By John Mauldin
I wasn’t consciously aware of how often I had trotted Minsky out as I sat (somewhat unstably, I have to admit) atop a headstrong horse in the foothills of the Argentine Andes the other day; but my precarious situation did somehow get me thinking of Minsky’s Financial Instability Hypothesis, and it occurred to me that both you and I might learn something by going right back to its source, which turns out to be a rather unprepossessing five-page paper Dr. Minsky published at Bard College in 1992.
Minsky’s work was roundly ignored by the economics profession and policy makers alike … until all hell broke loose in the financial industry and then the global economy in 2008. At the time (in Dec. 2007), I described Minsky’s thesis like this:
[E]conomist Dr. Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
The term Minsky moment was coined in 1998 by my good friend Paul McCulley (who, by the way, will once again entertain and enlighten us at the upcoming Strategic Investment Conference, May 13-16). He was characterizing the Russian default and ensuing Long Term Capital Management debacle, but he got to reprise the term (and how!) in ’08. And then everybody jumped on the “Minsky moment” bandwagon.
So today, let’s harken to the words of the man himself, in his “Financial Instability Hypothesis” paper from 1992.
I write tonight from my condo in La Estancia de Cafayate. Last Saturday we spent seven hours trekking the Andes highlands to spend a few days with my friend Bill Bonner (of Daily Reckoning fame). He and his wife Elizabeth are gracious hosts. His South American home is in the middle of 500,000 acres of some extraordinarily godforsaken land in the backside of the middle of nowhere. It comes complete with real-life gauchos, who have lived on the property for dozens of generations, and a herd of some 1000 sand-fed cattle. (In the dry season there is not much else for them to eat.) The area was settled from Peru in the 1500s. It is as remote as any place I’ve ever been, but it also shines with some of the most majestic beauty this writer has ever seen. If Montana is Big Sky Country, then this part of the world has to be called Muy Grande Cielo Campo. The valleys and surrounding mountains are larger and grander than any I have seen in my far-flung travels.
What passes for a road to Bill’s estancia is sometimes a dry, sandy riverbed but often just a track cut and mended by road graders from time to time through very rocky terrain and and over and through mountain passes.
But it was worth all the effort. I treasure the moments I get with Bill (and this time I was accompanied by David Galland, Olivier Garret, and Frank Trotter). I never know quite what to expect when I come to one of Bill’s “homes,” which are really just very large and very time-consuming projects, but he and Elizabeth seem to love it. As we arrived, one of the gauchos had discovered a few dead calves (otherwise healthy a few days before), and there was concern there might be a contagious disease, so they spent the next few days gathering what they could find of the herd, which was of course scattered all over heck and gone. Getting them into the pen and vaccinating them – and since they had them there, branding and gelding them as appropriate – was all in a very long day’s work. It had been many decades since I was anywhere close to that sort of work.
Some of you prone to wincing might want to avoid the following sentences. They had one young bull calf pushed into a chute where he was immobilized, and the head gaucho dropped into the chute behind him. The calf thereupon met his own Minsky moment. The gaucho, swear to God, pulled out a Swiss Army knife and proceeded to geld the unfortunate creature. It was not the clean, swift procedure I remember as a kid. I had no idea they made Swiss Army knives with that attachment. It seems to be missing in mine. The next time I go to Bill’s estancia, I am going to bring the gaucho a set of purpose-built clippers. I may even have them plated in stainless steel. It’s what you get for the man who has everything.
Our conversation at 10,000 feet in the Andes ranged far and wide but kept coming back to the intersection of economics, politics, and philosophy. And being basically off the grid for a couple days, we had plenty of time in the evening for conversation and even a little singing. Bill has written yet another book and writes daily for his own blog. After 30 years, we always have a lot to talk about. I live for days like this.
It is time to hit the send button, as there is a large group waiting at a local café for a reception. It is a beautiful night with perfect weather. It’s hard to think of place better suited for working vacation. Until this weekend…
Your glad he makes his living riding a computer analyst,
John Mauldin, Editor
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The Financial Instability Hypothesis
By Hyman P. Minsky
The Jerome Levy Economics Institute of Bard College
May 1992
The financial instability hypothesis has both empirical and theoretical aspects. The readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out ofcontrol. In such processes the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. Government interventions aimed to contain the deterioration seem to have been inept in some of the historical crises. These historical episodes are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system.
The classic description of a debt deflation was offered by Irving Fisher (1933) and that of a self-sustaining disequilibrating processes by Charles Kindleberger (1978). Martin Wolfson (1986) not only presents a compilation of data on the emergence of financial relations conducive to financial instability, but also examines various financial crisis theories of business cycles.
As economic theory, the financial instability hypothesis is an interpretation of the substance of Keynes’s “General Theory”. This interpretation places the General Theory in history. As the General Theory was written in the early 1930s, the great financial and real contraction of the United States and the other capitalist economies of that time was a part of the evidence the theory aimed to explain. The financial instability hypothesis also draws upon the credit view of money and finance by Joseph Schumpeter (1934, Ch.3) Key works for the financial instability hypothesis in the narrow sense are, of course, Hyman P. Minsky (1975, 1986).
The theoretical argument of the financial instability hypothesis starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system. The economic problem is identified following Keynes as the “capital development of the economy,” rather than the Knightian “allocation of given resources among alternative employments.” The focus is on an accumulating capitalist economy that moves through real calendar time.
The capital development of a capitalist economy is accompanied by exchanges of present money for future money. Present money pays for resources that go into the production of investment output, whereas the future money is the “profits” which will accrue to the capital asset owning firms (as the capital assets are used in production). As a result of the process by which investment is financed, the control over items in the capital stock by producing units is financed by liabilities – these are commitments to pay money at dates specified or as conditions arise. For each economic unit, the liabilities on its balance sheet determine a time series of prior payment commitments, even as the assets generate a time series of conjectured cash receipts.
This structure was well stated by Keynes (1972):
There is a multitude of real assets in the world which constitutes our capital wealth – buildings, stocks of commodities, goods in the course of manufacture and of transport, and so forth. The nominal owners of these assets, however, have not infrequently borrowed money [Keynes’ emphasis] in order to become possessed of them. To a corresponding extent the actual owners of wealth have claims, not on real assets, but on money. A considerable part of this financing takes place through the banking system, which interposes its guarantee between its depositors who lend it money, and its borrowing customers to whom it loans money wherewith to finance the purchase of real assets. The interposition of this veil of money between the real asset and the wealth owner is an especially marked characteristic of the modern world.” (p. l51)
This Keynes “veil of money” is different from the Quantity Theory of money “veil of money.” The Quantity Theory “veil of money” has the trading exchanges in commodity markets be of goods for money and money for goods: therefore, the exchanges are really of goods for goods. The Keynes veil implies that money is connected with financing through time. A part of the financing of the economy can be structured as dated payment commitments in which banks are the central player. The money flows are first from depositors to banks and from banks to firms: then, at some later dates, from firms to banks and from banks to their depositors. Initially, the exchanges are for the financing of investment, and subsequently, the exchanges fulfill the prior commitments which are stated in the financing contract.
In a Keynes “veil of money” world, the flow of money to firms is a response to expectations of future profits, and the flow of money from firms is financed by profits that are realized. In the Keynes set up, the key economic exchanges take place as a result of negotiations between generic bankers and generic businessmen. The documents “on the table” in such negotiations detail the costs and profit expectations of the businessmen: businessmen interpret the numbers and the expectations as enthusiasts, bankers as skeptics.
Thus, in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations. The key financial relationships link the creation and the ownership of capital assets to the structure of financial relations and changes in this structure. Institutional complexity may result in several layers of intermediation between the ultimate owners of the communities’ wealth and the units that control and operate the communities’ wealth.
Expectations of business profits determine both the flow of financing contracts to business and the market price of existing financing contracts. Profit realizations determine whether the commitments in financial contracts are fulfilled – whether financial assets perform as the pro formas indicated by the negotiations.
In the modern world, analyses of financial relations and their implications for system behavior cannot be restricted to the liability structure of businesses and the cash flows they entail. Households (by the way of their ability to borrow on credit cards for big ticket consumer goods such as automobiles, house purchases, and to carry financial assets), governments (with their large floating and funded debts), and international units (as a result of the internationalization of finance) have liability structures which the current performance of the economy either validates or invalidates.
An increasing complexity of the financial structure, in connection with a greater involvement of governments as refinancing agents for financial institutions as well as ordinary business firms (both of which are marked characteristics of the modern world), may make the system behave differently than in earlier eras. In particular, the much greater participation of national governments in assuring that finance does not degenerate as in the 1929-1933 period means that the downside vulnerability of aggregate profit flows has been much diminished. However, the same interventions may well induce a greater degree of upside (i.e. inflationary) bias to the economy.
In spite of the greater complexity of financial relations, the key determinant of system behavior remains the level of profits. The financial instability hypothesis incorporates the Kalecki (1965)-Levy (1983) view of profits, in which the structure of aggregate demand determines profits. In the skeletal model, with highly simplified consumption behavior by receivers of profit incomes and wages, in each period aggregate profits equal aggregate investment. In a more complex (though still highly abstract) structure, aggregate profits equal aggregate investment plus the government deficit. Expectations of profits depend upon investment in the future, and realized profits are determined by investment: thus, whether or not liabilities are validated depends upon investment. Investment takes place now because businessmen and their bankers expect investment to take place in the future.
The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated. In contrast to the orthodox Quantity Theory of money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they bebrokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market. This innovative characteristic of banking and finance invalidates the fundamental presupposition of the orthodox Quantity Theory of money to the effect that there is an unchanging “money” item whose velocity of circulation is sufficiently close to being constant: hence, changes in this money’s supply have a linear proportional relation to a well defined price level.
Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units.
For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.
It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
The financial instability hypothesis is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.
References
Fisher, Irving. 1933. “The Debt Deflation Theory of Great Depressions.” Econometrica 1: 337-57
Kalecki, Michal 1965. Theory of Economic Dynamics. London: Allen and Unwin
Keynes, John Maynard, 1936. The General Theory of Employment, Interest, and Money. New York: Harcourt Brace.
Keynes, John Maynard. 1972. Essays in Persuasion,The Collected Writings of John Maynard Keynes, Volume IX. MacMillan, St. Martins Press, for the Royal Economic Society, London and Basingstoke, p 151
Kindleberger, Charles 1978. Manias, Panics and Crashes. New York, Basic Books
Levy S. Jay and David A. 1983. Profits And The Future of American Society. New York, Harper and Row
Minsky, Hyman P. 1975. John Maynard Keynes. Columbia University Press.
Minsky, Hyman P. 1986. Stabilizing An Unstable Economy. Yale University Press.
Schumpeter, Joseph A. 1934. Theory of Economic Development. Cambridge, Mass. Harvard University Press
Wolfson, Martin H. 1986. Financial Crises. Armonk New York, M.E. Sharpe Inc.
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