Minsky Moments: What They Are and How to Avoid Them

Why and How Do Asset Prices Collapse? Minsky Moments Explained

Have you ever wondered why some markets experience sudden and dramatic crashes, wiping out the wealth of investors and triggering recessions? If so, you may be interested in learning about the concept of Minsky moments, named after the economist Hyman Minsky, who developed a theory of financial instability and crises.

What Is a Minsky Moment?

A Minsky moment is a sudden, major collapse of asset values which marks the end of the growth phase of a cycle in credit markets or business activity¹ A Minsky moment is preceded by a period of excessive speculation and risk-taking, fueled by easy credit and optimistic expectations. As asset prices rise, investors borrow more money to buy more assets, hoping to sell them later at a higher price and make a profit. This creates a positive feedback loop that reinforces the upward trend in asset prices and increases the leverage in the system.

However, this process cannot go on forever. At some point, the asset prices become so high that they are no longer justified by the underlying fundamentals, such as the income or cash flow generated by the assets. This makes the market vulnerable to any shock or change in sentiment that could trigger a reversal of the trend. For example, a rise in interest rates, a decline in earnings, a regulatory change, or a geopolitical event could cause some investors to sell their assets, either to realize their gains or to meet their debt obligations.

This initiates a negative feedback loop, as falling asset prices reduce the value of the collateral that supports the loans, forcing more investors to sell their assets to repay their debts or avoid margin calls. This creates a downward spiral of asset prices, deleveraging, and liquidity crunch, which can spread to other markets and sectors of the economy. As a result, the financial system becomes unstable and prone to panic and contagion, leading to a loss of confidence and a credit crunch. This, in turn, can have severe consequences for the real economy, such as lower output, higher unemployment, and deflation.

What Are Some Examples of Minsky Moments?

Minsky moments are not a rare phenomenon in history. In fact, some of the most devastating financial crises and recessions have been associated with Minsky moments. Here are some examples:

• The Great Depression of the 1930s: The stock market bubble of the 1920s, fueled by margin buying and speculation, burst in 1929, triggering a massive sell-off and a banking crisis. This was followed by a prolonged period of deflation, low growth, and high unemployment²
• The Asian Financial Crisis of 1997-1998: The rapid growth and capital inflows in several Asian economies, such as Thailand, Indonesia, and South Korea, led to a boom in asset prices, especially real estate and stocks, and a buildup of external debt. However, when the US dollar appreciated and interest rates rose, the Asian currencies came under pressure and some of them were forced to devalue. This sparked a wave of capital outflows, asset price collapses, and banking failures, which spread across the region and beyond³
• The Dot-Com Bubble of the 1990s and the Burst in 2000: The advent of the internet and the emergence of new technologies created a frenzy of investment and speculation in the tech sector, especially in the US. The Nasdaq index soared to unprecedented levels, driven by the expectations of high growth and profits. However, many of the dot-com companies were unprofitable and relied on external financing to survive. When the interest rates rose and the earnings disappointed, the bubble burst, wiping out billions of dollars of market value and causing a recession⁴
• The Global Financial Crisis of 2007-2009: The housing bubble in the US and some other countries, supported by low interest rates, lax lending standards, and complex financial innovations, burst in 2007, leading to a wave of defaults and foreclosures. This exposed the fragility of the financial system, which was highly leveraged and interconnected. The collapse of Lehman Brothers in 2008 triggered a global panic and a credit freeze, which required unprecedented interventions by central banks and governments to restore stability and confidence. The crisis had a lasting impact on the global economy, which suffered from low growth, high unemployment, and increased public debt⁵

How Can We Prevent or Mitigate Minsky Moments?

Minsky moments are difficult to predict and prevent, as they are often the result of human behavior and psychology, which are influenced by emotions, biases, and herd mentality. However, there are some possible ways to reduce the likelihood and severity of Minsky moments, such as:

• Improving the regulation and supervision of the financial system, especially the nonbank financial institutions, to ensure adequate capital, liquidity, and risk management standards, and to limit excessive leverage and interconnectedness⁶
• Enhancing the transparency and disclosure of the financial markets and institutions, to improve the information and monitoring of the asset prices, credit conditions, and potential vulnerabilities⁷
• Strengthening the macroprudential policies and tools, such as countercyclical capital buffers, loan-to-value ratios, and stress tests, to address the systemic risks and the procyclicality of the financial cycle⁸
• Promoting the financial literacy and education of the investors and consumers, to help them make informed and prudent decisions, and to avoid falling prey to irrational exuberance and overconfidence.
• Coordinating the monetary and fiscal policies, both domestically and internationally, to support the economic growth and stability, and to avoid creating distortions and imbalances in the financial markets.

Conclusion

Minsky moments are a phenomenon that can have devastating consequences for the financial system and the economy. They are caused by a combination of factors, such as easy credit, speculative activity, asset price bubbles, and leverage, which create a positive feedback loop that eventually reverses into a negative one. Minsky moments are hard to predict and prevent, but there are some possible ways to reduce their likelihood and severity, such as improving the regulation, transparency, macroprudential policies, financial literacy, and policy coordination of the financial system. By understanding the causes and effects of Minsky moments, we can hope to avoid or mitigate them in the future.