Hyman Minsky, a little-known economist, who for many years taught at the Washington University in St Louis, has suddenly become very famous, a little over thirteen years after his death.
The Wall Street Journal ran a piece on him on August 18, 2007, soon after the current financial crisis started, which said “The recent market turmoil is rocking investors around the globe. But it is raising the stock of one person: a little-known economist whose views have suddenly become very popular.”
What Minsky basically said was that “stability is destabilising”. As John Cassidy, writes in How Markets Fail–The Logic of Economic Calamities, “Minsky advanced the view that free-market capitalism is inherently unstable, and that the primary source of this instability is the irresponsible actions of bankers, traders, and other financial types. Should the government fail to regulate the financial sector, effectively, Minsky warned that it would be subject to periodic blowups, some of which could plunge the entire economy into lengthy recessions.” Cassidy has covered economics and finance at The New Yorker magazine since 1995.
And how do we reach a stage wherein the financial system simply blows up? It essentially starts when the times are good. “During the times of prosperity, banks’ appetite for risk-taking increases at the same time as businesses and entrepreneurs are seeking more money to finance expansion plans…with the borrowed money increasingly easy to come by, investment spending rises, and so do stock prices and corporate profits. This reinforces businesses’ demand for credit and the willingness of bankers and other lenders to supply it.”
As Minsky himself wrote and Cassidy points out “any period of economic stability “leads to an expansion of debt-financing — weak at first because of the memories of preceding financial difficulties.”
The first stage of this debt-financing Minsky referred to as “hedge finance.” The word hedge used here is not to be confused with hedge funds as the word hedge, back when Minsky coined the term, meant “to take precautions.”So what is hedge finance essentially?“In the early stage of the cycle, banks will lend only to businesses that are generating enough cash to meet regular interest payments and repay the principal on an amortised basis.”
But as the boom proceeds, banks move to speculative finance. As Cassidy writes “competition between lenders increases and their innate sense of caution gets diminished. Many of them make loans to borrowers who can meet only the interest payments: repaying the principals would be much beyond them. Loans of this nature have to be rolled over at regular intervals.”
After this stage, banks start giving loans even to people who are not in a position to even pay interest on their loans. “Eventually, banks start extending credit to people and firms that can’t even afford to make regular interest payments.” This stage Minsky called Ponzi finance as “repayment depends on the borrower somehow getting access to a new source of income.”
And this is exactly how it played out before the financial crisis hit. “The biggest rise in borrowing came in the financial sector. As interest rates tumbled, banks, investment banks, mortgage finance companies, real estate investment trusts, private equity companies, hedge funds, and financial companies of other types leveraged up their balance sheets in a manner that would have stunned even Minsky. In four years, the sector’s indebtedness jumped by $4.2 trillion,” writes Cassidy.
Also, with so much money being raised, the quality of lending fell and banks and mortgage finance companies started giving sub-prime home loans to borrowers who had a very bad credit record.
As Cassidy writes “At the fastest-growing mortgage lending companies…the internal culture was more akin to a Wall Street boiler room than a traditional bank. Account executives had to meet demand volume targets for loan originations. As the end of the month approached, they worked the phones frantically to meet them, paying little regard to the ability of borrowers to meet the commitments they were taking on…In 2001, the average value of a sub-prime mortgage was $151,000; four years later, it was $259,000.”
But the merry-go-round cannot go on forever. “No credit boom lasts forever…struggling to meet their financial commitments, some shaky borrowers are forced to sell off whatever assets they can liquidate.
“This,” Minsky noted dryly, “is likely to lead to a collapse of asset values,” which, in turn, can lead to “a spiral of declining investment, declining profits, and declining asset prices.” Unless the financial authorities intervene, lending public money freely to whoever needs it, the ultimate result could well be “a traumatic debt deflation and a deep depression.”
And that’s exactly how things worked out. The sub-prime borrowers were not in a position to repay the loan. All they were interested in is selling off the house, once the price goes up and cashing out. But one day, house prices stopped going up, and then there was a problem.
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