My wife is beginning to dread it when I talk about the economy (perhaps I’m being over-generous in saying “beginning”…). This past week, I even dragged my dear sister down into the muck. Now, poor reader, it’s your turn.
Government finances are looking more and more scary to me. I was reminded of this recently when recalling much of what I read about housing finance in 2003-2005 (yes, I was that early…and no, I didn’t make any money betting against it…).
In particular, I remembered the intellectual framework of one Hyman Minsky, a great economist most people have never heard about. His “Financial Instability Hypothesis” was frequently quoted with respect to subprime home loans.
In general, he said there are three types of lending, one following the other. As lenders proceed from one financial crisis to the next, they walk farther and farther out on the risk limb until they fall off. Then, they start all over again. Silly, isn’t it?
The first type of lending he called “hedge finance.” This is lending where the bank expects to be repaid both interest and principal. Seems infinitely prudent, huh? It is. But, when it works well for some time, financiers move out the risk limb.
Next comes what Minsky called “speculative finance.” This is where the lender expects to be paid interest, but not all the principal. Does that sound imprudent to you? It may, but it’s quite common. If you’ve ever paid 20% interest on a loan or credit card, you’ve participated in speculative finance. Banks charge that high interest rate because they don’t expect you (or someone else offered the same loan) to fully repay the principal. The high interest rate allows them to still make money even without full principal payment. This is very profitable business in good times, which leads lenders farther out the limb.
The final phase is called “Ponzi finance.” This is where the lender expects neither full interest nor principal payment. It only works as long as asset prices are rising, as was the case with the housing market, or as long as a “greater fool” can be found to buy the loan from the lender, also the case with housing. This is the phase that ends in tears.
Which, brings me back to government debt. A long time ago, the developed economies of the world went from hedge financing to speculative financing. They did this when they decided never to repay their debts, but simply to roll them over (which means using a new loan to pay off the old one) each time they come due.
Because governments don’t die like people do, they can–in theory–keep rolling their debts over forever. In practice, every government dies and every single one has defaulted at some point. If they haven’t, yet, it’s only a matter of time. If you don’t believe me, see the excellent work of Niall Ferguson, and Carmen Reinhart and Kenneth Rogoff.
Just like home loans progressed from speculative to Ponzi finance, I believe government debt is walking out the same limb, too. This struck me most profoundly this week because of two data points.
The first was when I read that U.S. mutual fund investors were putting 6 times as much money into bond funds as they were putting into stock funds. At the same time, any poll you read will tell you that the very same investors openly acknowledge that U.S. debt levels are a major problem and that they are skeptical the debt can be repaid. If people are investing in debt they think is bad, they are not expecting principal and interest–they are expecting a greater fool to buy their bonds at a higher price! That, my friends, is Ponzi finance.
The second data point comes from very smart, professional investors who support the deflation premise. Most such investors openly acknowledge that U.S. debt problems are almost insurmountable, but that they are investing in U.S. debt because they believe deflation will happen and that they can make money as U.S. debt prices rise (in deflationary times, people seek the same safe havens, like U.S. debt, thus driving up the price). Such investors aren’t saying they expect to hold that debt long term–they doubt that interest and principal will be repaid! They are overtly expecting to offload such “investments” on other dumb investors. Ponzi finance!
Like the housing market, this is likely to end in tears. The problem is getting the timing right (as it was with the housing market). With so many buying government debt they openly acknowledge is dodgy–at best–everyone will be looking for greater fools to sell to at the same time, and the race to the exits is likely to be ugly.
Although my wife hates to hear me say it, it’s getting scary out there. We can still pull back from the precipice, but time is running out. Our elected officials may suddenly become prudent (not in any democracy I know of). We may experience a growth boom that saves the day–until the next crisis. But, at some point over the next 5 to 10 years, we are going to live through the transition from Ponzi finance back to hedge finance, and that’s just plain scary.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.