A Minsky Moment?

John Plender wrote in yesterday's Financial Times,  "Complacent investors face prospect of a Minsky moment."  

One observation is hard to quarrel with, to wit,  "It is historically atypical in that the central banks have been encouraging market participants through quantitative easing to take on more risk to help stave off a perceived deflationary threat. This was, in a sense, a perpetuation of the asymmetric policy pursued by the Federal Reserve before the crisis." we have seen the Greenspan Put on the stock market, the Bernanke Put on the housing market, and are we now seeing the Powell Put on the current bubbles?

Financial assets have grown rapidly relative to the stock of physical capital and certainly some bubbles have been inflated, most notably the growth of unicorns.

On the the hand, he claims hat that "Since the Trump tax changes (sic) are unlikely to have more than a modest impact on potential output, the economy, already close to full employment, could run into capacity constraints."  This is unduly pessimistic.  The Paul Ryan/ GOP/Trump tax cuts have dramatically reduced the cost of equity and, for well capitalized companies, for corporate investment in real capital.  Reducing marginal individual tax rates improves incentives to work.  The limit on state and local tax deductions reduces the tax incentive to drive prices up in the most expensive markets in the nation.

The supply side tax changes combined with the administration's deregulation initiatives has accelerated economic growth after the slowest economic recovery in a century.  Growth, the first real wage rate rises since the 1990s, and the improved incentives have increased labor force participation by attracting workers who have given up or face disincentives to taking paying employment.  Workers on disability have reentered the workforce.  Yes the unemployment rate is the lowest in forty-nine years, but the prime age employment ratio is still below its level at the beginning of the 2007-9 recession even though it is eleven years later.

Not only did the 2017 tax act create supply side incentives for the real economy (which Mr. Plender judges too weak), but it also reduced the tax incentive to over lever.  It limited corporations' ability to deduct interest expense and the lower corporate marginal corporate tax rates reduce debt's tax subsidy.  The debt binges by Netflix and Amazon among others is their last hurray.  

Citing Dr. Doom (Henry Kaufman), Plender worries that "the 10 largest financial institutions held about 10 per cent of US financial assets. Today the figure is about 80 per cent."  While that may reduce the liquidity of financial markets, but it also makes the banking sector more stable.  Canada with similar concentration for a century or more has not had a banking crisis since the 1840s.  A shift of capital raising from the financial markets to the commercial banks by itself would increase the potential for economic growth.  A key initiative by the Republicans with some bipartisan support is to reduce the regulatory burden of smaller banks that are not a systemic threat and shifting the emphasis from regulation to capital.

Sexy is scary I

Butterwood argues in the Economist that the U.S. stock market is overvalued.  At 32.8, the Cyclically adjusted price earnings ratio (CAPE) is certainly pricey.  Perhaps that is one reason investors have backed off some of their love affair with FAANG stocks.

Buttonwood cites research by Research Affiliates, a fund-management group.
You can hear the authors of the research ("Cape Fear: Why CAPE Naysayers Are Wrong"), Rob Arnott Vitali Kalesnik Jim Masturzo, explain their thesis in in this video.

James Grant And Nouriel Roubini on Macro Risk

James Grant and Nouriel Roubini square off at the Octavian Institute:

China to Be Long On Gold & Real Estate and Short on the Dollar

Zhou Xin and Alan Wheatley report in the Guardian, "Li Lianzhong, who heads the economic department of the Party's policy research office, said China should use more of its $1.95 trillion in foreign exchange reserves to buy energy and natural resource assets.

"Speaking at a foreign exchange and gold forum, Li also said that buying land in the United States was a better option for China than buying U.S. Treasury securities.

"'Should we buy gold or U.S. Treasuries?' Li asked. 'The U.S. is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.'"

China has 1,054 metric tonnes which, with gold selling at $941/oz, is worth $35 billion compared to America's 8,133.5 metric tonnes worth $270 billion.

Dow Jones reported that gold was up during the day's trading: "The initial rise occurred on a day when the U.S. dollar weakened partly in response to comments from the People's Bank of China saying it will push for reform of the international currency system to make it more diversified and reduce over-reliance on the current reserve currencies, primarily the dollar. This particularly caught the eye of gold traders a day after a senior economic researcher in the Communist Party expressed concern about the dollar and said gold could be a better alternative.

"'The People's Bank of China's call for a new global reserve currency or super-sovereign currency will likely lead to further pressure on the dollar and gold buying,' said Mark O'Byrne, director of bullion dealer GoldCore. "


The BRIC countries have called for the creation of a new reserve currency or at least a reduced dependence on the dollar.

According to Zhou Xin and Alan Wheatley, "China disclosed on April 24 that it had increased its holdings of gold to 1,054 tonnes from 600 tonnes since 2003.

"However, China's foreign exchange reserves have grown so fast over the same period that gold's share of the stockpile, the largest in the world, has shrunk.

"Li cited the high share of gold in the foreign exchange reserves of the United States, Italy, Germany and France, to argue that China's gold holdings, which account for about 1.6 percent of its reserves, are too small.

REFORMING THE SDR

"China does not disclose the composition of its currency reserves, but bankers assume around 70 percent of it is held in dollar assets.

"China is the largest single holder of U.S. Treasuries, with $763.5 billion at the end of April, according to U.S. Treasury data. [ID:nTRU000389].

"Analysts say this data set understates the true number as it does not capture paper bought through dealers in London or elsewhere.

"Li said a second reason for buying more gold would be in anticipation of the yuan one day becoming a reserve currency.

"The yuan is not convertible on the capital account, meaning it cannot be freely traded for other currencies for financial transactions that are not related to trade.

"This rules out the yuan's use as an international reserve currency, for central banks would not be able to convert it quickly if necessary.

"But, in a very preliminary step towards that goal, China is paving the way for greater use of the yuan beyond its borders.

"
The People's Bank of China has arranged currency swap deals with six countries since December totaling 650 billion yuan ($95 billion) so that trade and investment with China can be conducted in yuan, not dollars.

"And China will soon allow selected firms in the southern province of Guangdong that trade with Hong Kong to settle their transactions in yuan, or renminbi.

"'If the yuan should go international or become a reserve currency, China needs more gold to back that,' Li said.

"When the yuan does become an international currency, which Li acknowledged was a long way off, he said the composition of the SDR should be reformed to include the Chinese currency.

Ideally, in the long term, the SDR would be made up of the dollar, euro, sterling and yen and yuan, each with a weighting of 20 percent, Li said.

"The SDR is currently made up of the dollar (with a weighting of 44 percent), the euro (34 percent), the yen (11 percent) and sterling (11 percent)

"The four currencies in the SDR, which must be convertible, are those issued by Fund members with the largest share of global trade. The weights assigned by the IMF are based on the value of exports and the amount of reserves denominated in those currencies.

"The composition of the basket is reviewed every five years. the next review is due in 2010."

Inflation is Bad, What about Asset Price Inflation?

You may be surprised to know who wrote "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some." The author is one of the finest economists of the twentieth century, an economist much mistreated by both his enemies and his followers, John Maynard Keynes. The quotation is from one of my favorite books, The Economic Consequences of the Peace. (Thurston Veblen reviewed the book with an ideological prism that seems quaint in retrospect.)

Note Keynes was an inflationist only in the starkly deflationary post-World War I Britain which returned to the Gold Standard at the pre-war parity. This policy forced Britain into a difficult deflation of prices and a real economic adjustment of heart wrenching dimensions. The alternative was to have Britain devalue the pound, undermine London's position as the world's capital market, and effectively default on its war debt (i.e., "Here we will pay you back the war debt, but with pounds that buy less in gold.") Britain chose economic and human disaster over financial disaster, although the choice was less obvious than my words suggest.

Why is inflation bad? It creates arbitrary redistributions of wealth and it distorts incentives. The lesson our current financial custodians fail to understand is that over expansions of credit sometimes result in the inflation of asset prices rather than the inflation of commodity prices: it inflates the prices of stocks rather than flows. But that also is unfair. They may perceive that positive conclusion. What they may fail to understand is its normative implication that asset price inflation is bad: that it too creates arbitrary redistributions of wealth and distorts incentives. Anyone who doubts that should look to the asset price bubbles of the late 1980s (house prices in New England and California); the dot com bubble of 1995-2000; and the housing bubble of 2004-6. Each created arbitrary redistributions of wealth. Each distorted incentives and created a misallocation of resources. Misallocations of resources can not be undone without pain.

In 2002 through 2004, Alan Greenspan worried about deflation: Commodity prices might fall! As the comedian in the Catskills might say, "We should have been so lucky already!"

Corrections made 1/31/2011