Monday, November 30, 2009

Managing the Mother of all Minsky Moments

During the 2008 Canadian federal election, I had the opportunity to be a political commentator for a cable television program. One thing that struck me during the campaign is that when the markets plunged, losing more than 30% of their value, the political class was at a loss to explain the events.

Remember the talk of how our economic fundamentals were sound, that a carbon tax would move us into a recession, and that there was no need to worry about returning to budgetary deficits? Well looking back, it now appears that our politicians really had no idea what was happening although they tried their best to grapple with the extraordinary events.

Certainly, from the perspective of those who believe in the efficient-market hypothesis, the market crash and the subsequent great global recession could not be foreseen. Fortunately, the failure to anticipate and account for economic events of this magnitude forced economists to look for other explanatory models. Much attention was then given to the work of Hyman Minsky and his Financial Instability hypothesis.

In short, Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

In other words, during the last federal election the economy passed through what is called a Minsky moment. Greed gave way to fear amongst lenders and borrowers, setting off a daisy chain of reduced expectations, credit contraction, asset liquidation, bankruptcies, layoffs, and reduced economic activity. Throughout the OECD, national governments were forced to intercede with massive injections of public funds in order to prevent a collapse of the financial and economic systems.

To that end, national governments turned to budgetary deficits in order to continue furnishing the governmental goods they provide while at the same time experiencing a significant drop in tax revenues due to the decrease in economic activity. Essentially, the infusion of public funds halted the economic decline. From the perspective of the financial industry and government fiscal policy, it is devoutly to be wished that the credit crisis will play itself out and economic growth returns so that the deficits are eliminated and the accumulated debt can be reduced.

However, there now appears the real possibility of passing through a Minsky moment of a much greater scale. Specifically, this moment entails the widespread realization that we have moved from a period of resource abundance to resource scarcity, and the resource in question is conventional oil.

Economic growth is fueled by the availability of cheap conventional oil. Despite our best efforts and brightest minds, there is no alternative energy source that comes close to producing an energy return on the energy invested to extract or produce conventional oil. It is by far the source of energy that has the highest energy density relative to its productions costs. Switching to alternative sources of energy, although desirable from an environmental view, carries the economic cost of reducing energy consumption and economic growth.

It is simply a question of physics. Less energy available means that less work can be done. Other energy sources will replace oil consumption but at a much higher cost, which reduces the amount of work that can be performed. From an economic point of view, this means an inevitable contraction of the global economy that will be qualitatively different. This contraction will not be short-lived, a part of the normal business cycle predicted by economic historians drawing upon Minsky’s work. It will be structural and will require a complete re-conception of the economic and financial systems.

Recently, global financial markets destabilized when it became apparent that the latest round of debt-fueled economic growth had played itself out. Without economic growth, companies become unable to pay back the interest on their debt. To make good on their financial obligations, assets must be sold, but in a market in which asset values are declining rapidly. Thereafter, a vicious circle develops where declining asset values further reduce the availability of credit and the capacity to service debt, which in turn causes bankruptcies, layoffs, reduced consumer spending, business investment, thereby leading to economic recession. Eventually, perceptions change when a critical mass of investors believe that the bust portion of the cycle has bottomed out and assets are then put back into more productive use, thereby generating higher profits, which in turn re-initiates the extension of credit, the appreciation of assets, hiring, consumer spending, and in turn economic growth.

This oscillation between boom and bust is sustainable as long as economic growth is sustainable over the long-term. However, the bust turns into a full-blown collapse if economic growth does not return. Having jettisoned the gold standard in favor of fiat currencies (money is created out of thin air upon the contracting of a debt obligation), the global financial system functions on the belief of continued economic growth. Without growth, the interest on acquired debt cannot be paid.

Debt relief can be obtained if it is believed that a recession will be short-lived, but if the contraction becomes structural, as would be the case once we begin to travel downwards from peak conventional oil production, defaults on debt obligations accompanied by massive asset liquidation will increase exponentially. In other words, the Great Global Recession turns into the Great Global Depression.

Interestingly enough, as George Monbiot noted, last week two whistleblowers from the International Energy Agency (IEA) alleged that it has deliberately upgraded its estimate of the world's oil supplies in order not to frighten the markets. Three days later, a paper published by researchers at Uppsala University in Sweden showed that the IEA's forecasts must be wrong, because it assumes a rate of extraction that appears to be impossible. In fact, almost every year the Agency has been forced to downgrade its forecast for the daily supply of oil in 2030: from 123m barrels in 2004, to 120m in 2005, 116m in 2007, 106m in 2008 and 103m this year. But according to one of the whistleblowers, even today's number is much higher than can be justified, and the International Energy Agency knows this.

Given the current levels of national debt, it would appear that borrowing from future generations to alleviate financial and economic crisis has reached its limits. Inevitably, the delivery of government goods will be reduced in order to bring some financial stability to government expenditures. However, another financial shock, much larger than the latest round, will create economic conditions beyond the capacity of governments to react. Laden with debt, national governments won’t be able to intervene in any meaningful way unless they reduce the systemic risk that their economies are now exposed to.

Two measures must be taken in the immediate future if we are to stave off economic collapse. The first is to increase the reserves that banks must maintain in order to make loans. Fractional-reserve banking within global financial markets amplifies systemic risk exponentially. To avoid a complete freeze of credit markets within a shrinking global economy, banks must be legislated to hold in reserve funds equivalent of at least 25% of their loan portfolios. Second, a financial transaction tax, similar in kind to the Tobin tax but applicable to all financial transactions, must be implemented. Funds generated from this tax should go towards either building up financial reserves or paying down the national debt.

To stay within the business as usual, good times are just around the corner, lets continue with the status quo is an invitation to simply wait for a Force 5 Hurricane to pass over, believing that will we simply be able to pick up the pieces and return to our previous lives with only minimal discomfort.

No comments:

Post a Comment

All comments will be reviewed before posting. Civility is a must.