Zero-based money risks trapping recovery

Isaac Newton may have conceptualised the effects of gravity when that mythical apple fell on his head, but could he have imagined Neil Armstrong’s hop-skip-and-jumping on the moon, or the trapping of light inside a black hole? Probably not. Likewise, the deceased economic maestro of the 21st century – Hyman Minsky – probably couldn’t have conceived how his monetary theories could be altered by zero-based money.

Minsky, originator of the commonsensical “stability leads to instability” thesis; the economist with naming rights for 2008’s “Minsky Moment”; the exposer of the financial fragility of modern capitalism; probably couldn’t imagine the liquidity trap qualities of zero-based money, because who could have conceived 30 or 40 years ago that interest rates could ever approach zero for an extended period of time? Probably no one.

Nor, more importantly I suppose, can Ben Bernanke, Mario Draghi or Mervyn King. In their historical models, credit is as credit does, expanding perpetually after brief periods of recessionary contraction, showering economic activity with liquid fertiliser for productive investment and inevitable growth.

If they were to adopt Minsky’s framework, they would visualise a credit system expanding from “hedge” to “securitised” to “Ponzi” finance, pulling back after 2008 to the stability of the less levered “securitised” segment, but then expanding again as government credit substituted for private deleveraging, providing a foundation for future growth of the finance-based economy.

Well, maybe not. In modern central bank theory, liquidity traps are a function of fear and unwillingness to extend credit based upon the increasing probabilities of default. This world is the second half of Will Rogers’ famous maxim uttered in the Depression: “I’m not so much concerned about the return on my money, but the return of my money.”

But what if the return on Will’s money could come into play as well? What if liquidity could be trapped by zero-based policy rates and the absence of yield across much of the triple-A yield curve? What if money could be stashed in a figurative mattress because it didn’t earn anything? What if there was a liquidity trap duality of too much risk and too little return? That would be quite different to our “Minsky Moment” of three years ago.

The modern capitalistic model depends on risk-taking in several forms. Loss of principal – as in default – necessitates the cautious extension of credit to those that presumably can use it most efficiently. But our finance-based Minsky system is dependent as well on maturity extension. No home, commercial building or utility plant could be created if the credit liability matured or was callable overnight. Because this is so, lenders require and are incentivised by a yield premium for longer-term loans, historically expressed as a positively sloping yield curve.

A flat yield curve, by contrast, is a disincentive for lenders to extend intermediate or long-term credit unless there is sufficient downside room for yields to fall and bond prices to rise, resulting in capital gain opportunities.

Historically, because nominal and real yields have been high and substantially positive, even in flat curves credit markets have continued to function, helping spur economic and asset price expansion. A liquidity trap caused by “zero-bound yields” has always been averted because, in the past, yields have had further to fall, meaning investors were comforted by the prospects of capital gains.

When all yields approach the zero-bound, however, as in Japan for the past decade and in many developed economies today, then the dynamics may change.

What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is 2 per cent of par and the downside substantially more?

Maturity extension for Treasuries, and then for corporate and private credit alike, becomes riskier. The Minsky assumption of rejuvenation once the public sector stabilises the credit system then becomes problematic. Instability may slouch back towards stability, but that stability may resemble more closely the zero-bound world of Japan over the past 10 years than the dynamic developed economy model of the past half century.

The global economy’s quest for a modern-day Keynes or Minsky may be frustrated by zero-based money that rations credit just as fiercely as it does risk. Minsky’s economic theory is now at the zero-bound.

Bill Gross is founder and co-chief investment officer of Pimco