Dodd Frank repeal: stability induces instability

Main Points

  • The abrupt shift towards financial deregulation is a bit spooky from an historical perspective. It may reflect that confidence has become quite high, which does not tend to predict high returns going forward.
  • But this is a pretty tentative thought and the evidence points away from the idea that the credit cycle is already dangerously overextended.

Regulation and intervention always create a moral hazard dimension.  In the absence of deposit insurance, a bank would be subject to depositor surveillance, and a run would occur if the bank lost the confidence of its depositors. With deposit insurance, the need for depositor surveillance is much diminished.  This may mean than banks and other financial institutions will take more adventuresome positions. The central bank and the deposit insurance organization must therefore contain the exposure of banks. Regulation becomes the other side of the coin of deposit insurance.

In financial markets, success can breed behavior that leads to failure. As I put it many years ago, “stability induces instability”.  The pattern of financing after a period of success can induce a thinning of the margins of safety between cash flows in and cash flows out. It can also lead to patterns of borrowing that assume asset values will appreciate and that reflect optimistic views about cash receipts. In this setting, speculative and Ponzi finance become more important.

Regulation to limit speculative Ponzi financing would be desirable. But it is very difficult to set up a regime of regulation which long remains effective. This is particularly true as the regulators live in the same environment as the regulated. The decrease in risk aversion by financiers is accompanied by greater permissiveness by the regulators. 

Hyman Minsky, 1986

Confirmation that the new Congress and Administration plan to repeal Dodd-Frank made me go searching for Minsky’s passage on the regulatory cycle.  I doubt I found the seminal statement, but I think the passage above from an article in 1986 probably captures it well enough.

The purpose of this post is to assess – or really, begin to assess – whether the new fashion for financial deregulation signals that we have entered a bubble phase.  To avoid suspense, my conclusion is that we are not yet dangerously advanced in that process.  But even that is tentative, because this is a new idea. This is pretty conceptual and largely for fun.

Before turning to the practical stuff, such as it is, I want to make a somewhat amateur observation about method here.  It seems to me, and to many others, that one of the reasons Minsky’s work received insufficient attention ahead of the late-2000s crash is that it did not accord very well with the micro-founded macro that had been ascendant to that point.

From the perspective of a macro model arising out of individual optimization, the idea that investors and regulators succumb to predictable oscillations of confidence seems ad hoc and just so. One can see why the micro-founded guys would not be attracted, a point Minsky himself seems also to have understood.

What is fun here is that Minsky skipped all that in favor of trying to understand the implications of what seemed to him to be a fairly reliable empirical regularity. As asset prices rise and memories of the last crisis fade, credulity increases.

About three decades after Minsky set out his main thesis, Daniel Kahneman became the first non-economist ever to win a Nobel Prize in economics, and arguably  (indirectly) for providing – empirical as opposed to merely axiomatic – justification for Minsky’s work.  Minsky’s point of departure is simply availability bias.  To me, that idea is so truthy and fun that I am just going to go ahead here and assume it is valid.

Opinions apparently vary on how availability bias might influence the regulatory regime, beyond the obvious point of making it pro-cyclical. Some would claim the regulators themselves suffer the bias. Others (e.g. Mancur Olson) might relate this to the influence of special interests ebbing and flowing as the public’s attention does as well. And I suppose you could say that all this gets reflected in elections.

In this context, we might say that full control by the GOP is actually more a reflection of excessive confidence than of disgust!

screen-shot-2016-11-17-at-10-40-38-amThat’s national recovery, not national rifle

In 1932, the capitalists wanted rescue from Roosevelt.  By 1936, with things looking better, they were all pearl clutchy about individual rights and signing up with the Liberty League. Down came those blue eagles.

At this point, though, I am wandering way beyond my competence and being pseudo philosophical like a bad David Brooks op-ed. Are there any other kinds? So lets get practical.  I have argued here, here, and here that the US economy does not appear yet to have entered the dangerously overextended phase of the cycle. And credit growth, itself, still appears moderate, although a bit less so in the business sector than in the household sector.

screen-shot-2016-11-17-at-10-32-56-am

A key point about credit growth in the business sector is that it seems to reflect more a case of increased financial engineering than real-economy imbalances. By this I mean, that corporations are not running capital spending well ahead of retained cash flow, which historically has been quite dangerous.

Instead, they are buying back equity. That process probably has to be disciplined at some point, which is yet another reason I am not too excited about the equity market here. The “easy” part of the rally is behind us. But this is less troubling than if the financial imbalance was funding a real-economy imbalance, which so far it seems not to be.

So if the geniuses are going to “unshackle” the banks and just let er rip, then that is bad, but first count to 100.