I guess I’m not the only one with the willies over how procyclical the financial system has become. In an interview surrounding his new book, Paul Volcker has sharply departed from current conventional central-bank wisdom, pointing importantly to the potent risk cocktail now mixing a decade of quantitative easing with the top of the business cycle and a sharp increase in market risk-taking. He’s also argued that the U.S. is now a “plutocracy.” He’s right – U.S. income and wealth inequality has hit new highs. And, when inequality is as bad it is, it exacerbates the risk of financial crises. Could our boom expire in a gentle, gradual way? Or, as Mr. Volcker fears, will markets restructured by a decade of central-bank and regulatory actions into arbitraging and yield-chasing run for cover if they take fright? And, if they do, how fast does this rout turn into another systemic crisis given that America is even less equal now than it was in 2007?
Mr. Volcker is almost alone among current and former regulators in his prescient grasp of the ways post-crisis policy fires up procyclicality in concert with ever-worse economic inequality. As we noted in our assessment earlier this week of the FSB’s forward-looking work plan, global central bankers and regulators are totally pleased with themselves about the bastion into which they’ve made the world’s biggest banks by dint of all the post-crisis standards. They’ve been worrying for years that costly bank rules realign finance into a “shadow-bank” business, with the 2018 statement showing that they’re still worried. What to do? So far, the FSB has taken what for it is a leap and renamed shadow banks as “non-bank financial intermediaries.” Progress of a sort, I suppose.
A look at just one asset class shows the deadly link between post-crisis policy and procyclicality, not to mention sad ironies about economic equality. As Bloomberg made clear just yesterday, global corporate debt is now a $14 trillion market. In the U.S., corporate exposures are at an all-time high as a percentage of the economy, with many loans deserving junk ratings despite the – yet again – light touch from the all-too generous rating agencies. With companies often using debt to repurchase shares, not to build capacity, or to finance highly-leveraged acquisitions for equity extraction, today’s corporate-debt market looks especially fragile.
And importantly so do all the lenders enabling this boom who number among the non-bank financial intermediaries FSB has fingered, but not substantively touched. More and more of U.S. corporate lending is going not just into the bond market, but also coming from business development companies, private-equity firms, and finance companies. Fine for credit availability for the biggest firms for their own purposes, but not so much for a sustained, liquid, prudent market backed by capital and liquidity.
The policy connection? Study after study we have assessed on our Economic Equality blog shows how quantitative easing stokes yield-chasing, especially by insurance companies, mutual funds, and pension funds outside the reach of post-crisis bank regulation. The market for all these high-risk, low-spread loans are, unsurprisingly, these same yield-hungry investors. An overly-hot corporate-debt market in which a lot of junk has almost no spread over full-faith-and-credit Treasury obligations is an artifact of a post-crisis financial market in which return-sustaining yields are impossible to achieve in safe assets. Money can’t sit in the vault and thus goes where monetary policy drives it unless rules or just plain prudence force restraint.
Importantly, the corporate debt described above isn’t to small businesses, the most effective engine of U.S. income equality and bottom-up growth. Almost half of the private workforce is employed by small businesses. But, U.S. banking agencies showed just yesterday that bank small-business lending has barely budged since 2016, even though the economy is, the Fed says, sound and growing.
The Fed has long suggested that small-business loan demand is down even though small businesses disagree. There’s demand – look for it not just by listening to small businesses, but also at the rapid-fire growth of P2P platforms willing to make loans banks can’t or won’t. Nonbank financial intermediation strikes again, due to a regulatory vacuum created by post-crisis policy and ultra-low interest rates. CCAR plays a role here , as does the fact that even small banks – the most important source of start-up lending – are struggling with an array of capital, compliance, and strategic questions that suppress their ability to support sustained, equitable growth.
Corporate debt isn’t the only market with all too much froth at this dangerous moment of market volatility, monetary-policy normalization (sort of), and geopolitical risk. Despite all the post-crisis rules, residential mortgages are also showing signs of irrational exuberance even as housing markets start to give up the ghost. And, as with corporate debt, the money is flowing to high-risk borrowers, not those in urgent need of their first mortgage to begin the path to family wealth accumulation. In a surpassing irony of post-crisis policy, the same speculative borrowers who precipitated the last crisis are flush with funds even as subprime purchase-money borrowers go begging.
Perhaps the most important point Mr. Volcker has made of late is that financial-market danger signs are often intuitively obvious. Those related to corporate leverage, U.S. inequality, and non-bank vulnerability are clearly flashing red in concert with a lot of external stress and risk. All too often, policy remedies come only after flaws that could have been readily remedied are exposed under acute stress. Then, of course, it’s too late. Let’s hope Mr. Volcker is wrong, but not wait to find out the hard way.