Saturday, March 20, 2010

The Coming Financial Reckoning Day

Many financial market readings, as the one in my previous post, highlight the perception that the economic turmoil is past. Central bankers and politicians, adherents of Keynesian philosophy, have put themselves at the forefront of proclaiming they have saved the world from an economic depression. In short, Keynesian philosophy, which at its root is anti-free market and believes government intervention in an economy is required, is misguided. It believes in the “broken window fallacy.” It believes in something for nothing. It believes that the solutions to all economic problems are tax and spend. Never mind that this defunct philosophy was proved wrong by the events of history, particularly during the 1970s. Yet it is back with a vengeance; but it will end like it did in the past: discredited.

The effects of the Keynesian policies, which are displayed by way of fiscal intervention (i.e. government spending), are evident in market variables. Monetary policy is subservient to fiscal policy under Keynesian philosophy. That is, monetary policy should augment fiscal policy. In other words, if the government needs to spend, the central bank needs to print money. Of course, court economists and politicians never put this way, but rather use obscure language that make it seem they know what they are doing.

Consider this graph. It displays the ratio of the market value of high yield debt to the market value of investment grade debt (U.S. corporate debt). [See here for a brief description of the data behind this graph.]

Market value of all fixed income securities move in inverse relation to yield (or interest rates). That is, a high market value reveals lower yield; and vice versa, a low market value reveals a higher yield. High yield debt is the current name of what was known as “junk bonds,” which is the riskier debt traded in the market. Investment grade bonds, on the other hand, are of high credit quality and therefore carry less risk. The yield, as you might expect, reveals the level of risk attributed by the market.

The ratio denoted in the graph has increased due a combination of higher market value of high yield in relation to investment grade. As previously mentioned, higher market values reflect lower yields. This means that the return on high yield debt has declined faster in comparison to investment grade. Another way of expressing this is by saying that the risk in high yield bonds has declined faster than the risk in investment grade bonds. The graph, if anything, demonstrates investors chasing higher returns. The greater demand for high yielding securities pushes the perceived (not the actual) risk downward.

This scenario reminds me of Minsky’s Financial Instability Hypothesis (FIH). The FIH describes “hedge finance” as conservative financial arrangements. More specifically, Minsky’s FIH points out that an capitalist economic system

transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

Although Misky was a proponent of some form of government intervention as a result of the instability he believe is inherent in capitalist economies, he nevertheless appropriately captures what is evident in terms of financial history. His conclusions are no less true today than they were when he first published his findings in 1992. Chasing higher yielding assets (and therefore risker assets) invariably pushes investors to "speculative and Ponzi units" of investment.

Therefore do not be amazed that we are following the same patters of the past. The next financial collapse will be of greater proportion than the 2008-2009, because of the excessive use of leverage.

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