by John Mauldin
Mauldin Economics
June 18, 2017

The Next Minsky Moment

Economics has its overused themes and phrases, too. One is “Minsky moment,” the point at which excess debt sparks a financial crisis. The late Hyman Minsky said that such moments arise naturally when a long period of stability and complacency eventually leads to the buildup of excess debt and overleveraging. At some point the branch breaks, and gravity takes over. It can happen quickly, too.

Minsky studied under Schumpeter and was clearly influenced by many of the classical economists. But he must be given credit for formalizing what were only suggestions or incomplete ideas and turning them into powerful economic themes. I’ve often felt that Minsky did not get the credit he deserved. I look at some of the piddling ideas that earn Nobel prizes in economics and compare them to the importance of Minsky’s work, and I get an inkling of the political nature of economics prizes.

Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH), incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher. “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” [Wikipedia]

Minsky came to mind because in the past week I saw yet more signs that financial markets are overvalued and investors excessively optimistic. Yet I still haven’t seen many references to Minsky. That’s a little surprising.

On reflection, I realized I hadn’t mentioned Minsky lately, either. That is a potentially dangerous oversight, because we forget his fundamental insights at our peril. Last week’s brief technology tumble should have been a wake-up call. So today we’ll have a little Minsky refresher and look at some recent danger signs. And I predict that we will soon see Minsky mentions popping up everywhere.

Natural Instability

Hyman Minsky, who passed away in 1996, spent most of his academic career studying financial crises. He wanted to know what caused them and what triggered them. His research all led up to his Financial Instability Hypothesis. He thought crises had a lot to do with debt. Minsky wasn’t against all debt, though. He separated it into three categories.

The safest kind of debt Minsky called “hedge financing.” For example, a business borrows to increase production capacity and uses a reasonable part of its current cash flow to repay the interest and principal. The debt is not risk-free, but failures generally have only limited consequences.

Minsky’s second and riskier category is “speculative financing.” The difference between speculative and hedge debt is that the holder of speculative debt uses current cash flow to pay interest but assumes it will be able to roll over the principal and repay it later. Sometimes that works out. Borrowers can play the game for years and finally repay speculative debt. But it’s one of those arrangements that tends to work well until it doesn’t.

It’s the third kind of debt that Minsky said was most dangerous: Ponzi financing is where borrowers lack the cash flow to cover either interest or principal. Their plan, if you can call it that, is to flip the underlying asset at a higher price, repay the debt, and book a profit.

Ponzi financing can work. Sometimes people have good timing (or just good luck) and buy a leveraged asset before it tops out. The housing bull market of 2003–07, when people with almost no credit were buying and flipping houses and making money, attracted more and more people and created a soaring market. The phenomenon fed on itself. Bull markets in houses, stocks, or anything else can go higher and persist longer than we skeptics think is possible. That is what makes them so dangerous.

Minsky’s unique contribution here is the sequencing of events. Protracted stable periods where hedge financing works encourage both borrowers and lenders to take more risk. Eventually once-prudent practices give way to Ponzi schemes. At some point, asset values stop going up. They don’t have to fall, mind you, just stop rising. That’s when crisis hits.

The Economist described this process well in a 2016 Minsky profile article. (Emphasis mine.)

Economies dominated by hedge financing – that is, those with strong cashflows and low debt levels – are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.

Minsky’s conclusions are indeed unsettling. He called into question the belief that markets, left to operate unimpeded, will deliver stability and prosperity to all. Minsky thought the opposite. Markets are not efficient at all, and the result is an occasional financial crisis.

Complacency in the midst of a wanton debt buildup was beautifully expressed in a remark by Citigroup Chairman Chuck Prince in 2007:  The Citigroup chief executive told the Financial Times that the party would end at some point, but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” [source]

Minsky wasn’t around to see the 2008 crisis that fit right into his theory. Paul McCulley attached Minsky’s name to it, though, and now we refer to these crises as “Minsky moments.”

Are we closing in on one now?

Learning the Rules

As I mentioned, technology stocks suffered from a little anxiety attack in the markets last week. It didn’t not last long and really wasn’t all that serious. (Yet.) It was nothing worse than what everyone called “normal volatility” ten years ago. But the lack of concern it generated this time is not bullish, in my view. More than a few investors seem to think that “nowhere but up” is somehow normal.

Doug Kass had similar thoughts (there’s that Zeitgeist trope thing again) and reminded us all of Bob Farrell’s famous Ten Rules of Investing. You could write a book about each one of them. I’ll just list them quickly, then apply some of them to our current situation. (Emphasis mine.)

1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras – excesses are never permanent.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
5. The public buys most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. (Sound familiar? Can you say FAANGs?)
8. Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree, something else is going to happen.
10. Bull markets are more fun than bear markets.

I think most of these rules are obvious to investors who experienced the 2008 mess, the dot-com crash, and (if you’re of a certain age) the 1987 Black Monday. Some of us can remember 1980 and ’82. ’82 was especially ugly. (I had just gotten my master of divinity degree, and all I knew was that the job market sucked.) Maybe we mostly forget these experiences, but hopefully we pick up a little wisdom along the way. The problem is that now a new generation of investors lacks this perspective. They had little or no stock exposure in 2008 and experienced the Great Recession as more of a job-loss or housing crisis than a stock market crisis.

Of course, the previous crises are no secret. People know about them, and on some level they know the bear will come prowling around again, eventually. But knowing history isn’t the same as living through it. Newer investors may not notice the signs of a top as readily as do investors who have seen those signs before – and who maybe got punished for ignoring them at the time.

Doug Kass notices. Here’s a bit from an e-mail conversation we had last week.

During the dot.com boom in 1997 to early 2000 there was the promise (and dream) of a new paradigm and concentration of performance in a select universe of stocks. The Nasdaq subsequently dropped by about 85% over the next few years.

I got to thinking how many conditions that existed back then exist today – most importantly, like in 1999, when there emerged the untimely notion of “The Long Boom” in Wired magazine. It was a new paradigm of a likely extended period of uninterrupted economic prosperity and became an accepted investment feature and concept in support of higher stock prices!

And in 2007 new-fangled financial weapons of mass destruction – such as subprime mortgages that were sliced and diced during a worldwide stretch for yield – were seen as safe by all but a few.

And, just like during those previous periods of speculative excesses, many of the same strategists, commentators, and money managers who failed to warn us then are now ignoring/dismissing (their favorite phrase is that the “macroeconomic backdrop is benign”) the large systemic risks that arguably have contributed to an overvalued and over-loved U.S. stock market.

Doug points especially to Farrell’s Rule 7, on market breadth. A rally led by a few intensely popular, must-own stocks is much less sustainable than one that lifts all boats. We see it right now in the swelling interest in FAANG (Facebook, Apple, Amazon, Netflix, Google). Tesla comes to mind, too. Their influence on the cap-weighted indexes is undeniably distorting the market. These situations rarely end well.

Chinese Minsky

What is behind these distortions? Ultimately, it’s about capital flows. Asset prices rise when demand outstrips supply, which is what happens when stocks or real estate or whatever are perceived as more rewarding than cash. Those with the most unwanted cash compete with each other to buy the alternatives.

The Fed and other developed-country central banks created a lot of liquidity in recent years, so that’s undoubtedly a factor. An even greater one may be China, though.

Consider China’s explosive growth. Its proximate cause is US demand and, to a lesser extent, European demand for Chinese exports. We sent them our dollars and euros; they sent us widgets and doodads. US dollars inside China are undesirable to wealthy Chinese and the Chinese government, so they send the dollars right back to us in exchange for other assets: homes, commercial real estate, stocks, Treasury bonds, entire companies.

Meanwhile, within China, the government aggressively encourages lending for projects a free economy would never produce. Let me make a critical point here: While the central bank of China is not doing much in the way of quantitative easing, the government’s use of bank lending gone wild is essentially the same thing. The banks have created multiple trillions of yuan every year for many years. If you add Chinese bank lending statistics to the quantitative easing statistics of the world’s major central banks, the number is staggering. I think it’s entirely appropriate to perform that calculation.

Beijing thinks this massive bank lending is useful in keeping the population happy, employed, and satisfied with their government. It has worked pretty well, too. It can’t work indefinitely, but the government seems bent on trying. Consider this June 14 Wall Street Journal report.

While Beijing is carrying out a high-profile campaign to reduce leverage in its financial markets with one hand, with the other it is encouraging more potentially reckless borrowing. This week, the regulator put pressure on the country’s big banks to lend more to small companies and farmers, while the government announced tax breaks for financial institutions that lend to rural households. That follows recent guidance that banks should set up “inclusive finance” units.

If the goal of lending to poorer customers sounds noble, the concern is that the execution will only worsen Chinese banks’ existing problems, namely high levels of bad loans and swaths of mispriced credit. Bank lending to small companies is already growing pretty fast, with non-trivial sums involved: It jumped 17% in the year through March to 27.8 trillion yuan ($4.084 trillion). That compares favorably with the 7% rise in loans to large- and medium-size companies over the same period.

Observers like me have been saying for years that China’s banking system is overleveraged and will eventually collapse. We’ve been wrong so far. Beijing’s central planners may be Communists, but they use the capitalist toolbox to their advantage.

 China will eventually face a reckoning. When it does, the impact will spread far outside China. What do you think will happen when Chinese money stops buying Vancouver real estate and US stocks? The outcome won’t be bullish.

The Swiss National Bank Is Doing What?

Pity the poor Swiss government. They have run their country well and don’t have a great deal of debt. They are a small country of just 8 million people, but they make an outsized impact on economics and finance and money.

Because Switzerland is considered a safe haven and a well-run country, many people would like to hold large amounts of their assets in the Swiss franc. Which makes the Swiss franc intolerably strong for Swiss businesses and citizens. So the Swiss National Bank (SNB) has to print a great deal of money and use nonconventional means to hold down the value of their currency. Their overnight repo rate is -0.75%. That’s right, they charge you a little less than 1% a year just for the pleasure of letting your cash sit in a Swiss bank deposit.

And the SNB is buying massive quantities of dollars and euros, paid for by printing hundreds of billions in Swiss francs. The SNB owns about $80 billion in US stocks today (June, 2017) and a guesstimated $20 billion or so in European stocks (which guess comes from my friend Grant Williams, so I will go with it).

They have bought roughly $17 billion worth of US stocks so far this year. They have no formula; they are just trying to manage their currency. Think about this for a moment: They have about $1000 in US stocks on their books for every man, woman, and child in Switzerland, not to mention who knows how much in other assorted assets, all in the effort to keep a lid on what is still one of the most expensive currencies in the world. I gasp at prices every time I go to Switzerland. (I will be in Lugano for the first time this fall.)

Switzerland is now the eighth-largest public holder of US stocks. It has got to be one of the largest holders of Apple (see below). What happens when there is a bear market? Who bears the losses? Print just more money to make up the difference on the balance sheet? Do we even care what the Swiss National Bank balance sheet looks like? More importantly, do they really care? We all remember European Central Bank President Mario Draghi’s famous remark, that he would do “whatever it takes” to defend the euro. We could hear the Swiss singing from the same hymnbook, by and by.

The point is that central banks and governments all the world are flooding the market with liquidity, which is showing up in the private asset markets, in stock and housing and real estate and bond prices, creating an unquenchable desire for what appear to be cheap but are actually overvalued assets – which is what creates a Minsky moment.

Now, remember what Minsky said. When an economy reaches the Ponzi-financing stage, it becomes extremely sensitive to asset prices. Any downturn or even an extended flat period can trigger a crisis.

While we have many domestic issues that could act as that trigger, I see a high likelihood that the next Minsky moment will propagate from China or Europe. All the necessary excesses and transmission channels are in place. The hard part, of course, is the timing. The Happy Daze can linger far longer than any of us anticipate. Then again, some seemingly insignificant event in Europe or China – an Austrian Archduke’s being assassinated, or what have you – can cause the world to unravel.

It’s a funny world. We have our rashes of zombie moves and 20 people in all corners of the planet inventing the same thing at the same time. And we have our central banks and governments exhibiting unmistakable herd behavior and continuing to do the same foolish things over and over. They never really intend to have the crisis that ensues.

Remember Farrell’s Rule 3: There are no new eras. The world changes, but danger remains. Gravity always wins eventually. It will win this time, too. And when it does, we will begin undergo the Great Reset.

by Michael Lewis
June 3, 2012
Princeton University

Thank you. President Tilghman. Trustees and Friends. Parents of the Class of 2012. Above all, Members of the Princeton Class of 2012. Give yourself a round of applause. The next time you look around a church and see everyone dressed in black it’ll be awkward to cheer. Enjoy the moment.

Thirty years ago I sat where you sat. I must have listened to some older person share his life experience. But I don’t remember a word of it. I can’t even tell you who spoke. What I do remember, vividly, is graduation. I’m told you’re meant to be excited, perhaps even relieved, and maybe all of you are. I wasn’t. I was totally outraged. Here I’d gone and given them four of the best years of my life and this is how they thanked me for it. By kicking me out.

At that moment I was sure of only one thing: I was of no possible economic value to the outside world. I’d majored in art history, for a start. Even then this was regarded as an act of insanity. I was almost certainly less prepared for the marketplace than most of you. Yet somehow I have wound up rich and famous. Well, sort of. I’m going to explain, briefly, how that happened. I want you to understand just how mysterious careers can be, before you go out and have one yourself.

I graduated from Princeton without ever having published a word of anything, anywhere. I didn’t write for the Prince, or for anyone else. But at Princeton, studying art history, I felt the first twinge of literary ambition. It happened while working on my senior thesis. My adviser was a truly gifted professor, an archaeologist named William Childs. The thesis tried to explain how the Italian sculptor Donatello used Greek and Roman sculpture — which is actually totally beside the point, but I’ve always wanted to tell someone. God knows what Professor Childs actually thought of it, but he helped me to become engrossed. More than engrossed: obsessed. When I handed it in I knew what I wanted to do for the rest of my life: to write senior theses. Or, to put it differently: to write books.

Then I went to my thesis defense. It was just a few yards from here, in McCormick Hall. I listened and waited for Professor Childs to say how well written my thesis was. He didn’t. And so after about 45 minutes I finally said, “So. What did you think of the writing?”

“Put it this way” he said. “Never try to make a living at it.”

And I didn’t — not really. I did what everyone does who has no idea what to do with themselves: I went to graduate school. I wrote at nights, without much effect, mainly because I hadn’t the first clue what I should write about. One night I was invited to a dinner, where I sat next to the wife of a big shot at a giant Wall Street investment bank, called Salomon Brothers. She more or less forced her husband to give me a job. I knew next to nothing about Salomon Brothers. But Salomon Brothers happened to be where Wall Street was being reinvented—into the place we have all come to know and love. When I got there I was assigned, almost arbitrarily, to the very best job in which to observe the growing madness: they turned me into the house expert on derivatives. A year and a half later Salomon Brothers was handing me a check for hundreds of thousands of dollars to give advice about derivatives to professional investors.

Now I had something to write about: Salomon Brothers. Wall Street had become so unhinged that it was paying recent Princeton graduates who knew nothing about money small fortunes to pretend to be experts about money. I’d stumbled into my next senior thesis.

I called up my father. I told him I was going to quit this job that now promised me millions of dollars to write a book for an advance of 40 grand. There was a long pause on the other end of the line. “You might just want to think about that,” he said.

“Why?”

“Stay at Salomon Brothers 10 years, make your fortune, and then write your books,” he said.

I didn’t need to think about it. I knew what intellectual passion felt like — because I’d felt it here, at Princeton — and I wanted to feel it again. I was 26 years old. Had I waited until I was 36, I would never have done it. I would have forgotten the feeling.

The book I wrote was called “Liar’s Poker.” It sold a million copies. I was 28 years old. I had a career, a little fame, a small fortune and a new life narrative. All of a sudden people were telling me I was born to be a writer. This was absurd. Even I could see there was another, truer narrative, with luck as its theme. What were the odds of being seated at that dinner next to that Salomon Brothers lady? Of landing inside the best Wall Street firm from which to write the story of an age? Of landing in the seat with the best view of the business? Of having parents who didn’t disinherit me but instead sighed and said “do it if you must?” Of having had that sense of must kindled inside me by a professor of art history at Princeton? Of having been let into Princeton in the first place?

This isn’t just false humility. It’s false humility with a point. My case illustrates how success is always rationalized. People really don’t like to hear success explained away as luck — especially successful people. As they age, and succeed, people feel their success was somehow inevitable. They don’t want to acknowledge the role played by accident in their lives. There is a reason for this: the world does not want to acknowledge it either.

I wrote a book about this, called “Moneyball.” It was ostensibly about baseball but was in fact about something else. There are poor teams and rich teams in professional baseball, and they spend radically different sums of money on their players. When I wrote my book the richest team in professional baseball, the New York Yankees, was then spending about $120 million on its 25 players. The poorest team, the Oakland A’s, was spending about $30 million. And yet the Oakland team was winning as many games as the Yankees — and more than all the other richer teams.

This isn’t supposed to happen. In theory, the rich teams should buy the best players and win all the time. But the Oakland team had figured something out: the rich teams didn’t really understand who the best baseball players were. The players were misvalued. And the biggest single reason they were misvalued was that the experts did not pay sufficient attention to the role of luck in baseball success. Players got given credit for things they did that depended on the performance of others: pitchers got paid for winning games, hitters got paid for knocking in runners on base. Players got blamed and credited for events beyond their control. Where balls that got hit happened to land on the field, for example.

Forget baseball, forget sports. Here you had these corporate employees, paid millions of dollars a year. They were doing exactly the same job that people in their business had been doing forever. In front of millions of people, who evaluate their every move. They had statistics attached to everything they did. And yet they were misvalued — because the wider world was blind to their luck.

This had been going on for a century. Right under all of our noses. And no one noticed — until it paid a poor team so well to notice that they could not afford not to notice. And you have to ask: if a professional athlete paid millions of dollars can be misvalued who can’t be? If the supposedly pure meritocracy of professional sports can’t distinguish between lucky and good, who can?

The “Moneyball” story has practical implications. If you use better data, you can find better values; there are always market inefficiencies to exploit, and so on. But it has a broader and less practical message: don’t be deceived by life’s outcomes. Life’s outcomes, while not entirely random, have a huge amount of luck baked into them. Above all, recognize that if you have had success, you have also had luck — and with luck comes obligation. You owe a debt, and not just to your Gods. You owe a debt to the unlucky.

I make this point because — along with this speech — it is something that will be easy for you to forget.

I now live in Berkeley, California. A few years ago, just a few blocks from my home, a pair of researchers in the Cal psychology department staged an experiment. They began by grabbing students, as lab rats. Then they broke the students into teams, segregated by sex. Three men, or three women, per team. Then they put these teams of three into a room, and arbitrarily assigned one of the three to act as leader. Then they gave them some complicated moral problem to solve: say what should be done about academic cheating, or how to regulate drinking on campus.

Exactly 30 minutes into the problem-solving the researchers interrupted each group. They entered the room bearing a plate of cookies. Four cookies. The team consisted of three people, but there were these four cookies. Every team member obviously got one cookie, but that left a fourth cookie, just sitting there. It should have been awkward. But it wasn’t. With incredible consistency the person arbitrarily appointed leader of the group grabbed the fourth cookie, and ate it. Not only ate it, but ate it with gusto: lips smacking, mouth open, drool at the corners of their mouths. In the end all that was left of the extra cookie were crumbs on the leader’s shirt.

This leader had performed no special task. He had no special virtue. He’d been chosen at random, 30 minutes earlier. His status was nothing but luck. But it still left him with the sense that the cookie should be his.

This experiment helps to explain Wall Street bonuses and CEO pay, and I’m sure lots of other human behavior. But it also is relevant to new graduates of Princeton University. In a general sort of way you have been appointed the leader of the group. Your appointment may not be entirely arbitrary. But you must sense its arbitrary aspect: you are the lucky few. Lucky in your parents, lucky in your country, lucky that a place like Princeton exists that can take in lucky people, introduce them to other lucky people, and increase their chances of becoming even luckier. Lucky that you live in the richest society the world has ever seen, in a time when no one actually expects you to sacrifice your interests to anything.

All of you have been faced with the extra cookie. All of you will be faced with many more of them. In time you will find it easy to assume that you deserve the extra cookie. For all I know, you may. But you’ll be happier, and the world will be better off, if you at least pretend that you don’t.

Never forget: In the nation’s service. In the service of all nations.

Thank you.  And good luck.