Minsky

Dan Davies comment at the Slack Wire

Well, there is the problem Minsky identified, of chasing yield from prudent standards of risk-taking into ponzi schemes.

This is a really common misunderstanding of Minsky, and it's his (and Charles Kindleberger's for endorsing it) fault for selecting a needlessly and misleadingly pejorative set of names for his financial structures.

A "Ponzi" project in Minsky's terminology isn't a Ponzi scheme, and it has no built in tendency to collapse. It's just a project that, for a meaningful period after its inception, doesn't generate enough cash flow to cover interest payments and so has to increase its debt to keep going. 

So, an example of a "Ponzi" project in Minsky's terminology might be ... going to university. College students don't generate cash flow and increase their debt to cover operating expenses.

And note, of course, that the classification of projects as hedge, speculative or Ponzi depends entirely on the term of the lending. There's no necessary connection between the riskiness of a project and its financing profile. For example, building a toll road between two highly-populated cities would be very likely a Ponzi project, but it is a very low risk loan indeed (similarly, shipping finance has this characteristic). Minsky had a Financial Instability Hypothesis, not a RealInstability Hypothesis, and most of the "risky" projects that he talks about are only really risky because they are exposed to the very liquidity risk that Josh (correctly) notes is reduced in an environment of surplus liquidity. It's a real misreading of Minsky to re-profile him as a theorist of Austrian-style malinvestment.

JW Mason replies

Yes, agree completely. 

One reason Minsky introduced these distinctions was to highlight the effects of changes in financial conditions on existing balance sheet commitments. In particular, since the line between speculative and Ponzi finance depends on a unit's ability to make current interest payments, where the line falls depends on the interest rate. "A speculative financing arrangement can be transformed into a Ponzi finance scheme by a rise in interest ... if earnings are better or costs, especially interest rates, fall, Ponzi financing may be transformed into speculative financing." The idea that low rates encourage risky financial commitments implicitly assumes that interest rates are known in advance, before the commitments are made. But in the real world, the effect of interest rate changes on the riskiness of existing commitments is more important.

This is the big argument of my "Fisher dynamics" papers -- the rise in interest rates under Volcker moved the aggregate balance sheet of the US household sector from speculative to Ponzi, despite a reduction in expenditure relative to income. (Although neither Arjun or I thought of using that language -- I'll have to add it to the next version.) As DD says, if you take Minsky seriously, then a concern with financial fragility favors keeping rates low, even if that does encourage taking on more "real" risk. 

 Six days later Bruce Wilder replies (after doing research?)

Minsky was a supremely articulate man, and I am sure he chose pejorative labels, advisedly.

D^2's example of a project to build a toll road, with its heavy element of construction financing, is a terribly misleading way to present Minsky's concept of Ponzi finance. Minsky's idea is not that some possibly worthwhile investment projects are Ponzi projects, but that the overall standard for fixing leverage ratios, in financing the nominal ownership and control of business assets, can shade over time, from predominately Hedge finance to Speculative finance, as conventions and expectations are shaped by recent experience.

For Minsky, Hedge finance, Speculative Finance, and Ponzi finance were three Ideal Types, corresponding to progressively greater debt to income ratios, that is, greater leverage, and possibly representing successive stages in the dynamic capital development of an economy progressing thru a cycle.

His notion was that one or another could be said to prevail in the economy at any one point in time, as conventional standards of what constitutes shrewd, but prudent judgment in borrowing and lending evolve, with common experience and expectations. When Hedge finance predominates, the economy as a system, in Minsky's view, is likely to be resilient, and apparently self-stabilizing in response to exogenous shocks or policy interventions, like a change in policy interest rates.

Experience with such stability, however, is likely to lead to greater and successful risk-taking by bankers and entrepreneurs, taking the economy toward a state in which speculative finance predominates, there is more debt introduced into the economy and higher leverage, which may take the economy into a sustained boom, and even to a state in which Ponzi finance predominates. 

An economy in which speculative finance predominates may not be as resilient, and an economy in which a standard of Ponzi finance prevails, may be at hazard of crisis and debt-deflation.

The ownership and control of a toll road could be financed to any of the three standards -- hedge, speculative or ponzi. The ultimate point of Minsky's scheme, though, is the dynamics by which such a business could be shifted, along with the economy as a system, along a continuum from one state to the next, from the cautious conservatism of hedge finance, through a heady period in which appreciation feels like growth in revenues, to pondering disinvestment as a way to channel more of the quasi-rents to debt or equity payments.

I think the term, Ponzi finance, was very much chosen to highlight the inevitability of collapse inherent in such a standard of finance.

Hyman Minsky at Wikipedia

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts....

The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. 

If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.

...

Economist Paul McCulley described how Minsky's hypothesis translates to the subprime mortgage crisis.[11] McCulley illustrated the three types of borrowing categories using an analogy from the mortgage market: a hedge borrower would have a traditional mortgage loan and is paying back both the principal and interest; the speculative borrower would have an interest-only loan, meaning they are paying back only the interest and must refinance later to pay back the principal; and the ponzi borrower would have a negative amortization loan, meaning the payments do not cover the interest amount and the principal is actually increasing. Lenders only provided funds to ponzi borrowers due to a belief that housing values would continue to increase. 

McCulley writes that the progression through Minsky's three borrowing stages was evident as the credit and housing bubbles built through approximately August 2007. Demand for housing was both a cause and effect of the rapidly expanding shadow banking system, which helped fund the shift to more lending of the speculative and ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher home prices. Since the bubble burst, we are seeing the progression in reverse, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages shifts back towards the hedge borrower. 

McCulley also points out that human nature is inherently pro-cyclical, meaning, in Minsky's words, that "from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system's reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt deflation." In other words, people aremomentum investors by nature, not value investors. People naturally take actions that expand the high and low points of cycles. One implication for policymakers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts.