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INEFFICIENT MARKETS - Stabilizing an Unstable Economy: What Would Minsky Do?

Can policymakers prevent a cycle of deleveraging from producing debt deflation and depression?

A year or so ago, the work of the late economist Hyman Minsky was known to only a small band of devoted followers. All that has changed since the onset of the current financial crisis. Today, Minsky’s financial instability hypothesis — the notion that economic stability encourages behavior on Wall Street and beyond that renders the financial system increasingly fragile — is attracting far more attention. Yet Minsky was interested not only in the buildup to a crisis but also in how depressions could be avoided and what measures were necessary to prevent future crises from occurring.

Most economists believe that the economy tends to be self-equilibrating and that crises occur only because of outside (or “exogenous” in econospeak) shocks to the system. In his book Stabilizing an Unstable Economy (1986), Minsky, however, argued that Wall Street and other financial players “generate destabilizing forces, and from time to time the financial processes of our economy lead to threats to financial and economic stability, that is, the behavior of the economy becomes incoherent.” The dramatic upheavals in the financial system over the past year can be seen as a vindication of Minsky’s assertion that “stability is destabilizing.”

In Stabilizing an Unstable Economy, Minsky pointed out that during periods of tranquility, banks innovate to escape regulatory shackles. At the same time, they boost profits by increasingly mismatching their assets and liabilities, borrowing short at cheap rates and lending for longer periods. This exposes them to danger should lenders suddenly become reluctant to roll over loans. Minsky noted that bankers, who are rewarded with stock options, will seek to grow assets rapidly and leverage their asset bases to enhance their company’s share price. In good times banks are prepared to lend more readily, even to those who are unable to repay their loans except by asset sales (what Minsky called “Ponzi finance”). One result of increasing financial laxity, according to Minsky, was rising corporate profits and asset prices.

A point is reached, however, in this virtuous cycle, when stability gives way to increasing instability. The financial disasters of the past year fit well with Minsky’s theory. Structured investment vehicles, or SIVs, are a good example. These were intended to keep bank loans off-balance-sheet (regulatory arbitrage), they displayed an extreme mismatch of assets and liabilities (mortgages were financed by loans rolled over in the asset-backed commercial paper market), and they were used to finance Ponzi borrowers (subprime mortgages). The biggest banking casualties to date have been those institutions that grew most rapidly during the preceding era of stability and were most exposed to a change in sentiment among lenders.

At the moment, banks in both Europe and the U.S. are tightening lending standards, reducing their leverage and bolstering their capital resources. Minsky believed that this vicious cycle of deleveraging, if left to its own devices, would produce a severe debt deflation and depression, such as occurred in the early 1930s. Fortunately, tools to prevent such a disaster from happening have been discovered. Large government deficits serve to bolster incomes and profits, thus “validating” unwieldy debt structures. The Federal Reserve Board is also ready to act as lender of last resort to the banking system. Both these processes are now under way.

But just because such intervention worked in the past, doesn’t guarantee current success. As Minsky observed, financial institutions change over time, so every crisis is different. “History is just history,” writes Minsky, “although the range of what can happen is limited by basic economic relations.” Take, for instance, the recently announced fiscal boost to the U.S. economy. Washington has announced plans for a $150 billion handout. That amounts to about 1 percent of U.S. GDP. But American households have been running a far larger deficit of their own. If consumers were to respond to falling home prices and tighter credit by deciding to save rather than borrow still more, then the planned fiscal measures could turn out to be insufficient.

Then there’s the question of the Fed’s role in stabilizing the banking system. So far, the Fed has taken a number of measures to help banks, in particular expanding the range of acceptable collateral against which it is prepared to lend. The trouble is that banks are not at the center of this crisis, which broke out in the securitized credit markets. According to Independent Strategy, a London-based research outfit, central bank reserves account for only 1 percent of global liquidity, while the securitized debt markets and derivatives markets are, respectively, 13 times and 75 times larger.

It’s also not clear yet how great the losses from the current mortgage mess will be. In a recent paper, Jan Kregel, a senior scholar at the Levy Economics Institute of Bard College, estimates that if U.S. home prices were to fall by some 30 percent, $900 billion in mortgage losses would be possible. On top of that, there are further potential defaults from lax lending to commercial real estate and private equity borrowers. In addition, counterparty losses are appearing now that bond insurers and some sellers of credit default swaps find themselves unable to make good on their obligations. Despite its seemingly magical ability to create money out of nothing, the Fed may find itself overwhelmed before this credit storm blows over.

Even if we are optimistic about the authorities’ ability to contain the crisis, there could still be a price to pay. Minsky argued that in order to prevent debt deflation, it is necessary to enhance cash flows and profits in the economy. “Stagflation,” he wrote, “is the price we pay for the success we have in avoiding a great or serious depression.” Yet recent experience does not support this claim — after all, the recessions of 1982, 1990 and 2001 were not followed by sharply rising inflation. Minsky’s answer would be that the U.S. current-account deficit, which has ballooned over the past 25 years, acted to counter inflationary pressures. According to this theory, the future path of U.S. inflation will depend on whether the U.S. trade imbalances increase or shrink. Kregel, however, is skeptical of this aspect of Minsky’s analysis, which he thinks was overly influenced by personal experience of the inflationary 1970s.

Finally, Minsky had several thoughts on how to prevent crises from breaking out. First, it is necessary for the authorities to accept his central idea that “stability is destabilizing.” Once they do so, it becomes clear that Fed policy “needs to continuously ‘lean against’ the use of speculative and Ponzi finance.” Regulators must restrain the extreme mismatching of deposits and liabilities that occurs in good times. In short, some type of qualitative credit control is necessary to prevent another generation of subprime, negative amortization mortgages and “covenant-lite” leveraged loans from appearing. Minsky also recommended abolishing corporate taxation because the deductibility of interest payments encouraged firms to take on too much debt.

Still, he didn’t have much confidence that his suggested reforms would achieve lasting success even if they were implemented: “There is no possibility that we can ever set things right once again and for all; instability put to rest by one set of reforms will, after time, emerge in a new guise.” Even the wisest legislator cannot prevent Wall Street from booming and busting.

Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.