It’s time to brush off the lessons we learned the hard way in 2008. Both the theory and the practice. Because a Minsky Moment may be in the making.
What?
You’ve already forgotten the theories that explained the 2008 financial crisis, then?
It’s all got to do with the economist Hyman Minsky and his theories about debt deflation. But first, I want to remind you why you need to know about such obscure-sounding ideas now before everyone else catches on…
Back in 2007, we didn’t know what subprime mortgages or securitisation were. And yet, it came to be the defining terminology of an episode in financial markets that nobody will forget.
Next came credit default swaps, bond yield spreads and the technicalities of euro bailout legislation as the European Sovereign Debt Crisis took hold.
Around the same time, Australia’s commodity bubble burst as everyday people suddenly became familiar with the intricacies of Chinese stimulus packages and the ghost cities they created.
I heard a trucker tell of the cryptography that governs Bitcoin [BTC] while sitting at a rest stop in the Nullarbor Desert in 2018. My wife called the hotel there ‘the worst in the world’, but crypto fever had reached even there.
More recently, the Ts and Cs of US bank deposit insurance hit the front pages and we all learned about the mortgage stress tests that banks are subjected to.
The point is that these topics come out of nowhere, define financial market action for a few years at most, and then disappear back into the academic literature…for a few years. Then they make a spectacular comeback just when everyone has forgotten about them and what they mean.
I think we may be on the cusp of a comeback in the terminology and economic theory that defined 2008. A period of financial meltdown.
Why?
Central banks around the world remain hellbent on putting out the inflationary fire that they fuelled in 2021. Inflation rates are still well above their target levels. And so central bankers continue to trot out speeches about how more must be done.
But prices are just one measure of their past monetary mismanagement. And behind rising prices lies something far more concerning…
Goldman Sachs:
‘The US money supply is shrinking for the first time since 1949 as savings deposits decline and the Federal Reserve shrinks its [US]$8 trillion balance sheet.’
The Financial Times:
‘Eurozone money supply has shrunk for the first time since 2010 as private sector lending stalls and deposits decline, in a financial squeeze that economists warn points to a further downturn ahead.
[…]
‘The main cause of the first decline in the bloc’s money supply in 13 years was a drop in the annual growth of lending to the private sector to 1.6 per cent in July, the slowest rate since 2016. Lending to governments also declined 2.7 per cent — the biggest fall since 2007.
The UK’s money supply dipped into a falling money supply in June by 0.8%.
The point is that the amount of money in key developed economies is falling. And let’s just say that this is one of the worst possible signs for economies and financial systems.
To understand why, we’ll have to return to my high school economics education. But don’t feel bad if you aren’t aware of the explanation. You’re not the only one. Those in charge have no clue either…
A few months ago, Federal Reserve Chair Jerome Powell was asked by a politician why central banks tend to target 2% inflation. The inference was that this is still 2% too high for those who struggle with the consequences of inflation. Especially after a recent experience with inflation in the double digits.
What made the exchange so fascinating was Powell’s inability to respond coherently. Quite frankly, he bungled the answer so badly that he was compared to Vice President Kamala Harris!
The correct response, as taught by my high school economics teacher, was that economists fear deflation so much that they require the inflation target to have a margin of error. In other words, inflation below 0% is so terrifying that a 2% target is needed to give central bankers some wiggle room.
Well, China just entered deflation. Consumer prices fell 0.3% in July. If mainstream economics is correct, this heralds the beginning of a terrifying debt spiral in the country. One that explains the tumbling Aussie dollar, but China’s fate is another story. One that increasingly resembles the US in 2008, funnily enough.
What makes deflation so scary is that it makes debt harder to pay. Just as inflation makes debt cheaper over time because it can be repaid with devalued money, deflation makes a debt burden feel heavier. This adds a headwind to the economy, which is dangerous because of the nature of debt and money. It risks a downward spiral of defaults and debt which is difficult to stop.
Defaults aren’t just an economic danger in and of themselves. They impact the money supply itself too.
The money your bank lends you doesn’t come from somewhere. It is created in the act of lending. And when you repay your debt, or default, the money disappears with it.
Thus, deflation can become a self-reinforcing spiral. More defaults cause the money supply to shrink, worsening deflation and causing even more defaults as a result. This causes debt deflation — when a debt crisis impacts the money supply and thereby becomes self-reinforcing.
A Minsky Moment is named after one of the two economists who detailed and researched debt deflations. It’s the point when the asset prices that were pushed up by the debt boom start to fall in anticipation or in response to less debt in the economy.
In China’s case, as in 2007 in the US, that’d be property. However, the chaos quickly spreads from there.
But the point is that one key part of the debt-deflation puzzle is already in place as the money supply shrinks. If inflation evaporates next, look out for the Minsky Moment as asset prices crash, as in 2008.
Regards,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
