10/28/2015

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Minksys five steps to contagion

by Tom Streithorst / November 18, 2011 / Leave a comment

The fear of
unsustainable debt
levels has spread from
Greece, first to Spain
and Portugal, then to
Italy and now to France,
Austria, even Finland.
World leaders fear contagion, the final act in financial
Investors who had been
crises
pleased to put their
money into dodgy
assets now fear everything but the very safest. In the old days, they
fled to gold. Today, the equivalent of gold is German bonds. Private
investors are selling everything else. There are few buyers beside
governments and the European Central Bank. The possibility of
defaults, of bank closures, and of global recession grows by the day.
How did we get here?
Contagion is what the great Hyman Minsky and his populariser,
Charles Kindleberger, call the final act in financial crises. According to
Minsky there are five stages between bubble and bust. The first is
displacement or innovation: something changes that makes a certain
investment more profitable. In the 1990s, the promise of European
unification and a single currency removed currency risk from the
minds of European bond traders. One of the most profitable
speculations towards the end of the last millennium was the
convergence trade between German and southern European debt.
Financiers were convinced that without the chance that the lira could
depreciate against the Deutschmark, that Italian and German debt
should have the same price. Now that proposition seems utterly daft,
but back then, it made traders lots of money.
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The second stage is expansion. Minsky reminds us that no boom can

occur without fuel and that fuel is cash. Without easy money,
bubbles dont grow.The fuel was the German current account
surplus. In the early years of this century, the German economy
boomed, exporting far more to the peripheral European nations than
it imported. This current account surplus needed to be spent and so
it flooded out of German banks into southern Europe, funding
condominiums in Spain and government pensions in Greece. For a
while, everybody was happy.
The next stage, euphoria, peaked sometime around 2006.The
spreads between German and Greek debt became infinitesimal.For
a few extra basis points, optimistic traders were willing to ignore all
sorts of dangers. Subprime mortgages, Indonesian corporate bonds,
Greek government debtwere priced as if they were almost risk free.
The sad thing: traders made fat bonuses during those happy days
despite the obvious idiocy of their speculations.
It turns ugly with the fourth stage, revulsion. The asset that had so
recently tempted investors now fills them with fear. After Lehman
Brothers, the sense of placid optimism evaporated and traders fled
to safe havens. The lust for higher yield was replaced with the need
to preserve capital, and investors burned by subprime debt
wondered where else they had been blinded.
The answer: Greece, with high wages and low productivity, with
spectacular government debt levels and little prospect for growth.
Before 2008, eager bankers rolled over Greek debt when it became
due, making paper profits for themselves and allowing continued
Greek profligacy. By 2009 they were desperate to get their money
out. To protect exposed banks the European Central Bank promised
massive infusions of capital to buy maturing Greek debt, thereby
keeping yields down to sustainable levels. The ECB had enough
money to bail out Greece (or more accurately to bail out the banks
that had lent to Greece) but nowhere near enough to bail out Spain
or Italy.
And that is why we are in this mess today. Sometime over the past
year, watching German politicians bloviate and Greek protestors riot,
markets lost their faith in the ability of European elites to manage the
crisis. Contagion has turned a mess that could have been
manageable to one that is out of control. Just as euphoria blinds
investors to risk, revulsion blinds them to opportunity. The
assumption that Greek bonds are as solid as German bonds mutated
into the fear that the Finnish or French economy is as fragile as the
Greek. Neoclassical economics assumes investors are rationalbut
Minsky knew better.

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Comments
atimoshenko
November 18, 2011 at 12:51

So is there any point at which finical markets are working

properly and creating value for the broader economy? From
the article it sounds as if financial markets have only two
modes suffering from a current crisis or setting the stage for
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modes suffering from a current crisis or setting the stage for

the next one.
REPLY

Tom Streithorst
November 18, 2011 at 16:15

The efficient market theory says that security prices are always
right. That clearly doesn't fit the evidence. However I don't
think that suggests that they are always wrong. What it does
suggest is that unregulated financial markets do not best
allocate societal savings, which is supposed to be their job.
REPLY

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