Why financiers periodically set fire to the economy

“Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles.”

John Cassidy, The New Yorker (4 February 2008)

Understanding Hyman Minsky’s “financial-instability” argument is all the vogue now. Initially dismissed as a radical crackpot, Minsky and his work are now receiving much critical attention.

Minsky’s model predicts 5 stages in an unregulated credit cycle: displacement, boom, euphoria, profit taking, and panic. He argued that these stages can be seen in all financial cycles. Displacement happens when investors get excited about something – which could be the arrival of the Internet, or an abrupt change in economic policy (such as a reduction in interest rates). Often, a speculative boom develops (such as America’s current housing bubble, or the crazy rise in Internet stocks in the late nineties).

The next stage is euphoria – a misplaced confidence that all is well and the world has changed for good. That is what we were being told at the height of the Internet boom – that dramatic productivity improvements would justify insane company valuations. More recently, it was believed that booming house prices could never fall. The credit boom extended into increasingly dubious markets – the now-infamous sub-prime sector – via new instruments such as mortgage securitisation.

After the euphoria stage, some smart operators will start cashing in and taking their profits, and the market will turn. As this happens, the real risks in the whole enterprise start to emerge. In the current case, it was the collapse of two Bear Stearns hedge funds in 2006 that presaged the worldwide credit crunch. Over time, huge financial institutions such as Citi and Merrill Lynch have joined the walking wounded. And American house prices are now falling at 10 per cent every year.

What should be done? Minsky recommended tighter regulation – intervention and institutional oversight. But that is the last thing that financial agents and free-marketeers want to hear. The Economist, for example, recently warned against knee-jerk responses to the crisis. It argues that busts are belated acts of cleansing by the market. But even ardent believers in the free market believe that more must be done to protect the rest of the economy from the crazed excesses of the money men.

Whatever governments do in response to this crisis, the canny investor would do well to heed the Minsky model. Whenever you see a boom building, know that a bust is on its way. As The Economist admits, “bubbles, excess and calamity are part of the package of Western finance.” The time to be particularly worried is when euphoria strikes – when the popular discourse is all about never-ending booms. In Kenya, we should watch our own NSE Index and the seemingly unstoppable growth of our banks. The music does eventually stop, and in the ensuing silence we discover that there are not enough chairs for everyone.

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