The work of the late economist Hyman Minsky has become increasingly relevant in recent years, as his understanding of the fragility of financial markets and their role in bubbles and busts was both deep and prescient.
Other economists generally viewed financial markets as playing not much more than an intermediary function, passively allocating excess savings to their most productive uses—in fact, many still see it that way. It’s one reason why virtually all business cycle modelers, including those at the Fed, didn’t see the great recession coming—their models either left out or underweighted the impact of the financial sector on the broader economy.
But a key Minsky insight, explained very readably here by John Cassidy, is that there’s a financial cycle within the business cycle, which basically goes from over-pricing to under-pricing risk. Caution yields to euphoria, hyper-cautious risk aversion to incautious risk seeking, and what I’ve dubbed the economic shampoo cycle—bubble, bust, repeat—is underway.
These thoughts came to mind as I read two articles over the past few days. The first describes what looks like a sharp uptick in merger activity, as debt is cheap, corporate earnings are strong, and “animal spirits” among the investor class, if not the middle class, are high and rising. The second is more of a microcosm; it’s a description of a hostile takeover bid by a hedge fund. The deal fell apart, but the hedge fund still walked away with over $2 billion in profit (the fund bought 10% of the target company’s stock, which rose sharply when a higher, rival bid was made).
Neither of these stories are obviously problematic (though the latter tells you a lot about our current inequality problem). A characteristic of the Minsky cycle is pervasive, diffuse credit, juiced by sloppy underwriting and “innovative” financial products, to borrowers who cannot realistically service the debt they’re taking on. The housing bubble is the classic example as its sustaining mechanism was ever-rising home values, since that was the only way many borrowers could pay their mortgages (by borrowing against their appreciating homes).
I don’t see that yet. These deals seem largely restricted to Wall St. as opposed to Main St. And many other signals show the US economy to be uniquely strong relative to most other advanced economies: GDP and job growth are solid if not flashy, household balance sheets are back to pre-recession, pre-leverage levels, and while interest rates are low (as they should be—there’s still too much slack in the economy), I don’t see a credit bubble.
But I suspect up there in economists’ heaven, Hy Minsky read the same articles I did—he probably called Keynes over to have a look—and raised an eyebrow. And when Minsky raises an eyebrow, we should all get a little nervous.
“which basically goes from over-pricing to under-pricing risk”
Still nobody seems to ask, “Who was underpricing risk?”
I’ve yet to see a single coherent explanation for the formation of the bubble. I know what caused it, but nobody seems interested in the truth. Everyone has a bone to pick with somebody and they can’t see the big picture, or they don’t like the answers.
Read Minsky and all will become clear!
“I’ve yet to see a single coherent explanation for the formation of the bubble.”
Andre Orlean. “Mimetic contagion and speculative bubbles.”
“The second is more of a microcosm; it’s a description of a hostile takeover bid by a hedge fund. The deal fell apart, but the hedge fund still walked away with over $2 billion in profit (the fund bought 10% of the target company’s stock, which rose sharply when a higher, rival bid was made).”
I guess what disgusts me is all the hedge fund types making BILLIONS without doing a day’s lick of work. Money chasing money, zipping around faster and faster, till it spins out of control.
GAWD how I want a financial transaction tax.
I agree. The two first things I would do, would that I could, is institute a 1/4% tax on financial transactions, and the removal of preferential tax rates on capital gains. All else can be discussed after that.
See, you hurt their fee-fees. The hedgies think that putting in twelve-hour days crunching numbers to find the best mix of tax-deductible interest, accelerated depreciation and tax havens is hard work, and it’s made worse by spending hours at a time flying business class all over the world. I hate travelling myself, so I guess I’m kinda sympathetic to the latter. My point is, they think they work harder than anybody else, and they’re smart, so they deserve to be hugely compensated. The fact that they don’t know what it’s like to spend ten hours out in the hot sun hoeing weeds in the cornfield is beyond their comprehension.
I need smelling salts.
I don’t have a citation, but I have read — repeatedly! — that by at least 2006, about 40% of US GDP came from finance. And yet the Fed’s models failed to account for the impact of the financial sector?!!
How is that even possible…?
Did these people never read newspapers or magazines?
Did they never walk through airports and see all the billboard ads for banks, credit cards, and other ‘special offers’? Loan offers were everywhere; they were like wall paper.
For years, every time I got on the Internet, I was barraged with ads for Countrywide or some other lender offering ‘too good to be true’ mortgages. I probably filled entire dumpsters with shredded bank solicitations hawking credit cards, mortgages, and other ‘financial products’ from Wells Fargo, Citibank, Bank of America, etc.
I cannot even fathom how the Fed missed the significance of the FIRE sector in US GDP. Incredible.
I think it’s because trying to include that stuff in their models makes them “intractible,” i.e. impossible to compute. I believe Milton Friedman was the one who taught that unrealistic assumptions don’t matter if your model makes a successful prediction. The fact that it made many unsuccessful predictions seems to be irrelevant.
Not 40% of GDP – 40% of corporate profits. Still, it’s enormous.
Seems to me that Baker has it right. There has to be an asset class where risk is underpriced. Reagan loosened the rule for Savings and Loans so they needed a bailout. There was the tech stock bubble, then the housing bubble. Where is that now?
There’s Bernanke’s “savings glut” a phrase he now is not happy with. Maybe’s it’s an investment shortfall. Two sides of one coin. And so interest rates are low as the central bank tries to boost aggregate demand. But credit is still pretty tight for people with lower incomes. Bernanke said he wasn’t able to refinance his mortgage.
The way to sustainability is to increase incomes to lower income folks rather than providing them more credit at the company store.
yes i agree that the bubbles came from loaning people money instead of paying them money
this was clearly artificial demand ( or least bubble demand )
and i believe the cause is that pay does not keep up with productivity
I still wonder without having seen an answer why a generation of under-investment in infrastructure does not account for a major part of the employment hole that we needed bubbles to fill. Employment levels did not recover fully from the 2000 levels, and we needed the housing bubble just to get the less-than-satisfactory level we got. Other countries, meanwhile are advancing far beyond the U.S. in their employment-to-population ratios, especially in the 25-54 prime working age segment, whereas the U.S. was near the top in that measure in 2000 — and was at the very top among the biggest Western economies then.
If it is correct that the infrastructure under-spending was a big cause of an endemic employment hole, then we need to look at new infrastructure spending as more than a short-term stimulus. Higher spending needs to be seen as a permanent feature– a lot more than shovel-ready projects — to get the country not only back to where it should be as a modern economy, but also to maintain that level of public infrastructure into the future.
But, of course, it is not politically feasible now. But some effort should be given even under those political circumstances for making the case, and not just with pro-forma statements and bills introduced, but with a full-throated and persistent explanation to the public of its importance, where the major gaps are, and how not doing it will hurt the country.
But, you see, that high employment-to-population ratio came after a tax increase. Tax increases are bad, tax cuts are good. Therefore we must accept as policy a lower employment-to-population ration in order to avoid tax increases. Oh, yeah, wage increases are bad, too. Fisher of the Dallas Fed calls them “wage inflation.” Policy must be adjusted to increase unemployment, lest people be able to bargain for higher wages.