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The Financial Instability Hypothesis (FIH)
Minsky on financial instability
Minsky wrote at length and on numerous occasions,13 on the FIH. No attempt is made to analyse the evolution of his theory, which appears to have increasingly stressed the endogeneity of the process and thereby reduced its reliance on external shocks. Kindleberger's influential book (1978) develops a theory of financial crises based on Minsky's earlier work, in which shocks are important, and this is discussed later. Minsky's more recent expositions (1982a, b, 1986) will be considered first in order to outline his hypothesis.
Minsky builds on Keynes (1937), which attempted to highlight the General Theory's essential ingredients and explain why output and employment are so liable to fluctuations. Like Shackle (1938, 1974) and others, Minsky regards Keynes (1937) as the ultimate distillation of Keynes's thoughts on money and finance and as providing a source for an alternative - to the ISLM14 and neoclassical synthesis - interpretation of Keynes' General Theory (GT).15 Classical and neoclassical economists tend to regard financial crises and major fluctuations in output and unemployment as anomalous and offer no theoretical explanation of them.
Keynes (1937) implies that the GT is a theory of the capitalist process able to explain financial and real sector instability as a result of market behaviour in the face of uncertainty. Investment decisions are seen as the key determinant of aggregate economic activity and can be understood only within the context of capitalist financial practices. Both investment and financial decisions are made on the basis of uncertain outlooks, and disequilibriatory forces therefore operate in financial markets where investors must raise finance. These forces affect the price ratio between capital assets and current output which, along with financial market conditions, determine investment. The two sets of prices in the ratio are determined in separate markets, which are influenced by different forces; consequently the economy is prone to fluctuations.
One interpretation of Keynes's work is that shocks emanate from financial markets and are spread by way of investment decisions. Because investment and financial decisions are made under uncertainty they can undergo marked changes in short periods of time. Changing perspectives affect the relative prices of various capital and financial assets as well as relative prices of capital assets and current outputs. 'Money enters into the economic scheme in an essential and peculiar manner' (Keynes 1936, p. vii), as a 'financing veil' (Minsky 1982a, p. 61) interposed between the real asset and the wealth owner. Wealth owners frequently have claims on money, rather than real, assets. The banking system plays a major role in the financial system by collecting deposits and lending them to finance the purchase of real assets. The 'financing veil' encompasses bank credit and other short-term financial instruments and does not correspond to a narrow or base money concept. This contrasts with the neoclassical synthesis in which money does not affect the essential behaviour of the economy (see Patinkin 1965).
Minsky (1982a, Ch. 3) builds on his interpretation of the GT to present the FIH as a theory of the business cycle. He views financial crises as systemic, endogenously generated events rather than accidents. To support his view he cites pre-Second World War history and the post mid-1960s period in which he believes financial instability is amply illustrated. This leaves the twenty post-war years, in which financial crises were notably absent, to be explained. Minsky attributes the stability in this period to a recovery from the deep depression of the 1930s and to the favorable conditions created by the need for post-war reconstruction. Others would argue that it represented the upswing of a long wave16 and/or the fruits of post-war economic co-operation which created the IMF, the IBRD and GATT.17 Since the mid-1960s, however, he argues that the historic, crisis-prone behaviour of economies with capitalist financial institutions has reasserted itself. Until now the Federal Reserve (Fed), the US central bank and lender of last resort (LOLR), has aborted embryonic crises which, he argues, are in any event unlikely to be similar in magnitude to previous crises because the government sector, which acts as borrower of last resort (BOLR)18 and which has introduced automatic stabilisers,19 is immensely larger. The Fed has acted as LOLR both domestically and, as issuer of the major international reserve currency, internationally, along with the IMF.20 Minsky further argues that the side-effects of aborting financial crises have been bouts of accelerating inflation.
Minsky observes that economies with modern financial systems are built on commitments to pay cash today and in the future. Money today is exchanged for money in the future by contracts and commitments to pay and cash in the future is exchanged for cash today. The viability of such relations rests upon cash flows received as a result of income-generating activities. Minsky focuses particularly on business debt, which is an essential characteristic of capitalist economies. To service business debts, firms must generate sufficient net reserve to meet gross payments due or to permit refinancing, which takes place only if expected future revenue is deemed to be sufficient. The net revenue is in turn largely determined by investment. Thus ability to debt-finance new investment depends on the expectation that new investment will be sufficient to generate cash flows large enough to allow current debts to be repaid or refinanced. An economy with private debt is, therefore, especially vulnerable to changes in the pace of investment, which is an important determinant of both aggregate demand and the viability of debt structures. In an economy in which debt finance is important, instability follows from the subjective nature of expectations about the future level of investment and returns from it and the subjective determination by banks and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets. Uncertainty becomes a major determinant of cycles.
In analysing the relation between debt and income, Minsky starts with an economy that has a memory of a recession, which is regarded as a disequilibrium phenomenon. Outstanding debt reflects the recent history so that acceptable liability structures and contractual debt payments are based on margins reflecting the risk that the economy may not perform as well as expected. As the period over which the economy performs well lengthens, the margins for safety decline and leverage increases because views of acceptable debt structures change. Increasing leverage raises the market price of capital assets and increases investment, and boom conditions emerge. Minsky argues that the fundamental instability of capitalist economies is upward, beyond stable growth. Periods of steady growth are transformed into speculative investment booms. This process is reinforced by financial innovation, including the introduction of new financial instruments which appear at times when the economy is thriving. The quantity of relevant, broad money increases and so too does the incidence of speculative finance.
Speculative economic units expect to fulfil their obligations by raising new debt and are vulnerable on a number of fronts. They must return to the markets to refinance debt and are particularly vulnerable to rises in nominal interest rates - which increase their cash repayments relative to their expected future receipts, whose discounted present value may well decline. Further, they are subject to sudden revaluations of acceptable financial structures. Not all units will engage in speculative finance. The more risk-averse will, for example, normally continue to operate with hedge finance, which takes place when cash flows from operations are expected to be large enough to meet payments commitments on debts as they fall due. This contrasts with speculative finance, in Minsky's usage, which occurs when anticipated capital flows are not expected to be sufficient to meet payments commitments and refinancing will be required. In addition to hedge and speculative finance there is what Minsky calls Ponzi finance, which is a sort of super-speculative finance which takes place when payments on debt are met by increasing the debt outstanding.
High and rising interest rates can force hedge finance units into speculative finance and speculative finance units into Ponzi finance, Minsky argues. Ponzi finance cannot carry on for long because feedback from the revealed financial weakness of some units affects the willingness of banks and businessmen to debt-finance others. Unless offset by government spending, the decline in investment that follows from the curtailment of finance will lead to a decline in profitability and ability to sustain debt. Quite suddenly a panic can develop as pressure builds to reduce debt ratios or 'overindebtedness'.
Minsky's FIH, therefore, attempts to explain how capitalist economies endogenously generate a financial structure which is susceptible to financial crises and how the normal functioning of the financial system in a recovery period will lead to a boom and a financial crisis. As the crisis approaches, the LOLR and BOLR must act to abort it and prevent debt deflation. Nevertheless, debt-financed investment and perhaps consumption expenditure will normally fall after the aborted debt deflation as a result of a reappraisal of the economic outlook, and a recession will follow. The government's expansionary fiscal activities and built-in stabilisers lead to an increase in the government deficit as income falls or growth slows down. The deficits sustain income and corporate profitability and feed secure negotiable financial instruments into portfolios hungry for safe and secure assets. The recovery from the recession can be quite rapid and can soon result in an inflationary boom if the government deficit financing persists. The implication of the FIH for policy in a financially sophisticated capitalist economy is that there is a need to curb the tendency of businesses and banks to engage in speculative and Ponzi finance while the economy is thriving and profits are seemingly validating the decision of lenders and borrowers.
The upper turning point becomes completely endogenous if it is accepted that interest rates rise in an investment boom and that the successful functioning of the economy induces profit-seeking bankers and their customers to engage in speculative and Ponzi financial arrangements and to economise on holdings of cash and liquid financial assets (Minsky 1982b). For the interest rate not to rise in an investment boom, the supply of finance must be infinitely elastic, which implies that a flood of financial innovation is taking place or the central bank is supplying reserves on demand (Minsky 1982b, 1957a). This in turn implies that investment is an ever-increasing proportion of output and accelerating inflation is tolerable (Minsky 1982b, 1957b). The 2007-9 Global Financial Crisis (GFC) in contrast was driven by a mortgage credit boom with the supply of finance sustained both by capital inflows from China, Japan, the Middle East and elsewhere and financial innovation involving securitisation and the growth of a shadow banking system, Rajan (2010).
The extent of the recession/depression following the crisis depends on the effectiveness of LOLR and BOLR intervention in restoring confidence. The post GFC recession was so precipitous that unconventional monetary policy, in the form of quantitative and credit easing involving central bank purchases of governance and other bonds, was required. The FIH described by Minsky (1982a,b) is, therefore, a semi-endogenous investment theory of the cycle based on a financial theory of investment. The full cycle is not endogenous unless the BOLR and LOLR are activated by policy rules or substantial built-in stabilisers are in place and are sufficient to abort the crisis and terminate the recession. Consumption is regarded as a stable function of income and plays a minor role, except implicitly via a stable multiplier. Investment, however, depends on finance, and sudden changes in expectations, which are likely under uncertainty, can both influence investment decisions and lead to a collapse in the financial relationships supporting investment. The FIH explains how a sustained expansion can be endogenously converted into a speculative boom which will ultimately lead to crises even in the absence of shocks. Adverse shocks might, however, be expected to terminate a boom prematurely in an economy where decisions are made under uncertainty. If they do not, however, short- and eventually long-term interest rates can be expected to rise and the discounted present value of future profit flows will be reduced. Speculative and Ponzi units will have to sell assets to meet their payment commitments but will find that the revenue from asset sales does not cover their debts; they may also incur 'fire sale' losses.21 Even if the LOLR and BOLR (and quantitative easing) avert the crisis, long-run expectations are likely to be adversely affected, risk premiums will increase and speculative finance will decline.
The FIH has been accepted by a number of economists, some of whose work is discussed below, and derided by others. A sample of the latter work is provided by comments on Minsky's (1982b) paper in Kin-demerger and Laffargue (1982). Flemming (1982) argues that Minsky's FIH is based on the assumption that economic agents cannot distinguish between a run of good luck and a structural shift in their environment. The crisis results from reductions in risk premiums and increases in speculative and Ponzi finance because economic agents incorrectly believe that there has been a structural improvement in economic performance. The implication of Flemming's remark is that, under rational expectations, the instability would disappear. In section 3.4 some of the literature on rational speculative bubbles, which demonstrates that this is not necessarily the case, is reviewed.
Flemming also observes that LOLR and BOLR intervention to abort the crisis and the ensuing recession creates a moral hazard which will itself increase risk-taking and is apparently inconsistent with the post-war stability which Minsky attributes to the enlarged role of government. This argument can, however, be turned round to support Minsky. The moral hazard may have increased the potential for a buildup of risky positions in the post-war period but the buildup may have been slow or held in check by regulations imposed on the US banking and financial system following the 1929 stock market crash and the rash of bank failures in the early 1930s. This buildup may have become critical by the mid-1960s; and/or competition in banking of finance, which increased from the mid-1960s onwards due to deregulation and internationalization, may have increased the level of financial instability. It is a widely held view that subsequent developments, through the 1970s and early 1980s, have resulted in an increased riskiness in bank portfolios supported by relatively lower capital holdings.22 Flemming concludes his critique23 by calling for a more explicit and quantitative development of the theory of financial instability, which he finds to be ambiguous.
Goldsmith (1982) entirely agrees with Minsky's plea for an integration of the theory of the financial system with that of the real economy and the need to understand financial development in any analysis of the modern economic process, but that is where his agreement ends. He is concerned by the absence of a definition of financial crisis in Minsky's and Kindleberger's work. Goldsmith therefore provides his own, which will be discussed in section 3.3.3. He argues, appealing to the evidence of economic history and the absence of crises, in terms of his definition, since the 1930s, that financial crises are a childhood disease of capitalism and not an affliction of old age. This is because, in his view, as capitalism has aged the financial system has not only become more complex but also more stable. The absence of major crises could of course be attributed instead, as implied in Minsky's work, to a better understanding of the capabilities of LOLR and BOLR intervention, improved automatic stabilisers and the existence of the FDIC24 in the United States. Goldsmith also takes exception to Minsky's use of the terms speculative and Ponzi finance. He believes that the former is a prejudicial term for an activity that is widespread and essentially sound because it is based on the law of large numbers and forms the foundation of the business of banks and other financial institutions that legally hold assets of longer maturity than liabilities. (See McCulloch (1986) for a contrary view.)
Melitz (1982) also argues that so-called speculative finance is basically sound and goes on to question the general applicability of Minsky's FIH to all capitalist economies. He notes that the basic examples are derived from US experience, while Kindleberger (1978) draws attention to a wide range of historical and international examples of financial crises. He doubts whether Minsky's arguments are applicable under alternative institutional arrangements, such as those prevailing in countries where banks have ready access to the LOLR, and calls for a fully specified financial fragility model with a plausible application somewhere. It is to be noted, however, that Kindleberger (1978) takes Minsky's work as a basis for his analysis of crises and seems happy with its widespread applicability.
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