Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait.
When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates.
The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.
Due to the overwhelming importance that the durability of economic growth has on future asset returns, I take a new approach in this article to drive home a message from our prior article The Death of the Virtuous Cycle.
In this article, I use two simple examples to demonstrate how the Virtuous Cycle (VC) and Un-Virtuous Cycle (U-VC) have benefits and costs to society that play out over time.
The Minsky Moment
Before walking you through the examples contrasting the two economic cycles, it is important to put debt into its proper context. Debt can be used productively to benefit the economy in the long term, or it can be used to fulfill materialistic needs and to temporarily stimulate economic growth in the short term. While both uses of debt look the same on a balance sheet, the effect that each has on the borrower and the economy over time is remarkably different.
In the course of his life’s work as an economist, Hyman Minsky focused on the factors that cause financial market fragility and how extreme circumstances eventually resolve themselves. Minsky, who died in 1996, only recently became “famous” as a result of the sub-prime mortgage debacle and ensuing financial crisis in 2008.
Minsky elaborated on his “stability breeds instability” theory by identifying three types of borrowers and how they evolve to contribute to the accumulation of insolvent debt and inherent instability.
- Hedgeborrowers can make interest and principal payments on debt from current cash flows generated from existing investments.
- Speculativeborrowers can cover the interest on the debt from the investment cash flows but must regularly refinance, or “roll-over,” the debt as they cannot pay off the principal.
- Ponziborrowers cannot cover the interest payments or the principal on debt from the investment cash flows, but believe that the appreciation of the investments will be sufficient to refinance outstanding debt obligations when the investment is sold.
Over the past 20 years, investors have been witness to a remarkable sequence of bubbles. The first culminated when an abundance of Ponzi borrowers concentrated their investments in the equity markets and technology stocks in particular. Technology companies, frequently with operating losses, raised capital through stock and debt offerings from investors who believed excessive valuations could expand indefinitely.
The second bubble emerged in housing. Many home buyers acquired houses via mortgages payments they could in no way afford, but believed house prices would rise indefinitely allowing them to service their mortgage obligations via the extraction of equity.
Today, we are witnessing a broader asset price inflation driven by a belief that central banks will engage in extraordinary monetary policy indefinitely to prop up valuations in the hope for the always “just around the corner” wealth effect.
Equity markets are near all-time highs and at extreme valuations despite weak economic growth and limited earnings growth. Bond yields are near the lowest levels (highest prices) human civilization has ever seen. Commercial real estate is back at 2007 bubble valuations and real assets such as art, wine, and jewelry are enjoying record-setting bidding at auction houses.
These financial bubbles could not occur in an environment of weak domestic and global economic growth without the migration of debt borrowers from hedge to speculative to Ponzi status.