Paul McCulley: Hyman Minsky Predicted the Bubble and Its Aftermath

Pimco’s Paul McCulley has a really superb article that ties the work of Hyman Minsky to the current economic collapse. If you don’t know Minsky, don’t worry McCulley does a great job of explaining his theories and then showing how eerily they comport to events of the past few years.

It’s a long but very readable article. Excerpting doesn’t do it justice but I’m going to do so anyway in an effort to encourage you to read the entire piece.

In Minsky’s theory, economic cycles can be described by a progression – I like to call it a “journey,” in forward or reverse – through those three debt units: hedge financing units, in which the buyer’s cash flows cover interest and principal payments; speculative finance units, in which cash flows cover only interest payments; and Ponzi units, in which cash flows cover neither and depend on rising asset prices to keep the buyer afloat.

The forward Minsky journey, this time around anyway, was the progression of risk-taking in the financial markets represented by the excess of subprime loans, structured investment vehicles (SIVs) and other shady characters inhabiting the shadow banking system. Their apparent stability begat ever-riskier debt arrangements, which begat asset price bubbles. And then the bubbles burst, in something I dubbed (years ago, in fact, when looking back on the Asian credit crisis) a “Minsky Moment.” We can quibble about the precise month of the Moment in our present Minsky journey. I pick August 2007, but would not argue strenuously with you about three months either side of that date.

Whatever moment you pick for the Moment, we have since been traveling the reverse Minsky journey: moving backward through the three-part progression, with asset prices falling, risk premiums moving higher, leverage getting scaled back and economic growth getting squeezed. Minsky’s Ponzi debt units are only viable as long as the levered assets appreciate in price. But when the price of the assets decline, as we’ve seen in the U.S. housing market, Minsky tells us we must go through the process of increasing risk-taking in reverse – with all its consequences.

The recent Minsky moment comprised three bubbles bursting: in property valuation in the U.S., in mortgage creation, again, principally in the U.S., and in the shadow banking system, not just in the U.S. but around the world. The blowing up of these three bubbles demanded a systemic re-pricing of all risk, which was deflationary for all risk asset prices. These developments are, as Minsky declared, a prescription for an unstable system – to wit, a system in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation.

When you’ve finished reading McCulley’s piece, you will have an appreciation of Minsky’s work, understand his concepts, see how well he predicted the boom and crash and appreciate the intricacies of working out of the box we’ve created for ourselves. McCulley should be proud of what he wrote.

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