Wednesday, July 31, 2013

The Eurozone Crisis Through The Eyes Of Hyman Minsky

“Over a period in which the econ­omy does well, views about accept­able debt struc­ture change.  In the deal-making that goes on between banks, invest­ment bankers, and busi­ness­men, the accept­able amount of debt to use in financ­ing var­i­ous types of activ­ity and posi­tions increases. This increase in the weight of debt financ­ing raises the mar­ket price of capital-assets and increases invest­ment. As this con­tin­ues, the econ­omy is trans­formed into a boom econ­omy.  The ten­dency to trans­form doing well into a spec­u­la­tive investment boom is the basic insta­bil­ity in a cap­i­tal­ist econ­omy.
“Each new instru­ment and expanded use of old instru­ments increases the amount of financ­ing that is avail­able and that can be used for financ­ing activ­ity. Increased avail­abil­ity of finance bids up the prices of assets and this leads to increases in invest­ment.
“Units which engage in spec­u­la­tive finance depend upon the nor­mal func­tion­ing of finan­cial mar­kets. In par­tic­u­lar, spec­u­la­tive units must con­tin­u­ously refi­nance their posi­tions.
“The views as to accept­able lia­bil­ity struc­tures are sub­jec­tive, and a short­fall of cash receipts rel­a­tive to cash pay­ment com­mit­ments any­where in the econ­omy can lead to quick and wide reval­u­a­tions of desired and accept­able finan­cial struc­tures. Whereas exper­i­men­ta­tion with extend­ing debt struc­tures can go on for years and is a process of grad­ual test­ing of the lim­its of the mar­ket, the reval­u­a­tion of accept­able debt struc­tures, when any­thing goes wrong, can be quite sud­den and quick.
“In addi­tion to hedge and spec­u­la­tive finance we can dis­tin­guish Ponzi finance—a sit­u­a­tion in which cash pay­ments com­mit­ments on debt are met by increas­ing the amount of debt out­stand­ing. High and ris­ing inter­est rates can force hedge financ­ing units into spec­u­la­tive financ­ing and spec­u­la­tive financing units into Ponzi financ­ing. Ponzi financ­ing units can­not carry on too long.
“Feed­backs from revealed finan­cial weak­ness of some units affects the will­ing­ness of bankers and busi­ness­men to debt finance a wide vari­ety of orga­ni­za­tions. Unless off­set by gov­ern­ment spend­ing, the decline in invest­ment that fol­lows from a reluc­tance to finance leads to a decline in prof­its and in the abil­ity to sus­tain debt. Quite sud­denly a panic can develop as pres­sure to lower debt ratios increases.”

--Excerpts from Minsky’s “The Finan­cial Insta­bil­ity Hypoth­e­sis: An Inter­pre­ta­tion of Keynes and an Alter­na­tive to Stan­dard The­ory”, Chal­lenge, March-April 1977, pp. 20–27. [source: Steve Keen’s DebtWatch].

Minsky’s model for the economy was informed by Irving Fisher’s Debt-Deflation Theory. They both offered models of the economy in which finance plays a dominant role (as opposed to, say, fiscal or monetary policy). In explaining crises and depressions, monetarists point to the money supply, Keynesians point to the government’s fiscal stance, and Fisher/Minsky point to the credit markets.

I don’t think that is necessary or correct to take an exclusivist stance in this debate. There is plenty of room for each of these theories to contribute to our understanding of economic cycles. Only angry academic economists feel constrained to argue for exclusive theoretic supremacy.

The eurozone debt crisis is a modern phenomenon in which all three theories contribute explanatory power: (1) fiscal: the Troika’s austerity program is depressing aggregate demand; (2) monetary: the ECB’s deflation policy has ensured that neither NGDP nor RGDP can grow, and that the real value of debt rises; and (3) credit: the steady withdrawal of credit from the private sector has thrown an anchor around the peripheral’s necks. Indebtedness grows while the economy shrinks. The harder they try to balance the budget, the higher the level of unemployment, misery and debt. Debt rises while NGDP declines (the “denominator problem”).

Back story: The eurozone periphery experienced a period of high confidence and low credit spreads following the introduction of monetary union. The bankable investment horizon was now much bigger; lending opportunities abounded. Cross-border lending was now domestic lending. Emerging economies became developed economies overnight. The opportunities to lend and invest were almost limitless. All bets were winning bets.

Euro euphoria permitted higher leverage for banks, companies and governments than prior to EMU. Higher leverage bid up asset values: an asset is worth what a bank will lend against it. Stocks, property, bonds: all rose on the tidal wave of rising debt. As Minsky would say, finance in peripheral Europe went from being self-liquidating, to being speculative, to being ponzied. Principal could be rolled over again and again, while interest was paid with new borrowing. Trichet declared that EMU was raising living standards; the euro project was a success; convergence would continue on the path to “ever deeper union”.

This revery ended in the fall of 2009, when Greece revealed that it had been cooking its books for years. Market psychology changed overnight: credits that had appeared eminently bankable and marketable were now suspect. “The reval­u­a­tion of accept­able debt struc­tures, when any­thing goes wrong, can be quite sud­den.” Government, corporate and bank credit ratios that had looked OK now looked toxic. The debt markets began to look for other dodgy credits, and discovered the PIIGS.  It was discovered that these countries were running big deficits, were piling up debt, and had bloated, unwieldy and opaque banking systems. Most of them had one or more big banks that no one wanted any exposure to. They looked scary.

In a monetary union, capital movement is unconstrained. It may take years to flow in, but it can leave in a couple of weeks. Capital movements are electronic; capital flight requires a key-stroke, or a committee meeting followed by a keystroke. Overnight, the whole world lowered its concentration limits for peripheral Europe: “Let’s take our clients’ exposure down from 30% to 10%; give the traders a few months to bring it down, but I want it brought down this year. The clients are nervous, especially about X, Y and Z.” Asset managers assured their clients and banks assured their boards that they were reducing their exposure to the PIIGS.

When your nation’s entire balance sheet is funded in foreign currency, capital outflow and the closing of the debt market are hard constraints. Whining won’t help. The only way to obtain wiggle-room is to beg from Germany, which is what Greece, Ireland and Portugal have had to do. Spain is next, but the Germans have bailout fatigue.

And that has led to the strange world into which the eurozone is heading today: a world where no sovereign or bank, no matter how big, is too big to fail. There will no safety net for bondholders, creditors or depositors. Governments are free to repudiate their debts, and banks to repudiate their deposits.

Ponzi schemes never end well. The eurozone’s ponzi scheme has ended. There is no more money flowing in, while debts continue to mature, interest has to be paid, deposits have to be redeemed, and pensions need to be paid--in euros, not funny money.

Germany has solved this problem by saying that everyone who participated in the eurozone ponzi scheme should have known better and should now “contribute” to the resolution. Debt is not debt; it’s a risk asset. Creditors are now expected to become willing or unwilling participants in a “fair and just” resolution of their debtor’s debts.

Trichet’s statement that default by a eurozone sovereign was “unthinkable” and “not under discussion” was rendered inoperable, as Ron Zeigler used to say. Now, it is not only “thinkable”, it is official policy. Sophisticated investors  should have known that, when Trichet said that it was “unthinkable”, his fingers were crossed. That’s the kind of thing that sophisticated investors should know: when the president of the ECB makes a policy statement, just insert “not”, or “I’m kidding, of course”.

So, now,  the flood waters are beginning to inundate the PIIGS. Their banks have started to fail, and their governments have begun to engage in “PSI” which means “repudiation” in Eurospeak. What’s going to happen to all those bloated and insolvent banks that dot the Mediterranean landscape? Who is going to write those checks?

Germany believes that it has established the Siegfried Line on its southern borders. The colonies can be sacrificed without endangering the Homeland. Germany should read a book*: I mean really, a virus which can kill your neighbors can kill you too. Once the word gets out that German banks are stuffed to the gills with all sorts of foreign and domestic dreck, and that they too may default on their bonds and deposits, the German banks may experience their very own Minsky Moment. I ask you, is there one solvent bank in Germany, or France? Which one? They disclose very little, and previous stress tests have been shown to be cheap lipstick. How can any counterparty really know anything about Commerz or Deustche? They certainly didn’t know much about Depfa or Hypo or WestLB.

People shouldn’t light fires in their own neighborhoods. Does anyone in Germany remember Danatbank**? Schadenfreude is not the best policy for financial stability.

*“Can It Happen Again?”, Hyman Minsky, 1982. The hardcover sells for $1,400 on Amazon.
**The collapse of Danatbank on July 13, 1931, triggered a loss of confidence in the German banking system, and produced  a wave of withdrawals from all other German banks, beginning the German Banking Crisis, which led to deflation, depression and political chaos.

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