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.

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.