Sunday, January 04, 2009

Reflation Economics (or "The Minsky Solution")

As your resident amateur economist, I would like to offer up an article coming from one leg of the PIMCO triumvirate (Paul McCulley, the others being Bill Gross and Mohamend El-Erian) who rule the private sector bond world.

McCulley is the Central Bank expert of the group and his expertise is near Nobel Laureate in its quality and insight. The PIMCO group anticipated the current banking crisis and declared the cause well in advance of the blowup. The PIMCO team labeled the cause as the "Shadow Banking System" and saw the leverage that was being created by hedge funds and others using the tools like "carry trade" to create money through leverage.

Like the rest of us, this group of economists thought the outcome of "shadow banking" would be inflation, as easy money created excess demand. None of them forecast the total collapse of the system and the resultant deflation. However, McCulley suggested the possibilty through his analysis of Hyman Minsky's work as an economist 30 years ago. McCulley uses Minsky to explain money growth and contraction, and does so at times with his stuffed bunny he keeps in his office (he calls "Bun-Bun").

I thought you might find this article insightful. Here is a sample with my paraphrasing in parantheses:

(It is the explicit responsibility of the Fed to provide a “more than proportionate” response to an economic contraction). That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can’t bear alone (that is to say, Capitalism is not a perfect economic system, but occassionally needs help when excess greed or fear get in the way). Only the Minsky Solution can lift that load.”

Here is the entire article:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+McCulley+All+In.htm

PIMCO and specifically, Paul McCulley, is the originator of the idea of “Shadow Banking”, which has come to dwarf the Federal Reserve system in the last 10 years. The amount of assets controlled by the shadow bank makes central bank policy implementation difficult, if not impossible. Shadow banking is the creation of money from nothing by private institutions, like hedge funds. Such financial institutiosn were increasingly deregulated in the 1990s and 2000s. Because they could use instruments like the “carry trade” to create money with very little invested capital, by use of massive leverage, the system effectively grew the money supply outside the control of the Central Bank. This was thought to be inflationary by the PIMCO team as late as 2007, but proved to be deflationary instead.

Now, that the shadow banking system is collapsing, it is following exactly the Minsky model. The Minsky Moment, modeled as the “Ponzi Unit” (in the McCulley chart), was achieved almost exactly at the time the biggest real-life ponzi scheme was uncovered, the Madoff Fund. Talk about life imitating art!!

So, the real central bank must transfer the leverage that is disappearing in the private sector, to the public sector, in order that the economy does not collapse into oblivion. I would like to ask Mr. McCulley what is the step to follow in the Minsky Model: how does the leverage that the public sector absorbs from the private sector get resolved? By time alone?

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

No comments: