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Wednesday, October 24, 2018

Primer: Minsky's Financial Instability Hypothesis

The "Financial Instability Hypothesis" is a phrase describing the economist Hyman Minsky's views on the driver of the business cycle. The description here is based on the essays found in the book Can "It" Happen Again? Essays on Instability and Finance. The objective here is to capture highlights of his thinking, and not attempt to cover the breadth of his world view.

If the reader wishes to find a fuller description, I would recommend the essay "The Financial Instability Hypothesis: A Restatement" on pages 90-116. This article is a very high level overview of that summary article. At the end of this article, I will comment on some of the implications of the hypothesis.

Discontent with Mainstream Theory

As is somewhat typical of heterodox economists, Minsky starts out the essay with a criticism of mainstream economics.
It is trite to acknowledge that the capitalist economies are "not behaving the way they are supposed to. [...] As a result, one source of the troubles of the capitalist economies is that the theory that underlies economic policy, which defines the "supposed to," just won't do for these economies at this time. (Page 90.)
In general, I am now trying to shy away from criticism of mainstream economics for the sake of criticising it, but it is very difficult to avoid it in this circumstance. The premise of capitalist economies existing in a coherent equilibrium state is utterly incompatible with the financial instability hypothesis. One can argue that most mainstream economists in practice are more reality-based than their mathematical theory, but the problem is that this mathematical theory is misleading in this case. There are perhaps other areas of macroeconomics where we can try to find a common ground between post-Keynesian economics and traditional mainstream macro, but this is not where it will happen.

Minsky argued that conventional economic theory of the time (the essay was published in 1978) had two problems:
  1. mainstream economic theory does not apply to the type of economy we actually have, which features capital assets and capitalist financing practices; and
  2. it has no explanation of financial instability.
One can immediately observe that forty years have passed since Minsky made that assessment; one of the side effects of the Financial Crisis was that the mainstream finally began to take financial instability seriously. I will not attempt to answer the question whether mainstream theory finally has an answer to the issues that Minsky raised then.

In any event, one key observation is that Minsky's arguments about financial instability roughly coincide with common sense observations of financial market participants. They seem so obvious that it is perhaps not clear how novel they are. However, this is completely unlikely mainstream macroeconomic theory, which offers almost no useful insights to market participants. Which is better: something obvious, or something that cannot be related to the facts on the ground?

Capital Assets

How capitalist economies treat capital assets is what sets them apart from the concept of barter exchange -- which underlies neoclassical mathematical models.

Minsky argues that there are two sets of prices that matter in a capitalist economy: the price of capital goods, and the price of current output (goods and services produced for immediate consumption).
  • The price of current output is determined by current views of demand conditions, as well as money wages.
  • The price of capital goods is determined by current views on future profits.
Although one could debate details, the practical distinction between the mainstream view of price determination and Minsky's for current output is not vastly the different. The contrast is found in the question of capital assets. In particular, there is a hidden complexity in the situation for capital goods, which is that aggregate investment is a source of profits for the business sector. (As I discussed in my Kalecki Profit Equation primer.) The more businesses invest, the greater the profits -- and the greater the value for capital goods!

The fact that he specifies "current views" is important; these views are the shifting, uncertain views as seen on business television interviews, and not the rational expectations equilibrium of mainstream theory. If those views shift, the price of capital assets shifts.

Hedge, Speculative, and Ponzi Finance

Minsky's description of how capital assets are financed was extremely catchy (at the cost of overshadowing the rest of his thinking). He divided the financing modes into three type: hedge, speculative and Ponzi.

We will illustrate these concepts by assuming that we have a capital asset that costs $100, and is expected to generate $10 in profit indefinitely. (Maintenance costs are taken into account as part of the profit figure.)

Hedge finance is stodgy: the cash flows from the investment will meet all contractual cash flows. For our example, this would be provided by borrowing $100 in a 20-year amortising bond with an internal rate of return of 5% (an annual payment of $8.02). Each year, the $10 profit is enough to cover the payment for the loan.

Speculative finance is actually what most financial market participants would think of as "normal": the profits are expected to cover the interest costs, but the borrower needs to roll over financing. For our example, that would be provided by issuing a conventional 5% 10-year bond. The asset is earning $5 a year above the interest cost, but the accumulated profits will not be enough to repay the bond principal after 10 years. If it can refinance the bond after ten years at 5%, the accumulated $5/year profits will be enough to pay back the principal by 20 years (lessened by the interest earned by the previously accumulated profits). The borrower is speculating that the financial markets will be accepting its paper in five years, so that it can refinance.

Ponzi finance captures the imagination: the firm cannot repay the loan with expected profits. The hope is that the value of the asset will increase by more than the cost of its financing. In this example, this would involve the firm borrowing at a rate of interest above 15%, on the hope that the capital asset will appreciate. Although most firms will always at least pretend that the return on assets will be greater than their borrowing cost, real estate is prime Ponzi finance territory.

If we go back to the essay "The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to 'Standard' Theory," Minsky describes how financing forms drift over time.
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 clear that the margin of safety built into debt structures were too great. (Page 65.)
Using his terminology, hedge units drift to become speculative units, and speculative units become Ponzi units.

The importance of conventions in finance is critical; a significant part of Minsky's writings details how those conventions shifted in the United States over time. The Great Depression seared a generation; financing structures after World War II were extremely conservative. Corporations proudly hung the documents announcing their AAA credit rating in boardrooms. However, after decades of quiet, animal spirits returned to financing arrangements, and the United States has been bumping into financial crises of various sorts since 1966.

The Role of Keynes

It should be noted that the terminology I describe here came from Minsky, but Minsky argued that Keynes was the inspiration (for example, as described on page 59). Keynes was somewhat trapped by existing classical thinking, and so the expression of his view was famously confusing.

Minsky describes Keynes as taking a "City or a Wall Street paradigm: the economy is viewed from the board room of a Wall Street investment bank" (page 61). Hence the emphasis on the nature of financing positions in capital assets, and the effect on the economy.

How Can We Apply the Hypothesis?

I would be best described as a Minsky-ite; most of my views probably were foreshadowed by something Minsky wrote. However, I would be somewhat cautious in how far we can push a narrow version of the Financial Instability Hypothesis.

If we look at the trends in finance leading from the 1950s towards the 2008 Financial Crisis, we can see how more speculative forms of financing pushed out stodgier practices. The Financial Instability Hypothesis fits that qualitative story to the letter.

The problems revolve around more quantitative aspects: can we use it to predict the business cycle? Financing practices continuously change; national statisticians can barely keep up with just aggregating all the forms of debt that investment bankers have created, never mind attempting to measure the conservatism of lending practices. That is, we can hope to measure debt growth; the challenge is whether the growth in debt can be sustained by borrowers. The only people who may have a good measure of this are the bankers themselves, but they are not going to march down to the regulators and admit that they think their customers are probably going to all default.

Mass defaults are a good measure of financial fragility, but back-casting the 2008 Financial Crisis in 2018 is not a particularly impressive analytical feat.

Concluding Remarks

This article has given a minimal description of the Financial Instability Hypothesis. Minsky wrote a lot more on the business, but we would start moving into more generic post-Keynesian views of the world, which are less distinctive. In my view, the most interesting parts of Minsky's analysis the historical discussion of the trends on financing practices over time. I have no doubt that many readers will find the discussion of the development of the Fed Funds market to be somewhat dry. However, when one considers the parallels to the more hair-rising developments that led up to 2008, one can appreciate that the Financial Crisis was not some "6 sigma event," rather the usual way in financial capitalism evolves if regulators give it free rein.

Link to Amazon.comCan It Happen Again?: Essays on Instability and Finance (affiliate link)

(c) Brian Romanchuk 2018

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