The "Minsky Moment"

ACCORDING to Andrew Smith, KPMG’s chief economist, a fellow of the Society of Business Economists and a board member of the Centre for International Business and Management at the Judge Institute, Cambridge, the financial crisis was inevitable. He tells TheBusinessDesk.com just why we should have all seen it coming.

“The long march back to boredom and stability starts tonight in Leeds is what Mervyn King, Governor of the Bank of England, said during his recent tour of Yorkshire.

King’s visit to the region came as local businesses are starting to accept that recession is a reality – the result of a financial crisis from far afield.

Recessions usually cause the financial system to weaken, but this time a weak financial system is threatening to cause recession.

In the 1970s, the trigger for recession was an economic shock – a sharp rise in the oil price – which deflated demand in oil consuming countries while at the same time setting off an inflationary spiral. In the recession of the early 1990s, different economies suffered for different reasons, for example, an overheating economy and housing bubble (yes, then as well) in the UK, which affected the economy up and down the country – unlike the previous recession of a decade earlier, when large swathes of the North’s industrial base were decimated. In each case, though, it was economic problems which precipitated the strains in the financial system, not vice-versa.

This time round, the financial system threatened to implode on its own – with knock-on effects on the wider economy, including the North, still to come. So how is it that solid, local businesses in a range of (non-financial) sectors are facing serious performance difficulties after a period of apparently unparalleled economic stability and in the absence of an external shock?

The economist Hyman Minsky put forward a simple model to explain why long periods of economic stability actually breed financial instability. In short, investors are lulled into a false sense of security which encourages them to borrow excessively and overpay for assets. The number of so-called “ponzi” borrowers, who cannot afford to pay either principal or interest but rely on ever-rising asset prices to stay afloat, multiplies. The “Minsky moment” comes when lenders realise that they, too, have taken on too much risk and cut back.

We are left with a mountain of under-priced debt (lenders have not charged enough to compensate for defaults), over-priced assets (which now have to find their own level), over-extended borrowers (who will have to cut back on spending) and potentially undercapitalised banks.

Governments have now taken decisive action to underpin the financial system, thus hopefully averting a re-run of the 1930s Depression or 1990s Japan. However, the adjustment to the deflating credit and asset price bubbles still has to run its course and business across the North may need to manage their assets and liabilities with great care during this time. The emphasis now must be on re-liquefying credit markets, via central bank cash injections, and further interest rate cuts, to ensure that businesses are not starved of funds and to ameliorate the worst effects on our economy as consumers cut back.

In the US and the UK house price booms and associated debt levels have been the most excessive and require the largest adjustments. Other economies are less exposed on this count but a globalised world, trade and financial market links mean that businesses in this region are not immune to the fall-out.”