Reckless and short-sighted politicians and central bankers are encouraging ever-increasing levels of both household and sovereign debt. As a result, western civilization is now experiencing significant economic and societal change. It’s happening as we speak, but it will likely accelerate until we reach a tipping point and something cataclysmic happens.

A wise personal financial plan would therefore include a process for exiting the fiat monetary system. Once the world loses faith in the US dollar, the euro, the pound, the yen, and every other currency now being printed into oblivion, it will probably be too late. I suspect this is why many of us are here on Steemit, to gradually transition from a dependence on a corrupt and doomed system.

Who was Hyman Minsky?

Yes, he was more than a man with an unfortunate name.

Hyman Minsky was an economist who warned decades ago about the dangers of excessive debt. Having earned a Ph.D. from Harvard, he taught economics at Washington University in St. Louis for over 25 years. Until the global financial crisis of 2007 to 2008, he was mostly ignored, and central bankers have rejected his conclusions.

Minsky argued that the primary cause of a financial crisis is the accumulation of private debt. He believed that asset booms and busts are inevitable in a debt-based economy, unless financial regulators step in to manipulate the system.

Three Different Types of Borrowers

His favourable view of central banks is his greatest flaw and technically classifies him as a Keynesian economist. Nonetheless, I believe he was on the right track and his labelling of three different types of borrowers is helpful in understanding how the accumulation of insolvent debt can bring down an entire financial system.

Since I work with property investors, I’ll apply his teachings to real estate.

1. Hedge Borrowers

Hedge borrowers are the most conservative and efficient of the three. They can fully cover all debt repayments, both principal and interest, from the current cash flows of their investments.

These are the real estate investors with principal plus interest loans on a positive or neutral cash flow property. The rental income generated by the asset pays the borrowing costs and also reduces the debt.

Rather than betting exclusively on future capital growth, these investors “hedge” against the risks of future serviceability and asset value depreciation by gradually reducing their debt exposure.

2. Speculative Borrowers

Speculative borrowers carry greater risk than hedge borrowers. The cash flow from their investments can only cover interest-only repayments. Their investments are not producing enough income to reduce the debt principal. Therefore, the borrower must sell the asset before the loan term expires or else roll-over the debt.

Speculative borrowers “speculate” primarily on capital growth, and secondarily on future borrowing ability. They are betting the asset will either be worth more at the time of sale, or they will be able to qualify for a loan to refinance the debt in the future.

3. Ponzi Borrowers

Ponzi borrowers take their name from the Italian con artist, Charles Ponzi. He became famous for devising a money-making scheme in the 1920’s by paying early investors using the investments of later investors.

Ponzi borrowers don’t have enough cash flow from their investments to make either interest or principal payments. They borrow under two primary assumptions:

Assumption 1: Income from other sources will be sufficient to make up for the cash flow shortfall of the investment.

Assumption 2: The appreciation in the value of the asset will be greater than the negative cash flow.

These are the real estate investors who are negatively geared. They carry the greatest risk and are the least efficient out of Minsky’s three different types of borrowers. Ponzi borrowers can only stay afloat through the perpetual appreciation of asset prices.

Who’s the Fool?

The “greater fool” theory states the price of an asset is determined, not by its intrinsic value, but by an assumption that another buyer will exist in the market in the future who is willing to pay an even higher price.

As long as the Ponzi borrower can find a “greater fool” who is willing to purchase the asset before the bust, the Ponzi borrower is saved. Then the new buyer becomes the next Ponzi borrower who perpetuates the folly, until they can no longer find anymore “greater fools.”

The inevitable fall of the Ponzi borrowers, once there are no more “greater fools” to be found, will eventually cause the entire financial system to collapse. When asset prices stop increasing, or worse, when the asset bubble bursts, the Ponzi borrowers begin defaulting. This then leads to a contagion that eventually takes out the speculative borrowers who can no longer roll over their debts. If the collapse is dramatic enough, the speculative borrowers will then take out the hedge borrowers.

How Should You Respond?

Minksy’s insights can offer the following pearls of wisdom for investors:

Hedge borrowers should maintain a healthy fear of debt.

If you’re a hedge borrower, don’t assume you’re safe just because you can pay your mortgage while reducing your principal. You still carry risks related to your asset’s performance, as well as the possibility of market contagion brought on by less efficient borrowers.

Reject the notion that there is good debt and bad debt. There is only bad debt and worse debt. Have a plan to pay off all debt as quickly as possible.

Speculative borrowers should seek to improve cash flow.

If you own an asset that is unable to produce enough income to cover borrowing costs while also reducing debt, you should either make the asset more efficient or sell it. If you are unable to improve the cash flow and choose to continue holding the property, do so with the full knowledge that you can only win if the asset’s value increases.

Eventually, you will need to sell to another speculative or even ponzi borrower who is a worse investor than you. Remember, a wave of defaulting Ponzi borrowers could someday take you out.

Ponzi borrowers should sell immediately, while there’s still a “greater fool.”

If you own assets that do not produce enough income to cover their own debt repayments, recognise that you’re a foolish Ponzi borrower. Without your salary or business income, and without perpetual capital growth in the value of your assets, your investing strategy is unsustainable.

Asset prices can’t increase forever. When central bankers finally lose control of the system or if interest rates rise, you, the Ponzi borrower, will be financially wiped out.

Have a plan to exit the debt-based, fiat monetary system as fast as you can.

Once the asset boom is over, and Ponzi borrowers begin defaulting, contagion will likely spread to the hyper-inflated bond market and the $600 trillion dollar derivatives market, wiping out highly-leveraged banks and debt-ridden governments. It will be complete and utter financial chaos.

Politicians will have little choice but to proceed with sovereign defaults, or else inflate their debt away by printing more and more worthless fiat currency.

In either scenario, you can expect many commodities, especially gold and silver, and likely cryptocurrencies, to be seen as safe-haven stores of wealth. If this scenario plays out, we can expect the values of these assets to increase significantly.

This is why I am long gold and one of the primary reasons I am investing my time in Steemit and looking for creative ways to power up. When the SHTF, I don’t want to be scrambling around, running for the exit behind a wave of other distressed sellers.

I first shared some of Minsky’s ideas in an article I wrote for PropertyInvesting.com.

@jasonstaggers