Wednesday, November 19, 2008

A Minsky Moment

a fierce economic cycle fueled the past decade. It went something like this:

* We needed ultra-low interest rates after 9/11.
* Those low rates fed insatiable demand for housing (real estate was especially attractive, because investors' fingers had just been burned by the dot-com bubble, so stocks were taboo).
* Rising home values led to a surge in consumer spending -- funded by debt, of course.
* Spending sprees led to massive trade deficits.
* Massive trade deficits led to massive capital inflows by foreign investors.
* Massive capital inflows kept interest rates low.
* Hey, hey ... low interest rates? We're back to square one!
* Repeat cycle until wealthy.

That self-reinforcing behavior carried us through the highs of last year. And, man, wasn't it good? Tiffany (NYSE: TIF) could hardly keep its display cases stocked. Homebuilders like Toll Brothers (NYSE: TOL) and Beazer (NYSE: BZH) could build without giving much thought about demand. Like any other bubble, people used phrases like "the new economy," chalking it up as globalization at its finest. The world lent. We spent. No one complained. Provided each party did its fair share of lending and spending, there wasn't much that could slow the cycle down.

That's when we had our Minsky moment.

Have a seat, Dr. Minsky will see you in a moment
A Minsky moment is a phenomenon named after economist Hyman Minsky, which describes what happens when an economy simply can't afford its debt anymore. Think of it in Wile E. Coyote terms: We reach the Minsky moment when, suspended in midair, we realize we've outrun our road, look down, and panic. The dangerous part isn't just that debt becomes a pain in the rear, but that it'll cause our half of the aforementioned cycle to grind to a halt.

That's where it gets ugly. When we can't come through on our half of the deal, things might start to spin in reverse. Events could go something like this:

* Lower home and stock prices leads to less consumer spending.
* Less consumer spending leads to smaller trade deficits.
* Smaller trade deficits lead to less foreign capital inflows.
* Less foreign capital inflows lead to higher interest rates.
* Higher interest rates cause property and stock values to plunge.
* Plunging values leads to less consumer spending.
* Less consumer spending ... haven't we been here before?
* Repeat cycle until broke.

That's one of the biggest threats to our economy today: the possibility of being sucked into another self-reinforcing cycle like we were in the past last decade. Only this time, it'll drive us unreasonably poorer, rather than unreasonably richer.

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