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 Professor of Economics and Head of Economics, History and Politics at Kingston University London, 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 private debts accumulated globally, 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.


  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


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