The Economist in their last issue ran an excellent article about the “Minsky’s Moment”, the last time his name and theory were evoked by the Economist was in 2009 after the financial crisis. I can’t help wonder if the Economist’s timing is not fortuitous.
The Economist articles, as well as many others on Hyman Minsky are certainly worth reading. The basis of his theory, which is a combination of the ability to finance debt with “seemingly” market stability is what causes the next crisis.
He broke debt financing into three basic buckets:
- Hedged Financing (low risk) = debt financing (principal and interest) is paid.
- Speculative Financing (risky) = debt financing in which interest is paid (interest only), and debt must be rolled.
- Ponzi Financing (very high risk) = debt financing in which more money is borrowed to pay existing interest on debt. The bet is that asset appreciation will appreciate fast enough that they can pay off the debt and interest.
Apple is an excellent example of Hedged Financing, not only does Apple have billions of cash to pay off their principal and interest, their cash flow easily covers their principal and interest financing.
While, General Motors (of old), before their bankruptcy, entered into the Ponzi Financing phase, in which they were borrowing money just to pay interest on existing debt. It was only a matter of time before they failed.
Minsky’s Moment is perpetuated when we are in what seems to be a stimulative economic environment, in which people’s appetite for risk increases and we see a higher increase in more risky debt financing.
How do we get to Minsky’s Moment?
How do we get to the Minsky Moment is an important question. It is not a difficult path, especially if the road to Ponzi Financing is paved with government and Federal Reserve interventionism.
Minsky, like many economists, are of the Keynesian economic school. While he certainly criticized Keynes theory, he also was its supporter. Obviously if you are only taught one economic theory, which is that same theory the government operates by, it is kind of hard to be objective. I believe this is one reason why Minsky remained in conflict with Keynes, while a supporter he also saw its significant flaws.
One basic theory of Keynes as a method for the government (central bank) to control economic growth is the lever of interest rates. In theory you raise rates and borrowing slows, lower rates and borrowing increases. It is a simple and logical theory on the surface, but one must consider other factors as a function of increase/decrease borrowing. For instance; what is the collateral used for the borrowing, what is the current debt leverage ratio of the debt issuing institution, what is the current inflation rate, what is the current wage growth / ability to finance debt, etc. As you can see there are a host of questions that also have an impact on borrowing, some may even have more impact than the rate of interest.
After the crisis the Fed has taken interest rates to zero and they have remained there, except for the one minuscule hike last December. We were told at the inception of QE (before they were numbered), that it was a temporary measure to “jump start” economic growth. Years later it has become the norm and certainly hasn’t worked as intended. No doubt it has kept the economy from further collapse, but we remain on the IV injection of Fed interventionism (as rates still remain close to zero, Fed continues to buy bonds, and Fed continues to buy mortgage back securities).
Getting back to the point, how do we get to a Minsky Moment, it is when debt financing becomes attractive. Certainly low interest rates is a huge factor, but it has taken some time for the other factors to take root. Banks (lending institutions) have to be willing to lend, to take more risk in their lending. After the crisis in 2008-2009 it has taken years for the lending firms to become more relaxed and to slowly lift restrictions. We have even seen government programs slowly slip back to what we call normal, with their easier (higher risk) lending standards. Freddie and Fannie, operating in some nether-world between public and private sector, continue to lend money.
As interest rates drop and lending becomes more “easy”, economy “seems” stronger, and stock markets rise – we see a general SLIDE up the scale of lending risk.
Hedged Financing gives way to more Speculative Financing -> Speculative Financing gives way to more Ponzi Financing. Eventually Ponzi Financing growth increases rapidly.
Are we facing a Minsky Moment?
Currently we are seeing a boom in Ponzi Financing, so much so we have even come up with a term for some of these companies that fall into this category, “Unicorns”. The name implies exactly what they are, yet investors flock to them – just like they did to Pets.com, Beanie Babies, and Tulips of the past. In the future we will certainly look back in embarrassment that the very name invoked HUGE RISK that was ignored.
We are also seeing a rather huge rise in market leverage ratios. While the NYSE Margin Index did peak out in June 2015 at $504 Billion, it has remained elevated in the $450 billion range, after a precipitous fall in the 1st quarter of 2016 when the market was in a short-term shock over potential economic growth.
While consumer debt continues to grow, a concern is that wage growth and employment growth are lagging behind. Debt to income ratios are rising. These factors all indicate a shift in the Minsky debt financing, up the scale towards Ponzi Financing.
A friend of mind pointed out, while certainly anecdotal, is the rise in these “house flipping” shows. I have also run into more people that are flipping homes or taking interest in it. While not proof, it does reflect the appetite for Ponzi Financing – as house flipping falls squarely in that category.
Another article in the Economist reflects, what I consider a grave concern, about Pension funds turning towards higher risk investments as current interest rates offer little return and lose against the rate of inflation. This too shows an appetite to shift up the scale of risk, which includes categories that may obfuscate Ponzi Financing schemes.
Are we there yet?
I don’t know, while I certainly believe the keg of debt is starting to over-flow, we are living in unprecedented times. It is hard to compare events in recent US history (since the birth of the Fed and fiat currency), because we have never been in a time which our own Federal Reserve if financing government debt and deficit spending. We have a lot of paper and ink to print money, so when do we run out?
The Fed’s bet is “all in” and based not on sound economic principals, but rather on “faith”. Faith that our money is sound, our government is sound, and that our economy in general is sound. Because if we look just at the math, removing our patriotism, trust, hope and faith – it is not good or even realistic. Government debt is insurmountable based on current revenue.
Government Ponzi Financing
It’s ironic that Yellen has quoted Minsky and has said the Fed has learned from it, but this was of course before she became Fed Chairman. Her actions and that of the Fed are in direct opposition to Minsky’s Moment.
Based on Minsky’s definition, our government falls in the Ponzi Financing bucket. Current government interest payments on existing debt is over $400 billion per year, even with interest rates close to zero. The government’s is current borrowing over $500 billion per year and that is just to finance existing debt.
While the government can certainly move out of the Ponzi Financing bucket when looking at the budget (which does not include entitlement programs), down a notch to Speculative Financing, it is virtually impossible (regardless of raising taxes and spending cuts) to move into Hedged Financing at this point. For the entitlement programs (Medicaid, Social Security, Post Office, etc.) they will continue to run at Ponzi Financing levels, revenue continues to run at steep short-falls vs expenditures.
Mathematically we are there in the Public sector, there is no doubt. The question is the private sector and that answer falls on the shoulders of the debt issuers. The question we must answer is how long can private sector debt financing leverage up before they can’t lend anymore? We continue to see debt ratios increase and in a fracture reserve banking system, as long as the Fed can finance them, we can leverage up. While BASEL III, Dodd/Frank, and other banking regulations have tried to harness, measure, and monitor risk levels it is at odds with Keynesians basic principal to borrow and spend to “jump start” the economy. BASEL III has raised minimum capital ratios to 4.5% and leverage ratios to 3%, and that is lowering the risk. Imagine what the minimum capital and leverage ratios were before!
The public sector will only fail when faith erodes, especially between trading nations. When China or some other major trading partner will no longer accept dollars. When and if that will happen is certainly up for theoretical debate, but we must remember while improbable it is certainly not impossible.
Our concern is the private sector and how much Ponzi Financing debt it can absorb. The level of Ponzi debt is rising and accelerating. There is not an infinite well of capital, even in a fractional reserve system. We are getting close, if not already there.
The Unknown Variable
There remains an unknown variable that will determine when and how bad the debt implosion will be. It is coming, that is inevitable, the questions are; when and how. The unknown variable is government and Fed interventionism. We are living in a new paradigm in which the government, central banks, and other institutions (IMF, World Bank, etc.) have stepped in to “save the day” by; altering lending rules, moving debt from private to public sector, monetizing debt, printing money, massive stimulus, devaluations, and programs yet to be invented.
We “seemingly” halted the last crisis with government / Fed interventionism, much of it is still in place. We have yet to determine or even know the cost of such ongoing interventionism.
The next crisis will come, I think sooner rather than later. We investors are falling over themselves to invest in Unicorn companies, house-flipping is in vogue, leverage ratios are accelerating, income growth remains paltry, job growth is good (but job quality is horrid), we are debating minimum wage levels (which tells you about the quality of jobs), debt financing is rising, and we are seeing a slide up the Minsky debt scale.
How will the government solve the next crisis? Who knows, rates are close or at zero and some countries have already moved into negative interest rates. Some nations are increasing their stimulus programs.
We are already pushing the “faith envelope” and the next crisis will certainly push it to cracking levels.
How did we get here?
In the simplest terms, we never deleveraged. Rather than taking the pain of the last crisis, the Fed and government stepped in. One could argue that failure was rewarded – Freddie, Fannie, AIG, GM, and host of companies were bailed out. Banks were not made smaller, but actually made bigger.
We can all agree that “Failure” sucks, but we must allow failure. Failure helps deleverage the system, it reduces risk and debt. Failure makes us stronger, by making risk a reality and realizing it properly, which allows us to respect risk. By not allowing failure we only make the problem bigger. If we are to be accountable and responsible, we must also assume the liabilities for our actions.
I have a saying; “You can choose to ignore the math, but in the end you can’t avoid it.”
Right now we are ignoring the math and that is perpetuating the Minsky Moment, the moment will come when we can’t avoid it any longer.
Support & Resistance
INDU 18,300 – 18,600
We seem to put in a bottom at 18,300 level in the short-term, with a 18,000 level on a broader pull back. We could see a push towards 18,600 before real selling pressure kicks in.
The recent break-out has created a pivot point at 2175. While we are above it today, a revisit to that level doesn’t mean support but rather volatility in which we could see a strong move higher or lower. I believe that it is a straddle strike.
The tech sector is in break-out mode. I help contribute to that by ordering a new Samsung Note 7 (just kidding). The market does seem a little long in the tooth at this point. I would look at the 4725-4750 on any pull back as a consolidation zone.
We seem to have some support at 1200 and the rocket move higher off that support was built on blow-out job numbers combined with a low expectation of a Fed rate hike. I can’t get bullish in here and while I think there is some consideration of adding inventory at 1200, I remain concern.
The VIX saw a small rise during the slight pull-back last week to support. However, it is back down and into the 11 range, we could even see 10 and if we get into the single digits it is DEFCON 1 condition. The VIX is not pricing in any significant downside risk at these levels. If one were to use the VIX as a measure of a potential market correction of 5%, it currently is telling us there is little to no chance in the near-term.
It’s hard to get long at these levels on job numbers alone as we look at inventory levels, wage growth, industrial spending, and productivity – all of which are showing business apprehension. Additionally and more concerning is the decline in top-line revenue on a year-over-year basis. Regardless of EPS and the bottom line, we have seen 10 – 40% declines in top line revenue from some big companies. Global growth is slowing as well as domestic.
Reliance on the CHINA boom to keep revenue growth going is no longer an option. While I have been a proponent of the future growth of Africa, South East Asia, and Latin America, they remain at early 1970s China economic levels. Africa and the rest will grow, but it will be a far more bumpy and slow ride than China.
When we see production slow and revenues decline, we see a rise in debt formation and also moving up the Minsky debt scale. All these signs are pointing to a Minsky Moment on the horizon.
Hyman Minsky (1919-1996)
Courtesy of Mises.org