Are we in the midst of a new golden age of capitalism or the biggest asset bubble in history?
Frankly, nobody can tell for sure. All we can realistically do is to assign probabilities to the two outcomes. Or, perhaps not even that. In its new annual report published on 27 June, the Bank of International Settlements (BIS) admitted as much. “Our understanding of economic processes may be even less today than it was in the past,” said the BIS. And: “We face a fundamentally uncertain world—one in which probabilities cannot be calculated—rather than simply a risky one.”
So, it is not surprising that there are smart men and women on both sides of the fence, arguing the bull and bear cases with equal conviction. But this week marks the 10th anniversary of the start of the Asian financial crisis—an earthquake that ripped through economies across the region. So, despite the ambiguities of the current situation, it is still worth trying to figure out whether the world is close to another big financial blowout.
Most of the debates are focused on the macro-fundamentals—exchange rates, current account balances and interest rates, for example. These are not unimportant. But there is another set of parameters that deserve equal attention—the balance sheets of companies, banks and investment bodies. Remember: while currency speculators fanned the fires of the Asian financial crisis, these fires were originally lit by weak balance sheets of banks and companies in the region.
The work of American economist Hyman Minsky gives us a useful framework to examine this issue. Minsky developed a theory of financial fragility that is stunning in its originality, and which tried to show that periodic financial crises are part of the logic of the economy rather than the result of external shocks. In other words, he said financial crises are endogenous rather than exogenous.
Minsky said balance sheets and cash flows go through three stages, which he termed hedged finance, speculative finance and ponzi finance. In the first stage, hedge finance, the cash flows generated from operations are enough to meet all financial obligations of a company. But as an economy grows, companies tend to take more risks. They move to the second stage—speculative finance. Here, their cash flow is enough to cover only debt payments; the actual debt is rolled over rather than repaid. Then there is the final stage of ponzi finance, when the cash generated from operations is not even enough to cover interest payments. The company either has to borrow more or sell off its assets to service its debt.
Ponzi finance is the last stage before a financial crisis and, after the crisis, companies go back to the first stage of hedge finance. And then the process starts all over again. Minsky has in recent years developed a following in the investment community, especially among the “world is a bubble” crowd.
Minsky’s analysis assumed a closed economy, without capital flows and volatile exchange rates. Some of his prescriptions, too, were controversial. He argued, for example, that the job of a central bank is not to control money supply but to stabilize the financial system. Yet, the broad three-stage classification he proposed is a good framework to understand the times we live in.
Now, look around. You’ll see leveraged buyouts, hedge funds and private equity funds making the headlines. They all have one thing in common—they constitute an arbitrage between the credit markets and other asset markets. In other words, these entities are borrowing at very low interest rates in one market and using the money to buy in another market (be it a company or any other asset class). A lot of the risk has been parcelled out and sold to investors across the world through synthetic securities. This looks a lot like what Minsky called ponzi finance.
On the other hand, the balance sheets of non-financial companies are in good shape, with low debt and high levels of cash. The question, then, is whether the power of ponzi finance is strong enough to topple the global economy in the coming years, despite strong economic and business fundamentals.
“I have proposed a ‘Minskian’ evolution from Money Manager Capitalism to Financial Arbitrage Capitalism. Command over the credit system —hence the capitalist economy—has shifted away from corporate boardrooms and institutional investors to investment bankers, derivative players, and the leveraged speculating community. Moreover—and in a momentous departure from Minsky’s era—the consumer loan has become the locus for system credit creation, supplanting business borrowing to finance capital investment,” wrote money manager Doug Noland in June 2005.
He was writing about the US. But these are words worth heeding for the rest of us as well.
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