February 2007 Article: Ponzi Nation - By Edward Chancellor
I found this article on Simoleon Sense.
Low volatility and easy credit are boosting asset prices. But according to the late theorist Hyman Minsky, today's stability may be sowing the seeds of its own demise.
Credit has grown rapidly in recent years. This expansion has come in many forms, from home mortgages to newfangled structured products created by clever financial engineers. There are, broadly speaking, two views about these developments. The conventional wisdom -- held by most economists and denizens of Wall Street -- is optimistic. Higher rates of credit growth and increasing levels of leverage, they maintain, are reasonable in light of increasing economic stability.
An opposing view -- held by a miscellaneous bunch, including some notable investors and Wall Street observers -- holds that the massive buildup of debt augurs ill. Drawing on the work of a little-known, deceased economist named Hyman Minsky, the pessimists contend that the recent calm has induced people to take on too much risk. "Stability is unstable," this group says, quoting Minsky. Like the differences of opinion toward the end of the last decade concerning the existence or not of a stock market bubble, the current argument will be settled only by the unfolding of events. Either the prosperity will continue in the years to come, or a financial crisis will occur.
But not everyone can afford to await the passage of time. Professional investors are paid to anticipate. Adherents to the conventional view will construct radically different portfolios from those who accept the instability hypothesis. Many investors, however, are undecided. They believe, or perhaps just hope, that prosperity will endure while at the same time they may feel uneasy about the growth of credit and other risk-taking behavior evident in today's markets. The purpose of this essay is to introduce Minsky's unorthodox ideas and relate them to recent developments in the financial world. Readers should then be better able to judge for themselves where they stand.
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Orthodox economics teaches that capitalism is essentially stable and that it tends toward equilibrium. Crises are either the result of preventable policy errors -- such as when a central bank pursues an overly restrictive monetary policy (an accusation commonly leveled against the Federal Reserve for its actions at the onset of the Great Depression) -- or they result from uncontrollable external shocks, such as the OPEC oil price hike in the early 1970s. Economists refer to such shocks as "exogenous." Minsky's view is radically different. He suggests that the crisis builds up inexorably from within, as people continually accumulate fixed liabilities in a world where future cash flows are uncertain. His crisis is "endogenous."
Minsky's cycle goes something like this: During a period of stability, financial relations become increasingly precarious. Ponzi finance is common. Banks and other financial institutions find novel ways to evade prudential regulations. Long-term assets are financed with short-term liabilities. Under such circumstances, it doesn't take much to trigger a crisis. As debt increases, the maximum rate of interest that an economy can sustain diminishes. The system becomes vulnerable to even a small rise in interest rates. Alternatively, an unexpected drop in profits or the failure of a financial institution may be all that it takes to generate a crisis.
Following the teaching of celebrated American economist Irving Fisher, Minsky held that the crisis has a deflationary impact as people seek to pay off debts. His prescription was conventional: More government spending and lower interest rates from the central bank could prevent debt deflation. His view on the consequences of these actions was less conventional. Minsky contended that successful interventions during crises discouraged financial conservatism. "If the boom is unwound with little trouble," he wrote in >Can "It" Happen Again?, "it becomes quite easy for the economy to enter a 'new era.'" People respond to the fact that the authorities are protecting them from financial catastrophe by plunging anew into risky activities. The successful resolution of a crisis creates a moral hazard.
Minsky's notion that stability induces people to take on more risk is supported by recent work in safety studies. John Adams, a British safety expert and author of >Risk (Routledge, 1995), asserts that we all come equipped with a "risk thermostat" that seeks to maintain the same level of risk. "People modify both their levels of vigilance and their exposure to danger in response to their subjective perceptions of risk," he writes.
People balance risk with reward. Incremental improvements in safety are likely to be accompanied by more risk-taking activity. When motorcyclists don helmets, they open up the throttle a little further. Contrary to common belief, the introduction of seat belt laws didn't produce a decline in accident levels. Risk was transferred rather than diminished. Faster cars ended up killing more pedestrians and cyclists. Safety interventions that don't affect the settings of our risk thermostat are likely to be frustrated by our behavioral responses.
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Related books:
Devil Take the Hindmost: A History of Financial Speculation
Stabilizing an Unstable Economy
Can "It" Happen Again?
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