Tuesday, June 2, 2015

Review of A Nation of Deadbeats: An Uncommon History of America's Financial Disasters by Scott Reynolds Nelson

Nelson's A Nation of Deadbeats chronicles the dozen major panics/banking crises/depressions that occurred between the ratification of the constitution and the Great Depression (on the order of once a decade).

His history is descriptive, not prescriptive; nor does he advance a theory of panics, which is a bit tedious because these panics are the same story, repeated as often as ebullient mood allows the behavior that creates them.

Over and over again, some innovator has created a successful proof of concept of value creation: canals, cotton, railroads, the internet. Entrepreneurs leap into action to commercialize it by replicating it. The diffusion of the innovation follows Everett Rogers' S-shaped curve.

Money is lent to entrepreneurs and since the innovation has a positive rate of return there is a virtuous cycle where everyone wins, which leads to copycat entrepreneurs and also copycat investors, who then increase leverage because spreads have declined but recent experience has shown the investment to be safe. But then comes the Minsky moment:

"[L]ong periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. The spiraling debt incurred in financing speculative investments leads to cash flow problems for investors. The cash generated by their assets no longer is sufficient to pay off the debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. This is likely to lead to a collapse of asset values. Meanwhile, the over-indebted investors are forced to sell even their less-speculative positions to make good on their loans. However, at this point no counterparty can be found to bid at the high asking prices previously quoted. This starts a major sell-off, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity, and a severe demand for cash"
The instant before the Minsky moment is obviously very dangerous for owners of investments, yet it seems to follow a pattern that makes it identifiable. Prior to the panic, investors are not distinguishing between good (simple, well-collateralized) and bad (inordinately complex, unsecured) debts. Narrow credit spreads, rising leverage, and desperation to "put money to work" are signs of the late stages of the musical chairs game. (Another sign are more complex debt securities and aggregations of debt that reduce the amount of information the ultimate creditor has about the borrower. This is the Panic theory of the 2008 crisis.)

After the Minsky moment, whatever is used to settle debts (i.e. cash) becomes extremely scarce. This is why the panics are worth waiting for. Note that most of these bargains are not being sold "voluntarily". Owners of insolvent enterprises always want to extend and pretend. They talk about the "option value" of their far, far out of the money equity claims. The forced selling happens via lender foreclosure, but also via open-ended investment vehicles like mutual funds, where redemptions force the managers to sell the investments indiscriminately.

The scarcity of cash results in lots and lots of political conflict over the value of money, which is part of a broader political conflict between creditors and debtors. Creditors need to be careful about thinking they have debtors cornered. Debtors outnumber creditors, so the rules can be changed. Drawing out the foreclosure process buys debtors time for reflation to rescue their claims. Another rule change is devaluation, which first was by going off the gold standard and then was through money printing. The post-2009 restructuring (no public auctions, quantitative easing) seemed to be designed to make sure that only the elites could get the benefit of the reflation. They weren't going to allow more Beals.

Fractional reserve banking does not work. All of the arguments against it - and the attempted patch, deposit insurance - have been borne out time and again. The only way that a thirty year loan is legitimate is if there is a lender who has agreed to lock money up for that amount of time. And who would? Hence the temptation for creaky banks that speculate on term spreads from a tiny capital base. And also the reason that residential real estate financing is nationalized.

Although I do think getting rid of fractional reserve banking and having sound money would result in resources being better allocated, I do not think these measures would end panics or the business cycle.

As Falkenstein concludes from his brilliant Batesian mimicry explanation of business cycles,
"recessions are not going away; they are endogenous because zero mimicry is not an equilibrium among insects, reptiles, or humans. Expect more unexpected recessions..."
Unless the nerd rapture has brought an end to the business cycle, right now just feels like one of the interminable waiting periods before another panic.


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