Understanding the Financial Crisis: Hyman Minsky's "Financial Instability Hypothesis"

by: Paul Rosenberg

Sun Sep 27, 2009 at 16:30


If you want to understand the financial crisis, there are a number of different levels you can approach it on.  But if you want to understand why capitalist financial systems repeatedly tend to crisis, you basically have two choices: Karl Marx and Hyman Minsky.  Marx's explanation is the falling rate of profit as technologies mature and competition intensifies.  Minsky's explanation is less well-known, but it deserves wider recognition.  There's surprisingly little online I've been able to find that can serve as an introduction to his basic insight, but it really only takes one good presentation, and fortunately I've found one-a presentation paper by Paul McCulley, "The Shadow Banking System and Hyman Minsky's Economic Journey".  As you can tell from the title, the paper actually does more than introduce Minsky's explanation, but the part of it that does introduce Minsky's insight is relatively self-contained, and the heart of it quotes directly from Minsky's own words.  The shadow banking system did not exist as we know it when Minsky developed his ideas, which are far more general in how they describe how financial markets change over time.

First, McCulley does a very brief, capsule setup of Minsky's work by way of Keynes.  He doesn't get into any of the details of Keynesian economics, but he nails the essence at one level--the difference between the micro and the macro, which then leads to a succinct statement of what Minsky did, followed by Minsky's own words, taking us to the very heart of his insight--the different sorts of of financing units, whose balance shifts over time, moving the economy from stability to instability.  Let's take this one piece at a time.  First the introductory nod to Keynes, and the nature of macro- vs. micro-economics:

Paul Rosenberg :: Understanding the Financial Crisis: Hyman Minsky's "Financial Instability Hypothesis"
Minsky may well have considered himself a Keynesian economist - he published his analysis and interpretation of Keynes in 1975 - but Minsky's own theories headed off in a new direction. Keynes is, of course, a solid place to start any adventure in economic theory. Remember that Keynes effectively invented the field of macroeconomics, which is founded on the proposition that what holds for the individual does not necessarily hold for a collection of individuals operating as an economic system. This principle is sometimes called the "fallacy of composition," and sometimes called the "paradox of aggregation." But we need not resort to fancy labels to define the common sense of macroeconomics.

Anybody who's ever been a spectator at a crowded ball game has witnessed the difference between microeconomics and macroeconomics: from a micro perspective, it is rational for each individual to stand up to get a better view; but from a macro perspective, each individual acting rationally will produce the irrational outcome of everybody standing up, but nobody having a better view.

I don't share McCulley's implied skepticism of Minsky's view of himself as a Keynesian-though that's a topic for another time.  But the rest I agree with completely.  The example McCulley choses is particularly apt, as it shows that macro-economics doesn't just see new phenomena emerge out of large aggregates-the way that temperature, for example, appears as a property of materials that can't be attributed to individual atoms or molecules.  Rather, what emerges is contrary phenomena, which can quite sensibly be attributed back to the micro level. That is to say, individuals at the ballgame can rationally chose not to stand up, because of the macro-level consequences.  This is commonly done via social norms, whether internalized or not ("down in front!")

Indeed, so-called "normed rationality" is pretty much ubiquitous in human affairs, whereas the abstract rationality of "homo economicus" has pretty much only been observed among students of economics, who have themselves adopted such "rationality" as the result of the social norms of the field.   One way of thinking about Minsky's theory, which we're just about to look at, is that it describes the process by which investment norms change through time, and thus how what is "rational" changes as well.

Here's McCulley's brief setup, and Minsky's own description of the core of his insight:

The Financial Instability Hypothesis

Minsky took Keynes to the next level, and his huge contribution to macroeconomics comes under the label of the "Financial Instability Hypothesis." Minsky openly declared that his Hypothesis was "an interpretation of the substance of Keynes's General Theory." Minsky's key addendum to Keynes' work was really quite simple: providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. Minsky summarized the Hypothesis beautifully in his own hand in 1992:

    "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 principal out of income cash flows. Such units need to 'roll over' their liabilities (e.g., issue new debt to meet commitments on maturing debt...

    For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principal 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....

These three types of financing units are the key to Minsky's theory, and relate directly to whether the economy will tend toward equilibrium and stability, as the hallowed imagery of the "invisible hand" hypnotizes us to believe, or whether it will tend toward a speculative boom-and-bust cycle, which has historically been observed repeatedly in actual economies.  The stark difference between classical and neo-classical theory, on the one hand, and this historical record on the other is something that conventional economics and conservative ideology tend to gloss over, if not deny, but Minsky's analysis of the three types of financing provide the tools for solving this puzzle:

    "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 deviationamplifying 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."

Those three categories of debt units - hedge (note: no relation to hedge funds),  speculative, and Ponzi - are the straws that stir the drink in Minsky's Financial Instability  Hypothesis. The essence of the Hypothesis is that stability is destabilizing because  capitalists have a herding tendency to extrapolate stability into infinity, putting in place  ever-more risky debt structures, up to and including Ponzi units, that undermine stability. The longer people make money by taking risk, the more imprudent they become in risk- taking. While they're doing that, it's self-fulfilling on the way up. If everybody is  simultaneously becoming more risk-seeking, that brings in risk premiums, drives up the  value of collateral, increases the ability to lever and the game keeps going. Human nature  is inherently pro-cyclical, and that's essentially what the Minsky thesis is all about. He  says "from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. 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."

There's a great deal of insight in very few words in the passage above.  I want to briefly highlight four things. First, it expresses a profoundly realist view of the world.  History has repeatedly shown that financial systems are inherently unstable.  Rather than ignore or deny this fact, or minimize the role that finance plays in the economy, Minsky seeks to describe, analyze and understand what most economists and the profession as a whole has chosen to ignore, for various reasons (it's too messy, it's ideologically unnerving, it's too unpleasant, etc.)  This is what science is all about-not a bunch of physics-envy models that are more reminiscent of Ptolemy than Einstein or Heisenberg.

Second, it implies a profoundly situationist view of the world.  While one might think of the three types of financing units as representing different mindsets, reflecting different internal dispositions-that of a conservative investor, vs. a financial speculator, for example-the reality is that the balance of financing types changes over time, influenced by the "tendency to extrapolate stability into infinity".  This is not to say that disposition doesn't matter.  It does.  But it matters far less in the long run than the changing situation as described by Minsky's theory.  (Recall from my diary yesterday how Minsky also writes about how the entire nature of capitalist financing has changed over time, a non-cyclical process that has produced distinctly different types of capitalism, whose differences are obscured by neo-classical approaches.)  Furthermore, the situation is not simply an external reality that shapes or limits our options, it quite literally seeps into us, shaping our very perception and conception of our options.  This is, for example, why "Human nature is inherently pro-cyclical"-we are all disposed to respond to the situation, and thus to be bullish or bearish depending on how others are.

Third, a key mechanism is projecting from a limited model, the "herding tendency to extrapolate stability into infinity".  To a certain extent, this is an inevitable outcome of human reason-we understand the unfamiliar, the distant, the uncertain, the abstract, in terms of the familiar, the near, the certain, the concrete.  But this also means that we tend to ignore what we know exists, but what we can't fully grasp, control, or use to our advantage.  And so it is that even though we know there are cycles of boom and bust, we tend to ignore them, and somehow convince ourselves that "this time it's different," and this time we really can extrapolate that stability, which is but one part of the cycle, out to infinity, as if the cycle would never cycle again.  It is the business of critical thought to get outside, or go beyond this natural tendency of human reason.

Fourth is the presence of self-confirming processes that prevent timely feedback, which would otherwise warn us of the need to correct ourselves:

The longer people make money by taking risk, the more imprudent they become in risk-taking. While they're doing that, it's self-fulfilling on the way up. If everybody is simultaneously becoming more risk-seeking, that brings in risk premiums, drives up the value of collateral, increases the ability to lever and the game keeps going.

This is a very deadly situation that only actors outside the market can do anything about.  But the shadow banking system was precisely the sort of market development that defeated any potential efforts to prevent this sort of self-deluding process from wrecking havoc the way it did.  And the deregulatory efforts of the late 1990s and beyond only intensified the risk by further removing existing barriers to such self-delusion.

BTW, it's also worth noting that this goes to the heart of why Social Security privatization was such a scam.  If one were to forcefully redirect trillions of dollars into the stock market, this would surely drive up stack prices, thus bolstering the impression that it was a brilliant idea.  But this kind of asset bubble creation is no more sustainable than any other sort of asset bubble creation.  The conservative political strategy is quite clear here: (1) make it politically impossible to question or change the basic operating rules, (2) then argue that given how things are run, the best thing to do is to take advantage of the "magic of the marketplace", (3) which turns out to be manipulated at a macro level by the forced influx of taxpayer's money.

This is just a cursory introduction to Minsky's ideas. But it should go a long ways toward helping folks understand just what it was that economists didn't understand-until it was too late.  And what far too many still don't understand even now.


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Great post (4.00 / 2)
But I would say that while Minsky is great he is not the end word.

If you want to understand the financial crisis, there are a number of different levels you can approach it on.  But if you want to understand why capitalist financial systems repeatedly tend to crisis, you basically have two choices: Karl Marx and Hyman Minsky.

I would say that for me the economist I look to again and again is Henry George. His magnum opus - still the best selling economic book of all time is titled:

Progress and Poverty: An Inquiry in the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth... The Remedy.

The economy has gotten much more complicated since George's time. George's modern exponents like Mason Gaffney and Nic Tideman and Fred Harrison(to name a few) do an excellent job of taking the Georgist principles into the modern age. But George still rings true in his perception of how modern economies don't account for land (of the Ricardian/Mill/Smith types) and economic rent in their calculations of how economies move. Not doing so keeps economies tending towards boom/bust cycles.

Like Minsky George could be really useful for understanding what is happening in the world right now.

George and his economic approach is also a unique in that he is deeply embraced by super lefties like Kucinich, Bill McKibben and Michael Kinsley and many others. At the same time Milton Friedman stated that George's approach to taxation was the only sane, fair and sustainable one that existed. Bill Buckley and Pat Toomey are also endorsers of George's approach to taxation. In my opinion George offers a way forward to cut across the left/right economic divide that offers a stable way forward.

If you are planning to read George I would suggest taking on the modernized language and abridged version by Bob Drake.


It's Been More Than 30 Years (4.00 / 2)
since I read Henry George, so "rusty" doesn't begin to describe it, and I haven't read any of the modernizers you mention. But I have to say that while I think his ideas are interesting, and definitely valuable in some respects, they really don't get at the fundamental causes of business cycles, because land is only one form of asset that can be subject to asset inflation.

So I'm not rejecting him overall, just saying that his approach is not as general.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3


[ Parent ]
I would say (0.00 / 0)
that George really does get at the core of business cycles because land (in the classical sense) and economic rent that comes from that is inequally distributed which allows for the boom bust cycle to continue which has everything to do with the business cycle.

Some prominent Georgists (Gaffney and Harrison and Michael Hudson, who is Georgish as opposed to Georgist) predicted the current economic crisis almost 10 years ago. My experience is that Georgists have their fingers on some subtle pulses in the economy.

Of course there have been lots of ignored voices in the discussion about the economy that we could all use some exposure towards. I just happen to think that George holds a unique space.

Thanks for the reminder about Minsky again.


[ Parent ]
Speculation Can Be In Any Asset (0.00 / 0)
just sayin.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]
Wow (4.00 / 2)
That little 12 pager about Minsky was fabulous.  Yes, the bankers tactics could fairly be described as trying an institutionalized Ponzi scheme.

The warning signs were clearly picked out 20 years before the bubble burst.  And, the warning signs are general enough that they can be used to identify different kinds of bubbles.  

The banks continue to fall into Minsky's traps.  Tight credit after the bubble burst was not supposed to happen according to Geithner and Bernanke once the TARP funds flowed but it did.  Minsky predicted that as part of his pattern in 1986.

The man may be dead but he still seems a shrewder guide by far than Geithner, Summers, and Bernanke.  


Human Nature Is Procyclical (0.00 / 0)
like the man said.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]
My two cents (4.00 / 1)
I usually enjoy reading your posts on the weekend, but I'm home sick today so I'm reading them now.

Anyway, I won't pretend to know anything about economics beyond econ101 and some Marx about 20 or so years ago, but I can't resist pointing out that you wrote:

...Minsky's analysis of the three types of financing provide the tools for solving this puzzle:

Are the tools simply knowledge of the patterns? This analysis seems to take the Wall St/banking/finance crooks off the hook for any responsibility. As if they couldn't stop themselves from leveraging pension plans, 401Ks, etc. even when they knew the bets they were making were bad. And when the house of cards fell in, you're saying the bail-outs and the TARP funds were more of the same?

You also say:

This is a very deadly situation that only actors outside the market can do anything about.  

Would banking and finance regulations interrupt these patterns?  


No, That's Not What I'm Saying (4.00 / 1)
Two things:  First, one can always analyze phenomena at multiple levels, so an analysis at one level does not invalidate or supercede analysis at another level--though it ought to help inform it.

Knowing that hate radio stirred up genocidal passions for months in advance does not absolve individuals of responsibility for participating in genocide, and the same thing is true here.

Second, it's always irresponsible to only blame bad actors.  The whole point of social knowledge, practically speaking, is to strengthen social institutions, and part of the reason for that is to protect against bad actors.  Thus, whenever we just blame bad actors--as the Obama Administration is doing wrt to torture, war, financial catastrophe & just about everything else--we are willfully contributing to future calamities, making ourselves, in effect, accomplices before the fact of future crimes.

Hope this clarifies things for you.  It's a good question & I'll try to be clearer about this in the future.

As for your closing question:

Would banking and finance regulations interrupt these patterns?  

That would be one of the major purposes of such regulations, if they were done right.  We need counter-cyclical social institutions to protect ourselves from our pro-cyclic foibles.

It's just what intelligent species do.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3


[ Parent ]
Thanks, I see what you're saying about the (0.00 / 0)
analysis. I needed that to not default to thinking about actual circumstances while reading Minsky's ideas.

Nevertheless, I still want to push you to apply the theory.

You noted in your original post that Minsky's patterns are not widely known. Will it be possible to get the Obama administration and/or Congress to consider Minsky's patterns when they are working on new finance regulations?

The House Financial Services Committee is right now debating Obama's new Consumer Finance Protection Agency and a host of new financial regulations proposed by the Administration. (http://www.washingtonpost.com/wp-dyn/content/article/2009/09/23/AR2009092302564.html
- story doesn't give much detail, just the usual political bullshit.)

They don't seem to make use of economic theories when they're working out legislation, at least it's not reported anywhere that I know of.

When all the hoopla was going on over the stimulus package I remember thinking why don't they just invoke Keynes - there's historical record to show that spending to get out of depression works. If they had maybe they would have made the stimulus bigger and therefore more effective.

Perhaps we should find out what economic theories are Geithner, Summers, etc. using? Also, I'm going to try and find out what's in this big Consumer Finance Protection Agency package.

Finally, I need to take issue with you when you accuse Obama of blaming past bad actors for torture, war, financial catastrophe, etc. I believe he has made pointed efforts not to blame past administrations. He did it with torture - he wasn't going to prosecute the offenders from the previous administration because the past is the past. After he became President he didn't talk about the bad decision to go into Iraq, he was focused on Afghanistan. I'm not saying I agree with Obama on these things, I'm saying that blaming current circumstances on past bad actors is not what he does.

I wish he would invoke previous administration(s) in explaining to the American people why we have to do now what we have to do.


[ Parent ]
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