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Financial Instability Hypothesis

Minsky argues that crises are endogenous to the capitalist system which differs from a Smithian view that free markets are efficient and socially optimal.
We start by pointing out that every financial unit has assets and liabilities with varying characteristics with the respect to liquidity and maturity. He identifies 3 categories of financial units: hedge finance, speculative finance and Ponzi finance. 
Hedge finance is a strong position which does not require buying and selling of assets or borrow and lending due to shortages in cash flows as such a unit has large cash flows from its operations and/or large cash reserves. There are a lot of hedge borrowers after a financial crisis, when people are cautious. Most importantly, borrowers can afford (they have sufficient cashflows) both the interest and the principal payment of their loans.
Speculative financial units have cash flows which meet interest payments on outstanding debt but requires rolling over debt, or liquidation of assets to meet cash flows. These borrowers increase in frequency as euphoria increases, and banks begin to lend money more freely. This type of finance is only stable if interest rates don't rise and the value of the assets doesn't fall.
Ponzi finance is a situation where cash flows do not meet interest payments on outstanding debt and hence depends upon a continuous increase in asset prices to remain in existence. Without an increase in asset prices a rapid liquidation of assets would ensue. 

The first theorem of Minsky's Financial Instability Hypothesis is that the economy will be sustainable if hedge units dominate within the system. More speculative and Ponzi units increase instability and risk.
The second theorem states that over long periods of time, economic units progress from being hedge units, to speculative and Ponzi units. This occurs because banks experience euphoria - stability in recent years, when most financial units were hedge financed, causes financial agents to be more optimistic about the future - and are more willing to lend to borrowers. In their pursuit for people to lend to, they inevitably lower their standards and so give finance to units who can't pay the principal (speculators), and eventually to those who can't even pay the interest unless asset prices rise (Ponzi finance). This last stage occurs because stability has been the situation for many years and there is a belief that the economy is tamed, and asset prices will continue to rise indefinitely.
Eventually, some external shock or merely a realisation of the financial situation, results in asset prices falling which means Ponzi financed units will begin to go bankrupt. This will cause a vicious cycle as lending dries up due to fear of instability and is exacerbated by the selling of assets. If enough agents in the economy need to liquidate assets then fire-sales may follow. A firesale occurs when lots of units are selling assets, driving their prices downwards (perhaps below a "fair" value) and meaning that more units have to sell further assets to prevent themselves becoming insolvent. This could lead to a Fisher debt-deflation spiral.

The margin of safety for a firm is the excess of future cash-flows from income-generating assets/production over cash-outflows of liabilities. This is the buffer zone which protects against the need to borrow or liquidate assets. During stable economic times, margins of safety are reduced: "stability is destabilising" - this is not necessarily confined to confidence or euphoria, but because lending models are typically back-ward looking, so if the economy has experienced stability for the last 5 years then most models - and agents' memories - will remember this stability and so expect the probability of default to be low. Agents within the system are unaware of the declining margins of safety. This increases lending to previously declined projects, which were deemed too risky, which can lead to asset-bubbles and an increase in the number of Ponzi agents.
Eventually a moment will arise when asset prices stop rising, Ponzi units face problems of financing cash flows on debt commitments and the fire sale of assets occurs: the market crashes. This is the end of the Minsky cycle and is known as a Minsky moment. Davidson (2008) defines a Minsky moment as "when the Ponzi pyramid financial scheme collapses" whilst Lahart (2007) believes it is "when over-indebted investors are forced to sell even their solid investments". The term was coined by Paul McCulley to describe the 1998 Russian financial crisis.

Minsky and Ferri added further to this initial theory by using "thwarting systems" to explain why instability wasn't more prevalent. They wrote that customs, institutions and policy intervention caused limits to how low an economy fell. Even the belief that institutions such as the government, or the central bank (often the lender of last resort), would not let a calamity occur can be stabilising and create a self-fulfilling prophesy. However, eventually every economic unit becomes aware of these thwarting systems and adjusts its behaviours to maximise returns based on this system. For example, the central banks role as a lender of last resort is a thwarting system which can prevent a calamity as agents realise they could be saved, and so fears of insolvency may not be necessary. Yet eventually firms become aware of this, and hence take risky action to profit-maximise, knowing that if they fail they will be bailed out.

Palley (2009) claims that the credit crunch was the end of a Minsky Super-Cycle. Such a cycle includes a series of normal Minsky cycles but ends when the thwarting mechanism is exhausted. It occurs over long periods of time and starts with regulatory control, moves to regulatory relapse before regulatory escape and eventually the bursting of the super Minsky cycle and a return to the beginning of the cycle. Regulatory control occurs when the government intervenes through regulation to reduce profits for financial institutions, perhaps by limiting their activities, or increasing their liquidty ratios. Regulatory relapse occurs when regulation is eased, perhaps due to lobbying by financial institutions and periods of stability which make economic agents forget about the dangers of unregulated activity. Regulatory escape is the culmination of this easing whereby financial institutions are free to do what they want. At the end of a super-cycle, when the thwarting mechanism has been exhausted, we return to a situation of regulation.
Throughout the occurence of this super cycle, ordinary Minsky cycles can occur but the range of fluctuations during this regular Minsky cycles increase as economic agents expand to overcome the thwarting systems to increase profits. It is important to remember that it is only the floors and ceilings which are changing whilst individual recessions can be stronger or weaker depending upon the situation.

The increased risk taking is also increased by data hysteresis (recent data shows period of stability), memory loss, culture change and financial innovation to maximise profits and overcome regulatory restraints.

Not all economists believe in these super-cycles as put forward by Palley. At any rate, it could be argued that we haven't yet come to the end of the super-cycle (because we haven't returned to a situation of regulatory control) which would suggest - according to this theory - that the next crash will be even larger. This might be justified by a belief that banks realise they are too big to fail, and having witnessed the enormous bail-outs of the 2007 Crash, increase risk-taking to maximise profits. On the other hand, some could argued that culture has changed within the financial system and the regulators are more vigilant, despite the lack of increase formal regulation.

Minsky believed that under the free market system we would naturally experience these boom and bust, Minsky cycles. For him, the only way to eliminate them was government intervention and regulation to prevent finance from expanding too much. He was therefore adamantly against the deregulation period in the 1980s - known as the Big Bang in the UK.

In a Minskian framework we can prevent financial instability by detecting and preventing Ponzi finance units and preventing banks from lending to them. The framework also suggests that we should reduce financial competition and innovation, which is often developed to overcome regulation and confuse regulators. Ponzi units can be detected, and prevented from borrowing, by using the following criteria:
Is continuous refinancing needed?
Is this need growing relative to outstanding debt?
Is underwriting collateral based or income based? (Collateral based lending is more prone to Ponzi financing)
Are rising asset prices needed for this economic process to continue?
Regulation could be introduced which prevents banks from lending to these Ponzi finance units, to prevent a Minsky moment from occurring. Such regulation could also encompass higher reserve-deposit ratios and regulate the type of assets that banks can hold as collateral as well as increasing the size of shareholder equity so the banks owners themselves have more to lose from any financial crisis, rather than depositors and taxpayers.

Palley provides the following policy prescriptions:
1. Policymakers should be skeptic towards any euphoria that accompanies the business cycle.
2. "Capitalist economies need significant regulation containing financial speculation and financial excess because the economy has an automatic behavioural tendency to instability".
3. Policy discretion is needed - in a Minskian framework - instead of policy rules, to allow for greater flexibility in the creation of thwarting institutions.

Page last updated on 10/08/15