Minsky Moment

Why is it, that we never really attempted to script a convincing narrative of the 2008 financial crash? What really happened? Was it rogue traders gone wild with hookers and blow? Was it a once in a lifetime “black swan” event that no one foresaw? Or was it something more systemic, related to the mania of deregulation? So far we don’t know. No one has been held accountable, with the exception of Bernie Madoff, who was so greedy he ripped-off his wealthy friends.

Lets look at this a little closer. Now, of course, it’s true that young traders were snorting coke and banging hookers. Shit, that’s what young traders do, especially when they have all that bonus money burning a hole in their pocket.

But a once in a lifetime event that no one saw? Please!

The answers are there, but they’re politically and economically inconvenient among a cast of bipartisan elite. Robert Rubin, Alan Greenspan, Timothy Geithner and others have defended themselves, asking–who could have known?

Well, for starters, the FBI, in 2004, warned of an “epidemic of mortgage fraud,” and it predicted an economic crisis if it were dealt with.

Economists who studied the Great Depression could have told you. One such economist, who understood this was Hyman Minsky. Minsky’s “Financial Instability Hypothesis”, states that, “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”

Boston Globe correspondent, Stephen Mihm, summarized Minsky’s theory in his article “When Capitalism Fails”: “In the wake of a depression,” he noted, “financial institutions are extraordinarily conservative, as are businesses.” With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

A “Minsky moment” – would create an environment deeply inhospitable to all borrowers.

The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

Stability leads to instability.  By zeroing in on capitalism’s genetic flaws, Minsky countered the prevailing orthodoxy that markets are fundamentally efficient and rational. He not only showed that capitalism was inherently crisis-prone, but also, that it was most vulnerable during those periods which seemed to be most stable. (Like during Greenspan’s “Great Moderation”.) Stability invites speculation and risk-taking. Investors are buoyed by market euphoria and fat returns; borrowing to purchase dodgy equities turns into a mania which distorts prices and leads to massive credit bubbles. Eventually, the foundation cracks and debts cannot be rolled over. Then markets tumble.

So it wasn’t a once in a lifetime “black swan” event, but the prevalent economic orthodoxy does not want to admit this, because that would wreck their beloved efficient and rational market hypothosis, that underpins their argument for the radical deregulation of financial markets we have witnessed in the last few decades. And this ideology helps explain why there have not been any real prosecutions, unlike the 1980’s Savings and Loan scandal.

William K. Black, former regulator and criminologist, who helped investigate the Savings and Loan scandal, has been a constant advocate for prosecutions, of white collar criminals as well as blue collar ones. He wrote a book entitled–The Best Way the Rob a Bank is to Own One, explaining the lure of  “control fraud.”

“Fraudulent lenders produce exceptional short-term ‘profits’ through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves. These exceptional ‘profits’ defeat regulatory restrictions and turn private market discipline perverse. The profits also allow the CEO to convert firm assets for personal benefit through seemingly normal compensation mechanisms. The short-term profits cause stock options to appreciate. Fraudulent CEOs following this strategy are guaranteed extraordinary income while minimizing risks of detection and prosecution.” (William K. Black, “Epidemics of’Control Fraud’ Lead to Recurrent, Intensifying Bubbles andCrises”, University of Missouri at Kansas City – School of Law)

And what does Professor Black say we should do?

“The government is reluctant to admit the depth of the problem, because to do so would force it to put some of America’s biggest financial institutions into receivership. The people running these banks are some of the most well-connected in Washington, with easy access to legislators. Prompt corrective action is what is needed, and mandated in the law. And that is precisely what isn’t happening.”

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