August 06, 2004

Revisiting Financial Arbitrage Capitalism

by Doug Noland

Wow, what a week. .................................................

Revisiting Financial Arbitrage Capitalism

I think a lot about Hyman Minsky on days like today. Back in December 2001, I wrote a piece titled "Financial Arbitrage Capitalism." The nature of the analysis - "updating" the brilliant Minsky's concept of Money Manager Capitalism - is among my personal favorites. While it is not my habit to dip into the archives, the environment beckons for some "Minskian" analysis.

Minsky's Money Manager Capitalism:

"The welfare state big government managerial capitalism largely but not completely divorced business profits (cash-flows) from private investment...It followed that the margin of safety which entered into the building of liability structures which reflected earlier experience were too big: the safe level of indebtedness was higher in the postwar economy than hitherto...the independence of operating corporations from the money and financial markets that characterized managerial capitalism was thus a transitory stage. 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, p. 113)

And I wrote in late-2001: "It is my contention that the essence of the American (and in many respects the American-dominated global) system evolved significantly and then diverged so profoundly over the past few years from Minsky's "Money Manager Capitalism" that it is today appropriate to distinguish an entire new stage of capitalistic financial development - the age of "Financial Arbitrage Capitalism." Whether this new stage is "retrograde" and untenable - as is our view - is the key economic issue of our time. At the minimum, this most unusual cast of financial institutions and structures provides a good basis for making sense out of the anomalous divergences in sectoral economic performance (record home and auto sales, as capital goods investment plummets), extreme disparities in relative pricing and profits throughout the economy and markets ("inflation vs. deflation" quandary), and general acute financial and economic fragility."

More than two and one-half memorable years later, there is absolutely no doubt in my mind that Financial Arbitrage Capitalism is both "retrograde" and untenable. That this reality remains unappreciated [in late-2001] is truly today's paramount economic issue. And I will go further, arguing that the past 18 months have been a period of "blow-off" excess in myriad strategies of leveraged speculation, and its gone full-blown global (Global Wildcat Finance). The recent inhospitable market environment marks the conclusion of the temporary respite from financial instability. [No, there was another respite from about 2003 to summer 2007.]

For several years, the system has experienced a most extreme episode of financial "profits" dictating lending, speculating, investing and spending patterns. Economic profits - as the genesis of sound and sustainable lending, investing, income growth, and resource allocation - have become only more irrelevant; a relic from a bygone era. The predictable consequences include myriad unwieldy Bubbles (Credit, asset, mortgage finance, leveraged speculation...). The financial system has become only more leveraged and dysfunctional, and the economic system more distorted and imbalanced. These dynamics are nowadays in full bloom.

Today's data and market reaction provided rather conspicuous evidence of the economic vulnerability and financial fragility associated with runaway financial speculation ("arbitrage" Capitalism). Near panic buying of Treasuries and foreign currencies was incited by additional evidence of weak job growth. Gold surged $6.90, and the dollar lost significant ground to virtually every currency, including the "developing economy" currencies. Benchmark Fannie Mae MBS yields sank 18 basis points to 5.25%, the lowest level since early April. California homes prices likely gained a couple thousand dollars to yet another new record.

If I believed that weak employment gains were the consequence of a typical economic slowdown, my analysis would go in a much different direction. But the current environment has nothing to do with tightened Credit conditions, reduced lending, or faltering spending. Rather, we are in the midst of ultra-easy Credit availability, gross lending excess, over-abundant liquidity, and record total Credit growth.

Total system spending remains robust, although there has been a marked shift in the nature of expenditures (as inflation effects tend to impose). Energy, imports, and housing are taking an increasingly disproportionate share, where enormous increases in nominal dollar expenditures have little impact on American job creation. A torrent of liquidity flows to California and other real estate markets (stoking financial "profits" for homeowners and lenders, along with an income windfall for real estate, mortgage and insurance brokers). Unprecedented dollar liquidity flows globally to pay for exports and to play higher-returning non-dollar assets. Here at home, an inflated cost structure throughout much of the economy restrains (jobs-producing) productive investment. Meanwhile, and importantly, the amount of liquidity and Credit necessary to sustain systemic Bubbles is problematic and approaching precarious. Again, the key issue is not economic weakness but spectacular structural imbalances and distortions.

.................., I am not yet willing to write off the U.S. and global economies. I will wait for signs of faltering liquidity and less profligate Credit Availability that could now develop any point. But I will say that when financial crisis arrives - when Financial Arbitrage Capitalism falters - the U.S. Bubble economy will prove shockingly vulnerable. I still find it amazing that after 70 years the economic community still lacks appreciation for the Acute Systemic Fragility that had evolved over the two decades preceding the 1929 stock market crash. The Crash rather abruptly brought to an end dysfunctional Monetary Processes. Leveraged speculation had over years evolved into the key source of finance/liquidity for both the markets and Bubble economy - going to (Fed-induced) "blow-off" excess during the critical 1927-1929 period. The unavoidable reversal of speculative financial flows - and resulting de-leveraging - exposed deep structural imbalances and distortions. Inflated asset prices sank, boom-time spending patterns were altered dramatically, investment collapsed, financial flows went absolutely haywire, and the global currency system unraveled. We're not there yet, but that doesn't mean we are not careening in that direction.