Indecent Bazaars. Thought of the Day 113.0


Peripheral markets may be defined as markets which generate only a small proportion of their financial inflows from local business and investors, but which attract the interest of ‘global’ investors. Emerging markets and markets for financial exotica such as financial derivatives are examples of such peripheral markets. Because emerging markets are largely dependent upon attracting international funds in order to generate increases in securities prices and capital gains which will attract further funds, they are particularly good examples of the principles of Ponzi finance at work in securities markets.

A common characteristic feature of peripheral markets is that they have no history of returns to financial investment on the scale on which finance is drawn to those markets in a time of capital market inflation. Such returns in the future have to be inferred on the basis of conjecture and fragmentary information. Investment decisions are therefore more dependent on sentiment, rather than reason. Any optimism is quickly justified by the rapid increase in asset prices in response to even a modest excess net inflow of money into such a market.

Emerging markets illustrate this very clearly. Such markets exist in developing and semi-industrialized countries with relatively undeveloped pensions and insurance institutions, principally because only a small proportion of households earn enough to be able to put aside long-term savings. The first fund manager comes upon such a market in the conviction that a change of government or government policy, or some temporary change in commodity prices, has opened a cornucopia of profitable opportunities and therefore warrants the dismissal of a history of economic, financial and political instability. If he or she is able with buying and enthusiasm to attract other speculators and fund managers to enter the market, they may drive up asset prices and make the largest capital gains. The second and third fund managers to buy into that market also make capital gains. The emulatory competition of trading on reputation while competing for returns makes international investment managers especially prone to this kind of ‘herd’ investment.

For a while such capital inflows into the market make everyone happy: international fund managers are able to show good returns from the funds in their care; finance theorists can reassure themselves that greater financial risks are compensated by higher returns; the government of the country in which the emerging market is located can sell its bonds and public sector enterprises to willing foreign investors and use the proceeds to balance its budget and repay its debts; the watchdogs of financial prudence in the International Monetary Fund can hail the revival of finance, the government’s commitment to private enterprise and apparent fiscal responsibility; state enterprises, hitherto stagnating because of under-investment by over-indebted governments, suddenly find themselves in the private sector commanding seemingly limitless opportunities for raising finance; the country’s currency after years of depreciation acquires a gilt-edged stability as dollars (the principal currency of international investment) flow in to be exchanged for local currency with which to buy local securities; the central bank accumulates dollars in exchange for the local currency that it issues to enable foreign investors to invest in the local markets and, with larger reserves, secures a new ease in managing its foreign liabilities; the indigenous middle and professional classes who buy financial and property (real estate) assets in time for the boom are enriched and for once cease their perennial grumbling at the sordid reality of life in a poor country. In this conjuncture the most banal shibboleths of enterprise and economic progress under capitalism appear like the very essence of worldly wisdom.

Only in such a situation of capital market inflation are the supposed benefits of foreign direct investment realized. Such investment by multinational companies is widely held to improve the ‘quality’ or productivity of local labour, management and technical know-how in less developed countries, whose technology and organization of labour lags behind that of the more industrialized countries. But only the most doltish and ignorant peasant would not have his or her productivity increased by being set to work with a machine of relatively recent vintage under the guidance of a manager familiar with that machine and the kind of work organization that it requires. It is more doubtful whether the initial increase in productivity can be realized without a corresponding increase in the export market (developing countries have relatively small home markets). It is even more doubtful if the productivity increase can be repeated without the replacement of the machinery by even newer machinery.

The favourable conjuncture in the capital markets of developing countries can be even more temporary. There are limits on the extent to which even private sector companies may take on financial liabilities and privatization is merely a system for transferring such liabilities from the government to the private sector without increasing the financial resources of the companies privatized. But to sustain capital gains in the emerging stock market, additional funds have to continue to flow in buying new liabilities of the government or the private sector, or buying out local investors. When new securities cease to attract international fund managers, the inflow stops. Sometimes this happens when the government privatization drive pauses, because the government runs out of attractive state enterprises or there are political and procedural difficulties in selling them. A fall in the proceeds from privatization may reveal the government’s underlying fiscal deficit, causing the pundits of international finance to sense the odour of financial unsoundness. More commonly rising imports and general price inflation, due to the economic boom set off by the inflow of foreign funds, arouse just such an odour in the noses of those pundits. Such financial soundness is a subjective view. Even if nothing is wrong in the country concerned, the prospective capital gain and yield in some other market need only rise above the expected inflation and yield of the country, to cause a capital outflow which will usually be justified in retrospect by an appeal to perceived, if not actual, financial disequilibrium.

Ponzi financial structures are characterized by ephemeral liquidity. At the time when money is coming into the markets they appear to be just the neo-classical ideal of market perfection, with lots of buyers and sellers scrambling for bargains and arbitrage profits. At the moment when disinvestment takes hold the true nature of peripheral markets and their ephemeral liquidity is revealed as trades which previously sped through in the frantic paper chase for profits are now frustrated. This too is particularly apparent in emerging markets. In order to sell, a buyer is necessary. If the majority of investors in a market also wish to sell, then sales cannot be executed for want of a buyer and the apparently perfect market liquidity dries up. The crash of the emerging stock market is followed by the fall in the exchange value of the local currency. Those international investors that succeeded in selling now have local currency which has to be converted into dollars if the proceeds of the sale are to be repatriated, or invested elsewhere. Exchange through the local banking system may now be frustrated if it has inadequate dollar reserves: a strong possibility if the central bank has been using dollars to service foreign debts. In spite of all the reassurance that this time it will be different because capital inflows are secured on financial instruments issued by the private sector, international investors are at this point as much at the mercy of the central bank and the government of an emerging market as international banks were at the height of the sovereign debt crisis. Moreover, the greater the success of the peripheral market in attracting funds, and hence the greater the boom in prices in that market, the greater is the desired outflow when it comes. With the fall in liquidity of financial markets in developing countries comes a fall in the liquidity of foreign direct investment, making it difficult to secure appropriate local financial support or repatriate profits.

Another factor which contributes to the fragility of peripheral markets is the opaqueness of financial accounting in them, in the sense that however precise and discriminating may be the financial accounting conventions, rules and reporting, they do not provide accurate indicators of the financial prospects of particular investments. In emerging markets this is commonly supposed to be because they lack the accounting regulations and expertise which supports the sophisticated integrated financial markets of the industrialized countries. In those industrialized countries, where accounting procedures are supposed to be much more transparent, peripheral markets such as venture capital and financial futures still suffer from accounting inadequacies because financial innovation introduces liabilities that have no history and which are not included in conventional accounts (notably the so-called ‘off-balance sheet’ liabilities). More important than these gaps in financial reporting is the volatility of profits from financial investment in such peripheral markets, and the absence of any stable relationship between profits from trading in their instruments and the previous history of those instruments or the financial performance of the company issuing them. Thus, even where financial records are comprehensive, accurate and revealed, they are a poor indicator of prospective returns from investments in the securities of peripheral markets.

With more than usually unreliable financial data, trading in those markets is much more based on reputation than on any systematic financial analysis: the second and third investor in such a market is attracted by the reputation of the first and subsequently the second investor. Because of the direct connection between financial inflows and values in securities markets, the more trading takes place on the basis of reputation the less of a guide to prospective returns is afforded by financial analysis. Peripheral markets are therefore much more prone to ‘ramping’ than other markets.

Why would such a crisis of withdrawal not occur, at least not on such a scale, in the more locally integrated capital markets of the advanced industrialised countries? First of all, integrated capital markets such as those of the UK, and the US are the domestic base for international investors. In periods of financial turbulence, they are more likely to have funds repatriated to them than to have funds taken out of them. Second, institutional investors tend to be more responsive to pressure to be ‘responsible investors’ in their home countries. In large measure this is because home securities make up the vast majority of investment fund portfolios. Ultimately, investment institutions will use their liquidity to protect the markets in which most of their portfolio is based. Finally, the locally integrated markets of the advanced industrialized countries have investing institutions with far greater wealth than the developing or semi-industrialized countries. Those markets are home for the pension funds which dominate the world markets. Among their wealth are deposits and other liquid assets which may be easily converted to support a stock market by buying securities. The poorer countries of the world have even poorer pension funds, which could not support their markets against an outflow due to portfolio switches by international investors.

Thus integrated markets are more ‘secure’ in that they are less prone to collapse than emerging or, more generally, peripheral markets. But precisely because of the large amount of trade already concentrated in the integrated markets, prices in them are much less likely to respond to investment fund inflows from abroad. Pension and insurance fund practice is to extrapolate those capital gains into the future for the purposes of determining the solvency of those funds. However, those gains were obtained because of a combination of inflation, the increased scope of funded pensions and the flight of funds from peripheral markets.

Ramping the Markets: Banking on Ponzi Finance. Thought of the Day 112.0

China Minsky

When funded pension schemes were first put forward at the beginning of the 1970s as a private sector alternative to state earnings-related pensions, the merchant (investment) banks and stockbroking firms that promoted them did not anticipate how successful they would become in that, by the following decades, pension schemes and allied forms of life assurance would come to own most of the stocks and shares quoted on the world’s stock markets. When pension funds held a minority of stocks, the funds could altogether put money into stock markets by buying stocks, or withdraw it by selling, without significantly affecting prices or the liquidity of the market as a whole. Now that pension funds and allied life assurance and mutual funds constitute the majority of the market, it is not possible for them to withdraw funds altogether without causing a fall in prices, or even a stock market crash.

Because of their success, pension funds have become the newest and possibly the most catastrophic example of Ponzi finance. The term Ponzi finance was invented by the American economist Hyman P. Minsky as part of his analysis of financial market inflation. It describes a form of finance in which new liabilities are issued to finance existing liabilities. According to Minsky, financial crises are caused by the collapse of ‘financial structures’ whose failure is precipitated by their increasing ‘financial fragility’. Financial structures are simply commitments to make payments in the future, against claims that result in incoming payments in the future. For Minsky, the characteristic feature of financial markets and financial speculation is that they afford opportunities for economic units to enter into future financial commitments, in the expectation of gain. In this respect, at least, they are similar to fixed capital investment. Success in securing gains persuades speculators to enter into further commitments, which become more ‘fragile’, i.e., more prone to collapse because future commitments become more speculative and less covered by assured financial inflows.

Minsky identifies three types of financial commitments, which are distinguished by the different degree of financial risk that they entail. In hedge finance, future commitments are exactly matched by cash inflows. A common example is the practice in banking of lending at variable or floating rates of interest. In this way, if a bank has to pay more interest to its depositors, it can recoup the increase by raising the interest rates that it charges to its borrowers (assuming that its depositors cannot withdraw their deposits before the term of the loan expires).

Speculative finance is characterized by certain commitments which have to be covered by cash inflows which may rise or fall, or uncertain commitments against a fixed cash inflow. If a bank lends money at a fixed rate of interest it is engaging in speculative finance, because it is running the risk that it may have to pay a higher rate of interest to depositors if interest rates rise. However, to set against this risk it has the possibility that the interest rates paid to depositors may fall, and it will thereby make additional gains from a wider margin between lending and borrowing rates.

Ponzi finance, in Minsky’s view, is a situation in which both commitments and cash inflows are uncertain, so that there is a possibility of an even more enhanced profit if commitments fall and the cash inflow rises. Against this has to be set the possibility that commitments and the cash inflow will move together so that only a minimal profit will be secured, or that commitments will rise and the cash inflow will fall, in which case a much more serious loss will be entered than would have occurred under speculative finance.

Ponzi finance lies behind the view that is no less erroneous for being widely repeated, that a higher return reflects the ‘greater risk’ of an enterprise. This is exemplified in the practice of banks charging higher rates of interest for what they perceive as greater risks. Behind this view lies the Austrian tradition, from Böhm-Bawerk onwards, of regarding economic outcomes as analogous to the gains and lotteries obtainable from repeated routine games, such as the tossing of a dice. The certain pay-off (or ‘certainty-equivalent’) is held to be lower than some possible pay-off. The association of the greater payoff with its lower probability then leads to a presumption that the latter ‘causes’ the former. However, the profits of companies and financial institutions are not the proceeds of gaming, however much enterprise in an unstable market system may appear similar to gambling. In fact, these profits are the outcomes of financial flows that ebb and progress through the economy, propelled by actual expenditure and financing decisions. The systems of financial claims and liabilities arising from those decisions become more fragile, as first speculative and then Ponzi financing structures come to predominate, and larger gains and larger losses may then be made. But the possibility of extraordinary profits or losses in Ponzi financing structures in no way means that realization of such profits is caused or justified by the possibility of the losses. Ponzi finance arises out of objective contractual obligations. The ‘greater risk’, which is held to justify a higher cost of finance, may be entirely subjective or a cover for monopoly profits in finance.

The simplest example of Ponzi finance is borrowing money to pay interest on a loan. In this case, the financial liability is increased, with no reduction in the original loan. Pyramid bank deposit schemes were the schemes after which this phenomenon is named, and they are perhaps the most extreme example of such financial structures. In a pyramid deposit scheme, the financier might take, say, Rs. 100 from a depositor, and promise to double this money after a month if the depositor introduces two new depositors at the end of that month. The two new depositors get the same terms and when they pay in their Rs. 100 respectively, Rs. 100 goes to double the money of the first depositor, and the other Rs. 100 is the financier’s profit. The two new depositors get their profit at the end of the next month from the new deposits paid in by the four new depositors that they introduce to the scheme, and so on. Initially, such schemes promise and deliver good profits. But their flaw lies in the fact that they require deposits to rise exponentially in order to pay the promised rewards to depositors. In the example that is described above, deposits have to double each month so that after one year, the scheme requires Rs. 409,600 in deposits just to keep solvent. After the thirteenth month, Rs. 819,200 would need to be deposited to keep up promised payments to depositors. Such schemes therefore usually collapse when they run out of gullible people to deposit their savings in them. While their life can be briefly extended by persuading depositors not to withdraw their profits, this cannot work for more than one or two payment periods, because such schemes are so dependent on increasing amounts of additional money being paid into them in each successive period.

Ponzi schemes are named after Charles Ponzi, an Italian immigrant who swindled Boston investors in 1919 and 1920 with a pyramid banking scheme. Minsky noted that Ponzi’s scheme ‘swept through the working classes and even affected “respectable” folk’. Because they prey on the poor and the ignorant, Ponzi schemes in banking are usually banned, although this does not prevent them from occurring in countries where it is difficult to regulate them. In Minsky’s view, financial collapses occur because booms in financial markets result in sufficient profits for speculative and Ponzi finance to induce a shift from hedge finance to speculative and Ponzi finance.

Ponzi finance in securities markets is much more common than in banking. Indeed, it is arguable that such finance is essential for the liquidity of markets in long-term securities: if a security is bought, it may have an assured ‘residual liquidity’ if it is a bond in that, when it matures, the money will then be returned to the investor. If, however, the security is a share which is not repaid by the issuer except on liquidation of the company, then it has no assured residual liquidity. Its liquidity depends on some other investor wishing to buy it at a reasonable price. If the share is to be sold at a profit, then the condition for this to happen is that demand for it has risen since it was bought. In this respect, liquidity and capital gains in the markets for long-term securities depend on Ponzi finance.

Ponzi finance was present at the very inception of modern stock markets. The South Sea Company and the Mississippi Company, whose stocks featured in the first stock market collapse of 1720, both ended up issuing stocks to raise finance in order to buy stocks to keep the market in their stocks liquid and stable. In modern times, this is a common feature of merger and takeover activity in capital markets. Corporate takeovers are frequently financed by issuing securities. The proceeds of the new issue are used to buy in the target company’s stock ‘at a premium’, i.e., at a price that is greater than the pre-takeover market price. The money raised by issuing the new stocks is used to pay the higher return to the stock-holders of the company being taken over. In this case, issuing new stock is exactly equivalent to the pyramid banking practice of taking in new deposits in order to pay an enhanced return to older depositors, which is the premium on the target company’s stock. The main difference between the two types of operation is that, during such takeover activity, the stock market as a whole functions as a pyramid banking scheme. However, precisely because it is the market as a whole which is operating in this Ponzi way, the pyramid nature of the venture is less obvious, and the gains are greater, because more and wealthier contributors are involved. Since this is an outcome of the normal functioning of the market, which may hitherto have been acting in a perfectly proper and respectable fashion, raising finance for industry and providing for widows and orphans, it is not possible to ‘finger’ the perpetrator of the pyramid scheme.

A more obviously controversial kind of Ponzi finance is the practice known as ‘ramping’ the market. A financier discreetly buys up a particular stock over a period of time, and then announces with great fanfare that he or she is buying in the stock. There are few markets in which emulatory competition is as strong as financial markets, where being conservative in practice and faddish in innovation are preconditions for a ‘sound’ reputation. The ‘sounder’ that reputation, the more likely it is other investors will imitate the buying strategy. Indeed, there is an element of compulsion about it, depending on the reputation of the investor. Those investors without reputation must follow for whatever reasons the investment direction signalled by investors with reputation, or else languish among lower-growth stocks. As the price of the stock rises due to the increased demand for it, such reputable financiers quietly sell out at a profit to their imitators, thereby confirming their reputation for financial ‘soundness’. Obviously, the better the reputation of the financier, the greater the gain from such an operation. To support such a reputation and legitimize the profits from trading on it, financiers will obviously attribute the gains from this practice to their own financial acumen, rather than confessing to having ramped the market.

The almost instantaneous dissemination of relevant information on which modern financial markets pride themselves (and which many financial economists believe makes them near perfect), also facilitates this kind of market manipulation. In securities markets, the investors emulating the financier are the equivalent of the new depositors. They too may make money, if they too can persuade subsequent new investors to buy at higher prices. As with the pyramid banking case, ramping markets depends on increasing interest by additional investors. Because in practice it is indistinguishable from normal trading (unlike pyramid banking, which is rather more obvious), and because any losers usually have other wealth to fall back on, such practices are frowned upon in securities markets, but cannot be eliminated. However, in the case of pension funds, the eventual losers will be ordinary working people, who will only have a minimal state pension in the future to fall back on. This makes it all the more important to understand how a reputable system for financing pensions has become a Ponzi finance scheme which will in future collapse.