Time to read some Minsky
on March 10th, 2008 at 11:13 am
The current turmoil on the Stock Market—and especially the sudden collapse of many once high-flyers—has taken a lot of people by surprise.
One person who, were he alive today, wouldn’t be the least bit surprised, is Hyman Minsky, who predicted that events like this would be a regular feature of a deregulated financial system.
He developed what he called “The Financial Instability Hypothesis”, and anyone who wants to understand today’s events needs to know about it.
The following is an extract from an article by Minsky in Challenge in 1977—well before even the 1987 Stock Market Crash—that provides a nutshell-sized precis of his theory.
As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event, it becomes apparent that the margins of safety built into debt structures were too great, As a result, over a period in which the economy does well, views about acceptable debt structure change.
In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price of capital-assets and increases investment. As this continues the economy is transformed into a boom economy.
Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital-assets exists and in which the extent to which such debtfinancing can be carried is determined by the market. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investmcnt boom is the basic instability in a capitalist economy.
Innovations in financial practices are a feature of our economy, especially when things go well. New institutions, such as Real Estate Investment Trusts (REITs), and new instrunient, such as negotiable Certificates of Deposit, are developed; old instruments, such as commercial paper, increase in volume and find new uses. But each new instrument and expanded use of old instruments increases the amount of financing that is available and that can be used for financing activity and taking positions in inherited assets.
Increased availability of finance bids up the prices of assets relative to the prices of current output and this leads to increases in investment. The quantity of relevant money, in an economy in which money conforms to Keynes’ definition, is endogenously determined, The money of standard theory— be it the reserve base, demand deposits and currency, or a concept that includes time and savings deposits—does not catch the monetary phenomena that are relevant to the behavior of our economy.
In our economy it is useful to distinguish between hedge and speculative finance. Hedge finance takes place when the cash flows from operations are expected to be large enough to meet the payment commitments on debts. Speculative finance takes place when the cash flows from operations are not expected to be large enough to meet payment commitments, even though the present value of expected cash receipts is greater than the present value of payment commitments. Speculating units expect to fulfill obligations by raising funds by new debts.
By this definition a “bank” with demand and short-term deposits normally engages in speculative finance. The RET, airlines, and New York City engaged in speculative finance in 1970-73. Their difficulties in 1974-75 were due to a reversal in present values (the present value of debt commitments exceeding the present value of expected receipts), due to both increases in interest rates and a shortfall of realized over previously anticipated cash flows.
During a period of successful functioning of the economy, private debts and speculative financial practices are validated. However, whereas units that engage in hedge finance depend only upon the normal functioning of factor and product markets, units which engage in speculative finance also depend upon the normal functioning of financial markets. In particular, speculative units must continuously refinance their positions. Higher interest rates will raise their costs of money even as the returns on assets may not increase.
Whereas a money supply rule may be a valid guide to policy in a regime dominated by hedge finanee, such a rule loses its validity as the proportion of speculative finance increases. The Federal Reserve must pay more attention to credit market conditions whenever the importance of speculative financing increases, for the continued workability of units that engage in speculative finance depends upon interest rates remaining within rather narrow bounds.
Units that engage in speculative finance are vulnerable on “three fronts.’ First, they must meet the market as they refinance debt. A rise in interest rates can cause their cash payment commitments relative to cash receipts to rise. Second, as their assets are of longer term than their liabilities, a rise in both long- and short-term interest rates will lead to a greater fall in the market value of their assets than of their liabilities. The market value of assets can become smaller than the value of their debts. The third front of vulnerability is that the views as to acceptable liability structures are subjective, and a shortfall of cash receipts relative to cash payment commitments anywhere in the economy can lead to quick and wide revaluations of desired and acceptable financial structures.
Whereas experimentation with extending debt structures can go on for years and is a process of gradual testing of the limits of the market, the revaluation of acceptable debt structures, when anything goes wrong, can be quite sudden and quick.
In addition to hedge and speculative finance we can distinguish Ponzi finance—a situation in which cash payments commitments on debt are met by increasing the amount of debt outstanding. High and rising interest rates can force hedge financing units into speculative financing and speculative fiwincing units into Ponzi financing.
Poni financing units cannot carry on too long. Feedbacks from revealed financial weakness of some units affects the willingness of bankers and businessmen to debt finance a wide variety of organizations. Unless offset by government spending, the decline in investment that follows from a reluctance to finance leads to a decline in profits and in the ability to sustain debt. Quite suddenly a panic can develop as pressure to lower debt ratios increases.
What we have in the financial instability hypothesis is a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis.
Excerpts from “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory, Challenge, March-April 1977, pp. 20-27. For copyright reasons, I can’t forward the entire article, but anyone who wants a copy who doesn’t have Web access to Challenge is welcome to send me an email requesting it.
I have also linked a lecture of mine which gives an overview of his theory, with quotes from other papers.
One person who, were he alive today, wouldn’t be the least bit surprised, is Hyman Minsky, who predicted that events like this would be a regular feature of a deregulated financial system.
He developed what he called “The Financial Instability Hypothesis”, and anyone who wants to understand today’s events needs to know about it.
The following is an extract from an article by Minsky in Challenge in 1977—well before even the 1987 Stock Market Crash—that provides a nutshell-sized precis of his theory.
Minsky on Financial Instability
The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety so that expected cash flows, even, in periods when the economy is not doing well, will cover contractual debt payments.As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event, it becomes apparent that the margins of safety built into debt structures were too great, As a result, over a period in which the economy does well, views about acceptable debt structure change.
In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price of capital-assets and increases investment. As this continues the economy is transformed into a boom economy.
Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital-assets exists and in which the extent to which such debtfinancing can be carried is determined by the market. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investmcnt boom is the basic instability in a capitalist economy.
Innovations in financial practices are a feature of our economy, especially when things go well. New institutions, such as Real Estate Investment Trusts (REITs), and new instrunient, such as negotiable Certificates of Deposit, are developed; old instruments, such as commercial paper, increase in volume and find new uses. But each new instrument and expanded use of old instruments increases the amount of financing that is available and that can be used for financing activity and taking positions in inherited assets.
Increased availability of finance bids up the prices of assets relative to the prices of current output and this leads to increases in investment. The quantity of relevant money, in an economy in which money conforms to Keynes’ definition, is endogenously determined, The money of standard theory— be it the reserve base, demand deposits and currency, or a concept that includes time and savings deposits—does not catch the monetary phenomena that are relevant to the behavior of our economy.
In our economy it is useful to distinguish between hedge and speculative finance. Hedge finance takes place when the cash flows from operations are expected to be large enough to meet the payment commitments on debts. Speculative finance takes place when the cash flows from operations are not expected to be large enough to meet payment commitments, even though the present value of expected cash receipts is greater than the present value of payment commitments. Speculating units expect to fulfill obligations by raising funds by new debts.
By this definition a “bank” with demand and short-term deposits normally engages in speculative finance. The RET, airlines, and New York City engaged in speculative finance in 1970-73. Their difficulties in 1974-75 were due to a reversal in present values (the present value of debt commitments exceeding the present value of expected receipts), due to both increases in interest rates and a shortfall of realized over previously anticipated cash flows.
During a period of successful functioning of the economy, private debts and speculative financial practices are validated. However, whereas units that engage in hedge finance depend only upon the normal functioning of factor and product markets, units which engage in speculative finance also depend upon the normal functioning of financial markets. In particular, speculative units must continuously refinance their positions. Higher interest rates will raise their costs of money even as the returns on assets may not increase.
Whereas a money supply rule may be a valid guide to policy in a regime dominated by hedge finanee, such a rule loses its validity as the proportion of speculative finance increases. The Federal Reserve must pay more attention to credit market conditions whenever the importance of speculative financing increases, for the continued workability of units that engage in speculative finance depends upon interest rates remaining within rather narrow bounds.
Units that engage in speculative finance are vulnerable on “three fronts.’ First, they must meet the market as they refinance debt. A rise in interest rates can cause their cash payment commitments relative to cash receipts to rise. Second, as their assets are of longer term than their liabilities, a rise in both long- and short-term interest rates will lead to a greater fall in the market value of their assets than of their liabilities. The market value of assets can become smaller than the value of their debts. The third front of vulnerability is that the views as to acceptable liability structures are subjective, and a shortfall of cash receipts relative to cash payment commitments anywhere in the economy can lead to quick and wide revaluations of desired and acceptable financial structures.
Whereas experimentation with extending debt structures can go on for years and is a process of gradual testing of the limits of the market, the revaluation of acceptable debt structures, when anything goes wrong, can be quite sudden and quick.
In addition to hedge and speculative finance we can distinguish Ponzi finance—a situation in which cash payments commitments on debt are met by increasing the amount of debt outstanding. High and rising interest rates can force hedge financing units into speculative financing and speculative fiwincing units into Ponzi financing.
Poni financing units cannot carry on too long. Feedbacks from revealed financial weakness of some units affects the willingness of bankers and businessmen to debt finance a wide variety of organizations. Unless offset by government spending, the decline in investment that follows from a reluctance to finance leads to a decline in profits and in the ability to sustain debt. Quite suddenly a panic can develop as pressure to lower debt ratios increases.
What we have in the financial instability hypothesis is a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis.
Excerpts from “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory, Challenge, March-April 1977, pp. 20-27. For copyright reasons, I can’t forward the entire article, but anyone who wants a copy who doesn’t have Web access to Challenge is welcome to send me an email requesting it.
I have also linked a lecture of mine which gives an overview of his theory, with quotes from other papers.
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