June 2012

Issue 144

Reflections

About this Newsletter Every Economists Career Ends in Failure

Reflections is a monthly publication The Irony of Hyman Minsky
written by John Gilbert, CIO,
GRNEAM. Each issue focuses on The economist Hyman Minsky held that capitalist economies are
current capital markets and investment
topics. Our clients find it somewhat inherently unstable because investments are financed with debt,
unique from many investment and the financial markets pricing of debt is volatile. Economies
publications typically received.
are prone to booms and busts as the cost of financing falls too
For More Information
For more information please contact far, or rises too much, revealing poor investment decisions.
one of our Marketing professionals:
This has always been obvious to observers of business cycles, of
Marie Callahan
which Minsky was one. Too many of his colleagues in economics
mcallah@grneam.com

Mike Gilotti ignore this, which we have found puzzling.

mike.gilotti@grneam.com
Ryan Saul
ryan.saul@grneam.com
General ReNew England
Asset Management, Inc.
Pond View Corporate Center
76 Batterson Park Road
Farmington, CT 06032
Tel. 860 676 8722
www.grneam.com
Minsky died in 1996 and missed the housing finance crash of
2007 to 2009, which is now a classic entry in the collection
referred to as Minsky Moments. The massive government
response as a lender and spender of last resort was just what
Minsky proposed in such a situation, as did Walter Bagehot
in London a century and a half earlier. Bagehot advocated
intervention as lender of last resort, but Minsky went far further
and was an unabashed advocate of Big Government (his
capitals) and a fan of Franklin Roosevelts programs of the 1930s.
Unfortunately nothing fails like success. Continual application of the lender and
spender of last resort principle gives risk takers the green light. The upcoming
fiscal debates in the U.S. will be difficult and will probably not address the issues
forthrightly. That leaves the central bank, with its assumed infinitely elastic balance
sheet, to play the role of fire department.
Central banking is a difficult job. Since we have recently been rather critical of
modern fiat central bankers putative stretching of the limits of their paper money,
we owe them a review of their case for the defense. The position of central bankers
in most developed countries is that deflationary risks are the greatest that they have
been since the 1930s, and require unconventional steps to forestall such a dreadful
outcome. In that, they are correct.
The risk is that their expansionary and stimulative policies will eventually debase the
purchasing power of the currencies with whose husbandry they are charged. There
are rules-based ways of approaching the Feds task, which they have rejected for now.
Certain of those rules are already calling for the Federal Reserve in the U.S. to raise
interest rates. But in fairness, there are multiple versions of such rules, so perhaps
the Fed gets a bye for the moment on ambiguity. It is instructive to note that in their
recent minutes they acknowledged considering a rules-based regime. At a minimum,
however, it would appear that it will be some time before that would be an important
part of Fed behavior.
To understand central bankers predicament, an accounting for the risks of
contraction on the one hand, and excessive expansion on the other, is in order.
Large and important contractionary tendencies are at work, without doubt. The
primary ones are debt and the anomaly of excessive investment.
Indebtedness is deflationary because the borrowers futures are entombed in
the enforceable contract of the loan. At some point too much debt is too much.
The research staff of the Bank for International Settlements showed that debt at
certain levels is an obstacle to future growth, and that we have passed that point in
developed countries.
Chart 1. Debt Limits Growth at Current Levels
Household Debt to GDP, OECD 18 Countries Corporate Debt to GDP, OECD 18 Countries
100 120
90
85% Threshold 100
80 90% Threshold
70 80
60
50 60
40
30 40
20 20
10
0 0
1980 1990 2000 2010 1980 1990 2000 2010

Government Debt to GDP, OECD 18 Countries

120
100
85% Threshold
80
60
40
20
0
1980 1990 2000 2010
Source: BIS (Cechetti, 2011)

2 GRNEAM
The second deflationary force is excessive investment. While there may still be
a perception that China has excess population, in fact China has an excess of
investment, not labor. In chart 2 we compare Chinas investment to GDP ratio
to the world.
Chart 2. Investment as Percent of GDP
50

45

40
Percent

35

30

25

20
1980 1985 1990 1995 2000 2005 2010

World China
Sources: IMF and GRNEAM

To put this in perspective, Japan and South Korea were aggressive investors relative
to GDP, and at their peak reached only about 35%. Chinas investment to GDP
ratio approaches 50%, which is a rather staggering number. Some observers
exaggerations of the Chinese investment problem should be regarded with
circumspection, but it is nonetheless clear that excessive investment persists. This
is, of course, a result of the command and control economy that perceived its own
ability to push a button labeled Investment to support employment. It has always
been true that in time this would be tested and perhaps fail.

China is a hybrid economic model which may not have much explanatory power
for other economies. But now, as the worlds second largest economy, errors in
its command and control economic system may have induced others, either from
opportunism or from lack of circumspection and risk control, to make parallel bets
that raise the stakes.
The commodity boom of the last decade is without doubt attributed to China. Two
of the biggest winners are iron ore, used in steel, and copper. These are among the
principal ingredients in high rise Chinese apartment buildings. Chart 3 shows their
prices relative to other commodities.
Chart 3. China Skews Commodity Demand
350

300

250

200

150

100

50
2009 2010 2011 2012
Copper Iron Ore Broad Commodity Index
Sources: Bloomberg L.P. and GRNEAM

Reflections, June 2012 3

Latin America and Africa are, relative to their economies, large producers of these
commodities. Unsurprisingly, there is massive parallel investment in those areas
as booming commodity prices stimulated investment in their economies. While a
superficial view may be that such economies are rightly investing in their own sui
generis growth, these booms are not self generated, but are products of a massive
positive shock from rising commodity prices. Consider Chart 4, which suggests a
covariance with China.
Chart 4. Developing World Investment Growth Contribution to Total World Growth,
5-Year Average
12%

10%

8%
China joined
World Trade
6% Organization

4%

2%

0%
1980 1984 1988 1992 1996 2000 2004 2008 2012
Sources: IMF and GRNEAM

It is evident that these two primary forces of deflation are powerful. Of the two
drivers of deflation, debt is resident in the developed world, and excessive investment
appears in the developing world. That leaves no obvious large engine of real growth
free of one constraint or the other. Certain companies, or industries, will by their
competitive advantages outrun these problems, but for economies overall, it is
difficult to evade gravity. So we have two principal deflationary forces that, it seems,
are serious, and supportive of central banks case. They are supportive as well, for
now, of todays exceptionally elevated bond prices in putatively safe sovereigns.

These deflationary tendencies are at variance with the track record of paper monies,
which over recorded financial history is exceptionally poor. Sovereigns without
constraints upon creation of money, or its raw material in a fractional reserve system,
bank reserves, have in time managed to impair the purchasing power of their
currencies. So it is interesting that, despite the general view that abundant labor
worldwide will keep inflation at bay, and specifically that China exports deflation,
Chinese wage inflation remains well into double digits (Chart 5).
Chart 5. China per Capita Wage Inflation
18%

17%

16%

15%

14%

13%

12%

11%

10%
2009 2010 2011 2012
Sources: China National Bureau of Statistics, Haver and GRNEAM

4 GRNEAM
Excessive investment and growing demand for the pool of previously low cost
labor may not produce persistently low inflation, but a shift in returns instead. It is
significant that the German government recently suggested that higher wage inflation
in Germany would be permissible. It is likely that returns on labor should rise, and
returns on capital should fall. Certainly the exceptional profit margins and share of
value added accruing to U.S. firms would seem to be at, or approaching, a high point,
as Chart 6 implies.
Chart 6. Profit % of Value AddedReturn to Capital Rising Relative to Labor
34%

32%

30%

28%

26%

24%

22%

20%
1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Sources: BEA and GRNEAM

Nonetheless, it is argued that the U.S. economy persists in performing below its
potential and that we need not worry about side effects. But, in fact, current policies
of exceptionally easy money are just the conditions that lead to bubbles, and some
may be appearing already. Farmland in the central United States is rising at the most
rapid rate since the 1970s (Chart 7).

Chart 7. U.S. Farmland Annual Price Change

40
Most Rapid
30
Since 1970s
20

10
Percent

-10

-20

-30
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Sources: Federal Reserve of Chicago and GRNEAM

Minsky alluded to the limits to Big Government, but did not regard them as
constraints. There are two principal constraints that can eventually impair
governments flexibility. They are creditworthiness for governments borrowing
in others currencies, and inflation for those borrowing in their own. Minsky
acknowledged the inflation risk, but did not foresee the massive accumulation of debt
that occurred in the last 20 years. His solution to instability was more government
rather than less, which contributed to just that debt accumulation.

Reflections, June 2012 5

There is an ironic twist for Minsky economics in current conditions. He classified
investment financing into hedge finance, when cash flows repay the debt, speculative
finance when only interest is covered, and Ponzi finance when cash flows do not even
cover interest and more borrowing is necessary to do so. Todays chronic primary
budget deficits have made governments themselves Ponzi finance mechanisms in
Minskys framework. That is not a salutary outcome when they are supposed to be
lender and spender of last resort.
Our concern with central bankers policies is not that they are trying to prevent a
reprise of the worst economic conditions of the last century. It is that there is no
consistent and rigorous plan for doing so. A purely judgmental program is likely to
exaggerate the conditions of the moment, discounting the longer-run, unintended
consequences of trying to manage them. Such an approach makes the emergence of
those unintended consequences certain. Yet another fire alarm will then sound, and
another set of ad hoc policies will emerge, giving rise to yet another cycle of error.
Minsky was correct in his diagnosis but wrong in his prescription. The risk takers can
run faster than the regulators. The cure is for the risk takers to discipline themselves,
and develop a collective culture of financial circumspection. It remains to be seen if
2008 to 2009 was enough of a lesson. The danger in central bankers racing to the
rescue is that the Lehman Lesson from the Minsky Moment will be forgotten, and the
damage incurred for naught.

6 GRNEAM
Reflections, June 2012 7
 2012 General ReNew England Asset Management, Inc.
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