All That Glitters / Are We All Brothers in a Giant Pyramid Scheme?

A year after the collapse of Lehman Bros. and two years after American housing prices peaked, it can be stated: Hardly anybody predicted the meltdown, and those who did failed to get the details right. Even the renowned American economist Hyman Minsky, who died in 1996, didn't foresee it. But the model he formulated in the 1980s does predict, with chilling accuracy, what actually did come about, and it may also hint what will happen in the future.

Minsky believed in Keynesian principles. But he went a step further, using Keynes' theories as a platform for his own model of the credit system, called the Financial Instability Hypothesis, to distinguish between stable and unstable financial systems.

Minsky began by defining three types of economic units. The first was Hedge units, which generate enough cash flow to enable them to meet all their liabilities, including interest and principal payments. The second was Speculative units, which are bodies that can service their debts but can't repay the principal. These units have to continually refinance their debts.

The third is Ponzi units, whose cash flow isn't enough to meet even interest payments. All they can do is borrow more, or sell assets.

From this, Minsky extracted two principles. One: The more speculative and Ponzi units there are, the deeper the economy sinks into a vicious cycle, with escalating instability pushing it further and further from equilibrium. The second is that there is no such animal as a permanently stable economy. When a boom is long enough and the public is optimistic enough, more and more speculative and Ponzi borrowers accumulate and the system slides into instability. This results in a repeating pattern of rising asset prices and debt, a bust and a drop in asset prices and leverage, followed by rising asset prices and debt.

Ultimately, Minsky postulates that since economic units in a capitalist system tend to believe a stable environment will always remain that way, stability itself sows the seeds of the next round of instability, in which hedge borrowers take on more and more debt, turning themselves into Ponzi borrowers. According to his model, there's no need for an external shock to burst the bubble. The borrowers simply reach the point where they can't service their own debt any more.

That point has come to be called the Minsky Moment.

Now from the theory to the practice. After years of financial stability, borrowers started taking on more and more debt. In the United States, homeowners took mortgages without thinking how they would return them. The idea was that the value of the house would keep rising, enabling them to refinancing their debt at any time. Companies also undertook more and more debt, competing over asset prices, thereby driving them up.

Almost everybody turned into speculative borrowers, and many, like Lehman Bros. and over here, Africa Israel, continued on to the Ponzi stage.

At some point between mid-2007 and mid-2008, the Minsky Moment arrived. Real estate prices, bonds, stocks and financial asset started to drop in value. Debts couldn't be refinanced any more. The system began to spiral down: dropping leverage, dropping prices, shattering confidence, and around and around it went.

The accuracy of the Minsky model doesn't stop there. He also predicted, more than 20 years ago, that the only way to stop the downward spiral was aggressive government intervention. Government would have to play the role of the "second party" to transactions. That is exactly what happened.

Minsky didn't say it would be easy. He postulated that government's reaction would be pro-cyclical. On the upswing, regulation is eased and on the downswing, it's tightened.

Economist Paul McCulley, who brought Minsky's theories back to prominence, adds that if the Minsky model describes what happened beautifully, then certain conclusions can be reached about human economic behavior. We act as a herd. When the good times are rolling, we become more and more optimistic, and less and less cautious.

We don't really analyze asset prices. We don't try to buy cheap and sell at the top. We buy things whose prices are rising.

We are greedy. We think we're smarter than everyone else and will manage to sell the asset we bought to somebody less smart than ourselves.

Could it be that we're all part of a giant Ponzi scheme?

Where are we right now in Minsky's scenario? We have apparently passed the Minsky Moment and the lowest point. Governments intervened and have become the biggest factor in the financial markets. In some marketplaces, such as stocks and bonds, prices have already risen sharply. In other areas, such as housing prices in Europe and the U.S., that hasn't happened yet. But the stage of panic and despair is evidently over.

In local terms, there seem to be a lot of borrowers climbing fast up the next wave. Households with means are borrowing again at low interest rates to buy houses for investment. They're borrowing a very large amount against very little equity. When interest rates rise again, they're going to turn from hedge borrowers into speculative ones.

Investors and companies that had been highly cautious as the year began are borrowing more again, too. Savers and investors have long since passed the stage of breathing easier at the all-clear and are turning optimistic again.

The best time to buy assets is naturally at the nadir. But if you missed that low point, take comfort in the thought that you're not alone. Gripped by panic in the first quarter of 2009, a lot of the smoothest movers in the marketplace missed it too. Few of them stocked up on cheap financial goodies.

Analysis of the crisis and the current stage, in Minsky terms, brings good news, and less good news.

The good news is that we're in the optimistic stage of the cycle, and there's a long road yet until we reach the next stage of exuberance, enthusiasm and euphoria - and a long way before we reach the next Minsky Moment. The less good news that it will come, again. We just don't know when.