Inefficient market: The Perils of Tanzi finance
Special purpose vehicles which concealed liabilities from investors, asset-backed securities collateralised with fake invoices, credit-linked notes which allowed the issuer to bet on its own creditworthiness, bonds which by secret covenant varied the coupons payable according to the company’s interest cover, liabilities sliced up and distributed in collateralised debt obligations, bank loans rendered safe with credit default insurance, and a myriad of finance company subsidiaries registered in off-shore tax havens. These are just some of the innovative ways that banks found of channelling funds to Parmalat, the bankrupt Italian food company. It might be apt to refer to such practices as ‘Tanzi finance’ in honour of the Parmalat’s imprisoned founder. After all, Calisto Tanzi’s financial arrangements conform very closely to the model of Ponzi finance, which is named after another Italian swindler.
In the United States, a ‘Ponzi scheme’ is synonymous with a chain-letter or pyramid scheme. A stock market bubble, for instance, is a type of Ponzi scheme. Ponzi finance, on the other hand, is a more sophisticated concept. It forms a central part of the ‘financial instability hypothesis’ of the late American economist, Hyman Minsky. Minsky saw the economy as comprised of individual companies and households, each of which had a balance sheet. Liabilities entailed future cash outflows which were matched by future cash inflows.
Minsky claimed that financing arrangements for corporations and households could be divided into three basic types, of varying degrees of risk. ‘Hedge finance’ describes the conservative arrangement when companies are able to meet all their liabilities, both interest and principal repayment, from current cash flows. Firms with ‘speculative finance’ can cover only their interest payments from earnings. Periodically they need to refinance the principal obligations. As a result, they are exposed to adverse market conditions and may at times be forced to sell assets to meet liabilities. ‘Ponzi finance’, according to Minsky, describes the situation when a company is unable to cover either its interest or principal repayments from current cashflow. Like Tanzi’s Parmalat, the Ponzi finance firm must continue to raise fresh funds in order to cover its financing deficit.
Minsky contended that the capitalist system was a fundamentally unstable system. A prime source of instability, in his view, was the profit-seeking behaviour of financial institutions. An economy might start out in what he called a ‘robust’ position, dominated by hedge finance. However, financiers earn profits for themselves by increasing the amount of leverage in the economy. Financial institutions also innovate to get round any restrictions placed on their behaviour. Over time, Minsky contended, the dominance of hedge finance in an economy gives way to speculative and Ponzi finance. At this point the economy enters a fragile state, and becomes susceptible to a financial crisis.
An economy dominated by Ponzi finance has three characteristics. First, it is dependent on continuing asset price inflation to thrive. Secondly, it feeds on ever larger amounts of credit. Thirdly, it is vulnerable to small rises in interest rates or any unanticipated downturn in earnings. This may force heavily indebted firms to raise cash by selling their assets. Such behaviour, when practiced collectively, can spark off a debt deflation and an economic collapse, as happened in the 1930s. When an economy dominated by Ponzi finance is threatened by a crisis, Minsky recommended that the authorities respond by lowering interest rates, providing liquidity to distressed capital markets and boosting government spending in order to maintain profits and ‘validate’ the existing debt structure.
It is by following such actions on many occasions since the Second World War that the United States has managed to avoid a repeat of the Great Depression. During Alan Greenspan’s tenure at the Federal Reserve, the US economy has sailed through the 1987 stock market crash, the Savings and Loan Crisis of the late 1980s, the collapse of the junk bond market in 1990, the Mexican crisis of 1995, the LTCM crisis of 1998 and most recently the implosion of the technology bubble.
Conventional wisdom says that as we have the tools, tried and tested, to deal with any financial crisis there is no need to worry about the build up of debt in any economy. This is to ignore the central message of the financial instability hypothesis; namely that over time the economy moves from a robust to a fragile state. Stability is destabilising. The longer the authorities succeed in preventing debt deflations and depressions the more they encourage the growth of Ponzi finance in the economy.
At first sight, Parmalat appears a classic case of Ponzi finance. Driven by their quest for profit, the investment banks found innovative ways to channel more and more debt to the stricken food company. The firm’s lacklustre operating companies were unable to bear such an enormous burden of debt. Fraud, and eventually bankruptcy, followed from this. In Minsky’s view the painful consequences of excessive Ponzi finance can always be averted by the prompt actions the authorities. If an economy were to become dominated by Tanzi finance, on the other hand, there would be too much debt and too much corruption to deal with. It would, quite simply, be beyond salvation.