Calling the Great Recession a balance sheet recession is the starting point for discussion of financial frictions because most macro economists assumed away the banking and financial system in order to make their models tractable. The balance sheet of businesses, consumers, and banks all matter, and the ability to liquidity assets or borrow are key frictions that impact spending and investment decisions. We now know that these simplifying assumption made all the difference in the world.
So what are the lessons for investors today? Without going through all of the modeling, there are some key friction themes that can lead to good take-aways for the everyday trader. Not surprising, many traders intuitively understand these frictions.
1. Flows matter - Regardless of what we may think about valuations, flows will impact price. Call it herd behavior, but capital flows will have real impacts. Flows both to and from asset classes have the potential for market dislocations. Currently, the outflows from emerging markets are driving currencies, EM stocks and bonds. Where money goes and where it comes from matters a lot in the short-run.
2. Credit creation and distribution matters - Credit creation will impact prices and it will come from various sources, not just banks. The foundation of the Minsky Moment view is that speculative credit will reach for return only to be at some point disappointed. Credit will also be based on the knowledge of borrowers. This knowledge becomes more uncertain in a changing economic environment.
3. Study of credit through the banking system is not enough - A corollary to the credit creation story is that classic banking analysis is not enough to understand credit flows. The mortgage market was outside the normal banking system and was not effectively monitored by central bankers. Credit channels are complex and need to be modeled beyond a simple banking system.
4. Noise matters - There are more frictions when there is more market uncertainty. Whether Lehman, AIG, or other large financial institutions, there was a lack of clarity about the risks inside the firms. Uncertainty causes the friction of inaction.
5. Arbitrage has limits - Markets are supposed to be self-correcting with deviations in price brought back in-line through arbitrage and quasi-arbitrage activities. However, if there is a lack capital engaged in these activities, there will be persistent price deviations. Arbitrage is a function of funding and knowledge. When there is a lack of secure funding and limited players with knowledge and capital, there will be price deviations and distortions.
6. Liquidity is often in short supply - If there is a lack of credit, arbitrage, and excessive noise, liquidity will be in short supply. Money will move to safety when there is a lack of liquidity or the perception that prices may be bought or sold near true value.
7. Labor markets have frictions - Retraining, changing locations, and learning all have costs, so the growth trends can be affected if labor markets do not or cannot functions smoothly. When balance sheets are impaired, selling homes and moving, getting retrained, or even fining the right job becomes more difficult.
All of the frictions on our list are to some degree still present in the economy. Regulation has impeded credit channels and distribution. Some of this is for the better, but it is natural that there will be an adjustment process which will slow distribution. The key phrase for any investor is that credit flows matter. Know your credit channels.