Yves here. This is the second part in a three-part series on how to fix what is wrong with credit rating agencies. Please see part 1 here.
By Susan Schroeder, a lecturer in the Department of Political Economy, University of Sydney, Australia, and author of Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets (Palgrave Macmillan, 2015). Originally published in the July/August 2016 issue of Dollars & Sense magazine; cors posted from Triple Crisis
A market economy is not completely unpredictable—it does have gravitational tendencies, such as a tendency towards a falling rate of profit. Those tendencies are created by the day-to-day activities of firms and consumers, and are further shaped by the contexts in which they are embedded, such as institutional configurations and social norms.
What is the source, then, of instability in capitalist economies? It emanates from firms’ quest for profit. Capitalism runs on profit. To enhance their profits, firms adopt production techniques that lower their per-unit production costs. As this occurs, each firm’s structure of production changes relative to industry norms. Firms that use lower proportions of labor relative to other inputs are deemed to be more efficient and will earn a better rate of return on their capital than firms that do not adapt. Firms also switch from one industry to another, or enter new industries, in a quest for higher returns. Firms must change in these ways in order to survive, and thrive, in a competitive market economy.
Changes to productive conditions within an industry and capital flows between industries, however, are major sources of instability. The mechanization of the production process, for example, increases the presence of capital relative to labor. This process is also facilitated by mergers and acquisitions. As each firm changes its production process, the average conditions of production for each industry change. Capital flows between industries will also affect the industry averages as weaker firms exit. Firms can never be exactly sure how they compare against the industry average at any point in time. The best they can do is try to lower the unit cost of output faster than their competitors. Moreover, economists have demonstrated that these activities create a third source of instability—a tendency towards a falling profit rate for the entire economy.
Debt exacerbates this instability. Firms use debt, supplementing their own retained profits, to finance investment that improves their structures of production. However, improvement comes at the expense of the increasing weight of debt service. As firms become increasingly fragile, collectively, the economy becomes less resilient, and more vulnerable to a debt-deflation process.
Minsky’s Financial Instability Hypothesis (FIH) succinctly identifies the role of debt and debt repayment in the business cycle. Minsky classified each firm as one of three types, according to the relation of its cash inflows to outflows. (Cash inflows—the firm’s sources of funding—consist of profit and new borrowing; outflows consist of new investment and debt service payments.) The three types are: hedged firms, speculative firms, and Ponzi firms.
A hedged firm enjoys profits high enough that it is able to finance both its debt-payment commitments and new investment from profits, without resorting to new borrowing. The firm can use any remaining funds to further pay down debt.
A speculative firm’s profits are high enough to cover debt service, but not enough for its investment needs. It must borrow if it is to finance new investment. Because it borrows, its future debt service commitments will be higher. Its cash inflows become increasingly committed to honor debt service. As such, a speculative firm is more financially fragile than a hedged firm.
Finally, a Ponzi firm’s profits are too low to meet even its debt service commitments, let alone its investment needs. This firm is at the mercy of financial investors who consider the likelihood that its situation will improve. If they consider this likely, they will lend it money until its profits strengthen and the firm shifts away from Ponzi into speculative or, perhaps, hedged. (This might be the case, for instance, if the firm is young or if an innovation needs more time to bear fruit.) If its fortunes do not improve, the firm will have to sell off assets in order to complete payments.
How does this translate into the dynamics of the economy as a whole? At the start of an upswing in the cycle firms are mainly hedged. Suppose, Minsky argues, that some event stimulates investment in a particular sector and boosts the profits of firms in that sector. As these firms expand, they generate demand for inputs from firms in other sectors, raising these firms’ profits as well. Moreover, as sectors strengthen, so does employment of workers which, in turn, spurs growth of income and consumption.
As the economy moves into a boom phase, the stability and strength of profit flows encourage firms to take more risk, funding new investment with debt. The distribution of firms shifts from mainly hedged to mainly speculative as the burden of debt service starts to increase.
As this business cycle reaches its peak and heads toward a downturn, profit flows stagnate and speculative firms now shift to Ponzi. Over the business cycle as a whole, as the distribution of firms shifts from hedged to speculative to Ponzi, the economy and its financial system become increasingly fragile. It will not take much to trigger a debt-deflation process.
A New Approach to Creditworthiness
The Minskian classification of firms can provide the foundation for a new way to rate firms’ creditworthiness. On the surface, it would look similar to what the rating agencies currently provide. With the FIH at its heart, however, the structure has the advantage of explaining and anticipating the distribution of firms across the different categories—hedged, speculative, and Ponzi—and the overall changes in the system.
The advantage of Minskian analysis is that one can examine not just the placement of the firms but how their context changes. A key relationship to monitor is the rate of return on new investment vs. the interest rate on investment-grade debt. If the rate of return is greater than the rate of interest, the economy is thought to be heathy as the return to a new unit of investment is able to cover the cost of new borrowing. Of course, the interpretation of this relationship needs to explore industry developments and the influence of government policies underlying those rates.
A public credit-rating agency (PCRA) could use such a system, alongside existing approaches, to review the ratings offered by the private rating agencies. It could facilitate the development of better methods of credit risk assessment and cash-flow analysis. A PCRA could facilitate public discourse and, by doing so, locate additional issues to address. Because of the possibility of conflicts of interest, sovereign debt issues would have to be left to an international credit rating agency, perhaps at the United Nations’ Department of Economic and Social Affairs.
A PCRA has the potential to work alongside a central bank to provide additional tools for managing the economy as a whole. Given the objectives of industrial development, a PCRA can suggest rate adjustments to lenders, in order to foster the development of new, key industries. Rate adjustments could also control overheating in certain sectors or industries, particularly those experiencing excess, speculative financial inflows. Rate adjustments could be made by modifying the interest rate on new lending. For instance, if the borrower operates in an industry which is thought to be at risk of overheating, the PCRA might recommend a premium of 5% on new lending to help cool activity. On the other hand, a lower interest rate could be suggested to promote industrial activities deemed socially desirable, such as the development of alternative energy.
In light of the recent financial meltdown, economic journalist Will Hutton has suggested direct government management of banks’ balance sheets. But a PCRA would have advantages over that approach. It would be less intensive for a government in terms of oversight. It would also maintain banks’ and rating agencies’ flexibility to locate new opportunities and markets. In a sense, a PCRA could be seen as facilitating cooperation between financial institutions, nonfinancial firms, and the state.
Of course, with the introduction of any new department or agency, there is a danger of “regulatory capture”—when a government agency is influenced by the entities it is supposed to oversee, to the benefit of those entities and not the public interest. There is evidence that credit-rating agencies use lobbyists to protect their independence and to blunt government efforts to hold the agencies accountable. For instance, the Sunlight Foundation notes spending by Moody’s, S&P, and S&P’s parent company McGraw Hill, on various public-policy issues, including “a provision in Dodd-Frank that would hold credit rating agencies liable for securities fraud.” The Center for Responsive Politics finds evidence of rating agencies lobbying on legislation that would enhance transparency, on the Securities and Exchange Commission (SEC) designation of what counts as a rating agency, and on the establishment of a commission to investigate triggers of financial crisis.
Recent research suggests that regulatory capture over an industry can be thwarted, for instance, by involving multiple regulators, empowering diffuse interests, and involving experts with independent opinions.
Where do today’s companies fall on the hedged > speculative > ponzi scale when ‘borrowing’ is done at someone else’s expense?
A point that the book makes is that there is an over-reliance on monitoring the conditions for financing; mainstream economics reinforces this narrow focus. The book suggests that one also needs to take into account the profitability of recent investments. The evaluation of the Minskian scheme for the US economy is available in the book.
All well and good. Though the analysis can be expanded by rewriting one sentence:
The transition to “ponzi government” status occurs at sovereign data ratios north of 100% of GDP.
Planet Japan is the poster boy here, at 240% or so. It’s so bad even the emperor wants to resign.
This is idiotic. The Japanese government creates it’s own money, unlike any private firm. How can it run out of money it can create out of nothing any time it likes?
And this 240% “debt” doesn’t scare away private companies who continue to buy as much of it as they can at less than zero effective interest rates. They would get a better return keeping their money in vaults, but instead they purchase government debt. Why would they be doing that if the Japanese government is “broke”?
What is interesting to me is that no one admits to the fact that when a government’s bonds are in demand globally, *of course* their issue is going to be higher than GDP. What investors are ‘buying’ in a ZIRP environment is simply a safe, stable place to stash their money. Japan can print to fund it’s domestic needs, *and* provide savings accounts to the world at large. The money deposited in bonds isn’t going anywhere, and there’s little to no debt service to pay on it. It’s just a safer bank.
Think political distress has more to do with perceived economic policy failure due in part to strength of the Yen in forex markets despite massive QE-NIRP efforts by the BOJ to suppress interest rates, reduce the currency’s relative attractiveness, and increase export price competitiveness. Japanese sovereign bond yields are now negative out beyond 10-year maturities. So it seems that investors are not overly concerned about Japan’s sovereign debt level.
IMO there is a big and complex story here alright. But perhaps not the one that appears at first blush.
Well, look, it’s not meaningful to apply the Minskian categorization of firms to governments. Randall Wray, one of Minsky’s students, forcefully argues against this. Governments are not firms.
This comment does raise an interesting point – what is debt sustainability in a Minskian framework? I don’t think there is a clear answer to this, just yet.
I think this is an important effort to examine profit and how it effects our economic system. The relationship to debt is important but I think the analysis should go deeper.
We have to have a clear understanding of what capital and labor mean in our economy. Sociology professor Vivek Chibber has some important points in his contribution to The ABCs of Socialism, “Why Do Socialists Talk So Much About Workers?”
“”Economic and political power is in the hands of capitalists, whose only goal is to maximize profits, which means that the condition of workers is, at best, a secondary concern to them. And that means that the system is, at its very core, unjust.””
“”It follows that the first step to making our society more humane and fair is to reduce the insecurity and material deprivation in so many people’s lives, and to increase their scope for self-determination. But we immediately run into a problem – the political resistance of elites.””
“”This ability to crash the entire system, just by refusing to work, gives workers a kind of leverage that no other group in society has,””
“”This combination of moral urgency and strategic force is why socialist politics is based on the working class.””
Thanks for the encouragement. The article tries to summarize key points of the book. The book provides a deeper analysis, with supporting empirical work.
It would be nice if the sharing economy can gain a bit more traction in order to promote a bit more self-sufficiency within communities. If markets are inherent unstable, and I believe they are, then folks needs to find ways to rely less on them.
Mainstream work on credit emphasizes symmetry –for every debtor there is a creditor–leading to an implicit notion of ‘all in it together’. What this neglects is not so much the institutional infrastructure of debt (which is important as is Susan’s work) but the politics of the relationship which is not substantively symmetric but asymmetric. Everyone (well nearly) can borrow but not everyone can lend. One example is the extent to which the wealthy ‘lend’ to governments and seek out the best quality government debt; the extent to which the wealthy seek judicial help in enforcing government repayment of debt and so forth. This asymmetry is ignored in too much of the discussion.
Income in the form of profits, wages, salaries and taxes generates a cash flow that sustain the commitments to repay debts contracted in the past. Unlike the classical world, in which money is a medium of exchange and has no effect upon the real exchange economy—in the paper world of Wall Street developments that centre around debt, finance and cash flows are the tail which frequently wags the dog of output and employment.