Hedge, speculative, and Ponzi financing units
A hedge-financed unit's expected cash flows cover both interest and principal. A speculative unit covers interest but must roll over principal, so it depends on refinancing markets.
Stabilizing an Unstable Economy
6 ideas
Stability is itself destabilizing
A run of good years without default makes borrowers and lenders revise their estimates of risk downward, so margins of safety shrink and leverage rises. The economy's financing mix drifts from hedge toward speculative and Ponzi positions. The calm period therefore produces the fragility that makes the next crisis possible, and the crisis comes from inside the system rather than from an outside shock.
Economy as interlocking cash-flow commitments
View the economy as a network of balance sheets in which every unit's debt payments are funded by other units' income and spending. Under this lens, the key question is whether today's cash flows can validate the debts taken on in the past. A fall in one unit's income passes along as other units' inability to pay.
Two-price system for assets and output
Capital assets and financial instruments are priced in asset markets by expectations and financing conditions. Current output is priced by production costs and markups.
Big government puts a floor under profits
When private investment collapses, a large government running deficits keeps aggregate profits from falling, because deficits add to business income. Sustained profits let firms keep servicing their debts, which stops a fall in income from turning into a debt-deflation spiral. This automatic support is a main reason there was no 1930s-style depression after World War II.
Lender of last resort validates risky finance
When a central bank rescues refinancing markets during a crisis, it prevents collapse. The same rescue also validates the risky financial practices that caused the fragility. Each successful intervention encourages more speculative and Ponzi financing, so rescues must be paired with active regulation and structural reform, or the system will need ever-larger bailouts.