“Success breeds a disregard of the possibility of failure”
When there are long periods of prosperity in an economy, the value of investments increase and there is a gradual change in the mindsets of people. The investors, banks, and companies tend to develop a misguided confidence that the rise will continue for a very long time. Slowly, there is an increase in the amount of risk taken. This extrapolation results in increasing speculation (making risky financial transactions) using borrowed money. These speculative investments lead to an increase in debt amounts.
As the amount of borrowed money shoots up, the assets are no longer able to dismiss the debts that were taken to acquire them. In this phase, the buyers can’t afford the interests on their own loans. With increases losses, the lenders start calling in their loans. Asset values decrease; Further, the indebted investors are forced to sell less speculative assets to pay off the accumulated debts.
Suddenly, the asset prices decrease rapidly. This quick and unprecedented collapse of asset values is called the ‘Minsky moment’.
The term was first coined during the Russian fiscal crisis (1998) by Paul McCulley of PIMCO. It was named after a famous American economist who noted that some financiers play the role of arsonists and set the entire economy on fire.
A long time ago, there was an owlish man with a bunch of grey hair. His name was Hyman Minsky (September 23, 1919 – October 24, 1996). Minsky was an American Economist who had grown up at the time of ‘The Great Depression’(1929-1939). When the entire world was recognizing America’s economic growth, he formulated a financial instability theory that suggested that a very long run of prosperity sowed the seeds of an impending crisis.
The American Economy was so strong those days that people thought that it was far-fetched to consider a breakdown. Days came and days passed as his works were ignored and put aside.
The Minsky’s moment did come.
US Economic Crisis
The period from December 2007 through June 2009 was the time of “The Great Recession”. Before 2007, the US housing market was one of the most prosperous markets around the globe. The market was booming with tremendous investments. People believed this to continue for a very long time, preferably forever. But as they say, nothing is permanent in this world.
People started taking a lot of loans as the size of the housing bubble increased. However, they were unable to pay back. The interests of those loans were greater than what they could afford. Shortly, the lenders started calling in their borrowers. The asset values, as predicted by Minsky, collapsed. Eventually, the economic bubble burst (An economic bubble is a speculative bubble that is formed when people don’t realize the intrinsic values of the assets. The trade in the assets starts occurring at prices far greater than their intrinsic values based on inconsistent views about the future. This finally leads to the bubble burst).
US subprime market moved from a levitating boom to an unexpected burst. This market failure went on to become an international banking crisis as the investment bank Lehman Brothers declared collapse on 15th August 2008. This bankruptcy spread the impact globally.
The bursting of the housing bubble leads to a massive job loss and tremendous loss of investment. People started keeping their money to themselves, they refrained from spending and investing. The negative scenario continued for a long duration. Even when the crisis ended, the shock was so prevalent and future so vague that the economies started thinking of respites from the reality.
Out of the blue, the long-ignored theory was rejuvenated. The magnitude of this crisis made the term ‘Minsky’s moment’ ubiquitous. People found Hyman Minsky’s wise words in their experiences- “Booms sow the seeds of busts” –The Minsky’s moment had shown its potency.
Three Types of Financing
The theory starts with the definition of investment and continues with the explanation of financing. Firms make investments so that they get future returns. Thus, money today is expected to translate into money tomorrow. The present money can either belong to owners or to outsiders (funds taken from financial institutes like banks). The balance between the two becomes critical when we decide financial stability.
Further, Minsky made a line of difference between three types of financing. The safest form of financing is called “Hedge financing”. In this financing, the firms rely on their future cash flows to repay their loans. The interests are paid by their own reserves. For this to happen, firms need to have limited borrowings and good profits.
The second is “Speculative financing”. This is riskier than hedge financing. In this, firms rely on cash flows to repay the interest on the borrowings. To repay the principal, the firms have to roll over their debts. This mechanism can work well till the economy functions smoothly. However, when the economy is distressed, the situation will be toppled.
The “Ponzi financing” is the riskiest. Neither the cash flows cover the interest to be repaid nor they cover the principal. If the firm’s assets are not enough to repay the loans, the firm can go into bankruptcy.
When such a case happens on a large magnitude, the financial markets topple. Prosperity leads to fragility, boom leads to bust.
Will it repeat?
May be. According to Hyman Minsky, an extended period of stability and complacency leads to the build-up of excess debt and over-leveraging. If we do not prepare in time, this naturally can propel Minsky’s moments.
There are always some economies that grow fast, become overconfident and lose their edge. India has a long way to go to attain that prosperity. If we ensure that we remain grounded and remember the constraints, we can create not only a progressive but a sustainable future economy.
Many Minsky’s moments will come and go. But an Indian Parent’s first instruction to his child- “Always save enough to sustain your future needs” will always hold true.