Inflation and the boom-bust cycle in corporate leverage

Financial engineering is an art not a science. The core of the subject is how to camouflage increases in leverage as the source of increased earnings on equity capital. This article explores how and why demand for financial engineers grows globally under the influence of inflationary U.S. monetary policy, and how a boom in their profession contributes to the potentially devastating effect of monetary inflation on economic prosperity. It considers how foreign countries could take steps to counter their vulnerability to financial engineers, with particular reference to the case of emerging markets and Japan who have experienced at times their maximum impact. The most effective defense is monetary, but this has rarely been implemented.

The key to understanding the link between U.S. monetary inflation and demand for financial engineers is the course of asset inflation. This is symptomized by empowerment of irrational forces in asset price determination. The drivers of these are inflamed mental impairments attributed to “hunger for yield” or “irrational exuberance” and behind these are various forms of “money being out of control.” The income-famine investor or the investor hooked on positive feedback from a cycle of capital gains stemming from below neutral interest rates becomes careless in applying normal healthy skepticism about speculative hypotheses. This includes a willingness to pay a substantial premium price for equity on account of earnings which have been boosted by financial engineers, even though he or she should realize that whatever boost exists could have been achieved on personal account. Vast equity buy-back programs are one of the biggest such tricks in the present cycle.

Behind the success of financial engineers during their boom-time are giant carry trades which flourish under U.S.-led inflation, especially into credit and foreign exchange. This has particular relevance to the emerging markets. Corporations there issue foreign currency debt in dollars, but also in negative rate yen and euros, to take advantage of big savings in interest cost. The buyers are unusually ready to overlook credit and exchange risks implicit in this operation. The emerging market countries could seek to cool the infernal machine of leverage by a dose of sound monetary mechanism which would send their currencies temporarily sky-high. This article considers how this could be done with less cost than widely supposed and extends the lessons to the larger country case of Japan, which so far has never sustained a policy of defying U.S. monetary experimentation.