Twenty-five years ago, maverick economist Hyman Minsky (1919-1996) noted that financiers periodically set the entire economy ablaze. Minsky warned that Wall Street encourages businesses and individuals to take on too much risk, generating ruinous boom-and-bust cycles. Minsky felt that only government regulation of the money men could break this painful cycle.
“Economies evolve, and so, too, must economic policy,” Minsky said.
He encouraged the reform of the financial system in order to prevent destabilization. Minsky broke down the boom-bust cycle into five phases:
1. Displacement: Occurs when investors get excited about something — an invention (such as the Internet), war, “easy money” or an abrupt change in economic policy.
2. Boom: Occurs when overall valuations exceed normalcy. The overheated housing market where speculators bought up numerous properties without putting up meaningful deposits exemplified the “feeding frenzy.”
3. Euphoria: Occurs when commercial lenders, banks or others extend credit to more dubious borrowers. Junk bonds promoted leveraged buyouts at unreasonable levels based on assets, cash flow or earnings
4. Profit-taking: Contrarians start profit-taking or short sellers pounce on overpriced stocks.
5. Panic: Occurs when a dramatic event leads to a massive change in psychology. The near bankruptcy of Bear Stearns, the financial problems of Citigroup and the meltdown of the subprime mortgage market reflect the consequences of panic.
Minsky would have approved of the innovative and dramatic steps taken in recent months by the Federal Reserve, the Treasury and foreign central banks to stop the financial crises throughout the globe.
Perhaps the most dramatic occurred Monday when Treasury Secretary Henry Paulson unveiled a sweeping plan that would overhaul the present patchwork system of overlapping regulatory bodies that is not equipped to deal with 21st century innovations.
It could possibly make the most profound changes to the regulatory environment since the Civil War. The plan, which Paulson says will likely face a lengthy and vigorous debate in Congress, follows other recent actions by regulators:
* Since August, the Fed has lowered the federal funds rate from 5.25 percent to 2.25 percent.
* The Fed has significantly loosened its criteria for acceptable collateral to borrow at the discount window by commercial and investment banks.
* For the first time since its founding in 1913, the Fed recently allowed investment banks who are prime dealers to post non-U.S. Treasury collateral in order to borrow for up to 30 days.
* Congress authorized a $160 billion economic stimulus package for taxpayers.
* The appropriate regulatory bodies have extensively broadened the lending limits of Fannie Mae and Freddie Mac, who are the largest providers of funds in the secondary mortgage market.
Unfortunately, while these governmental actions seem to be helpful at the fringes, they cannot cure several fundamental problems.
First, American housing prices rose too much — faster than median income by 33 percent between 2000 and 2006. “Sucker” initial mortgage rates, and 100 percent financing for home purchases stoked the housing fervor.
Second, the balance sheet of commercial banks, investment banks and bond insurers became too large relative to their equity base. A slight decline in the value of assets dramatically reduced the net worth of the above institutions. The problem became even greater when some of these assets were monitored.
These institutions held a large dollar value of inventory that cannot be carefully evaluated by third parties. This “Level III” inventory became significantly greater than the net worth of many institutions.
Third, the growth of the credit default market to behemoth size added to the precarious condition of financial institutions. The $45 trillion credit default market, an unregulated, off-balance sheet market, is about 10 times the size of the government market, seven times the size of the mortgage market, and eight times the size of the corporate bond market.
The tail indeed has become longer than the dog.
If Minsky were alive, he would urge an investigation on why federal regulators permitted the credit default market to mushroom without regulation and outside regulatory rules.
Minsky would have argued that for the capitalistic system to function best we need to make certain that key decision-makers receive compensation that rewards the achievement of profit goals over an extended time period such as 10 years rather the handing out of huge bonuses for meeting quarterly goals.
