Hyman Minsky - The Financial Instability Hypothesis

Hyman Minsky was an American economist who lived from 1919 to 1996, living through the Great Depression which undoubtedly moulded his heterodox post-Keynesian economics.

One of Minsky’s most significant contributions to the economic field was his Financial Instability Hypothesis (FIH), which has seen a growth in relevance over recent years with the Financial Crisis of 2008.

The conventional view is that a modern market economy is fundamentally stable, in the sense that it is constantly equilibrium-seeking and sustaining, and that some exogenous shock is necessary for some crisis to occur. However, Minsky challenged this perception with the FIH. Essentially, Minsky argues that stability is destabilising, and that the internal dynamics of a system can be solely responsible for market failures. The FIH maintains that the level of profits determines system behaviour, as aggregate demand determines profit, and so aggregate profits equal aggregate investment plus the government deficit. To Minsky, banks act as profit-making institutions, with an incentive to increase lending, which undermines the stability of the economy. Debt plays a crucial role in determining system behaviour, and so Minsky analyses three distinct income-debt relations for economic units.

The three stages of lending which Minsky identifies are the Hedge, Speculative and Ponzi stages.

During the Hedge stage, banks and borrowers are cautious and so loans are issued as modest normal capital repayment loans, where the initial principles and the interest can be repaid. Thus, the economy at this stage is likely to be equilibrium-seeking and containing. Following this period, the Speculative period emerges, where confidence in the banking system grows. As banks are heavily incentivised to make profits, loans are issued where the borrower can only afford to pay the interest, where the loan is against an asset which is rising in value. As a result of the increase in speculation, the economy becomes a ‘deviation-amplifying’ system. In continuation with the belief that asset prices will continue to rise, the third stage in the cycle, the Ponzi stage, emerges.

In the final stage of the FIH, the borrower can neither afford to pay the principal nor the interest on the loans which are issued by banks. Therefore, the three stages of the FIH suggest that, over periods of prolonged prosperity, economies tend towards economic structures which increasingly rely on unstable loans, away from the financial structure of stability in the initial stage. Minsky’s FIH proposes that the transition towards instability will inevitably culminate in a financial crash.

Despite not coining the term himself, Minsky’s FIH predicts that capitalist economies in the Ponzi stage will experience a ‘Minsky moment’. Crucially, the premise that asset prices will continue to rise is what Minsky’s FIH seeks to unpick as a naive assumption, which has critical implications in analysing the market - this premise underpins Ponzi finance. However, the ‘Minsky moment’ emerges when these asset prices begin to decline unexpectedly, and then the banks and the borrowers recognise the debt in the system.

This realisation is fundamental to the FIH, as it is the moment where the loans issued in the Ponzi stage, which the borrower has not the capacity to repay the principal nor the interest, are recognised to be impossible to pay off. In sequence, confidence in the system plummets to a stage where people rush to sell assets, which further results in a greater fall in prices. Minsky’s work on the FIH has become increasingly prevalent as of late, mostly due to the Great Recession, which is a testament to the accuracy of Minsky’s predictions.

In the years preceding the crash, regulation became more lax and new practices (such as securitisation and off-balance sheet leverage) spread about the system. Low interest rates provided a strong incentive to take on debt, and from 1997 to 2007, mortgage stock rose from $4.7tn to $14.1tn, pushing up house prices by more than 90%. However, this resulted in the financial sector building up a huge exposure to the housing market through mortgages to subprime borrowers.

Minsky recognised this stage as the Speculative and Ponzi stage, or the inherently unstable part of the market cycle. As subprime borrowers found themselves in negative equity, unable to refinance their mortgage and facing the effects of the adjustable-rate mortgages, subprime borrowers began to default. The Minsky moment occurred as house prices began to fall, which resulted in huge damage to the financial system and collateral damage to the rest of the economy. From 2005 to 2011, foreclosures skyrocketed from 800,000 to four million. In essence, the Financial Crash of 2008 is a perfect illustration of Minsky’s FIH, as it reveals how the economic system progressed through the three successive stages, and eventually culminated in a Minsky moment which plummeted the economy into chaos.

Minsky’s FIH maintains that business cycles are compounded out of the internal dynamics of the economy and the system of interventions and regulations.

To conclude, Minsky argues that periods of prolonged prosperity, the ‘tranquil period’, incentivise financial institutions to invest in riskier assets. However, riskier assets result in greater market exposure, making the system more vulnerable to defaults. As the lending criteria are relaxed, the increase in supply of credit increases the leverage of the banking system - the highly leveraged financial system is at risk of systemic collapse when asset prices fall. Minsky’s work on the instability of financial markets is heavily supported by evidence from the 2008 Financial Crisis, and thus holds significant weight as an economic hypothesis.

Max Martin