IS THE ECONOMY OF THE USA STALLING? (Wonkish)

LOW AND HIGH STALL SPEEDS AS A BETTER MODEL:

A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments, encouraged by a long period of prosperity and increasing values of investments using borrowed money . At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high prices previously quoted, leading to a sudden and precipitous collapse in asset prices and a sharp drop in market liquidity.

Paul Krugman is on a quest to develop a model (see the note below). But I propose a different model for what is going on now, encouraged by a possible cause for the fall off the sky of AF 447.

The longer going into leverage works, the safer it looks, and the more profitable it "proves" to be, and thus the more the overall Highly Leverage Investing augments (both because there are more HLI individuals, and more leverage used individually).

So, being profitable, this keeps on augmenting until the system is so leveraged that a small downward fluctuation will cause impossible losses, and the system breaks down.

There is something a bit similar in aviation, called the "coffin corner". This is what happens when planes fly at very high altitude (to save fuel). The higher the plane goes, the less dense the air is, so the less support the plane gets, hence the higher goes the low speed stalling speed.

Augmenting the speed ever more as one goes ever higher does not work, because parts of the wings may experience supersonic flow, hence shock, and detachment, causing a loss of support: this is the high speed stall.

Both speeds, the low speed stall, and the high speed stall, eventually meet, as a plane goes higher. In commercial operations, they can be uncomfortably close (typically 100 mph, but sometimes as little as 20 mph), putting planes at the mercy of a strong gust (more frequent these days at high altitude).

The lack of industrialization in the USA is causing the low speed stall to augment, and then, the increased leverage to extract profits nevertheless is creating the shocks. Soon the entire contraption may head straight down towards the ocean... Lest an industry be recovered in time...

Patrice Ayme
http://patriceayme.wordpress.com/
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From Krugman's blog, June 15, 2009:

"I’m on a continuing quest to develop a tractable model of Minsky moments. Why? you may ask. Why not go with verbal intuition? Well, I’m enough of a conventional economist to think that there’s no substitute for a model with dotted i’s and crossed t’s; it’s not THE TRUTH, but it really does help clarify your thinking.


So here’s where I am right now. There is a class of models — Shleifer and Vishny is my main inspiration, although other models, like Kiyotaki and Moore, are in the same spirit — in which you can get something like a Minsky moment. The story goes something like this (this isn’t quite how Shleifer-Vishny does it, but not too different):

There are three kinds of investors: ordinary investors who buy when the price is low and sell when it’s high; noise traders, who buy and sell randomly*; and highly leveraged informed investors (HLIs), who try to buy low and sell high with other peoples’ money. On average, the HLIs should earn a high rate of return.

However, Shleifer-Vishny assume that there are two periods before the goodness of investments is revealed to all — and in period 2 even good investments can look bad thanks to selling by those noise traders. And if the noise traders drive the price down sufficiently, HLIs can face margin calls, forcing them to liquidate and push prices even lower. This is more or less the Minsky moment.

But how do we make Minsky moments endogenous? Think about playing this game repeatedly, with the number of HLIs varying based on past performance. If there are very few HLIs, expected returns are high and the probability of a Minsky moment (and its severity if it happens) are low; this will tend to bring more HLIs into the picture, until the system is highly vulnerable. A bad draw on noise traders, and there’s an asset price plunge that hits the HLIs very hard. People decide that leverage is a bad thing, and for a while those who do go into leverage do very well. And the cycle begins again.

It’s crude. But I think it does get the nonlinearity Brad DeLong was looking for (though I’d better work up the actual algebra to make sure!).

*In his new book The Myth of the Rational Market Justin Fox traces the lineage of the noise-trade assumption to an unpublished paper by Larry Summers that began, THERE ARE IDIOTS."