A 'Minsky Meltdown'?

A Minsky Meltdown?

By John Bogle | 30 December 2008

An old story— perhaps apocryphal— tells of the tailor who made his living selling fine silk shirts to the wealthy wizards of Wall Street. When the stock market crashed in 1929, he delighted in their demise. But within a year, his own business, bereft of customers, itself went bankrupt.

The failure of our financial system, as this sad example makes clear, often resonates throughout our entire economy. Today, we already see the profound weakness in our financial sector finding its way into the rest of our economy. [[And, at breakneck speed! : normxxx]] It will be hard for many of our citizens, far less well-to-do than our moneymen and moneywomen, to bear. In 2006, the wealthiest 20 percent of wage earners in Manhattan made some $350,000 a year on average, nearly 40 times the $8,800-a-year income earned by the poorest 20 percent.

In my long career in finance, going way back to 1951, I've now witnessed 10 bear markets (defined as a decline in the stock market of 20 percent or more). The current bear market has been off by more than 50 percent, slightly larger than the 1973–1974 and 2000–2001 crashes. But this decline is the first that I can recall in which the distress of the financial markets so profoundly [[and so quickly: normxxx]] impacted the real economy of goods and services, of ordinary people, especially of those who had no real way to participate in the boom that led to the bust, but who are, nevertheless, now paying the penalty for the market's excesses. [[And, around the world! : normxxx]]

What we are increasingly seeing is the verification of "the financial instability hypothesis" put forth by the economist Hyman P. Minsky (1919–1996). In 1992, Minsky warned that "capitalist economies exhibit ... debt deflations which ... spin out of control ... [as] the economic system's reactions to a movement of the economy amplify the movement ... . Government interventions aimed to contain the deterioration [are often] inept in … historical crises."

Minsky concluded that over long periods of prosperity, the economy transits from financial structures that make for a stable system to ones that make for an unstable system— i.e., that "stability leads to instability," largely through what he described as hedging, speculation and Ponzi finance. In that sense, Minsky was a prophet of [several] of today's economic crises.

Another insight was also prophetic: "Institutional complexity [read: today's collateralized debt obligations and credit default swaps] may result in several layers of intermediation between the ultimate owners of the communities' wealth, and the [business and individual] units that control and operate the communities' wealth." This separation between ownership and control has now come to pass. In a mere half-century, we have moved from an ownership society (92 percent of all stocks owned by individuals; 8 percent by institutions) to an 'agency' society (24 percent and 76 percent, respectively), a change I've described as "a pathological mutation in capitalism".

How has this separation contributed to the recent crisis? First, because these new agents— institutional money managers advising mutual funds and retirement plans— have far too often placed their own financial interests ahead of the interests of fund owners and retirement plan beneficiaries, ignoring the interests of their own principals. And second, because these agents have departed from their traditional investment principles focused on the wisdom of long-term investing to a 'new' approach that relies on the folly of short-term speculation.

How great a departure does this change in investment principles represent? An enormous change, however rarely noted. Today, turnover of stocks in the United States, which ran in a range of 20 to 40 percent during my first 30 years in the mutual fund field, will come to more than 300 percent in 2008— something like 10 times as large. [[But in line with, though still greatly exceeding, that of 1929. See also, "The Inevitable Dénoument" by Alan M. Newman, editor, Crosscurrents: normxxx]]

Yet it is not Wall Street, but the ordinary citizens of the United States who will foot the bill. "The government," as always, has no money of its own. So it is paying the financial sector for its gross excesses with our money. We may pay for part of this bailout with higher taxes, but given our flawed political system, the cost is more likely to be extracted from future generations with dollars that buy less. Inflation is just another form of taxation, albeit one that is sharply regressive. [[In other words, as usual, those who benefitted least will bear the greatest burdon.: normxxx]]

As the woes of our financial system resonate through our economy, it seems crystal clear that our current recession will intensify— a "Minsky Meltdown" of significant proportions. While I believe that something more serious— obviously, a depression— is unlikely, we can't be sure whether our plummeting stock market: (a) has yet to adequately anticipate the depth of the economic downturn; (b) has already anticipated it; or (c) has anticipated something much worse than what is likely to transpire.

I'm inclined to believe that the answer is somewhere between (b) and (c). Why? Because the market value of U.S. stocks has tumbled by 50 percent— from $18 trillion to $9 trillion, and I just can't imagine that the value of American enterprise is $9 trillion lower than it was at the market high last October. Further, let's not forget that today's lower stock prices translate into stronger fundamentals underlying future returns:

• The dividend yield on the S&P 500— less than 2 percent in October 2007 and a skinny 1 percent in March 2000— is now 3.5 percent, a far larger contributor to future returns.


• The price-earnings multiple, 32 times at the 2000 market high, is now about 12 to 15 times (depending on whether we look at operating or reported earnings).


• The price of the S&P 500 Index is now about 1.8 times book value, a level not seen since 1990. (The price-book ratio reached the elevated level of 5.5 times in early 2000. [[for the significance of that, see "Valuing Wall Street: Protecting Wealth in Turbulent Markets" by Andrew Smithers and Stephen Wright: normxxx]])

As Benjamin Graham observed, in the short run, the market is a voting machine, but in the long run it is a weighing machine. Put another way, "The fundamental things apply as time goes by."

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Normxxx    
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