The Financial Instability Hypothesis

Financial Instability Hypothesis — Hyman Minsky on Ponzi Finance and Speculative Regimes

Tranquility then calamity

What followed the aftermath of the Second World War was two decades of “financial tranquility”, says American economist Hyman Minsky. Indeed, over the next twenty years, American financial markets did not experience a major meltdown.

But then in the late 1960s, as if suddenly, wave after wave of events brought the Federal Reserve back into action again. There was, to name a few, the credit crunch of 1966; the 1970 run on commercial paper after Penn Central Railroad collapsed; and the failure of Franklin National Bank in 1974.

Moreover, from the savings and loans crisis to the failure of Long Term Capital Management to the subprime mortgage crisis, government intervention was often necessary to stave off further damage and to build and rebuild safeguards for the future.

Yet, despite these calamities, neoclassical theory of economics had little to say about the prevalence of financial crises and the gyrations of economic cycles. They treated these shocks as anomalies and outliers.

But financial history tells us that economies and markets are not always self-correcting, equilibrium-seeking systems. In Minsky’s eyes, economic theory has ignored the role and nature of financial instability.

“The village fair paradigm shows that a decentralized market mechanism can lead to a coherent result, but it cannot explain the periodic rupturing of coherence as an endogenous phenomenon”.
Hyman Minsky. (1977). The Financial Instability Hypothesis.

Building on an interpretation of John Maynard Keyne’s general theory, Minsky posited his own financial instability hypothesis. He argues that it is more “reasonable to view financial crises as systematic rather than accidental events.” The hypothesis explains how an economy might generate its own instability from the inside out.

To begin, it is important to see the capitalist economic process not just as a problem of resource allocation between alternatives, but as a problem of “capital development of the economy.” That is, expectations about the future shape almost every economic variable, from employment levels to the price of assets to the risk appetite of entrepreneurs and creditors.

Intractable uncertainty and vulnerability

In this light, “investment and financing decisions are made in the face of intractable uncertainty”, Minsky writes. “And uncertainty implies that the views about the future can undergo marked changes in short periods of time.”

Moreover, capitalist economies function on the basis of exchange between the present and future. Companies and financial institutions make investment and financing decisions today in expectation of future profits.

Expectations and uncertainty, in turn, interact and interweave to pull the economy about. As such, views about the future determine the flow of credit and the price of financial and capital assets. And it is the realization of profits and output that determines whether financial obligations in an economy are ultimately met.

Realized output and profits, likewise, depend on the quantum and quality of investment. Thus, the balance sheet and credit worthiness of companies, governments, and households rely on investments too.

As Minsky sums it up:

“Investment takes place now because businessmen and their bankers expect investment to take place in the future… The behavior of our economy therefore depends upon the pace of investment.”
Hyman Minsky. (1977). The Financial Instability Hypothesis.

So as you can guess, market economies are unstable because “investment determines both aggregate demand and the viability of debt structures”; and investing, by nature, is an uncertain endeavor that relies in part on the subjective choices of entrepreneurs, governments, households and financiers.

Hedge, speculative, and Ponzi finance

Minsky goes beyond the standard theories of money, recognizing that financial intermediaries, like the rest of capitalism, are profit seekers too. From real estate investment trusts to mortgage backed securities, institutions will introduce all sorts of products and financial engineering to win more clients and deals.

It helps then, Minsky notes, to distinguish between three types of income-debt relations and innovations: hedge finance, speculative finance, and Ponzi finance. We have hedge financing when enterprises borrow within their means. They are able to meet all of their financial obligations with the cash they earn.

Financing is speculative when they cannot meet their principal obligations in cash, and have to rollover their liabilities to subsist. And in the case of Ponzi finance, the company cannot even make their interest payments. So they turn to ever more debt just to get by—living in hope or delusion that perpetual machines are real.

When the economy is humming, everything seems fine and dandy. Moderate growth and paper profits can disguise excessive risk and wrong doing. Good times will portray speculators and Ponzi artists in a fashionable light.

We know from history, of course, that such financing is forever vulnerable to sudden twists in economic conditions and changes of opinion. In the extreme, we get actual Ponzi schemes like Madoff Securities that must inevitably implode.

Theorems on financial stability

The first theorem of the financial instability hypothesis suggests that economies are stable under some financing regimes, and unstable under others. In particular, Minsky says that “if hedge financing dominates, then the economy may be an equilibrium seeking and containing system.”

But “the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.” This is not dissimilar to George Soros’ theory of reflexivity, which focuses on positive and negative feedback loops in the market economy.

Minsky’s second theorem suggests then that over stretches of “prolonged prosperity”, economies move from stable financial regimes to unstable ones. After some time, our animal spirits and short memories will seek projects and finance of the speculative and Ponzi sort.

Until next time

It doesn’t stop there, of course. In the modern capitalist economy, governments and central banks play a more active role in fighting recessions and crises. But as Minsky points out, it is this “system of interventions and regulations” that allows the entire process to restart anew.

Practitioners like Ben Graham felt similarly:

“When the going is good and new [security] issues are readily salable, stock offerings of no quality at all make their appearance. They quickly find buyers; their prices are often bid up enthusiastically… Wall Street takes this madness in its stride, with no overt efforts by anyone to call a halt before the inevitable collapse… When many of these minuscule but grossly inflated enterprises disappear from view… it is all taken philosophically enough as “part of the game.” Everybody swears off such inexcusable extravagances—until next time.”
Benjamin Graham. (1973). The Intelligent Investor.

Jumps, sputters, and stalls

Such “a theory of the capitalist economic process”, Minsky suggests, “is more relevant and useful for understanding our economy than the standard neoclassical theory.” The theory “fits the world in which we now live”—one that jumps, sputters, and stalls amidst an “epidemic of financial restructuring, bailouts, and bankruptcy.”

Of course, Minsky’s hypothesis is not the final say on the matter. Other models, like George Soros’ theory of reflexivity, Andrei Shleifer’s theory of investor sen t iment, Andrew Lo’s adaptive market hypothesis, Benoit Mandelbroit’s fractal view on finance, and Per Bak’s model of self-organized criticality, offer different vantage points on market dynamics.

Minsky does, however, leave us with some policy implications for the road ahead. One is a simple reminder “that policies which work in one financial regime may not be effective in another.” Because stability breeds instability, we must pay attention to the quality and direction of expectations, financing, and investment.

Finally, if we’re to make any progress, “we have to establish and enforce a ‘good financial society’ in which the tendency by business and bankers to engage in speculative finance is constrained.” This parallels Donald MacKenzie and Yuval Millo’s investigations into economic performativity, which shows how our economic theories can shape and reshape the markets of which we are embedded. Much of this, however, is another Gordian Knot that we must leave for another time.

Sources and further reading

Minsky, Hyman. (1977). The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory.
Minsky, Hyman. (1992). The Financial Instability Hypothesis. Working Paper No.74. The Jerome Levy Economics Institute of Bard College.

Tranquility then calamity