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| Ponzi finance is like an unstable house of cards |
The boom-bust cycle in economics is one which has many explanations. The Austrians blame malinvestments caused by central banks setting interest rates too low, Keynes blamed animal spirits and Marx warned it was falling profits that caused the bust. An increasingly popular explanation for the boom-bust cycle is the Financial Instability Hypothesis proposed by Hyman Minsky. The theory suggests that the rising proportion of debt relative to cash flow causes financial instability. This phenomena is inherent to a market economy and it is often summarised as "stability breeding instability."
I think there are some similarities with the Austrian malinvestment theory which I'll be covering in a future blog post.
This blog post is mostly a summary of journal articles from the Levy institute which are references at the end.
What is the Financial Instability Hypothesis?
The hypothesis refers to phases in which economic units go through as the economic cycle develops.There are three phases that economic units can involve themselves in:
- Hedge financing occurs when units can fulfil all of their contractual payment obligations by their cash flows. The more equity in the liability structure, the more likely they are a hedge financing unit.
- Speculative finance units can meet their payment commitments on their liabilities, even though they cannot pay back principal from income cash flows. Such units will "roll over" their liabilities.
- Ponzi finance units' cash flow from operations are not sufficient to fulfil either the repayment of principal or interest on outstanding debts. Such units can sell assets or borrow. Borrowing to pay interest lowers their equity. A unit that Ponzi finances, lowers the margin of safety that it offers the holders of its debt.
If hedge financing dominates, the economy is stable. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood the economy is in a deviation amplifying system (simply put, a big boom or bust).
Financial Instability Hypothesis Theorems
- The first theorem of the Financial Instability Hyphothesis (FIH), the economy has financing regimes under which it is stable and regimes in which it is unstable.
- The second theorem is that over long periods of prosperity, the economy transitions from a stable financial system to an unstable system. Capitalist economies transit from hedge financing units to a structure in which there is a large weight of speculative and Ponzi finance.
The FIH model does not rely on exogenous shocks to generate business cycles of various severity. The hypothesis holds that the business cycles of history are compounded by internal dynamics of a capitalist economy and the system of interventions and regulations that are designed to keep the economy operating within a reasonable bound.
Link to behavioural economics?
The paradigm shift away from assuming we are rational economic units to accepting the real world proof of the opposite, is a recent occurrence. Minksy refers to the "euphoric economy" which can be linked to biases such as the overconfidence bias and the herd mentality. There is no doubt that these traits exacerbate the bubbles and provide a fertile ground for speculative and Ponzi finance to emerge.Other important notes from Tymoigne (2010)
- Government deficits directly improve the financial strength of the private sector.
- Government deficit may be a problem if there's a stringent exchange rate regime (e.g. Greece - monetary sovereignty surrendered to the Eurozone) or if debt is issued in foreign currency (e.g. Argentina)
- Financial fragility is not a measure of the size of the leverage but the quality
- Bell (2009) found good indicators of banking crises include rapid loan growth, slow output growth, and rising real interest rates.
- Speculative and Ponzi finance haver a higher mismatch between assets and liabilities, which most of the time means that there is a high proportion of short-term debts and low liquidity buffers.
- Under Ponzi finance, it is expected that net worth and liquidity will decrease given asset values. This decline in net worth and liquidity will not be recorded in data until defensive position-making needs actually occur. If assets are valued on a market basis, and if their prices grow fast enough to compensate for higher debt or lower liquid assets, the decline in net worth can be avoided (Minksy 1964: 213ff.) In that case, the growing solvency of economy unit involved in a Ponzi process depends highly on the continuation of rising assets, rather than on the capacity to generate an income from the ownership of the asset. In fact, an economic unit involved in Ponzi finance is guaranteed to record very high short-term profits and so a very high increase in net worth for a short period.
Where are we now?
A few examples in recent weeks of Ponzi finance come from the China/commodity boom.The most obvious economy in the Ponzi finance phase is China. Just read this: (oringal here: http://english.caixin.com/2015-03-11/100790192.html)
"In years past, Rongsheng found it easy to get bank support for building orders. But according to a ship financing expert, banks changed their tune after Rongsheng started having trouble repaying loans. The repayment woes surfaced after the company apparently overstretched its order books to the point where it couldn't deliver vessels on time.
Rongsheng's weak financial position was highlighted by a third-quarter 2014 financial report in which the company posted a net loss of 2.4 billion yuan. It also reported 31.3 billion yuan in liabilities, including 7.6 billion yuan worth of outstanding short-term debt.
A source close to the company said Rongsheng's capital crunch has worsened since February 2014, when the CDB demanded more collateral after the company failed to make a scheduled payment on a 710 million yuan loan. When Rongsheng refused, the CDB called the loan. Other banks that issued loans to the shipbuilder have taken similar steps, said the source."
Just the other day another example of Ponzi finance came to light when Fortescue (ASX: FMG) tried to refinance their debt only to change the structure and then cancel the transaction. (original here: http://www.abc.net.au/news/2015-03-18/fortescue-debt-debacle-highlights-perilous-position/6328668 )
That initial deal was for a $US2.5 billion syndicated loan. It was scrapped yesterday in favour of the "Senior Secured Note Offering" which also has been junked in what can only be interpreted as a worrying development for the nation's third biggest iron ore exporter.
This sums up the situation well:
Imagine having nearly 9 billion of debt maturing in next 2-5 yrs & you sell one product.....at a loss.
— Greg (@macromusing) March 18, 2015
It is clear that FMG can no longer payback the principal and is in the speculative finance stage. As the price of iron ore falls below the cost of production, Fortescue is no longer profitable. At this stage paying interest becomes a problem as cash reserves drain and Fortescue enters the Ponzi finance stage. As long as iron ore prices continue to fall, Fortescue is guaranteed to become a Ponzi finance unit.
I have been a China bear for a few years now (see last year's detailed post here) and it looks like the wheels are finally coming off.
Conclusion
Minsky's FIH is an important theory for understanding how an economy can become unstable due to the debt financing decisions of economic units. It is a theory that should stand the test of time as most recessions and financial crises involve economic units that end up financing low quality investments. Recessions could be mitigated if policy makers monitor the quality of investments and take action before the financial system becomes extremely fragile.
References:
Minksy, Hyman P. 1992. Financial Instability Hypothesis. http://www.levyinstitute.org/pubs/wp74.pdfTymoigne, Eric. 2010. Detecting Ponzi Finance: An Evolutionary Approach to the Measure of Financial Fragility http://www.levyinstitute.org/pubs/wp_605.pdf
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