A Brief Lesson in Debt

Hyman Minsky (1919-1996) was a rather obscure economist who came up with an excellent theory of debt which seems especially appropriate to current events. In brief, he divided borrowers into three categories: the hedge borrower, who can make loan payments easily out of income and extinguish the principal; the speculative borrower who can make interest payments more or less easily out of income, but cannot repay the principal except by rolling over the debt; and finally the Ponzi borrower whose income does not cover even the interest on debts, and therefore needs an ever expanding supply of credit to service loan payments.

A clear example of the hedge borrower is the homeowner who takes on a traditional fixed mortgage, the payments of which are a fairly small part of his or her income. An example of the speculative borrower is the house buyer who takes out the interest-only mortgage hoping to sell the house at a profit. The ponzi mortgage borrower takes out the reverse amortisation mortgage, hoping the house will appreciate fast enough that he or she can refinance at a higher amount.

In the housing bubble bust of the last two years or so, most of the borrowers in the Ponzi category have already lost their houses. Most of the borrowers in the speculative category are 'underwater', and many have 'walked away'. An increasing number of mortgages in the hedge category are going delinquent due to falling incomes and rising unemployment. It is not pretty, and the situation will probably get worse. We expect, on the other side of this Depression, that hardly anyone will ever want to buy a house with a mortgage again.

Of course Minsky's model applies not only to mortgage borrowers, but to the banks that lend to them. Banks are completely dependent on continuously rolling over their entire debt structure. This is why they are the first to feel the strain of a credit crisis.

As things are currently unfolding, central banks and governments are stepping up to fund banks who need their debts rolled over. Banks are not as generous to their borrowers, and are mostly calling in risky loans, and mostly not expanding safe loans. This is hurting a great many businesses who rely on speculative finance, and will cause a great many to go under. We suspect a lot of individual borrowers who are getting their credit cards cancelled will also be forced into bankruptcy.

If the Depression continues to unfold along these lines, most speculative finance units (as Minsky would call them) will be euthanised. Exceptions will be made for banks, insurance companies, and public utilities. The consequences will be very dramatic: tens of millions of failed businesses and hundreds of millions, if not billions of downwardly mobile citizens.

We doubt this this process can be arrested until it is spent. If you are a borrower and you cannot pay your debts out of your income (and these days incomes are not so reliable), you will need to liquidate assets or default. The end result is that you will become poorer. So-called 'rescue plans' will be of little help. If you are able to service your debts - congratulations! - you will be fortunate enough to experience the down-not-so-much that is the new up.

Tragedy, or Farce?

With the latest joke rolling out of the Zimbabwe Central Bank, we wonder why such ridiculousness is able to thrive so long. In all honest, we feel that a $100 trillion note is probably Farce, but we really cannot be certain.

The history of Zimbabwe is most definitely one of Tragedy: a nation in continual economic collapse, aided and abetted by non-stop embargoes brought on by the United Kingdom and the United Nations, among others. The fine, upstanding governments of the world really know how to dole out "change," don't they?

It seems in history that every Tragedy has a correlating, and larger, Farce. In this case, the Farce is the embargoers -- the United States, the United Kingdom, the European Union -- following in the footsteps of the Tragedy they helped create. Many policies, such as price controls and rapid expansion of national money supply, have been well-tested by Zimbabwe's central bank.

In the flaming tailspin of the 2007 Depression, this collection of nations are flirting with the very same financial policies that Gideon Gono used to make Zimbabwe's hyperinflation-from-Hell. As the Wikipedia article notes, perhaps ironically, Mr. Gono is a "proved deflation-fighter." Mr. Bernanke, of the Federal Reserve, M. Trichet of the European Central Bank, and the Rt. Hon. Mr. Darling of the Bank of England are all working to fight deflation, as well.

They might not have noticed, but they're following in the footsteps of a failed nation.