Edward Chancellor's Ponzi Nation, Institutional Investor, 2/7/2007 is worth a read, particularly for those who need a refresher as to Hyman Minsky's life and work…especially his warning that "Stability Breeds Instability." This warning is at no time more urgently in need of attention than today. Yet too few hear or heed the warning. Chancellor describes the chasm that separates Cornucopian economists from we Cassandras. Below are a few snippets:
Some Concerned VoicesChancellor concludes with a section titled:…In October 2004, Malcolm Knight, general manager of the BIS, cautioned that "lending booms can boost economic activity and asset levels to unsustainable levels, sowing the seeds of subsequent instability." A large appetite for risk, Knight suggested, "can sow the seeds of subsequent problems."
Timothy Geithner, president of the Federal Reserve Bank of New York, has pointed out that "against the background of an apparently healthy financial system, market participants report a substantial rise in transactions leverage, erosion in the use of loan covenants, more favorable financing terms for hedge fund counterparties and especially a pressure to reduce initial margin against OTC derivatives exposure to hedge funds." At the Bank of England, deputy governor Sir John Gieve warned a gathering of hedge fund managers last July of the "danger that risk models are giving too much weight to the low volatility of recent times."
"There is an underpricing of risks in general in financial markets," Jean-Claude Trichet, head of the European Central Bank, told a BIS summit in Australia in November. "We don't exclude the possibility that there will be a repricing of risk." At the same meeting Australian Treasurer Peter Costello compared the current "general euphoria" to 1997 before the Asian crisis.
It's only to be expected that central bankers should attempt to jawbone market participants about taking on too much risk. "Moral suasion" is the fancy name given to this generally futile activity. However, other prominent figures in the financial world are also concerned. In a recent letter to investors, Jeremy Grantham, head of Boston fund manager GMO, observed that "long periods of stability cause all types of leverage and other risk-taking to grow. … This process can go on and on until finally something goes badly wrong."
Those who are concerned about excessive leverage often cite the work of economist Hyman Minsky. Grantham credits Minsky as the source for his observation that "stability is unstable." Over the course of the past year, Paul McCulley, Fed watcher and investment committee member at bond powerhouse Pacific Investment Management Co.; Michael Hughes, chief investment officer of Barings Asset Management; and James Grant of influential investment newsletter Grant's Interest Rate Observer have all cited Minsky to support their assertion that risks are rising as the rewards for taking risk have declined. …
Liquidity and CreditCredit has a paradoxical effect on stability. Although debt and leverage raise the level of risk, credit provides the markets with liquidity that serves to dampen volatility. Stock market volatility is inversely related to corporate profits. Credit growth boosts earnings, which in the U.S. have recently touched 40-year highs relative to GDP, thereby reducing volatility. Fridson suggests that the low current levels of distressed debt can partly be explained by the fact that many potentially troubled companies have access to finance. This keeps them out of the bankruptcy courts. Finally, Pimco's McCulley points out that the increased demand for risky assets has served to push down their volatility.
At the close of 2006, the markets were flush with liquidity. If credit were to take flight, however, the rocks submerged by this tide of liquidity might suddenly be revealed. This process already appears to be under way in residential real estate, where slowing home price inflation has been accompanied by a decline in mortgage growth, a drop in home sales and a rise in delinquencies on subprime loans.
Two contrasting hypotheses can explain recent developments in the financial world. The Great Moderation holds that owing to better policymaking and structural improvements to the financial system, both the economy and markets are more stable than in the past. The newfound stability is viewed as a secular development. In other words, it's here to stay. Therefore lower credit spreads and higher levels of leverage are justified. Investors persuaded by this view will have few qualms about buying risky assets despite their historically low yields.
Hyman Minsky, on the other hand, suggests that people's response to stability engenders instability. Such behavior is not necessarily irrational, as there are profits to be earned and bonuses to collect as long as the good times last. In fact, the cycle may extend as long as credit flows and people are hungry for risk. Yet Minsky's credit cycle heads inexorably toward a bust. Investors who accept this analysis will probably conclude that risk and reward are currently out of whack. They will position their portfolios defensively, keeping cash on hand to spend when the rewards for taking risk appear more compelling.
Edward Chancellor, an editor at breakingviews.com, is the author of Devil Take the Hindmost, a history of financial speculation.
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