11.16.08
Financial instability hypothesis
RG mail
by Hyman P Minsky
Working Paper No 74 (May 1992)
The Jerome Levy Economics Institute of Bard College
Prepared for Handbook of Radical Political Economy, edited by Philip
Arestis and Malcolm Sawyer, Edward Elgar (Aldershot, 1993).
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 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. 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 193Os, 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, Chapter 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. The 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. (page 151)
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 down side
vulnerability of aggregate profit flows has been much diminished.
However, the same interventions may well induce a greater degree of
upside (that is, 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,
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 be brokers 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: (for example 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. Allen and Unwin
Keynes, John Maynard, 1936. The General Theory of Employment, Interest,
and Money. 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, page 151
Kindleberger, Charles 1978. Manias, Panics and Crashes. Basic Books
Levy S Jay and David A. 1983. Profits And The Future of American
Society. 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. Harvard
University Press
Wolfson, Martin H. 1986. Financial Crises. M E Sharpe Inc.
http://www.levy.org/pubs/wp74.pdf