Sunday, September 27, 2009

The Minsky Cruise (part 2, Households)

Financial Instability Hypothesis: The idea that over periods of enduring economic expansion that only record a few small recessions, more and more economic units are involved, voluntarily or not, in Ponzi finance. Balance sheets become more sensitive to the nonrealization of expected cash inflows, changes in interest rates, changes in taxes, changes in asset prices and other factors that affect cash flows and funding methods. Levy Institute

When looking around for a scapegoat for the financial mess we're in, go directly to the mirror. While the government could have (should have, I believe, after looking at this data) been far more restrictive of the financial sector, we did vote them in.

First, the good news. The graph below depicts total financial wealth (i.e. non-tangible assets less financial liabilities not including mortgages) as a $ of GDP.

We're not broke, yet.

The next graph depicts the degree to which we've mortgaged our real estate.

Not so bad, right? At end 2008 property values we (collectively) owned half of our homes. We still have 30% more to mortgage before we get hit with a PMI. (if I don't joke, I'll cry)

Now for some bad news. Do you know there was a time when US households owned a good chunk of Treasury debt? Ah, the good old days of self-finance.

As of Q2 2009, the rest of the world owned 5 times the amount of Treasury Debt that US Households owned. Who needs to vote when you own the debt, eh?

Now for the Minsky part. The theory above, in layman's terms, argues that over time, when an economy expands without serious contractions, finances will become increasingly risky. Minsky wrote of a shift from hedge finance (when debt, both principal and interest, can be serviced from cash flows) through speculative finance (when debt must be rolled over as only interest payments can be serviced from cash flows) and into Ponzi finance (when cash flows cannot cover interest payments and thus new debt must be added or assets sold). The idea in the Ponzi finance stage is that asset appreciation will compensate for the extra risk.

In the Ponzi stage the economy becomes increasingly sensitive to changes in asset prices, like now.

The graphs below depict what I call Household (and Non Profit Organizations) liquidity (i.e. checking, savings and other time deposits, money market funds and all credit market securities (but no equities) less total financial liabilities as a % of GDP). The second graph of non-market liquidity is the same except with credit market assets removed.

Until the early 90s, there was enough cash (and cash equivalents) on hand to pay off all debt. If we include credit market securities, like Treasuries and (oops) Asset backed securities the personal sector had enough cash on hand or offsetting interest earning assets to pay off all debt up until 2002. Zero (or near) interest rates, of course, make the choice of being liquid a bit painful. It's almost as if the Fed wants to push the economy into a Ponzi finance state.

I don't mean to suggest we (collectively) are broke, just that, as Minsky argued (and the data bears out) our balance sheets are increasingly betting on real estate and equity price appreciation with borrowed money. Worse, the data above are not representative of the average joe. There's a lot of assets owned by a few people in this data (admittedly they owe a fair bit of the debt). The point though is that even in the aggregate data, there's not much slack to deal with cash flow interruptions, like unemployment.

I'll leave you with one final graph showing total and mortgage liabilities as a % of personal income to illustrate the point.

*yes, there's still more, but I'm going to sleep now. Back some time tomorrow with another dismal chapter.