Our past experience shows that when things start to go wrong in financial markets, they can go terribly wrong. Any day, any hour can turn into what is called a “Minsky moment”—a time when the sky starts falling. But a Minsky moment does not mean the end of the world. There is always hope. Such moments have come and gone many times in the past, leaving behind the memories, good, bad and ugly. When the dust finally settles and the skies clear, the financial market starts chasing new clouds.
Johnny: Minsky moment? Is it a new code name for another doomsday conspiracy?
Jinny: I don’t blame you for not being aware about the term. Hyman Minsky, the economist after whose name the term has been coined, is after all not a household name. But sometimes when the circular wind of confusion is blowing around, the thoughts of even obscure economists can sell like hot cakes. The subprime crisis and the accompanying meltdown in the financial market was just one such occasion when commentators wearing different hats started remembering what Minsky had said about the self-destructing nature of speculation fed by borrowed money.
Johnny: You have aroused my curiosity. Tell me what Hyman Minsky had to say about speculation.
Jinny: Minsky, an economist with a contrarian bent of mind, believed that all booms must end in bust. In fact, he believed that the larger the boom, the more severe the bust. But Minsky always wondered why it was like that. Why can’t we have an everlasting boom stretching forever in one direction much like traffic on a one-way street? Why, instead, should our economy continue to move between the two extremes of booms and busts? Minsky put the onus of all this trouble on speculative investments. When the economic tides are on the upswing, the vice of speculation slowly blocks all rational thinking in the market. A speculative investor buys an asset just to quickly sell it to another investor at a higher price. This leads to an upward spiral of prices not justified by economic fundamentals. Things reach fever pitch when speculative investors start pouring the fuel of borrowed money onto the fire of the investment boom. But sooner or later all speculative investments must reach a Minsky moment—a point when the cash generated by assets is not sufficient to take care of the repayment, and the spiralling debt starts swallowing all speculators one by one. Over-indebted borrowers are forced to liquidate even their good assets to make good on their loans. At this point, a major sell-off in the market leads to not only a sudden collapse in the prices of assets of all kinds but also to a severe loss of market liquidity.
Illustration: Jayachandran / Mint
Johnny: Sudden collapse of the whole market—this is what seems to have happened during the subprime crisis.
Jinny: Yes. The subprime crisis in the US is a good example of how a Minsky moment arrives on the scene. Things unfolded just as Minsky had predicted—low interest rates, rising asset prices, spiralling debt, appetite for taking on more risk, and then at last, the flutter of wings starting a storm.
The Minsky model of credit cycle talks about five stages of credit cycle—displacement, boom, euphoria, profit taking and panic.
Investors go through displacement when something new catches their fancy, which could be anything—a new technology, a new financial instrument like junk bonds and collateralised debt obligations or even a new look of money. Displacement lulls investors into believing that they are seeing a totally new world where trees are always laden with fruits. You just need to stretch up a little to get your hands full. The stage is set for boom, euphoria and profit taking. As boom turns into euphoria with ever higher profits, everybody wants to join in, unmindful of lurking risks. But when all the fruits are gone, euphoria turns into panic and panic turns into downfalls. It was after all the same old world where what goes up has to necessarily come down.
Johnny: Minsky’s words sound like a perfect diagnosis of an imperfect word.
Jinny: It may be so. What Minsky had said in his “financial-instability hypotheses” during the 1960s and 1970s sounds closer to the real world now after we have seen many financial booms and busts. It seems obvious that all bubbles follow a similar pattern.
But during the 1960s when many cheered the market mechanism as the most efficient machine ever discovered, Minsky’s talk of boom-bust cycles was dismissed as just an imagination of a crank pessimist.
Today, we realize that there is a need to keep our ears much closer to the ground. Minsky believed “economies evolve and so too must economic policy”. It’s only then we can break the old pattern of making new mistakes.
Johnny: That’s true, Jinny. We may at last succeed in building a new castle over the ruins of the old one.
What: The term “Minsky moment” has been coined after Hyman Minsky, an economist who believed that speculation fed by debt always leads to self-destruction.
Who: The term was coined by another economist, Paul McCulley, in 1988 to describe the Russian financial crisis.
Why: The term became more popular after the subprime crisis due to the resemblance of the cause with Minsky’s ideas.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com