Heard in the Village: July 2009

The interview of Paul McCulley, PIMCO ‘s economist, in the June 22, 2009 issue of BARRON’S was a topic in the village this month.He had called the financial melt down in 2007. A major cause was a number of unregulated non-bank financial entities that created conduits, collateralized debt obligations and structured investment vehicles. In the fall of 2007 these entities couldn’t get enough liquidity from regular banks to roll over their asset based commercial paper

He said the collapse of Lehman Brothers set off the “greatest margin call in the past 100 years.” The panic begot further selling. He said, ”It was the ultimate Keynsian paradox of thrift, in that the prudent actions of individual institutions to sell and get liquid collectively proved ruinous to the financial markets and economy in general.”

He thinks it will be years for the economy to get back to normal growth which is why he doesn’t believe hyperinflation is coming anytime soon. Inflation isn’t a problem with the current excess labor and industrial capacity. He likes investment grade bonds and Build America, taxable municipal bonds on which the government subsidizes 35% of the interest. He also thinks there won’t be any fed-funds hike until 2011. He believes the above because of his analysis of a neo-Keynsian named Hyman Minsky who was skeptical of the efficient markets and their self adjusting equilibrium.

Minsky believed mankind often acts in irrational ways which gives to endemic booms followed by “nerve shattering” busts. He also observed human behavior during debt cycles. “Debt leverage, of course, is what drives speculation during an upswing and then causes the collapse of asset prices and sometimes of the general economy on the downward swing in what I like to call "the Minsky journey.”

Minsky had 3 stages in the upswing of the credit cycle: the “hedge unit” when credit is extended to only those with the cash flow and resources to pay off the loans: the “speculative unit,” which pushes the lender and borrower into a more risky direction and finally the “ponzi unit,” when merrily rising asset prices, spurred by heavy speculative buying, cause both lenders and borrowers to cast caution to the wind. Both are relying on continued collateral value to bail out the loans. McCulley thinks any reforms won’t prevent future systemic risks because of human nature and financial innovation. The villagers agreed.

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