"...Mistakes are the portals of discovery." --- James Joyce
Dear new world Fools:
Begin Sojourn :
The morning air was cool and salty and still. Martin and Vicente Pinzón were kneeling in the sand, nervously glancing back and over the heads of the landing party. The morning stars were fading in the early light so they now needed to position the sunrise. The Pinzón brothers were respected, experienced, well traveled mariners. They were completely uncertain of where they were, and equally certain of where they weren't.
In front of Martin and Vicente were two Franciscans , kneeling in a line with Columbus.
With a sideways scowl, the friar next to Columbus got the hint, stood and blessed the ships and crews. As the exhausted men struggled up from their knees, Columbus turned toward the landing party and stood akimbo. He bellowed, "So? Who among you believed that we should sail into the abyss? Well? Is this the abyss? Perrrhaps this is a mirage??? Well? Can a sailor staaaand on a mirage? Eh?" Then he wagged his finger at the thick rain forest behind him. "Beyond those trees are great cities, markets full of spices, emeralds, silks and treasures beyond your imaginations. For this is not the abyss! Nor is this a mirage!" He jabbed his finger at the sand. "THIS IS INDIA!".
Then, pretending not to have noticed the Franciscan's replica wooden crucifix directly behind him, he picked up two fistfuls of sand and proclaimed with outstretched arms, "Yet, even those who doubted me will return home wealthy and dressed head to toe in silk robes and bags of gold coins hanging from their belts! He glared directly at the Pinzon brothers. "I swear this, by the stars"! Then he piously looked skyward and let the sand pour from his hands.
This dramatic moment of allegorical salvation would be short lived.
For as he was turning his eyes up, a real drama unfolded behind him. An unbelievably large rodent, one that any sailor would recognize, but huge, sprang from the jungle immediately followed by two arrows that pierced the sand. The amazed crew gawped with awe as the gargantuan rodent scampered along the sand and then dived back into the jungle.
At the very moment the last grains of sand fell from Columbus's hands, the creatures pursuers spilled out of the forest and froze at the sight at the Spaniards. By then Columbus had lowered his head and opened his eyes expecting to see shamed and repentant faces. Instead he was greeted with a thunderclap of laughter, hoots, whistles and shouts of OLE! He spun around to see what the matter was and could not believe his eyes.
And now, with his back turned, there were shouts : "Captain! They were so hurried to greet us they forgot their silk robes!"; then another: "Look! They're wearing bags of gold coins!" (more uproar). To make matters worse, the appalled Franciscans had halfway sprinted wide eyed and shouting toward the Arawak hunters, frantically grabbing and shaking their long frocks with one hand, and 'pointing' with the other.
The Arawaks, who were by now more puzzled than surprised, mistakenly interpreted the Franciscan's frenetic motions as a desire to trade the robes for the 'objects' that they were pointing at, causing them to completely unravel into uncontrolled, riotous laughter. This pantomime did not go unnoticed by the sailors, and within an instant, they too were completely possessed by hysteria.
Dumbfounded, confused and frustrated, not knowing which way to turn, Columbus looked to the Pinzóns and shouted, "who the devil are they? Vicente Pinzón could scarcely disguise his sarcasm. "Why, sir! Who else can they be, but Indians?"
It is dawn, 12 October, 1492 and in spite of diligence, courage, daring and a brilliant hypothesis, Christopher Columbus has grossly underestimated the size the world he lived and two civilizations hitherto unknown to each another, collided.
The global economy has also been on a journey and it seems that we too have landed on some strange unknown place. It isn't the intended destination. This journey based on the work of an economist Hyman P. Minsky is called the "The Financial Instability Hypothesis" but more poetically renamed 'Minsky Journey' by the respected and experienced Paul McCulley of PIMCO. (link follows post).
In a nutshell Minsky's premise categorizes three general debt units of an economic cycle: the Hedge Financing in which the buyer's cash flow can cover both interest and principal (traditional),
Speculative in which cash flow can cover the interest, but not amortize principal (like a balloon mortgage) and lastly, Ponzi loans in which cash flow covers neither interest nor principal, and depends on an assumption of a continually rising asset prices (like NIJA loans).
A Minsky Journey begins with stability. This stability (and competition) 'begets' complacency and then more risk taking which eventually leads to rising asset prices as capital becomes more available.
This complacency and rising asset price leads to more and more lending and to the next stage of 'speculative debt' and thus, more bidding up of the underlying asset. Under an assumption that the underlying asset prices will continue to rise, the final stage of lending, the 'Ponzi lending' which will eventually lead to unsustainable lending, i.e., instability, and finally collapse.
And indeed, this is precisely what happened with the housing bubble. Further, the severity of the implosion was 'amplified' due to the infamous unregulated shadow banking system, which sold and packaged and resold mortgages which were becoming more and more risky, and for which demand was insatiable. Mr. McCulley describes the process as 'feeding the beast'.
Financial institutions demanded more collateralized debt, which required more mortgages which drove up asset prices and reduced loan quality. And all under the false assumption that there was some kind of floor to asset prices (real estate). Indeed, recall Mr Dimon's recent testimony in which he admitted that a sharp decline of real estate prices was not considered a probable risk : "...We didn't stress test housing prices going down by 40%...", he said.
But so far, that's only half of the Minsky Journey.
The reverse Minsky Journey starts from the peak of instability and reverses the entire process with a vengeance : asset prices fall, risk premiums rise, the economy recesses, which causes the loan stages to collapse in reverse, which leads to more strict lending, slowing the economy, collapsing the next level and so on until the system reaches stability.
And for a long while, it seemed as though the the reverse journey was indeed over.
But recent 'credit events' in Spain, Portugal, Greece et. al., put this into question. And now there are now serious concerns with U.K. debt.
If there was a ship's log of the journey so far its most recent entry might be that our current stability in this Minsky Journey is merely a pause in doldrums. The reason being that Government has taken 'the other side of the trade'; or another way to look at it is that Government has taken the wind out of the sails of bad debt from the banks in order to reinflate the system and in the process now has lowered the quality of its' own sovereign debt, globally.
Of course, there must be a bad assumption on a Minsky Journey and indeed there is one, namely, China (and to a lesser extent India). The assumption is that these two emerging market countries will continue with sustainable high growth. For the sake of the argument, I offer two examples to the contrary from respected sources. There is a growing consensus :
"BEIJING, Feb 3 (Reuters) - A major Chinese bank has raised mortgage rates in one of the first signs of how a government lending clampdown is rippling...the liquidity tightening has weighed on investors worldwide, who fret that it will curb demand from an economy that has led the way out of the global financial crisis..."
"BBC News Monday, 8 February 2010....India's economy is recovering faster than expected - it grew at an annual pace of 7.9% in the three months.... policymakers are now starting to turn their attention to inflation....It also lifted its inflation forecast for the end of the financial year in March to 8.5%..."
Both countries are trying to contain unsustainable growth. In particular, they've reached a point of instability themselves. Now it's still possible that they will be able to engineer a smooth landing, but in reality, how probable is that especially in a country that has a politically sensitive, state controlled economy?
If these two governments "overshoot" their mark, which governments are wont to do, it could pull the support out from under already stretched commodity prices and create a 'domino effect' that carries over to all asset prices.
Lastly, one should take careful note of how the very threat of sovereign debt collapse has effected the Euro, Yen, Dollar, Treasury Yields, and last, but not least, U.S. and global Equity Markets over the past four weeks.
It's possible that equity markets have underestimated the size of the global economy much the same way that Columbus underestimated the size of the earth. The view of recovery might have been too narrow and we've merely landed off the coast of, true, a new economic world, but far, far from our intended destination.
The U.S. economy, as it stands on its' own may have bottomed. But from a bigger perspective, one that takes into account the relationships between the major global economies there is an ongoing forward Minsky Journey, whose 'Ponzi debt stage', like those of the weaker EU members are reaching their sustainable limits.
Your spiced Fool,
Here's the link for Paul McCulley's outline of the Minsky Instability Hypothesis. It's well worth your time an effort to read it, and then put it in perspective with sovereign debt, currency, commodity and, of course, equity prices.
"...Mistakes are the portals of discovery." --- James Joyce