One of the highlights of our visit to the Catena winery near Mendoza a few years ago was the opportunity to spend a few minutes in Nicolas Catena’s private study. Catena was an economics professor before he returned to the family wine business to guide it through the turbulent wine markets of the time and I was interested to see what was in his library (and on his mind) from those days.
As I scanned the bookshelves I was struck by the fact that, back in the late 1970s and early 1980s, Catena and I were following the same news reports and reading the same research, including books such as Charles P. Kindleberger’s classic Manias, Panics and Crashes: A History of Financial Crises. Relevant reading then and now, too, don’t you think?
This Time is Different?
It is easy to imagine that financial instability, including manias, panics, and crashes, is something that happens in other places to other people at other times, but the recent banking crisis in the United States (and elsewhere) brings the problem clearly to our attention, especially given the involvement of Silicon Valley Bank (SVB), an important part of the U.S. wine industry’s financial ecosystem,
It has always been the case that financial instability potentially affects all types of businesses and, as Professor Catena understood all too well, the wine business. But, as I argued in my book about the global financial crisis, it is easy to ignore risks, forget the lessons of crises of the past, or to simply conclude that “this time is different.”
Financial instability is baked into the cake, as they say. Crises are a durable feature of modern capitalism so businesses are unwise to ignore potential risks, both direct (the risk that someone who owes you money can’t pay) and counter-part risk (the risk that someone who owes money to someone who owes you money can’t pay).
Wine’s Minsky Moment
It is possible to argue that the four most relevant economists of the 20th century were Schumpeter, Keynes, Friedman, and Minsky. Joseph Schumpeter studied growth. John Maynard Keynes helped us understand unemployment. Milton Friedman’s ideas of money and inflation are very important. Schumpeter, Keynes, Friedman — these are names you might know. What about the fourth, Hyman P. Minsky?
This is a Minsky moment because his work examined instability and crisis, which he thought were an inherent part of the financial system. I first studied Minsky when I was writing my book Selling Globalization. Using Minsky’s analysis, I argued that globalization was more fragile than most scholars believed because it was built, fundamentally, on the unstable foundation of global finance. People thought I was crazy as I worked through my ideas … and then the Asian Financial Crisis hit!
How do financial crises start? And how do they end? Like Tolstoy’s unhappy families, each is different in the details, but Minsky established a general seven-stage pattern that is a good guide. I will paste an excerpt from my book Globaloney 2.0 below so that those of you interested in the details can follow along. Pay particular attention to the distress, revulsion, and contagion stages and see if they sound familiar.
Try to Remember …
So how should the wine industry react to financial crises like the one we are experiencing today? It would be easy to say that crises are a finance problem, not a wine industry problem. Wine just happened to get caught in the cross-hairs this time because of the SVB’s particular pattern of business. What are the odds of that happening again? That’s a fair point. Wine loans had nothing to do with the bank’s collapse.
My view is a little different. Financial crises are a wine problem because wine is a business and businesses are necessarily disrupted by unstable finance. Businesses need to take their financial risks more explicitly into account. That goes for wine businesses, too.
I don’t think that wineries in Argentina have forgotten this lesson, mainly because they have suffered repeated and severe crises (the current 100+ percent inflation rate suggests another crisis in on the cards).
The wineries who found their accounts at SVB frozen for a few days (because they exceeded the $250,000 limit to FDIC insurance that applied at the time) will not quickly forget this lesson, although I wouldn’t be surprised if the memory eventually fades once “normal” operations are fully restored. That’s one of the reasons why Minsky moments like this return.
Excerpt from Chapter 2 “Financial Globaloney: Safe as Houses” in Michael Veseth, Globaloney 2.0: The Crash of 2008 and the Future of Globalization (Rowman & Littlefield, 2010).
The leading authority on the theory of financial crises is Hyman P. Minsky, an economist who never received the respect he deserved within the profession because his theories challenged the orthodoxy that markets are generally quite stable (I will have more to say about this later).i Every financial crisis is different in the details (and not all bubbles or potential bubbles actually burst), but there is a family resemblance that Minsky explains as the seven stages to a financial crisis.ii
The first stage is called Displacement and it represents a change in expectations. It could be a new invention, discovery or government policy or it could be simply a change in expectations about the future. Whatever it is, Displacement creates a new object of speculation and at least some insiders rush in to take advance of the news.
Displacement happens all the time, of course. That’s why the stock markets go up and down every day and every hour of the day and every minute of every hour. People constantly react to real news, fake news and changing expectations. So there are a million little potential financial bubbles filling the market like fizz in a glass of Champagne, rising up and popping all the time. But some of them are a bit more substantial and gather the attention of both insiders and outsiders. It is hard to predict in advance when it will happen, but when it does a speculative bubble starts to form.
Minsky’s second stage is called Expansion. More and more money begins to focus on the speculative object, whatever it is – gold, silver, real estate or even tulip bulbs. The market can expand in several different dimensions. The most obvious, of course, is through money creation. When central bankers expand the money supply, as they sometimes do, they may expect that new funds will flow pretty much everywhere, but sometimes they are disproportionately diverted to particular investments fueling bubbles.
Leverage is another source of expansion. Leverage refers to the use of borrowed funds (other people’s money) to increase the return on your money. Suppose you have $1000 and you believe that XYZ Corporation’s stock will double in the value in the next month. You could invest your $1000 and, if you are correct, earn a $1000 profit, a 100% return. Or you could take your $1000 and borrow $9000 to invest $10,000 in total. This would be a leverage ratio of nine to one. If your expectations are fulfilled, the profit would be $10,000 on your $1000 investment (minus whatever interest costs you had to pay). Instead of a 100% return you would receive something approaching a 1000% return. Leverage is a wonderful thing when it works, but it is of course very risky. Just as you can earn much more than your initial stake you can also lose much more.
Expansion also takes place as the population of potential investors grows. Insiders (people with specialized investment knowledge) are joined by well-informed amateurs and then rank amateurs who sometimes just follow the herd based on what they read on the internet or hear from friends and co-workers. Water-cooler investors, I guess you could call them. The movement from professionally managed employee pension funds to individually managed 401k and similar retirement instruments has facilitated this sort of expansion in many countries. It is easy to belittle the ill-informed financial decisions that “blind capital” makes, but highly paid geniuses do not always out-performed them.iii
Finally, expansion can occur if the speculative object draws the attention of international or even global investment markets. Interconnected global financial markets are capable of focusing enormous sums on particular speculative objects, with predictable results. It is as if a giant magnifying glass focused the full power of the sun on some object or creature. Destruction seems assured, but first comes the heat.
Expansion does not always produce a crisis because investors can be fickle. There is always something new to consider, always a million different things to displace expectations and the funds that fuel expansion now can quickly withdraw and move on. The markets can achieve a state that Minsky calls Euphoria, however, if attention remains focus and expansion sustained. Euphoria produces a sense that investors can do no wrong. It is impossible to make a bad decision, since the general rise of the market covers any poor individual choices.
Economic logic simply evaporates in the Euphoria stage. Logic warns to buy less as price rises. Euphoria whispers that rising prices today are harbingers of even higher prices now – time to buy! And buy even more as those future price increases appear. The buying binge and the higher prices they produced are indeed self-fulfilling prophecies, which are the best kind. Sometimes Euphoria just fizzles out, but sometimes it can be sustained, especially if expansion from whatever source is maintained.
Distress comes next in the classic seven stage scenario. Distress is the moment when insiders begin to believe that the market cannot be sustained. Doubts creep in and alternative scenarios are reviewed. The market may pause or slow or the collapse could begin.
Revulsion follows as some investors begin to act upon their doubts. Insiders head for the door first, often leaving with substantial profits in their pockets. Others follow, causing the Crisis stage. The self-fulfilling rising price prophecy of Euphoria is reversed as lower prices trigger sell-offs that drive prices even further down. Everyone wants cash in this market, but it is hard to come buy. Who will lend in a falling market? Who will buy when prices are falling to fast? Someone does, obviously, but at much lower prices.
Crisis is often accompanied by the seventh stage, Contagion. The crisis in one market spreads to others. Contagion can happen in several ways. Sometimes the bubble in one market expands to others and all collapse at once. This was the case with the Peso Crisis of the 1990s. Unlucky investors, drawn to Mexico by the prospect of NAFTA gains, ended up putting money into many Latin American markets, all of which surged and then collapsed together. They called it the “Tequila Hangover” effect.
Leverage creates another contagion vector. As prices fall, leveraged investments go “under water” and speculators are required to put up additional funds. Since credit is hard to come by in the crisis stage, there is often little choice but to sell off good investments to cover losses on increasingly bad ones. Thus the Russian financial crisis of 1998 triggered contagion in Brazil as speculators sold off Brazilian investments to cover their rouble losses.
Finally, contagion can take place as credit markets freeze up generally. Businesses that are accustomed to ready access to credit (for themselves or their customers) are shocked as liquidity disappears. Economic misery spreads from the financial sector to the so-called real economy as declining wealth and restricted credit affect change buyer and seller behavior.
This is how a classic financial crisis unfolds. Not every crisis goes full term, of course, and the damage when they do is not always substantial. But as Kindleberger explained 30 years ago and Reinhart and Rogoff’s study has more recently confirmed, major damaging financial crises happen often enough to be considered a common feature of international finance. So no one should be surprised when these markets behave as they so frequently do.
i John Kenneth Galbraith is another economist whose status outside the profession was much higher than within it due to his failure to his unorthodox views.
ii See chapter 2 of Kindleberger Manias, Panics, and Crashes.
iii Walter Bagehot coined the term “blind capital” to refer to uninformed but enthusiastic amateur investors who are drawn into speculative bubbles.