Minsky were alive today he would see the huge investment fund managers, the hedge fund community, and Wall Street firms as the fundamental force behind today’s Acute Financial and Economic Fragility. He would surely see the current financial order as dysfunctional and unsustainable. And I am quite confident he would view the current trajectory of financial system and policy development as laying the groundwork for the next crash and depression.

Back in late-2001, I titled a Bulletin “Financial Arbitrage Capitalism.” I coined this term in what I referred to at the time as “updating” Minsky’s stages of financial Capitalism. Minsky theorized that a troubling stage of “Money Manager Capitalism” had evolved from the earlier manifestations of Manager Capitalism, Financial Capitalism, and Commercial Capitalism.

Minksy on “Money Manager Capitalism:” “The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits… As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question…

“In the present stage of development the financiers are not acting as the ephors of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today’s managers of money are but little concerned with the development of the capital asset of an economy. Today’s narrowly-focused financiers do not conform to Schumpeter’s vision of bankers as the ephors of capitalism who assure that finance serves progress. Today’s financial structure is more akin to Keynes’ characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde.” (Minsky, 1993)

I am even more convinced today than some six years ago that a whole new financial structure has evolved – and that it is definitely “retrograde.” The title “Financial Arbitrage Capitalism” is fitting for a Credit system and economy now dominated by an expansive “leveraged speculating community” seeking profits from variations and permutations of “borrowing cheap and lending dear”; by bond and investment fund managers whose entire focus is beating some indexed return; by rapidly expanding Wall Street balance sheets and influence; and by the entire wave of new Credit instruments, derivatives, and sophisticated models and strategies used for the paramount purpose of capturing “above-market” returns and resulting huge financial rewards.

The current system has experienced a broad transformation to a Credit mechanism dominated by market-based instruments, in contrast to the traditional predominant position held by the banking system all the way through Minsky’s “Money Manager” era. Today, the financial apparatus is “beholden” – not to a coherent banking system but instead - to an ambiguous thing called “marketplace liquidity” and the unwavering confidence such a mechanism requires. Importantly, momentous changes to the prevailing incentive system are also consistent with designating a new phase of Minskian Capitalism. Late in Minsky’s life, he expounded upon the role rising stock and corporate debt prices were playing in dictating various behaviors in the Credit system, markets and real economy. With “Financial Arbitrage Capitalism,” the bounty of seemingly limitless (until recently) speculative profits has created a reward system encouraging unprecedented debt creation, leveraging, and myriad forms and layers of financial intermediation.

I have labeled this current stage with the Minsky term “retrograde” specifically because only through the expansion of all facets of this Credit Bubble – debt creation, leveraging, and risk intermediation – will adequate new “profits” and debt service capacities validate and sustain the ever-increasing layers of debt and financial “arbitrage.” Minsky noted a fundamental weakness of Money Manager Capitalism: “Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits.” Financial Arbitrage Capitalism takes these defects to an entirely new level. Today, the major financial incentives dictating behavior are largely disengaged from the process of “capital development” and, furthermore, operate completely divorced from real economic profits overall. Or, more simply stated, current rewards spur the over-expansion of non-productive Credit – specifically debt instruments not supported by underlying wealth-creating assets (think subprime and high-yielding mortgages generally).

Mortgage Credit is the bedrock of “Financial Arbitrage Capitalism.” The Mortgage Finance Bubble provided – and continues offering to this day - the greatest bounty of speculative profits the financial world has known. It comes as no surprise that Pimco and Wall Street are these days fixated on home values and the pricing of mortgage-backed and mortgage-related securities and derivatives. That Trillions of real and financial resources were so badly misallocated through the Mortgage Finance Bubble years will definitely not dissuade the argument that Trillions more will be necessary to avert the scourge of “deflation”. Apparently, the more egregious the misallocation and resulting impairment to the Financial and Economic Structures the more imperative it is to throw more non-productive Credit Inflation at the problem – the mandatory fight to avert “deflation”.

For some time now, it has been my view that “Financial Arbitrage Capitalism” was sowing the seeds of its own destruction. The incentive structures were so deeply flawed; the analyses of the inner workings of this system were critically flawed; and policymaking was devastatingly flawed. The combination of rampant non-productive Credit growth, unprecedented system leveraging and speculative excesses, and resulting economic maladjustment ensured untenable system fragility. Still, the more apparent the underlying fragility becomes the greater the impetus to sustain the existing Financial and Economic Order. And the more conspicuous previous analytical and policy mistakes appear the greater the tendency to see no other alternative than to compound them. Mistakes beget ever-bigger mistakes. There is a desperate need to step back and come to grips with how dysfunctional this has all become.

Some seven or so weeks ago the existing Financial and Economic Order was in perilous jeopardy. Wall Street-backed finance was collapsing, and this implosion was about to invalidate our system’s underlying debt structure as well as the structure of the underlying Bubble Economy. But the Federal Reserve and Washington policymakers stepped in with radical measures. These included the Federal Reserve’s guarantee of ample liquidity for the Wall Street firms and virtually limitless “marketplace liquidity” throughout, as well as explicit and implicit federal backing for much of our mortgage Credit system. It may not have appeared momentous to most, but it basically placed Federal Reserve and federal government backing on trillions of securities and market liquidity risk more generally. In Minsky terminology, these measures at least temporarily “validated” the existing structure of “Financial Arbitrage Capitalism.”

Will policymaking succeed over the intermediate- and long-term? Not a chance. Policymakers do today retain capacity to convince the marketplace of their power to inflate the value of debt securities and asset prices more generally. But reflationary polices and other assurances will not rescue the system, specifically because there is today nothing to stem the ongoing distortions to the underlying real economy. Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary Credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices – but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it’s only real economy fundamentals that will determine the soundness and sustainability of a system’s Credit and Financial Structure.

Additional non-productive debt growth will definitely not alleviate the Acute Fragility associated with “Ponzi Finance” Credit system dynamics. Additional non-productive debt growth will also not stabilize dollar devaluation, nor will it help in stabilizing myriad problems at home and abroad associated with our monstrous Current Account Deficits. Instead, any extension of this period of Financial Arbitrage Capitalism will ensure the prolonging of borrowing and consuming excess, the gross misallocation of resources, massive trade deficits, a ballooning international pool of unwieldy speculative finance, and even wilder Global Monetary Disorder.

Indeed, Washington’s validation of the current dysfunctional Credit system structure could very well lay the groundwork for extreme global price distortions, volatility, and social/political unrest. On the current course of things, it’s difficult for me to not think in terms of NASDAQ 1999 or subprime 2006. Throw additional liquidity on overheated Credit, inflationary, and speculative “biases” and be prepared for the spectacular. When Financial Arbitrage Capitalism’s excesses were spurring acute U.S. securities market inflation, the system enjoyed a period of perceived rising wealth to go with a boom in Wall Street securities issuance (to help offset inflated demand). When this Structure’s excesses were directed at the Mortgage Finance Bubble, the upshots were inflating home prices along with attendant construction and consumption booms. Now, however, with acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability.

I argued back in 2002 that the overriding systemic issue was not “deflation” but rather myriad risks associated with an unfolding U.S. Credit Bubble. Now, some years later, these risks have expanded alarmingly, as runaway Credit Bubbles have ballooned both at home and abroad.