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Europe faces its Minsky moment

A “Minsky moment” is the economic phenomenon that occurs when over-indebted borrowers are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash. In any credit cycle or business cycle it is the point when borrowers begin having cash flow problems due to spiraling debt. At this point no counterparty can be found to bid at the high asking prices previously quoted; consequently, a major sell-off begins leading to a sudden and precipitous collapse in market-clearing asset prices and a sharp drop in market liquidity.

Modern finance (1982-) is the story of testing the limits of leverage (global debt capacity). The consolidated ratio of domestic credit to GDP for the developed world has been steadily rising for thirty years. Levels of indebtedness have reached unprecedented levels not seen since WW2. And these levels of indebtedness have been achieved in a world without financial repression: there are no war-bond drives, no interest ceilings, no Treasury-Fed treaty. This has all been accomplished in the free market.

And it is an impressive achievement: to be able to accumulate trillions upon trillions in debt in a free market without government compulsion. Although the phenomenon of the “debt supercycle” is not new, what we see today is the mother of all supercycles. Somehow, the developed nations have managed to build sufficient confidence in the stability of the financial system and the financial markets that investors willingly hold the debt of highly-leveraged borrowers whose only source of liquidity is more debt.

The principal drivers of this growth, both in the US and abroad, have been disintermediation and securitization. Prior to the modern era, the total amount of debt was limited by (1) the capital levels of financial institutions and (2) growth in pension assets.