My first degree was in engineering. I grew up liking the natural sciences and thought the social sciences were full of crap – too touchy feely and unobjective. That changed when I started preparing for business school and my then mentor suggested I read Ayn Rand. From there I discovered Ludwig von Mises, the Austrian school of economics, and realized economics was as objective as a natural science when seen through the Austrian lens.
Once I read Murray Rothbard’s Man, Economy and State, there was no going back. I loved economics and couldn’t get enough of using it as a lens to understand the world of finance. That started me down the rabbit hole of understanding business cycles, which is how I discovered Hyman Minsky.
Minsky postulated the Financial Instability Hypothesis, a novel way of looking at debt growth in the economy.
The Hedge Phase
Minsky uses the ‘Goldilocks phase’ of the economy as his starting point (the Austrian approach is much more rigorous, but that’s a different topic). In the Goldilocks phase, the economy has just come out of recession, bad debts from the prior business cycle have been wiped out, banks are cautious about lending, borrowers are gun shy, and credit growth is slow to pick up.
For a small business, banks are willing to extend a factoring loan but not a loan for equipment purchase. Debt accumulates slowly in this phase. There is little inflation, the economy is driven by productivity growth, and both labor and capital are equally rewarded.
The Speculative Phase
Of course, such conditions aren’t prone to lasting. The first borrowers who get access to equipment loans get to buy assets on the cheap. Others follow, and banks start lending more freely as they don’t want to miss out. The more banks grow their loan book, the more money they make for shareholders. The pressure to loosen lending standards takes hold.
As this phase progresses, the lessons of the past cycle would have been forgotten. A new narrative (“The New Economy”, “Housing for All”, “Generative AI”) has taken hold, and the popular press starts to put out articles arguing This Time is Different, that business cycles have been ended, that banks are in great shape – whatever works to quell people’s misgivings about the rise of debt.
Besides, by this point the economy is growing, interest rates are coming down, refinancing loans gets easier, asset prices move up, and it appears as if the increase in lending was conservative after all.
The stock market feeds this line of thinking by rewarding shareholders of companies that increased leverage. Investors clamor for growth, punishing companies that fail to borrow and expand.
This phase can last as long as productivity growth and debt growth keep pace with one another and generate real gains. The 1990s was one such period. But at some point, the incremental gains from debt go negative – asset prices can’t go up forever.
The Ponzi Phase
Speculation sows the seeds of its own demise. Covenant-lite loans become the norm. The old guys who used to worry about return of capital get kicked upstairs or retired early. The media fawns on innovative uses of credit and debtors become celebrities. Think Drexel Burnham and KKR in the 1980s.
Borrowers increase their leverage on the belief that asset prices will go up forever. No thought is given to downside risk.
The three phases are a continuum. It is difficult to put a pin on exactly when the economy moved from the Speculative phase to the Ponzi phase, except in hindsight. But understanding the Financial Instability Hypothesis provides a framework for understanding current events.
The Ongoing Minsky Cycle
Hedge phase: March 2022 Fed rate hike cycle triggered a sharp recession, followed by an immediate disinflationary Goldilocks environment.
Speculative phase: March 2023 bail-out of Silicon Valley Bank, the Bank Term Funding Program, and the UBS-Credit Suisse merger signaled that central banks were willing to do “whatever it takes” to support credit growth. This kickstarted the lending cycle. The November 2023 easing of financial conditions accelerated the speculative phase. See my December 2023 Macro Outlook.
Ponzi phase: Present day. The signs are all there.
“So, over the last 3 months, our margin loans are up by 16%. And which is rather -- it's a bit worrisome if you ask me because I think that equity prices are somewhat overextended. And I hope that as they come down, they will not come down too fast, so we can liquidate as it happens, and we will not end up with holding the bag of -- from people who are unable to meet their margin calls”. – Thomas Peterffy, Founder, Chairman and former CEO of Interactive Brokers (IBKR), speaking at the Goldman Sachs Conference this month.
The Magnificent 7 represent over 70% of the trading volumes on the Interactive Brokers platform.
MicroStrategy (MSTR), a failed software company that re-branded itself as a “bitcoin bank” is set to enter the Nasdaq 100 index on December 23rd, replacing known accounting fraud Super Micro Computer (SMCI).
Even the US government is in the Ponzi phase, announcing plans to increase the budget deficit to create a Strategic Bitcoin Reserve. In the old days, at least they built highways and utilities. Now, they’re simply debasing the dollar to purchase unproductive assets for no tangible benefit.
Bank credit is at all-time highs.
Financialization of the economy is going parabolic.
The smart money has left the casino.
It is one thing to establish that we’re in the Ponzi phase, but quite another to navigate it.
Navigating the Ponzi Phase
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” – Citigroup CEO Chuck Prince, July 2007.
While this quote has gone down in infamy, it is important to remember that from July to December 2007, the S&P 500 continued to hold up remarkably well. Ben Bernanke opined the sub-prime mess was grave but largely contained. Homebuilders even staged a furious rally to start off 2008.
Being a Cassandra too early is a career risk, as Morgan Stanley’s CIO Mike Wilson has discovered.
The Ponzi phase of the credit cycle has lasting power because resisting the FOMO and “underperforming” peers is a career risk. It is far better to drink the Kool-Aid and be short gamma (embrace tail risk) than to take the long view, tap out, and buy municipal bonds or gold.
My skill is being willing to underperform in the short-term in order to keep my capital intact and outperform in the long-term.
The Minsky Moment, the catalyst that unravels the Ponzi phase and creates the bust phase of the business cycle, could be weeks or months away. Fartcoin could be minting a new millionaire every day of the week – and I’ll still stay away from it.
I know from studying prior cycles, and my own trading experience, that the unwind will be swift when it occurs, and the warning signs will be easily missed or dismissed.
In hindsight, it is all obvious.
If the warning signs are flashing red, why do investors ignore them?
Because there is something very addictive about the notion that we can make money every day by doing what we know to be the wrong thing, simply because our doing so entices others to do the same. The greatest fool who buys the top – that can never be me because I’m smarter than the others, goes the thinking. And yet, it is a mathematical certainty that one of us is going to end up being the greatest fool, just as it is an economic certainty that the Ponzi phase leads to the bust. Debt cannot go up forever without a reckoning. This is true even during hyperinflationary periods – the bust phases are smaller and quickly overcome with more leverage and money printing, but they exist, nevertheless.
Minsky’s theory was dismissed not because he was wrong, but because nobody likes a Cassandra. To quote Keynes, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Buying bitcoin because everyone else is buying bitcoin, and losing 80% when everyone else is losing 80%, is not a career risk on Wall Street. Refusing to buy bitcoin when BlackRock says investors need to allocate 2% to it is a career risk. If you passed on it at $70k last month, you gotta buy at $104k now so you don’t look like an idiot at the office Christmas party. This is how the greatest fool emerges. He doesn’t want to be one, but he simply can’t risk not owning the one asset everyone’s talking about, no matter the price.
The longer the Ponzi phase lasts, the harder it gets to not capitulate, to not throw caution to the wind and join the Ponzi.
The short gamma trade is so pleasurable that it acts as an opioid on the risk control systems of institutional investors. Nobody cares about the 2018 volmageddon or the 2007 quant meltdown. They are just quaint historic anecdotes you bring up at dinner parties to sound smart. That stuff can’t ever happen again. Margin Call is just a cool movie and nothing more.
When the markets get to this phase, the rational investor only has two choices – (1) go with the crowd, deal with the fallout in a distant future far, far away; (2) take a career risk and hope the market changes before clients desert you.
Correctly identifying the current stage in the business cycle is easy, since it requires mere intellect, which is a given in the finance industry. The emotional aspect of navigating the Ponzi phase is much harder.
“How much longer can this go on, Kashyap?”
Does that matter? I have another 30 years in finance ahead of me. Debt-fueled bubbles come and go, leaving destruction in their wake. High quality businesses trading at 40 cents on the dollar won’t disappear – and will compound better than the assets which have caught everyone’s fancy.
Catching the falling knives is preferable to chasing the Ponzi.
It doesn’t matter whether the Ponzi phase lasts for a few more weeks or a few more months.
“If you can keep your head when all about you Are losing theirs and blaming it on you, If you can trust yourself when all men doubt you, But make allowance for their doubting too; If you can wait and not be tired by waiting… Yours is the Earth and everything that’s in it, And—which is more—you’ll be a Man, my son!” – Rudyard Kipling
Rejecting the Ponzi need not be a lone endeavor. Feel free to pass this article along and let’s get a conversation going.
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Good Trading!
Kashyap