Our favourite economist is back under discussion. As chaos hit in August 2007, economists, analysts and the media looked to the ideas of Hyman Minsky to help make sense of the seizures in credit markets. Minsky argued that a capitalist economy becomes ever more fragile over a period of prosperity, as stability encourages leverage, new ambitious debt structures (known as Ponzi financing) and eventually breeds financial and economic instability.
It all made so much sense. There was even something of a written tussle over who was first to apply Minsky’s concepts to the credit crunch of 2007.
But now it seems that we may not have had our Minsky moment after all: RGE Monitor points to a paper by Jan Kregel, a senior scholar at the Levy Institute where Minsky himself worked. It serves as an admirably clear recap of the past six months.
Kregel argues that despite the focus on Ponzi finance in recent commentary, Minsky’s most important contribution to the analysis of repeated financial crises was the idea of endogenous, or inevitable instability - or the concept of a lifecycle whereby stability gives way to fragility, through a declining “cushion” of safety in financial transactions and increased leverage. The current crisis though differs from a traditional Minsky crisis, says Kregel.
While the subprime mortgage debacle involved both Ponzi financing and declining margins of safety, the conditions were not produced by the kind of endogenous process described by Minsky, where as the universe of borrowing experiences become more positive a more confident and optimistic outlook become the rational reaction. No need for euphoria here.
The evolution of banking after the Glass-Steagall Act of 1933 created what is now known as the “originate and distribute” model. The ensuing deterioration in the cushions of safety did not arise from evaluation of credit risk in a period of stability; the bankers lost interest in credit risk all together.
The structures of the 2007 unwind are certainly Ponzi. But, says Kregel:
Since an investment-grade rating was crucial to the success of these instruments, financial institutions consulted with the rating agencies on the appropriate composition of the corpus collateral of the instrument, as well as on the structure of the liabilities. Thus, it was again the rating agencies that determined the appropriate margin of safety,which was determined by the agencies’ assessment of the statistical probability of the prepayment rate and the default rate of the underlying subprime mortgages.
We are left then with the economy caught “between the Scylla of falling consumer spending and the Charybdis of increasingly restrictive credit conditions”, with a bunch of assets that show every sign of being impossible to price efficiently, and an impotent Federal Reserve: “The discount window cannot provide funds to rebuild bank capital.”
From this perspective, the current crisis has little to do with the mortgage market (or subprime mortgages per se), but rather with the basic structure of a financial system that overestimates creditworthiness and underprices risk.
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