Why oil investors should have listened to Minsky

The price of oil seems to have stabilised – yet experts on the industry warn that this very stability could lead to speculation and a subsequent crash. Economist Hyman Minsky warned that markets have a habit of creating their own instability but was ignored, Robert Matthews writes

What's happened to the roller-coaster of oil prices? In the first decade of the millennium, the price zoomed past the US$100-a-barrel mark, then proceeded to lurch up and down for a few years.
But now it has settled down to boring predictability, barely shifting by more than a few per cent from about $110 per barrel for the past two years. As Reuters analyst John Kemp put it earlier this month: "The oil market has rarely been so quiet".
Indeed, you would have to go back to the early 1960s, when the Emirates began exporting oil, to see so little volatility in the market.
As Mr Kemp points out, a plausible explanation for the stability lies in the price instability that preceded it. Consumers have reacted to it by finding alternatives to oil, or making do with less.
Shale oil and biofuels have surged in popularity. Aircraft makers have rolled out new, more efficient designs – for example, Boeing's Dreamliner uses 20 per cent less fuel than the 767 it replaces.
Car manufacturers have seized on fuel economy as a major selling point and are heavily promoting hybrids, which are getting ever better. For a glimpse of the future, look at this season's Formula One cars, whose hybrid engines use more than 35 per cent less fuel than last year's designs.
So is oil price stability the "new normal"? Don't count on it, says Mr Kemp. He goes on to cite the work of a once-obscure American economist whose views on market stability are now becoming mainstream, Hyman Minsky.
Born in Chicago in 1919, Minsky originally trained in mathematics, then switched to economics, gaining a PhD from Harvard.
Perhaps as a result of being raised during the Great Depression, the focus of Minsky's career became understanding market movements and financial crises.
The cause of these most devastating of all economic phenomena remains hotly disputed – not least because they seem to lie beyond the reach of economic theory.
According to one of the founders of that theory (and one of last year's Nobel laureates in economics) Prof Eugene Fama of the University of Chicago, economists still argue over the cause of the Great Depression: "Economics is not very good at explaining swings in economic activity."
Minsky decided to try anyway, and came up with a theory that can be summed up in the phrase "stability is destabilising".
His basic claim could hardly be simpler – or more worrying. According to standard economic theory, markets are inherently pretty robust unless hit by unexpected shocks. The oil market is a case in point. In 1973, the Arab-Israeli War sparked a near-quadrupling in the price of oil, triggering global economic unheaval.
But according to Minsky, markets are quite capable of creating their own crises. They arise through the actions of what drives markets – human psychology. After a few years of stability, markets acquire a reputation for being stable to the point of tedium.
This leads to the emergence of riskier behaviour – and the use of ever-more debt and leverage, to make the most of the seemingly endless ascent of the market.
Eventually, the market reaches a state where only continued belief in its ascent can justify that ascent, as the risks being taken totally ignore the possibility of anything else happening.
In the face of such irrationality, any scare can cause the market to wake up from its delusion and crash, with devastating results.
Minsky showed how markets have repeatedly blown themselves up in this way, with historical examples such as the notorious South Sea Bubble and the Wall Street Crash of his childhood.
One might think that so plausible an explanation for so notorious a problem would have piqued the interest of other economists. Yet when Minsky published his key work on the subject in the mid-1980s, the silence was deafening. By the time of his death in 1996, he seemed destined to follow countless other academics into obscurity.
The global economic crisis that emerged in 2008 changed all that.As the first rumbles of the storm were heard in the summer of 2007, commentators started to talk of "the Minsky meltdown" that occurs when reality suddenly dawns on the markets.
Embarrassed by their dismal failure to predict the crisis, economists began to look again at Minsky's analysis of how stability breeds complacency, leading to catastrophe.
By 2009, Janet Yellen – now the head of the US Federal Reserve – was telling fellow economists that Minsky's work was "required reading".
Given the simplicity of his thesis, the wonder is that Minsky was ignored for so long.
Ironically, it may be that very simplicity that had deterred most economists from taking him seriously.
Over his career, Minsky saw economics become increasingly mathematical, its journals dominated by attempts at "modelling" the complex behaviour of markets with calculus and algebra. Minsky was quite capable of understanding all the equations – his first degree had, after all, been in mathematics.
But he wasn't impressed by them. He knew that translating real-world phenomena into the language of the Platonic world of mathematics involved making assumptions and simplifications. And when it comes to the economy, the devil is often in the detail.
Minsky shared his doubts about the mathematisation of economics with his hero, the British economist John Maynard Keynes.
As early as the 1930s, Keynes – also a former mathematician – had condemned the "maze of pretentious and unhelpful symbols" cooked up by his fellow economists.
Minsky stuck to the more descriptive approach of Keynes, with caveats and assumptions spelt out rather than buried in algebra.
It was an approach woefully out of fashion, with economists seemingly determined to make their papers at least as abstruse as those in theoretical physics. As a result, his papers were regarded as lightweight.
The shock of having failed to foresee the Great Recession may have shaken economists out of their complacency. Whether their new-found interest in Minsky will lead to better insights remains to be seen.
Certainly, when it comes to predicting the effect on oil prices of the turmoil in so many producer nations, all those economic equations seem as useless as ever.
Robert Matthews is visiting reader in science at Aston University, Birmingham