The Debt Cycle

Updated November 2018

With the level of consumer debt in the United States doing this:

...and this:

...and with house affordability in some markets declining like this:

...and this:

...and with the Canadian housing market doing this:

...I thought that it was the perfect time to look at a paper written by Paul McCulley during the height of the global financial crisis of 2008 - 2009 which was largely triggered by "stupid debt".  In this paper which looks at the shadow banking system, the author discusses Hyman Minsky's theory of the nature of financial instability and how a period of prosperity can lure investors to take on levels of debt that are unsustainable, creating an economic cycle.  This theory, called the Financial Instability Hypothesis was first released in May 1992 and goes a long way to explaining the Great Recession and why the economy, in large part, seems to be retracing the steps that it took in the years prior to 2008.

The financial instability hypothesis is simply explained as a theory of the impact of debt on the economy and the manner in which that debt is validated.  In a capitalist economy, the money flows from depositors to banks from banks to firms and, in the future, from firms to banks and then back to depositors.  The flow of money to firms occurs because there is an expectation of future profits and the flow of money from firms is financed by profits.  Therefore, as you can see, in a capitalist economy, the past, present and future are linked by financial relationships between parties.  The capitalist system is complicated by the accrual of debt; households use credit to purchase consumer goods and houses, businesses use debt to expand and governments use debt to fund their operations.  The financial instability hypotheses focuses on the profit-seeking activities of banks who grow their profits through financing economic activity in both the consumer and corporate sectors.  

Minsky proposes three distinct types of debt units:

1.) Hedge (no relation to hedge funds) - these financing units can fulfill all of their contractual payment obligations through cash flow.

2.) Speculative - these financing units can meet their payment commitments on the "income amount" on their liabilities but cannot repay the principal out of their cash flows.  These debt units need to roll over their liabilities to continue to make their payment commitments, for example, these units need to issue new debt to meet the commitments on their old debt - a prime example being government bonds which is never repaid but is rolled over as new bonds are issued to replace the maturing bonds.

3.) Ponzi - these financing units have cash flow that is insufficient to fulfill either the payment of interest due on the outstanding debt or to repay the debt principal.  These financing units can only sell assets or borrow more to pay what is owed.  As we all know, a Ponzi financing unit is an unsustainable model of debt and greatly lowers the margin of safety for debt holders.

Now that we have that background, let's look at Minsky's key conclusion:

"It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system."

The financial instability hypothesis has two theorems:

1.) the economy has financing regimes under which it is stable and financing regimes under which it is unstable.

2.) over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system i.e. the system will move from hedge finance units to speculative finance units to Ponzi finance units.

Here is another quote:

"In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values."

In other words, the longer that people make money by risk-taking, the more likely they are to make incautious financial decisions.  We need think no further than the massive economic instability created by the American banking sector which graciously extended mortgage funding to people who could ill-afford to purchase a house and the investment banking sector and their imaginative use of mortgage-based securities backed by these mortgages that ultimately proved to be worthless.

Here is a quote from the paper by Paul McCulley:

"The essence of the hypothesis is that stability is destabilizing because capitalists, observing stability in the present, have a herding tendency to extrapolate the expectation of stability out into the indefinite future, putting in place ever-more risky debt structures, up to and including Ponzi units, that cause stability to be undermined.

…the expectation of a reward to risk taking is self-fulfilling on the way up. If everybody is simultaneously becoming more risk seeking, risk premiums shrink, the value of collateral goes up, the ability to lever increases, and the game keeps going. Human nature is inherently procyclical, and that is essentially what the Minsky thesis is all about."

Minsky's theory clearly explains the boom-bust cycles that those of us who live in a capitalist system are very well acquainted with.  Economic stability begets economic instability because of the asset price increases and resulting credit excesses that they create and our inherent belief that nothing will ever go down in price, most particularly housing, a belief that proved to be profoundly wrong.

Given the fact that consumer debt in the fourth quarter of 2017 is now 18 percent above its post-Great Recession low in 2013 and is now $473 billion above its 2008 high, it is increasingly appearing that, once again, we are retracing the steps taken prior to the Great Recession and are setting ourselves up for the next economic contraction.  With central bankers around the world lulling us into a sense that the "interest rate good times" will never really end (or, if they do, they will quickly retrace their steps back to zero percent), consumers are creating the next period of economic instability, suggesting that the painful debt lessons of the Great Recession have long been forgotten.

Household Credit - Forgetting the Lessons of the Great Recession

With some experts predicting as many as four interest rate increases by the Federal Reserve during 2018, one aspect of the economy should be concerning to central bankers, that of personal debt, an issue with a direct relationship to the last recession.

According to the New York Fed's own Quarterly Report on Household Debt and Credit for the fourth quarter of 2018, household debt balances have achieved another record as shown on this graphic:

For the fourteenth quarter in a row, aggregate household debt rose in Q4 to $13.15 trillion, an increase of $193 billion on a quarter-over-quarter basis and a substantial $473 billion higher than the previous pre-Great Recession peak of $12.68 trillion which was achieved in Q3 2008.  As well, household debt is now 17.9 percent higher than its post-Great Recession nadir which was reached in the second quarter of 2013.

Mortgage debt is the largest component of consumer debt with total mortgage balances of $8.88 trillion at the end of 2017, a quarter-over-quarter increase of $139 billion.  Mortgage originations for the fourth quarter stood at $452 billion, down from $479 billion in the previous quarter.  

The only upside to the current consumer credit picture is that delinquencies, currently at 4.7 percent, are well below the levels experienced during and immediately after the Great Recession, a scenario that is likely to change substantially should the Federal Reserve, in its infinite wisdom, keep its tightening trajectory:

Nonetheless, of the $619 billion of debt that is delinquent, $406 billion is at least 90 days or more late with a slow but steady increase in severely delinquent auto loans and a significant increase in credit card balances that are delinquent as shown here:

One of the outstanding debt problems is loans to students.  Outstanding student loan debt grew to $1.38 trillion at the end of 2017 with 11 percent of aggregate student loans either 90 days or more late or in default.  

In case you were curious, there is a significant difference in the total debt balance per capita for various states as shown here:

California is a standout when it comes to per capita indebtedness, largely because of severely overpriced real estate in some of the state's real estate markets as you can see from this graphic which breaks down the composition of debt balance on a per capita basis:

Certainly, the overall consumer debt situation, particularly home equity lines of credit, are not at the dangerous levels experienced prior to the Great Recession, however, the long period of ultra-cheap borrowing has lured consumers to consume with borrowed money.  In combination with this:

...the long period of loose monetary policies by America's central bankers have convinced consumers that saving money is simply a waste of time and that it is more fun to borrow, borrow, borrow and buy, buy, buy.  The painful reality of over-consuming with debt may never come home to roost...with any luck.

Apparently, the hard lessons taught by the Great Recession have been long forgotten by many American households.