Friday, April 24, 2009

The Minsky Mash

TW: We have all probably learned more about economics recently than we would have preferred. The Great Contraction has pushed previously unknown to the masses economist Hyman Minsky to the forefront to occupy stature commensurate with Keynes and Friedman. At the risk of over simplification Minsky's work focused on the tendency of free markets towards bubbliciousness.

Many pro-cyclical factors combine to push free markets to extremes rather than moderation. Folks see higher real estate prices and jump in with not one but both feet, over-borrowing and over-lending. Folks see higher stock prices and do likewise and again not merely the ill-informed or over-greedy individual but their professional financial counterparts. Brash aggressiveness becomes the rule not calm risk assessment.


When pro-cyclical forces combine we get a steady virtuous, albeit hollow, circle upward, when the merry-go-round stops the circle of doom ensues rapidly. The potential answer counter-cyclical policies, but as an earlier post mentioned counter-cyclical policies are easier said than done. The piece below mentions the challenge of working against "Wall Street interests", but Wall Street indirectly (and with excessive hubris yada yada) represents main street's interest as well. Interest rate increases and other credit contraction mechanisms are the party stoppers few support especially in front of an election. Yet, this is the 2nd really profound bubble within a decade something is amiss, something must change.

From Economist:
"STABLE economies sow the seeds of their own destruction. That sounds like Karl Marx but it is the basic insight of Hyman Minsky, an economist of the mid-20th century whose reputation is being revived. Minsky argued that the financial system played a big role in exaggerating the economic cycle, one that was understated by conventional theory.

Investors, banks, companies and consumers all tend to be guilty of the sin of extrapolation; they assume the future will be like the recent past. After several years of steadily growing output and low inflation, people develop a misguided confidence that such benign conditions will continue. They are thus happy to borrow, and lend, more. As they do, the riskiness of the system steadily increases.

Minsky divided the process into three phases. In the first, investors take on little enough debt that they have no trouble meeting their capital and interest payments. In the second, they stretch their finances so they can only afford the interest. In the third, or Ponzi, phase they take on debt levels that require rising prices to be safely financed; the homebuyers who took on 125% mortgages at the peak of the property boom were a classic example.

When markets reach this fantasy land, a small change in the fundamentals or in investor attitudes can be enough to cause the system to unravel. Once prices start to drop, borrowers start to default on their loans, or seek to sell their assets, causing prices to fall further.

The cost of capitalism, to use the title of a new book* that draws heavily on Minsky’s work, is first, that financial bubbles are created and second, that governments are forced to rescue the sector when those bubbles pop. Those who believe blindly in free markets are thus mistaken, in the view of Bob Barbera, a Wall Street economist and the book’s author.

Government action is inevitable. In conventional industries, the demise of companies leads to “creative destruction” with capital being reallocated to more productive areas. But in banking and finance, a crisis leads to “deflationary destruction” as capital is eliminated. Businesses, investors and consumers lose confidence; borrowers are unable to repay their lenders, who suffer as well.

But by stepping in to rescue markets when they wobble, central bankers create asymmetric risk. Hence Mr Barbera rejects the idea, popular in the era of Alan Greenspan, that central banks should do nothing to burst asset bubbles.

Instead, he suggests that central banks should build the level of corporate-bond spreads into their models. When spreads are low, risk appetites are high, as they were in 2005-06. That should lead central banks to tighten monetary policy. When spreads are high, they should ease.

Whether that would have stopped the housing bubble is open to question. The Federal Reserve did indeed raise rates in 2005-06, albeit in a steady and unthreatening manner. Nevertheless, the current crisis suggests that monetary and fiscal policy cannot be driven exclusively by economic fundamentals such as inflation and unemployment. When interest rates are low, consumers and businesses do not just borrow money; they borrow money to buy assets, setting up a feedback loop that can eventually lead to a bubble. When such a bubble is inflating, government revenues (in the form of taxes on capital gains, bonuses, corporate profits and property sales) tend to be strong. As governments are now discovering, such revenues collapse very quickly when the bubble bursts.

But it is easy to get carried away during a boom; the strength of financial markets tends to be seen as a signal that the economy is soundly based. Those who work in the financial system are assumed to be the best and the brightest. Even the government seems to be in their thrall.

In a recent article, Simon Johnson, a former chief economist of the IMF, points out the parallels between emerging markets, where governments are dominated by the economic elite, and America, where officials glide easily between Wall Street and the Treasury. What is good for Goldman Sachs might turn out to be good for America, but it might be best if the government could make an independent judgment. If we accept Minsky’s idea that financial markets are not always right, then we might be willing occasionally to act against Wall Street’s interests, however loudly bankers would complain."
http://www.economist.com/finance/displaystory.cfm?story_id=13415233

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