Wednesday, May 13, 2009

The epoch of the US housing bubble may be over, but “the pressure for repeated injections of cheap finance is not.”

Reflecting on Hyman Minsky moment and voices from the Summer of 2007 ...

Enter Hyman Minsky. The late US economist offered a theory of the behaviour of lenders, which many have re-examined in recent weeks.

He said credit conditions became increasingly lax in times of good economic health. Then the credit supply would dry up (through such measures as the tightening of lending standards). Then liquidity dries up as lenders call in loans and borrowers sold liquid assets to comply. The final "moment " came when central banks cut rates to avert economic collapse.

The theory was drawn to fit a world where, as in 1929, the decision whether to extend credit rested with bankers. Now, it rests with the markets. But its potential relevance to current circumstances is clear.

George Magnus of UBS suggests reasons to believe a Minsky Moment can be deferred. First, housing problems take a while to unfold. Second, companies have cleaned their balance sheets and are not heavily leveraged. Third, there is still much liquidity in the world system. High energy and commodity prices suggest petro-dollars will not go away.

Finally, there is still no clear evidence of economic weakness, as the most recent data underscore, or of a significant return by inflationary pressures.

All these factors could change quickly. But even with credit valuations back to earth, markets believe Minsky's Moment of reckoning can be deferred further.

Panic follows mania as night follows day, says the FT’s Martin Wolf, back from summer leave with fresh insights into the present market upheavals. “The great 19th-century economist and journalist, Walter Bagehot, knew this better than anybody. ‘Lombard Street’, his masterpiece, is dedicated to the phenomenon. It is devoted, too, to how central banks should deal with its results”, he says.

Ours has been a world of “confidence, cleverness and too much cheap credit”, says Wolf: “This is not new… The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with ‘displacement’, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.”

“The fourth stage is over-trading, when markets depend on a fresh supply of ‘greater fools’. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry ‘bubble’ are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.”

In the latest cycle, notes Wolf, “displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing”. The easy credit was stimulated by innovations that allowed lenders to regard their service as somebody else’s problem. Then people started to buy dwellings to resell them. Subprime lending was a symptom of euphoria. “So, in a different way, was the rush of bankers into hedge funds” and of the big institutions into financing them. “Then came profit-taking, falling prices and, last week, true revulsion”.

This was what George Magnus of UBS bank calls a “Minsky moment” , notes Wolf: “The moment when credit dried up even to sound borrowers. Panic had arrived”.

The correct policy response is also well known, and was laid down by Bagehot himself, notes Wolf: “The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.”

In providing money to the markets, the ECB, the Fed, the Bank of Japan and other central banks have been doing their jobs, says Wolf. But, “whether the terms on which they have done this were sufficiently penal is another matter”.

Financial markets, and particularly the big players within them, “need fear”, says Wolf. “Without it, they go crazy.” Moreover, he adds, “it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust.”

The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in key housing markets in the 2000s, notes Wolf. “There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.”

Unfortunately, there is every chance of repeating mistakes, he warns. “A bail-out has already occurred in Germany, far from the epicentre. More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.”

The pressure on the Fed to cut interest rates will also grow, Wolf predicts. And, as Larry Hathaway and Mr Magnus of UBS note, this looks a much more significant event than the LTCM implosion in 1998, he adds. The consequences cannot be “ring-fenced”, as were those of LTCM. “Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.”

Such a period, “desirable in itself”, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system, predicts Wolf. But such pressure “should be resisted as long as possible.”

Yet, he concludes, “the underlying challenge confronting the world’s central banks remains”: huge surplus savings in key parts of the world; corporate sectors that do not need to borrow and so limited categories of creditworthy and willing borrowers, households in rich countries foremost among them. The epoch of the US housing bubble may be over, but “the pressure for repeated injections of cheap finance is not.”

(from, August 15, 2007)

No comments:

Post a Comment