Central banking: Edward Harris on why raising interest rates in an overleveraged economy is very risky

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Merijn T. Knibbe
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Even more about central banking. Why so much? Partly because people are writing very good stuff about it (like the AAA piece from Edward Harris below (excerpt)). Partly because we seem to see the end of the era of ‘pure’ inflation targeting. And (part of this last trend?) partly because soon Merkel and Macron will sit together to redesign the Eurosystem. Previous posts: ideas of Willem Buiter, Richard Werner, Thomas Mayer excerpts from a recent paper by Mike Konczal and Josh Mason and ideas from the German Handelsblatt shadow council.

As the Federal Reserve meets today [last week: M.K.] to decide how to communicate its messaging on future rate hikes and balance sheet reduction, financial stability will play a key role. Yesterday, I wrote about the Bank of International Settlements new warnings on financial stability. And just this morning, I read a piece from Goldman Sachs Asset Management EMEA division head Andrew Wilson, warning that the risk of overheating was real. So let’s put some framing around this issue and ask how the Fed reacts as the data come in down the line.

In the past decade on Credit Writedowns, I have had a lot of good commentary from different writers on financial stability. And most of it is based around Hyman Minsky’s Financial Instability Hypothesis. As someone who used to work in debt capital markets and do financial models for private equity investing and corporate finance for mergers and acquisition, I find the Minsky analysis a huge benefit in thinking about the macroeconomy that standard macro modelling techniques don’t incorporate. So I want to use this as the prism through which to look at the Fed’s reaction function to predict future yield curve flattening and the resulting economic impact.

Long cycles end with higher risk

First, here’s what Minsky’s hypothesis is all about. Let’s use excerpts from Randall Wray’s 2012 piece to make the case here. You can read the full piece here. And I will summarize in layman’s terms afterwards; but here’s what I want you to take away with my own highlights added in bold:

In his publications in the 1950s through the mid 1960s, Minsky gradually developed his analysis of the cycles. First, he argued that institutions, and in particular financial institutions, matter. This was a reaction against the growing dominance of a particular version of Keynesian economics best represented in the ISLM model. Although Minsky had studied with Alvin Hansen at Harvard, he preferred the institutional detail of Henry Simons at Chicago. The overly simplistic approach to macroeconomics buried finance behind the LM curve; further, because the ISLM analysis only concerned the unique point of equilibrium, it could say nothing about the dynamics of a real world economy. For these reasons, Minsky was more interested in the multiplier-accelerator model that allowed for the possibility of explosive growth…

…he examined financial innovation, arguing that normal profit seeking by financial institutions continually subverted attempts by the authorities to constrain money supply growth. This is one of the main reasons why he rejected the LM curve’s presumption of a fixed money supply. Indeed, central bank restraint would induce innovations to ensure that it could never follow a growth rate rule, such as that propagated for decades by Milton Friedman. These innovations would also stretch liquidity in ways that would make the system more vulnerable to disruption. If the central bank intervened as lender of last resort, it would validate the innovation, ensuring it would persist… profit-seeking innovations would gradually render the institutional constraints less binding. Financial crises would become more frequent and more severe, testing the ability of the authorities to prevent “it” from happening again. The apparent stability would promote instability.

With his 1975 book, …Minsky distinguishes between a price system for current output and one for asset prices. Current output prices can be taken as determined by “cost plus mark-up”, set at a level that will generate profits…

There is a second price system, that for assets that can be held through time; except for money (the most liquid asset), these assets are expected to generate a stream of income and possibly capital gains…The important point is that the prospective income stream cannot be known with certainty, thus is subject to subjective expectations…. Minsky argued that the amount one is willing to pay depends on the amount of external finance required—greater borrowing exposes the buyer to higher risk of insolvency. This is why “borrower’s risk” must also be incorporated into demand prices.

Investment can proceed only if the demand price exceeds supply price of capital assets. Because these prices include margins of safety, they are affected by expectations concerning unknowable outcomes. In a recovery from a severe downturn, margins are large as expectations are muted; over time, if an expansion exceeds pessimistic projections these margins prove to be larger than necessary. Thus, margins will be reduced to the degree that projects are generally successful. Here we can insert Minsky’s famous distinction among financing profiles: hedge (prospective income flows cover interest and principle); speculative (near-term income flows will cover only interest); and Ponzi (near-term receipts are insufficient to cover interest payments so that debt increases). Over the course of an expansion, these financial stances evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions.

Translation: Institutions matter. You can’t look at an economy without considering the structure of its financial arrangements because – contrary to the thinking that an economy is always in or trying to get back to some equilibrium – it’s really a messy world out there. Once you look at financial institutions in particular, you see that they are important in that they use debt and credit to bolster current output, sometimes by very large amounts.

But we also have to realize that their ‘price system’ is inherently more unstable and uncertain than the “cost plus mark-up” system of current output. And this, by definition, creates an inherent instability. How? The longer a cycle goes on, the more leveraged financiers feel cheated, as if they are constantly leaving money on the table; the margin for error they incorporate into their debt models simply proves time and again too large. And so they reduce that margin for error in order to reduce the money they leave on the table for debt investors.

Let me put this in corporate finance terms: as the cycle lengthens, projected levels of enterprise value to earnings before interest, tax, depreciation and amortization [EBITDA] increase, and so too do debt to EBITDA calculations, which serve as the margins for error in leveraged financial models. Right now, private equity firms are paying 10.7x earnings [EBITDA] for middle market companies. In my day as a leveraged finance associate 20 years ago, if that number was half as big it would have been considered high. So that gives you a perspective.

Now let’s remember that what makes this the most dangerous point in the cycle is that, as the margin for error is decreasing, monetary policy is tightening, increasing downside risk. Investors with 3-5 year investment exit time horizons are hoping that the cycle lasts through at least 2020 or 2022 because if they are caught in an investment for which they paid almost 11 times earnings when the cycle comes to an end, the losses will be enormous.

In the wider economy, the IMF has noted that more and more companies in the US are so-called “Zombies”, where interest coverage ratios are low. The Bank for International Settlements estimates that the zombie share of firms has doubled to 10% of US companies, with a combined market capitalization of $2.3 trillion