Should Central Banks Lend Unsecured To The Private Sector?

This article continues my sequence of articles on central banks as banks, which is projected to be a chapter in my banking manuscript. This article is relatively lightweight, but I wanted to break this issue out of another planned article.

What assets central banks should have on their balance sheet is controversial for some people, but for the post-World War II to 2008 Financial Crisis period, developed countries without currency pegs just held government bonds without raising questions from the bulk of economists. The Financial Crisis forced central banks to buy private sector assets, which re-opened this debate. This article looks at one type of private sector assets to be held — uncollateralised loans to the private sector.

The Perplexing Problem Of Credit In Macro

One of the major issues with the internal logic of neoclassical macro is the handling of credit risk. The problem of credit is acute for Dynamic Stochastic General Equilibrium models because they are allegedly based on “microfoundations.” However, the theoretical problems remain for any aggregated mathematical model. The advantage of heterodox economists is that they do not make a big deal about the alleged internal consistency of their mathematical models, and so they are more willing to hand wave around the issue.

Primary Credit Market Is Key

We are in the middle of a bear market for risk assets, and the key question is trying to figure out what turns this around. My argument is that it is going to be very difficult to read the entrails of market chart patterns, pandemic data, and policy responses to time the bottom. However, if one is not attempting to be a hero forecaster, one key thing to look for is a the resumption in corporate bond issuance. (This is the primary credit market; the secondary market is trading of existing bonds among investors. Pretty much all market data and colour is based on the secondary market.) My feeling is that policy makers are either going in the right direction (or are being dragged by the private sector), so policy uncertainty is becoming less of an issue. Instead, we are stuck more with the hard scientific question as to the effectiveness of social distancing, as well as medical treatments.

Spread Widening Jitters

Recent strains in the funding markets bear watching. I have seen a number of explanations regarding the LIBOR/OIS widening, but I am no longer in close enough contact with those markets to offer any strong opinions. I would rather look at other markets, and see whether there is any sign of spread widening in sympathy. As shown above, the 90-day A2/P2 U.S. commercial paper spread has been widening relatively rapidly, although the spread itself remains at a level that it has hit a few times previously in the post-crisis era.

Fixed Investment, Yields, And The Cycle

I am slowly moving towards the end of writing an ebook which discusses interest rate cycles. One of the theoretical topics of interest is the relationship between interest rates and fixed investment. Like many other post-Keynesians, I do not feel that interest rates are particularly important for the determination of the level of investment. This article is a brief introduction to this topic, focussing on what we know about the economic cycle.

Primer: What Is The Fair Value Of A Credit Spread?

The valuation of corporate bonds is difficult because the fair value of a corporate bond is driven by two sets of prices: the default risk free curve (usually defined by the bonds of the central government of that currency), and the spread of the corporate bond over that curve. When we look at investment grade corporate bonds, we are usually interested in the movements of the spread; the movement of the risk-free curve is the domain of interest rate analysts. For bonds trading with low spreads, the spread is equal to the expected annualized default loss rate for the bond plus some form of a liquidity premium.

Corporate Bond Market Stressed, But Not Yet In Crisis

There are any number of reasons to be worried about the outlook for the global economy and risk assets. One of them are the elevated spreads in the high yield ("junk") bond market. The chart above shows the option-adjusted spread (OAS) for the Merrill Lynch/Bank of America High Yield Master II (U.S. dollar) Index. It has marched out to a relatively high spread, although it is well inside the extremes seen during previous default crises (around 2001 and 2007). However, it is hard to distinguish current events from a "healthy repricing of risk" versus an incipient crisis.

Why China Should Become A Corporate Bond Dealer

In this latest "Stuff I Read On The Internet" entry, I look at two complementary posts on supply and demand issues in the bond market.

• In "Who's Afraid Of China?", Paul Krugman discusses the fears associated with China's massive Treasury bond holdings, and shows why they are not a worry. See the discussion on Mike Norman Economics with regards to how his taking the view of the dominance of rate expectations is a move closer to the MMT theoretical position (and mine).
• In "The Looming Bond Fund Crash", Paul Amery discusses the vulnerabilities noted by Citi Credit Strategist Matt King that are allegedly created by the shrinking dealer inventories of corporate bonds.

The win-win solution is obvious: the Chinese government should become a market maker in corporate bonds. They can easily ramp up their corporates inventory, and they can diversify their USD exposure away from Treasurys.

Bubble Or Business As Usual?

I have seen a fair amount of commentary arguing that the Fed is fostering a bubble or “financial imbalances” (as cited by the dissent of Esther L. George in the FOMC statement) with its policy of Quantitative Easing, Although the price movements of risk assets (the stock market and corporate bond spreads) may appear crazy and bubble-like, they are only following a pattern of behaviour that has been in place for decades. The fixation on the size of the Fed’s balance sheet is just the latest excuse that strategists have latched onto to explain price action that probably was going to happen anyway.

As the chart above shows, the S&P 500 stock price index (which I use as a stand-in for other risk assets like corporate spreads) has two regimes of behaviour:

1. A relatively steady upward march, with a few intermittent dips that rapidly reverse (green arrows). Hence “buy the dips” remains popular advice in financial folklore.
2. Occasional crashes that do serious damage to equity returns; typically associated with financial crises (red arrows. Note that I have not added red arrows for some episodes, like the 1987 crash, in order to keep the chart clearer.) Bulls who "buy the dip" too early here get crushed, adding to investor panic.

We are currently in an upward march phase, and the bears are being steadily squeezed. Hence, the widespread complaints of there being a “bubble”. But that is exactly what has happened during every other bull market, so this is only news if you focus on short-term noise and ignore longer-term trends.

This stock market behaviour may seem strange, but it actually reflects the weak form of market efficiency (which says that it is difficult to beat the market; I do not think that the markets have other mystical properties that are associated with market efficiency).

During a bull market, bulls will outperform bears. Realised credit losses are low, partially because refinancing is readily available, even for the dodgiest borrowers (“a rolling loan gathers no loss”). Investors that apply leverage to their portfolios of risk assets will handily outperform their more conservative peers. This creates a natural selection effect, with the assets under management by the bulls growing much faster than assets managed by conservative investors (either due to the higher returns, “career risk” among the bears, or performance chasing by investors).

This process continues until there is a critical mass of over-extended bulls. Once this occurs, almost any disturbance will force liquidation of positions, but with most investors now on the same side of the trade, pandemonium results. In many crises, it has taken direct intervention by central banks to put a floor under asset prices.

The reason why I view this as being an example of weak-form “market efficiency” – despite the fact that this behaviour is arguably crazy – is that this pattern of pricing cannot be beaten by investors in aggregate. If investors attempted to beat this cycle by keeping prices less volatile through the cycle, the performance by renegade investors who applied leverage to their portfolios will look even better (higher returns, low volatility). This state of affairs will continue until the bulls have regained the majority control of assets, and then cause a crash when they get overextended. A small investor could conceivably be able to read the cycle and time the market to get excess returns, but investors in aggregate cannot.

This financial market behaviour overlays a very similar dynamic that occurs in the real economy. Firms that expand using leverage will gain market share during the expansion at the expense of their more conservatively managed peers. Thus the real economy also has a selection mechanic that favors the use of leverage by firms. The financial market behaviour reinforces this real economy trend, to the point that financial market instability is now a major driver of real economy instability.

I associate this mode of analysis most closely with the work of economist Hyman Minsky, although the original source was Keynes’ views on the business cycle. This article by Randall Wray discusses Misky’s thoughts on the evolution of finance from near the end of his life in the early 1990s. Minsky argued that the instability created by the Savings and Loan Crisis was not just the result of deregulation; the changes seen in finance were a reflection of forces that are internal to capitalism (what I refer to here as “natural selection”).

It is fairly easy to justify a rally in risk assets right now. Global holdings of financial assets are dominated by institutional investors and/or individuals who face considerable pressure to meet post-retirement cash flows. Government bonds offer yields that are far below the returns desired to meet those actuarial needs. Meanwhile, equities offer much higher long-term expected returns than government bonds under almost all the assumptions for future earnings growth used by investors. Corporate bond spreads may be low, but they are still positive, and realised defaults will probably be small as long as the cycle does not turn. Additionally, corporate profits are high and cash distributed to investors largely ends up being reinvested in risk assets. This creates the “melt-up” dynamic that we are seeing.

However, this explanation does not satisfy most strategists, as it does not explain why equities have had their bear markets since the mid-1990’s (since the same factors were in place then), nor are there indicators that measure how overextended investors are (the details only emerge in the crisis post-mortem). Thus they seize on whatever justification they can find to explain the rally; in the current cycle, it is allegedly the Fed driving the cycle. However, I argue that it has historically been the case that it has been investor positioning that kills the cycle, not the level of Fed Funds (or the size of the Fed’s balance sheet).

Given that I feel that this manic-depressive market behaviour is the result of forces inherent to capitalism, I do not see any easy way to moderate it.

• U.S. policymakers do not even have a good reading of the level of labour slack in the economy; it seems unlikely that they could hope to sensibly regulate the pricing of long-duration risk assets.
• Regulations could eliminate some of the worst excesses in High Frequency Trading, but regulations are not going to change the actuarial realities faced by institutional investors.
• Forcing underwriters to hold equity in securitisations they create will not restrain the behaviour of investment bankers that are bullish on asset prices. In other words, such regulations will just create a dynamic that the most gullible investment bankers will end up with the greatest market share.
• I do not see any major political party in the developed world endorsing the nationalisation of fixed asset investment, which was Keynes’ solution to the cyclicality induced by financial market speculation. In any event, such a move would probably just mean that recessions would be induced by government policy errors instead of being the result of private sector mistakes.

As noted in the article by Randall Wray, if the economy is financed by conservative bank loan officers, the effect of the financial cycle could be reduced. Since traditional banks cannot get loans of their balance sheets, loan officers have to take into account potential downturns when extending financing. Therefore, returning to a traditional banking system, as was the case in the 1950’s, does seem like a solution. But as Minsky argued, this traditional banking system was replaced by “shadow banks” as the result of competitive pressures. It does not seem obvious that this evolution can be easily reversed.
 
(c) Brian Romanchuk 2013