On the Minskyan Business Cycle

[FRED]

On the Minskyan Business Cycle (pdf)
August 2006 (The Levy Economics Institute)

The essential insight Minsky drew from Keynes was that optimistic expectations about the future create a margin, reflected in higher asset prices, which makes it possible for borrowers to access finance in the present. In other words, the capitalized expected future earnings work as the collateral against which firms can borrow in financial markets or from banks. But, then, the value of long-lived assets cannot be assessed on any firm basis, as they are highly sensitive to the degree of confidence that markets have about certain events and circumstances that will unfold in the future. This means that any sustained shortfall in economic performance in relation to the level of expectations that are already capitalized in asset prices may promote the view that asset prices are excessive.

Once the view that asset prices are excessive takes hold in financial markets, higher asset prices cease to be a stimulant. Initially debt-led, the economy becomes debt-burdened. In this article, it is argued that Keynes’s views on the alternation of the “bull” and “bear” sentiment and asset price speculation over the business cycle can explain two of Minsky’s central propositions relative to business cycle turning points that have often been found less than fully persuasive: (1) that financial fragility increases gradually over the expansion, and, (2) that the interest rate sooner or later, increases setting off a downward spiral bringing the expansion to an end.

AntiSpin: Various working papers of The Levy Economics Institute of Bard College have informed iTulip prognostications for many years. For example, the particular mix of post-bubble reflation policies that were later adopted were well forecast by Levy at least a year in advance. This particular paper is more academic, but the conclusion is not:

The point of this paper has been to argue that ... just as in Minsky’s account, the expansion in the Treatise begins with optimistic expectations enabling firms to capitalize their expected earnings in financial markets and thereby finance their investment expenditures. During the upswing, the actual increase in profits validates the higher asset prices, spurring them to increase further. But, unlike asset prices, actual profits cannot increase at an increasing rate in the course of an expansion. Thus, the rise in profits increasingly lags behind the upward movement in asset prices. As economic performance begins to fall short of the level of expectations that are capitalized in asset values, the view that asset prices are excessive begins to take hold in financial markets and the bear position rises. This is the point at which higher asset prices tend to become a drag on the economy rather than a stimulant, and the pressure on the banking system to raise the interest rate begins to build. Thus, what ultimately impairs the ability of the banking system to accommodate a rising level of economic activity is the fact that at some point during an expansion the financial sentiment falters, and that is why sooner or later the interest rate rises as Minsky insisted that it does.

In other words, early in a business cycle, the rising prices of assets stimulate the economy by increasing the expected future price of those assets used as collateral for loans, and lenders are willing to extend additional capital in proportion to the expected future increased value of those assets. Further, creditors demand less interest in return for the risk they are taking to make loans because they expect the value of the underlying collateral to continue rising over the term of the loan, lowering their risk.

Late in the cycle, the process works in reverse. Asset prices reach a kind of tipping point where where creditors see more downside than upside in the value of assets as collateral. They demand higher interest rates on loans to make up for expected decrease in the value of collateral.

In the current instance, then, you might expect that as prices of assets fall, so will interest rates. But credit markets can distinguish between nominal and real price increases. If the nominal price of assets remain, for example, flat but real prices are increasing as in a deflation, then nominal interest rates may also remain the same, but the real rate of interest has increased.

[jeffolie]

Re: On the Minskyan Business Cycle

People's salaries are paid in nominal dollars not 'real' dollars. Houses are bought and sold in nominal dollars not 'real' dollars. 'real' dollars do not exist except in economists' concepts and their dismal science. Where do these 'real' interest rates happen, certainly not on accounting statements.

[jk]

Re: On the Minskyan Business Cycle

levy has been both a bit too early and a bit too gloomy in its predictions to date. david levy was interviewed by kate welling in barrons oct 1998, in the context of that year's turmoil [asia, russia, ltcm]. he was predicting a 75% probability of a recession in 1999, severe enough to be described as "a contained depression" -- contained by the social institutions put in place since the great depression, but likely not so contained, he said, in less developed countries where such institutions didn't exist. he also predicted a fed funds rate of 1% by the end of 1999- at the time a shocking notion, but a prescient if early one. the recession was going to made worse by the popping of the consumer spending bubble. in 1999.

i find minsky's instability model easier to think about than the cycle of capitalization notion presented here. if anyone wants a quick take on minsky, i recommend doug noland's credit bubble bulletin over at prudentbear.com. his first columns on minsky were in feb and oct of 2000. minsky discussed 3 types of finance: hedge finance, speculative, and ponzi finance. hedge finance is covered by assets on hand, and is the most conservative. this is when people say that banks will only lend money to people who don't need it. as borrowers and lenders become more confidant they feel comfortable with speculative finance, which is covered by expected revenues. as confidence grows still higher, people engage in ponzi finance, in which credit is covered by rising asset prices instead of revenues. i.e. ponzi finance depends on the expansion of a bubble. the capitalization model presented above, then, really applies most clearly to the ponzi phase.

[jk]

Re: On the Minskyan Business Cycle

But, unlike asset prices, actual profits cannot increase at an increasing rate in the course of an expansion. Thus, the rise in profits increasingly lags behind the upward movement in asset prices. As economic performance begins to fall short of the level of expectations that are capitalized in asset values, the view that asset prices are excessive begins to take hold in financial markets and the bear position rises. This is the point at which higher asset prices tend to become a drag on the economy rather than a stimulant, and the pressure on the banking system to raise the interest rate begins to build.

profits are at an all time high as a % of gdp. and when p/e's shot up we had the maestro taking out the pom-poms for the NEW ERA! which justified the higher p/e's, remember? has the bear position grown because of excessive asset prices? i don't think so. bubbles don't pop because of skepticism, they pop because of exhaustion. when everyone is bullish, everyone has already bought. it's like the joke about the guy who keeps buying a thinly traded stock, because the price keeps getting higher. when he finally decides to cash in his huge position, he says "sell." and the answer is, "to whom?"

and did the fed raise rates because it was pressured by high asset prices? the fed which swore to ignore asset prices? what i recall is that the fed raised rates in as gingerly and slow a manner as it could, so it could "reload the interest rate gun," which is to say so that it could prepare to lower them again to give the economy more stimulus when the time came. then the rationale switched to inflationary expectations, based on the still bogus cpi and which studiously avoids asset prices.

Late in the cycle, the process works in reverse. Asset prices reach a kind of tipping point where where creditors see more downside than upside in the value of assets as collateral. They demand higher interest rates on loans to make up for expected decrease in the value of collateral.

this is not what is happening. i don't see lending institutions demanding higher rates because of an expected decrease in the value of collateral. to the degree that lenders' rates are higher, it is a function of their own higher cost of funds. the direct lenders don't have to worry about the collateral because they securitize the loan anyway. and the purchaser of the securatized loan doesn't worry because the mathematical models say his bundle of loans is sufficiently diversified, and besides, he's given up a few basis points to have mgic wave its magic[!] wand over his security to say it's insured and triple A!

[jk]

Re: On the Minskyan Business Cycle

p.s. seano has reported that ca banks have tightened some of their lending standards recently. but this has happened after prices started to fall. the tightened standards appear to be the result of falling prices, not the initial cause of falling prices. of course the tightened standards will re-inforce and accelerate the fall, but i don't think any bankers watched the prices go up and thought "let's tighten standards while the prices are still going up, because this might be too high." more likely is: "let's see if we can pump more loans out into this burgeoning market."

[EJ]

Re: On the Minskyan Business Cycle

p.s. seano has reported that ca banks have tightened some of their lending standards recently. but this has happened after prices started to fall. the tightened standards appear to be the result of falling prices, not the initial cause of falling prices. of course the tightened standards will re-inforce and accelerate the fall, but i don't think any bankers watched the prices go up and thought "let's tighten standards while the prices are still going up, because this might be too high." more likely is: "let's see if we can pump more loans out into this burgeoning market."

The process is also influenced heavily by competitive pressures among banks.

If Bank A sees Banks B, C, and D starting to make suicide, liar and deathbed loans because, at the top of the cycle, banks have run out of what would have been considered at the bottom of the previous cycle "credit-worthy borrowers," they fear that the other banks are going to show better revenue numbers in following quarters, although they are taking on more risk. To the extent that the bank observes rising asset (collateral) values and expects these to continue, this contributes to their perception that the added risk is manageable, and they can't afford to sit on the sidelines and allow the other banks to gain a competitive advantage within that segment of borrowers. It's not unlike what happens at the top of stock market bubbles when the market of potential buyers of conventional mutual funds is saturated. New mutual funds that go after ever smaller niche markets are created until, at the top, you see the Mutual Fund for People Over 60 with Dogs Named "Bo."

As the price of the assets (collateral) declines, these more creative loans begin to look more risky relative to the revenue opportunity; the apparent return on risk appears to shrink. One bank, say, Bank C starts to cut back on these loans, and then Banks A, B and D soon follow, all without fear of losing relative competitive advantage. The process becomes self-fulfilling. As loan availability is reduced, fewer home sales occur, prices decline further, lending standards tighten some more, and so on.

In the previous cycle, this process ended when banks virtually stopped lending at all, for about six months in 1994. Then the zero reserve account was created, and the 3% account, and sweeps, per Aaron's research.

[Christoph von Gamm]

Re: On the Minskyan Business Cycle

And now the broadstreet media such as Business week are jumping on the Mortgage mania wagon: With its newest cover: Nightmare mortgages, finally BW has realized that the whole lending industry has exaggerated its marketing machine and will experience default rates increasing...

http://www.businessweek.com/magazine...position=link1