The Next Minsky Moment
“China’s economy has entered a state of new normal.”
– Premier Li Keqiang, 2015
“Success breeds a disregard of the possibility of failure.”
– Hyman Minsky
Welcome to the new, improved, faster-to-read, better yet
still-free Thoughts from the Frontline. My
team and I have been doing a lot of research on what my readers want. The
reality is that my newsletter writing has experienced a sort of “mission creep”
over the years. Bluntly, the letter is just a lot longer today than it was five
or ten years ago. And when I’m out talking to readers and friends, especially
those who give me their honest opinions, many tell me it’s just too much. There
are some of you who love the length and wish it were even longer, but you are
not the majority. Not even close. We all have time constraints, and I wish to
honor those. So I am going to cut my letter back to its former size, which was
about 50% of the length of more recent letters. (Note: this paragraph is going
to open the letter for the next month or so, since not everybody clicks on
every letter. Sigh. Surveys showed us it’ s not because you don’t love me but
because of demands on your time. I want you to understand that I get it.) Now
to your letter…
Hollywood thrives on tropes. Most things that are possible to
portray on film have been portrayed at some point in the last century. Today’s
producers mostly just rearrange those tropes – and that’s OK.
Much of what we think is new and different is actually one
variation or another on ancient themes. My favorite book genre, science
fiction, has many archetypal tropes that can be traced back to Greek mythology,
which itself must have grown out of tales that must have been told for
millennia. Thus it’s little wonder that the “zeitgeist” of our time seems to
produce a lot of zombie movies or asteroid movies or bad-alien movies. These
and many other tropes just “get in the air” and take on a life of their own.
It’s not just storytelling; it’s inventions, too. You must take a
minute to read this quote from Matt Ridley’s critically important book, The
Evolution of Everything:
Suppose Thomas Edison had died of an electric shock before
thinking up the light bulb. Would history have been radically different? Of
course not. Somebody else would have come up with the idea. Others did. Where I
live, we tend to call the Newcastle hero Joseph Swan the inventor of the
incandescent bulb, and we are not wrong. He demonstrated his version slightly
before Edison, and they settled their dispute by forming a joint company. In
Russia, they credit Alexander Lodygin. In fact there are no fewer than
twenty-three people who deserve the credit for inventing some version of the
incandescent bulb before Edison, according to a history of the invention
written by Robert Friedel, Paul Israel, and Bernard Finn. Though it may not
seem obvious to many of us, it was utterly inevitable once electricity became
commonplace that light bulbs would be invented when they were. For all his
brilliance, Edison was wholly dispensable and unnecessary. Consider the fact
that Elisha Gray and Alexander Graham Bell filed for a patent on the telephone
on the very same day. If one of them had been trampled by a horse en route to
the patent office, history would have been much the same.
I am going to argue that invention is an evolutionary phenomenon.
The way I was taught, technology was invented by god-like geniuses who stumbled
upon ideas that changed the world. The steam engine, light bulb, jet engine,
atom bomb, transistor – they came about because of Stephenson, Edison, Whittle,
Oppenheimer, Shockley. These were the creators. We not only credit inventors
with changing the world; we shower them with prizes and patents.
But do they really deserve it? Grateful as I am to Sergey Brin for
the search engine, and to Steve Jobs for my MacBook, and to Brahmagupta (via Al
Khwarizmi and Fibonacci) for zero, do I really think that if they had not been
born, the search engine, the user-friendly laptop, and zero would not by now
exist? Just as the light bulb was ‘ripe’ for discovery in 1870, so the search
engine was ‘ripe’ for discovery in 1990. By the time Google came along in 1996,
there were already lots of search engines: Archie, Veronica, Excite, Infoseek,
Altavista, Galaxy, Webcrawler, Yahoo, Lycos, Looksmart . . . to name just the
most prominent. Perhaps none was at the time as good as Google, but they would
have got better. The truth is, almost all discoveries and inventions occur to
different people simultaneously, and result in furious disputes between rivals
who accuse each other of intellectual theft.
In the early days of electricity, Park Benjamin, author of The Age of Electricity,
observed that ‘not an electrical invention of any importance has been made but
that the honour of its origin has been claimed by more than one person.
This phenomenon is so common that it must be telling us something
about the inevitability of invention. As Kevin Kelly documents in his book What Technology Wants, we
know of six different inventors of the thermometer, three of the hypodermic
needle, four of vaccination, four of decimal fractions, five of the electric
telegraph, four of photography, three of logarithms, five of the steamboat, six
of the electric railroad. This is either redundancy on a grand scale, or a
mighty coincidence. It was inevitable that these things would be invented or
discovered just about when they were. The history of inventions, writes the
historian Alfred Kroeber, is ‘one endless chain of parallel instances’.
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.
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.
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!
[JM note: Here’s the Wired
article Doug mentions: “The
Long Boom: A History of the Future, 1980-2020.”]
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.
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.
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.
It’s time to hit the send button. This week will be a full-on
sprint to try to get everything done before we leave for the Virgin Islands on
Saturday. You have a great week.
Your pondering the Great Reset analyst,
John Mauldin
0 comments:
Publicar un comentario