Approximately 60 years ago, economist Hyman Minsky introduced his Financial Instability Hypothesis. His central argument was that apparent economic stability often leads to instability. But how can that be?
Minsky noted that financial crises typically follow prolonged periods of economic stability and growth. It is during these prosperous times that the groundwork is laid for future turmoil. Essentially, extended stability encourages both borrowers and lenders to engage in increasingly high-risk activities. This behavior drives a steep rise in credit and debt, subsequently inflating asset prices.
As excessive optimism sets in, the economy becomes unstable. Lending and borrowing reach untenable levels, surpassing what the economic framework can support. Eventually, financial bubbles pop, causing asset prices to plunge and revealing the errors made during the preceding boom.
Last week provided a stark reminder of this reality, illustrating that stock values do not always rise. Moreover, there’s another possibility: stocks can indeed decline.
After a modest dip on Monday and Tuesday, followed by a significant rally on Wednesday, the market took a downturn on Thursday. The DOW fell by 264 points, marking its largest single-day drop since July 31.
The Ringing Grows Louder
What does this signify? Perhaps Friday’s bounce of 167 points indicates that good times will persist. However, it is more likely that we are witnessing the market’s final flourish.
As the seasons transition, with shorter days and crisp mornings, the stock market, too, stands on the brink of a transformative period. A Minsky tipping point could spark an extended selloff; in fact, that tipping point may have already occurred, though many remain unaware.
The adage goes, “No one rings a bell at the top.” Yet, if you take a moment to close your eyes and listen, you might hear multiple bells tolling. Each day, their sound grows more pronounced.
Factors contributing to this unease include ISIS testing President Obama, Putin leveraging political power, the threat of Ebola, and a toxic mix of escalating debt and sluggish growth. Not to forget, volatility had been at all-time lows, while stock prices reached unprecedented highs. The phase of quantitative easing is coming to a close, accompanied by unchecked increases in government debt.
Clearly, there are numerous indicators suggesting a stock market decline. Here’s one perspective that weaves many of these concerns together…
The End of Extend and Pretend
Economist Steen Jakobsen of Danish investment bank Saxo Bank warns that the three major economic powers— the U.S., China, and Europe—are headed toward a dramatic collapse in asset values. This crisis stems from economic models that prioritize consumption over productivity.
Jakobsen asserts, “We’re still not wise enough to realize that our current model resembles a Ponzi scheme racing toward its inevitable ‘Minsky moment.’” This term, ‘Minsky moment,’ was introduced by Pimco’s Paul McCulley during the Asian debt crisis of the late 1990s.
According to Jakobsen, the looming crash will be driven by unsustainable debt levels, occurring when the returns from assets fail to cover the debt incurred to acquire them. While he does not specify a timeline for his forecast, he emphasizes that central bankers and policymakers have ignored the issue of enormous debts, which will resurrect as low inflation or even deflation.
“We are still following the same worn-out script we’ve known for five years,” he says. “Keep interest rates low enough to manage the debt, pretend to have a credible plan, but avoid dealing with the fundamental issues and just buy more time. However, while this approach worked for quite some time, the dynamics are shifting now.”
Indeed, the Federal Reserve’s strategy of postponing economic issues with cheap credit and an illusion of stability is reaching its limits. Quantitative easing is nearing its conclusion, and the federal funds rate, which has hovered near zero for six years, cannot remain there indefinitely—certainly not for another six years.
Eventually, the stock market will recognize this reality, leading to a significant decline.
Sincerely,
MN Gordon
for Economic Prism
