Is Australia heading towards a “Minsky moment”? - Peter Bain

Hyman Minsky, if he were still alive, would have some interesting observations about Australia in 2020. The late American economist, whose theories experienced a revival following the GFC, was considered post-Keynesian and was critical of much of the deregulation of financial markets in the eighties. In particular, he warned against the perils of underregulated credit markets and the build up of private debt.

His financial instability hypothesis (FIH) predicted that at a particular point following the development of a speculative bubble, an economy would spiral out of control because private debt had hit a critical point and rapid deleveraging would occur.

The closest economic model I have seen to predicting that outcome is the very imperfect Elliott Wave Theory, and while relatively unusable as a forecasting tool, it paints a picture of the predictable steps in the development and collapse of bubbles and governments often misguided attempts to manage them.

In an extraordinary analysis somewhat analogous to quantum theory, Elliott predicts that just as naturally occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices. In the words of mathematician and author John Casti:

“It’s as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we’re all bound by the same order.”

Some Elliott Wave proponents believe we are the end of growth cycle lasting centuries.

The treasurer’s announcement last week of a reversal of credit reforms was a predictable but dangerous response to our COVID-induced recession. Governments and central banks across the world have thrown the kitchen sink at the global recession, using massive stimulus, record low interest rates and quantitative easing in an attempt to kickstart crushed economies.

But in Australia that comes at the end of two decades of measures aimed at keeping our housing debt bubble intact. Historically low interest rates and various property related incentives such as the first home buyers grant have driven asset prices and debt to world breaking levels and compensated for slow growth, allowing our standard of living to remain relatively unchanged, but endowing on future generations extraordinary indebtedness.

Up until recently, Australian government net debt has been relatively low by world standards, but has exploded since the GFC from near zero to in excess of a trillion dollars. The impost on our children and grandchildren is terrifying.

Frydenberg’s reversal of hard won reform following the banking inquiry is just the latest measure to keep the party going, but could be the final addition to the house of cards destined for collapse.

Minsky stated that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

This slow movement of the financial system from stability to fragility, followed by crisis, is something for which Minsky is best known, and the phrase “Minsky moment” refers to this aspect of Minsky’s academic work.

Minsky’s theory can be described in three stages using an analogy from the mortgage market: a “hedge” borrower would have a traditional mortgage and is paying back both the principal and interest; the “speculative” borrower would have an interest-only loan, meaning they are paying back only the interest and must refinance later to pay back the principal and the “ponzi” borrower would have a negative amortisation loan, meaning the payments do not cover the interest amount and the principal is actually increasing. Lenders only provide funds to ponzi borrowers due to a belief that housing values would continue to increase.

The progression through Minsky’s three borrowing stages was evident as the credit and housing bubbles built through approximately August 2007 in the US and is clear in recent years in Australia. In the US, demand for housing was both a cause and effect of the rapidly expanding shadow banking system, which helped fund the shift to more lending of the speculative and ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher home prices.

In Australia we are now seeing a move to the freeing of credit, which will likely drive further speculative borrowing. After the bubble finally bursts, the progression reverses, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages shifts back towards the hedge borrower.

Human nature is inherently pro-cyclical, meaning, in Minsky’s words:

“From time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.”

In other words, people are momentum investors by nature, not value investors. People naturally take actions that expand the high and low points of cycles. One implication for policy makers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts.

Relatively few Australian thought leaders are across such concerns. Steve Keen, John Adams and Martin North are exceptions. We would be fools to not understand their studies and heed their warnings.

Peter Bain is a Melbourne based businessman.  He holds an economics degree from Monash University.

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