Risk Latte - Talking to George Magnus

Team Latte’s Rahul Bhattacharya recently spoke with Geroge Magnus about Minsky and the State of Global Economy. Here is an excerpt from that interview.

Team Latte :
"Looking at the economy from a Wall Street board room we see a paper world - a world of commitments to pay cash today and in the future. These cash flows are a legacy of past contracts in which money today was exchanged for money in the future. In addition, we see deals being made in which commitments to pay cash in the future are exchanged for cash today. The viability of this paper world rests upon the cash flows…that business organizations, households, and governmental bodies, such as states and municipalities, receive as a result of the income-generating process. The focus will be on business debt, because this debt is an essential characteristic of a capitalist economy ."

This is what Minsky said in Inflation Recession and Economic Policy in 1982. How true is it today? If you were to sit in a board room on Wall Street today would you see a world different from that of Minsky's?

George Magnus:
Yes. This isn't to say that Minsky saw the world through rose-tinted lenses but today's world is more complex and more opaque than Minsky's was. The cash flows which Minsky alludes to are indeed an essential component of the modern paper or digitalized economy but what we are concerned about today encompasses other Minsky-esque phenomena, including counterparty risk and illiquidity, solvency risk and the crisis of collateral and ultimately, macroeconomic risk and central bank interventions.

Team Latte:
You have famously referred to a Minsky moment in a recent research report. What is a "Minsky moment"?

George Magnus:
For me a Minsky Moment is the point at which normal lending and borrowing behaviour is interrupted or compromised such that it threatens systemic risk and leads directly to the intervention of the central bank, whose function is to restore normality and ensure that sound creditors and borrowers are not sucked into a maelstrom of credit retrenchment.

Team Latte:
Would you introduce Minsky to our readers, please?

George Magnus:
Hyman Minsky was an American economist, who dies in 1996. He worked in the Keynesian tradition and his notable contribution (from my perspective) was to explain a curious contradiction of capitalism. Not quite Marx's contradictions but a contradiction nonetheless. Capitalism tends towards economic stability and the utilization of ever greater amounts of leverage in pursuit of growth and expansion. But the eventual abuse or excesses of leverage lead to chronic financial and economic instability - and possibly recession.

Team Latte:
Minsky contended that investment during boom times is financed through internally generated cash flows and debt and eventually, and due to desire of firms and entrepreneurs to over-expand, the gross level of debt will overtake the internally generated cash flows of the firm. Lenders, primarily the banks, will keep lending more and more, and with little regard to credit worthiness of the borrower and borrowers will borrow more than what they can repay. This will lead inflexion point in the credit cycle.

Is this what we are seeing today in the U.S and other G7 economies?

George Magnus:
Absolutely - though in fairness, it is largely a US phenomenon so far, based on the rapid deterioration in mortgage financing conditions and the US housing recession. But it is neither confined to US mortgage financing nor to the US alone. The deterioration in credit quality, delinquencies and defaults has already spilled over into leveraged loans, private equity and merger deals and the US auto and credit card sectors. It has also affected financial institutions in the UK , France , Germany , Australia and Taiwan and probably elsewhere too. What we are seeing is a revulsion against asset backed credit and securities, especially mortgage backed, and growing concerns about creditworthiness. I would submit that we are at the start of a deleveraging phenomenon that will be no momentary affair. Rather I can see this going on for the remainder of this year and through 2008.

Team Latte:
Your recent research report* in which you resurrected Minsky has received considerable attention around the world, at least amongst the financial markets practitioners and analysts. And Wall Street has for long embraced Minsky's theories and paradigm almost whole heartedly.

George Magnus:
I don't know why Minsky is not mainstream in Economics 101. But the fact that he isn't may explain partly why he doesn't figure prominently in contemporary economic thinking and analysis. But another reason is that a lot of economists, strategists and analysts simply don't want to believe what's unfolding - or they want to give their clients a 'good news' story to the effect that this turmoil will soon be over and the bull will be back. Well we all love bull markets - of course. But the reality is that the credit cycle has been the handmaiden of the bull and it's now turning. Not only that but this isn't simply a quick-fix liquidity cycle like 1987, 1998 and 9/11. This is about solvency - and its implications and repercussions are going to be quite different.

Team Latte:
As I said above that despite being popular amongst Wall Street bankers most mainstream economists and policy makers have generally shunned Minsky. Here is a recent quote from a blog that we came across on the internet (it seems that the author knew him personally): "Minsky was well known, but it seemed that many mainstream economists treated him as something of an anachronism. His model of financial instability was too crude, he pessimism too ingrained, his ideas too informed by psychology, his obsession with disequilibrium and bad lending decisions discordant in an environment that emphasized equilibrium and market efficiency".**

It is ironical that Minsky would become pessimistic about growth and business expansion at a time when the American economy was embarking on the longest expansionary period in its history, the early eighties.

Was Minsky really a man out of place in the Nineteen Eighties America?

George Magnus:
Not really in my view. Well, as you say, ironic maybe that he should have had such a dismal view about the credit cycle endgame at a time when the greatest post WW2 credit cycle was kicking off. But the acid test for this economist and economic theorist is ‘ was he right or wrong?' And of course he was right about the way the Savings and Loan crisis ended in 1989/90, right about the way the dot com crisis ended in 2001 and, I'd say, right about the way this credit cycle is ending now. Minsky was no business cycle forecaster and the insights he gave us as to the credit cycle and its nature offer us more than enough: leverage has a cycle - it's benign to start with, becomes increasingly powerful and then excessive with adverse consequences. Our past and still contemporary obsessions with equilibrium, new paradigms and market efficiencies are really what are out of place.

Team Latte:
An economist has commented that Minsky's Financial Instability Hypothesis was a conscious blend of Kalecki's "Principle of Increasing Risk", Fisher's "Debt Deflation Theory" and finally Keynes' "General Theory".

Is that an apt characterization?

George Magnus:
I think you'd have to put that to a student or teacher of economic thought for a proper answer. I'd say, with a slight sense of academic insecurity, yes.

Team Latte:
Minsky took Kalecki's premise and observed that as an expansion occurred in an economy (Hansen-Samuelson model) with infinitely elastic money supply corporations and small firms start to add bank debt to their balance sheets thereby raising the debt to equity ratio. This leads to increase risk for borrowers which attenuates the desire of the firms to invest thus reducing the marginal propensity to invest. This lowers the rate of increase in income in the whole economy.

Is this something that we are observing today in the world's major economies? And if it's really happening then will it really lead to an overall decrease in the income around the world?

George Magnus:
It is an interesting question and to which my response is a partial "no"; partial, in the sense that what we have today is not a crisis of corporate leverage and corporate balance sheet excess. That was the story in 2000 and 2001, after which we saw a massive corporate de-leveraging around the world. Although the flurry of firms participating in the boom in M&A and private equity (until May at least) have seen a strong rise in debt burdens, for example, in relation to cash flow and EBIT, the aggregate ratios of debt on the balance sheet for firms in the US, Europe and Asia have been pretty restrained and modest. So, from this point of view, looking at corporations to find the fault-lines is looking the wrong way.

The real story when it comes to leverage, de-leverage and threats to the global economy is to be found in a) US household balance sheets b) banking and financial institutions' balance sheets and c) the knock-on effects of what will probably be a US recession or something that feels like one for the rest of the world. In the corporate world, capex spending hasn't exactly been robust in the last 2 years. Better but not robust. Now that capital and credit are both less available and more expensive, we can hardly expect CEO's and CFO's to behave as though this was a great time to invest. They weren't before, so why now? But it's the US consumer and the behaviour of insured and formal banks and savings institutions that hold the key now - they are the difference between a long work out with limited global downside from the US and one with more substantial downside.

Team Latte:
Minsky's theory of capitalist development is finance-driven and the relationships between finance and business (economic output) are pivotal to the understanding of the broader question of capital accumulation. Entrepreneurs and corporations, healthy and sick, will after a point in time borrow more than they can possibly repay to expand production or their business output, until such time that credit becomes unsustainable and the bubble bursts.

In today's economy what is being financed and what is the key source of that financing?

George Magnus:
Assets, essentially, are what has been financed - whether these are housing assets, credit market assets or debt structures - and they've been financed essentially by asset backed securities markets and securitization. US households (but not only) have over-borrowed - while financial institutions have over-lent to other financial institutions.

Now it's time to pay the piper. Several players are facing solvency issues, including US homeowners, mortgage brokers, construction and homebuilding firms and non-insured banks and thrift institutions. While the aggregation of firms reveals few overall concerns about solvency and default risk, there's no question that cheap and plentiful credit has financed both share buybacks and the survival of many firms or the creation of new ones. As the credit cycle turns down, all of these participants and phenomena will be at risk.

Team Latte:
Shortly before he died in the mid nineteen nineties, Minsky thought that it was an exciting time for economists, at least for those economists who believed that economic behaviour leads to unstable dynamics***. The mid nineties also saw tremendous innovation in the financial derivatives market and there was an explosion of new derivatives products. Eventually, by the late nineties credit derivatives came to life and in the next half a decade these credit derivatives came to dominate the economic and the financial landscape.

Was the birth and eventual dominance of financial derivatives, especially credit derivatives a vindication of sorts of Minskian doctrine?

George Magnus:
Without a question! The Federal Reserve was established in 1913 in large measure to act as a bulwark against financial crises and banking failures and to introduce regulation, reserve requirements and so on in order to stabilize the financial system. In the 1980's and beyond, the prudential and regulatory environment was diluted or forsaken in the interests of financial globalization and the supposedly benign spirit of free markets. Financial derivatives and leverage along with and opaque and complex characteristics were the legacy of deregulation and innovation. For a while, all of this sat happily alongside or on top of a world of increasing economic stability, as defined by the collapse in measures of inflation and output volatility. The conventional wisdom became that this blend of stability and leverage was the new alchemy, the ‘science' that would lead to perpetual enrichment. Now we have our Minsky Moment and we are about to rediscover that the world changes but human behaviour is a constant.

*The Credit Cycle and Liquidity: Have we arrived at a Minsky moment? (UBS Research, March 2007)

** http://www.publicradio.org/columns/marketplace/farrell/2007/08/a_minsky_moment_1.html

***Hyman Minsky's Theory of Capitalist Development (Chris J. Wahlen, Institute for Industry Study, Cornell University )