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Home , Hyman Minsky, Paul McCulley

Minsky’s moment July 30, 2016 – The

From the start of his academic career in the stockmarket bust or crash, but modern 1950s until 1996, when he died, had, it seemed, vanquished their laboured in relative obscurity. His research worst demons. about financial crises and their causes attracted Against those certitudes, Minsky, an owlish man a few devoted admirers but little mainstream with a shock of grey hair, developed his attention: this newspaper cited him only once “financial-instability hypothesis”. It is an while he was alive, and it was but a brief examination of how long stretches of prosperity mention. So it remained until 2007, when the sow the seeds of the next crisis, an important subprime-mortgage crisis erupted in America. lens for understanding the tumult of the past Suddenly, it seemed that everyone was turning decade. But the history of the hypothesis itself is to his writings as they tried to make sense of the just as important. Its trajectory from the margins mayhem. Brokers wrote notes to clients about of academia to a subject of mainstream debate the “” engulfing financial shows how the study of is adapting markets. Central bankers referred to his theories to a much-changed reality since the global in their speeches. And he became a posthumous . media star, with just about every major outlet giving column space and airtime to his ideas. Minsky started with an explanation of The Economist has mentioned him in at least 30 . It is, in essence, an exchange of articles since 2007. today for money tomorrow. A firm pays now for the construction of a factory; profits If Minsky remained far from the limelight from running the facility will, all going well, throughout his life, it is at least in part because translate into money for it in coming years. Put his approach shunned academic conventions. He crudely, money today can come from one of two started his university education in mathematics sources: the firm’s own cash or that of others but made little use of calculations when he (for example, if the firm borrows from a ). shifted to economics, despite the discipline’s The balance between the two is the key question growing emphasis on quantitative methods. for the financial system. Instead, he pieced his views together in his essays, lectures and books, including one about Minsky distinguished between three kinds of , the economist who most financing. The first, which he called “ influenced his thinking. He also gained hands- financing”, is the safest: firms rely on their on experience, serving on the board of Mark future cashflow to repay all their borrowings. Twain Bank in St Louis, Missouri, where he For this to work, they need to have very limited taught. borrowings and healthy profits. The second, speculative financing, is a bit riskier: firms rely Having grown up during the Depression, on their cashflow to repay the on their Minsky was minded to dwell on disaster. Over borrowings but must roll over their to repay the years he came back to the same fundamental the principal. This should be manageable as long problem again and again. He wanted to as the functions smoothly, but a understand why financial crises occurred. It was downturn could cause distress. The third, Ponzi an unpopular focus. The dominant belief in the financing, is the most dangerous. Cashflow latter half of the 20th century was that markets covers neither principal nor interest; firms are were efficient. The prospect of a full-blown betting only that the underlying asset will calamity in developed economies sounded far- appreciate by enough to cover their liabilities. If fetched. There might be the occasional that fails to happen, they will be left exposed. 2

Economies dominated by hedge financing—that markets. To Minsky, this was an “unfair and is, those with strong cashflows and low debt naive representation of Keynes’s subtle and levels—are the most stable. When speculative sophisticated views”. Minsky’s financial- and, especially, Ponzi financing come to the instability hypothesis helped fill in the holes. fore, financial systems are more vulnerable. If His challenge to the prophets of efficient asset values start to fall, either because of markets was even more acute. Eugene Fama and monetary tightening or some external shock, the Robert Lucas, among others, persuaded most of most overstretched firms will be forced to sell academia and policymaking circles that markets their positions. This further undermines asset tended towards equilibrium as people digested values, causing pain for even more firms. They all available information. The structure of the could avoid this trouble by restricting financial system was treated as almost themselves to hedge financing. But over time, irrelevant. In recent years, behavioural particularly when the economy is in fine fettle, have attacked one plank of efficient- the temptation to take on debt is irresistible. market theory: people, far from being rational When growth looks assured, why not borrow actors who maximise their gains, are often more? add to the dynamic, lowering their clueless about what they want and make the standards the longer booms last. If wrong decisions. But years earlier Minsky had defaults are minimal, why not lend more? attacked another: deep-seated forces in financial Minsky’s conclusion was unsettling. Economic systems propel them towards trouble, he argued, stability breeds instability. Periods of prosperity with stability only ever a fleeting illusion. give way to financial fragility. Outside-in With overleveraged banks and no-money-down mortgages still fresh in the mind after the global Yet as an outsider in the sometimes cloistered financial crisis, Minsky’s insight might sound world of economics, Minsky’s influence was, obvious. Of course, debt and finance matter. But until recently, limited. were faster than for decades the study of economics paid little professors to latch onto his views. More than heed to the former and relegated the latter to a anyone else it was Paul McCulley of PIMCO, a sub-discipline, not an essential element in fund-management group, who popularised his broader theories. Minsky was a maverick. He ideas. He coined the term “Minsky moment” to challenged both the Keynesian backbone of describe a situation when debt levels reach and a prevailing belief in breaking-point and asset prices across the board efficient markets. start plunging. Mr McCulley initially used the term in explaining the Russian financial crisis of It is perhaps odd to describe his ideas as a 1998. Since the global turmoil of 2008, it has critique of Keynesian doctrine when Minsky become ubiquitous. For investment analysts and himself idolised Keynes. But he believed that fund managers, a “Minsky moment” is now the doctrine had strayed too far from Keynes’s virtually synonymous with a financial crisis. own ideas. Economists had created models to put Keynes’s words to work in explaining the Minsky’s writing about debt and the dangers in economy. None is better known than the IS-LM financial innovation had the great virtue of model, largely developed by and according with experience. But this virtue also , which shows the relationship points to what some might see as a shortcoming. between investment and money. It remains a In trying to paint a more nuanced picture of the potent tool for teaching and for policy analysis. economy, he relinquished some of the potency But Messrs Hicks and Hansen largely left the of elegant models. That was fine as far as he was financial sector out of the picture, even though concerned; he argued that generalisable theories Keynes was keenly aware of the importance of were bunkum. He wanted to explain specific situations, not economics in general. He saw the 3 financial-instability hypothesis as relevant to the Debtor’s prism case of advanced capitalist economies with Still, it would be a stretch to expect the deep, sophisticated markets. It was not meant to financial-instability hypothesis to become a new be relevant in all scenarios. These days, for foundation for economic theory. Minsky’s example, it is fashionable to ask whether China legacy has more to do with focusing on the right is on the brink of a Minsky moment after its things than correctly structuring quantifiable alarming debt growth of the past decade. Yet a models. It is enough to observe that debt and country in transition from socialism to a market financial instability, his main preoccupations, economy and with an immature financial system have become some of the principal topics of is not what Minsky had in mind. inquiry for economists today. A new version of Shunning the power of equations and models the “Handbook of Macroeconomics”, an had its costs. It contributed to Minsky’s isolation influential survey that was first published in from mainstream theories. Economists did not 1999, is in the works. This time, it will make entirely ignore debt, even if they studied it only linkages between finance and economic activity sparingly. Some, such as and a major component, with at least two articles , who would later become citing Minsky. As Mr Krugman has quipped: chairman of the , looked at how “We are all Minskyites now.” credit could amplify business cycles. Minsky’s Central bankers seem to agree. In a speech in work might have complemented theirs, but they 2009, before she became head of the Federal did not refer to it. It was as if it barely existed. Reserve, said Minsky’s work had Since Minsky’s death, others have started to “become required reading”. In a 2013 speech, correct the oversight, grafting his theories onto made while he was governor of the Bank of general models. The England, Mervyn King agreed with Minsky’s of in New York, where he finished view that stability in credit markets leads to his career (it still holds an annual conference in exuberance and eventually to instability. Mark his honour), has published work that Carney, Lord King’s successor, has referred to incorporates his ideas in calculations. One Levy Minsky moments on at least two occasions. paper, published in 2000, developed a Minsky- Will the moment last? Minsky’s own theory inspired model linking investment and suggests it will eventually peter out. Economic cashflow. A 2005 paper for the Bank for growth is still shaky and the scars of the global International Settlements, a forum for central financial crisis visible. In the Minskyan banks, drew on Minsky in building a model of trajectory, this is when firms and banks are at how people assess their assets after making their most cautious, wary of repeating past losses. In 2010 , a Nobel prize- mistakes and determined to fortify their balance- winning economist who is best known these sheets. But in time, memories of the 2008 days as a New York Times columnist, co- turmoil will dim. Firms will again race to authored a paper that included the concept of a expand, banks to fund them and regulators to “Minsky moment” to model the impact of loosen constraints. The warnings of Minsky will on the economy. Some researchers fade away. The further we move on from the last are also starting to test just how accurate crisis, the less we want to hear from those who Minsky’s insights really were: a 2014 discussion see another one coming. paper for the Bank of Finland looked at debt-to- cashflow ratios, finding them to be a useful indicator of systemic risk.