Have we reached a Minsky moment?
Simon Wilson Apr 05, 2007
If economist Hyman Minsky is right, then our economy is like a giant Ponzi scheme, and the rush for the exits is due to start. Is he right? Simon Wilson reports.
Why is Minsky suddenly popular?
Minky was a moderately well-known US economist who died in 1996 at the age of 77. He was well regarded within academia, but it wasn’t until after his death that he became a cult hero among more bearish commentators after his model of a credit-driven asset-bubble, proposed back in the 1970s, was almost uncannily played out shortly after he died. Minky’s postulated stages of how a bubble develops and ends (see below) described almost exactly the rise and demise of the tech bubble. And now the US subprime mortgage meltdown is following a similar pattern.
What were his economic ideas?
Minsky is most famous for the idea that ‘stability is unstable’. In short, unusually long periods of economic stability lull investors into taking on more risk. This leads them to borrow excessively and to overpay for assets. Minsky suggested three main types of borrower, increasingly risky in nature. Hedged borrowers can meet all debt payments from their cash flows. Speculative borrowers can meet their interest payments, but have to keep ‘rolling’ the debt over to pay back the original loan. Ponzi borrowers (named after the notorious American pyramid-scheme conman) can repay neither the interest or the original debt, and rely entirely on rising asset prices to allow them continually to refinance their debt. The longer a period of economic stability lasts, his argument goes, the more society moves towards being full of Ponzi borrowers, until the entire economy is a house of cards, built on excessively easy credit and speculation.
Is this an orthodox view?
No. Mainstream economics generally views capitalism as essentially stable – tending towards steady growth. Crises arise either from preventable mistakes by policy makers (eg, the Federal Reserve’s too-tight monetary policy, widely supposed to have exacerbated the Great Depression), or by external shocks, such as Opec’s oil price hike in the early 1970s. Minsky, by contrast, argues that capitalism is prone to crises from within; even good times are destined to end as people start to get cocky about risk and borrow too much.
Why is he so relevant now?
Minsky’s Ponzi borrowers are all too familiar from the US subprime debacle. But Minsky went further, describing the process whereby financial institutions, which also take more risks when stability reigns, devise ways of getting round regulations and norms once seen as prudent. Again, we can see this in US senators and regulators’ current concerns about lax mortgage lending – but it also applies more broadly. Joseph Schumpeter (under whom Minsky studied) is famous for the idea that capitalism renews itself through competition and innovation – ‘creative destruction’ that chucks out the bad and ushers in the good. But while Schumpeter focused on technology’s role in driving capitalism, Minsky’s focus is on banking and finance. In a 1993 essay, Schumpeter and Finance, he wrote: “Nowhere is evolution, change and Schumpeterian entrepreneurship more evident than in banking and finance and nowhere is the drive for profits more clearly a factor in making for change.” It’s this focus on financial innovation as a destabilising influence that is now ringing alarm bells on Wall Street and in the City.
Why should we worry about instability?
Because much of the financial world shows signs of the same kind of “this-time-it’s-different” mentality, as Edward Chancellor says in Institutional Investor. The success of the authorities in avoiding a deflationary bust in 2002 through easy-money policies encouraged people to take on huge debts, while competition among big lenders has loosened lending standards (making the present private-equity boom possible, for example). The rise of credit derivatives means loans are increasingly parcelled up in innovative ways, insured, reinsured, and sold on – using a web of transactions to bypass regulations intended to protect the credit system, as Minsky predicted. The question now, as UBS economist George Magnus put it, is “have we reached a Minsky moment”?
What’s a Minsky moment?
The Minsky moment comes when “lenders become increasingly cautious or restrictive and when it isn’t only over-leveraged structures that encounter financing difficulties”, says Magnus. Then, Minsky’s credit cycle, extended beyond apparent breaking point as long as there are profits to make and bonuses to collect, tips towards bust. As Chancellor concludes, “investors who accept this analysis will probably conclude that risk and reward are currently out of whack. They will position their portfolios defensively, keeping cash on hand to spend when the rewards for risk appear more compelling.”
How does Minky’s bubble model work?
Minsky said that a bubble begins with a ‘displacement’, such as a significant invention – the internet, for example. This creates profitable opportunities in the sector affected, but alone it’s not enough – financial innovation is needed to give people access to the cheap credit required to kick-off the next phase: overtrading. People pile into the sector, driving demand and prices higher. A euphoria phase ensues as ‘Ponzi’ investors speculate, often with borrowed money, on the basis that a ‘greater fool’ will buy their assets at an even higher price. But eventually, whether down to insiders selling out, or lenders tightening lending criteria, the market hits a peak, panic sets in, there’s a stampede out of the market, and bankruptcies ensue.
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