by Chris Becker
Has the RBA woken up to Minsky’s financial instability hypothesis and other theorems about how a post-financial economy really works?
As the Australian economy tips over the mining capital expenditure cliff and into the great unknown, the RBA is pushing the non mining sector to start investing. This is not a sign of confidence, unless your name is Mad Adam, but a signal to those of us who understand Minsky that trouble lies straight ahead.
From Peter Martin at The Age, discussing the recent findings of the RBA Bulletin:
The latest figures show mining and non-mining companies are planning to cut investment in the coming year despite record-low rates making borrowing for investment cheaper than ever.
The answer is that most businesses don’t factor those rates into their calculations.
Questions asked in its regular liaison meetings with business leaders reveal that most won’t approve projects unless their rate of return is above a “hurdle” of 10 per cent. The bank says some set the hurdle at 15 per cent, and some as high as 30 per cent – well above their cost of capital.
Importantly, the hurdle rates are often left unchanged for years, even when interest rates drop. A paper included in the latest Reserve Bank Bulletin reports that some hurdle rates have not changed in years.
Another decision-making rule that takes no account of interest rates is the payback period. The most common payback period expected by businesses is three years…
Should we be at all surprised by these findings? Corporate Australia is dominated by a laziness brought about by entrenched rent-seeking, media obfuscation and rampant oligopoly behaviour. Why innovate – hell, take risk at all – when you can book steady returns on the back of speculative asset bubbles and protected industries?
The short-term nature of corporate investment, looking at only a three year payback period (note how Woolworths is getting punished for daring to see beyond 2-3 years on its massive investment in the Masters DIY brand) is also starkly brought into focus here.
Before looking at Minsky and why it matters, let’s have a quick review of the statistics behind business investment in Australia. Without looking past the headline, you’d think everything is fine, why is the RBA on this bent?
As this chart shows, business investment as a share of nominal GDP has ballooned from the previous recession low of 10-12% to almost 18%, falling back to an above average high of 16% as the mining capex boom unwinds. But looking through the headline capex, non-mining components have stalled on a nominal basis and are likely to fall in the years ahead:
Closer still and we can note that the decline of manufacturing is explicitly shown in the huge reduction in machinery and equipment investment, with engineering taking the lion share, now reversing:
The non-mining sector’s reluctance to invest is clear when we look at the internal and external financing. Note how business credit post-GFC has plummeted back to the pre-GFC average, while interest paid as % of profits is at a record low. Why? Because of massive capital raisings in the GFC that have plummeted return on equity (ROE), which puts to question why aren’t business accepting much lower IRRs (internal rates of return) on new projects, instead of holding lower return cash close to their chests?
We can see that effect clearly when stripping out the banks, which hoovered up huge amounts of shareholder savings in shoring up their capital during the crisis, and only they have benefited from lower interest rates since, maintaining 15% ROEs:
Non financials have barely gone to the market for any capital, showing a huge reluctance to invest as their cash balance sheets bulge out and become as lazy as their executives.
A lack of a mature corporate debt market is also to blame here and an unwise slavish devotion to dividend payouts, thus reducing scope for growth.
And now to Hyman Minsky, who has had the explanation about this stage in the cycle, but has been ignored by mainstream economics. From Wikipedia:
Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.
As the economy contracts into recession, Minsky explains that even viable, lower IRR projects are deferred and deferred until the frightened corporates start to get itchy as lower interest rates make even the lowest hanging fruit too tempting not to pass up. Due to the normal clearing out processes of regular recessions (and this is a key point!) the expected rate of return exceeds expectations and behaviour starts to change. The cycle bottoms and off we go again!
However, the key difference is when you have frequent recessions as part of a normal business cycle, not the “Great Moderation” of 20 plus years of no recession, lauded by the mainstream commentariat as a reflection of superb monetary and fiscal policy.
Err no. This is “stability = eventual instability” writ large. Too long without the clearing out process of a recession and you have entrenched rent seeking, protected industries, protected labour and pensions and too high asset prices that cannot be allowed to come down for those more prudent and entrepreneurial to pick them up and start the process anew. And too much private debt, thus restricting consumers, even at ZIRP or NIRP from finding “animal spirits” again.
You know, we used to call this capitalism. Minsky and his followers had it right for years, while the RBA and the Pitchford Thesis and other failed hypotheses have been swept aside in the post-GFC era. Central banks are now playing catch up.