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During the second half of the twentieth century, economist Hyman Minsky provided a set of guidelines to identify what makes financial markets fragile and economies unstable. It is the midpoint of 2022, and a crypto Minsky moment is underway.
Investment professional Paul McCulley coined the term “Minsky moment.” He did so when describing the dynamics of an earlier financial crisis, the Asian Debt Crisis of 1997.
Minsky actually died in 1995, and so was not alive either to witness for the 1997 Asian currency crisis, or to see his name used in a catchphrase for economic instability. Nevertheless, the term “Minsky moment” has stuck.
Here are three facets of the crypto Minsky moment that is ongoing.
1. At the beginning of 2022, Bitcoin
2. Hedge funds are shorting shares of Tether
3. The crypto-lender Celsius is now fighting for its life.
In February 2022, Bitcoin was trading in the neighborhood of $44,000. At that time, I warned that crypto-investors needed to pay attention to how the issues Minsky studied applied to cryptocurrency markets. Now that these markets are experiencing a Minsky moment, let me just recapitulate in hindsight what I warned about in foresight.
Minsky’s framework features about a dozen major components. Below are six that just leap out.
1. Fringe finance: This was the term Minsky applied to what Paul McCulley — and now the rest of us — call “shadow banking.” Shadow banks are financial institutions that operate outside the central banking system, and do not have the central bank as their lender of last resort. Crypto-markets are a perfect example of fringe finance, as they operate at the fringe of the global financial system.
2. Speculative and Ponzi finance: Minsky warned about debt finance in which the source of the funds for making interest payments and repaying principal is price appreciation rather than cash. Prudent debt finance, Minsky was very clear to say, is based on hedge finance, where cash generation, not price appreciation, provides the funds for borrowers to fulfill their obligations to lenders.
Minksy warned, very loudly, that when market participants are gripped by euphoria, they shift from hedge finance to speculative and Ponzi finance. The stability issues associated with Tether and TerraUSD
3. Asset pricing bubbles associated with financial innovation: Those wondering what an asset pricing bubble looks like need only look at Bitcoin’s history. Those wondering what financial innovation looks like, need only look at how DeFi has evolved to produce assets like Tether and lending institutions like Celsius.
4. Excessive leverage: Celsius has an assets-to-equity ratio of 19-to-1, much higher than 9-to-1 for the average North American bank in the S&P 1500 Composite index. Assets-to-equity is a standard ratio measuring leverage: the higher the ratio, the higher the leverage.
5. Bank runs, beginning with the commercial paper market: Tether is concerned about a run on its stablecoin, as investors rush to sell their Tether coins en masse. There are rumors that the assets backing Tether include highly risk commercial paper issued by Chinese entities. Tether denies the rumors, but that has not stopped hedge funds who are shorting the Tether to express their concerns that this is the case.
6. Too big to fail: Minsky asserted that during a financial crisis, governments would engage in what he called “contingency socialism” and rescue firms that are too big to fail. At this stage, there appear to be no firms large enough to qualify as too big to fail. TerraUSD certainly did not so qualify.
I am not saying that cryptocurrencies have no fundamental value, and in fact I believe that they do. Economists call the concept “value in use,” which they contrast with “value in exchange.” The problem is that there has been a large gap between crypto value in use and “crypto over-value in exchange.”
Crypto investors might believe that they are making bets on crypto-fundamentals; and indeed they might be doing so, to a small extent. The thing is to a large extent, most of what they are betting on is sentiment. Minksy warned that euphoria will surge during economic expansion, at least until the Fed raises interest rates to address inflation. Then investors’ sense of euphoria collapses, and with it asset prices.
As Yogi Berra once said, and might have said again in connection with Minsky’s perspective and crypto markets: It’s deja vu all over again.
Crypto euphoria is in a state of collapse, which is why crypto markets are experiencing a Minsky moment. Down the line, a crypto phoenix will rise out of the ashes, with less euphoria, similar to the way that the dot-com sector emerged from the dot-com bubble. Until then, investors of all stripes would do well to pay attention to what Minsky taught.