We were Keynesians. Then we were Monetarists. Now, everybody is an Austrian. The reference is to the Austrian school of economists not necessarily one of geography. Austria – the country – is rather caught up in the credit crisis as it banking system seems to be heavily exposed to economically weak and financially struggling central and eastern european economies.

This is a re-issue of Minsky’s book originally published around 1986. There was steady demand for the book despite it being out of print. Prices on e-Bay were upwards of $1,000 especially after interest in Minsky’s work exploded in 2007 as the current financial crisis unfolded.

"Stabilizing An Stable Economy" seeks to explain why modern economies are liable to fluctuate and how the obvious instability can be masked for a time. Minsky’s central thesis is that stability in financial markets engenders instability as a result of a number of inherent tendencies in the financial system. Minsky’s insights into financial markets specifically speculative finance, increasing debt levels, decreasing debt quality and economic volatility are well worth reading. Minsky’s caution about what he called “balance sheet adventuring” could almost be a by-line for the modern age of finance.

Minsky’s view was that modern financial markets are “conditionally coherent” and characterised by “periods of tranquility”. Excessive risk taking driven in part assumptions about levels of risk, inherent investment biases as asset prices increase and increased leverage leads to market breakdowns.

Minsky’s analysis seems eireely prescient anticipating many elements of the current financial crisis. It seems the world is having a “Minsky moment”. If Minsky had lived to witness the present crisis, he could be excused for an entirely self-satisfied “I told you so!”

Niall Ferguson (2008) "The Ascent of Money"

The title is a self conscious reference to the Jacob Bronowski’s path breaking "Ascent of Man" – a television history of scientific progress. Ferguson, a respected historian and author of acclaimed two volume biography of the Rothschild Family (The House of Rothschild), attempts a financial history of the world.

"The Ascent of Money" is divided into six parts – money; bond markets; stock markets; insurance and risk; real estate (housing); global money (essentially Bretton Woods 2). There is an afterword that is an afterthought probably prompted by the current financial crisis.

"The Ascent of Money" is an uneven work. At its best, it is engaging, lucid and insightful in the analysis of the role of money in economies. The book is at its best when it is deals with the past. The writing is vivid and brings the characters and episodes to life.

The difficulty with the book is its ambition. It is challenging to reduce the complex history of a tangled specialist subject into a simple series of narratives and themes. This leads to simplifications that are questionable. The author’s concept of “Chimerica” – a financial amalgam of America and China – is not entirely convincing. As events may demonstrate, Chimerica may well prove an evanscent Chimera.

"The Ascent of Money" also seems less assured when dealing with the present. The intricacies of modern finance are glossed over. The text may also be over reliant on the views and opinions of a few people - George Soros and Ken Griffin (founder of the, now embattled, mega hedge fund Citadel).

The form of the book and especially the writing style is a concession to its context – the ubiquitous “Major Television Series”. "The Ascent of Money" often reads like a script of a TV series rather than a cohesive work of history. A musical could be next!

Despite shortcomings, "The Ascent of Money" is an entertaining history for the ordinary reader interested in an introduction on the role that money has played in civilisation. The book, rushed out to capitalise on the current interest in finance, explores ideas that are now in a process of fundamental revision. Perhaps history can only be written about distant events of long dead souls and fallen empires and houses.

Bill Bonner and Addison Wiggin (2006) "Empire of Debt"

"Empire of Debt" is a sardonic, penetrating analysis of debt and credit in the modern economy, with a particular focus on the world’s largest borrower – the USA.

Bonner and Wiggin are contrarian investors who are the President and Editorial Director respectively of a financial newletter – The Daily Reckoning. Their thesis is that empire (in the political sense) fuels an insatiable appetite for financial excess required to support the costs of the supporting infrastructure of Pax Americana. Central to their theme is the concept of consuetudo fraudium – habitual cheating.

The book’s structure is linear. It weaves it way through American history identifying the key inflection points and identifying the growing tide of financial debauchery.

Much of the analysis is not original and many of identified failings have been identified by other analysts. What makes "Empire of Debt" interesting is that Bonner and Wiggin write with sardonic wit about the trapping of modern economy and finance – Bill Gates is “where God goes for a loan”. Nothing and no one is spared.

At times, the book’s analysis is repetitive and the unremitting bleakness difficult. However, "Empire of Debt’s" great achievement is its cohesive and consistent analysis of the trajectory of finance and economics. Published in 2006, the book anticipates the current financial crisis with considerable accuracy. Bonner and Wiggin are intellectually successors to both Minsky and an earlier economist and social observer – Thorstein Veblen.

Michael Pettis (2001) "The Volatility Machine" Anastasia Nesvetailova (2007) "Fragile Finance"

Emerging market investing has never been for the faint hearted. 2008/ 2009 may well prove to be yet another Minsky moment – there have been many – in the history of emerging market lending. Cross border loans to central/ eastern Europe and Latin America (a serial defaulter) may provide a new phase in the current financial crisis.

"The Volatility Machine", written by Michael Pettis (now an acedemic but previously an practitioner), is an interesting exploration of financial crisis in emerging markets. It’s central thesis is that such crisis are caused more by problems in management of country balance sheets than (the more commonly accepted hypothesis) economic mismangement. Pettis argues, sometimes persuasively, that emerging market investors and borrowers underestimate the magnitude and effect of volatility on these economies and the structure of financing. The book highlights the disconnect between the work of economists (such as those employed by the IMF and World Bank) and market practitioners.

"Fragile Finance" focuses on recent financial crisis (specifically the Asian, Russian and Argentine crisis). The book explores how the liberalisation of financial markets, the proliferation of derivatives, and new financial techniques translate into financial crisis for emerging countries. The fragile nature of finance that frequently undermines the stability of the economy is the central focus of the analysis. The analysis is unashamed based on Minsky. But then we are all Austrians now.

As Keynes observed: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

The outlook for banks remains grim.

The asset quality of major banks remains uncertain. Svein Andresen, secretary general of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: “We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.”

Despite significant writedowns, sub-prime assets remain vulnerable. Other assets - consumer credit, SME loans, corporate lending and high yield leverage loans to private equity transactions- all look vulnerable as the real economy slows. Banks have increased provisions but it is not clear whether they will be adequate.

Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks financing directly from investors. Banks also hold lower quality assets to boost returns.

Bank balance sheets also now hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transaction and derivatives (of varying degrees of complexity). Sometimes, the assets don’t appear on balance sheet being held in complex off-balance sheet structures with various components of risk being retained by the bank. Further write-downs in asset values cannot be discounted.

Banks require re-capitalisation. The capital is requiredto cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Earning growth in recent years has been driven by a rapid expansion of lending – both traditional and disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings.

Lack of lending capacity may also affect other activities. Corporate finance and advisory fees are driven by the capacity to finance transactions and also co-investing in risk positions. Lower origination of lending driven deals may reduce this income significantly. Banking fees for leveraged finance deals are down 90%.

Structured finance has contributed strongly to earnings in recent years. Securitisation, including CDO activity, has been a major growth area. Volumes have collapsed. The slowdown in structured finance has complex effects. Banks generated large earnings from off balance sheet vehicles in the shadow banking system. The vehicles provided banks with the ability to “park” assets and reduce capital. They also provided significant revenue – management fees; debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon.

Trading revenue has been a bright spot. Increased volatility and much wider bid-offer spread have generated increases in both client driven and proprietary trading earnings. Volatility and the need to adjust trading positions created strong trading flows and earnings. As the markets stabilise, trading flows and earnings decline.

Several factors may limit trading income. Derivatives and structured investments, especially complex products, generated significant earnings. Problems in structured finance highlighted concerns about complexity, transparency and valuation. Market volatility has resulted in significant losses in some structured investments. Revenues may diminish as investors and borrowers curtail their use of such instruments preferring simpler products that are less profitable to the bank.

Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow through consolidation, investor redemptions and reduced leverage. Derivatives and hedging activity from private equity transactions and structured finance has been significant. Hedging revenues typically contribute 50% or more of bank earnings from a private equity transaction. Reduction in financial sponsor activity will limit revenue from this source.

Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on availability of counterparties and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.

Future earnings will be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital levels for some transactions exacerbating the capital problem.

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.

Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 14.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.

Banks also face additional short-term costs. Litigation against banks has increased. There may also be prosecutions of banks. The costs of these are unknown. In the longer term, banks face higher regulatory and compliance costs.

Accounting factors may also affect any earnings recovery. FAS157 allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.

As credit spreads increased, banks have taken substantial profits to earnings from revaluing their own liabilities. If markets stabilise and the credit spreads for banks improves then banks will have to reverse these gains. There may be significant mark-to-market losses especially on new debt issues by banks at high credit spreads since mid-2007. Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the “gilded age” of bank profits may be difficult to recapture.

Glamorous banks reliant on “voodoo banking” may find it difficult to achieve the high performance of the “go-go” years.

Banks with sound traditional franchises that have avoided the worst excesses of the last 10-15 years will do well in the changed market environment. Such old fashioned banking may ironically do well in the “new” environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a “flight to quality”.

Will the recovery in bank stocks take the form of “V” or “U”? It may be a “L”. With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are “too big to fail”. This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a “L” (Kirsten ITC font) – note the small upturn at the far right of the flat bottom.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.