What's the greatest threat to the financial system?

Contrary to conventional wisdom, one commentator believes that it is not central bank rate decisions which determine inflation/deflation. What's more, whilst we worry about interest rates, we ignore a much more serious issue.

This article has been based upon a recent 16-page essay by H. Woody' Brock*, entitled "Inflation Its Origins, and Likely Behaviour". We start with part of his opening paragraph.

"Never in our memory has discussion of such an important issue been as devalued as this has been of late, with non-sensical assertions about "liquidity" and "the Fed" issued by people who ought to know better. In particular, the widespread assumption that monetary policy is Fed funds rate manipulation and nothing more is especially problematic. So is the equally widespread belief that changing the Fed funds rate is the correct way to control growth of the economy and inflation on Main Street (e.g., the Consumer Price Index [CPI]) and inflation on Wall Street (e.g., asset bubbles). This is a reductio ad absurdum at best, and a contradiction in terms at worst!"

To expand that point, he explains that for the period from 1965 to now, two quite different inflation regimes existed. From 1965 until 1981, the Dow lost, in real terms, two-thirds of its value, starting and finishing at the level of 1000, and the CPI almost tripled from 31.5 to 90.9. Following this from 1981 until 2000, financial net worth rose by the highest amount in history with bonds and stocks exploding in value and the inflation rate fell from 13.5% in 1980 to only 1.9% at the start of 2000. Following 2000, stock markets lost value but in their place a massive bubble in real estate occurred whilst retail price inflation remained subdued.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The behaviour of inflation on Wall Street was diametrically opposite to that on Main Street during two entire regimes. Two different logics' were clearly at work.

What determines asset market inflation/deflation?

Asset market inflation/deflation are, Woody maintains, caused by two things: an increase in optimism/pessimism and an increase in the availability/unavailability of credit. Optimism on its own, is never sufficient to fuel a bubble, easy credit also needs to be readily available. If one analyses the property market bubbles in recent years, the common denominator has been the availability of credit, irrespective of financial strength and great optimism. This time round it went about as far as it can go with loans available at the recent credit peak to almost anyone, for almost any amount, without proving either adequate income or necessarily making any contribution. Even borrowers with adverse credit histories and no money could join in!

Woody' says it is not cheap credit that must be available, but easily available credit. Lower interest rates, when credit is not readily available, will not help markets to rise and in the same way higher interest rates, when credit is readily available, will not cause prices to fall.

But optimism is vital, in Japan interest rates at the lowest levels imaginable did not cause increased investment nor economic recovery because pessimism reigned.

What is the role of Central Banks?

Much of the confusion is because for two important reasons Central Banks no longer control credit markets. The first reason is that banks can make loans and then get them off their balance sheets by selling them on to other investors such as hedge funds and pension funds, so freeing the decks for more lending. The second, much of the lending in today's world is done by non-banks. Non-banks can raise limitless sums by issuing bonds. All of the above activity is outside of the control of the Central Bank.

Woody is particularly scathing about Alan Greenspan's part in these matters, saying, in the concluding paragraph of his essay:

"In this regard, for all Alan Greenspan's accomplishments as Fed chairman, his disregard of the problem of excess leverage will go down as his signature failure. We forecast that it will soon be broadly recognized that leverage is the principal threat within the financial system not interest rates and inflation. And with the demise of Rational Expectations economic theory (aka Efficient Market theory), this will become recognized by academics as well. We will dust off Hyman Minsky's work and recognize that the management of leverage is a prime responsibility of government."

The dangers of excess leverage

Unfortunately, we have only space enough to pick from this important essay. What we have tried to point a finger at is the scale of the problem that might exist unless governments recognise the danger that now lurks beneath the surface caused by inflated asset prices and record levels of leverage. That danger might be exposed if asset values fall significantly.

For those who don't understand how serious can be the consequences of excessive leverage and falling asset values, they only have to look at reported events at the Amaranth Hedge Fund. This hedge fund recently suffered a 75% collapse in value as a consequence of heavily leveraged positions in sharply falling gas futures. The surprise was the list of good names that were investors in that fund; Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank, Mann Investments and Goldmann Sachs!

*Woody Brock is President of Strategic Economic Decisions, Inc.


By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/