Hyman Minsky: Why Is The Economist Suddenly Popular?

Simon Wilson - Fri 13 Apr, 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?

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?

Minsky 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 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 that?

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.

By Simon Wilson in MoneyWeek magazine www.moneyweek.com.

Click here to sign up for a FREE trial: