Time to read some Minsky

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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.

Hyman Minsky, 1919-1996

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.

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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19 Responses to Time to read some Minsky

  1. Zoo says:

    Thanks for post­ing the link to your lec­ture Steve. In slide 30 you say:

    It fol­lows that the fun­da­men­tal insta­bil­ity of a cap­i­tal­ist econ­omy is upward. The ten­dency to trans­form doing well into a spec­u­la­tive invest­ment boom is the basic insta­bil­ity in a cap­i­tal­ist economy.””

    The obvi­ous and much-taled-about man­i­fes­ta­tion of the spec­u­la­tive invest­ment boom in OECD coun­tries has been/is hous­ing bubbles.

    Now my ques­tions: Do you also see the Aus­tralian resources boom as another bubble/instability? Also, since early last year, there has been a lot of spec­u­la­tion about a “world­wide com­modi­ties bub­ble”, and now a “t-bills bub­ble” in the USA as investors “flee to safety”. So can the insta­bil­ity in cap­i­tal­ism also be down­ward? I mean it seems like most west­ern economies are tank­ing at the moment, and yet there are new “insta­bil­i­ties form­ing in com­modi­ties and trea­suries and other things. Or is this just the left-overs from the same easy credit cycle…?

    Hope my ques­tion makes sense! Would love to hear your thoughts on this.

  2. Steve Keen says:

    Hi Zoo,

    When Min­sky said the fun­da­men­tal insta­bil­ity is upward, he didn’t mean that it never went down! Instead, most crit­ics of cap­i­tal­ism hypoth­e­sise some ten­dency to stag­na­tion; Min­sky sees instead a ten­dency to take on too much debt dur­ing a boom.

    The com­modi­ties thing today is to some extent a one-off: the entry of China (and also India) into the mar­ket sys­tem at a time when we’re reach­ing resource con­straints on the planet. So while the easy credit cycle added to the upswing, the cir­cum­stances today are also unique.

    That said, a lot of debt would have been taken on to finance the attempt to fill these resource orders. If the lead­ing OECD nations then go in to a finan­cial cri­sis and their economies tank, then that invest­ment in resources will become unprof­itable rapidly, and the bub­ble in resource prices will reverse.

    This is my night­mare sce­nario: that even though we’re hav­ing infla­tion forced now by Global Warm­ing and Peak Oil, a seri­ous down­turn now could lead to a col­lapse in com­mod­ity prices and there­fore a switch from them caus­ing infla­tion to defla­tion. Then the global econ­omy would really be up #*&% creek with­out a paddle!

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  8. Steve Roth says:

    I real­ize this is an old post, not sure you fol­low old com­ments, but…

    I am utterly befud­dled, yet again, by Minsky’s fail­ure to state in many pas­sages whether he’s talk­ing about finan­cial assets or real assets, finan­cial “invest­ment” (aka sav­ing) or real invest­ment (aka invest­ment spend­ing). He gives the impres­sion of buy­ing in to the wide­spread notion that they are fun­da­men­tally synonymous.

    Not that that makes him wrong. (QTC; he’s right.) And I’m think­ing that he quite pos­si­bly dis­tin­guished between the two quite clearly in his own mind. But his fail­ure to do so in his writ­ing makes it seem muddle-headed.

    My two cents…

  9. Steve Keen says:

    Hi Steve,

    Min­sky was cer­tainly aware of the dif­fer­ence, but he tended to take a “for granted” per­spec­tive on the phys­i­cal econ­omy and focus on the machi­na­tions of Wall Street over the finan­cial one. You’ll find more of a dis­cus­sion of the dis­tinc­tion in his book John May­nard Keynes (which as you may know is not a biog­ra­phy but the best book-length state­ment of the Finan­cial Insta­bil­ity Hypothesis–far bet­ter than his later Sta­bi­liz­ing an Unsta­ble Econ­omy).

    I think the descrip­tion of Min­sky as a Hedgehog–who knows not many lit­tle things but “one big thing”–explains a lot here.

    This per­spec­tive of tak­ing the phys­i­cal econ­omy for granted–as a cycli­cal entity how­ever, not one in equilibrium–may be part of why he didn’t get on with the per­son on whom I have based the phys­i­cal side of my own Min­sky mod­els, Richard Good­win. They worked at the same uni­ver­sity for sev­eral years, but never col­lab­o­rated (in an email from Richard Good­win dis­cussing my work on Min­sky, he described Min­sky as hav­ing “swanned in” to his then uni­ver­sity, and made it clear that–for rea­sons I per­son­ally rejected–he saw work­ing on the mon­e­tary side of the econ­omy as a waste of time).

  10. Steve Roth says:

    Thanks for the reply, Steve. I haven’t read JMK (The Book) yet, will do so. Though I won­der if it’s nec­es­sary in order to fully grasp his one big idea…?

    Just to say, I think it’s clearer to talk about real vs finan­cial (a la Beze­mer) than phys­i­cal ver­sus finan­cial. Real assets include (in addi­tion to struc­tures, hard­ware, and soft­ware) infi­nite vari­eties of human, cul­tural, and orga­ni­za­tional cap­i­tal: ideas, knowl­edge, meth­ods, tech­niques, busi­ness processes, skills, etc., that can be cre­ated and devel­oped through invest­ment spend­ing (flow­ing out of the stock of finan­cial “assets”).

    Those largely intan­gi­ble and unmea­sur­able (non-physical) assets may con­sti­tute by far the largest pro­por­tion of real assets. Look­ing around at all the busi­nesses I’ve run, I’ve always been amazed at how lit­tle “stuff” we had. The busi­nesses’ value was all about being a going con­cern, and that was all a result of intangibles/unmeasurables. Hence the wide­spread val­u­a­tion ter­mi­nol­ogy: “good will” and “stock­holder equity.”

    BTW, I’ve read and re-read Debunk­ing Eco­nom­ics, sent it to a few friends. Tried to track down a way to write to George Soros, to sug­gest that he give it away for free to every eco­nom­ics under­grad who asks. Could make for some very amus­ing class time… Look­ing for­ward to the next edition.

  11. Steve Keen says:

    I think his papers in “Can “It” Hap­pen Again? are suf­fi­cient Steve. JMK was his first (and last) attempt to be sys­tem­atic about it on a grand scale.

    Take the point re real vs phys­i­cal, but in eco­nomic mod­el­ing I mainly focus on the lat­ter rather than the for­mer. The cre­ative account­ing buried in much of what is called “good­will” also sends my cyn­i­cal gene apoplec­tic; but I acknowl­edge the impor­tance of intel­lec­tual cap­i­tal in gen­uine companies.

    And if you pull off the Soros con­nec­tion, I’ll fly to wher­ever you are for a cel­e­bra­tory drink. Sec­ond edi­tion should be out by the end of September.

  12. Steve Roth says:

    Yeah there’s a rea­son national accounts only count struc­tures, hard­ware, and soft­ware. The other stuff is really unmea­sur­able. That’s why it all get tossed into the resid­ual (“good will”), even by steely-eyed investors. Just to say, unmea­sur­able is far from unimportant.

    Another exam­ple: I did a back-of-the-envelope calc sug­gest­ing that non-remunerated (and unmeasured/uncounted) but decid­edly pro­duc­tive “home work” in the U.S. is equiv­a­lent to a third of mea­sured GDP.

    Not that I’m sug­gest­ing you should be cor­rect­ing your work based on that. Just sayin’.

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  16. Ron Bowd says:

    This is a triv­ial note, how­ever, the URL link above to the lec­ture on Minsky’s the­ory has 4 wwww’s rather than 3. One ‘w’ needs to be removed.

    http://wwww.debtdeflation.com/blogs/wp-content/uploads/2008/03/KeenManagerialEconomicslecture09EconomyAlternative.ppt

  17. Steve Keen says:

    Thanks Ron, I’ve fixed it.

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  19. Kozak says:

    This is a very sim­ple expla­na­tion of the Min­skian moment that you can for­ward to your non econ­o­mist friends

    http://www.oftwominds.com/blogjuly12/neofeudal-middle-class7-12.html

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