This post talks about someone who has influenced modern investing and banking to a great deal – Hyman Minsky.
Hyman Minsky was a Jew born in 1919 at Chicago to immigrants from Belarus. He studied in the famous Chicago University and taught economics at the Washington University he died in the year 1996.Like most people who grew in the depression years he was preoccupied with causes of the great depression. Unlike most economies who believed in the equilibrium model where the economy grew steadily under stable conditions. They believed that crisis were caused by external shocks like war or technological innovations like the internet or the railroads .In their model the banks were considered only as pipes that transferred money from avers to borrowers and did not study it much. Minsky disagreed he treated banks as institutions which were there to make profits for their shareholders and therefore had an incentive to lend money.
Minsky’s theory can be explained in three words stability is instability. He correctly summarized that the seeds of the next crisis is sown by the bankers when the times are good. According to him the bankers moved the economy from stability to instability by their lending practices urging profitable customers to borrow more when times are good and progressively getting reckless with the quality of customer as the boom progresses. He concluded that there are three types of customers of the bank .
Namely:
- A) Hedger,
- B) Speculator,
- C) PONZI operator.
Hedgers are borrowers from the banks who can repay both principal and interest for the money they have borrowed from the bank and do not require cash flows from the assets that have been purchased using borrowings.
Speculators are borrowers who leverage banks to borrow more assets but are in a position to pay interest alone from present cash flows but need the banks to rollover the principal and reissue the loan to them.
Ponzi operators are the third category of borrowers who depend upon the price of the purchased assets to continuously to rise to enable them to pay both interest and principal. The moment the price of the asset purchased stagnates or falls they will default as their margin evaporates quickly.
At the beginning of as the economy grows the bankers are very prudent and only lend to hedgers as the economy grows and the competition intensifies and everyone scrambles for a profit the quality of the borrower deteriorates till it reaches the point where people with no income proof get loans and everyone thinks they can earn money by flipping assets.
Till the moment arrives when the asset prices take a pause and begin to decline and defaults begin by the Ponzi operators and the contagion spreads as the banker refuse to rollover principal for the speculators and finally the Hedger find it difficult to borrow. This moment when asset prices begin to unravel was named as Minsky moment by economists who followed him.
Minsky believed that the central bank playing the lender of the last resort would restore stability to the system. Subsequent events have shown that the central bank s sow the seeds of the crisis by keeping interest rates artificially low for too long a period. The 2008 housing crisis fits the Minsky hypothesis perfectly. The cure prescribed by the Federal Reserve has created an artificial boom in Wall Street. The intelligent investors await the coming of the next Minsky moment.
Is Raghuram Rajan the honourable Reserve Bank of India Governor listening?
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