Is the Federal Reserve trying to thread Cleopatra’s needle with an over cooked piece of spaghetti while simultaneously herding a bunch of feral cats gathered at the edge of a cliff? Best of intentions aside, the Fed’s semi-coherent policy might save half the cats but the other half will likely fall into the abyss. The question is which half will be saved?
Regarding semi-coherence, the Fed might learn a thing or two from the old adage most frequently attributed to retail baron John Wanamaker about the advertising industry:
Half the money I spend on advertising is completely wasted; the trouble is, I don’t know which half.”
Google’s pay-per-click solved that problem for the advertising industry. Maybe the Fed should figure out a pay-per-click model for monetary policy.
Old business models die hard. When it comes to central banking the foundational policy wisdom about financial crises revolves around two ideological constructs: “too big to fail” and “lender of last resort.” But book-ended by the 2008 Great Financial Crisis and the Covidolypse it seems the Fed has been exploring and tinkering, lest I say experimenting, with their business model. From ZIRP (zero interest rate policy) to NIRP (negative interest rate policy), QE1 (Quantitative Easing I) , QE2 (Quantitative easing 2) , TARP (Troubled Asset Relief Program) , TALF (Term Asset-Backed Securities Loan Facility) and so forth resulted in low inflation and free money that begets sloppy (undisciplined) capital setting the stage for asset bubbles across almost all asset classes and sectors. Ultimately all Frankenbubbles burst after the “over-lending” comes to a halt, the regulators, auditors and SEC and like magic a Minsky Moment is upon us.
According to ChatGPT 4.0
“a Minsky Moment is is a term used in economics to describe a sudden, sharp collapse of asset prices after a period of rapid growth or excessive speculation. The concept is named after American economist Hyman Minsky, who extensively studied financial crises and developed the Financial Instability Hypothesis.
According to Minsky’s hypothesis, there are three stages in the financial cycle: hedge finance, speculative finance, and Ponzi finance. During the hedge finance stage, borrowers can repay both the principal and interest on their loans. In the speculative finance stage, borrowers can only afford to pay the interest, relying on the continued appreciation of asset prices to refinance their debt. In the Ponzi finance stage, borrowers cannot even pay the interest on their loans and rely solely on further appreciation of asset prices to service their debt.
The Minsky Moment occurs when asset prices stop rising and the Ponzi finance stage is no longer sustainable, leading to a sudden and severe market collapse. As investors realize that they cannot rely on rising asset prices to pay off their debt, they rush to sell their assets, causing prices to plummet further. This rapid decline can trigger a financial crisis, as was the case in the 2008 global financial crisis, which had elements of a Minsky Moment.”
-ChatGPT 4.0 (note this definition was added after the original December 2022 publication date)
There is a famous anecdote about going bankrupt: When asked how Joe went bankrupt Joe responded, “first slowly then all at once.”
As we enter the Minsky Moment phase another financial phenomenon starts to take hold: fair value accounting moves to center stage further exacerbating an already unstable situation. Trying to establish permanently impaired values in a collapsing market with few to no willing buyers or sellers is a fool’s errand that makes matters worse. But that’s how the system works… or is supposed to work to re-establish credibility and trust in the numbers. Contagion risk, loss of confidence, market confusion etc start to foment an enormous self-fulfilling prophecy. The Feds start trying to put the toothpaste back in the tube but sadly it’s too late and extraordinary extemporaneous “solutions” are thrown into the mix without the wisdom, foresight, or experience to understand the inherent nature of markets and all the unintended consequences or knee jerk policies that tend to come up with temporary solutions instead of addressing the long term structural problems further stressing the system. Or said more succinctly, we rush to come up with seemingly plausible solutions– often a solution to the wrong problem.
“Horror Vacui “(Nature abhors a vacuum)
Aristotle
Another lesson for the Fed comes from the oracle of Omaha himself, Warren Buffett, who cautions , “never try to sell a poodle to someone looking to buy a beagle.” Seems the market only wants to buy a beagle and Powell & Co. only have poodles for sale. Just as nature abhors a vacuum, financial markets abhor uncertainty. Given the unprecedented confluence of global challenges, the Fed’s response, seems to be as likely making a 7-10 split (professional bowlers have only a .7% probably of making that spare). The Feds lack of coherence have left the markets uncertain what they are even uncertain about…other than everything. But even worse is the loss of confidence in the Fed (sorry Chairman Powell) and The Treasury Department (sorry Secretary Yellen). But loss of confidence undermines trust and all the banking system has to run on is trust. That era really began on August 15, 1971 aka the “Nixon Shock” when the dollar was decoupled from gold and the printing presses have been rolling for nearly 50 years of printing dollar. Floating currencies mean that everytime any rate or price change occurs the entire matrix of global of assets gets repriced.
The world today doesn’t make any sense so why should I paint pictures that do?
“Pablo Picasso”
The dilemma-saddled Fed Chairman Jay Powell finds himself in a bit of a quandary. He’s trying to sell the market a Picasso (a poodle or perhaps a labradoodle) , when what they really want is a beautiful, easy to understand Rembrandt or a Reubens or even a Monet (a beagle). Representational art was displaced by abstract art with the advent of the camera– George Eastman’s Kodak camera. But markets hate abstraction even more than they hate a vacuum. Yet central banking only works well, if history rhymes let alone repeats itself. Control ambiguity is necessary lest we encounter the death of moral hazard necessary to try to keep the squidlets in line (good luck with that.)
It wouldn’t be too difficult to make the case: “Half of Federal Reserve monetary policy is completely wasted; unfortunately we don’t know which half.” Not only is it wasted it’s downright dangerous bordering on an existential threat to civilization. There’s a 50% chance (a completely non-scientific conjecture) that 10 or 20 years from now people will look back at the period 2008- 2023 and equate Federal Reserve monetary policy to bloodletting as a state of the art medical procedure. (The same might also be said about our country’s fiscal policy.)
The idea that one man’s weathervane decision-making ripples through the financial markets at speed of light should call into question the wisdom of building a global financial system upon the shakiest of foundations. The three biggest risks confronting central bankers are: contagion, contagion, and contagion.
Having lived thru the Fed Chairman regimes of short-termer Arthurs Burns, Bill Miller, Paul “Tough Love” Volcker, Alan “the Put” Greenspan, Ben “the Put 2.0” Bernanke and Janet Yellen it is abundantly clear that Federal Reserve policy is anything but a science. A word of advice: the words “Federal Reserve” and “experiment” should never appear in the same sentence.
Before 2008, the regularly occurring financial crises of the 80’s and 90’s were mere annoyances dealt with deftly by an understanding of how to stabilize and clear the market over 24-36 months plus or minus. The standard protocol is to project confidence, stand ready to flood the market with enough liquidity and subtly remind people that Citibank is never going under and depositors will get 100 cents on the dollar. And don’t forget about moral hazard. Remember Enron? Even though a major financial crisis was averted Arthur Andersen was dragged into the courtyard and very publicly got their brains blown out for their egregiously bad behavior. Accountability for the people whose business was accountability. People even went to jail! Enron’s Ken Lay died before his sentencing but Jeff Skilling got to practice up on his golf while spending a dozen years in the slammer.
Up until the Great Financial Crisis federal reserve policy had a predictable pattern and rhythm for the myriad of crises since the early 90s. The crises came, they were swiftly and deftly managed (relatively speaking), confidence was restored, and then like magic in 24-36 months business was pretty much back to normal. But the yield curve configuration gave the Fed plenty of room to maneuver. Some lessons were learned, others not so much, and some not at all. But the Fed steady-as-she-goes by 2008 realized they were going to need a bigger boat… a much bigger boat. Controlled ambiguity, avoiding moral hazard, accountability and unlimited liquidity at the quick and ready could usually stabilize a market crisis in 24-36 months– give or take. Just enough time for Blackstone, Apollo, Carlyle, Goldman “the Vampire Squid” Sachs to make billions. By 2010 Goldman Sachs no longer had clients, they only had counterparties according to the Squid Master Lloyd Blankfein
THOUGHT EXPERIMENT
Think of this as a thought experiment for dealing with the unprecedented GFC in 2008. WHAT IF….
- …WHAT IF the Fed had simply bought in the $300 billion or so of subprime mortgages, ring-fenced them in a bad bank a la Resolution Trust Corp? Instead we let $300 billion of subprime NINJA loans (no income, no job, no assets) morph into a $100 trillion global meltdown. Everything is interconnected. Contagion, contagion, contagion. As Sam Zell likes to say, “when the tide goes down we get to see who’s wearing a bathing suit.”
- …WHAT IF the Fed and the U.S. Treasury had jointly announced to the world that the financial markets we no longer functioning properly and therefore fair value accounting would be adjusted; fair value accounting by definition implies willing buyers and willings sellers. If the markets are not functioning properly the fundamental tenet of fair value goes out the window. That would throw a wrench into fair value accounting which distorts everything in a market experiencing a death spiral. Every asset is connected to every other asset – whether correlative or non-correlative. What brought down the house of cards in 2008 wasn’t really the subprime detritus; it was only $300 billion crisis and easy enough to manage. But the real culprits? Those who made dubious margin calls at the speed of light. The margin calls were made in the lenders’ “sole discretion” with no recourse forcing all whose positions were financed with repo (repurchase agreements) to top up their collateral (within 2 hours) or forfeit their collateral altogether. Hardly a willing buyer and a willing seller. As all securities are interconnected, securities lenders were grabbing collateral to cover their repo loans like drunken sailors at nickel beer night. Ironically for the vast majority of the market, the securities, excluding the subprime crapola, were performing as were the underlying assets that constituted the array of rated and unrated securities. There were many instances where lenders made egregious margin calls simply because they could. Since most language repo agreements at the time provided the lender with sole discretion in marking to market. If you disagreed with the lenders marks, tough bananas.
- …WHAT IF Fed and Treasury had simply set up a post facto tribunal (think of South Africa’s Truth and Reconciliation Panels) to arbitrate bad faith or inappropriate margin calls and provided a clawback mechanism? Perhaps a modicum of accountability might have moderated the downward spiral as the markets seized up completely. And if it were determined that the margin calls were inappropriate, painful penalties could be assessed against the transgressor. A little accountability never hurt anyone. Keep in mind antitrust damages are subject to treble damages lending true accountability for bad behavior. Remember those rating agency text messages? Remind me again– who went to jail?
- .. WHAT IF the Fed had focus on stabilizing spreads with global master credit spread swap agreements rather than flooding the market with unlimited liquidity (whether M1 or M2) that created massive asset bubbles resulting in zero or even negative interest rates of unprecedented proportions. The Fed was simultaneously manipulating the dead cat yield curve with artificially low interest rates and playing chicken with the market. Remember at some point those chickens will come home to roost. They always do.
Note to self: in dysfunctional markets fair value accounting creates epic anomalies in the structure of credit spreads across the entire debt spectrum from AAA to BB-rated securities. When BB spreads on mortgage back securities instantaneously widen from 275 basis over treasuries to 600 over then 1200 over to “no bid” what the hell do you think is going to happen to valuations? Keep in mind other than the subprime “crap” the securities and assets underlying the securities were by and large performing.
When moral hazard was thrown to the wolves, Wall Street learned that too big to fail coupled with the Fed “put” turned monetary policy into a game of cat-and-mouse flipping coins: heads I win, tails you lose. Asymmetric risk is the breakfast of champions for Masters of the Universe.
Geitner and Paulson’s QE1, QE2, TARP, TALF etc. staved off a short term crisis by kicking the can down the road inflating the Fed balance sheet to a whopping $2 trillion which by the way has ballooned to $31 trillion due to deficits and the covidalypse. The Rahm Emanuel’s crisis had gone to waste and some 15 years later we are still trying to find the can. Let’s be clear: the can is still there. As Powell tries to herd all the stray cats who expect him to put a bowl of milk out on the front porch, seems they don’t believe him even when he says he’s serious. The Fed’s loss of credibility (i.e. trust), use of “uncontrolled” ambiguity and hard-to-read messaging could lead to a Roubini-esque self-fulfilling prophecy of biblical proportions. Clearly Powell has yet to master the art of Greenspeak who did at least understand and embrace controlled ambiguity.
The only way to restore functioning markets is to restore trust and credibility… everything else is an experiment. Oh yeah. FTX and SBF should be a clarion warning to politicians and regulators: don’t try to regulate something you don’t understand. Mazars resigning from auditing crypto (on the heels of resigning as Donald Trump’s auditors) should be a massive shot across the bow: if you can’t get auditors to audit proof of reserves, proof of assets or proof of liabilities no institution in its right mind will touch this stuff. For those of you have bothered to read or pretend to understand the pseudonymous Satoshi Nakamoto’s Bitcoin white paper one thing is clear. The fundamental premise of Bitcoin is that trust can be created between untrustworthy parties algorithmically without a trusted intermediary to avoid what’s called the double spend problem. Trying to create trust between inherent untrustworthy parties is a really bad idea. Or as Alan Greenspan testified in Congress regarding the GFC– “there was a flaw in my ideology.”
One former lender of last resort, J.P. Morgan himself, said it best in the Pujo Hearings in 1906:
“The first thing…is character … before money or anything else. Money cannot buy it.… A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business.”
Maybe it’s time to get back to fundamentals. So when will things get back to normal and stabilize the global financial system? When trust trades at par.
ps. How’s this for a novel idea: if you want a soft landing bring in Sully Sullenberger to run the Fed.
NOTE TO READER: This article was published in December, 2022 before the collapse of SVB, First Republic and Signature Bank.
