The resurrection amidst the recent market turmoil of economist Hyman Minsky and his theories on credit supply and systemic risk has been traced (not least by FT Alphaville) to a number of sources. Among them is George Magnus, now senior adviser at UBS, who some (including the FT’s Martin Wolf ) credit with coining the term the “Minsky moment”: the point at which credit supply starts to dry up, even to sound borrowers, and the central bank is obliged to intervene.
In Thursday’s FT, Magnus says that moment “has duly arrived”. The Fed’s decision to lower the discount rate last week, while largely a symbolic act, was greeted with much enthusiasm - “not least because of a sense of relief that the Fed was prepared to act,” he notes.
But while equity markets have stabilised temporarily in anticipation of a Fed loosening, credit markets “remain deeply troubled,” he says.
The immediate focus is on short-term funding, financing flows and counterparty risk. This week, three-month US Treasury bills touched 2.99 per cent, compared with a yield of 5 per cent a month ago. Investors are avoiding securities collateralised against or invested in mortgages. This ‘Minsky moment’ is not yet over - interest rates in the US and perhaps elsewhere will come down sooner or later. The path ahead is littered with losses, lawsuits and greater regulation.
But what about the economic consequences?, asks Magnus.
Hypothetical scenarios revolve around whether declines in interest rates will spur a new round of risk-taking and debt, or whether we will be left pushing on that “wretched piece of string” (the term widely used to describe the Bank of Japan’s failed attempts in the mid-1990s and early 2000s), says Magnus.
If the former, it will give longevity to the economic expansion, culminating in 2008 in the revival of higher inflation and interest rate fears. If the latter, we may at best face slow growth and higher unemployment until 2009, with interest rates declining in most places through next year.
In Magnus’s view, two main propositions define the outlook: “First, the flight from debt in this downswing may be as potent as the rush towards it on the upswing”. It is most likely, he warns, that the reduced availability of cheap credit is going to lead to a sharp reverse in US spending on goods and services and assets.
Second, “current credit cycle concerns are about solvency, not liquidity per se, as was the case in 1998, after which the world economy recovered quite promptly”. This time, the problem is about solvency among homeowners, builders, mortgage providers and financial institutions, he notes.
“The US, of course, is on the front line, but there will be knock-on effects elsewhere,” he says. “But the threats to growth in most cases appear to lie in the as-yet-uncertain impact on growth in developed economies”.
The most likely outcome will not be a total decoupling in which the US takes it on the chin and other regions get off scot-free. The world economy is likely to lose momentum and the only question is how much. This will depend on the extent of the US slowdown.
Lower interest rates might work again, “but downside risks to house prices and construction remain, with threats of an increase in both housing inventories and home repossessions”.
Added to these worries is an increase in the cost of capital, a cyclical switch from building up debt to rebuilding savings and probable declines in consumer and business confidence. It is hardly surprising , then, that Magnus’s conclusion is that all this suggests “the business cycle is going to get quite rough”.
