12/28/2001 Financial Arbitrage Capitalism *

The year ended with uncustomary relative quiet. For the week, the Dow, S&P500, and Transports gained 1%. The Morgan Stanley Cyclical index added 3%, increasing its 2001 gain to almost 5%. The Utilities added 3%, while the Morgan Stanley Consumer index was unchanged. The broader market again outperformed, with the small cap Russell 2000 adding 2% (2001 gain of 2%) and the S&P400 Mid-cap index adding 3%. Technology stocks bounced back from last week’s selling, with the NASDAQ100 and Morgan Stanley High Tech indices gaining 2%. The Street.com Internet index jumped 5%, with the NASDAQ Telecommunications and Semiconductor indices rising 3%. Financial stocks were strong, with the AMEX securities broker/dealer and S&P Bank indices adding 2%. Biotechs added 3%. With bullion dropping $1.50, the HUI Gold index declined about 1%.

The Credit market ended the year generally fighting back a flurry of stronger economic data. For the week, two-year Treasury yields declined 5 basis points to 3.06%, while 5-year yields were basically unchanged at 4.42%. Longer-dated Treasuries did not fare as well, with 10-year Treasury yields increasing 2 basis points to 5.11% and long-bond yields jumping 9 basis points to 5.54%. Benchmark mortgage-back yields generally increased 3 basis points, while the implied yield on agency futures contracts declined 3 basis points this week. The spread on Fannie Mae’s 5 3/8 2011 note narrowed 1 to 75. The 10-year dollar swap spread narrowed 1 to 79. Bond markets were generally under pressure globally, as UK benchmark yields jumped above 5% to levels not seen since early September. German 10-year government yields rose to almost 5%, the highest rates since mid-July. Ten-year yields in Australia ended the year at almost 6%, up more than 100 basis points from last month’s lows. The beginning of the New Year does not appear to present the most hospitable environment for bond markets at home or abroad. The dollar index gained fractionally this week, with the yen suffering its worst yearly drop against the dollar since 1989.

Broad money supply (M3) surged $47.8 billion last week to $8.1 trillion, making it a truly incredible $385 billion (18.5% annualized) expansion over the past 14 weeks. Demand deposits increased $12 billion and savings deposits expanded almost $17 billion. Institutional money market fund deposits jumped $22 billion. Institutional money fund assets have jumped $190 billion (70% annualized) over 14 weeks and $417 billion, or 54%, over 52 weeks.

On the back of the strongest one-month jump in consumer confidence since February 1998 (93.7 vs. 84.9), both new and existing November home sales were reported today stronger than expected. New homes sold at a rate of 934,000 units, the strongest pace since March and up 6% year over year. The average price of $198,700 was down 5.7% year over year. Through November, new homes have sold at a blistering pace of 912,000 units, about 3% above 1998’s record. For comparison, last month’s sales were 40% above the level from November 1995 and more than double recession level lows from 1991. November existing home sales came in at a rate of 5.21 million, now putting 2001 on pace to surpass 1999’s record 5.21 million sales. The average price (mean) of $182,900 was up 3.6% year over year. For comparison, last month’s sales were 25% above levels from November 1995 and up 70% from November 1990. In a development to watch closely, the Mortgage Bankers Association weekly index of mortgage purchase applications surged almost 17% last week, easily setting an all-time record. This index has now jumped 40% off of October lows. On the other hand, applications to refinance have collapsed back to July levels and are now in line with year ago activity.

Dec. 28 Bloomberg – “Companies sold a record $819.7 billion in bonds this year as firms…took advantage of the lowest interest rates in four decades to refinance debt… Companies sold 43 percent more bonds this year than the $573.8 billion in total debt issued in 2000… Investment-grade companies sold $741.3 billion of bonds in 2001, Dealogic said, topping the previous high of $527 billion set last year… Junk-rated companies sold $78.4 billion of debt, up 66 percent from $46.8 billion last year…”

Dec. 28 Bloomberg – “Investors poured more money into U.S. bond mutual funds than stock funds for the first time in a decade, retreating from equities in droves. Bond funds will get about $87.1 billion this year, the most since 1986, according to estimates by TrimTabs.com… Equity funds will net about $28.5 billion, down from a record $309 billion last year, the lowest since 1990.”

Today’s Wall Street Journal carried a piece by Greg Ip and Jacob Schlesinger “Did Greenspan Push US High-Tech Optimism Too Far?” The article addressed a central issue: “The Fed’s growth debate amounts to an argument over what kind of economy America can look forward to once the recession ends: one of rapidly rising living standards, low inflation, low interest rates, and federal budgets in reasonable balance – like that in most of the 1950s and 1960s – or a much-less-robust version.” Well, the current financial and economic backdrop could not be more unrecognizable as compared to the relative stability of the ‘50s and ‘60s. It will, furthermore, be the sustainability of current financial structures, atypical economic dynamics, and the seemingly vulnerable global purchasing power of the dollar that will determine the “robustness” of future U.S. prosperity, not Alan Greenspan’s nebulous, singular, wishful notion of “productivity.” In this vein, there is simply no analysis more apposite than that from the brilliant Hyman Minsky.

“In both Keynes and Schumpeter the in-place financial structure is a central determinant of the behaviour of a capitalist economy. But among the players in financial markets are entrepreneurial profit-seekers who innovate. As a result these markets evolve in response to profit opportunities which emerge as the productive apparatus changes. The evolutionary properties of market economies are evident in the changing structure of financial institutions as well as in the productive structure. In the Theory of Economic Development Schumpeter called the banker/financier the ephor of market economies. The ephor was a magistrate of Sparta who contained and controlled the kings. In Schumpeter’s vision it is the banking structure of a capitalist economy which controls and delineates what can be financed, and only that which is financed enters the realm of the possible. But nowhere is evolution, change and Schumpeterian entrepreneurship more evident than in banking and finance and nowhere is the drive for profits more clearly the factor making for change. But in an evolutionary system the power and efficacy of the ephor is also endogenously determined. To understand the short-term dynamics of business cycles and the longer-term evolution of economies it is necessary to understand the financing relations that rule, and how the profit-seeking activities of businessmen, bankers and portfolio managers lead to the evolution of financial structures.” Hyman P. Minsky, Schumpeter and Finance from Market and Institutions in Economic Development: Essays in Honour of Paulo Sylos Labini, 1993, p. 106

To garner better understanding as to the causes and ramifications of recent financial and economic turmoil it is helpful to contemplate the nature of dominant financial entrepreneurs, institutions, relations and structures. Minsky saw in capitalist economies “at least four models of the structure of relations among business, households and finance… Although all four coexist in advanced capitalistic economies, they can be viewed as stages in the development of capitalist finance. These are (1) commercial, (2) financial (3) managerial and (4) money market capitalism. These stages are related to what is financed and who does the proximate financing.” (I have used various excerpts from Minsky’s above-mentioned writing in an attempt to at least provide a flicker of illumination for the great depth of his pertinent analysis.)

Commercial Capitalism - The essence of commercial capitalism was bankers providing merchant finance for goods trading and manufacturing. “Commercial capitalism created a hierarchy of contingent commitments. The normal function of the economy saw the creation and the unwinding of these contingent commitments. When a contract that creates credit is fulfilled credit is destroyed… In commercial capitalist arrangements bankers financed producer’s inventories, but not the stock of durable capital assets used in production.”

Finance Capitalism – “The industrial revolution led to a great increase in the relative importance of machinery in production and therefore of the non-labour costs that prices had to cover…The nineteenth century was the first great era of putting in place industry that required expensive and durable capital assets…In Great Britain and the United States commercial banks…were not the main conduit for funds to corporations to finance positions in the expensive capital assets that made the industrial revolution possible. The flotations of stocks and bonds and the trading of existing stocks and bonds became intertwined in security markets…the capital development of these economies mainly depended upon market financing. The main institutions of the financing markets were investment bankers… The great crash of 1929-1933 marked the end of the era in which investment bankers dominated financial markets.” (Minsky, 1993, p. 108/109)

Managerial Capitalism – “In the world of Schumpeter, Kalecki and Keynes, profits depend upon financed investment and financing depended upon the funds made available through the intervention of commercial and investment banks. During the great depression, the Second World War and the peace that followed government became and remained a much larger part of the economy…government deficits led to profits. A major social policy in most capitalist economies was to improve the housing stock. In the United States this took the form of government support of mortgages and the institutions that financed mortgages…The fundamental Schumpeterian view that the process of entrepreneurs investing and bankers financing these investments leads to profits as a distributional share was violated in the post-Second World War economy where debt-financed government spending and mortgage-financed household purchases of new housing (facilitated by government endorsement) generated profits. The role of bankers as the ephors of the decentralised market economy was reduced when government took over responsibility for the adequacy of profits, of aggregate demand. The flow of profits that followed from the deficits of governments and from debt-financed housing construction meant that the internal cash flows of firms could finance their investments…firms rather than bankers were the masters of the private economy…The flaw in managerial capitalism is the assumption that enterprise divorced from banker and owner pressure and control would remain efficient…The social policies of this era led to the emergence of private pension funds…as the era progressed, individual wealth holdings increasingly took the form of ownership of the liabilities of managed funds…” (Minsky, 1993, p. 110/111)

Money Manager Capitalism – “The welfare state big government managerial capitalism largely but not completely divorced business profits (cash-flows) from private investment…It followed that the margin of safety which entered into the building of liability structures which reflected earlier experience were too big: the safe level of indebtedness was higher in the postwar economy than hitherto…the independence of operating corporations from the money and financial markets that characterized managerial capitalism was thus a transitory stage. The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits…As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question”

“In the present stage of development the financiers are not acting as the ephors of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today’s managers of money are but little concerned with the development of the capital asset of an economy. Today’s narrowly-focused financiers do not conform to Schumpeter’s vision of bankers as the ephors of capitalism who assure that finance serves progress. Today’s financial structure is more akin to Keynes’ characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde.” (Minsky, 1993, p. 113)

It is my contention that the essence of the American (and in many respects the American-dominated global) system evolved significantly and then diverged so profoundly over the past few years from Minsky’s “Money Manager Capitalism” that it is today appropriate to distinguish an entire new stage of capitalistic financial development - the age of “Financial Arbitrage Capitalism.” Whether this new stage is “retrograde” and untenable – as is our view - is the key economic issue of our time. At the minimum, this most unusual cast of financial institutions and structures provides a good basis for making sense out of the anomalous divergences in sectoral economic performance (record home and auto sales, as capital goods investment plummets), extreme disparities in relative pricing and profits throughout the economy and markets (“inflation vs. deflation” quandary), and general acute financial and economic fragility.

Minsky’s “Money Manager Capitalism” aptly recognized the increased power wielded by mutual and pension fund managers in their aggressive pursuit of returns and capital gains, with the emphasis on more aggressive use of corporate leverage, mergers and acquisitions, and “restructurings” to enhance the value of publicly traded shares and private equity. Generally, the goal of the financial entrepreneur was to profit through growth and building enterprise value. However, and especially over the past year, financial power has subtly yet markedly shifted from traditional institutional fund managers, the crowded venture capitalist arena, and the scores of IPO dealmakers to “sophisticated” Wall Street financial players incorporating various forms of financial engineering (typically, variations of “spread trades”). While assets have shrunk and scores of equity mutual funds have been closed, 1,000 new hedge funds are said to have joined the fray as industry assets continue their historic Bubble ascent. Securities broker/dealer leveraging as well runs unabated, with assets jumping $260 billion (44% annualized) during the second and third quarters to almost $1.5 trillion, about double from just four years earlier. It is worth noting that “corporate equities” comprised just 4% of securities broker/dealer assets at Sept. 30th. Outstanding primary dealer repurchase agreements now approach an unfathomable $2 trillion, having surpassed $1 trillion for the first time during 1997.

Along with the $500 billion hedge fund community (with unknown total leveraged holdings), today’s powerbrokers include the money center banks and brokers, government-sponsored enterprises, the rating agencies, financial guarantors, the money fund complex, and, of course, the leverage speculating community’s investment banking partners responsible for creating and distributing the necessary “Financial Arbitrage” fodder -- such as convertible bonds, mortgage and asset-backed securities, trust certificates, CDO instruments, agency bonds, high yielding junk debt, derivative structures, etc. Reuters stated the case succinctly: “Hedge fund managers reign as kings of the money management industry -- and their average gains were in the black this year in a volatile market that saw mutual funds show declines.” The story also stated that when Treasury Secretary O’Neill “assembled Wall Street’s elite for a meeting earlier this year,” the likes of hedge fund managers Louis Bacon, Dan Burton, and Stanley Druckenmiller attended.” “Masters of the Universe”…

It is also worth noting that while global stock sales dropped 35% this year, sales of U.S. convertible bonds surged 41% to $168 billion. U.S. asset-backed security issuance of about $330 billion will easily surpass last year’s record sales of $293 billion. There will also be new issuance records for both agency and mortgage-backed securities, with Bloomberg’s tally showing $835 billion of mortgage-backed y-t-d sales compared to 1998’s record $723 billion. Sure, the stock market remains a critical cog in the wheel of the U.S. financial system. But the heart and soul of contemporary American capitalism lies within the Credit system and its ability to create and finance the holdings of enormous quantities of new debt. Like never before, Financial Arbitrage dominates the entire Credit creation process, with a great deal now at stake as to its capacity to sustain the U.S. mortgage finance and consumption Bubbles.

Nowhere is the financial system transformation made more conspicuous than with what we call the “structured finance ratio” -- the combination of GSE assets and outstanding mortgage and asset-backed securities as a percentage of GDP. Back in 1984, $608 billion of “structured” securities were about 15% of GDP. At the conclusion of 1994 outstanding GSE and mortgage/asset-backed securities had surged to $2.8 trillion, or 40% of GDP. By the end of the third quarter, $7 trillion of these securities were 69% of GDP and growing rapidly. It is justifiably tempting to identify the Fed-orchestrated 1998 bailout of Long-Term Capital Management as a seminal event “validating” the then rapid evolution toward a state of “Financial Arbitrage Capitalism.” There are clearly disturbing parallels to how the Mexican bailout set the stage for one wild and terminal period of leverage and speculative excess throughout the emerging debt markets – particularly in SE Asia, Russia, Brazil, and Argentina. Today, unrivaled excesses continue to play out largely in U.S. mortgage and consumer debt instruments. From the end of 1997 through September 30th (15 quarters), total GSE assets and mortgage/asset-backed securities expanded by a stunning $4 trillion, or 75%, while GDP over this period increased $1.9 trillion, or about 22%. In less than four years, the “structured finance” ratio jumped from 48% of GDP to 69%! The past four quarters have been even more climactic, with GSE assets increasing $338.5 billion (18%), “mortgage pools”/mortgage-backs $344.7 billion (14%), and asset-backed securities $279.6 billion (16%). This $962.8 billion increase (16%) in “structured finance” compares to about a $250 billion (3%) increase in GDP. Meanwhile, over the past year non-financial corporations increased borrowings by $497 billion, or only 4%. Never has the creation of “non-productive” debt so dominated a Credit system. What’s going on here?

First of all, we would be committing an error if we fixated too long on the numbers. For both the economy and financial system, the move to “Financial Arbitrage Capitalism” is as much a “qualitative” issue as it is “quantitative”. Minsky developed a view of what was then a newfound “Wall Street Paradigm” that saw shortsighted fund managers dictating system dynamics in the name of shareholder value, along the way creating increasingly fragile corporate debt structures and setting in motion other important marketplace and economic dynamics. He keenly appreciated that financial systems evolve over time from a robust to a fragile state of finance, as stability and success lead to the acceptance (by borrowers and lenders) of riskier debt structures and more vulnerable financial relationships, while at the same time fostering more pronounced levels of speculation. Minsky also clearly recognized that “lender of last resort” and other actions by the Federal Reserve that worked to insulate market participants from losses would nurture risk-taking practices and other deleterious marketplace behavior and dynamics. In this regard, I would argue that over the past few years there has been an historic paradigm shift in market dynamics, financial structures, and systemic vulnerability. Not only has there been grossly too much debt created, systemic risk has grown exponentially with the remarkable deterioration in the quality of underlying Credits.

From Minsky (1993): “The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country.” In today’s stage of “Financial Arbitrage Capitalism” the U.S. financial sector has accumulated unprecedented leverage, beholden to the vagaries of the repo and money market for continued refinancing. It is the assurances and direct market interventions by the Fed and GSEs that have largely been the impetus for the explosion of speculation and leveraged holdings. A peculiar regime – operating in a most perverted marketplace - has risen to absolute dominance in which the main business of the financial markets has become the over-financing of existing (real and financial) assets and consumption-related receivables, with non-productive debt virtually supplanting the financing of capital development. The Credit system has regressed to the point of being virtually decoupled from productive investment as well as overall economic performance, with the key inflationary manifestations arising in the asset markets and through intractable trade imbalances.

An integral aspect of this stage of market dynamics, institutional development, and resulting financial structures has been an unheard of wholesale transformation of risky loans into perceived safe monetary assets. This has imparted unprecedented power (and systemic risk) to financial intermediaries, particularly the non-bank institutions and Wall Street “structured” vehicles and instruments. In this regard, we have experienced nothing less than an historic paradigm shift, with profound ramifications for financial fragility and economic stability. In the grand scheme of things, the “shareholder value” epoch - that financed heady economic growth and for some time served the system relatively well - revolving around acquiring undervalued assets, strategic M&A, “restructurings”, and, above all, aggressive growth, has largely run its course. And with goods-producing profits in a tailspin and an overvalued dollar pushing global competitiveness even further beyond reach, today’s financial entrepreneurs look askance at financing new long-term capital assets or goods producing enterprises generally. The faltering economy and industry profits have, ironically, only further validated the transformation to Financial Arbitrage Capitalism. The reign of the businessman and enterprise entrepreneur has been toppled, the local banker’s non-factor status has been further assured, and true business profits have been supplanted as the keystone of American Capitalism. The game that’s working today is to borrow cheap, lend dear; leverage there, “hedge” with a short position here; write one option, use the premium to buy another; repo this, swap that – one way or the other, the “hot” pursuit of seemingly endless “spread” profits. The Master of the private economy is no longer the firm, the banker or the equity manager. The King of Financial Arbitrage Capitalism is the financial arbitrageur.

An unshackled contemporary monetary system, particularly through money market intermediation, allows the availability of unlimited short-term borrowings whose price is set by the Fed irrespective of supply and demand. This is an extremely potent and precarious source of liquidity. No longer is bank finance (and refinance) necessary for speculation, with players rejoicing at the endless supply of liquidity now underwritten by Fed and GSE interventions and manipulations. And for the other leg of the “arb,” a GSE-induced mortgage finance Bubble and the related unrelenting consumer borrowing boom provide a thus far inexhaustible supply of higher-yielding loans to “structure” into “top-rated” securities. Actually, considering the extreme degree of financial sector leverage, endemic speculation, and general uncertainty, the evolution of American institutions, financial structures, and market dynamics have (by design) created a seductively “stable” financial regime. Yet complacency is unjustified and dangerous. We would argue that the “success” of the Fed and GSE-orchestrated liquidity assurances, working in tandem with the proliferation of “structured finance,” in sustaining Credit excess has only exacerbated the historic Credit Bubble and imparted devastating structural damage upon the U.S. economy.

As noted by Minsky, “financial structure is a central determinant of the behavior of a capitalist economy.” We have witnessed the financial community’s increasing concentration on mortgage and consumer debt instruments fuel a self-reinforcing housing Bubble and hopeless over-consumption. It should go without saying that there are terrible long-term financial and economic consequences for a system that creates and directs enormous disproportionate purchasing power and “profits” to the likes of homeowners, retailers, foreign producers, aggressive lenders and financial speculators, at the expense of traditional domestic entrepreneurs, goods producers, capital goods manufacturers, exporters, savers, and prudent investors. It is simply difficult to imagine a financial system imparting greater imbalances on an economy. Most regrettably, the financing of sound business investment has become a pathetically trivial aspect of contemporary finance, with the reality that mortgage and consumer loans are much more attractive instruments for the Master Financial Arbitrageur. After all, how else can such enormous increases of Credit not lead to growth in output and problematic rising interest rates? These are unmistakably dysfunctional monetary processes.

The flaw in Financial Arbitrage Capitalism lies with the assumption that the Fed can guarantee the incessant marketplace liquidity necessary to keep the financial sector and asset market Bubbles levitated without inciting even more perilous speculative excess and resulting financial and economic maladjustments. There is as well a serious dichotomy, with the Financial Arbitrage community a powerful tool for Federal Reserve policy. Yes, this keenly captive audience does quickly and forcefully stimulate Credit on demand (at the first hint of Fed rate cuts). Yet this only leads to more precarious financial sector leveraging and the creation of additional suspect debt. The cost of this convenient mechanism is that systemic crisis lies in wait for the next tightening cycle or any circumstance that incites a liquidation of speculative positions. We have not heard the last of widening spreads, dislocations in the repo market, or general marketplace liquidity problems.

Importantly, Financial Arbitrage now permeates the system. For the household sector, mounting mortgage debt is perceived as cheap after-tax finance against higher yielding stock and bond portfolios, as well as for funding retirement accounts. From Federal Reserve data “Assets and Liabilities of the Personal Sector,” we see that in less than four years, holdings of financial assets increased $2.8 trillion (11%), while total liabilities jumped $3.0 trillion (39%). Over this same period (1998 through Sept. 30th 2001), financial sector Credit market borrowings increased $3.7 trillion, or 67%, to $9.1 trillion. The Fed also constructs a “rest of world” balance sheet. Looking at the “rest of world,” we see that total holdings of U.S. financial assets increased $4.36 trillion, or 125%, to $7.8 trillion since the end of 1995 (23 quarters). “Foreign Direct Investment” accounted about 20% of the increase, rising $876 billion to $1.52 trillion. Equity positions increased $1 trillion to $1.54 trillion, while holdings of corporate bonds increased $813 billion to $1.18 trillion, agency debt jumped $497 billion to $665 billion, Treasuries increased $340 billion to $1.2 trillion, and “other” added $690 billion to $898 billion. Over this period, “rest of world” U.S. liabilities increased $2.4 trillion to $4.3 trillion. Let there be no doubt, foreign-based financial institutions have been and remain key players in U.S. Financial Arbitrage. This at least partially explains the dollars strength in the face of enormous current account deficits and a collapsing technology Bubble. We don’t, however, see this as comforting news for the future.

It has been a curious enigma that the foundation of Credit Bubble analysis rests on the Federal Reserve’s own “flow of funds” Credit data, although the institution of the Fed seems oblivious to Credit and monetary theory. So I will admit to being tickled when I stumbled across two articles (Monetary Analysis and the Flow of Funds, by John C. Dawson, and An Analytic Summary of the Flow-of-Funds Accounts, by the Fed’s own Stephen Taylor) addressing the Fed’s “flow of funds” Credit data in the May 1958 issue of The American Economic Review, complete with a “discussion” by none other than Alan Greenspan.

From Greenspan: “Taylor is right pointing out that the basic problem in handling flow-of-funds accounts is the primitiveness of our financial theory. These accounts are extremely elaborate and extraordinarily well constructed. But unless we know what we want to use them for, they are of as much practical value as a table of random numbers…I think a considerable improvement could be made in Dawson’s type of financial model if some explicit measure of business confidence were brought into the picture. An attempt to measure financial flows strictly on the basis of real variables such as inventory investment, capital outlays, and homebuilding is going to catch us off base in periods of rapidly changing business and consumer psychology. In periods of high confidence there is a tendency for existing capital assets to be monetized as consumers and businessmen both attempt to pyramid on thin equities. There is a definite tendency, for example, for new mortgage debt on existing homes to fluctuate with the stock market, wholly aside from the trend of housing turnover. A similar pattern evidently shows up in personal loans… This is not to say that consumer and mortgage debt finance the stock market, but rather that the same over-all optimism in the future which buoys up stock prices induces borrowing and spending. A closer fit between new home purchases and mortgage debt could be obtained if this component of old home debt were separated out, and perhaps joined with security market banks loans, and both made to depend on stock prices.”

As is generally the case, we have no qualms with the analysis of the young Alan Greenspan. Yet these comments make it even more frustrating that Credit theory is in reality more “primitive” today than when these comments were made some 43 years ago. In an entertaining coincidence, the same May 1958 issue of The American Economic Review included comments by John (“Gurley & Shaw”) Gurley: “As a nation we have been upset about our monetary system for over a hundred and fifty years. Some even get violent about it. I know of a man right now who would like to shoot every single member of the Board of Governors of the Federal Reserve System. Others with more placid natures set up monetary commissions. The rest of the population, it seems, testifies. This continual worrying about money has had, and still has, a fairly solid foundation. But the source of the worries has shifted over time as financial development has solved one problem only to reveal others.”

Buried in Gurley’s discussion was a data “morsel” indicative of the momentous differences between today’s financial and economic environment and those from the stable late 1950s. During “the past decade…money supply has risen by only 18%, which was far below the 85% rise in GNP…” For those believing that the current environment portends 1950s and early ‘60s-style tranquility, there is going to be a rude awakening. Financial Arbitrage Capitalism is neither sound nor stable. Indeed, it inherently foments self-reinforcing financial and economic imbalances.