Sic Semper Tyrannis

In his May 2nd, 2008 New York Times article "Determining Who gets to Ride the LifeBoat", Floyd Norris discusses this issue of mortgage "bailouts" and economic downward spirals. Many have acknowledged that the question of "who is worth helping" is a thorny one -- in theory, it would take a court case and judge for each and every underwater borrower to determine if they were culpable or predated upon, and hence worthy of public aid. Obviously, that approach won't work for what must (presumably) be a rapid, broad-brush bailout.

Nothing new there. But what is interesting is the second half of Norris' article, where he takes a cue from a Bush Administration official's mention of the late economist Hyman Minsky. Minsky has been mentioned quite frequently over the past year on blogs and then the mainstream media (and now, apparently, in political circles), in my mind, because of his insights about the importance of the credit cycle to the economy. That immediately leads to exploring the causes of the credit cycle, and questioning how to ameliorate them.

But Norris and many in government apparently now are reading Minsky a bit differently, and the lessons they are gleaning from Minsky deeply concern me.

Follow up:

Norris starts out mentioning what Minsky is most famous for, his "financial fragility hypothesis", which (broadly) says that banks and other finance sector participants will engage increasingly reckless lending, and extended more and more credit over the course of the economic cycle. Thus the longer the economy seems "stable", the more fragile it is actually getting.

Minsky takes this to be a property of the capitalist system, and suggests (a-la Keynes) that the government can intervene to prevent a catastrophic collapse in asset values, hence arresting a downward economic spiral into depression.

This is where Norris gets off: "the government should do something" is the end of the ride for him. He quotes Robert Barbera of ITG, who says

"It invites a calculation that says 'We are all a lot poorer, because our house values have fallen"" ... "That can become a self-reinforcing negative dynamic" that makes consumers fearful to spend and persuades them that buying a house is foolish until prices have fallen further.

That does sound scary. Nevermind that, perhaps, consumers are a lot poorer. Or more accurately, are not as rich as they thought they were. The government should do something!

I agree with Norris that we are currently engaged in a downward spiral. Where I differ is on the question of what should be done about it -- I would argue: "nothing", as far as market intervention goes. Providing shelter for homeless people foreclosed on is one thing, but attempting to inflate their house values or renegotiating their loans even if they took them on knowingly will just make matters worse. In specific, these forms of intervention will delay the correction of the market to a sustainable level.

Norris thinks that Minsky would support market intervention to "soften the blow" and "halt the downward spiral", and maybe he's right. But I think we can draw a better lesson from Minsky than that -- perhaps better than Minsky himself intended.

Minsky mostly focused on credit bubble dynamics within the private sector. Fractional reserve lending-driven cycles of easy credit and panic have been going on since this form of banking has existed (over 400 years). Indeed, the notion that there is a credit cycle as part of the "business cycle" has largely been lost to modern, mainstream economics. This is one reason Minsky's work has appeared more relevant lately. Mainstream economists -- even Nobel Laureate academic eggheads -- did not anticipate the current crisis at all. This is not surprising, since their favored macro-economic metrics do not involve credit at all (and where credit is included, it is counted more or less interchangeably with money supply and "wealth").

But In my opinion, Minsky's great insight is not so much that there is a credit cycle -- this has been argued separately by Austrian economists like von Mises -- but to detail this cycle, pointing out that it culminates in finance so unsound and reckless that Minsky called it "Ponzi finance" (which is perpetrated by "Ponzi units"). Ponzi units can only stay alive by extending more credit to both new borrowers and old ones (re-financing), even when they are already in distress, and knowingly do so as a business strategy.

Sound familiar?

It should, especially if you've checked out my Mortgage Lender Implode-o-Meter in the past year, which has documented the implosion of hundreds of what were essentially Ponzi finance units.

The shuttered Bear Stears, numerous hedge funds, and the rest of the ailing money center banks (now rapidly selling off pieces of themselves to foreigners to stay afloat) amidst this crisis have also fallen victim to the blowup of Ponzi finance units (their own and others).

So Minsky was right about where this would lead.

Now on to the point about the "government saving us".

I see two huge problems with a push for that, and if Minsky were around now, he would probably agree (he never witnessed the greatest of the bubble excesses).

The first problem is that, far from happening privately and in isolation from the government, the government actually aided, abetted, exacerbated, encouraged, and enabled the bubble. This has been its modus operandi for the better part of thirty years. Low interest rates, lax bank regulation in terms of reserves, failure to police predatory lending, and the implied guarantees and "safety nets" of the FDIC, Federal Home Loan Banks, FHA, and Fannie and Freddie, all actively factored into blowing not only the current bubble but a series of bubbles stretching back to the 1980s.

In fact the government's "bail out on the public dime" reaction to the S&L bubble and collapse simply emboldened the banking system to take even greater risks. The "shadow bailout" of Long Term Capital Management (the hedge fund that imploded in 1998) had a similar effect on hedge funds, private equity, and proprietary trading operations at banks.

Some would even argue that the severe moral hazard that is now baked into America's financial cake goes back to the bailout of Crysler in 1979. But now this is all routine and surprises no one. For example, in 2006 Delta Airlines filed bankruptcy, and the government happily folded its pension liabilities (one of the biggest factors weighing on them) into the government Pension Benefit Guarantee Corporation. No one batted an eyelash. The same will probably happen for GM.

The "Greenspan put" of interest rate lowering was notorious during the last Fed Chairman's tenure, and now under Bernanke there is a "Bernanke put" of inventing arbitrary debt laundering facilities and debt backstopping (some of it arguably illegal), which has put even the Maestro to shame.

So government, far from a bystander, has set the stage for our most recent Minsky cycles of credit and collapse.

I would argue, based on that fact, that the proper correction to the problem is to get the government out of the business of active intervention in business and finance. There should be no "last" bailout; because then there will never be a true "last" bailout. Any intervention should not extend beyond basic law and order and personal welfare: making sure the predatory are punished and their victims made whole, and making sure everyone has shelter and food and a fair chance to start over if they've lost everything. Hint: they will only get such a fair chance if the government stops its mass manipulation of the private sector, especially the banking system.

If you disagree with that and think the government should come to our aid by propping up the housing market, then fine. But then you must deal with a second problem, and this one is far less philosophical:

The government has no resources with which to "bail" anything.

We are in debt and deficit and have been for years -- and now, moreso than ever. This buildup in debt is part-in-parcel of the Minsky credit cycle, and it does greatly effect the so-called "private" markets (Chinese and Arab buying of government-guaranteed mortgage securities was one of the main drivers of low mortgage rates in the 2004-2006 period).

That very complex of unusually high foreign buying of US debt (that is, lending to us) is now being choked off by its own consequences: the collapse of all the US credit markets, and most of the rest of our financial markets. This is no surprise, as the whole thing effectively became a Ponzi Unit through its own excesses.

The upshot is we aren't going to be able to increase our borrowing to fix the problems now. And we can't enter a war to generate the necessary stimulus (a-la FDR) because we're already completely extended fighting two of them. Production is already at a peak, so there's no way to increase it to generate surplus output we can use to paper over the problem economic areas. In fact these latter two points are connected -- virtually all of the capital investment in America in the past three decades went into the military and military-related expenditures overseas, rather than truly productive areas like manufacturing back here at home, so we have nothing we can gear up to generate surplus output.

We are thus faced with the farcical situation where the government has already begun "bailing", but it is having to borrow even more to do so. Since we're past the point of exhaustion (beyond the "Minsky moment") already, this borrowing is apt to have increasingly disastrous effects. Look at the $160 billion emergency stimulus bill congress passed a few months ago (with checks having started going out in the mail a few days ago). The government is immersed in a record-breaking fiscal deficit -- so bad the Treasury Borrowing Committee is crying "uncle" -- so where is it going to get the money to pay these checks?

More borrowing, of course. But what happens when you add more borrowing when the supply of lenders is shrinking? Interest rates go up.

The Fed currently has a policy of holding interest rates down, to hold together the creaking financial system. As we discussed, borrowing is already dramatically ramping up because of structural spending needs, the war, and now bailouts. These two objectives are in conflict. Something will have to give.

Whether the Fed allows it or not, interest rates will rise. The Fed may succeed in artifically holding down interbank rates, but this will not help most of us. Soon we will be faced with the ultimate farce of mortgage rates dramatically rising because of all of our national borrowing, even though much of it has been piled on to help out those harmed by the housing bubble! Push down in one place, the misery moves somewhere else.

It is time to give up and start over. Because the Minsky cycle and Ponzi finance dynamics have risen to the national scale, there is no way out. We simply have to let the bubble burst, help our neighbors out the best we can, and build a new financial system that isn't dependent on a series of ever-increasing props from the government to survive.

Bonus: Minsky Meme-ography

In researching Minsky and stepping back over his re-introduction into the public discourse over the past year and a half, I compiled a short bibliography of pages representing what I believe are the notable major citations. Some light Googling seems to confirm these are indeed the major ones, in the proper order:

1. March 13, 2007. Russ Winter - "The Minsky Moment: They Can Run, But They Can’t Hide"

2. April 28, 2007. iTulip.com - "How Finance Capital Cripples Industrial Capital: The Role of Fractional Reserve Banking"

3. May 4, 2007. "Fisher, Keynes, Minsky, and Keen on "Bubbles in Everything" and Debt Deflation"

4. July 30, 2007. Nouriel Roubini - "Are We at The Peak of a Minsky Credit Cycle?"

5. August 18th, 2007. Wall Street Journal (via Eric Back) - "Minsky Gains Credence in Wake of Market Meltdown"