Saturday, July 18, 2009

The Minsky moment

The Economist (17 July) asks what went wrong and how the crisis is changing economic thinking. It writes: 'Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world'.

The current crisis has revived the debate among rival economic theories. Monetarism is dead and keynesianism is back. An economist, H.Minsky* has gained influence over a decade or so; although educated at Chicago , Minsky was nonetheless an enemy of the "Chicago School" of economists, who typically believe in the efficiency of markets. Building on Keynes' General Theory, Minsky argued that crises were integral to financial markets.

Minsky claimed that in prosperous times, when corporate cashflow rises beyond what is needed to pay off debt, a speculative bubble develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

In other words, the longer economic stability lasts, the more risks borrowers will take. His model of the credit system shows that the cause of instability is the accumulation of debt. He distinguishes three types of borrowers (hedge borrowers, speculative borrowers and Ponzi borrowers). While some debtors are perfectly sound, others can only pay off their interest by renewing their loans. The third group of borrowers (that he calls Ponzi) sounds dangerously familiar: they borrow based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments.

The 'Minsky moment' - a term coined by an American economist, Paul McCulley** is the point in a credit or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden collapse in asset prices and a sharp drop in financial liquidity.

Minsky's financial instability hypothesis has received revived attention during the 2008 subprime crisis due to the debt accumulation problem. McCulley illustrated the three types of borrowing categories using an analogy from the mortgage market: a hedge borrower would have a traditional mortgage loan and is paying back both the principal and interest; the speculative borrower would have an interest-only loan, meaning they are paying back only the interest and must refinance later to pay back the principal; and the Ponzi borrower would have a negative amortization loan, meaning the payments do not cover the interest amount and the principal is actually increasing. Lenders only provided funds to Ponzi borrowers due to a belief that housing values would continue to increase.

McCulley writes that the forward progression through Minsky's borrowing stages was evident as the credit and housing bubbles built through approximately August 2007. Demand for housing was both a cause and effect of the rapidly-expanding shadow banking system, which helped fund the shift to more lending of the speculative and Ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher housing prices. Since the bubble burst, we are seeing the progression in reverse, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages model shifts back towards the hedge borrower.

As Henry Kaufman, a Wall street economist and banker writes in the foreword of Minsky's book: 'now it is time to take seriously the insights of Hyman Minsky and build upon his groundbreaking work in order to find ways of putting our financial system on a more solid footing'. This sounds as a serious warning, but this means putting an end to the greed and cupidity of bankers. We badly need ethical rules and regulation to bring radical changes in the financial system.

* Hyman P. Minsky, Stabilizing an Unstable Economy, 2nd edition, Foreword by Henry Kaufman- McGraw Hill 2008

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