Private Debt and Instability

Eric Tymoigne
Modern Money
Spring 2015
 Road Map
1- Fisher’s Debt Deflation
2- Minsky and the Financial Instability
Hypothesis
3- Extension to open economy
4- How to deal with a debt-deflation
 Learning outcomes
• A debt deflation leads to a break down of market-
clearing mechanisms
• Significant financial crises are the result of the inner
workings of capitalism. They are not the result of bad
luck (black swan), market imperfection or individual
imperfections: perfect competition reinforces
instability
• There are means available to prevent major financial
crises.
• There are straightforward means to deal with a debt
deflation
 Fisher: Debt-Deflation Theory
• Market mechanisms breakdown under the
combination of over-indebtedness and
deflation: lower prices do not clear markets
but make matter worse
• Over-indebtedness  sell assets  deflation
 difficulty to recover money  over-
indebtedness
 Inability to Service Debt from Income
shortage of cash: overindebtedness

+
distress sales

Overindebtedness means that economic agents do not have enough cash to service their debts.
Shortage of cash leads to distress sales (hence the “+” sign: move in the same direction)
 Inability to recover enough fund
shortage of cash: overindebtedness

+
distress sales
-

+
debt liquidation

Debt Disease
-
+ prices
quantity of money

Higher Distress sales lead to higher debt liquidation: loans are repaid and written off
This has two impacts on the balance sheet of banks
Asset: loans decline
L and NW:
- checking accounts decline (loans repaid by using money) so quantity of money declines (hence the “-” sign: moves in
opposite direction to debt liquidation)
- net worth declines: counterpart to default and writeoffs, and value of assets going down

The lower quantity of money leads to lower aggregate demand for goods and services and lower demand for illiquid assets.
Thus prices fall, which increases the amount of distress sales

OVERALL: POSITIVE/REINFORCING FEEDBACK LOOP: DISRESS SALES LEAD TO MORE LIQUIDATION WHICH
LEADS TO MORE DISTRESSES SALES
 Self-reinforcing deflation
shortage of cash: overindebtedness

+
distress sales
-

+
debt liquidation
Dollar Disease
Debt Disease
- -
+ prices
quantity of money

Higher Distress sales leads to even lower prices of goods and services and assets,
Which leads to more distress sales
 Negative impact of profit and further
deflation
shortage of cash: overindebtedness
-
+
net profit
distress sales
- +

+ Profit Disease
debt liquidation
Dollar Disease
Debt Disease
- -
+ prices
quantity of money

+
profit and net
worth

lower prices of goods and services and assets lead to lower profit and net worth, which
leads to lower net profit (profit – debt service), which creates a higher shortage of cash
 Negative impact on spending
shortage of cash: overindebtedness
-
+
net profit
distress sales
- +

+ Profit Disease
debt liquidation
Dollar Disease
Debt Disease
- -
+ prices
quantity of money

+
profit and net
worth
+

Amplifier effect
Less profit and income means less spending +
economic activity
And so less economic activity, which leads
to less profit and income: income multiplier
Decline in Confidence and Rise in willingness
to hoard
shortage of cash: overindebtedness
-
+
net profit More debt liquidate lowers
distress sales
- + Confidence in the future, which
Push economic unit to hoard
+
debt liquidation Profit Disease more (i.e. spend less of their
Dollar Disease money: V goes down) so prices
Debt Disease
-
decline
-
+ prices
quantity of money
+
+
profit and net
worth
money velocity Pessimism
Pessimism + +
+ Amplifier effect
confidence +
economic activity
-
 Rising interest rate Lower profit and NW
Reduces the creditworthiness
of economic units so banks
shortage of cash: overindebtedness Charge a higher interest rate
- So debt serve rises and so net profit
+ declines
net profit
distress sales -
- +
cash commitments
+ +
debt liquidation Profit Disease
Dollar Disease
Debt Disease Risk premium disease
- -
nominal interest
+ prices
quantity of money - rate
+
+
profit and net
worth
money velocity Pessimism
Pessimism + +
+ Amplifier effect
confidence +
economic activity
-
All these feedback loops reinforce the debt deflation according to Fisher: an initial small problem that was limited
to a small area of the economic system becomes destructive and impacts many economic units that previous
were not overindedbted (unemployment, strong business lose customers, value of assets declines).
 When does debt-deflation stop if
left alone?
shortage of cash: overindebtedness
-
Debt burden
+
net profit
distress sales - -
- +
cash commitments
+ +
debt liquidation Profit Disease
Dollar Disease
Debt Disease Risk premium disease
- -
nominal interest
+ prices
quantity of money - rate
+
+
profit and net
worth
money velocity Pessimism
Pessimism + +
+ Amplifier effect
confidence +
economic activity
-
Andrew Mellon’s advise to Hoover: “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will
purge the rottenness out of the system.”
Fisher: Under debt-deflation, cleansing aspects of market break down: even “good apples” are liquidated.
 Minsky
• Why are economic unit overindebted in the first place?

Mainstream answer: large unexpected random adverse shock (black swan,

once-in-century credit tsunami)
Minsky Answer: “Stability is destabilizing”: Over period of prolonged
expansion, the financial positions of economic units become more and more
fragile, i.e. not unusual adverse movement in economic variables have large
negative consequences on balance sheets.
Þ Rising financial fragility leads to overindtedness, which leads to financial
instability (debt-deflation): Financial Instability is not an accident, it is the
produce of the economic system we used
Þ Financial instability is not a rare event. It has been contained through
specific policies since WWII
Þ All major financial crises of the 20th century had some Minskian
component: underwriting problem, fiscal and monetary tightening, etc.
(was analyzed 1933 US, 1990 Norway, 1997 Asia, 2008 US and Europe)
 Some core elements of Minsky’s theory
a) Bankers
• Role:
– Judge the creditworthiness of potential borrowers
– Allow a smooth financing and funding of economic
activity: their IOU is a monetary instrument.
• Two main desks:
– Loan-officer desk: “designated skeptics” who “transform
optimistic views of profit expectations put forth by
potential borrowers into realist expectations”
– Position-making desk: finance, refinance and/or liquidate
existing asset positions of the bank
• Evolution of the banking sector since the early
1980s:
Commitment model → originate-to-distribute model
• Loan officer is central • Position-making desk is central
• Profit comes from interest-rate • Profit comes from fees from
spread distributing and servicing
 structured products (MBS, etc.)
Incentive to establish long-term 
recurring individualized Incentive to generate as much
relationships with borrowers loans as possible and to distribute
 them as widely as possible
Incentive to judge creditworthiness 
carefully • No Incentive to judge
creditworthiness carefully
• Incentive to enhance
creditworthiness (AAA securities
out of subprime loans)
b) Financial obligations and financial commitments
• Financial obligations create financial commitments:
interest payment, wage payment, rent payment,
insurance premium, etc.
• Minsky focuses especially on two types of cash
commitments: interest and principal payments
CC = (a + i)L
a: amortization rate Þ principal payment
i: interest rate Þ interest payment
L: outstanding debt
• CC is compared to the income of the borrower: gross
profit of firms, wage income, etc.
• Minsky focuses especially on the firm-sector: compare
gross profit (П) to CC
c) Monetary interrelations: Kalecki’s equation of profit
The spending of some agents generates incomes for others:
spending sustains profit, which sustains employment, which
in turn sustains spending.

Aggregate monetary gross profit is determined by aggregate

spending:
Wd + П + T ≡ C + I + G + NX
Substracting Wd and T on each side we get:
П ≡ C - Wd + I + G - T + NX
But, Sw = Wd – C so
П = I – Sw + DEF + NX
“Workers spend what they get and capitalists get what they
spend.”
d) Financial aspects of economic decisions: the margins of safety
Margins of safety are protections established by borrowers and lenders
against default:
– Net-worth margin: Value of asset purchased relative to amount borrowed
($300,000 house and $200,000 mortgage) Þ if default occurs it is possible
to sell the asset to repay debt
– Cash margin: amount of cash and non-strategic liquid assets
– Cash-flow margin: Value of cash inflow relative cash outflow (П = $500, CC =
$200)

Minsky defined three types of margins of safety, and focused on the cash-flow
margins: Compare П and CC.
– Hedge: E(Пt) > E(CCt) t
– Speculative: E(Пt) > E(iLt) Þ refinancing need for principal Þ outstanding
debt does not decrease
– Ponzi: E(Пt) < E(CCt) t<n Þ refinancing for the whole amount due Þ
outstanding debt grows.

One can also look at underwriting: move away from income-based lending
(payment of debts based on expected income earned) toward asset-based
lending (payment of debts based on expected capital gains from reselling
assets)
The more an economic unit tends toward a Ponzi financial position, the more fragile its
financial position is.

“Fragile” = weak = small or no buffer to protect against financial adversity = high

dependence on refinancing channels

Hedge position: no need to refinance or liquidate assets to service debt => no

dependence on changes in the state of financial markets + large protection against
adverse events in cash-flow generating activity
Speculative position: need to refinance or to liquidate assets to be able to service
debts => dependence on the state of financial markets (rising interest rates,
declining asset prices, credit rationing)
The Financial Instability Hypothesis
FIH: during period of prolonged expansion (that may record
small recessions), the proportion of economic unit using Ponzi
finance rises.
• Structural causes:
- Banks are speculative units: maturity of liability is short relative to maturity of asset =>
need to refinance. Banks aim at lowering maturity of their assets => promote speculative
finance in non-bank sector
• Economic causes
– Change in the banking business
– Search for profit: ROE = ROA x leverage
– Market saturation: Limited pool of safe borrowers
– Inequalities
– Unexpected events
• Policy reasons:
– Deregulation, desupervision and deenforcement: fraud grows
– Fiscal policy: willingness to reach a surplus
• Socio-psychological reasons
– Long period of prosperity leads to a decline in risk perception
– New economy conventions
 Long-term economic expansion, Financial innovations

Economic success Market saturation, Inflationary pressures

 (expected or actual), “imperative” to
Rational increase in optimism balance federal budget
 
Increase in the willingness to use Higher T, Lower G, Lower I, Higher i
external funds and “short-term” loans (growth or level)
(short relative to the funded projects) 
 Decline in growth of П, increase in the
Loosening in credit criteria: smaller growth of CC
margins of safety 
 П < CC may appear
E(П) < E(CC) may appear + higher
sensitivity to changes in optimism
Increasing financial fragility
 Implications
• Timing of a financial crisis is impossible to know but
one can recognize the underlying trends that raise
financial fragility: the goal is not to predict but to
recognize trends so they can be stopped early when
no crisis is in sight. (fix your brakes before their fail,
do not care when they will fail)
• Crises are not random rare events: they will occur
frequently unless there are means to prevent them
– Regulation, supervision, and enforcement
– Big bank: Lender of last resort sustain asset prices (and so
net worth)
– Big government: fiscal deficit sustain income and cash
flows
• Addendum: Impact of the originate-to-
distribute model on the FIH: no need for long-
term expansion in order to have a high
proportion of Ponzi projects because:
– No incentive to judge creditworthiness carefully
– Incentive to enhance creditworthiness

Þ A large proportion of Ponzi positions may

exist from the beginning of the expansion
Condition of occurrence and non-occurrence
The FIH will no appear if:
- A sovereign government is the main engine of
growth: increase the liquidity of position of all
private economic agents
- If lenders are willing to be highly selective in
their lending policy
The FIH will occur if:
- Government tends to raise interest rates, and to balance its budget over a
long period of expansion: squeezes net cash flow on both sides (revenues
and costs).
- People are unaware of monetary interrelations, i.e. of the social
implications of their individual decisions, what Minsky calls the “peculiar
circularity of a capitalist economy” (Minsky 1986a: 227)

→ Minsky’s theory does not rest on asymmetry of information because

nobody knows, or wants to know, the “true” model of the economy =>
good surprise
 Extensions to Open Economy:
Exchange rate risk
• In addition to all the previous sources of problems, cash flows
become dependent on exchange-rate fluctuations if there is a
mismatch of currency between inflows and outflows :
– Cash inflow risk: earn most revenues in foreign currency
(¥) to service debt in domestic currency ($)
• $-denominated debt service ($80)
• ¥-denominated profit (¥100)→ need to convert into $ to service $-
debts ($100 if $1 = ¥1) → exchange rate risk
• If ¥ depreciates ($0.5 = ¥1) → less $ obtained per ¥ earned ($50)
→ problem to service $-debts ($50 < $80)
• If a business goes into foreign-debt by relying on expectations that
the domestic currency will appreciate enough to service the debt,
then this is Ponzi finance.
 Extensions to Open Economy:
Exchange rate risk
– Refinancing risk and cash outflow risk: decline in net worth
due to reevaluation of foreign-currency debts in (¥)
• A US firm borrowed ¥1000.
• On balance sheet of the US firm, valuation of ¥-debt is done in
domestic currency ($): $1000 (if $1 = ¥1) → exchange rate risk
• If ¥ appreciates ($2 = ¥1) now the foreign-debt is reevaluated in
dollar-denominated balance sheet: $2000
• Higher principal and interest payment in terms of dollars (potential
problem to service debt that requires refinancing) + Net worth falls
(by $1000) → harder to refinance and borrow.
Extensions to Open Economy: Case
of Asian Countries
– Domestic economies (e.g. Thailand with Bath: ฿)
have:
• Pegged their currency to the dollar: maintaining a fixed
$/฿ exchange rate is a policy of government.
• Borrowed in ¥ and $, earned ¥ and $ but $ is important.
• ¥ appreciate relative to $: payment of ¥-debt with
dollar earnings becomes more difficult + financial
capital flows out of Thailand
• Thai government cannot maintain the peg: ฿
depreciates against both ¥ and $: dollars earnings in ฿
falls, and foreign debts are revaluated upward.
 How to stop and prevent a debt deflation
• Stop the liquidity crisis: central bank provide funds at penalty rate, against safe collateral, to
solvent institutions.
– Recent crisis: central bank provide funds at 0%, against poor to toxic collateral, to questionable
institutions, to non-bank entities
• Stop the solvency crisis: bank holiday to examine financial institutions books in details for a week
and to close insolvent banks, reworking of debts of non-bank agents (possibly via government),
large-scale long-term fiscal policy to sustain aggregate income.
– Recent crisis: no significant analysis of books (only 2 Fed people sent at Lehman brothers, superficial
stress test, no detailed analysis), insignificant and slow fiscal action to stabilize income, hide losses
of financial institutions (level 3 valuation), injection of capital in banks via Treasury without any real
congressional oversight, no significant reworking of debts on non-bank agents.
• Change incentives and regulation, supervise and enforce: prosecute top managers for fraud, cease
and desist orders, major reworking of regulation and supervision to deal problems
– Recent crisis: Not a single prosecution even though fraud is obvious (ask FBI, and rating agencies
that finally had a look at loan tapes), civil instead of criminal cases (the financial institution pays
fines and promises not do it again), no major reregulatory trends (in fact deregulation of Dodd
Frank is already starting before it is fully implemented: securitization is growing fast again), no
enforcement of existing laws prior and during crisis.
Þ Even though a financial system may be on the brinks of collapse and panic is generalized,
regulatory must follow the law: if necessary use emergency executive powers (bank holiday) to
shut down the financial system temporarily and get to the bottom of the problem. Lenience will
lead to long-term instability because of the existence of government safety net (Moral hazard).
Without safety net (big bank, big gov), economic crises would be very severe.