Synopsis: The second in the series about the Minsky Moment and how it changed economics.

Click here to read the original article.

1. Click here to read the introduction post.
2. Click here to read the first post on asymmetric information.

Discussion:
 
Hyman Minsky
 
Hyman Minsky is best known for his work on what causes a financial crisis. His work remained unnoticed throughout his lifetime and for a long while after. This is, in large part, due to the fact that his work was not in conformity with mainstream economics. While the majority of economists believed that markets were efficient (explained under ‘Context’), Minsky argued that inefficiency is what causes financial crises, and called this hypothesis the “financial-instability hypothesis”.
 
The financial-instability hypothesis
 
This describes how “long stretches of prosperity sow the seeds of the next crisis”, according to The Economist.
 
First, Minsky defined investment as giving money in the present in return for getting money back in the future.  For example, an ice cream machine is an investment. An ice cream parlor gives money right now to buy an ice cream machine. Due to the ice creams the machine produces, the firm gets money back in the future.
 
Where does the ice cream parlor get the money to buy the machine? It can get it from two sources: its own funds or others’ funds (e.g. the bank). The balance between the two sources is key to explaining financial instability.
 
Next, Minsky describes three types of investments.
 

1. Hedge financing: All of a firm’s borrowing is repaid with its future cash flow (explained in ‘Key Terms’). In order for this to work, a firm must have little borrowing and lots of profits. This is the most stable type of investment.
2. Speculative financing: Cash flow covers interest payment but firms must roll over their debt to repay the principal (explained in ‘Context’). This is riskier than hedge financing.
3. Ponzi financing: Cash flow covers neither principal nor interest; thus, a firm is forced to rely on the value of the asset to cover its costs (explained in ‘Context’). If the value of the asset falls, either due to contractionary monetary policy or an external shock, the firm will have to default.

 
These three types of financing are illustrated in the diagram below.

​Thus, an economy with mostly hedge financing is the most stable. An economy dominated by Ponzi financing, on the other hand, would mean that all asset values are vulnerable to external shocks of any kind, which, in turn, would hurt the economy. An economy could restrict itself to hedge financing, but will not do so. During times of healthy economic growth, firms are increasingly tempted to invest in riskier projects, and banks are increasingly tempted to finance these projects through riskier means, i.e. speculative and Ponzi financing. This is because they believe that a firm can ultimately pay back its debt, given the good growth.
 
Thus, an economy dominated by hedge financing slowly becomes an economy dominated by Ponzi financing, and a drop in asset values leads to a financial crisis. In other words, economic stability breeds instability.
 
The point at which asset prices start plunging is called a “Minsky moment”, which is a term coined by PIMCO’s former chief economist Paul McCulley. A Minsky moment is now synonymous with a financial crisis. This is illustrated in the diagram below.

Neither The Economist nor Minsky himself provided an explanation for the trough in the business cycle, but an explanation can be extrapolated from the cause of a Minsky moment. The Minsky moment is the point at which asset values collapse through some external shock (e.g. monetary tightening), or, more importantly, banks stop lending due to faltering confidence. Thus, the trough might be when banks once again resume lending when confidence picks up and they believe that the investment projects are safe.
 
If we assume this to be the reason for a trough, then we can assume that even without any external shocks (such as government intervention or a war), the business cycle would occur.
 
Minsky today
 
At the time, Minsky’s work was disregarded. People believed that markets are efficient and stable. Now, behavioral economics has adopted the idea that markets are not efficient.
 
Minsky and the nature of economics
 
The financial-instability hypothesis explains a very specific situation in which a stable economy leads to an unstable economy due to increasingly risky investments and financing. This goes against the grain of economic theory, which aims to explain a general concept. Take, for example, the theory of demand, which states that for any normal good, the increase in the price results in a decrease in demand. Thus, the theory of demand explains a multitude of economic situations – the financial-instability hypothesis does not.
 
For this reason, mainstream economics ignored Minksy’s hypothesis. After his death, and after the financial crisis, his work gained popularity and relevance.
 
The implications of the hypothesis
 
The world is still shaken up by the Global Financial Crisis (GFC) and its aftermath. Investment is much less risky now than it was pre-GFC. But if we were to look at the future of the global economy using Minsky’s hypothesis, the conclusion is clear: economic actors will forget, or perhaps ignore, the warnings of the GFC in favor of riskier and riskier financing.
 
Looking further
 
Looking past The Economist article, there are some things worth mentioning.
 
The application of the Minsky moment can be seen in the financial world. Firms have to make two types of decisions: which investment projects are worth pursuing, and how to finance them (i.e., through their own funds or borrowed funds). As the economy picks up steam, firms start undertaking riskier projects and they also start financing them with more of borrowed funds. This eventually leads to a Minsky moment of instability.
 
The other interesting point about Minsky’s work is what generates business cycles, and why they are self-adjusting. Mainstream thinking follows Keynesian economics: peaks and troughs are determined by whether an economy is above or below full employment. Minsky provides an alternative explanation to why the business cycle is self-adjusting.

Key Terms:
 
Cash flow: The amount of money generated by a business.
 
Context:

1. What does “markets are efficient” mean?

This refers to a hypothesis called the efficient market hypothesis.
 
The efficient market hypothesis states that all the available information in a market is already reflected in the price. One of the implications is that it is impossible to “beat the market”.
 
For example, assume the price of Disney shares is $10 per share. Disney then releases the news that a new movie is coming out, and everyone reacts immediately by buying Disney shares in the hope that when the movie comes out, the value of the share will appreciate. The share now costs $11. When the movie actually comes around, the market would have already reacted to the news and the price of the share will stay at $11.
 
An individual might try to beat the market by investing in a share given new information, but ultimately, according to the efficient market hypothesis, he or she will not be able to.

2. What does it mean to roll over debt to repay principal?

A firm rolls over its debt by borrowing principal from another bank.
 
Suppose an ice cream firm borrows $100 to buy an ice cream machine from Bank 1. The interest rate at Bank 1 is 10% a year. Thus, after a year, the ice cream firm must pay $110 to Bank 1.
 
At the end of year 1, the ice cream firm has made $30. Thus, it still needs to get $80 from somewhere to pay back Bank 1. The firm goes to Bank 2 and borrows $80 at 10% a year. It can now pay back Bank 1.
 
At the end of year 2, the firm owes Bank 2 $88. If the firm has made $30 again during year 2, it must borrow again to repay the principal from Bank 2.
 
This is how a firm rolls over debt. In theory, as long as the profits exceed the interest rate, a firm will ultimately be able to pay back all its debt.

3. How would an asset cover a firm’s costs?
​
Selling off an asset would get a firm money, which it can then use to pay back the bank. If the value of the asset falls, then it may not be able to cover the principal or the interest rate it owes the bank.

Synopsis: How should China deal with its economic problems?

This post combines two articles by The Economist. Click here and here to read them.

Discussion:

These two articles discuss the current problems China is facing, potential solutions and its consequences.

China has been showing cracks in its economic structure for the past six months, and with the stock markets crashing on January 4 2016 and an increased debt-to-GDP ratio of about 300%, the problems with the Chinese economy are now being closely watched by everyone. According to the article “Rocks and Hard Places” (RHP), however, it is the foreign exchange market that bears watching for those wishing to know about the state of China’s economy.

China’s pegged exchange rate is much higher than its exchange rate would be in a floating system, and many believe that devaluing the yuan and bridging the gap between the real exchange rate and the current one would ameliorate the economy.

Asian countries during the Asian financial crisis faced a similar predicament to the one China is facing – According to “Fight or Flight” (FF), investor outlook turned from bullish to bearish, resulting in a great outflow of capital. Thus, reserves dwindled and the governments could no longer maintain a pegged currency. The key difference between those Asian countries and China is that China has, and has had for a while, tight capital controls. According to FF, during China’s great boom in the 2000s, foreign direct investment (FDI) was permitted while hot money was tightly controlled.

These preventive measures did not stop the depletion of China’s reserves – now down to $700bn, “thanks to capital flight and sinking asset values” (FF). An increase in China’s outward FDI paired with a decrease in inward investment resulted in the lowest net flow of inward investment since 2000.
​
While China wishes to impose tighter capital controls to prevent a dwindling of reserves and tightening of domestic credit (explained in ‘context’), there is “no painless way to do so” (FF).
In terms of exchange rates, the Chinese can either keep the exchange rate steady or devalue the exchange rate. Keeping the exchange rate steady is a feasible option as China has $3.3tn in reserves. Here are the consequences for either action:

In terms of strengthening capital controls to reduce leakages, the Chinese government is already cracking down on banks in Macau and Hong Kong to keep them from helping leak money from China. If leakages increased, the government could decrease the cap on foreign transfers. This, however, would deter foreign investors, which would undermine growth.

However, according to RHP, these trade-offs to rebalance the Chinese economy are only short-run. Strengthening capital controls by locking down the capital account in the long-run could be vastly beneficial: free from the pressures of the global markets (explained in ‘context’), the government could “clean up bad debts and push through structural reforms needed for long-run growth”. In fact, locking down the capital account would result in unfreezing those accounts during a time when the Fed is not raising interest rates, which would deter investors from moving their money to the U.S.

Chances are, however, that if capital accounts were locked, the government would do little to implement structural reforms but would instead use it as an excuse to “rollover bad debts and delay reform” (RHP), i.e. following the Japanese path (explained in ‘context’).

In fact, despite the fact that locked capital accounts would allow for more flexibility in China’s monetary policy, the government “would find itself cornered” (RHP): once interest rates and reserve ratios were near zero, QE would lead to a further imbalance in the economy. The government would have to respond with massive fiscal stimulus or depreciation to allow for further monetary policy, all of which are irreversible actions for a few generations to come.

Instead, China may have a slightly less bitter pill to swallow. Given its capacity for lots of fiscal stimulus (government debt is low; thus, the government has room to borrow and then spend), it could force banks to “recognize bad loans, close insolvent businesses, and use that capacity to ease the pain on creditors and shore up banks” (RHP). This, still, may result in a sharp slowdown of growth, and perhaps even a recession. However, these are pills that other countries have followed and survived through. The question is whether the Chinese government was built to cope with such drastic measures (explained in ‘context’).

At the current time China is not facing an imminent crisis. It has “ample reserves, capital controls, trade surplus and a determinedly interventionist state” (FF). Increased purchase of foreign securities may, in fact, decrease the effect of depreciation on debt (explained in ‘context’). However, it remains that should China ever come to face such a crisis, its results would be disastrous.

Key Terms:

1. Capital account: a sum of private and public investment flowing in and out of a country.

2. Reserve ratios: a ratio of all deposits into a bank that must be held by the central bank. China’s reserve ratio is currently at 7.5%.

3. Bullish vs. bearish: Bullish means upward trending while bearish means downward trending.
4. Hot money: money that can be liquidated immediately. This is unlike FDI, which can be liquidated after a set amount of time (usually a few years).

5. Hard currency is the name for dollars, euro, yen, i.e. the more important currencies.

Context:

​1. What is the relationship between reserves and a pegged (or fixed) exchange rate? An exchange rate is pegged by the central bank’s buying or selling the domestic currency.

Let the supply and demand for yuan be denoted by S and D respectively. This results in a quantity of yuan in the market Q and exchange rate E. A decrease in the demand of yuan from D to D’ would lower the exchange rate to E’, where the quantity of yuan in the market is Q’. For the PBOC to increase the exchange rate back to E, where it was earlier, it has to decrease the supply of yuan. To do so, it has to sell other currency that the PBOC keeps in its reserves in exchange for the yuan, leaving less yuan in the market at S’. The exchange rate is once again E.

Thus, if China wishes to maintain its exchange rate, it must keep selling off its reserves, i.e. a depletion of reserves.

2. Why is there capital flight in China? This is because of investors’ fear that China is slowing down and their subsequent wish to withdraw investments from China and invest elsewhere.

3. Why do tighter capital controls lead to a “tightening of credit”? The amount of bank deposits will decrease, so banks cannot make as many loans; thus, credit conditions tighten.

4. If a decrease in exchange rates would not increase exports, why did China do so well during its more prosperous periods? When China faced good growth, it wasn’t the devaluation of the yuan that made it so successful (the yuan held steady). At that stage, there was enough capacity for exports to grow, with enough demand. After the GFC, China could not export as much because of decreased demand. They turned to investment, which is now faltering.

5. Why does purchase of foreign securities “hedge firms with foreign-currency debts against depreciation”? If firms have foreign currency debts and the currency depreciates, the debts increases. If firms have foreign assets, then it would reduce the impact of the debt.

6. Why would locking down the capital account free China from the “pressure imposed by global markets”? Without the capital lockdown, at sight of a higher interest rate in the U.S., investors would take their money from China and invest in the U.S., but with the capital lockdown, whatever the global market decisions are, a certain amount of investment stays in China.

7. How would China follow the Japanese path should they fail to implement structural reforms? Before Japan’s deflationary spiral, Japanese banks had bad debt and didn’t have them written off, leading to deflation.
​
8. Why would China not be built to deal with the drastic measures proposed by The Economist? The problem is that China is communist: they’ll give people jobs, security, etc. as long as they don’t question the government. A loss of jobs thus leads to a criticism of the Chinese government, a risk China may not be willing to face due to fear of political reform.

Synopsis: Paul Krugman provides a graphical representation of S.R.’s article, which discusses the flaws with the claim that China has wasted $6.8tn on investments.

Click here to read the original article.

Click here to read the blog post on S.R.'s article.

Discussion:
This article substantiates the article written by S.R. (found here), while pointing out the graphical representation of Mr. Xu and Mr. Wang’s paper and thus highlights the problem with their claims.

Krugman also adds that an increasing ICOR does not mean wasted investment; it just suggests diminishing marginal returns.

Context:
Looking at Figure 1, which describes diminishing returns as we move along the curve from A to B to C, we must notice that Krugman has used the axes titles “output per worker” and “capital per worker”. Why has he used per worker instead of “total output” and “total capital”? If the graph were to show “total output” and “total capital” with the same curve, the analysis would be as such: the reason why total output does not increase as total capital increases is because there aren’t enough workers to use the increasing amounts of capital. This does not show diminishing returns, it just shows inefficiency. If we measure both per worker, which standardises the unit between both axes, we can see diminishing returns.

Discussion:
This article discusses the view that public investment by itself can potentially be more harmful than helpful when poor countries to catch up.  The IMF cites a few reasons for this:

1.     Many countries waste money on useless investments.  This is because, during times of big push, governments implement shelved but rejected plans – as it turns out, they are usually objected on the grounds that its impact in the long run would be meaningless.  Nonetheless, the case of already having the project planned out and support from government officials who had earlier supported the i.e. makes the useless investment project easy and quick to implement.
2.     The crowding-out effect can reduce private investments that could have been more beneficial.
3.     Expanding on useful projects (e.g. rebuilding after way) only provides diminishing marginal returns on capitals.
4.     The government saddles itself with high debt

For public investments to have a positive impact, governments must address the problems above, as well as amass information about which investments are the most useful ones.

For more on infrastructure and investment, read “Concrete Benefits” and “Bridges to Somewhere”

Synopsis: Should the U.S. invest in infrastructure now?

Click here to read the original article

Discussion:
This article argues that the U.S. government must take the opportunity now to increase public investment, before this fiscal climate changes.  The writer argues that the fear of increasing taxes to fund such projects is unfounded, as is the fear of slipping further into debt.  He or she cites examples of a boost in GDP due to such projects, covering and surpassing the debt caused.  In fact, it is with slow-growing economies that borrowing and funding is most profitable, due to low interest rates and minimal competition for loans.  It is for these reasons that the writer argues that the U.S. should invest in public goods – the economic climate is just right.  The only problem is what to invest in: while most economies can easily pinpoint deteriorating infrastructure, those projects may be a waste of time and money.

Key words:
Natural monopoly – This is where the lowest price can only be achieved if the market has a monopoly. The article gives three examples of natural monopolies:
“telephone network, electricity grid or sewer system.” The article goes on to explaining why it is best to have a natural monopoly – “fixed costs… are typically high and operating costs relatively low”.
Crowding in – This is the opposite of the crowding out effect, and is where government spending on public projects boosts the demand for a good, and so, increases the private investment in it.

For more on infrastructure and investment, read “Government Spending Booms Not So Great for Long-Term Growth” and “Bridges to Somewhere"

Discussion:
This article describes the influx of Chinese investment on Europe.  As part of its outbound investments model, Chinese investment has increased multifold.

One problem the Chinese are facing with investment abroad is the presence of labor and environmental laws. Usually, such laws are overlooked in China. Nonetheless, it is likely that investment in Europe will steadily increase.

Still, Europe may be getting in its own way, in that it might be discouraging the Chinese from investing in the EU. The EU has so far been benefitting with the influx of investment, especially into those countries who have been hit the hardest by the debt crisis (the PIGS countries – Portugal, Italy, Greece and Spain). But Europe is unwilling to sell China it’s more advanced technology and does not have much else to offer China.

Regardless, it is clear that private investors are entitled by the reduction in asset prices in Europe, and it is clear that Chinese investment in Europe will increase with time.