Explainer: Minsky Moment
We’ve come across a large and increasing amount of articles recently referring to something called a Minksy moment. As the term makes its gradual journey from academia, to the blogosphere, to the financial press, to your door, we thought it would be useful to explain exactly what a Minsky moment is.
The term was first coined by Paul McCulley of PIMCO in 1998. It’s a direct reference to the notable work of economist Hyman Minsky, whose primary focus in the 1960s and 70s was the misunderstood linkages between the economy and financial markets. Minsky’s model made the basic case that in a free market economy, booms and busts are inevitable. And so, he fittingly described his theory as the “financial instability hypothesis.”
Here’s how a Minsky cycle works:
1. Stable growth breeds confidence,
2. Investors take on more risk by purchasing assets backed by debt financing,
3. This leads to ever increasing speculation,
4. Which ultimately ends in a crash.
The forces behind this cycle are also compelling:
1. There’s a healthy expansion.
2. This leads to leverage-driven activity.
3. The combination of leverage and investing lead to euphoria and overtrading.
4. Insiders begin taking profit.
5. Liquidations ensues to cover loans as insiders lead asset selling.
6. Widespread panic takes over as all assets are sold.
There’s an interesting debate going on right now that relates not to the complete cycle, but to the progenitor of the crash portion of it. Commonly referred to as a “displacement” event, the financial media are laser-focused on what catalyst might lead to the point where insiders begin taking profits, and the downward cycle might begin. The leading candidate is, of course, the winding down of central bank easing, but the results of those policies – assuming they become reality – remain to be seen.
In the broadest terms, Minksy cycles are characterized by a dangerous feedback loop between leverage and inflated asset prices and minksy moments are when it all starts to fall apart. Many people point to the Housing Bubble that started to unwind in 2007 as an example, at least inasmuch as investors demanded increasingly speculative mortgage loans to purchase increasingly dubious homes (textbook step 2 above). And their certainly was an across-the-board decline in asset prices as things started to fall apart and liquidated the same homes to cover loans (step 6). But the term has failed to go away for one simple reason: there was virtually no overall decline in debt when the housing bubble burst.
As this chart shows, from 2007-2009, stock prices had a severe crash, but the overall debt picture in the US was pretty stable. This goes against our intuition because from a personal perspective, it’s quite true that private investors deleveraged. However, rather than those bad loans being written off, they were more often nationalized via TARP and a multitude of quantitative easing programs. Rather than resetting the collective balance sheet, loans were simply shuffled from one spot in the ledger to another.
Macroeconomic policy is not our game here at SKEW, nor is market timing, so we’re in no position to speculate about whether or not we’re on the brink of a Minksy moment. But we do understand the potential for adverse outcomes due to the vicious cycle of deleveraging via asset sales.
As far as we can tell, investors have searched for yield in increasingly speculative assets, purchasing them through increasing amounts of leverage. And while we haven’t the slightest idea what the near future holds, it certainly appears that the required mix of conditions – high debt levels and inflated asset prices – exists.