Keynes, Minsky and the state of global markets today
Aug 12, 2007
A lot of investors, and surprisingly a lot of veteran market watchers, are asking a simple question: how could a small disturbance in the U.S. sub-prime mortgage market cause a riot in the global equity markets? How could equity markets around the world tumble and hit severe turbulence because of such a seemingly isolated and uncorrelated event?
Chaos theorists may have a field day, and math and systems nerds might bring out their non-linear feedback theories out of their closets.
We will, however, refer to the work of two economists, one very famous and the other not so famous until recently. In fact, we will simply quote these two economists and let the reader judge whether he can get any clues to the above questions.
John Maynard Keynes came out with his General Theory of Employment, Interest and Money in 1936 when the world was in its seventh year of Great Depression. Policymakers, investors and bankers were lying prostrate; they were frustrated baffled and rendered impotent and the masses in the western hemisphere, especially in the United States were going to bed hungry. There was bafflement at the fact that the standard economic theory at the time - the classical school of thought - had completely failed to predict the coming of the Great Depression. There was frustration and a feeling of impotence because all policy measures had at best produced very meager outcomes.
We'll however like to highlight an excerpt from that book which could be put in context to today's equity and credit markets.
Let's hear what Lord Keynes had to say in his General Theory seventy years ago:
"So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. That is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas a weakening of either is enough to assure a collapse, a recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition. " J.M. Keynes, The General Theory 1936 p. 158
Hyman Minsky, an American economist, studied John M Keynes in great detail. Unlike many of his contemporaries he looked at the macro economy from a Wall Street board room and then wondered aloud as to what causes "long waves" of business cycles. Let's hear what he had to say in 1975 when he was commenting on Lord Keynes work in his own book:
"The state of credit reflects bankers' views toward borrowers, and bankers finance the positions of both real-asset holders and equity-share holders. A revision by bankers of their views about the appropriate leverage to use in financing positions in capital assets will not necessarily cause an immediate revision in the market value of these assets- especially if the prospective yields and the capitalization ratio are unaffected. But such a revision of bankers'' views can have a strong impact upon equity prices..." Hyman P. Minsky, John Maynard Keynes, 1975 p. 119
In the same book, he further says:
"A key contribution of Keynes to the study of disequilibrium processes is the explicit introduction of the perspective that changes induced by disequilibrium in a particular market may have their major effect upon the initially affected market by first affecting conditions in other markets; that is, the reaction to a disequilibrium in one market may induce disequilibria in other markets. The question arises whether these intermarket feedbacks lead to a new equilibrium or whether the feedback process exacerbates the initial disequilibrium. " Hyman P. Minsky, John Maynard Keynes, 1975 p.49
Minsky had no idea about CDOs or default swaps but knew better than anyone then and perhaps any banker now, as to how corporate cash flows and leverage impact business cycles:
"How do units get into a position where their cash outflow due to commitments is greater than their cash inflow due to operations? One way is deliberate, when a unit is engaged in an investment program that requires external financing. Another way is by error, such as overestimating the net cash inflow, or by being unduly optimistic about sales or costs. A further way is by having debtors on owned contracts default - which in a closely articulated set of layered financial relations can have a domino effect. Firms may also deliberately and actively speculate by taking a chance that refinancing will be available at a reasonable rate. This will be done if more favorable refinancing terms are available on short-term liabilities than are available on long-term liabilities, or if terms on long-term liabilities are viewed as being unduly high, so that they are expected to be lower in the relevant future. " Hyman P. Minsky, John Maynard Keynes, 1975 p. 88
Reference: The passages are referenced from the writings of Doug Noland, March 20, 2001 as reported in the website www.safehaven.com
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