When confronted with perplexing macroeconomic and capital market developments, I inevitably grab for my frayed copy of Keynes' The General Theory (1936), seeking succor in the master speculator's words. Call it triage for the brain. The last time I did so feverishly was the week after Christmas 2000, when I re-read The General Theory three times. I also re-read Schumpeter's Capitalism, Socialism, and Democracy (1942), Minsky's Stabilizing an Unstable Economy (1986), and Kindleberger's Manias, Panics and Crashes (1978). The outcome of all that serial re-reading was the January 2001 Fed Focus, "Capitalism's Beast of Burden." ¹

That essay remains the favorite thing I've ever written, and its conclusion remains as true today as it was eighteen months ago:

Corporate America Must Check Itself Into The Betty Ford Center
For Balance Sheet Rehabilitation

Figure 1
Source: FactSet, Steve Kim (CSFB)

Following the Volcker Doctrine
Mr. Greenspan did, of course, see the beast, and attacked it by rapid-fire cutting of the Fed funds rate from 61/2% to 13/4% before the end of 2001. And he has resisted incessant calls this year - from both within the FOMC and from Wall Street - to "take back" any of that easing. Mr. Greenspan is wisely following what I call the "Volcker Doctrine," his predecessor's injunction in 1998 that the Fed should "make its mistakes where it knows how to fix them."

In the current circumstance, that means the Fed should be far more "tolerant" of the risk of a 100-200 basis point increase in inflation than of the risk of a 100-200 basis point decrease in inflation. Indeed, I would not consider a 100-200 basis point increase in inflation to be a "mistake" at all, but rather confirmation of reduced risk of a similar decrease in inflation, which would categorically be a "mistake."

But even if you were to consider such an increase in inflation to be a "mistake," as I'm sure many readers would, it would be no big deal to "fix it." Any sophomore macroeconomics student with a vague understanding of the (cyclical) Phillips Curve knows the "fix": hike rates and throw some people out of work. No macroeconomics student knows, however, how to fix a self-feeding deflationary "mistake."

Well, some of us think we do, in our incessant calls for the Bank of Japan to simply print Yen until the (domestic!) purchasing power of the Yen goes down (domestic inflation goes positive). No apology from me for advocating such an approach. But it is not as easy as it seems, because deflation undermines the "money goodness" of nominal debt contracts, and capitalism is founded on nominal debt contracts. Debts cannot be honored in deflation-adjusted "real" dollars (Yen); only nominal dollars (Yen) will do.

Deflation is indeed the beast of burden that private enterprise cannot bear alone, because the private sector does not own a press that prints money. Only "we the people" can address deflation risk, by demanding that our government lever its balance sheet to support nominal aggregate demand, underwritten by liberal use of the Fed's power to print money. Yes, that's the essence of Keynesian macroeconomics: attack private sector deflation with public sector reflation. And policy makers owe nobody any apology for doing so, as it is capitalism's own excesses and hubris that create deflation risk. When capitalism's stuff is hitting the oscillator, it is democracy's duty to unplug it. ²

Mr. Greenspan is trying with a 13/4% Fed funds rate, and fiscal authorities are trying with budget deficits of some 2% of nominal GDP. Will it be enough? A few months ago, I thought so, and said so. ³ But I'm also mindful of Keynes' dictum that when a man gets new information, he should be willing to change his mind. And recent months have revealed new information: many, far too many, balance sheets in Corporate America are not just infected with illiquidity, but are reeking with the gangrene of default risk.

The evolving "crisis" in Corporate America is not just about a few crooks in the executive suite, but rather too much debt relative to a "balance of risks" tilted towards deflation (the FOMC may say that the "balance of risks" is balanced between deflation and inflation risks, but from a policy perspective, that is poppycock, per the Volcker Doctrine; and Greenspan knows it).

Minsky (Not Keynes, Not Randy Johnson) Is The Big Unit
On the matter of corporate debt, it was not Keynes, but his interpreter Hyman Minsky who offered the key insight into today's woes in the corporate debt market: the "financial instability hypothesis." Minksy provided a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. Here's his hypothesis, summarized by his own hand in 1992:

• "Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on 'income account' on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to 'roll over' their liabilities - issue new debt to meet commitments on maturing debt. For Ponzi units , the cash flows from operations are not sufficient to fulfill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes."

  
  
  

• "It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."

  
  
  

• "In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out position. This is likely to lead to a collapse of asset values."

Minsky passed away in 1996, as corporate financing patterns of the New Age Economy were following precisely his script, moving progressively toward Ponzi Finance Units. And at the end of the decade, the Fed did indeed declare the economy to be in an inflationary state (even if it wasn't) and sought to exorcise the (irrelevantly low) inflation with monetary constraint (I like how Minksy called it "constraint," rather than "restraint"…a more fulsome word!).

And sure enough, Ponzi Finance Units have been evaporating ever since, with ever more putative Speculative Finance Units being exposed as Ponzi Finance Units in drag. These developments are, as Minsky declared, a prescription for an "unstable system" - to wit, a system in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation. Eighteen months ago, I dubbed the outlook to be a Minksy Moment.

It still is. I don't, however, think we've reached a "tipping point" into a Minsky Meltdown in the United States. But we're far closer to the point than I thought we would get eighteen months ago, or even three months ago. What frightens me most is the herd notion "in play" right now that all Speculative Finance Units must strive to rehabilitate themselves into Hedge Finance Units; to wit, that the only truly "money good" credit is a borrower that can both service and amortize its debt with cash flow from its operations. This is the emerging, and frightening paradox of our times: for a company to prove that it is a going concern, it must prove that it could liquidate itself.

Cutting Capex And Issuing Shares (Stop Buying Them Back!)
Are The Treatments Of Choice

Figure 2
Source: Federal Reserve Flow of Funds

Are You A Going Concern, Brother?
Capitalism can't function on this basis. To be sure, a cash flow-based "liquidation test" can make sense for individual companies, notably for those that are on the destructive end of entrepreneurial capitalism's process of creative destruction. Earnings "before interest, taxes, depreciation and amortization" (EBITDA!) should indeed be used to liquidate companies that have one foot in the grave and the other on a banana peel. To wit, positive net cash flow represented by the non-cash expense of depreciation should not be re-invested in the business, but rather used to liquidate - amortize! - the company's liabilities. And when such a process has run its course, the company should simply evaporate, as the company's assets, having not been replaced/restored with a portion of the cash flow generated by those very same assets, become fully "depreciated."

Consider, for example, the buggy whip business - or the buggy business itself, for that matter! - on the cusp of the invention of the automobile. There was no need for buggy whip companies to re-invest their cash flow into newer, and better buggy whip factories. Instead, the "right" thing for them to have done was to "annuitize" the cash flow of their existing buggy whip factories: sell "mortgage-style amortization" (MSA) bonds to buy back their shares, and let the MSA bonds and the buggy whip factories go off into the sunset together.

And the "right" thing for the bought-out shareholders of the buggy whip companies to have done, of course, would have been to use their "freed-up" cash to re-invest in shares in the automobile business! Well, that's not quite "right," I hear some of you appropriately retorting, because the automobile business was littered with failures in its early days. Very true.

But if the essence of capitalism is about "creative destruction," then the corporate finance analog is that equity capital should be "churned" from sunset industries to sunrise industries. And part of the way that should be done is "monetizing" the cash flows from the dusk and re-cycling them into the dawn. There are many ways to do that, of course. MSA bonds are an esoteric vehicle, which should probably be used more often. ⁴ More commonly, at least historically, sunset companies have paid out very generous dividends, serving the same purpose of channeling the cash flow represented by non-cash depreciation expense to shareholders, rather than into re-investment in the underlying business.

Managements are frequently criticized for such "liquidation" policies, ridiculed for their "failure" to find profitable growth opportunities. But not all businesses are growth businesses; indeed, if the capitalist concept of "creative destruction" means anything, it means that some businesses should be in phased liquidation, even as others are in phased incubation. This process is the genius of capitalism; it is also called economic progress.

A Kind Word for the Middle Aged!
Between the creative and destructive stages in a company's life, there are the middle-aged years, that blissful zone occupied by most companies (as in human life, middle age is a very, very wide chronological corridor!). And "middle-aged" companies can be, and usually are, Speculative Finance Units: sufficient leverage to "maximize" return on equity (cutting down the taxman's take, in good ole Modigliani-Miller fashion!) ⁵, consistent with "minimizing" risk in the roll-over of maturing liabilities (which must be "rolled," since the cash flow of the business is sufficient to service its debt, but not to amortize its debt).

And there is nothing intrinsically wrong with middle-aged companies being Speculative Finance Units: they are entitled to the presumption that they are going concerns and, accordingly, entitled to the presumption that they can roll over their debt as it matures. If and when "the market" starts questioning the viability/survivability of this broad cohort of "middle-aged" companies, capitalism has a "macro" problem, not a "micro" problem.

It's the corporate version of Keynes' paradox of thrift: rational company-specific efforts to de-lever cumulate to beget the irrational collective outcome of debt deflation. Put more bluntly, if and when "the market" demands that Minsky's Speculative Finance Units - as a group - transform themselves into Hedge Finance Units, capitalism as we know it faces a systemic crisis. Modern day, market-based capitalism cannot function if all companies must prove they are going concerns by proving they have the financial flexibility to go out of business (amortize their debt, rather than roll it over).

In this connection, I should note that Minsky should have divided his Hedge Finance Units into two cohorts: those that are "going concerns," and those that are "diminishing concerns." From a debt investor's perspective, there is no material difference; both are "money good" credits. From an equity investor's perspective, however, there is a huge difference in determining the "appropriate" valuation for a company (P/E, or EBITDA multiple). This distinction is also hugely important to the macroeconomics of capitalism's staying power. But from "the market's" current narrow perspective of lending money with a "money-good" myopia, it's a difference without a distinction.

Time For Greenspan To Get Serious
Both Keynes and Minsky concluded that when capitalism "seizes up" (a favorite Greenspan expression!), policy makers must take decidedly anti-capitalist actions to save capitalism from itself. For Keynes, that meant levering the government's balance sheet with deficits, not on the expectation of ever repaying the debt, but rather to stimulate aggregate demand sufficiently to allow the private economy to "grow out" of its debt burdens. Minsky certainly was a fiscal expansionist, too, perhaps even more Keynesian than Keynes himself!

But what Minsky really focused on was the need, once capitalist finance had morphed into the "de-stabilizing" zone, for a lender of last resort to lend with boldness: Capitalism's vast "middle-aged" population of companies (Speculative Finance Units) must be supported in rolling over their maturing debts.

As a practical matter, that meant, and still means today, that the Fed must be willing to use all its powers to save capitalism from itself. Slashing short-term interest rates, as Greenspan prudently and wisely did last year, certainly is part of the process. But if and when the corporate lending/bond markets start demanding that all Speculative Finance Units transform themselves into Hedge Finance Units, the Fed must directly or indirectly declare its willingness to "monetize" private sector debt obligations.

The direct method, of course, is to open the discount window to the corporate sector, not just the banking sector. That is indeed a last resort action by the lender of last resort, and should never be used, except perhaps in times of war. Let me state for the record that I'm not recommending it now! The indirect way for the Fed to stop a Minsky Moment from becoming a Minsky Meltdown is for the Fed to order the banking system to quit withdrawing from "liquidity lending."

Yes, I used the word "order" on purpose: commercial banks, and only commercial banks, have a special relationship with the Fed, as only they have access to the Fed's discount window. The quid pro quo of that special relationship is that commercial banks are supposed to lend when the capital markets are caught in a paroxysm of rectitude.

Banks never want to do so, of course, as bank underwriting standards have a long history of being pro-cyclical: money for all during parties, and money for none during hangovers. When inflation was much higher, this was not an egregious problem. But now, with inflation near the "tipping point" into deflation, the pro-cyclicality of bank lending is noxious at the macroeconomic level.

Bottom Line
It is time for Mr. Greenspan to order banks to expand their "liquidity" lending, and cease contracting it: good loans are made in bad times, and the time has come to make them! And as part of the "deal," it is time for Mr. Greenspan to commit actively to pursue higher inflation, by declaring the "doctrine" of pre-emptive tightening to be dead: short rates will not be raised to prevent rising inflation, but only raised once inflation is rising.

Capitalism's beast of burden won't go away until the Fed is willing to slay it. It's time for Mr. Greenspan to use all his armaments. Unless he does, he will ride into the sunset himself as the Pretender, who started out so young and strong against inflation, only to surrender to debt deflation.

Paul A. McCulley
Managing Director
July 3, 2002
mcculley@pimco.com

1 See "Capitalism's Beast of Burden," Fed Focus, January, 2001.

2 See "Rotor Tilling Behind Bill's Tractor," Fed Focus, June, 2002.

3 See "Eating Crow With A Dr Pepper Chaser," Fed Focus, April, 2002.

4 PIMCO's Ray Kennedy recently detailed to me a wonderful example, in which a MSA bond was issued to monetize the cash flows of a leaded-gas refinery; leaded gas is most certainly a "sunset" industry here in the United States!

5 See "Getting Traction In Your Vision," Fed Focus, August, 2001.

Mr. Greenspan did, of course, see the beast, and attacked it by rapid-fire cutting of the Fed funds rate from 61/2% to 13/4% before the end of 2001. And he has resisted incessant calls this year - from both within the FOMC and from Wall Street - to "take back" any of that easing. Mr. Greenspan is wisely following what I call the "Volcker Doctrine," his predecessor's injunction in 1998 that the Fed should In the current circumstance, that means the Fed should be far more "tolerant" of the risk of a 100-200 basis point in inflation than of the risk of a 100-200 basis point in inflation. Indeed, I would not consider a 100-200 basis point increase in inflation to be a "mistake" at all, but rather confirmation of reduced risk of a similar decrease in inflation, which would categorically be a "mistake." But even if you were to consider such an increase in inflation to be a "mistake," as I'm sure many readers would, it would be no big deal to "fix it." Any sophomore macroeconomics student with a vague understanding of the (cyclical) Phillips Curve knows the "fix": hike rates and throw some people out of work. No macroeconomics student knows, however, how to fix a self-feeding deflationary "mistake." Well, some of us think we do, in our incessant calls for the Bank of Japan to simply print Yen until the (domestic!) purchasing power of the Yen goes down (domestic inflation goes positive). No apology from me for advocating such an approach. But it is not as easy as it seems, because deflation undermines the "money goodness" of debt contracts, and capitalism is founded on debt contracts. Debts cannot be honored in deflation-adjusted "real" dollars (Yen); only dollars (Yen) will do. Deflation is indeed the beast of burden that private enterprise cannot bear alone, because the private sector . Only "we the people" can address deflation risk, by demanding that our government lever its balance sheet to support aggregate demand, underwritten by liberal use of the Fed's power to print money. Yes, that's the essence of Keynesian macroeconomics: attack private sector deflation with public sector reflation. And policy makers owe nobody any apology for doing so, as it is capitalism's own excesses and hubris that create deflation risk. When capitalism's stuff is hitting the oscillator, it is democracy's duty to unplug it. Mr. Greenspan is trying with a 13/4% Fed funds rate, and fiscal authorities are trying with budget deficits of some 2% of nominal GDP. Will it be enough? A few months ago, I thought so, and said so. But I'm also mindful of Keynes' dictum that when a man gets new information, he should be willing to change his mind. And recent months have revealed new information: many, far too many, balance sheets in Corporate America are not just infected with illiquidity, but are reeking with the gangrene of default risk. The evolving "crisis" in Corporate America is not just about a few crooks in the executive suite, but rather (the FOMC may say that the "balance of risks" is balanced between deflation and inflation risks, but from a policy perspective, that is poppycock, per the Volcker Doctrine; and Greenspan knows it). On the matter of corporate debt, it was not Keynes, but his interpreter Hyman Minsky who offered the key insight into today's woes in the corporate debt market: the Minksy provided a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. Here's his , summarized by his own hand in 1992: Minsky passed away in 1996, as corporate financing patterns of the New Age Economy were following precisely his script, moving progressively toward Ponzi Finance Units. And at the end of the decade, the Fed did indeed declare the economy to be in an inflationary state (even if it wasn't) and sought to exorcise the (irrelevantly low) inflation with monetary constraint (I like how Minksy called it "constraint," rather than "restraint"…a more fulsome word!). And sure enough, Ponzi Finance Units have been evaporating ever since, with ever more putative Speculative Finance Units being exposed as Ponzi Finance Units in drag. These developments are, as Minsky declared, a prescription for an "unstable system" - to wit, a system in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation. Eighteen months ago, I dubbed the outlook to be a Minksy Moment. It still is. I don't, however, think we've reached a "tipping point" into a Minsky Meltdown in the United States. But we're far closer to the point than I thought we would get eighteen months ago, or even three months ago. What frightens me most is the herd notion "in play" right now that Speculative Finance Units must strive to rehabilitate themselves into Hedge Finance Units; to wit, that the only truly "money good" credit is a borrower that can both service and amortize its debt with cash flow from its operations. This is the emerging, and frightening paradox of our times: for a company to prove that it is a going concern, it must prove that it could liquidate itself. Capitalism can't function on this basis. To be sure, a cash flow-based "liquidation test" can make sense for individual companies, notably for those that are on the destructive end of entrepreneurial capitalism's process of creative destruction. Earnings "before interest, taxes, depreciation and amortization" (EBITDA!) should indeed be used to liquidate companies that have one foot in the grave and the other on a banana peel. To wit, positive net cash flow represented by the non-cash expense of depreciation should not be re-invested in the business, but rather used to liquidate - amortize! - the company's liabilities. And when such a process has run its course, the company should simply evaporate, as the company's assets, having not been replaced/restored with a portion of the cash flow generated by those very same assets, become fully "depreciated." Consider, for example, the buggy whip business - or the buggy business itself, for that matter! - on the cusp of the invention of the automobile. There was no need for buggy whip companies to re-invest their cash flow into newer, and better buggy whip factories. Instead, the "right" thing for them to have done was to "annuitize" the cash flow of their existing buggy whip factories: sell "mortgage-style amortization" (MSA) bonds to buy back their shares, and let the MSA bonds and the buggy whip factories go off into the sunset together. And the "right" thing for the bought-out shareholders of the buggy whip companies to have done, of course, would have been to use their "freed-up" cash to re-invest in shares in the automobile business! Well, that's not quite "right," I hear some of you appropriately retorting, because the automobile business was littered with failures in its early days. Very true. But if the essence of capitalism is about "creative destruction," then the corporate finance analog is that capital should be "churned" from sunset industries to sunrise industries. And part of the way that should be done is "monetizing" the cash flows from the dusk and re-cycling them into the dawn. There are many ways to do that, of course. MSA bonds are an esoteric vehicle, which should probably be used more often. More commonly, at least historically, sunset companies have paid out very generous dividends, serving the same purpose of channeling the cash flow represented by non-cash depreciation expense to shareholders, rather than into re-investment in the underlying business. Managements are frequently criticized for such "liquidation" policies, ridiculed for their "failure" to find profitable growth opportunities. But not all businesses are growth businesses; indeed, if the capitalist concept of "creative destruction" means anything, it means that some businesses should be in phased liquidation, even as others are in phased incubation. This process is the genius of capitalism; it is also called economic progress. Between the creative and destructive stages in a company's life, there are the middle-aged years, that blissful zone occupied by most companies (as in human life, middle age is a very, very wide chronological corridor!). And "middle-aged" companies can be, and usually are, Speculative Finance Units: sufficient leverage to "maximize" return on equity (cutting down the taxman's take, in good ole Modigliani-Miller fashion!) , consistent with "minimizing" risk in the roll-over of maturing liabilities (which must be "rolled," since the cash flow of the business is sufficient to service its debt, but to amortize its debt). And there is nothing intrinsically wrong with middle-aged companies being Speculative Finance Units: they are entitled to the that they are going concerns and, accordingly, entitled to the that they can roll over their debt as it matures. If and when "the market" starts questioning the viability/survivability of this broad cohort of "middle-aged" companies, capitalism has a "macro" problem, not a "micro" problem. It's the corporate version of Keynes' paradox of thrift: Put more bluntly, if and when "the market" demands that Minsky's Speculative Finance Units - as a group - transform themselves into Hedge Finance Units, capitalism as we know it faces a crisis. Modern day, market-based capitalism cannot function if companies must prove they are going concerns by proving they have the financial flexibility to go out of business (amortize their debt, rather than roll it over). In this connection, I should note that Minsky should have divided his Hedge Finance Units into two cohorts: those that are "going concerns," and those that are "diminishing concerns." From a debt investor's perspective, there is no material difference; both are "money good" credits. From an equity investor's perspective, however, there is a huge difference in determining the "appropriate" valuation for a company (P/E, or EBITDA multiple). This distinction is also hugely important to the of capitalism's staying power. But from "the market's" current narrow perspective of lending money with a "money-good" myopia, it's a difference without a distinction. Both Keynes and Minsky concluded that when capitalism "seizes up" (a favorite Greenspan expression!), policy makers must take decidedly anti-capitalist actions to save capitalism from itself. For Keynes, that meant levering the government's balance sheet with deficits, not on the expectation of ever repaying the debt, but rather to stimulate aggregate demand sufficiently to allow the private economy to "grow out" of its debt burdens. Minsky certainly was a fiscal expansionist, too, perhaps even more Keynesian than Keynes himself! But what Minsky really focused on was the need, once capitalist finance had morphed into the "de-stabilizing" zone, for a lender of last resort to lend with boldness: Capitalism's vast "middle-aged" population of companies (Speculative Finance Units) must be supported in rolling over their maturing debts. As a practical matter, that meant, and still means today, that the Fed must be willing to use its powers to save capitalism from itself. Slashing short-term interest rates, as Greenspan prudently and wisely did last year, certainly is part of the process. But if and when the corporate lending/bond markets start demanding that Speculative Finance Units transform themselves into Hedge Finance Units, the Fed must directly or indirectly declare its willingness to "monetize" private sector debt obligations. The direct method, of course, is to open the discount window to the corporate sector, not just the banking sector. That is indeed a last resort action by the lender of last resort, and should never be used, except perhaps in times of war. Let me state for the record that I'm not recommending it now! The indirect way for the Fed to stop a Minsky Moment from becoming a Minsky Meltdown is for the Fed to order the banking system to quit withdrawing from "liquidity lending." Yes, I used the word "order" on purpose: commercial banks, and only commercial banks, have a special relationship with the Fed, as only they have access to the Fed's discount window. The of that relationship is that commercial banks are supposed to lend when the capital markets are caught in a paroxysm of rectitude. Banks never want to do so, of course, as bank underwriting standards have a long history of being pro-cyclical: money for all during parties, and money for none during hangovers. When inflation was much higher, this was not an egregious problem. But now, with inflation near the "tipping point" into deflation, the pro-cyclicality of bank lending is noxious at the macroeconomic level. It is time for Mr. Greenspan to order banks to expand their "liquidity" lending, and cease contracting it: good loans are made in bad times, and the time has come to make them! And as part of the "deal," it is time for Mr. Greenspan to commit actively to pursue higher inflation, by declaring the "doctrine" of pre-emptive tightening to be dead: short rates will not be raised to prevent rising inflation, but only raised once inflation is rising. Capitalism's beast of burden won't go away until the Fed is willing to slay it. It's time for Mr. Greenspan to use his armaments. Unless he does, he will ride into the sunset himself as the Pretender, who started out so young and strong against inflation, only to surrender to debt deflation.

Mr. Greenspan did, of course, see the beast, and attacked it by rapid-fire cutting of the Fed funds rate from 61/2% to 13/4% before the end of 2001. And he has resisted incessant calls this year - from both within the FOMC and from Wall Street - to "take back" any of that easing. Mr. Greenspan is wisely following what I call the "Volcker Doctrine," his predecessor's injunction in 1998 that the Fed should In the current circumstance, that means the Fed should be far more "tolerant" of the risk of a 100-200 basis point in inflation than of the risk of a 100-200 basis point in inflation. Indeed, I would not consider a 100-200 basis point increase in inflation to be a "mistake" at all, but rather confirmation of reduced risk of a similar decrease in inflation, which would categorically be a "mistake." But even if you were to consider such an increase in inflation to be a "mistake," as I'm sure many readers would, it would be no big deal to "fix it." Any sophomore macroeconomics student with a vague understanding of the (cyclical) Phillips Curve knows the "fix": hike rates and throw some people out of work. No macroeconomics student knows, however, how to fix a self-feeding deflationary "mistake." Well, some of us think we do, in our incessant calls for the Bank of Japan to simply print Yen until the (domestic!) purchasing power of the Yen goes down (domestic inflation goes positive). No apology from me for advocating such an approach. But it is not as easy as it seems, because deflation undermines the "money goodness" of debt contracts, and capitalism is founded on debt contracts. Debts cannot be honored in deflation-adjusted "real" dollars (Yen); only dollars (Yen) will do. Deflation is indeed the beast of burden that private enterprise cannot bear alone, because the private sector . Only "we the people" can address deflation risk, by demanding that our government lever its balance sheet to support aggregate demand, underwritten by liberal use of the Fed's power to print money. Yes, that's the essence of Keynesian macroeconomics: attack private sector deflation with public sector reflation. And policy makers owe nobody any apology for doing so, as it is capitalism's own excesses and hubris that create deflation risk. When capitalism's stuff is hitting the oscillator, it is democracy's duty to unplug it. Mr. Greenspan is trying with a 13/4% Fed funds rate, and fiscal authorities are trying with budget deficits of some 2% of nominal GDP. Will it be enough? A few months ago, I thought so, and said so. But I'm also mindful of Keynes' dictum that when a man gets new information, he should be willing to change his mind. And recent months have revealed new information: many, far too many, balance sheets in Corporate America are not just infected with illiquidity, but are reeking with the gangrene of default risk. The evolving "crisis" in Corporate America is not just about a few crooks in the executive suite, but rather (the FOMC may say that the "balance of risks" is balanced between deflation and inflation risks, but from a policy perspective, that is poppycock, per the Volcker Doctrine; and Greenspan knows it). On the matter of corporate debt, it was not Keynes, but his interpreter Hyman Minsky who offered the key insight into today's woes in the corporate debt market: the Minksy provided a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. Here's his , summarized by his own hand in 1992: Minsky passed away in 1996, as corporate financing patterns of the New Age Economy were following precisely his script, moving progressively toward Ponzi Finance Units. And at the end of the decade, the Fed did indeed declare the economy to be in an inflationary state (even if it wasn't) and sought to exorcise the (irrelevantly low) inflation with monetary constraint (I like how Minksy called it "constraint," rather than "restraint"…a more fulsome word!). And sure enough, Ponzi Finance Units have been evaporating ever since, with ever more putative Speculative Finance Units being exposed as Ponzi Finance Units in drag. These developments are, as Minsky declared, a prescription for an "unstable system" - to wit, a system in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation. Eighteen months ago, I dubbed the outlook to be a Minksy Moment. It still is. I don't, however, think we've reached a "tipping point" into a Minsky Meltdown in the United States. But we're far closer to the point than I thought we would get eighteen months ago, or even three months ago. What frightens me most is the herd notion "in play" right now that Speculative Finance Units must strive to rehabilitate themselves into Hedge Finance Units; to wit, that the only truly "money good" credit is a borrower that can both service and amortize its debt with cash flow from its operations. This is the emerging, and frightening paradox of our times: for a company to prove that it is a going concern, it must prove that it could liquidate itself. Capitalism can't function on this basis. To be sure, a cash flow-based "liquidation test" can make sense for individual companies, notably for those that are on the destructive end of entrepreneurial capitalism's process of creative destruction. Earnings "before interest, taxes, depreciation and amortization" (EBITDA!) should indeed be used to liquidate companies that have one foot in the grave and the other on a banana peel. To wit, positive net cash flow represented by the non-cash expense of depreciation should not be re-invested in the business, but rather used to liquidate - amortize! - the company's liabilities. And when such a process has run its course, the company should simply evaporate, as the company's assets, having not been replaced/restored with a portion of the cash flow generated by those very same assets, become fully "depreciated." Consider, for example, the buggy whip business - or the buggy business itself, for that matter! - on the cusp of the invention of the automobile. There was no need for buggy whip companies to re-invest their cash flow into newer, and better buggy whip factories. Instead, the "right" thing for them to have done was to "annuitize" the cash flow of their existing buggy whip factories: sell "mortgage-style amortization" (MSA) bonds to buy back their shares, and let the MSA bonds and the buggy whip factories go off into the sunset together. And the "right" thing for the bought-out shareholders of the buggy whip companies to have done, of course, would have been to use their "freed-up" cash to re-invest in shares in the automobile business! Well, that's not quite "right," I hear some of you appropriately retorting, because the automobile business was littered with failures in its early days. Very true. But if the essence of capitalism is about "creative destruction," then the corporate finance analog is that capital should be "churned" from sunset industries to sunrise industries. And part of the way that should be done is "monetizing" the cash flows from the dusk and re-cycling them into the dawn. There are many ways to do that, of course. MSA bonds are an esoteric vehicle, which should probably be used more often. More commonly, at least historically, sunset companies have paid out very generous dividends, serving the same purpose of channeling the cash flow represented by non-cash depreciation expense to shareholders, rather than into re-investment in the underlying business. Managements are frequently criticized for such "liquidation" policies, ridiculed for their "failure" to find profitable growth opportunities. But not all businesses are growth businesses; indeed, if the capitalist concept of "creative destruction" means anything, it means that some businesses should be in phased liquidation, even as others are in phased incubation. This process is the genius of capitalism; it is also called economic progress. Between the creative and destructive stages in a company's life, there are the middle-aged years, that blissful zone occupied by most companies (as in human life, middle age is a very, very wide chronological corridor!). And "middle-aged" companies can be, and usually are, Speculative Finance Units: sufficient leverage to "maximize" return on equity (cutting down the taxman's take, in good ole Modigliani-Miller fashion!), consistent with "minimizing" risk in the roll-over of maturing liabilities (which must be "rolled," since the cash flow of the business is sufficient to service its debt, but to amortize its debt). And there is nothing intrinsically wrong with middle-aged companies being Speculative Finance Units: they are entitled to the that they are going concerns and, accordingly, entitled to the that they can roll over their debt as it matures. If and when "the market" starts questioning the viability/survivability of this broad cohort of "middle-aged" companies, capitalism has a "macro" problem, not a "micro" problem. It's the corporate version of Keynes' paradox of thrift: Put more bluntly, if and when "the market" demands that Minsky's Speculative Finance Units - as a group - transform themselves into Hedge Finance Units, capitalism as we know it faces a crisis. Modern day, market-based capitalism cannot function if companies must prove they are going concerns by proving they have the financial flexibility to go out of business (amortize their debt, rather than roll it over). In this connection, I should note that Minsky should have divided his Hedge Finance Units into two cohorts: those that are "going concerns," and those that are "diminishing concerns." From a debt investor's perspective, there is no material difference; both are "money good" credits. From an equity investor's perspective, however, there is a huge difference in determining the "appropriate" valuation for a company (P/E, or EBITDA multiple). This distinction is also hugely important to the of capitalism's staying power. But from "the market's" current narrow perspective of lending money with a "money-good" myopia, it's a difference without a distinction. Both Keynes and Minsky concluded that when capitalism "seizes up" (a favorite Greenspan expression!), policy makers must take decidedly anti-capitalist actions to save capitalism from itself. For Keynes, that meant levering the government's balance sheet with deficits, not on the expectation of ever repaying the debt, but rather to stimulate aggregate demand sufficiently to allow the private economy to "grow out" of its debt burdens. Minsky certainly was a fiscal expansionist, too, perhaps even more Keynesian than Keynes himself! But what Minsky really focused on was the need, once capitalist finance had morphed into the "de-stabilizing" zone, for a lender of last resort to lend with boldness: Capitalism's vast "middle-aged" population of companies (Speculative Finance Units) must be supported in rolling over their maturing debts. As a practical matter, that meant, and still means today, that the Fed must be willing to use its powers to save capitalism from itself. Slashing short-term interest rates, as Greenspan prudently and wisely did last year, certainly is part of the process. But if and when the corporate lending/bond markets start demanding that Speculative Finance Units transform themselves into Hedge Finance Units, the Fed must directly or indirectly declare its willingness to "monetize" private sector debt obligations. The direct method, of course, is to open the discount window to the corporate sector, not just the banking sector. That is indeed a last resort action by the lender of last resort, and should never be used, except perhaps in times of war. Let me state for the record that I'm not recommending it now! The indirect way for the Fed to stop a Minsky Moment from becoming a Minsky Meltdown is for the Fed to order the banking system to quit withdrawing from "liquidity lending." Yes, I used the word "order" on purpose: commercial banks, and only commercial banks, have a special relationship with the Fed, as only they have access to the Fed's discount window. The of that relationship is that commercial banks are supposed to lend when the capital markets are caught in a paroxysm of rectitude. Banks never want to do so, of course, as bank underwriting standards have a long history of being pro-cyclical: money for all during parties, and money for none during hangovers. When inflation was much higher, this was not an egregious problem. But now, with inflation near the "tipping point" into deflation, the pro-cyclicality of bank lending is noxious at the macroeconomic level. It is time for Mr. Greenspan to order banks to expand their "liquidity" lending, and cease contracting it: good loans are made in bad times, and the time has come to make them! And as part of the "deal," it is time for Mr. Greenspan to commit actively to pursue higher inflation, by declaring the "doctrine" of pre-emptive tightening to be dead: short rates will not be raised to prevent rising inflation, but only raised once inflation is rising. Capitalism's beast of burden won't go away until the Fed is willing to slay it. It's time for Mr. Greenspan to use his armaments. Unless he does, he will ride into the sunset himself as the Pretender, who started out so young and strong against inflation, only to surrender to debt deflation.