BY JOHN MAULDIN
Economics has a lot of overused themes and phrases. One of them is highly relevant today yet forgotten by many.
At some point the branch breaks, and gravity takes over. It can happen quickly, too.
Three Types of Debt
Hyman Minsky spent most of his academic career studying financial crises. He wanted to know what caused them and what triggered them.
His research all led up to his Financial Instability Hypothesis. He thought crises had a lot to do with debt. Minsky wasn’t against all debt, though. He separated it into three categories.
- The safest kind of debt Minsky called “hedge financing.” For example, a business borrows to increase production capacity and uses a reasonable part of its current cash flow to repay the interest and principal. The debt is not risk-free, but failures generally have only limited consequences.
- Minsky’s second and riskier category is “speculative financing.” The difference between speculative and hedge debt is that the holder of speculative debt uses current cash flow to pay interest but assumes it will be able to roll over the principal and repay it later.
Sometimes that works out. Borrowers can play the game for years and finally repay speculative debt. But it’s one of those arrangements that tends to work well until it doesn’t.
- It’s the third kind of debt that Minsky said was most dangerous: Ponzi financing is where borrowers lack the cash flow to cover either interest or principal. Their plan, if you can call it that, is to flip the underlying asset at a higher price, repay the debt, and book a profit.
How Ponzi Financing Triggers a Full-Blown Crisis
Ponzi financing can work. Sometimes people have good timing (or just good luck) and buy a leveraged asset before it tops out.
During the housing bull market of 2003–07, people with almost no credit were flipping houses and making money. It attracted more and more people, which created a soaring market. The phenomenon fed on itself.
Bull markets in houses, stocks, or anything else can go higher and persist longer than we skeptics think is possible. That is what makes them so dangerous.
Minsky’s unique contribution here is the sequencing of events. Protracted stable periods where hedge financing works encourage both borrowers and lenders to take more risk.
Eventually, once-prudent practices give way to Ponzi schemes. At some point, asset values stop going up. They don’t have to fall, mind you, just stop rising. That’s when crisis hits.
The Economist described this process well in a 2016 Minsky profile article. (Emphasis mine.)
Economies dominated by hedge financing – that is, those with strong cashflows and low debt levels – are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.
Markets Are Not Efficient Whatsoever
Minsky’s conclusions are indeed unsettling. He called into question the belief that markets, left to operate unimpeded, will deliver stability and prosperity to all. Minsky thought the opposite. Markets are not efficient at all, and the result is an occasional financial crisis.
Complacency in the midst of a wanton debt buildup was beautifully expressed in a remark by Citigroup Chairman Chuck Prince in 2007:
The Citigroup chief executive told the Financial Times that the party would end at some point, but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.
He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” [source]
Minsky wasn’t around to see the 2008 crisis that fit right into his theory. Paul McCulley attached Minsky’s name to it, though, and now we refer to these crises as “Minsky moments.”
Get a Bird’s-Eye View of the Economy with John Mauldin’s Thoughts from the Frontline
This wildly popular newsletter by celebrated economic commentator, John Mauldin, is a must-read for informed investors who want to go beyond the mainstream media hype and find out about the trends and traps to watch out for. Join hundreds of thousands of fans worldwide, as John uncovers macroeconomic truths in Thoughts from the Frontline. Get it free in your inbox every Monday.