Revisiting Minsky

Financial crises are predictable!

In this paper, Greenwood et al. estimate the probability of financial crises as a function of past credit and asset price growth. They construct an indicator  for the onset of a financial crisis using historical data on the growth of outstanding credit to nonfinancial businesses and households as well as data on the growth of equity and home prices from 42 countries over the 1950–2016 period. Their indicator is called Red-zone or R-zone. A country is in the R-zone if nonfinancial business credit growth over the past three years is in the top quintile of the historical distribution, and stock market returns over the same window are in the top tercile. Some of their findings include:

• Once a country enters the R-zone, the probability of experiencing a financial crisis within the next three years is 45% for countries that are in the business R-zone, and 37% for countries in the household R-zone. This means that after entering the R-zone, crises are slow to develop, suggesting that policymakers have time to act based on early warning signs;
• Overheating in credit markets has a global component and is correlated across countries;
• Overheating in the business and household credit markets are
  separate phenomena. In the rare occasions when they happen in tandem, as in Japan in 1988, the financial crisis is particularly dangerous.

Our findings favor the Kindleberger-Minsky view of credit cycles and financial crises. [E]xpectations errors (typically due to over-extrapolation) lead to excessive borrowing and investment during credit booms. Since these overly optimistic beliefs will be disappointed on average, they predictably give rise to credit busts and financial crises. In this way, the Kindleberger-Minsky view provides a foundation for the “credit supply shocks” that are often used as a starting point for modeling economic busts.

Predictable Financial Crises
Authors: Robin Greenwood, Samuel G. Hanson, Andrei Shleifer, Jakob Ahm Sørensen
From: Harvard University, Copenhagen Business School

Minsky moments and monetary policy

The model: The authors are using a three-period model of a Minsky cycle with two types of agents, namely savers and borrowers. Borrowers, who can be households or financial intermediaries, borrow from savers to finance the purchase of a risky asset. Expectations are extrapolative i.e. the agents believe that high past returns predict high future returns. Episodes of complacency accompanied by rising asset prices and growing leverage come to an end in a “Minsky moment”. At that point, risk is re-priced, asset prices crash, imprudent borrowers de-lever, aggregate demand falls, and a recession ensues.

What is the optimal policy, one that ensures macroeconomic and financial stability, during a boom?

• When both monetary and macroprudential policies are available it is optimal to use macroprudential policy to limit leverage and monetary policy to ensure that output is at potential. In this case, limiting leverage falls on macroprudential policy, and managing beliefs/asset prices on monetary policy;
• Absent macroprudential tools, monetary policy should lean against the economy at time 0 in order to reduce the bust at time 1. In this case, in order to improve financial stability, monetary policy should sacrifice perfect macroeconomic stability.

Taming a Minsky Cycle
Authors: Emmanuel Farhi, Ivan Werning
From: Harvard University, MIT