Wednesday, March 19, 2008

Minsky analysis of bubbles

The late Hyman P Minsky believed that Wall Street encourages businesses and individuals to take too much risk, generating ruinous boom-and-bust cycles. His "financial instability hypothesis", first developed in the sixties, was condemned as not worthy of serious consideration. John Cassidy has analysed the sub-prime mortgage crisis in terms of this hypothesis.

The Minsky’s model of the credit cycle has basically five stages - displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. Cassidy writes, "The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks."

As a boom leads to euphoria, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. If it was junk bonds in the eighties, it was securitization of mortgages that got created now. At the peak of the market, in mid-2006, the smart traders and hedge fund managers cashed out and booked their profits. The panic bugle was first sounded in in July, 2007 as two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed.

Update 1
The Economist has this article on Minsky bubbles. It writes, "Government action is inevitable. In conventional industries, the demise of companies leads to “creative destruction” with capital being reallocated to more productive areas. But in banking and finance, a crisis leads to “deflationary destruction” as capital is eliminated. Businesses, investors and consumers lose confidence; borrowers are unable to repay their lenders, who suffer as well. But by stepping in to rescue markets when they wobble, central bankers create asymmetric risk."

Update 2
See also this excellent summary of Minsky's teachings by Rajiv Sethi.

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