Perhaps the question we are asked most frequently is when things will get back to normal, meaning in most investors’ eyes the way they were before Lehman. Unfortunately, our answer is “That bird has flown” and we are now dealing with, and will continue to deal with for many years, a very different environment. The mainstay of that difference is a lack of trust between those that have money to invest and those that want to use it for risky undertakings, and, in particular, a lack of trust in the banking system that used to intermediate between these two groups. The result is a glut of savings available to “safe” investments driving risk-free yields to very low levels. However, the central banks, by buying bonds and manipulating long term interest rates lower, are introducing a significant risk of capital loss into even “risk-free” assets. Investors are both moving and driven out the risk and yield curves, and returns on riskier investments are falling. The decline in returns at the precise time many investors want to start spending investment income has pushed up prices for proven existing income flows. Meanwhile, a combination of distrust and a reduced pool of money that will wait long periods before income is produced have generated fewer green-field investments in physical plant and equipment, resulting in a slower potential growth path for the economy.
We are neither monetarist nor Keynesian, but rather institutionalist and a storyteller. We see the current situation as the culmination of a long path where growing reliance on banks and the central bank to maintain economic growth has run aground. Both re-establishing trust and balance in the old system or building a new one will take time – likely many years and at least one more economic shakeout to test the results. In the meantime, we expect sub-standard economic growth, low inflation, low interest rates, growing concentration in market power, and rising government intervention in the form of higher taxes and regulation. This is not a unique situation; it existed in the early 1900s before the Federal Reserve was created and in the 1930 when the Federal Reserve was far too timid. Now, despite aggressive Fed intervention, QE lacks traction. This is not the 1970s. A smaller banking system means less nominal growth, and a more nearly zero-sums world. We expect in time, some capital will be destroyed – particularly by ill-fated investments while reaching for yield – and eventually the traditional balance between savings and investment (and interest rates) will return to “normal”. However, that day is still far away in our view, and the date of the next shakeout is in between now and then.
The Minsky Moment in Banking
Once upon a time, long ago and far away, banks use to operate by taking in deposits at 3% and lending them out at 6% and going home at 3PM. The Federal Reserve regulated this system by requiring that banks hold a certain amount of reserves against their deposits to reduce the risk of a bank run. They also required a bank to hold a minimum amount of capital in case their investments went bad. Banks that wanted to make more loans than they had deposits depended on correspondent bank relationships where banks with limited loan opportunities would make deposits in other banks with better opportunities. The correspondent relationships increased the efficiency of the banks by allowing diversification and directing deposits toward the best yielding investments.
In time, banks discovered ways to reduce their required reserves and increase the amount of deposits that were generating returns – but, at increased risk to the system from runs. Repurchase agreements (repos) were used to reclassify deposits from high reserve categories to low or no reserve categories. The interest rate on the repurchase agreement was a function of the potential earnings on the freed reserves. Banks with limited investment opportunities could now lend their un-borrowed deposits, or excess reserves, to banks with greater opportunities. The interest charged for lending these funds overnight was the federal funds rate. This development led the Federal Reserve to move from using reserve requirements as their preferred tool for controlling growth in the money supply to managing the federal funds rate. The Fed actively participated in the federal funds market in competition with banks, selling repos backed by reserves created with a stroke of the pen if they wanted interest rates to fall and buying up excess reserves via reverse repos if it wanted to raise rates.
In this new world, the Federal Reserve targeted an interest rate, and allowed the market to determine the level of reserves (and hence the money supply) that were consistent with that rate. An expansion of loans, which raised money supply, naturally could generate either higher real growth or higher inflation depending on the actual scarcity of labor and capital. If inflation rose, the Fed throttled back the economy by raising interest rates. If growth faltered, it lowered interest rates by creating new reserves with a stroke of the pen to incentivize new lending. Unused reserves earned nothing, so the banks always had an incentive to maximize lending or circulate excess reserves via the federal funds market to earn a positive rate.
Under the new system, deposits found their highest use because any lender anywhere in the US could make a loan – even if they had no deposits – as they could always borrow excess reserves in the federal funds market. In effect, every bank was a correspondent bank to every other bank. However, it also meant that the most aggressive banks – those most willing to put their capital at risk – dominated the system. Due to the advantages of diversification, this tended to favor big banks. They could bid aggressively for the potentially most lucrative loans knowing they could get funding in the federal funds market. Moreover, since the Fed was targeting an interest rate, if banks bid up the federal funds rate as they sought to expand their lending, the Fed would increase the supply of reserves to keep the federal funds rate at the target. Thus, the most optimistic lenders ultimately determined the growth in money supply, generating real economic growth if they were right and inflation (from more money chasing the same number of goods and services) if they were wrong. The Fed would step in to reduce lending at the end of the cycle after over optimism pushed up actual or expected inflation.
The secret to the long running success of this system was that money supply (the Fed focused on M2) never fell during these corrections. A slowdown in the rate of growth was enough to rein in economic activity and cause inflation to recede. With money supply always larger than before, there was always someone in the system who could buy up the best of the bad investments of the overly aggressive lenders – funded at lower prices funded at lower interest rates, so with less risk. That is, strong hands that could withstand short term declines in returns or hits to capital benefitted by picking up the pieces of viable projects after a bust. Again, this tended to favor big banks with deep capital pools.
The Minsky moment arrived in the banking system when the most aggressive lenders realized they did not have to hold the loans they made on their balance sheets at all. They could package up the loans and sell them to investors in the asset backed securities market – which is to say, the non-bank market. The most aggressive lenders were effectively mortgage brokers, who had no skin in the game. Often these were smaller banks trying to become bigger banks via fee income rather than return on assets. In any case, the fact that the loans were placed outside the banking system meant that an expansion in lending did not result in the Federal Reserve creating new reserves and increasing the money supply. Money attracted to these asset backed securities was competed away from other viable investments – reducing the pool available for plant and equipment — resulting in slower real economic growth and so subdued CPI (as opposed to asset) inflation despite aggressive lending. The trouble began when non-bank entities important to the banking system (like Bear Stearns, and later AIG and Lehman) foundered under the capital losses from these over aggressive investments. It was no longer the responsibility of the Fed to bail them out, but the much less practiced Treasury – and we all know how that went.
Living in a Low Growth World
In the aftermath of Lehman, confidence in the system has been shattered and the game has changed. The Federal Reserve has pumped reserves into the system, but with risk adjusted rates of return below zero banks would rather take 16 basis points for holding them than lend them out. These excess reserves, created with the stroke of a pen, have been used to buy bonds — which has allowed the Federal Government to increase spending via the safety net and avoid a 1930s style feedback loop from falling employment. Other nations have gone the austerity route with the outcomes one would have expected based on historical precedent. Money supply has expanded since Lehman, but as the growth in excess reserves is effectively electronic vault cash, there has been a sharp reduction in velocity – that is, a decrease in the efficient operation of the banking system.
A return to normality depends not on increasing the banking systems reserves, but rather on increasing its capital. Bankers are reticent to lend because they remain uncertain about the viability of their existing capital base and would rather stay in the status quo than take on new risk. The FDIC, in its infinite wisdom, has made it difficult to create a de novo bank, so little new capital is entering the system. Rather, banking functions are moving into the non-banking sector. This puts the economy in an environment like under the Gold standard, when investors compete in a zero sums game. For over thirty years, the Federal Reserve effectively has been allowing the money supply to increase in anticipation of investments successful results– and reining in lending when excessive activity threatens to become inflationary. An expanding nominal economic pie – even before bank funded investments generated output – provided the liquidity to bid up prices for labor and capital without requiring a decline somewhere else. The competition was for growing market share in a growing pie. In a low growth world, weak firms are more likely to see revenues decline and face margin squeezes. Already cautious banks will naturally want borrowers to have more skin in the game, making it tough for small businesses – while the bigger firms have better access to capital pools at risk-taking non-bank lenders.
The post-Lehman period, like after the Panic of 1893 and the Great Crash is a period where the populous wants greater regulation of the laissez-faire investment environment that led to economic calamity. In both the early 1900s and 1930s, when money supply growth was limited, governments attempted to balance the deficits created by the crisis by raising taxes – particularly on the wealthy – and so reduced saving (read capital) in precisely the group that might have picked up the pieces once resource prices had fallen during the correction. Sound familiar? We expect that higher taxes will continue to erode capital, but that it is during the next downturn the true correction of excess savings will occur – especially from losses among investors that are reaching for yield now. Note, the ultimate solution that generated a return to higher interest rates after the early 1900s and 1930s were capital destruction during WWI and WWII. Hopefully, this time it will simply take bad economic policies elsewhere (austerity in Europe, inflation targeting in Japan) to destroy enough of their capital that global balance is returned. Low interest rates will not last forever, but history suggests the workout takes a very long time.