Rolfe Winkler

Just finished a fantastic book that I recommend to all: The Origin of Financial Crises by George Cooper

In it, he takes down the Efficient Market Fallacy Hypothesis, demonstrating why it has made modern risk management dangerous and rendered Central Bank policy harmful.  Along the way there is a fantastic discussion of inflation, for those who don’t quite understand what it is.  He also discusses how to get Central Bank policy back on the right track.

I thought I’d share one particularly erudite passage that explains Keynes’ approach to reversing economic contractions, and its drawbacks.  Since this approach has been adopted by policy-makers of all stripes, it’s rather important to understand what it is:

There is no more powerful mechanism for the short-term amplification of corporate profits than to persuade some element of the economy — government, household, or corporation — to spend above its income.  Conversely there is no surer way to erode corporate profits than to permit any of these groups to save their income.

This process through which borrowing and savings drive economic activity is the essence of Kenyes’ famous “paradox of thrift” and of his recommendation for fiscal stimulus.  In the paradox of thrift, if one section of the economy tries to save money, it will reduce the income of another section of the economy, and this will likely find its way back to undermine the income of the original savers, leading them to further reduce their spending, causing a self-reinforcing cycle of declining activity.  If, for whatever reason, the majority of agents in an economy become more risk averse, deciding to increase their savings rate together, they could find themselves in a self-fulfilling economic contraction.

Keynes worked out that the escape route from the “paradox of thrift” was to get some agent (the government) to spend more money, thereby boosting profits, encouraging more borrowing, generating more profits, leading to a virtuous cycle of economic expansion.  Keynes was concerned with finding a policy to help economies escape the Great Depression leading him to emphasise the “paradox of thrift” element of the story.  Minsky, however, took Keynes’ theory to the logical conclusion, arguing that borrowing can lead to a self-reinforcing positive spiral.  This positive spiral could be though of as a “paradox of gluttony” whereby higher borrowing producers higher profits, thereby ratifying the decision  to borrow and spend more.

The paradox of thrift and gluttony are important because they are linked to the same credit creation process that drives asset market instability…The additional borrowing associated with an asset price boom will likely flow back into additional asset purchases, but part will also be converted into higher levels of debt-financed spending…

Too much credit, in other words, supports the illusion that assets are worth more than they really are.  Miami condos that have seen their prices collapse 50% since the peak were only worth the higher price because credit was available to finance the transaction.

The point is one I’ve made here many times: An economy can’t borrow to infinity, so Keynes self-reinforcing positive spiral is clearly unsustainable.  The more debt we pile on to feed the illusion of high asset prices, the more painful the inevitable reversal.

It’s handy to keep this stuff in the back of your mind when Bill Gross—chief of PIMCO, one of the largest asset managers in the world—says the following (emphasis his):

To PIMCO, the remedy for this deflationary delevering and mini-depression is simple and almost axiomatic: stop the decline in asset prices.

Naturally the only way to do this is to borrow and spend more.

The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices.

Can you guess what Gross wants the government to do?  That’s right, have taxpayers buy banks’ bad assets in order to prop up their values:

The original focus of the TARP was on asset prices, but the prior Administration quickly lost its way or perhaps its nerve. Like his Road Runner nemesis, Wile E. Coyote must now extend some infrequently used figurative wings to avoid the deflationary precipice below. Support asset prices.

As I argued in my Daily News piece, this approach gets it exactly WRONG.  Asset prices have to be allowed to fall and those that lent based on inflated asset prices have to take their share of losses.  This means Bill Gross and his investors have to be taken to the cleaners.

But politicians are clearly following Bill’s advice.  I recommend readers hold on to their wallets.  And read George Cooper’s book.  One last passage to share:

…Endless credit expansion [is] dangerously destabilizing.  As each successive attempted credit contraction is successfully counteracted with engineered stimulus [fiscal OR monetary], the economy is pushed into a state of ever greater indebtedness, presenting the risk of a still more violent contraction in the future.  Over time, a policy of always maximising economic activity implies a constantly increasing debt sotck and progressively more fragile financial system.