Arnold Kling  

Ponzi Finance

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Russ Roberts writes,


the traditional investors in this market who had demanded insurance or other forms of protection from credit risk, stepped to the sidelines and were replaced by investors who didn't care. Very interesting. Something changed. What was it exactly? What caused it?

Earlier, Roberts refers to a paper by Mason and Rosner, who wrote in early 2007,

annual issuance of CDOs has grown from nearly zero in 1995 to over $500 billion in 2006. In fact, CDO issuance is growing so fast that new issuance in 2006 amounted to approximately the total of the three preceding years summed together.

The phrase "Minsky moment" comes to mind. I don't care much for Minsky myself. I heard him give a talk back when I was at the Fed in the early 1980's. He was predicting doom, as seems to be the wont of both left-Keynesians and Austrians. He seemed to make a great deal of what I think of as a simple accounting identity, namely that private saving plus government saving equals foreign saving. In standard notation,

(S-I) + (T-G) = (X-M)

Minsky breaks S into two components--personal saving and corporate profits. He then points out that when the government runs a deficit, corporate profits are high. This is true, other things equal, given the accounting. But I personally don't think that taking an accounting identity and holding other things equal is a very good way to do macroeconomic theorizing.

Profits are important to Minsky, because he says that when firms finance investment out of earnings that is the safest form of finance. The next safest is when they finance investment out of debt. The least safest is what he calls Ponzi finance, which means that they will have to keep obtaining new financing to keep going.

Anyway, reading the Mason-Rosner paper, two things struck me. One was how irrational the investors were. The other was how rapidly the market grew.

A rapidly-growing, irrational market suggests a Ponzi scheme. People are drawn to it because they see others getting rich, and as more people get drawn to it, more people get rich.

I think there is something to be said for thinking of the 2005-2006 period in the mortgage market as Ponzi finance. The observation that the seasoned investors dropped out and new investors came in during that period would be consistent with that.

I always keep coming back to my hatred of the bailouts. As central to the economy as the financial system is supposed to be, why is it necessary to keep the folks who fell for a Ponzi scheme in business? Why must we dread that these fools would have to shut their doors? Why don't we think of it as a good thing?


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COMMENTS (9 to date)

Virginia Postrel has an interesting article in the new Atlantic on some experimental work by Vernon Smith. Evidently, it turns out that even fully informed investors will inflate the value of an asset by trying to fleece dummies in the market before it crashes.

One upshot of the experiments could be the following: the more investors believe behavioral economics to be true, the more likely bubbles will develop in markets trading in assets. As long as I’m overly confident in my own rationality and knowledge (a bias behavioral economics confirms) and as long as I think everyone else is a moron (my overconfident belief in behavioral economic theory in general) then it will make sense for me to buy assets now in the hopes of selling dearly to others later, when the rising momentum of irrationality has swept them away.

http://www.theatlantic.com/doc/200812/financial-bubbles

Brian Shelley writes:

All people take limited pieces of information and make base broad assumptions. It's a time saving device, but it isn't 100% accurate. There is diminishing marginal gain from each additional piece of information, therefore people just approximate using the limited information they already have. In this case, they extrapolated rates of return. As rates of return continued longer and longer the tighter and tighter their information sets implied further rates of return. Thus the "Ponzi" scheme.

It is the same sort of thinking that got Beanie Baby and baseball card booms going.

I met someone from Colorado who is not educated and owned a furniture moving business. When he said (and I paraphrase), "We just saw prices going up 6-7% a year, so we decided to buy the biggest house for which we could get a loan. Then, we would stay there and suffer through high payments until we can sell a few years later and pocket the equity when we moved to a smaller house." It suddenly dawned on me that this may not be how we model economics, but this is the way that the human brain works.

Lord writes:

Why? Not because I care at all whether they fail, but without a replacement of their impact on the economy we are in dire straits. They were the economy for several years and there won't be any quick replacement of them.

Grant writes:

The Timid Scholar, thanks for the interesting link.

I have one big reservation about accepting the ponzi hypothesis: If traders were knowledgeable about the bubble, why don't they short the market? Why is it more profitable to fleece the fools?

Another, smaller reservation: If the smart are taking advantage of the dumb, is this really a bad thing? This is a transfer of investing power from the foolish to the wise.

Could new financial instruments be created that give the knowledgeable traders the incentive to break down bubbles instead of blow them up?

fundamentalist writes:

I had an old professor in econ who said the most common mistake is the belief that the good times will last forever. If people believe that, then why not take risks that you see others taking and making a lot of money from? While Austrians may be too gloomy, might that not be better than mainstream econ which never sees gloom and has never foreseen a recession?

floccina writes:

I have a question for anyone on this forum:

Does government money the Federal Reserve and the FDIC create economic dangers even greater than what preceded them? Is it even less in the interest of politicians than speculators to end bubbles early when they can be ended safely? We know that bubbles and depressions occured before these things but is it possible that we have grown away from fractional reserve banking with it money supply risks as other investments became available?

FDIC was republican creation even FDR knew it was a bad, moral hazard creating idea. Do we need instead to discourage people from putting much money into fractional reserve/maturity transforming banks? It seems that they are the most dangerous of investments to the economy as a whole and so they should be the most dangerous investments to investors.

floccina writes:

Profits are important to Minsky, because he says that when firms finance investment out of earnings that is the safest form of finance. The next safest is when they finance investment out of debt. The least safest is what he calls Ponzi finance, which means that they will have to keep obtaining new financing to keep going.

Along this line I am somewhat puzzled as to why public companies do not issue more stock to fund investment when dividends are much lower (enough to make up for any decline in the stock price caused by the new stock and the tax difference) than interest rate rather. They could then buy back stock rather than paying off the loans the dividend would be less than the interest and equity is safer than debt.

The Snob writes:

Along this line I am somewhat puzzled as to why public companies do not issue more stock to fund investment when dividends are much lower... than the interest rate

I don't see how this works unless the investment activity fails to increase the stock's price. If a $1m investment increases profits by $1.5m, then the share price should go up proportionately. So the original shareholders get to either accept their dilution, or they're forced to buy back their own success at full price.

If you think you can invest money in your business and earn a 20% return, then it's a lot better to borrow it at 7% and keep all the upside to yourself. Also, registering and selling new shares of stock can be a much more complex transaction than issuing debt.

Lewis writes:

The market has always been a ponzi if you get yours before the bubble burst than you are a wise investor if you don't than you are fool that has help make others a wise investor

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