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A Minsky moment

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Tuesday, Jul 8, 2008

That we measure consumer confidence and sentiment and report the figures with great portentousness has always troubled me. It’s not just the unsettling implication that the intention to consume more is inherently good, and a positive sign for all of us—though that has certainly contributed to the wasteful, throwaway economy we currently enjoy, in which sensibly reusing goods registers as damage to the economic picture. But is there really something all that relevant in how people feel about spending their money? Shouldn’t we stick to the data about what they are actually doing? Surveys seem an especially dubious way to get at the truth, given that people routinely exaggerate or misrepresent their behavior when they are put in the spotlight and are taken seriously for once. But the scrutiny to which economists and policymakers subject these figures is enough to lead one to suspect that the economy runs on nothing but optimism—that what is produced and sold is in a way secondary or even beside the point. What’s scary is that this might be true.


Yesterday in the FT Wolfgang Münchau mentioned (and dismissed) the possibility that the world economy has reached what is known as a Minsky moment.


Hyman Minsky, the 20th century US economist, formulated the long forgotten, and recently rediscovered, financial instability hypothesis, according to which capitalist economies, after a long period of prosperity, end up in a vicious circle of financial speculation. The Minsky moment is the point when what economists call this “Ponzi game” collapses.


The WSJ‘s Justin Lahart offered this more specific explanation last year:


At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. “This is likely to lead to a collapse of asset values,” Mr. Minsky wrote. When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash [that can force central bankers to lend a hand]. At that point, the Minsky moment has arrived.


In other words, risky assets are sold along a chain of investors, with each investor confident they will be able to sell the asset along to a bigger sucker and take profits in the process. Eventually, though, investors run out of suckers, the accumulated debt engenders fire sales and spiraling depreciation, and central banks are forced to become suckers of last resort. Vox EU’s compendium of analyses of the subprime crisis offers this description the logic leading to a Minsky moment: it “starts with unrealistically high asset prices and buildups of leverage based on momentum effects, myopic expectations and widespread overleveraging of consumers and firms.” Myopic expectations seems a good way to describe what surveys about consumer sentiment and confidence are likely to record, no matter how far in the future the time period is that the people surveyed are supposed to prognosticate about. It seems possible that such surveys have the effect of fostering myopic expectations, generating a seemingly statistical and sound basis for such optimistic feelings (that is, while the Minsky moment is building). The consumer opinion measures are trailing indicators that often are passed off as leading indicators, so they incubate optimism even when people are starting to wonder where the next sucker is. Such surveys are not passive gauges but are actively constructing the sort of sentiment it seeks to measure by the momentum of its own periodicity and the assumptions built into the questions, that consumerism is rational and reflective rather than impulsive with motives poorly understood even by those caught up in them.


What precipitates a Minsky moment is some vague awareness that things can’t go on forever, but it’s not clear what triggers it. John Cassidy notes in this New Yorker essay about Minsky moments that “the onset of panic is usually heralded by a dramatic effect,” but that is to say it’s only apparent after the fact. The inevitable end seems a problem for game theory: Tyler Cowen linked yesterday to an excerpt from Richard Tuck’s new book, Free Riding, which aims to make the case that individual action is meaningful even when the difference it makes seems indiscernible. In the excerpt, he looks at the prisoner’s dilemma and notes that cooperation among participants can develop as long as no one believes the end of the game is near:


There is now a large literature examining the possible strategies which can arise in repeated games of this sort. An obvious one, which is the subject of a whole book by Robert Axelrod, is ‘tit for tat’: if you defect from our common enterprise and make me suffer, next time round I will defect and make you suffer, and so on until we end up co-operating. This is also in effect what has been suggested by modern economists as the correct strategy for firms under oligopolistic conditions. Of course, if we know the games are going to end at a determinate point, tit for tat ceases to make sense as a strategy as the last round approaches, though precisely where it ceases has been a matter for debate. Strictly speaking, prior knowledge of where the sequence of games will end ought to dictate non-co-operation in every round.


If the consumer-driven economy is one big prisoner’s dilemma—one in which it makes sense to extend credit only if you suspend what seems to be your dominant strategy—then it’s imperative that the end of the game never seems near and that continuing the game almost becomes more important than winning it. Only the players are playing to win, not merely to play—though merely playing may be analogous with the inherent benefits of living in a prosperous society. (In other words, there aren’t consumer-confidence surveys in Zimbabwe.) But the cooperation in this case becomes a kind of momentum-driven speculative mania, with each tit-for-tat raising the overall stakes and leaving a residual of mounting risk. Eventually this risk appears to outweigh the gains of cooperation—even the circumscribed ones presumed by accepting implicit cooperation as a strategy. “At some point,” Tuck writes, “the players will decide that the end is close enough to abandon this strategy and move to full non-cooperation.” This is the point at which they no longer fear reprisals from the other participants, where they see trust as a scam, possibly because they see their own trustworthiness as dubious.


Consider this story from today’s FT, which begins:


Credit rating agencies failed to properly manage conflicts of interest in assigning top ratings to bonds backed by subprime mortgages and other assets, the Securities and Exchange Commission has concluded.


And this story, in which Gillian Tett notes, “Few bankers want to hear dissent about the models when they are enjoying a profit bonanza. Greed is what drives much of the modern financial world—combined with fear of getting sacked.” Greed and fear, however, seem to be motives pulling the economy in opposite directions; their tension supplies the dialectic that may have the economy careening from bubble to bubble, from Minsky moment to Minsky moment. Or it might allow, in Münchau’s phrase, for “Minsky’s moment to become an eternity.”

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