Minsky’s Zombies

Hyman Minsky was an economist who studied financial crises.  He created a framework for understanding periods of financial instability.  This structure has three phases.  The Hedge Phase is the period immediately after a crisis, when both borrowers and lenders are cautious.  Here debt is created in circumstances when both parties have a high level of confidence in the leverage being repaid in full.  This is followed by the Speculative Borrowing Phase during which, as the name suggests, increasing competition between banks for business causes them to become more willing to lend to those with a shrinking probability of fully repaying the debt.  The third and final stage is called the Ponzi Phase (named after the fraudster Charles Ponzi), and it involves much more speculative lending, ultimately collapsing when borrowers can cover neither interest payments nor the actual principle due.

As a response to the last financial crisis which resulted in the Great Recession that ended in 2009, measures were put in place to minimize the likelihood of another housing-related meltdown.  But have they insulated our economy entirely from another credit cycle crunch?  Unfortunately, this can’t be known for certain, so we should not let our guard down entirely.  Greed and speculation have always figured out ways to circumvent rules.

According to this article from Bloomberg, over one in five companies in the Russell 3000 (a comprehensive benchmark of American stocks) qualified as zombie companies at the end of last 2021.  These are firms that are not earning enough to meet even the interest payments on their debt.  Prior to some of the strong inflation data which has generally put some upward pressure on interest rates this year, companies might have been able to refinance their obligations at more favorable terms to make ends meet, but that’s tougher to do in a rising-rate environment because the new debt is likely to be more expensive.

It is tough to know what will lead to the next credit crunch or when it will happen.  While there may be other potential catalysts, as of right now zombies look like a potential threat.  Minsky’s framework led Paul McCully (then of PIMCO) to coin the phrase Minsky Moment.  It’s the point in time when deteriorating credit accelerates at a pace that makes it virtually impossible to curb. Just as we experienced after Lehman’s collapse, cleaning up the aftermath becomes the only way to deal with the problem.  If these zombies continue to multiply, let’s hope the American economy has enough mops to soak up the consequences fast enough to keep it from spilling over further into other areas of our lives.