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Analysis/Comment Last Updated: Nov 4, 2010 - 2:56:00 PM


The Credit Crisis: Denial, delusion and the "defunct" American economist who foresaw the dénouement
By Michael Hennigan, Founder and Editor of Finfacts
Sep 17, 2008 - 4:52:07 AM

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The Credit Crisis: Denial, delusion, hubris and many more terms come to mind amidst the turmoil of the credit crisis but a maverick American economist foresaw the current dénouement and argued that,even in the absence of external shocks, financial markets are not the efficient models promoted by mainstream economists, but have an inherent tendency to develop instability, which culminates in severe economic crises.

The renowned British economist John Maynard Keynes, concluded his famous book, The General Theory of Employment, Interest and Money, which was published in 1936: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist."

Hyman Minsky became a "defunct economist" in 1996 at the age of 77. Although born in Chicago, Minsky was regarded as a crackpot, by the "Chicago School" of economists, who believed that markets were efficient. Since he died, a decade of financial crises has began to lend credence to his ideas.

Minsky, a PhD from Harvard University, worked at the University of Washington in St. Louis and also sat on the board of a local bank.

Minsky argued that the key mechanism that pushes the economy towards a crisis is the accumulation of debt.

When times are good, investors take on risk; the longer times remain good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Minsky wrote.

Minsky distinguishes between three types of borrowers. The first type he labels hedge borrowers who can meet all debt payments from their cash flows.

The second type are speculative borrowers who can meet interest payments but must constantly roll over their debt to be able to repay the original loan.

The third group of borrowers Minsky labeled Ponzi borrowers (named after the swindler Charles Ponzi); they can repay neither the interest nor the original loan. These borrowers rely on the appreciation of the value of their assets to refinance their debt.

Minsky said that the financial structure of a capitalist economy becomes more and more fragile during the period of prosperity. In short, the longer the prosperity, the more fragile the system becomes, Minsky argued.

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.

Hyman Minsky (1919–1996)
This framework of thinking comprises the essence of what Minsky dubbed the Financial Instability Hypothesis (FIH) - brief summary written by Minksy in 1992.

Minsky said that in good times, banks and other intermediaries focus on innovation with regard to the assets they acquire and the liabilities they market. In effect, he argued that during good times, financial intermediaries try to lure investors to buy the debt by means of sophisticated innovations.

In a paper he co-authored, Minsky said that “apt intervention and institutional structures are necessary for market economies to be successful.”

Former Fed Chairman Alan Greenspan has argued that a bubble should be allowed to burst as it is difficult to pinpoint when to prick it.

That claim has lost some currency, in recent times.

A system where individual bank traders had no reason to co-operate with other departments while they have millions of dollars of incentives to go it alone with high-risk, high-return strategies with no payback required if the rainmaking turns to disaster, contains the seeds of its own destruction..

The seven largest US banks paid their bankers $95bn in compensation between 2005 and 2007, according to the consultancy firm Accenture.

What other industry pays it staff some 50 per cent  or more of their annual revenues?

Financials as a percentage of S&P 500 market capitalisation rose from 8% in 1990 to almost 25% at the height of the housing boom and in recent times, the cut of the Fed's federal funds rate to 1% facilitated the out-of-control asset boom.

James Grant, the editor of Grant's Interest Rate Observerwrote in the Wall Street Journal last July that Wall Street is usually described as an industry, but it shares precious few characteristics with the metal-fasteners business or the auto-parts trade. The big brokerage firms are not in business so much to make a product or even to earn a competitive return for their stockholders. Rather, they open their doors to pay their employees -- specifically, to maximize employee compensation in the short run. How best to do that? Why, to bear more risk by taking on more leverage.

Grant cites Morgan Stanley, which had a ratio of assets to equity of 33 times at year-end 2007 from 26.5 times at the close of 2004. In 2007, Morgan Stanley paid out 59% of its revenues in employee compensation, up from 46% in 2004.

They borrow to the eyes and pay themselves lordly bonuses. Naturally -- eventually -- they drive themselves, and the economy, into a crisis. And to the scene of this inevitable accident rush the government's first responders -- the Fed, the Treasury or the government-sponsored enterprises -- bearing the people's money.

Recently, Prof Peter Morici wrote in Finfacts: ...the banks' problems are much deeper and far reaching than their losses on subprime securities. Citigroup's losses on Old Lane hedge fund provide a classic illustration. To attract CEO Vikram Pandit, Citigroup purchased Old Lane for $800 million. Although the fund never made much profit, the transaction netted Pandit $165 million. Subsequently, Citigroup wrote down more than $200 million in losses. Pandit used some of his proceeds to purchase the late actor Tony Randall's Manhattan apartment for $17.9 million, and Citigroup shareholders took the loss. Nothing Bernanke has proposed will stop that kind of reckless behavior, which has nothing to do with the subprime debacle.

All this coincides with the reality of falling real incomes for the typical middle class and lower income American families.

During the Irish housing boom, a small number of economists effectively became PR men for the Irish construction industry. While promoting dud shares would invite attention from the Financial Regulator, there was no need for restraint in blind or self-interested marketing support of house sales or poor standard apartment units.

Then for the general public, as now, credibility was lent to an "expert" or "top economist" by the media, with no reference to the track record or selectivity. There is always a rush to get a filler soundbite and besides, economically illiterate journalists are not a scarce species.

Minister for Finance Brian Lenihan has said that the Irish people were responsible for the out-of-control housing boom while the cheerleaders understandably want to move on.

In April 1973, Time Magazine reported that "White House Press Secretary Ronald Ziegler enlarged the vocabulary last week, declaring that all of Nixon's previous statements on Watergate were "inoperative." Not incorrect, not misinformed, not untrue—simply inoperative, like batteries gone dead."

Far from declaring past positions as inoperative, there is still denial, which was the subject of a New York Times article on Monday.

"Because after you get past the mind-numbing complexity of the derivatives that are at the heart of the current crisis, what’s going on is something we are all familiar with: denial,"Joe Nocera wrote. "Indeed, it is not all that different from what is going on in neighborhoods all over the country. Just as homeowners took out big loans and stretched themselves on the assumption that their chief asset — their home — could only go up, so did Wall Street firms borrow tens of billions of dollars to make subprime mortgage bets on the assumption that they were a sure thing."

Last week, Bank of Ireland economist Dan McLaughlin said Irish house prices are falling at a reduced pace but he omitted an important qualification from the producer of the price index permanentTSB, which said that July data was based on a small sample, which "was a factor in the very low decline in average prices during July."

Also last week, Bloxham Stockbrokers economist Alan McQuaid who a year ago was "sick to death" of critics of the Irish economy, forecast GDP growth of 4 per cent in 2010.

I wrote that while falling commodity prices, interest rates and an easing in the credit crisis, are realistic expectations for 2010 with the beginning of a global recovery, it would be a serious mistake to believe that the scenario of the ESRI's Medium Term Economic Review, would inevitably kick-in.

In the Irish Times on Tuesday, NUI Galway university economist Alan Ahearne said in relation to the question: How painful will the economic downturn be and long will it last?- "The simple and honest answer is that the slump will be severe and will probably last longer than most people think. The consensus among economic forecasters is for a moderate decline in real GDP this year, followed by a pick-up to low positive growth in 2009. A robust recovery, with growth of roughly 4 per cent, is pencilled in for 2010."

Finfacts Reports:
US Treasury and Federal Reserve to propose sweeping plan to stem the worst financial crisis since the 1930's
IMF says worst of the financial crisis may still lie ahead; Storm can be weathered without a damaging global recession; Recovery to be only gradual
US Securities and Exchange Commission to issue temporary ban on short-selling; Irish and UK regulators announce bans to protect financial stocks from shorting
The Credit Crisis: Denial, delusion and the "defunct" American economist who foresaw the dénouement
Panic on Wall Street: Barometers of stress hit World War II levels; Fears grow about credit-default swaps on more than $62 trillion in debt (Thursday report - - See why Warren Buffett termed credit default swaps and derivatives "weapons of mass destruction" in 2003.)
Irish Economy: Ireland is faced with new challenges as the US financial sector faces retrenchment and transformation
Analysis: Irish Economy - Cowen and the 100 days' milestone - a Political Pygmy amongst the Oireachtas Lilliputians
Irish Services Strategy Group Report: Political whitewash ignores overwhelming dominance of foreign-owned firms in Irish service exports thereby neutering strategy for Irish firms
IBEC and understanding the world East of Suez
Whitaker Tribute Conference: International academic says Ireland’s economic institutions “seem inherently quite vulnerable to corruption, special pleading, ‘jobs for the boys’ and other such undesirable distortions"
The Irish Mind and the Knowledge Economy: Should we bank everything on fuzzy leprechaunic political dreams?
Irish investors were the second biggest net investors in commercial property across Europe in 2007
Foreign-owned firms were responsible for 90.2% of Irish exports in 2006 - including both merchandise goods and internationally traded services
International house price comparison index for 2007 ranks Dublin, Ireland and Beverly Hills, California for world's most expensive comparable management level family homes
Irish full-time employment in manufacturing and internationally traded services fell 10,297 in the period 2000-2007 while the total workforce expanded by 60

Ahearne said that this projected path for economic activity looks implausible.

It's simply a matter of a choice between reality and denial.

As I have no guaranteed pay cheque, I have no desire for a hairshirt but spoof results in delusion as for example last Friday's Government report,which sought to give the impression that Irish service exports are not dominated by American firms.

Finally, a recently published book, The Origin of Financial Crises, by George Copper, a London-based fund manager, has received favourable reviews and the Economist has termed it the best book so far on the credit crisis.

Cooper's main argument is that asset markets are peculiarly vulnerable to boom and bust, and are therefore the real destabilising force in the financial system, while central banks concentrate on consumer prices.

Cooper says that central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the slightest hint of crisis, central bankers have responded by cutting interest rates to stimulate their economies and prevent asset prices from falling. He says central banks should permit some short-term cyclicality in order to purge the system of excesses.

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