Calm markets have some worried about a new bubble. The real problem is that we are still living with the old one.
For the past couple of weeks, the buzz on Wall Street has been the lack of buzz. Volatility and measures of expected volatility like the “fear index” are way down. Stock indexes are in record territory, bond yields are low (meaning high prices), and junk bonds are hot.
This is starting to worry some people, now including officials at the Federal Reserve, who think investors may be starting to take this calm for granted, piling on more risk. (Then again, a fair chunk of the carping about investor “complacency” is coming from stock and bond traders, who make their living on volatility. They’re getting killed right now, a tragedy for no one but them.)
This all bringing back again talk of the ideas of late economist Hyman Minsky and his financial instability hypothesis. The idea is that safety begets risks. Investors start to get used to the idea that their investments reliably pay off, bidding up prices so that return gets lower. That spurs them to start taking increasingly speculative bets, until the whole thing comes crashing down. This was a pretty compelling idea back in 2008, which sure did look like a “Minsky Moment.”
But if you think we’re on the cusp of another Minsky moment, maybe you’ve forgotten exactly what happened in the 2000s. You know, the part where banks flooded the country with loans that could never be paid back. Minsky said financial systems runs through cycles. There are periods dominated by “hedge” borrowers (as in, they’ve hedged their bets) who can cover easily pay off their debts. Later comes speculative finance, and then “Ponzi” finance—people who can’t hope to make their bets work out unless asset values keep rising. Minsky in his paper didn’t mention fraud, but the fact that he named this after a famous rip-off artist is instructive.
The point is: The 2007 and 2008 crash didn’t happen just because people were willing to pay high price-earnings ratios on stocks, or because 401(k) investors picked the wrong mutual funds. When the economic tide turned, we found out that a lot of the American mortgage-finance system was built on some combination of sharp-elbows hustle, hiding the ball and outright fraud. Barry Ritholtz has a list of investigations he’d like to see here. You know this story but here’s a fresh data point from Heather Boushey:
By 2006, loans had become so disconnected from prudent business practices that “an unusually large fraction of subprime mortgages originated in 2006 and 2007 [became] delinquent or in foreclosure only months later.”
The effect of this, once real estate prices started to fall, was that households were awash in debt they couldn’t carry. The Great Recession and the doldrums that have followed are the result of families struggling to deleverage.
I wouldn’t argue the financial industry has become inherently more honest since 2008. Let’s say instead that the pickings are slim. (As John Kenneth Galbraith slyly put it, the “bezzle”—the “inventory of undiscovered embezzlement” that builds up in a boom—gets smaller when money is tighter.) So one ingredient still missing for another Minsky moment is the spread of new crazy mortgage products. Households have been too busy paying off the last Minsky-ish bubble. Here’s what’s happened to household debts as a share of disposable income in the past few years.
Debts have been dropping like a hot rock. So is everything fine then? Absolutely not. It took this massive, years-long unwind just to get as back to some semblance of normal.
And of course “normal” isn’t quite the right word for where we are now. Getting from 2008 to here required waves of foreclosures, short sales, walk-aways and bankruptcies. The number of jobs is only now touching pre-recession counts, but we need more than that, because the population has grown. The economy is fragile, and not because people are taking lots of new risks. Because we still haven’t worked off the legacy of the old ones.
And that’s the tough spot for Fed officials right now. They sound worried about the markets. But the rest of the economy is too weak for them to pull back. What we’re seeing now is that the Fed has limited tools. They can get markets to perk up, but direct help to get households on firmer footing—by for example, helping them to reduce principal on underwater mortgages—was a decision for the politicians, and they didn’t do it. If we get a correction, it won’t be a Minsky Moment, but a Minsky Echo.