Saturday, 8 May 2010

Creative destruction and the Minsky moment

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

In this post I will review the consequences of this week price action.

I will also point out the current Minsky moment and theory as well as reviewing the Austrian Business Cycle Theory which if applied could have prevented much of the current mess we are in.
I will also underline again the incredibly accurate analysis and forecast made by Joseph Schumpeter in his book Capitalism, Socialism and Democracy.

From Wikipedia:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity."

The Minsky Theory:

"Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility.

-for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.

-for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.

-for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed."

We have reached this moment this week. CDS prices are rising fast and furiously (Itraxx Main 5 year is now around 140 Bps an Itraxx Crossover 5 year is at 605 bps). I have witnessed similar price action in the credit market in August 2007 following the demise of the two highly leveraged Bear Stearns funds that collapse which triggered the subprime debacle. Some so called experts where at the time telling everyone that subprime was a small problem that could be contained. Same is happening today, some experts are telling us Greece is a small problem that can be contained. We are all witnessing the contagion in the market hence the Minsky moment we are in!

TED spread is widening and this is clearly a sign of liquidity strain in the system as well as the widening in the OIS-Libor spread.

As per the Wall Street Journal on Friday, Short term lending is rising which is a sign of rising liquidity concern and counterparty risk aversion in the financial markets. This explains why there is 40 bps difference between the Itraxx Main 5 year CDS and the Itraxx Senior Financial Index 5 year CDS.

In normal markets Itraxx Financials index trades below Itraxx Main Europe as per below graph:

"The three-month dollar-lending rates among banks, the London interbank offered rate, or Libor, rose Friday, to 0.42813% from Thursday's 0.37359%, the highest since August, as risk-wary banks became more reluctant to lend to each other. Dollar Libor, which peaked in July 2009, has been mostly stable since the fall of 2009, but started to pick up again this past March.

Short-term funding markets already had shown signs of liquidity strains Thursday amid worries about counterparty risk with European banks."

Source Bloomberg

Fear gauges in the government bond market was higher Friday. The TED spread, measures the gap between the "risk free" rate three-month Treasury bills and the London interbank offer rate on three-month dollars, reached 30 bps, setting up a new high for the year so far...

Another indicator I mentioned previously as an indicator of risk spiking up is the VIX (on the 10th of April I argued that market were too complacent and the VIX was too low and VIX was at a very good entry point):

Source Bloomberg

The higher the VIX, the higher the fear and panic in the market.

We have witnessed all of the above towards the previous catastrophic Lehman collapse.

Now to the explaination of the Minsky moment, the Austrian Business Cycle Theory explains partly and the economic reasons behind our current financial crisis since 2007.

As per Wikipedia:

"The Austrian business cycle theory ("ABCT") is an explanation of the primary causes of business cycles held by the heterodox Austrian School of economics. The theory views business cycles (or, as some Austrians prefer, "credit cycles") as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.

Austrians believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

Given these perceived damaging and disruptive effects caused by volatile and unsustainable growth in credit-sourced money, many Austrians (such as Murray Rothbard) advocate either heavy regulation of the banking system (strictly enforcing a policy full reserves on the banks) or, more often, free banking. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory."

Alan Greenspan maintained interest rates too low for too long: 2000 to 2006 the creation of the bubble which led to the bust.

The Austrian Business Cycle Theory explains what happened very clearly:

"The boom then, is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires."

"The monetary boom ends when bank credit expansion finally stops - when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. Evidently, the longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures and depression readjustment. There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action."

Main critics of the Austrian Business Cycle theory such as Paul Krugman and Gordon Tullock argue the following:

"Mainstream economists argue that the theory requires bankers and investors to exhibit a kind of irrationality – that they be regularly fooled into making unprofitable investments by temporarily low interest rates."

Fabulous Fab Abacus CDO anyone?
Well guess what, bankers and investors exactly did that when they bought transactions similar to the Abacus CDO, and yes they were indeed fooled into making "unprofitable investments" enticed by the AAA provided by the complacent rating agencies which were being paid to issue the ratings by the very banks, issuing these structured credit transactions to these "sophisticated investors". This what some of the CDOs were all about (not all of them though as it depends what securities you include in the structure...).

The European govermnents are trying to postpone the day of reckoning for Greece and the markets are clearly showing they are not buying it.

The best for Europe would be a major debt restructuring for Greece, reducing the interest rate they have to pay, extending the maturity of the debt and the bondholders taking a haircut on their holdings.

The level of debt for Greece is clearly unsustainable and no matter how much money European countries will throw at it, it will not resolve the structural issues at the core which are widespread corruption in the Greek system, complete lack of fiscal discipline and fraud in the entire country.

To entice Greeks to accept the austerity measures, bond holders taking a haircut on their holdings would alleviate the pain and entice the Greek population to accept more willingly the austerity measures. The issues are that without being able to devaluate their currency, Europe is just trying to postpone the day of reckoning for Greece.

Creative Destruction and Schumpeter's contribution:

Schumpeter view on the demise of capitalism and "creative destruction":

"Schumpeter's theory is that the success of capitalism will lead to a form of corporatism and a fostering of values hostile to capitalism, especially among intellectuals. The intellectual and social climate needed to allow entrepreneurship to thrive will not exist in advanced capitalism; it will be replaced by socialism in some form. There will not be a revolution, but merely a trend in parliaments to elect social democratic parties of one stripe or another. He argued that capitalism's collapse from within will come about as democratic majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and destroy the capitalist structure. Schumpeter emphasizes throughout this book that he is analyzing trends, not engaging in political advocacy. In his vision, the intellectual class will play an important role in capitalism's demise. The term "intellectuals" denotes a class of persons in a position to develop critiques of societal matters for which they are not directly responsible and able to stand up for the interests of strata to which they themselves do not belong. One of the great advantages of capitalism, he argues, is that as compared with pre-capitalist periods, when education was a privilege of the few, more and more people acquire (higher) education. The availability of fulfilling work is however limited and this, coupled with the experience of unemployment, produces discontent. The intellectual class is then able to organise protest and develop critical ideas."

Schumpeter view on democracy:

"In the same book, Schumpeter expounded a theory of democracy which sought to challenge what he called the "classical doctrine". He disputed the idea that democracy was a process by which the electorate identified the common good, and politicians carried this out for them. He argued this was unrealistic, and that people's ignorance and superficiality meant that in fact they were largely manipulated by politicians, who set the agenda. This made a 'rule by the people' concept both unlikely and undesirable. Instead he advocated a minimalist model, much influenced by Max Weber, whereby democracy is the mechanism for competition between leaders, much like a market structure. Although periodic votes by the general public legitimize governments and keep them accountable, the policy program is very much seen as their own and not that of the people, and the participatory role for individuals is usually severely limited."

It is very important to review Schumpeter's view of democracy but also understanding the incredible fragility of democracy due to human nature and the role our policiticans have played, in today's major financial crisis.

The below quote is supposedly attributed to Alexander Fraser Tytler (1770), Cycle of Democracy but unverified. It makes never the less a very interesting point.

"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits the public treasury with the result that a democracy always collapses over lousy fiscal policy, always followed by a dictatorship. The average of the world’s great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to Complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage."

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