Ponzi Finance and the Fed

By: JD Evans Click author's name for more of his/her articles

The Federal Reserve reported that as of June 30, 2009 downright U.S. debt was $52.8 trillion. Total U.S. obligation includes government, corporate and consumer debt. Importantly, however, it does not include a few trillion in "off balance sheet" financing, contingent unfunded pension plans for corporate and property and local governments, or unfunded liabilities of the U.S. government for such items as Medicare, Social Security and other programs. Currently GDP stands at $14.2 trillion, so there is approximately $3.73 in debt for every federal of output in the United States, a level unprecedented in our record.
Normally, obligation levels as a percent of GDP would be uninteresting and immaterial; however, the current level of obligation is unique in two ways. First, the asset side of the compensate sheet purchased by the debt is falling in price. Second, the cash that was borrowed to purchase those assets was often fraudulently expended. Neither the borrower nor the lender really expected the debt to be serviced. Rather, each party expected the asset cost to rise extinguishing the debt.
This type of financial arrangement was correctly analyzed by the famous American economist Hyman Minsky in his paper, "Financial Instability Hypothesis", in which he described three phases of obligation financing. The first is "hedge finance", where the lender expects a return on both principal and interest. The second is "speculative finance" where the lender expects to get interest on the loan but perhaps not the principal. The third case, where the lender expects neither the principal nor interest to be returned, is referred to as "ponzi finance". This was typified in the last company cycle by loans issued defenseless documentation, no feeling payment household loans, extremely low cap rates on commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the debtor is left with dying asset values that preclude the rollover of their obligations.
Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices that were inflated by the speculation of earlier years. The aftermath of that speculation and its impact on the economy has been thoroughly studied prior to our present company cycle by the economists of yesteryear who marveled at the mania in the collective mindset of private citizens and their elected representatives who produced such bubbles.
The most distinguished of these economists was Irving Fisher (1867-1947), who in 1933 wrote about this difficulty of over-indebtedness (Irving Fisher, 1933, Econometrica, "The Debt-Deflation Theory of Great Depressions"). He stated flatly that over-indebtedness was the dissimilarity between normal business cycles (recessions), which occur frequently through "over-production, inventory misjudgment, or commodity cost fluctuations" and drastic company cycle fluctuations (depressions).
Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined a pattern of economic developments that will take sediment when the debt cycle is broken. Seemingly old news, but it is interesting to apply his sequence of events to today's economic developments as there are disturbing similarities.

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