In the 1980’s deregulation was all the rage. Reaganomics sat in the driver’s seat of a U.S. economy that saw sustained and stable growth throughout the 1980’s. The trend was to deregulate the financial industry with bills such as the 1980 Depository Institutions Deregulation and Monetary Control Act and the 1982 Garn-St Germain Act. Most economists believed that financial deregulation of this era was crucial to future stable growth. But while many economists were riding on this trend, one was predicting the future.
In 1986, Hyman Minsky, an economics professor with a Ph.D from Harvard, wrote “Stabilizing an Unstable Economy.” This paper theorizes how unregulated growth in the economy can cause serious recessions. The following quote, a favorite of mine, comes from this 1986 publication:
“Several years ago a television commercial asked ‘Where’s the beef?’. As economic theorists, bankers, or regulators and guarantors we have to be concerned with what determines the cash flows falling short of the commitments. In both economic theory and practical affairs of the world the question is ‘Where’s the cash flow?’”
At the time of this publication, his work went rather under the radar, with many economists disregarding his theories as speculative or unimportant. Deregulation of the financial industry really did lead to stable growth for the economy. But just as with most good things, it can be hard to see the negative side effects, and over 20 years later we would see the importance of asking “Where’s the cash flow?”
In 2008, the housing market crashed sending the economy into a tailspin. The Dow Jones Industrial Average dropped 50% in less than 18 months. Millions lost their jobs as the unemployment rate doubled from 5 percent to 10 percent in just two years. We forgot a valuable lesson from Minsky, nobody was looking for the cash flow.
The housing bubble was essentially caused by it’s own success. Financial institutions made money by packaging mortgages, which were safe and unrisky at the time, and sold them as CDO’s. Everyone wanted to buy these CDO’s because the common notion was that everyone paid their mortgage which made the assets safe and reliable. The problem became over time that there are only so many houses to sell, so they started bundling subprime mortgages. Here in lies Minsky’s predictions. As financial institutions sold and bought these loans like normal, nobody was looking at the cash flows. Most of the mortgages in theses “safe” CDOs were in reality extremely risky and not being paid. In 2008, the bubble bursts and we have our “Minsky Moment.”
Minsky’s 1992 paper, “The Financial Instability Hypothesis,” explains the crash even better. Minsky categorized debt as being either hedge, speculative, or ponzi financed. Essentially the idea is that as the economy grows more and more, firms move from being hedge financed to speculative or ponzi financed. The economy will eventually experience inflation which will cause the Fed to raise rates and constrain the money supply. If this happens while too many firms are speculative or ponzi financed, many of these firms become unable to pay their debts, and in turn their stakeholders come down with them. If the economy is too interconnected, the whole thing could collapse.
I hope this sounds familiar. We saw exactly these forms of debt financing before the housing crash in the form of loans such as interest-only, adjustable rate, and negative-amortization. Minsky was right all along, even 20 years before the crises. But can we learn anything from Minsky, or are we just bound to repeat the same things with another bubble?
Minsky opted for more regulations and overlook of financial institutions. He sought to create an economy that remained stable with less fluctuations in either direction. In 2009, Janet Yellen stated much of the same things, she said “it seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face.” There were some regulations set after the crash, most notably the Dodd-Frank Act, however some seem to have forgotten Minsky’s lessons already and seek to dismantle the Act. However things go, it is important to remember to ask “Where’s the beef?” Erh, sorry, “Where’s the cash flow?”