Financial instability is nothing new. A great scholar into the dynamics of financial booms and busts was the late economist Hyman Minsky. (He died in 1996.) I remember Minsky striding through the annual meetings of the American Economics Association, piles of paper tucked under arm, enthusiastically expounding his ideas and theories to (mostly) small audiences. Minsky was well known, but it seemed that many mainstream economists treated him as something of an anachronism. His model of financial instability was too crude, he pessimism too ingrained, his ideas too informed by psychology, his obsession with disequilbrium and bad lending decisions discordant in an environment that emphasized equilibrium and market efficiency. But Minsky did have an appreciative audience on Wall Street, especially among economists with a global outlook and investment bankers that cut deals in all corners of the globe.
Minsky was a leading scholar into the relationship between the business cycle and the credit cycle. Good economic times fueled optimism among borrowers and lenders. Gradually, both borrowing and lending became increasingly speculative until it reached the "Ponzi" stage. At that point there was no chance of borrowers being able to repay their debts and lenders weren't going to get their money back. Charles Dickens aptly captured the Ponzi moment: Credit is a system whereby a person who cannot pay gets another person who cannot pay to guarantee that he can pay.
George Magnus, senior economic advisor at UBS Investment Research, describes the Minsky typology this way:
The essential characteristic of economic stability from Minskyâ€™s point of view is that debt becomes increasingly easy to validate. In other words, it encourages leverage and, sooner or later, new and more ambitious debt structures. Minsky called these financial structures hedge, speculative and Ponzi (so-called after Carlo Ponzi who created and was ruined by a pyramid finance scheme in Boston in 1920). The more the economy moves from hedge finance towards Ponzi finance, the greater the susceptibility to instability.
Hedge financial structures have debt that is typically a small proportion of liabilities and readily renewable because of the adequacy of cash flows in
relation to contractual payments.
Speculative structures (including perfectly sound firms and banks) may have cash flows that arenâ€™t large enough to meet payment commitments, even though the present value of expected cash receipts is greater than that of payment commitments. They may have to keep issuing new debt to finance maturing debt commitments.
Ponzi structures have to raise ever greater amounts of debt to finance all
commitments and may not be able to repay principal or even debt service
without so doing. The more inflationary an economy is, the greater the risk that rising interest rates will turn speculative structures into Ponzi structures, that these structures will â€˜evaporateâ€™ and that asset values will collapse with serious deflationary consequences and damaging implications for the economy.
So, are we at a Minsky Moment? It certainly seems so. But will the current credit squeeze will turn into a full-blown credit crunch? I don't think so. (And I believe that's the message of the stock market rally.)
One reason for sketicism is that corporate balance sheets are flush with cash. Anotjher factor is that the strength of the global economy. There appears to be ample liquidity sloshing around the global financial system. I also think the Fed is right to let the Darwinian process of the market hammer banks and Wall Street lenders.
That said, the risk of a credit crunch is real. e is very real. And if it gets much worse I wouldn't be surprised to see the Fed abandon its tough stance and cut its benchmark interest rate. I bet that's what Minsky would be calling for right now.