Monday, February 09, 2009

Minsky Meltdown?

While I have been on sabbatical preparing webcasts to supplement the text book treatments of core macro issues (growth, business cycles, inflation, deficits) it is apparent that the severity of the current economic crisis has taken many macroeconomists and policy makers by surprise. One economist who would not be surprised by the current debt crisis is the late great Hyman Minsky who is finally getting some of the respect that he deserved in his lifetime. In the mid-1960’s when prominent American economists were debating whether "fine tuning" made business cycles a subject only for the economic history books, Minsky developed his unique financial theory of the cycle. Minsky argued that the economic conditions that converge to create a deep depression are generated and tend to accumulate over a series of more mild cycles. During the upswing phase of a long wave when only milder contractions take place, Minsky argued that "systematic changes in the financial structure occur.

According to Minsky interrelated systematic changes in the financial system that occur over a long wave expansion are of several types. First, the ratio of debt to income tends to rise progressively for all economic agents. People increasingly finance their spending by borrowing and debt-service payments rise relative to incomes. The financial changes that build up during the expansion and allow a growing debt-income ratio eventually constrain the economic sectors that are leading the continued expansion making them much more vulnerable to any shortfall in income.

Secondly, stock market prices and real estate assets tend to rise quickly as the upswing of the long wave matures. (Sound familiar?) As the long wave progresses the market value of these assets are bid up not only on the basis of their past performance, but also on the basis of expectations of future growth. If these inflated asset prices are reincorporated in the financial system as security for debts, as in the case of the low margin stock market during the decade preceding the Great Crash of the 1930’s, the financial system becomes highly vulnerable to any decline in asset prices.

Third, over time there is a decrease in the size of ultimate liquidity relative to other financial assets which makes the financial system less stable and more prone to losses. An economy's stock of ultimate liquidity consists of those assets whose nominal value is essentially fixed and which are not the liabilities of any private unit within the economy. Because these assets have no risk of default they are readily available to meet various payment commitments.

Minsky suggested that these systemic changes will impair the overall stability of the economic system and will lead eventually lead to a deep depression. Although Minsky passed away in 1996 the systemic changes that he described in his writings seemed to have converged to create a “Minsky moment” which is not melting away quickly even with the unprecedented use of monetary and fiscal policy.

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