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A Minksy moment is a phrase that is named after the philosophy of Hyman Minsky, a US economist of the 20th century who held a pessimistic view about the stability of financial markets. Minksy believed that free markets are fundamentally unstable because speculation raises prices to an unnaturally high level that inevitably leads to catastrophic collapses. The idea is based on the premise that speculation creates only an illusion of growth known as a bull market, that is later proved unsustainable when a liquidity squeeze occurs. A liquidity squeeze is the growth of a predominant perception among lenders which culminates in a Minsky moment, where a belief in the scarcity of available investment money in the market leads to a tightening of lending by banks. This further acts as a feedback loop mechanism to raise interest rates in the economy and credit requirements by the banks, where it reduces the flow of capital overall.
While the Minsky moment concept is named after Hyman Minsky's economic philosophy, it was first coined in 1998 by Paul McCulley, a global investment manager who used it to refer to the Asian financial crisis of the time. The Asian crisis occurred because speculators raised the value of currencies in the Asian markets that were tied to the US dollar to such an extent that the value of such currencies eventually plummeted. The underlying principle behind such trends is that liquidity risk increases to a point where trading in currency or actual securities reaches a point where the market itself cannot sustain enough of a volume of trading to maintain the current prices. When this happens, it is inevitable at some near-term point that an abrupt shift in perceptions known as a liquidity squeeze will occur.
As valuation of securities and currency increases in markets, investors are encouraged to leverage their assets to gain a larger stake in the rise in prices, which allows for greater profits if prices continue to rise. Hymen Minsky believed that, the longer that this trend is perpetuated and the more global it becomes, the greater the ensuing crash or correction in the markets will be. When a Minsky moment becomes so severe that a liquidity squeeze begins to affect the overall economy, it is often necessary for central banks in many nations to step in and try to reverse the trend by pumping capital into the market from national treasuries.
After a period of decline in markets has come to dominate the landscape, it is common for investors to instead fall into a reverse type of bad investment trend known as a bull trap. A bull trap occurs right after a Minsky moment takes place when a company or security that has been declining in value is suddenly seen as about to shift direction and head upwards, encouraging heavy investment to make a large profit from the growth. Most of the time, however, the decline continues unabated and any new investment loses further value.
The subprime meltdown in the housing market that occurred between 2007 and 2008 in the United States is an example of how a Minsky moment takes place. Speculators in real estate increasingly invested in mortgages on home loans made at risky subprime interest rates because lenders were willing to take chances on making the loans with the belief that the economy would continue to grow and the loans would pay off large profits. When foreclosure of homes started to increase, however, lending practices tightened, causing a liquidity squeeze and sudden reverse of the trend of perceived rapid growth in the housing market. This caused a devaluation in the housing sector overall and losses for banks and investors who had heavily leveraged their assets to buy into the market.